To Determine the Impact of How Risk Managers of
Irish Financial and Non-Financial Institutions can
Effectively Utilized Derivatives Contracts to Hedge
Risk- („Risk Reduction‟)
Dissertation submitted in part fulfilment of the requirements for
the degree of
M.Sc. in International Accounting and Finance
@
Dublin Business School
Adeniyi Adekoya
10131831
August 2015
Adeniyi Adekoya (10131831)
2
Declaration
I declare that this research is my original work and that it
has never been presented to any institution or university
for the award of Degree or Diploma. In addition, I have
referenced correctly all literature and sources used in
this work and this work is fully compliant with the Dublin
Business School‟s academic honesty policy
Signed: Adeniyi Adekoya
Student No: (10131831)
Date: 15th August 2015
Relevant word count: 25,000 approx.
Supervisor Name: Mr. Enda Murphy
Adeniyi Adekoya (10131831)
3
Acknowledgments
Throughout this degree journey, I give all thanks to Almighty for sparing my
life and my family members, blessing me with good health, peace of mind
and strength to begin and complete this course. I am most grateful for all He
has done for me. There are a number of people that I would like to
acknowledge for their assistance and support to me. Perhaps, my profound
gratitude goes to all and sundry who have assisted me in one way or the
other in making this dissertation and, my Master‟s Degree in International
Accounting and Finance a reality.
Firstly, I wish to express sincere appreciation to my extremely inspiring,
extraordinary and kind Supervisor, Enda Murphy, a Senior Lecturer at
DBS for showing interest in this research work. His constructive criticisms,
advice, suggestions, and understanding have been very encouraging. Enda,
many thanks for all the assistance and support as I do appreciate it. Well
Done-Maith Thu! May Almighty God bless you and yours-Amen!
Moreover, I am also grateful to all my lecturers at the DBS for their valuable
assistance and contribution to my course work especially James Brown
and Andrew Quinn. Andrew, you made a remarkable difference to my
academic life since I met you during my Diploma Program in Funding and
Treasury. May Almighty God bless you and yours-Amen!
Furthermore, I am also appreciative to all DBS Library Staff especially
Sarah Kelly, Debora Zorzi and Colin O‟Keeffe who all provided me
extraordinary and amazing assistance especially to my dissertation
Adeniyi Adekoya (10131831)
4
project at the time of need and made a notable difference when completed-
May Almighty God bless you all-Amen!
Also, without mincing words, I am heavily indebted and grateful to a special
person in my life – Kareemat Adesimisola, my lovely wife who sacrificed
time, resources, and all what it takes to keep the home front and provided
me moral and financial support in ensuring this program a success.- May
Almighty God bless you-Amen!
And of course, I am grateful to my lovely children – Michael, Mary, Mark and
Melinda for their understanding and not posing any challenges to me during
the program. May Almighty God bless you all-Amen!
Finally, I express my sincere gratitude to my mother in America, Kunle
Salami, Mr and Mrs Sowemimo, Mr and Mrs Onesirosan, Bukkie
Sowemimo and Mr and Mrs Oriyomi Toyosi Adekoya for their moral, love
and understanding. May Almighty God bless you all-Amen!
Dedication
May all the praises be to Almighty God, the one who make all things
possible, where human beings thinks it is impossible.
To my darling wife, Simisola, and the greatest gifts and sources of our
happiness, Tomisin, Temitope, Timitayo and Titilopemi.
Adeniyi Adekoya (10131831)
5
Abstract
Derivatives contracts (DC) which have grown world-wide can effectively be used to
reduce risk through hedging strategies. Many studies, both theoretical and empirical,
address the important roles of derivatives markets in an economy and this study reveals
that there are positive impacts on FNFIs to use DC to hedge risks and create liquidity
efficiency income that is more effective and welfare-improving method to deal with price
volatility. Nevertheless, it has been established that using derivatives contracts (for
instance CDS) do have negative effects, although not in Ireland but in the US, which can
lead to exacerbated volatility and seldom cause crisis (financial and economic) that could
amplify the negative effects and accelerate contagion as experienced in Ireland in
2008.Thus, loss venture of this derivatives for the institutions concerned has to do with
the problem of application, that is, the way in which the derivatives contracts has been
used (i.e. wrong motive).
