The Sage of Omaha dubbed derivatives as the weapons of mass destruction (read: Warren Buffet on derivatives). In fact, derivatives, specifically credit default swaps, are the instruments that are responsible for the recent financial crisis that vaporised billions of dollars from the global financial system.
And as I read more and more annual reports of companies, I repeatedly encounter derivative financial instruments that were accounted for in the balance sheet. The point to note here is that it is not unusual to notice that a small amount is reflected in the balance sheet under 'Fair Value adjustment of derivative financial instruments', but if you dig deeper into the financial footnotes (which is buried deep within the annual report), you will notice that the contract notional amount dwarfs what is stated on the balance sheet by many times. e.g. a fair value adjustment of S$10mil, but the notional contract amount is S$300mil. To the lay investor, such large variance in declared numbers versus 'buried' data does makes one wonder if the company has been cooking the accounts a la Enron style.
Derivatives: What are they?
The intent of derivatives is to reduce the risk of one party and "eliminate bumps for one party", as how Buffett coined it. The value of such instruments are dependent (or derived from) on the underlying value of other financial instruments, hence the name derivatives.
There are three major classifications for derivatives: options, forwards/futures, swaps. In modern day economics, all three elements feature in a company's financial statements. Options (or rights to buy) are given out to employees as part of their Employee Share Option Scheme (ESOS). Forwards/futures are employed by companies to derive some form of stability and predictability in commodity or currency prices for the next few years. Swaps are used on interest bearing loans so that the companies can swap floating interest rates with another party in return for a fixed interest rate.
Futures/forwards and swaps marry the demands of two different groups of investors: one who desires stability, and another who desires to profit from the speculative movements. But in any case, as a whole, it's a zero sum game in the transfer of wealth between both parties.
Such derivatives are either traded over-the-counter (OTC), i.e. private deals that are executed by market makers, or through an organised exchange like NYMEX. In over-the-counter contracts, it's basically a legal agreement between two parties without going through any intermediary. For swaps, over-the-counter deals are the most common method of transaction. For organised exchanges, typically a margin account is opened and a collateral is placed as a form of guarantee.
Forward/Futures contracts
Here's why companies will consider futures/forwards: currency rates and commodity prices (e.g. steel) fluctuate significantly. If a company frequently have to deal with foreign currencies or buy commodities in its day-to-day operations, it makes sense for the company to have some form of stability and predictability in its income sources by entering a forward contract with another party. In this way, risks in price movements are removed and the company does not have to constantly worry about costs increase over the short run.
Basically, two parties will arrange to come together and agree on a price of the currency/commodity to be exercised at certain time in the future. As a form of mutual assurance, an asset is placed under collateral by both parties, i.e. in the event of default by one party, the collateralised asset will be seized to fulfill the original promise.
Interest Rate Swaps
Companies take loans, which banks offer at floating interest rates, dependent on the monetary policy of the central bank and the market conditions. However, if the company also desires to enjoy some form of stability and predictability in its interest payments, they can enter into a contract with another party where their floating rates are swapped for a fixed interest rate.
Points to note about derivatives
Counter-party risk
Transactions executed over-the-counter have an underlying assumption: both parties are able to honour their financial obligations as stated in the contract. However, in the event that either party is unable the service it's obligations, then such a mechanism will have failed as a risk management tool and the affected party will then have to pay at the existing market rates.
Collateral and creditworthiness
Forwards/futures are based on an underlying collateral asset as well as the creditworthiness of the company. This meant that the company is exposed to additional risks: in the event that the underlying collateral asset loses value significantly, or the company's credit rating is downgraded, it may be enforced upon the company to "top up" its collateral within a short span of time. Without which, the company will face liquidity problems; assets will then be placed on fire sale prices, and the company may face bankruptcy.
Preclusion of any favourable fluctuations
Since a certain fixed value is locked in, engaging in swaps or forwards/futures also meant that the companies are precluded from enjoying any favourable fluctuations. And such are clocked as "potential loss" or "net negative gain on fair value adjustment'
Financial loopholes
Such derivatives can be buried and made invisible in the financial statements. What the company simply has to do is to create an associate company or subsidiary and hide the accounts for such derivatives within. Large amounts of assets can be placed as collateral for derivative trading, and what only appears is a change in the net asset value of the associate company with no mention of derivatives at all in the entire annual report. In fact, this is how a lot of companies in US went under in the recent past, and the public is kept in the dark all the while.
Potential Pandora's Box
In the wrong hands, derivatives can be very dangerous tools. If there are insufficient controls in place, a rogue trader in the company who is overly empowered to leverage and make decisions for selfish reasons can easily bring a company down to its knees overnight. Take a look at this latest piece of news, look at how 3 rogue traders vapourised US$81 million from the company and made attempts to cover it up.
Derivatives gains and losses as a distraction
Gains or losses of derivatives are mandated to be reported on the financial statements and are subject to public scrutiny. Such gains/losses can grow to become a very major distraction to the company management. Instead of focusing on growing profits from operations, what is feared is that the management will direct more attention at at growing their accounting profits from derivatives trading.
Valuation of derivatives
Singapore follows the standards, word for word, as set by International Accounting Standards Boards (IASB) (read here). Under the accounting rules as stated in IAS39, the companies are required to measure the value of the contracts based on the prices in the market at that point in time, and this is also known as fair value and mark-to-market accounting. The net change in the value of the contract is then reported on the balance sheet as "net fair value adjustment of derivative financial instruments".
The profits or losses accruing from this realisation of fair value are then reported on the statements. However, in reality, such losses are just opportunity cost as a result of the company's decision to hedge against fluctuations, while the one time extraordinary gains are pure luck due to market movements of currency or commodity prices.
What to take note of
For an accurate measure of intrinsic value, businesses must be valued based on their operating profits, such one time extraordinary gains arising from derivatives sales are not to be taken into consideration. Conversely, when a company reports losses, the keen-eyed investor must be sharp enough to discern these "potential losses" from actual losses accruing from operations.
My final comments on derivatives: Beware, Beware, Beware
Swaps and futures/forwards are double-edged swords: the outcome of the use of it hinges a lot on the person who wields it. Companies that employ such derivative financial instruments must use it only for risk hedging. However, this is very difficult to ascertain and such companies are deemed to be more risky. It's never a comforting thought that an internal rogue trader can bring about the collapse of the entire company overnight through derivative trading. So, to avoid having any sleepless nights, one should refrain from investing in such companies. It is little wonder that Warren Buffett shut down an arm of derivatives trading in one of his businesses.
So, to invest? Or not to?
On this point, I hold a different view from the Sage. All investment decisions are made based on a simple baseline of risk-reward: such companies should be considered for as a worthwhile investment when the value proposition in terms of risk-reward spread provides an extremely compelling argument. The marginal increase in risk has a corresponding large increase in potential returns.
1. there is an impressive profitability of more than 20% sustained growth
2. high margin of safety in the comparison of price/intrinsic value and Book Value
3. sustainable competitive advantages and barriers to entry are high
To mitigate investor's risks arising from the presence of derivatives to an acceptable level, the companies must fulfill the below conditions, over and above all the other criteria for a high quality company:
1.The directors hold very significant stakes in the company, in excess of 50%.
2.The directors have sufficiently demonstrated that a robust system of controls and check-and-balance is well in place to prevent systemic abuse of derivatives.
3.An esteemed chartered accountant sits on the independent board of directors to provide for check-and-balance.
As usual, YMMV.
(For further reading on derivatives, check out this wikipedia link)
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