FINANCIAL MARKETS

Using Derivatives: What Senior

Managers Must Know
by David Weinberger, Peter Tufano, Cheryl Francis, Arvind Sodhani, David Yeres, John T. Smith,
Paul J. Isaac, and Brandon Becker
FROM THE JANUARY–FEBRUARY 1995 ISSUE

What Senior Managers Must Know

It is difficult to pick up a newspaper these days without seeing another article about a major
company that has taken an unexpected financial loss due to derivatives transactions gone
awry.

The use of derivatives—a broad term referring to such diverse instruments as futures, swaps,
and options—has become increasingly popular in recent years as corporations look for new
and better ways to manage financial and operating risks. The high-profile losses of Procter &
Gamble, Metallgesellschaft, and other companies are sending an important signal to senior
managers: Financial decisions that were previously designed and implemented by specialists
need to be monitored more closely from the very top of organizations.

In “A Framework for Risk Management” (November–December 1994), authors Kenneth A.

Froot, David S. Scharfstein, and Jeremy C. Stein presented a guide for helping managers
develop a coherent risk-management strategy. This issue’s Perspectives section opens up the
discussion on derivatives to a group of experts—a derivatives marketer, a finance professor,
two corporate treasurers, an attorney, an accountant, an investor, and a regulator.

What do senior executives need to understand about derivatives and how they work?
Recognizing that most day-to-day decisions involving derivatives will remain within the
jurisdiction of corporate financial staffs, what kind of specialized training and control systems
should companies be prepared to put in place? How should CEOs think about disclosure of
their derivatives positions to shareholders and directors?

Eight experts comment on what every top-level manager needs to know about using
derivatives.

What does every top-level manager need to know about using derivatives?

David B. Weinberger is a managing director of Swiss Bank Corporation in the capital markets
and treasury area and a general partner of O’Connor Partners in Chicago, Illinois. He has been
involved in trading, quantitative research, and product development in the securities
industry for nearly 20 years.

Derivatives is a misleading keyword for the discussion at hand. It raises the ugly specter of
Tuesday night calculus homework and, more important, it suggests that these instruments
represent a fundamental asset class like real estate, which they don’t. Derivative instruments
is a much better term. However, this discussion shouldn’t be about derivative instruments
per se but about risk management. Derivative instruments are no more than tactical tools—
albeit very valuable ones—for implementing risk-management strategies.

Every business needs to expose itself to risks in order to seek profit. But there are some risks
that a company is in business to take and others that it is not. Consider the case of an airline
that has an opportunity to buy the rights to serve a new route from Chicago to London. The
expected return-on-equity might be about 25%, but the chance of an outright loss might be
35%. This is the type of risk the airline is in business to take, even if the fear of losing money
keeps its executives awake at night. However, top management might be able to reshape the
risk by selling an investor an option on a share of the profits from the route. The additional
income from the sale of the option might be enough to lower the probability of outright loss
to, say, 10%, while the expected return-on-equity might fall to only 20%.

Some examples of risks that most companies are not in business to take are exposures to
fluctuations in short- or long-term interest rates, currency exchange rates, oil prices, or equity
market levels that affect stock price and hence financing opportunities. Returning to the
airline example, there is an obvious risk associated with the income from the London route
due to fluctuations in the dollar/sterling exchange rate. The airline is in business to try to
profit from flying to London, so it makes sense to expose itself to the risk of uncertain
demand for seats on the route. However, its goal is not to try to profit from exchange rates, so
it should probably minimize its exposure to dollar/sterling fluctuations. By managing
financial risks well, companies can improve their flexibility and adaptability in managing the
other sorts of business risks that can’t be avoided. A risk-management program should reduce
a company’s exposure to the classes of risk it is not in business to take while reshaping its
exposure to those it is.