Perhaps, the fundamental reasons for the derivatives negative effects on risk
management are associated with the leverage nature of derivatives markets transactions,
the non-quantification of risks, non-setting of risks limits, non-monitoring of both, lack of
information and non-transparent reporting of transaction risks, non–evaluation of the
soundness of the counter-party risks, unsophisticated or insufficient risk management
controls in financial and non-financial institutions, as well as weak regulatory and
supervision system termed ‗light touch regulation‘.
Interestingly, academic literature clearly concludes that for countries derivatives markets
to fulfil the functions of risk reduction, price discovery, hedging role, redistribution of
income and stabilization compared to what has occurred in established markets, countries
financial systems needs to be supported by sound macroeconomic fundamentals and
updated financial policies and regulations. Likewise, scholarships have argued that while
there is no uniform optimal development strategy, that countries can adapt to sequence or
structure their derivatives markets; gradual development schemes accounting for
dynamics in different markets should be encouraged.
Additionally, for an optimal productive derivatives markets to reduce risk will require more
fundamental reforms that will make it possible for market participants and regulators to
determine and make judgement whether the risks faced by companies and institutions
have been effectively been hedged with public information available from these markets in
order to avoid speculation, volatility and the building up of risks in the system. Obviously,
the quantification of risk, the setting up of risk limits and the monitoring of those risk limits
will assist markets participants to manage their risk.
Strikingly, other vital requirements to be initiated when using the derivatives markets are:
the setting up of the counterparty risk limits in the derivatives markets transactions in
order to assess whether counterparty may default, the market participant exposures,
borrowing conditions of the counterparty, ability to repay back their debts, the
counterparty appetite for risk-taking, the liquidity and solvency status and the
establishment of more Central Counter-Parties Clearing House (CCPCH) as suggested
by Charlie McCreevy’s for the European CDS markets which he said will undoubtedly
improve the operational efficiency of derivatives contracts markets to function fully in
these highly interconnected global financial markets ensuring electronic trade execution,
affirmation and confirmation indeed.
Keywords: Financial and Non-Financial Institutions, Ireland, Derivatives
Contracts, Hedging, Risk Management
Adeniyi Adekoya (10131831)
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Table of Contents Page
Declaration…………………………………………………….. ..2
Acknowledgements…………………………………………….3
Dedication……………………………………………………………………4
Abstract……………………………………………………………5
List of Tables and Figures……………………………………..6
Acronyms (Abbreviation) ……………………………………..13
Chapter One: Introduction
1.0 Introduction………………………………………………………………..14
1.1 Background Information and Overview………………………………..14
1.2 Research Problem………………………………………………………..24
1.3 Research Objectives………………………………………………………26
1.4 Rationale and Justification of the topic…………………………………28
1.5 Research Questions……………………………………………………..30
1.6 Research Hypothesis…………………………………………………….33
1.7 Research Approach………………………………………………………36
1.8 Learning Style and Suitability of the Researcher……………………..37
1.9 Contribution and Recipients of the Study……………………………..40
1.10 The Scope and Limitations of the Research…………………………..41
1.11 Dissertation Organisation and Structure………………………………43
Chapter Two: Literature Review
2.0 Literature Review………………………………………………………….46
2.1 Literature Introduction…………………………………………………….47
2.2 Literature Review: Theme -1 (Financial and Non-Financial………….50
Institutions)
2.3 Literature Review: Theme 2 – (Risk Management)……….……………55
2.4 Literature Review: Theme 3 – (Derivatives Contracts)…………………56
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2.5 Literature Review: Theme 4 – (Hedging)…………………………………58
2.6 Contextualizing the Research in the Literature…………………………..62
2.7 Quantification / Measurement of Risk …………………………………….63
2.8 Setting of Risk Limits and the Monitoring of Quantification and
Setting of Risk Limits…………………………………………………………….66
2.9 Learning‘s from 2008 Financial and Economic Crisis …………………69
2.10 The Impacts of the ‗New Capital Transparency and
