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Risk management is taking a new dimension these days with individuals using derivatives of some kind to hedge their risk. Earlier, companies did not disclose their exposure to derivative contracts and were in a soup when the tide turned against themthe worst example being that of Long-Term Capital Management. However, FASB introduced a new norm FAS-133 in 1998 with effective implementation from June 2000 to protect investors from unseen derivative exposures that companies do not disclose in their statements. What is FAS-133? What are the guidelines? How does it help the investor? Read on the answers.
Managing risk has become inevitable in the corporate world. With the blowing winds of globalization, the ability to compete judges a "firm's survival". Though elimination of risk is the most preferred strategy, it is yet not feasible. Neither is risk aversion a profitable recourse, for that would be a losers' game in "the survival of the fittest". So the obvious choice is to live with risk but learn to minimize the unfavorable. Most firms use derivative instruments such as forwards, futures, options and swaps to mitigate risk rather than avoid it. A primary motive of using derivatives is to reduce risk that arises due to changes in the market price of underlying commodities/assets or interest rates or due to currency exchange fluctuations. Yet, derivative instruments are not risk free. If used for speculation, they prove to be extremely risky. If leveraged, minor adversities in price or interest rate changes may result in huge losses.
While the usage of derivatives has grown by leaps and bounds, regulators have remained silent spectators till recently. Though the derivatives were to be used for managing risk with good corporate governance, most of the firms were tempted, and started using them for profit generating motives. The absence of proper accounting standards also led to lack of appropriate recognition, measurement and disclosure. Moreover, low transaction costs, free availability of information and minimal impact costs led to exponential usage of derivatives. The result was disasterEnron and Long Term Capital Management (LTCM), the Greenwich, Connecticut hedge fund that lost $4.6 bn on more than $1 tn of derivatives. Table-1, discloses the losses suffered by companies during the last decade.
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