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Feb 2016

The Use of Derivatives: Hedging Risk vs. Speculation

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Derivatives were first introduced in order to neutralize the financial risk corporates are faced with in their daily business. It all started off pretty straightforward and has become less and less so over the years – not an uncommon scenario in today’s highly complex financial environment. This did and does not only concern banks but any financial intermediaries and all kinds of businesses. The sheer size and organizational structure as well as the ever increasing globalization of many corporates have given rise to more and more complex financial transactions and risks; and derivatives are one of the means of responding to them. In addition to interest and FX risk we’re now also dealing with increased commodity risk in treasury.

So it all started with the elimination of financial risk, i.e. hedging a financial position in connection with a company’s deals and transactions as part of their core business. However, the last financial crisis clearly highlighted that to some financial players the use of derivatives is more than a hedging strategy. Initiatives such as EMIR and FinfraG attempt to collate data on trading in derivatives to gain more insight into their use, misuse and abuse. Far from the initial objective of reducing risk, some companies focus on nothing other than maximizing their profits. Derivatives have a high leverage effect which means that they can yield high profits at very little cost. This makes them very attractive for speculation, and it is the negative cases that the media has been keen to pick up on. In turn, media coverage on derivative speculation has created an unfair image in the public mind.

Hedging risk vs. speculation: where do we as corporate treasurers position ourselves when it comes to the use of derivatives? We can see the same two “profiles” in treasury: on one hand the “speculators” whose treasury departments aim to use derivatives most cleverly in order to maximize company profits, boost their position in the market and systematically make money. One the other hand we have those treasurers whose responsibility it is to develop hedging strategies in order to reduce or even eliminate risks. To them, it is not about making money by means of financial transactions but by means of manufacturing goods or providing services – the company’s actual business.

Whichever side you might lean towards, one thing is beyond question: the transactions underlying business activity always create risks, and it is a treasurer’s responsibility to tackle these risks and in most cases reduce them to a certain level. Unfortunately, it is part of human nature that we like to compartmentalize when it comes to bad memories; for derivatives this can mean distorted risk profiles. Just think of speeding tickets that despite best intentions just do not make people drive slower next time. In the same way, potential profits can be so tempting that they eclipse any potential losses, despite the fact that experience should mean we know better. Every gambler, every casino, every betting shop works this way. If everyone always acted rationally, such business models would be doomed from the very start.

And it is also human nature that we don’t question our initial intentions until something goes wrong and we need to justify our derivative strategy. This is true for every accident, for every loss, for every speeding ticket, for every business model – for everything in life that hasn’t worked out the way we had hoped. Way too often we turn a blind eye to risks and only try to shut the stable door after the horse has bolted. But what is a treasurer’s underlying responsibility? What is the original concept behind derivatives? It is the hedging of financial risk in connection with a company’s deals and transactions.

If more companies were to refocus on these fundamentals we could avoid much potential and actual damage. There will always be those who speculate and this article isn’t aimed at them. But everyone else should first analyze their risk profile and then seek a suitable instrument for neutralizing risk and a successful way of implementing it. This would suddenly make the evaluation of instruments, the justifications for auditing or for management and the representation in a business context very simple. If more companies were to concentrate on eliminating risk through suitable instruments instead of using extravagant and “custom” finance constructions, the benefits in terms of security and reliability would be enormous. Maybe we could even do without mandatory reporting for derivatives for companies as this was ultimately introduced to establish whether large scale short selling, in other words speculation, creates dangerous imbalances on the financial markets and therefore negatively influences market prices for financial products and commodities.

Any treasurer who now thinks this all sounds a bit boring should maybe consider who will have to shoulder the consequences of such speculative behavior in the end. Maybe going to a casino would be a better way of seeking the buzz of gambling. There, anyone can speculate to their heart’s content: with their own money and without endangering the finances of any business or public institution.

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