# Financial Derivatives and Risk Management - Modern Banking

Types of Financial Derivative

Before looking at how banks manage credit and market risk, this section considers the role of financial derivatives in risk management, because they are part of a bank’s tool kit for managing risk. provided some basic definitions and noted the rapid growth in the derivatives market after 1980.

Financial Derivatives (or derivatives for short) are instruments that allow financial risks to be traded directly because each derivative is linked to a specific instrument or indicator (e.g. a stock market index) or commodity.22 The derivative is a contract which gives one party a claim on an underlying asset (e.g. a bond, commodity, currency, equity) or cash value of the asset, at some fixed date in the future. The other party is bound by the contract to meet the corresponding liability. A derivative is said to be a contingent instrument because its value will depend on the future performance of the underlying asset. The traded derivatives that are sold in well-established markets give both parties more flexibility than the exchange of the underlying asset or commodity.

Consider the case of the pig farmer who knows that in six months’ time s/he will have a quantity of pork bellies to sell. The farmer wishes to hedge against the fluctuation in pork belly prices over this period. He/she can do so by selling (going short) a six-month ‘‘future’’ in pork bellies. The future will consist of a standard amount of pork bellies, to be exchanged in six months’ time, at an agreed fixed price on the day the future is sold. The agent buying the pork belly future goes long, and is contractually bound to purchase the pork bellies in six months’ time. The financial risk being traded is the risk that the value of pork bellies will change over six months: the farmer does not want the risk, and pays a counterparty to assume it. The price of the future will reflect the premium charged by the buyer for assuming the risk of fluctuating pork belly prices. The underlying asset (or ‘‘underlying’’) is a commodity, pork bellies, and the futures contract is the contingent claim. If the actual pork bellies had been sold, the farmer would face uncertainty about price fluctuations and might also incur some cost from seeking out a buyer for an arm’s-length contract. The future increases the flexibility of the market because it is sold on an established market. Similarly, in the currency markets, futures make it unnecessary for the actual currency (the underlying instrument) to be traded.

The key derivatives are futures, forwards, forward rate agreements, options and swaps.

Table above summarises the different types of derivatives, and shows how they are related to each other.

Summary of Derivatives

Germany’s Deutsche Terminb¨orse. These exchanges also act as clearing houses. If a trader from Barclays Capital sells a future to the Royal Bank of Scotland Group (RBS), LIFFE will buy the future from Barclays and sell a future to RBS. This way, neither bank need be concerned about counterparty risk, that is the failure of one of the two banks to settle on the agreed future date. However, LIFFE does incur counterparty risk, which it minimizes by requiring both banks to pay initial and verification margins. An initial marginis paid at the time the contract is agreed. However, between the time of the agreement and its expiry date, the price of the future will vary. The future will be marked to market each day, and based on the daily movement in the price, a variation marginis paid and settled, i.e. if losses are incurred, the bank has to pay the equivalent amount of the loss to the clearing house, while the other bank has made a profit, which it receives from the clearing house.

Some banks will have millions of futures (and options) being traded on a given day, so at the end of the trading day, traders will receive their net profits, or pay their net losses to the clearing house.

Over the counter (OTC) market instruments, tailor-made for individual clients, consist of forwards, interest rate and currency swaps, options, caps, collars and floors, and other swap-related instruments. Table shows they grew 50-fold, from $1.3 to$61.4 trillion between 1988 and 2000. Note the share of the OTC market as a percentage of the total market has risen from just over 50% in 1988 to 81% by 2000. OTC derivatives are attractive because they can be tailor-made to suit the requirements of an organisation. They are also the principal source of concern for regulators, because of the added risks inherent in this type of market. For example, in the absence of an exchange, there is no clearing house, so the two parties incur counterparty risk. For this reason, an increasing number of OTC markets do require margins to be paid.

Though Table indicates a rapid growth in the derivatives markets, their use by banks is concentrated among a few of the world’s largest banks. A 1998 BIS survey reported that 75 market players are responsible for 90% of activity in financial derivatives.

This confirms earlier studies (e.g. Bennett, 1993; Sinkey and Carter, 1994). The key US and European banks such as Deutsche, Dresdner, Citigroup, JP Morgan Chase and Nations Bank dominate the derivatives market. Sinkey and Carter found that within the USA, 13 members of the International Swaps and Derivatives Association accounted for 81.7% of derivatives activities. Other banks have access to risk management opportunities offered by derivatives market through correspondence relationships with one of the main players. The survey was reviewing OTC markets, and reports that interest rate instruments (mainly swaps) make up 67% of the market, followed by foreign exchange products (30% – forwards and foreign exchange swaps); equities and commodities make up 2% of the market.

