Things that seem to be free may cost a lot
12 October 2001, The Financial Times, London 
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Warren Edwardes
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understanding and innovating in the world of derivatives" Feb. 2000, Financial
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Systran
by Alta-Vista Translation Services
LETTERS TO THE EDITOR: Things that seem to be free may cost a lot, Financial Times; Oct 12, 2001
From Mr Warren Edwardes.
Sir, Mr Jon Moynihan (Letters, October 8, 2001) suggests that companies providing employee options should hedge and crystallise their value through hedging in the market. Sounds pretty good advice. However, it relies on the company in question buying an appropriate hedge.
Marconi appears to have "hedged" using forward contracts rather than options ("Marconi faces Pounds 200m loss on option hedge", October 7, 2001). Options grant the right but not the obligation to buy or sell something at a predetermined price. But forward contracts incorporate the right and the obligation to exchange at the agreed rate. Hence Marconi's loss.
In my book Key Financial Instruments I stated the obvious: "There is an enormous difference between something being cheaper and costing less money!" Forward contracts do not involve the payment of an up-front insurance premium and appear to be zero-cost or free. But adverse movements can lead to a substantial cost under a forward contract. Things that appear to be free can end up costing more than other things at an apparently higher price.
Warren Edwardes, Chief Executive, Delphi Risk Management, 3 Hyde Park Steps, St George's Fields, London W2 2YQ
Full insight
Warren Edwardes' best-selling book Key Financial Instruments: understanding and innovating in the world of derivatives, (Financial Times Prentice Hall) is widely acclaimed for demystifying derivatives. He writes "there is an enormous difference between something being cheaper and costing less money!"
In 1999 Marconi provided many of its employees the right to 1,000 free shares each, provided that the company's share price increased from £8 at the time to £16 over a five-year period. In other words, Marconi provided its employees with share options at no cost - a not unreasonable means of motivation. However, unlike The Equitable Life which gifted certain policyholders with free interest rate options but neglected to hedge the risk, Marconi set up a hedging programme to hedge its risk.
But Marconi's hedge appears to have involved entering into forward contracts to buy the shares at a pre-determined price, at a price of about £8 each.
A spokesman for Marconi is quoted as saying "At the time the funds were hedged, it was a prudent and sensible decision."
Marconi appears to have "hedged" using forward contracts rather than options. Options grant the right but not the obligation to buy or sell something at a pre-determined price. But forward contracts incorporate the right and the obligation to exchange at the agreed rate. Thus when the share price fell, Marconi remained obliged to pay the difference between the hedge contract rate of £8 and the current price and put up collateral to reflect the future value of the transaction. Marconi had given options to its employees. If the share price rose above £16, employees had the right to Marconi shares. But if the share price plummeted, as subsequently happened, employees had no obligation to receive shares.
Hedging options with forwards is standard practice amongst banks and some corporates, but the hedges need to be dynamically managed.
Just as The Equitable Life was reluctant to buy interest rate insurance to meet its option gifts, Marconi appears to have been reluctant to buy share price insurance and it entered into forward contracts locking itself into a fixed rate. Forward contracts do not involve the payment of an up-front insurance premium. They appear to be zero-cost or free. But adverse movements can lead to a substantial cost under a forward contract. Things that appear to be free can end up costing more than other things at an apparently higher price.
Contact:
For informed and expert comment on this highly topical issue, speak to Warren Edwardes, author of Key Financial Instruments and ceo of the financial product innovation and risk management consulting firm, Delphi Risk Management. Edwardes often acts as a derivatives expert witness.
"For those who wish to discover the delightful world of derivatives without the daunting task of understanding the usual gobbledegook, Key Financial Instruments is the decisive, dazzling read of the decade." Jim Courtney, Publisher, Global Trading.
".. I found it to be a collection of telling vignettes, which provide a series of fascinating insights into product development and marketing in particular .. the real pleasure of the book is when Edwardes is just expounding his business philosophy. He uses a lot of quotations and anecdotes from all walks of life to illustrate his points, which are usually fairly simple but often ignored in reality. ...The book is written in a lively entertaining manner and gives many insights into Edwardes own personality ..." Seana Lanigan of erivativesreview.com details
Nicola Farnell of CITPR: 01908 542777, 07799 664658, nicola.farnell@citpr.com
Warren Edwardes, ceo, Delphi Risk Management: 020 7724 4606, 07941 916328, we@dc3.co.uk
Warren Edwardes' Publications
Background
Marconi down 11% on news of £200m hedging loss
By Caroline Daniel, IT Correspondent and FT.com staff, Published: October 7 2001 21:48Marconi shares hedge turns into £210m loss
By Melanie Wright (Filed: 08/10/2001) Telegraph Group LimitedMarconi Website
The attached Form 20-F was filed with the US SEC on September 28, 2001
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"Derivatiphobia: a director's guide to derivatives", Dec. 1998, Treasury Management International, London
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"The financial future" October 2000, Finance Asia, Hong Kong
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