Author: Ben Mattlin
Corporate use of derivatives is becoming increasingly commonplace, but while they are easier than ever to use, the risks still remain.

fe_derived_valueBig Last June the gross market value of outstanding over-the-counter derivatives soared to a whopping $10.7 trillion, as measured by the Bank for International Settlements, a Basel, Switzerland-based clearinghouse for central banks. That number, which represents the total replacement cost of those contracts, was an 83% increase from the year before. The “notional amount”—how much money actually changed hands for those derivatives—jumped to $270.1 trillion, nearly 23% ahead of the prior year. And those figures are only for OTC derivatives. Another $57.8 trillion worth of exchange-listed futures and options was transacted in December 2005, the most recent figure available—a 24% jump from a year earlier.
Clearly, the array of financial instruments that fall under the umbrella term “derivatives” has become “endemic,” as one industry analyst observes: “Worldwide, the financial industry can no longer function without derivatives.” But why have they become so important? How are corporations using them? And perhaps most importantly, what are the risks and potential rewards of investing in these complex securities?

Transferring Market Risk

Shirazi:“All derivatives are a way
of transferring market risk”

When US Treasury secretary John Snow visited Japan in October last year, the consensus was already growing that the country’s economy had finally hauled itself out of recession. Secretary Snow was clear as to the reasons for the turnaround: the clean-up of the banking sector, deregulation and the overhaul of key parts of the corporate sector. “The lesson is that steadfast commitment to good policy, and political leadership that takes the risks to put good policies in place, pays some dividends,” he said, referring to other hidebound economies in the eurozone.
The subtext of his remarks: Japan got better because it got more like the US.

And it’s true that much of the medicine administered in recent years had a free-market label on the bottle. Japanese companies have shed jobs over the past five years. Corporate cross-holdings have begun to unwind: Around one in five Japanese shares are now held by “friendly” investors, compared to almost one in two in the late 1980s. And, of course, Prime Minister Junichiro Koizumi used the privatization of the Post Office as a totem for wider changes in the country and the ruling LDP party in his wildly successful September 2005 election campaign.

Little wonder, then, that outsiders view Japan’s rebound through an Anglo-Saxon prism.

But look again, and this recent recovery looks, well, a lot more Japanese. Pick apart the components of the rebound. Sure, consumers have been opening up their pocketbooks a little more, but at close to 30% of GDP, household savings rates are the highest in the developed world. This is anything other than a US-style economy powered by individuals using houses as cash machines. And, yes, companies are meaner, leaner. Almost one in three workers are part-time now, a shift that has spurred the growth of two-income households—as well as a flood of books bemoaning the accompanying insecurity. But in an important sense Japanese companies had already written the textbook on lean production. Star performers such as Toyota are world leaders in the use of advanced robotics. Investment by Japanese companies accounts for around 40% more of the country’s GDP than in the US or Germany.
That gap is widening further: According to the Bank of Japan, manufacturing capital expenditure grew by 12.9% in 2004 and 15.5% in 2005. The spur for that spending splurge: an export drive erected on the back of a swooning exchange rate and ballooning world demand. Some 30% of GDP growth over the past four years came from exports, a figure only Germany could come close to in the developed world.

Sure, this party must come to a close sometime. The currency is already sharply up and is likely to go further. “Once this appreciation has started, it is hard to stop,” says Takatoshi Ito, a professor at the University of Tokyo and a former deputy finance minister. “¥100 [against the dollar] is no barrier.” And, yes, important questions remain about the long-term viability of the Japanese economic model (see main story). But for the moment at least, this recovery is about Japan doing what it has traditionally done best: making high-end products at home to sell abroad.

Corporations Focus on Hedging

Lovi:“There’s bound to be some
big blowup in the future”

Though many financial-services professionals may be expanding their positions in the derivatives market in search of capital appreciation—especially when traditional investments such as stocks and bonds are generating lackluster returns, at best—corporate participants are primarily active in derivatives for these kinds of hedging purposes. Among the current favorites are credit derivatives. They provide a hedge in case one of your close business partners—a supplier or customer, typically—falls on bad times. “If your biggest client is IBM, and you’re afraid IBM is going to slip on a banana peel, you might get coverage based on IBM’s creditworthiness,” says Andrea Kramer, head of the financial products, trading and derivatives group at Chicago-based law firm McDermott Will & Emery.

To purchase credit or other types of derivatives, companies can turn to any reputable financial-services provider. Many large corporations, however, handle derivatives transactions in-house. In either case, they should start by reviewing corporate policies and procedures in detail. What has the board of directors actually authorized? Investing in derivatives for speculation—that is, to shore up sagging earnings or fill a hole on the balance sheet—is generally considered a dangerous game, but hedging against future problems is not only acceptable, but often imperative.
Finance-savvy lawyers should be consulted to help negotiate and review all trading contracts under consideration. These documents lay out terms and expectations, and they take into account innumerable scenarios that could emerge. There may be regulatory issues to consider, too, depending on the industry, the type of derivative and the location. “For insurance companies, for example, it’s necessary to consult state insurance regulators in both the home state and any states where the company does business,” says Kramer.