The capital needed to finance the derivative is lower than it would be if the bank were financing the instrument itself. The main difference between the risk associated with derivatives and traditional bank risk management is that prior to these financial innovations, banks were concerned mainly with the assessment of credit risk, and after the Third World debt crisis (1982), a more specialised form of credit risk, sovereign risk. Banks continue to lend to countries, corporations, small businesses and individuals, but banks can use derivatives to:

• Hedge against risk arising from proprietary trading;
• Speculate on their trading book;
• Generate business related to transferring various risks between different parties;
• Use them on behalf of clients, e.g. putting together a swap arrangement, or advise clients of what instruments they should be using;
• Manage their market (including interest rate and currency risk) and credit risk arising from on- or off-balance sheet activities.

The growth in the use of derivatives by banks has meant management must consider a wider picture, that is, not just on-balance sheet ALM, but the management of risks arising from derivatives. These OBS commitments improve the transparency of risks, so risk management should be a broad-based exercise within any bank.

Futures

A future is a standardised contract traded on an exchange and is delivered at some future, specified date. The contract can involve commodities or financial instruments, such as currencies. Unlike forwards (see below), the contract for futures is homogeneous, it specifies quantity and quality, time and place of delivery, and method of payment. The credit risk is much lower than that associated with a forward or swap because the contract is marked to market on a daily basis, and both parties must post margins as collateral for settlement of any changes in value. An exchange clearing house is involved. The homogeneous and anonymous nature of futures means relatively small players (for example, retail customers) have access to them in an active and liquid market.

Forwards

A forward is an agreement to buy (or sell) an asset (for example, currencies, equities, bonds and commodities such as wheat and oil) at a future date for a price determined at the time of the agreement. For example, an agreement may involve one side buying an equity forward, that is, purchasing the equity at a specified date in the future, for a price agreed at the time the forward contract is entered into. Forwards are not standardised, and are traded over the counter. If the forward agreement involves interest rates, the seller has the opportunity to hedge against a future fall in interest rates, whereas the buyer gets protection from a future rise in rates. Currency forwards allow both agents to hedge against the risk of future fluctuations in currencies, depending on whether they are buying or selling.

Forwards are customised to suit the risk management objectives of the counterparties. The values of these contracts are large, and both parties are exposed to credit risk because the value of the contract is not conveyed until maturity. For this reason, forwards are largely confined to creditworthy corporates, financial firms, institutional investors and governments. The only difference between a future and a forward is that the future is a standardised instrument traded on an exchange, but a forward is customised and traded over the counter. To be traded on an exchange, the market has to be liquid, with a large volume. For example, it will be relatively easy to sell or buy dollars, sterling, euros or yen for three or six months on a futures market. However, if an agent wants to purchase dinars forward, then a customised contract may be drawn up between two parties (there is unlikely to be a ready market in dinars), which means the transaction takes place on the forward market.

Or, if a dollar sale or purchase is outside one of the standardised periods, it will be necessary to arrange the transaction on the forward market.

Banks can earn income from forwards and futures by taking positions. The only way they can generate fee income is if the bank charges a client for taking a position on behalf of a client.

Options

At the date of maturity, if an agent has purchased yen three months forward (or a future), he/she must buy the yen, unless they have traded the contract or closed the position. With options, the agent pays for more flexibility because s/he is not obliged to exercise it. The price of the option gives the agent this additional flexibility. The first type of option traded on an exchange (in 1973 in Chicago) was a call option. The holder of a Europeancall option has the right, but not the obligation, to buy an asset at an agreed (strike) price, on some specified date in the future. If the option is not exercised, the buyer loses no more than the premium he/she pays plus any brokerage or commission fees. The holder of a call option will exercise the option if the price of the asset rises and exceeds the strike price on the date specified. Suppose an investor buys a call option (e.g. stock in IBM) for $100 two months later. The underlying asset is equity, namely, one share in IBM stock. The agreed price of$100 is the strike price. If IBM stock is more than $100 on the specified day it expires, the agent will exercise the option to buy at$100, making a profit of, for example, $10.00 if the share price is$110. The call option is said to be in the moneybecause the strike price is below the stock price. If the strike price exceeds the market price – the call option is out of the moneybecause money is lost if the option was exercised. Though there is no point in exercising the option, the holder does not necessarily lose out because the whole point of buying the call option was to gain some flexibility, which in turn could have been used as a hedge during the life of the option.

The underlying asset upon which the option is written can be a currency, commodity, interest rate (bonds) or equity. As Table shows, in 2000, they made up about 33% of exchange traded derivatives, though some are traded on the OTC markets. The buyer has the potential to gain from any favourable net movements between the underlying market and the strike price. The seller of the option obtains any fees but is exposed to unlimited loss should the option move so that the strike price is below the current spot price. Americancall options work exactly the same way but give the holder more flexibility because the option can be exercised during a specified period, up to the expiration date. Both types of options are traded in the European, American and other markets.

