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The devil is in derivative!

Sep 21, 2006

Yesterday, the financial world was jolted by news of a big hedge fund, which lost more than US$ 3.5 bn in a gas futures contract. While the news did not get as much media attention as the 1998 debacle of the LTCM hedge fund where it had Nobel Prize winners on its rolls, it nonetheless highlights the danger of dealing with financial instruments such as futures or more generally derivatives. Mind you, these were not the only cases of misuse of such instruments and the subsequent nasty outcomes. Prominent debacles include the 1994 bankruptcy of Orange County, one of California's richest, due to investments in some ultra-sophisticated derivatives and the 1995 failure of the 200-year old Barings Bank as a result of unauthorized futures and options trading by a rogue employee. Besides, the fear of a lot more financial institutions losing their shirts owing to such leveraged positions continues to loom large.

Infact, this is what Warren Buffett, widely acknowledged as one of the shrewdest investors ever, had said about derivatives in Berkshire Hathaway's 2002 annual report.

"The derivatives genie is now well out of the bottle, and these instruments will almost certainly multiply in variety and number until some event makes their toxicity clear. [They] are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal."

And Buffett is not alone in deriding derivatives; a lot of other value investors share his views. One would now ask 'What is it that make these instruments so risky?' The answer lies in the fact that derivatives are financial instruments that have no intrinsic value but derive their value from something else. They are mainly utilised for hedging the risk of owning things that are subject to unexpected price fluctuations e.g. foreign currencies, food grains, commodities and even equities.

Let us take an example to clarify things further. Consider the case of Mr. Chandar. He is a farmer and is certain that he can harvest 20 tons of rice. Currently, rice is trading at Rs 5 per kg. At current price levels, he will earn Rs 100,000 that will cover his yearly expenses. But he knows that if there were a bumper crop of rice all over the state, he would be forced to sell his rice at as little as Rs 2 per kg. In that case, he would fall short to meet the expenses.

So Chandar goes to the local rice merchant, Thakur, and enters into an agreement that three months hence, he will sell his twenty tons of rice to him at the rate of Rs 5 per kg. Now, our Thakur is not a simpleton and knows that three months hence, all the farmers would be selling their produce, and the rates that would be then would be about 15% to 20% lower than what it is now. So, Thakur offers to buy the rice at the price of Rs 4.2 per kg.

At this, Chandar argues that it is equally likely that in event of a poor crop, the price of rice may be higher than what it is now. Thakur and Chandar finally agree to a price of Rs 5 per kg of rice for 20,000 kgs to be delivered at Thakur's shop after three months.

This is what we know as the most primitive kind of a derivative contract. Such contracts are called "Forwards" (or a Forward Contract) and is one of the simplest type of a derivative contract. In order to cater to a large number of Chandars and Thakurs and to make sure that both the parties honour their commitments, boards or exchanges have been set up across the world which oversee derivative contracts in virtually every commodity and financial security.

So far so good! So long as the purpose of such contracts is to hedge against a possible fall or rise in prices, derivatives can prove to be an extremely useful tool. However, if speculators board the bus to benefit from the discrepancy in prices, then we might have huge problems in our hands. Speculators have no other interest apart from making bucks by benefiting from the gyration in prices. They just hope that the seller is wrong temporarily so that they can sell the contract at a higher price to some other guy and profit from the same. It is when these bets go wrong, hedge funds like Amaranth or LTCM, which use ultra-leveraged money to invest in such kind of contracts, vanish without a trace thus eroding considerable amount of wealth in the process.

These short-term contracts go against the very grain of value investing, which is based on principles that 'existence of value in the absence of assets' and 'predicting short-term price movements' can both prove to be a risky proposition. No wonder, it does not find a place in the investing world of value investors. As long as the purpose is to hedge against price fluctuation of some underlying asset, then the use is justified but if it is used as a source to earn quick money, then we might be in for some nasty surprises.

In these turbulent times in the Indian market, a lot of investors might be tempted to use such instruments in view of the fear that since it has run up quite a bit in the recent past, a correction is long overdue. Hence, any further purchase of equity should be hedged against a possible fall in order to minimise the damage. There is little wrong in this approach except for the fact that if it is being used for quick money making then be prepared to watch your hard earned money go down the drain. Infact, given its inherent risks, try and avoid it altogether. Happy investing!

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