versions of this article have been published as:
"Demystifying Derivatives", Jun. 95, Treasury Today, Institute of Chartered Accountants in England & Wales, London
"Derivatiphobia(tm)" Mar. 97, The Bridge Guide to Corporate Treasury in Asia 1997, Hong Kong
"Demystifying Derivatives: A cure for Derivatiphobia(tm)", Summer 98, Forex & Global Markets, London link
"Derivatiphobia(tm): a director's guide to derivatives", Dec. 98, Treasury Management International, London link
"Derivatiphobia(tm): a director's guide to derivatives" Global Treasury News link
"Derivatiphobia(tm): a guide to derivatives", 2nd Quarter 99, Princeton Economics Journal, Princeton Economics International, Princeton USAlink
This article and speech will form the basis of the forthcoming book by Warren Edwardes
"Key Financial Instruments: understanding and innovating in the world of derivatives" 4 February 2000, Commissioned by Financial Times Prentice Hall ISBN 0273 63300 7 London link
by Alta-Vista Translation Services
Derivatiphobia (tm): A Director's Guide to Derivatives
by Warren Edwardes
Warren Edwardes, Chief Executive of Delphi Risk Management London and Visiting Professor at the Korea Banking Institute. The London-based Delphi is a training and consulting firm in financial product innovation, engineering and communication and risk management. He was previously on the Board of Charterhouse Bank and has worked in the treasury divisions of British Gas, Barclays Bank and Midland Bank. He first researched into what were later to be called "derivatives" in 1975. Since then he has devised and transacted several structures that form part of the history of derivatives. This article is based on "derivatiphobia" published in the Bridge Guide to Corporate Treasury in Asia 1997 and in Forex and Global Markets.
The recent spate of derivatives disasters in Asia as well as in nearly every corner of the globe has led to a fear more paralysing than that of flying or indeed of spiders. Derivatiphobia(tm) has replaced Arachnophobia in the psychiatrists office. Perhaps it is the mystique surrounding the subject?
What's the difference between a Flip-Flop Option and a Knockout Option?
They were both seen at the Olympics. A Flip-Flop Option was a floor movement by Olga Korbut and a Knockout Option was used by George Foreman.
Derivatiphobia (tm), the spine-chilling fear of anything associated with the "D" word has reached epidemic proportions. Young Nick Leeson brought "Derivatives" to the front page of every newspaper. But rest assured - derivatives are not going to be swept under the carpet. The hitherto arcane subject has, arguably, more than its fair share of jargon. This article takes a fresh look at derivative products, clearing away the myths surrounding the subject. You may have read that Mr. Leeson was doing "straddles". He was in for the "high jump" but was the young man born when Dick Fosbury first flopped over the bar?
It is hardly surprising that disasters have occurred. A senior manager in the treasury department of a Top 5 British corporation said: "neither our board nor our auditors understand what theyve been told". Do not as a Director be afraid to ask the simplest of questions - and persist until you understand the answer.
Neither a borrower nor a lender be
Shakespeare wrote in «Hamlet», "Neither a borrower nor a lender be". No doubt he was looking forward to an explosion in off-balance sheet "derivative" products some 400 years later. The term "derivative" has been used for about a decade. In fact I was offered a position in 1987 as "head of derivative products" in the London branch of a US bank - the trouble was although I was familiar with swaps and options, I hadnt heard of a "derivative"!
A derivative is a treasury or capital markets synthetic off-balance-sheet instrument that is derived from or bears a close relation to a cash instrument. There are two basic types of derivatives: Forwards and Options. The contracts could be OTC (over-the-counter or between a corporate and its bank or bank-to-bank) or Exchange Traded (exchange traded forward contracts are known as futures contracts as in the former hunting ground of Mr. Leeson - SIMEX).
To a greater or lesser extent all derivatives provide Leverage. When an investor buys a government bond or a share s/he pays cash for it - up front. Under an OTC forward contract, the treasurer has to satisfy the companys bank of its credit-worthiness. Under an exchange traded contract, the investor has to place margin - initial and variation. Initial margin represents the exchanges view of what an investor could lose in a bad day (SIMEX doubled initial margin post Barings). Variation margin reflects the actual movement in the market. The investor gains and loses on a day-by-day basis. This makes futures the most transparent of derivative contracts. Funds have to be authorised and raised daily to cover losses. Losses cannot be carried forward on a year by year basis as happened at Showa Shell of Japan.
