Errol Danziger
Danziger Structured Finance
Introduction
“Risk” is a synonym for uncertainty or unfamiliarity. Something that is unfamiliar or unknown is more risky than something that is familiar.
All investments are based on a forecast of some kind, that is, on some assumption about the future. Every investment has uncertainty built into it and every investor is exposed to risks of various kinds. Investment return is therefore uncertain by definition and is thus the inevitable by-product of taking risk.
There are three categories of investment risk or financial risk: market risk, credit risk, and operational risk. Market risk is the risk of incurring losses due to changes in market factors—prices, volatilities, and correlations. It includes asset liquidity risk and the credit risk associated with investments. Market risk can, in turn, be subdivided into interest rate risk, equity risk, currency risk, commodity risk, and liquidity risk.
The omnipresent existence of financial risk means that risk management is essential to investment management. The overriding purpose of risk management is the preservation of wealth. In the long term, an investment manager focuses on expected return on investment. A risk manager, on the other hand, maintains that one cannot manage expected return, but one can manage risk. There is a trade-off between risk and expected return and one cannot be considered without reference to the other. This means that all risks that are associated with an investment have to be balanced with the investment opportunity and there should ideally be a balance between the intentional assumption of risk and the hedging of risk. The perception that there is a relationship between investment and risk is widely accepted in the banking sector. Modern banks do not manage investment portfolios: they manage risk—their long-term investment strategies are to define the risks to which they wish to be exposed and to manage that exposure appropriately.
The Role of Derivatives in Risk Management
A derivative contract is a bilateral agreement that provides for payment to be made by one contracting party to the other, the amount of such payment to be quantified at a future date based on the value of an asset, index, or rate at that future date. The asset, index, or rate, which determines the amount to be paid, is referred to as the derivative’s underlying. The underlying of a derivative is a specified interest rate, security price, commodity price, foreign exchange rate, index of prices or rates, or some other variable. A derivative is thus a financial instrument the value of which depends on the future performance of an asset of variable value, usually a cash market security or commodity, financial or commodity index, or notional amount. The notional amount of a derivative is a number of currency units, shares, bushels, pounds, or other units specified in the contract. A derivative requires no initial net investment or an investment that is smaller than would be required for a cash market investment and it permits net settlement or performance that is equivalent to net settlement. The settlement of a derivative contract with a notional amount is determined by the interaction of the notional amount with the underlying: the interaction may be by multiplication, or may be formulaic.
The main economic advantage of derivatives is that they facilitate the transfer of financial risks. Derivatives facilitate efficient and cost-effective risk management. The need for such risk management arises because participants in investment markets have different perceptions of risk. They may wish to reduce or eliminate risk, they may accept a certain level of risk but wish to stabilize risk at that level, or they may wish to increase the level of risk that is assumed. They do this by transferring risk to other market participants or by assuming risks of other participants that are transferred to them.
Derivatives are thus used for trading, hedging, and arbitrage. Trading with dividends involves entering into risk positions, with the object of earning profits when forecasts are met. Most derivative trading involves traders and hedgers, who secure the equilibrium and liquidity on the exchange-traded futures and options markets. A trader wishes to assume the very risk that the hedger wants to eliminate. Hedging is the process of securing an existing or planned portfolio against market fluctuations. Hedgers use derivatives to reduce funding costs, diversify sources of funding or avoid market volatility. Arbitrage constitutes the making of trades in order to exploit market imbalances for the purpose of making risk-free profits. Arbitrageurs ensure that the prices of forward transactions deviate minimally, if at all, and for a short time only from their theoretical values.
The success of derivatives has been attributable to the market risks embodied in the high volatility and associated risks relating to currency, equity, and bond markets. Managing those risks is critical for investment success. An investor may wish to avoid the risk of incurring losses on his portfolio. A speculator may wish to deliberately undertake increased risk in order to earn profits from forecasting market development correctly. They enable investors to transfer unwanted risks to other market participants.
Although derivatives allow investors to manage the financial risks associated with their investment transactions, there are also risks inherent in the use of derivative products, many of those risks being market-related.
The Classification of Derivatives
Derivative contracts are classified based either on the manner in which they are entered into, or based on the type of rights and obligations that they bring into existence.
Based on the manner in which derivative contracts are entered into, there are two broad classes of derivatives: ETD (or exchange-traded derivatives); and OTC (or over-the-counter derivatives).
