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Don’t Knock Derivatives

Absa Capital

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.