Adequacy – (Basel III) …………………………………………………………..71
2.11 The Role of Derivatives Markets…………………………………………74
2.11.1 Why derivatives are important in an economy?……………………………78
2.11.2 What are the risks involved in Derivatives and why do we need
to evaluate the soundness of counter party risk?………………………………….79
2.11.3 Example of Ryanair hedging strategies………………………………83
2.12 Literature Review Conclusion……………………………………………86
Chapter Three: Research Methodology
3.0 Research Methodology………………………………………….…………..90
3.1 Research Questions, Aim and Themes……………………………………93
3.2 Research Design …………………………………………………………….94
3.3 Research Philosophy ………………………….…………………………….96
3.4 Research Approach………………………………………………………….104
3.5 Research Strategies…………………………. ……………………………..109
3.6 Sampling……………………………………………………………………….112
3.7 Data Collection………………………………………………………………..119
3.8 Data Analysis …………………………………………………………………124
3.9 Plans for Completion …………………………………………………………126
3.10 Research Ethics……………………………………………………………..128
3.11 Research Limitations…………………………………………………….….130
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Chapter Four: Data Analysis, Findings and
Discussions
4.0 Introduction…………………………………………………………………….132
4.1 Research Process……………………………………………………………..133
4.2 Survey Distribution Process and Responses……………………………….134
4.3 Survey Background Questions and Data Analysis…………………………134
4.4 Survey Research Questions, Data Analysis and Discussions…………..138
4.5 Discussions Conclusion………………………………………………………163
Chapter Five: Conclusion and Recommendations
5.0 Introduction……………………………………………………………………..165
5.1 Conclusion………………………………………………………………………166
5.2 Limitations of the Research…………………………………………………..172
5.3 Recommendations for Further Research……………………………………172
Chapter Six: Self-Reflection on Own Learning
Curve and Performance
6.0 Self-Reflection on Own Learning Curve and Performance………………175
6.1 Introduction……………………………………………………………………..175
6.2 Learning Styles…………………………………………………………………177
6.3 Academic and Professional Background…………………………………….184
6.4 Research Process Assessment……………………………………………….186
6.5 Personal Development during Master‘s Studies…………………………….188
6.6 Conclusion on Self-Reflection…………………………………………………192
References……………………………………………………………..194
Adeniyi Adekoya (10131831)
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Appendices
Literature Appendix 1: Types of Risk and Risk Management…………………215
Literature Appendix 2: Types of Derivatives Contracts ……………….……….234
Literature Appendix 3: The Financial Crisis of 2008……………………………242
Literature Appendix 4: Valuable Quotes and Commentaries………………….251
Literature Appendix 5: BIS Basel III ―New Capital Transparency and
Adequacy (NCTA) ‖ Reforms…………………………………………………….259
Literature Appendix 6: Working Examples of Derivatives Contracts
Hedging Strategies (DCHS)……………………………………………………….264
Appendix 7: Other Research Strategies………………………………………….272
Appendix 8: Research Survey Process…………………………………………..285
List of Tables and Figures
List of Tables
Table 1: Public Debt as a percentage of GDP, (selected Countries)…………246
Table 2: Individual Bank Minimum Capital Conservation Standards…………262
Table 3: Individual Bank Minimum Capital Conservation Standards
(When subject to 2.5% countercyclical capital requirement) ………..263
Table 4: Differences between Deduction and Induction ……………………….108
Table 5: Quantitative and Qualitative Research…………………………………120
Table 6: The Advantages and Disadvantages of Secondary Data…….………124
Table 7: VAR King up the Right Tree – Learning Styles Descriptions…………182
List of Figures
Figure 1A-B-C: Types of Risk (Systematic and Unsystematic Risk)……………18
Figure 2A: The Structure of Derivative Financial Market…………………………20
Figure 2B: Size of OTC and Exchange-Traded Markets………………………….21
Adeniyi Adekoya (10131831)
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Figure 3: Structure of the Research Project Process……………………………23
Figure 4: Structure of the Research Project………………………………………43
Figure 5: Logical Research Process………………………………………………44
Figure 6: Swiss Franc‘s Appreciation against selected major Currencies……53
Figure 7: How many Euros it takes to buy Swiss Franc…………………………54
Figure 8: Hedging (Price risk management)…………………………..………….61
Figure 9: Relationship between risk and return………………………………….65
Figure 10: Treasury Limits – Limits Control and Business Processes…………67
Figure 11: Exchange Traded derivatives and OTC Traded Derivatives……….77
Figure 12: OTC Derivatives Growth between years December
2000 to June 2010……………………………………………………………………77
Figure 13: Total OTC Derivatives between years December