Of course, a company also faces indirect and more subtle financial risks. For example, what
will happen to the value of its real estate if real long-term interest rates increase significantly?
Or, even if the company doesn’t operate in Germany, how might a change in the dollar/mark
exchange rate affect the pricing flexibility of the competition and hence the company’s
profits? And often overlooked are risks that don’t appear on the books but are just as real as
those that do—for example, the expected present value of the Mexican warehouse facility
(exposed to both dollar/peso and interest-rate fluctuations) that the company may need to
build within the next few years. As Froot, Scharfstein, and Stein argue, a company’s ability to
take full advantage of business opportunities increases as it learns to anticipate and manage
its exposure to a wide variety of risks.
Obviously, no CEO can be expected to manage all the details of a company’s risk-management
program. But it is the CEO’s responsibility to ensure that the process that is in place is well
thought-out and complete. The first step in designing a risk-management strategy is to
identify the full scope of risks the business is exposed to and to understand the parameters
(such as exchange rates) that drive the exposures. Companies should then establish a sensible
risk-management program based on the following steps:

Quantify the various exposures. For example, the airline can estimate the relationship
between income on the London route and the dollar/sterling exchange rate (which involves
changing demand as well as currency translation). Ranges and relative probabilities should be
used rather than single value estimates. Well-reasoned quantification, despite its
imperfections, will be surprisingly powerful.

Aggregate all exposures to the same underlying parameter even though they may come from
different aspects of the business. In this way, a company can net out internally as much
exposure as possible without having to create hedging transactions externally.

Select the appropriate financial instruments to offset the risks. Management should bear in
mind that by using derivative instruments (as is often necessary), a company is not creating
new exposures to outside parameters but adjusting exposures it already has.

Lay out the anticipated performance of the various instruments as a function of the outside
parameters, and create a system for monitoring that performance. Unanticipated positive
performance is as dangerous as unanticipated negative performance—both indicate that some
aspect of the hedge has not been properly understood. Profit or loss on the derivative
instruments themselves is not relevant. The issue that matters is the total performance of the
hedging instruments plus the underlying exposures.

The CEO must be constantly mindful that the activities I have described are not designed to
increase expected profits (at least in the short term) but rather to adjust exposures (and hence
position the company to increase profits and value over the long term). Seeking additional
profits directly from using these instruments may or may not be appropriate for a particular
company’s situation, but it is a completely different objective that needs to be managed
separately and differently. Recent headlines about derivatives losses seem to refer, for the
most part, to cases in which management lost sight of this distinction.

In today’s complex world, financial risk management is not just a theoretical nicety; it is a
practical necessity. Derivative instruments can help companies manage their risks with
maximum efficiency. And used properly, derivative instruments don’t create surprises. They
help minimize them.

Financial risk management is not just a

theoretical nicety; it is a practical necessity.
Used properly, derivative instruments don’t
create surprises; they help minimize them.
Peter Tufano is an associate professor at the Harvard Business School in Boston,
Massachusetts. His research focuses on the corporate use of modern financial technology.

Recently, a director of a well-known U.S. consumer-products corporation went out of his way
to defend one of the company’s financial transactions: “We just bought puts to hedge our
foreign currency risk, but we’re not involved with derivatives!” My well-meaning
acquaintance was attempting to distance himself and his organization from the “d” word,
despite the fact that options are in fact derivatives—contracts whose value depends on an
underlying asset or process. This story illustrates a general misunderstanding of derivatives,
but it has a more optimistic interpretation as well: My acquaintance was trying to understand
the function served by his company’s options. He focused not on the derivative products but
on the needs they served.
If we look closely, derivatives are deeply embedded in the operations of modern
corporations; some companies have even recognized that financial technologies can support
new strategic choices. Derivatives are finance’s version of computers. Computing technology
can be found not only in system units, keyboards, and monitors but also buried inside
telephones, vehicles, and industrial machines. More important, it allows companies to engage
in just-in-time production, carry out direct-marketing programs, and provide customers with
timely, valuable information. Computing technology must be understood within the context
of the strategic opportunities it affords companies; for some, it is an integral tool of
competitive strategy.

Like computers, derivatives—the product of financial technology—are widespread in

corporations. Derivatives can be found not only in exotic turbo swaps but also embedded
within ordinary security offerings, supply agreements, price lists, compensation packages,
and customer warranties. For example, when a U.S. company’s French salesforce quotes fixed
prices in francs for goods to be delivered next June, that company is bundling a foreign-
exchange derivative with its product. Today financial engineering provides companies with
more latitude than ever before in using derivatives to advance their strategic goals.

