Finance Essay


Risk is pervasive. Multinationals face currency exchange rate fluctuations, developers rise and fall with interest rates, and airlines are subject to the dance of oil prices. All business enterprises fear higher taxes. The prosperity of enterprises is subject to variations in the market and legal environment in obvious and subtle ways. Kismet, not just the talent and pluck of management, seemingly determines the long-run success of individual business enterprises.

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Yet with the emergence of the modem derivative, corporations need no longer take the world as it is. Derivatives allow corporations to insulate themselves from, amplify, or otherwise modulate the impact of changes in interest and exchange rates and commodity, equity, and real estate prices. In some circumstances, even changes in statutory income tax rates can be hedged against. In effect, corporations can increasingly determine the market and legal environment in which they will operate. If clever and careful enough, a corporation can avoid the chaos of the real world. A corporation can enter a private “derivative reality,” a synthetic world purged of risks it deems undesirable.

When should a corporation enter this derivative reality for hedging purposes? In the central part of this Article, I show that it is impossible to answer this question in a meaningful way without considering the very nature of the corporation, an inquiry that reveals fundamental, yet largely unrecognized, limitations to the current corporate paradigm.

The prevailing legal and financial analyses have to a significant extent failed to recognize the relationship between the use of derivatives and the nature of the corporation, much less deal with its implications. As a theoretical matter, this failure raises questions not only as to the coherence of the typical legal and financial analyses of derivatives use, but also as to the coherence of existing conceptions of the corporation itself. As a practical matter, this brings into question some of the underlying presumptions on which corporate decision makers and financial regulators have relied in dealing with derivatives.

This research focuses on the most immediate concern: how this failure on the part of the prevailing analyses undermines the ability of corporate managers and boards of directors to evaluate the true benefits of hedging and thus to frame an appropriate hedging policy. I show that some of the resulting problems are serious, but can be solved through a systematic, interdisciplinary exploration of some plausible alternative conceptions of the nature of the corporation. As an initial matter, the choice of conception–for instance, as among what I have termed the “traditional conception,” the “pure shareholder wealth maximization” conception, and the “blissful shareholder wealth maximization” conception–determines the types and amounts of corporate hedging behavior that are appropriate. This exploration is enriched by terminology economists have developed to compare national economic systems.

The other resulting problems are more difficult to resolve. The systematic, interdisciplinary approach proves insufficient. it turns out, quite surprisingly, that existing conceptions of the corporation do not provide a sufficient theoretical base on which to build a rational hedging policy. I show that, pending a new corporate paradigm, consideration of corporation-specific shareholder expectations and associated disclosures must supplement existing conceptions of the corporation as polestars for corporate hedging behavior.



Responses to particular problems are involved by hedging techniques in the finance, as well as, in other fields. Nevertheless, various more-general forces are being focused frequently by the discussion. In the result, an impetus to the hedging techniques is provided by this focus, such as, regulation results in the incentives, and communications and computer technology improves. In addition, financial volatility is increased, and financial sector confronts greater competition, by which, academic financial research is advanced in this regard. BIS 1986.

A Janus-like quality is found in the regulation, as it has been considered for the hedging techniques. Incentives are often provided by particular regulations for the hedging techniques. However, the actual introduction of hedging techniques requires the regulatory assent, and part of the feasibility, as well as, success is an accommodating regulatory framework. For instance, the Eurocurrency market can be considered outside the field of derivatives. The growth of this market is contributed by the regulatory restrictions on banks of the United States. However, the permission, as well as, acquiescence of the regulatory authorities is required by the operations of the Eurocurrency market. In this regard, the authorities of both the countries, that are, country of origin, as well as, the outside country. More specifically, where foreign currency deposits are bid by the banks, and foreign currency loans are provided by the banks, the banks of these countries are only implemented with the operations of the Eurocurrency. In addition, external convertibility of currencies in the domestic banks for the creation and transfer of the deposits in the banks of countries are permitted for the Eurocurrency operations.

In the case of derivatives, regulatory assent is largely applied with similar remarks. The exchange is involved in the approval of exchange-traded derivatives, and responsibility is undertaken by the regulatory body. Over-the-counter (OTC) derivatives, customized betting devices issued to particular clients, are subject to the jurisdiction of the body regulating the issuing institution. This is likely to leave certain end-users of derivatives, such as non-financial corporations, largely or completely outside the regulatory framework. But although lacunae of this kind are of concern to policymakers [see U.S. GAO 2004, chaps. 5 and 7], the resulting unregulated spaces are unlikely to be the location of much hedging techniques in derivative betting devices. (These observations should not be taken to imply that regulatory frameworks for derivatives are uniformly effective. My sequel indeed will illustrate that this is far from being true.)

In the business press, reporting of a financial derivatives disaster hardly leaves a day. One of the several recent examples is the spectacular loss by Barings PLC. However, in recent years, tremendous growth has been experienced by the financial derivatives markets, which is not news. Financial services industry is not confined by the associated problems, which are used by the financial derivatives. Derivative financial betting devices are used by all the types of entities in all the industries. Some of the examples of these entities are non-profit organizations, manufacturing organizations, etc. In addition, large corporations are not limited with their use. Recent reported losses have underscored this wide use of financial derivatives. The board of directors, as well as, senior management often surprise apparently due to the abovementioned underscoring.

Introduction to Chapter

With respect to hedging techniques generally, and those affecting derivatives more particularly, the enabling impact of improvements in communications and computer technology is always stressed. But rather less attention is paid to the institutions and knowledge on which these improvements impinge. The financial sector has historically been a repository of vast knowledge of techniques for managing the risks associated with its operations. This knowledge has included ways of unbundling risks (often through the creation of betting devices which can also be used for speculation). As a result, the sector’s response to the effects of reductions in the costs of information and computation has been rapid. The pace of hedging techniques has also benefited from a willingness on the part not only of product designers in banks themselves, but also of academic financial researchers to explore the potential of concepts closely linked to actual financial practice. This interaction between activities such as trading and the generation of more systematic knowledge seems to me an analogue for finance of similar processes for crafts and skills more generally, on the one hand, and science, on the other, whose fruitfulness has been emphasized, for example, by John Dewey and by members of the radical science movement in Britain in the earlier part of this century [eg, Dewey 1982, 73-74. Bernal 1971, 49-50].

One last introductory point I should like to make concerns the way in which one set of hedging techniques involving derivatives is capable of opening the way for others. This depends crucially on the development of markets for derivatives, owing to the way in which such markets make it possible for participants to lay off risks, including those associated with new betting devices. The point can be illustrated for OTC derivatives. The exposure of dealers in the more complex OTC betting devices now common, which combine features of different generic derivatives, can be disaggregated into their constituent risks, which are then laid off through the taking of offsetting positions in derivatives as well as other financial assets through trading on exchanges or transactions in other simpler OTC betting devices in the Interbank market. (1)

A broad range of financial betting devices is being covered by the financial derivatives. The other financial betting devices are used for the derivation of value of this broad range of devices. In this way, assets and indices are underlined by it. Listed futures, options, forwards, as well as, swaps of current and interest rates, and several other combinations of the abovementioned betting devices have been included in this range. Financial derivations might be employed by commercial, as well as industrial companies, which have been referred as the end-users. In the result, costs of the raw materials are hedged, borrowing costs are capped, and enhancement of the earnings are some of the outcomes of this employment.

A number of financial derivatives characteristics should be mindful by the auditors.

Off-Balance-Sheet Nature

The full extent of involvement might not be indicated by trial balance of an entity’s amount, since no cash changing hands are entered in the financial derivatives contracts. Moreover, significant unrecorded gains and losses can perform the purpose without the implementation of necessary controls for the recording of the changes in value.


Particular needs of an end-user are often observed high structuring of their needs by financial derivatives contracts. As a result, the usage of a particular instrument, as well as, its valuation and accountability is not always clear. In addition, the accountability of the desired economic objectives that should be achieved is also not clear. In this regard, the actual terms and effects of a particular financial derivatives contract might be misunderstood by an entity. In the result, the confusion may result in the embarrassment and potential problems.


New opportunities have been created by the financial engineers for the further magnification of significant advantage financial derivatives that have already been represented. For instance, interest payments might be required by the swaps of leveraged and interest rate. In a specified market rate, an entity will be exposed to potential losses, which may be disproportionate to the change of interest rate.


In some cases, illiquidity might be observed in the financial derivatives markets, by which, problems regarding the valuation of betting devices, as well as, in the unwinding positions might be created.

Unclear Accounting and Tax Rules

The rapid development of new financial derivatives products, as well as, their uses has not been kept pace with these rules. In fact, existing anomalies are often used to take advantage by the product designers.

Legal Risk

The terms of financial derivatives contracts have not been enforced by some entities against counterparty. For instance, in a regulated industry, the authority for the entrance into transaction is not governed by a government agency. In addition, contract terms and its clear documentation is often lack by these agencies. Foreign counterparties might be used for the heightening of enforceability risks, until the occurrence of bankruptcy or insolvency of the counterparty.

Operational and Control Risk

Financial derivatives transactions are often originated by the treasury department of a company. Sometimes, the responsible bodies for the recording of transactions, as well as, tax reporting are not taken into coordination and consideration by the department.

Research Question

The question of the value of financial derivatives, and their concern by the auditors is being addressed by this research. Reasons for the explosive growth in the use of financial derivatives, and referred terms must be understood by the auditors.


For all the entities that have been engaged in the transactions of financial derivatives, significance of the audit implications should be clear in it.

Research Methodology

A comprehensive literature review is the research methodology of this study.
Chapter Layout

In this study, chapter 1 comprises of an INTRODUCTION describing the gist of the paper including all main points regarding the issue. In its 2nd chapter of the study, Methodology has been defined including its approach also. The 3rd chapter of the study is a review literature related with the given topic. Chapter 4 is all about data analysis. Chapter 5, the last chapter of this study, concludes the study with practical recommendations.
Concluding Remarks

The importance of these broad forces is not doubted by the intention of the remarks. However, certain relations have been pointed out in these remarks, by which, parts of the following will be illuminated by it.