2000 to June 2010 US$ Trillions…………………………………………………….78
Figure 14A: Domestic –Foreign Allocation………………………………………..216
Figure 14B: Risks using Bond and Stock Allocation……………………………..217
Figure 15: Types of Risk in Finance……………………………………………….218
Figure 16: Charge-off Rates for Commercial Banks Lending
Activities from 1984-2009…………………………………………………………….224
Figure 17: Average Percentage Increase in House Prices,
1997-2005 (Selected Countries)…………………………………………………….243
Figure 18: Long Straddle Strategy …………………………………………………271
Figure 19: The ‗research onion‘……………………………………………………..95
Figure 20: Elements of research Design……………………………………………96
Figure 21: An overview of Research Philosophy…………………………………..99
Figure 22A-B-C: Research Approaches Process…………………………………105
Figure 23: Archival Research Process……………………………………………..277
Figure 24: Grounded Theory Process…………………………………………..…280
Figure 25: Research choices based on Saunders et al…………………………283
Figure 26A: Types of Research Design – Qualitative and
Quantitative Research……………………………………………………………….283
Figure 26B: Details of Primary Research Methods and Techniques
of data collection involving Qualitative and Quantitative Research…………….283
Adeniyi Adekoya (10131831)
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Figure 27: Depict the Sampling procedures…………………………………….113
Figure 28A-B: Sampling Techniques…………………………………………….116
Figure 29: Different types of questionnaire ……………………………………..121
Figure 30: The methods of Data Collection……………………………………..123
Figure 31: Percentages of Age Group of the Participants………………………135
Figure 32: Percentages of Academic Qualifications of the Participants………136
Figure 33: Percentages of Financial and Non-Financial Institutions…………..137
Figure 34: Respondents‘ views of the Impact of effectively utilizing
Derivatives Contracts to hedge risk variables- (‗Risk Reduction‘)…………….138
Figure 35: Respondents‘ views of the Impact of Financial and
Economic Crisis of 2008 on Institutions and Companies ………………………141
Figure 36: Respondents‘ views of Financial and Economic
Crisis of 2008 was as a result of using Derivatives Contracts…………………..144
Figure 37: Respondents‘ views of the change in attitude towards
‗Risk Management‘ after the Financial and Economic Crisis of 2008…………146
Figure 38: Respondents‘ views of the Impact on FIs
of the requirements for the ―NCTA‖– (Basel III)………………………………..…148
Figure 39: Respondents‘ views on the Quantification or
Measurement of Risk…………………………………………………………………150
Figure 40: Respondents‘ views on the Setting of Risk Limits……………………151
Figure 41: Respondents‘ views on the Monitoring of both the
Quantification and the Setting of Risk Limits…………….………………………..152
Figure 42 Respondents‘ views on the purpose of using
Derivatives Contracts [Hedging-in-House Risk]…………………………………..154
Figure 43: Respondents‘ views of the purpose of using
Derivatives Contracts [Selling to Clients for Hedging]……………………………155
Figure 44: Respondents‘ views on the purpose of using
Derivatives Contracts [Own-Accounting-Trading]………………………………..156
Figure 45: Respondents‘ views on the Evaluation of the Soundness
of Counter-Party Risk when using DCHS…………………………………………157
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Figure 46: Respondents‘ views on the decision of the types
and usage of DCs………………………………………………………………….159
Figure 47: Respondents‘ views on the positive impact of using
Derivative Contracts to hedge risk by creating LEI……………………………..160
Figure 48: Respondents‘ views on the barriers in Ireland to
Effectively use DCs in Managing and Hedging Risk…………………………..162
Figure 49: Kolb’s Learning Styles…………………………………………………178
Figure 50: Honey and Mumford (1986, 1992) Four Possible Learning Styles.180
Figure 51: VAR King up the Right Tree -Learning Styles………………………182
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List of Acronyms / Abbreviations
ACCA: Association of Chartered Certified Accountants
AIG: American International Group
Anglo: Anglo-Irish Bank
AT–Asset Turnover
BBC: British Broadcasting Corporation
BIS- Bank for International Settlements
BOE: Bank of England
BOD-Board of Directors
CA- Current Assets
CBI: Central Bank Ireland
CCP: Central Counter Parties
CCPCH: Central Counter Parties Clearing House
CDS: Credit Default Swaps
CDO: Collateralized Debt Obligations
CEO: Chief Executive Officer
CF: Corporate Failure
CFD: Contract for difference
CFO: Chief Financial Officer
CG: Corporate Governance
CL- Current Liabilities
CR- Current Ratio
CRO- Credit Risk Officer
DC- Derivatives Contracts
DCHS: Derivatives Contracts Hedging Strategies
DOF: Department of Finance
