Wharton Impact

In the past, when companies were burned by risky financial bets, many responded by taking the loss and perhaps making a few policy changes. Few companies, however, put formal policies in place to protect themselves from future downturns.

Learning from their past, and from the recent derivatives fiascoes, companies are now beginning to realize that hedging risk is possible — and perhaps vital — for surviving the increasingly complex 1990s.

Wharton faculty examine how companies are going about managing risk.Are U.S. Companies Using Derivatives Responsibly?

A number of high-profile cases over the past year has shown companies getting burned by using derivatives for speculative purposes. But are most firms using these investments to make a killing in the market, or are they using them to hedge risk?

Researchers at Wharton’s Weiss Center for International Financial Research, together with Chase Manhattan Bank, recently surveyed 530 firms to create a profile of the corporate derivative investor.

They found that over a third of the companies surveyed reported they use derivatives primarily to manage risk. More than 75 percent said they use them to hedge commitments, the majority doing so frequently. Only 40 percent use them to hedge the balance sheet. Of the 31 percent who use derivatives to hedge across markets, only a minority do so frequently. Of the 40 percent of the companies who use derivatives to “take a view” on the market (speculating on the direction of interest rates or foreign exchange movements), only 8.2 percent do so frequently.

Swaps are the derivatives used most often for interest-rate risk management (63 percent). Foreign exchange rate risks are most often managed with OTC forwards (49 percent), although swaps (22 percent) and OTC options (25 percent) are used frequently.

Almost a third of the large firms in the survey (market value more than $530 million) use derivatives, compared with 13 percent of small firms (market value less than $50 million). Commodity-based industries such as agriculture, refining, and mining are the highest users (50 percent), followed by manufacturing (40 percent), and public utilities (30 percent). Derivative use is least common in service industries (23 percent).

The researchers also asked the firms how concerned they were over several issues related to using derivatives. Accounting risk was the issue that received the most concern, with 26 percent expressing high concern and 37 percent expressing moderate concern. The firms were least concerned with the cost of derivatives or the transaction costs incurred when buying them.

Richard Marston and Gary Gorton, “Wharton Chase Survey of Derivative Usage Among U.S. Non-Financial Firms: Executive Summary,” February 1995.

Characteristics of Firms Hedging with Derivatives

Many corporate decision-makers have realized that derivatives can serve a number of purposes — to hedge risks, lower borrowing costs, or engage in speculative trading for profit. But what types of firms are most likely to use derivatives?

Catherine Schrand, assistant professor of accounting, Christopher Geczy of the University of Chicago, and Bernadette Minton of Ohio State University examined the use of derivatives by Fortune 500 firms. They tested theories of optimal risk management to determine which types of these firms are more likely to use derivatives and why.

The researchers found that firm characteristics affect not only the company’s decision to use derivatives, but also which types of derivatives it uses.

Firms with a combination of high-growth opportunities but limited access to external financing are most likely to use derivatives. Such a firm might not have the cash on hand to jump into new investment opportunities and may be forced to borrow from banks, which is potentially more expensive. Maintaining an adequate stock of internal buffer funds for investment projects, then, is useful. Derivatives can be used to lower this cash-flow variation, increasing the chances that the firm will have money to invest in new projects. Firms with heavy research and development expenditures or companies with low liquidity are more likely to use derivatives for this purpose.

Firm characteristics affect managements’ decisions as to which type of instrument they use. Highly-leveraged firms and those with tighter financial constraints are more likely to use interest rate derivative instruments, while those with high foreign income and lower debt-to-equity ratios are more likely to use currency derivatives.

Christopher Geczy, Bernadette Minton, and Catherine Schrand, “Why Firms Use Derivatives: Distinguishing Among Existing Theories,” June 1995.

