Derivatives aren’t available for every risk source, but they do cover many categories affecting the concerns of large numbers of commercial enterprises. Given such wide coverage, it’s reasonable to question why some firms bearing these exposures use derivatives while others don’t. Ultimately, the underlying issue is knowledge and understanding—or possibly misunderstanding.
Derivative contracts are often portrayed as the bad boys of the financial marketplace, but this characterization misrepresents most derivatives and their uses. In fact, most derivatives are plain vanilla, capable of achieving very understandable and reasonable objectives. Typically, these (or very similar) economic outcomes could be achieved without derivatives, but derivatives often offer a more efficient and cost-effective way to realize desired results, particularly when an adjustment is desired after an initial transaction has already occurred.
All derivatives are contractual arrangements that generate payoffs that depend on changes of some external reference price or index. And while these contracts can be used by a wide variety of institutional actors, they are generally used for one of two purposes: either as hedging instruments, where the contracts balance off some preexisting risk, or to speculate on a coming price change for some asset or portfolio of assets.
Generally, corporate finance applications would fall under the hedging category, where commercial enterprises with exposure to interest rates or foreign currency exchange rates or price risk would mitigate these risks by entering into related derivative positions, arranging the contracts to pay off when that preexisting risk contingency is realized. A corollary to this rule, however, is that if the risk doesn’t come to fruition and instead, the underlying exposure benefits the enterprise, the hedging derivative would be expected to generate a corresponding loss.
In contrast to these corporate applications, when derivatives are used for trading purposes or for investment purposes, for the most part, the derivative contracts would be used to take on risk. These uses would be speculative transactions, and like virtually any other speculation, if you’re right you win and if you’re wrong you lose. The vast majority of the bad press on derivatives relates to these speculative applications, where the culprit was really poor business controls rather than the derivatives, per se. Headline losses attributed to the use of derivatives weren’t the fault of derivatives. Rather, they were the fault of the traders making bigger bets than they could afford and putting the viability of their organizations in jeopardy.
Returning to the commercial hedging transactions, the most typical hedge objective is locking in forthcoming prices that would otherwise be uncertain. Clearly, in retrospect, once you do lock in a price, you may end up regretting that decision if the feared adverse price change fails to develop. In this situation, the loss on the derivative obviously would have been avoided if you hadn’t hedged in the first place. This possibility is part of the calculus that should be understood prior to making the decision to hedge.
For corporate financial managers, the most widely used derivative instrument is the interest rate swap contract, relating to interest rate exposures. These days, commercial bankers often require commercial customers to borrow on a variable rate basis, thereby forcing these customers to bear the risk of rising interest rates. When these borrowers pair these exposures with an interest rate swap contract, the derivative serves to swap those variable cash flows for fixed cash flows.
The borrowing company still pays the bank a variable interest payment, but the terms of the swap contract—which might be transacted with that same bank or some other swap dealer—impose two additional cash flow obligations—a variable receipt cash flow designed to offset the original variable exposure paid to the bank, and a fixed payment cash flow. Combining the cash flow obligations of the swap with the original variable payment to the bank effectively transforms the variable rate debt into a synthetic fixed-rate debt.
Importantly, swap contracts don’t require any upfront cash payments. Instead, these contracts are entered into as handshakes, reflecting a promise and obligation to make future settlements in the prescribed manner that serve to achieve the intended outcome.
Besides locking in prices, derivatives can also be used to establish worst case price outcomes. This objective can be realized by buying caps or floors in connection with repetitive pricing exposures (e.g., a series of purchases or sales at yet-to-be determined market prices) or option contracts for individual price exposures. A purchased call option giving the right to buy a currency or commodity serves to ensure some worst-case, maximum purchase price, while a purchased put option giving the right to sell ensures a worst-case minimum sales price. These kinds of derivatives require an upfront cost—i.e., option premiums—where the cost would be different at different times, as market conditions varied.
Probably the most typical adverse outcome for derivatives has to do with the fact that, with derivative positions, the losing party has to pay up, in cash. Large market moves can and do stress the financial system, but to a large degree, this systemic risk has been addressed by the Dodd-Frank Act and evolving practices relating to the use of collateral adjustments in connection with derivative positions. These refinements generally serve to alleviate this concern by forcing many derivative users to settle derivative losses in cash before they have a chance to fully metastasize. Bearing this feature of derivatives in mind, derivative users need to be mindful of derivatives’ cash flow obligations and contain their use to manageable volumes.
Ira Kawaller is founder of Kawaller and Co. LLC, a consulting company that offers strategic advice and expert witness services relating to derivative instruments.