DJIA: Dow Jones Industrial Index
DTCC- US Depository Trust Clearing Corporation
E&L- Equity &Liabilities
EU- European Union
FASB: Financial Accounting Standards Board
FCIR: Financial Crisis Inquiry Report
FCIC: Financial Crisis Inquiry Commission
FDIC: Federal Deposit Insurance Corporation
FEC: Financial and Economic Crisis
FIs: Financial Institutions
FNFIs: Financial and Non-Financial Institutions
Fed: Federal Reserve
FR: Financial Regulator
Freddie Mac: Federal Home Loan Mortgage Corporation
F/S- Financial Statements
GAAP: Generally Accepted Accounting Principles
GM: General Motors
GPM- Gross profit Margin
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HRM: Human Resource Management
HS- Hedging Strategies
HS- Historical Simulation
IMF: International Monetary Fund
IFSC: International Financial Service Centre
IMF: International Monetary Fund
INBS: Irish Nationwide Building Society
IPO: Initial Public Offering
ISE: Irish Stock Exchange
IT: Information Technology
LBs: Lehman Brothers
LEI: Liquidity Efficiency Income
LSE: London Stock Exchange
MCS: Monte Carlo Simulation
NCAs: Non-Current Assets
NCF: Net Cash Flow
NCL: Non-Current Liabilities
NCTA: New Capital Transparency and Adequacy
NED: Non-Executive Directors
OCs: Operating Costs
OECD: Organization of Economic Corporation and Development
OPM: Operating Profit Margin
OTC- Over the Counter
PB- Pictured Below
PBT: Profit before Tax
TAs: Total Assets
SML: Securitisation of Mortgage Loans
SNB: Swiss National Bank
SOFP: Statement of Financial Position
STO: Short terms Obligations
UK: United Kingdom
U.S: United States
VaR: Value at Risk
RWA: Risk Weighted Assets
RMBS: Residential Mortgage Backed Securities
SEC: Securities & Exchange Commission
SME: Small & Medium Sized Enterprises
TARP: Troubled Asset Relief Program
Adeniyi Adekoya (10131831)
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Chapter One
1.0 Introduction
1.1 Background Information and Overview
To a great extent the effective utilization of derivatives contracts is an essential
component of risk management that is used in reducing risks faced by many
FNFIs and there is a risk/return trade-off- [Ward, (2010)]. Perhaps, following the
financial crisis of 2008 caused by many factors explained briefly in the next
chapter (Literature Appendix 3), the risky-investments made by many FNFIs
around the world including Ireland due to low-interest rates and light-touch
regulation by the authorities in the belief of a continuous appreciation of these
investments which later turn out to be bad with negative consequences for
countries‘ economies.1
As a result of the bad investment with its contagion negative effects on the
economy with shortages of liquidity for both banks and the bond market, the Irish
economy weakened and the Irish government were forced to restructure many
areas of the economy including the financial sector through fundamental reforms
brought in by the CBI and the government. While the Irish economy and financial
sectors are now making remarkable progress to date, yet there are still some vital
1 According Alan Greenspan President of the Federal Reserve from 1987 to 2006: ―Crisis will
happen again but it will be different, and that is human nature. Unless somebody could find the way
to change human nature, we will have more crises, and none of them will look the same because
no two crises have anything in common, except human nature‖ (The Age of Confidence, 2009). In
essence, Alan Greenspan attributed the 2008 FEC to „Human Nature‟ as nobody is above mistake
and crisis will occur again but it will not be the same and we will all eventually pass through it with
time.
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issues such as: risk management; corporate governance; the use of derivatives
contracts to reduce risk and the regulation of the DC markets (especially hedge
funds) have not yet been fully resolved.
However, there has been tremendous development in the field of risks
management using DC and the whole derivatives markets over the two last
decades especially in the financial sector- Beegun, and Leroy (2009), (Chen,
2011), Bacha, (2013), and Bodnar, et al 2013). Initially there are only few
exchanges – traded derivatives markets that exist which allow FNFIs to hedge
against certain risks for a short period and in a limited way (Miloš Sprčić , 2007).
Meanwhile, in order to have better understanding of risk and risk management
using DC, the author discusses briefly – what is risk and risk management in
financial and non-financial institutions? What are derivatives and why the use?
