Analysis managing the derivatives risk: 'weapons of mass destruction'? In the wrong hands, sure. But also essential financial tools - Finance

Chief Executive, The, Jan-Feb, 2004 by Gregory J. Millman

Should a similar derivatives crisis occur today, there's little chance it would sink the entire financial system. If anything, the recent wave of corporate scandals has shown just how salutary derivatives can be. "People say well, Enron, but derivatives weren't really part of Enron's collapse," says AIG's Patrikis. "Yes, they had a trading business, but Enron was just good, old, pure ignoring the rules." In fact, the derivatives markets may have helped prevent a financial domino effect. "Derivatives have permitted financial risks to be unbundled in ways that have facilitated both their measurement and their management," Fed Chairman Alan Greenspan said last May. "Even the largest corporate defaults in history (WorldCom and Enron) and the largest sovereign default in history (Argentina) have not significantly impaired the capital of any major financial intermediary."

To be sure, CEOs need to have solid risk-monitoring systems in place. And it's worth remembering that there is one infallible warning sign of impending derivatives disaster: free money. All of the companies that racked up huge derivatives losses had been making attractive profits for no apparent reason, except what seemed an astute sense of which way the market would move. In effect, they had been speculating, not hedging, with them. It may seem slightly paranoid to question an offer of a free lunch. But in the derivatives business, as in any other, only the paranoid survive.

Global over-the-counter derivatives market

Interest rates

Notional amounts outstanding in billions

Dec. 2001   $77,568
June 2002   $89,955
Dec. 2002  $101,658
June 2003  $121,799

Foreign exchange

Notional amounts outstanding in billions

Dec. 2001   $16,748
June 2002   $18,068
Dec. 2002   $18,460
June 2003   $22,088

Source: Bank for International Settlements

Note: Table made from bar graph.

RELATED ARTICLE: Not Just An Economic Tool

Derivatives have become so much a part of the corporate financial and strategic toolkit that some companies have begun using derivative math to crunch numbers for decisions that don't even involve derivatives instruments.

This so-called real-options analysis looks at staged investments in long-term projects--in areas ranging from pharmaceutical research to oil-field development--as if each cash commitment were an options purchase. Adherents say this kind of discipline provides a better picture of economic returns than traditional discounted cash-flow analysis.

"We don't have a crystal ball. We need to think how the future may unravel and we need to understand the uncertainty we're looking at," says Alexander Van der Putte, senior strategy and portfolio advisor to the committee of managing directors at Royal Dutch/Shell.

Within Shell, Van der Putte adds, there's virtually a global network of people who are capable of analyzing a project in real-options terms.

--G.J.M.