RISK AND REWARD
in the Futures Industry Association
November/December 1994 Issue on Risk
Procter & Gamble
posts losses of $157 million by virtue of derivatives positions.
Atlantic Richfield, the American energy giant, loses some
$22 million in financial derivatives in an employee investment
fund it manages. Piper Jaffray loses $700 million in a U.S.
Government-bond fund. Metallgesellschaft, the German industrial
giant, comes close to receivership after losing nearly $2
billion in derivatives.
such as these and many more have recently shaken the financial
community—the reported losses are nearly $7 billion since early
1993. Their cumulative effect has resulted in increased media
discourse on the dangers of derivatives and signalled an alarm
in the corporate sector. These headlines have also acted as an
impetus for federal authorities to examine the need for regulations
over this huge, complex, and relatively new market arena. Clearly,
such headlines are proof that derivatives represent a complex
financial instrument that can result in serious financial losses.
But that should not be startling—the marketplace is by definition
filled with inherent risk. The critical questions posed by these
headlines is whether risk disclosure is necessary and whether
derivatives pose an increased systemic threat to the financial
fabric of the world sufficient to require stringent federal regulations.
this discussion it is imperative to understand the history of
derivatives, what they are, their risk and purpose. Economist
Henry Kaufman points out that the current trend toward using
derivatives was the result of a dramatic rise in "floating rate
financing opportunities; massive securitization of mortgages
and other financial products; sweeping internationalization of
trading of currencies, bonds and equities; a striking shift toward
portfolio investment; and a worldwide explosion of budgetary
Kaufman's historical overview is quite correct as far as it goes.
But the driving force behind the growth of derivatives was not
changes in the financial environment, but rather radical technological
advancement—particularly in computer science. This technological
revolution affected the entire world. The forces it unleashed
produced profound transformations in every component of civilization—from
science to finance. To be more specific, computer technology
has moved the world from the big to the little, from the vast
to the infinitesimal.
physics, we moved from General Relativity to quantum physics,
and in biology from individual cells to gene engineering. The
world's first understanding of the atom was simply as a solid
central nucleus surrounded by tiny orbiting electrons. However,
new computer technology brought a much clearer comprehension
of the complexity of the atom, its subatomic particles of electrons,
protons and neutrons, and its nucleus containing intricate combinations
of quarks. Similarly, in biology, technological advancements
taught us that cells, originally thought to be simple repositories
of chemicals, are more like high-tech factories in which complex
chemical reactions produce substances that travel via networks
markets, the evolution was strikingly similar. When advancements
in computer technology were applied to established investment
strategies, the result was remarkable. Just as it did in the
sciences, market applications went from macro to micro. Intricate
calculations and state-of-the-art analytical systems ensued,
offering financial engineers the ability to divide financial
risk into its separate components. Derivatives—the financial
equivalents to particle physics and molecular biology—were born.
The primary purpose of these instruments is not to borrow or
lend funds but to transfer price risks associated with fluctuations
in asset values.
process was initiated by the financial futures revolution in
1972. The Chicago Mercantile Exchange recognized that futures
market risk-transfer mechanisms applicable to agriculture were
equally relevant in finance. The International Monetary Market
thus was launched with the express purpose of developing futures
trade in financial instruments. This revolutionary innovation
created the first broad-based risk management products and ushered
in the Era of Financial Futures. Modern academic theory then
acted as a catalyst in the process by fostering the principle
of risk management as a necessary business regime. Thereafter,
evolution in world economies, as Mr. Kaufman noted, transformed
these relatively simple tools into the present genre of complex
engineers using their computers began to comb world markets searching
for inefficiencies, financial exposure, and investors' dilemmas,
to create synthetic financial instruments to solve the perceived
risks. Consequently, an infinite number of derivative products
were created whose values depend on the value of one or more
underlying assets or indices of asset values. Simple futures
contracts in foreign exchange, Eurodollars, and bonds evolved
into complex swaps and swaptions, strips and straps, caps and
floors. Investment methodologies were transformed from all-encompassing
traditional strategies to finely-tuned modern portfolio theories;
long-term hedging evolved into on-line risk management.
