Why do companies use derivatives

Hedges help a company manage costs. Speculation may expose companies to devastating losses, and it may be dangerous. If a treasurer uses derivatives to exchange the fixed deutsche-mark interest rates of the bonds for a variable rate in U. If, however, the treasurer chooses not to hedge the fluctuating interest and currency rates that can affect the bonds, the investment is highly speculative.

In other words, when it comes to investing in long-term German government bonds, not using derivatives becomes a form of speculation.

A simple rule of thumb can help managers distinguish between hedging and speculation: employ derivatives to transfer risk, but never succumb to the temptation to trade in risk for its own sake. A simple forward contract in currencies will always end predictably. Never underwrite risk. Let the market underwrite it for you.

A simple rule can help managers distinguish hedging from speculation: employ derivatives to transfer risk, but never succumb to the temptation to trade in risk for its own sake.

To ensure that the financial staff will separate hedging from speculation, senior executives must first set clear and consistent expectations for managing risk. They must reinforce those expectations with unambiguous guidelines, including parameters for dealing with credit exposure, liquidity risk, and event risk. Senior management should require the financial staff to report on derivatives activities in a timely fashion.

And it should reward performance that consistently meets its expectations. A large unexpected gain is equally as troublesome as an unexpected loss. Perhaps most important, senior managers should provide the financial staff with the resources to meet those expectations. One critical resource is the software necessary to value all derivatives in-house: to price, track, and account for them. Derivatives are essential tools for companies participating in the global financial auction for assets and liabilities.

Companies that shun the use of derivatives hamper the ability of their financial staffs to provide basic services. Those that relax constraints without losing sight of fundamentals stand to reap significant rewards. For the last 15 years, he has specialized in derivatives-related issues for major corporations and dealers. How should CEOs respond when their chief financial officers propose that the company initiate or expand the use of financial derivatives?

However, before embracing that position and turning the financial staff loose, CEOs must analyze what an active derivatives program would mean to the company and how such a program could be controlled. Once authorized, trading in these instruments takes on a life of its own. Decisions to use derivatives are sometimes made in minutes or even seconds, and they may only involve a trader who alone understands the transaction. But the financial commitment may be large and long term.

Derivatives can be unforgiving. They require managers who will actively help develop and implement detailed instrument- and risk-specific board policies and who will strictly enforce compliance.

CEOs should recognize that derivatives are not merely another corporate strategy for managers and employees to implement. The presence of experienced trading personnel is a good start, but it may not be enough.

Derivatives offer a menu of hundreds of transaction variations. Even the more sophisticated corporate trading rooms master only a few types of transactions and instruments. Not long ago, an Indiana court in Brane v. Do not read too much into this: it does not mean that CEOs or boards must be aware of or understand the mechanics of each trade. However, their general duty of care requires that the boards be satisfied that management is adequate to implement board policy decisions.

And the CEO should ask senior managers to verify that training and software systems are up to the job. The CEO should play an active role in the formulation of derivatives policies. Top-level managers, not the financial staff or derivatives dealers, should make decisions about the purposes and limits of a derivatives program. Through the periodic review of the transaction portfolio and well-designed reports, the CEO can avoid unpleasant surprises of the sort experienced by Metallgesellschaft.

Adding insult to injury, some noted economists blame the shocked board for taking precipitous actions that turned paper losses into catastrophic actual losses. The starting point for any derivatives policy is a clear articulation of its purpose. Hedging is usually restricted to reducing exposure to a specified business risk and often involves a certain cost—for example, paying an option premium or foregoing a profit opportunity.

Risk management, substituting a new and potentially more favorable risk for an existing one, is a more flexible concept and generally less expensive. It can sometimes even turn a profit. However, while risk management can be good and prudent business, beware that it can also turn into speculation. Consider Drage v. Bankers Trust that the dealer concealed the potential for large losses.

Finally, a savvy CEO will want to know that the compensation plan in place for derivatives-related personnel is not subverting policy. Compensation must be adequate enough to attract and retain traders who are capable of analyzing complex instruments. However, a system that gives bonuses based on profits from hedging or risk management provides dangerous incentives. John T. Any CEO considering using derivatives needs to develop a sense of the accounting, disclosure, and control issues related to their use.

Unfortunately, the accounting rules are confusing because, at this time, no comprehensive accounting standard for derivatives exists. For example, it is not always clear when derivatives should be marked to market or when they qualify for accrual accounting or deferral accounting.

The rules vary depending on the instrument in question and what that instrument is used for. Needless to say, accounting conclusions on derivatives can differ. At this point, the best a company can do is to ensure that its accountants have a complete understanding of how different derivatives and activities should be treated and of which areas lack definition. While the accounting conventions are still evolving, the rules for disclosure are becoming clear.

For derivatives held or issued for trading purposes, corporations must disclose the average fair value during the reporting period and as of the end of period, and net gains or losses from trading activities. For derivatives held or issued for purposes other than trading, companies must disclose their objectives, their strategies for achieving those objectives, their recognition and measurement policies, and information about hedges of anticipated transactions.

For now, the new standard encourages, but does not mandate, disclosure of all quantitative information related to market risks. However, the disclosure requirements may get more rigorous over the next several years in response to demands from investors and regulators. The voluntary disclosures may become requirements. When it comes to control, CEOs should understand that people have different levels of experience and understanding about derivatives, different appetites for tolerating or taking risk, and different views on activities that constitute hedging.

In addition, certain characteristics of derivatives underscore the importance of having detailed policies approved at the highest levels of an organization. Derivatives include a wide variety of instruments, and some of them have features that can be both complex and difficult to understand. Their leverage and liquidity characteristics make them ideal not only for risk management but also for speculation. If a company uses derivatives for risk-management purposes, it may be difficult to gauge the ultimate effectiveness of the instruments until the positions are closed out and converted to cash.

Given these characteristics, CEOs must be very cautious about how they assign authority and responsibility. In many companies, this approach may be at odds with current trends toward increased delegation. However, given the complexity of and confusion about derivatives, CEOs should make a conscious decision about how much discretion managers should have in using derivatives.

In addition, the nature and the degree of the risks associated with derivatives requires that companies develop procedures for monitoring results. JCI is then left only with the floating-rate debt and has therefore managed to convert a variable-rate obligation into a fixed-rate obligation with the addition of a derivative. Note the annual report implies JCI has a perfect hedge : The variable-rate coupons JCI received exactly compensate for the company's variable-rate obligations.

Companies depending heavily on raw-material inputs or commodities are sensitive, sometimes significantly, to the price change of the inputs. Airlines, for example, consume lots of jet fuel. Historically, most airlines have given a great deal of consideration to hedging against crude-oil price increases.

Monsanto produces agricultural products, herbicides, and biotech-related products. It uses futures contracts to hedge against the price increase of soybean and corn inventory:. We have reviewed three of the most popular types of corporate hedging with derivatives. There are many other derivative uses, and new types are being invented.

For example, companies can hedge their weather risk to compensate them for the extra cost of an unexpectedly hot or cold season. The derivatives we have reviewed are not generally speculative for the company. They help to protect the company from unanticipated events: adverse foreign exchange or interest rate movements and unexpected increases in input costs.

The investor on the other side of the derivative transaction is the speculator. However, in no case are these derivatives free. Even if, for example, the company is surprised with a good-news event like a favorable interest rate move, the company because it had to pay for the derivatives receives less on a net basis than it would have without the hedge.

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