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What are the Risks?

Sources 

For most derivatives applications, the associated risks are not much greater than those associated with investment in the securities markets.  However, the character and degree of risk undertaken with derivatives varies with the type of instrument used and the way in which it is implemented.  Some of the more common sources of risk are summarized below.

Credit Risk - Credit risk is the risk that a party will fail to meet its financial obligations under a contract.  To mitigate this risk, exchange-traded futures are marked-to-market on a daily basis; in addition, investors are required to maintain sufficient collateral (known as margin in this context) to cover the estimated maximum daily loss. 

These requirements, in combination with a clearinghouse guarantee on every transaction, reduce the credit risk associated with exchange-traded futures.  In the 1994 CIEBA survey, approximately 36% of private pension fund derivative holdings were in exchange-traded futures and 4% in exchange-traded options.

Derivative instruments that are traded over-the-counter as opposed to on public exchanges may entail greater credit risk because such contracts are not always subject to daily mark-to-market valuation.  Moreover, counterparties may not be as well capitalized as exchanges. 

Managing the credit risks associated with these instruments is not inherently different from managing a corporate bond portfolio.  Credit risk for both derivatives and corporate bonds can be minimized by selecting only those counterparties/issuers that are deemed to be highly creditworthy.  In addition, diversifying this exposure can reduce overall portfolio risk. 

An important difference between derivatives and bonds is that with most derivatives the basis of the counterparty risk is not the principal amount of the security; rather, it is the change in the market price of the underlying instrument.  The CIEBA survey indicated that approximately 33% of private pension funds' use of derivatives was in non-publicly traded currency forwards, which trade through the major global banks, and 2% were in swap agreements. 

Leverage - Leverage can take the form of either explicit borrowings or implicit leverage in the payout pattern of a derivative's investment return.  In the case of explicit borrowings, more capital is at risk than the amount funded by the investor (e.g. futures purchased on margin), and the performance of the derivative will magnify the return of the underlying security in a proportionate fashion. 

Implicit leverage results from the characteristics of the derivative itself, which may have a magnified return under certain market conditions, but not in others.  For example, stock options and certain types of structured notes are designed to produce higher returns than do the underlying securities when markets move in a particular direction; the degree to which the return is leveraged when markets move in the opposite direction is dependent on the characteristics of the specific derivative instrument.

Both explicit and implicit leverage in the context of unanticipated interest rate moves led to substantial losses for some investors in the 1990s.  However, based on the CIEBA survey results, leveraged positions accounted for only 0.2% of private pension fund assets and, as a result, have not posed a meaningful risk to the funded status of these private pension plans or the benefit security of participants in these plans.

Liquidity - Liquidity risk arises when an investor is unable to sell or offset a derivative position at or near the previous market price due to a dearth of buyers or a disruption in the market.  Market depth is usually a greater concern in the over-the-counter derivatives transaction because is may be either more complicated in structure or customized to the needs of the original investor.  However, some over-the-counter markets are well established and highly liquid.  For example, forward currency contracts are traded on the "interbank market" which is the most active, liquid market in the world.

Liquidity risk due to disruptions in the market for exchange-traded derivatives was addressed as a result of the severe imbalance in supply and demand for index futures in the market crash of October 19, 1987.  Since that time, the implementation of financial linkages across exchanges and "circuit breakers" to halt trading temporarily when prices move more than a specified amount have proven successful in providing market stability and liquidity.

Another type of liquidity risk is the uncertainty of the availability of funds to meet payment obligations on settlement dates or to meet margin calls.  Because most pension funds invest the majority of their assets in highly marketable securities and use minimal leverage, liquidity is generally readily available and has not posed a problem for pension fund investors.

Other Risks - Market risks of various sorts must be considered when entering into derivatives transactions. In addition to risks such as equity, currency, and interest rate risk, which affect the underlying securities and derivatives markets alike, there are characteristics that are unique to some derivatives.  For example:

The price of an option is determined by its strike price, the time to expiration, and other elements that are the source of opportunity and of risk.

The risk of a mismatch in the variables that affect a derivative and the security that underlies it could result in an imperfect hedge.

Deficiencies in information systems or internal controls could result in an unexpected loss.  For example, the foreign exchange (FX) market trades 24 hours a day.  If FX derivatives are used to take market risks, the investment manager must have the systems and staffing to manage continuous price movements.

Not fully understanding a complex derivative could create operational and related risks.

It is the responsibility of the investor and user of derivatives to be fully informed and understand the risks associated with derivative instruments and the investment strategies employed.

Controls 

The moderate use of derivatives by the private retirement plans in the survey, the focus on exchange-traded futures and foreign currency forwards, and the minimal use of leverage have enabled plan sponsors to minimize risks unique to derivatives.  In addition, most plan sponsors maintain guidelines that incorporate risk constraints and review their derivatives exposures regularly.

Survey results show that portfolio managers to whom investment authority is delegated also maintain tight controls on their use of derivatives.  In 1994, over 94% maintained guidelines on permitted derivative applications and risk, and 85% used stress testing, simulation, or sensitivity analysis to ensure that they adequately assessed the risk of loss under a wide range of scenarios.

The introduction of FAS 133 in 2000, which governs corporate derivatives' disclosure has introduced greater scrutiny in this area, and presumably, greater awareness of the risks in and prudence of their usage.

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bulletTable of Contents 

bulletHow are Derivatives Used? 

bulletIntroduction 

bulletWhat are the Risks? 

bulletExecutive Summary 

bulletSummary 

bulletWhat is a Derivative? 

 

 

 

 

 

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