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Why use derivatives? Back  
Philip Lenehan says that when used to hedge risks rather than speculate, derivatives are valuable tools and don’t deserve the bad press they have received.
In the last 20 years, non-financial corporations of all shapes and sizes have been awakened to the financial risks present in the new global economy. Over this period, the financial services industry has invented remarkable new products for managing these risks. The question now facing companies is how to accurately identify and measure these new risks, and which risk management products to use. In Ireland, the arrival of the Euro in particular has opened up the variety and competitiveness of hedging products available to the corporate treasurer.

The growth in the market
As product markets have become more global so have the risks facing corporations. Before the early 1970’s foreign exchange, interest rates and even commodity prices were only occasionally a concern for corporate managers. Consequently financial market volatility was low enough not to have an impact on the financial strategies of most businesses.
The markets changed dramatically in the 1970s as currencies floated post Bretton Woods, oil prices soared and interest rates rose dramatically. For the first time many finance departments had to address some difficult issues regarding the effect of these movements on business operations and ultimately, corporate profits.
Importers and exporters now faced uncertain costs and revenues. Even domestic companies worried about competition from foreign companies due to comparative advantage gained from movements in exchange rates. Similarly interest rates rose significantly. US dollar long-term rates, which had been in a range of two to five per cent since the 1930’s, rose to 14 per cent in 1981.
It was these events, which led to the growth of an entirely new financial market. The market’s goal was not to trade assets, but risk itself. This development has become known as the ‘derivatives market’. A derivative can be defined as any contract that derives its value from some underlying asset. There are three basic types of derivatives: forwards and options and swaps. A forward contract is a firm commitment to buy or sell something at a future date. An option gives the buyer the right but not the obligation to buy or sell something at a future date. A swap is an agreement to swap one set of cash flows for another.
While the financial derivatives market exploded in the 1970/80s as outlined above, derivatives are not new and have been around in one form or another for hundreds of years. There is evidence that ancient farmers used forward contracts to sell their products ahead of harvest. Organised futures exchanges for commodities were established in the US as far back as the 1800s.
Despite some of the bad press around derivatives, they are here to stay. A recent survey from the Bank for International Settlements (BIS) on positions in the global over-the-counter (OTC) derivatives market shows that the business expanded at a brisk pace in the three years ending June 2001. According to their preliminary data, the aggregate stock of contracts outstanding stood at nearly $100 trillion at end-June 2001, 38 per cent higher than three years ago. These values include contracts held by financial as well as non-financial institutions, however studies indicate that usage by non-financial corporations is a significant portion and certainly our experience in Bank of Ireland would back this up.

Some simple examples
The ultimate goal of derivatives is to allow one party (the corporate), to transfer financial risk to another (usually a bank), who either has an offsetting risk position or can more effectively manage the risk. To look at a couple of simple examples:
Consider an Irish company with sales in the US that knows it will receive $5m in six month’s time. If the US dollar weakens the Irish company will lose out. To hedge this the company has a number of alternatives, two of which are as follows:
(a) It can either enter into a forward contract with its bank that locks in the exchange rate at which the US dollars are transferred into Euros in six months time, thus eliminating the exchange rate risk.
(b) Alternatively it could buy a put option on the US dollar against the Euro that guarantees a minimum exchange rate but lets the company use a better exchange rate if the market rate in six months time is more favorable.
Interest rate risk derivative contracts are increasingly popular, particularly in Ireland where the FX risk for many corporate treasurers has decreased with the advent of the Euro allowing them time to concentrate on their interest rate exposure. Depending on the profile of their assets treasurers can use interest rate swaps to either convert their variable rate borrowings to fixed rate or alternatively to convert fixed rate debt to floating rate debt. Similar to our FX example above the treasurer can use interest rate caps to protect against higher rates but continue to benefit should rates remain low. There are numerous alternatives a treasurer might consider but any more detailed hedging structures are generally built from these basic building blocks.

Some of the recent high profile cases involving the misuse of derivatives have led to the spine-chilling fear of anything associated with the word ‘derivative’. Indeed I have heard one tongue in cheek description of derivatives as, ‘…any security on which investors have lost a substantial amount of money…’. Seriously though, the highly respected head of the US Federal Reserve Bank, Alan Greenspan, recently commented, ‘…derivatives have enhanced the overall efficiency of financial markets and the economy…’. The high profile cases that went wrong are well documented from ‘Orange County’ and ‘Hammersmith and Fulham’ to ‘Proctor and Gamble’. In each of these cases the controls and procedures around the use of derivative contracts within the organisation were seriously lacking. Like most modern inventions - if used correctly - derivatives are powerful and valuable tools. The stories told about misuse do not represent the vast majority of cases where derivatives effectively reduce risk. The friendly face of derivatives - not as trading instruments but as hedging tools that provide businesses with the means of transferring and managing risk - has been much less visible.
In the past, boards of directors have been reluctant to allow their treasurers to use derivatives. There is no doubt that in this day and age, where corporate governance has never been more in the spotlight, directors have an obligation to fully understand the nature of the hedging instruments, which their company might use effectively to manage financial risk. The effective management of financial risk frees the executives of the company to concentrate on the core business. Other benefits lie in the reduction of volatility in earnings, thus reducing the cost of finance from bankers/ shareholders. The successful case by the shareholder of a grain co-operative in the US a number of years back, against its board of directors for failing to hedge exposures, suggests that avoiding derivatives is not a safe option. Derivatives are valuable tools if used correctly to hedge risks rather than speculate. The longer-term answer is for boards to do their homework on derivatives rather than to impose a ban.

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