What are the different hedging strategies? What are the views of past scholarships
in the field of risk management using DC? Full discussions of the various themes
will take place in the next chapter (i.e., Literature Review) and all other important
topics that are related to the research topic.
What is risk?
Risk is the chance that a bad outcome will happen. The more that a risk is
associated with an investment, the higher the expected return-vice-versa and
certainly, probabilities can be assigned to future outcomes or expected return2.
2 We use standard deviation that measures the magnitude of dispersion of the returns around their
average. For example if we want to determine the riskiness of an asset, we first need to calculate
the average return of that asset and determine how much the actual return differs from the average
in a typical year.
Adeniyi Adekoya (10131831)
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[Jorion, (2007); (Ward, (2010); Durbin (2011) and McDonald, (2013)]. The differenttypes of risks faced by FNFIs are: credit risk, market risk, operational risk, foreign
exchange risk, sovereign risk, technology risk, interest rate risk, liquidity risk,
insolvency risk, off-balance-sheet risk, etc. Perhaps, as noted these risks are not
unique to particular FNFIs but are faced by all global FNFIs– [Ward, (2010) Hull,
(2012), Durbin (2011); McDonald, (2013) and Panaretou et al. (2013)]. Therefore,
risk manager of these institutions is responsible for managing the risk and any
uncertainty of cash inflows to meet the financial obligations and to make best use
of the available resources-(Bodnar, et al 2013).
According to Ward, (2010), Hull, (2012), Durbin (2011) and McDonald, (2013) the
risk manager of these institutions will have to identify the risk, quantify the risk
exposure, assess the impact and examine alternative risk management tools
available by selecting the appropriate risk management approach before
implementing derivatives contracts hedging strategies (DCHS) and monitor the
program in order to achieve its objectives. From the use of DC, the main
advantages arises, whereas it is clear that from the recent 2008 financial crisis,
the use derivatives especially (CDS)3 have a longer lasting negative impact on
FNFIs and it raises the awareness and is important to underpin the disadvantages.
Undoubtedly, Dowd , (1998), Dempster, (2002) and Dione, G (2013) said that the
risk managers will have to recognise (proactive) the possibilities of different
outcomes of using DC and ensure that activities are directed towards making an
acceptable set of outcomes while reducing undesired outcomes within an
acceptable tolerance level indeed.
Furthermore more, FNFIs have two types of risk – [Jorion, (2007), Ward, (2010),
Durbin (2011) and McDonald, (2013)]. They are systematic and unsystematic risk-
(See Figure 1A). The former cannot be diversifies away – (i.e., uncontrollable by
3 Many abbreviations are used in this research project which the full meaning is reflected at the
beginning of the research project-Many thanks for your understanding
Adeniyi Adekoya (10131831)
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the organisation and macro in nature), however, the latter unsystematic – (i.e.,
controllable by the organisation and micro in nature), can be diversified away –
(See Figure 1B and 1C) respectively.
Figure 1A: Types of Risk4
Figure 1B: Systematic Risk
4 The Source for many Figures used in the research project are images taken from Google website:
https://www.google.ie/search
Adeniyi Adekoya (10131831)
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Figure 1C: Unsystematic Risk
Perhaps, systematic risk uncertainty resulting from changes in market price
requires managing the risk from active trading strategies and creating hedging
strategies to counteract the market risk. Market risk is affected by other risk such
as interest rate risk, credit risk, operation risk, and foreign exchange risk which
can be measured over periods as short as one day and in terms of dollar or euro
exposure or as a relative amount against some benchmark -Allayannis, and Ofek,
(2001). Trading risk which is part of market risk of FIs exposes the trading of
financial products which sometimes can be very costly for the institutions if the
