Derivatives and corporate risk management



During recent financial turmoil derivatives and risk management plays a pivotal role in the survival and success of the organisation. Banks and financial institutions giving more importance to risk management tools, and derivatives are considered as very important tool for risk management namely - credit default swaps, credit linked notes, interest rate swaps, currency forwards and futures etc to hedge and reduce the risks. As firms are looking for good risk managers in current situations my study critically analyses the effective management of different types of risks with the help of derivative instruments and importance of risk management strategies in banks to manage and reduce risks.

The project will also put a light on better risk management practices adopted by banks in current global financial crisis and different type's derivatives used to reduce the risks in firms. Adding to this there will be a comparative analysis of risk management at Goldman Sachs and Lehman Brothers which analyses the reason for the impressive performance by Goldman Sachs on the other hand huge losses and bankruptcy of Lehman Brothers, and finally suggesting better risk management techniques through my tests and observations.

Literature Review
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Eden Yu and Ivan Chin (2001) in their research paper "Managing risk by using derivatives", they have critically analysed how companies in Hong Kong have managed risks by using derivatives. They conducted a survey to find out what kind and to what extent financial engineering tools are used. Survey reveals that derivatives are widely used instruments to manage risks and most of the companies' measure the risk prior to including derivatives in the portfolios. The value-at-risk model is the most widely used risk management technique, followed by scenario analysis and building block approach.

It's been found that companies use derivatives to manage foreign exchange and interest rate risks. Many companies use equity derivatives (index futures & index options). The survey also reveals that forwards and swaps are the widely used instruments to manage foreign exchange risk and interest rate risk in the market. These companies consider derivatives important and useful tool for risk management. Most of these companies use derivatives to hedge and reduce risk; some others use derivatives for arbitrage through derivatives.

Gregory Duffee and Chunsheng Zhou (2001) research paper analyses the use credit derivative as a risk management tool in banking. Study finds out that banks can use credit derivatives like credit default swaps (CDS) and other credit instruments to temporarily transfer credit risks of their loans to others and there by reducing the probability of the defaulting loans trigger the bank's financial distress. As its been observed that credit derivatives are more efficient in transferring risks than other, more established tools, such as loan sales without recourse, and these instruments makes it easier for banks to transfer credit risks. It's been observed that the credit derivatives will improve the capital allocation by reducing investment in poorly graded projects.

This work also identifies the limitations of the credit derivatives, as bank can sell-off any part of the loan in order to reduce its costs of financial distress, however bank has superior information about quality of the loan, the loan market is affected by an asymmetric-information problem. If the asymmetric-information problem is sufficiently severe, the loan-sale market will be of limited use to the banks and financial institutions.

Bernadette Minton and Rene Stulz (2005) in their research work they have critically analysed use of credit derivatives by banks to reduce risks which examines the use of credit derivatives by US banks from 1999 to 2003 with assets in excess of one billion dollars by using Federal Reserve Bank of Chicago database. The study finds out that large banks use credit derivatives in huge volume to reduce risks. Few banks are net buyers of credit protection and they buy credit derivatives to hedge loans. Banks are more likely to be net credit protection buyers if they involve in asset securitization, lending of foreign loans and have lower capital ratios, a higher ratio of risky assets to total assets, lower balance of liquid assets, and a higher fraction of non-performing assets. The probability of a bank will be a net credit protection buyer is positively related to the value of industrial and commercial loans in a bank's loan portfolio and negatively related to other types of bank loans. The use of credit derivatives by banks is limited because of adverse selection and moral hazard problems that make the market for credit derivatives illiquid for the credit exposures of banks.

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It's been found that banks with less capital, more non-performing assets (NPA), with low liquidity and with low interest margins to be more likely to hedge the risks since such banks are more likely to face financial distress. However Morrison (2001) argues that the usage of credit derivatives would adversely affect banks by reducing their incentives to monitor and to screen borrowers and further, the usage of credit derivatives would make bank loans less valuable to borrowers because the loans would require less of a certification effect. So this securitization process removes the credit risk completely from the bank's balance sheet.

Jan Barton (2000) research examines the effects of derivatives use on earnings management behaviour. He developed a self-selection simultaneous-equations model that has analysed the managers' readiness to use derivatives as risk management tool and manage discretionary accruals. Empirical research results from estimating the model data for a sample of 304 Fortune 500 organisations indicate that firms with larger derivatives portfolios have lower levels of discretionary accruals. Results also suggest that manager's use discretionary accruals and derivatives as partial substitutes to smooth earnings so as to reduce agency costs, income taxes, and information asymmetry.

