Interest rate derivatives and asset-liability management by commercial banks

New England Economic Review, Jan-Feb, 1995 by Katerina Simons

RELATED ARTICLE: Box 3: The Risk of Derivative Instruments

The risks associated with derivative activities can be divided into five types, namely market, liquidity, credit, operational, and legal risk. These risks are the same as those associated with more traditional financial instruments, such as stocks, bonds, mortgages, or bank deposits. However, because derivatives often combine these risks in new or unfamiliar ways, managing the risk of derivatives may present additional challenges.

Market Risk

In its most basic form, market risk refers to fluctuations in the price of a financial instrument. The assessment of market risk of derivatives depends on the valuation of underlying instruments. It is relatively straightforward for forward-based derivatives, as a change in the price or rate of the underlying asset generally results in a proportional change in the price of the forward-based derivative.

The assessment of market risk for options-based derivatives tends to be more complex, however. The value of most options is determined by five factors: (i) the price of the underlying asset; (ii) the exercise price of the option; (iii) the time to expiration of the option; (iv) the volatility of the price of the underlying asset; and (v) the discount rate over the life of the option.

Market risk of derivatives must be evaluated on a portfolio basis, in the same way as the market risk of any other financial instrument. An institution may hold a derivative contract to offset the market risk of a specific asset or liability or to reduce the overall market risk of its portfolio. Thus, the market risk of a derivative instrument to the institution is not measured by the price fluctuations of that individual contract. Rather, the relevant issue is whether or not the instrument reduces the overall market risk of the institution's portfolio.

Liquidity Risk

Liquidity risk refers to the risk of reductions in market liquidity. It arises when a large transaction in a particular instrument can have a noticeable impact on its market price. This makes risk management more difficult and expensive. A somewhat different type of liquidity risk is associated with sudden erosions of liquidity, sometimes associated with an extraordinary event or some other market disruption.

Credit Risk

Credit risk is the risk that a loss will occur when the counterparty defaults on a derivative contract. This risk fluctuates over time with the value of the contract and, therefore, must be evaluated for both "current" and "potential" exposure. Current exposure is the cost to replace the transaction if the counterparty defaults today. The replacement cost differs from (and is usually much smaller than) the notional principal of a contract, which is simply the hypothetical basis on which payments are calculated. The replacement cost could be positive or negative, depending on the changes in the market value of the contract since the original transaction occurred. When the market value is negative, the remaining party does not incur a loss when its counterparty defaults.