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A practical approach to using derivatives: Part II Back  
In this second of a two part series on the derivatives market Paul McEnroe looks how corporate treasures can incorporate derivatives into their hedging strategy.
Derivatives actively trade in two markets, the OTC and the Exchange Traded market. Any transaction that takes place between two counterparties that does not involve a formal exchange, is said to be an over-the-counter transaction, these are typically telephone or screen-based trades (e.g. Where XYZ Corporation enters into an interest rate swap directly with Bank of Ireland to hedge their loan portfolio).
Exchange Traded Contracts refer to financial instruments listed and traded on formal exchanges, such as the Chicago Board of Trade.

Why use derivatives?
Given the volatility experienced in both interest rate and foreign exchange markets in recent years, corporate treasurers have become acutely aware of the need to have a prudent hedging strategy in place. The key challenge for the treasurer is to identify the key risks to which the corporation is exposed, and to transform unacceptable risks into an acceptable form, by applying an appropriate hedging program. The goal of any such program should be to achieve the optimal risk profile, which balances the benefits of protection against the costs of hedging.
Risks should be identified in terms of operating and financial risks. Operating risk is defined as the risk associated with manufacturing and marketing activities: these are the inherent risks of the corporation’s core business. Financial risks refer to the risks a corporation faces due to its exposure to market factors such as interest rates, foreign exchange rates, commodity prices and equity prices.
Once all of the financial risks have been identified, a treasurer must decide upon the appropriate hedging strategy. Some corporate treasurers still associate derivatives with speculation and will at this stage adopt a ‘no hedge’ strategy, which is in fact also speculative since unhedged positions exposes the corporation to the randomness of the markets. Alternatively they will use traditional hedging tools such as outright forwards, that will fix the liability. These tools, although effective at immunising exposure may not be the optimal hedging solution, since increases in bottom line profitability may be achieved by considering a derivative based solution. Far from increasing risk or being speculative, a properly constructed derivative hedge will always lower risk and may increase return.
Increasingly, the trend for corporate treasurers has been to apply specifically tailored derivative solutions to hedge their exposures. While this trend is most apparent in the U.S. where derivative use for hedging is very high (see chart below), Bank of Ireland Treasury and International Banking are increasingly seeing many European clients adopting similar strategies. Treasurers have found it beneficial to work closely with their Banks to create solutions which limit their exposure to adverse market movements, while at the same time granting them the flexibility to benefit from potential upside market moves. This is the main advantage of derivatives and is what sets them apart from traditional hedging techniques.

Key risks
Despite the benefits to be gained from using derivatives, history has demonstrated that, when using derivatives there are a number of key risk areas of which the corporate treasurer must be cognisant. The principal risks to consider are as follows:

• Credit risk: The risk of loss from a counterparty in default, or from a pejorative change in the credit status of a counterparty that causes the value of their obligations to decrease.
• Liquidity Risk: The risk that a financial market entity will not be able to find a price (or a price within a reasonable tolerance in terms of the deviation from prevailing or expected prices) for one or more of its financial contracts in the secondary market.
• Market Risk: The exposure to potential loss from fluctuations in market prices (as opposed to changes in credit status).
• Legal Risk is the general potential for loss due to the legal and regulatory interpretation of contracts relating to financial market transactions.
• Operational Risk: The potential for loss attributable to procedural errors or failures in internal control.
• Technological Risk: Refers to the exposure to potential loss from system failure or inadequacy

Given the risks and potential pitfalls highlighted above, the following are some useful guidelines to take into consideration when dealing in derivatives:
1. Clearly understand the purpose for using derivatives in a particular transaction: speculation, hedging or reducing funding costs.
2. Be aware of any leverage in derivatives’ positions, particularly in complex positions, as this can magnify the contract’s price swings (volatility).
3. Listen to your bank - derivatives’ dealers necessarily have a depth of product knowledge.
4. Understand the derivatives’ risks, especially in worst-case scenarios. Failure to appreciate the risks will make monitoring & measurement problematic.
5. Know your exit costs: What will it cost to unwind a position later?
6. Establish a loss strategy, if speculating, (the maximum allowable loss before closing a derivatives position) and stick with it.
7. Identify key operational risks and establish clear and defined internal controls.
Increasingly, the use of derivatives by corporate treasurers is regarded as a pre-requisite for cost-effective and efficient treasury management. Most banks are able to offer a suite of derivative products to match requirements, several banks offer financial engineering capabilities that can construct tailor-made treasury solutions. Whilst the risks of using derivatives are well documented, an understanding of the products and careful management of exposure will avoid the identified pitfalls and lead to a beneficial utilisation of derivative instruments. Looking to the future, the only constraint on the growth of the derivatives market will be the imagination of market participants.

Paul McEnroe is principal dealer at Bank of Ireland Treasury & International.

Note: The first part of this article was published in the May issue of Finance.

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