Exchange traded put optionsfirst appeared in 1977,24 and give the holder the right (but not the obligation) to sell an underlying asset at an agreed price at some specified date in the future. This time, if, on the specified date, the price of the asset is less than the strike price, the holder will profit by exercising the option and pocketing the difference between the strike price and the share price (if an equity). Suppose an agent buys a put option for a barrel of wheat, at an agreed price of $50.00 in three months’ time. On the specified date three months later, the price of wheat has fallen to$45.00 per barrel.

Then the option is exercised: the holder buys wheat in the market at $45.00 and sells it for$50.00.

The subject of options pricing can fill an entire book, and the objective here is to identify the factors influencing the price of options and return to the main theme. risk management. One can summarise it reasonably simply. To understand how an option is priced, think what buyers pay for. They are buying flexibility and/or to hedge against risk exposure. This is because stock, commodity and other financial markets can be volatile, and like the farmer selling wheat three months in the future, the agent is hedging against losing money as a result of volatility. So the more volatile the asset, the higher the price of the option.

The time to expiry also affects the price of the option, and the relationship is non-linear. Suppose an option expires in 60 days. Then when the option was agreed only one or two days before, the price is not affected much – there is a small decline in price because the exercise date is still quite far away. As the option ages, the fall in price will be much steeper between two days than it is when the option was only one or two days old. After two days, 2/60ths of the time value has eroded but after 50 days, 5/6ths of the time has eroded, and there is less time for the instrument underlying the option to move in a favourable direction. The loss of time value as the option ages is known as time decay, hence the option price tends to decay while T is positive, then vanishes on the expiry date. The final, direct influence of the price of the option is the difference between the strike price (Sk) and the spot price, i.e. the current price of the underlying instrument (Sp).

To summarise:

call option price = f[max{(Sp − Sk, 0); V, T}]
put option price = f[max{(Sk − Sp, 0); V, T}]

where:
Sk: strike price
Sp: spot price
V: volatility, always a positive influence on the call or put option price
T: time to expiry, the option price tends to decay when positive and vanishes on expiry

The value of an option can never be negative Options can be bundled together to create option-based contracts such as caps, floors or collars. Suppose a borrower issues a long-term floating rate note, and wants partial protection from a rise in interest rates. For a premium, the borrower could purchase a Cap, which limits the interest to be repaid to some pre-specified rate. A Floormeans the lender can hedge against a fall in the loan rate below some pre-specified rate. Collars, where the buyer of a cap simultaneously sells a floor (or vice versa), mean the parties can reduce the premium or initial outlay.

Currency Options are like forward contracts except that as options, they can be used to hedge against currency fluctuations during the bidding stage of a contract. Purchasers of options see them as insurance against adverse interest or exchange rate movements, especially if they are bidding for a foreign contract or a contract during a period of volatile interest rates.

Call options for assets have, in theory, unlimited scope for profit because there is no ceiling to the price of the underlying instrument, such as a stock or commodity. For example, unexpected news of a widespread failure of the cocoa crop can cause the price to soar, or there can be bubble-like behaviour in certain shares, such as the technology stocks in the 1990s. Provided the option is exercised before the bubble bursts, option holders can make a great deal of profit. At the same time, their losses are limited to the premium they pay on the option.

For put options, the price of the underlying instrument can never fall below zero, so there is a ceiling on profits for puts. To see the contrast, return to the cocoa example. Suppose an agent buys a call option with a strike price of $60, that is, a right to buy a unit of cocoa for$60. In the event of widespread crop failure, the price soars to $100 per unit, giving the holder of the call option a profit of$40. The agent’s profit is unlimited because the price, in theory, can keep on rising. But for a put option, where the holder has a right to sell a unit of cocoa, the profit is limited. If the strike price for the put option is $50, in the event of a cocoa glut, profits are limited to$50 because the cocoa price cannot fall below zero.

Consider the example below, taken from The Financial Times. Table is part of the figures reproduced from The Financial Times. The table states that the index is ‘‘£10 per full index point’’. It is possible to buy a call or put option for the FTSE 100 index at different levels. All profit and loss figures are multiplied by 10 to give the appropriate sterling sum.

C reports the call units and P the put units, for a given FTSE index level, for July to December – each is priced at £10 per unit. On 24 June, the volume of puts (29 273) far exceeded that of calls (12 965), possibly because it had risen strongly in the spring of 2003, and many more agents are looking for the right to sell rather than buy options on the FTSE index, anticipating a greater downside than upside risk in the coming months.

Suppose the agent decides to purchase a call option on the FTSE 100 at 3725, to expire in July. On 24 June, the agent buys 351 units at £10 per unit for the right to buy at 3725 in July. The right is exercised if the index exceeds 3725 in July, but not otherwise. At 3726, the agent recoups £10 from the £3510 paid, so exercises the call, even though s/he makes an overall loss. The break-even point is 4076: (3725 + 351) = 4076. Suppose the Index is 4276 in July. The agent can sell at 3725, and makes (4276 − 3725 − 351)(£10) = £2000.

