Risks Involved in Derivative Contracts

Derivatives are considered to be extremely risky. The market is divided in two fronts when it comes to the opinion about risks involved in a derivative contract. Some people are of the opinion that since derivatives are not new securities by themselves, how can they introduce new risk in the market? The opposing camp agrees to this argument. However, they also state that derivatives are capable of concentrating the risks in such a manner that the system cannot absorb them easily.

That being said, derivatives do create a wide variety of risks. Some of them have been discussed in this article:

Counterparty Risk

About three quarters of the derivatives contracts across the world are entered over the counter. This means that there is no exchange involved and hence there is a probability that the counterparty may not be able to fulfill its obligations. This gives rise to the most obvious type of risk associated with derivatives market i.e. counterparty risk.

Counterparty risks have many names. They are sometimes called legal risk, default risk, settlement risk etc. Essentially all these risks refer to the same risk. When one party enters into an agreement with another party, there is a chance that one of them may not follow through with the commitments. This could happen at various stages. For instance, if the contract is not drafted then it would be called legal risk. On the other hand, if the other party defaults on the day of the settlement, then it would be called settlement risk. Hence, all these risks can be put together in one category called counterparty risk since all of them pertain to willful or innocent default by the counterparty.

Price Risk

Derivatives being traded on the securities exchange are a relatively new phenomenon. Hence, all participants including the most seasoned ones are clueless as to what should the pricing of these derivatives be. The market is functioning in terms of superior knowledge relative to peers. Hence, there is always a risk that the majority of the market may be mispricing these derivatives and may cause large scale default. This has already happened in an infamous incident including the company called “Long Term Capital Management (LTCM)”. LTCM became part of a trillion dollar default and became a prime example as to how even the smartest management may end up wrongly guessing the price of derivatives.

Agency Risk

A very less talked about problem pertaining to derivatives market is that of agency risks. Agency risk simply means that if there is a principal and an agent, the agent may not act in the best interest of the principal because their objectives are different from that of the principal. In this scenario it would mean that if a derivative trader is acting on behalf of a multinational corporation or a bank, the interests of the organization and that of the individual employee who is authorized to make decisions may be different. This may seem like a small problem. However, if we consider what happened at companies like Barings Bank and Proctor and Gamble then the true picture emerges.

Barings Bank was an industrial age bank that had a reputation that people could vouch for. However, as the new age dawned, Barings Bank ventured into derivatives trading. They had a division that would execute bets on behalf of the clients. Traders that could make successful bets were highly rewarded. Amongst them was a trader named Nick Leeson who would later become famous as the “rogue trader”.

Nick Leeson used the bank’s own money and made huge bets in the derivatives market. For some time he was making a profit. However, soon the size of his ambition grew and he siphoned off more money to the derivatives market. Finally, the bets became so large that by the time the issue became apparent to the senior management, Barings Bank was bankrupt! Nick Leeson had fled Singapore and was arrested and sentenced to prison!

The above example clearly explains that kind of risks that organizations face when they allow traders to make highly leveraged bets on their behalf. Also, since derivatives do not appear on the financial statements, the management finds it difficult to keep track.

Of course, organizations have evolved a lot more since Nick Leeson’s era. Internal controls are extremely strict and bets made by traders are closely monitored. However, the agency problem is still alive and kicking. Any firm that wants to trade derivatives must pay close attention to and create a plan to mitigate this risk.

Systemic Risk

Systemic risk pertaining to derivatives is widely spoken about. Yet it seems to be less understood and almost never quantified. System risk refers to the probability of widespread default in all financial markets because of a default that initially started in derivative markets. In simple words, this is the belief that because derivatives are so volatile, one major default can cause cascading defaults throughout the derivatives market. These cascading defaults will then spin out of control and enter the financial domain in general threatening the existence of the entire financial system. This view has been prevalent for a long time. However, it was often dismissed as a silly doomsday prediction. In 2008, most people found out that it wasn’t that silly and farfetched at all.

The logic behind this point of view is that most organizations dealing with derivatives have other businesses too. Consider banks like JP Morgan and Goldman Sachs. They also have retail and corporate banking businesses. However, in the event of a default, if banks like JP Morgan take huge losses in derivatives markets, it may affect businesses on the main street as well.

Systemic risk pertaining to derivatives is not faced by any particular party. It is faced by the entire system. At the present moment, regulation is being proposed as being the viable solution to this problem. Regulators across the world are spending days and nights working out a plan that helps to reduce or evade systemic risk.

Therefore, dealing with derivatives is largely about learning how to manage these risks effectively. The market is never secure when such high leveraged investments are involved. Hence, when it comes to derivatives, a vigilant trader is a good trader.