Restructuring your balance sheet in various ways by using derivatives

Unless you have been living on Mars for the last few years the acronym WMD or weapons of mass destruction has, thanks to George Bush and friends, become a well-known acronym.

Another person fascinated by it is Warren Buffett, CEO of Berkshire Hathaway. However, Buffett did not mean military might when he spoke about WMD. Instead he used the phrase in a letter to his shareholders to describe derivatives. I think Buffett was being a little unfair, but before explain why, let us understand what derivatives actually are.

Derivatives are financial instruments whose payoffs are based on the performance of some specific underlying asset, reference rate or index. The first derivative transaction was recorded over 20 years ago and since then it has grown into a $60 trillion (Dh220.2 trillion) worldwide industry. The derivatives market has seen phenomenal growth, averaging 26 per cent per annum over the last 10 years. Given this backdrop, there must be some merit in the product.

The first derivative transaction was done in 1981, and took the form of what is commonly called a "cross currency swap".

The deal was done between IBM and the World Bank. To give you a brief background, IBM had debt in German marks and Swiss francs. The dollar had appreciated considerably against these two currencies and interest rates in them had also gone up. So it made economic sense for IBM to replace the debt with dollars. However the task of recalling existing German mark and Swiss franc loans and issuing new dollar-denominated debt would not only have been onerous but also expensive.

The World Bank, on the other hand, wanted to raise funding in marks and francs to on-lend to their own customers but had greater pricing prowess when it came to raising US dollar funding. The solution lay in a derivative in which the World Bank raised dollars which were swapped for marks and francs with IBM.

The Virginia Slims ad line "you have come a long way baby" applies rather well to derivatives, and since 1981 we have seen the sophistication of this market increase exponentially. If for you the word "Monte Carlo" only conjures up images of an exotic holiday resort, rather than a simulation methodology, I will not waste your time delving into the technicalities of derivatives and jargon such as volatility, convexity, smile, path dependency, digitals (to name but a few). I will instead try and focus on some hypothetical examples to highlight the uses of derivatives.

A local car dealer in Germany is facing competition from dealers selling Jap-anese cars. These dealers have been able to cut prices as the yen has been falling sharply as Japan goes into throes of recession, thereby making it cheaper to import cars from Japan.

The German car dealer can actually use derivatives to restructure a part of his liabilities into Japanese yen and take benefit of the depreciation even though his own cars are invoiced in euros. This is just one example, derivatives can be used to restructure your balance sheet in various ways imagine having a dollar loan but paying yen Libor on it because you think the Bank of Japan will not hike rates. Your loan principal however remains denominated and payable in dollars.

Your balance sheet could have short-term liabilities but long-term assets. Derivatives can be used to manage the interest rate risk that this tenor mismatch throws up. Alternatively, you are a manufacturing company and the largest buyer of your product could be based in a politically unstable country, which is worrying.

You could take out some insurance via the derivatives route by betting on the way credit spreads for that country are likely to change if the situation was to worsen.

Derivatives also allow you to cash in on your instincts. For example, you may believe that interest rates in the US will not rise as fast as the market is currently forecasting. You can enhance the yield on your dollar assets by betting against the market view.

At times you can take advantage of aberrations in the market for example in certain Asian markets, clients have used derivatives to generate dollar funding at a spread below Libor.

To put it succinctly, various derivative products can be structured to manage 'financial' risks such as transaction and translation exposure, as well as 'economic' risk arising from the markets you operate in and the competition that you face.

However like everything else in life, there is no "free lunch". Any derivative product which throws up the possibility of potential gains also brings with it certain risks and, needless to say, the adage "the greater the return, the greater the risk" still holds true.

What is important is to recognise the value of derivatives, understand the risks that you are getting exposed to, and to be comfortable dealing with the downside risks in case things do not work out as expected.

After all, the derivatives industry is not about magic, it is about market expectations and probability you win some, you lose some and you stack the odds against yourself if you do not have a well defined risk management policy.

In the end you must remember that "perfect hedges" only exist in Japanese gardens and the only way to immediately double your money is to fold it!

The writer is regional head of sales, HSBC Global Markets, Middle East. The views expressed here are his own and not necessarily those of his employer.