Managers can use derivatives to reduce the volatilities of earnings and cash flows arising from changes in interest rates, foreign currency exchange rates, commodity prices, and other risk factors.

Anwer Ahmed, Anne Beatty and Carolyn Takeda (1997) critically analyses the evidence of the Interest rate risk (IRR) management activities of the commercial banks and their use of derivatives. They found out that

  • The banks mainly focus on managing interest rate sensitivity of net income rather than the interest rate sensitivity of stock returns.
  • The liquidity is directly related to interest rate risks taken by banks and inversely related to managerial quality and bank size.
  • The derivative users have a lower IRR exposure compared with non-derivative users and derivative usage reduces
  • Christopher Geczy, Bernadette Monton and Catherine Schrand (1997) have critically analysed the use currency derivatives by organisations. Study examines that companies with higher growth potentials and tighter financial constraints are more likely to use currency derivatives. The study suggests that companies might use derivatives to reduce cash flow variation and firms with extensive forex exposure and economies of scale in hedging activities are also more likely to use currency derivatives.
  • It's been evident that the companies with higher economics of scale in implementing and maintaining risk management techniques are more likely to use currency derivatives and firms with currency exposures resulting from foreign operations are more likely to use forwards or forwards in combination with futures or options and currency swaps. Firms with higher variation in flow of cash or accounting earnings resulting from exposure to foreign exchange risk have higher potential benefits of using currency derivatives.

    Anthony Santomero (1997) has critically evaluated financial risk management systems in financial institutions. This analysis covered a number of North American financial institutions as well as number of firms outside US. This analysis covered both philosophy and practice of financial risk management. The study finds out state of risk management techniques in the industry and evaluates the standard of practices. The report also discusses the problems of the financial industry and elements that are missing in the current risk management procedures.

    It's been observed that commercial banks were mainly worried about risks like market risk, credit risk, liquidity risk, operational risk. Banks manages market risks like interest rate and foreign exchange risk by hedging against these risks and by limiting the sensitivity towards undiversifiable factors, as well as limiting their exposure to it. When it comes to managing credit risk banks closely watch for financial condition of the borrower as well as value of underlying collateral. Many banks use credit rating, credit scoring techniques and appoint credit review committee to review and manage credit risk in the banks.

    Banks follow value at risk model (VaR) and risk metrics to manage interest rate risk. They also make use of cash, futures and swap markets to reduce risks. To manage foreign exchange risk banks keep currencies in real time systems with spot and forward positions marked-to-market and position limits are set by front desk and by individual trader, with monitoring done in real time by some banks and on a daily closing at other banks. VaR system and stress tests are used to evaluate the potential loss and to reduce the risks.

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    Certified Public Accountants (CPA) Australia (2006) report on managing financial risk has critically analysed that the different financial instruments can be used together or separately to produce complex derivative products which is very much helpful in reducing risks.

    Its been observed that interest rate risk can be mitigated by including a mix of fixed and floating rate debt with a range of maturities in the liability portfolio ensuring that new or replacement debt is added to portfolio in a way that it minimises the concentration of maturity or reprising dates. In some banks debt interest rates and maturities are closely looked after with underlying assets. Derivatives such as swaps and options are used to exchange floating interest rates with fixed rates or vice versa. Some financial institutions are managing forex risk by creating a natural hedge by borrowing in the foreign currency assets so that changes in value may be directly offset against each other. Some other financial institutions uses different types of financial instruments such as forward foreign exchange contracts, currency swaps, currency futures and options contracts to manage forex risks effectively. Its been also identified that organisations manages commodity risks by a range of financial instruments that includes forward sales and purchases, futures, options and swaps. This commodity risks can be managed by using financial instruments which are traded on recognised commodity exchanges such as New York Mercantile Exchange (NYMEX), Chicago Board of Trade (CBOT) and London Metals Exchange (LME) etc.

    Amiyatosh Purnanandam (2006) in his research work he has critically analysed that the banks with greater chances of financial distress manages their interest rate risk more aggressively by means of on-balance sheet and off-balance sheet instruments. Banks which use derivative instruments remain immune to the monetary policy shocks. Findings suggest that the usage of derivatives minimizes the effect of macro economic shocks on a firm's operating policies. Banks use different types of financial tools such as interest rate derivatives to manage these risks. It's been found out that banks should hedge its market risks where they don't hold any special monitoring advantages. This implies that the interest rate risk management techniques should improve the efficiency of banks by allowing them to handle more credit risk efficiently.

