Financial Risks in Derivatives Markets

Institutions
Center by
Ludger Hentschel
Clifford W. Smith, Jr.

96-24
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 1
Risks in Derivatives Markets

November 20, 1995

Abstract : The debate over risks and regulation in derivatives markets has failed to provide
a clear analysis of what risks are and whether regulation is useful for their control. In this
paper we provide a parametric model to analyze default risk in derivative contracts. A firm
is less likely to default on an obligation on derivatives than on its corporate bonds because
bonds are always a liability, while derivatives can be assets. Using default rates for
corporate bonds, we provide an upper bound for the default risk of derivatives—one
substantially lower than the popular debate seems to imply. Systemic risk is the
aggregation of default risks; since default risk has been exaggerated, so has systemic risk.
Finally, this debate seems to have ignored what we call "agency risk." Features of widely
used incentive contracts for derivatives traders can induce them to take very risky
positions, unless they are carefully monitored.

Keywords : Agency risk, default, derivatives, futures, forwards, hedging, options, risk
management, regulation, swaps.

1
Ludger Hentschel and Clifford W. Smith are at the William E. Simon School of Business Administration, University
of Rochester, Rochester, NY 14627.

The authors gratefully acknowledge financial support from the John M. Olin Foundation and the Bradley Policy Research
Center, as well as helpful conversations with D.H. Chew, S.P. Kothari, R.J. Mackay, and C.W. Smithson. In addition, two
anonymous referees made many helpful suggestions. Parts of the analysis in this paper appeared in less technical form in
"Controlling Risks in Derivatives Markets," Journal of Financial Engineering, (Vol. 4, No. 2, pp. 101-125).
1. Introduction
The continuing discussion of risks and regulation in derivative markets illustrates
that there is little agreement on what the risks are or whether regulation is a
useful tool for their control.1 One source of confusion is the sheer profusion of
names describing the risks arising from derivatives. Besides the “price risk” of
potential losses on derivatives from changes in interest rates, foreign exchange
rates, or commodity prices, there is “default risk” (sometimes referred to as
“counterparty risk” ), “liquidity (or funding) risk,” “legal risk,” “settlement risk”
(or, a variation thereof, “Herstatt risk”), and “operations risk.” Last, but not
least, is “systemic risk’’—the notion of problems throughout the financial system
that seems to be at the heart of many regulatory concerns.
In this paper, we analyze the risks associated with derivative transactions,
and the impact of regulation in limiting these risks. We provide a simple, para-
metric framework in which one can analyze price, default and systemic risk. In
section 2, we review price risk—that is, the potential for losses on derivative
positions stemming from changes in the prices of the underlying assets (for in-
stance, interest rates, exchange rates, and commodity prices). In section 3, we
examine default risk by either party to a derivatives contract—a risk that we
believe has been largely misunderstood and exaggerated. The existence of price
risk has been documented by several large, highly publicized derivatives losses.
There are, however, hardly any examples of default in derivative markets. We
argue that this is a trend can be expected to continue.
In section 4, we argue that systemic risk is simply the aggregation of default
risks faced by individual firms in using derivatives. In brief, we argue that
the possibility of widespread default throughout the financial system caused by
derivatives has been exaggerated, principally due to the failure to appreciate the
low default risk associated with individual derivative contracts. Partly for this
reason, current regulatory proposals should be viewed with some skepticism.
In particular, none of the proposals recognize the fundamental dependence of
default risk on how derivatives are used.
1
We use the term derivative to refer to financial contracts that explicitly have the features
of options, futures, forwards, or swaps.
2 Risks in Derivatives Markets

In section 5, we suggest that recent, highly publicized losses can be at-

tributed largely to improper compensation, control and supervision within firms.
We define derivative risks stemming from these sources as “agency risks”, a ref-
erence to the principal–agent conflicts from which they arise. For instance, we
believe that some standard evaluation and compensation systems can be ill-
suited for employees granted decision rights over derivatives transactions. Firms
that pay large bonuses based on short-term performance can encourage excessive
risk-taking by employees. Despite limited public discussion, it appears that firms
are aware of these issues and are working to control the problems. In section 6,
we offer a few concluding remarks.

