LOUVAIN SCHOOL OF MANAGEMENT

LLSMS2009 - RISK MANGEMENT OF

FINANCIAL INSTITUTIONS

2 N D CASE STUDY :

THE DERIVATIVES

Professor : HENRARD Luc Students : DE BROUWER Rodolphe

LOTOKO DIESE Aristote

MAKANGU MPEMBELE Axel

NAUWELAERTS Pierre

ACADEMIC YEAR 2016-2017

 1. WHAT IS A DERIVATIVE ?

In simple term, a derivative is a financial instrument whose value is based on something

else. Derivatives have no direct value in and of themselves, their value is derived from
some underlying assets (e.g. equities, bonds, real estate, commodities, etc). The
underlying asset does not have to be acquired.

To be more precise, derivatives are a security, a contracts between two or more parties,
those parties agree on how the performance of the underlying asset much the asset price
will change over a specific period. Those parties also agree on a set of terms and
conditions that determine their rights and duties. Derivatives play an important role in
the economy and are often traded as speculative investments (a financial bet) or to reduce
the risk of a position (a risk management tool to make a hedge)

We identify two groups of derivatives contracts:

Over-The-Counter derivatives (OTC): these contracts are traded off-exchange and

so doing, directly between two parties. The terms and conditions are then
determined by the counterparties.
Exchange-Traded derivatives (ETD): these contracts are traded on a recognized
exchange. The terms and conditions are non-negotiable and the prices are publicly
available.
The most common type of derivatives contracts are futures, forwards, options and swaps.

Futures: these contracts are traded on a recognized exchange and the

counterparties trade on a price agreed upon today with an asset having payment
and delivery at a pre-agreed point in the future.
Forwards: these are bespoke contracts where the counterparties agree on buying
or selling an asset at a specified moment in the future at a price agreed upon
today.
Options: these standardize contracts give one party the right (not the obligation) to
purchase (call option) or to sell (put option) at a pre-agreed price (called a strike
price).

Derivatives contracts have many advantages :

A great risk management tool if applied judiciously (they are a form of insurance)

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 Improve market efficiency for the underlying
Can yield important return if the value of the underlying asset moves the way the
speculator expects
Possibility to create advanced investment strategies

That being said, derivatives products raise controversy. Indeed, despite all those
advantages, not everyone agrees to use them. In a 2002 letter to Berkshire Hathaway
shareholders, Warren Buffett describes derivatives as financial weapons of mass
destruction, carrying dangers that, while now latent, are potentially lethal. Derivatives
are highly volatile and many experts blame them for the role they have played in the
2007-2008 financial crisis. Those products are now under scrutiny and government
regulation.

2. WHAT IS/WAS THE SIZE OF DERIVATIVE'S MARKET IN

2007 AND NOW ?

Around 25 years ago, the derivatives market was small, but it has rapidly grown as a
ginormous market. The derivatives market simply exploded since 1990. Some analysts
even say that this market is more than 10 times the size of the world GDP. According to
the US Department of Treasury, the derivatives market is continuing its rapid growth
even after the 2008 global recession. Besides, 95% of all US derivatives are held by just
five big banks and their holding companies. Let is try to put some numbers behind all
that. The derivatives market is one of the biggest in the financial world. According to the
BIS report, the global derivatives market amounted 457 trillion in June 2007.
Furthermore, this market is the fastest growing in the financial world, its size has
increased by around 24 percent per year. 700 trillions, this is the size of this market. The
global derivatives market is larger today than in 2007 and this, despite the recession. The
OTC segment is leading the path there, meaning that investors are willing to take more
risk in order to make more money, this mean that derivatives are mostly used for
speculative purposes. Putting derivatives traders to an operational risk. This is why
reforming this market is in the regulators agenda, a market so big is inherently systemic.

3. WHAT ARE THE PROS AND CONS OF AN OTC

DERIVATIVES ?

As we know, OTC derivatives were one of the causes of the crisis in 2008. But if these
derivatives were created it is because they have also some positive points for the different

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counter parties. According to our research, we noticed three major points in favor of over
the counter derivative but also three important points in disfavor of them.

What are the pros of derivatives?

Firstly, one of the main pros is that companies can take into account the future spot price
of their product without trying to guess wildly. So derivatives allow companies to
forecast in firms accounting with a fixed price.

