Derivatives Revisited

erivatives debacles have provided some of the past decade’s most devastating financial headlines. Names such as Long Term Capital Management, Orange County and Baring Brothers bring to mind situations where derivatives failed—often miserably (see exhibit 1, below, for details). Several losses were enormous—an estimated $2 billion for Orange County and $4 billion for Long Term Capital. Other incidents resulted in highly publicized lawsuits between derivatives buyers and sellers, such as Procter & Gamble’s lengthy dispute with Bankers Trust.

The causes of these losses varied. Among those frequently cited were traders working without adequate supervision, pricing models that failed to account for extreme market movements and market illiquidity. Although derivatives abuses have been absent from the headlines lately, some incidents still make news, such as Sweden’s Electrolux AB’s 1999 loss of more than 55 million German marks (approximately $28 million) due to an employee’s unauthorized futures trading.

Given the negative publicity that derivatives—instruments that derive their value from another financial instrument or commodity such as interest rates, stock prices or precious metals—received in the 1990s, a casual observer might have predicted that corporations would cut back on their use of these instruments. But that hasn’t happened. The Association of Financial Professionals (AFP) 1999 member survey found that 63% of the respondents used over-the-counter (OTC) derivatives. (Exhibit 2 explains some of the key differences between OTC and exchange-traded derivatives.) Among companies with annual sales over $500 million, reported usage was even higher, at 78%.

Global derivatives activity also continues to expand. The Bank for International Settlement in Basle, Switzerland, reported an $81.5 trillion notional amount (see the glossary) of OTC derivatives outstanding at the end of June 1999, up from $72 trillion in June 1998, as shown on exhibit 3. Exchange-traded contract volumes around the world have grown dramatically, almost tripling from 1990 through late 1999, as illustrated in exhibit 4.

As CPAs and financial managers know, handling derivatives can be difficult for any company. Having a clear understanding of what you’re doing with derivatives and why certainly can help, as the sidebar, “Dealing With Derivatives,” explains. It’s also important for CPAs to understand the changes in how derivatives are bought, sold and managed as a result of the last decade’s problems. This article offers the views of some industry insiders on what those changes are and what they mean for the future of derivatives use.

PROBLEMS UNCOVERED

Despite continued growth, much of the 1990s was a difficult time for derivatives. “Many of the companies we spoke to in 1994 wanted to send this message publicly: ‘We don’t use derivatives,’” says James J. Vinci, CPA, co-head of the PricewaterhouseCoopers financial risk management practices for the Americas region. “They needed to manage the public perception based on what the media was reporting. Some of the things companies did with derivatives in the mid-1990s were speculative. Today there is much better understanding of what is a speculative vs. a nonspeculative use. As a result, I believe there is less speculation going on.”

Exhibit 3: Global OTC Derivatives Market

National amounts outstanding in trillions of U.S. dollars Source: Bank for International Settlement, Basle, Switzerland. Copyright 1999.

Exhibit 4: Global Exchange Traded Contract Volumes

Trading Volume (Number of Contracts) *Through November Source: Derivatives: Valuable Tool or Wild Beast? by Brian Kettell. Copyright 1999 by Global Treasury News ( www.gtnews.com ). Reprinted with permission.

Those interviewed for this article agreed unanimously that the well-publicized problems led to changes in the derivatives industry. “In some high-profile cases in the early 1990s, companies lacked a full understanding of the benefits, risks and consequences of their derivatives activities,” says Robert Walsh, CPA, partner in charge of capital markets and treasury services for global financial services industries at Deloitte & Touche in New York City.

Walsh believes derivatives users today better understand the nature of their funding and risk management activities and focus on them more. “Users have more insight today, a much higher level of awareness. That insight dampens some of the excesses that gave the market a black eye several years ago. Derivatives’ complexity continues to increase, but people are paying better attention and have more information than they did four years ago.” As an example of this better understanding, Walsh points to the widespread use of stress testing, a technique that allows users to examine a derivative’s behavior under extreme market conditions.