2. Price Risk
The modern analysis of financial derivatives is unified by the successful applica-
tion of absence of arbitrage pricing arguments. In their seminal work, Black and
Scholes (1973) and Merton (1973) first showed how to price options—the last
class of derivatives to elude this analysis—via absence of arbitrage.
The ability to use arbitrage pricing in valuing derivatives has at least one
profound implication for the current public debate on derivatives. Redundant
securities logically cannot introduce any new, fundamentally different risks into
the financial system. To the extent that derivatives are redundant, they cannot
increase the aggregate level of risk in the economy. Derivatives can, however,
isolate and concentrate existing risks, thereby facilitating their efficient transfer.
Indeed, it is precisely this ability to isolate quite specific risks at low transactions
costs that makes derivatives such useful risk-management tools.
For derivatives, the composition of the replicating portfolios can vary con-
siderably over time and maintaining these portfolios can involve extensive and
costly trading.2 Even if such trading costs introduce a degree of imprecision into
derivative pricing models, virtually all derivatives can be valued using arbitrage
models. (In fact, to the extent that transaction costs introduce a degree of im-
2
Note that the trading required to replicate the payoffs depends critically on the other
outstanding positions managed by the firm. Required trading costs for a market maker with an
extensive derivatives position book are generally dramatically less than the sum of the trades
to replicate the individual contracts.
Sec. 2] Price Risk 3

precision into derivative pricing models, derivatives are likely to provide more
efficient hedges than “synthetic” derivatives used to hedge the same risks. )
The standard use of derivatives is in managing price risks through hedg-
ing. Firms with a core business exposure to underlying factors such as com-
modity prices, exchange or interest rates, can reduce their net exposures to
these factors by assuming offsetting exposures through derivatives. Rational,
value-maximizing motivations for such corporate hedging activities are provided
by Mayers and Smith (1982, 1987); Stulz (1984); Smith and Stulz (1985); and
Froot, Scharfstein, and Stein (1993) among others.
Although risk aversion can provide powerful incentives to hedge for indi-
viduals, this usually is not the motive for large public companies whose owners
can adjust their risk exposures by adjusting the composition of their portfolios.
Rather, current theory suggests that incentives to hedge stem from progressive
taxes, contracting costs, or underinvestment problems. All of these issues are
internal to the firm and cannot be solved by external investors.

2.1. Exposure

For simplicity, we assume that the value of the firm is inherently quadratic in a

assume that the firm is operating with fixed production technology and scale

case, the firm has an incentive to reduce its exposure to the underlying factors
in order to reduce the quadratic cost term.
This formulation can be interpreted as a local approximation to firm value
for any of the aforementioned hedging motives. For example, if taxes motivate
hedging, after-tax income is a concave function of income and the quadratic
specification can be viewed as an approximation to after-tax income. Similarly,
3
While this gives rise to negative firm values, adding back a constant mean does not
produce additional insights.
4 Risks in Derivatives Markets

if bankruptcy or underinvestment costs rise as firm value falls, then the above
formulation can approximate this behavior.4

2.2. Hedging

Next, assume that there is a set of financial instruments with mean zero (net)

be applied to any financial contract in efficient markets. For derivative contracts

such as forwards, futures, or swaps, whose payoffs are linear in the underlying

For derivatives like forwards and options, the single payment date is an
accurate representation of the actual contract. For derivatives like futures and
swaps with multiple payment dates, this characterization ignores the sequential
nature of payments. For these contracts, the single payment date can be inter-
preted as the maturity date of the contract, with all payments cumulated to
maturity.
If the firm can transact in this financial market without costs, then firm
value is given by

(2)

The characterization of the firm and its derivatives positions in eq. (2) ab-
stracts from most dynamic intertemporal features. The single-period framework,
however, permits us to better focus on the relation between derivatives positions
and default than alternative dynamic approaches. Johnson and Stulz (1987),
for example, assume that the net worth of an option writer and the underlying
price have a constant correlation that is exogenous to their model. Conditional
on this assumption, they can exactly price options with default risk. Cooper
and Mello (1991), Sorensen and Bollier (1994), Jarrow and Turnbull (1995), and
4
Although we don’t view this as the typical hedging motivation, our parameterization of
firm value also can be interpreted as a quadratic approximation to the concave utility function
of a risk averse owner.
5
Referring to these cases, we will not always make a careful distinction between underlying
prices and payoffs. For contracts such as options, whose payoffs are nonlinear in the underlying
price, this distinction is important, however.
Sec. 2] Price Risk 5

Longstaff and Schwartz (1995) also provide pricing models for financial contracts
in the presence of default risk. They make the same tradeoff as Johnson and
Stulz (1987) and take the source of the default risk as exogenous to their model.
In contrast, we structure our model specifically to illustrate that the correlation
between firm value and derivative obligations is a crucial ingredient in default
risk, and furthermore that this correlation depends on the firm’s derivatives po-
sition.

