10 misconceptions about financial derivatives.

• Author: Siems, Thomas F.

The tremendous growth of the financial derivatives market and reports of major losses associated with derivative products have resulted in a great deal of confusion about these complex instruments. Are derivatives a cancerous growth that slowly but surely is destroying global financial markets? Are people irresponsible if they use financial derivatives as part of their over-all risk-management strategy? Are financial derivatives the source of the next U.S. financial fiasco -- a bubble on the verge of exploding?

Those who oppose financial derivatives fear a financial disaster of tremendous proportions -- one that could paralyze the world's financial markets and force governments to intervene to restore stability and prevent massive economic collapse, all at taxpayer expense. Critics believe that derivatives create risks that are uncontrollable and not well-understood. Some liken derivatives to gene splicing -- potentially useful, but certainly very dangerous, especially if used by a neophyte or a madman without proper safeguards.

Nevertheless, financial derivatives have changed the face of finance by creating new ways to understand, measure, and manage financial risks. Ultimately, they offer organizations the opportunity to break financial risks into smaller components and then to buy and sell those components to meet specific risk-management objectives. Moreover, derivatives allow for the free trading of individual risk components, thereby improving market efficiency. Using financial derivatives should be considered a part of any business' risk-management strategy to ensure that value-enhancing investment opportunities can be pursued. Let us examine 10 myths, or common misconceptions, about financial derivatives.

Myth #1: Derivatives are new, complex, high-tech financial products created by Wall Street. Financial derivatives have been around for years. Derivatives, as their name implies, are contracts that are based on or derived from some underlying asset, reference rate, or index. Most common financial derivatives can be classified as one, or a combination, of four types: swaps, forwards, futures, and options that are based on interest rates or currencies.

Wall Street's "rocket scientists" continually are creating new, complex, sophisticated financial derivative products. However. these all are built on a foundation of the four basic types. Most of the newest innovations are designed to hedge complex risks in an effort to reduce future uncertainties and manage risks more effectively. The newest innovations require a firm understanding of the tradeoff of risks and rewards. To that end. users should establish a guiding set of principles to provide a framework for effectively managing and controlling financial derivative activities. Those principles should focus on the role of senior management, valuation and market risk management, credit risk measurement and management, enforceability, operating systems and controls, and accounting and disclosure of risk-management positions.

Myth #2: Derivatives are purely speculative, highly leveraged instruments. Put another way, this myth is that "derivatives" is a fancy name for gambling. Has speculative trading of derivative products fueled the rapid growth in their use? Are they used only to speculate on the direction of interest rates or currency exchange rates" Of course not. The explosive use of financial derivative products in recent years was brought about by three primary forces: more volatile markets, deregulation, and new technologies.

The turning point seems to have occurred in the early 1970s with the breakdown of the fixed-rate international currency exchange regime, which was established in 1944 and maintained by the International Monetary Fund. Since then, currencies have floated freely. Accompanying that development was the gradual removal of government-established interest-rate ceilings. Not long afterward came inflationary oil-price shocks and wild interest-rate fluctuations. Financial markets were more volatile than at any time since the Depression.

Banks and other financial intermediaries responded by developing financial risk-management products designed to control risk better. The first were simple foreign-exchange forwards that obligated one party to buy and the other to sell, a fixed amount of currency at an agreed date in the future. By entering into a forward contract, customers could offset the risk that large movements in foreign-exchange rates would destroy the economic...