Exchange-traded derivatives, such as commodity futures and listed equity options, are standardized contracts that are actively traded on public exchanges. A clearing house acts as the central counterparty for each transaction. In order to protect itself from default by any market participant, the clearing house requires each market participant to pledge collateral called “margin” for each open position, that is, for each contract for which performance is pending. Profits and losses on each contract are calculated and netted at the end of each trading day and, at the opening of the market on the following trading day, the exercise price of the contract is adjusted to match the previous day’s closing spot price of the underlying.
Margin covers the maximum expected loss that might be incurred by the market participant on the following exchange trading day. Unlike payment against delivery for cash market transactions, which must take place within two or three days of the completion of the transaction contract, settlement of exchange-traded derivatives takes place on specific dates, called the settlement date. Thus exchange-traded futures and options contracts provide for settlement on just four specific dates during the year.
Exchange-traded derivatives have standardized contract specifications, and are revalued marked-to-market—or margined daily by the clearing house. By entering into a counter transaction, an investor can neutralize (close out) his contractual rights and obligations prior to the maturity date of the contract. Any profits or losses incurred on a contract that has not been closed out are credited or debited daily. Organized derivatives exchanges thus provide investors with the facilities to contract based on market perception and in accordance with appetite for risk, but without having to buy or sell the underlying commodities, securities, or equities. Exchange-traded derivatives comprise a mature market that has been active for decades and the traded instruments that are traded on the exchanges are regulated by the exchanges on which they are traded as well as by governmental securities authorities. Because exchange-traded derivatives are actively traded, the market performs a constant pricing function.
OTC derivatives are derivative contracts that are individually negotiated and customized for the specific needs of a particular investor. They meet a specific investment or trading requirement more easily than a standardized derivative. OTC derivatives often have an element of both risk hedging and speculation, so that the same derivative contract may be a hedge for one end-user and a speculation for another. OTC derivatives are repriced periodically, usually monthly or six-monthly, by a process called “marking-to-market.” Customized OTC derivatives may have a limited or no trading market and, therefore, no market price. Market participants determine prices themselves, using complex and often proprietary pricing models.
Every derivative contract has either a forward-based format or an option-based format. Forward-based derivatives include forward contracts, futures contracts and swap agreements. A forward-based derivative has a symmetrical risk profile, in which the seller’s loss equals the buyer’s gain, and vice versa.
Forward contract. A forward contract is an OTC derivative that is customized for the needs of the contracting parties. It provides that one party will buy and the other party will sell a designated quantity of the underlying at a pre-agreed price on a specified future date. Contractual performance takes place at maturity of the contract, on which date either cash settlement, that is, the cash value of the contract, or the underlying is conveyed through physical delivery by the seller to the buyer. A forward contract functions in the same way as an insurance policy, limiting both profits and losses. This is called reduction of variance, where “variance” is defined as the extent to which possible outcomes depart from the expected return, so that an event with only one outcome has zero variance. Because a forward contract limits losses as well as profits, on account of the requirement to make a fixed payment to the counterparty notwithstanding favorable or unfavorable price variations in the underlying, possible outcomes will depart less from the expected return when a forward is used to limit risk exposure.
Because a forward contract calls for bilateral future performance, however, it involves significant credit risk, in the form of risk of loss for both parties resulting from the contracting counterparty failing to perform. As the value of the forward contract is only conveyed at maturity, price changes can lead to large gains or losses on the contract by either party. The gain to one counterparty in a forward-based transaction is always equal to the loss incurred by the other party. This is called symmetry of risk and it is the most important feature that distinguishes forward-based transactions from option-based transactions.
Futures contract. A futures contract is a forward-based derivative that is standardized and exchange-traded. Standardization of futures contracts results in the quantity and quality of the underlying, the time and place of delivery of the underlying and the method of payment in respect of each contract of the same series of futures contracts being identical, with only the price being negotiated. Standardization of a futures contract implies that it is fungible and can therefore be transferred from investor to investor.
Standardization and fungibility results in futures markets being highly liquid. This market liquidity, together with small contract size, facilitates the ability of a large number of investors and speculators to be able to trade in futures. Futures contracts are settled by physical delivery or close out, so that where the price of a futures contract rises, the contract buyer can realize a profit by selling the contract: closing out by entering into a counter-transaction releases both contracting parties from their contractual obligations.
Swap agreement. A swap agreement is a notional principal contract that obligates the two contracting parties to exchange payment streams that are based on a notional amount, on periodic payment or settlement dates. The notional amount, which is the underlying of the swap, is not usually exchanged and the two payment streams are usually netted, with only the difference being paid by the party who is the net debtor to the creditor party.
