Demystifying Financial Derivatives

By René M. Stulz

The Merriam-Webster dictionary defi nes a in the fi eld of chemistry as “a substance that can be made from another substance.” Derivatives in fi nance Twork on the same principle.

These fi nancial instruments promise payoffs that are derived from the value of something else, which is called the “underlying.” The underlying is often a fi nancial asset or rate, but it does not have to be. For example, derivatives exist with payments linked to the S&P 500 stock index, the temperature at Kennedy Airport, and the num- ber of bankruptcies among a group of selected companies. Some es- timates of the size of the market for derivatives are in excess of $270 trillion – more than 100 times larger than 30 years ago. When derivative contracts lead to large fi nancial losses, they can make headlines. In recent years, derivatives have been associated with a few truly notable events, including the collapses of Barings

20 The Milken Institute Review Bank (the Queen of England’s primary bank) and Long-Term Capital Management (a hedge fund whose partners included an economist with a Nobel Prize awarded for breakthrough research in pricing derivatives). Derivatives even had a role in the fall of Enron. Indeed, just two years ago, Warren Buffett concluded that “derivatives are fi nancial weapons of mass destruction, carrying dangers that, while

michael morgenstern now latent, are potentially lethal.”

Third Quarter 2005 21 financial derivatives to depreciate a bit), the exporter is guaranteed But there are two sides to this coin. Al- to receive $118 million at maturity. though some serious dangers are associated Hedging consists of taking a fi nancial po- with derivatives, handled with care they have sition to reduce exposure to a risk. In this ex- proved to be immensely valuable to modern ample, the fi nancial position is a forward con- economies, and will surely remain so. tract, the risk is depreciation of the euro, and the exposure is €100 million in six months, the nuts and bolts which is perfectly hedged with the forward Derivatives come in fl avors from plain vanilla contract. Since no money changes hands to mint chocolate-chip. The plain vanilla in- when the exporter buys euros forward, the clude contracts to buy or sell something for market value of the contract must be zero future delivery (forward and futures con- when it is initiated, since otherwise the ex- tracts), contracts involving an to buy porter would get something for nothing. or sell something at a fi xed price in the future (options) and contracts to exchange one cash Options fl ow for another (swaps), along with simple Although options can be written on any un- combinations of forward, futures and options derlying, let’s use options on common stock contracts. (Futures contracts are similar to as an example. A on a stock gives forward contracts, but they are standardized its holder the right to buy a fi xed number of contracts that trade on exchanges.) At the shares at a given price by some future date, mint chocolate-chip end of the spectrum, while a gives its holder the right to however, the sky is the limit. sell a fi xed number of shares on the same terms. The specifi ed price is called the exer- Forward Contracts cise price. When the holder of an option takes A obligates one party to buy advantage of her right, she is said to the underlying at a fi xed price at a certain fu- the option. The purchase price of an option – ture date (called the maturity) from a coun- the money that changes hands on day one – is terparty, who is obligated to sell the underly- called the option premium. ing at that fi xed price. Consider a U.S. export- Options enable their holders to lever their er who expects to receive a €100 million pay- resources, while at the same time limiting ment for goods in six months. Suppose that their risk. Suppose Smith believes that the the price of the euro is $1.20 today. If the euro current price of $50 for Upside Inc. stock is were to fall by 10 percent over the next six too low. Let’s assume that the premium on a months, the exporter would lose $12 million. call option that confers the right to buy But by selling euros forward, the exporter shares at $50 each for six months is $10 per locks in the current forward exchange rate. If share. Smith can buy call options to purchase the forward rate is $1.18 (less than $1.20 be- 100 shares for $1,000. She will gain from cause the market apparently expects the euro stock price increases as if she had invested in 100 shares, even though she invested an RENÉ M. STULZ is the Reese professor of money and amount equal to the value of 20 shares. banking at Ohio State University. A version of this article With only $1,000 to invest, Smith could appeared in the Summer 2004 issue of the Journal of Economic Perspectives. It is published here by permission of have borrowed $4,000 to buy 100 shares. At the American Economic Association. maturity, she would then have to repay the