All these computations exclude any interest foregone, between the time an agent buys/pays for the call and exercises it. The call price rises with time because the greater the time between when the call was purchased and its expiry, the greater the chance the index will move in the agent’s favour.

FTSE 100 Index Option (£10 per full index point)

Consider the put prices, given by the P column. Again, they rise over time, i.e. from July to December, for the same reason as the call prices. Here, the agent chooses to buy a put (the right to sell the option), to be exercised in July. S/he pays (10)(£10) = £100 for the right to sell the index at 3725. The break-even is (3725 − 10) = 3715. If, in July, the index is >3725, the option is not exercised. For example, if the FTSE is at 3730, the agent will lose money: (3725 − 3730 − 10)(£10) = £150, the option would NEVER be exercised – the agent loses the initial £100 plus the £50 implicit in the FTSE indices!

If the index is <3715, the agent will not just exercise the right to sell, but will earn an overall profit. Suppose the index has declined to 3615 in July. Then, for an initial stake of £100, the agent makes (3725 − 3615 − 10)(£10) = £1000.

In December, the price of the put is 112, and the agent will pay £1120 for the right to sell at 3725. The option will be exercised at any price below 3725. The break-even is 3725 − 112 = 3613. If the index falls to 3724, the agent will exercise because even though a loss is made, it is a loss of £1110 rather than £1120. If the index is at 3613, then exercise, but no profit is made; if the index is below 3613, then the profit is positive. For example, at 3600, the profit is:

(3613 − 3600)(£10) = £130

The risk is borne by the writersof options, the other party, who agrees to deliver/buy the underlying asset, and receives the premium for entering into the agreement. For a call option, the larger the difference between the strike and spot prices of the underlying asset, the bigger the losses, because the writer is committed to deliver the asset at the strike price. If the spot rises by a large amount, the writer, in theory, has to buy the asset at this high spot price, then deliver it to the agent who has exercised the option to purchase at the lower strike price. For a put option, the risk of loss is limited, since the price cannot fall below zero.

Just as in theory, profits for some options are unlimited for the holder, the downside is the losses incurred by the writer of the option, usually a bank or other type of financial institution. In the cocoa case, the writer has to buy the cocoa unit for $100 but sell it to the holder for$60. So the writer’s losses are $40 less the premium. On the other hand, for a put option and a glut in the cocoa market, losses are limited to$50, less the cost of the premium. If there is a crop failure, then the put option won’t be exercised and the writer makes a profit equal to the premium.

While option writing can be highly profitable, the potential for losses on options written for equities and commodities is unlimited – option writers will need to have a large amount of capital available to cover the institution. Given that the downside of writing a call option is potentially large, clearing houses (exchanges for traded options) that register and settle options will require a writer to make a deposit to cover an initial margin when the option contract is initiated. In addition, the exchange will specify an amount that must be deposited as a maintenance margin, and writers must ensure the deposit never falls below this level. In the case of rising cocoa prices, this margin would fall as the spot price increased, so the writer would have to top up the margin to keep it at maintenance level.

Some options are traded on exchanges, while others are OTC. There is no clearing house for OTC options but increasingly, parties are imposing margin-type requirements.

Swaps

Swapsare contracts to exchange a cash flow related to the debt obligation of two counterparties. The main instruments are interest rate, currency, commodity and equity swaps. Like forwards, swaps are bilateral agreements, designed to achieve specified risk management objectives. Negotiated privately between two parties, they are invariably OTC and expose both parties to credit risk. The swap market has grown rapidly since the late 1980s, for a number of reasons. Major financial reforms in the developed countries, together with financial innovation, has increased the demand for swaps by borrowers, investors and traders. This in turn has increased liquidity in these markets, which attracts more users. It is also a means of freeing up capital because it is moved off-balance sheet, banks also have to set aside capital for off-balance sheet activity.

The most common type of interest rate swap is also known as the vanilla interest rate swap, where the two parties swap a stream of future fixed rate payments for floating rate payments. Suppose Jack owns SINCY plc and has a fixed rate liability. Gill owns HEFF plc and has a floating rate liability. If they agree to swap future interest payments, then Jack will commence making a net floating rate payment; Gill a net fixed rate payment. The principal on the two respective loans is not exchanged, and both are still liable to make interest payments to their respective creditors. Why enter into a swap agreement? Often it is because there is an opportunity for arbitrage, if each party borrows in markets where they have a comparative advantage. Suppose HEFF plc has a better credit rating than SINCY plc. They can use the difference in credit rating to save on interest payments. Both Jack and Gill want to borrow for 5 years by issuing 5-year bonds. Jack has a better credit rating, and can get the 5-year loan at either 10% fixed rate or a floating rate equal to Libor + 0.5%. Gill can borrow the same amount but, respectively, for 12.5% or Libor + 1%. If they take full advantage of the arbitrage opportunity before them, Jack borrows at the fixed rate of 10%; Gill borrows at the floating rate of Libor + 1%. Jack borrows at a fixed rate, even though he wants floating rate. Gill does the reverse. Together, these two save 2% (the difference between the fixed and floating rate differentials), and they agree to split the saving. If Jack gets 0.75% and Gill gets 2.5%, Jack’s loan is 0.75% cheaper than if he had borrowed on the flexible rate market, and Gill saves 1.25% because she has borrowed on the fixed rate market.