A Forward Contract is a firm commitment to buy or sell something. The contract could be for foreign currency, gold, sugar or oil. A variant on a Forward Contract is a Forward Contract for Differences (FCFD). This is a Forward Contract but is settled in cash based on price movements. A Forward Rate Agreement (FRA) is used by corporate treasurers to protect against future short-term interest rate costs (or returns). A similar contract was known as the Forward-Forward in the late 70s. It was derived from a combination of, say, a six-month borrowing and a three-month deposit. Unlike the FRA, the Forward-Forward was not cash settled. It created a borrowing of three months in three months time. The FRA locks in the market component only for the borrowing or investment - LIBOR. Contracts for Differences also encompass the interest rate swaps that allow a savings bank to provide fixed rate mortgages. Swaps are, in essence, series of three-month FRAs.
An option gives the buyer, on payment of an insurance premium, the right but not the obligation to buy or sell something in the future. Nothing particularly new here. Centuries ago there was a market in Holland in tulip bulb options. They include the interest rate options sold by Hammersmith & Fulham, the British Local Authority, to generate cash and thereby by-pass the UK governments external financing limit. Trafalgar House of the UK in its take-over manoeuvrings for a UK Electricity Utility bought options from Swiss Bank on a basket of electricity company stocks. S&P 500 and FTSE 100 options are used to provide guaranteed no-loss investment products.
If it is not clear what a "straddle" is or you confuse it with a "strangle" dont feel intimidated. They are both combinations of easily explained options. You need to know WIGO - What Is Going On. If it cant be explained dont permit it until it can. If someone wants to sell you a Deferred LIBOR setting swap and you dont know why you should buy it - then dont. The salesman will have a very good reason - his needs for a new Mercedes coupe are probably greater than yours!
Shell Shocks but no soft option
Boards have been for some time rightly apprehensive about derivatives following the losses sustained by firms such as Procter & Gamble, Showa Shell, Metallgesellschaft, Allied Lyons and Daiwa. The successful case by the shareholders of a grain co-operative in the US against its board directors for failing to hedge exposures suggests that avoiding derivatives is not a safe option. Ignominious ignorance isn't blameless bliss.
The focus here is to introduce a way for a finance director and his treasurer to select a hedge given the nature of their institution's appetite for risk, its performance measurement yardstick and its forecasts on rate direction.
To Hedge or not to Hedge
Should the option be Out-of-The-Money (OTM)? An OTM US Dollar Call option purchased by a Corporation is such that it gives the buyer the right but not the obligation to buy US Dollars against Sterling at lower than the current forward rate - fewer Dollars per Pound. Should the option be At-The-Money (ATM)? An ATM US Dollar Call option is to buy dollars at a rate exactly equal to the current forward rate. Would an In-The-Money (ITM) option be advisable? An ITM Dollar Call is such that the rate is better (higher) than the ruling forward rate and consequently results in a higher insurance premium. In extremis an option to buy Dollars at £/$ 2.50 for a year would be very deep In-The-Money. It would be almost certainly exercised. Therefore an extremely deep In-The-Money is an exact substitute for a forward contract which is bound to be exercised. An extremely Out-of-The-Money option is a substitute for an uncovered position or no hedge at all.
The continued publicity surrounding Billion Dollar losses on derivatives suggests that a firm's appetite for risk is an important determinant of hedge choice. There is, however, disagreement on how such decisions should be judged. "Cover everything automatically in the forward market" or "Leave everything uncovered until spot and blame losses on the Bundesbank" may be politically sensible approaches. Conventionally, option salesmen have advised corporate treasurers to buy OTM options. Why not "in-the-money" ITM structures? Do they really cost more? Is a forward contract cost-free?
In a casino's Roulette Table a zero and often a double zero are acceptable to gamblers. A player can walk away from the game (usually!) with, at most, the funds brought to the table lost. He puts up limited capital. The casino has an unlimited capital exposure and cannot, other than through bankruptcy, turn clients away. In the old television game "Double Your Money" contestants often, quite rationally, took the money and stopped playing the game - even if on a simplistic probability calculation they should have continued. The value of the certain gains in-hand outweighed the possible benefit through a chance win of a larger sum.
A firm's Benefit or Utility function should be developed based on risk appetite and its performance yardstick. Monetary profits and losses should be mapped onto Benefit Gains and Pains. Perhaps the benefit function should be such that the Pain value of a loss of $200 million should be three times the Pain value of a loss $100 million. Moreover, the Benefit function will generally not be symmetric around a nil profit/loss result. The loss of $200 million is generally much more painful for an organisation than the positive benefit of a gain of $200 million. The value of income is seldom disposable. It with this very much in mind should a potential corporate buyer examine the benefits of options sold by banks or the value of the services and claims of the various "dynamic hedging" exposure management firms. These firms attempt to replicate options for their clients by putting on and then adjusting forward exchange contracts. Under this dynamic hedging system the client is not, however, comforted with the strictly limited exposure generated by an option purchased.
