How Companies Use Derivatives

Derivatives play an integral role in helping companies manage risk and are likely to occupy an increasingly prominent place at firms that are seeking shelter from the volatility of the financial markets.

A recent study found that while derivative usage is far from widespread, many companies rely heavily on instruments that help reduce the risks of fluctuations in interest rates, currency-exchange rates, commodity prices and equity markets. In fact, of the companies that regularly use derivatives, 42% say their usage has increased while only 13% of those companies say usage has declined, according to the "1998 Survey of Derivatives Usage by U.S. Non-Financial Firms."

The survey, which tracked responses from about 400 companies, is the third in a series of studies conducted by the Weiss Center for International Financial Research of the Wharton School and CIBC World Markets, an arm of the Canadian Imperial Bank of Commerce. The chief aim of the surveys is to compile a database on risk-management principles that can be used for academic research.

"The overriding message of the surveys is that derivatives seem to be a permanent part of many companies’ financial tool boxes," said Wharton’s Gordon M. Bodnar.

Derivatives are complex financial instruments that "derive" their value from an underlying instrument or asset such as a commodity or a currency. They are used to manage a wide variety of risks. For example, a company that owes a large amount of debt at a variable, or floating, interest rate may prefer to lock in its debt at a fixed rate to insulate itself from an interest-rate hike. The company could enter into a derivative contract that would essentially allow it to "swap" interest rates with a company seeking to switch from a fixed to a variable rate.

The researchers say the survey helped them gain additional insight into derivatives, providing information about the types of companies that use derivatives, what kinds of derivatives they use, and how these companies approach and evaluate risk management. The following list highlights some of the findings.

• Larger companies, primary-product firms, and manufacturers–many of whom trade internationally and therefore are subject to currency fluctuations–are more likely to use derivatives than smaller firms or firms in the service industry. However, usage among service firms is increasing at a significant pace.
• About 83% of companies that use derivatives do so to curb the risk of foreign currencies, 76% of firms use derivatives to hedge against changes in interest rates, 56% seek to protect themselves against commodity-price fluctuations, and 34% use derivatives that are based on equity, or stock, markets.
• Companies with significant foreign-exchange exposure typically hedge only a small percentage of their positions and most of the hedges are "short-dated" have maturities of less than 90 days.
• A majority of companies are not concerned about the Financial Accounting Standards Board’s recent modifications to rules concerning derivatives, which require significant changes to the way derivatives are measured and reported on a firm’s financial statements.
• Many companies try to guard against the potential pitfalls of derivatives by employing a written policy governing their use and 40% of companies insist on a credit rating of AA or better for counter parties in derivative transactions.

New to survey this year were questions designed to measure the popularity of various flavors of derivatives and to elicit an understanding of how companies measure the effectiveness of their derivatives. The researchers found that companies generally stick with basic, or "vanilla," options and largely eschew more exotic versions. Oddly, more than half of the surveys respondents said they do not measure their derivatives against a well-specified benchmark. This admission suggests that many companies, therefore, do not have a good handle on whether their use of derivatives is paying off.

The study also explored the motivation of companies that use derivatives. While most firms use them to manage risks they routinely encounter, a surprising 40% of the respondents evaluate their derivatives according to the profits they generate rather than by their effectiveness in reducing volatility or boosting risk-adjusted performance.

"If that finding holds up after further testing, it’s a bit disturbing," Bodnar said. "If companies are looking at derivatives as a way to boost profits, that practice is directly at odds with the basic principle of risk management, which is to pay to reduce your risk."

Several profit-motivated derivative plays, notably Procter & Gamble’s foray in the early 1990s, turned into high-profile "train wrecks" that resulted in large write-offs, Bodnar said.

Finally, the study’s findings indicate that companies not currently using derivatives may begin to gradually delve into the instruments. The researchers cited three main reasons to expect this increased acceptance: Company risk managers will likely become more comfortable with derivatives. Over time, the instruments will shake the stigma created by much-publicized derivative blow-ups. And, as volatility in the financial markets increases, companies will seek out ways to hedge their risks.

Bodnar said the fourth survey in the Wharton/CIBC series will likely come sometime in late 1999 or early 2000 and will be aimed at building on the stockpile of existing data while also exploring new avenues, particularly in the foreign-currency arena.