Risk management calls for new and innovative tools to control and/or minimise the risk and its effects. Yet, these new risk management tools are in themselves origins of new forms of risk (Sharma, 2008).
Inherent risks of using derivatives versus other Financial Instruments
The term "derivatives," has been bandied about and demonized by many writers. However, the researcher needs to determine whether or not derivatives are "evil" in this respect, no matter how much disgruntled modern-day traders and economists demonize them. It is also important to recognise that derivatives consist of wagering on something with intrinsic value, like a commodity.
Prior to the 1990s, knowledge about derivatives was not common outside the most sophisticated investment circles (Adams and Runkle, 2000). Two different schools of perspective developed. On the one hand, investors who are victims of extreme financial loss and bankruptcy view derivatives as destructive instruments, similar to the intensity caused by a herd of stampeding buffalos. Here, it seems that avoidance is the best solution. On the other hand, enlightened investors associate derivatives to a team of horses, which when harnessed and used appropriately become productive, effective, and efficient tools, maximising resources and reducing risk.
In the US, approximately 75% of the largest companies use derivatives instruments (Holland and Schiller, 1994). According to the United States General Accounting Office (GAO) (1994), the surge in derivative use within the past two decades is a result of fundamental changes in global financial markets, leading to increased demand for cost-effective protection against the risks known to result from movements in foreign exchange rates, interest rates, equities, and commodity prices. The G30 reported that 94% of Fortune 500 CEOs are satisfied with their firm's use of derivatives.
The trouble with the misuse of derivatives begins when unforeseen market changes require one party to the contract to post large amounts of cash quickly to cover collateral obligations. There are some infamous cases in which the use of derivatives has been involved with large-scale financial failures. Oppositions to derivatives, point to the widespread financial losses and bankruptcy during the 1990s. In fact, from 1982 to 1992, the total reported monetary loss associated with derivatives is estimated to be about $2.1 billion, and in 1994, this loss skyrocketed to $10 billion (Muehring, 1995). Apart from those labelled in the in this thesis, some other most notable publicly reported or acknowledged derivatives losses include: Proctor & Gamble; Dell Computer; Atlantic Richfield Co.; Merrell Dow Inc.; Mead Corp.; Paramount Communications; Caterpillar Financial Services Unit; City Colleges of Chicago; Odessa College; Escambia County, Florida; and Wisconsin's investment fund (Leckey, 1994).
Firm failures attributed to derivatives also extend from Western to Asian firms. In fact, derivatives are highlighted during the 1998 Asian currency crisis, specifically in South Korea (O'Brien, 1998a). In its lawsuit against a large South Korean bank and a South Korean investment firm, J.P. Morgan & Co. sued the latter for their inability to fulfil obligations on swap contracts relating to exchange of US dollars for some Southeast Asian currencies (Frank, 1998). SK Securities countered the lawsuit stating that J.P. Morgan in Korea failed to adequately inform them about the risks brought about by derivatives transactions.
Moreover, the steep devaluation of the Russian ruble in Mid-August of 1998 is another case, which shook investors' confidence in the foreign market and the use of derivatives (Newsday, 1998). Though most American banks could absorb the losses of the ruble devaluation, some have experienced severe losses. The Republic New York Corporation reported losses in Russia equal to its total third-quarter earnings for 1998 (O'Brien, 1998b).
The publicised firm failures have raised questions as to whether derivatives are riskier than other investments. Taking off from a portfolio perspective, derivatives reduce rather than increase risk because they are used most often to hedge existing portfolio risk (Frankel, 1995). Others argue that it is the speculative impulse of investors that creates risk not derivatives. Furthermore, many say that derivatives are less risky than other types of investment instruments (Muehring, 1995). In support of derivatives, a managing director at Bankers Trust said, "People lost a lot more money in the two-year Treasury note than they ever did in derivatives" (Muehring, 1995: 22). Therefore, there is a wide perception that derivatives are not riskier than any other investments. Derivatives can neither create nor destroy risk; they can only transfer existing risk from one investor to another (Adams and Runkle, 2000).
