Question

Enrons collapse, the biggest Chapter 11 bankruptcy in U.S. history, has been attributed in part to the companys reckless use of derivatives. Is this a valid accusation? Fully explain and support your response.

Using real-world examples, discuss two other financial derivatives used by domestic and/or multinational firms to hedge risk. What are the advantages and disadvantages of using derivatives?

Answer 1

Yes, this is a valid accusation and Enron’s reckless use of derivatives did lead to its bankruptcy and collapse to a considerable extent. Enron used derivatives and the profit that it generated from its derivatives trading operation was used to mask losses of its main businesses. There was fraudulent manipulation of profits from derivatives. The profit that it generated from its derivatives operation was used to cover the losses in its businesses of gas and power, fiber-optic bandwidth and water systems. Enron used derivatives to create a complex web of off-balance sheet items and deals. Complex financial partnerships were structured through special purpose vehicles (SPVs). Unprofitable new businesses were financed using debt easily thanks to the company’s derivatives position. The value of Enron’s troubled businesses inflated and this eventually led to its collapse.

Two other types of derivatives used by domestic and/or multinational firms to hedge risk are swaps and forward rate agreements. Many companies in the real world use swaps for the purpose of oil and gas hedging. For example companies like BP, Shell etc. hedge their crude oil production using swaps to ensure that their revenue meets/exceeds their budgeted estimates.

Advantages of using derivatives are that it can be used to hedge risk exposure, it can be used for underlying asset price determination. It increases market efficiency of the financial markets while opening up access to unavailable assets and markets. The disadvantages are mainly the high risk involved as derivatives have high volatility that opens up exposure to potentially high quantum of losses.