2.3. Impact of Hedging

The optimal position in the financial contracts is found by optimizing the value

(3)

(4)

is the matrix of

(5)

To be an effective hedge, the financial contract must be highly correlated

is small in order to limit the introduction of additional uncertainty through

of derivatives is that they individually target the potentially large sources of

variation, such as interest rates, exchange rates, or commodity prices, without
introducing additional sources of variation.
6 Risks in Derivatives Markets

FIGURE 1: Firm value, exposures, and hedging.

that the firm’s exposure to x is negative. 6 To display the payoff from the finan-

by the dashed line. Finally, the dashed and dotted curve labeled VH shows the
net exposure of firm value including the derivatives contracts.
The figure shows that hedging operates through two channels. First, the
hedge reduces the net exposure to the underlying risk factor, which reduces
variation in firm value. This is evident from the reduced slope of VH compared

The exposure shown in figure 1 might be appropriate for a chemical pro-

an oil producer is likely to have a positive exposure to the price of crude oil. In
our framework, the oil producer’s firm value would be that of the oil consumer

producer, but it would be upward sloping. In this case, hedging would again
reduce both the slope and the concavity of this value function.

as exposure in the context of exchange and interest rates, respectively.

Sec. 3] Default risk 7

3. Default risk
Default risk is the risk that losses will be incurred due to default by the counter-
party. As noted above, part of the confusion in the current debate about deriva-
tives stems from the profusion of names associated with default risk. Terms such
as “credit risk” and “counterparty risk” are essentially synonyms for default risk.
“Legal risk” refers to the enforceability of the contract. Terms such as “settle-
ment risk” and “Herstatt risk” refer to defaults that occur at a specific point in
the life of the contract: the date of settlement. These terms do not represent
independent risks; they just describe different occasions or causes of default.
In most derivatives contracts, either party may default during the life of
the contract.7 In a swap, for example, either side could default on any of the
settlement dates during the life of the swap. In practice, a firm may be able to
accelerate default. For example, once it becomes clear that a firm will ultimately
be unable to meet all of its obligations, the firm may elect to enter bankruptcy
proceedings now, even though current obligations do not force this step. The
firm would only chose this path if it is in the firm’s best interest, and hence there
may be an optimal default policy. While such timing issues may be important,
especially for firms near bankruptcy, we abstract from these complications and
continue to focus on the default risk posed by one side of the contract at a single
payment dates.8
Default risk has two components: the expected exposure, (the expected
replacement cost of the contract minus the expected recovery from the counter-
party) and the probability that default will occur.

3.1. Expected exposure

The expected exposure measures how much capital is likely to be at risk should
7
Options form the notable exception to this rule. An option buyer cannot default after
the purchase of the option since he does not have any further obligations to pay under the
option contract. Hence, in option markets only the option writer poses default risk.
8
One reason we believe that this is a reasonable tradeoff is that it is unlikely that payments
obligated under derivatives trigger default. The more likely it is that default is triggered by
obligated payments to other claim holders, the less important it is to focus on the intertemporal
details of the cashflows under derivatives contracts without modeling these details of bond,
employee, and lease contracts.
8 Risks in Derivatives Markets

the counterparty default. The notional principal amounts of derivatives like

forwards and swaps grossly overstate actual default exposure. For example, in
interest rate swaps only net interest payments are exchanged. These payments
are a small fraction of the notional principal of the swap. In fact, the US General
Accounting Office (GAO) estimates that the net credit exposure on swaps is
approximately l% of notional principal.
In addition to the expected value of the derivative at the time of default, ex-
pected exposure also depends on expected recovery rates after default. (Current
capital standards implicitly assume that the recovery rate is zero, which leads
to a material overstatement of the expected loss.) Most swaps are unsecured
claims in bankruptcy proceedings. For unsecured (senior) claims, recovery rates
average about 50% (Franks and Torous, 1994—for collateralized claims recovery
rates are closer to 80%. )
Finally, the expected exposure depends on whether the contract includes
imbedded options. Specifically, if the swap stipulates a floor rate, the buyer’s
obligations and the magnitude of the losses it could cause in a default are con-
tractually limited.

