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Role of Derivatives on Financial Products

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Title: "Derivatives are now a well established part of every financial institution's financially engineered products. Discuss, in depth, the role that derivatives are playing in financial products/portfolios and the risks that they remove (and create)"

Introduction

Past three decades have witnessed an expansion in global trade and continuing technological developments. This has resulted in an increase in market volatility and enlargement of business and financial risks and has led to an increase in demand for risk management products. The types of risks faced by corporations today have not changed; rather, they have become more complex and interrelated. The increase in demand for risk management products and the complexity of risks is reflected in the growth of spectrum of financial contracts called derivatives. Derivatives are now a well established part of every financial institution’s financially engineered products. Derivatives have become an integral part of the financial markets because they can serve several economic functions.

Though there has been an incredible growth in the derivative market, there has also been an increase in reports of major losses associated with derivative products. For example, derivatives led to a collapse of Barings Bank (the Queen of England’s primary bank), bankruptcy of Orange County California and also had a role in the fall of Enron. All this has resulted in a great deal of confusion about effectiveness of derivatives in risk management.

What are Derivatives?

Derivatives are complex instruments that have become increasingly important to the overall risk profile and profitability of organisations throughout the world. Broadly defined, derivatives are contracts that primarily derive their value from the performance of underlying assets. Derivatives contracts are entered into throughout the world on organised exchanges and through over-the-counter (OTC) arrangements.

Types of Derivatives

Derivatives come in various shapes and forms such as futures1, forwards2, swaps3, options4, structured debt obligations and deposits, and various combinations thereof.

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1Futures are contracts to buy or sell specific quantities of a commodity or financial instrument at a specified price at a specified time in the future.

2A forward contract obligates one party to buy the underlying at a fixed price at a certain future date from a counterparty, who is obligated to sell the underlying at that fixed price. (Source: Demystifying Financial derivatives, Rene A Stulz)

3A swap is a contract to exchange cash flows over a specific period.

4An option can be a call option or a put option. A call option on a stock gives its holder the right to buy a fixed number of shares at a given price by some future date, while a put option gives its holder the right to sell a fixed number of shares on the same terms.

Benefits of Derivatives

Derivatives are put to three key uses:

  • Hedging by entering into derivatives transactions for offsetting existing risks. The existing risks could be an investment portfolio, price changes of a commodity or perhaps investments in a foreign country. Derivatives make it possible to hedge risks that otherwise would be not be possible to hedge.
  • Speculating through hedge funds to generate profits with only a insignificant investment, essentially by putting money on the movement of an asset.
  • Exploiting Arbitrage opportunities throughout the world markets.

Thus, risk management is one of the primary purposes of derivatives.

Role of Derivatives in Risk Management

As indicated above, derivatives are important tools that can help organisations meet their specific risk-management objectives. Derivatives allow organisations to break up their risks and distribute them around the financial system through secondary markets. Thus, derivatives help organisations in risk management.

Risk management is not about the removal of risk but is about its management. An organisation can manage its risks by selectively choosing those risks it is comfortable with and minimising those that it does not want. Through derivatives, risks from traditional instruments can be effectively unpackaged and managed independently. If managed properly derivatives can help businesses save costs and increase returns.

In addition, derivatives make underlying markets more efficient. Derivative markets produce information which at time is the only reliable information available to base critical business decisions on. For example, reliable information about long-term interest rates can be obtained from swaps, because the swap market may be more liquid and more active than the bond market.

Using Derivatives

Many organisations use derivatives conservatively to counterbalance risks from fluctuating currency and interest rates. Individuals and firms use derivatives to achieve payoffs that they would not be able to achieve without derivatives, or could only achieve at greater cost.

Derivatives are used by both financial and non-financial institutions and organisations.

Financial organisations use derivatives both as risk management tools and also as a source of revenue. From a risk management perspective, derivatives allow financial institutions to identify, segregate and manage separately the market risks in financial instruments and commodities. Cautious use of derivatives provides managers with effective risk reducing opportunities through hedging. Derivatives may also be used to reduce financing costs and to increase the yield of certain assets. In addition, derivatives are a direct source of revenue through market-making functions, position taking and risk arbitrage to most of the financial organizations (source: http://www.bis.org/publ/bcbsc211.pdf).

Derivatives are used by non-financial organisations for hedging and for minimising earnings volatility. For example, derivatives are used to hedgeinterest-rate risks. If the company strongly believes that interest rates will drop between now and a future date, it could purchase a futures contract. By doing so, the company is effectively locking in the future interest rate. Similarly, companies that depend heavily on raw-material inputs or commodities are sensitive, sometimes significantly, to the price change of the inputs. For example, most airlines use derivatives for hedging against crude-oil price.

Some firms use derivatives to reduce tax liability and at times to speculate.

