NEW YORK (MainStreet) — Since the Great Recession, hedging with derivatives – particularly, those known as mortgage-backed securities – was seen as a major contributor to the economic downfall, creating a sense of ill-will about these financial contracts. But before then, derivatives didn't have a good reputation, either. Way back in 2002, billionaire Warren Buffet called derivatives "financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal."
So perhaps to many, derivative trading should be banned. Yet with the right application, using derivatives to hedge against risk could increase a company's value — at least, that's according to research by Hayong Yun and Francisco Pérez-González, two researchers whose academic study on derivatives recently won the prestigious first prize in corporate finance from the Brattle Group. The Brattle Group Prizes annually identifies the best research from the Journal of Finance.
For Yun, studying derivatives was a logical step forward.
"Empirically proving hedging increases firm value is one of the long standing challenge for finance researchers," Yun told MainStreet. Believing derivatives must have some kind beneficial role, he set to find out what it was.
During the financial crisis, "various financial engineering products - broadly referred to as derivatives - led to distortion in incentives of market participants, and [were] partially responsible for market failures," Yun said. Derivatives allowed a company to unload or transfer risk to another party, which created an environment for high risk trading and "various moral hazards stemming" from "a lack of skin in the game."
Yun's research examined certain utility companies located in hazardous weather areas and non-hazardous weather areas before and after 1997, the year that weather derivatives were made available. Utility companies located in areas with unpredictable weather, such as those in the Midwest, were valued approximately 3% to 4% lower than those utility companies in areas with more stable weather.
According to Yun, companies located in unstable weather locations "could not undertake all profitable projects" before the derivatives market opened, since banks were less likely to loan to them. So there was an investment gap between the fair and risky weather utility companies, but it disappeared when the derivative market opened. In essence, the hazardous weather companies' values increased to be on par with the fair-weather locations after the weather derivatives were introduced.
For Yun, the good side of derivatives started to shine through, even if popular opinion remains skeptical at best.
"My understanding is that derivatives do play a positive role. So, in the public debate on regulating derivatives, one should weigh the upside and downside of derivatives in a balanced way," writes Yun.
Part of the problem may be a public misunderstanding of derivatives — the feeling that they are some strange force used by only the most evil, cat-stroking, cigar-sucking Wall Street fat cats.
But in reality, "there's nothing magic about derivatives," says Sergio Lence, a professor and Marlin Cole Chair of International Agricultural Economics at Iowa State University. In fact, they have been part of our financial system for a very long time.
Derivatives were used well before the stock exchange opened, over 150 years ago. Way back in 1848, traders operating under the just-opened Chicago Board of Trade didn't know how expensive grain was going to be the following year. This was a problem for traders. In order to hedge against this unknown price fluctuation, the farmers could sign off on an agreement which set a pre-determined price the traders would buy the grain for, during the following season. In effect, the first futures derivatives, then known as "to-arrive" contracts, were established "almost immediately" after the CBOT opened, according to the U.S. Commodities Futures Trading Commission.
Fast-forward to 2014 and derivative trading has mutated into a much more complex beast far different from its more humble beginnings. And with much complexity can come more corruptibility.
"The higher the complexity of the situation, the more someone might try to take advantage," said Lence.
On their own, derivatives aren't good or bad. But when the market crashed, they became synonymous with risk taking, not risk hedging, and were stigmatized by an association with greed and recklessness. So why not just hedge against it and ban derivatives altogether?
"It would be a bad thing to do," said Don Chance, a CFA and professor of finance at the E. J. Ourso College of Business at Louisiana State University. Chance, who has authored three books on derivatives, believes the new financial regulations went far enough.
"It went pretty far and is extremely complex. The regulatory agency has the right to write all sorts of rules under the Dodd-Frank Act," said Chance.
Both Chance and Lence expressed skepticism of a summary of Yun's findings, but neither was dismissive of it. Lence said he found it hard to believe the study was able to quantify an increase in firm value, but noted, "just because it isn't easy to measure doesn't mean it doesn't exist, or it doesn't have some value."
For Yun, the study marks the beginning of a more balanced look at derivatives.
"This is a small step forward towards scientifically addressing the positive impact of derivatives on firms," Yun said. "There should be many more studies that also consider the causal negative impact of derivatives -- speculation, skewing incentives."
Of course, for a general opinion toward derivatives to change, that will take a lot of research.
--Written by Craig Donofrio for MainStreet