Use of Derivatives in Risk Management
Teresa Fritz
Ashford University
Managerial Financial BUS 650
Dr. Wendy Achilles
April 2, 2012

Use of Derivatives in Risk Management Risk management is in a company’s wonders all the time, the managers need to watch closely at all times to stay on top to make sure they have time to react to a risk that may arise. By using derivatives management may be putting their company at risk and need to know the common risks that are involved and know how to avoid them. Ten of the failures are poor governance and tone at the top, reckless risk taking, inability to implement enterprise risk management, nonexistence, ineffective or inefficient risk assessment, falling prey to Herd Mentality, misunderstanding the mindset of “if you can’t measure it, you can’t manage it”, accepting a lack of transparency in high-risk areas, nit integrating risk management with strategy-setting and performance management, ignoring the dysfunctionalities and blind spots of the organizations culture, and not involving the board in a timely manner (Beaumier, DeLoach). The derivatives that are used for risk management are interest rate derivatives such as interest rate swaps, interest rate caps, basic swaps, and rate lock (Kelly). All companies should have a policy that states derivatives can only be used for risk management purposes and not for speculating interest rate movements (Kelly). Derivatives used for risk management can be a good thing and can also be a risky problem if someone is not paying attention to what is happening in the company. When a company puts into action a form of derivatives it is usually to protect the company, but this doesn’t always protect a company, it could cost more than had they paid everything down the way they’re contract was written. Often times a company will make poor judgments and are focused on the short term of a company rather than the long term and they take risks by mortgaging the future for today’s problems (Beaumier, DeLoach). What a financial officer needs to do to keep from running a company into the ground or financing it into the ground would be to watch for the signs of risk. One of the signs would be leadership failure in order to prevent this would be to make sure that the dominate chief executive is not ignoring the warning signs that are posted by the risk management team by resisting the news or facts given to them. Another indicator that there is an issue would be that management either does not understand the nature of the risks undertaken by the organization or they never obtain the knowledge of what is really going on (Beaumier). When entering into a new market, or introducing new products, or investing in any new business is not only the management evaluating it, the financial officers also need to be informed so that they may inform the managers if this would be a safe and equitable project to go into. When management does not involve the board in strategic issues and policy matters in a timely fashion this can also be considered a risk (Beaumier). Some indicators of reckless risk taking problems would me the responsibility for risk management is not adequately defined or are linked to an incentive program and they are left to take on new projects and get the company in further debt than they are and then times change and the company is in trouble for these ventures. Managers and board members must always be on top of all projects that are being introduced into a company (Beaumier, DeLoach). A company has star performers making loads of money for the company but no one knows how they are doing it is an indicator of trouble ahead (Beaumier). There are ticking time bombs and management is not aware of the problems and the significant conflicts of interest in complex and difficult to measure areas (Beaumier). Management and the board are surprised when a problem occurs and wonder why they didn’t know what was going on. To avoid costly failures managers must understand how their money is being made and know the risks that are involved at all times. Identifying your most trusted positions and who they are and what actions can subject the company to significant risk events (Beaumier). By paying attention to what is or is not going on around you will help a company find and realize there is a risk forming. Warren Buffet describes derivatives as “instruments of mass destruction.”(Kelley). Why do organizations us derivatives, they use them in a number of ways. If used correctly they are beneficial such as Southwest who uses future contracts that keep the cost of fuel at a price that they can offer you a ticket now and you use it six months later they are not losing money on that transaction. Southwest did not have to worry about the price of fuel spiking upward and your ticket not covering the cost of flying (Kelley). Or when a farmer gets a contract for his crop while it is still standing, he doesn’t have to worry about prices falling before it goes to market (Kelley). By using interest rate caps, interest rate swaps, interest locks, or basis swaps they are using derivatives to run their companies. Ann Galligan Kelley listed these forms of interest rate derivatives:
1. Interest rate swaps synthetically convert variable rate debt to fixed rate and vice versa. For example, if a university can efficiently issue variable rate debt but would prefer not to be exposed to potential future interest rate increases, the university could enter into an interest rate swap with another group, called counterparty, to effectively convert its variable rate debt to "synthetic" fixed rate debt.
2. Interest rate caps can limit exposure to interest rate volatility. For example, an organization with variable rate debt may be willing to tolerate interest rate increases up to a certain level or believe that interest rates will remain low. But the organization may want to limit its interest rate risk by purchasing an interest rate cap, which ensures that the organization won't pay an interest rate exceeding the rate prescribed in the cap.
3. Basis swaps manage or change the "basis" on which variable interest rates are calculated. These are more commonly associated with revenue bonds where an organization's income may depend on a particular interest rate index, yet the debt the organization has issued is based on a different index. For example, if revenues are based on the prime interest rate but the interest expense that must be paid is a function of London Interbank Offered Rate (LIBOR), and the traditional correlations between these two indices digress, a basis swap will protect the entity from market dislocations. Companies use LIBOR to determine the price of many financial derivatives, including interest rate swaps. This is the average short-term deposit rate that banks participating in the London money market exchange offer each other.
4. Rate locks are based on interest rate swaps and used to hedge, or "lock in," an interest rate for an upcoming bond issue. These are really nothing more than institutional versions of an interest rate lock fee that someone might pay to lock in an interest rate when applying for a home mortgage. (Kelley) The risks of using these could be that it could cost your company millions to terminate an existing contract, the risks that CFP’s and controllers need to know would be the counterparty/credit risk, basis risk, termination risk, and credit downgrades. If you are managing a company, always make sure you read the fine print and know what you are signing (Kelley). Risks on the counterparty could be that the entity on the other side may not be able to fulfill its obligation in paying your contract and you could become in default of your contract (Kelley). The basis risk is that an entity that is hedging may not get the interest rates so would not be using this to the full benefits they thought they would get (Kelley). Termination risk is like I spoke before that there could be a charge for terminating and it could cost more than you expected so you need to be aware of this cost (Kelley). Credit downgrades are consequences when your credit downgrades or a default occurs (Kelley). Being aware of these risks will keep you aware of how your company is doing and make sure that when signing a contract read the fine print to make sure you are not getting in over your heads. Making sure your companies policies for derivatives addresses all situations. The markets with derivative instruments used by institutional entities are treasury bills, notes, and bonds, mortgage-backed securities, equity securities and related indexes, global currencies, energy such as crude oil, natural gas, electricity, commodities such as grains softs, metals, etc. We use these derivatives for two main reasons, high and variable levels of market volatility and limited ability to manage risk exposure with policy procedures. Many companies use these derivatives to keep from getting their company in trouble and most of the time it works but sometimes the efforts that are put into trying to stop a risk from happening it costs more than the risk itself. In order to avoid risks sometimes we need to embark in using tools that will prevent us from going under and sometimes it is best to let it go. When using formulas to figure the risk involved in a company changing interest rates or staying with the interest rate that they have already borrowed at could mean the difference of making it or not. Using derivatives instruments is not generally the problem it is the management’s use of the instruments. The problems stem from issues that can be as simple as ignorance or laziness or being misled by an investor or broker, management must always stay on top of the business to alleviate the problems that can occur.

References
Beaumier, C., & DeLoach, J.. (2011, September). Ten Common Risk Management Failures and How to Avoid Them. Business Credit, 113(8), 46-48,50-52. Retrieved April 1, 2012, from ABI/INFORM Global. (Document ID: 2456085051).
Kelley, A.. (2011).Why a Good Derivatives Policy Could Protect Your Job. Strategic Finance, 92(12), 47-49. Retrieved April 1, 2012, from ABI/INFORM Global. (Document ID: 2373925441).