Risks Associated with Derivatives

Although derivatives are legitimate and valuable tools for hedging risks, like all financial instruments they create risks that must be managed. Warren Buffett, one of the world's most wise investors, states that “derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.” (Source: Gabriel Kolko, Weapons of Mass Financial Destruction)

On one hand derivatives neutralise risks while on the other hand they create risks. In fact there are certain risks inherent in derivatives. Derivatives can be dangerous if not managed properly. Numerous financial disasters such as Enron can be related to the mismanagement of derivatives. In the 1990s, Procter & Gamble lost $157 million in a currency speculation involving dollars and German Marks, Gibson Greetings lost $20 million and Long-Term Capital Management, a hedge fund, lost $4 billion with currency and interest-rate derivatives (Source: Ludger Hentschel and Clifford W. Smith, Jr., Risks in Derivative Markets) . It is key to consider that it has not been the use of derivatives as a tool which has led to the downfall of these companies but the misuse of such instruments.

The kinds of risks associated with derivatives are no different from those associated with traditional financial instruments, although they can be far more complex. Different derivatives have different risk profiles. For some derivatives though the risk may be limited, the profit potential may be unlimited. For example, the risk of loss with a derivative contract which grants a right to buy a particular asset at a particular price is limited to the amount paid to hold that right. However, profit potential is unlimited. On the other hand there are certain other derivatives that exhibit risk characteristics in which while potential gain is limited, the losses associated with the derivative is unlimited. For example, a derivative contract which grants the right to buy a particular asset at a particular price may have the associated potential profit limited to the amount received for giving that right, but because the asset has to be delivered to the counterparty at expiry of the contract, the potential loss may be unlimited.

Most of the risk of derivatives is due to the complexity of the structure of the derivative instruments. Apart from the structure of the instrument itself, the source of a lot of the risk associated with derivative contracts arises from the fact that they are leveraged contracts. Derivative products are ‘leveraged’ because only a proportion of their total market exposure needs to be paid to open and maintain a position. Thus, the market exposure with derivative contracts can be several times the cash placed on deposit as margin for the trade, or paid in the form of a premium. Derivative contracts also have the ability to create artificial wealth and this creates additional risk. The artificial wealth skews the values of underlying assets considerably.

Fundamentally, risks from derivatives originate with the customer and are a function of the timing and variability of cash flows.

Types of Risks Associated with Derivatives

In general, the risks associated with derivatives can be classified as credit risk, market risk, price risk, liquidity risk, operations risk, legal or compliance risk, foreign exchange rate risk, interest rate risk, and transaction risk. These categories are not mutually exclusive.

Credit risk

 

Derivatives are subject to credit risk or the risk to earnings or capital due to obligor’s failure to meet the terms of a contract. Credit risk arises from all activities that can only be accomplished on counterparty, issuer, or borrower’s performance. Credit risk in derivative products comes in the form of pre-settlement risk and settlement risk.

  • Derivatives are exposed to pre-settlement credit risk or loss due to failure to pay on a contract during the life of a transaction by the counterparty. This credit risk exposure consists of both the replacement cost of the derivative transaction or its market value and an estimate of the future replacement cost of the derivative. Even out-of-the-money derivative contracts have potential pre-settlement credit risk.
  • Derivatives are also subject to settlement risk or loss exposure arising when an organisation meets its obligation under a contract before the counterparty meets its obligation.

Settlement risk generally exists for one to two days from the time an outgoing payment instruction can no longer be cancelled unilaterally until the time the final incoming payment is received and reconciled. This risk is due to the fact that it is almost impractical to arrange simultaneous payment and delivery in the ordinary course of business. In the case of international transactions settlement risk may arise because of time zone differences. This risk is usually greater than pre-settlement risk on any given transaction.

Market risk

 

Derivatives are also subject to market risk Market risk or risk due to unfavorable movements in the level or volatility of market prices. Market risk results from exposures to changes in the price of the underlying cash instrument and to changes in interest rates. Though market risk can be created or hedged by derivatives such as future or swap in a clear-cut manner, it is not so simple in the case of options. This is because the value of an option is also affected by other factors, including the volatility of the price of the underlying instrument and the passage of time. In addition, all trading activities are affected by market liquidity and by local or world political and economic events.

Price Risk

 

Price risk is an extension of the market risk. Price risk is the risk to earnings or capital arising from changes in the value of portfolios of financial instruments. The degree of price risk of derivatives depends on the price sensitivity of the derivative instrument and the time it takes to liquidate or offset the position. Price sensitivity is generally greater for instruments with leverage, longer maturities, or option features.

Price Risk can result from adverse change in equity prices or commodity prices or basis risk. The exposure from an adverse change in equity prices can be either systematic or unsystematic risk. As equity markets can be more volatile than other financial markets equity derivatives can experience larger price fluctuations than other derivatives. Commodity derivatives usually expose an institution to higher levels of price risk because of the price volatility associated with uncertainties about supply and demand and the concentration of market participants in the underlying cash markets. Price risk may take the form of basis risk or the risk that the correlation between two prices may change.

