In Defense of Derivatives

Between Enron, WorldCom, and Global Crossing, the controversial financial instruments have gotten a bad rap. Here's the truth.

Gene Callahan & Greg Kaza from the February 2004 issue

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Consider a simple derivative, such as a stock option. Let's assume you could buy a share of IBM stock today at $100. Alternatively, you could buy an option granting you the right to buy a share of IBM stock at $100 at any time during the next six months. It should be clear that if you are interested in owning IBM you probably would consider such an option valuable. After all, should the share price of IBM plunge in the next half a year, you need not exercise your option, saving you from taking a bath. On the other hand, if IBM rises above $100, you can exercise your option and immediately make a profit.

The essence of derivatives is that they allow investors to separate out various aspects of an asset, and trade those aspects separately, rather than in a bundle. For example, when purchasing a share of common stock outright, the buyer gets both the upside and the downside potential of the stock. But by purchasing a "call" option, the buyer acquires only the upside potential.

Or consider David Bowie's sale of his royalty income, which separated the income stream from his song rights from the rights to the songs themselves. While the singer still controlled the use of his own songs, all of the royalty income from them flowed to those who bought the Bowie Bonds. From Bowie's point of view, his financial future was too dependent on the vagaries of his popularity. By selling some of his royalty income to others, Bowie was able to diversify his investments. (We assume that he did not spend the entire $55 million on a huge shopping spree for his supermodel wife Iman.) He reduced the risk that a major shift in the public's musical taste would leave him a pauper. Meanwhile, investors who had not previously had any stake in the sales of Ziggy Stardust could diversify into that area and earn a decent interest rate while doing so.

Similarly, a farmer who does not wish to concern herself with the dynamics of the wheat market can sell her crop "forward" (i.e., sell it at a specified future date for a price determined today). She can gain even more flexibility by purchasing a "put" option on the wheat -- buying the right, but not the obligation, to sell her crop at a certain price (the option's "strike price") over a specified period of time. If the spot wheat price falls below the strike, she can exercise her option and protect herself from losses. If the price rises above the strike, she can let the option expire and sell her crop at the higher price. Naturally, such flexibility has value to the farmer, and she must pay a price to others to persuade them to take on some of her risk.

"It is widely recognized that OTC ["over-the-counter," i.e., not traded on an exchange] derivative instruments are important financial management tools that, in many respects, reflect the unique strength and innovation of American capital markets," said Arthur Levitt, then chairman of the Security and Exchange Commission, in 1998 testimony to Congress. "OTC derivative instruments provide significant benefits to corporations, financial institutions, and institutional investors by allowing them to manage risks associated with their business activities or their financial assets. These instruments, for example, can be used by corporations and local governments to lower funding costs, or by multinational corporations to reduce exposure to fluctuating exchange rates."

How important are derivatives to multinationals? Consider this passage from IBM's 2002 annual report: "The company operates in approximately 35 functional currencies and is a significant lender and borrower in the global markets. In the normal course of business, the company is exposed to the impact of interest rate changes and foreign currency fluctuations, and to a lesser extent equity price changes. The company limits these risks by following established risk management policies and procedures including the use of derivatives and, where cost-effective, financing with debt in the currencies in which assets are denominated."

For the economy as a whole, the benefit of such activities is a simple extension of Adam Smith's 227-year-old insight that the division of labor increases overall productivity. By employing derivatives, David Bowie can focus on making music, the farmer can concentrate on farming, IBM can specialize in computer manufacturing, and financial market traders can worry about pricing assets and evaluating their risk.

Scary Monsters

Still, derivatives are newfangled enough that traders, CFOs, accountants, and investors remain on the learning curve for properly using and analyzing these instruments. We can expect these specialists to make miscalculations, occasionally serious ones. The media and general public, meanwhile, are a few steps further behind in understanding.

Take Enron. Derivatives did play a role in what was the second-largest bankruptcy in U.S. history (behind only WorldCom), but not in the way most people think. The Houston energy company did not go bankrupt because it lost money in derivatives trading. In fact, Enron was tremendously successful in its trading operations, racking up billions of dollars in profits. As documented by economic historian Frank Partnoy, the company went under not because it was losing money but because it tried to use these profits to disguise heavy losses in its consulting and technology businesses. When the accounting shenanigans were exposed, the company's credibility evaporated, as did its sources of credit and cash. The company was killed by a lack of cash flow, not a lack of profits.

But there are other troubling aspects of derivatives. For one thing, they may be used in what is called "regulatory arbitrage." Partnoy notes, in his financial history Infectious Greed (2003), that "bank regulators, by tightening their focus on banks to reduce their risks and prevent a banking crisis...pushed credit risks onto other, less regulated institutions." In other words, while it may have made sense in other ways for banks to retain more of their own credit risks, the regulatory environment prompted them to trade that risk away. Similar types of regulatory arbitrage have motivated other economic actors, such as insurance companies, to enter into derivative contracts that otherwise would have been unattractive to them.

It's clear that the legal system has a role to play in preventing financial scams. It is also clear that if a particular regulation is desirable, the use of derivatives to dodge it is not. If the regulation is not desirable, it is simply generating transactions that serve no purpose other than evasion, thus creating superfluous costs and transferring risk from specialists (such as banks and insurance companies) to the less experienced.

Another problematic aspect of derivatives is their often unmonitored use by government agencies. While there has been increased legal and social pressure on private corporations to be transparent in their use of derivatives, politicians have shown little interest in similar standards for government derivatives trading.

Some of the biggest users of derivatives are government-sponsored enterprises (GSEs) such as the mortgage-lending institutions Fannie Mae, Ginnie Mae, and Freddie Mac. Doug Noland of PrudentBear.com, a site that advises investors from a bearish perspective, notes, "We have Fannie Mae, Freddie Mac, and the Federal Home Loan Bank system with total holdings [of derivatives] approaching $2.2 trillion and guarantees for another $1.5 trillion of securities."

This year, FM Watch, a coalition of financial service and housing-related organizations dedicated to monitoring GSEs, reported: "One of the GSEs was able to make its RBC [risk-based capital] virtually disappear through use of derivatives and other risk-hedging devices." FM Watch recommends that GSEs' "disclosures should be at least as complete as those provided by other publicly-traded companies and issuers."