Derivative products serve many important purposes for corporations, institutional investors, and other end users. Used properly, derivatives are powerful and efficient tools for, among other things, lowering funding costs, enhancing investment returns, and hedging interest and exchange rate exposure.
But as the recent experiences of the Proctor & Gamble Co., Askin Capital Management, and many others illustrate, derivatives also pose substantial risks.
The risks, often only vaguely understood, have caused industry, groups, lawmakers, central bankers, and other to ponder both the potential impact of derivatives on the stability and effective functioning of financial markets, and the potential need for additional regulation.
They have also caused senior management of many end users to reevaluate the suitability of derivatives for their institutions.
The following discussion is intended to assist end users in understanding derivatives risks by clarifying the principal types of risks and the methods used to manage them.
Market Risk. This is the risk of a change in a derivative's value due to a change in the price of the underlying index or asset. Derivatives' market risks are similar to those of forwards and options, since derivatives in essence are bundles of forwards and options.
A forward obligates one party to buy and the other to sell the underlying at a specified time and price; an option grants the holder the right, but not the obligation, either to buy or to sell the underlying asset at a specified time and price.
The market risk of forward-based derivative is straightforward, since changes in value tend to be directly proportionate to changes in the price of the underlying asset. But the market risk of an option-based derivative can be far more complicated, because it depends on the variables of option valuation, e.g., the option's exercise price, the time remaining to expiration, and the volatility of the underlying.
Market risk is managed by frequently marking a portfolio to market. The resulting valuations can then become the basis of an appropriate hedging strategy involving entering into offsetting transactions, taking opposite positions in underlyings, and closing out positions on negotiated bases.
Credit Risk. To an end user, this is the risk that a dealer will default in performing its contractual obligation. Credit risk creates exposure equal to a contract's replacement cost, or market value which for forwards is the net present value of all future cash flows. And derivatives are zero sum transactions where a gain to one party is a loss to the other. Therefore, positive market value to an end user is negative to the dealer, and visa versa. A party whose contract has positive market value is "in the money" and has extended credit to the counterparty, which is "out of the money."
Proper credit risk management begins with calculations of a portfolio's current credit exposure. Commentators strongly recommend that end users also track future, or "potential" exposure, based both on expectations of probable future market conditions and on "worst case" scenarios.
With exchange-traded futures, which are similar to forwards except that all nonprice terms are standardized, credit risk is managed by daily settlement of gains and losses and by performance bond and margin requirements. In addition, contracting parties have minimal credit exposure, since the conterparty to every futures trade is a clearinghouse, not an individual firm or exchange member.
In contrast, an end user of over-the-counter derivatives manages its credit exposure by setting, monitoring, and adhering to dealer credit limits and creditworthiness standards. Dealers need high credit ratings to compete, and their creditworthiness is relatively easy to asses, especially since Moody's Investor Service Inc. now assigns counterparty ratings to virtually all U.S. bank and thrift Institutions active in the derivatives market.
An end user with a high credit rating should also insist that any collateralization requirement imposed by a dealer be made applicable to both parties.
Legal Risk. This is the risk of loss due to the unenforceability of an in-the-money contract. From the end user's perspective, perhaps the greatest enforceability risks arise in connection with bankruptcy and insolvency. Most derivatives are documented with "master agreements" that contain the basic terms of the parties' relationship, except that the economic terms of each trade are set forth on separate confirmations supplementing the master.
A master is typically based on an industry form, such as the 1992 master agreements prepared by the International Swap Dealers Association. The terms of a master agreement will, among other things, permit a party to terminate the agreement and all related trades upon the counterparty's bankruptcy or insolvency.
It further provides for "close-out netting" whereby the nondefaulting party calculates the market value of each trade at termination based on a methodology stipulated in the contract, and then,aggregates all resulting values to reach a single, net termination value payable to or by the nondefaulting party. The master agreement normally permits a nondefaulting party to apply collateral it holds toward any termination payment owed to ti by the defaulting patty.
