Balance Sheet

Creating wealth from thin air

David Damant,
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 OFFSHORE

Creating wealth
from thin air
Are derivatives the key to immense financial success or disastrous
collapse? David Damant offers us his view on the nature and value of
derivatives and a prediction of the benefits that they may provide if correctly handled,
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while sounding some warning notes to those involved

DO NOT KNOW what the general which previously could not be easily avoid them altogether. They may try,

I perception might be of new financial

instruments – derivatives such as
options, swaps and futures. No
doubt to many people, including
many politicians, they are financial
devices which may appeal to some in
the markets but otherwise are simply
dangerous, giving rise to situations like
the collapse of Barings. Those a bit
closer to the subject may
see them as useful in
particular instances. I
wonder how many obser-
We are in the presence of a
vers of the present scene
realise that we are in the
revolution so dramatic that
presence of a revolution so
dramatic that the entire
the entire financial future of
financial future of the world
will be changed and, assum-
the world will be changed
ing that these instruments
are correctly handled, this change will be
of the very greatest benefit to society as a
whole.
The position can be clearly set out.
Enterprises can use these devices to
transform almost any aspect of their
business and of the structure of their
financial statements. They can consider
cutting out unprofitable activities and
making up the gap with appropriate
financial instruments; they can deal
financially rather than physically with
commodities and they can easily
rearrange their financial activities in
such a way as to apportion risks and
returns exactly as they require. Directors
can take the risks they want to take and
not those they do not want to take. Risk
avoided can be insured.
For example, a company’s balance
sheet and therefore its activities may be
financed by fixed-rate dollar debt, but if
the company has, over the years, seen its
non-American activities grow, that debt
can be swapped into the most appropri-
ate matching alternative – say, variable
rate Deutschmark debt. Certain triggers
(caps and collars) can be built in to such
positions, to limit or even remove cer-
tain adverse chances in the company’s
business in the future. In the profit and
loss account, forecast cash flows can be
anticipated and turned into early income
or postponed into later income, or
changed into a different currency. One
could indeed define financial instru-
ments as a means of modifying future
cash flows – their size, timing and
certainty. There is literally no end to
what can be done; and it will be done.
Everything can now be turned into
something else.
Some companies argue that, in view
of the dangers involved, they will stick
to very simple financial instruments or
but they will not succeed. Quite soon,
competition will force them to move in
the same direction as their more enter-
prising competitors. In any case, the
underlying (real economy) dangers exist,
whether they are insured (or matched, or
magnified) or not, and this is often over-
looked, while the dangers of investing
(or mis-investing) in derivatives are
apparent. It will not be long
before every company, or
every large company, is
making large and increas-
ing use of derivatives which
will completely transform
the company’s financial
activities and structures.
By the correct reappor-
tionment of risks and
uncertainties, the cost of
capital will fall. There is a major ‘catch-
up’ factor as the misapplied capital (and
with derivatives available nearly all the
world’s capital can be seen as misapplied
to some degree) is rightly positioned. As
a result, investors will accept, correctly,
a lower return. The wealth released will
be sensational.
There can be few mechanisms in the
world today that, on a purely technical
basis, can be of such great benefit to the
wealth of mankind. But this factor is not
generally recognised, and this lack of
recognition has three facets. First, deriv-
ative instruments are seen as an ‘add-
on’. They are not seen as central.
Second, improved accounting in general
is not seen as a powerful aid to cheaper

VOL 8 NO 1 | BALANCE SHEET | 37

 OFFSHORE

markets. When a derivative instrument

Whether the new regulations will
be applied with sufficient rigour in
individual companies, or in enough
companies, remains to be seen
capital – this is a sad blind spot. And
third, the arrival of derivatives poses, in
turn, three dangers; and the dangers are
more apparent than the hidden cost of
capital.
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most popular attention. This is in part
due to a number of high profile disasters
– Orange County, Procter & Gamble
and notably Barings. The Barings crisis
probably had its most important effect
is applied by a company – modifying its
asset or liability structure, or its antici-
pated income – the economic reality for
the company is altered. This changed
reality must be reported to the capital
markets. Accounting standards-setters
all over the world – the International
Accounting Standards Committee
(IASC), and the Financial Accounting
Standards Board in the States – have
been wrestling over this problem. It is
likely that in due course an internation-
al consensus will be achieved. But it is
also likely that the consensus will

