Reluctantly Greek
By forcing non-financial companies to record the mark-to-market of their derivatives positions in the balance sheet and, possibly, the income statement, the new derivatives accounting rules (the infamous FAS133 and IAS39) transform corporate treasurers into traders. Like a magic wand, the new standards suddenly expose treasurers to wild-swinging fluctuations in derivatives values, a worry that was previously the exclusive preserve of trading professionals who, after all, have always been paid based on those mark-to-market variations.
Without a doubt, FAS133 and IAS39 have dramatically altered hedging decisions inside corporate fortresses, and made life much harder for treasurers. Some of the well-known possible negative effects of the new standards are enhanced artificial income statement volatility, heavy workload, extra investments in systems, and large and disturbing earnings restatements due to implementation technicalities. Such are the unpleasanties forced upon companies by regulators. Most of the attention and analysis of the new rules have focused on those aspects (predictably so, as earnings volatility and restatements tend to hit the headlines).
A point that has been less covered is the fact that, by treating treasurers as if they were derivatives traders, accounting authorities now force the former to be exposed to those devious things prone to inflict cold sweats at night to every option trader in the world: the famous “greeks”, the parameters that in exquisite detail describe and enumerate the various mark-to-market risks faced by anybody that holds an option position. Delta, for example, tells us by how much the market value of the option would change following a small change in the underlying asset (foreign exchange, interest rates, commodity). Gamma, in turn, measures by how much delta itself would change after a small move in the underlying. Vega deals with the risk of changing volatility. Theta describes the option value´s sensitivity to the passage of time (unlike the case of fine wine, as time passes by an option is, generally, assumed to lose value). As the greeks are the tools conventionally used to measure options mark-to-market changes, FAS133 and IAS39 make them, for the first time, essentially relevant for corporates. Movements in gamma or vega can now have important balance sheet and earnings ramifications for companies whose executives (let alone shareholders) had never before heard of such terms.
It seems highly unfair to expose treasurers to new risks that have nothing to do with how their companies make a living and that did not priorly exist (such as volatility or the passage of time), and to make them monitor these risk parameters on a continuous basis like their stress-eating counterparts on the trading floor. The new accounting rules make very relevant what is in fact very irrelevant.
Let´s analyze some of the weird (and disturbing) effects that the greeks can inflict on corporates’ reported results. Take theta for instance. For a regular (“plain vanilla”) option, theta is always negative. That is, as time passes by the option´s value diminishes. In trading jargon, this is known as “time decay” and explains why options are said to be “wasting assets”. Time is beloved by option holders because it gives more chances for market movements, and this magnifies the opportunities for the option to expire in-the-money and deliver a payoff. Now imagine the press release of an options-using corporate that has suffered an earnings setback due to mark-to-market deterioration of its derivatives portfolio simply because, well, time went on: “Q2 was slower than expected because earnings suffered due to the fact that time passed by. If time had not passed by, we would have been fine. It´s not our fault that time passes by!”.
Things are even worse in the case of some exotic options, such as knock-out options, where the contract gets cancelled if the underlying asset reaches a certain pre-set level. These options can show flip-flopping greeks, that switch from negative to positive or vice versa (vanilla greeks, in contrast, never change sign). Theta can suddenly go from the usual negative to positive (the passage of time becomes valuable). Vega similarly flip-flops, in this case from the usual positive to negative (market fluctuation becomes undesirable). Thus, the following awe-striking corporate statement could take place: “Q1 results were helped by increased volatility; Q2 results were hurt by increased volatility” or “Increased volatility helped us before it harmed us”.
Forget the fact that investors and shareholders don´t really understand why volatility (never mind time) should matter when it comes to the bottom line of a non-financial company. With flip-flopping greeks, they can´t even understand whether the company is long volatility or short. Or long time or short time. Can you picture outsiders scratching their heads wondering whether the company benefits or not from the ticking of the clock? Surreal? You bet.
