The derivatives scare

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Saturday , May 10, 2008 at 2057 hrs There is nothing new about derivatives. They have been in use since the 18th century when agriculturalists used them to hedge their agri-commodities exposure. It was only once we knew how to price these, thanks to the Black-Scholes-Merton equation, that they became popular on Wall Street. With their rise, we were introduced to a strange new beast—the quants. These physicists and math PhDs brought with them their deterministic bias to solve problems in finance. The result was highly structured products that could be customised for specific purposes and had the propensity to make news headlines for the wrong reasons.

As the name suggests, these are securities that provide special features on an underlying asset such as equity or debt (currency and interest rates) and even weather impact. There are two types of derivatives: the standardised type that are traded on the exchanges and the structured products that you transact with a financial institution (FI), also called over-the-counter products.

The underlying idea has remained the same: derivatives transfer risk, much like life insurance. Just as an insurance premium is a fraction of the insured amount, derivatives are much cheaper than underlying assets. But unlike insurance that require an insurable interest (it is rendered void if you don’t), derivatives are notionally priced on the underlying asset. An option to buy Reliance shares, for instance, has no direct impact on the stock itself. And so we come to the real reason these products have caught the popular imagination—gearing and its speculative potential.

The great advantage and also drawback is the inherent leverage worked into these products. You can buy a unit of 100 shares for about 1/10th the price or lower. This excites speculators and arbitrageurs—especially in debt and currency markets, with only a few basis points to play with. Nothing wrong so far, just a tool for efficient trade. The problem is that the pricing is complex. In options, for instance, there are six variables that interact and change one another. A directional bet with these instruments can go wrong easily. So, how is the risk managed? Through hedging or reverse trades. For companies, that means that they have debt or cashflow in currencies that they are hedging and for FIs (counterparty), it means spread trades that limit the exposure within defined limits. Naked directional positions are an invitation for trouble.

The current derivatives malaise in corporate India is a live example. Cross-currency swaps, for instance, lets companies access cheaper interest rates overseas (FCBs) and swap that with their domestic rupee cash flow. This directly impacts the cost of capital. So, what went wrong? If a company has minimal transactions in, say, the Swiss franc in its operations and does not hedge through a reversing trade—it is taking a directional bet on currency movements and interest rates. In plain English, it is speculating. This is best left to people better suited for the job and who have the risk management tools to limit exposure. And even they lose very often.

How did Indian corporates get into a mess? A bull market has inherent momentum which makes some short order punts look like sure bets. An unexpected change, say unusual strength in the US dollar, can drastically change things, and if you are holding an open position, you’re in trouble. A look at annual reports for 2007 will leave no doubt that companies were quite active in these markets. That is a clear problem for investors. You bought a company for its core business. If you wanted directional bets on the market, you would have gone to a hedge fund. Being off-balancesheet, these transactions are difficult to spot. The only reason companies should be using these instruments is to hedge cashflow risk not inherent to the core line of business—retain the risk they are paid to manage and transfer the rest to people better suited to it.

But this is easy money when things are going your way—the lure is real. But once markets turn, all sorts of excuses and alibis are exchanged. Derivatives are a zero-sum game: your winnings come directly out of the coffers of the counterparty. These are also wasting assets, that is, they have defined life terms, so their value drops with each passing day. Unlike stocks that can recoup losses over time, derivatives have to be closed to avoid further losses. That brings in the spectre of “marking” these products “to market”, which means that they will now show up on balancesheets. This explains why companies have found religion all of a sudden. Banks, on other side of these trades, are not unscathed either.

For investors, it’s clear. If companies won’t govern their treasury operations with due prudence, it is time they provide full disclosure on these transactions so that investors can judge for themselves the level of risk they are willing to bear.