Summary

Derivatives activity at commercial banks, as measured by total notional values of over $56 trillion as of December 31, 2002, continues to grow dramatically. Derivatives serve an essential role in the U.S. and world economies but also present certain risks to the deposit insurance funds. This FYI explains what these risks are and describes how they are managed within commercial banking.

Derivatives: What They Are and the Role That They Have in the Economy

Derivatives are financial instruments or contracts with values that are linked to, or derived from, the performance of underlying financial instruments, interest rates, currency exchange rates, or indexes. In a simplified sense, a derivative links its holder to the risks and rewards of owning an underlying financial instrument without actually owning the financial instrument.

Derivatives are important to the financial markets and the world economy because they provide a means for companies to separate and trade various kinds of risks. The ability of participants in the financial markets to adjust specific risk exposures enhances the efficiency of capital flows by allowing companies to conduct business activities without amassing certain risks that would otherwise attend that business. For instance, mortgage lenders that are comfortable with the credit risk of mortgage lending may be less comfortable with the amount of exposure to interest rate movements that accompany a large mortgage portfolio. A mortgage company can use derivatives to lessen their exposure to the effect that interest rate movements might have on the value of their business and continue to make mortgage loans. Mortgage borrowers benefit from these arrangements because mortgages are cheaper when lenders have choices about the risks that they retain.

Notional Amounts Measure Derivatives Activity Not Risk

At $56 trillion—a dollar figure that is more than five times GDP—the notional amount of derivatives outstanding can seem daunting. However, the notional amount of a derivative contract is merely the reference point to the underlying instrument. It serves as the basis for calculating cashflows under the contract. For example, a very typical derivative contract would be to pay the 10-year Treasury rate on $1 million in return for a floating rate on the same amount. The notional amount of the contract is $1 million. This amount does not change hands; but for each payment period, the 10-year Treasury rate is multiplied by $1 million to calculate the fixed-rate payment.

While the notional amount is a proxy for the amount of derivatives activity, it does not measure the riskiness of the activity. The notional amount itself is seldom at risk of loss with derivatives. Instead the derivatives investor is at risk of loss from changes in prices of or rates earned on the physical or financial assets that the notional amount represents.

When the derivatives market as a whole is in view, it is important to consider that offsetting positions that add to gross notional amounts do not necessarily add significantly to total market risk. This concept is illustrated in Transaction Scenario 1.

Transaction Scenario 1:

A derivatives transaction example that illustrates the relationship between notional amounts and potential risk.

An American firm holds $2 million in cash. This company is planning to buy equipment from a German manufacturer six months from today that, given today’s exchange rate, is valued at $2 million US Dollars (USD).

Given its plans to purchase this equipment, its cash position in USD actually represents a foreign exchange (FX) exposure to the exchange rate between USD and German marks (DM). The firm calls a derivatives dealer and enters into a FX contract that obligates the firm to sell DM six months from today at today’s exchange rate. In so doing, the American firm locks in the USD price of the equipment, thereby hedging its foreign exchange risk. If DM appreciate, the equipment becomes more expensive in terms of USD; but the firm profits in its derivatives contract by roughly the same amount.

After entering the transaction with the American firm, the dealer bank enters into a contract with a hedge fund to sell DM six months from today at today’s exchange rate, thereby completely offsetting its exposure to the exchange rate between USD and DM. In actuality, the exchange rates used on both sides of the transaction might be slightly different, allowing the dealer bank to make a spread on the transaction to compensate it for making a market in DM forward agreements.

The hedge fund enters the transaction because its managers believe that DM will weaken against USD in the next six months and the fund is willing to speculate in order to profit from that movement.