Chapter # 2
Research Methodology

A comprehensive literature review is the research methodology of this study.
Introduction to Chapter

Some derivatives have a long history, while others are of more recent origin. Forward contracts, that is to say, contracts for deferred delivery, were used for transactions on organized markets at least as early as those of medieval and Renaissance Europe. Alongside of the use of such contracts in the trading of goods, even then there was also speculation on foreign exchange rates by methods resembling derivatives. For example, wagers were made on foreign exchange rates at Spanish fairs in sixteenth-century Antwerp and were settled in a manner similar to the use of offsetting positions on modern futures exchanges [Ehrenburg 1928]. Futures evolved from forward contracts as progressive standardization of contract terms became possible, and with it greater transferability of contracts and ease of settlement. Rice trading in seventeenth-century Japan is often cited as furnishing the first historical example of a futures market in something like the modern sense [Alletzhauser 1990, 26-27. Teweles et al. 1974, 8-9]. OTC foreign exchange options were available in nineteenth-century Germany [Yeager 1976, 269].

During the period from the middle of the nineteenth century until the late 1960s the expansion of futures and option trading on exchanges involved commodities. Financial derivatives, principally forward exchange contracts and share options, were mostly supplied OTC. The enormous growth of financial derivatives since the late 1960s is linked to the introduction of the trading on exchanges in an expanding range of financial futures and options.

The most widely used of recently introduced generic OTC financial derivatives are currency and Inter st-rate swaps. These were an extension of parallel and back-to-back loans originally designed to enable firms to get round controls on international capital transactions intended to impede access to borrowing a foreign currency or to increase the cost of such borrowing. Under these arrangements one company lends its currency to another company or to another company’s subsidiary in return for an offsetting loan in the borrower’s currency for itself or one of its own subsidiaries. From such exchanges of borrowings developed the idea of a contractual agreement between counterparties to exchange series of payments in the same or different currencies. Since these payments are often linked to obligations on the counterparties’ borrowing, swaps make possible reductions in their costs of financing on the basis of savings due to the exploitation of their comparative advantages in raising funds in different financial markets. Many of the newer OTC financial derivatives are based on combinations of generic contracts (such as swaptions or options on swaps, and compound options or options on options) or their extension to an increased number of periods (such as various multi-period options).

In order to facilitate understanding of the remainder of this paper, a few general remarks about the use and valuation of derivatives may be helpful. Derivatives (whether or not traded on an organized exchange) are contracts specifying rights and obligations that are based upon, and thus derive their value from, the performance of some underlying instrument, investment, currency, commodity or service, index, right, or rate. (2) In a futures or forward contract, one party (the long) agrees to buy something in the future from another and the second (the short) to sell it. As already mentioned, futures contracts (unlike forwards) are traded on organized exchanges and are thus standardized (with respect to size or quantity, grade or quality, and date and execution of delivery), only the price being negotiated. On most exchanges (though not the London Metal Exchange (LME) at the time of the default on the tin market described below), a clearinghouse interposes itself between buyers and sellers as the counterparty to every transaction. The buyer and the seller post performance bonds (initial margin), which is held by the clearinghouse. Margin payments (on many exchanges in the form of so-called variation margin) are made subsequently in response to a daily process of marking-to-market, which reflects the changes in the price of contracts. Depending on the contract, settlement at maturity can take place either through delivery of the commodity or financial instrument or through the payment of cash. But in practice, most positions in futures are offset before maturity: longs can cancel their obligations by selling an identical contract, receiving a profit or loss equal to the difference between the price at sale and that at initial purchase. and shorts can achieve the same result by buying an identical contract, in this case profit or loss being equal to the difference between price at purchase and that at initial sale. Profits and losses on positions for the purpose of margining are calculated similarly, that is, as the difference between the current price and that at the time of the original transaction.

The generic types of options are calls and puts. A call grants the purchaser the right (but without obligation) to buy an asset at a pre-set price (the strike price) from its seller or writer. A put grants its buyer the right (without obligation) to sell an asset at the strike price to the writer. Options are sold OTC or on exchanges. Trading in options on exchanges shares many features with trading in futures, that is to say clearinghouses, margin payments for the writers of options who are exposed to risks due to movements in the price of the asset in relation to the strike price, and the possibility of settlement through offsetting (in the form of sales of contracts by longs and purchases by shorts). The value of the positions of longs in exchange-traded options rises or falls with the price or premium of the option, and vice versa for option writers.

Exchange-traded derivative contracts can be valued at the prices at which they are bought and sold daily. Valuation of OTC derivative contracts, which is required for purposes such as internal control, financial reporting and supervision, and the settlement of obligations in insolvencies, is more difficult. Various techniques are used, most of them designed to provide estimates of replacement value or cost.

Location of Methodology

The methodology of this paper is confined within qualitative (phenomenological paradigm) approach.
Reason for Using Aforementioned Methodology

Knowing the inevitable factor that a comprehensive literature review makes us comprehend the existing scenario with a quite down-to-earth approach, this study goes for review of related literature throughout in this paper.
Data Collection Methods

An all-inclusive study of related books, journal articles and magazines is the Data collection methods of this paper.

The data for the empirical analysis are from the Federal Reserve System’s Report of Condition and Income for Commercial Banks (i.e., Call Report). These data were obtained from the Chicago Federal Reserve Bank’s Bank Condition and Income Database website We employ derivatives data, at the bank level, as of year-end 2006.

Table 1 provides a breakdown of derivatives usage, by contract type, for U.S. commercial banks. At year-end 2006, banks held approximately $20.5 trillion of derivative contracts. Interest-rate futures, forwards, swaps, and options accounted for over $13 trillion, or almost two thirds of the total amount. Foreign-exchange contracts accounted for most of the remaining third of the total or $6.7 trillion. Equity, commodity, and other contracts amounted to about $370 million or just under two percent of the total amount.

Interest-rate swaps were the most important individual contract type, amounting to just over $7 trillion and over half of all Interest-rate contracts. In addition, Interest-rate swaps accounted for better than a third of the total amount of all derivative contracts. Inter stingly, forwards, rather than swaps, were the most important of the foreign-exchange contracts. Foreign-exchange forwards amounted to $4.7 trillion, or almost one quarter of total derivatives and just over 70 percent of all foreign-exchange contracts.

Table 2 shows the breakdown of derivatives use by size. Panel a reports the distribution of all derivatives by size category, whereas Panel B breaks out the usage by contract type. From this table, the importance of size, as a factor in the use of derivatives by banks, is readily apparent. Only approximately 2 percent of banks with total assets less than $1 billion used derivatives (210 out of 9,197) whereas more than two thirds of banks with assets greater than $1 billion were users (274 out of 400). Panel B shows that smaller user banks (assets less than $1 billion) primarily use Interest-rate derivatives. Only in the largest size category (assets greater than $10 billion) do a majority of banks use foreign-exchange contracts.

We categorize those banks that are members of the International Swaps and Derivatives Association (ISDA) as dealers. These banks are not only involved as endusers of derivatives but are also heavily involved as dealers of OTC derivative products. Table 3 compares the use of derivatives by the 12 ISDA members banks (dealers) against the other 472 non-dealer banks. The 12 dealer banks accounted for almost 96percent of total derivatives usage at year-end 2006. Dealers accounted for more than 94percent of the Interest-rate contracts, 98percent of the foreign-exchange instruments, and virtually all equity contracts.

Validity and Reliability of Research Method

Validity and reliability of our research method is undeniable due to the fact that all reviewed book, journals and magazines articles are recognized worldwide.
Framework for Analyzing Study

The study has been analyzed within the framework of existing research paradigm especially designated for such financial studies.
Concluding Remark

Financial derivatives are not a passing fad, but an integral element in corporate risk management for the 1990s and beyond. Thus, auditors must approach financial derivatives not as a narrowly focused supplement to the audit plan, but as an ongoing and integral part of the audit process. We hope the, procedures and considerations described here will provide a basic framework for addressing this important and timely subject.

Chapter # 3
Literature Review

In a 2002 report prepared for the central banks of the Group of Ten, systemic risks are defined as those having the potential to cause a systemic crisis. Such a crisis is “a disturbance that severely impairs the working of the financial system and, at the extreme, causes a complete breakdown in it. … Systemic crises can originate in a variety of ways but ultimately they will impair at least one of three key functions of the financial system: credit allocation, payments, and the pricing of financial assets. A given financial disturbance may grow into a systemic crisis at one point in time but not another, depending on the financial and economic circumstances when the shock occurs.”

The main risks other than systemic that are associated with derivatives positions are credit, market, liquidity, settlement, operational, and legal risks, of which the most important to my subsequent discussion are the first three. Credit risk is due to the possibility that counterparty will default on obligations. Market risk is that of loss due to changes in the market value of a position before it can be offset or liquidated. Liquidity risk is usually defined as having two dimensions – cash liquidity or funding risk, and market liquidity risk. Cash liquidity or funding risk results from periodic needs for liquid funds that cannot be precisely forecast in advance. Market liquidity risk is due to the possibility that the transactions of a participant in derivatives markets will affect prices. Even though these risks are not themselves systemic, they can cause problems capable of posing a systemic threat, especially owing to ways in which they may interact.

Introduction to Chapter

The potential of non-systemic risks to generate systemic problems in certain circumstances has important implications for prevention. Measures directed at non-systemic risks, as a by-product, have the effect of rendering systemic threats less likely.