Business strategists have urged companies to differentiate their products to sustain higher
prices. In pursuit of this goal, modern financial technology can be an ally. In New England, for
example, the retail market for oil burners is highly competitive. To differentiate their
products, sellers occasionally offer promotional gimmicks or service contracts. Some
companies have bundled oil burners with fuel supply agreements that cap the homeowners’
cost of heating oil. In essence, these contracts redefine the product: from a metal box that
burns oil to energy at a known cost. In turn, this new product can support an entirely
different marketing strategy: “Heat your house for under $x per year!” Whether this strategy
is prudent for a particular company depends on marketing and competitive considerations
and how much the company must pay to manage its risk, but it is the derivative contracts that
give marketers new flexibility.
Strategists have also advised companies competing in commodity industries to become low-
cost producers. The search for lower costs often compels companies to find more efficient
means of production, distribution, and sales—and financial engineering can help here too. For
example, suppose a company finds a high-quality, low-cost supplier abroad, but neither the
company nor the potential partner is willing to bear exchange-rate risk. By using foreign-
exchange contracts, the company can separate sourcing decisions from their currency
implications. Alternatively, suppose a company wants to sell surplus real estate but seeks to
avoid or defer the large transaction costs and capital gains taxes. The company could enter
into real-estate swaps—the practice of exchanging returns on real estate for predesignated
market rates—thereby permitting it to exit from real estate investments without incurring the
same level of current costs.

In these examples, marketing, sourcing, and divestiture decisions are an integral part of a
broad strategic plan. The financial staff, working in concert with others in the organization,
offers companies new or lower-cost alternatives using new financial technologies. While the
financial staff may advise on and implement derivative transactions, the goals the company is
trying to achieve with those transactions are set by top management, much as computing
needs should be determined by users. Without effective and broad input on the use of
technologies, companies risk buying more computers primarily to satisfy technocrats or more
derivatives primarily to let treasurers bet on interest rates or currencies.

I do not mean to downplay the critical and valuable role played by financial staffs. Energy
derivatives, foreign-exchange derivatives, and real-estate swaps are all complicated
transactions, and if not managed correctly, they can create bigger problems than the ones
they purport to solve. Just as most CEOs and computer users are unlikely to master all the
technical points of computing and networking technologies, so neophytes cannot be
expected to be competent enough to manage the nuances of financial technology.

However, it is equally unreasonable to expect that technically trained financial experts will
master the nuances of competitive strategy. Top-level managers who wish to use the new
financial technology to their best advantage will need a working understanding of their
potential strategic uses, a highly trained financial staff to provide advice and execution, and
cross-functional collaboration that persistently focuses on the advancement of strategic
goals. The current debate over the corporate use of derivatives is misplaced and needs to be
put back on track by focusing on the strategic opportunities afforded by derivatives. Just as
senior executives worry about financial losses due to the improper or unauthorized use of
derivatives, so they must turn their attention to the real losses created by their failure to
exploit the new financial technologies.

The current debate over the corporate use

of derivatives needs to be put back on track
by focusing on the strategic opportunities
afforded by derivatives.
Cheryl Francis is the treasurer of FMC Corporation, a manufacturer of chemicals, machinery,
and defense systems headquartered in Chicago, Illinois. She was formerly CFO of the
company’s gold-mining subsidiary.

Corporations manage risk in a variety of ways: through insurance, letters of credit, the
structuring of joint ventures, and the use of derivatives. It’s up to a company’s CEO and board
of directors to determine to what extent the company uses derivatives to manage risk. One
common strategy is to authorize hedging for the purpose of protecting all of the company’s
known exposures. For example, many companies think little of pricing sales to a foreign
customer in the local currency and then hedging that exposure in the financial markets. Some
companies go farther and also hedge anticipated exposures, such as a percentage of expected
sales to long-standing overseas customers. These approaches, however, are a far cry from
speculation in the derivatives markets.

Once a company decides to manage certain risks in the derivatives markets, senior
management and the board should establish specific guidelines for how managers using
derivatives should operate. To avoid debilitating financial losses, this policy should be fully
explained and strictly enforced.

A company must initially define which kinds of derivatives it should use. The derivative
products a business selects should be appropriate for the particular exposure it is protecting.
For liquidity, companies should stick with standard products. Beyond that, they should avoid
leveraging positions, which will magnify risk; using multifaceted products, which can change
in unexpected ways; or using products that are not directly related to the risk. For example,
using diesel-fuel futures to hedge a natural-gas exposure may seem safe in view of the long
history of the relationship between the two fuels, but in a dynamic market that relationship
could break down.

