Derivatives Are Complex, Often Risky

Derivatives are investment contracts whose values are based on, or “derived” from, the performance of an underlying security, interest rate or market index. A derivative based on interest rates, for instance, might change in value in tandem with the difference between bond yields in New York and Germany. Or a derivative’s value could be based on a comparison of changes in oil prices and interest rates.

With Thursday’s disclosure of dramatic, derivatives-linked losses in Orange County’s investment portfolio, here are some questions and answers about these complex financial deals:

Isn’t this more like Las Vegas than Wall Street?

Not necessarily. If the investor is an airline that would go bankrupt if both its borrowing costs and fuel costs spiraled out of control, a derivative whose value went up as those costs rose would protect it from losses. If, on the other hand, the investor is simply making a bet on the direction of those markets, that would amount to speculation, and the potential for losses could be great.

Why have derivatives become so controversial?

By their nature, derivatives are complex. And given advances in the computer technology needed to calculate their values, they are becoming even more so. Several major corporations and some municipalities discovered this year that derivatives contracts they thought they understood actually were far beyond their comprehension.

That became an issue when interest rates soared earlier this year.

The “break” in the interest rate markets led to unexpected behavior among especially complex derivatives deals. When interest rates rise, the value of bonds and other debt securities falls. If this happens with unprecedented speed, derivatives based on those securities become exceptionally risky. Such staid corporations as Procter & Gamble and Gibson Greeting Cards lost millions of dollars; both have sued Bankers Trust Co., which created and sold the derivatives, charging that the bank misled them about the risks of the contracts.

One particularly risky aspect of derivatives is that no standard or regulated market exists for them.

Are there other dangers?

Derivatives are also tricky because they involve “leverage”--that is, borrowing money to invest. Leverage tends to improve the return of a profitable investment; you put up only a portion of the investment, yet reap all the gain. But it also exacerbates the scale of a potential loss because the investor must shoulder the entire loss and pay off the lender. Many derivatives transactions are leveraged by nature because they employ futures and options contracts, which require investors to put up only a portion of the money at risk. When the markets turn ornery, the investor can lose more than his or her initial stake.

What was Orange County investing in?

Orange County’s derivative investments appear to have included structured notes. These are investments designed to pay a given return if interest rates remain within a certain range; if they go higher or lower than the specified range, the notes pay no interest, and thus their market value deteriorates sharply. Because interest rates have continually surprised the market this year, they might well have rendered structured notes worthless.

Do derivatives have any place in a county, municipal or other public portfolio?

Sometimes they do. Any big investor faces difficulties moving large sums of money around quickly; derivatives can help by simulating the performance of a direct investment until the investor can actually put up his capital. In other cases, public investment funds might want to invest in a new market but also might want to or insure against, certain risks in that market.

Indeed, counties, municipalities, and other public bodies are major users of derivatives. Los Angeles County used a derivative when it sold bonds in September. To meet a requirement that the interest rate on the bonds remain below 8%, the county entered into a transaction called a swap, which caps the county’s potential interest outlay at that level. In all, $7 billion in municipal bonds sold this year encompassed some form of the most common derivatives.