We are very fortunate to have a guest post from a seasoned financial expert, Zachary. Get on your thinking caps, readers. He is addressing a crucial if complicated subject with which we need to become familiar, if we aren’t already.
Derivative Contracts as Risk Management Tools
Laymen, and even some financial professionals, can be excused for being confused by media coverage and government pronouncements about derivative contracts. Most of this material has been prepared either by non-professionals with little actual knowledge, or by high-level professionals whose written product is replete with specialized vocabulary and statistical concepts that most people do not have the background to understand.
Contrary to the impression given by the media, derivatives are not at all a new concept. They are contracts whose value comes from (is “derived” from) the value of a specified commodity, or risk-based financial instrument.
The earliest contracts arose in agriculture, when farmers would attempt to protect the value of a crop that could not be sold until a later date. They would enter into a contract today to sell all or a portion of their crop at a specified future date at a specified price, thus, in effect, insuring themselves against possible declines in market prices.
As international trade grew, buyers and sellers had an additional risk factor to deal with in the form of possible changes in the value of foreign currency. They would approach their bankers to assist them with this problem, and the banks, in attempting to manage their risks with foreign currencies, developed active foreign exchange markets, and various types of derivative contracts (i.e. contracts whose value depended on foreign exchange rates) to manage that risk.
Over time the tools for accurately valuing these contracts became progressively more sophisticated. By the mid-1990s, it was possible to enter into derivative contracts covering such arcane things as ocean freight rates, and bunkers (fuel) for ships. Various trading houses began to use derivative contracts, in combination with a variety of other financial instruments, to create the complex financial instruments that many people believe were at the heart of the financial meltdown [that many others feel is not yet over].
Historically, derivative contracts were instruments created in order to allow the parties to the contracts to manage or control various risks they faced in the economic environment. They served a bona fide economic purpose, and could generally be considered a good thing. I would like to emphasize this point, because it was the abuse of these contracts, using self-serving risk management practices that resulted in the problems we experience today.
Risk Management for Derivatives
The first step in any kind of risk management is to measure the cash flow from all the instruments in the portfolio. In complex portfolios, the calculation is itself complex: so complex in fact that it could not be done with the then existing technology.
Before the advent of cheap computing power, therefore, risk managers simply made assumptions: typically, that the risk was 15% to 20% of the face amount of the contract. This approach lacked precision, as the percentage was arbitrary.
Note: Much of the media discuss derivatives in terms of the face amounts of the contracts, known in the trade as “notional amounts.” But the actual amount at risk is, with very few exceptions, far less than the notional amounts. This is because as long as there is an active market in the commodity or financial instrument to which the contract refers, the parties may acquire another contract taking the opposite risk direction.
An important corollary: Notional amounts are poor, highly misleading measures of risk. They do not take into account risk positions in the opposite direction: In fact, such offsetting risk positions are added to the total notional amount, rather than deducted from it, as would be more appropriate.
On the other hand, risk management professionals focus on the NET amount at risk, as they should, [not the face amounts].
Statistically based Value at Risk [VAR] systems, made possible only by the availability of large amounts of cheap computing power, were the next phase in the development of risk management principles. VARs have dominated the market for quite some time. This concept calculates the potential risk in derivative contracts on the basis of historical variations in their prices. As a general rule, bank regulators have pressed banks to use very conservative measures–three standard deviations rather than two, for example–and then require additional allowances for high stress situations. This is referred to as “stress testing.”
As risk management principles became more and more statistically based, they were increasingly sensitive to a) the actual variation and relationship between the factors; and b) the intensity of the stress situations.
Long Term Capital Management (LTCM), a hedge fund manager active in the early 1990s, was owned and staffed by people with expertise with complicated statistical models. They believed their models, and at times stretched the credibility of underlying relationships. For example, a transaction based on Russian Government bonds was hedged with oil price derivatives, on the theory that Russian Government bonds would move to some degree along with certain Russian oil prices. When the transaction failed, it turned out that the resulting losses were much larger than anticipated. In statistical terms, the stress was way beyond what was expected.
The LTCM Russian transaction was not a normal banking transaction. However, 10 years later, bankers were still structuring transactions in which they tried to hedge risks by accepting as fact statistical relationships that had no basis in reality. There has been little change: For example, transactions were structured to hedge the values of securities issued on the basis of underlying mortgages, without taking into account that the underlying volatility of real estate-based securities was inherently much greater than for other interest bearing securities. This was because of the relationship between interest rates and mortgage re-financing: As interest rates decline, mortgage re-financing tends to increase as borrowers act to reduce their costs. The faster that rates decline, the greater will be the level of re-financing. The “bottom line:” The value of these securities is highly volatile, materially impacting the risk to the parties writing credit derivatives on their value.
Derivatives can be a valuable part of any risk management strategy. However, if they are not governed by sound risk management practices (including but not limited to conservative reserving) they can be counterproductive and dangerous. Abuse and media hype have added to both the confusion and hysteria.
Here’s your opportunity to ask an expert your questions about risk management and derivatives!
Folkenflik wrote that major newspapers in Chicago, Houston and San Francisco admitted that they published print and/or online items under fake bylines.
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