Advocates of corporate commodities hedging have long hyped Barrick Gold as a classic example of how hedging can help boost profits. Although many gold producers don't hedge their production, Barrick does-and profits from it. One oft-cited study by Peter Tufano, a professor at the Harvard Business School, showed that returns on Barrick shares were several times higher than those of a basket of eight major gold producers for the years 1987 to 1992. Since 1989 Barrick has received $54 per ounce more on its gold production than the average spot price. (See Derivatives Strategy, December/January, 1996.)

Late in January, however, Barrick announced it was readjusting its hedging policy: it would hedge forward sales only two years in advance, instead of the three-year policy it now has in place. Several market sources believe that Barrick is responding to pressures from shareholders who think that the five-year high hit by spot gold is a harbinger of things to come, and want Barrick to ride the coming surge.

There are several factors that clearly influenced this decision. The gap between gold spot and higher forward rates (contango, in commodities parlance) has narrowed considerably in recent months. The cost of borrowing gold has also increased because central banks have been supplying less gold to the market. Actual gold lending rates have jumped from one percent in 1995 to 2.5 percent. Late in 1995, for the first time in history, the forward rate was actually lower than the spot market (backwardation).

The impact of these trends on a company like Barrick can be serious. One of its key strategies is to borrow gold, then sell the gold for dollars and use the proceeds for capital construction. Historically this approach tends to be cheaper that direct financing in capital markets. But as the spread between the spot and forward rate narrows, the gold producer ends up locking in less of a premium, and therefore faces a greater chance that the normal volatility of the price will lift spot prices above the forward rate. What's more, as the volatility of the spot price has increased, option prices for gold options have risen, making the terms of the zero-cost collars it purchases in the OTC market less attractive.

The strangest aspect of the story is why Barrick went to such great pains to trumpet the announcement in the financial press. It made some observers wonder if this was not a forewarning that it would soon scrap all hedging. "The curious thing is why they bothered to make an announce a change in their cost of funds methodology," says Douglas Newby of Moyes Newby, a corporate finance boutique that specializes in the mining industry. "It would normally be an internal matter. They are clearly signaling to the market that the perception of Barrick as a classic hedger is wrong."

C*ATS Devours LOR/Geske Bock

The software rumor mill began to churn soon after SunGard bought Renaissance late last year. Word had it that C*ATS Software, one of Sungard's major competitors, was searching for an acquisition to augment its own product line and to help it take on the new double threat.

On January 30, 1996, the widespread predictions finally came true: C*ATS announced its acquisition of Los Angeles-based LOR/Geske Bock, a leading risk management software vendor for banks and dealers. Under the terms of the agreement, the publicly held C*ATS (NASDAQ: CATX) will pay approximately $3.3 million in shares of its common stock in exchange for 100 percent of the outstanding shares of LOR/Geske Bock. Dr. Robert Geske and Dr. Jerome Bock, the two founders of LOR/Geske Bock, will join C*ATS's board of directors and take on management roles within the newly merged corporation.

The two recent mergers point to a new era of consolidation in the financial software industry and narrow the field of risk management software firms to choose from. Says one New York-based software executive, "As consolidation occurs, the differences between 'big' and 'small' software companies will become more pronounced. The time when anybody with a textbook, some rudimentary C-code and a modem could start a financial software company from their garage is long gone. Software firms that have yet to take off are not long for this world. I expect a major die-off over the next two years."

Derivatives exist in separate realities: one bright and upbeat, the other overcast. That is the upshot of the latest and one of the most comprehensive surveys of the use of derivatives by non-financial corporations, conducted by the Wharton School of Business in conjunction with CIBC/Wood Gundy. The sunny news is that in terms of actual converts, derivatives are gaining. More corporations said they use derivatives at year-end 1995 than a year earlier-41 percent versus 35 percent. But the holdouts are not a happy bunch: so that the future rate of conversion may be slow.

Non-users, Wharton found, have a wide range of justifications. In all, 39 percent of them said they were concerned over negative public perceptions by shareholders and analysts. An almost equal number, 37 percent, were paralyzed by the complexity issue-declaring they simply lacked adequate knowledge to be comfortable using derivatives. But the most prevalent negative perception, shared by some 47 percent of the sample, was that the cost of derivatives outweighs the benefits. (The total exceeds 100 percent due to double-counting.) The remainder of non-users believed their exposures weren't large enough to need risk management.