3.2. Probability of default

Default on any financial contract, including derivatives, occurs when two condi-
tions are met simultaneously: a party to the contract owes a payment under the
contract, and the counterparty cannot obtain timely payment.9 Under U.S. law,
this means that the defaulting party either has insufficient assets to cover the
required payments, or has successfully filed for protection under the bankruptcy
code.
The fact that default only occurs when two conditions hold simultaneously
implies that it is a bivariate phenomenon. To capture the nature of default risk,
we therefore have to consider the bivariate distribution of the counterparty’s
obligation under the derivative contract as well as its ability to pay. For simplic-
9
In our discussion of default, we generally ignore technical default since it has no direct
cash flow consequences. However, many derivative contracts have “cross-default” clauses which
can place a party into technical default. Should the counterparty try to unwind the contract
under the default terms but fail, then default occurs. On the other hand, if the contract can
be unwound at market value, then technical default has no valuation consequences.
Sec. 3] Default risk 9

FIGURE 2: Insolvency and default on derivatives.

Conversely, we assume that the firm’s obligation under the derivative contract

is illustrated in figure 2. Although the firm is insolvent in the shaded areas

of quadrants II and III, it only owes payments on the derivative in the shaded
areas of quadrants III and IV. Hence, default on the derivative is confined to the
cross-hatched area in quadrant III.
The probability of default is given by the joint probability that the firm

(6)

which is given by the cumulative density function

10 Risks in Derivatives Markets

FIGURE 3: Firm value and asset prices. The case of zero correlation.

Moreover, if we are willing to make specific distributional assumptions

and Wishart densities.) In principle, one could also directly estimate the joint

As we will argue later, however, default is a relatively rare phenomenon, which

implies that the default probability depends strongly on the tail behavior of the
density. This makes precise empirical estimates difficult.

3.2.1 Complete hedging

in default, respectively. In figure 3, the inside contour contains the combinations

Sec. 3] Default risk 11

FIGURE 4: Default and the correlation between firm and derivative value.

will be outside the next largest contour drops to 1%; and the probability that

the joint density in figure 3, the likelihood of default in eq. (8) is less than ¼%,
the volume above the shaded default area in quadrant III and underneath the
probability density function.

lated. While this may be the case, generally the two could have either positive
or negative correlation. Figure 4 illustrates how the correlation affects the like-
lihood of default. In both panels of figure 4, the distribution shows a strong
correlation between the value of the firm and the payoff from the derivative.

(9)
12 Risks in Derivatives Markets

3.2.2 Partial hedging

Panel A of figure 4 illustrates the negative correlation between firm value and

arise when the firm in figure 1 is holding fewer than the variance-minimizing

the contract is lower than if firm and derivative value are uncorrelated.10 The
l% confidence region barely touches the shaded area of quadrant III. Compared
to figure 3, a considerable amount of the probability mass has been shifted from
quadrant III to quadrant II—away from the default area.11

3.2.3 Overhedging

the firm’s assets. This situation can arise if a firm with negative core exposures

firm, the likelihood of distress-induced default on the derivatives is higher. Now

the l% confidence region reaches well into the shaded area of quadrant III and
probability mass has been shifted to the default area. Alternatively, the positive

long position in the derivative.

Figure 4 shows that the likelihood of distress-induced default on derivatives
increases with the correlation between the value of the firm and the value of the
derivative.

10
This is true in the typical case when there is considerable residual variation. If a perfect

insolvent or default.
11
The panel assumes that the negative net exposure does not stem from a large short

default area would be the area of insolvency in quadrant II.

Sec. 3] Default risk 13

FIGURE 5: Derivatives positions and the probability of default

3.3. Decomposing the probability of default

One can decompose the probability of default, P(D), into the probability of in-

Figure 5 presents this decomposition graphically for a range of hedge ratios,

The probability of insolvency and the probability of default conditional on

insolvency both depend on the correlation between the value of the firm and
the value of the derivative. This correlation changes as the firm varies its hedge
ratio. With incomplete hedging, as the firm increases the size of its hedging

position minimizes variations in firm value and the risk of insolvency. As the
firm increases its hedge ratio beyond this point, the firm overhedges and reverses
its net exposure. Eventually, firm volatility is dominated by the variations in
the derivatives position.
14 Risks in Derivatives Markets

When the hedge ratio is below zero, the firm is using derivatives to increase
its exposures rather than to reduce them. Nonetheless, as long as firm value has
to fall below its expectation to induce insolvency, the probability of insolvency
is less than ½. This is indicated by the fact that, regardless of correlation, only
half of the probability mass is below the horizontal axis in figure 4.
The middle panel of figure 5 shows how the probability of default condi-
tional on insolvency depends on the hedge ratio. As the firm increases its hedge
ratio above zero, it also increases the correlation between the value of the firm
and the value of the derivatives. This consequently increases the probability of
default conditional on insolvency since more of the probability mass is shifted
into the default region. At a hedge ratio of 1, firm and derivative value are un-
correlated (as in figure 3) and the probability of default given insolvency is ½ for
symmetric unexpected changes. But, if the hedge ratio is negative, default risk
jumps immediately. In panel A of figure 4, this would have the effect of switch-
ing the default area into quadrant II; hence the discontinuous increase in the
default probability.12 In the extremes, if the firm acquires very large derivatives
positions, the firm is sure to default on these positions in the event of insolvency.
Alternatively, the probability of default conditional on insolvency can be
interpreted as the probability of default on derivatives relative to the probability