22 The Milken Institute Review loan. The gain made upon exercising the op- ward contracts. Instead, the payoff is a com- tion is therefore similar to the gain from a le- plicated function of one or many underly- vered position in the stock – a position con- ings. When P&G lost $160 million on deriva- sisting of purchasing shares with one’s own tives in 1994, the main culprit was an exotic money plus money that’s borrowed. However, . The amount it had to pay on the swap if Smith borrowed $4,000, she could lose up depended on the fi ve-year Treasury note yield to $5,000 plus interest if the stock price fell to and the price of the 30-year Treasury bond. zero. With the call option, the most she can Another example of an exotic derivative is a lose is $1,000. But there’s no free lunch here; , which pays a fi xed amount if she’ll lose the entire $1,000 if the stock price some condition is met. For instance, a binary does not rise above $50. option might pay $10 million if, before a specifi ed date, one of the three largest banks Swaps in Indonesia has defaulted on its debt. A swap is a contract to exchange cash fl ows over a specifi c period. The principal used to pricing derivatives compute the flows is the “notional amount.” Derivatives are priced on the assumption that Suppose you have an adjustable-rate mort- fi nancial markets are frictionless. One can gage with principal of $200,000 and current then fi nd an asset-buying-and-selling strategy payments of $11,000 per year. If interest rates that only requires an initial investment that doubled, your payments would increase dra- ensures that the portfolio generates the same matically. You could eliminate this risk by re- payoff as the derivative. This is called a “repli- fi nancing with a fi xed-rate mortgage, but the cating portfolio.” The value of the derivative transaction could be expensive. A swap con- must be the same as that of the replicating tract, by contrast, would not entail renegoti- portfolio; otherwise there would be a way to ating the mortgage. You would agree to make make a risk-free profi t by buying the portfo- payments to a counterparty – say a bank – lio and selling the derivative. equal to a fi xed interest rate applied to An example will help. Consider the euro $200,000. In exchange, the bank would pay forward contract described earlier. At maturi- you a fl oating rate applied to $200,000. With ty, the exporter has to pay €100 million and this interest-rate swap, you would use the receives $118 million. A replicating portfolio fl oating-rate payments received from the can be constructed as follows: borrow the bank to make your mortgage payments. The present value of €100 million and invest the only payments you would make out of your present value of $118 million in Treasury bills own pocket would be the fi xed interest pay- that come due the day the derivative contract ments to the bank, as if you had a fi xed-rate matures. At maturity, you are guaranteed to mortgage. Therefore, a doubling of interest have $118 million in hand and have to pay rates would no longer affect your out-of- back the borrowed euros plus interest, which pocket costs. Nor, for that matter, would a come to €100 million. The forward contract halving of interest rates. must thus be priced so that the exporter is in- different to using the forward contract or the Exotics replicating portfolio to hedge. Otherwise, any An exotic derivative is one that cannot be cre- investor could make easy, guaranteed money ated by mixing and matching option and for- by buying dollars against euros using the