Defaults posing serious threats to the organized exchanges on which they took place have historically been very rare. One such threat arose in October 1985 with the announcement by the buffer stock manager of the International Tin Council (ITC) that the organization was unable to meet obligations estimated at approximately [pounds] 900 million in the form of futures contracts to buy tin on the London Metal Exchange (LME) and of loans from banks.(3) At that time, the LME had no clearinghouse, and trading was on a principal-to-principal basis. The response of the LME was to suspend its tin market. Eventually, in March 1986, a decision was made to conduct a “ringout” under which all outstanding LME tin contracts were settled at a single fixed price (based on the prevailing free-market price). By the time of the reopening of the tin market in 1989, the LME was operating with a clearinghouse established in May 1987 under the new regulatory framework for financial markets in the United Kingdom resulting from the Financial Services Act of 1986.

What makes the default on the tin market of more than purely historical Inter st is the way in which the fears it aroused bring out the nature of the function performed by the clearinghouse of a futures or options exchange. In evidence presented to the Trade and Industry Committee of the House of Commons of the United Kingdom in February 1986 [Kestenbaum 2001, 57-58], a hypothetical “Armageddon scenario” is described under which the failure of one member of the LME to meet its obligations to another leads to contagion first within the tin market itself and then further a field. Under this scenario, the LME reopens with the ITC unable to honor its commitments so that it defaults when tin covered by its long position is presented for payment. The broker who is long is forced to sell in order to mitigate his losses, and the tin price declines. Banks now sell tin held as collateral. Falling prices eventually cause the insolvency of the broker, who then ceases trading in other commodity markets. The liquidation of unwanted positions now spreads to other brokers and other markets. The outcome in the words of the evidence to the Trade and Industry Committee is that “since [the members of the LME] have heavy commitments in the bullion market, the foreign exchange market, and the soft commodities markets, their demise will cause a domino effect all across the spectrum of financial institutions and trading firms centered in London.”

A major function of an exchange’s clearinghouse is to prevent such a domino effect, which results from the concentration under principal-to-principal trading of the impact of the default of a member of the exchange on one or a small number of other members. An appropriately designed clearinghouse guarantees the performance of contracts through its role already mentioned as the counterparty to every transaction. Its margining procedures limit its losses in the event of the default of an exchange member, and its resources are adequate to cover such losses. But note the proviso, “appropriately designed.” The following cautionary tale shows how the mere existence of a clearinghouse is not necessarily a defense against disaster.

Theoretical Framework to Analyze Study

Literature review is the Theoretical framework to analyze our study.
Existing Literature

The commercial importance of the use of derivatives comes to mind most immediately. The derivatives market is huge: on crude, “notional amount” basis, the derivatives market is currently in the range of seventeen to thirty-five trillion dollars. Furthermore, derivatives comprise an important business for some major financial institutions. For example, in both 1993 and 1994, the majority of Bankers Trust’s earnings came from helping clients manage their financial risks and from the financial trading and positioning of securities, derivatives, currencies, and other assets for its own account.

Even those instances of derivatives use that have actually–or are merely perceived to have–gone haywire are themselves commercially noteworthy. In 1992, unbeknownst to senior management until it came time to close the books for the year, traders at Showa Sekiyu K.K, the Japanese affiliate of the Royal Dutch Shell group, had lost a billion dollars speculating in currency derivatives. In late 1993, Metallgesellschaft AG, one of Germany’s largest companies, discovered problems with the oil derivatives transactions that its main U.S. subsidiary had entered into for hedging purposes. Those initial derivatives transactions, or if some critics are correct, the subsequent attempt to deal with those initial transactions, contributed to losses in excess of one billion dollars and the near-bankruptcy of the German parent. And in 1994, increases in U.S. interest rates caused massive changes in the value of certain investments, including certain interest rate swaps. Some swaps losses triggered lawsuits. the brouhaha resulting from lawsuits against Bankers Trust brought by Procter ; Gamble and Gibson Greetings proved newsworthy.

Though the reasons are less obvious, the regulatory implications of the value of derivatives to corporations are also important. These regulatory reasons involve a subtle shift in animating vision and regulatory emphasis that has occurred within the past year or so. From the beginning of the explosive growth of the derivatives market in the early 1980s,[12] two visions have served to animate the debate over the regulation of derivatives and of new financial products generally.

Threatened Melt-Down of the Hong Kong Financial Futures Market (4)

The stock market crash of October 1987 had reverberations throughout the world’s financial markets. Hong Kong’s stock market was one of those most severely affected, and only a large rescue package saved the stock futures exchange from complete collapse. The initial price decline in Hong Kong’s stock market (11 percent in the Hang Seng Index) took place before the opening of markets in the United States on Monday, October 19. The governing committee of the stock exchange reacted with a decision to close the exchange for the rest of the week and to suspend trading in stock futures.

During the following days, the authorities were made aware that the resources of the Hong Kong Futures Guarantee Corporation (HKFGC) would be insufficient to meet widespread defaults on the Hong Kong Futures Exchange (HKFE), and that a collapse of the HKFE could lead to massive selling of stocks hedged with futures contracts or held as part of arbitrage operations. As a result, a rescue plan was put together for the HKFGC. On Monday, October 26, prices on the stock market plunged again by 33 percent. Most of the loan was quickly used to cover defaults on the futures exchange, and the government was forced to assemble another rescue package of the same amount (which in the event was not drawn down).

The main idea behind derivatives is the risk-reduction or hedging. As Rogers (1999) states, it provides the investors with more effective control and protection against price volatility. Further, they are used by speculators and arbitrageurs, who trade them for profit and take advantage of price differences between derivatives markets and instruments.

The derivatives function as a form of insurance, guaranteeing that the value of specific asset would remain unchanged and free from market influences. The derivative instruments of Futures and Options are thoroughly discussed in the next sections, where focus is put on their benefits and implications.

Options are probably the most common derivatives and are available on many underlying securities. They authorize the buyer with the right, yet not oblige, to buy or sell certain asset at a predetermined price and over limited period of time. The so-called strike price is the one at which stocks can be bought (call option) or sold (put option). Additionally, the main advantage of the options is their flexibility. They adapt to perfectly suite the needs and the situation of a customer (Brinblatt, 2002).

“An option contract gives its holder the right, not the obligation, to purchase (call) or sell (put) a specific security or other asset at a pr?d?t?rmin?d price for a defined period of time. THz seller (or “writer”) of an option stands on the other side of the contract and assumes the obligation dictated by the option contract if it is ?x?rcis?d by its holder. In return for assuming th? risks inherent in the transaction, the option writer receives a premium, which is the market pric? for th? option contract itself. Certain options, such as calls and puts on NYS? listed stocks, ar? trad?d on public ?xchang?s, whil? oth?r mor? customiz?d products may b? trad?d dir?ctly with financial institutions. For ?xampl?, suppos? a h?althcar? organization’s ?ndowm?nt fund is giv?n 100,000 shar?s of stock in Company XYZ, Inc., with a pric? of $55.375 p?r shar?, with th? proviso that it not s?ll this stock for at l?ast six months. Th? organization’s ?ndowm?nt is much larg?r than b?for?, but it is now h?avily conc?ntrat?d in company XYZ. Th? ?ndowm?nt fund manag?r might b? worri?d about what would happ?n if th? stock pric? d?clin?s sharply ov?r th? n?xt s?v?ral months b?for? som? of th? XYZ stock can b? sold to b?tt?r div?rsify th? portfolio. A solution to this dil?mma is to buy put options in amounts ?qual to all, or p?rhaps just som?, of this stock, with an ?xpiration dat? six months in th? future. Put options will give th? fund manager a pr?d?t?rmin?d minimum pric? (th? “?x?rcis? pric?”) at which h? or sh? will b? abl? to s?ll th? stock, r?gardl?ss of its actual pric?.

In th? ?xampl?, th? fund manager d?cid?s to purchas? XYZ puts with an ?x?rcis? pric? of $50 and an ?xpiration dat? of six months aft?r th? purchas?. Th? option pr?mium is $62.50 p?r contract (on? contract ?quat?s to 100 shar?s of stock). If th? manager chos? to h?dg? half th? position (50,000 shar?s), h? or sh? would buy 500 contracts for a total pr?mium of $31,250. This mov? would buy six months of prot?ction that th? stock pric? will not fall b?low $50 p?r shar?, and th? maximum loss that could b? incurr?d on th? h?dg?d shar?s would b? $268,750 (plus th? pr?mium paid for th? options) out of an initial $2,768,750. Sinc? th? ?ndowm?nt fund owns th? und?rlying stock, th? fund manager also may choos? to pay th? $31,250 pr?mium on th? put options by s?lling call options with approximat?ly th? sam? pr?mium pric?. Such a mov? would r?strict th? profit if th? stock go?s up in pric? but will accomplish th? primary obj?ctiv? of limiting downsid? risk without r?quiring any imm?diat? out-of-pock?t ?xp?nditur?”. (Using derivatives to hedge against the unexpected, n.d.)


“A forward is an agr??m?nt wh?r?by a buy?r and a s?ll?r agr?? to trad? a sp?cific amount of a d?signat?d s?curity or oth?r ass?t at a pr?d?t?rmin?d pric? at a future dat?. For ?xampl?, a h?althcar? organization might hav? outstanding bonds with abov?-mark?t int?r?st rat?s. Tax laws, how?v?r, may pr?v?nt s?lling a traditional “advanc? r?funding” issu? to imm?diat?ly captur? th? d?bt s?rvic? savings. Th? conv?ntional strat?gy would b? to wait until th? first optional call dat? on th?s? bonds (?g, July 1, 1998) and th?n do a curr?nt r?funding at that tim? if int?r?st rat?s provid? a savings. But th? issu?r, of cours?, fac?s th? risk that int?r?st rat?s may ris? b?tw??n 1996 and 1998, making th? r?funding transaction un?conomical. Through a “municipal bond forwards” transaction th? issu?r can s?ll a bond issu? bas?d on pr?s?nt int?r?st rat?s but d?lay th? d?liv?ry of th? bonds until 1998. As a r?sult, th? organization will lock in a guarant??d amount of savings and ?liminat? this mark?t risk. Th? downsid? is that th? issu?r is forgoing pot?ntially gr?at?r savings if int?r?st rat?s ar? low?r in 1998”. (Using derivatives to hedge against the unexpected, n.d.)

