DERIVATIVES: NOT A FOUR LETTER WORD

Essay submitted to Frontiers of Financial Management
1995 Edition
February 15, 1995

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Alan Greenspan, Chairman of the Fed, summed it up: The array of derivative products that has been developed in recent years has enhanced economic efficiency. The economic function of these contracts is to allow risks that formerly had been combined to be unbundled and transferred to those most willing to assume and manage each risk component.(1)

He went on to explain, that as competitive pressures have intensified and as interest rates, exchange rates, and other asset prices have tended to be quite volatile, many financial and nonfinancial businesses, federally sponsored agencies, and state and local governments have concluded that active management of their interest rate, exchange rate, and other financial market risks is essential. Financial derivatives, especially customized OTC derivatives, allow financial market risks to be adjusted more precisely and at lower cost than is possible with other financial instruments.(2)

While there are critics, the foregoing is the orthodox view. Indeed, California's Orange County as well as the spate of recent reported corporate losses from derivatives notwithstanding, most of the world's knowledgeable experts have recognized that as a result of derivatives application, risks are reduced, losses are minimized, and profit is increased over a wide sphere of financial enterprise. For these reasons, derivatives are a mainstream element of the global banking business and a major source of earnings for approximately 150 of the world's largest commercial banks and securities firms which are active dealers in these markets. Their customers have come to recognize that the inherent risks in the marketplace, if left unmanaged, can jeopardize their ability to perform their primary economic functions successfully.

Derivatives today are applied within two separate regimes: Over-The-Counter (OTC) derivatives—traded privately among banks and their large corporate and institutional customers; and Exchange-traded derivatives—financial and commodity futures and options. Combined, these two sectors represent a multi-trillion-dollar market. By Wall Street Journal estimates, the derivatives markets are far larger than even estimates by the General Accounting Office, its "notional" total may top $35 trillion.(3) The OTC derivatives market now greatly overshadows exchange-traded futures instruments. One reason is that in futures an offsetting position eliminates the original contracts, not so in the OTC market where the original contract remains in place increasing the total size of the market. OTC markets generally also lack the regulatory control of federal authorities to which futures and options exchanges are subject. Nor do OTC markets have the protective components of the exchanges, namely: daily mark-to-the-market value adjustments, margin deposits, price and position limits, and most notably the guaranty of a central clearing house.

Economist Henry Kaufman offers an insight as to how and why the derivatives market developed and why it has been so successful. He states that the current trend toward using derivatives was the result of a dramatic rise in "floating rate financing opportunities; massive securitization of mortgages and other financial products; sweeping internationalization of trading of currencies, bonds and equities; a striking shift toward portfolio investment; and a worldwide explosion of budgetary deficits."(4)

Mr. Kaufman's historical overview is quite correct as far as it goes. But the driving force behind the growth of derivatives was not changes in the financial environment, but rather radical technological advancement—particularly in computer science. This technological revolution affected the entire world. The forces it unleashed produced profound transformations in every component of civilization—from science to finance. To be more specific, computer technology has moved the world from the big to the little, from the vast to the infinitesimal.

In physics, we moved from General Relativity to quantum physics, and in biology from individual cells to gene engineering. The world's first understanding of the atom was simply as a solid central nucleus surrounded by tiny orbiting electrons. However, new computer technology brought a much clearer comprehension of the complexity of the atom, its subatomic particles of electrons, protons and neutrons, and its nucleus containing intricate combinations of quarks. Similarly, in biology, technological advancements taught us that cells, originally thought to be simple repositories of chemicals, are more like high-tech factories in which complex chemical reactions produce substances that travel via networks of fibers.(5)

In markets, the evolution was strikingly similar. When advancements in computer technology were applied to established investment strategies, the result was remarkable. Just as it did in the sciences, market applications went from macro to micro. Intricate calculations and state-of-the-art analytical systems ensued, offering financial engineers the ability to divide financial risk into its separate components. Derivatives—the financial equivalents to particle physics and molecular biology—were born. The primary purpose of these instruments is not to borrow or lend funds but to transfer price risks associated with fluctuations in asset values.

The catalyst of this metamorphosis was modern academic theory which fostered the principle of risk management as a necessary business regime. This philosophy spurred the idea of dividing risk into its basic components. Financial engineers using their computers began to comb world markets searching for inefficiencies, financial exposure, and investors' dilemmas, to create synthetic financial instruments to solve the perceived risks. Consequently, an infinite number of derivative products were created whose values depend on the value of one or more underlying assets or indices of asset values. Simple futures contracts in foreign exchange, Eurodollars, and bonds, first launched in Chicago in 1972, have evolved into complex swaps and swaptions, strips and straps, caps and floors. Investment methodologies were transformed from all-encompassing traditional strategies to finely-tuned modern portfolio theories; long-term hedging evolved into on-line risk management.

