LEARNING TO LIVE WITH DERIVATIVES 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.
By Terence P. Pare REPORTER ASSOCIATE Tricia Welsh

(FORTUNE Magazine) – THE RUBICON was in Cincinnati last March. Even as Procter & Gamble was piling up a pretax loss of $157 million by trading in derivatives, it was becoming blazingly clear that despite all their built-in perils, these otherworldly financial instruments had thoroughly insinuated themselves into the heart of business. As the huge size of the market -- over $12 trillion -- attests, corporations have found plenty of uses for derivatives. Intel, Merck, and others successfully employ them to manage the risks of fluctuating interest and exchange rates. For now, such expertise may represent a competitive edge. But soon, understanding how even the most complex derivatives work will be a competitive necessity. Accordingly, 92% of the CEOs from 200 of America's biggest companies say they plan to continue to use derivatives, a new FORTUNE poll indicates. All this activity swivels the floodlight onto the hitherto low-profile corporate treasurer. It used to be that these men and women kept quiet track of a company's finances. Now they have metamorphosed into high-stakes ''risk managers.'' Given the fact that the die is cast and derivatives are here to stay, the question is, How should treasurers be using them? A hell of a lot better than they do now, is one obvious response. In April, soon after P&G announced its loss, Gibson Greetings, also based in Cincinnati, and Mead Corp., 48 miles away in Dayton, revealed that they too had taken a beating during flings with derivatives, losing $20 million and $12 million respectively. Soon joining this stricken Ohio trio were a variety of pension funds and mutual funds. Other victims may include taxpayers in the state of Florida. Unless interest rates cooperate, the state will be out $98 million. Now add the name David Rockefeller to the roll. Rockefeller, a former chairman of Chase Manhattan, served as CEO of Rockefeller Center Properties, the real estate investment trust that holds a mortgage on part of the New York City landmark. (Japan's Mitsubishi Estate Co. holds the majority interest.) Under Rockefeller's stewardship, the REIT embarked on a series of interest rate derivatives during the late 1980s. Rockefeller stepped down in 1992, but by then the swaps were costing the company more than $15 million a year in extra interest expense. At the end of 1993, to unwind some of the contracts, the company took an extraordinary loss of $3.5 million. That may be pocket change for a grandson of John D., but it is equal to about 10% of the company's annual operating income. Worse may come: At the end of March, the derivatives still on the books were underwater by $42 million. Over the past 12 months, virtually every kind of institution that handles other people's money has taken a hit from derivatives, and the disclosed losses are mounting. Over this period, companies reported derivative-based losses of over $8 billion, more than double the amount lost in the previous ten years in such investments. As the table shows, the phenomenon reaches way beyond U.S. shores. Indeed, derivatives are intrinsically a global business. Basically, derivatives are financial instruments whose value is tied to something else -- called an ''underlying'' by the trade -- such as equity or an indicator like interest rates. When consumers pay extra to get an interest * rate cap on an adjustable-rate mortgage or demand a slightly higher rate of interest on a municipal bond that has a call option, they are dealing in derivatives. Corporations use similar caps and options, and scores of other types of financial devices as well. NOT SURPRISINGLY, derivatives are proving a much tougher sell in the wake of very public recent losses. Howard Sosin, for example, who made his name as a financial wizard while running a derivatives operation at American International Group, still has not been able to find a corporate backer for the similar business he wants to set up on his own account. John Meriwether, the legendary bond trader from Salomon Bros. made famous in Liar's Poker, is having only slightly better luck starting up his hedge fund, a type of investment vehicle that often uses derivatives. Meriwether, who resigned from Salomon after the 1991 U.S. Treasury bond auction scandal, recruited financial theorists with impeccable credentials, including Harvard professor Robert C. Merton and Stanford's Myron Scholes, to help launch his venture, Long Term Capital L.P. But again, finding investors was hard. Despite published reports that Meriwether had raised more than $2 billion as of this past March, Meriwether actually managed to raise only $547 million by that time, $100 million of which came from the firm's principals. So far, most big corporations have managed to avoid major losses by keeping their risk- management operations relatively simple. About two-thirds of CEOs in the FORTUNE poll, for example, say that they use only the more traditional, straightforward derivatives such as options, which are traded on organized exchanges. Up until now, they have steered clear of the more high-powered over-the-counter products like the leveraged swaps that produced so much woe in Ohio. But sirens beckon from all directions, as dealers, driven by the relentless logic that the richest returns come from the strangest products, conjure up ever more esoteric offerings. In the cauldron now, for example, are electricity derivatives that utility companies would use to manage the risks of fluctuating power demand. Successful users of exotic, or at least