Future Contracts

“Future contracts ar? on? of th? old?st and most common forms of d?rivativ? instrum?nts. Futur?s ar? standardiz?d forward contracts that ar? trad?d on public ?xchang?s. Th?y allow th? parti?s to th? trad? to lock in pric?s for sp?cific amounts of s?curiti?s, commoditi?s, curr?ncy, or oth?r ass?ts to b? d?liv?r?d at som? future dat?. Th? ?xchang? functions as a middl?man, providing an organiz?d trading ?nvironm?nt and guarant??ing paym?nt for both buy?rs and s?ll?rs. Futur?s hav? b??n us?d for many y?ars by farm?rs and oth?r commodity produc?rs to s?t s?lling pric?s b?for? th? d?liv?ry of th?ir goods. By ?stablishing th?ir s?lling pric? upfront, s?ll?rs ar? r?li?v?d of risks of d?liv?ring products that cannot b? sold for mor? than th? cost of production.

Dir?ct us? of futur?s contracts has limit?d applicability to h?althcar? organizations. Highly sophisticat?d prof?ssional mon?y manag?rs may us? futur?s and options on futur?s ti?d to stock and bond mark?t indic?s to h?dg? larg?, institutional inv?stm?nt portfolios. For ?xampl?, a mon?y manager might h?dg? a larg? stock portfolio by s?lling Standard & Poors’ 500 stock ind?x futur?s”. (Using derivatives to hedge against the unexpected, n.d.)

Structur?d inv?stm?nt products

“Th? t?rm “structur?d inv?stm?nt products” appli?s to a wid? array of innovativ? inv?stm?nt v?hicl?s. Th?s? inv?stm?nt v?hicl?s ar? contractual agr??m?nts b?tw??n an inv?stor and a financial institution that d?fin? th? t?rms for payment of int?r?st, r?paym?nt of principal, and ?stablishm?nt of collateral, or security. Structured investment products ar? diff?r?nt from conv?ntional inv?stm?nt instrum?nts in that th?y ar? dir?ct, privat? agr??m?nts b?tw??n th? two parti?s and th?y poss?ss som? f?atur?s not found in standard inv?stm?nt s?curiti?s–for ?xampl?, gr?at?r fl?xibility and low?r risk. Oft?n d?rivativ? transactions ?nabl? financial institutions to off?r th?ir custom?rs th? uniqu? inv?stm?nt advantag?s that mak? th?s? products attractiv?”. (Using derivatives to hedge against the unexpected, n.d.)

“Two ?xampl?s of th? us? of th?s? products ar? full-fl?x r?purchas? agr??m?nts and forward purchas? agr??m?nts. Full-flex repurchase agr??m?nts (“r?pos”) ar? commonly ?mploy?d for th? inv?stm?nt of construction funds from a bond issu?. A full-fl?x r?po is uniqu? in that it combin?s a singl? fix?d int?r?st rat? for th? duration of th? construction p?riod with th? ability to withdraw funds at par at any tim? to pay construction draws. Thus, an inv?stor will hav? a known rat? of r?turn, no r?inv?stm?nt risk, and compl?t? fl?xibility in acc?ssing th?s? funds wh?n n??d?d. By contrast, mor? conv?ntional inv?stm?nt v?hicl?s off?r ?ith?r a high d?gr?? of fl?xibility in acc?ssing principal, combin?d with short-t?rm variabl? int?r?st rat?s, or fix?d-t?rm rat?s but mor? difficulty in pr?cis?ly tying principal withdrawals with construction paym?nts. A forward purchas? agr??m?nt is inv?stm?nt contracts that will provid? a fix?d rat? of r?turn on cash-flow str?ams that will occur in th? future. For ?xampl?, a h?althcar? organization that is going to mak? a monthly d?posit into a bond sinking fund may ?nt?r into a forward purchas? agr??m?nt that will provid? a fix?d int?r?st rat? on th? balanc? in this fund until th? mon?y is paid out to bondhold?rs. Th? t?rm of a for-ward purchas? agr??m?nt may b? as short as thr?? to fiv? y?ars or may ?xt?nd to final maturity of th? bonds. If th? organization choos?s,it may ?v?n ?l?ct to r?c?iv? all th? int?r?st incom? up front in a singl? lump sum paym?nt. By ?nt?ring into such an agr??m?nt, th? organization will r?c?iv? an imm?diat? incr?as? in its r?turn ov?r pr?vailing short-t?rm rat?s, but it will los? out in th? long run if short-t?rm yi?lds incr?as? to a l?v?l high?r on av?rag? than th? rat? paid und?r th? agr??m?nt”. (Using derivatives to hedge against the unexpected, n.d.)

Interest Rat? Swaps

“Interest rate swaps ar? an agr??m?nt b?tw??n two parti?s to ?xchang? int?r?st paym?nt str?ams of diff?ring charact?r according to a pr?d?t?rmin?d formula and bas?d on th? sam? und?rlying principal amount. For ?xampl?, an issu?r with long-t?rm, fix?d-rat? d?bt outstanding may b?li?v? that int?r?st rat?s ar? going to d?clin? in th? for?s??abl? future and, th?r?for?, would lik? to hav? th? int?r?st rat? on th? d?bt d?clin? along with th? mark?t as a whol?. On? way to accomplish this would b? to ?nt?r into an int?r?st rat? swap agr??m?nt in which th? issu?r would conv?rt th? fix?d-rat? d?bt for a p?riod of tim? into floating-rat? d?bt that would d?clin? if th? for?cast of a drop in int?r?st rat?s was corr?ct. Conv?rs?ly, an issu?r with variabl?-rat? d?bt might ?nt?r into a swap to fix th? int?r?st rat? for a p?riod of tim? if th? issu?r w?r? worri?d that int?r?st rat?s might incr?as? in th? future”. (Using derivatives to hedge against the unexpected, n.d.)

Interest Rat? Options

“Interest rat? options apply to borrow?rs or inv?stors in variabl?-rat? d?bt. Th? most common int?r?st rat? options ar? known as caps, floors, and collars. An int?r?st rat? cap s?ts a c?iling abov? which a variabl? int?r?st rat? (or int?r?st rat? ind?x) will not ris?. An int?r?st rat? floor s?ts th? int?r?st rat? (or ind?x) b?low which an int?r?st rat? will not fall, and an int?r?st rat? collar is th? combination of a cap and floor in th? sam? contract. A collar s?ts a maximum and minimum rat? band in which a variabl? int?r?st rat? will float during th? t?rm of an agr??m?nt. Thus, an issu?r of variabl?-rat? d?bt who is worri?d about th? cost of dramatic incr?as?s in short-t?rm int?r?st rat?s may, in ?ff?ct, purchas? “insuranc?” against that cost by buying an int?r?st rat? cap through a financial institution. An inv?stor in short-t?rm funds may b? worri?d about int?r?st rat?s falling too low; a floor would ?nsur? at l?ast a minimum rat? of r?turn, r?gardl?ss of mark?t rat?s, for th? duration of th? floor agr??m?nt”. (Using derivatives to hedge against the unexpected, n.d.)

Combined Float?r/Inv?rs? Floater Bonds

“A float?r/inv?rs? float?r bond is an innovativ? and compl?x d?rivativ? v?hicl? that arriv?s at a cons?rvativ? and conv?ntional r?sult–long-t?rm, fix?d-rat? d?bt financing. A long-t?rm fix?d int?r?st rat? is achi?v?d for a bond issu?r by actually s?lling two diff?r?nt s?curiti?s– a conv?ntional auction rat? or variabl?-rat? d?mand bond and an inv?rs? floating rat? bond in which th? int?r?st rat? floats in th? opposit? dir?ction of th? corr?sponding conv?ntional float?r. Th? combination of th? two rat?s moving in opposing dir?ctions yi?lds a singl?, long-t?rm fix?d int?r?st rat? for an issu?r for th? duration of th? bonds. Th? popularity of this product was cr?at?d by th? prolong?d d?clin? in int?r?st rat?s during th? mark?t ?nvironm?nt of th? 1980s and ?arly 1990s. In that mark?t ?nvironm?nt, th? yi?ld of inv?rs? float?r bonds actually incr?as?d as oth?r int?r?st rat?s in th? ?conomy f?ll. This b?cam? a highly attractiv? instrum?nt for offs?tting th? d?clin? in oth?r inv?stm?nt r?turns. As a r?sult combin?d float?r/inv?rs? float?r issu?s oft?n w?r? sold at int?r?st rat?s b?low thos? on traditional long-t?rm, fix?d-rat? bonds”. (Using derivatives to hedge against the unexpected, n.d.)

A healthcare organization, for ?xampl?, might b? abl? to s?ll $50 million in conv?ntional 20-y?ar fix?d rat?, tax-?x?mpt bonds at 6.25 p?rc?nt. A float?r/inv?rs? float?r bond yi?lding 6 p?rc?nt might b? structur?d by s?lling $25 million in floating-rat?, tax-?x?mpt bonds and $25 million in inv?rs? float?r bonds. Th? floating rat? portion might carry a rat? of 4.50 p?rc?nt; th? inv?rs? floating rat? is s?t by a formula of 12 p?rc?nt minus th? floating rat? (7.5 p?rc?nt). Thus, $25 million at 4.50 p?rc?nt and $25 million at 7.50 p?rc?nt ?quals $50 million at 6 p?rc?nt. A month lat?r, wh?n th? variabl? rat?s ar? r?s?t again, ?ach of th? und?rlying pi?c?s will lik?ly carry diff?r?nt yi?lds, but th? formula as it appli?s to th? inv?rs? float?r portion still will r?sult in an ov?rall rat? of 6 p?rc?nt. Th? only rat? th? bond issu?r ?v?r has to know is th? 6 p?rc?nt fix?d int?r?st rat?; all th? variabl? rat? risk is born? by th? inv?stors.

