'By far the most significant event in finance during the past decade has been the extraordinary development and expansion of financial derivatives. These instruments enhance the ability to differentiate risk and allocate it to those investors most able and willing to take it - a process that has undoubtedly improved national productivity growth and standards of living.'-- Alan Greenspan, Chairman, Board of Governors of the US Federal Reserve System. The latter makes it clear that according to him derivatives are up till now the best thing that has happened in Finance. Derivatives help to mitigate risks such that investors are better able to survive in the financial world. David Koenig(2004) instead advanced that financial risk management is not about avoiding risk. Rather, it is about understanding and communicating risk, so that risk can be taken more confidently and in a better way. Tsatsu Tsikata, chief executive of Ghana National Petroleum Corp(1997) said that "not managing risk is itself a risky option."
Brian Quinn, director of Bank of England stated that "There are no fundamentally new or different risks in derivative products, rather ... familiar kinds of risks are presented and combined in novel ways". Derivative products have undoubtedly allowed management to achieve significant gains in the efficiency of their businesses, so much so that the successful use of derivatives has become an essential component of product management. Merton Miller(1992 ) added that Efficient risk sharing is what much of the futures and options revolution has been all about. Sarah Orsay('Derivatives Strategy',1997) went further by saying that people are not apologizing anymore for using derivatives. They've realized that they are not the evil instruments they have been made out to be.
Still some are of the view that these derivatives might as well be very dangerous. For example, Warren Buffett stated that "We view them as time bombs both for the parties that deal in them and the economic system ... In our view ... derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal." However Terente P. ParéFortune(1994) was more optimist and described derivatives as: "They're here, they're weird, and they're not going away. Yes, these beasties bite, but companies that tame them have a competitive edge".
In the last twenty years, a number of studies have examined the risk management practices within nonfinancial companies. For instance, some studies in Uk report on the use of derivatives by nonfinancial firms (see for example: Belk and Glaum (1990), Bodnar, Hayt, Marston and Smithson (1995), Bodnar, Hayt and Marston (1996); Belk and Edelshain (1997); Berkman, Bradbury and Magan (1997); Grant and Marshall (1997); Fatemi and Glaum (2000); and Jalilvand, Switzer and Tang (2000)). Yet, another group of researchers has investigated the determinants of corporate hedging policies (e.g., for example: Géczy, Menton, and Schrand (1997); Jalilvand (1999); Adedeji and Baker (2002); Berkman, Bradbury, Hancock and Innes (2002); and Shu and Chen (2002)). Corporate risk management is thought to be an important element of a firm's overall business strategy. Stulz (1996: pp. 23-24) draws upon extant theories of corporate risk management to argue "the primary goal of risk management is to eliminate the probability of costly lower-tail outcomes - those that would cause financial distress or make a company unable to carry out its investment strategy".
Financial derivatives- foreign exchange, interest rate, and commodity derivatives - are important means of managing the risks facing corporations. Finance theory indicates that hedging increases firm value if there are capital market imperfections such as expected costs of financial distress, expected taxes and other agency costs. Theoretical models of corporate risk management indicate that derivatives use increases with leverage, size, the existence of tax losses, the proportion of shares held by directors, and the payout ratio. The corporate use of derivatives decreases with interest coverage and liquidity (Smith and Stulz (1985), Froot, Scharfstein and Stein (1993) and Nance, Smith and Smithson (1993)).
However, previous studies find only weak evidence consistent with theory. Mian (1996) finds that there is an empirical evidence on the determinants of corporate hedging decisions. He ensures that although the evidence is inconsistent with financial distress cost models, it is mixed with respect to contracting cost, capital market imperfections, and tax-based models. Géczy, Menton, and Schrand (1997) show that firms with greater growth opportunities and tighter financial constraints are more likely to use currency derivatives. Also, they find that firms with extensive foreign exchange rate exposure and economies of scale in hedging activities are more likely to use currency derivatives. Howton and Perfect (1998) find that swaps are the most often used interest-rate contract, and forwards and futures the most often-used currency contract. Gay and Nam (1998) find that firms with enhanced investment opportunity sets use derivatives more when they also have relatively lower levels of cash. Their results show that firms can and do use derivatives as one strategy to maximise shareholder value.
Nguyen and Faff (2002) argue that leverage, size and liquidity are important factors associated with the decision to use derivatives. Tufano (1996) finds that cash flow hedging strategies allow firms to avoid the dead weight of external financing by setting their internal cash flows equal to their investment needs. Guay (1999) concludes that firms using derivatives to hedge, and not to increase entity risk. Firm risk declines following derivatives use. Haushalter (2000) shows that companies with greater financial leverage manage price risks more extensively. His results also show that larger companies and companies, whose production is located primarily in regions where prices have a high correlation with the prices on which exchange-traded derivatives are based, are more likely to manage risks. Berkman, Bradbury, Hancock and Innes (2002) show that size and leverage are the main explanatory variables for derivatives use in both industrial and mining companies in Australia.
Although many firms and individuals use derivatives as part of an overall strategy to manage the various financial risks they face (e.g. interest rate risk, foreign currency risk, commodity price risk and equity price risk), misuse of these derivative instruments results in huge losses of several companies. In relation to this,we can refer to Walter D. Hops, Treasurer, Ciba-Geigy(1994) who said that "Derivatives are nothing more than a set of tools. And just as a saw can build your house, it can cut off your arm if it isn't used properly. Also William Driver pointed out in The New York Times(1976) that "there's no such thing as "zero risk." Karpinsky (1998) and Singh (1999) discuss the various financial disasters relating to the use of derivative instruments. Karpinsky (1998) gives examples of some derivatives losers. For instance, Sumitomo Corporation lost $3,500 million in 1996 because of Copper Futures; Metallgeselschaft lost $1,800 million from oil Futures in 1993; Kashima Oil lost $1,500 million from FX Derivatives in 1994; Orange County lost $1,700 million from Interest Rate Derivatives in 1994; Barings Bank lost $1,400 million from Stock index and Bond futures and Options in 1995; and Daiwa Bank lost $1,100 million from Bonds in 1996.
In the cases cited above where companies have made huge losses through the trading of derivatives, the problems are not so much with the derivatives themselves but rather than with the way that are used or misused. Some of these disasters have involved unauthorised trading (for example, the Barings bank), raising the possibility that a significant number of companies may not have in place with appropriate controls or monitoring procedures to regulate their derivative positions (Watson and Head, 1998). Thus, it is very important for companies that they cannot ignore the need for well-defined risk management policies. It is also sensible for companies to outlaw the use of derivatives for speculative purposes.
