Strategies&Tactics Risk Management Programs & The Use of Derivatives
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Risk Management Programs & The Use of Derivatives

Summary Overviews

As the title implies, two main subjects will be addressed in this article; the elements involved in developing, managing and evaluating risk management programs; and, an overview of the use of derivatives within a risk management program. A third subject, early warning signs, is also addressed in an effort to provide some insight into the type of conditions that tend to accompany inappropriate uses of derivatives. Given the complexity of the subject matter, comments will be made at a summary level. References to detailed information sources will be provided for further reading and inquiry.

Risk Management Process

Regardless of type of institution within which risk is being, or needs to be, managed, there are a few basic elements common to all. These basic elements will be described in summary form in the following comments and include:

Internal education.
Risk identification and quantification.
Decision to manage or accept risk exposure.
Risk management alternatives.
Strategy development and implementation.
Accounting, recordkeeping, and reporting.

Internal Education

This is the most basic element of any management process. It is so basic, that it is often times overlooked. Specifically, there needs to be an on-going process of systematically improving Board, Management, and Staff literacy regarding the various types of risks inherent in conducting their business and how those risks can be managed. The primary focus of this educational effort is to facilitate the internalization of the capability to make and implement risk management decisions in a consistent and disciplined manner on an on-going basis.

Risk Identification and Quantification

For financial intermediaries there are five main risk types, all of which are capable of being managed to acceptable levels. These risks include:

1. Interest rate.
2. Price (valuation).
3. Prepayment.
4. Credit.
5. Exchange rate.

Once the type of risk to be managed has been identified, the next issue becomes the objective quantification of that risk. Depending on the type of risk, there are several commercially supported computer models available. And despite a lot of the academic rhetoric about the limitations of spreadsheets, an Excel spreadsheet application in combination with some very basic VBA (Visual Basic for Applications) routines (formerly called macros) can be used to model, and professionally present, just about any imaginable risk analysis. Regardless of the specific modeling approach employed, there are at least three key elements that need to be included in the quantification effort to enable subsequent risk management decisions:
  1. Underlying assets and liabilities creating the risk exposure. Key issue is to examine both the asset and liability side of the risk exposure to enable an understanding of the individual portfolio exposure as well as the net exposure created by the combination.
  2. Term of risk exposure. Key issue is to determine the length of time the exposure is expected to exist. An important sub-issue is to determine if the exposure is a one time event, or if it is a continuing series of events.
  3. Direction of risk exposure. Key issue is to determine the directional interest rate, price, or exchange rate movement to which the underlying risk position is exposed. This is not a forecast, it is simply a determination of the market environment within which the underlying risk position is negatively (and positively) impacted.
As a result of addressing the foregoing risk identification and quantification issues, it is fairly easy to construct a graphical representation of the "as is" performance profile of the underlying balance sheet or portfolio. This can be as simple as creating a graph of a single security portfolio, or as complex as executing a series of sophisticated balance sheet, cash flow, income statement, and econometric models representing the relationships of a myriad of interrelated business activities or portfolio holdings. Regardless of how simple or complex the effort, an "as is" profile can, and must, be produced before implementing strategies to alter the profile. The reasons for this are fairly straightforward:

  • • Without an understanding of the "as is" profile, it is difficult, if not impossible, to evaluate the effectiveness of any strategy implemented to alter the "as is" profile.
    • Regardless of how well intentioned management's risk management efforts might be, without an understanding of the "as is" profile, many risk management strategies actually end up exacerbating risk exposure as opposed to managing it towards the desired profile.

    This "as is" performance profile will be very useful in establishing a reference point by which all subsequent decisions can be evaluated and facilitated.

    Decision to Manage or Accept Risk Exposure

    The driving force of any effort to manage risk is the conscious decision, by management, to either accept or modify the risk exposure quantified as being inherent in the underlying balance sheet or portfolio. Naturally, this type of decision needs to be made within the context established by the goals and objectives that make up the Company's business plan, and the environment within which the resulting risk management strategies will be implemented.

    Risk Management Alternatives

    Once a conscious decision has been made to manage a given risk exposure, management's attention should then turn to an evaluation of the effectiveness (risks, costs, and benefits) of the various risk management alternatives. As a general rule, there are three main alternative risk management categories from which to draw:

