Derivatives don’t deserve their bad name, says Jennifer Conrad, the McMichael
distinguished professor of finance at UNC Kenan-Flagler.
Yes, they may have contributed to the current economic crisis, as investment banks
loaded up on mortgage-related derivatives that neither their traders nor risk
managers fully understood. Yes, they had a role in the mid-’90s collapse of England’s
Barings PLC, where a trader used them to bet heavily—and wrongly—on the direction
of the Japanese stock market. And, yes, they helped along the 1994 bankruptcy of
Orange County, California, where they bamboozled the local treasurer.
But those debacles obscure the practical ways that many stable companies use
derivatives daily to hedge risks, Conrad says. In a recent study on worldwide
derivatives use, Conrad and two co-authors found that, on average, corporate
derivatives investors in the late 1990s and early part of this decade were older,
larger firms that were more exposed to exchange and interest-rate risk than other
companies. They tended to operate in commodities-based industries like oil
production and agriculture. In other words, they might have been roughnecks, but
they weren’t rogues.
Conrad did the research with Greg Brown, who’s also a Kenan-Flagler finance
professor, and Sohnke Bartram, a professor of accounting and finance at England’s
Lancaster University. They examined nearly 7,000 nonfinancial firms headquartered
in 47 countries. Conrad says that the heft of their dataset gives their conclusions
The study, titled, “The Effects of Derivatives on Firm Risk and Value,” found that
derivatives allowed users to damp a variety of risks and—even more striking—helped
them to weather the 2001 global recession better than many firms did. Simply put,
derivatives investments appeared to make these companies less risky than average.
“Hedging with derivatives is associated with significantly higher value, abnormal
returns, and larger profits during the economic downturn in 2001-2002, suggesting
firms are hedging downside risk,” they write.
“Our results suggest, at a minimum, that firms reduce cash-flow risk, total risk and
systematic risk significantly through financial risk management with derivatives,”
Conrad and her co-authors add. They thus conclude that, “On average, firms are
hedging rather than speculating with derivatives.”
Derivatives are, as their name implies, financial instruments derived from underlying
assets, indices or even other derivatives. Their most common forms are forward
contracts—known as futures if they’re traded on exchanges—options and swaps. A
wheat grower, for example, might use a futures contract to lock in a price for its
grain and thus protect itself from a plummeting market between planting and
The three scholars’ findings square with what logic and stories from the field had
suggested for years. As a professor, Conrad had discussed with her students the
many practical ways that firms might use derivatives and offered up examples of
these uses in action. But until this study, she hadn’t verified whether those
anecdotes were exceptions or the rule. Just because, for example, Southwest Airlines
managed to use derivatives for years to hedge away the risk of rising fuel prices
didn’t mean that other firms did. Others might have been speculating.
Derivatives skeptics certainly believed that many users were rashly betting, not
prudently hedging. As billionaire investor Warren Buffett had famously put it,
“Derivatives are financial weapons of mass destruction.”
And derivatives do resemble deep water or dark caves—they’re scary insofar as
they’re mysterious. Many people, even otherwise canny investors, don’t take the
time to understand them—they’re complex and can be mathematically knotty—and
thus people hear about them only when a big investment goes horribly wrong and
hits the pages of the popular press.
But corporate financial executives and sophisticated traders use them in mundane—
and helpful—ways every day, Conrad points out. The most obvious technique is the
hedging that Conrad, Brown and Bartram document. Here, multinationals might
employ swaps to protect their profits against swings in the values of the currencies in
the countries in which they operate. Or hog producers might invest in pork belly
futures—bellies are the source of bacon—to protect themselves against sinking pork
prices. “If you can use a derivative to lay off some risk, that can be a good thing,
and perhaps you should consider it,” Conrad says.
Another derivative use is what might be called prudent speculation. Here, an investor
might buy a derivative not to gamble but in hopes of profiting from her specialized
knowledge of a specific corner of the market or development in the economy.
“Speculation has a pejorative ring to it,” Conrad says. “But when you buy a hundred
shares of IBM, you’re speculating that IBM is going to go up. The derivative markets
just provide another vehicle for people to impound their information into the
market.” By bringing their knowledge forward in the form of derivatives trades, these
investors allow the market to allocate resources more efficiently than it otherwise
A third use of derivatives is arbitrage, where investors aim to profit from exploiting
price differences between markets. Derivatives are another tool that arbitrageurs use
to try to profit from the anomalies that they identify.
Interestingly enough, the sort of hedging that Conrad, Brown and Bartram highlight
has long been as controversial among finance scholars as derivatives are among
members of the general public. Some academics argue that companies shouldn’t
hedge but instead should devote themselves single-mindedly to their core
businesses. Investors can hedge on their own by buying derivatives or other
securities when doing so serves their purposes, these thinkers say.
Conrad, for her part, doesn’t find that argument convincing and considers hedging a
legitimate tool for corporate managers. “There’s a real question about whether
individual investors can do this kind of risk reduction on their own,” she points out.
“Trading in derivatives is difficult. Transaction costs might be too high, and
[individual] investors might not have adequate information to hedge the risks that
the firm faces.”
For evidence of the perils for ill-informed folk, one needs to look no further than
Orange County, Calif. There, the county treasurer, Robert Citron, borrowed heavily
and bought derivatives, even though, as a lifelong government worker, he had little
expertise in them. When the market turned against his trades, Orange County was
driven into bankruptcy—at the time, the biggest municipal financial failure ever.
Even shrewd Southwest Airlines doesn’t always profit from its derivatives trades. As
fuel costs fell over the second half of 2008, its hedges against higher oil prices
ending up costing it money, resulting in its first loss in 17 years.
So, yes, derivatives can be perilous, even for experienced users, but “they aren’t
evil,” Conrad concludes. “To the extent that you believe that firms are doing the right
thing in reducing some types of risk, then derivatives are useful.”