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 also use derivative products to provide risk management services to their customers. Sometimes, where the bank chooses to be the risk 'acceptor', this will leave it with a risk exposure; in other cases, the bank will match this risk by an offsetting derivatives position with another customer.
How are financial derivatives used? ›
Financial derivatives enable parties to trade specific financial risks (such as interest rate risk, currency, equity and commodity price risk, and credit risk, etc.) to other entities who are more willing, or better suited, to take or manage these risks—typically, but not always, without trading in a primary asset or ...
What are financial derivatives mainly used for? ›
Financial derivatives are used for a number of purposes including risk management, hedging, arbitrage between markets, and speculation.
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.
What are examples of derivatives in banking? ›
Derivative transactions include an assortment of financial contracts, including structured debt obligations and deposits, swaps, futures, options, caps, floors, collars, forwards, and various combinations thereof.
What are 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 financial derivatives and how do they work? ›
Derivatives are complex financial contracts based on the value of an underlying asset, group of assets or benchmark. These underlying assets can include stocks, bonds, commodities, currencies, interest rates, market indexes or even cryptocurrencies.
What are the two main purposes for financial derivatives? ›
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 derivatives are used in real life? ›
To determine the speed or distance covered such as miles per hour, kilometre per hour etc. Derivatives are used to derive many equations in Physics. In the study of Seismology like to find the range of magnitudes of the earthquake.
What are financial derivatives in simple words? ›
Definition 1. Financial derivatives are financial instruments the price of which is determined by the value of another asset. Such an asset, ie the underlying asset, can in principle be any other product, such as a foreign currency, an interest rate, a share, an index or a commodity.
Derivatives are financial instruments that have values derived from other assets like stocks, bonds, or foreign exchange. Derivatives are sometimes used to hedge a position (protecting against the risk of an adverse move in an asset) or to speculate on future moves in the underlying instrument.
How much do banks have in derivatives? ›
four large banks held 87.8 percent of the total banking industry notional amount of derivatives. credit exposure from derivatives increased in the third quarter of 2023 compared with the second quarter of 2023. Net current credit exposure increased $35.0 billion, or 12.9 percent, to $308.0 billion.
What bank has the most derivatives? ›
JPMorgan Chase, in particular, is noted for its substantial exposure to derivatives risk, topping the list with roughly $58 trillion in derivatives. The mounting scale of derivatives owned by banks raises several questions and concerns among regulators and investors.
How does derivatives reduce risk? ›
A derivative can both reduce risk, by providing insurance (which, in financial parlance, is referred to as hedging), and magnify risk, by speculating on future events. Derivatives provide unique and different ways of investing and managing wealth that ordinary securities do not.
How do banks use financial leverage? ›
The leverage ratio is used to capture just how much debt the bank has relative to its capital, specifically "Tier 1 capital," including common stock, retained earnings, and select other assets. As with any other company, it is considered safer for a bank to have a higher leverage ratio.
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.