Basis risk is the risk that the yield curve turns negative, thereby affecting the relationship between the future price and the bond, which in turn will affect the value of the portfolio. In the foreign exchange markets, there are two main types of swaps. An FX swapinvolves the exchange of principal on a debt obligation (in different currencies) at the beginning and end of the transaction. The equivalent would be for the two parties to enter into a spot currency exchange, and a foreign exchange rate forward: they agree to swap back the currencies at a fixed price and on a specific date.

A currency swapis a contract between two parties to exchange both the principal amounts and interest rate payments on their respective debt obligations in different currencies. There is an initial exchange of principal of the two different currencies, interest payments are exchanged over the life of the contract, and the principal amounts are repaid either at maturity or according to a predetermined amortisation schedule.

The need for currency swaps arises because one party may need to have its debt in a certain currency but it is costly to issue that debt in the currency. For example, a US firm setting up a subsidiary in Germany can issue US bonds but not eurobonds because it is not well known outside the United States. A German company may want to issue dollar debt, but cannot do so for similar reasons. Each firm issues bonds in the home currency, then swaps the currency and the payments. Unlike an interest rate swap, the principal is exchanged, which creates additional risks. These are credit risk (risk of default on the debt) and settlement or Herstatt risk if there is a difference in time zones.

The market for credit swapsbegan to grow quickly in the early 1990s. There are two main types: a credit default swap and a total return swap, discussed below. Both are examples of credit derivatives. Credit derivativesare OTC contracts, the value of which is derived from the ‘‘price’’ of some credit instrument, for example, the loan rate on a loan. Credit derivatives allow the bank or investor to unbundle or separate an instrument’s credit risk from its market risk. This is in contrast to the more traditional credit risk management techniques (discussed below), which manage credit risk through the use of security, diversification, setting the appropriate risk premium, marking to market, netting, and so on. By separating the credit risk from the market risk, it is possible to sell the credit risk on, or redistribute it among a broad class of institutions. Credit derivatives are used to protect against credit events, which can include:

• A borrower going bankrupt;
• A default on the payments associated with a particular asset.

The credit derivatives market grew very rapidly in the later half of the 1990s. It has risen from 0 in 1996 to $800 billion in 2000 to$2 trillion in 2002, measured by the amount of net sold25 protection. At the time of writing, it is expected to double again to $4 trillion by 2004. The main players are the top seven US banks, which have a market share of 96%.26 Based on a survey by Fitch ratings undertaken in 2003: • Banks and brokers are net buyers of protection –$190 billion, a tiny percentage of total loans.
• Insurance firms are net sellers of protection – $300 billion. • European regional banks are net sellers of protection –$76 billion.

