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Derivatives have come under scrutiny in recent times, owing to the use of hedging

instruments by companies for financial mismanagement. The misuse of derivatives


has put many companies in the legal line of fire. The popular notion that derivatives
caused the downfall of companies like Enron, is however, not true. The derivatives
by themselves are not damaging. It is their misuse that can cause trouble for
businesses.

What are Derivatives?


Derivatives are financial arrangements by which your company earns profits based
on the functioning of an underlying asset.

If used properly, derivatives can store up your company's defense against many
economic problems.

Advantages of Derivatives
1. Flexibility

Derivatives can be used with respect to commodity price, interest, exchange rates,
and equity price. They can be used in many ways.

2. Risk Reduction

Derivatives can protect your business from huge losses. In fact, derivatives allow you
to cut down on non-essential risks.

3. Stable Economy

Derivatives have a stabilizing effect on the economy by reducing the number of


businesses that go under due to volatile market forces.

Disadvantages of Derivatives
If derivatives are misused, they can boomerang on the company.

1. Credit Risk

While derivatives cut down on the risks caused by a fluctuating market, they
increase credit risk. Even after minimizing the credit risk through collaterals, you still
face some risk from credit protection agencies.

2. Crimes

Derivatives have a high potential for misuse. They have been the caused the
downfall of many companies that used trade malpractices and fraud.

3. Interest Rates

Wrong forecasts can result in losses amounting to millions of dollars for large
companies. They can wipe out small businesses. You need to accurately forecast the
long term and short term interest rates. This is something that many businesses
cannot do.

Minimizing Risks with Derivatives


So how do you minimize the above-mentioned risks with derivatives? Here are some
suggestions.

1. Future Exchanges

Arrange the derivatives through future exchanges. You may need to put in a lot of
work here. You must keep track of all adjustments in the market worth of the
underlying asset.

2. Asset and Liability Driven Transactions

The transactions should be driven by asset and liability management. You should not
speculate based on future forecasts.

3. Derivative Policy

A good derivative policy focuses more on cost management and less on forecasting.
It should aim for cutting down expenses and costs.

Additional Help

While dabbling in derivatives is risky if you choose to speculate, derivatives can be


an important tool for financial structuring and cost management if you use them
correctly. If you do not know how to start investing in derivatives, you can consult a
small business advisor or financial consultant. Remember, if you do go for
derivatives, always play by the book and never try anything illegal.

HOW RISK CAN BE MANAGED USING


DERIVATIVE?

Over the past decade, the risks arising from organizations' use -- or, more typically, misuse -- of
hedging instruments such as futures and options have become all too clear. These tools played a
role in the bankruptcy of Orange County, Calif., in 1994 and Enron's 2001 implosion.
More recently, allegations have surfaced that mortgage giant Fannie Mae has improperly
accounted for its hedging activities.
Given these and similar events, it's reasonable to ask why any company would give derivatives a
second glance. But it would be a mistake to assume that the hedging instruments themselves
were the primary cause of the derivatives scandals. The reality is that Enron et al. either used
these tools inappropriately or accounted for them deceptively.
If they're used carefully -- and admittedly, that can be a big "if" -- hedging products and strategies
can help organizations reduce risk. "They're like a hammer," says Steven Mann, associate
professor of finance at Texas Christian University's Neeley School of Business in Fort Worth.
"You can either build a house or kill someone."
In fact, companies that shun derivatives may be exposing themselves to unnecessary risk. "There
are people that avoid [derivatives] to the peril of the company," notes Steven Braverman,
managing director with Tahoe Advisers LLC, a derivatives consulting firm in Englewood Cliffs,
N.J.
For some organizations, derivatives are indispensable. Consider the recent surge in energy
prices. Crude oil leapt from about $34 per barrel in January 2004 to $55 in late October. If they
didn't routinely hedge, businesses that purchase large amounts of fuel oil -- airline companies, for
example -- would have faced an enormous increase in their operating costs.
For the most part, corporations use hedges to protect themselves against a quartet of exposures:
swings in interest rates, commodity prices, foreign exchange rates and equity values. In addition,
businesses are increasingly hedging against credit risk -- exposures arising from a drop in the
value of another organization's corporate debt.
Companies can arrange hedges through futures exchanges such as the Chicago Mercantile
Exchange, but futures contracts involve considerable work because the parties must record any
changes in the market value of the underlying asset and settle any profit or loss on a daily basis.
(See Derivatives' Diversity sidebar.) The exchanges are used primarily by dealers and
professional traders, according to Charles Smithson, partner with Rutter Associates, an advisory
and education services firm in New York City.
Many companies prefer to use the over-the-counter (OTC) market, Smithson notes. To set up an
OTC hedge, a company contracts directly with a dealer. These transactions are usually
straightforward. "You describe what you want, and the dealer puts together the structure,"
Smithson says.