clearly that the probability of default on derivatives is always less than the
probability of default on debt. Furthermore, for derivatives used to hedge (0

on debt. Not only is the default risk of derivatives significantly lower than that of
the firm’s debt, but hedging with derivatives helps reduce the default risk of debt
by offsetting the firm’s core business exposures. Without doubt, the probability
of default on derivatives that are used to hedge is low by the standards of default
on corporate debt.
Finally, the bottom panel of figure 5 explicitly shows the probability of de-
fault on the derivative—the product of the probabilities in the two panels above.
The probability of default is always less than ½, and much lower than that for
12
lf (unhedged) firm value and the derivative are uncorrelated, then the probabilities are
symmetric about zero derivatives positions and do not have a discontinuity at gamma = 0.
Sec. 3] Default risk 15

typical derivative positions with hedge ratios between zero and one. Nonethe-
less, as the size of the derivatives position becomes very large, net firm value
(including the derivatives) and the derivatives become more highly correlated.
For extreme positions, the firm’s payoffs are almost entirely derivatives related.
If the derivative payoffs are symmetrically distributed about zero, there is a
50% chance that the derivative finishes out of the money, that the firm becomes
insolvent, and defaults on the derivatives contracts.
To the extent that corporations use derivatives to hedge, we can use general
corporate default rates to assess the default risk of derivatives. Altman (1989)
reports that 0.93% of all A-rated corporate bonds default during the first ten
years after being issued. This evidence suggests an average annual default rate
of 0.1%. For the special case of a firm negotiating an at-market swap that com-
pletely hedges the firm’s interest rate exposure, the default rate on the swap will
be half the default rate on the debt. (For an at-market swap, future interest
rates are as likely to be above as below the swap rate; if the firm completely
hedges its exposure to interest rates, firm value and interest rates are uncorre-
lated.) Consequently, a conservative estimate of the average annual default rate
on swaps used to hedge the exposures of an A-rated firm is 1/20 of one percent
(see Figure 5).

3.4. Default exposure

In the special case of independence between the derivatives payoffs and firm
value, the default exposure is simply the product of the expected exposure and
the probability of default. We have already estimated each of these two compo-
nents. Our conservative estimate of the default probability is 0.0005. We have
also argued that the expected loss on an unsecured swap is 0.5% of notional
principal. Therefore, a conservative estimate of the annual expected default cost
is 0.00025% of notional principal. This means that on a $10 million interest rate
swap, the expected annual cost of default is no more than $25.

3.5. Corporate use of derivatives

At this point, the evidence on corporate derivative use is still somewhat prelim-
inary. Yet, the existing evidence supports the hypothesis that firms use deriva-
16 Risks in Derivatives Markets

tives to hedge.
Dolde (1993) reports the results of a survey of the risk-management prac-
tices of 244 Fortune 500 firms. The overwhelming majority responded that their
policy is to hedge with hedge ratios between zero and one. Although many
firms adjust this hedge ratio on the basis of their market view, only 2 of the 244
firms responded that they sometimes choose hedge ratios outside the 0-1 range.
Furthermore, a considerable body of theory (see Mayers and Smith 1982, 1987;
Stulz 1984; Smith and Stulz 1985; and Froot, Scharfstein and Stein 1993) pre-
dicts a set of firm characteristics that should be associated with higher demand
for hedging and hence larger derivatives positions. Nance, Smith and Smith-
son (1993); Booth, Smith and Stolz (1984); Block and Gallagher (1986); Hous-
ton and Mueller (1988); Wall and Pringle (1989); Hentschel and Kothari (1994);
and Mian (1994) generally report empirical support for these predictions. Yet, if
firms were using derivatives simply to speculate, one would not expect to observe
this association between firm characteristics and derivatives use.
While the general evidence suggests that firms typically use derivatives
to hedge, derivatives dealers have particularly strong incentives to ensure that
customers with low credit ratings use the derivatives to hedge. In particular, the
relatively high default risk makes it unlikely that a dealer would sell derivatives
to a poorly rated credit if the firm is using the derivatives to “double up” an

4. Systemic risk from derivatives

As noted above, one of the prominent concerns of regulators is “systemic risk”

arising from derivatives. Although this risk is rarely defined and almost never
quantified, the systemic risk associated with derivatives is often envisioned as
a potential domino effect in which default in one derivative contract spreads to
other contracts and markets, ultimately threatening the entire financial system.

