This is the risk radar that investors switch off when they buy a company based on perceived reputation. Reputation is used instead as the proxy for risk management. Thus, many investors went into Enron, Worldcom or Equitable Life because they were regarded as good pedigree companies. Long-Term Capital Management, adorned with a Nobel prize-winner on board, had a total market exposure estimated at $1250 billion against its capital of $800 million.
Many people just want rapid profit, but they do not have a clue about real risk management. Setting an investment project goal with a risk limit is essential; it is not an optional extra. A predefined project by RAMP methodology has goals, expected performance and variance reporting. This puts adverse CEO spotting back on the project agenda.
Finding the company on our corporate AEW radar can warn us that the company is about to “blow”. This organic-based system uses both figures and mathematical techniques, but is more about the manner in which human beings operate. The forensic evidence can be tracked down in audit trails. There are scents given off by CEO sharks associated by red flags alarm signals for indicating weak banks.
There are essential tools to identify weak banks using early warning techniques. This subjects the supervisor’s data on the bank to a stress testing process, of the bank’s expenses, asset quality of portfolio and their funding. Then we can derive a better risk-discounted picture of the earnings, capital and solvency. This is followed by qualitative (note not quantitative) modelling:
Qualitative data
Management/board of directors have oversight administration deficiencies; the oversight committee may not be empowered, or it is too chummy with the CEO.
Risk management has deficiencies in resourcing, empowerment and skills.
Strategic mistakes have been made by the board into the market.
Quantitative data
Performance-related rise in declared profits, asset value, sales.
Aggressive growth and expansion strategies.
Sudden and major deterioration in earnings.
Basel II recognises that such operational risk weaknesses cause big problems for the investors. Its AEW10 system also focuses on warning signs in:
Board management quality.
Effectiveness of policies, procedures and planning.
Execution of risk management controls and audits.
Quality of MIS systems and reporting processes.

However, the danger is that individuals and corporations might not understand the value or operation of the investments being sold. It sounds like another Millennium Dome. This makes for a bad investment project. Under RAMP methodology, there are minimum criteria for a successful and desired result:
Clearly stated and understood objectives.
Defined scope of the project investment.
Clear responsibilities and project ownership of these parties.
Estimated budget for the project.
Defined end-state for the project.
Milestone date of project end.
Under extremely unclear financial engineering or complex business lines where none of the above conditions exist, then a successful outcome is very unlikely. Thus, clients may be occasionally oversold derivative products and inappropriate investment strategies. It is not just the banks and investment funds who have lost. The main losers are the humble private investors.

Investor risk is perceived as fear or underperformance, notably in losing the value of the original investment. Substantial benchmarking occurs, notably in the comparison of returns against inflation, stock-market and other industrial yardsticks. Similar executive peer-group pressure and benchmarking lead them to see who gained the highest award from the remuneration committee. Not all CEOs are intent on removing value from the company, a fine minority contribute by increasing investor wealth whether in share price or earnings per share.
The hazard remains that many CEOs are executive recruitment failures. They create negative shareholder return and blacken the name of the company. Reputational risk emerges as one of the more obscure risks, while being costly too. An incompetent executive seems to be excusable in the markets, certainly if we believe the newspaper accounts; being crooked is not. Either way, CEO tenure is usually short term, so CEOs may adopt the attitude: “Better clean up the company assets before they boot me out.”
We have seen that the Board of Directors is not always an adequate counter to the ego of the CEO and the wish for more M&A and self-aggrandisement. Non-executive directors, who are enlisted in a cabal to add to the existing yes-men on the Board, can never serve to deter the company from embarking on an unacceptably risky course. We need an essential set of conditions for successful corporate guidance.
An appropriate range of multidisciplinary skills
Power to ensure effective implementation of decisions
Ability to undertake effective assessments of the soundness of decisions associated with projects
Suitably qualified and dedicated support staff for the collection and analysis of data
Otherwise, we are condemned with the dire corporate leadership that has steered so many companies on the rocks.
An incompetent or crooked CEO underperforms colleagues and rivals. The bottom line is either the profit level or the share price. They fail on both scores. Failure should destroy their reputation in the industry. While the CEO can inflict great damage upon the company, reputational risk decrees that the executive can be punished with the embarrassment of being summarily ejected. By then it may be too late. There are two subrisks operating here – stemming from:
an inept executive;
a crooked executive.
What to do? Risk management becomes an empirical business study in corporate control.
We have seen how risk comprises:
hazard;
catalyst;
result.
We come back to the risk of a shark attack described in previous posts. The shark has a large dorsal fin that alerts us to its impending attack. We have already detailed an AEW warning system to alert us to the adverse CEO choice.
There are various risk management techniques to shed light upon a dark corporate operational area. These can include more effective interviewing to bring unsuitable executive candidates under the spotlight. Another is to undertake a management review of the control structure for recruiting key staff. Redesign the audit processes to block potential fraudulent financial statements passing the accounting process.
Compare this risk management arsenal against the risk of a fraudulent CEO. Fraud needs conditions:
1. motivation;
2. opportunity;
3. rationalisation.
We deploy risk countermeasures:
1. Anti-fraud motivation measures – better training of staff and recruitment, screening and interviewing of new applicants, monitor HR performance at work plus instigate an effective ethics programmes.
2. Anti-fraud opportunity measures – better staff monitoring, accounts screening, external audits, limit IT systems access and raise security physical access limits.
3. Anti-fraud rationalisation measures – raise chances of detection, raise punishment levels to act as deterrent, lower expectations of profit.
Risk management is really about a logical sequence of tasks to protect the business investment. The enterprise risk management strategy or life-cycle could be outlined as the series of tasks.
I. Risk detection.
II. Risk countermeasures.
III. Risk monitoring.