Creating a Hedging Policy


The key to effective hedging is to leverage derivatives in a disciplined manner in order to reduce
risk while ensuring that treasury managers resist the temptation to speculate on the direction of
markets and prices. "Transactions should be asset-and-liability-management driven, not based on
a view of the future," notes Robert Brooks, Ph.D., SouthTrust professor of financial management
at the University of Alabama in Tuscaloosa.
Companies that use derivatives need a comprehensive hedging policy. It should define the risks
that the organization will hedge against and the types and quantities of instruments it will buy;
specify the costs the company will incur to hedge; and identify the persons responsible for
executing transactions, monitoring the hedging program's performance and reporting it to the
board.
"People have to know what the rules are," says Bennet Koren, partner and head of the consumer
financial services group with law firm McGlinchey Stafford in New Orleans. "The stakes are too
high to have it any other way, in terms of potential losses."
When Southern Co., an Atlanta-based energy company, implemented a hedging program in 2001
to reduce its exposure to fluctuating energy prices, its senior management decided to establish a
risk control office, says Wayne Moore, director of regulatory affairs and energy policy. "That was
to ensure that a risk management policy was in place, along with risk limits, and [to specify] the
types of commodities and instruments" that the company would use, he reports. "If a transaction
is not in the policy and doesn't line up with business objectives, people can't enter into it," he
notes.
Southern's corporate governance board is responsible for approving its hedging policies. The risk
control office, which reports to the CFO, is responsible for implementing those policies and
independently measuring and monitoring the exposures that the company's business units
manage. This division of duties "ensures compliance with risk management and credit policies,"
Moore says.

A Structured Program
Dallas-based Southwest Airlines Co. is another organization that takes a consistent, disciplined
approach to its hedging activities. "We focus not on forecasting where prices are going but on
managing costs," says Laura Wright, senior vice president of finance and CFO. Most of the
company's hedges are geared toward smoothing volatility in its fuel costs, which constitute its
second-largest expense category behind salaries and benefits, according to Wright.
The goal of Wright and her colleagues is to hedge 50 percent of the company's exposure two
years out and to be 80 percent to 100 percent hedged during the current period. "It's a structured
program," she says. "We start early, establish a budget, build positions and layer them in."
Southwest's hedging program uses a combination of call options, fixed-price agreements and
collars. Call options give the company the right, but not the obligation, to buy a specified amount
of an underlying asset at a set price -- the strike price -- at a future time. If the market price of the
asset falls below the strike price, Southwest simply lets the option expire.
Fixed-price agreements are privately arranged hedges in which Southwest agrees to pay, at a
specified future date, the price stipulated in the contract for a future delivery of a commodity. If the
market price is higher than the contract price at settlement time, the counterparty pays the
difference. If the market price is lower than the contract price at settlement, Southwest incurs that
additional expense. "There are no dollars up front, and you're protected from upward price
increases," Wright says.
Collars are options that incorporate a price floor as well as a price cap. Say the parties agree that
the collar's floor will be $30 and its limit $35. If the average daily price of the underlying
commodity during the life of the hedge exceeds $35, the counterparty pays Southwest the
difference between the average price and the $35 strike price. If the average price is below $30,
Southwest pays the counterparty the difference. If the average price comes in between $30 and
$35, both parties walk away with nothing.