The negative perception on derivatives is a result of confusion due to complexities associated with most derivative transactions (Frankel, 1995). The complexity of derivatives is attributed to many factors. One of these is the customisation of many of the derivatives to the needs of the individual investor and the other is the failure to test derivatives outside the confines of a hypothetical model. Moreover, statements and recommendations made by brokers can both inadvertently and intentionally mislead investors (a result of an ironic relationship that can possibly develop between brokers and investors) (Adams and Runkle, 2000). Other factors that contribute to the complexity of derivatives include confusing documentation, faulty disclosure of risks, and underdeveloped accounting considerations (Manning, 1995). Each of these deficiencies adds to the other obstacles, such as valuation difficulty and risk determination (Baird et al., 1995). These complexities are amplified by inadequate internal management controls (Adams and Runkle, 2000).
The already complex nature of most derivatives is made more complicated by the use of deficient risk measurement mechanisms, inadequate risk management controls, and poor understanding of the significant role of derivatives in investment strategies. This confusion often results from a mixture of these factors that leads to the misuse of derivatives, and eventually, in damaging losses. The most complicated derivatives tend to be customised OTC derivatives, which frequently consist of a combination of several derivatives that are often hypersensitive to changes in the underlying market (Knap, 1994).
Derivatives introduce new ways to manage risks. However, contrary to what one may think the risks involved in derivatives are neither new nor unique. Many of the financial risks to which entities may be exposed by derivative activity are the same as for activities with other financial instruments. These are summarised as follows:
(a) Market risk is a concept that is associated to the economic costs which results from the negative variations in terms of the derivatives' fair value (Auditing Guidance Statement , 2002). Market risk is the exposure to the possibility of financial loss caused by adverse changes in the values of assets or liabilities in all investments (GAO, 1994). The concept could also refer to fluctuations in the price of a financial instrument (Simons, 1995). The complexity of managing it lies in the measurement, wherein the assessment of market risk of derivatives depends on the valuation of the underlying instruments (Simons, 1995). With the use of tools such as the value-at-risk, the amount to be lost from an adverse market movement is predicted. With this strategy, market risk limits that have been agreed upon by senior management and the board of directors are compared, thereby evaluating the current derivatives strategy (Adams & Runkle, 2000).
The utilisation of value-at-risk methodology, also aids the investor in implementing an appropriate hedging strategy to minimise these excessive market risks. According to Simons (1995), market risk of derivatives must be evaluated on a portfolio basis. An institution may hold a contract of this financial instrument to minimise the market risk of a specific asset or liability. However, it remains that the important issue is whether or not the instrument reduces the overall market risk of the institution's portfolio (Simons, 1995).
There are other risks that are seen to be relevant to this, and these include the following:
• Price risk is the risk, which arises from the changes in the price level (Auditing Guidance Statement , 2002). The change could be from foreign exchange rates, interest rates, and others which are related to the index, price, and others. The two risks seen from this end involves that of foreign exchange and interest rate (Auditing Guidance Statement , 2002);
• Liquidity risk is associated with the changes in the viability of the derivative to be sold or disposed of in the market (Auditing Guidance Statement , 2002). There is always the risk for derivatives, in terms of liquidity, when there is insufficient contract or entities to enable a contract to be closed (Auditing Guidance Statement , 2002).
• Economic losses that may occur when there is insufficient or distorted information in the market and trades are carried out according to this or poor valuation models (Auditing Guidance Statement , 2002).
• Basis risk is encountered, when derivatives are used for purposes of hedging and the basis changes while the hedging contract is still open (Auditing Guidance Statement , 2002). The term "basis," is defined as the difference between the price of the item hedged and the price of the other related instrument intended for hedging (Auditing Guidance Statement , 2002). Risk is experienced herein when the basis will change and the relationship between the two prices would not remain perfectly correlated (offsetting each other as perfectly as they did).
(b) Credit risk is the risk, which occurs when a client or the opposite party does not have the capability to settle the obligation, in part or in full, at the due date or any period thereafter (Auditing Guidance Statement , 2002). This risk is the positive value that is placed on the obligation incurred by the counterparty. That is the value of the economic benefit that can be lost (Auditing Guidance Statement , 2002). Another factor that affects the degree of exposure to this kind of risk is the constant fluctuations in the prices and the structure of particular derivatives (Auditing Guidance Statement , 2002).
Credit risks exposures in some derivatives markets become quite volatile, raising the degree of credit risk because the markets are unstable (Auditing Guidance Statement , 2002). Means through which credit risk can be minimised include exchange-traded derivatives, which obligate daily settlement of changes in position value, requiring collateral, and assigning credit limits (Auditing Guidance Statement , 2002).