Economically, a swap is the equivalent of a series of forward contracts. Each swap payment date or swap settlement date effectively represents the maturity date of one forward contract and the commencement of a new contract that will mature on the next settlement date. Swaps are individually negotiated and are not exchange-traded.
Option contract. An option is a contract or financial instrument under which the grantor or writer of the option gives the option grantee or holder the right, but not the obligation, by exercising the option, to buy—in the case of a call option—or to sell—in the case of a put option—a specified asset at a predetermined price, called the strike price of the option, at either a fixed future date, or on one or more of a specified number of future dates, or on a date chosen by the option holder not later than the last day for exercise of the option.
The option holder pays a fee, called the option premium, to the grantor for the rights conferred by the option contract. Where the holder of the option has not exercised it by the last day fixed for exercising the option, the option expires unexercised and the option premium remains the property of the option grantor. Because the option holder can choose to either exercise the option or let it expire unexercised, the holder benefits from favorable price movements in the underlying, but loses only the premium paid for the contract in the event of unfavorable price movements. The option grantor, on the other hand, has committed to a firm obligation with respect to the underlying: he has no discretion with regard to the exercise of the option, and must stand ready to sell to or buy from the option holder, in the event that the holder chooses to exercise the option. Consequently, option-based derivatives involve asymmetrical risk, because the option buyer risks only the option premium, while the seller’s potential loss is unlimited.
Option-based derivatives are used mainly for hedging and for speculation. Speculators use options because of the leverage that options grant relative to the value of the underlying, “leverage” meaning that a percentage change in the underlying will result in a greater percentage change in the value of the option. Speculating in options can, therefore, be more profitable and more risky than investing directly in the underlying. Speculators seek to increase risk, and thus return, and profit from market price fluctuations in the option contract itself. An option can also be used for reducing or maintaining risk through hedging. Hedgers seek to reduce the risk of current or anticipated investments through the use of an offsetting option position.
Risks Associated with Derivatives
The risks of using derivatives—market risk, credit risk, legal risk, operational risk, liquidity risk, and systemic risk—are not unique and are also encountered in traditional lending or investment. But it should be noted that the use of OTC derivatives is often particularly risky, because these contracts are customized for the needs of a particular counterparty with the result that risks associated with the use of the contracts may be assembled in new and unexpected ways.
Market risk is the risk of loss from adverse price movements in the market for the underlying asset. Investors typically manage market risk on a portfolio basis, combining offsetting positions to determine net risk exposure, and hedging any net excess risk by entering into futures or options contracts. To determine the net risk of a portfolio, an investor deconstructs the contracts that make up the portfolio according to their underlying market risk factors—delta, elasticity, convexity, volatility, time decay, basis and discount rate risk—so that those risks can be netted or managed in some other way.
Delta is the name given to the rate of change in the value of a derivative contract for a given change in the value of the underlying asset. For example, the value of an option with a delta of 0.5 changes to the extent of 50 pence for every £1 that the value of the underlying changes. A derivative contract or investment portfolio is said to be “delta hedged” or “delta neutral” if a derivative has been entered into to offset the value of the underlying in proportion to the delta of the contract or the portfolio. Delta is always a value between 0 and 1, which means that, ignoring other distortive factors, the value of a derivative cannot change to a greater extent in absolute terms than the value of the underlying. A swap usually has a delta of 1, so that a price movement in the underlying produces an equivalent price movement in the swap. The delta of an option moves less linearly from 0 to 1, as the option moves from having a negative value to having a significantly positive value; in other words, the closer that an option is to having a positive value, the faster delta changes. Convexity risk is the rate of change in delta relative to changes in the price of the underlying.
In percentage terms, the price fluctuations of futures and options, relative to invested capital or to pledge collateral, are much greater than those of the underlying instrument. This is called the leverage effect. Leverage may also be defined as the ability of an investor to control a large notional amount of an underlying through a relatively small capital outlay. Both forward-based and option-based derivatives are leveraged, because at a comparatively small capital cost in the form of margin or premium, the investor is exposed to a significantly larger amount of the value of the underlying. This means that investing or pledging a small capital amount can control larger amounts. The trading of derivatives can thus offer great profit potential, but can also offer an extensive exposure to risk. In the context of options, leverage or elasticity is a measurement of the percentage change in the price of an option given a 1 percent change in the price of the underlying. Elasticity of options is usually positive, so that for example, a 1 percent change in the price of the underlying option is usually accompanied by a percentage change greater than 1 percent in the option premium. This relationship is called the “leverage factor” of options.
