Soon after Virginia Tech finance professor Robert Mackay mailed invitations to the inaugural meeting of his new discussion group in 1990, he received a call from the portfolio manager of one of the nation's largest pension funds. He'd love to attend, the man said, but Mackay would have to devise another name for his group. "His boss just couldn't approve travel for a meeting of ... the 'Weird Instruments Study Committee,'" Mackay recalled with a chuckle.

The forum Mackay envisaged would bring together academic researchers, government regulators, and industry executives for informal lunch discussions every month about a class of financial instruments known as derivatives. He and two co-founders thought up the "weird instruments" name, he explains, because "everybody seemed to think that derivatives were so strange." The group later adopted the less whimsical "Financial Innovation Study Committee" as its formal moniker, but retained the original one as an affectionate nickname.

Five years and half a dozen financial debacles later, derivatives had attracted names that were less than sentimental. "Esoteric" and "dangerous" were terms the media frequently used to describe derivatives during the past two years of spectacular losses suffered by the Mexican government, Procter and Gamble, Gibson Greetings, Orange County, and lastly, Barings Bank.

Much of the early reporting on derivatives, say Mackay and finance colleague Don Chance, was "shallow, misleading ... almost hysterical." A standard joke among derivatives traders, weary of the negative press, was that the definition of a derivative was "any apparently complex financial instrument in which someone has suffered a loss."

Are derivatives a perilous new tool? Not really, say Chance and Mackay. "Just as corporations may make unwise decisions and lose a lot of money in the non-derivatives area," says Chance, "they may also make unwise decisions about derivatives investments. It's the imprudent use of these instruments that's the problem."

Are derivatives difficult to understand? They appear complex, Mackay says, but they're really made up of only a few basic building blocks of futures, options, or swaps. Snapping these together, Lego-style, in different ways and with other financial devices, can produce fairly intricate instruments.

Mackay, whose experience in government includes serving as chief of staff of the Commodity Futures Trading Commission and as a member of the President's Working Group on Financial Markets, currently teaches at Virginia Tech's Northern Virginia Graduate Center, where he directs the Center for Study of Futures and Options Markets. The center, established in 1989, is sponsored by the Pamplin College of Business.

Mackay points out that derivatives are actually an important part of most people's lives. Home mortgages, for instance, are derivatives of a sort. Both flexible-rate and fixed-rate mortgages typically have a range of options that allow homeowners to hedge against the risk of interest rate increases (through rate caps) or decreases (through refinancing).

Derivatives are also an important component of most pension funds. The Virginia Retirement System, for example, uses derivatives to manage cash flow in its investments with the goal of increasing the yield on its pension funds - and paying retirees greater benefits.

Derivatives, Mackay says, offer many advantages if used carefully. They give users - from farmers and agricultural processors to airlines, oil refiners, and multinational companies in any line of business - a cheap and effective way of reducing their vulnerability to fluctuations in interest rates, commodity prices, or currency exchange rates.

Despite the frustrations of dealing constantly with the same old questions about derivatives, Mackay says, these are heady times for derivatives experts. It's an "incredible experience," he says, to be a part of "a highly competitive, dynamic, innovative, and truly global industry."

A recent project was sponsored by the Group of 30, a private think tank headed by former Federal Reserve Board chairman Paul Volcker. As the project's advisor, Mackay helped write the group's influential report, Derivatives Practices and Principles, which defined 24 principles of good risk management, "from articulating the responsibilities of board members and senior directors to suggesting who should be authorized to do a trade."

Mackay assisted with other reports and surveys that followed and conducted training programs for U.S. government agencies and Eastern European central banks. He has been cited in numerous media and has lost count of the number of talks he has given on derivatives and risk management.

In a survey of more than 100 studies on derivatives published over the past three years, Mackay and another researcher found that derivatives provide substantial benefits to individual firms and the overall economy and that their use should not be unduly regulated or restricted. But the studies also recognized the need for better financial risk management.

One vital first step would be to provide education and training. "Today's financial manager not only has more tools available for controlling risk, but also has a much greater need for meticulous training in the theory and practice of financial risk management," says Chance. He and Mackay have developed an MBA "track" that will allow students who are specializing in finance to further concentrate in derivatives and financial risk management. The track will be offered this fall in the Pamplin College's MBA program on campus and at the Northern Virginia Graduate Center.

"Our program comprises rigorous course work in corporate finance, investment banking, and financial derivatives. It will prepare students to develop, market, and use a variety of derivatives to manage the financial risk of a firm," says Chance. Fewer than 10 U.S. universities, he notes, currently offer "serious" derivatives programs, and Virginia Tech is among them.

Mackay also developed a six-month certificate program in financial risk management for professionals that is being offered jointly through the university's Continuing Education Center. A number of Northern Virginia firms that are major derivatives users have already expressed interest, he says, in customized training programs from Virginia Tech.

"In general, people shouldn't have a reflex reaction to the D word," Mackay says. "But if you discover that your local municipal authority is somehow earning a 24 percent return when others are earning only eight percent, you might want to ask how that is being done and whether good risk management principles are in place."

Whether you're the president of McDonalds - a major user of derivatives - or a small business owner, Mackay says, the core questions people should ask of their bankers, pension fund managers, or other relevant officials remain the same: "If you're using derivatives, do you know what you're doing, and do you have the proper controls in place?"

Sookhan Ho is the public information officer for the Pamplin College of Business.

Derivatives are financial instruments that are based on the values of other financial instruments such as interest rates, foreign exchange rates, commodity prices, or stock market indexes.

Futures and options are two examples of derivatives. A stock index futures, for instance, is a contract to buy a stock portfolio at a fixed price in the future. It is a derivative because its value is determined by the value of the underlying stock. A futures contract is rather like a commitment to buy Girl Scout cookies, says finance professor Don Chance. "You sign up now and agree to pay a fixed price for them when they're delivered later."

A stock option is a contract granting the right to buy or sell a particular stock at a fixed price sometime in the future. You can compare them to manufacturers' coupons. A 50-cent coupon for laundry detergent, for example, gives you the right to buy the product at the specified discount of 50 cents.

Derivatives' main advantage, says Chance, is that they allow individual investors or businesses a way to transfer risk to someone else for a price. Thus, IBM, which sells computers worldwide, can safeguard its earnings against losses stemming from currency price fluctuations by buying from derivatives traders currency options that fix in advance the U.S. dollar's exchange rate for, say, Japanese yen.