In-House or Outsourced?
Organizations looking to implement a hedging program often face staffing challenges. Many
treasury departments are already struggling to meet all of their responsibilities, and they may lack
the time needed to get up to speed on derivatives.
Companies can turn to third-party providers, such as investment banks. But Brooks advises
against that move. "It may be wise to listen to a cardiologist, but it's not wise to listen to an
investment banker regarding hedging risk," he says. One reason some outsourced hedging
programs fall short is that they are sold, rather than bought, he notes. The banker may have an
incentive to sell you a more complicated product than you need because it comes with a bigger
fee.
Because the market is disjointed, various financial institutions offer very similar products at
different prices, according to Som Dasgupta, head equity trader with PNC Capital Markets in
Pittsburgh. Choosing a provider without carefully investigating a range of offerings can be a costly
mistake -- to the tune of six or seven figures even on a single hedge. Brooks notes that "it doesn't
take very long to accumulate losses due to inappropriate hedging activities or noncompetitive
pricing." Before signing any outsourcing contract, companies should seriously consider adding a
derivatives manager to their treasury staff.
Treasurers that decide to outsource their department's hedging function must understand their
company's risks and the options available for mitigating them. Matt McLaughlin, president of
consulting firm Midstream Partners LLC in Bedford, Texas, says treasury executives should ask
themselves these key questions: "What are you trying to protect -- cash flow? [In] what manner?
For what time period? When? What are you going to hedge it with? What will it cost?" Only after
they have answered these questions should treasurers meet with investment banks to obtain
competitive bids on hedging services.

FAS 133
Many companies with in-house hedging programs have seen big increases in their workload
since 1998, when the Financial Accounting Standards Board issued FAS 133 ("Accounting for
Derivative Instruments and Hedging Activities"). This standard is intended to remedy the abuses
that dogged derivatives in the 1990s and to provide more visibility into hedging transactions.
While many in the industry agree there's a need for greater transparency, the recordkeeping
requirements generated by the rule have created massive amounts of work for treasurers and
corporate accoun-tants. The sheer volume of the standard -- it spans several hundred pages --
makes it confusing to follow and arduous to adhere to. "If you call three people, you'll get four
opinions" about the rule's requirements, says David Scheidt, partner with Decision Analytics, an
investment advisory firm in San Francisco.
An organization's accounting and auditing staffs typically have responsibility for valuing its
hedging instruments and activities under FAS 133, but treasurers need a basic understanding of
the rule. Otherwise, their hedges may fail to qualify for hedge accounting. That might mean that
the gain or loss on the hedging instrument ends up being reported in a different time period from
the one in which the gain or loss on the hedged item is reported, "fostering a higher degree of
volatility than would be the case if the two effects were realized concurrently," according to Ira
Kawaller, president of Kawaller & Co. LLC, a risk consultancy in Brooklyn, New York.
FAS 133 requires organizations to show that their hedging transactions are "effective" -- that is,
they do in fact offset the risk they're intended to hedge. In general, the derivative should offset the
exposure by at least 80 percent, says Steve Kuhl, vice president of risk solutions with London-
based Travelex, a foreign exchange services provider. The portion of the derivative's gain or loss
that covers the exposure is called its "effective portion." Any part of the instrument's gain or loss
that fails to offset the exposure is its "ineffective portion."
FAS 133 permits three approaches to valuing derivatives. The first applies to fair value hedges --
that is, those designed to mitigate exposure to a change in the fair value of an asset or liability
that's already on the organization's balance sheet. Companies must recognize the gain or loss on
the hedging instrument in earnings in the same period in which they recognize the offsetting gain
or loss on the hedged item.
The second valuation method applies to cash flow hedges -- derivatives intended to mitigate
exposure to variation in the cash flows of a future transaction. This category includes, for
example, some types of futures contracts intended to hedge against a rise in a commodity's price.
At the end of the accounting period, the effective portion of the derivative's gain or loss is reported
within other comprehensive income, and the ineffective portion is reported in earnings. When the
hedged transaction occurs and affects earnings, the effective portion of the hedge is reclassified
into earnings.
The third method covers hedges intended to mitigate risks arising from various transactions
involving foreign currencies. The gain or loss on the derivative is reported in other comprehensive
income. After that, the treatment varies, depending on the type of exposure the hedge is intended
to protect against.

