Derivatives are becoming increasingly complex in the world economy. This article explores the growing risks of derivatives and the existing monitoring mechanisms to manage risk intelligently. Derivatives are also pervasive in global finance.
U.S. commercial banks currently hold a notional value of $244 trillion in derivatives. The world derivatives market may be in excess of $700 trillion. The actual trading exposure, which is measured by VaR (Value at Risk), is about $700 million. The net current credit exposure (NCCE) of commercial banks to derivatives is $353 billion, due to bilateral netting. Potential Future Exposure (PFE) is $814 billion, bringing Total Credit Exposure (NCCE + PFE) to $1.2 trillion. The total amount of credit derivatives outstanding is about $15 trillion.
Classic derivative transactions include swaps, futures/forwards, credit derivatives and options. Swaps are used very much like the name suggests. That is to swap (exchange) cash flows at a certain date. These types of derivatives are used principally for interest rate swaps, but can be utilized to swap cash flows from equities, commodities, or foreign exchange currency.
A forward transaction requires the party to buy or sell a certain equity, commodity or foreign currency at a set price and point in time. Engaging in a future is almost the same agreement as a forward. The position is usually opened on margin, and is traded marked to market. The position may be closed out at any time.
Credit derivatives involve an assumption or a hedging of risk on any kind of asset, or liability. Options give the owner a right to buy or sell the underlying security before or on the expiry date at a specific price.
As far back as 2003, the OCC (Office of Comptroller of the Currency) issued a report on the fourth quarter of 2003 bank derivatives. The 2003 report specified classic risks in derivative transactions. These risks were a function of counterparty exchange of nominal principal, volatility of interest rates and currencies used to make contract payments, the maturity and liquidity of contracts and the creditworthiness of counterparties to the transaction.