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A BREATHTAKING ARRAY OF NEW FINANCIAL INSTRUMENTS IS FAST CHANGING THE STAID OLD WORLD OF FINANCE. SO-CALLED DERIVATIVES ARE MAKING TIME-HONORED CORPORATE FINANCIAL PRACTICES OBSOLETE, OFTEN VIRTUALLY OVERNIGHT. IT IS FAR FROM COINCIDENCE THAT THE TRADITIONALLY RESERVED FINANCE FUNCTION WITHIN ORGANIZATIONS IS INCREASINGLY BEING SPRUCED UP WITH MONIKERS LIKE RISK: MANAGEMENT AND FINANCIAL ENGINEERING. As FOR THE FUTURE DERIVATIVES-DRIVEN PACE OF CHANGE IN FINANCE, THE FAMOUS LINE BY AL JOLSON IN THE MOVIE, THE JAZZ SINGER, IS SURELY OPERATIVE: "You AIN'T HEARD NOTHIN' YET, FOLKS."
For managers, derivatives are at once everything from the devil incarnate through to the promised land. The upside potential in derivatives to increase profits, competitiveness and flexibility while reducing risk is immense. The downside is the possibility that some combination of badluck and bad management will produce enterprise-threatening financial losses that quite literally come right out of the blue. Derivatives can create the kind of financial nightmare that makes managers immediately drop everything. Financial crisis has a history of promptly relegating to the back burner key longer-term management responsibilities such as new product development, product quality, customer satisfaction, and staff training, motivation and morale.
Many derivatives involve mindbending quantitative relationships that are well beyond the training, capability and interest of most of those ultimately responsible or the performance of businesses. It is with good reason that specialists in derivatives have come to be called the rocket scientists of finance.
Alas, the complexity of derivatives does not absolve managers of the obligation to assure their safe, profitable and efficient use. The challenge is to capture the benefits of derivatives but in the process make sure that the company has not been unduly compromised. One of the tasks of the manager is to distinguish between those issues that really matter and those that only look as if they matter. For many enterprises, derivatives are firmly in the former category; manager should prioritize them accordingly.
DERIVATIVE POSSIBILITIES UNLIMITED
At the conceptual level, the derivative is straightforward. It is a financial instrument that derives its value from the value of an other financial instrument. Bonds, stocks, currencies and commodities are examples of underlying instruments.
The list of derivatives grows unabated, with the only limit being the seemingly boundless ingenuity of the financial engineers...