432 Planning and Forecasting
original partners who were required to run the fund until it was ultimately liq-
uidated in 1999. The bottom line is that LTCM had lost $4.5 billion since the
start of 1998. These losses included the personal fortunes amassed so quickly
by the founding partners, which totaled $1.9 billion at one point but were com-
pletely wiped out by the end.
Moral of the Story
The lesson from these case studies should now be obvious. Risk management is
not the art of picking good bets. Bets no matter how good are speculation.
Speculation increases risk, and subjects corporations, investors, and even mu-
nicipalities to potential losses. Derivatives are powerful tools to shed risk, but
they can also be used to take on risk. The root causes of the debacles described
in these cases are greed, speculation, and in some cases incompetence, not de-
rivatives. But just as derivatives facilitate risk management, they facilitate
greed and speculation. Anything that can be done with derivatives, can be
done slower the old fashioned way with positions in traditional financial instru-
ments. Speculators have always managed to lose large sums. With the aid of de-
rivatives they now can lose larger sums faster.
Superior intellect and sophistication cannot protect the speculator. As the
Long-Term Capital Management story illustrates, when you are smarter than
the market, you can go broke waiting for the market to wise up.
Government regulation is not the answer either. The benefits of regula-
tion must be weighed against the costs. Derivatives, properly used, are too im-
portant in the modern financial marketplace to be severely restricted. Abuse
by a few does not warrant constraints on all users. A better solution to prevent
repetition of the past debacles is full information disclosure by firms, portfolio
managers, and municipalities. Investors and citizens should demand to know
how derivatives are being used when their money is at stake. Better informa-
tion and oversight is the most promising approach to prevent misuse of deriva-
tives while retaining the benefits.
Derivatives can be dangerous, but they can also be tremendously useful.
Dynamite is an appropriate analogy. Misused, it is destructive; handled with
care, it is a powerful and constructive tool.
Derivatives are tools that facilitate the transfer of risk. Interest rate de-
rivatives enable managers to shed business exposure to interest rate f luctua-
tions, for example. But when one party sheds risk, another party necessarily
must take on that very exposure. And therein lies the danger of derivatives.
The same instrument that serves as a hedge to one firm, might be a destabiliz-
ing speculative instrument to another. Without a proper understanding of de-
rivatives, a manager who intends to reduce risk, might inadvertently increase
it. This chapter aims to provide the reader with a basic understanding of deriv-
atives so that they can be used appropriately to manage financial risks. This un-
derstanding should help the reader avoid the common pitfalls that have proved
disastrous to less informed managers.