Vol 2 (2005) - Issue 5

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Derivatives: A Problem Child or Are They Simply Misunderstood?

Are fears about derivatives justified?

‘Financial weapons of mass destruction’ and ‘complex financial instruments that are not understood by top management’.
These are some of the commonly held perceptions about derivatives, adding further fuel to the negative publicity generated through the high profile failures of China Aviation Oil (‘CAO’) (losses of USD 550million), Long Term Capital Management (‘LTCM’) (losses of USD 4 billion) and Barings Bank (losses of GBP 830 million). However, are these fears really justified and what impact do they have on restructurings?
Whether the fears are justified or not, derivatives play an important and an increasing role in corporate risk management. They are expected to play an increasingly large role in restructurings going forward. Fitch Ratings statistics indicate that over 90% of companies use derivatives, the majority of them for managing risk.
Advisors and other stakeholders are likely to see the implications of derivatives in many more cases going forward. Restructuring professionals need to understand the issues and ways to mitigate their impact to drive through a restructuring and prevent a bad situation becoming worse.
This article discusses derivatives and their potential impact on a restructuring scenario and necessarily focuses on the more simple forms of derivatives. As derivatives become more complex, so too do the issues and solutions involved. Expert advice should be sought at an early stage if the risks associated with derivatives are to be mitigated.

What is the purpose of derivatives?

A derivative is a financial instrument whose value is derived from the performance of another underlying reference point, such as single or indexed debt, equity, commodity, etc.
Derivatives are not new - the first recorded use of them dates back to 1750 BC. In 500 BC, olive derivatives were being used, and in the seventeenth century there was a vibrant market in tulip options in Amsterdam.
By any standard, however, in the last thirty years we have seen an exponential increase in derivative use driven by several factors: firstly, Black and Scholes algorithms for calculating the worth of an option; secondly, the immense advances in computer power; and thirdly, significant declines in transaction costs and increases in market liquidity.
The principal purpose of using derivatives was to convert unwanted risks into a more acceptable risk or cash. They are an effective method of passing risk from those that don’t want it to those who do.

How are derivatives used?

Fundamentally, derivatives are not complicated and are based on three building blocks:

- Forward contracts - the obligation to buy or sell at a specific price at a specific time period;

- Option contracts; the right to buy or sell at a specific price at a specific time period;

- Swaps - A contract for periodic future exchange.

Derivatives become complicated with ‘exotic combinations’ of the above forms to achieve unique corporate purposes. The more complex they are, the harder they are to understand and manage. This makes them inherently more risky for all participants, particularly those with less sophisticated risk management techniques.
Table 1 overleaf illustrates some of the key market participants and their use of derivatives. A corporation’s use of derivatives tends to, and arguably should be, limited to managing risk. Migrating from hedging to speculation, however, requires minimal initial commitment. It promises the lure of high returns; the probability of losses is often overlooked.