Although derivatives are referred to as weapons of mass destruction by Warren Buffet, expertise can ensure that financial derivatives help firms hedge their risks and reduce costs
Risks faced by firms can be divided into three categories: Market, commercial and external events. Market risks relate to price movements in financial markets and include interest rate risk, foreign exchange risk and commodity price risk. In many cases, such exposures can be managed using financial derivatives. Commercial risks are inherent in the operation of the firm and are generally subject to a certain extent, to managements control or influence.
Among such risks are failures of internal processes and actions by competitors. The management of such risks, although a concern of business executives, cannot typically be accomplished with derivatives or other kinds of financial contracts. External events risks are not necessarily firm-specific, and can stem from non-market events such as natural catastrophes or changes in tax or regulatory policies.
Hedging by utilising derivatives is one of the risk management strategies used by firms to manage risks. Corporations use hedges to protect themselves against a quartet of exposures: Swings in interest rates, commodity prices, foreign exchange rates and equity values. However, using derivatives is like a double-edged sword. If a manager gains expertise in using them, they can be beneficial for organisations else create havoc.
What is hedgingIJ Hedging is reduction of financial price risk (exposure to risk of loss resulting from fluctuations in exchange rates, commodity prices and interest rate changes) through usage of off-balance sheet financial instruments (ie, derivatives) such as interest rate or foreign exchange forwards, futures, swaps and options. However, since the past two decades, hedging is being referred to as an activity which helps reduce or cancel out the risk imposed by another investment.
Many associate financial markets mostly with equity market. However, the financial market is much broader, encompassing bonds, foreign exchange, real estate, commodities and numerous other asset classes and financial instruments. Of all markets, the derivatives market has seen the highest growth in recent years. According to the most recent data from the Bank for International Settlements (BIS), the total notional amount outstanding for contracts in the derivatives market stood at an estimated $542.4 trillion which is several times the size of the world economy.
The growth of derivatives is tremendous and this due to several factors like technological enhancements leading to development of sophisticated risk management tools, increased integration of local financial markets with global markets and increased volatility in asset prices in financial markets.
History is a witness. Since the 1990s, companies worldwide have got into derivative deals, believing that prices of currencies, bonds and commodities or any other underlying asset would be generally predictable. This was not to be so and during the global financial crisis, there were turns in the road and many companies, that did not anticipate these turns, ended up in the ditch.
To name a few big companies, Enron, in 2001, filed for bankruptcy for trading energy derivatives and guaranteed to give equity stock if the counter party’s assets declined in value. lo behold, the dot-com bubble, burst in 2001 worldwide, causing huge compensation to counter parties. In 2004, China Aviation Oil Corp faced a loss of $550 million by betting heavily on a fall in the price of oil during October 2004 and going short on oil futures.
On the contrary, New York oil futures surged to a record $55.67 a barrel in October and creditors were forced to close a number of derivative contracts. Similarly, Amaranth Advisors lost six billion dollars in 2006 by speculating in natural gas futures. And who can forget Barings Bank, with a long standing history of 225 years, being brought down by negligent decisions and lack of internal controls.
Indian companies, particularly exporters, also faced losses during the 2008 global meltdown due to derivative holdings. An example is ludhiana-based hosiery and cycle industry, which according to experts had estimated notional losses of two to three billion rupees in derivative products and had also moved court against banks for mis-selling. Nahar Industrial Enterprises and Jawaharlal Oswal Group had moved court against Axis Bank while Garg Acrylics ltd, with interests in steel and textiles, had moved court against ICICI Bank. These companies used derivatives for cost-reduction purposes but lack of knowledge about the instruments and dependency on banks led to their downfall. Therefore, extreme caution needs to be exercised while using derivatives.
Hedging should be the main motive of firms using financial derivatives rather than as a tool of speculation. But with the large intensity of losses faced by companies, will using financial derivatives for hedging be worthwhileIJ And should they be fearedIJ The answer appears to be no and several studies have proved that using derivatives to minimise risk is likely to enhance firm value but derivatives should be properly understood and the risks measured before applying. The dramatic increase in the use of derivatives worldwide has generated great interest in how firms used derivatives and the factors that determined its usage. Hedging using derivatives can help companies in different ways.
Firstly, financial derivatives mostly help firms with the possibility of financial distress to reduce the costs associated with it. A firm is said to be in the state of financial distress when a fall in its earning power creates a possibility that it will not be able to pay off its debts.
Secondly, firms which have an underinvestment problem when they are not able to make capital expenditure due to the fact that external funding is costly and at the same time they do not have enough internally generated funds, can use derivatives for hedging as it can improve their net cash flows and thirdly, financial derivatives are particularly helpful for firms with a high exposure to foreign exchange rate risk and their use can enhance value.
What type of firms in India use financial derivatives and is it value-enhancingIJ A study conducted by the author of 120 companies listed on National Stock Exchange (NSE) over a period of eight years, shows that larger firms in India have significantly higher use of derivatives, suggesting that larger firms have the capability of engaging in derivatives trading due to economies of scale in establishing and at the same time maintaining the expertise.
In addition, it is found that hedging using derivatives is value-enhancing as firms that use derivatives have higher liquidity, higher revenue and more assets as compared to firms that do not use derivatives. Usage of derivatives also have a positive influence on performance indicators like market capitalisation, enterprise value and income of firms.
Although derivatives are referred to as ‘weapons of mass destruction’ by Warren Buffet and they are considered ticking time bombs but with caution, expertise and focusing more on need than greed can ensure that financial derivatives help firms hedge their risks and reduce costs.
(The writer is Assistant Professor, Amity University)