Third Quarter 2005 23 financial derivatives Until the 1970s, derivatives mostly took the cheaper approach and selling dollars against form of option, forward and futures contracts. euros using the more expensive approach. Except for futures contracts on commodities, Note that the value of a forward contract the trading of derivatives had been done can change over its life. If the euro appreciates “over the counter,” meaning without interme- unexpectedly, the replicating portfolio makes diation by an organized exchange. But in 1972, a loss; the present value of the euro debt of the Chicago Mercantile Exchange started trad- the portfolio increases unexpectedly, but the ing futures contracts on currencies. The Chi- value of the Treasury bills would not increase cago Board Options Exchange, where stock commensurately. Since the replicating portfo- options are traded, was founded in 1973. In lio has the same payoff as the forward con- the late 1970s and early 1980s, the swaps mar- tract, the loss means that the value of the for- ket took off. Exotic derivatives trading ex- ward contract has become negative. ploded a few years later. The replicating portfolio strategy is tricki- The OTC derivatives markets are decen- er to devise and implement for options. In tralized and unregulated (except by contract their pathbreaking (and Nobel Prize-win- law), and the parties are not required to re- ning) work, Fischer Black and Myron Scholes port transactions. However, since an OTC de- provided a mathematical solution for calcu- rivative trade typically involves a bank or a lating the option price at any time during the regulated broker, the quasi-governmental life of the option. Bank for International Settlements has been able to estimate the size of the OTC market the growth of for derivatives by surveying fi nancial fi rms. derivatives markets In June 2004, the total notional amount of Some of the earliest derivatives were linked to derivatives traded over the counter was $220 tulip bulbs in Holland and to rice in Japan in trillion. This fi gure is a proxy for the value of the 17th century. But derivatives markets were the underlyings against which claims are small until the 1970s, when economic condi- traded in the derivatives markets. The euro tions, along with advances in the pricing of forward contract example discussed earlier derivatives, led to spectacular growth. In that had a notional value of $118 million, while decade, the of interest rates and cur- the interest-rate swap had a notional amount rency-exchange rates increased sharply, mak- of $200,000. Interest-rate swaps represent 56 ing it imperative to find effi cient ways to hedge percent of the . related risks. Meanwhile, deregulation in a va- In 1987, the notional amount of interest- riety of industries, along with soaring inter- rate swaps outstanding was $865 billion; 17 national trade and capital fl ows, added to the years later, it was $127 trillion, implying demand for financial products to manage risk. growth at an average annual rate of 34 percent. Development of the Black-Scholes formu- The notional amount of exchange-traded de- la in the early 1970s, along with the introduc- rivatives (futures and options) grew from $616 tion of cheaper, faster computers to manage billion in December 1986 to $50 trillion in the computations, changed the trading of de- mid-2003, for an average annual growth rate rivatives forever. Thereafter, fi nancial engi- of 29 percent. neers could invent new derivatives and easily Adding up the OTC market and the ex- fi nd their value. changes, the notional amount of derivatives

24 The Milken Institute Review was some $270 trillion at the end of June greater cost. Derivatives make it possible to 2004. To put this number in perspective, the hedge risks that otherwise would be not be capitalization of all the markets for corporate possible to hedge. And when economic actors debt and equity in the world was $31 trillion can manage risk better, risks are borne by at the end of 2003. those who are in the best position to bear A second way to look at the size of the de- them, and fi rms can take on riskier but more rivatives market is as follows: Suppose that profi table projects by hedging. every party and counterparty had to write off A second important benefi t is that deriva- all derivatives contracts. For each swap con- tives can make underlying markets more effi - tract, one party would write off an asset, the cient. First, derivatives markets produce in- positive value of the contract at that time, and the counterparty would write off a liability. Now, just add up the positive value of all con- tracts at that time. By this net mea- sure, the aggregate value of OTC derivatives outstanding in June 2003 was $6.4 trillion – a big num- ber, but nothing compared to the notional amount of contracts out- standing.

the benefits of derivatives Derivatives are priced by construct- ing a hypothetical replicating port- folio. So who needs them? If deriv- atives can be replicated perfectly, limiting their use would change nothing. formation. For example, in a number of Well, not quite. First, individuals and non- countries, the only reliable information about fi nancial fi rms face much higher trading costs long-term interest rates is obtained from than fi nancial institutions. Thus, replicating a swaps, because the swap market is more liq- derivative like a call option would be prohibi- uid and more active than the bond market. tively expensive. Second, for derivatives that Second, derivatives enable investors to trade include option features, the replicating port- on information that otherwise might be pro- folio strategy typically requires trades to be hibitively expensive to use. For instance, sell- made whenever the price of the underlying ing stock short (that is, selling stock you don’t changes. Third, identifying the correct repli- own) is often diffi cult to do, because the cating strategy is often a problem. shares must be borrowed from someone who The main gain from derivatives is there- does own them. This slows the speed at which fore to permit individuals and fi rms to achieve adverse information is incorporated in stock payoffs that they would not be able to achieve prices, thereby making markets less effi cient.

michael morgenstern without derivatives, or could only achieve at With put options, a derivative that mimics