Dealing with credit is never an easy task because in managing this type of risk, the rapidly changing extent of exposure has to be considered (GAO, 1994). The intensity of this risk is greater with OTC derivatives contracts than with exchange-traded ones, because exchanges reduce it, since they require both buyers and sellers to post margin collateral. Exposure to such risk can also be minimised by establishing limits on the amount of exposure to each counterparty individually and avoiding concentrating derivatives transactions with a single counterparty.
Among newer products, credit derivatives are considered to be a major innovation (Park, 1998). The market for this type of tool has grown rapidly since the 1992 conference of the International Swap Dealers Association (Kijima & Muromachi, 2000). As already stated, Credit risk is seen to be the danger associated with the actual or probable non-performance by a firm. It is the risk that a loss will occur when the counterparty fails on a derivative contract (Simons, 1995). Credit derivatives are financial instruments whose payoffs are linked to the credit characteristics of reference assets' values (Kijima and Muromachi, 2000).
The growth of this, has been widely attributed to the increasing number of banks that have latched onto the potential for this product, both for commercial customers and for their own portfolios (Asher, 1998). Most analysts believe that the customers are likely to be mainly commercial banks (Park, 1998). With the introduction of credit derivatives, the traditional role of assuming risks involved in lending could now be played by non-banks. In addition, since commercial banks are regulated, these types of derivatives also bring with them a few public policy concerns for example capital requirements and deposit insurance pricing (Park, 1998).
Although the market is still quite small compared to other derivative types, it is positively bringing in business volume. In a survey by the British Bankers Association, the worldwide market for credit derivatives rose from below $50 billion in 1996 to $170 billion in the following year (Asher, 1998). According to the International Swaps and Derivatives Association (ISDA), the worldwide OTC credit derivatives market showed a total notional outstanding volume of $621 billion as of the end of 2001, which is because of the increased need for protection against bankruptcies and a decline in high yield and emerging market bonds (Clarke, 2001). ISDA also reported that the global volumes in credit derivatives grew 22 percent in the first half of 2007, and are up 75 percent on the year. Their volumes surged to $45.46 trillion, from $24.42 trillion at the end of 2006. (Reuters, 2007)
Moreover, data gathered from US regulators showed the market for credit derivatives among commercial banks in the US market dramatically increased from $97 billion in 1997 to $148 billion in the end of first quarter in the following year (Asher, 1998). These are popular in the US because it provides better margins than the cash market for corporate bonds. Hedge Funds typically use credit derivatives as structured products, which can be customized to improve pricing and efficiency distribution (Clarke, 2001).
In an article about credit risk, Park (1998) noted that the largest potential of credit derivatives lies on loans. These kinds of derivatives are popular among investment companies with large amounts of illiquid bonds, to enable the transferring of default risk without selling the bonds. They are also popular among insurance firms, where regulations require them to hold specific assets to maturity.
In reducing credit risk selling loans is traditionally an option. In this context, the potential of credit derivatives manifests that, credit derivatives make it possible for banks to lessen the credit risk without selling the loans, thus enabling banks to maintain the relationship with borrowers since derivatives do not necessitate their consent or knowledge. However, Park (1998) argues that most bank loans are not easily marketable, and that selling loans can damage the rapport with borrowers, which is important in the business of banking (Park, 1998).
Despite the fact that credit derivatives as financial instruments have grown in importance, the literature on the pricing of credit derivatives is not so extensive (see Duffie, 1998; Kijima, 2000). Longstaff and Schwartz (1995) formulated the credit spread directly using a stochastic differential equation, while Kijima and Komoribayashi (1998) considered credit options based on the Markov chain model of Jarrow, Lando and Turnbull (1997). Duffie (1999), proposed a random walk model to value a credit swap, and provided a survey of credit swap valuation, respectively. While Duffie (1998), obtained the general pricing formula for credit derivatives with the first-to-default feature, Kijima (2000) provided an analytical solution for the price of a credit swap of the basket type.
According to Kijima and Muromachi (2000), the key to value credit risk is constructing the default model using two approaches based on the arbitrage-free pricing methodology: the structural model (see Madan and Unal, 2000) and the reduced-form model (see Singleton, 1995). Madan and Unal's (1998) archetype is not as "reduced" as other intensity models developed later, but it combines features of both intensity and classical firm value models, therefore, it is called a hybrid credit risk pricing prototype (Grundke and Riedel, 2004).
