Using Derivatives: What Seniors Managers

Must Know
Mohammad Sameer Ansari – IMB2020008
Nowadays, a large corporation has suffered an unanticipated financial loss as a result of erroneous
derivatives trading. Derivatives — a broad phrase that encompasses a wide range of products such as
futures, swaps, and options – have grown in popularity in recent years as businesses seek new and
better methods to manage financial and operational risks. In this case study, eight experts discuss
what every senior executive should know about using derivatives.

David B. Weinberger
David B. Weinberger is a general partner of O'Connor Partners in Chicago, Illinois, and a managing
director of Swiss Bank Corporation in the capital markets and treasury department. For over two
decades, he has worked in the securities sector in trading, quantitative research, and product
development.
In order to make a profit, every company needs to take risks. However, certain risks are acceptable
for a firm to incur, while others are not. Exposures to variations in short- or long-term interest rates,
currency exchange rates, oil prices, or equity market levels that impact stock price and hence
financing prospects are some examples of risks that most firms are not in business to accept. The
first step in designing a risk-management strategy is to identify the full scope of risks the business
is exposed to and to understand the parameters (such as exchange rates) that drive the exposures.
Companies should then establish a sensible risk- management program based on the following steps:
• Calculate the different exposures.
• Even if they come from various parts of the company, aggregate all exposures to the same
underlying metric.
• To mitigate the risks, use the suitable financial instruments.
• Lay down the expected performance of the different instruments as a function of the external
parameters, and devise a way to track it.
In today’s complex world, financial risk management is not just a theoretical nicety; it is a practical
necessity. Derivative instruments can help companies manage their risks with maximum efficiency.

Peter Tufano
Peter Tufano is a Harvard Business School associate professor in Boston, Massachusetts. His study
focuses on the usage of current financial technologies by businesses. If we look closely, we can see
that derivatives are deeply ingrained in the operations of modern firms; some have even realized that
financial technology might help them make new strategic decisions. Companies should distinguish
their products, according to business experts, in order to maintain higher prices. Modern financial
technologies can help you achieve this aim. This new product, in turn, may support a whole different
marketing strategy: "Heat your house for less than $x per year!" Whether or whether this technique
is appropriate for a given firm is determined by marketing and competitive factors, as well as how
much the company must spend to manage risk, but derivative contracts provide marketers with
unprecedented options. However, expecting technically skilled financial professionals to
comprehend the complexities of competitive strategy is also unrealistic. Top-level executives who
want to make the most of new financial technology will need a thorough understanding of its
potential strategic applications, a well-trained financial staff to provide advice and execution, and
cross-functional collaboration that is relentlessly focused on achieving strategic objectives.

Cheryl Francis
Cheryl Francis is the treasurer of FMC Corporation, a Chicago-based maker of chemicals,
equipment, and military technologies. She was previously the company's gold-mining subsidiary's
CFO. Risk is managed in a number of ways by corporations, including insurance, letters of credit,
joint venture structure, and the use of derivatives. It is up to a company's CEO and board of directors
to decide how much derivatives are used to control risk. Senior management and the board of
directors should develop precise instructions for how managers employing derivatives should
function after a firm agrees to handle certain risks in the derivatives markets. This regulation should
be thoroughly communicated and carefully followed to avoid crippling financial losses. After
determining the right derivatives, a corporation must clearly define the lines of decision-making
power. Depending on the magnitude of the transaction, FMC demands increasingly greater degrees
of management sign-off. Another thing to bear in mind is that corporations who use derivatives incur
the danger of the institution with which they are dealing failing to meet its obligations. As a result,
firms should have policies in place that restrict the overall amount of exposure to any one institution
depending on its credit rating. After a corporation has done everything, it can to set the best rules
and explain its expectations, it must implement efficient mechanisms to monitor its derivatives
holdings. It is impossible to overestimate the value of good monitoring systems. CEOs should avoid
utilizing derivatives unless they are willing to invest in strong monitoring systems.

Arvind Sodhani
Derivatives can be used to hedge or speculate by businesses. Consider a long-term German
government bond investment that meets the credit standards of any treasurer's charter. If a treasurer
utilizes derivatives to swap the bonds' fixed deutsche-mark interest rates for a variable rate in US
dollars — a cross-currency interest-rate swap – the investment is floating rate, non-speculative, and
based on US dollars. The investment is very speculative if the treasurer chooses not to hedge the
variable interest and currency rates that can influence the bonds. In other words, not employing
derivatives while investing in long-term German government bonds is a type of speculation.
Managers can distinguish between hedging and speculating using a simple rule of thumb: Use
derivatives to shift risk, but don't fall prey to the lure of risk trading for its own reason. To guarantee
that the financial staff distinguishes between hedging and speculating, top executives must first
establish clear and consistent risk management standards. Financial employees should be required
to report on derivatives activity in a timely manner by senior management. It should also recognize
and reward performance that regularly fulfils its goals. Perhaps most importantly, senior managers
should ensure that the finance team has the resources necessary to fulfil those goals. The most
important resource, however, is experienced individuals who will meet management's objectives
while adhering to the specified criteria. Companies that refuse to employ derivatives limit their
finance staff's capacity to perform essential services.

