The derivatives demon raises its head again

The news shocked the market as the CEO of the bank, Jamie Dimon, was regarded as a prudent financial-risk manager. When US policymakers wanted to control large financial institutions’ proprietary trading, he led the opposition to the idea. His stand alerted policymakers, and the bank is now under investigation. One way or another, JP Morgan’s large loss will give policymakers additional justification for controlling the trading activities of “too big to fail” banks – and probably the derivatives markets too. 

A derivative instrument is a financial contract whose value derives from a basic underlying market. For example, the foreign exchange spot is the basic underlying market upon which the derivative called a foreign exchange forward is traded. An FX forward is an agreement between two parties to exchange currencies at an agreed rate at a future date. When two parties are involved, the market is known as over-the-counter (OTC). There is another market, called Exchange-traded, among the most famous of which is the Chicago Mercantile Exchange (CMT). The CMT has been operating as an exchange-traded market for futures and options contracts in 1848 – 164 years ago. Futures and options contracts are kinds of derivatives traded on the CMT based on foreign exchange, interest rate, bonds, agriculture, energy and metal assets. We use derivatives for hedging (to mitigate risk) and for trading (taking calculated risk in expectation of making a profit). 

The concept of using derivatives for hedging is simple. If you are an exporter who expects to receive payments in foreign currency in the future, you may sell the proceeds forward to your bank to lock in the rate. Or you may sell future contracts in the futures exchange market. To take another example, if cotton farmers fear that the cotton price will drop then they would want to lock in the price before harvest by selling cotton futures contracts. Meanwhile, cotton buyers can buy cotton futures to hedge against a rise in price. Traders, however, have nothing to do with manufacturing or producing goods. They simply use the market view to take up a “buy” or “sell” position and hope to take profits later. 

If the use of derivatives sounds so simple and has survived the test of time for more than a century, why are we having a problem now? Policymakers try to regulate derivatives markets and control banks’ trading because the last global financial crisis arose from the collapse of the US property market and the credit derivatives which derived from property portfolios. The other reason for regulation is that the value of outstanding derivatives contracts is very large. A report by the Bank for International Settlement last June estimated that approximately $700 trillion in over-the-counter contracts is outstanding. 

In our opinion, there are three factors that make derivatives seem like a scary monster today. First, it can be difficult to find the fair value of some derivatives instruments. The financial market has grown more complex over the last 10 or 20 years. Banks now need to use mathematicians, statisticians or financial engineering to come up with models to price or value derivatives instruments. Each institution has its own model and whether it is good or bad, only time will tell. Second, is market complexity. There are times when we want to do hedging but cannot find a direct precedent for our contract. Then we need to find a proxy and study its price movements for a correlation so as to come up with a hedging ratio. The correlation itself will change over time so the hedging won’t be as effective as we might think. Third, is risk management. We must fully understand both the pricing model in all its complexity and the changes in the market. We must be well prepared when things go wrong. 

Sad to say, we may think we know the risk and how to effectively control it, but reality sometimes wrong-foots us. 

 

Padej Piroonsit is head of Global Sales at CIMB Thai Bank. Views expressed are his own.