By Erik Banks (auth.)
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Additional resources for The Credit Risk of Complex Derivatives
Sample text
During the early 1990s Belgium purchased a variety of leveraged barrier options on CHF/$ from Merrill Lynch. 4b on an unrealized basis at their peak) it closed down the positions and sued the bank. 6 The banks were accused of arranging “derivative transactions” that actually functioned as loans and allowed the company to understate its leverage position. Merrill Lynch paid US$80m to regulatory authorities for its part in arranging transactions that ultimately helped Enron hide losses and understate debt levels: one of the Merrill Lynch strategies involved a series of round-trip energy swaps.
The second component of the risk-return equation focuses on the specific risk characteristics of an instrument. Risk, as we shall discuss in the next chapters, comes in many different forms, including credit, market, liquidity, settlement, operational, legal, and sovereign. Not all risks are present in every transaction, but an appropriate risk-return mechanism should account for any elements that do exist. A basic tenet of finance demands that greater risk carry greater return. Accordingly, a derivative with large or complex hedging, liquidity, and market or operational risks should feature a larger gross spread: one that accounts for the added challenges and uncertainties.
Once again, there was concern that the collapse of the firm would lead to the failure of other dealers and energy companies (as many had dealt with the company on an unsecured basis since it maintained an investment grade rating until two months before its collapse). The bankruptcy and subsequent unwinding of positions was organized; although some firms sustained losses, the process was orderly and no systemic damage occurred. 1 Highlighted below is a summary of significant OTC and exchangetraded derivative losses of the past 20 years.