These figures leave a gap of about $186 billion, which may be explained by the refusal of hedge funds to participate in the Fitch (2003) survey. The smaller regional banks that are net sellers of insurance include Germany’s Landesbank. This has raised concerns among regulators, especially for the lack of transparency in the treatment of credit derivatives on the accounts of banks and insurance firms. In their defence, the positions are quite small, and they are getting a higher yield for relatively little risk. They are also a way for these banks to diversify into US firms. The key issues arising from the growth of this market include: • Improvements in disclosure of credit risk details. • Information on positions taken by hedge funds. • Is the market dispersing credit risk or concentrating it? The findings reported by Fitch (2003) tend to support the idea that the market is spreading credit risk across a greater number of players. There are two main types of credit derivatives/swaps. A Credit Default Swap(CDS): all bonds and loans carry a risk premium. Here one party A (e.g. a bank) pays the risk premium on a loan to party B, an insurance against the risk of default. If the borrower defaults on the bond or loan, then party A gets a cash payment from B to cover the losses. If there is no default, counterparty B keeps the risk premium. For example, a bank might make an annual payment to another agent, who pays the bank for the default should there be a default on a loan (or loans), equal to the par value of the defaulted loan, less its value on the secondary market. The Fitch survey found single name CDSs made up 55% of the market, rising to 80% if insurance firms are included. Portfolio products (synthetic collateralised debt obligations, basket trades) made up most of the rest of the market. The respective market shares are 63% for the North American market; 37% for Europe/Asia. An issue that could undermine the growth of this market is the debate over what constitutes a credit event, that is, default. The main problem is with restructuring, and when it constitutes default. For example, with a syndicated loan, participants could enter into a restructuring with a plan to trigger a default and collect payments from the buyer of the CDS. In Europe, buyers of credit protection favour a broad definition of restructuring because when a borrower encounters payment difficulties, the problem is usually resolved through informal negotiation between the two parties. In the USA, amore narrow definition is acceptable to those buying credit risk. Fitch (2003) reported 42 credit events, few of which were controversial. However, Railtrack (in the UK – nationalised by the British government in 2002) and Xerox in the USA have been challenged. The Xerox case prompted some sellers (e.g. insurance firms) to refuse to agree on a CDS if restructuring was included as a credit event. They were of the view that Xerox’s loan financing was not due to problems with its financial position, yet swaps were triggered. Other credit events included Enron and Argentina, and no financial institution found its solvency threatened as a result of exposure, which indicates this market is fulfilling its role of spreading credit risk. However, some experts take a less sanguine view. Credit risk is being transferred away from banks, which have the most sophisticated models for analysing it, to other financial institutions, such as insurance firms (or pension funds), with little or no expertise in the area. A total return swapinvolves two parties swapping the total returns (interest plus capital gains or minus capital losses) related to two assets. Consider a simple example. Asset A is on bank A’s balance sheet, and the bank receives a fixed interest rate from that asset. Asset B is held by a counterparty, call it Bank B. This asset is linked to a floating rate, that is, Bank B receives a stream of income at some variable market rate (e.g. Libor or some other benchmark rate). In a total return swap, Bank A makes periodic payments27 to Bank B, which are linked to the total return of the underlying asset A, in exchange for, from Bank B, periodic floating payments which are tied to a benchmark such as Libor (e.g. semi-annual cash flows linked to a six-month Libor), that is, the total return on asset B. Usually the swap agreement is for three to five years, but the maturity of the underlying asset may be much longer. A total return swap may involve a bond or portfolio of bonds, a loan or loan portfolio, or any other type of security. The receiving party need not be a bank. It could be an institutional investor, insurance firm, or some type of fund specialising in these type of swaps. Suppose Bank A lends money to a borrower at a fixed rate, and some time during the period of that loan, the borrower begins to encounter difficulties repaying the loan, increasing the credit risk associated with it, resulting in a lower credit rating on the loan. This is an adverse credit event for Bank A because the value of its asset, the loan, falls. The bank has agreed a total return swap with Bank B, to hedge against the possibility of this adverse credit event. Bank A pays the counterparty the initial interest rate charged on the loan plus any change in the value of the loan, if the credit event occurs. This is a cash outflow for Bank A, and represents income for the counterparty, Bank B, the fee paid to B because it is taking on the credit risk associated with Bank A’s loan. If the adverse credit event occurs, then Bank A pays less: the fixed interest rate minus the reduction in the loan value. Thus, Bank B receives a reduced cash inflow. Its cash outflow to Bank A is based on an asset paying a flexible rate (e.g. interest rate plus Libor). In the absence of an adverse credit event, the swap becomes a standard (pay fixed/receive floating) interest rate swap. If Libor is correlated with the adverse credit event, and rises, then the payment made by Bank B to A will rise if the adverse event occurs, which further compensates for the reduced value of A’s loan. However, Libor could fall, depending on the nature of the credit event (see below). Furthermore, unlike the pure credit swap, there is some basis risk because if Libor changes, the net cash flows of the total return swap change, even in the absence of a credit event. Bank A may opt for this type of swap if the bank has had a long relationship with the borrower, but is concerned that the borrower could default on the loan (e.g. because of political upheaval in the borrower’s country, adverse currency movements, or because there is an unexpected decline in demand for that firm’s product). In these situations, the bank may want to preserve the relationship, perhaps because the firm is a customer for other types of bank business. Since the loan never leaves Bank A’s loan book, the borrower need never know of the bank’s concern, yet Bank A has hedged against any possible adverse outcomes. Bank B is attracted to the swap because it gets an unchanged cash inflow if there is no adverse credit event, and because the fixed interest rate may prove higher than the average variable rate it pays to Bank A. An equity swapis an agreement to exchange two payments. Party A agrees to swap a specified interest rate (fixed or floating) for another payment, which depends on the performance (total return, including capital gains and the