Academic journal article Journal of Accountancy

Derivatives Revisited

Academic journal article Journal of Accountancy

Derivatives Revisited

Article excerpt

Companies are still using them successfully

Derivatives debacles have provided some of the past decade's most devastating financial headlines. Names such as Long Term Capital Management, Orange County and Baring Brothers bring to mind situations where derivatives failed--often miserably (see exhibit 1, for details). Several losses were enormous--an estimated $2 billion tot Orange County and $4 billion for Long Term Capital. Other incidents resulted in highly publicized lawsuits between derivatives buyers and sellers, such as Procter & Gamble's lengthy dispute with Bankers Trust.

Exhibit 1: Derivatives Losses in the 1990s

Company/Entity                 Amount of Loss   Area of Loss

Air Products                     $113,000,000   Leverage and
                                                currency swaps.

Askin Securities                 $600,000,000   Mortgage-backed
                                                securities.

Baring Brothers                $1,240,500,000   Options.

Cargill (Minnetonka Fund)        $100,000,000   Mortgage
                                                derivatives.

Codelco Chile                    $200,000,000   Copper and precious
                                                metals futures and
                                                forwards.

Glaxo Holdings PLC               $150,000,000   Mortgage
                                                derivatives.

Long Term Capital Management   $4,000,000,000   Currency and
                                                interest rate
                                                derivatives.

Metallgesellschaft             $1,340,000,000   Energy derivatives.

Orange County                  $2,000,000,000   Reverse repurchase
                                                agreements and
                                                leveraged struc-
                                                tured notes.

Proctor & Gamble                 $157,000,000   Leveraged German
                                                marks and U.S.
                                                dollars spread.

Source: Derivatives: Valuable Tool or Wild Beast? by Brian Kettel. Copyright [C] 1999 by Global Treasury News (www.gtnews.com). Reprinted with permission,

The causes of these losses varied. Among those frequently cited were traders working without adequate supervision, pricing models that failed to account for extreme market movements and market illiquidity. Although derivatives abuses have been absent from the headlines lately, some incidents still make news, such as Sweden's Electrolux AB's 1999 loss of more than 55 million German marks (approximately $28 million) due to an employee's unauthorized futures trading.

Given the negative publicity that derivatives--instruments that derive their value from another financial instrument or commodity such as interest rates, stock prices or precious metals--received in the 1990s, a casual observer might have predicted that corporations would cut back on their use of these instruments. But that hasn't happened. The Association of Financial Professionals (AFP) 1999 member survey found that 63% of the respondents used over-the-counter (OTC) derivatives. (Exhibit 2, explains some of the key differences between OTC and exchange-traded derivatives.) Among companies with annual sales over $500 million, reported usage was even higher, at 78%.

Exhibit 2: Key Differences--OTC vs. Exchange-Traded Derivatives

Here are some key contract features:

Over-the-Counter               Exchange-Traded

Private transaction            Public price quote
Credit risk                    Limited credit risk due to clearing
                                 house
Wide range of structures and   Standard contracts and size
  contract size
Many currencies                Major currencies
Any maturity                   Standard expiration dates

Source: Derivatives: Valuable Tool or Wild Beast? …

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