In terms of the gross notional amount of derivatives outstanding in the banking system, the transactions in this example contribute $4 million: the sum of both the bank’s FX contracts. In terms of market risk, these transactions contribute nothing. There is, however, credit risk associated with the dealer bank’s position. While the transaction is open, the exchange rate that the market expects between DM and USD may change. If DM depreciate (a change unfavorable to the American firm’s FX derivatives position), then the contract between the dealer and the American firm increases in value to the dealer. This increase in value and potential future increases in value during the contract’s life represent credit exposure of the dealer to the American Firm. 1

While Derivative Notional Values have Grown, the Number of Banks Involved Has Not

The vast majority of U.S. banks manage their interest rate and other risks within their balance sheets and do not use derivatives. As of December 31, 2002, 439 institutions or 5.6 percent of commercial banks held some amount of derivatives. The percentage of banks holding any derivatives peaked at a little more than 7 percent in the third quarter of 1995.

Chart 1 shows the growth of the notional value of derivatives divided into three broad categories of underlying instruments: interest rate contracts; foreign exchange contracts; and equity, commodity, and other contracts. 2 The extraordinary growth in notional values is due to the growth of interest rate contracts, which, as of December 31, 2002, amounted to a little over 86 percent of the $56 trillion derivatives market.

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The Nature of Derivative Activities in Commercial Banking

There are three broad kinds of derivatives activities: hedging, dealing, and speculating. While each of these activities is found to some extent in commercial banking, dealer activities dominate.

When used for hedging, a derivative position is employed to offset or reduce the risk associated with an existing balance sheet position or future planned transaction. Dealing in derivatives consists of taking an intermediary role and making contracts available for customers to earn fees. Dealers may enter into offsetting positions with other customers or manage derivatives risk in other ways. Speculators enter derivative transactions in order to profit from expectations that are different from the market’s expectations about how derivatives prices will move.

Most commercial banks enter derivatives transactions as hedgers or dealers. In terms of notional amounts outstanding, derivatives activity is highly concentrated at dealer banks. In terms of the number of institutions holding any amount of derivatives, most are hedgers using interest rate contracts. The extent of speculation within commercial banking is more difficult to determine because it is not reported as such and speculative-type risks arise from certain dealer activities.

A Risk Ranking of Derivatives Activities

The risk associated with hedging, dealing, or speculating varies substantially. While poorly managed operational risk could lead to losses in any derivatives activity, a generalized rank ordering of derivatives risk can be constructed. Generalizations about the rank ordering of risk are helpful in understanding the nature and source of the risk inherent in the $56 trillion of notionals outstanding. Diagram 1 provides a grid for considering the rank ordering of risk in the derivatives market.

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Transaction Scenario 2: A derivatives transaction example that illustrates how a derivative’s riskiness is related to the volatility of the factors that determine its value and the sensitivity of the derivative to changes in those factors.

Transaction 1: An Interest Rate Swap

Party A agrees to pay party B a fixed rate of 6 percent and receive from party B the 3-month Treasury rate for a period of 2 years beginning November 15, 2000, on a notional value of $1 million. Party A would enter such a transaction either to profit from a view that rates were going to rise or to hedge a balance sheet position that was subject to erosion in value if rates were to rise, such as holding Treasury bonds. If the short-term rate falls, Party A will lose on its derivatives position. Assuming for simplicity that the 515 basis point decline in 3-month Treasury rates that actually occurred during this contract period was evenly distributed over the two years, Party A would have lost a little more than $57 thousand in the transaction—less than 6 percent of the notional value.

Transaction 2: An Equity Contract

Party A agrees to pay party B a fixed rate of 6 percent and receive from party B the return on the NASDAQ composite for a period of 2 years beginning November 15, 2000, on a notional value of $1 million. Assuming, again for simplicity, that the almost 45 percent decline in the NASDAQ that actually occurred during the contract period was evenly distributed over the two years, Party A would have lost almost $343 thousand in the transaction—more than 34 percent of the notional value.