Case Studies

How did the HKFGC get into a situation where the imminent exhaustion of its resources threatened the continued functioning of the HKFE? Here we must look more closely at the HKFE’s clearing arrangements. If a clearinghouse is to function properly, it is essential that the arrangements for margin payments are in good working order and that its back-up resources should be large enough to meet obligations caused by the defaults. Neither condition was met by the HKFE in autumn 1987. The amount available to meet a drain on the HKFGC was wholly inadequate. Moreover, under the framework of the HKFE, the funding of the HKFGC, a company owned by six banks and the clearinghouse itself, was not the collective responsibility of clearinghouse members, the assumption being that ownership of the HKFGC by large Hong Kong banks would ensure their support for preserving the integrity of the HKFE. Furthermore, the vulnerability of the market to a sharp movement in prices was increased by the failure of many futures brokers to enforce their customers’ margin requirements, which were apparently financed with credit extended by the brokers.

The lessons learned from this experience led to thoroughgoing reforms by the Hong Kong authorities, who included a clarification of the position of the clearinghouse, now a wholly owned subsidiary of HKFE and, as an integral part of it, a reserve fund able to call on large resources for meeting the consequences of defaults.
Strains in U.S. Markets during the October 1987 Crash (5)

The more robust institutional frameworks of futures and options exchanges in the United States withstood the stress imposed by the October 1987 crash. My remarks here will be limited to the performance of clearance and settlement during a period of greatly increased trading volumes and fast-moving markets. This topic is of Inter st not only owing to the contrast with the experience of Hong Kong described above, but also because the institutional and regulatory frameworks of U.S. futures and options exchanges increasingly serve as models for those of other countries.

The functioning of clearance and settlement arrangements for financial futures and options exchanges in the United States during the crash was in sharp contrast to that in Hong Kong. For example, clearing and settlement on October 19 in the markets for stock futures, in spite of the largest ever one-day change in the Standard and Poor’s (S&P) index of 500 stocks (which underlies the most widely traded futures contract), took place without the failure of a single clearinghouse firm. On the Chicago Mercantile Exchange, on which the S&P futures contract is traded, margin calls reached $2 billion, a level 20 times greater than the 1987 average for months prior to October [Mayer 1988, 78]. The market break was unsurprisingly accompanied by signs of strain. Importantly, from the regulatory perspective, lags in payments threatened increases in the short-term exposures of clearinghouses to clearing banks (through which clearing members’ margin payments are received by clearing-houses) and in those of clearinghouses to their customers.(6) Such lags are an abiding source of concern to financial regulators owing to the fear that sharp rises in short-term exposure during fast-moving markets can adversely affect perceptions of creditworthiness, with potentially serious consequences for the entire process of settling margin obligations. Owing to the lags observed during the crash, steps were subsequently taken to reduce further the likelihood of hitches in clearing and settlement in U.S. futures markets.

Collapse of Barings: Internal Controls and Derivatives Markets

In general, the story of the events leading to the collapse of Barings in February 2005 has been widely told, but many details, some probably important to understanding the principal actors behavior, remain unclear. The crisis broke with the disclosure by Barings of large losses at its Singapore subsidiary, Baring Futures (Singapore) (BFS), and of its inability to meet margin payments, due to the Singapore International Monetary Exchange (SIMEX), on outstanding futures positions. As the crisis unfolded, it emerged that the losses of BFS substantially exceeded the capital of Barings, which was in consequence insolvent. An attempt at refinancing was undertaken by the Bank of England but was abandoned when no way was found to cap the losses on BFS’s outstanding positions in the futures and options markets.
Derivatives at Banks (national value, billions of dollars)

The losses that caused the insolvency of Barings resulted from positions taken by the Head Trader and General Manager of BFS, Nicholas Leeson, who had arrived in Singapore in March 2002. Management believed his trading to have been highly profitable, his arbitrage activities generating reported revenue of [pounds] 28.5 million in the last three quarters of 2004 (and leading to his characterizations by the head of the Financial Product Group of Baring Investment Bank as a “turbo arbitrageur”). But appearances were deceptive. As early as July 2002, Leeson established an account (88888), in which were subsequently booked loss-making transactions as well as fictitious ones and other reporting adjustments designed to conceal his true positions. Losses in this account amounted to [pounds] 2 million in 2002, [pounds]21 million in 2003, and [pounds]185 million in 2004.

The generation of fee income is a major incentive for banks to provide risk-management services to corporate clients, a motive coincident with the declining importance of the traditional business of banking (King  & Lipin, 2004). More than 30 years ago, Kane and Malkiel (1965) emphasized the importance of “other services” (beyond loans and deposits) to the bank-customer relationship. More recently, Smith (2003) argues that bankers must recognize the potential benefits of selling risk-management services. The obvious benefits come from the generation of fee income and the opportunities for bankers to create value through cross-selling and enhanced customer relationships. Less obviously, since hedging with derivatives can reduce the probability of financial distress for client firms, banks also benefit by reducing their risk exposure to their customers.

In spite of its obvious appeal, the dealing and trading of derivative products as a bank profit center requires a substantial investment in financial, intellectual, reputational, and, to a lesser extent, physical capital–barriers to entry. Although Tufano (1989) does not deal with derivatives per se, his analysis of financial innovation and first-mover advantages in investment banking describes the high costs associated with the development of new products. The development of derivative products should be subject to similar costs. In addition, Hunter and Timme (1986) argue that size and technical efficiencies permit the largest banks to exploit innovations most efficiently. On balance, this suggests that dealing activities should be limited to a unique set of the largest and most strategically placed banks, and that smaller banks would have little opportunity to offer risk-management services to their customers.

In late January 2005, as a result of management’s reaction to concerns expressed by SIMEX and others as to the size of Baring’s futures positions on SIMEX and the Osaka Securities Exchange (OSE), Leeson was instructed not to increase his positions from current levels. However, this instruction was not implemented and during the weeks that followed, as the management of Barings began to grasp that its understanding of important aspects of BFS’s operations was incorrect and that through them the group was exposed to large risks, Leeson continued to trade. The general trend of his transactions during the period that followed was in the direction of an increased long position in equity futures at a time when the Nikkei index of share prices was tending to fall, and an increased short position in Inter st-rate futures (the JGB and Euroyen contracts) at a time when their prices were tending to rise. His losses between the beginning of 2005 and Barings’s insolvency amounted to more than [pounds]600 million. Almost [pounds]500 million of this total was incurred in February, a figure suggesting that the group could have been saved if the instruction to Leeson not to increase his positions had been enforced.
Emerging Issues

Basic audit objectives should be focused by the auditors with the help of a thoughtful reading of the above list. Rights and obligations, completeness, and existence, as well as, occurrence are some of the areas of implementation of objectives. In the various stages of a typical audit, financial derivatives and their guidelines have been provided in the following:


A thorough understanding of the use of financial derivatives by a client is gained by the starting point. The identification of nature, as well as, extent of involvement of an entity should be focused by the auditors. In this regard, the types of financial betting devices, as well as, their intended purposes have been included in the focusing. For this purpose, operational areas that are found outside the financial reporting group should be involved sufficiently by the auditor. Possibly, the other areas, and the treasury function should also involved by the auditor.

During the planning phase of an engagement, auditors also must make a preliminary assessment of management controls over financial derivatives activities. This will provide a basis for determining the nature and degree of testing of such controls, with the goal of determining the extent to which the controls can be relied on. Some of the key controls that should be present, including both high-level and more detailed controls, include
* Authorization of the entity’s financial derivatives program by senior management and the board or an appropriate board committee, such as audit or finance.
* Policies and procedures to limit and monitor the extent of market and credit risk assumed in financial derivatives transactions. An entity should clearly define which betting devices are to be used for particular purposes, the extent and limit of their uses and the authorized counterparties with whom the entity may enter into financial derivatives transactions. Systems and reporting mechanisms should be established to detect report and act on violations of such limits as well as on changes in the counterparties’ credit status.
* Policies and procedures to reduce credit risk on transactions by obtaining adequate collateral, third-party guarantees or letters of credit, for example, and by using master netting agreements with counterparties.
* Appropriate monitoring controls to ensure transactions are reviewed for compliance with established policies, are properly authorized and are accurately recorded.
* Proper segregation of duties between those originating financial derivatives transactions and those approving and recording them by having, for example, transaction confirmations from counterparties received by someone independent of the originator.
* Procedures to measure and monitor the results of financial derivatives transactions against objectives. Normally this requires an entity to properly value or “mark to market” outstanding financial derivatives transactions. There also should be procedures for monitoring the accuracy of such valuation techniques, including controls over any computer models employed. When more complex financial derivatives and hedging techniques are used, entities should consider performing sensitivity analyses and stress tests against a full range of potential market movements.
* Periodic review by internal audit or some other group, with prompt action on the results of these reviews.
* Establishment of clear accounting and tax policies for financial derivatives use and procedures to ensure proper recording of transactions in accordance with these policies. When hedge accounting is employed, such transactions should be properly designated as hedges and should comply with other relevant criteria specified in applicable accounting and tax rules and regulations.

