The CEO’s Guide To Derivatives

Customized swaps, futures, options, and forwards are crucial to effective risk management. But handled incorrectly, they may be risky business themselves.

March 1 1994 by J. Carter Beese Jr.


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’s 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, the 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 ement of an overall risk management system. But these new instruuments 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’s 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 mortgage 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 as 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 reduce 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 of 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 percent 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 (see graphic). 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 flows 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.

MANAGEMENT AND BOARD CONCERNS

Recognizing that derivatives have become a widely used tool among finance teams in major corporations, what do CEOs and boards of directors need to know to properly manage these operations? The Group of Thirty, in its comprehensive study of the derivatives market, outlined 20 recommendations for dealers and end users active in derivatives. Two of the recommendations are particularly relevant for senior management of corporate end users.

First, the highest levels of senior management must pay attention to their firms’ derivatives activities. This recommendation also suggests that a firm’s policies for derivatives should be an integral part of its overall policies for risk taking and risk management. I believe firm management should, and, in fact, must, go further than that. The anecdotal evidence in the marketplace that senior management is worried about its own lack of understanding of OTC derivatives and about its overreliance on specialists is troubling. Senior management must not only “pay attention to their firms’ derivatives activities” but also must develop a thorough understanding of the products, the risks their firms assume because of this activity, and the manner in which those risks are managed and controlled.

Board audit committees also must make sure that firm internal and external auditors ask the right questions. This analysis should include identifying a group in the firm primarily responsible for risk management and determining:

  • Whether the members are separate from the traders incurring the risk.
  • Whether this valuation group arrives at the assumptions in its pricing models independently or receives key input data from the originator of the trade.
  • Whether internal controls and information systems are reliable and working well.
  • Whether credit exposure to specific counterparties is being marked to market.

Also critical is centralized risk management for the holding company and its subsidiaries.

Next, the Group of Thirty recommends that pending the arrival of harmonized international standards, dealers and end users should voluntarily adopt accounting and disclosure practices that provide greater transparency. To the extent that settlement values under derivatives contracts are largely contingent, which is often the case throughout the life of a derivative contract, current accounting standards do not require settlement values to be reflected in firms’ balance sheets.

The financial statements of entities with OTC books far in excess of their capital are, for all intents and purposes, opaque. That lack of transparency means that assessing counterparty risk requires much more than traditional analysis of balance sheet disclosure. For the first time in recent memory, you cannot assume that by looking at a firm’s balance sheet, you can adequately understand its business or financial health.

This raises an interesting question. At what point does a firm incur a legal obligation to disclose to investors the nature and extent of its derivatives activities? Consider, for example, the case of the Japanese oil company that lost over $1.5 billion trading currency derivatives. The magnitude of this trading activity clearly appears to constitute a “material fact,” since it would reasonably be expected to influence an investor in his or her decision to either buy or sell the company’s securities. In fact, the question arises: Did the company incur an obligation to inform the marketplace about the presence of this new business line? One of the most thought-provoking items a board member might hear is, “We made $10 million on our hedged portfolio last year.” The inquisitive board member responds: “Are we hedging or are we speculating?”

As this example illustrates, the rapid growth of the derivatives market, and in particular the introduction of new products and strategies, has left the accounting profession behind the curve. To date, accounting practices largely have developed by analogy to practices of other similar instruments and may not always best reflect the economics of derivatives transactions or allow investors to fully understand and evaluate the attendant risks.

For these reasons, international efforts to harmonize accounting treatment of off-balance sheet items must be encouraged. The Financial Accounting Standards Board recently took an important step in this direction by issuing accounting standards governing the disclosure of information about the nature, extent, and terms of financial instruments with off-balance sheet credit or market exposure. Under these guidelines, public reporting companies must disclose the “fair value” of derivative instruments and provide other disclosures regarding off-balance sheet risk, such as maximum exposure, concentrations of counterparty risk, losses in the case of counterparty failure, and collateral. Public companies that have material exposures as a result of current or contemplated transactions in derivatives are required under SEC rules (Regulation S-K, Item 303) to discuss the commitments and uncertainties that may have a material effect on liquidity or operating results in the future. The FASB also currently is studying ways to address the accounting treatment of swaps and other derivative products as part of its comprehensive review of new financial instruments.