In this blog we have discussed many aspects of forward contracts and forward markets. We will conclude the post (and each of the following posts, which cover futures, options, and swaps) with a brief discussion of the role that these markets play in our financial system. Although forward, futures, options, and swap markets serve similar purposes in our society, each market is unique. Otherwise, these markets would consolidate.
Forward markets may well be the least understood of the various derivative markets. In contrast to their cousins, futures contracts, forward contracts are a far less visible segment of the financial markets. Both forwards and futures serve a similar purpose: They provide a means in which a party can commit to the future purchase or sale of an asset at an agreed-upon price, without the necessity of paying any cash until the asset is actually purchased or sold. In contrast to futures contracts, forward contracts are private transactions, permitting the ultimate in customization. As long as a counterparty can be found, a party can structure the contract completely to its liking. Futures contracts are standardized and may not have the exact terms required by the party. In addition, futures contracts, with their daily marking to market, produce interim cash flows that can lead to imperfections in a hedge transaction designed not to hedge interim events but to hedge a specific event at a target horizon date. Forward markets also provide secrecy and have only a light degree of regulation. In general, forward markets serve a specialized clientele, specifically large corporations and institutions with specific target dates, underlying assets, and risks that they wish to take or reduce by committing to a transaction without paying cash at the start.
Forward contracts are just miniature versions of swaps. A swap can be viewed as a series of forward contracts. Swaps are much more widely used than forward contracts, suggesting that parties that have specific risk management needs typically require the equivalent of a series of forward contracts. A swap contract consolidates a series of forward contracts into a single instrument at lower cost. Forward contracts are the building blocks for constructing and understanding both swaps and futures. Swaps and futures are more widely used and better known, but forward contracts play a valuable role in helping us understand swaps and futures. Moreover, as noted, for some parties, forward contracts serve specific needs not met by other derivatives.

As derivative markets develop, options (and even some other types of derivatives) have begun to emerge on such underlyings as electricity, various sources of energy, and even weather. These instruments are almost exclusively customized over-the-counter instruments. Perhaps the most notable feature of these instruments is how the underlyings are often instruments that cannot actually be held. For example, electricity is not considered a storable asset because it is produced and almost immediately consumed, but it is nonetheless an asset and certainly has a volatile price. Consequently, it is ideally suited for options and other derivatives trading.
Consider weather. It is hardly an asset at all but simply a random factor that exerts an enormous influence on economic activity. The need to hedge against and speculate on the weather has created a market in which measures of weather activity, such as economic losses from storms or average temperature or rainfall, are structured into a derivative instrument. Option versions of these derivatives are growing in importance and use. For example, consider a company that generates considerable revenue from outdoor summer activities, provided that it does not rain. Obviously a certain amount of rain will occur, but the more rain, the greater the losses for the company. It could buy a call option on the amount of rainfall with the exercise price stated as a quantity of rainfall. If actual rainfall exceeds the exercise price, the company exercises the option and receives an amount of money related to the excess of the rainfall amount over the exercise price.
Another type of option, which is not at all new but is increasingly recognized in practice, is the real option. A real option is an option associated with the flexibility inherent in capital investment projects. For example, companies may invest in new projects that have the option to defer the full investment, expand or contract the project at a later date, or even terminate the project. In fact, most capital investment projects have numerous elements of flexibility that can be viewed as options. Of course, these options do not trade in markets the same way as financial and commodity options, and they must be evaluated much more carefully. They are, nonetheless, options and thus have the potential for generating enormous value. Again, our emphasis is on financial options, but readers should be aware of the growing role of these other types of options in our economy. Investors who buy shares in companies that have real options are, in effect, buying real options. In addition, commodity and other types of options are sometimes found in investment portfolios in the form of “alternative investments” and can provide significant diversification benefits. To this point, we have examined characteristics of options markets and contracts. Now we move forward to the all-important topic of how options are priced.