4.1. Defining systemic risk

For the purposes of this paper, we define the systemic risk of derivatives as
widespread default in any set of financial contracts associated with default in
Sec. 4] Systemic risk from derivatives 17

derivatives. If derivative contracts are to cause widespread default in other

markets, there first must be large defaults in derivative markets. In other words,
significant derivative defaults are a necessary (but not sufficient) condition for
systemic problems. While this interpretation of systemic risk is consistent with
most others, we believe that focusing on default is useful because it has definite
cash flow consequences and is more operational.13
Even if systemic risk is simply the aggregation of the underlying risks, be-
cause the underlying risks are correlated, one cannot simply sum them to find the
total. Some argue that widespread corporate risk management with derivatives
increases the correlation of default among financial contracts. What this argu-
ment fails to recognize, is that the adverse effects of shocks on individual firms
should be smaller precisely because the same shocks are spread more widely.
More important, to the extent firms use derivatives to hedge their existing expo-
sures, much of the impact of shocks is being transferred from corporations and
investors less able to bear them to counterparties better able to absorb them.
It is conceivable that financial markets could be hit by a very large distur-
bance. The effects of such a disturbance on derivative markets and participants
in these markets depend, in particular, on the duration of the disturbances and
whether firms suffer common or independent shocks.
If the disturbance were large but temporary many outstanding derivatives
would be essentially unaffected because they specify only relatively infrequent
payments.14 Therefore, a temporary disturbance would primarily affect contracts
with required settlements during this period.
If the shock were permanent, it would affect derivatives in much the same
manner that it affects other instruments. If the underlying price increases, long
positions gain while short positions lose. Since derivative contracts are in zero
net supply, the gains exactly equal the losses.
A critical question in evaluating systemic risk concerns the extent to which
defaults across derivatives markets, and financial markets in general, are likely
13
The Bank for International Settlements (1992), for example, defines systemic risk to
include “widespread difficulties.” Although this definition agrees with ours in spirit, it is less
observable.
14
The payments under path-dependent derivatives, like Asian options for example, can be
affected by temporary disturbances long after the disturbance has subsided.
18 Risks in Derivatives Markets

to be correlated. There are reasons to expect that defaults on derivatives con-

tracts are approximately independent across dealers and over time. Dealers have
powerful incentives to assess the default risks of their customers. In practice, a
strong credit rating is required of derivatives customers. Second, as we have dis-
cussed in detail, firms using derivatives to hedge their exposures, are most likely
to become insolvent precisely when their derivatives are in the money. Price
shocks in the underlying derivative do not cause these firms to default on the
derivative.
In this sense, derivative defaults are significantly more idiosyncratic than
defaults on loans. For example, a large increase in interest rates is much more
likely to produce defaults on floating-rate bank loans than on interest rate swaps.
For partially hedged firms, the correlation among loan defaults is likely to be
higher than the correlation among derivative defaults. Hence, diversification is
a more effective tool for managing the credit risk of derivatives than loans. This
is why derivatives dealers carefully monitor and ultimately limit their exposures
to individual counterparties, industries and geographical areas.

Finally, dealers with a carefully balanced book and substantial capital re-
serves can absorb individual defaults by their counterparties without defaulting
on their other outstanding contracts.

4.2. Systemic risk, the payment system, and banking regulation

Banks are among the most active participants in derivatives markets. They par-
ticipate in two primary capacities. Many banks are active end users of derivatives
in order to manage their own portfolio risks. Furthermore, many banks are active
market makers in derivatives. These banks either act as market makers directly
or through increasingly common, separately capitalized derivatives subsidiaries.
Banks are also among the most heavily regulated financial institutions.
One justification for this regulatory burden on banks is to limit externalities their
insolvencies might impose. In particular, bank failures can impose externalities
on the financial system as a whole by disrupting the payment system.
While these concerns are valid, our previous analysis suggests that deriva-
tives are unlikely to be a major cause for bank failures. In neither their end
Sec. 5] Agency Risk 19