But let's look on the bright side. First off, manufacturing companies are roughly twice as active in their use of derivatives as service firms-despite their 50-50 distribution in the overall economy. Over 90 percent less of derivatives users are bent on reducing volatilities of cash flow or earnings. Only a tiny minority-8 percent-consider derivatives a tool in managing market value, and a niggardly 1 percent of the sample place a high value on balance sheet, or transaction, hedging.

Nor were the users of derivatives entirely sanguine. They were asked by the Wharton folk to weigh their concern on a number of sensitive issues. The three winners (clocking the highest anxiety) were (1) headaches about credit risk; (2) risk of evaluating derivative-type transactions; and (3) qualifying for hedge accounting. On the latter issue, the researchers probed further and found that nearly a third of the sample are affected by accounting rules. As a result, half say they hedge less than they would otherwise, and about two thirds forego transactions of a type they'd otherwise have done.

So is the glass half full or half empty? Full if you consider that derivatives use made considerable progress in a year of continuing scandals, exposés and litigation. Empty if one measures the majority of corporates still sitting on their hands.

The great $10.8 trillion world swap business has a corner Charles Dickens might have written about: the back offices of dealer firms where hundreds of low-paid clerks toil by matching incoming fax confirms with tickets and/or outbound fax paperwork to counterparties. True enough, many brokers have tried to drag this sector into the modern electronic environment, but their efforts have been hobbled by a lack of standards and protocols.

That's all in the past, thanks to a new agreement between the International Swaps and Derivatives Association (ISDA) and SWIFT, which will henceforth be the conduit for confirms. The codes are MT360 for a single currency interest rate swap, MT361 for a cross-currency swap, and MT362 for a reset confirmation. Says Peter Guldentop, SWIFT's senior manager for standards, "We are pleased to work with ISDA to develop a solution that will enable dealers to reduce operational risk, with the added benefit of increasing automation and reducing processing costs."

Dealers that wanted to set up triple-A rated derivatives product companies have had to choose between two different types of structures that kick in if they go bankrupt. In termination structures sported by Morgan Stanley, Merrill Lynch and others, the original contracts are cash-settled before maturity. In continuation structures in use by Lehman and others, a contingent manager is responsible for the original instrument until maturity.

In January Bear Stearns announced it was setting up two new subsidiaries that give clients a choice, a continuation structure, or a termination one.

A month later, another new wrinkle in triple-A rated subs came to light. Dai-Ichi Kangyo Bank forged a bond with Merrill Lynch, to use the latter's derivatives product company, on a fee per transaction basis. This is the first time a Japanese bank has in effect rented the throughput of a rival credit. The deal may be an indication of the difficulty this Japanese bank has had in setting up a sub of its own and soothing counterparties anxious about the fragility of Japan's financial institutions.

A Good Market Year Meant Bad News for Hedging

We all know that 1995-particularly the second half-was a bang-up year for equities. But how did it affect the listed equity derivatives markets? A recent report by Goldman Sachs' equity derivatives research team titled "Global Derivatives Trading in 1995" concludes that strong equity markets discouraged hedging. Volume in US and European stocks was up last year, but volume in the equity futures and options markets was flat in the United States and actually declined in most of the European markets. The behavior reflects a trend seen in earlier bull markets: in rising markets where volatility is low, active managers pick out stocks they like. In falling markets managers are more likely to use derivatives to hedge the stocks they already own.

Positive market returns also put a damper on options volume and volatility. Says the Goldman Sachs report, "Options hedging strategies like covered calls and collars did not perform well as global markets rallied, causing investors to reduce their short call/long put positions toward the end of the year." As a result, the spread in implied volatility between out-of-the-money puts and calls was at the low end of its historical range.

The near-record equity returns went hand-in-hand with below-average volatility. "In fact," continues the report, "if we look at past years where the S&P returned above 25 percent, there has never been a year with lower realized volatility than what we experienced in 1995." As a result, it's likely that returns will fall and volatility will rise in 1996. The report also notes that "stocks proved to be slightly more correlated with each other in 1995 than they were in the 1991­1993 period, making it more difficult to add value through stock selection."