What does the unsettled state of the accounting for derivative products mean for senior management and board audit committees? When preparing financial statements, public reporting companies should not take a minimalist approach to accounting and disclosure. Besides inviting needless exposure to potential legal risk, firms reluctant to adequately discuss the nature and extent of their derivatives activities may find themselves arguing with the SEC over the adequacy of their annual disclosure documents. To facilitate market transparency and prepare themselves for heightened standards that are coming, firms should take a proactive approach.

For those firms that decide using derivatives is not worth the trouble, a word of caution. In a case that could have profound implications for senior management, a state court in Indiana held in Brane v. Roth that management and directors were liable for not using derivatives. The case involved a lawsuit by members of an agricultural cooperative against the co-op’s management for over $400,000 in grain sale losses. The plaintiffs successfully argued that the losses could have been avoided if the managers had hedged the sales in the grain futures market. Under the reasoning of the Brane decision, Indiana law dictates that a director of a corporation has a duty to be acquainted with hedging. While this case has limited applicability, it may well mark the beginning of a legal trend as the area of derivatives becomes more developed under state corporate law.

REGULATORY CONCERNS

To adequately understand this market, senior management also should be aware of regulatory concerns and actions with regard to derivatives. In addition to the traditional focus on full disclosure, customer suitability, and anti-fraud protections, there are some systemic concerns unique to the derivatives market. During periods of market stress, concerns arise with regard to the possibility of a “ripple effect” and the impact of derivatives activities on the liquidity of the cash market. Under a potential ripple effect, the increased use of derivatives could lead to the failure of one or more derivatives dealers, with this failure creating ripple effects throughout the OTC market for dealers and end users. Similarly, in an extreme market stress environment, the liquidity of the nation’s equity markets could be strained by the selloff of stocks and futures by derivatives dealers trying to adjust their hedges to accommodate rapidly changing market risks.

To address these concerns, the SEC created the following four themes for oversight of derivatives activities:

Risk assessment. To properly regulate this market, you first must understand its size and scope. Accordingly, in 1992 the SEC adopted a risk-assessment program that requires broker-dealers to report on a quarterly basis the size of their derivatives exposure in terms of both notional amount and replacement cost value. The SEC presently is analyzing quarterly filings received from approximately 250 broker-dealers with over 700 significant affiliates.

Capital. Strong capital requirements serve as an essential regulatory tool in protecting customers and mitigating systemic problems. The SEC recently issued a concept release soliciting public comment on a broad range of issues relating to the appropriate capital treatment of derivative products under the commission’s net capital rule. This review seeks to strike the appropriate balance between investor protection and the efficient use of capital for broker-dealers.

Accounting. Good accounting is the underpinning of good risk management and good regulatory oversight. The lack of harmonized accounting standards looms on the horizon as one of the biggest and possibly most difficult issues dealers, end users, and regulators will confront in this market.

Coordination. A cooperative dialogue and periodic information-sharing among regulators and market participants is essential to understand the aggregate size of the market and properly identify potential systemic stress points.

ON THE HORIZON

The explosive growth of the derivatives market shows no signs of abating. Derivative products allow end users to hedge risks they are unwilling to bear. And in a world in which increasing market and business linkages create exposure to currency, commodity, and interest rate risks on a daily basis, the need for derivative products is evident.

Less evident, however, is the way regulators will react to this phenomenon. The Bank of England, the Bundesbank, the International Monetary Fund, the Commodity Futures Trading Commission, and the U.S. House of Representatives Banking Committee Minority Staff all have issued reports on this market. The tone of these reports has varied greatly, and commentators have drawn analogies between the derivatives market and the S&L crisis.

I reject this analogy. As a regulator, I don’t believe you can navigate the twists and turns of the road ahead by looking exclusively in the rear-view mirror. While there certainly are lessons to be learned from prior experiences, including the S&L crisis, cops do walk the beat with regard to derivatives.

But no amount of regulation will substitute for effective management by senior executives and boards of directors. And reliance on outside experts is not enough. Management and boards must take an active role in understanding how their company uses, or should use, derivative products. Used wisely, these products offer an effective way to hedge risks. Used unwisely, they offer an effective way to lose money.


J. Carter Beese Jr. has served as the commissioner of the Securities & Exchange Commission since March 1992. He was a partner of investment banking firm, Alex. Brown & Sons, and a director of the Overseas Private Investment Corp. The views expressed in this article are those of Commissioner Beese and do not necessarily represent those of the SEC, other SEC commissioners, or the staff.