Third Quarter 2005 25 financial derivatives The way managers are paid affects the ex- the dynamics of selling short, investors can tent to which fi rms hedge. In general, fi rms more easily take advantage of adverse infor- for which options are a more important com- mation about stock prices. ponent of managerial compensation are less In theory, this cuts both ways; derivatives likely to hedge. That makes sense: in many sit- can also disrupt markets by making it easier uations, managers who hold options benefi t to build speculative positions. But there isn’t from increased volatility, since their options much evidence that derivatives trading has will be worth more if the stock price rises but actually increased the volatility of the return the option will never be worth less than zero of the underlying assets. if the stock price falls. Finally, fi rms some- times do use derivatives to speculate. who uses derivatives and why Banks and investment banks make mar- The most comprehensive study of the use of kets in derivatives, but they also take posi- derivatives by nonfi nancial fi rms was made tions in derivatives to manage risk. In the by Sohnke Bartram, Gregory Brown and third quarter of 2003, the banks with the 25 Frank Fehle (all University of North Carolina), largest derivatives portfolios held 96.6 per- who examined some 7,300 nonfi nancial fi rms cent for trading purposes and 3.4 percent for from 48 countries, using corporate reports risk-management needs. from 2000 and 2001. They found that 60 per- Little is known about derivatives’ use by cent of these firms used derivatives. The most individuals. What evidence there is, though, frequently used were foreign-exchange deriv- suggests that individuals fail to exploit them atives (44 percent of fi rms), followed by inter- fully. For example, home mortgages in the est-rate derivatives (33 percent of fi rms) and United States typically contain an embedded commodity derivatives (10 percent). Swaps option – the borrower has the option to pre- and forwards are used more than options. pay the mortgage. Typically, though, mortgage Wayne Guay (University of Pennsylvania) holders exercise this option later than justi- found that when fi rms started using deriva- fi ed by models of option pricing. tives, on average their stock return volatility fell by 5 percent, their interest-rate exposure the risks of derivatives at the firm level fell by 22 percent, and their foreign-exchange exposure fell by 11 percent. Clearly, fi rms do Derivatives that trade in liquid markets can use derivatives for hedging, although if fi rms always be bought or sold at the market price, hedged systematically, the evidence suggests so mathematical models are not required to they would use derivatives much more than value them. Valuation is much more prob- they actually do. lematic when trading is illiquid. In these Firms use derivatives for other reasons, cases, models have to be brought to bear to too. Gordon Bodnar, Gregory Hayt, Richard value derivatives – a procedure called “mark- Marston and Charles Smithson, writing in ing them to market.” And, in the words of a Financial Management in 1995, found 28 per- skeptical Warren Buffett, “In extreme cases, cent of the fi rms they surveyed used deriva- mark-to-market degenerates into what I tives to minimize earnings volatility. There is would call mark-to-myth.” also evidence that fi rms use derivatives to re- The Black-Scholes formula for options duce tax liability. valuation assumes, among other things, that