Tests of controls: As with any other audit area, auditors should perform tests of controls to determine the degree of reliance that can be placed on the internal control system as a basis for reducing substantive testing. While specific tests will vary from entity to entity depending on the types of transactions and the nature of the control systems, some typical tests of controls over financial derivatives activities might include those of
* Compliance with approved policies, such as whether the entity adhered to established market and credit risk limits, the reporting of any instances in which such limits were exceeded and whether appropriate remedial action was taken.
* Individual transaction authorizations, including evidence of approval by a responsible official independent of the transaction originator.
* Completeness of recording of transactions, including the functioning of specific controls over capturing trades and review of periodic reconciliations of trade activity and related balances. Auditors also should consider confirming the details of a sample of transactions directly with the counterparties involved.
* Valuation procedures employed by the entity. This includes a review of any internal valuation models, sample comparison of valuations produced by these models with independent outside valuation sources (quoted prices for exchange-traded options and futures, dealer quotes for currency and Interest rate swaps and pricing services and possibly valuation specialists for unique and highly structured financial derivatives), testing of inputs (such as yield curves for currency and Interest rate swaps and volatilities for options) to the internal models against current market data and testing of the consistency of the values ascribed by the company’s models by the use of selected test transactions or by reference to actual sale or purchase transactions.
* The proper classification of transactions for accounting and tax purposes. Because these rules are complex and still evolving, the appropriate treatment may not always be clear. For example, certain transactions, while functioning as an economic hedge, may not qualify for hedge accounting. Similarly, certain transactions may be viewed as speculative for tax purposes, resulting in capital gain or loss treatment. Auditors should review and test the procedures in place to appropriately identify and address these issues.
* Procedures for authorizing new counterparties, for obtaining collateral or guarantees, letters of credit and master netting agreements and for monitoring counterparties’ credit status. The Committee of Sponsoring Organizations of the Tread way Commission is addressing the application of its work, Internal Control-integrated Framework, to this area by developing a guide, Internal Control-Financial derivatives, which is expected to be released this year.

Substantive tests: Given the complexity of individual financial derivatives transactions and the large dollar amounts often associated with them, it is not surprising auditors often choose to rely heavily on substantive tests to satisfy their audit objectives. Typical tests include
* Confirming with counterparties outstanding transactions as of the balance sheet date.
* Reviewing individual transaction terms by reference to contracts or trade tickets.
* Verifying yearend valuations and reconciliation of profit and loss balances.
* Reviewing credit risk and exposure related to counterparties and the establishment of appropriate credit reserves, if warranted.
* Reviewing tax attributes of financial derivatives transactions in conjunction with overall tax accrual audit procedures.

Chapter # 4

Now let us examine more closely the roles of major actors in this drama. Leeson concealed his true positions through systematic misreporting and falsification of records. The misreporting included alteration of the prices of transactions that actually took place, distribution of the booking of transactions between account 88888 and other accounts in such a way that losses were recorded in the former, the booking of fictitious transactions to offset losses, and the writing of options to generate income for the same purpose. The falsification involved not only the internal reports of Barings, but also those submitted to SIMEX. One of Leeson’s objectives with regard to the latter was to reduce increasingly large margin payments due from BFS to SIMEX’s clearinghouse. Employees at BFS appear to have adopted a complaisant attitude toward Leeson’s instructions, thus facilitating his task of concealment. However, the entry of [pounds]50 million at the end of 2004 as the premium received from a fictitious sale of options to the firm, Spear, Leeds and Kellog (SLK), was one of the developments that alerted both senior management in Barings and its auditors to the problems at BFS.

Because only a relative handful of banks are able to be major dealers of risk-management/ derivative products, the remaining banks that are involved in the derivatives market use them primarily as endusers. To hedge against or speculate on, the movement of economic variables. An important question is: “Why do so few banks (only about 5%) use derivatives to manage their risk?” In answer to this question, Geczy, Minton, and Schrand (2004) argue that incentives to hedge, created by market imperfections, are necessary but not sufficient to induce firms, including banks, to hedge risk with derivatives. In addition, banks must consider the level of risk they face, the costs of managing that risk, and the regulatory environment.

Smith and Stulz (1985) argue that hedging can reduce the probability of bankruptcy by reducing the variance of cash flows. Banks with a higher probability of financial distress would be most likely to benefit from a hedging program. This implies that banks with greater leverage, and hence a greater probability of experiencing bankruptcy, are more likely to use derivatives to hedge. Further, the extent of hedging should be related to the amount of debt in a bank’s capital structure.

The business of banking includes a number of important risk factors (for example, default or credit risk, Interest-rate risk, and foreign-exchange risk) that may be related to the use of derivatives for hedging purposes. Interest-rate risk arises because of duration mismatches resulting from borrowing short and lending long, the traditional business of banking. The greater the duration mismatch, the greater is the effect of unexpected changes in Inter st rates on a bank’s market value (Flannery ; James, 1984. Kwan, 2001). Because higher levels of risk should provide incentives to hedge, we hypothesize a positive relationship between duration-mismatched balance sheets and derivatives usage by banks.

Another important consideration is the interaction between Interest-rate risk and credit risk. Schrand and Unal (1998) investigate hedging and coordinated risk management used by thrifts to control both credit risk and Interest-rate risk. If banks are practicing coordinated risk management, then the use of derivatives to hedge Interest-rate risk should also be related to a bank’s credit exposure. If banks use derivatives (to hedge or speculate) in response to credit risk, a positive relationship is expected to exist between loan losses and derivatives use. In contrast, a bank’s credit risk may have no bearing on its use of derivatives. The most widely used derivatives contracts, Interest-rate swaps, are used to hedge Interest-rate risk. Moreover, credit derivatives, which would be appropriate for hedging credit risk, are a recent innovation and not widely used by banks at present. On balance, if banks hedge their credit exposures at all, they do so indirectly.

Prior studies of financial distress have found that the costs of bankruptcy are proportionally greater for smaller firms (Warner, 1977), which suggests that smaller banks would benefit the most from hedging with derivatives. However, the costs of implementing a risk-management/hedging program using derivatives may keep smaller banks from participating. The costs might include the hiring of skilled personnel and the implementation of internal-control systems necessary to participate in the market for derivatives. In addition, margin requirements and the maintenance of regulatory capital are also costs of using derivatives. Booth, Smith, and Stolz (1984) find that smaller banks have a problem hiring and retaining the skilled employees needed for an effective risk-management program. Their research is paralleled by Block and Gallagher (1986) who find similar results for non-financial firms.

Other prior research has also documented the importance of size in banks’ use of futures (Koppenhaver, 1990), swaps (Kim & Koppenhaver, 2003), and Interest-rate derivatives (Carter & Sinkey, 1998. Gunther & Siems, 2006). This finding is also found in studies of non-banking firms. For instance, the use of derivatives is found to be positively related to size in the insurance industry (Colquitt & Hoyt, 2004) and for non-financial firms in general (Nance, Smith & Smithson, 2003. Mian, 2006). On balance, we expect a positive relationship between size and the use of derivatives. One potential exception to this is the case of smaller banks that are members of a bank-holding company. These banks might be able to take advantage of corporate-level resources to pursue a risk-management/hedging strategy.

The regulatory environment may also be an important factor in how derivatives are used by banks. Capital-adequacy requirements and deposit insurance may provide their own incentives to either use or not use derivatives. At present, risk-based capital standards require banks to support their derivatives activities with capital. Merton and Bodie (2002) argue that the required capital, which they term “assurance capital,” serves as a cushion against losses, and thus is an alternative to frequent surveillance. This suggests a positive relationship between equity capital and derivatives usage.

As the Report of the Board of Banking Supervision expresses it in a single-sentence paragraph (para. 13.16 on p. 234), “Leeson was not properly supervised.” The most important fading of internal control at Barings as it affected Leeson was the lack of segregation at BFS of the front office (through which trading itself was conducted) and the back office (where the recording and settlement of trades and the movement of funds took place). This failing was crucial to the practices of concealment described above.

Deficiencies of internal control also permitted the transfer without proper accounting of increasingly large sums from London to Singapore to finance the margin payments due on the futures positions of Barings in the markets of Singapore and Japan. The financing of much of Leeson’s concealed trading in Singapore and Japan took place via an account in London covering the mismatch (the so-called “top up” account) between the total funding of BFS and that allocated to particular purposes such as the financing of the segregated accounts associated with clients’ futures and options positions managed by Barings. The total sums in the “top up” account amounted to [pounds]22 million at the end of 2003 (already large for an account designed to facilitate settlement and to take care of mismatches in a firm’s internal reporting), [pounds]120 million at the end of 2004, and no less than [pounds]306 million on February 24, 2005. The transfers took place in spite of the continuing inability of the management of settlements in London to reconcile them with other information on the outstanding loans of Barings to clients.

The external auditors of Barings failed to identify losses at BFS due to account 88888 during the period up to the end of 2003. Auditing for 2004 of the accounts of BFS and of the units of Barings in London responsible for financing margin payments in Singapore and Japan was not complete by the time of the group’s insolvency. However, auditors in both Singapore and London had given an overall clean bill of health to the internal controls of both BFS and the London end of the futures and options operations of Barings in Asia. Nevertheless, the auditors in Singapore did query the SLK receivable mentioned earlier and drew it to the attention of their counterparts in London, a step which contributed to the belated realization of management in London of the problems at BFS.

The Bank of England was apparently not alerted to the rapid increase in financing for the futures and options trading of Barings in Japan and Singapore in early 2005. The Bank had not yet received before the insolvency the scheduled quarterly return on the large exposures of Barings, which would have covered lending to the bank’s Singapore subsidiary. Moreover, it had not been warned by authorities in Japan or Singapore of the expansion in the positions taken by Barings, nor was it apparently aware of concerns in these countries’ markets themselves. The subject of the large exposure of Barings to OSE and SIMEX had been an issue in its supervisory relations with the Bank of England for some time owing to regulations under which the Bank is notified of transactions bringing an institution’s exposure to a single counterparty or groups of related counterparties above 25 percent of its capital base, and under which, since 2004, such transactions are no longer supposed to be allowed. Throughout much of 2003-2004, the reported exposure of Barings to OSE had exceeded 25 percent of the capital of the group, and this had also sometimes been true of its reported exposure to SIMEX. These reported exposures excluded the sums in the “top up” account described above. The Bank of England’s relatively relaxed view of the laxness of Barings regarding its large exposures appears to have reflected misconceptions regarding the risks associated with the trading operations of Barings in Japan and Singapore, in particular its belief that these operations involved primarily trading on behalf of clients and intra-day arbitrage between markets in Singapore and Japan.

