What are the Risks?
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
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
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
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
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.
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
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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