In their classic investment text, Security Analysis (1934), Benjamin Graham and David Dodd tell us, “An investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative”. Finance has come a long way since then, but yesterday’s prejudices die hard. The economic meltdown has generated a lot of heat about derivatives, which some critics wildly deride as “weapons of mass destruction” or tools for gamblers seeking to turn a little money into a lot. But this condemnation is misguided, for it can deprive enterprises of the real benefits of derivatives: to prevent a large amount of money from becoming a little.
On 15 October, the US House financial services committee approved legislation that would, for the first time, regulate derivatives and require that swap transactions between major financial players viewed as posing systemic risk be conducted over transparent exchanges. The rules would exempt enterprises—such as manufacturers, airlines and life insurers—that use derivatives to hedge against business risk. This exemption underscores their utility as valuable business management tools.
At core, derivatives and their benefits concern the likelihood of a future event and its consequence. For example, an Indian export-driven company with significant dollar revenues and rupee expenses may want to ensure that rupee devaluation will not leave it insolvent. To do so, it may enter into a forward contract with a buyer who will pay a set rate for the dollar receipts. While the exporter is willing to give up profit if the dollar-rupee currency market suddenly turns up, the buyer (or counterparty) is willing to take the risk the market will turn down—in return for a chance that it will go the other way. There are many other types of such products.
That is not to say there is no risk. A key problem that we have seen during the recent crisis is that markets are not always efficient and they are prone to extreme event risk. For example, the market might wrongly model the risk embedded in a class of financial instrument, causing participants to flee the class and stop trading upon revelation of the error. Or normally correlated assets may diverge for an unexpectedly long period of time, causing a vicious cycle where companies keep dumping these assets.
Yet, those aren’t the risks the US government seeks to contain with its legislative recommendations.
In fact, the recommended changes are virtually irrelevant in India, because here the derivatives marketplace is tightly regulated and the types of permissible transactions are severely limited. This does not mean, however, that Indian companies are immune to systemic and extreme event risks as they cascade from foreign markets.
During the meltdown, Indian companies were severely affected when US and European enterprises suddenly found themselves in a liquidity crisis. Foreign companies repatriated as much foreign investment as possible, causing an abrupt decline in the value of the rupee against the dollar. There was also a sudden drop in export demand and downward pressure on prices. The result was an economic debacle for a number of Indian companies that had not taken adequate steps to protect themselves—including some that had entered into derivative transactions to protect against foreign currency movements, but had not taken steps to adequately understand and manage the associated downside risk.
This experience highlights the need for Indian companies to ensure that they have in place the appropriate governance and risk management structures. These will produce the transparency, responsibility and accountability needed to ensure that derivatives are not used to earn a little extra money, at the risk of losing a lot, but are utilized to manage real business risks.
Jonathan Rosenoer is a Europe-based partner with KPMG now working in India to support the firm’s financial risk management clients. Comments are welcome at firstname.lastname@example.org