DERIVATIVES Overview Part 1

DERIVATIVES Overview - Session 1

WHAT IS A DERIVATIVE?

 A derivative is an instrument whose value is "derived" from the price of some underlying instrument, reference amount or index.

It generally represents a contractual relationship between two parties.

Cash flows are exchanged between parties based on price/index movements.

The terms of the agreements may be customized or they may be standardized to facilitate exchange clearance.

Customized agreements are usually referred to as Over The Counter Transactions. (OTC)

Generally doesn’t require physical delivery of the reference asset.

WHAT ARE DERIVATIVES USED FOR?

Trading
- Speculation (e.g., bet on movements in an underlying security, index, interest rate, commodity, currency or other financial instruments).
 - Arbitrage (utilized by many fund managers to take advantage of expected market movements or arbitrage opportunities, hoping to decrease financing costs or increase yields on existing investments (e.g., capitalize on anomalies in the market).
 - Lower costs (to reduce financing costs, manage interest or currency-sensitive assets and liabilities, increase investment yield [through trading activities or by taking advantage of arbitrage opportunities], and provide favorable tax, accounting, or regulatory treatment (e.g., European markets may offer lower borrowing cost than US markets
- borrow Euro and swap to USD).

Risk Management or Strategic Applications

 - Diversification (e.g., swap American exposure for Asian exposure)

 - Hedging (change the rate structure of debt from variable to fixed to protect against adverse changes in interest rates).

 - Insurance (e.g., protect against large movements in currencies, credit events, or interest rates).

 - When used properly, are an effective risk management tool and can be used to achieve a variety of financial objectives.

BASIC DERIVATIVE TERMINOLOGY

Knowledge of the following terms will be helpful in considering whether a financial instrument or other contract meets the definition of a derivative.

Underlying - An underlying is a specified interest rate, security price, commodity price, foreign exchange rate, index of prices or rates, or other variables. An underlying may be the price or rate of an asset or liability but it is not the asset or liability itself.

Notional amount - A notional amount is a number of currency units, shares, bushels, pounds, or other units specified in the contract. The settlement of a derivative is a function of the notional amount and the underlying. For example, the settlement of an interest rate swap is determined by multiplying the interest rate (the underlying) by the notional amount. Reference of a notional amount, however, is not an essential characteristic of a derivative; a payment provision may be used instead.

Payment provision - A payment provision specifies a fixed or determinable settlement to be made if the underlying behaves in a specified manner.

Initial net investment - Many derivatives do not require any initial investment, but some require an initial net investment, either as compensation for the time value of money or for terms that are more or less favorable than market conditions.

Net settlement - Under a net settlement agreement, neither party is required to deliver an asset that is associated with the underlying and that has a principal amount, stated amount, face value, number of shares, or other denomination that is equal to the notional amount.

AUDITING CONSIDERATIONS

Auditing Fair Value

 - Understand the entity's process for determining fair value measurements and disclosures and the relevant controls, and assessing risk.

 - Consider whether we need the support of a specialist/expert

 - Test the entity's fair value measurements and disclosures

 - Evaluate the results of audit procedures and determine whether fair value measurements and disclosures are in conformity with GAAP

 - Obtain management representations and communicate with the audit committee

RISKS

 - Organizations that trade or invest in derivatives must understand the products and the associated risks to use them effectively

 - Internal controls should be established to monitor the use of derivatives and to ensure that the results achieved are consistent with management’s objectives

 - The creditworthiness of counterparties should be assessed to avoid assumption of unnecessary credit risk

Users should understand the market risk associated with the underlying financial instruments and the level of correlation with the related derivative

 - Tax, accounting, and regulatory implications should be evaluated to understand all reporting requirements

Derivative risk can be broken into several risk categories:

I. Counterparty Risk (credit risk) - Credit risk is the risk of loss due to a counterparty defaulting on a contract or more generally the risk of loss due to some “credit event”.  Traditionally this applied to bonds where debt holders were concerned that the counterparty to whom they’ve made a loan might default on a payment (coupon or principal).  For that reason, credit risk is sometimes also called default risk.

II. Market Risk (loss of value) - Market risk is the risk that the value of the investment will decrease due to moves in market factors.  The four standard market risk factors include:

-          Equity risk, or the risk that stock prices will change

-          Interest rate risk, or the risk that interest rates will change

-          Currency risk, or the risk that foreign exchange rates will change.

-          Commodity risk, or the risk that commodity prices (e.g. grains, metals, etc.) will change.

III. Settlement Risk (getting paid) - Settlement risk, is the risk that a counterparty does not deliver the security or its equivalent in cash value as defined in the original agreement.

IV. Operational Risk (internal control) - Operational risk is defined as the risk of loss resulting from inadequate or failed internal processes, people and systems, or from external events.  Examples:

 - Technology failure

 - Business premises becoming unavailable

 - Inadequate document retention or record-keeping

 - Poor management, lack of supervision, accountability and control

 - Errors in financial models and reports

 - Attempts to conceal losses or make personal gains (rogue trading)

 - Third party fraud

V. Liquidity Risk (ability to unwind position) - Liquidity risk arises from situations in which a party interested in trading cannot do so because of little to no market demand in the asset.  Liquidity risk becomes particularly important to parties who are about to hold or currently hold an asset, since it affects their ability to trade.

VI. Legal Risk (enforceability) - Legal and regulatory risk, arises from a contractual perspective, in determining whether enforceability rights exist in the derivative contract.  Additionally, governments may change laws in such a way as to adversely affect an entity’s contract.

VII. Correlation Risk - Risk that a derivative’s value will not change in the same manner as the underlying instrument.  In part, this is possible because derivatives markets do not require the same initial cash investment and thus can attract more speculative activity.  It is particularly important where an entity uses a derivative to hedge something other than the identical underlying.  Even though there may be significant historical correlation between the price changes of the underlying and the actual instrument owned, there is no guarantee that this correlation will continue.

VIII. Complexity Risk (hedge does not work) - When a derivative contract is entered into for “hedging” purposes and the contract does not specifically reduce or cancel out the risk in another investment.

IX. Accounting Risk (fair value) - Risk that the transaction is improperly accounted for (or not recorded at all) or that it is valued incorrectly.