The major differences between structural and reduced-form approaches, is that the structural model explicitly defines the default event in terms of the firm value and its capital structure to evaluate the probability of default and the payments, whereas the reduced-form model does not define the default event and assumes that the default intensity at any time prior to maturity is given exogenously (Kijima and Muromachi, 2000). Hence, the primary advantage of the structural approach is its economical intuition, while the reduced form approach is analytically more tractable and easy to implement (Kijima and Muromachi, 2000).
Risk managers illustrate their prioritisation of risk management activities using a peeling-an-onion analogy in which the resulting priorities have produced the derivative tools needed to manage the outer layers of the risk onion (Moser, 1998). After dealing with the outer layers, risk managers have to focus on the inner layers of the onion, especially credit risk, to gain competitive advantage in the global marketplace. In order to achieve this goal, financial institutions whose borrowers are concentrated in geographic sectors, seek methods to improve their diversification of credit exposures (Moser, 1998). The efforts of risk managers are proceeding on two fronts: they are (1) developing methods to measure credit risk exposures; and (2) engineering derivative contracts to enable transference of credit risk exposures (Moser, 1998).
Although credit derivatives are important for hedging and securitising credit risk, some researchers have raised concerns that they may destabilise the banking industry. In examining whether financial innovation of credit derivatives makes banks more exposed to risk of credit, Instefjord (2002) answers the question of whether it is possible that financial innovation of derivatives makes a firm more volatile. In his article, Instefjord (2002) noted that banks operate in a systemic environment, which implies that firm risk has relevance beyond the firm's shareholders. Nevertheless, the theoretical literature in this field is nonetheless limited; the issue risk measurement has chiefly occupied the bank risk literature.
A major problem for bank regulators is the evaluation of the given risk exposure of the bank. According to Berkowitz and O'Brien (2002), banks' internal risk measurement technology is not perfect. As a response, Instefjord (2002) identifies the factors that make a bank inclined to increase its exposure to perceived risk regardless of how well it can be measured. These should not be taken to imply that risk measurement is unimportant. According to Instefjord (2002), the imperfection of risk measuring technology is a prime motivator for understanding the factors that drive risk-taking behaviour.
With the recent development of the credit derivatives market, the banking sector is emerging as a sector with similar characteristics as the oil industry, whereby crude oil derivatives have been traded for a number of years as a means of managing firm risk. Altman et al. (1998) observe that banks no longer want to make loans and hold them either to maturity or charge-off. Rather, they are increasingly willing to consider transacting their assets in counterparty arrangements in which the credit risk exposure is shifted as the total risk of the original lender is reduced.
According to Instefjord (2002), this is also supported by the data on credit derivatives trading. However, most people would argue that the supply of derivatives essentially reduces bank risk. For example, Rule (2001) argues that the development of the credit derivatives markets provides benefits for financial stability as they allow the origination and funding of credit to be separated from the efficient allocation of the resulting credit risk. Thus, in opposition to the commodity sector, credit derivatives trading can be socially beneficial in a systemic sector (Dow, 2000).
Furthermore, Instefjord (2002) sees the need for an additional element - the deadweight costs of financial distress coupled with a rigid balance sheet - to link risk acquisition driven by private profit motives to the potential social costs of destabilisation.
Although financial distress costs are not necessarily the whole story, as both theoretical and numerous empirical studies argue, they are certainly not implausible. These costs induce banks to actively manage their risk exposures and incorporate risk management as an integral part of the activities that generate shareholder value (Instefjord, 2002). In support of this contention, the British Bankers' Association Credit Derivatives Reports (1999/2000 and 2001/2002) have shown that a number of banks in the London market believe that credit derivatives trading is more important in terms of active portfolio/asset management than in terms of compliance with regulation.
In terms of innovation of credit derivatives, there are several threads of related literature. The first strand investigates the effects of the lender-borrower relationship when loans can be hedged in the credit derivatives market (Morrison, 2001). According to Duffee and Zhou (2001), although this type of derivatives can protect lenders from adverse selection costs ex post, they can also prevent efficient lending ex ante. On the other hand, Morrison (2001) states that credit derivatives contribute directly to reducing welfare by causing a disintermediation effect in the credit market. The second thread provides analyses and evaluations of methods for market and credit risk measurement (Duffie and Pan, 1997). The third thread involves financial innovation, which has been largely analysed as an endogenous process. Loosely related in these three strands is the body of literature that tackles assessment and control of the risk acquisition policy of the bank by an outside regulator (Freixas and Rochet, 1998).
