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Home > Financial Risk Management Best Practice > Dangers of Corporate Derivative Transactions

Financial Risk Management Best Practice

Dangers of Corporate Derivative Transactions

by David Shimko

Executive Summary

  • Derivatives can be extremely effective risk management tools when used correctly.

  • Used incorrectly, derivatives can cost firms hundreds of millions of dollars and damage the hard-won reputations of firms and managers.

  • Most derivative debacles could have been avoided had appropriate checklists been followed and corrective action taken.

  • Successful derivative transactions require significant analysis, senior management understanding and judgment, and due skepticism regarding advice from conflicted counterparties.

Overlooked Risks

It’s easy for managers to overlook risks. Financial risk managers may ignore nonfinancial risks. Business managers responsible for a particular line item (such as costs) may downplay risks unrelated to their particular line item. Firms often manage their risks compartmentally—for example: the treasury department for foreign exchange and interest rates; the procurement department for commodity purchases; and the insurance department for catastrophic risks.

By its nature, any derivatives transaction introduces an enterprise-wide risk, even if it has a narrow purpose. Therefore, derivative transactions must be analyzed and managed systematically to ensure consistency with corporate objectives, suitability of the transaction, and avoidance of unintended consequences of the process.

Many soft risks can be avoided by following the steps on this derivatives transaction checklist:

  • Verify consistency with risk policy and corporate objectives. Has the risk policy been updated to reflect current business strategy?

  • Consider the impact of potentially offsetting risks on the balance sheet.

  • Examine legal and regulatory requirements to assure compliance.

  • Anticipate possible future legal and regulatory changes.

  • Simulate possible outcomes of the derivative transaction under many scenarios.

  • Establish the correct accounting treatment.

  • Ensure the accounting treatment has the desired result in all scenarios.

  • Understand when the desired accounting treatment cannot be attained.

  • Make sure the firm has the personnel and systems to trade, monitor, and report derivatives activity.

  • Communicate objectives to all stakeholders.

  • Plan communication strategies for alternative future outcomes.

  • Anticipate reputational risk due to possible adverse outcomes.

  • Predetermine performance measurement criteria.

  • Undertake review by audit committee (some firms will have a risk management committee).

  • In the absence of sufficient internal expertise, seek outside evaluation.

  • Determine in advance how ongoing valuations and risk assessments will be performed.

  • Provide updated performance reports referencing communicated objectives.

  • Study exit strategies in the event that conditions change materially.

  • Consider personal political risk to managers under different outcome scenarios.

Failure to Reduce Risk

Although a derivative usually meets its narrow goal of reducing a particular risk, it is often the case that the derivatives transaction fails to reduce corporate risk materially. Indeed, some may actually increase the overall net risk profile.

For example, many firms hedge their foreign exchange risk carefully, perhaps not realizing that foreign exchange risk may be a very small part of the overall corporate risk profile.1 In many cases, tacit speculation occurs under the guise of hedging, particularly if the trading activity gets hedge accounting treatment.

More generally, derivative transactions supported by a particular department will likely reduce departmental risk but may not reduce the overall risk of the firm. For example, a large software firm may want to hedge its interest rate risk, without realizing that the interest rate risk pales in comparison to the business risks of software development and sales.

The only remedy for this problem is to build a firm-wide risk model, even if it is approximate in many ways, to understand the impact of a particular derivatives strategy on the firm. The firm-wide risk model should include market, credit, operational, and event risks in order to be as complete as possible. With this kind of model in place, the benefits of risk management can be more precisely measured in order to compare the benefits to the costs. The following steps may be added to the checklist above:

  • Build a model of the firm that simulates all material risks.

  • Overlay the proposed derivative on the firm model.

  • Test cash margin requirements, credit exposures, and accounting outcomes from the model.

  • Document courses of action for select scenarios.

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Further reading

Books:

  • Brown, Gregory W., and Donald H. Chew (eds). Corporate Risk: Strategies and Management. London: Risk Books, 1999.
  • Hull, John C. Options, Futures and Other Derivatives. 7th ed. Harlow, UK: Prentice Hall, 2008.
  • Kolb, Robert W., and James A. Overdahl. Understanding Futures Markets. 6th ed. Malden, MA: Blackwell, 2006.
  • McDonald, Robert L. Derivatives Markets. 2nd ed. Boston, MA: Addison-Wesley, 2005.
  • Smithson, Charles W. Managing Financial Risk: A Guide to Derivative Products, Financial Engineering, and Value Maximization. 3rd ed. New York: McGraw-Hill, 1998.

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