    1. Policy decisions - This category is made up of the business policy decisions management makes in their on-going effort to achieve their competitive position and financial performance objectives. These are usually the least costly to implement, but are somewhat limited in their utility to manage all the exposure to be managed without eliminating profit potential. Regardless of this limitation, this alternative, at minimum, should be exhausted before utilizing derivatives.
    2. Cash market transactions - This category is made up of the conventional transactions management employs to manage the Company's balance sheet in conformance with industry practices and regulatory guidelines. For financial intermediaries these are usually money market, fixed income, mortgage-backed, and equity securities related transactions. These alternatives are best utilized when there is exposure remaining to be managed after management has exhausted policy decision alternatives and before utilizing derivatives.
    3. Derivatives - This category is made up of financial instruments that have been derived from underlying instruments that have similar, if not the same, characteristics as the assets and liabilities that make up the Company's risk position (balance sheet or portfolio). These instruments include; forwards, futures, options, swaps, etc. Since this category tends to have more inherent risks, derivative alternatives should be utilized only when there is risk remaining to be managed after management has exhausted all policy decision and cash market transaction alternatives.
    It is important to note that even though management may make a conscious decision to manage a given portion of the Company's risk exposure, and may deliberately act to conscientiously exhaust all policy decision and cash market transaction alternatives, there may remain some exposure still yet to be managed. When this occurs, management's attention needs to be focused on evaluating the risk/reward profile associated with utilizing derivatives to manage the remaining exposure. This analysis, on occasion, will reveal that the risks associated with utilizing a derivatives based strategy may be greater than the benefits of trying to manage the remaining unmanaged exposure. Therefore, there are times, wherein, there is no practical alternative available to management other than continued acceptance of the unmanaged risk exposure.

    Strategy Development and Implementation

    Regardless of the type of risk exposure and how it was quantified, regardless of why management decided to manage the exposure, and regardless of the risk management category from which the strategy is drawn, there are five basic issues that need to be addressed in order to develop and implement a strategy in such a way as to minimize, as opposed to exacerbate, the Company's exposure:
    1. Establish a reference point from which strategies will be developed and by which strategies will be evaluated. The "as is" performance profile as previously described is helpful in this regard.
    2. Clearly state and document the objectives underlying the strategy.
    3. Ensure suitability of strategy, both initially and by tactical adjustments on an on-going basis, by making sure that the decisions, actions, and instruments making up the strategy and tactics produce a profile that, when added to the "as is", mitigates as opposed to exacerbates the underlying position's exposure. This can be accomplished by modeling the effect the strategy and related tactical adjustments have on the "as is" performance profile.
    4. As a general rule there is more than one strategy and related set of tactical adjustments that can be considered suitable for accomplishing most objectives. Therefore, management needs to objectively evaluate (in both favorable and unfavorable market environments) and select the most suitable strategy for implementation. This can be accomplished by comparing the resulting "adjusted" performance profiles to each other and to the "as is" profile.
    5. Implement the selected strategies and tactical adjustments in a manner consistent with established and approved policies and procedures.

    Accounting, Recordkeeping and Reporting

    The primary focus of this element of the risk management process is to ensure accurate accounting, recordkeeping, and reporting of the results of all strategies. By doing so, objective evaluations of risk management efforts will be enabled. There are three important applications of this point:

    1. Proper accounting treatment for GAAP and tax purposes .
    2. Systematic reconciliation of internal transaction and position records with brokerage firm records.
    3. Periodic reporting to Board, Management, and regulatory agencies.

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  • Derivatives Overview

    What Are Derivatives?

    An instrument whose structural characteristics and variables are based on the structural characteristics and variables of other more basic underlying instruments. These structural characteristics and variables include -- amount and timing of cash flows; maturity and expiration dates; and exposure to interest rate, credit, prepayment, valuation, and exchange rate risks. Derivative instruments include, forwards, futures, options, swaps, caps, ceilings, floors, collars, etc.

    Active Derivative Markets

    The markets with derivative instruments most commonly used by institutional entities include:

    • Treasury Bills, Notes, and Bonds.
    • Mortgage-backed securities.
    • Equity securities and related indexes.
    • Global currencies.
    • Energy (crude oil and derivative products, natural gas, electricity).
    • Commodities (traditional grains, softs, metals, etc.).

    Why Use Derivatives?

    There are two main reasons for the use of within derivatives within a risk management program:
    1. High and variable levels of market volatility. These conditions have existed since the mid 1970's.
    2. Limited ability to adequately manage risk exposure by just using policy decisions and cash market transactions.
    Exchange Traded vs. Over-The-Counter (OTC)

    There are two main forums within which derivatives trade - organized exchanges and over-the-counter (OTC). They are similar in many respects, but do have important distinguishing features as illustrated in the following table:

    Exchange Traded
    Examples Forwards, Caps, Floors, Collars, Swaps, etc. Futures and Options.
    Market Networks consisting of market makers who exchange price information and negotiate transactions. Organized exchanges in Chicago, New York, Kansas City, and other capital markets around the world.
    Agreements Custom-tailored to meet specific needs of counter-parties within accepted guidelines. Standardized contracts.
    Risk Default/credit risk to the counter-parties. Guaranteed contract performance.
    Regulation Not formally regulated. U.S. exchanges regulated by Commodity Futures Trading Commission (CFTC).
    Ability to Value Varies by market - some have electronic posting, others require individual inquiry and valuation. Daily settlement and intra-day prices electronically posted.

    Unique Terminology

    One of the most significant obstacles to overcome in the use of derivatives is getting a good handle on the use and meaning of the unique phrases utilized by market participants. The list is extensive, therefore, please refer to Glossary for a more detailed treatment of this issue.

