Derivatives and Mass Destruction
In an interview with Fortune magazine in March 2003, Warren Buffet defined derivatives as "a weapon of mass destruction." But now that the mass destruction has happened, René Stulz, from Ohio State University, maintains that derivatives were not the weapon that created the destruction. This was discussed this morning during the presentation Hot Issues: The use of derivative products in business and in leverage and buyout operations, organized by Progetto Fintema at Bocconi and coordinated by Cesare Conti, Associate Professor of Corporate Finance.
The restrictive regulations that have been cranked out in the past year and a half, said Stulz, have convinced many companies to stop hedging risks with derivative products. This is a serious error, as derivates continue to be the cheapest tool available to businesses to protect themselves from possible financial setbacks.
"The point is that there is no symmetry between unexpected earnings and unexpected losses," continued Stulz. "Take the example of air transportation, which is exposed to a fluctuation in oil prices while ticket prices stay the same for relatively long periods of time. The large losses that could incur in periods of high fuel costs are not balanced by the earnings when fuel costs decrease, because losses force the company to reduce or defer investments and to cut personnel, undermining future growth and causing concern both in the workforce and in clients."
Stulz suggests a different reading of the company balance sheets that report losses from derivatives. Using the private company Southwest Airlines as an example, which recorded a loss in the third trimester of 2008 of 120 million dollars, the first in 17 years. This loss is attributable to the accounting of losses for 247 million on derivatives, devalued due to a reduction in fuel cost. "So, an accounting loss shouldn't be confused with an economic loss," asserted Stulz. "In the first place, the same derivatives that create losses today created earnings in the past, in order to counterbalance rising fuel prices. In the second place, when looking at losses in derivative value, earnings from the decrease in the price of fuel should also be considered."
The alternative to derivatives, says Stulz, are increasingly more expensive. Operative alternatives can be hypothesized, such as the acquisition of an oil company by an airline, but they are complex solutions and may generate inefficiencies. A similar response is diversification, which achieves the same objective of risk reduction. Lastly, the allowance of large quantities of liquidity forces the company to forsake multiple investments.
"Ultimately," said Stulz, "companies that use derivatives have a better chance of investing in better projects and therefore encourage growth."
As for the role of derivatives in the past weeks" financial crisis, Stulz admitted that they have made the situation more complex. The situation has brought excessive financial incentives to the defendant's seat, which excessively magnified each fluctuation. In addition, derivatives were used ineffectively, not to cover risks but to bet on fluctuations. "The new regulations are important," he concluded, "but we need to be careful not to drain the market."
In response to a question from the audience, Stulz stated that derivatives could perhaps be most useful in Italy, a country with a large proliferation of family companies. In this case, in fact, there is a clear interest to minimize the volatility of family wealth, which could induce companies to forsake better investments. Derivatives, reducing the risks, would allow just this minimization.