The motivations of the principal actors in the Barings collapse remain somewhat obscure. Barings itself was an institution with relatively limited capital, a position typical of a long-established merchant bank. Presumably this left it dependent on the money markets for important amounts of the financing of its newer activities such as futures and options trading, so that its profits would have been sensitive to premia on the rates of Interest charged to it. If true, this vulnerability would help to explain the anxiousness of those in the upper echelons of Barings that misreporting and other weaknesses of internal controls in connection with the SLK transaction (now known almost certainly to have involved forgery) should not be the subject of a reference in the auditors’ management letter concerning BFS. The Report of the Board of Banking Supervision mentions management’s concern as to possible regulatory problems in Singapore that might result from such a reference. But it is also plausible that the anxiousness was part of a more general concern as to reactions in the money markets to disclosure of this matter, at least until after problems associated with the SLK transaction could be reported as having been solved. Management’s response both to discovery of the SLK transaction and to awareness of market concerns as to the size of the positions of Barings in the Japanese and Singapore markets is also revealing in other ways. There appears to have been a belief that a reasonable amount of time was available to handle these difficulties, including the possibly substantial but probably (as it was believed) one-off loss involved. The response does not indicate awareness of the danger that the General Manager of BFS could become a veritable loss-making machine capable of destroying the entire group in less than a month.

Regulation and Control

The current gamut of financial futures, options and swaps is a relatively recent development. Unsurprisingly, therefore, regulatory frameworks for derivatives are still underdeveloped in several ways, and despite recent tendencies in the direction of convergence there remain significant differences among them.
Improvements to Exchanges

Reference has already been made to a number of reforms of organized exchanges, which clearly had the reduction of systemic risk as a major objective. The establishment of a clearinghouse for the LME falls into this category, as does the overhaul of the legal and institutional framework of the HKFE after the crash of 1987. The lessons drawn from the crash also led to measures elsewhere designed to strengthen exchanges for periods of stress. For example, in February 1988 a guarantee fund of [pounds] 100 million was set up to back futures and options contracts cleared by the clearinghouse of the London International Financial Futures Exchange (LIFFE), whose backing had earlier consisted only of the relatively small equity of the firm owning the clearinghouse and the moral obligation of its shareholders (an arrangement similar to that before the crash in Hong Kong) [FRBNY 1989a, 15-20]. In the United States, much regulatory attention was paid to ways of reducing short-term exposures during the clearing and settlement process [FRBNY 1989b, 96. FRBNY 1990, 17]
Internal Controls

Internal controls for dealers in and users of derivatives have recently been the subject of recommendations by various bodies. The study of derivatives published in 2003 by the Group of Thirty has attracted particular attention in this context. The Group’s recommendations concern such topics as the oversight of derivatives activities at the highest level of management, clear lines of authority for risk management functions that maintain their independence from dealing, comprehensive systems for measuring risks and for internal control, and various aspects of the international legal framework as it bears on such subjects as netting and disclosure. Similar ground was covered in papers issued simultaneously by the Basle Committee on Banking Supervision and the Technical Committee of the International Organization of Securities Commissions (IOSCO) (8) There is now also a trend toward according banks’ internal controls an explicit role in standards used in prudential supervision and toward greater reliance on data generated in connection with these controls for supervisors’ information requirements.
Prudential Standards

Improvements in national prudential regimes for derivatives are increasingly being shaped by initiatives at the international level. These initiatives were initially directed at derivatives as part of proposals and measures designed to reduce or control the broad categories of financial risk associated with banking and the securities business in general. For this purpose, derivatives were singled out only to the extent that their features required special treatment. More recently, guidelines put forward by international bodies have also been concerned with certain aspects of derivatives as such.

Credit risk associated with derivatives is now covered by EU directives on capital standards for banks (9) and by the 1988 agreement, “International Convergence of Capital Measurement and Capital Standards,” reached by the Basle Committee on Banking Supervision. Since the Basle Committee is increasingly accepted as the main source of standards for international banking, its guidelines on this subject are likely to serve as a model for banking regimes worldwide. Market risks are covered by EU’s Capital Adequacy Directive (CAD), due to come into force in 2006. (10) Initial proposals of the Basle Committee on this subject in April 2003 [BCBS 2003] (which followed lines similar to those embodied in the CAD) were criticized by banks. As a result, in revised consultative proposals of April 2005 [BCBS 2005a. BCBS 2005b], the Basle Committee has now put forward the alternative of using banks’ internal models for measuring market risks for the purpose of calculating capital charges. This alternative would be subject to supervisors’ satisfaction concerning qualitative standards regarding a bank’s organization of its risk management function and quantitative standards for the way in which its value at risk is calculated. (11) For banks not using comprehensive risk management models, supervisors would use a slightly revised version of the Basle Committee’s more standardized approach to the measurement of capital charges for market risk proposed in April 2003.

Thus, the outcome of initiatives so far is only the beginnings of a harmonized regime of international standards for the regulation of derivatives activities, with a coverage of both subjects and financial firms that is incomplete. The EU directives apply to both banks and securities firms throughout member countries of the Union. However, the capital standards of the Basle Committee are directed only at internationally active banks. Countries are granted some latitude as to the scope of the standards’ application at national level. In this context it should also be noted that the remit of banking supervisors in many countries covers securities business at most partially.

Chapter # 5

The impact that a corporation’s hedging behavior could have on an investor is especially troublesome if such hedges are entered into after the investor has bought the shares and the nature and extent of such new hedging transactions are not immediately and effectively announced to the public. The investor would not even realize that he no longer had the kind of exposure to the natural resource he had contemplated. He would not have the opportunity to sell those shares quickly and buy the shares of some other company in the same industry that does not hedge. To the extent that an investor’s expectations are predicated upon the apparent risk attributes of the corporation, any mechanism (such as hedging) that alters those attributes in an opaque fashion endangers the investor’s overall financial strategy. The more opaque this change is, the more insidious its effects are likely to be. Unfortunately, anecdotal evidence suggests that corporate disclosure about derivatives is often quite limited.

The collapse of Barings sent shock waves through the financial markets. However, subsequent initiatives originating with regulators and the industry itself have been directed mainly toward improved enforcement of existing rules and steps to bring firms, traders, and exchanges closer to best practices as defined and recommended by various bodies in recent years. This absence of radical new measures or proposals is not surprising since failures of generally accepted standards for internal controls and lax enforcement of existing banking regulations contributed so blatantly to the collapse. In the aftermath of the collapse of Barings, various proposals have recently been floated for improving the functioning of, and reducing risks in, derivatives markets. None of the ideas on the table will eliminate systemic risks from derivatives markets so long as financial markets more generally continue to be subject to periods of high volatility when market liquidity dries up and buyers of betting devices are simply no longer available. But one of the proposals does merit a mention here.

This proposal is directed at the incentive structure embodied in typical remuneration packages for the traders of financial firms. (12) These consist of a basic salary together with a profits-linked bonus, which can be very large and thus can provide an incentive to sometimes undesirably high risk taking. Under the proposal, bonuses would depend not only on the levels, but also on the variability of profits, being positively related to the former and negatively to the latter. Some firms have already moved toward basing traders’ remuneration on a formula under which the profits made by units in excess of those on a risk-free portfolio are compared with an aggregate benchmark reflecting risks and returns in the market as a whole,(13) but the practice does not yet appear to be general. Redesigning remuneration packages would probably have significant effects on behavior in derivatives markets, since bonus structures have a pervasive impact on risk taking at the level of the trading desk [Ray 2003, 398-402].

Introduction to Chapter

Depending on the significance of a client’s financial derivatives activities, auditors should consider supplementing the above procedures with appropriate representations from client senior management and communication with both senior management and the board or appropriate board committees, such as audit or finance.

Representation about financial derivatives activities should be included in the overall client representation letter, with specific separate letters from individuals, if appropriate. It should reveal to the auditor all known transactions, appropriate characterization of hedges and proper valuation of financial derivatives for financial statement presentation and disclosure.

Given the attention paid to financial derivatives transactions by analysts, the business press, the SEC and other regulators, this topic has been an agenda item this past year at virtually every public company audit committee or board meeting. There is a growing expectation that external auditors will provide insights into a company’s control over, financial derivatives and the appropriateness of its financial reporting and disclosures of these activities as well as a candid assessment of the company’s financial derivatives profile. Heavy financial derivatives activity, complex transactions, aggressive accounting, weak controls or limited disclosures obligate auditors to discuss the details and implications of these matters with the board or audit committee.


In addition to the above audit procedures, the evolving nature of financial reporting and disclosure for financial derivatives, as well as the heightened focus by financial statement users on financial derivatives, places a burden on auditors to properly focus on presentation and disclosure issues. Key issues for auditors to assess include
* Proper use of hedge accounting in accordance with applicable Financial Accounting Standards Board pronouncements, Emerging Issues Task Force consensuses and other relevant guidance.
* Appropriate disclosure of accounting policies adopted.
* Appropriateness of disclosures of information required by FASB Statement no. 105, Disclosure of Information about Financial Betting devices with Off-balance-Sheet Risk and Financial Betting devices with Concentrations of Credit Risk, Statement no. 107, Disclosures about Fair Values of Financial Betting devices, and Statement no. 119, Disclosure About Derivative Financial Betting devices and Fair Value of Financial Betting devices, which significantly expands the required disclosures.
* For Securities and Exchange Commission registrants, a review of additional footnote disclosures and management’s discussion and analysis. Last year, the SEC formed a financial derivatives task force and sent comment letters to hundreds of registrants requesting additional detailed disclosures and commentary about financial derivatives activities and the effects on a company’s reported results, financial position and liquidity.
Response and Synthesis

As financial derivatives losses become more common, it’s important for auditors to understand financial derivatives and the significant audit implications for entities that use them. Financial derivatives use-and losses-are not limited to large corporations.