    Strategic Applications of Derivatives

    Derivatives, like most tools, are neutral until utilized. It is with utilization that positive and negative attributes can identified. The main utilization issue related to the use of derivatives is the use to which management is applying derivative strategies - hedging or speculating. Hedging is generally perceived to be good and speculating is generally perceived to be bad. However, there are three thoughts that should be kept in mind when considering these generalizations:
    1. Hedging rationale and the related documentation is oftentimes cleverly utilized to disguise speculation. Therefore, the real issue is how to properly distinguish hedging from speculating. This is more difficult than it would appear. Many would point to a textbook description to describe an appropriate hedge. Textbook descriptions are just that. They are used to illustrate hedging concepts and principles. Real time implementation, under changing market conditions, has considerably more imperfections than what can be adequately described in a textbook illustration. However, these imperfections are not justification for speculating. They are simply an additional risk that management must learn how to manage. The key to distinguishing between hedging and speculating rests in management's discipline in consistently applying the precepts outlined in the foregoing risk management process discussion.
    2. Speculation is an inherent part of human behavior and when managed properly can produce very constructive results. However, some entities are precluded, by regulations or internal policies and procedures, from speculating with derivatives. The paradox of this is that these same entities, for the most part, are allowed to speculate through policy decisions and cash market transactions. And, furthermore, are, in effect, speculating when they are not hedged. Therefore, the issue becomes one of knowing when and how to properly speculate as a function of the business and regulatory environment within which the management activity is taking place.
    3. Regardless of whether management is hedging or speculating, there is one very dominant consideration inherent in both - prudent management of the risks associated with the underlying activity.

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    Accounting Issues

    Given that most institutions that employ derivatives are publicly traded entities, many of which are also regulated, GAAP is extremely important.

    Relevant Pronouncements

    New Developments

    Disclosure Requirements (Hedging vs. Trading)

    Early Warning Signs

    Recent Catastrophes

    The problem is not with the derivative instrument. The fundamental problem is with management's use of the instruments. These problems stem from issues as simple as ignorance and laziness to as complex as being deliberately misled by an unscrupulous trader or broker. Regardless of the underlying causes, there are several common threads tend to run throughout the recent catastrophic events sensationalized by the popular media:

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    No Policies or Procedures

    The negative issues that tend to be related to an absence of documented policies or procedures include:
    • No record of Board and Management approval.
    • Inadequate independent trade verification.
    • Failure to conduct independent portfolio and position valuation.
    • Lack of consistent reporting to Board and Management.

    Ignorance is Bliss

    Management does not know its position or the risk caused by this position due to inadequate operations and management information systems. Management is misled only by its own faulty controls process.

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    Inadequate Explanations of Strategy

    Management unable to clearly explain the rationale underlying the objectives, risks, and rewards of a strategy.

    Inadequate Risk Analysis and Controls

    Excessively large positions undertaken by an institution with the knowledge of its management, but without proper risk quantification and analysis. This exposure is exacerbated when large positions are linked to high leverage instruments or positions that magnify firm's exposure to market movements. Management is fully aware of the size of the position, but does not recognize its risks.

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    Management and Trading Activity Inconsistent with Company Business Goals

    This can be deliberate or inadvertent. Either way, the result is usually catastrophic. It is preventable by periodically reviewing risk management policies and procedures to ensure consistency with the overall context established by the Company business plan goals and objectives.

    Rogue Trader

    Deliberate effort by a trader to hide either the size of his position or the full extent of his losses, typically because he has exceeded the position size or loss limits set by management or has used unauthorized instruments.

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    Loss Recovery vs. Exposure Stabilization

    Loss recovery refers to situations, wherein, management's attention and actions are focused on attempting to recover from some serious problem adversely affecting the Company's financial condition and performance. Common elements in these type situations include:

    • The development and implementation of strategies that create risk in the hopes of achieving extraordinary gain.
    • High levels of emotional involvement in the decision making process which tends to lead to irrational actions and undesirable results.
    • The development and implementation of strategies that create risk in the hopes of achieving extraordinary gain.
    • High levels of emotional involvement in the decision making process which tends to lead to irrational actions and undesirable results.

    Exposure stabilization refers to risk management strategies developed and implemented to stabilize a yield, cost, or net interest margin regardless of market volatility. The condition being stabilized can either be a positive, or it can be a negative that needs to be kept from getting worse.

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    Summary Comments

    Given the broad scope of the topic - Risk Management Programs and The Use of Derivatives, our comments have been kept to a summary level. For more detailed information refer to following Bibliography, and email and WebSite references. The key points to remember in developing, managing, and evaluating risk management programs and the use of derivatives is:

    1. Board, Management, and Staff commitment to staying abreast of developments that enable systematic elevation in their literacy regarding the various types of risks inherent in conducting their business and how those risks can be managed.
    2. An unwavering discipline in consistently applying the precepts outlined in the risk management process discussion.

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    Links to Related Resource


    International Swaps and Derivatives Association (ISDA)
    Applied Derivatives Trading (ADT)
    RiskMetrics & VaR (JPMorgan)
    • Strategies & Tactics Performance Profile


    AICPA search for derivatives

    Price / Interest Rate Quotes



    Chicago Mercantile Exchange
    Chicago Board of Options Exchange




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