In addition, companies are always looking for more capital to protect the risks they take,
they use classic instrument like bonds, stocks. But there are also the derivatives that are
non-classic instrument. In fact with them, they can cover exposure at interest risk rate or
change risk rate but also risks linked to commodities. So the idea was to find new sources
of capital at favorable rates then a lot of corporations tried to issue bonds in different
countries or markets whose interest rates are most favorable.

Thirdly, companies can use derivatives as tools for financial and non-financial enterprises
to analyze risks but also to make decisions about these different risks. So for example, if
they can take risks or not or if they have to ensure against risks or not.

Moreover, with derivatives companies could ensure their securities with

options/swaps. The advantage is that firms can place a bet (with another market
participant) on the fall of the value of one security. After that, when that happens, to
"swap" that security for another one held by the other participant.

What are the cons of derivatives?

Derivatives are very versatile instruments because they can be used for hedging,
speculation and for arbitrage. This is this strong versatility that cause many problems
because sometimes traders who have a mandate to hedge risks or follow an arbitrage
strategy become (consciously or unconsciously) speculators. The results can be
disastrous. Example of Nick Leeson at Barings Bank explains that. So to avoid the sort of
problems Barings encountered, it is very important for both financial and non-financial
corporations to set up controls to ensure that derivatives are being used for their intended
purpose (Financial Blogger, 2013).

The second derivatives problem is that there is no real rules or strong rules. It is why
there is some uncontrollable speculation for this market. So, the solution could be to set
up some formal rules that ensure market stability and integrity and as result the
safeguarding of the collective interest of market participants.

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The third one is the wild overstating of reported earnings on derivatives because they are
based on todays earnings. However, todays earnings could be calculated with many
inaccuracies for many years. This last point shows that derivatives are not the most
confident financial product so we think that more regulation is unavoidable. Then we
could have for example better risk management or a reduction of fraud and higher levels
of clarity regarding the complexities of the derivatives market (Gross, 2010).

4. GIVE AN EXAMPLE OF A DERIVATIVE PRODUCTS THAT

ADD VALUE TO A RETAIL CUSTOMER, A SME AND A
CORPORATE?

By conducting business and trading goods, derivatives' users are subject to some risks.
Thus, derivatives allow its users to hedge their risks and transfer them from risk-averse to
risk-oriented people. That is what we are going to be doing in that question by giving
some examples of derivative products that add value to retail customer, a SME and a
corporate.

Firstly, we are going to talk about retail customer. As a reminder, a retailer is a company
that only sells products to the end-user. In order to well understand how it works, we are
going to illustrate it with a concrete example. Assume a hardware store that sells bronze
wires. It can have many incentives to hedge the risks of the production that he sells.
Indeed, it is possible that the price of bronze rises due to a significant reduction of its
global resources. In that case, whether the store raises its selling prices and thus will lose
a large part of its customers, whether it does not change its selling prices and thus reduces
its margin. Both options are not profitable for the store. Thus, the store will use a
forward commitment, which is an agreement between two parties (the store and its
supplier) to engage into a transaction at a later date and at an established price. For
example, the store has computed that he needs to buy bronze wire at 5 from its supplier.
Indeed, the store would like to buy it at less than that amount. Nevertheless, indicators
shows that the price will increase or stay the same. Thus, for the long-term and thanks to
that forward agreement, the hardwarestore will hedge the risks of its business.

Secondly, a problem against which a SME is trying to cope is liquidity shortage. For that
purpose, the SME can manage to get a loan from a bank. Logically, interests must be
paid on it and those are calculated on a variable rate. But that situation does noet satisfy
them because the company could anticipate a potential rise of that variable rate. Indeed,
it should be preferable to have a constant rate that its financial forecasting can repay. In
order to reduce the risk, the SME could enter a(n) (interest rate) swap contract with

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another firm, especially a floating-rate receiver swap, payer fixed rate. The overall idea
is that the SME A will pay fix interests to SME B, and will receive floated interests from
that same company. Finally, the most important thing before contracting a swap is to
ensure the financial strenght of the other company.

Suppose, a big american company that trades with an european one. Those will be
subject to the exchange rates between the currencies. For example, if the euro currency
rises up against dollars, they will have to pay more for the same quantity of product.
Thus, compare with the previous trades, they will have to pay more than before. In order
to avoid it, they can buy an option (see question 1). That agreement allows the american
company to buy a certain amount of euros at a fixed rate. That derivative product is
really interesting. Indeed, suppose the two scenarios. First, euros has fallen against
dollars, thus, the american company can buy the product at the current exchange rate,
which is really advantageous for it because it will pay less than expected. The second
possibility is that euros has risen up against dollars. In that case, the company will use its
option and will not have to pay more.