user nor their market maker capacities do banks face unusually large risks in
derivatives markets.
Just like other firms, banks that use derivatives to hedge their exposures
have lower default risk on their derivatives than they have on their other fixed
obligations. In the case of banks, these obligations include debt and deposits.
Moreover, this risk management with derivatives makes the bank less likely to
default on any of its obligations.
Although market making is likely to expose banks to some additional de-
fault risk, this risk is likely to be smaller than the risks associated with more
traditional banking activities like lending. As we have already noted, because
default on derivatives is more idiosyncratic than default on loans, diversification
is a more effective tool in managing default risk in derivatives than in loans.
Furthermore, to the extent that banks’ derivatives subsidiaries can shield their
parents from losses at the subsidiaries, the current movement toward conducting
most market making in derivatives through such subsidiaries reduces the banks’
default risk.
The most prominent recent bank failure, the failure of Barings Bank, was an
isolated failure and did not result in problems that can be described as systemic.
Nor did the failure result in material difficulties for the payment system. The
bank was simply wound down in an orderly fashion. Instead, the case of Barings
Bank demonstrates another, far less talked about type of risk in derivatives
markets: agency risk.

5. Agency Risk

The derivatives losses incurred by firms like Procter & Gamble, Gibson Greet-
ings, and Barings Bank gained notoriety because of their size—not because there
was serious concern that the companies would default on the contracts. Never-
theless, these losses share a disturbing pattern of inappropriate incentives and
ineffective controls within the firms. In many instances, the magnitudes of the
derivative losses and hence the underlying derivative positions came as surprises
to senior management and shareholders. This suggests that employees with the
authority to take such derivatives positions were acting outside their authorized
scope and were not acting in the best interests of the firms’ owners.
20 Risks in Derivatives Markets

This misalignment between owners’ objectives and employees’ actions

makes this a typical agency problem. Employees in the derivatives area (the
agents) are not working toward the general corporate objectives set by senior
management and shareholders (the principals). Given the nature of the problem,
we will refer to the associated risks as “agency risks.”
In our simple setting, such agency problems exist whenever the agent in

deviate from the position that maximizes the value of the firm. For concreteness,

hedging costs.
Problems of this type are not special to derivatives; they arise in many
different settings where principals and agents have divergent interests. Since the
agent’s incentives are affected by the structure of the organization, the design
of the organization can either exacerbate or control these incentive problems.
There are three critical facets of organizational structure: evaluation and control
systems, compensation and reward systems, and assignments of decision rights
(see Brickley, Smith, and Zimmerman, 1996). Although no single organizational
structure is appropriate for all firms, there are several general features that
should help control agency risk in derivatives.

5.1. Evaluation and control

Recent regulatory proposals to increase the required disclosure of firms’

able and hence reduce monitoring costs.

Our framework suggests that current and proposed disclosure standards do
not achieve perfect observability. For one, firms are only required to report the
size of their derivative positions, they do not have to provide information about
the exposures (“deltas” in options parlance) of these positions. In addition, the
exposures are only reported on the balance sheet dates, yet exposures can change
over time even if the positions remain fixed. Moreover, for outsiders the core
Sec. 5] Agency Risk 21

exposures of the firm can be difficult to measure, making it hard to ascertain

whether the firm is engaged in an optimal hedging program.
Only absent information costs does our simple model suggest that future
disclosure standards should include more detailed information about derivatives
and firm exposures. If it is costly to gather and maintain this information,
or if the information has private value, full disclosure is generally suboptimal.
Nonetheless, net, core, and derivatives exposures are surely among the most
important pieces of summary information in evaluating the performance of a
firm’s derivatives activity.
The recent derivatives scandals also point out, however, that monitoring
even within the firm can be difficult. Managers at firms like Barings Bank and
Procter & Gamble claim they were not aware of the full extent of the derivatives
activities of their subordinates. This is an internal control problem that financial
accounting standards simply cannot solve. Our analysis summarized in figure 5
provides some solace in this regard. The figure shows that the actual hedge posi-
tion has to deviate strongly from the variance-minimizing position to materially
increase the risk of insolvency or default on the derivatives. Nonetheless, even
in the absence of default, such deviations have costs that are determined by the
curvature of firm value.
Careful control and supervision is critically important for derivatives. Al-
though leverage is one of the features that makes derivatives attractive hedging
instruments, it also makes it harder to monitor derivatives activity by reducing
the cash flows at initiation of the contracts. The problem can be compounded
by the steady increase in available maturities, which extend the time required to
determine the ultimate net gain or loss from the contracts.

5.2. Compensation and incentives

compensation to the objective, one can induce employees in the derivatives area
to adhere to the hedging program if the firm’s core exposures are observable.
22 Risks in Derivatives Markets

hedging activities by employees.

