Business Perspectives By Mano Mahadeva, CPA, MBA | Column Editor
Derivatives – Part Deux A derivative is a financial instrument that offers a return based on the return of some other underlying asset. That is, a return derived of another and named as such. The history of these instruments is surprisingly longer than most people realize and is traced back to the mid-1700s when farmers had to protect themselves from declines in prices due to overproduction or drought. Derivatives come in two flavors – plain vanilla and exotic. There are four classifications of “plain vanilla” derivatives: • swaps – helps one to exchange payments in a different currency; • options – gives one the right, but not the obligation, to buy an asset in the future, at an agreed upon price; • futures – the right to buy an asset in the future at a fixed price; and • forwards – similar to futures, but more customizable in terms of size, expiration date and price. These four classifications come in two types – exchange traded and over-thecounter transactions. The former consists of the “option to buy” and the “right to sell” shares in the market. The latter, and the larger of the two, are arranged between two parties. The other flavor of derivatives – exotic – comprises all other classes. This is the class that creates problems. Companies use derivatives as a hedge to reduce cash flow volatility and earnings volatility. Derivatives are used to speculate, enhance returns, undertake arbitrage, transform cash flow, or structure a desired position. However, the possibilities for direct and indirect use of derivatives are endless, as users continue to innovate with traditional and exotic products. Derivatives serve a variety of purposes in the global economic system. They make underlying markets more efficient by producing information and by enabling investors to trade on information that may
otherwise be unavailable or expensive. Second, derivative markets provide opportunities to break financial risks into smaller components and then buy or sell those components to meet companyspecific risk management objectives. Third, derivative markets are driven by low transaction costs, as they are a means to manage risk and in effect, serve as a form of insurance. If the cost were high, it would never grow and probably never exist. Fourth, firms of all sizes benefit from the use of derivatives. However, derivatives are complex instruments to use. For the end user, making a choice among instruments is not easy. To make a choice, one needs an understanding of the risk-return tradeoff of the instrument and an awareness of the accounting, financial and legal consequences of the company’s earnings and cash flow. Without a clearly defined risk-management strategy, the use of these instruments can be a hazard. Comparative analyses by industry, product and even country are no easy task due to regulatory and accounting applications. Disclosure of derivatives has increased, but it may be impossible to list all the details of a company’s derivative activity and all details of its risk. Then there are valuation issues that conflict with management incentives, as well as assessing the true cost of a derivative, when one takes into account the cost of the associated risk. In 2005, due to the rapid growth of derivative instruments and the collapse of
Orange County, Freddie Mac and Barings, Warren Buffett led a blistering attack on derivatives, calling them “financial weapons of mass destruction” in an annual letter to his shareholders. Bill Gross, Manager of PIMCO bond funds, joined him. In hindsight, they were right. Risk exposures were not fully understood. Financial models managed and measured risks. Common rules were violated easily and often. Rare tail risks and low probability, system-wide adverse events derailed the economy in 2008. In its wake, the regulation of derivatives became a primary focus of financial regulatory reform. In July 2010, the Dodd-Frank Act was signed into law by President Barack Obama (see cover story), which established a new framework for regulatory and supervisory oversight of the over-the-counter derivatives market, estimated at more than $600 trillion. Derivatives have redefined the financial services arena. These instruments are here to stay as they can provide an efficient way to transfer risk from those who do not want it to those who do. These are powerful tools, which can be used in the management of risk. However, with power comes danger. Therefore, they must be used with the necessary care, knowledge and controls to avoid disaster. Managing risk is part of what companies must do to generate sustainable growth of shareholder value. This provides an opportunity for the CPA to assess and recommend pragmatic alternative solutions to help provide resilience to unexpected circumstances. n
Mano Mahadeva, CPA, is executive director with U.S. Oncology in Plano. He serves on both the Editorial Board and the Business and Industry Issues Committee for TSCPA. Mahadeva can be reached at mano.mahadeva@usoncology.com.
Today’sCPA
| SEPTEMBER/OCTOBER 2011
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