26 The Milken Institute Review markets are frictionless, interest rates are parties who both want that particular set of fi xed, and trading is possible all the time. Yet, risk characteristics and are confi dent that while the shortcomings of Black-Scholes are they understand what they are getting. obvious, there is no general agreement on what would work better. Transparency and Reliability of Accounting Even relatively simple derivatives contracts Consider a 30-year swap contract in which can be badly misvalued. Chase Manhattan Enron delivered gas at regular intervals and ended up with some very expensive egg on its received fi xed amounts of cash over time. The face when it discovered in 1999 that one of its value of this contract had to be marked to foreign-exchange traders had misvalued for- market each quarter for accounting purposes. ward contracts to the tune of $60 million. In However, it can be tempting to tweak as- 2004, the National Australian Bank reported sumptions – say, about the growth in the stor- currency-option losses in excess of $280 mil- age cost of gas decades down the road – in a lion U.S., due in part to incorrect valuations. way that has a substantial impact on present Two interesting studies show substantial profi ts. And, not surprisingly, Enron was not disagreement among experts on the value of reluctant to make the best of the ambiguous. derivatives. In one, the Bank of England asked Though concerns about disclosures of de- dealers to value a number of different deriva- rivatives positions have increased recently, the tives and found that while the dealers had information disclosed typically focuses on the similar numbers for the most actively traded stand-alone risks of derivatives rather than derivatives, they were sometimes far apart for the context in which the derivatives are used. more complicated ones. In the other, Antonio If a fi rm uses derivatives to hedge, it can take Bernardo and Bradford Cornell of UCLA had on a large amount of seemingly risky deriva- access to data for an auction of 32 mortgage- tives in the name of reducing risk. Although derivative securities. The average amount by disclosure requirements for derivatives are which the highest bid price exceeded the low- not much help in seeing how they are used, est bid price was a remarkable 63 percent. But some fi rms do report the impact of their in spite of the practical diffi culties in valuing hedging activities on various risks. derivatives, current U.S. accounting rules re- Another problem is that it can be a major quire fi rms to mark to market the derivatives challenge for a fi rm to describe all the details positions on their balance sheets. of its derivatives risks. For example, Enron had complicated derivatives with credit-rating Market Liquidity triggers that required it to make payments if If a fi rm buys a widely traded plain vanilla de- its credit rating fell below a specifi ed level. rivative – say, a put option on the euro with a Once Enron’s credit cratered and the triggers maturity and exercise price common in the were activated, it could no longer survive be- marketplace – it is generally easy to sell. How- cause the required payments were too large. ever, it can be harder to get out of long-matu- rity contracts and complicated derivatives. Derivatives and Incentives First, it is much more likely that there is risk The sale of a derivative generates revenue. A involved in the replicating strategy for such wise trading fi rm will typically hedge the de- derivatives. Second, a complicated derivative rivative that it has sold. But placing a value on only appeals to a small number of counter- the derivative and the corresponding hedge

Third Quarter 2005 27 financial derivatives tives have made considerable progress in can be diffi cult in an illiquid market. And ex- measuring the risks of derivatives portfolios. ecutives do not always have strong incentives One popular measure is called value-at-risk to side with risk managers who want to value (or VaR). For instance, a 5 percent value-at- derivatives conservatively. For example, when risk of $100 million means that there is a 5 a conservative valuation would cause a fi rm percent chance the derivative user will lose to show a loss, top executives may fi nd rea- $100 million or more in a specifi ed time pe- sons to side with traders who prefer a more riod. With another measure, called a stress aggressive stance. test, the fi rm computes the value of its deriva- Derivative trading does not require much tives portfolio using hypothetical scenarios. cash. Swaps, for example, have no value at ini- For example, it might compute the value of tiation, so a fi rm with a good credit rating can its portfolio if the Russian fi nancial crisis of build a big portfolio of them without writing 1998 were repeated. checks. As a result, derivative trading can look Many fi rms with large portfolios of deriva- very profi table when its revenue is compared tives now report their value-at-risk and may to the cash investment. also report the outcomes of various stress Yet, derivative trading generates revenue tests. But these measurement tools do not al- by assuming additional risks. And proper ways work well. During the Russian crisis, evaluation of the profi tability of derivatives banks exceeded their VaRs more than their requires taking into account the capital re- risk models suggested they should have. quired to support those risks. The major banks have developed approaches that allow who gets hurt by derivatives losses? them to do just that. Other fi rms, though, are more likely to ignore the cost associated with With a derivative, somebody’s loss is inevita- the increase in risk, which leads them to over- bly somebody else’s gain. For instance, with a state profi tability. recent $550 million derivatives loss of China Aviation Oil, the counterparties to the deriva- Understanding the Risks tives contracts made some of that money (the In 1994, a fi rm in Cincinnati called Gibson rest has not been paid because of the compa- Greetings lost of its profi ts for the year, thanks ny’s bankruptcy). So, for a derivatives loss to to its operations in derivatives. One of its de- create a loss to society as a whole, there must rivative contracts worked like this: A swap also be some “deadweight” costs incurred specifi ed that starting on April 5, 1993 and along the way. In many cases, these costs are ending October 5, 1997, Gibson would pay small or nonexistent. But derivatives losses Bankers Trust the six-month LIBOR (the can lead to fi nancial distress at the fi rm level London Interbank Offering Rate), a com- and, in exceptional circumstances, can have monly used interest rate, squared, then divid- more pervasive effects on the economy. ed by 6 percent times $30 million. In return, Bankers Trust paid Gibson 5.50 percent times The Derivatives Risks of $30 million. Such exotic transactions raise Financial Institutions concerns that some parties involved don’t In the third quarter of 2003, insured com- fully understand the risks they are taking. mercial banks in the United States had deriv- In the past decade, regular users of deriva- atives positions with a total notional amount

