Derivatives have created a turmoil in the business community around the world because of the losses and bankruptcies it brought about in several well established Companies. The most famous one is the Barings Bank bankruptcy amounting to a loss of $1.3 billion perpetrated by just one trader. Procter & Gamble (P&G) lost $100 million to Bankers Trust (BT) through the exotic interest rate swap contract. P&G sued BT complaining that some of the risks involved on the swap had not been adequately disclosed by BT. BT answered that it should have been the responsibility of P&G to know the terms and condition of the contract before signing it. In the end P&G and BT settled with P&G paying BT about $35 million. Just very recently, Societe Generale incurred a $7.2 billion loss in January 2008 due to a rogue trader misusing futures contracts.
What are derivatives? What makes it risky? Or is it really that risky or is it just the parties abusing the features of it that makes the investment risky? One of the most distinguishing factor of derivatives compared to normal investments is that an upfront cash investments is not necessarilly needed. For example a forward or a swap contract don’t need an initial payment at the beginning. Or if an inital investment is needed, a very minimal amount of its notional value is sufficient, for example in the case of an option contract, a premium of just about 2% to 5% of its notional amount is what you need to shell out on day one. The value of the derivatives upon maturity depends upon the changes in the underlying index such as exchange rate, interest rate or equity index.
There are two typical uses of derivatives: hedging and speculation. One practical application of hedging is the use of foreign exchange forward contract to hedge foreign currency risk. For instance, you are expecting to receive a 100,000 foreign currency in 3 months time but don’t want to accept risk of losing the value of your 100,000 foreign currency when converted into a domestic currency. You can enter a forward exchange contract to fix the value of your foreign currency in domestic currency amount. In this way you have protected yourself from the foreign exchange rate exposures. Speculation comes in when you’re just betting with the changes in the foreign exchange rates by entering into a forward contract event if you’re not protecting any exposure like the hedging situation.
A derivative is also useful when a company wants to change the exposure of its fixed interest rate loan into a floating interest rate loan because of a decreasing interest rate outlook in the future. The company has two options. It can either terminate the old fixed interest rate loan and enter into a new floating rate loan or it can just enter into a receive fixed-pay floating interest rate swap. Terminating the old loan and obtaining a new one involves a substantial transaction cost which will not be incurred when an interest rate swap is used.
These are just the two most famous and practical applications of derivatives. In the past two decades, derivatives have gained popularity as a risk management tool in managing several market risks (e.g. interest rate risk, foreign currency risk, equity price risk, commodity price risk). The proper use of derivatives helps companies mitigate the impact of its exposures on market risks. However, the misuse of it can bring a very disastrous effect to a Company which may end up to huge losses or even bankruptcy just like what happened to Barings Bank.
Finally, I can compare a derivative into any other simple things around us which when used properly brings goodness but when abused, it stings! Can you think of a specific analogy?
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Tags: Derivatives, Investments
Thankyou for your insightful explanation of derivatives.
I am aware of another use for them as well. Since they require little up front outlay, they make a great gift to give to a friend or loved one on a special occaison.
You could give your sweetheart 1000 US$1million/Peso FX Futures contracts for a fraction of the cost of an expensive diamon necklace. Plus, once you have transferred the contracts into her name, any daily mark to market gain will be earned by her, so it will be like the gift that keeps on giving.
Of course, if you forecast unwisely, the contracts may lose money too, but heck, they are in her name now, so any losses are her problem.
That’s a brilliant idea Mr Advisor. However, you should keep in mind that if the contracts keep on losing it’s like giving “liability” present to your loved ones. They may not like it. Maybe you can give a losing derivative position deliberately as a gift to your enemy.
The one that usually initiates this abuse of derivative transactions are the banks. They’re the ones offering these to companies, which the latter by themselves are not usually aware of the risks or their actual exposure subject of the hedge.
Hey Mr. Wilson, your website is getting exciting huh? Keep ‘em coming!