Despite the headlines, the vast majority of derivatives transactions in the 1990s were problem-free. “We’ve seen remarkably few train wrecks relative to other financial markets,” says Tanya Styblo Beder, a managing director with Caxton Corp., a $2.2 billion hedge fund in New York City. Beder, who also serves as chairwoman of the International Association of Financial Engineers, points to the market’s growth as proof the industry successfully weathered the high-profile incidents. “Perceived problems raise people’s awareness and remind them to look at all the things they should have. If anything, the derivatives market’s growth has continued,” she says.

Derivatives users also seem satisfied with the market’s status. Among the AFP survey respondents, 89% reported satisfactory relationships with their OTC derivatives dealers. No survey respondent experienced a default with a contract counterparty.

USING DERIVATIVES TO HEDGE RISK

As Vinci points out, most businesses do not speculate with their derivatives positions. According to the AFP, most users—more than two-thirds—entered contracts for hedging/risk management and in conjunction with plans to obtain funding. The risks that users cited most frequently included interest rates (increased cost of funds), foreign exchange rates (unfavorable currency movements) and commodities (increased cost of materials or lower selling prices).

Martin Trueb, treasurer of Hasbro Inc. in Pawtucket, Rhode Island, says his company’s derivatives use focuses almost exclusively on managing foreign exchange risk. “Simply put, our goal is to improve the predictability of annual costs,” he says. “Our product and pricing cycles are such that we have to set our prices at the beginning of the year even though we don’t receive products until the end of the year. We have to live through the year with the prices we’ve set.”

Hasbro affiliates buy products that are billed in U.S. and Hong Kong dollars, which means the company has local currency revenue but foreign currency costs. “Our real goal in using derivatives is to protect the local currency margin,” Trueb says. “If you set your price in January in euros and the euro weakens against the dollar, your product costs go up tremendously. We try to lock in as much of that cost as early as possible so management can set prices and be comfortable those prices are adequate to deliver the promised profits.”

Edward Arditte, vice-president and treasurer of Textron Inc. in Providence, Rhode Island, focuses on two primary risks in his company’s hedging activities. “To us, financial risk management is oriented toward two exposures: interest rate and currency,” Arditte points out. “The currency exposures come from our day-to-day operations. As a general rule, we deal with roughly 20 currencies. Most of our exposure is in three: the euro, Canadian dollars and British pounds sterling, which account for 90% or more of our exposure.”

Arditte says his division is responsible for working with Textron’s business units to help them identify their risk exposures and then hedge them as part of the management process. “We are not a profit center that looks to make money on movements in the currency markets. Instead, we focus on risk identification and minimization via hedging.”

As a result of the last decade’s lessons on the risks of complex derivatives, most corporations typically use simpler contracts today. To hedge foreign exchange exposures, users most frequently turn to OTC forwards, swaps and options in that order, but to manage interest rate risk, they prefer swaps, options and forwards, respectively. “The lion’s share of users tend to be plain vanilla—the standard interest rate swap is still the instrument companies use most pervasively,” says Ira Kawaller, PhD, founder of consulting firm Kawaller & Co. LLC in Brooklyn, New York. “What’s misleading is that the trade press tends to cover the latest bell-and-whistle innovations—you see a lot written on exotic derivatives. But that’s a small population of users. For example, the use of credit derivatives (an OTC instrument that derives its value from the price of a credit instrument) is growing very rapidly, but it’s still inconsequential compared with the volume of plain swaps.”

THE NEED FOR TIGHTER CONTROLS

Another important outcome of the past is increased internal control over derivatives-related activities. “Back in the mid-1990s, boards of directors and senior managements became alarmed by what had happened in their own organizations or more likely what they had read in the newspapers,” says Richard Singer, a director in KPMG’s capital markets consulting group in New York City. “They began to do due diligence on their own companies’ derivatives activities.” Singer notes that companies realized they could not simply abandon derivatives—the instruments had become a key risk management tool. “Rather than throwing up their arms and ending the use of derivatives, they took serious prophylactic measures (described below) to minimize the risks.”

In describing these measures Singer points to two organizational developments that many companies adopted following the disasters of 1994 and 1995. The first was the creation of a “middle office,” found primarily in financial institutions. This department reviews derivatives transactions before trades are placed to ensure policy compliance.