Once a company has specified the appropriate derivatives, it must spell out clearly the lines of
decision-making authority. FMC requires progressively higher levels of management sign-off
based on the size of the transaction. For example, any anticipatory hedges in excess of $10
million require the approval of the treasurer as well as the appropriate group’s operating vice
president; anticipatory hedges of more than $20 million require the approval of the CFO.
Transactions of long duration and those in nontraditional or illiquid markets require still
higher levels of sign-off.

Another point to keep in mind is that companies using derivatives run the risk that the
institution they are dealing with won’t be able to live up to its commitments. For this reason,
companies should have rules limiting the amount of total exposures to any one institution
based on its credit rating.

One of the keys to using derivatives properly is education and training. Of course, companies
must pay close attention to the hiring and training of the traders and other individuals who
will be handling their derivatives activity. But education and training about the use of
derivatives must extend farther into the management ranks of the business. For a company to
manage its exposures effectively, it must first know that it has them. To that end, the
company must educate managers to identify risks and communicate them. At FMC, we spend
a lot of time training managers all over the world about hedging practices and the objectives
of our risk-management program. These managers work not only in finance but also in sales,
marketing, and purchasing. Our approach is based on the philosophy that these managers,
interacting with customers and suppliers, should first identify FMC’s exposures.

Using Derivatives: What Senior Managers Must Know

One final critical step remains once a company has done everything it can to establish the best
policies possible and to communicate its expectations: it must develop effective ways to
monitor its derivatives positions. The computer systems available today at reasonable prices
are particularly effective and are becoming increasingly powerful with time. For example, the
treasurer’s office at FMC can use its own computers to track price information on every
derivative in use and every transaction undertaken in real time. We mark our portfolio to
market daily. Our computer systems can generate three standard reports at any time: the first
report shows the activity (the size and the number of transactions); the second shows the size
of the exposures (the net portfolio held at any given time); and the third shows how FMC’s
various hedging instruments match up in terms of their maturities. The treasurer’s office can
also conduct sensitivity analyses of market changes—for example, an analysis of what will
happen if the price of gold falls by $50 per ounce.

The importance of effective monitoring systems cannot be underestimated. Unless CEOs are
prepared to invest in excellent monitoring systems, they should think twice about using
derivatives.

Arvind Sodhani is vice president and treasurer of Intel Corporation in Santa Clara, California,
which uses derivatives extensively.

Derivatives are simply the building blocks of financial instruments—and whether they are
destructive or beneficial depends on context. Companies can employ derivatives to construct
a hedge or to speculate. Hedges help a company manage costs. Speculation may expose
companies to devastating losses, and it may be dangerous.
Consider an investment that would meet the credit requirements of any treasurer’s charter:
long-term German government bonds. If a treasurer uses derivatives to exchange the fixed
deutsche-mark interest rates of the bonds for a variable rate in U.S. dollars—a cross-currency
interest-rate swap—the investment is floating rate, U.S.-dollar-based, and nonspeculative. 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. But when
you sell an option on a currency that you don’t own and look to make a profit, you underwrite
risk. If the gamble doesn’t work in your favor, you will make headlines. 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. But the most critical resource is, of course,
experienced personnel who will perform to management’s expectations within the
established guidelines.

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.

David Yeres is a partner at the law firm of Rogers & Wells in New York, New York. 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? In the CFO’s view, using such tools as
swaps, options, and futures can enable the company to manage risk like never before.
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. They do not need to become number crunchers, but their legal
obligations to make informed decisions will require them to understand how the derivatives-
transaction process works and how certain characteristics of derivatives relate to the
company’s objectives, structure, and culture.

CEOs do not need to become number

crunchers, but they do need to understand
how derivatives relate to the company’s
objectives, structure, and culture.
Derivatives have important differences from a company’s other business activities. 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. As a result, a CEO’s assumption that good managers have
assembled the right staff is risky when it comes to a new derivatives program. Not long ago,
an Indiana court in Brane v. Roth held the board members of a grain cooperative personally
liable to shareholders for losses due to an untrained and unsupervised manager’s failure to
implement the board’s hedging authorization. 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. In the event that derivatives-trading results are
expected to be large enough to materially affect the company’s earnings, the CEO should also
oversee the derivatives risk-management process. Through the periodic review of the
transaction portfolio and well-designed reports, the CEO can avoid unpleasant surprises of
the sort experienced by Metallgesellschaft. Press reports indicate that Metallgesellschaft’s
supervisory board was unaware of the derivatives cash-flow requirements of its U.S.
subsidiary until those requirements exceeded $1 billion. 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. The CEO
should understand from the beginning whether the program’s goal is hedging or risk
management. 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. Procter & Gamble, one
shareholder’s suit filed in Hamilton County, Ohio, against P&G’s board members and senior
managers. The shareholder alleges that P&G’s 1994 interest-rate derivatives losses were not
the result of hedging but rather of risk taking—contrary to the company’s public filings and
stated policy. For its part, P&G has sued the dealers, alleging in Procter & Gamble 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. Smith is a partner at the national office of Deloitte & Touche in New York, New York.
He is head of the firm’s financial instruments research group as well as a member of the
Financial Accounting Standards Board’s financial instruments task force.