As a consequence of their application, risks are reduced and profit is increased over a wide sphere of financial enterprise and in various ways—from businesses whose efficiency is enhanced, to banks whose depositors and borrowers are benefited; from investment managers who increase their performance for clients, to farmers who protect their crops; and from commercial users of energy, to retail users of mortgages. The negative headlines we read, I dare say, represent a distorted view of what is going on derivatives. A company that loses money in derivatives but continues to make money in its core business usually announces both events, but only the losses make news. A company that makes money from derivatives operations as well as from its core business, will say little if anything about the derivatives profits since it might detract from favorable views about its ability to make profits in its core business. A company that is saved from losses to its core business by virtue of derivative hedges, will seldom tell this story since once again it might put in question its ability to make money at its core business. Indeed, you hear very little about the multitude of corporate end-users of derivatives who made money, sometimes big money, from derivatives, simply because it doesn't serve its core-business image to underscore other profitable firm activities. In truth, profits from derivatives and particularly prevention of loss to core business by reason of derivatives far and away outweigh the headlines about losses. But we seldom hear about it. And not all the headlines we read about derivatives have anything to do with derivatives risk -- the $1.5 losses sustained by Orange County was a consequence of failed speculation, little else.

However, the foregoing does not imply that derivatives are a panacea for the world and without risk to the user. The recent report of the U.S. General Accounting Office (the GAO Report) correctly enumerates four sets of risks posed by derivatives: (1) Credit Risk. The exposure to the possibility of loss resulting from a counterparty's failure to meet its financial obligation; (2) Market Risk. Adverse movements in the price of a financial asset or commodity; (3) Legal Risk. An action by a court or by a regulatory body that could invalidate a financial contract; and (4) Operations Risk. Inadequate controls, deficient procedures, human error, system failure, or fraud.(6)

While these general types of risk exist for many financial activities, the GAO emphasizes that "the specific risks in derivatives are relatively difficult to manage because of the complexity of some of these products and the difficulties in measuring these risks." More important, as Mr. Greenspan acknowledged, "Even if derivatives activities are not themselves a source of systemic risk, they may help to speed the transmission of a shock from some other source to other markets and institutions.(7)

For one thing, failure of a major derivatives dealer could impact its counterparties. This represents the chain reaction peril that many observers have verbalized. For another, there are the unknown dangers created by a wide assortment of OTC financial options, and to an extent even exchange-traded options. These range from simple standard options to a complex species of hybrid instruments that combine futures, swaps, and options. Or as Henry Kaufman succinctly stated in recent congressional testimony, "writing over-the-counter options, particularly the more complicated ones, is a very different business from the traditional activities of a bank or a securities firm.(8) There is also an emerging genre of contingent options where payment is a function of multiple possibilities. Since these contingent options create risks that cannot be perfectly hedged, the resulting risks normally need to be managed through a process of dynamic hedging—an inexact science that can heighten price movements and produce unknown consequences.

For these reasons it is imperative for users of derivatives to institute the safeguards recommended by the G-30 Report and the Federal Reserve. Specifically:

1. The use of derivatives in a manner consistent with the overall risk management and capital policies approved by boards of directors.

2. The adoption of consistent counterparty credit limits.

3. The adoption of a procedure of marking positions to the market.

4. The use of a consistent measure to calculate daily the market risk.

5. The conduct of regular simulations of stress-tests.

In addition, I also wholeheartedly support regulations which require full disclosure and comprehension of the risks inherent in OTC derivatives when offered for investment or speculative purposes to the general public—just as they are required in regulated futures. Derivatives do not represent a traditional investment class with which the public is generally familiar. Rather, they embody complex and sophisticated instruments of modern finance—best employed in risk management techniques. Let us be clear: The laissez-faire attitude about OTC derivatives is over. The OTC market community must recognize that the need for stricter internal controls is imperative and that more education and disclosure is necessary. Like everything else in life, derivatives will not always accomplish their intended objective. Things go wrong, bad judgments are made, or the unexpected intervenes.

However, if as a consequence of negative headlines, corporate boards decide to refrain from prudent use of derivatives because of fears of consequential losses to their corporate bottom line, wait until those boards see the reduction in their corporate bottom line as a consequence of abstention from derivatives application. Let's face it: Today's world demands cost-efficient instruments that can protect from inherent financial risks and hedge against interest rate and exchange rate exposure, to manage assets and liabilities, to enhance equity and fixed income portfolio performance, and to protect against commodity price rises or mortgage interest expense.

Let us also be mindful that the quintessential element in the evolution of mankind has been its ability to invent and innovate. It is this remarkable capability of the human race that has enabled it to advance so rapidly from the invention of the wheel to the jet plane, from hieroglyphics to computers, from healing with leeches to triple by-pass heart surgery. This astonishing progression has one common denominator critical to its success: the freedom of individuals to experiment and invent without government interference.

____________________

     (1) Testimony before the Subcommittee on Telecommunications and Finance of the Committee on Energy and Commerce, U.S. House of Representatives, 25 May 1994.

     (2) Ibid.

     (3) WSJ, August 25, 1994,

     (4) Henry Kaufman, "Financial Derivatives in a Rapidly Changing Financial World," London, England, 14 October 1993.

     (5) Tom Siegfried, "Discoveries," Dallas Morning News, 14 December 1992.

     (6) The U.S. General Accounting Office Report, "Financial Derivatives: Actions Needed to Protect the Financial System," May 1994.

     (7) Ibid 5

     (8) Statement of Henry Kaufman, Committee on Banking, Finance and Urban Affairs, U.S. House of Representatives, 23 June 1994.

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