The relative risk of these two contracts is apparent when one considers the historical changes in 3-month Treasury rates versus the historical changes in NASDAQ returns and the impact that these changes have on the gains and losses associated with the derivatives position. Although short-term rates moved significantly during the past several years, these changes are eclipsed by the changes in NASDAQ return during the past several years. 3

Contract Type Risk Ranking

Transaction Scenario 2 illustrates why interest rate contracts generally are less risky than other derivative types, such as equity derivatives contracts. Despite the changes in short-term rates described in the scenario—which were large by historical standards—losses on the interest rate contract are a small percentage of the notional amount. An exposure to the NASDAQ during the same time period resulted in a loss that amounted to a significant percentage of the notional value. Commodity contracts can resemble equity contracts in terms of riskiness.

Although foreign exchange and interest rate contracts enjoy many theoretical similarities, the placement of foreign exchange contracts above interest rate contracts in the risk matrix reflects greater inefficiency in the foreign exchange market and the fact that with foreign exchange forward contracts, although the notional amount is not contractually at risk of loss, it is frequently exchanged. This exchange could increase the operational and credit risk associated with the transaction.

Activities Risk Ranking

The relative riskiness of the major derivatives activities relates to several attributes of each activity. By definition, hedging is a risk mitigating activity. Although it is not without its risks, these risks, which are discussed below, are small relative to the other derivatives activities.

Derivatives dealers are exposed to at least the same risks as hedgers, and they incur additional operational risks as a result of the sheer volume of derivatives activity they undertake. Furthermore, the strategies used by dealers in managing derivatives positions are not of equal risk and some strategies can result in speculative-like risks. Dealer strategies are discussed below.

Pure speculation in derivatives can be extremely risky because derivatives can facilitate magnified risk exposures and high leverage from a capital standpoint. For example, derivatives can be fashioned that allow speculators to be highly exposed to risk with very little capital or cash investment. Due to the leveraged nature of the investment, relatively small unexpected changes in underlying values can compromise a speculator’s capital base.

The Extent and Risk of Hedging

The primary risk of hedging lies in the potential for correlations between the derivative value and the hedged item to change from what was observed or assumed when the hedge was constructed.

In terms of the number of institutions holding derivatives, a vast majority of the banks that use derivatives (339 or 77 percent) hold them solely for hedging purposes. However, in terms of dollar volume, these hedging-related holdings amount to less than one half of one percent of total notionals. Most of the derivatives (90 percent) held for hedging purposes are interest rate contracts, indicating that banks are mostly using derivatives to hedge interest rate risk.

Derivatives held for hedging purposes may be somewhat more than indicated by this number. Banks that are motivated to hold derivatives for hedging purposes may use a trading account for accounting reasons. Under Financial Accounting Standard (FAS) 133, the hurdle for using hedge accounting is higher than it was previously. For example, so-called macro hedging does not get hedge accounting treatment under FAS 133. 4 Without hedge accounting, a company’s earnings are subject to additional volatility due to the marking of the hedge to market without marking the hedged assets or liabilities to market. To avoid this earnings volatility, a company might establish a trading account and hold both the derivative hedge and the hedged balance sheet items in the trading portfolio where both are marked to market and the gains and losses that run through earnings are mostly offsetting.

The risk of hedging lies mostly in how much the value of the derivatives contract varies in relation to the value of the hedged item. This relationship is referred to as correlation. The least risky hedge exhibits relative price movements between the derivative value and the hedged item that have been consistent over time and that are close to completely opposite, that is, the price movements have tended to offset one another over time.

The risk that hedgers face was exemplified during the market disruption that followed the fall of Long Term Capital Management and Russia’s debt default in the last several months of 1998. The spread between mortgage rates and 10-year treasury securities widened unexpectedly during this time. Traditionally, hedgers of certain mortgage-related products rely heavily on the stability of the relationship between these rates.

When this relationship destabilized, hedges performed in ways that were not predicted, and in some cases, would-be hedgers experienced losses on both the derivatives contract and the asset it was intended to hedge.