Financial derivatives represent a broad range of financial betting devices that derive their value from other betting devices, including futures and options, forwards, currency and Inter st rate swaps and various kinds of combinations.

Auditors should understand the characteristics of financial derivatives that may have an impact on how the audit of an entity that uses them will be conducted. Characteristics that auditors will need to consider include their off-balance-sheet nature, their complexity, the leverage involved, and their illiquidity, the absence of clear accounting and tax rules, the legal risks and the operational and control risks.

When planning an audit, auditors need a clear understanding of how an entity uses financial derivatives. It also will be necessary to test the entity’s internal control system to determine its reliability with regard to financial derivatives transactions. Auditors also must focus on financial statement presentation issues to ensure statement users have a clear idea of how an entity uses financial derivatives and to satisfy all of the reporting requirements for public companies.

The impact of monetary phenomena regarding the goods and services production has been incorporated by the institutional analyses of the economic process from the outset. Pecuniary and industrial employments have been distinguished by Thorstein Veblen. Distinguishing between the manufacturing of goods and money generation has been done by Wesley Mitchell. Real and financial values have been distinguished by John R. Commons. A dialectical relationship between the flows of material and money has been required, which resulted in the seeking of the abovementioned.

In response to the deregulation of financial markets, as well as, hedging techniques, rapid evolution was observed in the financial derivatives market in the 1980s. a value of more than $8 trillion in outstanding contracts has been observed in the market due to the encompassing of futures, currency swaps, options, and swaps of the interest rates. While business enterprises have been assisted by these hedging techniques in hedging risk, conditions for the heightening of financial fragility have been created by these techniques on an international scale.

Concluding Remark

The derivatives market has grown into a substantial new segment of the international financial system in just over a decade. By enabling both conservative hedging activities and more speculative bets on the price movements of underlying assets, this market has provided new benefits and costs to market participants and societies. Increasing concentration in segments of the derivatives markets, greater linkages between financial markets created by derivatives trading, and the lack of transparency associated with swaps have all contributed to greater risks of systemic failure. This heightened degree of financial fragility poses a potential threat to social provisioning as a broadly based dislocation of the international financial system could spread to the real sector of the global economy. Thus far, the regulatory response has lagged badly. The sporadic intervention of central banks has averted contagion in the financial system as insolvent major banks have sought to unwind their derivatives obligations. Improved minimum capital standards and coordination of banking supervision at the supranational level are useful first steps toward limiting the extent of financial fragility presented by derivative markets. But the larger task remains ahead: to institute a supranational lender of last resort that has not only the ability to effectively prevent systemic failure but to discipline speculative behavior that undermines social provisioning.

Technological advances create new possibilities. The question of when corporations should take advantage of advances in financial technology and enter into a derivative reality proves much more difficult than current legal and financial analyses typically suggest. Some difficulties, such as those arising from the gap between lawyers and financial theorists, can be overcome–but this approach ultimately proves insufficient. Not only does the question implicate the very nature of the corporation in manifold ways, but answering the question within the existing conceptual framework proves impossible. Existing inconsistencies and frailties in classic principles of corporate law become manifest and unacceptable. It is advisable for corporations to consider supplementing existing, general rules of corporate law with customized programs to shape and adhere to the “hedging expectations” of their own shareholders. While not conceptually pure, it is a way station that corporations can and should use in traveling to worlds they themselves now create.

It can be doubtlessly concluded that if the companies do not understand well all the financial innovations many investment damages would emerge from their inappropriate usage. However, with proper education and implementation these innovations might turn into excellent source of revenues.


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Financial derivatives-related losses

Barings PLC. $1 billion loss resulting in the company’s collapse. The loss resulted from unauthorized trading in Nikkei index future

Metallgesellschaft. $1 billion loss related to the use of energy futures and other financial derivatives that were hedges of future fixed-price sales commitments.

Piper Jaffrey. $700 million loss in mutual funds from investments in interest rate financial derivatives.

Kidder Peabody. $350 million “phantom” profit related to trading in so-called government strips.

Proctor & Gamble. $157 million loss on closeout of leveraged interest rate swaps.

Cargill. $90 million loss in value of mortgage-backed financial derivatives

Investors Equity Life insurance Company of Hawaii. $90 million loss resulting from trading in treasury bond futures.

Air Products & Chemical. $60 million loss in value of leveraged interest rate swaps due to increased interest rates.

Harris Trust and Sayings Bank. $51 million loss in investments in collateralized mortgage obligation financial derivatives.

Financial derivatives: Key questions

1. What is the extent and nature of the entity’s use of financial derivatives? What betting devices are used, for what purposes, how often and in what notional-contract amounts?

2. Have senior management and the board of directors (or a committee of the board) authorized the use of financial derivatives and key aspects of the program?

3. Have detailed written policies and procedures covering the use of financial derivatives been developed?

4. Are there appropriate monitoring controls to ensure that transactions are properly authorized, comply with established policies and limits and are accurately recorded?

5 Is there proper segregation of duties between those originating financial derivatives transactions and those responsible for approving and recording them?

6. Does the entity have policies and procedures to adequately control credit risk with counterparties?

7. How does the entity monitor and review the results of its financial derivatives programs against objectives? 8. Have clear accounting and tax policies been established for financial derivatives use, and do these policies comply with applicable rule*s and regulations?

9. Has financial derivatives activity been subject to periodic internal audits? If so, what have the results been?

10. Has financial derivatives activity been properly reflected, disclosed and discussed in the financial statements, annual report and Securities and Exchange Commission and other regulatory filings in accordance with applicable generally accepted accounting principles, SEC and regulatory requirements?

Table 1 The derivatives activities of U.S. commercial banks as of year-end 2006
Legend for Chart:

B – $ Billions
C – Percent of type
D – Percent of total

A                                         B        C        D

Inter?st-rate contracts

Swaps                                   7,070    52.7%    34.5%
Futures                                 1,482    11.0%     7.2%
Forwards                                1,719    12.8%     8.4%
Exchange-traded options                   946     7.0%     4.6%
OTC options                             2,211    16.5%    10.8%
Total Inter?st-rate contracts          13,427   100.0%    65.6%

Foreign-exchange contracts

Swaps                                     471     7.0%     2.3%
Futures                                    10     0.2%     0.1%
Forwards                                4,728    70.7%    23.1%
Exchange-traded options                   471     7.0%     2.3%
OTC options                             1,011    15.1%     4.9%
Total foreign-exchange contracts        6,692   100.0%    32.7%

Equity contracts

Swaps                                      26    13.3%     0.1%
Futures                                    23    11.9%     0.1%
Forwards                                    0     0.0%     0.0%
Exchange-traded options                    25    12.8%     0.1%
OTC options                               122    62.0%     0.6%
Total equity contracts                    196   100.0%     1.0%

Commodity ; other contracts

Swaps                                      35    20.6%     0.2%
Futures                                    10     5.8%     0.1%
Forwards                                   68    40.0%     0.3%
Exchange-traded options                    15     9.0%     0.1%
OTC options                                42    24.5%     0.2%
Total commodity ; other contracts         170   100.0%     0.8%
Total derivative contracts             20,485       NA   100.0%

Table 2
The distribution of derivatives use by bank size as of year-end 2006
Panel A. Distribution of total derivatives contracts

Legend for Chart:

A – Total assets ($ millions)
B – Number of banks With derivatives
C – Number of banks Without derivatives
D – Percent with derivatives

A                     B       C         D

;/= 100               26    6,236     0.42%
100-300               84    2,162     3.74%
300-500               40      372     9.71%
500-1,000             60      217    21.66%
1,000-5,000          145      120    54.72%
5,000-10,000          56        6    90.32%
; 10,000              73        0   100.00%
;/= 1,000            210    8,987     2.28%
; 1,000              274      126    68.50%
All banks            484    9,113     5.04%

Panel B. Distribution of different types of derivatives

Legend for Chart:

A – Total assets ($ millions)
B – Banks using derivatives # Banks
C – Banks with Inter?st-rate contracts # Banks
D – Banks with Inter?st-rate contracts % With
E – Banks with foreign-exchange contracts # Banks
F – Banks with foreign-exchange contracts % With
G – Banks with all other contracts # Banks
H – Banks with all other contracts % With

A                B      C       D     E      F     G      H

;- 100           26     24    92.3     2    7.7    0     0.0
100-300          84     77    91.7     8    9.5    3     3.6
300-500          40     38    95.0     5   12.5    0     0.0
500-1,000        60     56    93.3     9   15.0    3     5.0
1,000-5,000     145    133    91.7    35   24.1    8     5.5
5,000-10,000     56     55    98.2    27   48.2    2     3.6
; 10,000         73     73   100.0    60   82.2   17    23.3

All banks       484    456    94.2   146   30.2   33     6.8

Table 3
Composition of Global Financial Derivatives Market
(As of year end 2005)

Percentage of                         Percent by
Derivative Type  total financial  Underlying Security  underlying
derivatives                           Security

Inter?st rate        96.5 %
Futures           18 %            Currency              1.0
Equity                2.5

Inter?st rate        27.0
Forwards          42              Currency             73.0
Equity                0

Inter?st rate        89.0
Options           13              Currency              3.5
Equity                7.5

Inter?st rate        82.0
Swaps             27              Currency             18.0
Equity                0

Inter?st rate        62.5
Total            100              Currency             36.0
Equity                1.5
Source: General Accounting Office, Financial Derivatives: Actions Needed to Protect the Financial System, GAO/GGD-94-133, May 2006