Financial Weapons of Mass Destruction (WMDs) - that's how derivatives are referred to by an authority no less than Warren Buffett. Interestingly, that is exactly what they have proven themselves to be on numerous occasions in the past several years. There is a general agreement that when inadequately understood and transacted, they are potentially lethal to a firm and even to economies as a whole. However, in the right hands and with the right risk management governance structure, processes and systems in place, hedging structures (as opposed to speculative positions) based on derivatives, remain unmatched in their ability to offer risk mitigation and a risk-reward payoff. The payoff, if properly understood and managed, proves valuable to organisations as they seek to protect themselves from the volatility that has been prevalent in the global commodity, foreign exchange, rates, credit and equity markets. Mr Buffett himself certainly agrees, as is evident from the large contracts that he is taken on the long term equity index price levels where he views the risk-reward trade-off as favourable.
The losses and challenges that a number of companies, both Indian and international, have faced in recent years have been well publicised. No doubt several of these can be blamed on greedy, bonus-oriented bankers with scant regard for the appropriateness of what they missold; there were nevertheless, many instances where the firms were only too ready to wash their hands off the trades once things started moving the wrong way. The treasury profits they had made in the past several quarters quickly ballooned to huge hits on the bottom line, which in many cases wiped out significant chunks of capital and impacted the ability of the firm to continue on a going concern basis. The legal wrangles – not just in India but across Asia and Europe – are testimony to this.
Key questions
While the regulators, banks, and corporate clients have tightened the screws somewhat in recent years, the importance of
Why do we want to hedge, and how does this fit in with the risk appetite of the firm?
What instruments do we want to use, and what are the pros and cons of alternate instruments/approaches?
Do we have the right governance structure in place, including the right people?
Are the price/levels that we are targeting aligned with the view of the senior management/Board?
Do we have the analytical tools and systems in place to understand precisely what the structure we are buying is? Is it still within the firm's risk appetite under stress scenarios?
Do we have the tools and ability to monitor the underlying changes in value on a daily basis, and the processes to raise and act upon ‘red flags' when things start going wrong?
Do we have to discipline to be able to take the losses once the risk appetite loss threshold is breached?
Significant benefits
Once these questions have been adequately understood, thought through and addressed, the economic benefit they deliver to the user is quite meaningful. Whenever there have been large losses, the primary cause can be traced back to the organisation's inability to think through these issues satisfactorily. It is useful to remember the words of John Maynard Keynes, who famously stated: “Markets can remain irrational a lot longer than you and I can remain solvent.”
The key challenges for an organisation that seeks to embark upon an efficient and effective derivatives hedging programme is to ensure that the right individuals, operating under an effective governance framework and supported by the right tools, infrastructure and reporting, undertake transactions that are aligned with the firm's risk appetite. Accordingly, this appetite needs to be rigorously defined. Once the trades are taken on the books, these need to be scrupulously monitored on a regular basis, with the appropriate red flags raised when the outcome is not on expected lines. Effective management of financial risks has hitherto been considered the domain of banks and financial institutions, but the recent financial crisis has shown organisations the significance of proactively managing financial risks, and protecting the bottom line from unexpected financial hits. A fairly rigid policy and guideline framework is required, combined with rigorous implementation in practice.
Even if a framework exists in the organization, there is still merit in seeking specialist advice to rigorously test it for gaps compared to what leading global firms do. Are the stress-testing scenarios considered robust enough? Is the current risk management framework too dependent on specific individuals; is the risk management institutionalized? All of these are critical to effectively manage risk. With the right tools and risk management, derivatives can well be the airbag that absorbs the impact of a crash, rather than a WMD that devastates.
(The author is an Executive Director with KPMG.)