The Future of Hedging


Despite the complexities of FAS 133, companies are increasing their use of sophisticated
hedging tools such as credit derivatives -- agreements that transfer credit risk from one party to
the other for a fee. For example, if a manufacturer holds debt in a wholesaler, it may pay a
counterparty to take on the risk that the wholesaler will default. During the first half of 2004, credit
derivatives' notional amount -- the value of their underlying instruments -- grew 44 percent to $5.4
trillion worldwide, according to a survey by the International Swaps and Derivatives Association in
New York City.
Down the road, treasurers may find themselves hedging against an even broader range of risks
than they do now. "We're still in the beginning of hedging," says Robert Shiller, professor of
economics at Yale University and author of "The New Financial Order: Risk in the 21st Century"
(Princeton University Press, 2003).
Shiller predicts that companies eventually will be able to hedge against fluctuations in home
prices. This would be a boon to businesses whose performance is tied to the housing market,
such as homebuilders and mortgage companies. He has been working for several years to
introduce home-price hedging instruments to the markets, and he has registered one such
derivative with the SEC.
Whatever the exposures they need to hedge or the instruments they decide to use, companies
must keep a clear focus on the basics: managing risk, staying disciplined, and keeping their
hedging transactions as simple and cost-effective as possible. "The key is a systematic program,"
says Southwest Airlines' Wright. "That means setting prices and targets that fit in your cost
structure and then staying with it."

Derivatives' Diversity
Derivatives are financial securities that derive their value from the worth and characteristics of
another security -- for example, a stock or currency -- or a physical asset such as a commodity.
Key categories of derivatives include the following:

• Forwards. In a forward contract, one party agrees to sell to the other a specific quantity of
a commodity, foreign currency or financial instrument at a specified price at a given date
in the future. Because the contract is not settled until it matures, each party takes on the
risk that the other might default.
• Futures. Like forwards, futures contracts call for future delivery of an underlying asset at a
stipulated price. Unlike forwards, however, futures are traded on an exchange. The terms
of the contract -- for example, the date and location of delivery -- are standardized.
Futures contracts are "marked to market" on a daily basis -- that is, the parties record any
change in the price of the underlying asset and settle their margin accounts accordingly.
This eliminates the credit risk inherent in forwards.
• Swaps. These privately negotiated contracts are similar to forwards in that their
characteristics, such as delivery arrangements and credit procedures, are determined by
the contracting parties. They differ from forwards in that the parties also agree to settle
their accounts on a regular basis -- for example, every couple of months.
• Options. An option is a contract that gives its holder the right, but not the obligation, to buy
or sell a specified amount of an underlying asset at a set price, called the strike price.

Southwest Airlines Co. uses call options, among other hedging instruments, to hedge against
changes in fuel prices, says Laura Wright, senior vice president of finance and CFO. By
purchasing call options, the company secures its future supply of fuel at a price specified today. If
crude oil prices rise, Southwest still can purchase oil at the strike price. If oil prices fall below the
strike price, Southwest simply lets the option expire. "We're just out the premium," Wright says