A lot has been written about how derivatives can help manage risk better ... and a lot more has been written about how derivatives can break an organisation. Losses at Baring, Daiwa, Sumitomo, Procter & Gamble, SinarMas, Fulham and Hammersmith, Shell - Showa, etc. have hogged the limelight over the past few years. Some of these did not involve derivatives transactions at all, and, in my opinion, all of these losses arose because of poor operational controls. Unfortunately, derivatives got a bad name in the process.
In the last in this series of articles, I will take a look at the risks in derivatives. In fact, these risks exist in all the trading activities - foreign exchange, interest rates, commodities, etc. Everyone likes to say that they have great risk management systems. Then a hole in the balance sheet is discovered and everyone hit becomes silent. One of my favorite quotations is from an annual report of Sumitomo a few years back -
Yosuo Hamanka is one of the largest copper traders in the world. He is the head of Sumitomos copper metals team... the best estimates are that Sumitomo Corporation handles double the volume of its next competitor in the physical market for copper. Hamanaka says that the pre - eminent position of Sumitomo Corporation in copper trading is attributable to expertise in risk management.
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Within a few years Sumitomo realised that its expertise in risk management was not that hot and Hamanaka lost them over a billion dollars. The flaws in their risk management system were many. There was too much reliance on the integrity of the dealers. Job rotation ensured that Hamanaka remained in his job for years while his bosses kept getting rotated--hence, his bosses did not know enough about what Hamanaka was doing. Internal audit was ignored to large extent. Segregation of duties between the front office (i.e. the dealers) and the back office (i.e. the processing area) was not properly done.
There are basically five types of risks in foreign exchange, derivatives, interest rates etc. They are :
Price Risk
Credit Risk
Liquidity Risk
Operations Risk
Legal Risk
Price risk is the risk that movements in prices or values will result in loss for a company. This could happen because of sudden or gradual price movements. Assume Company A took a loan of US $ 15 million repayable after seven years. At the end of seven years, the rupee has depreciated by 50 per cent. The cost of this debt to Company A is hence the interest cost plus the rupee depreciation of 50 per cent. This risk can be hedged, for example (regulations permitting), by Company A swapping its dollar liability for a rupee liability with a bank. There are various models to quantify price risk. The RBI recently advised banks to adopt a simple model for assessing the value at risk on their exposures. Price risk is of greater concern when revaluing option books since the payouts are non-linear and, in case of exotic options, market rates for volatility may not exist.
Credit risk is the risk that a counterparty will fail to perform an obligation owed to the organisation. There are two types of credit risk--pre-settlement risk (PSR)and settlement risk (SR). PSR is the risk that the counterparty defaults before the maturity date. In this case, the loss is only the cost of substituting the contract, which should normally be a percentage of the notional principal (based on the tenure and the product). SR is the risk that one counterparty fulfills its obligations under the contract but the other counterparty does not. In this case, the loss would be the entire amount initially remitted. SR assumes greater importance in a global market because counterparties are based and settlements take place in different time zones. For example, assume that Bank B buys yen against dollars from Bank C, both of whom are based in Mumbai. Bank C would pay out the yen before 9 am in Mumbai (since yen settlements take place in Tokyo) but receive the dollars only after the close of business in
Mumbai (since dollar settlements take place in New York). There is a risk that during the day in Mumbai Bank B may go bankrupt and not pay the dollars after receiving the Yen in the early hours of the morning. And this has happened. Herstatt Bank in Europe did just that - this risk is now called Herstatt Risk.
Liquidity risk is the risk that a lack of counterparties will leave a company unable to liquidate or offset a position (or unable to do so at or near the previous market price). This could occur when there is an overheated market and the system receives a sudden shock.
Operations risk is the risk that a firm will suffer a loss because of human error or deficiencies in the system or controls. In my opinion, the huge losses that have occurred recently in the derivative, foreign exchange and bond markets are a result of faulty systems. A bad dealer can cause the loss of a few million dollars (based on his stop loss limits). But when an organisation loses a billion dollars, the blame lies solely with managerial incompetence--either the managements did not understand the markets, risks or systems that were involved, or they deliberately chose to ignore the shortfalls in the systems. Each of the large losses were the result of poor controls - improper capturing of deals, inadequate Chinese walls between proprietary and client books, wrong revaluation of portfolios, non-segregation of front and back offices... the list goes on. The need for proper accounting of derivative and foreign exchange transactions cannot be overstated. The accounting profession globally has invariably been
slow in keeping pace with changes in financial instruments. Basic issues like hedge accounting for banks have still not been made mandatory.
Legal risk is the risk that a company will suffer a loss as a result of contracts being unenforceable or inadequately documented. The landmark case is Fulham & Hammersmith where it was opined that the derivative contracts that certain boroughs entered into were ultra vires and hence were void. Banks were, thus, unable to recover derivative losses from these counterparties. Consequently, it is imperative that proper documentation be used be used for derivatives transactions. The recently revised Internal Control guidelines of the RBI recommends that banks sign certain standard international documents with their clients (IFEMA, ISDA, and ICOM) to ensure legal enforceability of these transactions. FEDAI has obtained legal opinion that these contracts (subject to jurisdiction amendments) are legally enforceable in India.
In conclusion, I would like to say that the proper introduction of rupee - based interest rate and foreign exchange derivatives would help all market participants reduce risks (and will not, as is widely believed, increase risk) and provide certainty of cash flows. This certainty of cash flows will go a long way in increasing flows of underlying trade and capital transactions, which is needed to push in India forward into the global markets.
Luis Miranda is vice president and head (foreign exchange & derivatives) at HDFC Bank. The views expressed here are the authors own.
(To be concluded).
All the losses were a result of poor, operational control.