Coordinating Risk to Maximize Profits

Current models of risk management are generally concerned with explanations for the reduction of optimal total risk. Yet many firms may actually want to reduce some risks through active portfolio management while remaining exposed or seeking exposure to others, according to Catherine Schrand, assistant professor of accounting, and Haluk Unal, visiting professor of finance. By using derivatives or other investment and financing decisions, risk management activities can not only alter the level, but also the optimal allocation, of risk exposure within a firm’s portfolio.

For instance, when a savings and loan (S&L) issues loans, it is simultaneously taking on some credit risk and some interest rate risk. These firms don’t really know what’s going to happen with interest rate risks and therefore use derivatives to reduce these risks. But S&Ls do have control over credit risk, because they can issue mortgages to those with better credit. By reducing that non-controllable interest rate risk to an optimal level, the S&Ls can increase their exposure to credit risk, the area in which they have greater expertise.

To identify “coordinated risk management within firms,” Schrand and Unal examined 81 savings and loans which converted from a mutual form of ownership to a stock ownership structure during the period between 1984 and 1988. They found that the managers of the newly-converted S&Ls increased exposure to credit risk by taking on additional risky real estate projects. At the same time, they reduced interest rate risk by using both on-balance sheet techniques and derivative instruments. Together, these results support the notion of coordinated risk management.

Agency theory proposes that firms which are going public will maximize shareholder wealth by increasing total firm risk. Using their coordinated risk management model, the researchers found S&Ls followed this theory, but increased their risk by using the coordinated risk management approach.

Schrand and Unal concluded that institutions which anticipated greater growth capacity at the time of conversion not only better managed their on-balance sheet interest rate risk, but also used higher levels of derivatives. Managers of those institutions with greater interest-rate risk purchased fewer shares, on average, at conversion and continued to mismanage their interest-rate risk for a number of years after conversion.

Catherine Schrand and Haluk Unal, “Hedging and Coordinated Risk Management: Evidence from Thrift Mutual-to-Stock Conversions,” May 1995.

Pricing Insurance Derivatives

In response to recent natural disasters, the Chicago Board of Trade introduced insurance futures to provide a hedge against catastrophic property insurance loss. The CBOT has created a loss-ratio index of a number of insurers, and divides those losses by the premiums collected over the same time period. Insurance firms can then buy catastrophe insurance futures to hedge their underwriting risks.

For example, an insurer could buy an option that the loss ratio will fall within the 40 percent to 60 percent spread. If losses fall within this spread, the insurer would exercise the option and then sell the contract at a profit, which would compensate the insurer for its underlying losses. If the ratio does not fall within this spread, the option is worthless.

The price of the futures contract at any given time reflects the market’s expectation of the quarter’s catastrophic loss in relation to the earned premiums for that quarter. The insurer gains from a long position if the settlement price is greater than the price at the inception date of the contract.

J. David Cummins, Harry J. Loman Professor of Insurance and Risk Management at Wharton, and Helyette Geman, a professor at ESSEC in France, examined the current models used to price CBOT’s catastrophic insurance futures and created a new model which incorporates the unique features of these derivatives.

Since the CBOT’s insurance futures are an accumulation of indices over a three month period, conventional option pricing models aren’t completely applicable because they’re meant for options that settle on the value of an index at a specific point in time. Cummins’ model uses an Asian approach, where an option is exercised based on its average price over a specific period.

The researchers’ model is also the first to incorporate jumps or catastrophes with an Asian approach to pricing. Instead of viewing these events as anomalies, or unaccountable events, their model incorporates small and large jumps in industry losses as a standard feature.

Cummins and Geman believe that these futures represent an attractive alternative to reinsurance. If their use grows, these derivatives may become a vital tool for insurers to manage catastrophic risk.

“The CBOT insurance futures and call spreads offer an important new example of risk securitization,” the researchers said. “Maintenance of viable insurance markets for high-exposure losses such as property catastrophes and commercial liability is likely to become increasingly dependent on insurance derivatives.”

J. David Cummins and Helyette Geman, “Pricing Catastrophe Insurance Futures and Call Spreads: An Arbitrage Approach,” The Journal of Fixed Income, March 1995.

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