The existence of liquidity implies that the derivative contracts can be entered into at any time, in any volume, without overly affecting market prices. The trading of standardized contracts in public derivative markets ensures market liquidity because it results in a concentration of order flows. Flexibility is thereby ensured, so that investors and speculators can contract based on market assessment and appetite for risk.
Volatility risk is the degree to which the value of an option is affected by changes in volatility levels, in other words, price movements of the underlying asset. Volatility is an important factor in option pricing, because the more volatile the price of an underlying, the underlying rate or the return generated by the underlying, the greater the value of the option in respect of that underlying. Common measures of volatility are historical volatility and implied volatility. Historical volatility measures past market movements, but may not be an accurate indicator of future volatility and, consequently, is seldom regarded as an accurate index for use in option pricing. Implied volatility is derived from all the known characteristics of an option that must have been used in establishing and maintaining the option’s market price. Because volatility is the only pricing input other than short-term interest rates that is not directly observable, its source requires subjective determinations and estimation. Volatility is a critical measure in the hedging of an option portfolio, because implied volatility often changes without any change occurring in the price of the underlying asset.
Time decay is the loss in value of an option due to the passage of time, assuming constant price and implied volatility of the underlying. An option that has the same price as the value of the underlying asset, or a price which is below that of the underlying asset, loses value over time, because, as the option approaches maturity, the probability that it will acquire positive value decreases.
Basis risk or correlation risk is the risk of market inefficiency, that is, the risk that the price of a derivative will not be perfectly correlated with the price of the underlying asset in its cash market. Basis risk translates into the risk that hedges composed of offsetting contracts in the cash and derivatives markets may become unbalanced, thus resulting in hedge imperfection.
Discount rate risk is the risk that the value of a derivative will be affected by changes in the market interest rate used to discount future cash flows to present value. For options, a higher discount rate usually means a higher value for call options and a lower value for put options, due to the lower present value of the exercise price.
The Management of Market Risk
There are many different ways in which derivative holders, whether dealers or end-users, manage market risk. Dealers mark contracts to market at least daily, or calculate the market risk of a derivatives portfolio daily, while taking into account all major market risk components, and comparing the result to pre-established market risk limits.
The price of a forward-based derivative is based on the price of the underlying asset, adjusted for the time differential between the contract date and the settlement date. The reason for such adjustment is that the buyer earns interest on the deferred purchase price during the period for which the contract is open and avoids incurring costs of carry during that period, while the seller may derive a convenience yield benefit by holding the underlying in inventory during the contract period. Forward-based derivatives are subject mainly to the market risk factor of delta and are not usually susceptible to elasticity, time decay, volatility, or convexity risk, so that changes in the price of the underlying produce proportional changes in the value of the derivative.
Although forward-based derivatives are subject to basis risk and discount rate risk, these risks are seldom hedged. The hedging of a forward-based derivative involves the aggregation as a group of derivatives of similar asset classes, so that forwards offset other forwards and any residual risk is delta-hedged. Forward-based derivatives have relatively straightforward market risk profiles, so that the hedging and monitoring of risk is easier than is the case for option-based derivatives. A forward-based derivative can thus be hedged with a proportional amount of the underlying and the hedge will remain stable.
The exposure of option-based derivatives to market risk factors results in greater complexity. Because option-based derivatives are subject to convexity risk, the relationship between the option price and underlying asset price is not constant. Options are also subject to volatility risk and time decay risk, even if the price of the underlying remains constant. The basis of an option, however, is usually left unhedged. Consequently, a delta-hedged options portfolio is not static and is monitored and readjusted over time, in a process called “dynamic hedging.” Dynamic hedging involves its own risks; thus, the cost of hedging may be greater than expected, or prices may move significantly before positions can be adjusted, resulting in losses. A decision must be taken how often to rehedge as a result of price changes in the underlying or expected price volatility. The more frequently the hedge is balanced, the greater the protection against loss, but frequent adjustments involve expense. This means that successful dynamic hedging depends on accurate forecasts of both market volatility and interest rates. Option-based derivatives of similar classes are thus aggregated and managed as a group, by the offsetting of options with options and dynamic hedging of any residual risk arising from mismatches in the options portfolio.
Basis risk or correlation risk is caused by inefficiencies between the derivatives market and the underlying market. This risk is beyond the control of the investment manager and cannot therefore be hedged. Interest rate risk can be hedged by acquiring short-term securities, such as UK government gilts.
Market risk may also be measured as value-at-risk or capital at risk, using probability analysis based on a common confidence interval and time horizon, with “capital at risk” defined as the maximum loss expected to be exceeded with a set probability over a fixed period.