...And a Lousy Year for Pensions

Whether or not 1995 was a good year for pension funds depends on which side of the balance sheet one looks at. On the asset side, as everyone knows, the stock and bond markets yielded returns rarely seen as a group. "What a year it looked like for asset allocation specialists," says Ronald Ryan, president of New York-based Ryan Labs. "Consultants around the globe might think it's time to leap for joy! Au contraire, my friends."

The bad news, he explains, is that pension fund liabilities-the present value of what they must ultimately pay out to retirees-soared. The result: assets "underperformed liabilities by 12 percent, making 1995 one of the worst years on record."

That grim assessment comes courtesy of the Financial Accounting Standard Board (FASB) which defines the method for liability computation. According to the FASB's reasoning, the market value of assets has to be compared to the present value of liabilities, calculated using individual discount rates for each liability payment date in the future. In other words, year-end liabilities are lined up from year one to year 30, and a present value is calculated for each year as if it were invested in high-quality zero-coupon bonds.

Taking the FASB at its word, Ryan created a Liability Index, based on an archetypal pension fund, whose beneficiaries have a post-retirement life span ranging between fifteen and eighteen years, and created an equally weighted portfolio of Treasury STRIPS from one to 30 years. This cluster of STRIPS, which is highly interest-rate sensitive, jumped 41.16 percent last year, while the Ryan composite of typical pension assets climbed only 29.8 percent.

Ryan argues that investment return targets should synchronize with liabilities, not with some number derived from asset returns. "Since the objective of any investment strategy is to fund liabilities, and liabilities are measured as very high quality, long-duration bonds, it doesn't make any sense to base investment return targets on, say, an equity index," he believes.

His argument is not just a quibble about modeling. He claims the data will have real-life consequences. Given that there is $3 trillion in pension assets, a 12 percent underperformance amounts to $350 billion. "This underperformance should cause an alarming disruption in the funding ratio, causing severe pension contributions, and deficits, to appear in 1996," Ryan warns.

Derivatives quants, you have your marching orders: it's time to dream up some strategies more closely linked to the FASB's liability computation method. Watch this space.

No, Virginia, Volatility is Not Increasing

It is an article of faith among US and British central bankers-and derivatives traders-that world financial volatility has increased in the last decade and that it is wrecking havoc on our economies.

Nonsense, says a new book published by Frederic L. Pryor, a economics professor at Swarthmore College. In Economic Evolution and Structure (Cambridge University Press), Pryor looks across the entire spectrum of the economy and concludes, "no upward trend in overall volatility is apparent."

In one chapter Pryor collected data on month-to-month and quarterly volatility on 64 different variables and used them to compare the 1950-59 period with the 1983-90 period. While FX and equity prices registered higher volatility in recent years, production, price and labor indicators have all registered major declines. Within the financial sector there are some areas where volatility is less pronounced: bonds with longer maturities are less volatile than bonds with shorter maturities. Oddly, differences in fixed income risk ratings seem not to affect outcomes-so that no apparent relationship between risk and volatility came up in the study.

Volatility in the GDP and major aggregates, and for national income, has been decreasing. Same goes for employment and unemployment. Conclusion: "With the exception of increased volality in exchange rates, most predictions about changes in volatility appear completely wrong," says Pryor. "Excathedra remarks of central bankers about increasing volatility must be taken with a grain of salt."

So must the pronouncements of doomsayers, such as those who espouse the idea that the economy is increasingly vulnerable to seismic shocks that may precipitate a depression. In an interview with Derivatives Strategy, Pryor was careful to warn readers against becoming too sanguine: "Volatility measures are really tricky because much depends on the end-points chosen. Some people measured volatility just after the 1987 crash and guess what? They found volatilities were very high!"

Pryor's analysis suggests the possibilities of firewalls between the financial and the real economy. His data shows that there was no spillover effect into the general economy from the surge in FX and equity volatilities. Among the handful of economists interested in the problems of frailty and fragility, Pryor likens himself to the "guy who jumps off the Empire State Building and on the way down, at the 30th floor, says, `So far, so good.'"