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© Copyright 2000 Rogers Media. The following article first appeared in the February 2001 edition of
BENEFITS CANADA magazine.
Demystifying derivatives
Derivatives are a valuable money management tool. A successful program is fairly priced and clearly
understood.
By Barbara Clapham
Derivatives can play a useful role in fund management as part of hedging strategies, managing credit risk,
reducing costs and increasing the foreign content of a fund beyond the limitations of the foreign content rule.
Basic steps can be taken to ensure a derivatives program is properly implemented and clearly understood.
Claude Lamoureux, president and chief executive officer of Ontario Teachers' Pension Plan Board in Toronto
has 10 rules for a successful derivatives program:
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It must be in writing.
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It must be explainable in one page.
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Each board member must understand the program.
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The fund manager in charge of the program needs to have a very competent accounting group.
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Accounting must be clear.
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Reporting must be simple and fast.
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A good support system should be in place.
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The culture must encourage quick acknowledgement of error or loss.
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The external auditor must be treated as a partner.
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And finally, to paraphrase Warren Buffet, the program must be structured in such a way that a lesser
mortal can run it . . . because one day one will run it.
COMMUNICATION IS KEY
Lamoureux believes that honest and timely communication between all parties involved in the derivatives
program is vital. Anything that is not clear should be questioned immediately.
Key questions that should be asked when considering a derivatives strategy include:
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What is the worst that can happen?
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How quickly will it be reported?
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Are we speculating or hedging?
If these questions cannot be answered simply and to everyone's satisfaction, the caution flag should be
raised.
For example, in the case of the Barings derivatives scandal, someone certainly should have questioned why
trader Nick Leeson wanted to transfer more than the capital of the firm to Singapore. An article in The
Economist published after the bankruptcy of Barings, illustrates how profits took off dramatically when
Nick Leeson started his magic. "Very few people wanted to question him too much," Lamoreaux says, "and no
one wanted to stop this gravy train. In the end it was just that, and Barings went bankrupt."
ONE-PAGE EXPLANATION
Alan White, professor of finance at the Rotman School of Management at the University of Toronto agrees
with the rule that a derivatives transaction should be able to be explained on one page of text (or in one
diagram).
Another cornerstone is pricing. This may not be a great concern for derivatives priced with two-way markets
in which you can buy or sell, since the spread will indicate how much the bank is taking out of the deal
(from this they pay their trading costs and generate their profits). For derivatives without two-way
prices, though, caution should be exercised.
"You should not invest in derivatives for which you are not able to determine the fair market value," White
says. "For many of these transactions, the whole objective of them is to make them look attractive to you,
when in fact they are very unattractive. And some banks are pretty good at this game."
Fund managers who wish to trade derivatives should either have the ability to independently calculate their
value, or not be in the game.
Barbara Clapham is editor of Canadian Investment Review and a contributing editor to BENEFITS CANADA.
CONFERENCES
High-Tech Financing North
Feb. 12 to 14, 2001
Toronto Hilton Hotel
Update your knowledge of the venture capital scene with seminars on financing strategies, the rise of
corporate venture capital and the role of angel investors. To register, call (800) 363-0722. In Toronto,
call (416) 665-6868.
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