Derivatives have assumed increasing importance as a risk management tool for corporate treasurers. The variety and flexibility of these innovative financial tools afford greater protection and effective management of any treasury exposure and the purpose of this article is to give a high level view on the workings of the derivative market.
Today the derivatives market turnover is worth in excess of $100 trillion per annum. Derivatives are being widely used on a daily basis by market participants of all types in order to hedge their treasury exposures. The derivatives market has not been without a number of high profile disasters over the past decade or more (Table 1). However, to blame these losses on derivatives themselves would be grossly erroneous. In each case there were very obvious reasons for losses incurred, ranging from fraud, inadequate controls, incorrect risk & pricing models, to just plain ignorance. Thus the losses were caused by the abuse/misuse of derivative products.
Following these disasters there have been calls for improvements in both the control and regulation of, the derivative trading and accounting environment, to prevent these disasters from occurring again. The largely successful introduction of FAS133 and IAS 39 are the most recent attempts to increase transparency and therefore create a more robust market. In reality though, it will never be possible to legislate or regulate against further derivative related losses occurring again, since over- regulation would merely stifle the very market it sought to protect. Regulators must adopt a practical yet sensible approach, which was most recently reflected by Fed chairman Alan Greenspan in the wake of the Enron disaster, who was quoted as saying, ‘Derivatives do not appear to be a smoking gun, instead, properly used they lower the risks in the economy and may have helped avoid a breach in the financial system over the past year. There is nothing inherently negative about them.’
The derivative
The first step to appreciate the benefits that can be attained from the prudent use of derivatives is to develop an understanding of the basic theory. The Accounting Standards Board, defined derivatives as follows: ‘Derivative is a generic term that covers a wide range of financial instruments, which derive their value from an underlying rate or price. The most commonly traded derivatives are futures, forward rate agreements, swaps and options. These basic structures can be applied to a myriad of underlying assets, the value of which is dependant upon changes in rates or prices, such as currency rates, interest rates, equity, asset or commodity prices. ‘
Futures contracts: An exchange-traded obligation to buy or sell a financial instrument, or to make a payment at one of the exchange’s fixed delivery dates, the details of which are transparent publicly on the trading floor, and for which contract settlement takes place through the exchange’s clearinghouse.
Forward rate agreements (FRAs): A forward rate agreement is a cash-settled obligation on interest rates for a pre-set period on a pre-set interest rate index with a forward start date. A 3x6 FRA on US dollar LIBOR (the London Interbank Offered Rate) is a contract between two parties obliging one to pay the other the difference between the FRA rate and the actual LIBOR rate observed for that period.
Swaps: Swaps are customised OTC (over-the-counter) instruments under which two parties exchange payments at specified intervals over a specified period of time. They are typically based on interest rates or foreign exchange rates, but can also be linked to equity or commodity prices.
• Interest rate swap: An exchange of cash flows based upon different interest rate indices, denominated in the same currency on a pre-set notional amount, with a pre-determined schedule of payments and calculations. Usually, one counterparty will received fixed payments in exchange for making floating payments.
• Currency swap: An exchange of interest rate payments in different currencies, on a pre-set notional amount and in reference to pre-determined interest rate indices, in which the notional amounts are exchanged at inception of the contract, and then re-exchanged at the termination of the contract at pre-set exchange rates.
Options: The right but not the obligation to buy (or sell) some underlying cash instrument at a pre-determined rate on a pre-determined expiration date in a pre-set notional amount. Options may be entered into in respect of interest rates, exchange rates, equity prices or commodity prices or their derivatives.
Paul McEnroe is principal dealer at Bank of Ireland Treasury & International. Note: the 2nd part of this article will be published in the June issue of Finance. |