today are applied within two separate regimes: Over-The-Counter
(OTC) derivatives—traded privately among banks and their large
corporate and institutional customers; and Exchange-traded derivatives—financial
and commodity futures and options. Combined, these two sectors
represent a multi-trillion-dollar market. The OTC derivatives
market now greatly overshadows exchange-traded instruments, however,
it lacks the protective components of the exchanges, namely:
daily mark-to-the-market value adjustments, margin deposits,
price and position limits, and most notably the guaranty of a
central clearing house. OTC products generally also lack the
regulatory control of federal authorities to which futures and
options exchanges are subject.
evolution is the offspring of necessity—derivatives have grown
because they are essential. Today's world offers a highly complex
and hazardous economic environment where competition is global,
financial volatility is continual, and opportunities rapidly
appear and disappear on a constantly changing financial horizon.
Today's world demands cost-efficient instruments that can protect
from inherent financial risks, adjust portfolio exposure between
securities and cash, hedge against interest rate and exchange
rate exposure, manage assets and liabilities, enhance equity
and fixed income portfolio performance, and protect against commodity
price rises or mortgage interest expense.
a result of derivatives application, risks are reduced, losses
are minimized, and profit is increased over a wide sphere of
financial enterprise—these positive results go mainly unreported
in the media. And the constructive effects go far beyond direct
benefits to the private sector. Both exchange-traded and OTC
derivatives foster rapid growth in international trade and encourage
capital flows. These instruments serve to funnel excess savings
from mature industrialized countries into higher yielding opportunities
in developing nations. By providing the means to manage risk,
financial derivatives reduce the cost of capital, thereby facilitating
investment, economic growth, and the raising of living standards.
the foregoing does not imply that derivatives are a panacea for
the world and without risk to the user. The recent report of
the U.S. General Accounting Office (the GAO Report) correctly
enumerates four sets of risks posed by derivatives:
risk. The exposure to the possibility of loss resulting
from a counterparty's failure to meet its financial obligation;
risk. Adverse movements in the price of a financial asset
risk. An action by a court or by a regulatory body that
could invalidate a financial contract; and
risk. Inadequate controls, deficient procedures, human
error, system failure, or fraud.(3)
these general types of risk exist for many financial activities,
the GAO emphasizes that "the specific risks in derivatives
are relatively difficult to manage because of the complexity
of some of these products and the difficulties in measuring these
risks." On the basis of this difference, the GAO concludes that
there is a need for new federal regulations. Many experts argue
this conclusion. In their opinion, the only compelling rationale
for new federal regulations is if derivatives substantially increased
systemic risk. That has not been the finding by most studies.
most widely recognized report on derivatives—The Group of Thirty
(G-30) chaired by former Federal Reserve Board chairman Paul
Volcker—concluded that: "Derivatives by their nature do not
introduce risks of a fundamentally different kind or of a greater
scale than those already present in the financial markets. Hence,
systemic risks are not appreciably aggravated."(4) In
other words, dividing risk into its basic components does not
create a greater quotient of risk than what was already present.
The present Chairman of the Fed, Alan Greenspan, and the CFTC
reached a similar conclusion and rejected the notion that derivatives
require fundamental changes in regulatory structure. In testimony
before Congress earlier this year, Alan Greenspan, generally
praised derivatives, stating "The Board believes that the
array of derivative products that has been developed in recent
years has enhanced economic efficiency. The economic function
of these contracts is to allow risks that formerly had been combined
to be unbundled and transferred to those most willing to assume
and manage each risk component . . ."(5)
would, however, be foolish to conclude that derivatives pose
no dangers and that the market system cannot be improved. As
Mr. Greenspan also pointed out, "Even if derivatives activities
are not themselves a source of systemic risk, they may help to
speed the transmission of a shock from some other source to other
markets and institutions.(6) Or
as Henry Kaufman succinctly stated in recent congressional testimony, "writing
over-the-counter options, particularly the more complicated ones,
is a very different business from the traditional activities
of a bank or a securities firm.(7)
one thing, the failure of a major derivatives dealer could impact
its counterparties. This represents the chain reaction peril
that many observers have verbalized. For another, there are the
unknown dangers created by a wide assortment of OTC financial
options, and to an extent even exchange-traded options. These
range from simple standard options to a complex species of hybrid
instruments that combine futures, swaps, and options. There is
also an emerging genre of contingent options where payment is
a function of multiple possibilities. Since these contingent
options create risks that cannot be perfectly hedged, the resulting
risks normally need to be managed through a process of dynamic
hedging—an inexact science that can heighten price movements
and produce unknown consequences.
