Derivatives, says Professor Robert Merton in an interview with Gillian Tett in the FT, are grossly misunderstood.
The co-creator of the Black-Scholes formula argues that most companies have been extraordinarily inefficient in their use of capital, because they have not worked out which risks they have a comparative advantage in handling - and which they do not. Managers have wasted capital by inadvertently assuming risks they are ill-suited to hold, such as property exposure (via real estate assets) or markets (through pension holdings).
However, if companies would only shed that risk, or outsource the management of it, they would have more capital to support growth, Prof Merton argues. And one of the best ways to do this, he concludes, is to use derivatives. “The major advantages of using derivatives are that they are efficient in transferring huge amounts of risk. They can be customised, and policies implemented with them [are] reversible and non invasive,” he enthuses.
Such evangelical zeal may for some be a cause of concern - because Prof Merton, before creating a financial consultancy, IFL, with Roberto Mendoza and Peter Hancock, previously at JPMorgan, was a partner at the poster-child for wholesale financial implosion, LTCM.
If things go wrong, he says, it should not be blamed on these instruments per se, but on the way they are used. And he insists it is entirely possible - desirable, in fact - for institutions to use them for benign purposes that reduce exposure to risk. “Asking whether the world today wants to use derivatives or not is a bit of a meaningless question - it is like asking whether we want to use cars. They are an integral part of the financial system,” he says.
“Derivatives are like anti-lock brake systems in a way - there is no question that they can make things safer, but only if people choose to use them that way. Often they don’t - they might choose, for example, to drive faster in worse weather. Often we have chosen to use these tools not to decrease risks but to increase the benefits of taking the same risks.”
IFL has now upped its ambitions by linking up with another consultancy called Marakon - but has already made a striking convert to their cause. In the past year IFL has been designing a new pensions system for Philips, the electronics group. It uses derivatives to customise an individual’s long-term investments - fine-tuning them to whatever level of pay-outs, contributions and risk profile he or she prefers.
The scheme, which is neither a standard defined contribution system nor a defined benefit plan, has been adopted by Philips’ top 400 executives in Europe and will be rolled out across the European operations this year.
Behind the scenes he and his colleagues are now drawing up other schemes to help companies manage capital or fight off the private equity threat. “[Applying finance science to companies] is a fascinating intellectual challenge,” enthuses Prof Merton. “But it is obviously also a commercial opportunity.”
