Tuesday, June 06, 2006


Derivatives Get the Blame



In a recent Washington Times article entitled "Derivatives: Global roulette wheel", editor-at-large Arnaud de Borchgrave describes a global market now topping $300 trillion as reason to "fasten your seat belt". It's not clear what precipitated his dire warnings about systemic risk and classification of risk management talk as "gobbledygook to the layman". (Take a look at our March 2006 posting about derivatives.)

It's true that the use of derivatives introduces incremental risk such as the possibility of counterparty non-performance or problems with settlement. (Arguably netting and collateralization help to reduce some of the transaction-specific risk.) At the same time, derivatives used properly (and this is an important qualifier) can mitigate financial risk, transform cash flows, transfer risk, enhance asset performance or otherwise synthesize exposure to a particular risk-return position. How else could the market have grown to its giant size had it not been for a large number of participants who were (and are) willing to trade with each other?

At the risk of dating myself, I did an analysis about fifteen years ago that showed that derivatives-related losses were a fraction of disappearing dollars due to fixed income security defaults for the time period in question. It would be interesting to update the analysis and gauge whether derivatives are indeed the equivalent of a financial hurricane, wreaking damage far and wide.

One key issue (among many) is the measurement of risk. Consider a fixed-to-floating interest rate swap with a $20 million notional principal amount or "face value". Depending on the particular counterparties and deal structure, this popular size measure fails to convey meaningful information about potential loss. The incremental exposure for a counterparty that hedges its short-term commercial paper costs by entering into a swap as a fixed rate payor is not the same as a counterparty that receives floating in anticipation of higher rates.

Derivatives are not necessarily for the faint of heart nor should they be shunned as the proverbial bad boy of finance.
posted by Susan Mangiero at 6/06/2006 12:05:00 AM