    So this study shows that hedging of interest rate risk shall increase firm value by reducing the transaction cost of bankruptcy. It's been argued that banks should hedge so as to avoid the cost of external financing during low internal cash-flow period. Derivatives instruments have an ability to make lending polices of the banks less sensitive to external shocks by generating higher cash flows. Findings also show that big banks with liquid balance sheets are less prone to the Fed policy shocks.

    Higher internal cash flows and capital position improves the creditworthiness of banks. Therefore organisations should hedge more if it has higher expected costs of bankruptcies and higher credit risks and associated cost of failure. At the same time a firm's likelihood probability of default will come down if it hedges more.

    David Carter and Joseph Sinkey (1998) in their research paper they have critically investigated use of interest-rate derivatives by US commercial banks. This study was focused on the end users of interest rate derivatives rather than dealers. It's been found that use of interest rate derivatives is directly related to interest rate risk exposure and this is measured by absolute value of 12 month maturity gap, and it's been evident that banks that participate more regularly in interest-rate swaps have stronger capital positions. It's been found that banks use three types of derivative contracts to mange interest rate risks. This study shows that swaps account for 69%, options for 23%, and futures and forwards accounted for 8%. Banks should use interest-rate derivatives to offset mismatches between rate-sensitive assets and liabilities so that they manage their interest rate exposure in better way.

    George Allayannis and Eli Ofek (1997) in their research work they have critically examined use of currency derivatives to manage exchange rate exposure in US multinationals, exporters and manufacturers. They have examined whether organisations use currency derivatives for hedging or for speculative purposes. The study founds out that firms use currency derivatives for hedging as the use of derivatives significantly reduces the firms' exchange-rate risk. Study identifies that the decision to derivatives usage depends upon exposure factors like foreign trade and foreign sales.

    The study finds out that US multinationals, exporters and manufacturers are not significantly affected by exchange rate fluctuations as they make extensive use of foreign currency derivatives and different types of hedging instruments to safeguard themselves from unexpected movements in exchange rates. It's been evident that exchange rate exposure increases with the percentage of foreign sales and decreases with percentage of foreign currency derivatives.

    Andrew Marshall (1999) has critically analysed foreign exchange risk management practices in UK, USA and Asia Pacific multinational companies in his research work. It's been evident that 75% of UK multinationals relies heavily upon currency swaps and forwards to manage this risk. It's been found that Asia-Pacific companies primarily use forward contracts, options and swaps to manage exchange rate risk. US and Asia Pacific multinationals who manage this exposure in a sophisticated manner as currency options are popular with about half of the organisations in USA and Asia Pacific. The Asian Pacific firms seem to be the more sophisticated derivative users and have moved on from the simple forward contract. Currency options are also popular in the smaller size. The results revealed that a majority of UK multinationals do not favour the exchange-traded instruments such as currency futures and options. However, Asia Pacific firms were more likely to use a large number of external instruments and the exchange traded instruments.

    Gordon Bodnar, Richard Marston and Greg Hayt (1998) conducted a research on financial risk management in US firms and they have found that foreign exchange (FX) risk the risk is most commonly managed by firms with derivatives, being done so by 83% of all derivative users. Interest rate (IR) risk is the most commonly managed risk with 76% of firms using IR derivatives. Commodity risk is managed with derivatives by 56% of derivative users, where as 34% of firms manage equity risk by derivatives.

    Among primary product firms, commodity risk is effectively managed risk with 79% firm's using derivatives. 95% manufacturing firms use FX derivative to mange FX risk where as service firms manage IR risk and FX risk with derivative usage rates of 78% versus 72% respectively. Service firms are less concerned about equity risk as only 22% indicating equity derivative use. Most of the firms that use IR derivatives reported that they make use of IR derivatives to swap from floating rate debt to fixed rate debt to add to this it been noted that 60% of firms indicated that they use interest rate derivatives to swap from fixed rate debt to floating rate debt.

    Ahmed El-Masry (2006) has done a critical analysis on derivatives use and risk management practices by UK nonfinancial companies. The results of the study indicate that the larger firms are more likely to use derivatives than medium and smaller firms. It's been observed that majority of the firms have internal guidelines about the usage of derivatives with forwards/futures and swaps.

    The most commonly hedged exposures are off-balance-sheet commitments 83.3% hedge monthly, translation of foreign accounting 77.8% hedge yearly and 22.2 % per cent hedge monthly, arbitrage borrowing rates across currency 67.7% hedge monthly and 33.3% hedge yearly, foreign repatriations 55.6% hedge quarterly, on-balance sheet transactions 50% hedge monthly and 20% hedge weekly, anticipated transactions expected beyond one year 40% hedge quarterly, 30% hedge monthly, 20% hedge yearly, competitive economic exposures 40% hedge monthly, 40% hedge quarterly, 20% hedge yearly, and the anticipated transactions expected for one year or less, 31.25% hedge monthly and 31.25% hedge quarterly.