trading is not hedged and it goes wrong similar to what we have experience
during the 2008 FEC.5
Thus, from the risk management point of view using DC to hedge the risk,
Allayannis, and Ofek, (2001) argued that derivatives can be used to reduce
institutions risks on a daily basis when carryout their operations. What is
Derivatives Contracts (DC)? Derivatives are financial contracts whose value is
derived from an underlying asset. 6 Perhaps, DC are used to redistribute risks
5. For details, see Ward (2010), Durbin (2011) and McDonald (2013).
6 The financial service sector has responded by developing a variety of products which are designed
to hedge against risk. In the main, these products are paper securities (contracts) which are
attached to the underlying assets, such as cash, commodities or currencies. These paper
securities are called derivatives because they derive value from movements in the value of the
underlying asset. Some managers do not purchase derivatives to manage risks. Instead they
Adeniyi Adekoya (10131831)
20
generated in the real economy, and are consequently important tools for financial
intermediaries to transfer risk; for managing and hedging contractual risks (risk
reduction) that arise in the institution‘s normal course of business activities. Other
motives for the use is to change the nature of a liability; to reflect a view on the
future direction of the market; to change the nature of an investment without
incurring the costs of selling one portfolio and buying another and to acquire risk
with the aim of locking in an arbitrage profit – (high risk trading), such as currency
risks, interest rates risk, and credit risk etc. – fully discussed in detail in the
Literature Appendix 2. The types of DC available are forward contracts – traded
‘Over the Counter-OTC’ and futures, options, swaps, warrant and structured
products etc. which are traded on an ‘Exchange’ which can be used to manage
and hedge risks. Figure 2A below denotes the structure of the derivative financial
market and Figure 2B shows the size of amount of OTC and Exchange Traded
Markets.
Figure 2A: The Structure of Derivative Financial Market
purchase derivatives for own accounting trading purposes. In these circumstances, the risk
manager makes an assumption as to the direction of the fluctuation in the underlying assets. This
leaves them exposed to losses if their assumptions do not hold.
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Figure 2B: Size of OTC and Exchange-Traded Markets
Source: Bank for International Settlements. Chart shows total principal amounts
for OTC market and value of underlying assets for exchange market between June
1998 to June 2007 in $trillion.
Meanwhile, the 21st century has shown growth in DC usage to reduce risk driven
by fast technologies and globalization as many FNFIs are facing new challenges
with increase speed. As a result, new DC are developed which provide a platform
for innovative and hedging strategy apart from using debt instruments to hedge
financial risk (Sorin and Silvia, 2009, page 90). These instruments are traded Over
the Counter (OTC) or Exchanges.
Therefore, hedging using DC helps to reduce cost of risk and distress of FNFIs
including the amount of corporate tax paid (Mayers and Smith 1982; Smith and
Stulz 1985). Perhaps, Chen, (2011) argued that after controlling for fund strategies
and it characteristics, the creation and use of these DC instruments on average
exhibit low funds risk. DC is between two (or more) parties where payment is
Adeniyi Adekoya (10131831)
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based on (i.e., “derived” from) some agreed-upon benchmark. The different types
of DC they listed are: forward contacts, future contracts, options, swaps, bonds
(debt Instruments), hedge funds stripped mortgage-back securities-(Hull, 2012);
Perez-Gonzalez, and Yun, and (2013).
Indeed, Hull, 2012 stated that these derivatives are used for hedging (risk-
reduction) and or speculation (high risk trading). The ways derivatives are used to
hedge these risks are: (a) to reflect a view on the future direction of the market, (b)
to lock in an arbitrage profit, to change the nature of a liability, (c) to change the
nature of an investment without incurring the costs of selling one portfolio and
buying another etc.
However, if risk managers lack foresight in hedging strategy or greedy in terms of
speculative motives by taking their eye off the ball, the use of these DC to hedge
the different type’s risks can have negative effects and can prove to be expensive
mistakes or costly for the institution(s) involved if it wrongly use as can be seen
from the past. For example, Nick Leeson 1995 Barring‘s Bank-$1 billion loss
scandal, 1996 Sumitomo Corporation lost $2.6 billion in commodity futures trading,
John Rusnak of All First/Allied Irish $691 million loss. The reason for the loss of All
First/Allied Irish $691 million loss is that Rusnak was a currency trader who did not
hedge his FX currency position. With this un-hedged position facing losses, he
panic and entered false options in the system which made it look like his position
was hedged. This false options entered by Rusnak kept the bank from discovering
the losses on FX currency and furthered bets was placed on (rise of the yen)
causing a great loss to the bank of $691 million.
Other big losses by FIs are: Subprime Mortgages (up to $40 billion); Societe
Generale Bank ($7 billion); Amaranth ($6 billion); LMTC ($4 billion); Daiwa ($1
billion); Midland Bank ($500 million); Kidder Peabody ($350 million); National
Westminster Bank ($130 million).For Non-financial institutions losses from
derivatives are: Metallgesellschaft ($7 billion); Orange County ($2 billion); Shell
($1 billion); Hammersmith and Fulham ($600 million); Allied Lyons ($150 million);
Adeniyi Adekoya (10131831)
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Procter and Gamble ($90 million); and Gibson‘s Greetings ($20 million. Source:
Hull (2012) and Goyal, A. (2015) – DBS Lecture notes on Derivatives delivered by
Murphy (2015) and Quinn (2015).
