The Changing Use of Derivatives: More Hedging, Less Speculation

During the derivatives crisis of the early- and mid-1990s, one magazine illustration showed a dark, ghostly planet exerting a dangerous gravitational pull on the known world nearby, depicting how trillions of dollars in swaps, forwards, strips, options and other exotic contracts could topple ordinary stock and bond markets.

 

Gibson Greetings and Procter & Gamble were shaken by immense losses on derivatives speculations in that decade, while Orange County, Calif. was forced to file for bankruptcy as a result of its treasurer’s failed derivatives bets.

 

Back then, many worried that corporate treasurers and other executives were being lured into high-risk, leveraged derivatives bets by slick Wall Street salesmen who understood little more about these strange products than their customers did. But disaster did not strike after all, and derivatives rarely make news today. Did they fall into disfavor?

 

No, says Wharton accounting professor Wayne Guay. Derivatives are still among us. “The derivatives industry seems to be fairly healthy,” he suggests. “The numbers don’t indicate any real decline in the use of these instruments.”

 

What has changed, he explains, is the way derivatives are used in a market that has matured. “Twenty years ago, it was a new type of market. Derivative securities were not that common.” Today, by contrast, many derivatives contracts are standardized, well understood and economically priced. High-risk gambles like those that torpedoed Orange County, Gibson and P&G are far less likely than conservative plays meant to hedge against loss in underlying markets such as energy, commodities or currencies.

 

To see how much risk companies face through their derivatives bets, Guay and S. P. Kothari, an accounting professor at MIT’s Sloan School of Management, examined financial statements for 1997 from 234 large, randomly selected non-financial firms that used derivatives. (While financial firms use more derivatives than non-financial firms, the authors’ research applies only to non-financial firms). They looked at how the firms’ cash flows would be affected by extreme changes in interest rates, currency exchange rates and commodity prices – factors that can make derivatives contracts soar in value or suddenly turn worthless. “We find that for most firms the quantity of derivatives that they are using is quite insignificant compared to how big these companies are,” says, Guay, whose research paper is titled “How Much Do Firms Hedge with Derivatives?”

 

There are many types of derivatives, all sharing a basic characteristic: They are based on an underlying financial instrument such as a stock, bond, currency, commodity, index or interest rate.

 

Many derivatives are designed to be used conservatively, as insurance policies to hedge against the possibility of loss in risky business environments. For example, a common derivative for hedging is the forward contract, where a firm agrees to buy or sell some currency or commodity at a specified price sometime in the future. For example, on Jan. 31, 2003, a firm might enter into a contract with another party to buy one million barrels of oil on Jan. 31, 2004, at a fixed price of $20 per barrel. If the price of oil on Jan. 31, 2004, turns out to be greater than $20 per barrel, the firm will make a profit on the derivative and if the price of oil turns out to be less than $20 per barrel, the firm takes a loss on the derivative. However, either way, the firm has hedged its oil needs by guaranteeing that it will only have to pay $20 million to buy one million barrels of oil.

 

For most types of derivatives, minor price changes will not cause large price swings in the value of the derivative. However, if firms enter into exotic and leveraged derivatives, minor price changes can lead to very volatile price swings. This is what caused so much trouble in the high-profile cases a decade ago.

 

Guay and Kothari found that derivatives involving currency exchange-rate and interest-rate hedges were the most widely used at the companies they studied, with contracts typically covering periods of between one to five years. For example, says Guay, an American company might sign a contract with a German supplier for a shipment of semiconductors to be delivered in six months at an agreed-upon price in euros. But if the dollar were to fall in relation to the euro in the meantime, the cost to the American company would go up.

 

“Clearly, the final amount they pay to that German firm is dependent on the dollar-euro exchange rate,” Guay points out. “A company might say, ‘We want to lock in the price. We don’t want to be subject to that uncertainty.’” So the Americans could go to a securities firm and purchase a futures contract to buy euros at today’s price in six months.

 

If the dollar rises in value against the euro, the firm is still obligated to pay the agreed upon price for the euros. In hindsight, the firm might wish it hadn’t entered into the derivative contract because it forces the firm to pay more to acquire the euros than if the firm simply went out and bought euros on the date it pays the German firm. However, the opposite is true if the dollar rises against the euro. In this case the firm is pleased that it entered into the derivative contract because it allows the firm to pay less to acquire the euros than if the firm simply went out and bought euros on the date it pays the German firm. Regardless of whether the derivative gained or lost value in hindsight, the firm successfully used the derivative to “lock in” the dollar cost of purchasing the semiconductors.

 

Aside from currency contracts, derivatives are common in many volatile markets, such as oil, copper, steel and grain. A company that has taken out a variable-rate loan might use an interest-rate swap to hedge against the possibility that rates would rise, while a company that has made a variable rate loan might use a different contract to hedge against the possibility rates would fall. Some derivatives contracts are standardized, others are tailored to the customer’s needs.

 

In most cases, Guay and Kothari found, the money that could be gained or lost through the derivatives contracts they examined would be small relative to the firm’s size, even under the most extreme and unlikely situations.

 

“Our results suggest that the magnitude of the derivatives positions held by most firms is economically small in relation to their entity-level risk exposures,” the authors conclude. The median firm, for example, held interest-rate or currency-exchange derivatives that equaled only 3% to 6% of the firm’s total interest-rate or currency exposure. Generally, they add, derivatives bets are too small to have much affect, positive or negative, on companies’ stock prices.

 

Given that the expense of maintaining a derivatives’ program is “not trivial,” it is unclear how the benefits of using derivatives in small quantities outweigh the costs. One might expect that many companies would forego hedging minor risks with derivatives because things are likely to even out over time: Losses on one non-hedged position may be offset by gains on another, says Guay.

 

Guay and Kothari argue that their results may be consistent with companies using derivatives to fine-tune overall risk-management programs that include other techniques. A firm concerned about fluctuating exchange rates, for example, might set up an overseas factory that can do business in the foreign currency. Companies can vertically integrate to gain some control over costs of supplies and raw materials. Alternatively, rather than enter into company-wide derivatives programs, some companies may allow mangers of individual operating divisions to initiate derivatives positions on their own. A hedge may be large for the division but small for the company as a whole, Guay says.

 

But use of derivatives for speculation rather than hedging appears to be small. New regulations were enacted after the early ‘90s disasters to require companies to more fully disclose their derivatives positions. Boards of directors are more likely to be watching than they were a decade ago, Guay notes, adding “For most firms, it’s not a time bomb ticking. “Even if they are using them in a bad way, they are not using them in huge quantities.”

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