The second that other companies—including many nonfinancial businesses—established were risk management units, each with an appointed risk manager. “These groups tend to be made up of both businesspeople and staff with strong quantitative skills,” Singer observes. “They monitor the risks associated with their companies’ derivatives transactions, testing to be sure positions are within the limits set by their corporate boards and senior managements and to make sure hedge positions are doing the job within hedging programs.” In addition to their monitoring role, these groups also advise managements on how derivatives affect the organizations’ overall liquidity and on the adequacy of their hedging structures.

Whatever organizational structure a company uses, it’s critical to monitor derivative trades and positions constantly. The sidebar “Managing Operational Risk,” lists some steps CPAs can take to help their employers keep track of derivatives activity. Textron’s Edward Arditte says his company has “tight controls for delegation of authority. The banks we work with have documentation from us that restricts who can execute trades and limits how much they can execute. In addition to the traditional financial controls, we have reporting processes that are both internal and system-based. By generating regular reports and by having to account for this activity on our books, all of us pay attention to it on a regular basis.”

The problems of the past also led derivatives dealers to modify their sales practices. “When the market got a black eye, it wasn’t good for the sell side,” says Deloitte’s Walsh. “Those kinds of events are bad for business. There have been a number of industry-led or government-encouraged initiatives to establish more appropriate standards of behavior. The last crisis on the sell side was Long Term Capital, which raised concern about systemic risk and inappropriate leverage. The industry came together—clearly encouraged by government—looked at the issues, came up with recommendations and is implementing them. As a result we’ll have better transparency, more information and fewer surprises.” (See exhibit 5, below, for key recommendations from Sound Practices for Banks’ Interactions with Highly Leveraged Institutions. )

Leslie Rahl, president of New York-based consulting firm Capital Markets Risk Advisors, Inc., also points to lessons that sellers gleaned from the 1990s. “Sellers learned about the need for suitability and communications standards with end-user clients,” she says. “Now there are much stricter standards within institutions as to what is an appropriate level of client communication. There are also processes for making sure that someone at a level more senior than the individual who is executing a complex trade is aware of and approves the trade.”

Some observers believe FASB Statement no. 133, Accounting for Derivative Instruments and Hedging Activities, will further improve the derivatives control process. “Statement no. 133 will—in the long haul—add to the trend of greater insight, attention and awareness of what people are trying to accomplish,” says Walsh. “There will be a lot of implementation challenges, but now that companies are focused on the standard, they are talking about new processes, new technology and revised hedging strategies. Wall Street also is focused on the statement and is looking at new strategies and products to help companies meet their hedging objectives. The focus needed to achieve hedge accounting under the new standard is going to be a higher level of understanding than under the old standards.”

FASB issued Statement no. 133 in mid-1998, but its implementation date was postponed. Companies must apply it to the first quarter of the first fiscal year beginning after June 15, 2000. This means a company with a fiscal year ending on June 30 must apply Statement no. 133 beginning July 1, 2000. A calendar-year company would apply the statement beginning January 1, 2001. While some companies elected early application, most generally did not.

LOOKING AHEAD

The market’s growth confirms derivatives’ position as an entrenched financial management tool. Although some users inevitably may experience problems similar to those of the past, better understanding and tighter controls on both buyers’ and sellers’ activities should reduce the number of disasters. Walsh points to recent activity in the market for electricity derivatives as proof the market has matured.

“Consider,” Walsh says, “today’s market for electricity derivatives. While they are not broadly traded, the majority of utilities use them. If you look at each of the last two summers, we had tremendous volatility in that market.” The spot market for electricity, Walsh says, went to extreme levels because warm weather drove up electricity prices due to capacity shortages in the system. Companies that had planned on relatively stable prices were forced to pay more when the derivatives contracts settled.

What was the final result? “There were a few high-profile losses, which the industry focused on and responded to. People lost money, but the events came and went without the fanfare of four years ago. I attribute that to the fact that people are more aware of how to use these tools, so we have fewer surprises.”