Failure to Reduce Risk
Although a derivative usually meets its narrow goal of reducing a particular risk, it is often the case that the derivatives transaction fails to reduce corporate risk materially. Indeed, some may actually increase the overall net risk profile.
For example, many firms hedge their foreign exchange risk carefully, perhaps not realizing that foreign exchange risk may be a very small part of the overall corporate risk profile.1 In many cases, tacit speculation occurs under the guise of hedging, particularly if the trading activity gets hedge accounting treatment.
More generally, derivative transactions supported by a particular department will likely reduce departmental risk but may not reduce the overall risk of the firm. For example, a large software firm may want to hedge its interest rate risk, without realizing that the interest rate risk pales in comparison to the business risks of software development and sales.
The only remedy for this problem is to build a firm-wide risk model, even if it is approximate in many ways, to understand the impact of a particular derivatives strategy on the firm. The firm-wide risk model should include market, credit, operational, and event risks in order to be as complete as possible. With this kind of model in place, the benefits of risk management can be more precisely measured in order to compare the benefits to the costs. The following steps may be added to the checklist above:
Build a model of the firm that simulates all material risks.
Overlay the proposed derivative on the firm model.
Test cash margin requirements, credit exposures, and accounting outcomes from the model.
Document courses of action for select scenarios.