Much-Misunderstood Derivatives Play a Key Role in Managing Risk

Mary Schapiro, chairwoman of the Commodity Futures Trading Commission, recently was quoted as saying that the current media definition of a derivatives transaction seems to be “any financial transaction in which a large amount of money is lost.”

That definition is wrong.

Despite the financial woes of Orange County and Britain’s Barings bank, market analysts and regulators understand the true importance of derivatives. They readily agree that, overall, derivatives can be tremendous tools for reducing market risk.

The term derivatives covers a lot of territory, and often is much misunderstood. That confusion has been augmented by congressional calls for regulation of derivatives, even though many derivative products already are regulated.

Think of derivatives as a pie cut into three pieces:

* Piece No. 1 represents those derivatives that are securities subject to the authority of the Securities and Exchange Commission. They include structured notes, options on securities and security indexes, asset-backed securities and exchange-traded currency options.

* The second piece of the pie--the largest and what most people are talking about when using the term derivatives --represents futures and options traded on exchanges, such as the Chicago Board of Trade, that are regulated by the Commodity Futures Trading Commission.

* The third slice represents over-the-counter instruments offered by dealers, including banks and brokerage firms. This category, which includes exotic-sounding products such as swaps, caps, forwards, collars and options, to name a few--is what has initiated much of the attention in Washington and the media.

All the uproar has overshadowed the value of derivatives, particularly those traded on an exchange.

All transactions made with exchange-traded products are fully guaranteed by clearinghouses, so any possibility of loss resulting from a default by one of the trading partners is virtually eliminated. The clearinghouses impose a margin system that requires investors to post a certain percentage of “good faith” money to ensure they will perform on their open futures and options contracts. If losses rise, so too will the margin requirements--immediately alerting investors to potential problems. Likewise, products traded on an exchange provide complete price transparency. At any point, investors can see the exact value in other derivative alternatives.

While all the specifics of Barings’ losses in the Singapore futures market are not yet in, U.S. exchanges employ stringent surveillance procedures that would make such an incident highly unlikely.

At the Chicago Board of Trade, for example, all trades executed on the floor are submitted to the clearinghouse and matched on a continual basis throughout the day, allowing the exchange to oversee a firm’s risk exposure. Margins are calculated and collected at least twice daily. Large-trader reports generated daily by the exchange enable it to compare the financial exposure created by a particular trader to a firm’s overall capital. Finally, in the United States, market surveillance is coordinated among all exchanges as well as the Commodity Futures Trading Commission.

Despite all this, unsettling reports of losses caused by derivatives trading are spurring many corporations to reassess their strategies of interest-rate risk management. Certainly, there are lessons to be learned from the reported mishaps, but we must refrain from throwing the baby out with the bathwater.

Derivatives trading, like any investment, involves risk. But when used correctly, derivatives fill an invaluable role in managing risk. For example, food-processing firms always face the risk of escalating costs. To control those costs, a major cereal company can manage its price risk in the grain markets at the Chicago Board of Trade. Likewise, pension and mutual fund managers use the board’s financial markets to better manage investment risk in their portfolios.

Much as an insurance policy protects against potential losses being caused by unexpected events, derivatives products provide businesses and institutional investors with a mechanism for protecting their investments from losses that can be caused by fluctuations in world interest rates, currencies, commodities and equities markets.

*

Speculative losses such as those incurred by Barings and Orange County do not imply that derivatives are inherently dangerous. After all, if a batter strikes out in the ninth inning, we cannot blame the bat; it was its use--or misuse--that caused the problem. Some speculative losses, Federal Reserve Board Chairman Alan Greenspan recently noted, are a price we have had to pay “for a valuable addition to our financial system.”

The people who trade every day in Chicago’s futures markets understand that derivatives are an integral element of today’s financial marketplace. So do the chief financial officers of corporations and the pension and mutual fund managers who have scored spectacular gains for their shareholders and customers through the use of derivatives.

They have shown that derivatives can become a household word--for all the right reasons.