Don’t Knock Derivatives
The global financial crisis has put derivatives firmly in the sights of regulators and media commentators, but for those who are charged with managing corporate treasury operations, it is important to cut through the hype and get a firm grasp of what these tools offer in terms of sound risk management processes.
In its simplest form, a derivative is a financial instrument which derives its price from another underlying component and its value is influenced by factors such as time and leverage. However, high profile international blow-outs such as Orange County (which in 1994 became the largest US county to ever go bankrupt on the back of poor treasury decisions) or Barings (which saw ‘rogue trader’ Nick Leeson lose more than $1.3bn speculating) have given the instruments a bad name.
Closer to home there was no shortage of criticism for South African Airways (SAA) and its ill-fated hedging strategy which saw the airline take a R9.8bn hit through financial markets instruments between 2003 and 2004. A lot of this criticism, however, may well be misplaced.
“If one dissects the facts around the SAA case for instance, derivatives themselves were not the bad guy, but rather the financial reporting around them which created the problems,” says Chris Paizis, Head of Corporate Distribution at Absa Capital.
In the case of Orange County or Barings, says Paizis, the derivatives were deployed without mandates and this had created fear and uncertainty for treasurers contemplating using these tools to manage risk.
“The first question I should be asking myself is what my risk management mandate is and then I should be asking myself if I understand it and am able to effectively communicate it,” says Paizis.
He uses the example of a basic forward exchange contract, which is an instrument which almost all treasurers will be familiar with. The contract is a form of a derivative, the terms and risks are clearly defined and the treasurer can work out with some degree of confidence and certainty how much volatility they are likely to face.
Derivatives are more than just speculation
Over the last few years the derivatives market in South Africa has evolved significantly with a lot of investment in new products and technology platforms as well as improved regulatory structures. These include equity, currency, commodity, interest rate and agricultural futures which see significant volumes pass through their markets each month.
For a country like South Africa, which is heavily dependent on its resources sector but has limited sources for capital, commodity derivatives have provided an alternative opportunity for funding. While many market participants have focused on growth in the equity Single Stock Futures (SSF) market, which tripled in three consecutive years from 2005 to 2007, other markets have also grown significantly. Between 2001 and 2008, the interest rate derivative market in South Africa had grown by 412% in terms of average daily trade and by the end of 2007, the country had 9% of the total overall market share of over the counter (OTC) derivative trading activity in emerging markets.
On the whole this growth is encouraging but as with every growing industry, there are bound to be hiccups along the way. While South Africa was shielded from some of the more spectacular collapses seen in the international markets, it has had some bumps and bruises along the way as market participants have worked hard to understand the best use for these instruments.
Breaking down the mystique around derivatives further, Paizis draws an analogy around insuring a sports car such as a Ferrari. The driver needs to understand the value of the underlying asset, the risks they anticipate facing and how much protection they need to buy relative to the risk. Ideally you don’t want to have to tap into the protection but it is reassuring to know it is there. “What you want is a prudent and flexible risk management tool,” he says.
Many South African investors will remember back to 2008 where the SSF and Contracts for Difference (CFD) markets were rocked by derivative trades gone bad and will use this as a reason to avoid these instruments. At the time there were a lot of questions about whether they were properly regulated and were operating in sufficiently liquid markets. These criticisms are perhaps unfounded considering how highly South Africa ranks in terms of international benchmarks. In 2010 the World Economic Forum Competitiveness report saw the Johannesburg Stock Exchange ranked first out of 139 countries for its regulation. Other areas where South Africa scored highly included the financing through the local equity market at 7th, availability of financial services at 7th, soundness of banks at 6th and legal rights of investors at 6th.
Paizis points out that the interest rate market in South Africa is also very well developed and the country had developed a 30 year interest rate swap market before it had one for the 30 year bond contract.
Two areas where derivatives can be very helpful are around mitigating risks you don’t want to take in financial markets and secondly it can help change the profile of your debt, which can be a very useful tool for many cyclical industries.