Derivatives & Management of Risk
Derivatives are investments that depend on an underlying security based on some future date. Since it is difficult to predict when something will occur, derivatives are seen as something of a gamble. As a result, many liken derivatives to a lesson in how to manage risk. Risk is the uncertainty an investor experiences regarding the outcome of an investment. Risks abound and can be due to many unforeseen and uncontrollable factors. Investors typically balance risk by making sound financial goals and objectives, managing the allocation of the investment portfolio and by selecting investments based on individual appetite for risk.
Keywords Arbitrage; Derivatives; Diversifiable Risk; Embedded Derivatives; Hedge; Investment Risk; Non-diversifiable Risk; Pure Risk; Risk; Speculative Risk
Risk and uncertainty are an inescapable part of investing. Fredman & Wiles (1998) called risk "the possibility of loss, damage, or harm" where risk depends on the individual and the individual's appetite or tolerance for risk. Managing risk is very important for successful long term investing. Investors can use various strategies such as diversification and asset allocation to reduce risk. Ultimately, the investor must compare financial objectives to the risk and return rates of investments.
A derivative is a financial asset that gets its value from an ordinary security like a stock or bond (Morgenson & Harvey, 2007). Faerber (2006) defined derivatives as "securities that derive their value from other securities and involve transactions that are completed at a future date." Derivatives are used to hedge against changes in interest rates and currency exchange rates. Numa (n.d.) stated that derivatives are typically used to provide the investor with several investment strategy options including "speculation, hedging, arbitrage" and a combination of these. Speculation is when the investor buys financial products with the hope of profiting from the fluctuation in the products. Hedging is a financial strategy where the investor chooses assets based on the attempt to reduce the possibility of negative portfolio impact by balancing or canceling out the risk. Arbitrage is buying a financial asset at one price and selling it at a different one, hopefully higher, in a different market such as a different country.
Molvar & Green (1995) noted that derivatives are the results of wizardry by financial engineers on Wall Street. These engineers have taken ordinary financial instruments and combined them in new ways to exploit various risk and reward scenarios. The impact of 'derivatives' have made them a case study in how to manage risk. A Federal Reserve board member is quoted as saying that derivatives are not the problem but the reaction to the risk caused by them is the issue. Derivatives are found to be popular with many types of entities because of the flexibility in choosing risk and reward scenarios. Derivatives are a multi-trillion dollar market and are popular with insurance companies, manufacturers, banks, not-for-profit organizations and government.
Some focus on the historical negatives of derivatives while others caution against generalizing derivatives as bad. Liu (2002) traced the "beginning of finance globalization" to the oil crisis of the 1970s that required multinational banks to find borrowers in other countries. These developing countries became embroiled in debt. The International Monetary Fund created bailouts for developing countries that decreased spending and currency devaluation in the 1980s. In the 1990s, derivatives became a new form of finance flowing to developing countries which were termed "newly industrialized economies" (NIEs). Some feel that derivatives were a critical factor in the 1997 Asian financial crisis. Derivatives in this case were used to creatively reallocate risk and help financial institutions gain tax advantages, avoid accounting rules and receive advantages over the exchange rates. Liu believes that investors become interested in derivatives because of high returns but want higher profits than risk which causes financial institutions to have some unfunded risk.
Tyson (2003) considered derivatives such as futures and options no better than gambling and advised against investors (especially novices) getting involved with them. "Options on futures and futures do walk hand in hand; most traders are trading these two interchangeably and simultaneously" says Ira Krulik, C.O.O. of New York Portfolio Clearing (Timberlake, 2011). One reason futures and options can be risky is because the investor is trying to predict activity in the short-term movement of a specific security and can result in large losses. Short term market movements tend to be rapid and unpredictable in any direction. The short term changes are catalysts that make investors jump in and out of markets quickly (Alvares, 2007). Tyson noted that some professional investors use options and futures to provide a hedge against some risk but found the value limited for the average investor.
Investor Attraction to Derivatives
Fredman & Wiles (1998) indicated that derivatives rose on the investor radar screen in 1994 because of high profile failures of bond and money market funds. Some feel that the 1994 crisis put a permanent blemish on the derivatives market. Because of action by the Securities and Exchange Commission (SEC), today there is less risk from derivatives today as some of the more dangerous ones have been outlawed. Although derivatives can be used in a generic sense to include futures and options, they can also be seen in several customized versions such as collateralized mortgage obligations and structured notes. Derivatives have inherent leverage and can move in the same or in a different direction than the underlying security and are more volatile than the underlying security. Derivatives have a "gearing" feature with attracts attention from investors because the derivative could experience a large return of say 100% in a very short period such as days while the underlying security only rises 10%. Gearing is the ratio of what you put in and your return. Fredman & Wiles (1998) stated that bond managers would use derivatives for the following reasons:
- To reduce or hedge an unwanted risk.
- To make speculative bets on a market or security.
- To increase returns in an effort to offset lofty expenses, especially 12b-1 fees.
The pressure to deliver high returns in a competitive market can make the benefits of derivatives attractive. The increased volatility that derivatives offer can be exciting to the speculative investor but often beyond the individual investor's educational understanding. Fredman & Wiles agreed that derivatives aren't necessarily bad but felt that it was more of a question of how and when derivatives are used, for what purpose and in what quantities. The preferred method is to use derivatives in moderation. Fredman & Wiles suggested avoiding any mutual fund with extra high returns as compared to others and any portfolio with higher than average performance and expenses.
Types of Derivatives
In 1994, the derivatives market was divided into exchange-traded and over-the-counter (OTC) derivatives. Exchange traded derivatives are futures and options contracts, while OTC derivatives are less liquid swaps, options and forward contracts. OTC trading, which tends to be less strictly regulated and thus can be more flexibly applied, is positively associated with abnormal return (AR) and return on asset (ROA), while exchange trading is not. After the US financial crisis, exchange trading, which is more heavily regulated and thus has lower credit risks, is positively associated with AR and ROA (Jin-Yong, 2013). Economic Trends (1994) noted the 1992 year-end dollar value of exchange traded derivatives as $5 trillion and the over-the-counter derivatives as $7.5 trillion. Economic Trends pointed to financial institutions using derivatives as a hedge against interest rate changes as the reason for the rapid growth in derivatives. Davenport (2003) positioned the amount of derivatives in U.S. banks in mid-2003 as nearly $62 trillion. This value is 10 times the national debt. The ten year growth in derivatives is stunning but derivatives still remain a mystery to most investors. Davenport (2003) listed seven companies as primary participants in dealing in derivatives. These companies are:
- J.P. Morgan Chase & Co.
- Bank of America Corp.
- Citigroup. Inc.
- Wachovia Corp.
- Bank One Corp.
- HSBC Holdings PLC
- Wells Fargo & Co.
Davenport suggested that instead of hedging against risk, these banks were assuming more risk because they saw a marked increase in the risk exposure from derivatives.
Numa (n.d.) found that the most common derivatives the average investor would see would be "futures, options, warrants and convertible bonds." However, the other types are limitless based on how investment banks choose to combine investments. Because a derivative is based on a contract and not an asset, they tend not to be standardized. According to Numa, if an investor has any money in a pension fund or insurance policy, the investor's funds are probably invested in derivatives with or without the investor's knowledge.
What is Risk?
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