Behind the Scenes of the Market: Derivatives and Risk

Do you ever wonder how a company like MF Global, which most of us had never heard of before recently, could send the market into a panic over potential banking losses? Our financial system has become so interconnected that a seemingly small player can pose a major risk to major financial institutions, and investors may not even know about the risk.

Today, I'm going to cover some of the ways derivatives pose risks to our financial system and the way banks and other institutions look at that risk.

What a derivative was supposed to be
Derivatives, futures contracts, and a variety of other financial instruments were invented to be a service to those producing real products. For instance, oil and gas companies like ATP Oil & Gas (NAS: ATPG) and Kodiak Oil & Gas (NYS: KOG) use derivative contracts to hedge against falling oil and gas prices that could affect future revenue. This is extremely valuable when they are planning millions of dollars in capital spending to build wells to produce fossil fuels because they can hedge the risk by selling derivatives against expected production.

Farmers use similar contracts to hedge against falling commodity prices when their crop is harvested. Swaps, forward contracts, and other instruments are used to lower operational risks at many large companies, especially those with exposure to currency or commodity risk.

What derivatives have become
In the normal ways of Wall Street, if some derivatives are good, more must be better. Wall Street went crazy and took "normal" derivatives like interest rate swaps to the extreme by selling credit default swaps, correlation swaps, and a multitude of complex products that helped contribute to the risks we saw in the financial crisis.

Everyone from JPMorgan (NYS: JPM) to Goldman Sachs to Citigroup (NYS: C) got involved in one way or another. These contracts became so complicated that these firms began coveting quantitative geniuses with math and science PhDs, instead of traditional finance graduates, to build trading models and structured products that seemed to be low-risk trades.

The scariest part was that many of these products were traded via instant messaging -- the same medium you use with friends today to discuss last night's game.

But derivatives served a purpose and made a lot of sense for unloading risk that banks didn't want to have on their balance sheets.

The buck stops somewhere
Let's look at an example of how derivatives are traded and where they can go wrong.

When a bank sells structured products to customers, it often takes some sort of risk onto its balance sheet. It offsets this risk with another security or series of securities. An example would be selling a structured product that pays interest based on floating interest rates and currency exchange rates in Australia. For example:

• Goliath National Bank: This fictional bank sells the structured product to a U.S. customer wanting exposure to Australian interest rates, taking on interest rate and currency risk in the process. To offset this risk, Goliath enters into an interest rate swap with Aussie Bank to make the product a fixed rate obligation. It also enters a currency swap with Kangaroo Currency Trading Hedge Fund to eliminate currency risk. The bank's final position is neutral to changes in Australian interest rates and exchange rates.

• Aussie Bank's final position is the Australian interest rate risk from the swap with Goliath National Bank. Aussie will presumably use that risk to offset other positions the bank has built.

• Kangaroo Currency Trading Hedge Fund has Australian-dollar-based currency risk that it will trade in the currency market.

Everyone is happy with the trade because Goliath National Bank has offset its interest and currency risk, Aussie Bank's interest rate swap offsets other positions, and Kangaroo Currency Trading Hedge Fund has derivatives to trade against.

But what happens when one of Kangaroo Currency's other positions goes terribly wrong and the fund goes under? Now Goliath National Bank has exposure to risks that it didn't count on. And if Goliath teeters as a result, then Aussie Bank may be next in line down the chain.

This very simple interconnection shows how AIG (NYS: AIG) , Lehman Brothers, and MF Global caused such problems when it appeared they would fail. The connections were much more extreme, creating a domino effect -- except you have no idea how big the dominos are or how hard they will fall.

Risk and the Black Swan
One problem that the spread of derivatives described above creates is a skewed view of what the risks are. Every bank and hedge fund has an eye on risk, but they all need a way to quantify risk and put a number to it. How do you do that when you have a multitude of counterparties, underlying assets, and products?

One solution they've come up with is using standard deviation of daily, weekly, and monthly returns. But these models make assumptions about default, hedged risk, and a number of other factors -- assumptions that may or may not be correct.

Is this the correct way to calculate risk? Standard deviation implies that losses big enough for a bank to fail would be statistically impossible. But we know these statistical improbabilities, or Black Swans, do indeed happen -- and regularly.

If a bank "sells" risk to a hedge fund using daily returns to define risk, does that make the bank's position safe? Isn't hedging just making another bet that could go wrong?

Banks that kept their holdings relatively simple and counterparty risk minimal, such as Wells Fargo (NYS: WFC) and US Bancorp (NYS: USB) , survived the crisis better than those who took more complex positions. It's now much easier to see why.

Things to think about
There's no right or wrong answer to the questions I've posed above, but it shows that the black box banks have a lot of risks that management would like you to think are safe. But it doesn't take much to start a landslide that could bring the whole house of cards crashing down.

Editor's note: A previous version of this article referred to an entity that was meant to be fictitious but in fact exists. We regret the error.

At the time thisarticle was published Fool contributor Travis Hoium does not have a position in any company mentioned. You can follow Travis on Twitter at @FlushDrawFool, check out his personal stock holdings or follow his CAPS picks at TMFFlushDraw.The Motley Fool owns shares of Wells Fargo, JPMorgan Chase, and Citigroup. Motley Fool newsletter services have recommended buying shares of Goldman Sachs. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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