Instefjord (2002) finds that financial innovation is an important factor driving a model determined by costs of financial distress. In this context, the fundamental question is which markets are most likely to open (Duffie and Rahi, 1995). This question may be answered using many perspectives. If the innovator is a planner, the question is answered in the context of maximising welfare for all agents (e.g., Dow, 1998). Using the perspective of a firm or an individual selling new financial claims, it is answered in the context of maximising the revenue for the innovator (e.g., Rahi, 1996), and if the innovator is an intermediary who profits from other agents trading the new claims, it is answered in the context of maximising trade commission or other forms of trade-related revenue such as the bid-ask spread (e.g. Allen and Gale, 1994). It is thus important to know who controls the innovation process.
Overall, Instefjord (2002) concludes that financial innovation in the credit derivatives market may increase bank risk, particularly those that operate in highly elastic credit market segments. Credit derivatives trading are, therefore, a potential threat to bank stability even if banks use these instruments solely for the purpose of hedging, or to secure their credit exposures.
(c) Settlement risk is the risk that one side of the transaction is settled without gaining compensation or value from the other. This risk can be minimised through a "master netting agreement" where the parties are able to set off their positions (Auditing Guidance Statement, 2002).
(d) Solvency risk is encountered, when parties are not able to pay committed or contracted amounts when these contracts mature. For example, they are unable to pay the margin call on a future when this becomes due because of an adverse price movement (Auditing Guidance Statement, 2002).
(e) Legal risk involves the losses that are incurred due to the legal and/or regulatory actions that arise, which makes the terms agreed upon invalid. Examples of this include prohibitions regarding derivatives investment and changes in legal statutes pertaining to taxes (Auditing Guidance Statement, 2002).
(f) Operational Risk is the risk that arises from the loss due to the failures and insufficiencies encountered with the operations of an entity. In this case, it is the result of not understanding how to use derivatives, with the consequence of wrong decisions being taken and the instrument being misused.
As corporations face various hazards, corporate risk management programs aim to manage such risk exposures systematically, to increase firm value. In reaction to the impact of serious financial losses by prominent firms and local governments due to inappropriate risk management programs based on financial derivatives, a survey in The Economist (1996) focuses on "other ways of spreading risk in non-financial companies" (p. 18). Specifically, it discusses natural hedges and operational hedging. The major goal in corporate risk management programs is to increase shareholder wealth by enhancing firm value through treating exposure management (Boyabatli and Toktay, 2004).
Paradoxically, finance theorists, building on Modigliani and Miller's (1958) work, assert that under perfect and complete markets, corporate risk management programs do not add any value. Here, finance theorists forward the assumption that shareholders through asset diversification can reproduce the benefits of any risk management activity by firms. Risk management cannot create value by undertaking activities that investors can do equally well (Boyabati and Toktay, 2004).
The first step in risk management is the identification and assessment of risk exposure (Bodie and Merton 1998). In addition to market risk, credit risk, and systemic risk, other types stem mainly from firm operations. Kleindorfer and Van Wassenhove (2002) recognise risk management in the global supply chain and discuss two broad categories: disruption risk due to accidental or purposeful triggers and supply-demand coordination risk. According to Billington et al. (2003), uncertainties about demand for products and supply of key inputs are the greatest dangers for most manufacturers. These create a supply-demand mismatch that results in financial losses (Boyabatli and Toktay, 2004).
After determining their risk portfolio, firms can employ a significant number of tools to manage them. Although financial tools, such as derivatives, are applicable for firms that have risk exposures contingent on asset prices, other types sourced from firm operations cannot be managed through the use of financial contracts (Guay and Kothari, 2002).
Investments having real option features are the prevalent instruments used for managing operational risk exposures (Boyabatli and Toktay, 2004). According to Triantis (2000), real options are opportunities to delay and adjust investments and operating decisions over time, in response to the resolution of uncertainty. The value of real options, is driven not only by timing, but also by scope (Billington et al., 2003).
