Page 188 - DCOM510_FINANCIAL_DERIVATIVES

Unit 12: Risk Management of Financial Derivatives

Market deregulation, growth in global trade, and continuing technological developments have Notes
revolutionised the financial marketplace during the past two decades. A by-product of this
revolution is increased market volatility, which has led to a corresponding increase in demand
for risk management products. This demand is reflected in the growth of financial derivatives
from the standardised futures and options products of the 1970s to the wide spectrum of over-
the-counter (OTC) products offered and sold in the 1990s.

12.1 Risks Associated with Derivative Activities

Risk is the potential that events, expected or unanticipated, may have an adverse impact on the
bank’s capital and earnings. There are nine categories of risk for bank supervision purposes.
These risks are: strategic, reputation, price, foreign exchange, liquidity, interest rate, credit,
transaction, and compliance. These categories are not mutually exclusive. Any product or service
may expose the bank to multiple risks.

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Caution Derivative activities must be managed with consideration of all of these risks.
Many products and instruments are often described as derivatives by the financial press and
market participants. Financial derivatives are broadly defined as instruments that primarily
derive their value from the performance of underlying interest or foreign exchange rates, equity,
or commodity prices.
Financial derivatives come in many shapes and forms, including futures, forwards, swaps,
options, structured debt obligations and deposits, and various combinations thereof. Some are
traded on organised exchanges, whereas others are privately negotiated transactions. Derivatives
have become an integral part of the financial markets because they can serve several economic
functions. Derivatives can be used to reduce business risks, expand product offerings to customers,
trade for profit, manage capital and funding costs, and alter the risk-reward profile of a particular
item or an entire balance sheet.
Although derivatives are legitimate and valuable tools for banks, like all financial instruments
they contain risks that must be managed. Managing these risks should not be considered unique
or singular. Rather, doing so should be integrated into the bank’s overall risk management
structure. Risks associated with derivatives are not new or exotic. They are basically the same as
those faced in traditional activities (e.g., price, interest rate, liquidity, credit risk).

Notes Fundamentally, the risk of derivatives (as of all financial instruments) is a function
of the timing and variability of cash flows.
Derivatives are high-risk instruments and hence the exchanges have put up a lot of measures to
control this risk. The most critical aspect of risk management is the daily monitoring of price
and position and the margining of those positions. The exposure from an adverse change in
foreign exchange rates is a function of spot foreign exchange rates and domestic and foreign
interest rates. Any forward premium or discount in the value of a foreign currency relative to
the domestic currency is determined largely by relative interest rates. Foreign exchange rates
can be and have been very volatile (e.g., EMS crisis of 1992). Accurate measurement of derivative-
related risks is necessary for proper monitoring and control. All significant risks should be
measured and integrated into a bank-wide or corporate-wide risk management system.

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