Options in which the asset underlying the futures is a commodity, such as oil, gold, wheat, or soybeans, are also widely traded. There are exchange-traded as well as over-the-counter versions. Over-the-counter options on oil are widely used.
Our focus in this blog is on financial instruments so we will not spend any time on commodity options, but readers should be aware of the existence and use of these instruments by companies whose business involves the buying and selling of these commodities.

In earlier posts we covered futures markets. One of the important innovations of futures markets is options on futures. These contracts originated in the United States as a result of a regulatory structure that separated exchange-listed options and futures markets. The former are regulated by the Securities and Exchange Commission, and the latter are regulated by the Commodity Futures Trading Commission (CFTC). SEC regulations forbid the trading of options side by side with their underlying instruments. Options on stocks trade on one exchange, and the underlying trades on another or on Nasdaq.
The futures exchanges got the idea that they could offer options in which the underlying is a futures contract; no such prohibitions for side-by-side trading existed under CFTC rules. As a result, the futures exchanges were able to add an attractive instrument to their product lines. The side-by-side trading of the option and its underlying futures made for excellent arbitrage linkages between these instruments. Moreover, some of the options on futures are designed to expire on the same day the underlying futures expires. Thus, the options on the futures are effectively options on the spot asset that underlies the futures.
A call option on a futures gives the holder the right to enter into a long futures contract at a fixed futures price. A put option on a futures gives the holder the right to enter into a short futures contract at a fixed futures price. The fixed futures price is, of course, the exercise price. Consider an option on the Eurodollar futures contract trading at the Chicago Mercantile Exchange. On 13 June of a particular year, an option expiring on 13 July was based on the July Eurodollar futures contract. That futures contract expires on 16 July, a few days after the option expires.” The call option with exercise price of 95.75 had a price of $4.60. The underlying futures price was 96.21. Recall that this price is the IMM index value, which means that the price is based on a discount rate of 100 – 96.21 = 3.79. The contract size is $1 million. The buyer of this call option on a futures would pay 0.046($1,000,000) = $46,000
and would obtain the right to buy the July futures contract at a price of 95.75. Thus, at that time, the option was in the money by 96.21 – 95.75 = 0.46 per $100 face value. Suppose that when the option expires, the futures price is 96.00. Then the holder of the call would exercise it and obtain a long futures position at a price of 95.75. The price of the underlying futures is 96.00, so the margin account is immediately marked to market with a credit of 0.25 or $625.” The party on the short side of the contract is immediately set up with a short futures contract at the price of 95.75. That party will be charged the $625 gain that the long made. If the option is a put, exercise of it establishes a short position. The exchange assigns the put writer a long futures position.