dividend) of an equity index. An equity basis swap is an agreement to exchange payments based on the returns of two different indices. A cross-currency interest rate swapis a swap of fixed rate cash flows in one currency to floating rate cash flows in another currency. The contract is written as an exchange of net cash flows which exclude principal payments. A basis interest rate swapis a swap between two floating rate indices, in the same currency. Coupon swaps entail a swap of fixed to floating rate in a given currency. Like forwards and options, hedging is one reason why a bank’s customers use swaps. In a currency, interest rate or credit swap market, a customer can restructure and therefore hedge existing exposures generated from normal business. In some cases, a swap is attractive because it does not affect the customer’s credit line in the same way as a bank loan. Currency swaps are often motivated by the objective to obtain low cost financing. In general, swaps can be a way of reducing borrowing costs for governments and firms with good credit ratings.Hybrid derivatives These are hybrids of the financial instruments discussed above. Variable coupon facilities, including floating rate notes, note issuance facilities and swaptions, fall into this category. A swaptionis an option on a swap: the holder has the right, but not the obligation, to enter into a swap contract at some specified future date. Variable coupon securities are bonds where the coupon is revalued on specified dates. At each of these dates, the coupon rate is adjusted to reflect the current market rates. As long as the repricing reflects the current interest rate level, this type of security will be less volatile than one with a fixed rate coupon. The floating rate notes (FRNs)have an intermediate term, whereas other instruments in this category will have different maturities. All the periodic payments are linked to an interest rate index, such as Libor. A FRN will have the coupon (therefore the interest rate payments) adjusted regularly, with the rates set using Libor as a benchmark. Note issuance facilitiesare a type of financial guarantee made by the bank on behalf of the client, and have features similar to other financial guarantees such as letters of credit, credit lines and revolving loan commitments. Why Banks Use Derivatives It is important to be clear on the different uses of these instruments by the banking sector. Banks can advise their clients as to the most suitable instrument for hedging against a particular type of risk, and buy or sell the instrument on their clients’ behalf. This may help the bank to build on relationships and open up cross-selling opportunities. Additionally, banks employ these instruments to hedge out their own positions, with a view to improving the quality of their risk management. Banks also use derivatives for speculative purposes and/or proprietary trading, when trading on the banks’ own account, with the objective of improving profitability. It is the speculative use of derivatives by banks which regulators have expressed concern about, because of the potential threat posed to the financial system. They may also use them for purposes of hedging, which can increase the value of a bank by reducing the costs of financial distress or even compliance costs when meeting regulatory standards. Non-financial corporations are attracted to derivatives because they improve the management of their financial risks. For example, a corporation can use derivatives to hedge against interest rate or currency risks. The cost of corporate borrowing can often be reduced by using interest rate swaps (swapping floating rate obligations for fixed rate). Banks are paid large sums by these firms to, for example, advise on and arrange a swap. However, some corporations, whether they know it or not, end up using derivatives to engage in speculative activity in the financial markets. There have been many instances where corporate clients have used these derivative products for what turned out to be speculative purposes. One customer of Bankers Trust, Gibson Greetings, sustained losses of$3 million from interest rate swaps that more than offset business profits in 1993. The case was settled out of court in January 1995, after a tape revealed a managing director at Bankers had misled the company about the size of its financial losses. In December 1994, Bankers Trust agreed to pay a $10 million fine to US authorities, and was forced to sign an ‘‘agreement’’ with the Federal Reserve Bank of New York, which means the leveraged derivatives business at Bankers Trust is subject to very close scrutiny by the regulator. Bankers Trust was also bound by the terms of the agreement to be certain that clients using these complex derivatives understand the associated risks. In 1994, the chairman of Procter and Gamble (P&G) announced large losses on two interest rate swaps. The corporate treasurer at Procter and Gamble had, in 1993, purchased the swaps from Bankers Trust. The swaps would have yielded a substantial capital gain for Procter and Gamble had German and US interest rates converged more slowly than the market thought they would. In fact, the reverse happened which, together with another interest rate swap cost the firm close to$200 million. The question is why these instruments were being used for speculative purposes by a consumer goods conglomerate, and whether the firm was correctly advised by Bankers Trust. Procter and Gamble refused to pay Bankers Trust the $195 million lost on the two leveraged swap contracts. P&G claimed it should never have been sold these swaps, because the bank did not fully explain the potential risks, nor did the bank disclose pricing methods that would have allowed Procter and Gamble to price the product themselves. The publication of internal tapes which revealed a cynical attitude to the treatment of customers was unhelpful for the bank. In one video instruction tape shown to new employees at the bank, a BT salesman mentions how a swap works: BT can ‘‘get in the middle and rip them (the customers) off’’, though the instructor does apologise after seeing the camera; another said how he would ‘‘lure people into that total calm, and then totally f- - - them’’.29 An out of court settlement was reached in May 1996 but only after an opinion given by the judge, who considered both parties to be at fault. P&G’s argument that swaps came under federal jurisdiction was rejected, as was their claim that BT has a fiduciary duty to P&G. The court also opined that Bankers Trust had a duty of good faith under New York State commercial law. Such a duty arises if one party has superior information and this information is not available to the other party.30 Bankers Trust was acquired by Deutsche Bank in 1998. Other well-known US banks, namely Merrill Lynch, Credit Suisse First Boston (CSFB) and some smaller banks, were sued by a local government in Orange County, California, after it was forced into bankruptcy in late 1994. The county borrowed money from Merrill to purchase securities for its investment fund. Merrill also underwrote and distributed the securities. CSFB underwrote an Orange County bond issue. The fund made a$700 million profit, but losses quickly mounted after an unexpected rise in interest rates. Orange County’s borrowing costs soared and the value of the securities in the investment fund collapsed.