An end user must, however, carefully consider the effects of applicable bankruptcy laws on the enforceability of its master agreements. Bankruptcy laws in many countries raise concerns over the ability of a nondefaulting party to enforce early termination rights, close-out netting provisions, and related contractual rights against the bankrupt defaulting party without the bankruptcy trustee's consent.
Prior to receiving consent a nondefaulting party would have been exposed to swings in its portfolio's market value and, despite bankruptcy protections, in the value of its collateral.
Also, there was gear concern that bankruptcy and insolvency rules permitted a trustee or receiver to "cherry pick," or reject an insolvent dealer's out-of-the-money contracts and accept, or continue, only its in-the-money contracts. Cherry picking could cause serious losses, because nondefaulting parties would have to continue making full payment on their losing trades while receiving only a claim in bankruptcy for their gains. Bankruptcy concerns with institutions organized in the U.S. have diminished due to recent amendments to the Bankruptcy Code and to similar laws governing the insolvency of financial institutions not subject to the Code. The amendments expressly permit the exercise of termination fights and rights to apply collateral, and they uphold close-out netting.
However, the scope of the amendments is somewhat uncertain, because they apply only to expressly enumerated types of products and to products similar to those enumerated. So, rights of parties to equity derivatives, for example, which are not enumerated, might not be protected by the amendments. Also, significant enforceability concerns remain with respect to foreign dealers whose bankruptcies would not be subject to U.S. laws.
Therefore, before entering into a master agreement, an end user should seek assurances regarding both the legal nature of the proposed transactions and, if applicable, the bankruptcy rules of its foreign dealer's country of organization. Such assurances can often be obtained from U.S. and foreign counsel involved in the transaction and from publicly available legal opinions and memoranda rendered to or prepared for regulators and industry groups by U.S. and foreign law firms.
End users should also consider lowering credit limits for dealers organized in countries whose bankruptcy laws do not recognize early termination rights, close-out netting, and rights against collateral. They should avoid, or lower exposure limits for, products as to which legal assurances are not received.
Documentation Risk. This risk encompasses losses resulting from inadequate documentation. Most agreements are prepared on industry forms edited by dealers to fit particular transaction. Often the end user reviews the edited version simply to confirm the accuracy of basic economic terms and identifying information while assuming the remainder of the terms are well-balanced and straightforward.
Although the forms may be fair, they permit parties to make modifications and elections that substantially alter the forms' effects. An end user's failure carefully to review the edited versions could result in substantial losses. For example, a critical issue to an end user is the method of payment to apply upon a default termination.
The ISDA master agreements permit the parties to elect limited two-way payments using the "first method."
This can be dangerous, since the first method is in essence a walk-away clause that excuses an out-of-the-money nondefaulting party from making the termination payment it would otherwise have had to make.
Put differently, the clause might exacerbate a financially troubled end user's condition by causing it to forfeit its gains precisely when they are needed most. Similarly, a recent buyer of fully paid currency options signed a contract that permitted the dealer to terminate upon adverse changes in the buyer's financial condition -- even though the buyer had no remaining payment obligations.
Also, master agreements may permit one party to terminate the agreement or suspend its payment obligations due to the other's failure to provide "adequate assurances" of its ability to perform. But "adequate assurances" is undefined and open to interpretation.
For example, does it require the posting of collateral? Or, the delivery of a letter of credit? Or, might the delivery of current financial statements suffice?
In general, derivatives documentation raises many of the same issues found in traditional credit documentation.
Although standardized forms are used, they remain complex, sophisticated documents intended to leave a host of critical issues to be resolved by negotiation between the parties.
Operational Risks. These encompass risks ranging from inadequate senior management supervision to back office failures.
An important aspect of the management of these risks is the development of adequate systems and controls. These include the adoption of written policies and procedures and the performance of routine internal audits.