Derivatives and 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

Finance > Derivatives & Management of Risk

Overview

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.

Derivatives

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.

Strengths

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.

Weaknesses

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?

Investing

Investors have many reasons for investing. Preparing for a variety of future events is a major thrust. Planning for retirement, a child's education, future medical costs or simply ensuring that the investor can manage rising costs and live comfortably. Faerber (2006) suggested five steps to decide how to invest. These include:

• Determine your financial objectives.
• Allocate your assets.
• Prepare your investment strategy.
• Select your investments.
• Evaluate your portfolio.

While this may seem like a straightforward plan, many investors may not have the patience to be thorough in executing it.

Financial Objectives

Financial objectives are as varied as the number and type of investors in the myriad of investments possible. Some objectives may be fairly short term such as saving for a car or long term such as planning for retirement. When considering the alternatives, the investor must evaluate the timeline for the investment, when the return may be needed and the risk involved. When thinking about time, the investor must also consider what time or stage of life he or she is in. Young investors are likely to have different objectives than middle aged or older investors. (2006). Once the investor is clear on their financial objectives, the next step in the process is to figure out where to invest among the alternatives available.

Types of Investments

Faerber divides the types of investment available into financial investments and non-financial investments. Non-financial investments include real estate, collectibles and precious metals. Financial investments can be grouped into four major categories:

• Money market securities: Short term with maturities of one year or less.
• Debt securities: Fixed income with maturities greater than one year.
• Equity securities: Long term securities that do not mature.
• Derivative securities: Securities deriving value from other securities involving transactions completed at a future date.

Types of Investment Risk

Faerber defined risk as "the variability of returns from an investment or the uncertainty related to the outcome of an investment." There are many different types of risk. Risk is the "degree of uncertainty of return on an asset" (Morgenson & Harvey, 2002, p. 284). There have been three types of investment risk identified: Business risk, valuation risk and force of sale risk.

• Business risk means losing value due to "competition, mismanagement financial insolvency." There can also be a high level of risk based on industry.
• Valuation risk is when a stock may be valued too high for its future performance.
• Force of sale risk is being forced to potentially unload a stock that due to market circumstance. This risk can be incurred by attempting to predict when the appreciation of the stock will occur.

Faerber (2006) mentioned additional types of investment risk including: Business risk, financial risk, market risk, operating risk, interest-rate risk, purchasing power (inflation) risk, event risk, exchange rate risk, liquidity risk.

• Business risk is uncertainty related to a company's sales and earnings.
• Financial risk is when a company cannot meet financial obligations. If a company has little or no debt then it has little or no risk.
• Market, interest-rate, exchange-rate, inflation and event risk all fall under the category of systematic or non-diversifiable risk. This risk type is external to an entity and affects all securities.
• Unsystematic risk such as operating risk is specific to a company or industry.
• Groz (1999) called investment risk the chance that you will not achieve the goals you set for investment in the time you wanted to achieve them. If that were to happen, the investor might have to forego various financial plans or look for other sources to address financial obligations. Market risk is when an investment is volatile or goes up or down rapidly and possibly unexpectedly. Many investors have little appetite for volatility. In these cases, the investor should only invest what he or she can accept losing and invest only in investments with limited risk.

How to Manage Risk

Diversifiable risk can be described as risk that can be managed or averted by "pooling risks." Investors who wish to avoid risk will pay for insurance against that risk's occurrence. Insurers increasingly manage asset risk with options, futures, and other derivatives (Fodor, Duran, Carson, & Kirch, 2013). Choudhury advises using derivatives or hedging (correlating stocks) to mitigate risk. Systematic risk can be accomplished by diversification but would require a portfolio of an incredible size to completely allow for this type of risk.

Mutual Funds

Lim (2005) recommends mutual funds as having the advantage of providing the investor with "instant" diversification. Lim noted that stock funds could own about 170 stocks at a time while bond funds could own 300 — 400. Avoiding stock specific risk requires the investor to have at least 50 stocks in a portfolio and mutual funds are an easy answer to this dilemma. Another benefit Lim pointed out is the professional management of mutual funds which allows the investor to have less of an educational burden when trying to manage risk. Mutual funds can also be obtained at reasonable minimum investments of $1000 — $3000 putting them within reach of the average investor.

Asset Allocation

Other ways to reduce risk include diversification through different types of assets (not just a large, balanced quantity) and by investing for the long term instead of getting in and out or expecting instant riches. Investors will lose less money in the long run by holding investments longer. The odds of losing money in a one year period are 27% as compared to holding an investment for 10 years when the odds of losing money are 4%. This practice is called this asset allocation or spreading the risk around. Asset allocation requires looking at financial goals and the additional step of weighing the advantages and disadvantages of a particular investment. Tyson (2003) advised students of investing to engage in "focusing on the risks you can control." The investor has to accept some volatility with stocks and growth oriented investments. Diversification is also recommended as a strategy to mitigate risk. He felt there were two big benefits of diversification including reduced volatility and higher returns for the risk involved.