Merrill, CSFB and other banks found themselves being accused by Orange County, and in a separate case filed by 14 other governments that were part of the investment pool (the so-called ‘‘Killer Bs’’), of encouraging the Treasurer, Robert Citron, to invest in speculative securities, and making false statements about the health of the county’s investments. Some litigants even claimed the banks had a duty to inform them that the Treasurer’s actions were inappropriate. The county also sued KPMG, its auditor, Standard and Poor’s (for giving its bonds too high a rating), and 17 other banks.

The case never had its day in court because all the parties settled out of court. Merrill Lynch paid Orange County $420 million, and two years later (in 2000), settled with the ‘‘Killer Bs’’ for$32.4 million. Substantial settlements were also reached with KPMG, CSFB and the other banks. In total, the settlement reached roughly $800 million. Given the$700 million in profit the fund made before the interest rate collapsed, the county was almost fully compensated for the $1.8 million loss. The banks were probably concerned they might be convicted by a jury, though they claimed they settled to avoid mounting legal costs. The question is whether the banks were guilty, given the interest rate products were not particularly complex, and the Treasurer’s conviction for securities fraud – he seemed to be knowledgeable about the investments. Also, local governments collect taxpayers’ money to fund expenditure. The norm is for the money to be invested in relatively safe assets, such as Treasury bills and certificates of deposit, not to run an investment fund in the hope of making capital gains in the financial markets. In Japan, the currency dealers of an oil-refining company, Kashima Oil, entered into binding forward currency contracts, buying dollars forward in the 1980s (in anticipation of future purchases of oil), which led to losses of$1.5 billion. Metallgesellschaft, a German commodities conglomerate, lost $1.4 billion in oil derivatives because they sold long-dated futures, hedging the exposure with short-dated futures. It left the firm exposed to yield curve repricing risk, a type of basis risk – the price of the long-dated futures increased but the short-dated prices declined. Other examples of non-financial firms reporting significant losses because of trading on the financial markets include: Volkswagen, which lost$259 million from trades in the currency markets in the early 1980s; Nippon Steel Chemical, which lost $128 million in 1993 because of unauthorised trading in foreign exchange contracts; and Showa Shell Seikiyu, which lost$1.05 billion on forward exchange contracts. Allied-Lyons plc lost $273 million by taking options positions, and Lufthansa lost$150 million through a forward contract on the DM/US\$ exchange rate. Barings plc, the oldest merchant bank in the UK, collapsed after losing over £800 million after a trader’s dealings in relatively simple futures contracts went wrong.

The above cases illustrate the need for managers to ask why an instrument is being used – that is, is it for hedging or speculative purposes? Additionally, as illustrated by the Metallgesellschaft case, all parties to a hedging arrangement must ask whether an instrument used to hedge out one position has exposed a party to new risks.

Any bank dealing in derivatives is exposed to market risk, whether they are traded on established exchanges, or, for OTC instruments, there is an adverse movement in the price of the underlying asset. For options, a bank has to manage a theoretically unlimited market risk, which arises from changing prices of the underlying item. Banks will usually try to match out option market risks, by keeping options ‘‘delta neutral’’, where the delta of an option indicates the absolute amount by which the option will increase or decrease in price if the underlying instrument moves by one point. The delta is used as a guide to hedging. In swap contracts, market risk arises because the interest rates or exchange rates can change from the date on which the swap is arranged.

Derivatives expose banks to liquidity risk. For example, with currency options, a bank will focus on the relative liquidity of all the individual currency markets when writing them, especially if they have a maturity of less than one month. Swap transactions in multiple currency markets also expose banks to liquidity risk. Additional risks associated with derivatives include operational risk – e.g. system failure, fraud or legal problems, where a court or recognised financial authority rules a financial contract invalid.

To summarise, once banks begin to deal in derivatives, they confront a range of risks, in addition to credit risk. Most of these risks have always been present, especially for banks operating in global markets, where there was a risk of volatile interest or exchange rates. What these instruments have done is unbundle the risks and make each of them more transparent. Prior to their emergence these risks were captured in the ‘‘price’’ of a loan. Now there is individual pricing for each unbundled risk. In the marketing of these new instruments, banks stress the risk management aspect of them for their customers.

Essentially, the bank is assuming the risk related to a given transaction, for a price, and the bank, in turn, may use instruments to hedge against these risks. The pricing of each option, swap or forward is based on the individual characteristics of each transaction and each customer relationship. Some banks use business profit models to ensure that the cost of capital required for these transactions is adequately covered. In a highly competitive environment, a profitable outcome may be difficult to achieve, in which case the customer relationship becomes even more important.