Indeed, because the objective is to stabilize firm value or taxable income,
incentive compensation for treasury employees might be cheaper to implement
than for many other employees, all else equal. The typical cost of incentive com-
pensation is the increased income risk for the employee. Risk averse employees
demand higher average compensation to bear this risk. Yet, employees charged
with reducing risk face less risk when they are successful.

For derivatives employees in trading or market-making functions, the sit-

uation is somewhat different. Here, the objective is not to stabilize firm value
but to generate profits. For any high-leverage financial contract, strong incen-
tive compensation based on the payoff to the contract can have undesirable side
effects.

The primary problem in linking pay to derivative profits is the limited li-
ability of employees. Although employees can participate in the upside, they
usually have insufficient resources to share large negative outcomes. This asym-
metry induces option-like features in compensation plans based on trading prof-
its. Compensating employees on the basis of long-term performance reduces
these option-like features that would otherwise encourage traders to take riskier
positions than is optimal from the owners’ perspective.

One way to reward traders for good performance without forgiving all losses
is to base more of the compensation on long-term performance. For example, in a
good year, a trader might have part of a bonus paid into a deferred compensation
account. If subsequent performance is also good, the account continues to grow.
On the other hand, if the trader is simply taking large bets, half of which lose,
then the bonus account is reduced during years with poor performance. In this
way, derivatives traders share responsibility for their losses as well as gains.

5.3. Decision rights

For most corporations, derivatives activity is not entirely static, the way we have
characterized it in our model, but it moves relatively slowly. Most firms’ hedging
demands do not change much on a daily basis. In such cases, it is not critical that
individual employees have decision rights over derivatives positions. Allocating
Sec. 6] Conclusion 23

the decision rights to a team of treasury employees is likely to improve internal

controls at low cost.
In contrast, derivatives traders and dealers typically have—and should
have—substantial decision rights over the positions they assume in derivatives.
Moreover, typical employment in the derivatives area also suggests that an opti-
mal compensation package should have strong incentive components (see Holm-
strom 1979). In particular, improved performance can generate very large ad-
ditional profits, and, normal trading activities are readily observable. There is
also no reason to believe that employees in the derivatives area are more risk
averse or less responsive to incentives than other employees.
Setting position limits for traders contains the size of the positions that they
could assume. Separating trading and settlement responsibilities (something that
apparently was not done in the case of Barings Bank) allows firms to monitor
derivatives activity. This separation is also necessary to ensure compliance with
position limits.
Many firms are changing the ways in which they manage their derivatives
operations to account for these agency issues. As we gather more experience with
these compensation and control systems, control of these problems is likely to
improve. Nevertheless, the recent losses demonstrate that agency risk is currently
a material problem for many firms.

6. Conclusion
We provide a parametric model of hedging which captures the major hedging
theories. With the aid of this model, we show that firms that use derivatives
have lower default probabilities on these derivatives than they do on their debt.
Based on this insight and empirical evidence on bond default rates, we compute
a conservative default probability for derivatives. We estimate that the expected
annual loss due to default on a $10 million interest rate swap is unlikely to exceed
$25.
Given these small default rates, we argue that systemic risk, the proba-
bility of widespread default, is even smaller. To the extent that derivatives are
being used primarily to hedge rather than to speculate, the default probability
24 Risks in Derivatives Markets

associated with derivatives is less than half the default probability on debt issued
by the same firms. Furthermore, derivatives markets act to reduce systemic risk
by spreading the impact of underlying economic shocks among a larger set of
investors in a better position to absorb them.
Establishing effective public policy toward derivatives requires accurate as-
sessment of both the risks associated with derivatives and the benefits offered by
the instruments. Of course, the misuse of derivatives can be costly. Nevertheless,
a growing body of academic evidence suggests that these tools are typically used
by firms to hedge their exposures.
Although we conclude that default and systemic risks are not major prob-
lems in derivatives markets, we argue that many firms are exposed to agency
risk. This risk arises when employees have decision rights over derivatives and
misaligned incentives relative to the firm but are not properly monitored. The
proper balancing of decision rights, incentives and control is a major firm-internal
concern for firms with derivatives activity.
We are concerned about this misidentification of the nature of the risk that
regulation might address. Although many regulatory proposals focus on default
and systemic risk, the problem cases appear to involve agency risk. The internal
nature of this problem is apparently not recognized in many regulatory propos-
als, nor is regulation likely to be a particularly effective tool in overcoming this
problem. Nonetheless, recent disclosure proposals which would allow firms to use
private valuation models for their derivatives positions form a noticeable excep-
tion. Such standards encourage monitoring at least as much as they encourage
transparent disclosure.

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