Risk/Reward Relationships

Managing risk means understanding what risk means to the investor's personal portfolio. Alvares (2007) noted that investors may shy away from a certain percentage of loss on the investment portfolio but may be more tolerant of the risk when the percentage is translated into a real sum of money. Risk isn't easy to calculate because of an inability to predict market volatility. The investor should note the level of risk and reward for specific investments. Alvares (2007) showed the lowest risk-return scenario as having cash invested but has a risk of being susceptible to inflation. Next highest in risk but still low in return are government savings instruments and bonds. Debt mutual funds have higher risk but better returns than guaranteed instruments. Real estate and precious metals are riskier but have returns that usually beat inflation. Equity mutual funds have high risks and returns while direct equity investments have the highest returns and the highest risks. It is also recommended that investors take a long term, 10 year view of investments to reduce risk and spreading the risk around among stocks. A disciplined investor will also regularly buy when the market is down to increase portfolio returns. Alvares (2007) found that real estate investors were most vulnerable to risk because the risk is too concentrated in one type of asset.

Alvares (2007) suggested six ways investors can mitigate risk including:

• Obtaining life insurance.
• Don't invest based on the highest return because the risk may be equally high or higher.
• Diversify your portfolio.
• Avoid over-leveraging because it can multiply your losses.
• Invest for the long term.
• Mix your portfolio with different kinds of assets to beat inflation.

Viewpoint

Implications of Unmanaged Risk

Quantifying risk can be difficult because a number of factors seen and not seen have to be taken into account and ultimately the investor can only control his or her own actions. Investing in the stock market can be compared to investing money through a savings account, as the stock market may exhibit volatility but outperform the savings account in terms of inflation. Investors may make mistakes in managing risk because of emotion or may simply choose not to manage risk because of a lack of information and education about investments. Sometimes investors end up in riskier situations than needed because of an over-reliance on professional investment advisors. Bad experiences in investing may also create an environment where the investor refuses to take any risk at all.

Risk can be created and unmanaged by habits the investor has such as unbridled, excessive spending and consumer credit card debt. It is suggested that those serious about investing eliminate personal addictions that cost money such as smoking, drinking, drugs or gambling. These habits create risk because they cost money unnecessarily, jeopardize the investor's financial clarity and position and reduce the amount of money available to invest. These may seem like small issues but can result in long term ramifications to the investor's health and financial status. A reduction in general spending can be used to fund retirement accounts. In addition, when unmanaged risk is incurred through heavy speculation in derivatives and the investor wins, it adds to the "aura" of the fund manager as a genius and fuels more investment in derivatives. This occurs even though neither the fund manager nor the investor knows why the investment won (Davenport, 2003).

Orange County & Derivatives Decline

Orange County, California (National Review, 1994) was one of the entities that suffered from the derivatives decline in 1994. The treasurer had to rebuild the County's image and struggle to meet payroll for more than 70,000 employees (Banham, 1998). The County was positioned to profit if interest rates fell because the derivatives in the County's investment portfolio were destined to fall if the interest rates rose. The risk was high because the investments were funded through borrowing and cash-on-hand would have to be used to cover margin calls. Other organizations that were adversely affected included Proctor and Gamble and Sears. The National Review (1994) blamed the money managers and those in charge of financial affairs for the governments and companies affected. Their actions did not protect stockholders and stakeholders and ignored risk. Although derivatives were heavily regulated in 1994, these events still occurred, prompting additional action by the SEC. Another result of unmanaged risk — wherever blame is placed — is additional government and regulatory intervention to protect investors against poor decision-makers and advisors.

Banham (1998) looked at the aftermath of the Orange County derivatives scandal and noted that over $600 million in settlements was negotiated by the Orange County treasurer from Merrill Lynch, Morgan Stanley, Dean Witter and Nomura Securities for "bad advice on derivatives." Davenport (2003) noted that Orange County lost $2 billion through derivatives. Tsiantar & Schneider (1994) reported that Proctor & Gamble lost $102 million, PaineWebber bond fund — $33 million and a BankAmerica fund lost $17.4 million all from derivatives.

Orange County ended up with a large settlement but also had to increase taxes and suffer bankruptcy. A partner at a local accounting firm ran against the Orange County treasurer and won in part by revealing the danger of the County's portfolio of derivatives. Another result of unmanaged risk even though the former Orange County treasurer bears some blame is market regulation or correction to investment companies that provide advice. Molvar & Green (1995) noted the fear of systematic risks that could collapse financial markets as the thrust for greater derivative regulation. Investors may hope that this makes financial advisors more wary and twice as careful, but the investor has to take responsibility for risk acceptance and financial understanding of investments.