customized, products include Merck CFO Judy Lewent. She imagines a future where financial devices would even allow companies to hedge the risks of changing tax rates. In such a world, simply sticking to the safe and familiar could very well mean spotting the other guy points. Like it or not, irresistible financial ! innovation will force more and more corporate users to develop expertise in derivatives, if only to be able to turn away Flash Gordon when he comes calling with the latest financial invention from the rocket scientists back at his bank. Says Dominic Casserley, a director of McKinsey & Co.: ''Five years from now, any CFO or treasurer will be fully conversant with how derivatives work in order to fulfill his job.'' Investors have already found fault with some companies for failing to ''derivate'' -- a verb jokingly created by J. Peter Grace, chairman of W.R. Grace & Co. Shareholders in Compaq Computer recently lost a suit in federal court in Houston, the company's hometown, that charged Compaq with failing to hedge its foreign-currency exposure properly back in 1991. In the past three years, though, Compaq has increased its use of derivatives and now uses foreign-currency options to hedge its anticipated international sales. At the end of 1993, Compaq booked a $13 million gain from these derivatives. Wall Street analysts also are demanding expertise in derivatives management. For example, Deborah Bronston of Prudential Securities knocked her earnings estimate for Cone Mills, a textile company in Greensboro, North Carolina, down 5 cents to $1.90 because she believes that the company hasn't sufficiently hedged its exposure to changing cotton prices. Says Philip McBride Johnson, a partner specializing in derivative products in the Washington law offices of Skadden Arps Slate Meagher & Flom: ''It's beginning to become an expectation that if the capacity to hedge exists and it can be done safely, there will be criticism and possibly litigation if advantage isn't taken of that opportunity.'' Such opportunities have existed for thousands of years. Book I of Aristotle's Politics, written about 2 1/2 millennia ago, contains a story about Thales the Milesian and what translates as ''his financial device.'' Thales was exceptionally gifted at reading the stars, but, like Aristotle, he was a philosopher and therefore flat broke most of the time. One winter Thales foresaw an abundant olive crop and used some of what little money he had to reserve exclusive use of all the local olive presses. Essentially, Thales was buying options, with the underlying being the rental rate for the presses. When the foreseen bumper crop came in, Thales became that insufferable combination -- a man who was both rich and right. TODAY'S WINNERS may on occasion display similar insufferability, but the derivatives they use have undergone all kinds of financial engineering. Thus the choice of forwards, futures, swaps, options, swaptions, and the like, giving rise to talk of deltas, gammas, rhos, and thetas -- a new argot packed with more Greek than a New York City diner. Behind the babel, though, all these contracts work in the same basic way: A change in the value of the underlying benefits one party to the detriment of the other. The increased value of Thales' olive press option, for example, was squeezed out of the press owners, who missed the chance to charge more when demand increased, and local farmers, who had to deal with Thales' monopoly rather than competing owners of presses. This seesaw relationship allows users of derivatives to transfer risk that they do not wish to bear to a party who, for a price, is prepared to assume it. It also enables some users to speculate and others to hedge their risks. Hedging is invariably cited by critics and advocates alike as the best use of derivatives. Companies put on hedges not to generate profits but to fix what are usually variable costs like foreign-exchange translations. Thus a U.S. company with contracts to sell products in Germany might buy derivatives that will rise in value if the dollar falls against the mark during the waiting period before the deals close. This provides predictable profits. Banks will often extend more favorable financing terms to such companies because loan officers feel that their more stable earnings make for more reliable credits. Theoretically, hedging also allows the managers of a company to concentrate on their core business and not worry about the forces roiling the currency markets or driving interest rates up and down. Even the best-laid hedging plans must be carefully monitored and adjusted, a fact of life that Rockefeller Center Properties ignored to its cost. In mid- 1987 the company had $578 million in convertible debt outstanding and wanted to redeem as much of it as possible, particularly since the interest on $335 million of that was scheduled to jump from 8% to 13% in 1995. The outfit issued commercial paper to finance some of this repayment. But because commercial paper has to be refinanced every few months, it is the equivalent of variable-rate debt. To hedge its interest rate risk, the REIT began swapping its variable-rate obligations for longer-term fixed payments -- far too long, as it turned out. Interest rates fell, leaving the company paying ( about 9.7% on $285 million in debt and receiving just 3.4%. The REIT, which went public in 1985 at $20 a share, now sells for around $5. That attracted bottom fisher Richard Barone of Maxus Investment Group in Cleveland. ''Few investors,'' he says, ''expected that the Rockefeller Center REIT would end up at this low point.'' Of course, there is no reason a company or fund should