One measure of the significance of derivative hedging activity for an institution is its effect on the bank’s income. Hedging has a significant impact on net operating income at several institutions. As of December 31, 2002, 23 banks that use derivatives to hedge, reported an effect from hedging that amounted to more than 10 percent of net operating income during the fourth quarter of 2002.

The Extent and Risk of Dealing in Derivatives

Nearly 81 percent of the $56 trillion notional value of derivatives represents interest rate contracts at five dealer banks.

The top 5 derivatives dealers hold 93 percent of total notionals. 5 More than 86 percent of these dealers’ holdings are interest rate contracts. Therefore, in terms of the derivatives risk matrix, a vast majority of commercial bank derivatives activities is in interest rate contracts at a few dealer banks.

These dealers conduct derivatives activities as part of their total trading operations, which makes analyzing derivatives risk difficult to isolate from total trading risk. Furthermore, if a bank is speculating in derivatives, it occurs within these trading portfolios and is not reported separately.

In customer-related derivatives trading activities, banks engage in some combination of matched trading, market making, and positioning. 6 The relative mix of these three methods, to a large extent, determines not only the magnitude of the market risk of the individual bank’s derivatives trading but, because of the derivatives dealers’ market dominance, this mix also drives total derivatives market risk in commercial banking. These trading methods are discussed below in order of increasing risk.

Matched Trading

When matched trading, a dealer enters into a trade with a customer and then enters into an equal, offsetting position with another counterparty. A dealer bank that uses matched trading to manage market risk eliminates most of the market risk of its activities. The effectiveness of matched trading in controlling market risk is considerable because its effectiveness does not rely on model accuracy to the extent that other methods of controlling market risk do. Errors in modeling the market values of one side of the transaction are likely to be counterbalanced by offsetting errors on the other side of the transaction. Although market risk may be neutralized in matched trading, the trading bank retains credit risk on both sides of the transaction.

Market Making

Market makers stand ready to enter into certain contract types without regard to whether they have an offsetting transaction. In accumulating inventory during a given day, intra-day positions develop that result in market risk. Market makers are compensated for market, credit, and liquidity risks through the bid/ask spread, and may experience additional profits or losses from this intra-day positioning. A bank’s success in market making depends on the accuracy of its pricing models. Unlike the matched trader, the market maker is likely to be subject to unfavorable movements in their markets that occur during the day. Generally, a market maker will significantly offset these risks at the end of the trading day.

Positioning

Positioning occurs when a trader, perhaps expecting favorable market movements, executes a transaction with a customer without establishing an offsetting position. Other reasons to maintain open positions include the need to maintain an inventory of financial instruments for distribution to customers, the existence of a large position from a customer transaction that takes time to close out, and the need to aggregate a sufficient number of small transactions to be economically efficient to hedge. Unlike the market making strategy, these positions can be carried over for more than a day leaving more time for the markets to move unfavorably. Positioning embodies speculative-like risks that need to be monitored and controlled carefully.

Speculative and Proprietary Trading

Speculative and proprietary trading are distinguished from other trading activities in that they are not initiated to serve customers. A bank engages in speculative trading for the sole purpose of increasing its earnings. A bank may engage in proprietary trading for a number of other reasons. 7 Among these reasons are to increase experience and expertise in the markets, and to diversify risks associated with other trading positions.

Types of Risk at Dealer Banks

Dealer banks face three major risks from derivatives activities. These risks are market risk, credit risk, and operational risk.

In Table 1, a calculation based on a bank’s reported market values of derivatives holdings is used as a proxy to estimate the extent to which the bank is not using matched trading to manage its market risk. 8 Using this proxy technique, in the aggregate, commercial banks have unmatched market values totaling $33 billion. Three of the five dealer banks have unmatched market values that account for over 88 percent of the commercial bank aggregate. While this calculation could reveal apparently open positions, it should be interpreted with care. Banks may have positions in nonderivative assets and liabilities that either exacerbate or mitigate their derivatives positions.

Table 1: Contract Market Values: Positive Values Net of Negative Values by Contract Type