“The world of banking has changed radically as a consequence of the recent crises and it is still changing. The rise of the universal banking model seems almost unstoppable, basically driven by the desire for an accelerated consolidation. The impact of increasing regulatory transparency and Integration will become a major challenge for the banking industry as a whole”.
And such regulation begins at home in the form of self regulation. Creating a best practices framework is the first ideal step in such self regulation.
What are derivatives, their need and suitability?
Derivative instruments are financial contracts whose value is derived from the value of underlying assets, credit, interest or exchange rates or indices. Financial Accounting Standards 133 paragraphs 6 to 9 very clearly define what a derivative instrument is and paragraphs 10 and 11 cover what it is not. Derivatives markets are one of the fastest growing divisions of international financial markets.
If properly used, derivative instruments can provide a potentially useful and valuable risk management tool. When judiciously applied, they can effectively reduce risks and transaction costs and when strategically planned, they can facilitate yield enhancement.
To decide on the suitability of a derivative transaction, the users alone are responsible. They can only decide whether the derivative instruments are suitable for them in the light of their circumstances and financial position. Invariably the market finds some users taking up derivative instruments that are not suitable for them and also in volumes much beyond their requirements. Naturally these unfit derivative instruments spell disasters for such wrong users.
The following checklist may help in ascertaining the suitability of derivative instruments in business applications
- Knowledge and expertise to understand the risks associated with derivative instruments.
- In particular, how they are valued and priced and the sources of risk
- Understanding that the derivatives are basically financial instruments
- The benefits of the derivatives should match the business objective
- Recognition that these instruments can be more volatile than investing directly in the underlying
- Acceptance that one can lose the entire capital invested in derivative instruments
- Understanding that there can be a counter party risk
Thus derivatives can become effective valuable tool if properly used and can also turn into wild beast if liberties are taken to indulge in overtrade or speculate. The derivative strategies must be consistent with the scope and objectives of business. They should be applied on a case to case basis according to business’s risk-return preferences. Given these objectives, certain types of derivative instruments and strategies may be even inappropriate for some businesses.
Classification of derivatives
The market classifies derivative instruments as simple, medium and complex basing on certain characteristics like standardization, liquidity, long established instrument, underlying, single name, index, basket, intraday price, closing price, etc. Some examples are:
Simple type derivative instruments
- Foreign exchange forward contracts
- Interest Rate Swaps
- Currency Swaps
- Swaptions
Medium type derivative instruments
- Contract for differences
- Standardized index swaps
- Variance/Volatility Swaps
- Inflation Swaps
- Constant Maturity Swaps
- Commodity Index Derivatives
- Hedge Fund Index Derivatives
Complex type derivative instruments
- Total Return Swaps
- Equity Swaps
- CDS Single/Basket
- Exotic OTC options
In some markets, they are classified as standard, non standard and combination derivatives. Some examples are:
Standard derivative instruments
- Single financial instruments that are used to hedge a recognized underlying financial exposure
- Forward foreign currency contracts
- Interest Rate Swaps and Forward Rate Agreements
- A single Option Put, Call, Cap, Floor
- Currency Swaps
Non Standard derivative instruments
- A derivative associated with commercial exposures and contracts and anything that does not fall into these categories
- Embedded options
- Barrier options
- Cylinders and Collars
- Yield enhancement investment products
- Weather derivatives
- Hybrid specific structures
- Credit derivatives
- Any one sided written option
- Combination derivatives
- A productized structured derivative used to hedge a recognized underlying financial exposure