City & Business: Banking on derivatives

EDWIN ARTZT, chief executive of the American consumer products group Procter & Gamble, has asked to have dollars 100,000 cut from his annual bonus. The gesture - it's hard to call it much more when Artzt's pay will still rise 8 per cent to dollars 2.3m this year - was because of the embarrassing dollars 157m P&G dropped after speculating in the high-risk derivatives market.

So far, there's no sign that his counterpart at Glaxo, Sir Richard Sykes, plans similar self-flagellation. Glaxo last week put a pounds 115m figure on the losses it sustained investing in gilts and derivatives earlier this year.

Artzt's explanation that he knew nothing about the problem until shortly before it became public knowledge in April sounds lame. Chief executives should make it a priority to find out precisely how they are using derivatives (they almost certainly are).

The more I learn about these animals, the more convinced I am that sooner rather than later a substantial company is actually going to be ruined by a derivatives investment that goes wrong. I know of one Continental company that has got itself into a horrendous hole. The derivative product it was sold was a kind of geared swap. It was, needless to say, fiendishly complicated: the eventual outcome depends on the difference between the spot rates of two European currencies in 1999. But the horrifying aspect of the tale is that although the agreement with the bank said the principal was dollars 50m, the maximum possible liability for the company turns out to be a horrendous dollars 1.8bn. At present, the company is looking at a loss of dollars 150m and things could get much worse. Not surprisingly, the matter is now with m'learned friends.

Corporate treasurers are having the wool pulled over their eyes. Some investment banks, usually American, although the Swiss and the Brits are catching on fast, are deliberately tailoring derivative products to entrap particular treasurers. (These are not the relatively straightforward off- the-peg deriviative products we describe on page 13.)

A favourite ploy is to offer attractive terms in return for the treasurer agreeing, in effect, to pay a massive penalty should an unlikely set of circumstances prevail. If the treasurer believes, say, that interest rates will never go above 10 per cent, or that sterling will never rise above dollars 2.00, a product is specifically designed to clobber the company only in those 'impossible' circumstances. The treasurer's mindset is such that he discounts the risk. He knows interest rates could never reach 10 per cent, so he sees the product as a wonderful risk-free investment. He's done a fantastic deal, he thinks to himself. The board, even if consulted, are usually blinded by the mathematics and can do little except take the treasurer's word that all is well.

Some of those devising and selling derivatives are no better than snake-oil salesmen. Beware.