Ross et al.: Fundamentals
of Corporate Finance, Sixth
Edition, Alternate EditionVIII. Topics in Corporate
Finance- Risk Management: An
Introduction to Financial
Engineering
(^808) © The McGraw−Hill
Companies, 2002
In Their Own Words...
Charles W. Smithson on Who Uses What
For the secondconsecutive year, the Wharton
School has surveyed the use of derivatives by
nonfinancial U.S. corporations. In October 1995,
questionnaires were sent to 1,999 randomly selected
corporations and an additional 159 Fortune 500 firms.
Responses were received from 350 firms (a response
rate of 16 percent).
The percentage of respondents reporting derivatives
use increased to 41 percent, from 35 percent in 1994.
Of firms that responded to both surveys, the proportion
using derivatives rose only slightly, from 37 percent to
38 percent in 1995. Derivatives use continued to be
related to firm size. Only 13 percent of the 1995
respondents with a market value of less than $50 million
said they used derivatives, compared with 48 percent of
firms valued at $50–250 million and 59 percent of
companies worth more than $250 million. The figure for
the largest firms was slightly lower than in 1994 but
medium-size firms have become far more likely to use
derivatives. In 1994, only 30 percent of respondents in
the $50–250 million bracket said they used them.
Firms that do not use derivatives were asked to rank
their most important reasons for this from a list of seven.
The most frequently cited was “lack of significant
exposure” (65 percent put this as either their first,
second, or third most important reason). The next most
frequently cited reasons were “expected costs exceeded
the benefits” and “concerns about the perceptions of
derivatives among investors, regulators, or the public.”
Of derivatives users, the vast majority employed the
instruments to manage their foreign exchange and
interest rate exposures (76 percent and 73 percent,
respectively). Many also used derivatives to manage
commodity exposures (37 percent) but only a small
percentage for equity exposures (12 percent). Forward
contracts were the dominant tool for foreign exchange
risk management, swaps for interest rate risk
management, futures for commodity price risk
management, and OTC options for equity exposures.
Derivatives users were asked to rank their risk
management objectives. Most put managing volatility as
“most important”—in cash flows by 49 percent or in
earnings (42 percent). Hedging to manage market value
directly was ranked “most important” by only 8 percent
and balance sheet hedging (also referred to as
translation hedging) by only 1 percent.
Firms were most likely to use foreign exchange
derivatives to hedge firm commitments and transactions
that were anticipated to occur within a year.
Anticipated transactions beyond one year were
“frequently” hedged by only 11 percent of derivatives
users although “sometimes” hedged by 43 percent. This
suggests that many firms have a long horizon for their
foreign currency risk management. Reported hedging
of economic exposure decreased in 1995, with only
8 percent of derivatives users indicating they
“frequently” hedged for that reason, down from
16 percent in 1994. Hedging the balance sheet
(translation exposure) “frequently” was also down in
1995, falling from 22 percent in 1994 to 14 percent
in 1995. The main reason firms used interest rate
derivatives was to alter the interest rate sensitivity of
existing debt.
To assess the influence of a firm’s market view on its
derivatives activity, the 1995 survey asked derivatives
users to indicate how often their market view led them
to take an active position or to alter the timing or size
of hedges. With respect to foreign exchange risk
management, only 6 percent indicated that they actively
took positions on a frequent basis. For firms that
“frequently” altered the size or timing of hedges based
on a market view, the figures were only 12 percent and
11 percent, respectively. But, higher proportions
“sometimes” altered their hedging policy, 33 percent,
48 percent, and 61 percent, respectively. The frequency
with which firms altered their interest rate risk
management strategy based on a market view was
essentially identical.
The “train wrecks” in 1994 and 1995 brought
derivatives a great deal of publicity—much of it
negative. To gauge the impact of this on end-users, the
survey asked respondents to indicate their degree of
concern about various issues mentioned frequently in
the press. The greatest source of concern was credit
risk, specified by 33 percent. Users also expressed
concern about evaluating the risks of derivatives
transactions and uncertainty over accounting treatment.
Given the concern about evaluating the risks of
derivatives transactions, it is not surprising that end-
users have enhanced their capacity to do this. The
survey found that tools for evaluating derivatives risk,
such as scenario analysis, were in widespread use.Charles W. Smithson is the former managing director for research in the global risk management sector of Chase Manhattan Bank. He has been actively involved in the develop-
ing discipline of financial risk management. In addition to his articles in academic and professional journals, he is author of Managing Financial Riskand coeditor of The Hand-
book of Financial Engineering(with C. W. Smith). He is also coauthor of Managerial Economics(with S.C. Maurice and C. R. Thomas) and an economic perspective on commodity
“crises,”The Doomsday Myth(with S.C. Maurice). He is currently the managing partner of Rutter Associates.
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