Derivatives - The Beauty

Financial markets have grown more volatile since exchange rates were freed in 1973. Interest rates and exchange rates now fluctuate more rapidly than at any time since the Crash of 1929. At the same time, companies' profit margins have been squeezed by the lowering of trade barriers and increased international competition. The result is that companies worldwide have been forced to come to terms with their financial risks. No longer can managers stick their heads in the sand and pretend that because their firms make cars, or sell soap powders, they need only worry about this year's convertible or whether their new formula washes whiter than Brand X. As many have found to their cost, ignoring interest-rate, currency or commodity risks can hurt a company just as badly as the failure of a new product.

Derivatives offer companies the chance to reduce their financial risks - chiefly by transferring them to someone (usually a bank) who is willing to assume and manage them. As they realize this, more and more companies are using derivatives to hedge their exposures. America's General Accounting Office reported that between 1989 and 1992 derivative volumes grew 145% to $12.1 trillion (in terms of the notional amount represented). This does not include about $5.5 trillion of foreign-exchange forwards. Interest-rate risk was the main risk hedged - at the end of 1992, interest-rate contracts accounted for 62% of total notionals, compared with 37% for foreign exchange.

In the US companies can now be sued for not hedging their exposures. In 1992, the Indiana Court of Appeal held that the directors of a grain elevator co-operative had breached their fiduciary duty by failing to sell forward the co-op's grain to hedge against a drop in prices. Since 90% of the co-operative's operating income came from grain sales, its shareholders argued that it was only prudent for the directors to have protected the co-op from the huge losses it suffered (Brave v Roth, Indiana Court of Appeal). In another case, shareholders sued Compaq Computers for violating securities laws by failing to disclose that it lacked adequate mechanisms to hedge foreign-exchange risks.

Hedging does not necessarily remove all of a company's financial risk. When a firm hedges a financial exposure, it is protecting itself against adverse market moves. If the markets move in what would normally be the company's favour, the hedger could find itself in a position that combined the worst of both hedged and unhedged worlds. For many firms, though, this is a worthwhile price to pay for ensuring stability or certainty for some of their cashflows.

(From Managing derivative risks by Lillian Chew)