Magazine article Business Credit

Choosing Soldiers and Systems

Magazine article Business Credit

Choosing Soldiers and Systems

Article excerpt

How do you avoid getting burned by derivatives? While the Group of 30's recommendations for using derivatives focused primarily on the impact for financial intermediaries, it did offer some guidelines for companies that aren't in the business of trading derivatives. For instance, your senior management needs to set policy for your firm's use of derivatives, and you need a knowledgeable, trained staff suitable for that use (don't hire a rocket scientist if you want to do simple interest-rate hedges - people like to use their talents).

You also should "stress test" your transactions, use master netting agreements with your credit risk, because you've just shifted your rate exposure to a credit exposure.

I think the two key recommendations from the Group of 30 are the most important. First, you must have independent risk-management oversight. At Baxter, we have two and one-half people working with derivatives (I say one-half because one person is always coming up to speed). Given the level of hedging we do, that number is appropriate, but it does make independent oversight tougher.

If you have only one or two people in your firm who truly understand your derivative transactions, you may have a case where the same person originates a trade and effectively manages the "back office." Even if you have someone outside of treasury who handles trade confirmations and payments, if that person doesn't understand derivatives, do you really have independent risk-management oversight? I think you can - if you follow several simple guidelines.

First, spread the expertise. Baxter sends people from our internal-audit staff and our accounting, tax, and legal departments to "derivatives" training, because we want other people within the company to understand the financial instrument.

Also, make many of your decisions by consensus, as we do at Baxter. This may mean that you sometimes miss an opportunity when the market moves because decision making takes longer, but ultimately you'll do only those transactions that people in other departments are comfortable with. That's a good check-and-balance system.

At Baxter, we also share a lot of information with our investment bankers, and we insist on benchmarking transactions with more than one bank, all of which understand our business and our goals. This approach won't fit every company, in particular those that prefer to keep their financial institutions at arm's length. But I think developing long-term relationships with your bankers is important because they become yet another source of checks and balances. …

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