an example of the unpredictable ramifications of contingent options,
consider the last few minutes of trading on the New York Stock
Exchange Thursday, August 25, 1994 as a result of expiring "Flex" options
on the CBOE. In the unwinding of arbitrage positions in Chicago
in the AMEX Major Market Index (XMI) contracts, there seemingly
was created the need to purchase $200 million of stock on the
closing bell in New York. As a result, the Dow jumped nearly
20 points in the last minute of trade. Fortunately, this contingency
involved expiring calls—which caused the market to rally.
Few objections are raised when the result is positive. But for
the sudden influx of a mere $200 million to have that effect
makes you wonder what would happen if a really sizable contingent
option is unexpectedly triggered . . . and what if the next time
it involves expiring puts!
I wholeheartedly endorse private sector implementation—by dealers
as well as end-users—of sound risk management practices as recommended
by the G-30 Report and the Federal Reserve. Specifically:
The use of derivatives in a manner consistent with the overall
risk management and capital policies approved by boards of directors.
The adoption of consistent counterparty credit limits.
The adoption of a procedure of marking positions to the market.
The use of a consistent measure to calculate daily the market
The conduct of regular simulations of stress-tests.
also wholeheartedly support regulations which require full disclosure
and comprehension of the risks inherent in OTC derivatives when
offered for investment or speculative purposes to the general
public—just as they are required in regulated futures. Derivatives
do not represent a traditional investment class with which the
public is generally familiar. Rather, they embody complex and
sophisticated instruments of modern finance—best employed in
risk management techniques.
us be clear: The laissez-faire attitude about OTC derivatives
is over. I applaud SEC Chairman Levitt's initiative for a Derivatives
Policy Group, a private sector task force on derivatives. The
OTC market community must recognize that the need for stricter
internal controls is imperative and that more education and disclosure
is necessary. Indeed, the notoriety received by the headlines
has served the important purpose of energizing industry leaders
to act responsibly or face the onslaught of burdensome federal
regulation. Unfortunately, these headlines may also serve to
unduly frighten boards of corporate end-users. This could prove
disastrous. Indeed, if corporate boards refrain from prudent
use of derivatives because of fears of consequential losses to
their corporate bottom line, wait until those boards see the
reduction in their corporate bottom line as a consequence of
abstention from derivatives application.
no mistake about it: The value of derivatives is not an imaginary
notion. These instruments are not a selective luxury that can
be done without. If the use of financial derivatives as a hedge
mechanism is excessively restricted, the consequences to the
world's financial fabric will be much harsher than anyone realizes.
In our global market environment—driven by constant and changing
market risks, instantaneous information flows, and sophisticated
technology—derivatives are an essential instrument of finance.
They are indispensable in the management of risk and of immense
benefit to a nation's economy.
Kaufman, "Financial Derivatives in a Rapidly Changing Financial
World," London, England, 14 October 1993.
Siegfried, "Discoveries," Dallas Morning News, 14 December
U.S. General Accounting Office Report, "Financial Derivatives:
Actions Needed to Protect the Financial System," May 1994.
of Thirty, "Derivatives: Practices and Principles," July 1993.
Alan Greenspan, Chairman, Federal Reserve Board, Subcommittee
on Telecommunications and Finance, Committee on Energy and Commerce,
U.S. House of Representatives, 25 May 1994.
of Henry Kaufman, Committee on Banking, Finance and Urban Affairs,
U.S. House of Representatives, 23 June 1994.
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