Clearly, from the loss analysis above of both FNFIs, it will surely have great impact
on these institutions operations. In this case, the risk management appeal is more
relevant, because it holds the primary concept of shock appeal to risks variables
which is the core need and essence of this research project stands to investigate.
By using DCHS, it will play an active role in risk management. Thus, it is important
to understand and analyse how DC works, what does it consist of and how can it
be used effectively and efficiently.
Perhaps, going more in depth within the topic, it becomes crucial to understand
how the hedging strategy will be applied to shocks in risk variables. All of these
topics and themes (risk variables and derivative contracts) will be looked through
and analysed more in depth in the next chapter of this dissertation. The main
questions and motives of the research arise through the analysis of the secondary
data. So, does the author wish to do research? The answer is yes, consequently,
we follow the ‗Research Project Process‘ outline in Figure 3 below.
Figure 3: Structure of the Research Project Process
Adeniyi Adekoya (10131831)
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1.2 Research Problem
Background to the research problem
Many countries including Ireland FNFI have undoubtedly witnessed significant
financial instability recently. Indeed, Patrick Honohan7, describes the situation as
“one of the most expensive financial crises in world history” (Browne, 2011), which
has impacted on the general public leading to depressed economic growth,
increase unemployment and the destabilisation of the wider economy‖ (O’Sullivan,
K. and Kennedy, T. 2010, page 224). The Governor‘s view then received full
support from other eminent academic scholars such as: David McWilliams of
Kilkenomics, Brian Lucey of TCD, and UCD Economist – Colum McCarthy.
Whilst the 2008 FEC was not exclusive to Ireland FNFIs alone, the impacts of the
crisis on these institutions caused by the underestimation of risk and risk
management, light touch regulation, wrong use of DC (especially CDS), lack of
corporate governance in the board of these FNFIs, human nature-greed and
hubris, – (A world-wide problem especially in the City of London and Wall Street)
makes this a fascinating area to research in order to get a clearer picture.
Perhaps, the aim of this research is to verify or reject research hypothesis which is
explained in the later section. The research problem emerged as one the reason
for the recent 2008 FEC in Ireland and this may be due to the inability of risk
7 Patrick Honohan is the Governor of the Central Bank of Ireland and a „world and master class
Professor of Economics and a graduate of London School of Economics‟. He will be retiring
by the end of this year 2015- Many thanks to him for his contribution to promote the growth of Irish
economy in the last five years which Patrick as the Head of CBI has made a remarkable progress.
Adeniyi Adekoya (10131831)
25
managers of FNFIs to effectively utilized DC to hedge their risk variables (risk
reduction).The reason for the inability of risk managers or failure rate often may be
due to miscalculation or error in wrong use DC for hedging strategy or may be for
speculative own accounting trading purposes. Moreover, some of these institutions
only have little regard for the day to day risk they face in their daily operations or
do not have standard hedging strategy polices in place for ‗risk reduction‘ –
McDonald, (2013) and Durbin (2011). Therefore, the risks manager in charge
should able to use the rights hedging strategy appropriately and must meet these
challenges of using the correct DCHS.
In this context and given vast literature on DC, it is essentially timely to investigate
or to conduct a retrospective examination of risk manager‘s attitude to effectively
utilizing DC to hedge FNFIs risk in order to achieve our objectives of ‗risk
reduction‘. Moreover, we determine if risk manager attitude have change towards
risk management in terms of measuring risks, setting of risk limits, monitoring
both, and the evaluations of the soundness of counter party risk when using DC to
reduce risk since the crisis and to demonstrate a holistic approach to risk reduction
which will lead to success by creating awareness and providing for risk managers
prospects to plan and execute successful hedging strategies alternatives where
applicable.
Besides, most FNFIs suffered from the recent 2008 FEC as we intend to
investigate the impact on institutions business activities including investigating
whether the crisis was cause as a result of using DC to hedge risk and determine
the impacts of BIS Basel III (NCTA) on FNFIs operations. Thus, the need to evolve
a proper DCHS are necessary for the liquidity and solvency of these institutions as
a possible development could indicate the consequences of the risk managers
unable to provide the proper use of DCHS correctly.
