René Stulz on Derivatives

10 April 2009 at 1:17 pm Peter G. Klein Leave a comment

| Peter Klein |

In case you missed it, Tuesday’s WSJ ran an op-ed by René Stulz, one of the world’s elite researchers in empirical corporate finance, “In Defense of Derivatives and How to Regulate Them.” Highlights:

That derivatives benefit our financial system and our national economy is well established. Twenty-nine of the 30 companies that make up the Dow Jones Industrial Average use derivatives. According to data from Greenwich Associates, two-thirds of large companies (those that have sales of more than $2 billion) use over-the-counter derivatives and more than half of all mid-size companies (those that have sales between $500 million and $2 billion) are very active in derivatives markets. Derivatives are necessary and helpful tools for companies seeking to manage financial risk.

The most important benefit of derivatives is that they allow businesses to hedge risks that otherwise could not be hedged. This does a number of positive things. It transfers risk, allowing firms to guard against being forced into financial distress. It also frees lenders to offer credit on better terms, giving companies access to funds that they can use to keep their doors open, lights on and, even, invest in new technologies, build new plants, or hire new employees.

It’s important for regulators not to overreact by pushing for counterproductive new rules. The regulators, after all, were no better at foreseeing the current crisis than the private sector, proving that regulation has obvious limits and cannot replace efforts by financial institutions to devise risk-management approaches that enable them to cope with crises in the financial markets of the 21st century.

Derivatives are not just for Fortune 500 companies either:

For those unfamiliar with market jargon, credit default swaps, which are most often in the news, are simply financial contracts between two parties. If, for example, you own bonds in a company and are worried that the company will default, you can manage your risk and protect your holdings with a credit default swap. Under it, you would make regular payments to maintain the contract. If the company does not default, you’re out-of-pocket the payments. But if the company does default, the swap serves as a form of insurance by giving you the right to exchange the questionable bonds for the principal amount, or to be reimbursed in other ways. There’s nothing exotic or complex about these contracts. They can be highly valuable for Main Street firms, because they enable them to protect themselves against the failure of large customers.

However, Main Street firms cannot afford derivatives unless there is a competitive market for them with participants willing to take the opposite position. Restricting access to derivative markets, which is being proposed by some in Congress as well as by some regulators, would make the costs of derivatives prohibitively expensive and eliminate liquidity.