Is “Derivative” a Four-Letter Word?

Our wheat farmer sold wheat futures to reduce business risk. But if you were to copy the farmer and sell futures without an offsetting holding of wheat, you would increase risk, not reduce it. You would be speculating.

Speculators in search of large profits (and prepared to tolerate large losses) are attracted by the leverage that derivatives provide. By this we mean that it is not necessary to lay out much money up front and the profits or losses may be many times the initial outlay. “Speculation” has an ugly ring, but a successful derivatives market needs speculators who are prepared to take on risk and provide more cautious people such as farmers or millers with the protection they need. For example, if there is an excess of farmers wishing to sell wheat futures, the price of futures will be forced down until enough speculators are tempted to buy in the hope of a profit. If there is a surplus of millers wishing to buy wheat futures, the reverse will happen. The price of wheat futures will be forced up until speculators are drawn in to sell.

Speculation may be necessary to a thriving derivatives market, but it can get companies into serious trouble. The nearby Beyond the Page feature describes how the French bank Societe Generale took a €4.9 billion bath from unauthorized trading by one of its staff. The bank has plenty of company. In 2011, Swiss bank UBS reported that a rogue trader had notched up losses of $2.3 billion. And in 1995, Baring Brothers, a blue-chip British merchant bank with a 200-year history, became insolvent. The reason: Nick Leeson, a trader in Baring’s Singapore office, had placed very large bets on the Japanese stock market index that resulted in losses of $1.4 billion.

These tales of woe have some cautionary messages for all corporations. During the 1970s and 1980s, many firms turned their treasury operations into profit centers and proudly announced their profits from trading in financial instruments. But it is not possible to make large profits in financial markets without also taking large risks, so these profits should have served as a warning rather than a matter for congratulation.

An Airbus 380 weighs 400 tons, flies at nearly 600 miles per hour, and is inherently very dangerous. But we don’t ground A380s; we just take precautions to ensure that they are flown with care. Similarly, it is foolish to suggest that firms should ban the use of derivatives, but it makes obvious sense to take precautions against their misuse. Here are two bits of horse sense:

Precaution 1: Don’t be taken by surprise. By this we mean that senior management needs to monitor regularly the value of the firm’s derivatives positions and to know what bets the firm has placed. At its simplest, this might involve asking what would happen if interest rates or exchange rates were to change by 1%. But large banks and consultants have also developed sophisticated models for measuring the risk of derivatives positions.

Precaution 2: Place bets only when you have some comparative advantage that ensures the odds are in your favor. If a bank were to announce that it was drilling for oil or launching a new soap powder, you would rightly be suspicious about whether it had what it takes to succeed. You should be equally suspicious if an oil producer or consumer products company announced that it was placing a bet on interest rates or currencies.

Imprudent speculation in derivatives is undoubtedly an issue of concern for the company’s shareholders, but is it a matter for more general concern? Some people believe, like Warren Buffett, that derivatives are “financial weapons of mass destruction.” They point to the huge volume of trading in derivatives and argue that speculative losses could lead to major defaults that might threaten the whole financial system. These worries have led to increased regulation of derivatives markets.

Now, this is not the place for a discussion of regulation, but we should warn you about careless measures of the size of the derivatives markets and the possible losses. In June 2017, the notional value of outstanding derivative contracts was $628 trillion.³³ This is a very large sum, but it tells you nothing about the money that was being put at risk. For example, suppose that a bank enters into a $10 million interest rate swap and the other party goes bankrupt the next day. How much has the bank lost? Nothing. It hasn’t paid anything up front; the two parties simply promised to pay sums to each other in the future. Now the deal is off.

Suppose that the other party does not go bankrupt until a year after the bank entered into the swap. In the meantime interest rates have moved in the bank’s favor, so it should be receiv­ing more money from the swap than it is paying out. When the other side defaults on the deal, the bank loses the difference between the interest that it is due to receive and the interest that it should pay. But it doesn’t lose $10 million.

The only meaningful measure of the potential loss from default is the amount that it would cost firms showing a profit to replace their positions.

Source:  Brealey Richard A., Myers Stewart C., Allen Franklin (2020), Principles of Corporate Finance, McGraw-Hill Education; 13th edition.