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

There will be another derivatives disaster, and it could happen in 2004. With interest rates and inflation at historic lows, someone, somewhere is probably using swaps or options to make a dumb bet on what looks like a sure thing. And history shows that bets on "sure things" can be some of the riskiest of gambles. But derivatives themselves aren't the problem. In fact, properly used, they're part of the solution.

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True, some very smart people are very worried about derivatives. Warren Buffett, in his annual letter to Berkshire Hathaway shareholders a year ago, famously called derivatives "financial weapons of mass destruction." Frank Partnoy, a former derivatives broker turned law school professor and author of the critically acclaimed Infectious Greed, raised an equally red flag. "A lot of corporate executives are scared to death of their derivatives exposure," he said in a recent interview with Chief Executive.

If Partnoy is right, there must be a lot of knees knocking in the C-suite. According to the International Swaps and Derivatives Association, 92 percent of the world's 500 largest corporations use derivatives. The trade group announced in September that the volume of basic interest-rate derivatives, the most widely used form of derivatives, had grown by roughly 25 percent during the first half of 2003, to what experts call a "notional principal" of $123.9 trillion. (The Swiss-based Bank for International Settlements, which also tracks the derivatives industry, reports a slightly lower figure; see charts, next page.)

The term can be misleading. Notional principal isn't actually money at risk, but rather a factor in determining the amount of protection a derivative provides. Suppose a bank sells an interest-rate protection to a corporation by offering to swap a fixed rate for a floating rate on a $10-million debt issue. The notional principal will be $10 million, but the only real risk is the difference between the fixed and floating rates. Even so, that bank will usually hedge its own risk by entering a swap with another bank. So instead of one swap with a notional principal of $10 million, there are two swaps with a total notional principal of $20 million. What's more, the second bank will probably hedge all or part of its risk. With rare exceptions, every participant in the derivatives markets is trying to take as little risk as possible.

There may be a lot of derivatives outstanding, but they haven't made the world a riskier place. In fact, thanks to derivatives, the financial world is a lot safer than it used to be. Most companies that use derivatives do so to protect themselves against potentially ruinous currency and interest-rate fluctuations. No one has even begun to quantify the potential damage these risks can inflict. But in the past they have wiped out entire companies, savaged whole industries, even sent sovereign nations down the financial drain.

Unlike some derivatives, these risks aren't remote or hard to understand. Any CEO whose company has a major Japanese or European competitor knows that a strong dollar poses a business risk. Any real estate or home-improvement company CEO knows that interest rates matter to the bottom line. Hedging of such interest-rate and currency risks accounts for the lion's share of corporate derivatives use. With all these derivatives sloshing around, it's reasonable to assume someone may be using derivatives to speculate recklessly. But, as Tanya Azarchs, managing director of financial services rating at Standard & Poor's, puts it: "It's a lot like a gun. The risk depends on the user."

In fact, derivatives have become so much a part of the global financial system that it is hard to imagine the system functioning without them. Sophisticated derivatives tools allow both financial and nonfinancial companies to examine their risks and make decisions about which ones to take and which to ensure against. In the past, a bank that offered a 30-year fixed-rate mortgage took an enormous risk. If rates fell, the borrower could prepay. If rates rose, the borrower could keep the low-interest-rate mortgage--and the bank would have to pay more for capital. That kind of mismatch helped cause the savings and loan crisis of the 1980s. Now, thanks to derivatives, lenders can hedge.

Derivatives also have made it possible for companies to tap new sources of capital at favorable rates. Corporations can issue bonds in the country or market whose interest rates are most favorable, and use derivatives to swap the debt into the currency they need. Recently, the emergence of credit derivatives has meant that a banker never has to say no to a corporate borrower, and may not even have to syndicate a big loan. The bank can make the loan and hedge the risk by using credit swaps--essentially, insurance against default. Who provides the insurance? Insurance companies are the market's biggest players; others include regional banks that might want a piece of a major company's credit but can't get through the door.

"It gives the banks a way to separate the lending or relationship function from the decision whether or not to hold long-term credit exposure to a company," says Roger Merritt, managing director of the credit policy group at Fitch Ratings. "We understand that more and more corporate treasurers are becoming aware that this market exists and are watching how their name trades in the credit derivatives market." The companies whose credit risks are most often hedged using credit derivatives include General Motors, Daimler-Chrysler, Ford, General Electric and France Telecom, according to a Fitch report.

Protection as Well as Risk

In the global economy, currency risk is a fact of business life. Even firms that never export or import may face currency risk, as American machine-tools makers discovered in the early 1980s when currency shifts handed Japanese competitors a significant price advantage. There are three main kinds of currency risk: transaction, translation and strategic. Transaction risk can result in a foreign-currency receivable losing dollar value because of currency shifts. Translation risk can lead to earnings from foreign subsidiaries contributing less to reported dollar earnings. Strategic risk, faced most famously by companies like Caterpillar and Kodak, can enable a foreign competitor to reap a competitive windfall from currency rates.

Companies have used derivatives to protect themselves against all three types of currency risk. "Derivatives, like insurance, are a way to spread risk so that the people who can afford to bear it will be able to bear it," says Ernie Patrikis, senior vice president and general counsel of American International Group. He is also a director of the International Swaps and Derivatives Association and a former first vice president and chief operating officer of the Federal Reserve.

What about the risk of derivatives themselves? Look at the record of derivatives fiascos and you'll see they all have one thing in common: uncontrolled speculation. In a sense, fear of derivatives is the best thing investors and CEOs could hope for. Nick Leeson, who brought down Barings Bank with massive derivatives bets, wasn't sufficiently scared. Neither were the Nobel laureates at Long Term Capital Management, the hedge fund that almost brought down the world financial system a few years back when its derivatives bets went wrong. Procter & Gamble, Gibson Greetings, California's Orange County and the Piper Jaffray family of funds all made headlines because of their derivatives disasters in the mid-'90s. The reason? They were comfortable with the exotic derivatives risks they took because they thought they weren't risks at all. In their minds, they were just taking what looked like free money to carry what someone else thought was a risk.

They ignored the fundamental principle of investing: There is no return without risk. The same thing happened to Japanese financial institutions in the late '80s, when they agreed to insure their Western counterparts against a possible fall in the Nikkei index by selling Nikkei puts. They weren't worried. The Japanese stock market couldn't fall, right?

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.