Due to the difficulty of defining operational risk, there is currently no generally accepted definition, but for the purpose of this dissertation, the definition of Blacker (1988) is adopted. He sees it as a risk type, which is distinct from credit, market, and banking book interest rates and defines it as the result of failure or breakdown in the operational process. However, to make a clear-cut model of operational risk in modern banks is more complex and difficult (Hoffman and Johnson, 1996, Thompson and Frost 1997).
Operational risk is a fast-developing field, which has taken much attention from industries and government in recent times. Several landmarks in operational failures have been experienced over the years, such as Worldcom, Baring, LTCM, Lehman Bros and National Australia Bank. In response to continuing financial mismanagement (fraud, unauthorised trading or erroneous long-term views, criminal activity and speculation), the Basel Committee treated it (operational risk) in the New Basle Capital Accord (BIS, 2001) as one part of risks that are required to reserve capital just like credit risk or market risk.
The final adaptation of the Basel II accord had been delayed; but fortunately, the agreement of Basel II accord in principle was accomplished in July of 2002, thus benefiting the biggest, global banks, because they can be rewarded with a lower capital requirement if they develop sophisticated internal risk management measures of their own (Mun, 2002). The 2006 revision for the Basel II, contains the detailed framework that aids the member-countries to secure international convergence on revisions to supervisory regulations governing the capital adequacy of internationally active banks, by setting the least possible set of standards that are to be accepted (Basel Committee on Banking Supervision, 2006). Its aims include the development of a framework that would strengthen the stability and soundness of the global banking system even further, whilst maintaining sufficient consistency, such that the capital adequacy directive (CAD) will ensure a level playing field and not be a source of competitive disparity among global active banks. The Basle Committee believes that "the revised Framework will encourage the adoption of stronger risk management practices by the banking industry, and views this as one of its major benefits" (BIS, 2004). In Europe, Basel II has been transposed into the Capital Adequacy Directive (CAD) (known also as Capital Requirement Directive CRD).
In operations management, there are two streams of research originating from two separate, but conceptually similar, definitions of the operational hedging. The first definition, as introduced by Huchzermeier (1991) and quoted in Ding and Kouvelis (2001) states that "Operational hedging strategies can be viewed as real (compound) options that are exercised in response to demand, price and exchange rate contingencies faced by firms in a global supply chain context" (p. 2). The second definition, is provided by Van Mieghem (2002) who defines operational hedging as "mitigating risk by counterbalancing actions in a processing network that does not involve financial instruments" (p.271)
Postponing the logistics decision (Ding and Kouvelis, 2001), switching production and sourcing strategies contingent on demand and exchange rate uncertainties (Cohen and Huchzermeier, 1999), switching among supply chain network structures (Huchzermeier and Cohen, 1996), holding excess capacity (Cohen and Huchzemeier, 1999) and delaying the final commitment of capacity investments, are means of operational hedging (Boyabatli and Toktay, 2004). According to Cohen and Huchzermeier (1999), these real options, used as operational hedges, mitigate the risk exposure in the long run, by reducing the downside risk. These real options are forms of operational flexibility, created through the deployment of excess capacity and stochastic recourse. Cohen and Huchzermeier (1999) define operational flexibility as a firm's ability to anticipate and respond to changes in market conditions flexibly by means of the firm's operations. Using these options enables multinationals to exploit the volatility in the environment (Boyabotli & Toktay, 2004).
Huchzermeier and Cohen (1996) analyse operational flexibility, which they define as the ability to switch among different global manufacturing strategy options. With operational flexibility, the volatility of firms' cash-flows is not eliminated, but exploited. This form of operational hedging utilises the global supply chain network design, to mitigate against exchange rate exposure, which increases the value of the firm and decreases its downside risk (Huchzermeier and Cohen, 1996). Cohen and Huchzemeier (1999), illustrate how the deployment of excess capacity can be a source of operational flexibility in the global supply chains, by showing that investing in capacity in excess of the aggregate demand forecast provides flexibility in coping with demand uncertainties.
Allayannis et al. (2001) illustrate that firms use operational hedges to manage their risks. Real options in the operations management literature are operational hedging mechanisms (Boyabatli and Toktay, 2004). The existence of risks that can only be managed operationally (Triantis, 2000) means that operational hedging comprises an integral part of firm-level risk management programs.
