In this article, we outline how and why banks and other financial companies use derivatives, and how they can be used to manage risk.
In this article, you will be learning about the simplest and most common derivatives – forwards, futures and options – and how they can be used to manage risk.
Here, we will give you a quick picture of how and why banks and other financial companies use derivatives.
How do banks use financial derivatives?
Various financial companies have different roles. In retail banking a bank attracts deposits and makes loans.
The difference between interest rates on loans and on deposits creates a profit. How would low or zero interest rates affect the profit potential from retail banking?
Can you see an incentive for larger banks to engage in potentially more profitable activities like derivatives?
Banks play double roles in derivatives markets
Banks play double roles in derivatives markets. Banks are intermediaries in the OTC (over the counter) market, matching sellers and buyers, and earning commission fees.
However, banks also participate directly in derivatives markets as buyers or sellers; they are end-users of derivatives.
Banks use derivatives to buy protection
First, let’s see how banks use derivatives to buy protection on their own behalf. Banks use derivatives to hedge, to reduce the risks involved in the bank’s operations.
For example, a bank’s financial profile might make it vulnerable to losses from changes in interest rates. The bank could purchase interest rate futures to protect itself.
Or, a pension fund can protect itself against credit default. Suppose it has invested in corporate bonds and would like to purchase insurance against the possibility of default.
The pension fund could purchase a credit default swap (or CDS). The seller (or writer) of the CDS promises to pay the face value of the bond if the bond becomes worthless.
AIG, bailed out in 2008, had written CDSs on over $500billion of assets, including $78billion on complex securities backed by mortgages and other loans.
There are two sides to every derivative transaction
You can see that for every derivative transaction there are two sides – one party wants to protect themselves against risk, and another party is willing to take on that risk, for a fee.
How do banks take on risks?
How do banks take on risk? Suppose you have invested in a stock. To protect yourself against potential price falls you could purchase a put option from a bank.
You pay an option premium and buy the right to sell the stock at an agreed price at an agreed date. At that date, if the stock price has fallen significantly, you can exercise the option and sell the stock at the agreed exercise price.
The bank receives the option premium, and they take on the risk that they may have to buy the stock from you at a price much higher than the market price.
Over the period 2004–08 Berkshire Hathaway earned $4.8billion in premiums for writing 15-year put option contracts on the S&P500 and FTSE100 indices.
The difference between banks and non-financial firms
An important difference between banks and non-financial firms is that banks have to abide by capital regulations.
Banks cannot lend all their capital; they are required to hold a proportion of the bank’s total capital (eg, 8%) to sustain operational losses and to honour withdrawals.
What is the significance of this? On the one hand, banks are motivated to operate in the derivatives market to compensate for the regulatory capital.
On the other hand, losses on derivatives may cause a bank not to have sufficient regulatory capital, which means the bank is not well prepared to deal with shocks in the financial system. This happened in the 2007–08 global financial crisis.
References:
Buffett, Warren, 2009, Letter to the Shareholders of Berkshire Hathaway
Kellogg Insight, August 2015 – What Went Wrong at AIG?
FAQs
Banks use derivatives to hedge, to reduce the risks involved in the bank's operations. For example, a bank's financial profile might make it vulnerable to losses from changes in interest rates. The bank could purchase interest rate futures to protect itself. Or, a pension fund can protect itself against credit default.
How are derivatives used in finance? ›
Overview. Financial derivatives are used for two main purposes to speculate and to hedge investments. A derivative is a security with a price that is dependent upon or derived from one or more underlying assets. The derivative itself is a contract between two or more parties based upon the asset or assets.
How do banks use interest rate derivatives? ›
Interest rate derivatives are often used as hedges by institutional investors, banks, companies, and individuals to protect themselves against changes in market interest rates, but they can also be used to increase or refine the holder's risk profile or to speculate on rate moves.
What are the basics of derivatives in banking? ›
Derivatives are financial contracts, set between two or more parties, that derive their value from an underlying asset, group of assets, or benchmark. A derivative can trade on an exchange or over-the-counter. Prices for derivatives derive from fluctuations in the underlying asset.
What are the benefits of bank derivatives? ›
Derivatives allow market participants to allocate, manage, or trade exposure without exchanging an underlying in the cash market. Derivatives also offer greater operational and market efficiency than cash markets and allow users to create exposures unavailable in cash markets.
Are bank loans derivatives? ›
Credit Derivatives
A CDS is a derivative of a loan (or several loans) between a lender and a borrower. That loan is known as the reference obligation. The buyer of a CDS (also known as the Protection Buyer) makes regular periodic payments to the seller (also known as the Protection Seller).
What is an example of a derivative in finance? ›
What are Derivative Instruments? A derivative is an instrument whose value is derived from the value of one or more underlying, which can be commodities, precious metals, currency, bonds, stocks, stocks indices, etc. Four most common examples of derivative instruments are Forwards, Futures, Options and Swaps.
What are the three main uses of derivatives? ›
Investors typically use derivatives for three reasons—to hedge a position, to increase leverage, or to speculate on an asset's movement. Hedging a position is usually done to protect or insure against the adverse price movement risk of an asset.
What is the main purpose of using derivatives? ›
In calculus, derivatives are incredibly important because they allow individuals to study how functions change over time. In other words, derivatives provide information about the direction a function is moving at any given point.
How do banks use interest rate swaps? ›
An interest rate swap occurs when two parties exchange (i.e., swap) future interest payments based on a specified principal amount. Among the primary reasons why financial institutions use interest rate swaps are to hedge against losses, manage credit risk, or speculate.
There are two ways in which a bank can manage its interest rate risks: (a) by matching the maturity and re- pricing terms of its assets and liabilities and (b) by engaging in derivatives transactions.
What exactly are the risks posed to banks by financial derivative instruments? ›
Among the most common derivatives traded are futures, options, contracts for difference (CFDs), and swaps. This article will cover derivatives risk at a glance, going through the primary risks associated with derivatives: market risk, counterparty risk, liquidity risk, and interconnection risk.
How do you explain derivatives to dummies? ›
Derivatives are any financial instruments that get or derive their value from another financial security, which is called an underlier. This underlier is usually stocks, bonds, foreign currency, or commodities. The derivative buyer or seller doesn't have to own the underlying security to trade these instruments.
What are the 4 main types of derivatives? ›
The four different types of derivatives are as follows:
- Forward Contracts.
- Future Contracts.
- Options Contracts.
- Swap Contracts.
They allow investors to speculate on the future value of a company's stock without actually owning the stock itself. Equity derivatives include futures and options, which can be used by investors to speculate on the direction of the underlying asset or hedge against losses when prices fall.
How do banks use financial derivatives to mitigate risk? ›
Banks use derivatives to hedge, to reduce the risks involved in the bank's operations. For example, a bank's financial profile might make it vulnerable to losses from changes in interest rates. The bank could purchase interest rate futures to protect itself. Or, a pension fund can protect itself against credit default.
Do investment bankers use derivatives? ›
The bottom line is that trading and selling of derivatives has become an important business of investment banks. In fact, this is what investment banks are now largely known for.