not speculate in derivatives -- provided investors know how their money is being put at risk and that the market has an opportunity to price the stock accordingly. Trouble is, accounting conventions and the rules for disclosure about derivatives have not kept up with the pace of financial innovation. As a result, no one is really sure just what should be disclosed or how the various kinds of derivatives should be accounted for. For their part, companies have been reluctant to volunteer much detail on their own trading, particularly when they treat derivatives as a profit center. One reason for such modesty is that investors may shy away from the uncertainties that trading in derivatives can create. And so they should in some cases. Dell Computer diversified into derivative trading only to take two big hits: It lost $25 million from foreign currency trading in fiscal 1992, and in the first six months of this fiscal year booked losses of about $35 million before tax to close down its derivatives position. Wall Street breathed a sigh of relief. Says Tom Meredith, chief financial officer for the Austin, Texas, PC maker: ''We're entirely out of derivatives. We're on the record with our philosophy; it's no secret.'' OTHER COMPANIES have been reluctant to own up. When P&G and Gibson Greetings first announced their losses, both suggested that they might have been bamboozled by Bankers Trust, the dealer who sold them the derivatives. But the companies' own records make it clear that both had knowingly gotten into leveraged derivatives, essentially betting interest rates would stay low. The red ink came when the Federal Reserve pushed up rates higher and faster than anyone expected. Inevitably the trading profits of the two companies went south, taking earnings with them. So far, none of these Buckeye outfits have made full disclosure of what transpired. Instead, their press releases have dwelled on the complexity of the instruments involved. More sophisticated users of derivatives, like Intel and Merck, take such complexities in their stride. But they still face the knotty problem of * pricing the little beasties. Because many of these instruments are custom-made for the user and therefore trade on no organized exchange, one cannot use newspapers or on-line services to check their daily prices. Instead, pricing derivatives requires mathematical computer models that use variables like possible future interest rates to determine what the derivative may be worth. The trouble with models is that they all too often fall short of the mark. One reason: Data input practices vary enormously among model users. Some of the series on stock prices commonly used to price derivatives go back only to 1988, and thus exclude the October 1987 crash. If you compare the results from the six most common pricing models, says Tanya Styblo Beder, a derivatives consultant with Capital Market Risk Advisors in New York City, ''it is not uncommon to find price differentials of 60% for complex derivatives and up to 10% for plain-vanilla derivatives.'' For David Askin, who once basked in a do-no-wrong rep among bond traders, a computer model fell so far short of reality that he and his investors tumbled into the fault that swallowed three funds at his Askin Capital Management L.P. Askin had just about all his investors' money in mortgage derivatives. But when interest rates rose last February, the market for these securities collapsed. Rather than paying attention to the quotes he was getting from dealers, Askin chose to listen to his computer. He dismissed the dealers as ''hysterical.'' When he reported to investors in early March, Askin based his valuation of the portfolio mainly on the model rather than on the market, telling his clients that his funds were down just 1.7% the previous month. In the marketplace, they had fallen by more than 20%. But Askin held on, hoping prices would shape up and behave more logically -- more along the lines of his computer model's predictions, that is. They didn't. Prices kept falling. Brokers began to demand more collateral to secure the loans that Askin had taken out to leverage his investments. By the time the market did settle down, the three funds were in Chapter 11, and Askin's investors have yet to see anything of their $600 million. Merck uses computer models too, but in times of doubt or disagreement the company prescribes brainpower and abiding respect for market forces. Because Merck spends so much money on research and development -- over $1 billion last year -- chief financial officer Lewent has always been interested in ways to quantify the risks involved in this most difficult to measure investment. To do so, she and her team, now 450 strong, put together what they call the research planning model. Developed ten years ago, it uses probability distributions for scientific, economic, marketing, and therapeutic variables. Modeling techniques typically guide Merck's most important strategic decisions, including the 1993 purchase of Medco Containment Services, a pharmaceutical-benefits-management company in Montvale, New Jersey. From this kind of R&D analysis, it was a relatively small step down in complexity to applying risk measures to derivatives. In the late 1980s Lewent developed the revenue hedging model, which not only prices the most complex derivatives but also continually updates values and suggests adjustments to the portfolio. So far, Lewent says, the model works just fine. Even so, Merck restricts itself to nonleveraged derivatives, such as simple currency options. And when dealers pitch new products to her, she hopes they come in a crowd. Says she: ''The best