NCUA: "The Empirical's New Clothes" ... Derivatives: Part IV- "The Magic Risk Fairy"

Definition: A derivative is a financial transaction which transfers risk between two parties, usually for a fee. 

There are hundreds of definitions for derivatives, but this one is particularly instructive on one of the key, rock-solid, basic truths of financial derivatives  That core, immutable truth is that a derivative "transfers" risk - it does not eliminate risk! 

Don't Worry! I won't bite you
... but once !

When a credit union does an interest rate "swap" or "cap" transaction, the CU contracts to transfer some internal risk exposure to a "counterparty" - usually to a Wall Street bank.  The five counterparties which dominate the derivatives market are: Citigroup, Morgan Stanley, BofA, Chase, and Goldman Sachs.


The CU has transferred the risk - usually within narrowly defined limits - but the risk still very much exists.  The "limits" usually involve prescribed time frames ( one day, one month, one year, etc.) or within some proscribed interest rate or price range. Again, derivative contracts never eliminate risk and generally have time horizons shorter than the actual "life of the risk".  

Your mitigation of risk with a derivative is only as strong as the financial strength of your counterparty (AIG was the largest financial triple-AAA counterparty in the world as of September, 2008 - just prior to its $86 billion bailout by the American taxpayer. ) The more sound the counterparty, the higher the price of the derivative - cheap coverage can be very expensive.

"The Future Is Predictable..."

Your mitigation of risk is only as good as your choice of the correct swap/cap ranges and limits , as defined in your derivatives contract. (Know of at least two credit unions currently paying  dearly in fees because they never anticipated rates falling below 4% and therefore didn't pay up to "cover" that exposure!). The tighter your ranges and limits, the cheaper the cost of the derivative - being "frugal" with a derivative cover is a risk within itself. 


Predicting the future remains a game of chance, regardless of the string of Christmas tree financial ornaments with which it may be gilded. There are no Wall St. risk fairies, ready to accept your risk problems out of the goodness their hearts. Even for CUte l'il puppies...


"Mitigated risk" has a nasty habit of showing back up on your financial doorstep at the most inopportune time!

Long Term Capital Management (LTCM) remains the poster child for "true believers" in financial derivatives. LTCM, whose founders included two Nobel winning derivative economists, failed in 1998 due to hubris, leverage, and an eventually fatal belief that its risks had been fully"mitigated". In the financial autopsy report on the multi-billion dollar failure prepared by Merrill Lynch, the investment bank observed that mathematical risk models [ i.e., derivatives] "may provide a greater sense of security than warranted; therefore reliance on these models should be limited."

Perhaps the credit union movement can become the next derivatives poster child !!  

Don't you think you should try asking a few questions?