Liquidity risk

 

All organisations involved in derivatives face liquidity risks. Liquidity risk is the risk to earnings or capital from an organisation’s inability to meet its obligations when they are due, without incurring unacceptable losses. This risk includes the inability to manage unplanned decreases or changes in funding sources. An organisation involved in derivatives faces two types of liquidity risk in its derivatives activities: one related to specific products or markets or market liquidity risk and the other related to the general funding of the institution’s derivatives activities or funding risk.

  • Market Liquidity Risk

Market liquidity risk is the risk that an organisation may not be able to exit or offset positions easily at a reasonable price at or near the previous market price because of inadequate market depth or because of disruptions in the marketplace. In dealer markets, market depth is indicated by the size of the bid/ask spread that the financial instrument provides. Similarly, market disruptions may be created by a sudden and extreme imbalance in the supply and demand for products. Market liquidity risk may also result from the difficulties faced by the organisation in accessing markets because of its own or counterparty’s real or perceived credit or reputation problems. In addition, this risk also involves the odds that large derivative transactions may have a significant effect on the transaction price.

  • Funding Liquidity Risk

Funding liquidity risk is the possibility that the organisation may be unable to meet funding requirements at a reasonable cost. Such funding requirements arise each day from cash flow mismatches in swap books, the exercise of options, and the implementation of dynamic hedging strategies. The rapid growth of derivatives in recent years has focused increasing attention on the cash flow impact of such instruments.

Operations risk

 

Like other financial instruments, derivatives are also subject to operations risk or risks due to deficiencies in information systems or internal controls. The risk is associated with human error, system failures and inadequate procedures and controls. In the case of certain derivatives, operations risk may get aggravated due to complexity of derivative transactions, payment structures and calculation of their values.

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Legal or compliance risk

Derivative transactions face risk to earnings or capital due to violations, or nonconformance with laws, rules, regulations, prescribed practices, or ethical standards.

The risk also arises when the laws or rules governing certain derivative instruments may be ambiguous. Compliance risk exposes an organisation involved in derivatives to fines, civil money penalties, payment of damages, and the voiding of contracts. Besides, legal and compliance risk may adversely affect reputation, business opportunities and expansion potential of the organisation.

Foreign Exchange Rates Risk

Derivatives traded in the international markets are also exposed to risk of adverse changes in foreign exchange rates. Foreign exchange rates are very volatile. Foreign exchange risk is also known as translation risk. Foreign exchange rates risk in derivatives is the risk to earnings arising from movement of foreign exchange rates. This risk is a function of spot foreign exchange rates and domestic and foreign interest rates. It arises from holding foreign-currency-denominated derivatives such as structured notes, synthetic investments, structured deposits, and off-balance-sheet derivatives used to hedge accrual exposures.

Interest Rate Risk

Interest rate risk is the risk to earnings or capital arising from movements in interest rates. The magnitude of interest rate risk faced by derivatives from an adverse change in interest rates depends on the sensitivity of the derivative to changes in interest rates as well as the absolute change in interest rates. The evaluation of interest rate risk must consider the impact of complex illiquid hedging strategies or products, and also the potential impact on fee income that is sensitive to changes in interest rates. When trading is separately managed, this impact is on structural positions rather than trading portfolios.

Financial organisations are exposed to interest rate risk through their structural balance sheet positions.

 

Transaction risk

 

Another risk associated with derivatives is transaction risk. In fact transaction risk exists in all products and services. Transaction risk is the risk to earnings or capital arising from problems with service or product delivery. This risk is a function of internal controls, information systems, employee integrity, and operating processes. Derivative activities can pose challenging operational risks because of their complexity and continual evolution.

Thus, derivatives are subject to various technical risks. The problems surrounding the use of derivatives in recent years have primarily been due to difficulty in understanding these risks and thus using appropriate derivatives for risk management purposes. Derivative use is sometimes misunderstood because, depending on the terms of derivative it may be used to increase, modify, or decrease risk. In addition to the technical risks highlighted herein, there may also be a fundamental risk that the use of these products may be inconsistent with entity-wide objectives.

Conclusion

Derivatives will continue to be an important business tool for managing an organisation’s risk management. In fact the significance of derivatives is expected to increase with the development of new derivative products that refine and improve the ability to achieve risk management and other objectives. However, it is important that organisation’s using derivatives for risk management completely understand the nature and risks of derivatives. This requires effective control is critical to any well-managed derivative operation.

 

References:

[Accessed 31 December, 2006]

  • Kenneth A. Froot, David S. Scharfstein, and Jeremy C. Stein, A Framework for Risk Management, Harvard Business Review, November-December 1994, pp. 91-102.
  • Ludger Hentschel and Clifford W. Smith, Jr., Risks in Derivative Markets,

http://fic.wharton.upenn.edu/fic/papers/96/9624.pdf [Accessed 30 December

2006]

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