ARE derivatives a threat to savings, pensions, and other monetary accounts?
``Yes,'' says finance professor Marshall Blume, but probably only in infrequent situations.
``Are we sufficiently safe from a systemic collapse of the global financial system'' that might be triggered by trading in derivatives? asks the Wharton School, University of Pennsylvania professor. His answer: ``Yes.''
Derivatives have once again come into the spotlight following the recent collapse of Barings PLC, a venerable British bank; Barings incurred losses estimated at $1.5 billion when a young trader bought high-risk derivatives linked to price fluctuations in the Japanese stock market. Unfortunately, Barings is not alone. Many companies, including Proctor & Gamble, the Japanese oil refiner Showa Shell, Germany's Industrial Group Metallgeselschaft, and Glaxo Drug in Britain have all suffered derivative losses.
Mutual funds have also been hit. Community Bankers United States Government Money Market Fund was forced into insolvency, and Piper Jaffray Institutional Government Income Portfolio, a bond fund, incurred losses of some $139 million.
Stung by losses and negative publicity, six of Wall Street's biggest securities firms announced yesterday that they will voluntarily put derivatives business under a tighter set of controls. The new standards, developed in cooperation with government regulators, cover four areas:
* Frequent and more detailed reporting of derivative deals to regulators.
* Better internal monitoring of derivative risks.
* Assessing whether a company's capital is sufficient for the risks taken.
* Greater attention to corporate customers' understanding of how derivatives work, updates on their worth, and clear, written evaluations of the risks.
The participating firms include CS First Boston Inc.; Goldman, Sachs & Co.; Salomon Brothers Inc.; Merrill Lynch & Co.; Lehman Brothers Holdings Inc.; and Morgan Stanley & Co.
Still, financial experts say risks from trading in derivatives are limited and localized. Moreover, some experts say the public is being unnecessarily frightened by television and press reports about derivatives, such as last Sunday's airing on ``60 Minutes.''
The ``60 Minutes'' show brought the concept of derivatives into millions of living rooms. One reviewer, writing in the Wall Street Journal, praised CBS for raising the issue. But not all experts were pleased. ``The report turned me off, so I turned the show off,'' says Walter Frank, chief economist of the Money Fund Report, published by IBC/Donoghue Inc., in Ashland, Mass. Mr. Frank says that, contrary to implications of the show, very few Americans are at financial risk from the use - or misuse - of derivatives, especially in money market funds.
Derivatives are complex financial instruments whose value is derived from an underlying asset, security, or index.
There is currently a lot of misinformation about derivatives, says Hans Stoll, director of the Financial Markets Research Center at Vanderbilt University in Nashville. What derivatives do is to allow companies ``to separate their funding operations from risk,'' since derivatives - at their best - enable money managers to offset, or hedge against, particular losses, such as losses from fluctuations in international currency transactions. Used in this sense, derivatives are ``risk aversion'' mechanisms, he says.
That is not to say that derivatives, if misused, are not dangerous, says Stoll. ``They can be.'' But some derivatives ``have been around for centuries,'' Stoll says.
``To some extent, the concern about derivatives has been exaggerated,'' says Henry T.C. Hu, a a derivatives expert at the University of Texas, Austin. ``Ordinary investors should not be as worried about derivatives as they should be about other financial matters,'' such as the increasing tendency of older Americans to invest in equity mutual funds. ``What if the stock market crashes?'' asks Professor Hu. ``Can they absorb the losses'' from their equity funds?
Hu says it would be wrong to be complacent. ``Derivatives definitely merit close review,'' he says. Much is unknown about how they work in global finance, he says. But Hu believes the issue must be kept in perspective and that additional regulation, if any, should be incremental. Recent losses remain small in relation to the sheer enormity of the $12 trillion global derivatives market, he says. The term ``derivative'' is being too loosely applied, Hu argues. The larger problem in the case of most recent derivatives' debacles has been a lack of in-house management controls, not just the trading practices themselves, Hu says.
How do you protect yourself? According to Mr. Frank of IBC/Donoghue Inc., carefully read your prospectus on a mutual fund to see if, and how, a fund deals in derivatives; diversify your investing portfolio to reduce the risk of serious losses; and most of all, be suspicious about funds that substantially overperform the market. Find out why.
Dr. Blume says mutual funds should provide more detail in a prospectus, such as whether the fund management uses derivatives merely for hedging purposes, to offset possible losses, or for speculative gain.
Major losses over the past year
Orange County, Calif. $1,700 million
Barings Bank 1,450 million
Eastman Kodak 220 million
Proctor & Gamble 157 million
Air Products & Chemicals 122 million
Chemical Bank 70 million
Piper Jaffray 70 million*
*A shareholder settlement on $139 million in mutual fund losses.