28 The Milken Institute Review of $67.1 trillion, with 96 percent of the total sures suggest that no large bank is seriously at held by seven banks. risk because of its derivatives holdings. Banks generally report the market risk of their trading positions – the risk associated What Would Happen if a Major Dealer with possible changes in fi nancial prices and or User Collapsed? rates. For instance, J.P. Morgan Chase report- Bankruptcy law contains an automatic-stay ed a value-at-risk of $281 million on the last provision that prevents creditors from requir- day of 2003, which meant there was a 1 per- ing immediate payment, making it possible cent chance that it would make a one-day loss for their claims to be resolved in an orderly on its trading portfolio in excess of $281 mil- fashion. Interest-rate swaps and some other lion. Of course if the bank actually started derivatives are exempted from this automatic losing sums of this magnitude, it would take stay, however. Instead, the parties to a swap steps to cut its risk. Note, moreover, that, at contract use a master agreement that specifi es the time, stockholders’ equity in J.P. Morgan how termination payments are determined in Chase was $43 billion. Thus, by any standard, the event of a default. Without this exemp- the bank’s derivatives risks seemed manage- tion from the automatic stay, defaults on de- able. rivatives contracts would present a consider- A large bank might make signifi cant losses able problem, since counterparties would in if one or several of its large derivatives coun- some cases have to wait (sometimes for years) terparties defaulted. However, participants in for their claims to be adjudicated, leaving fi nancial markets have strong incentives to them with mostly unhedgeable risks. control counterparty risk. Fully 65 percent of Consider a bank that experiences a default plain vanilla interest-rate swaps were collater- on a derivative contract. It chooses to ask for alized in 2001. Parties also put triggers in de- termination of the contract and is due a pay- rivatives contracts, forcing the counterparty ment equal to the market value of its position to post more collateral if it becomes less cred- at termination. If the position was hedged, itworthy. One result: In the United States, the bank has only the hedge on its books after charge-offs from derivatives losses by com- the default, without having the contract it was mercial banks have been small compared to trying to hedge. The bank’s risk has increased, charge-offs from commercial loans. and it may not have received the cash pay- Two issues are still worth considering here. ments that were promised. The bank may First, even if large losses at the fi rm level then lack the liquidity to make payments it would impose large costs on the fi nancial sys- owes, which leads to further problems. tem, fi rms have little incentive to take such Under normal circumstances, markets are externalities into account. Second, though ex- suffi ciently liquid that the bank can quickly isting measures capture most risks, they can’t eliminate the risk created by default. But the capture risks we do not know about. In 1998, situation may be direr if the default occurs in liquidity risk – the risk associated with the a period of economic turmoil. If all banks are cost of selling a position quickly – was cru- trying to reduce risk, they may all get stuck, cially important, but it was not included in because there is only a limited market for the most models. The bottom line: while impos- positions they are trying to sell. In such a sit- sible to answer the question of whether un- uation, the Federal Reserve would have to known risks are large, the conventional mea- step in to provide liquidity. Given the central