Judgement after the fact
International surveys of Corporate Treasurers have suggested that the main benchmarks for foreign exchange transaction exposure are spot, forward cover and budget rate spread equally amongst companies. In many cases the application of these benchmarks is simple and relatively arbitrary. A cynical view would be that the performance measurement yardstick most often used in practice, though seldom explicitly, is based on judgement after the fact given the more favourable between the forward rate available at the time.
Ready Reckoner Charts can be created to suggest choice of hedge given the performance measurement yardstick, risk bearing capacity, and the Treasurer's spot rate out-turn views. Risk Shy managers mirror their yardsticks. They fully cover forward foreign exchange exposures if measured versus a forward cover yardstick. Risk Shy treasurers keep their loans and deposits on short-term maturities if their measurement criteria so encourages. The Risk Lover behaves as though s/he has unlimited capital at disposal and full autonomy. Risk Managing Treasurers will not adopt such extreme positions. They will lean towards OTM or ITM options subject to yardstick.
The Ready Reckoner Charts could provide the basis for an examination by the firm's Treasury Committee of its objectives, policies and strategies. Measurement versus spot, forward or an ATM option are but three special cases. In setting a yardstick, motivation must be balanced by discipline and control.
Watch your bank
Given the two-way risk nature of derivatives such as Forward Exchange Contracts, FRAs (interest rate hedges) and swaps, corporations should carefully consider the selection of their counterparties. They should establish credit lines for banks subject to the bank's creditworthiness. Furthermore, just as the Bank for International Settlements in Basle (BIS) is requiring banks to set aside capital for dealings in off balance sheet transactions, corporations should allocate reserves against derivative transactions in relation to their bank's credit rating.
Dealers can outwit accountants
Derivatives provide Finance Directors with very useful tools for managing risk or for providing clients with an enhanced service; because they are off-balance sheet and dont require a significant cash outlay (if at all) they can quickly spell big trouble.
Most good dealers can outwit their internal or external auditors. Moreover, individual performance bonuses can encourage at best "accounting engineering" a "double-or-quit" attitude or outright fraud. Dealers have a free option. Employers dont sue them for losses. Bonuses should be based on team performance - conspiracies seldom hold firm for long. Ensure sound character of Treasury staff. This is just as important as technical ability and ensure that Treasury performance targets are realistic.
Ever sophisticated technology is not the solution. On the morning of December 7th, 1941 the latest technological device alerted its operator. The place was Pearl Harbour, Hawaii and the device was the Westinghouse long-range radar. A squardon of planes approaching was detected by the machine but the officer assumed that the planes were American B-17s. The rest is history.
Computer outputs have to be correctly interpreted in a very short time. And the assumptions behind complex derivative models and inputs must be carefully examined and agreed to by controllers and management. If the dealer can't explain a third-degree derivative to you in simple terms and you can't explain in front of shareholders at an Annual General Meeting, ask yourself the questions:
Is it appropriate to this business? Do we really need to do it?
If the answers are Yes and Yes, make sure you understand it.
The evil that men do lives after them
Shakespeare pointed out a common directors' dilemma: that whilst errors of judgement stand out to be criticised in hindsight, 'the good lies interred with their bones' - although it seems unlikely that a derivatives dealer will meet the fate of Julius Caesar. However, we can recall with some irony the voters' support for Orange County's Treasury in the days when it was making money and lowering taxes; and consider that Barings' board was taking its share of the jailed Mr. Leeson's profit before his fall. But such are the inevitable perils of managing other people's money!
Few boards understood what treasurers were doing
Finally, it is incumbent on the boards of directors to understand and use appropriate derivatives. Shareholders have successfully sued when they have not been used. They might eventually get very annoyed if they are misused. The Financial Times Lex column of 9 March 1995 said: "The retreat by industrial companies is also sensible given that few boards really understood what their corporate treasurers were doing. But derivatives are still valuable tools if used to hedge risks rather than speculate. The longer term answer is for boards to do their homework rather than to impose a ban."
related article: "Less Technophilia - have faith in fools",
Leader Column, Apr. 1999, Treasury Management International, London link
4th Quarter 1999, Global Trading, London link
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