Warren Buffett describes derivatives as "instruments of mass destruction."
With this warning from Buffett, don't be lulled into complacency by the recently approved 2,315-page Dodd-Frank Wall Street Reform and Consumer Protection Act. This legislation strives to increase the transparency in the pricing and trading of derivatives. CFOs and controllers, however, should still ensure that their organization has a comprehensive, up-to-date derivatives policy to not only protect the organization from derivative risks, but also the CFOs and controllers from criticism for not adequately informing management of the unforeseen risks.
Even if your organization doesn't use derivatives currently, it's your responsibility as a financial manager to know the risks and advantages of having a comprehensive derivatives policy in place. Your organization will then be prepared when the next Wall Street investment banker proposes the next exotic product to senior management using derivatives.
Why Are Organizations Using Derivatives?
Companies use derivatives in a number of ways. For the most part, they can be beneficial when used correctly. The next time you fly Southwest Airlines, the fuel for that jet may have been hedged using futures contracts, a type of derivative. Hence, when you bought your ticket six months in advance, Southwest wasn't at risk if fuel prices spiked upward. Derivatives can also help a farmer who wants to lock in a price for his crop while it's still in the field and not risk taking a lower price when the crop goes to market.
Many companies are now using derivatives to convert variable rate debt to fixed rate debt to lock in the existing low interest rates. Companies are also using interest rate caps to limit exposure to potential interest rate volatility. Interest rate swaps have been around for years and are actually quite prevalent in the governmental and non-profit world. According to the Bank for International Settlements' June 2010 report, "The total notional value of interest rate derivatives including swaps reached nearly $450 trillion as of June 30, 2010." Although management should be aware of all facts, entities often enter into these long-term risky contracts without fully understanding the potential risks and implications. That's why it's important that policies and procedures be in place before even considering derivatives.
The most common types of interest rate derivatives include interest rate swaps, interest rate caps, basis swaps, and rate locks. Let's take a look at each type.
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,...
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