Third Quarter 2005 29 financial derivatives Many strategies employed by LTCM in- role of Treasury securities in dynamic hedg- volved taking long positions in bonds that ing, the Fed might also have to intervene to LTCM perceived to have too high a yield in settle down the Treasury market. light of their risk, and then hedging these po- sitions against interest-rate risk with deriva- The LTCM Collapse tives or short positions in U.S. Treasuries. The collapse of the hedge fund Long-Term When Russia defaulted on its sovereign debt Capital Management (LTCM) is often cited as in 1998, there was a general fl ight to safety by investors around the globe. Interest rates on Treasuries fell, but the yields on the bonds held by LTCM did not fall as much; so LTCM had loss- es on its hedges not matched by gains on the market value of its bonds. LTCM’s losses then triggered a vicious circle. As the fund registered losses, it sold some assets, which put pressure on prices. More important, the market perceived that liquidation of its positions became more likely. Trad- ers who knew about LTCM’s portfolio could position themselves so that they would not be hurt by a liquidation and might even benefi t from it. Their actions put pres- sure on prices, further re- ducing the value of an example of a crisis linked to derivatives LTCM’s portfolio – which made liquidation that could have led to a meltdown of the en- more likely and hence created incentives for a tire fi nancial system. At the end of July 1998, new round of trading. LTCM held assets worth $125 billion, which What’s more, as prices moved against were fi nanced with about $4.1 billion of its LTCM and liquidity in the markets was dry- own capital along with loans. It also had de- ing up, counterparties were trying to maxi- rivatives with a total notional amount in ex- mize the collateral that they could obtain

cess of $1 trillion. from the giant hedge fund on their marked- michael morgenstern

30 The Milken Institute Review to-market contracts. This generated further might still have ended in bankruptcy. It is dif- marked-to-market losses for LTCM. Finally, fi cult to say, then, whether the risk to the investors and banks that in normal times economy would have been greater or smaller would have bid for assets in the event of an had LTCM been subject to restrictions on its LTCM liquidation were facing losses of their use of derivatives. Its leverage would have own. Some were forced to sell assets that been lower. But in replicating derivatives on LTCM also held, putting yet more pressure on its own, it might have needed to trade more in prices. By mid-September, LTCM could only illiquid markets. avoid default by closing its positions or re- ceiving an infusion of capital. what to make of it all Closing LTCM’s positions would have been Derivatives allow fi rms and individuals to exceptionally diffi cult, since it was a party to hedge risks or to bear risk at minimum cost. more than 50,000 derivatives contracts and They can also create risk at the fi rm level, es- securities positions in markets where liquidi- pecially if a fi rm is inexperienced in their use. ty was now low. For creditors, the most effi - For the economy as a whole, the collapse of a cient solution was to take over the fund, inject large derivatives user or dealer may create sys- some cash, and liquidate the portfolio slowly temic risks. On balance, derivatives plainly or fi nd a buyer for it. make the economy more effi cient. However, A potential buyer did appear: Warren Buf- neither users of derivatives nor their regula- fett’s Berkshire Hathaway and Goldman Sachs tors can afford to be complacent. bid $4 billion for the portfolio. Instead, credi- Firms have to make sure that derivatives tors chose to inject $3.6 billion into the fund are used properly. This means that the risks of and took control, with the LTCM partners re- derivatives positions must be measured and taining some ownership. There was no de- understood, and that fi rms must have well- fault and no public bailout; the creditors defi ned policies for derivative use. What’s eventually took more money out than they more, a fi rm’s board must know how risk is put in. managed within the fi rm and what role deriv- We will never know what would have hap- atives play. pened if LTCM had defaulted. But one lesson For their part, regulators need to monitor is clear: When a market participant that is fi nancial fi rms with large derivatives posi- large relative to the markets gets in trouble, its tions very carefully. Though regulators seem diffi culties may affect prices adversely. That to be doing a good job in monitoring banks makes its situation worse – a fact that does and brokerage houses, the risks taken by in- not fi gure in models treating economic agents surance companies, hedge funds and govern- as passive price-takers. ment-sponsored enterprises like Fannie Mae If LTCM had been denied easy access to and Freddie Mac are not equally well under- derivatives, it could have manufactured its stood and monitored. own. This would have decreased its profi ts a Should we fear derivatives? Most of us bit, and might have been too expensive for choose to fl y on airplanes even though they some strategies. sometimes crash. But we also insist that But LTCM would still have been very high- planes are made as safe as it makes economic ly levered, would still have registered ex- sense for them to be. The same logic should tremely large losses in September 1998, and apply to derivatives. M

Third Quarter 2005 31