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?

In their most basic form, derivatives are nothing new. Any stock with a call option attached is an equity derivative. Yet new types of derivatives—often with complex, multilayered structures—are emerging all the time. “There are a million ways to slice and dice derivatives,” says one market data collector and former trader. “If there’s a profit to be made, people are going to find it—or invent it.”

 

For corporates, however, there’s more to derivatives than profit potential.  Because they pay out when certain events occur—the underlying stock reaches a particular price, for instance, or crude oil hits a certain predetermined price point—they can be structured to support any number of outcomes. “Fundamentally, all derivatives are a way of transferring market risk,” says Ray Shirazi, a partner in the capital markets group of law firm Cadwalader, Wickersham & Taft in New York. “If you have an interest-rate-sensitive business—you’re a lender or borrower, let’s say—you can try to stabilize your interest-rate exposure by hedging it with interest-rate derivatives. A lot of airlines are entering into oil-price derivatives to stabilize their long-term fuel costs.”

 

Besides oil derivatives, there’s a wide variety of commodity derivatives that are triggered by changes in raw materials pricing. Also popular are currency derivatives, which lessen the risk of volatility in exchange rates. There are even weather derivatives, which provide a hedge for agricultural and other commodity-dependent businesses. Like all derivatives, weather derivatives protect against undesirable events, even if they are normal, predictable events like heavy rain or drought. “All you need is an objective weather measure, such as the National Weather Service, and if that weather event happens, you get a payout,” explains Brian O’Hearne, managing director of the environmental and commodity markets unit at Swiss Re, the reinsurance giant based in Zürich, Switzerland, and a leading provider of weather derivatives.
In a sense, these types of derivatives are like an insurance policy—with several key differences. “With derivatives, there’s no need to prove an insurable interest or proof of loss,” says O’Hearne. “With insurance, you only collect if you can prove you suffered damages.” For bigger catastrophes, there are catastrophe bonds—derivatives that pay out after earthquakes and other unforeseen tragedies.

 

 

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.”

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 professionals."

 

 

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

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