    A large number of the firms use IR derivatives to swap from floating-rate debt to fixed-rate debt at 41.2%. In addition to swapping existing debt, IR derivatives are also used by a significant proportion of firms to fix in advance the rate or spread on new debt issues as well as to take positions to reduce costs or lock-in rates. It's been found that firms use different types of options to manage risks such as FX risk, IR risk and commodity risk. Firms using derivatives, 68.75% reported that they have used some form of options. FX options are the most popular, used by 65.3% of the firms, where as IR and commodity options are used by 30.4% and 4.3% of the firms using derivatives respectively. Options usage is more in foreign currencies and interest rates.

    The study indicates that one third of the firms don't use derivatives because their exposures are not considerable. The most important point why they don't use derivatives are concerns about disclosures of derivatives activity required under FinancialAccounting StandardsBoard (FASB) rules and concerns about the perceptions of derivatives usage by investors, regulators, analysts, public and costs of establishing and maintaining derivatives programmes exceeding the expected benefits. The study concludes that most important objective of the firms behind the use of derivatives is to manage volatility in cash flows and the market value of the firm followed by managing the volatility in accounting earnings and managing balance sheet accounts or ratios. The study also shows that the most common instrument to hedge the exposure for contractual commitments or repatriations is options.

    From the above literature reviews it's been observed that firms consider derivative as a very important tool in managing risks and many firms' measure risks before including derivatives in their portfolios. Organisations widely use variety of derivatives to manage, reduce and hedge different kind of risks, mainly foreign exchange risk, interest rate risk, credit risks. Its been found out that firms manage these risks by using derivatives like - credit derivatives (credit default swaps, credit linked notes, total return swaps) currency derivatives, interest rate derivatives, equity derivatives etc.

    Aims of the study

    During recent days risk management became very important aspect of global banking and financial services industry. During recent volatile environment banks are facing a huge amount of risks such as - credit risk, foreign exchange risk, interest rate risk, liquidity risk and market risk which affects bank's survival and success. These risks can be effectively managed and reduced by using different kinds of derivatives. The main aim of this project is to conduct empirical analysis on the following elements:

    • To analyse the effective management of different types of risks with the help of derivative instruments.
    • To analyse banks risk management strategies and techniques to manage risks with the help of derivatives.
    Objectives of the study
    • To critically analyse importance of risk management strategies in banks during current difficult situations.
    • To describe the importance of derivatives in managing and reducing risks.
    • To analyse the best risk management practices adopted by banks in current global financial crisis.

    As my study is focusing towards effective risk management with the help of derivatives, in order to analyse this I would like to use secondary data as informational source for my study. As this information is very much advisable and feasible for my area of study where I can gather information regarding derivative and risk management techniques, different types of derivative instruments used for managing different kinds of risks, importance of risk management strategies in banks with the help of finance and economics journals, books, finance and investment websites.

    Along with this I will be critically analysing comparative case of risk management at Goldman Sachs and Lehman Brothers. As Goldman Sachs turned out be a biggest winner of the current financial crisis where as Lehman Brothers filed for chapter 11 bankruptcy. As Lehman Brothers lent huge amount of sub-prime loans and lost US$14bn in the crisis this made Lehman Brothers to file bankruptcy. However Goldman Sachs turned out to be the biggest winner of the financial crisis as it bought US$ 20bn worth of credit default swaps from AIG to protect against risks. This made Goldman Sachs real winner during current financial crisis. Adding to this I will be conducting a beta coefficient test on both the banks so that one can measure the risk and take appropriate steps to manage risks with the help of derivatives.

    Scope and limitations of the study
    • Date collection is done through secondary resources.
    • The time allotted for the study is very short for discussing it in detail.
    • Study analyses only limited risk management techniques with the help of derivatives.
    Proposed structure of the study

    Chapter 1: Introduction.

    Chapter 2: Literature Review - Risk management with the help of derivatives

    Chapter 3: Research Methodology

    Chapter 4: Research results and discussion.

    Chapter 5: Findings & Conclusions.


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    Electronic Reports
  • Yu, E. Chin, I and Hang, H. (2001). Managing risk by using derivatives: The Case of Hong Kong firms. Available: Last accessed 26 November 2009
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