The CEO's guide to derivatives - financial derivatives - Finance

Chief Executive, The, March, 1994 by J. Carter Beese, Jr.

Customized swaps, futures, options, and forwards are crucial to effective risk management.

But handled incorrectly, they may be risky business themselves.

Technology experts say that on average, the world's collective capacity to compute and to communicate increases by a factor of 10 from one decade to the next. In other words, in 1990 our computers and telecommunications systems were 10 times faster than they were in 1980. All that is about to change, however. According to techies, the world now stands on the edge of a quantum leap forward. During the next 10 years, our ability to compute and to communicate will increase by a factor of 100.

This explosion in new technology will have profound implications for the world' capital markets--and the companies that access them. Technology now permits capital to move in and out of new opportunities at the touch of a computer key. And market linkages facilitate the free flow of capital across the globe.

In conjunction with this extraordinary capability, new and increasingly sophisticated financial products are changing our markets. In many respects, th simple terms of "stocks" and "bonds" seem relics of the past. Today's complex financial instruments are better defined in terms of cash flow and volatility characteristics. In the corporate finance world, it is possible to take a plain vanilla, fixed-rate bond, and through financial engineering, change its payment structure, its currency, its maturity, its rating; give it equity characteristics; and slice and dice it into tranches.

FINANCIAL TOOLS

At the forefront in this financial revolution is the increasing use of derivative products. Once considered the alchemy of rocket scientists, derivatives now constitute a widely accepted tool for today's CFO. Finance departments use derivatives as an essential element of an overall risk management system. But these new instruments also pose risks for corporate end users, risks not necessarily germane to the business lines most corporate executives are familiar with. In this new environment, senior management and boards of directors have an obligation to thoroughly understand and effectively manage the risks derivative instruments pose.

Derivatives encompass an array of financial products, including swaps, futures, options, and forwards, that derive their value from other assets, such as equities, debt, foreign currency, and commodities. Some derivative products, such as options on securities, can be standardized products traded on options exchanges; others, such as currency and interest rate swaps, often are customized to suit the needs of individual end users, and purchased and sold in the over-the-counter market.

As a practical matter, the derivative products assuming a larger role in today' OTC market are similar to, if not the same as, exchange-traded futures and options, except they add a key element of credit risk not present in standardized exchange-traded products. The presence of this credit risk in OTC transactions prompted the OTC mantra, "Know thy counterparty."

Why are OTC derivatives popular among corporate end users? The answer: flexibility. OTC derivatives can be structured to match the portfolio, or the investment strategy, of a corporate end user. As a result, these products offer end users the ability to manage risks that might otherwise make certain investments or business activities impracticable. In addition, OTC derivatives allow institutions to "synthetically" gain exposure to equity, bond, or mortgag markets around the world that otherwise might not be available.

REDUCING RISKS

Many corporate end users primarily use derivatives as a hedging instrument. Corporations use derivatives to reduce risks inherent in their business, such a managing currency risk arising from foreign-exchange exposures and commodity risks arising from commodity-price exposures. Corporations also use derivatives to hedge interest rate and currency risks arising from new financings, to reduc funding costs, and to diversify funding sources.

For example, a corporation may be able to reduce its funding costs by obtaining financing from one market and then swapping, via a currency swap, all or part o the cash flows into the desired currency and interest rates. When used effectively, savings, in terms of decreased funding costs, are likely to accrue to the borrower in the range of 10 to 25 basis points. Currency swaps also can help companies alleviate such funding problems as the lack of available credit in local foreign markets, high interest rates in available markets, foreign-exchange controls and regulations in the countries involved, as well as tax and accounting problems.

Flexible and useful as hedging instruments, derivative products quickly have become indispensable to business everywhere. In a recent survey of private-sector companies conducted by the Group of Thirty, an association of major international financial institutions, 83 percent of the respondents considered derivatives either imperative or important for controlling risk within their organizations. According to the Group of Thirty's survey of industry practice, 87 percent of the reporting private-sector corporations use interest rate swaps, 64 percent use currency swaps, 78 percent use forward foreign-exchange contracts, 40 percent use interest rate options, and 31 percen use currency options. As of June 30, 1993, one estimate of the total derivative exposure of the top eight U.S. commercial bank dealers was $9.7 trillion in total notional amount. The notional amount represents the principal balance underlying a derivative agreement. It is the amount upon which payments to counterparties are calculated, and it functions as the fictitious principal generating the cash flow's in a derivative agreement. The two parties to a derivative agreement trade the cash-flow yield, not the notional amount. The notional amount is not at risk; typically, only 2 percent to 5 percent of the notional amount represents credit exposure. In terms of growth trends, a recent report by U.S. banking agencies concluded that the OTC derivatives market increased by over 790 percent from year-end 1986.