An Assessment
The widespread use of exchange-traded derivatives had a modest start in the mid-20th century, when most transactions were in respect of commodities. Since then, the number and subject matter of standardized derivative contracts, both commodity-based and financial, has increased significantly and the use of such contracts, both by producers and commodity users, as well as by speculators, has grown dramatically. In tandem with this development, the use of OTC derivatives has also grown hugely, as more opportunities for harnessing the benefits of derivatives have been identified.
The growth in derivative use, however, has not been uneventful. Major losses have been incurred by derivative market participants and these losses have been widely publicized. In the 1980s, the London borough of Hammersmith and Fulham, which had contracted interest rate swaps for speculative reasons, defaulted on these contracts after having incurred large losses due to an adverse movement in interest rates; the House of Lords subsequently held that the borough was not liable on the contracts as it had lacked the statutory authority to enter into them. In the early 1990s, US company Gibson Greetings lost substantial amounts on interest rate swaps that it had contracted in an attempt to control its interest expenses. At about the same time, Procter & Gamble incurred large losses on complex total-return swaps that it had entered into in an attempt to alter the profile of its interest receipts and expenses, and Orange County of California filed for bankruptcy after it incurred huge losses, having entered into reverse repos and inverse floaters, which were less usual derivative contracts but were highly leveraged, and generated enormous losses due to adverse market interest rate movements. In 1995, short straddles entered into by Nick Leeson in relation to financial futures traded on Asian markets resulted in the failure of his employer, Barings Bank. In 1998, hedge fund Long Term Capital Management incurred large losses as a result of having entered into total-return swaps based on the value of Russian government securities, which defaulted; LTCM was rescued by the US treasury authorities and a number of large banks, which sought to avoid any domino effect on other financial sector firms. The bankruptcy of Enron in 2001 was partly due to its failed market-making attempts with regard to commodity derivatives.
These events have given rise to a degree of nervousness mixed with skepticism, regarding both the usefulness of derivatives and the extent of the corporate and systemic risks that their use has created, both for end-users and for the financial system in general. Suspicion about derivatives is typified by a 2003 claim by Warren Buffett that derivatives are time bombs and financial weapons of mass destruction.
The other side of the picture is that prophesies of derivative-triggered doom have neither been realized, nor is there any real sign that they ever will be. The numbers of derivatives contracted and the value of underlying and notional amounts is constantly increasing. New investment-related uses for derivatives are frequently being explored and offered to market participants. Trading companies are becoming more accustomed to compiling a risk balance sheet and to harnessing derivatives in order to lay off non-core risks to others more willing and able to bear those risks.
Moreover, there is a growing awareness on the part of corporate managements of the potential of derivatives to increase desirable risk and to attenuate risk that managements seek to avoid. This has been exemplified by the widespread use by large banks of interest rate swaps to manage interest rate risk and of credit default swaps to avoid sectoral and customer-centered credit limits.
The challenge for the future will be to educate managements in other sectors about the benefits of derivatives and to increase the usefulness of derivatives through lateral creativity with regard to the ways in which derivatives can usefully be put to work. All of these factors point to a burgeoning future role for derivatives, as more and more interest is focused on the commercial usefulness of the contracts.
Editors Update
Recognize that this was drafted in 2007 just prior to the crisis and indeed derivatives (in particular, OTC derivatives) performed amazingly well during the crisis. However, regulators were concerned about a perceived lack of transparency in the market. I am far from sure where they obtained these concerns from since in a professional’s market such market making activities are clearly of general benefit. Rather than implementing a systems of post trade notification, which would have been both cheap and would not have distorted the market, regulators have instead tried to shoehorn the OTC market into an STD structure.
This is a mistake which they will regret. It was unnecessary. The previous structure enabled professional firms to utilize credit mitigation techniques to minimize the risk. That has now been replaced with placing collateral in the form of margin at exchanges. This undermines the financial pricing of derivatives and had rendered some parts of the market moribund. As we move into an increasingly risk volatile world the importance of derivatives for both currency and interest rates has never been clearer. When the next crisis comes, which is likely to be a too small to survive crisis, these new regulations will be seen to hinder the solutions we would wish to employ.
I provide one final parting shot. There is no transaction that you need to send to central counterparty if you think through what you are trying to achieve. There are better and more cost-effective alternatives available if only you allow yourself to consider them. As regulations change the solutions change with them and innovation is required. That this is in part innovation back to the past is perhaps even more surprising. The risk managers need to drive and be part of this movement and not just be another part of the ban k allowing regulation to dictate decisions which will be seen with hindsight to have been inappropriate.
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