These three dangers are: systemic in other financial institutions and in involve a complete move to fair values
risk; the lack of control of the use of ordinary companies – it underlined as of all financial instruments, assets and
derivatives; and the risk of mis-reporting clearly as possible the inherent dangers liabilities (including the company’s own
to the capital markets. Two of these are of inadequate internal controls. In any long-term debt, and the swaps which
widely recognised. The third is of case, this is another area where enough may or may not cover it).
dramatic importance for the profession people are concerned with the problem There will also need to be disclosures
of fund management and investment to give some likelihood of success, but of a company’s policies on derivatives
analysis, yet is given little attention. whether the new regulations will be and a sensitivity analysis to show the
There is a systemic risk that, as a applied with sufficient vigour in individ- effects of the company’s derivative posi-
result of the misuse of derivatives within ual companies, or in enough companies, tion. It is extremely unlikely that com-
a major financial institution, the remains to be seen. panies will welcome accounting stan-
institution may fail and, through a Assuming that the system as a whole dards along these lines. They will shine a
domino effect, bring the international survives, and that most companies use light on the internal mechanism of a
financial system into chaos and collapse. derivatives correctly and have adequate company which has never been shone
There are very few players in this game internal controls, the third problem then before. But unless the capital markets
at a level that would really present a risk arises. It is one which has received an understand what is going on, they will
to the system. But close regulation is inadequate degree of attention. It is the ask for a higher return on capital rather
necessary for the largest financial insti- question of reporting the state of a com- than the lower return justified by the use
tutions – weekly or even continuous pany using derivatives to the capital of these instruments. Note also that this
monitoring is required.
This problem of the risk to the sys-
tem is generally recognised. Central
banks and other regulators are aware of
the dangers involved. The Fed’s action in
respect of Long Term Capital
Management is indicative of this.
Considerable expertise is being brought
to bear, under a short timescale resulting
at least in part from political pressure,
such as that of the US Congress which,
having seen the Savings and Loan crisis
develop, is determined not to see such a
development again (and the derivatives
field is very clearly in its sights). We
cannot be sure that the safeguards which
are being put in place will prevent a
serious shock for the system as a
whole, but at least enough people are
worrying about and focusing on the
problem.
It is the second problem, the lack of
internal controls, which has excited

38 | BALANCE SHEET | VOL 8 NO 1

 line of argument is not a matter of
avoiding collapse or loss: it is a symmet-
rical consideration, asking the compa-
nies to disclose to the shareholders and
bondholders how future cash flows will
be modified by derivatives (upwards or
downwards), and therefore how those
future cash flows need to be discounted
into a present value in the markets.
The possibilities for the use of
derivatives to achieve remarkable results
have indeed been recognised by many
companies and by many investment
bankers. The concentration of intellec-
tual power in the major financial centres
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such as the City of London or Wall
Street is extraordinary. There are
probably now many more very bright
people in financial institutions than
there are in all the universities put
together. One has to be temperamen-
tally very academically inclined not to
move to a financial centre if one has
first-class degrees in finance theory and
allied subjects. Not only are the financial
rewards large and in many cases
enormous; the work also is extremely
stimulating and almost exactly the same
as in the academic world – indeed,
the difference between academic work
on mathematics and derivatives, and
the work in the real world, is almost
non-existent.
There is also a filter in the financial
world – a high degree of ability is
required in order to generate these
instruments and apply them to particu-
lar cases, so that financial engineering is
more and more carried out at a very
sophisticated level. This must lead to a
very high reward structure for a certain
group of people, quite a small group on
the national level. Noticeable numbers
of people will be earning hundreds of
thousands and indeed millions. Yet the
benefit they can bring to the efficiency of
commerce and industry, and to society
as a whole, is fully commensurate with
this level of reward. A team sitting in
London and restructuring a large British
company in one or more of the ways
briefly summarised in this article can
save that company many millions and
the largest companies billions.
Financial engineering can make a
company – indeed all companies which
apply these techniques – more in line
with economic reality and more able to
change with economic reality. What
looks in one sense like a series of pieces
of paper is in another sense a reformat-
ting of an enterprise in line with the real
world. Like the information technology
revolution generally, these benefits may
be to some extent invisible but they are
nonetheless large.
By the use of derivatives, we can
now create enormous wealth, as if it
were out of thin air, and continue to do
so. On the other hand, we could see a
disaster for the system, a chaotic lack of
controls and serious mispricing in the
capital markets. We have been offered
the choice. The best chance is that we
shall succeed, but we may not be under-
stood. ■
David Damant is
president of the
European Federation of
Financial Analysts
Societies and a member
of the Board and the
Executive Committee of
the IASC.
VOL 8 NO 1 | BALANCE SHEET | 39