Derivatives present growing risk management threat

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LONDON - The growing popularity and rapid evolution of over-the counter (OTC) derivatives is making it increasingly difficult for risk managers to keep track of their risk exposures, according to a new report.

The study from software provider Celent: Risk and Pricing Analytics: Addressing Valuation Challenges in OTC and Structured Products, warns that the risk associated with the use of derivatives is being underestimated, as illustrated by incidents such as the collapse of Aramanth and last month’s losses at Bank of Montreal.

“The derivatives market has soared, driven by the growth in hedge fund activity, the pursuit of higher gains beyond traditional capital returns, and the use of derivatives to manage risk. The combined notional value for all derivatives was $375 trillion at the end of 2006, growing at an average of 144% per annum since 2000, according to the Bank of International Settlements and the International Swaps and Derivatives Association. We anticipate this aggressive growth to continue, and for the market to crack the $500 trillion mark in 2008,” says Celent.

However, not only are the risks involved in such investments poorly understood, the possible large returns have attracted investors with little idea of the risks they are about to take on.

“The stellar growth in certain markets has lured an increasing number of participants with little experience in those markets. They may not necessarily have the same level of insight and expertise into the behaviour of the markets as traditional users,” the report notes.

The study goes on to suggest the necessity for frequent re-evaluation of risk management processes to ensure they are keeping pace with new risk liabilities.

“The risk management processes themselves need to be subjected to more rigorous risk assessments and a ‘robustness health check’ on a regular basis, to identify risk vulnerabilities, and to put in place appropriate controls and reviews.”

To prove its point, the report highlights the case of Bank of Montreal, whose commodity business lost CAD350 million this year due to downturns in market conditions and natural gas prices. Significantly, the trades and positions the bank held were all within the firm’s risk parameters, yet the potential scope and impact of these contracts should they go wrong, did not register with senior management.

The report speculates that such occurrences could be prevented by regular review of risk mitigation processes, and better alignment between deal-level pricing and portfolio risk.