5. DO YOU BELIEVE THAT DERIVATIVES ARE DANGEROUS

FOR THE STABILITY OF THE FINANCIAL MARKET ? WHY ?

There is no definitive answer to this question. It is not black or white, it is grey and
everyone will have his own shade of grey. Derivatives have strong opponents like, the
Nobel laureate in economics, Joseph Stiglitz or the famous business magnate Warren
Buffett. Stiglitz said that the use of derivatives should be outlawed. Warren Buffet
referred to it as financial weapons of mass destruction or as a potential time bomb in
the system. You could also read that derivatives are financial hydrogen bombs created
by 26 year-olds with computers wrote by Wall Street wise man Felix Rohatyn ( Jorion,
1995, p. 4). On the other hand, the defenders are saying when used in the right way and
carefully, the derivatives are an incredible tool of risk-management. The defenders have
also got a Nobel laureate into their ranks. Myron Scholes said about a ban of derivatives,
that it would be a Luddite response that takes financial markets back decades. Another
defender of the cause is Ren M. Stulz, a famous professor, who said in 2005 that the
derivatives already showed there were tremendously valuable in our modern economy
when handled with precautions, and he affirms that it will reliably remain so. Who is
right and who is wrong?

One of the biggest arguments against derivative is that it raises the volatility in the
underlying market. Numerous empirical researches were conducted on that matter. The

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conclusions of those researches are almost unanimous, the derivatives have no effect on
the rise of the volatility. The results even suggest that derivatives enable a rising of spot
trades. Other analyses show a diminution of total and specific risks of a company when it
uses derivatives. It shows also a creation of value for the shareholders. The derivatives
are one of the greatest innovations in the last 30 years for the financial world. It allows
endless possibilities because it can be based on any kind of assets.

As written just above, the researches show almost unanimously that derivatives are not
bad for the market, but that does not mean there are not dangerous. We can see it
through the history of finance. Many crisis find their originated from, at least partly,
derivatives like the Subprime crisis in 2008. Indeed, there are some elements that could
lead to another economic crash. Those financial products are complex and as Richard
Bookstaber a former head of market-risk management at Morgan Stanley said
complexity cloaks catastrophe. The people who use derivatives should clearly be aware
of the risks they take and that the tools that we have do not always allow us to manage
perfectly the risks or calculate them. Most of the billion-dollar loss that happened where
due to an illusion of control and an underestimation of the risks. As Robert C. Merton
said It is wrong to believe that you can eliminate risk just because you can measure it.
Moreover, the traders were putted in an environment where their controllers were
sometimes inexperienced and had a low budget to oversight them, where they were
motivated with multimillion incentive packages. This situation led them to take more
risks, because of greed, and not manage them like they were supposed to. When someone
is murdered, you do not blame the gun, you blame the person who pulled the trigger.
That risk-taking could lead to a dangerous concentration of risks and contagion
phenomena. Dr. Raghuram Rajan explained it perfectly in 2005: WHILE THE
SYSTEM NOW EXPLOITS THE RISK-BEARING CAPACITY OF THE
ECONOMY BETTER BY ALLOCATING RISKS MODE WIDELY, IT ALSO
TAKES ON MORE RISKS THAN BEFORE. MOREOVER, THE LINKAGES
BETWEEN MARKETS, AND BETWEEN MARKETS AND INSTITUTIONS,
ARE NOW MORE PRONOUNCED. WHILE THIS HELPS THE SYSTEM
DIVERSIFY ACROSS SMALL SHOCKS, IT ALSO EXPOSES THE SYSTEM TO
LARGE SYSTEMIC SHOCKS.

In conclusion, derivatives can be financial weapons of mass destruction when they are
misused, but they should not because they can improve the markets and help in the
management of risks. In order to accomplish that there are a few refinements to do. The
OTC should migrate to organized markets, at least the standardized ones. It would

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reduce the risks and improve the liquidities. The financial institutions should give
appropriate traineeship to their employees that work with derivatives and set up a clear
risk management policy to use the derivatives properly. The derivatives are an incredible
financial product with endless possibility of development and profit. And as powerful as
it is it need to be well regulated and controlled otherwise it will definitely lead us to
another major financial crisis.

6. BIBLIOGRAPHY

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Bezzina, F. H., Grima, S. (2012). "Exploring factors affecting the proper use of
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Bloomber. (2016). Buffett Says Derivatives Time Bomb May Elude Auditors'
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November 2016.
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