In order to understand the risks in financial derivative contracts, one must first understand derivatives and the purpose for which they are employed. A financial derivative is the security or financial instrument that depends or derives its value from an underlying asset or group of assets. They are simply contracts between two or more parties. The value of such a contract is determined by changes or fluctuations in the underlying reference asset value. Financial derivatives are contracts for differences performed with the exchange of cash flows.
There are two groups of contracts: exchange and custom. Exchange contracts are traded on a recognized exchange, with the counterparties being the holder and the exchange. The contract terms are non-negotiable and their prices are publicly available, e.g., futures and listed options. Custom contracts are traded off-exchange with specific terms and conditions determined and agreed by the buyer and seller—e.g., forwards and swaptions. The primary difference is standardization versus customization. Both types of contracts have secondary risks as explained below but the credit risk of custom contracts is elevated since, unlike the exchange, there is no guarantee of the contingent credit risk.
Financial derivatives can be used for a variety of purposes but are mainly used for hedging—i.e., in the reduction of risk. They are used to hedge interest rates, inflation, equity, foreign exchange, price risk, and commodities. While these derivatives are set for a purpose of reducing a primary risk, the employment of these transactions gives rise to secondary risks embodied in the trade—namely market and credit risk. Market risk is the sensitivity to movements in prices, foreign exchange, commodities, interest rates, and inflation. The result would be a diminishing real return in the value of the cash flow. Credit risk is the risk that the counterparty with whom the trade was transacted defaults and is unable to perform its obligation. The result would be a need to replace the existing contract if possible with another counterparty.
CREDIT RISK MEASURES AND CONTROLS
The following metrics can be used to monitor and measure credit replacement risk exposure. These include notional value of contracts, current mark-to-market, expected exposure, and stressed future potential exposure. Some of these metrics are more refined than others. Notional contracts provide information regarding the total size of a product with a counterparty. Unlike bonds and loans, the notional value of a derivative does not reflect the actual risk, since the long and short positions may have different maturities, coupon details, options, and terms. Current mark-to-market is a snapshot of the current exposure to a counterparty typically adjusted to reflect any netting (e.g., ISDA agreements) and collateral arrangements. This, however, does not consider any future sensitivity changes.
The latter two metrics need more calculation and calibration. Expected exposure represents the expected positive mark-to-market profile of a swap or portfolio of transactions reflecting any netting and collateral arrangements at different points in the future. The paths can be generated using a Monte Carlo simulation with implied market volatilities and correlation parameters. Stressed future potential exposure is a further distillation to the expected exposure but is enhanced by using stressed parameters (e.g., worst case historic volatilities/correlation parameters).
Counterparty risk is managed with the approval of an internal credit review and assigning—based on that review—risk limits for each counterparty. Risk limits would be based on: internal/external counterparty rating, market capitalization, maturity buckets, and product types. This internal credit review is for all counterparties including exchange counterparties. The entire process above would be embodied in a policy and procedures document with the inclusion of roles and responsibilities and governance oversight.
Further counterparty risk mitigation can take the form of collateral arrangements and collateral management. Collateral is used to facilitate trades between two parties by providing security against the possibility of default of a counterparty. Bespoke contracts—i.e., OTC derivative exposures—are managed via credit support annexes under International Swap and Derivatives Association Master Agreements (ISDAs) setting out collateral arrangements. Credit support agreements are used for derivative transactions as a way of reducing the mark-to-market exposure to a counterparty. Under a credit support agreement the counterparties agree to collateralize the net mark-to-market exposure of the portfolio with a defined pool of eligible assets (e.g., cash, government bonds). The collateral is transferred to the other party when the portfolio of transactions under the respective agreement is a net negative amount for the transferring party. For exchange traded contracts, collateral in the form of margin is mandated as per the exchange requirements.
MARKET RISK MEASURES AND CONTROLS.
The most common industry tool to measure market risk is value-at-risk (VaR). The tool is commonly deployed and serviced by third parties’ providers. VaR as a single metric conveys a single consolidated view of the exposure all assets and liabilities have to risk sensitivities such as interest rate, FX, credit, inflation, equity risks, etc. VaR calculates an expected loss amount that may not be exceeded at a specified confidence interval over a given holding period, assuming normal market conditions. The higher the portfolio’s VaR, the greater its expected loss and exposure to market risks. Firms typically have VaR limits at both the individual and enterprise level. VaR has its doubters and critics but nevertheless it remains the standard tool.
Further enhancement involves active market risk management incorporating both netting and hedging. Netting is the combination of trades, both long and short, on financial derivative instruments and/or security positions which refer to the same underlying asset, irrespective of the contract’s due date. Hedging refers to combinations of trades on financial derivative instruments and/or security positions which do not necessarily refer to the same underlying asset, with the sole aim of offsetting risks linked to positions taken through other instruments/positions.
The identification, assessment, control and monitoring, of both credit and market risk is an ongoing process and needs to be reviewed on a regular basis. The whole process must be well documented by means of a policy and procedures document. While you cannot totally eradicate credit and market risk, you can mitigate by monitoring, being aware, and taking active steps.