One recalls the hedge fund Long-Term Capital Management that was operated by some Nobel prize winners in economics. It was such a big hedge fund and it took such a huge position in derivatives that when it miscalculated and turned up a loser, it threatened to bring down the banking system. Fortunately, economic leaders found ways to unwind the transactions and keep everything running smoothly. But, if economics Nobelists can err that badly, what about us mere mortals?

 

There are three types of derivatives markets: exchange derivatives, over-the-counter derivatives, and swaps. Exchanges exist that standardize certain features of derivatives by specifying amounts, product descriptions, delivery instructions, and settling up. This standardization helps facilitate the trading of derivatives, though some find the uniformity confining in certain situations.

Over-the-counter derivatives allow participants to create their own contracts but brokers have to find somebody willing to accept these custom-made contracts. Swaps provide one the opportunity to swap one item for another, such as a fixed-interest loan for a variable-interest loan. In practice, the items usually are not actually swapped, but the difference in cash flows is settled up by one party paying the other the difference between the two cash streams. A few large business enterprises such as Freddie Mac participate in all three markets.

 

Policy makers should examine and debate at least three issues with reference to derivatives. One of the most basic issues surrounds the credit risk of counterparties, those who are committed to make cash payments when certain conditions occur.  For example, Freddie Mac in 2002 employed derivatives with a notional value greater than one trillion dollars. At that size there only a few firms with which Freddie can transact. While these firms have strong credentials and great financial strength, the concentration of risk might prove worrisome. If only one of these organizations encounters financial misfortunes or engages in accounting scandals, the commitments under the derivatives would not be met, the hedged risk rears its ugly head, and much havoc begins to wreck the American economy. These nightmares fortunately are improbable; unfortunately, the probability of occurrence still exceeds zero.

 

One curious prospect is whether managers hedge economic or accounting risks. Economic risks are real and worthy of hedging; accounting risks are mirages and are not worth hedging. An example of a real risk is a cereal manufacturer who is waiting for the wheat crop to harvest. The company can hedge against future price increases by purchasing a futures contract. The effect of such a contract is to lock in today's price of the grain, thereby eliminating any chance for the price to vary.

 

For an example of an accounting hedge, consider a firm with a foreign subsidiary that transacts all business within the foreign country. Some firms will hedge their “exposure” to a translation loss, but it is not clear why. Any reductions to the firm's shareholders' equity section are accounting transactions only. It is unclear what is being hedged or why managers engage in such hedging.

 

Another consideration is that in the real world there are no perfect hedges. This fact has two interesting facets. If the company is large and the hedge is imperfect, then the hedge can actually introduce new sources of gains and losses. If it bets the wrong way on (say) an interest rate swap and has a notional value of one billion dollars, even an error of one point in the interest rate percentage (on an annual basis) leads to a cash outflow of $10 million. Material gains and losses can mount up quickly.

 

In other words, some hedges might in fact not be hedges but speculative positions. In this case usage of derivatives might be giving only an illusion of security, for the derivatives are actually adding to the risk of the portfolio.
Accounting for derivatives adds to these concerns because Statement No. 133 captures the economic effects incompletely and at times poorly. In part this is due to the fact that many managers, especially of financial institutions, generally think of hedging on an overall or portfolio basis, while the FASB requires them to account for hedges on an individual basis.

 

Worse, even if we could discover the best way to account for derivatives, accounting moves too slowly to help the investment community. Losses from derivatives can explode rapidly in a corporate setting, but accounting can report on those activities only months later. In a lot of ways, accounting just does not help society in controlling the application of derivatives.

 

Summing up, these tidbits indicate that now might be the time for regulators to rethink and reevaluate whether derivatives should remain essentially unregulated. Mishandling of derivatives hurts not only the corporation but many others in society as well.