Besides a legal opinion, accounting and tax expertise and, of course, trading capabilities, companies considering using derivatives also need a credit-risk evaluation. Again, this can be handled in-house or outsourced. “Before you enter into contracts with other parties, it’s important to assess the risk you’ll be taking on. Are the other parties trustworthy? What’s their creditworthiness?” explains Kramer.

Companies with a long-standing relationship with a bank often let the bank handle the whole operation. While that is understandable, it can be a mistake. Derivative products tend to be so complex that they require very sophisticated professionals to oversee them. Unless a company has the necessary in-house expertise, it would be well advised to seek help from a firm that is part of the International Swaps and Derivatives Association (ISDA), an independent trade group.
It’s also a good idea to shop around when seeking outside help. Fees can vary widely and are not always obvious upfront. “Typically, the fees are embedded in the purchase,” cautions Kramer. “They’re buried in the bid-ask spread, so often you don’t know what you’re paying.”

Despite these dangers, a growing body of regulations aims to make derivatives safer than ever. “They’re being accepted as a normal part of financing, as natural hedging devices,” says Ellen Clark, a derivatives and structured-finance attorney at DLA Piper Rudnick Gray Cary in New York. “They’re not considered alternative investments any more.” She cites a change in accounting rules that requires derivatives to be listed on the balance sheet, for more open disclosure. This is true even for some of the newer forms of derivatives, such as those based on underlying real estate transactions. “They simply fill the real estate allocation in the company’s portfolio,” Clark says.

While regulatory agencies continue to encourage caution among investors, Clark points to one recent development that should give derivatives-holders some comfort. Last year’s Bankruptcy Reform Act, which made it harder for individuals to declare insolvency, included a provision that ensures speedy resolution of derivatives and other financial contracts in the event of a bankruptcy. “There is now some legal certainty about how derivative products are unwound if there is a bankruptcy,” asserts Clark. “You can now immediately terminate and settle without having to go through a lengthy bankruptcy court process. This removes a degree of uncertainty and frees the market to have more fluid
liquidity. It’s a big milestone.”


-e and commodity
derivatives likely to grow more slowly

Other experts sound a more cautious note. “These products can get so complex, even people who think they understand them can be taken by surprise,” says John Lovi, a derivatives litigator with Steptoe & Johnson in New York. “There’s bound to be some big blowup in the future—a couple of major disruptions or even a full-blown crisis.” Wall Street, he says, is “desperately” trying to sell credit derivatives to corporate clients, hoping to seize an opportunity. “There’s not yet a level of sophistication on the corporate side equal to that on Wall Street,” Lovi contends. “Companies have done a lot to become more sophisticated about credit derivatives, but there are still many who underestimate the risks. That’s one reason I’m a busy guy as a litigator.”

Lovi urges companies to establish a network of checks and balances. Derivatives can be so difficult to understand that they’re effectively unmanageable by any one person. “A company’s star derivatives person shouldn’t be the one engaging in them, or you could run into major problems,” he warns. “There needs to be oversight by knowledgeable

Continued Growth

O’Hearne:“There’s no need to prove
an insurable interest or proof of loss”

Yet others have a more optimistic view. They cite the ease of trading listed derivatives. “The markets are becoming increasingly transparent, especially with the advent of electronic markets. Also, there are many more underliers than ever before, such as options on a multitude of ETFs,” says Alexander Wohl, head of equity derivatives trading at investment bank Jefferies & Co. in New York, referring to exchange-traded funds. Wohl postulates that corporations have a lot of cash on hand these days, and they “look to derivatives to enhance their stock repurchase programs,” he says. So confident are he and his employer in the strength of derivatives demand that Jefferies has expanded its derivatives operations to meet the swell.

Still, some observers take a more philosophical, measured approach. “There are risks in the financial system, and they certainly can manifest themselves in the derivatives market, but they’re just as likely to emanate initially from within the cash markets,” notes Shyam Venkat, head of financial risk management at PricewaterhouseCoopers, the financial advisory firm in New York. He expects the popularity of credit derivatives to continue growing as market participants seek to hedge their credit risk exposure. On the other hand, interest-rate, commodity and foreign-currency derivatives are “likely to grow more slowly,” says Venkat, “because they are more mature sectors.”

One thing is certain at least: Companies that don’t take advantage of derivatives are likely to fall behind. Says Kramer at McDermott Will & Emery: “If you’re a candy bar maker and there’s a spike in chocolate prices because of a cocoa bean shortage—there was a drought somewhere—you’d better have a derivative to offset your additional expense, or you’ll lose business to a competitor who does.”

Ben Mattlin