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. In October 1994, the Financial Accounting Standards Board (FASB) issued a standard
requiring companies to make a distinction between derivatives held or issued for trading
purposes and for purposes other than trading (Statement of Financial Accounting Standard
Number 119, “Disclosure About Derivative Financial Instruments and Fair Value of Financial
Instruments”). 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. For this reason, the user’s intent may not be evident. 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. The greater a CEO’s concerns about the effects of derivatives, the less
discretion he should give employees involved in managing their use. In addition, the nature
and the degree of the risks associated with derivatives requires that companies develop
procedures for monitoring results. Even companies that consider their internal control to be
adequate have incurred unexpected losses when policies were either too broad or
insufficiently detailed or understood.

CEOs must be cautious about how they

delegate responsibility: the greater their
concerns about the effects of derivatives,
the less discretion they should give
employees.
A company’s reasons for using derivatives should always be linked with its broad objectives.
Any derivatives policy should include specific provisions for authorizations and approvals,
activities for which the use of derivatives is permitted, the extent and limitations of such
activities, products authorized for use, and limitations on market and credit exposures.

Paul J. Isaac was formerly chief economist at Mabon Securities in New York, New York, where
he also ran pilot programs in the use of derivatives for securities trading departments. He is
currently a private investor.
As an investor, I welcome any CEO’s decision to explore the use of derivatives. But my
enthusiasm is tempered by a concern that top-level managers could easily lose sight of the
business forest in quest of the derivatives tree.

Investors as a group share several fundamental views regarding derivatives. First, derivatives
are one set of tools in a company’s kit for managing risks. They have an insurance function
and can be a means of altering the form of a company’s capital structure, reducing costs, or
conforming financial risks more to the characteristics of the company’s ongoing business. No
matter how carefully derivatives are managed, though, investors will always view them as a
cost.

Second, we investors are exceedingly skeptical of management’s ability to add value to our
investment by running derivatives as a profit center instead of as a way to manage costs.
Should we, as investors, wish to make market bets, we can do so ourselves in precisely the
form we find most attractive: we’ll hire specialized money managers or buy positions in the
large derivatives houses that trade at among the lowest price-to-earnings and price-to-book
ratios and probably the highest return-on-equity/price-to-book ratios of any sector in the
equity market. It is very doubtful that any individual company, given its disadvantages of
scale and market information, will be able to enhance an investor’s total return by operating
derivatives as a profit center—even if the company is as skillful as the derivatives
intermediaries are.

Third, investors expect companies to disclose aggregate derivatives activity and its general
nature. We will be concerned if a particular company uses derivatives considerably more than
its peers, and we don’t want to see overall activity growing far in excess of the volume of the
underlying business. If either situation occurs, investors will want detailed explanations.

Theoretical constructs are often used to value complex instruments. In the past, their use
occasionally masked real and undisclosed economic deterioration in material transactions.
Should a company’s stock plummet due to such a disclosure, be prepared for a class-action
insult on top of the market injury.
Finally, investors are most concerned about the effect that heavy involvement in derivatives
will have on management’s ability to compete in the basic business. Focusing too much on
derivatives and global models may distract key financial personnel from the nitty-gritty,
analytical, control-and-coordination functions intrinsic to the constant change and
improvement needed in any business. The pernicious effects of diverted attention may
become apparent only over time.

The use of derivatives expertise must be viewed in its overall context—as risk-management
tools serving the basic business. If it is not, investors are likely to cut a company’s stock price
to reflect the complexity of the business, its financial opacity, and the potential for increased
economic volatility.

Brandon Becker is the director of the Division of Market Regulation of the U.S. Securities and
Exchange Commission. The views expressed are those of the author and do not necessarily
represent those of the SEC or of the author’s colleagues at the SEC.

