WHAT'S NOT TO LOVE ABOUT A DERIVATIVE?
By DAVID R. HENDERSON

(FORTUNE Magazine) – If you were walking in a rough neighborhood, wouldn't you want a street-smart tough guy who also has integrity by your side? In the complex world of derivatives, Merton H. Miller is that guy. With the stock market gyrations of October and November, many investors have worried that options and other derivatives have made financial markets less stable. In his latest book, Merton Miller on Derivatives (John Wiley & Sons, $34.95), Miller puts that worry to rest. Since being awarded the Nobel Prize in Economics in 1990 for his insights in corporate finance, Miller, an emeritus professor at the University of Chicago's Graduate School of Business, has carried on a crusade, in speeches and writing, to explain how derivatives work. His latest book is an edited selection of the best of those speeches and articles. In it, Miller shows--with clarity, punch, and humor--just how off-base and uninformed most criticisms of financial derivatives are.

Miller's main theme is that companies don't use financial derivatives to make huge bets but to do exactly the opposite--get out of bets by buying insurance. Miller reports, for example, his conversation with the treasurer of a medium-sized oil company in Chicago who bemoaned his company's losses when the Gulf war's end brought down the price of oil. "It serves you right for speculating and gambling," Miller told him.

"Oh, no, we didn't speculate. We didn't use the futures market at all," insisted the treasurer.

"That's exactly the point," Miller replied. "When you hold inventory, nonhedging is gambling. You gambled that the price of oil would not drop and you lost."

Miller brings this same clarity to his discussion of index futures. He gives the example of a pension fund that would like to shift a portfolio of stocks to Treasury bills. The direct way would be to sell stocks and buy T-bills, incurring broker fees in the process. The indirect way, explains Miller, which accomplishes the same goal at about one-fifth the transaction cost, is to hold on to the stocks and sell S&P 500-index futures contracts.

What about the recent fiascoes with derivatives that caused huge losses for Metallgesellschaft (MG), the German conglomerate, and for Orange County, Cal.? Surely they are good grounds for further government regulation of derivatives. No, replies Miller. He shows that the derivatives MG used to hedge its price risk on long-term oil contracts led to large cash drains for margin payments as oil prices fell, losses that were offset by gains on contracts for future delivery of oil. These sure gains in the future were not as visible as the margin-call losses in the present. The new management of MG foolishly canceled the forward contracts. In other words, it let buyers out of obligations to buy oil at hefty prices relative to the then-lower market price.

The Orange County case is simpler: County treasurer Citron used derivatives to speculate, not hedge, betting that interest rates wouldn't rise. When interest rates rose, Orange County taxpayers lost. What those cases really show, writes Miller, is that firms and government agencies that use derivatives must pay attention to what they're doing, because some people can always figure out ways to lose money.

So why, according to Miller, have the New York Stock Exchange and the brokerage industry been so hostile to derivatives? The reason can be summed up in one word: competition. If investors reduce their risk in stocks not by selling stocks but by selling index futures, neither the NYSE nor brokers get any of the action.

Miller points out that the Securities and Exchange Commission, its constituents in the brokerage industry, and its congressional overseers complained about competition from index futures long before the October 1987 crash. They used the crash to argue for shifting regulatory control from the Commodity Futures Trading Commission to the SEC. After the crash, President Reagan appointed investment banker Nicholas Brady head of a commission to figure out what caused it. "No one who actually knew anything about index futures or options was asked to serve," Miller writes. Brady, who became Treasury Secretary, pushed unsuccessfully to bring index futures under SEC regulation.

Miller seems optimistic about the prospects for holding off regulation that would monopolize the financial industry. He puts the U.S. market in perspective by noting how cartelized Japan's market is. Japan's Ministry of Finance, writes Miller, "is, unashamedly, the managing director of the domestic stock brokerage industry cartel in Japan." If U.S. investors avoid that fate, and it looks as if we will, Miller deserves much of the credit.

--David R. Henderson

DAVID R. HENDERSON is a research fellow at the Hoover Institution and teaches economics at the Naval Postgraduate School.