defense for a purchaser is having multiple bids.'' EVEN THE BEST models cannot eliminate bad luck, which means it is extremely important that users of derivatives establish well-understood controls. At chipmaker Intel, in Santa Clara, California, treasurer Arvid Sodhani will look at any derivative a dealer brings him, no matter how wild and woolly it seems. What keeps everyone in the saddle is a clearly articulated and strictly enforced set of risk parameters. Among the unbreakable rules: Intel must be able to run any derivative offering through its pricing model. Because longer- term derivatives are more risky, Intel will do deals for five years or more only with outfits possessing a AAA credit rating. Everyone, from the board on down to Sodhani's staff of 25, understands those rules. As long as his team keeps within those bounds, says Sodhani, ''we look at just about everything that's been invented, and we invent stuff ourselves.'' A recent creation by Sodhani was an elegantly simple $300 million issue, subsequently dubbed Step Up warrants. Issued when the stock was trading for about $60, this equity derivative gives the holder the right to purchase Intel common stock at a range of prices beginning at $71.50 when the 20 million warrants first became exercisable in May 1993 and ''stepping up'' $3 a year thereafter to $83.50 in March 1997. The warrants expire the following year. In ! effect, the derivatives converted the market's optimism about Intel's future growth into cool, pragmatic cash -- a fine payoff. Within clearly defined parameters, risk managers should establish goals. Keith Lyon, Duracell International's treasurer at headquarters in Bethel, Connecticut, set a target debt structure after the company went public in 1991. He decided to set a range of 30% to 40% for fixed- vs. floating-rate debt, using derivatives to achieve the correct balance. He still uses the system, but only to keep on course. Then he stops. Goals give risk managers a benchmark against which they can measure their success, a critical need if one is to improve the process. The British post office has a system in place that enables treasurer David Cromwell to do just this. Because the Brits send more mail abroad than they receive, their post office must settle up with different postal services around the world for deliveries that begin in Britain, where they are paid for, but which are delivered in some other country. Settlement costs can easily reach $140 million for Royal Mail International, the operating unit that handles this business. Large fluctuations in that cost could easily produce havoc in the post office's budgets and cash flow. At the beginning of the year, Cromwell meets with the post office's senior line managers, and together they develop a prediction of what they expect by way of currency risks in the coming year. Cromwell then describes how he expects his hedging strategy to work and what it might cost. At the end of the period he compares the results with what would have happened had they done nothing, and what would have happened had they eliminated all risk by buying contracts that removed all uncertainty about exchange-rate risk, a very expensive proposition. Naturally the line managers get to see the results too. Says Cromwell: ''Benchmarking makes us accountable to the line managers, who are, after all, paying for the derivatives.''

U.S. investors, who also foot the bill for derivatives, ought to have that kind of openness from management. And they just might be getting more soon. The Financial Accounting Standards Board, the main rulemaking body for accountants, has proposed new rules that would require companies to tell shareholders about gains or losses from hedging. Companies that trade derivatives would be bound to disclose any profits or losses, along with the fair value of the derivatives still on their books. These proposals could go , into effect this year. The Securities and Exchange Commission is also pushing companies that it knows use derivatives to disclose more about their activities. Walter Schuetze, the SEC's chief accountant, says the agency will be pushing even harder in the future. Many companies will resist opening up about their derivative practices. FORTUNE's poll found that about 39% of CEOs thought shareholders were being told enough already. Says Kirk Thompson, CEO of J.B. Hunt Transport: ''The SEC is going overboard in making us disclose things the average person doesn't need or understand.'' About an equal number of CEOs polled, however, said that companies should tell more. Sweeping aside all the arguments about the difficulty of explaining derivatives, Daniel F. Akerson, CEO of General Instrument, says: ''My own feeling is that these things can become too complicated. If a derivative is something that you can't explain to one of your shareholders, it may well be something that you ought not to be doing.'' Or as a rap version might go, ''If you wanna derivate, you gotta explicate.'' When all is said and done, there is something inherently hubristic about the very idea of risk management. By definition, a risk is a chance and therefore not entirely subject to anyone's control, unless the one is He Who Does Not Play Dice. Investors know that their money is at risk when they buy stock in any company. But they need to know what the risk is. Now that companies have crossed the river into derivative territory, it might be useful to recall that Julius Caesar, the man who famously crossed the river Rubicon, explained his strategies very well indeed and was a most successful global CEO. But then, like P&G, Gibson, and Mead, he did meet his comeuppance in March.