In summary, the finance literature demonstrates that operational protection mitigates firms' risks by operational means (Boyabotli and Toktay, 2004). The operations management literature views operational hedging strategies originating as real options from two separate, but not conceptually different, definitions. Operational flexibility created through real options and geographical diversification, which is the primary operational hedging strategy dealt with in these literatures. Compared with financial hedging, operational hedging requires higher levels of capital investment, but creates long-term hedges against risk exposures. Moreover, operational flexibility has a value creation capability through arbitrage and leverage opportunities. Thus, in finance, this kind of flexibility is considered an operational hedging strategy only when there is a risk avoidance rationale for using it.
There are numerous other risks that may be encountered; however, these are usually combinations of those described above (Auditing Guidance Statement, 2002). Another common type is that which applies to commodities, where the quality that is prescribed and expected is not attained (Auditing Guidance Statement, 2002).
Inherent risk happens when an account balance or particular transactions are falsified or fraudulently entered when there are no internal forms of control. It could also happen when combined with other account transactions (Auditing Guidance Statement, 2002). Therefore, controllers and users should also understand the components that have an impact on the evaluation of the risks identified in derivatives. These factors include:
The economic and business reasons for a company's derivative activity. since this might influence the decisions to go long or short an underlying asset (Auditing Guidance Statement, 2002);
The position required, which can range between that of elimination of risk (hedging) to maximisation of profits (speculating). Inherent risks linked to speculative maximisation of profits are very different from risk management (hedging) (Auditing Guidance Statement, 2002). The management of risk for the derivative activity also varies according to the risks associated with each type of function (Auditing Guidance Statement, 2002).
The degree of complexity found in the features of the derivatives. The common notion held for derivatives and its complexity is that the higher the degree of complexity, the greater is the difficulty in determining the fair value that is to be placed on the said derivative. The fair value for some derivatives can be obtained through independent financial sources such as financial publications and broker-dealers that are considered external to the entity. Determining the said fair value could prove to be difficult especially when the derivatives contracts are custom-made/personalised according to the client needs, are not regularly traded, or are traded only in markets where no prices are published. However, a model can always be formulated in order to facilitate the assessment of its value. Valuation risk and model risk are the two risks encountered here. The first type of risk arises when the fair value of the derivative is wrongly determined. The second one refers to the risk associated with the imperfections and subjectivity of the models and their related assumptions. Both these risks impact the valuation assessment of the derivative (Auditing Guidance Statement , 2002).
The involvement of exchange of cash in the derivative activities. There are a considerable number of derivatives, which do not involve the exchange of cash at the beginning of the contract or may have irregular cashflow patterns at certain periods of time or at the end of the contract. There is a great threat that these contracts are not entered (completely or in part) and properly acknowledged in the financial statements (Auditing Guidance Statement , 2002).
The experience of the entities involved. Entering into contracts involving complex derivatives, without proper knowledge and experience increases inherent risk of misuse. Knowledge and training regarding these instruments should be present among the people directly interacting with derivatives, the dealers, and the people in risk management, governance, compliance and other regulatory functions (Auditing Guidance Statement , 2002).
The inclusion of the derivative as an embedded feature in the agreement. The inherent risk here is that management is not able to identify the derivative included within the contract. Therefore management will not be able to identify its impact (Auditing Guidance Statement, 2002).
The existence of external factors. These might affect the assertions made with regard to derivatives. For instance, the changes in credit risks of the entities in industries, which are already declining, enhance the inherent risk for the assertions made with regard to the valuation of the derivative. Moreover, the changes in the interest rates also affect the valuation of the derivatives, where its price is affected by the said interest rates (Auditing Guidance Statement, 2002).
Whether the derivative is traded on local or foreign exchanges. The different factors related to the cross-border exchanges could also increase the inherent risk for derivatives, since changes in laws and regulations together with exchange rate and economic conditions have several implications on derivatives (Auditing Guidance Statement, 2002).
The said factors add to the inherent risks associated with assertions made with regard to rights and obligations and valuation. There is also the risk seen in cases where the losses incurred due to derivatives trading becomes higher than the value stated in the balance sheet for the said derivative (off-balance-sheet risk). For example because of a fall in the price of a commodity in the market an entity may have to incur losses in order to close off a commodity's forward position. In other cases, it is said that losses may cast doubts on whether the company still has the capability to go on. However, it is possible for the entity to conduct analyses on sensitivity or value-at-risk in order to evaluate the hypothetical effects of the risks on the derivative instruments (Auditing Guidance Statement, 2002).