CEOs must help their boards of directors understand clearly the risks associated with the use
of financial derivatives, and directors must assume responsibility for making informed
decisions about their companies’ investment policies.

Derivatives pose unique challenges to directors because of the complexity of some derivative
instruments and their potential leverage. Although a company may achieve lower funding
costs and realize other benefits through the use of derivatives, companies that use them must
be aware of multiple risks—among them legal, market, operational, credit, and liquidity risks.
Boards must be familiar with and have a broad understanding of these risks and set clear
objectives for senior managers regarding how the company will use derivative instruments. In
addition, the board must ensure both that the company has adequate risk-management
controls and qualified personnel in place to monitor the company’s risk position and that the
company’s investments are in keeping with its overall objectives.
When defining the company’s fundamental risk-management policies, directors should
consider its broader business strategies and management expertise and adopt policies
consistent with the company’s overall business objectives. Directors should require that the
board be informed of the company’s risk exposure and of the effect adverse market and
interest-rate conditions may have on the company’s derivatives portfolio. Along with senior
management, directors should identify those individuals who will assume responsibility for
managing risk as well as those who will have the authority to engage in derivative
transactions.

When defining a company’s risk-

management policies, boards of directors
should consider broader business strategies
and management expertise.
In addition, directors must fully understand the corporation’s obligations to account for and
publicly disclose information about derivatives activities. Such obligations include the
disclosure requirements set by federal securities laws, especially Item 303 of Regulation S-K
(“Management’s Discussion and Analysis of Financial Condition and Results of Operations”)
and standards set by FASB. These include standards for disclosures set forth in Statement of
Financial Accounting Standard Number 119, which must be made in the 1994 year-end
financial statements of companies with at least $150 million in assets. Because these
standards are changing rapidly, directors must continue to keep abreast of them.

Companies with significant derivatives activity should consider the use of textual and
quantified information that may provide investors with a better understanding of the type,
extent, and potential effects of these activities. Information that companies should consider
disclosing includes revenues from derivatives trading, including a breakdown of revenues
derived from foreign-exchange, interest, equity, and other types of derivative products; the
types of instruments used and the specific risks being managed with each; a summary of open
derivatives positions at the end of the period, including for each major category of derivative
instrument the notional amount, carrying value, fair value, and gross unrealized gains and
losses; and quantified information about terminated hedges, including the amounts of
deferred gross realized gains and losses from hedges terminated before maturity.
Additionally, companies could disclose the controls and the measures used both to manage
derivatives and to provide investors with market and credit-risk exposure estimates.

In this way, CEOs and boards of directors can formulate consistent and prudent investment
policies.

A version of this article appeared in the January–February 1995 issue of Harvard Business Review.

David Weinberger (david@weinberger.org) is a senior researcher at Harvard’s Berkman Center for

Internet & Society, and the author, most recently, of Too Big to Know. Visit his blog at www.JohoTheBlog.com

Peter Tufano is the Peter Moores Dean at the University of Oxford’s Saïd Business School. He serves on the
FDIC’s Committee on Economic Inclusion, and is the co-founder of Doorways to Dreams Fund, a nonprofit that
seeks to find innovative financial services to serve low to moderate income families.

Cheryl Francis is the treasurer of FMC Corporation, a manufacturer of chemicals, machinery, and defense systems
headquartered in Chicago, Illinois. She was formerly CFO of the company’s gold-mining subsidiary.

Arvind Sodhani is vice president and treasurer of Intel Corporation in Santa Clara, California, which uses derivatives
extensively.

David Yeres is a partner at the law firm of Rogers & Wells in New York, New York. For the last 15 years, he has
specialized in derivatives-related issues for major corporations and dealers.
John T. Smith is a partner at the national office of Deloitte & Touche in New York, New York. He is head of the firm’s
financial instruments research group as well as a member of the Financial Accounting Standards Board’s financial
instruments task force.

Paul J. Isaac was formerly chief economist at Mabon Securities in New York, New York, where he also ran pilot
programs in the use of derivatives for securities trading departments. He is currently a private investor.

Brandon Becker is the director of the Division of Market Regulation of the U.S. Securities and Exchange Commission.
The views expressed are those of the author and do not necessarily represent those of the SEC or of the author’s
colleagues at the SEC.

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