David Yeres
How should CEOs respond when their chief financial officers propose that the company initiate or
expand the use of financial derivatives? However, before embracing that position and turning the
financial staff loose, CEOs must analyze what an active derivatives program would mean to the
company and how such a program could be controlled. They do not need to become number
crunchers, but their legal obligations to make informed decisions will require them to understand
how the derivatives-transaction process works and how certain characteristics of derivatives relate
to the company`s objectives, structure, and culture. Derivatives have important differences from a
company`s other business activities. Decisions to use derivatives are sometimes made in minutes or
even seconds, and they may only involve a trader who alone understands the transaction. Decisions
concerning the aims and boundaries of a derivatives programme should be made by top-level
management, not financial employees or derivatives traders. If the company's derivatives trading
results are projected to have a major impact on profitability, the CEO should also be in charge of the
derivatives risk management process. According to press reports, Metallgesellschaft's supervisory
board was ignorant of its U.S. subsidiary's derivatives cash-flow requirements until they topped $1
billion. The CEO should know whether the program's purpose is hedging or risk management from
the start. Hedging is generally limited to minimizing exposure to a specific business risk, and it
frequently has a financial penalty, such as paying an option premium or missing a profit potential.
To guarantee that the financial staff distinguishes between hedging and speculating, top executives
must first establish clear and consistent risk management standards.

John T. Smith
Any CEO considering using derivatives should familiarize himself or herself with the accounting,
transparency, and control challenges that occur as a result of their usage. Because there is currently
no comprehensive accounting standard for derivatives, the accounting rules are complicated. The
greatest thing a firm can do to guarantee comprehensive accounting is to ensure that its accountants
have a thorough awareness of how various derivatives and operations should be handled, as well as
where areas are lacking in definition. In October 1994, the Financial Accounting Standards Board
(FASB) released a standard requiring companies to differentiate between derivatives held or issued
for trading purposes and derivatives kept or issued for non-trading reasons. For the time being, the
new standard promotes, but does not compel, the publication of all quantitative market risk
information. As a result, in the next years, disclosure standards may grow increasingly strict in
response to investor and regulatory expectations. Because of these characteristics, CEOs must
distribute power and responsibility with considerable prudence. This method may run counter to
many businesses' current delegating patterns. Given the complexities and ambiguity of derivatives,
CEOs should determine how much discretion managers should have when using them. The more
concerned a CEO is about the ramifications of derivatives, the less discretion he should provide
those in charge of their administration. Furthermore, organizations must develop ways for tracking
results due to the nature and severity of the risks associated with derivatives.

Paul J. Isaac
A variety of basic ideas regarding derivatives exist among investors as a group. To begin with,
derivatives are one of the risk managements tools available to a corporation. They provide an
insurance function and can be used to alter a company's capital structure, reduce expenditures, or
better match financial risks with current activities. Investors will always perceive derivatives as an
expense, regardless of how skillfully they are managed. Second, we investors have reservations
about management's ability to employ derivatives as a revenue generator rather than a cost-cutting
instrument. We can make our own bets in whatever way we see fit, including hiring experienced
money managers or buying holdings in large derivatives businesses. Third, investors want
companies to report their overall derivatives activity as well as the type of activity they engage in.
We will be worried if a corporation uses derivatives much more than its competitors. Too much
emphasis on derivatives and global models may take key financial personnel's focus away from the
nuances, analytical, control, and coordination tasks that are critical to any company's constant
transformation and progress. Distracted attention's harmful implications may take some time to
show. The use of derivatives knowledge should be viewed as risk-management tools that
complement basic company operations. If it isn't, investors will likely cut a company's stock price
to reflect the company's complexity, financial opacity, and increased risk of economic instability.

Brandon Becker
Because of their complexity and possible leverage, CEOs must ensure that their boards of directors
are well-informed on the dangers of financial derivatives; derivatives provide particular problems to
directors. Employers must be mindful of a variety of risks, including legal, market, operational,
credit, and liquidity problems. CEOs must ensure that their boards of directors are aware of the
dangers associated with financial derivatives. The board of directors must ensure that the firm has
suitable risk management processes in place, as well as qualified personnel to monitor the risk status
of the organization. It must also ensure that its investments are in line with its overall objectives.
Directors should insist that the board of directors be updated on the company's risk exposure as well
as the potential impact of adverse market and interest rate circumstances on the derivatives portfolio.
Directors should designate the personnel who will be in charge of risk management alongside senior
management directors. The company's duties to account for and publicly report information linked
to derivatives activity must be properly understood by the board of directors. Federal securities laws
and FASB standards impose disclosure obligations as examples of such responsibilities. Because
standards change so frequently, directors must stay up with them. Derivatives trading income may
be declared by companies. Quantitative data may aid investors in better understanding the nature,
scope, and prospective outcomes of these activities. Companies could divulge their derivatives
management controls and techniques, as well as provide assessments of market and credit risk
exposure. This allows CEOs and boards of directors to adopt consistent and intelligent investment
programmes.