Terms & Concepts

Arbitrage: The act of taking advantage of differences in price between markets.

Derivatives: Financial instruments whose value comes from other financial instruments.

Diversifiable Risk: Risk that can be mitigated through diversification. Also known as unsystematic risk.

Embedded Derivatives: (also called structured notes or hybrid instruments — a hybrid of different types of investments) Derivative contracts that exist as part of securities.

Hedge: A transaction that offsets an exposure to fluctuations in financial prices of some other contract or business risk. It may consist of cash instruments or derivatives.

Non-diversifiable Risk: Risk that cannot be mitigated through diversification. Also called systematic risk.

Pure Risk: Where no gain occurs but where it is possible for no loss to occur.

Risk: The chance that a damaging outcome will occur resulting in a loss.

Speculative Risk: Risk where it is possible for a gain or loss to occur.

Bibliography

Alvares, C. (2007). Balancing the risks. Business Today, 16, 134-138. Retrieved September 16, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=25829723&site=ehost-live

Banham, R. (1998). Local hero. Treasury & Risk Management, 8, 26. Retrieved September 16, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=1246341&site=ehost-live

Choudhury, G. (n.d.). What is financial risk? [Working Paper]. Retrieved September 16, 2007, from http:// www.theshortrun.com/finance/Chou's%20SR%20article.doc.

Davenport, T. (2003). Assessing risk: Peeling apart data on derivs. American Banker, 168, 1. Retrieved September 16, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=10170344&site=ehost-live

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Faerber, E. (2006). All about investing: the easy way to get started. New York: McGraw-Hill.

Fodor, A., Doran, J. S., Carson, J. M., & Kirch, D. P. (2013). On the demand for portfolio insurance. Risk Management & Insurance Review, 16, 167-193. Retrieved November 21, 2013, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=91957828&site=ehost-live

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Jin-Yong, Y. (2013). Volume of derivative trading, enterprise value, and the return on assets. Modern Economy, 4, 513-519. Retrieved November 26, 2013, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=91690771&site=ehost-live

Kennon, J. (2007). The 3 types of investment risk. About.com investing for beginners. Retrieved September 22, 2007, from http://beginnersinvest.about.com/cs/valueinvesting1/a/080103a.htm

Lim, P.J. (2005). Investing demystified: a self-teaching guide. New York: McGraw-Hill.

Liu, H.C.K. (2002). The dangers of derivatives. Asia Times Online, Retrieved September 22, 2007, from http://www.atimes.com/global-econ/DE23Dj01.html

Molvar, H.D. & Green, J.F. (1995). The question of derivatives. Journal of Accountancy, 179 55-61. Retrieved September 16, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=9503214684&site=ehost-live

Morgenson, G. & Harvey, C. R. (2002). The New York Times Dictionary of Money Investing. New York: Times Books.

Numa.com. (n.d.). The derivatives FAQ. Retrieved September 16, 2007, from http://www.numa.com/ref/faq.htm

Squeezing Orange County. (1994). National Review, 46, 17. Retrieved September 16, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=aph&AN=9501077508&site=ehost-live

Timberlake, J. (2011). NYPC eyes options for growth. Wall Street Letter, 01-02. Retrieved November 21, 2013, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=65205732&site=ehost-live

Tsiantar, D. & Schneider, M. (1994). Looking out for derivative dangers. Newsweek, 124, 64. Retrieved September 16, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=9406287539&site=ehost-live

Tyson, E. (2003). Personal finance for dummies. Indianapolis: Wiley Publishing.

Suggested Reading

Dempsey. M. (2002). The nature of market growth, risk, and return. Financial Analysts Journal, 58, 45-59. Retrieved September 16, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=7026952&site=ehost-live

Financial Pipeline (n.d.). Derivatives related terminology glossary. Retrieved September 22, 2007, from http://www.finpipe.com/derivglossary.htm

Fitzgerald, J. (2007). Don't put all your risk in one bucket. Money Management, 21, 24-25. Retrieved September 16, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=26235188&site=ehost-live

Methanex, Nova blossom on methanol price runup. (1995). Chemical Marketing Reporter, 247, 8. Retrieved September 16, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=9503035098&site=ehost-live

Robertson, K. (2007). The other side of generally accepted financial theories. 401K Advisor, 14, 3. Retrieved September 16, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=26225650&site=ehost-live

Webb, J.A. (2001). Hedging your bet. LP/Gas, 61, 38-40. Retrieved September 16, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=5331294&site=ehost-live