A study of uses and misuses of derivatives

Abstract

Overview- Derivatives activity continues to increase globally although they have provided a few of the largest financial disasters. The debate on their use and misuse has never been stopped and is still to some extent unresolved (Fernandez-Laviada, Martinez-Garcia and Montoya Del Corte, 2008). Therefore, identifying the real fundamental reasons for these problems when using derivatives is essential to help prevent new financial scandals. Purpose - The study seeks to determine whether the derivative instrument is the reason for the various problems faced by firms when using them. It seeks to identify and characterise the important determinants of safe derivative use and attempts to determine which of these determinants emerge as significant predictors of the difficulty often encountered by firms when using derivatives. Hypothesis - "There are a manifold of reasons concerning 'users' and 'controllers', rather than the derivative instruments themselves, that lead to unprofitable decisions." Research questions 1. What are the governing factors that influence the safe use of derivatives? 2. Is the problem the derivative instrument itself? Should derivative use be considered madness? Are they so bad and dangerous? Design/methodology/approach - A mixed approach of qualitative and quantitative analysis, following a conceptual framework was used in this study to understand the role played by derivatives in the problems faced by firms and to answer the research questions posed. Financial firms (Barings Bank Plc, Allied Irish Bank and Societe Generale), the financial Crisis of this decade; and non-financial films (Metallgesellschaft and Enron) cases of debacles blamed on derivatives are studied in debt and the factors influencing the safe use of derivatives are extracted. The selection of cases was determined following a review of literature and cases and the researcher' experience. The choice was made mainly based on the amount of publicity these firms attracted about their misuse of derivatives, therefore purposive sampling. A web-based questionnaire was completed by 420 international users/ and controllers of derivatives, selected via purposive and snowball sampling techniques. This questionnaire was purposely designed for the study and included both closed-ended and open-ended questions. The measures obtained from the closed-ended questions were analysed quantitatively, while the answers to the open-ended questions (which were not obligatory and were answered by 52 of the participants) were analysed qualitatively. Moreover, interviews were carried out with 46 international users and controller, also selected via purposive and convenience sampling techniques. These were asked six open ended questions purposely designed for the study. A featured participant among the interviewed was Mr. Nick Leeson. The data collected was analysed qualitatively. Findings - The empirical study identifies six factors that account for 68.2% of the variability in the derivative safe use and in five factors, the scores varied as of function of demographic variables. Additionally, two of these factors emerged as the significant predictors in classifying whether or not a company often encounters difficulty when using derivatives, with an overall holdout accuracy of 74.7%. When this is compared to the the other qualitative findings, the factors identified are 26, with Internal Controls, Standards, Knowledge, Understanding, Awareness, Complexity, Greed, Hubris, desire for Power and Perception of the usefulness of derivatives being those factors influencing the safe use of derivatives which were highlighted by all sources. Originality/Value -This study provides empirical and qualitative evidence that the incorporation of control factors as well as demographic factors make a significant contribution to the understanding of safe derivative use. Derivatives are useful financial instruments but if the implication of such factors is not looked into, then the true value and qualities of the derivative instrument are obscured. Keywords - financial derivatives, safe derivative use, derivative misuse, management control and process, users, controllers, risk management, internal control.