There can be no doubt that derivatives are powerful tools for risk management. If used improperly, however, derivatives can produce disastrous results. With derivatives becoming increasingly important, it has become crucial for banks, financial institutions and indeed non-financial companies to properly assess, manage and account for risks arising from derivatives transactions. While many earlier chapters have dealt with the use of derivatives in the management of risk, this chapter deals with the management of risks arising from the use of derivatives.

Enterprise risk management – covering not only financial but many other kinds of risk – is a rapidly expanding subject by itself. This chapter is a brief and introductory overview of the main principles and practices relating to a subset of those risks – the risks arising from derivatives.

An enterprise is subject to many kinds of risk and derivatives are just one and not necessarily the most important. Nevertheless, several characteristics of derivatives make them ‘special’ and different from management of many other types of financial risk. First and foremost, derivative instruments are highly ‘geared’. Because of this, it is possible in certain kinds of derivative transactions to lose far more than the original capital deployed in the transaction. In a normal business deal, with an investment of 10 million the maximum loss that can be suffered is 10 million or thereabouts. However, if 10 million is deployed in a derivative transaction as margin through writing of options or a speculative futures contract, it is quite possible to lose 100 million, that is, ten times the value of the capital put in. This is the single most important reason why derivative transactions require a much tighter supervision and control mechanism.

Secondly, derivative markets move at great speed. The markets are open virtually on a twenty four-hour basis, due to the integration of various exchanges across the world. Big price movements can occur overnight. (This is a feature they share with stock and spot foreign exchange markets.)

Thirdly, several derivative transactions fall into a grey area between hedging and speculation. Derivative securities used as hedges are a risk-reducing device, but derivatives used for speculation become a risk-enhancing device.