As we noted in earlier posts, the currency forward market is quite large. The same is true for the currency options market. A currency option allows the holder to buy (if a call) or sell (if a put) an underlying currency at a fixed exercise rate, expressed as an exchange rate, Many companies, knowing that they will need to convert a currency X at a future date into a currency Y, will buy a call option on currency Y specified in terms of currency X. For example, say that a U.S. company will be needing €50 million for an expansion project in three months. Thus, it will be buying euros and is exposed to the risk of the euro rising against the dollar. Even though it has that concern, it would also like to benefit if the euro weakens against the dollar. Thus, it might buy a call option on the euro. Let us say it specifies an exercise rate of $0.90. So it pays cash up front for the right to buy €50 million at a rate of $0.90 per euro. If the option expires with the euro above $0.90, it can buy euros at $0.90 and avoid any additional cost over $0.90. If the option expires with the euro below $0.90, it does not exercise the option and buys euros at the market rate.
Note closely these two cases:
Eum expires above $0.90
Company buys €50 million at $0.90
Eum expires at or below $0.90
Company buys €50 million at the market rate
These outcomes can also be viewed in the following manner:
Dollar expires below €1.1111, that is, €1 > $0.90
Company sells $45 million (€50 million X $0.90) at € 1.1 1 1 1, equivalent to buying €50 million
Dollar expires above €1.1
11 1, that is, €1 < $0.90
Company sells sufficient dollars to buy €50 million at the market rate This transaction looks more like a put in which the underlying is the dollar and the exer- cise rate is expressed as €1.1 11
1. Thus, the call on the euro can be viewed as a put on the dollar. Specifically, a call to buy €50 million at an exercise price of $0.90 is also a put to sell €50 million X $0.90 = $45 million at an exercise price of 1/$0.90, or €1.11 1 1.
Most foreign currency options activity occurs on the customized over-the-counter markets. Some exchange-listed currency options trade on a few exchanges, but activity is fairly low,

In earlier posts, we devoted considerable effort to understanding the Eurodollar spot market and forward contracts on the Eurodollar rate or LIBOR, called FRAs. In this post, we cover options on LIBOR. Although these are not the only interest rate options, their characteristics are sufficiently general to capture most of what we need to know about options on other interest rates. First recall that a Eurodollar is a dollar deposited outside of the United States. The primary Eurodollar rate is LIBOR, and it is considered the best measure of an interest rate paid in dollars on a nongovernmental borrower. These Eurodollars represent dollar-denominated time deposits issued by banks in London borrowing from other banks in London.
Before looking at the characteristics of interest rate options, let us set the perspective by recalling that FRAs are forward contracts that pay off based on the difference between the underlying rate and the fixed rate embedded in the contract when it is constructed. For example, consider a 3 X 9 FRA. This contract expires in three months. The underlying rate is six-month LIBOR. Hence, when the contract is constructed, the underlying Eurodollar instrument matures in nine months. When the contract expires, the payoff is made immediately, but the rate on which it is based, 180-day LIBOR, is set in the spot market, where it is assumed that interest will be paid 180 days later. Hence, the payoff on an FRA is discounted by the spot rate on 180-day LIBOR to give a present value for the payoff as of the expiration date.
Just as an FRA is a forward contract in which the underlying is an interest rate, an interest rate option is an option in which the underlying is an interest rate. Instead of an exercise price, it has an exercise rate (or strike rate), which is expressed on an order of magnitude of an interest rate. At expiration, the option payoff is based on the difference between the underlying rate in the market and the exercise rate. Whereas an FRA is a commitment to make one interest payment and receive another at a future date, an interest rate option is the right to make one interest payment and receive another. And just as there are call and put options, there is also an interest rate call and an interest rate put.
An interest rate call is an option in which the holder has the right to make u known interest payment and receive an unknown interest payment. The underlying is the unknown interest rate. If the unknown underlying rate turns out to be higher than the exercise rate at expiration, the option is in-the-money and is exercised; otherwise, the option simply expires. An interest rate put is an option in which the holder has the right to make an unknown interest payment and receive a known interest payment. If the unknown underlying rate turns out to be lower than the exercise rate at expiration, the option is in-the-money and is exercised; otherwise, the option simply expires. All interest rate option contracts have a specified size, which, as in FRAs, is called the notional principal. An interest rate option can be European or American style, but most tend to be European style. Interest rate options are settled in cash. .
As with FRAs, these options are offered for purchase and sale by dealers, which are financial institutions, usually the same ones who offer FRAs. These dealers quote rates for options of various exercise prices and expirations. When a dealer takes an option position, it usually then offsets the risk with other transactions, often Eurodollar futures.
To use the same example we used in introducing FRAs, consider options expiring in 90 days on 180-day LIBOR. The option buyer specifies whatever exercise rate he desires. Let us say he chooses an exercise rate of 5.5 percent and a notional principal of $10 million. Now let us move to the expiration day. Suppose that 180-day LIBOR is 6 percent. Then the call option is in-the-money. The payoff to the holder of the option is This money is not paid at expiration, however; it is paid 180 days later. There is no reason why the payoff could not be made at expiration, as is done with an FRA. The delay of payment associated with interest rate options actually makes more sense, because these instruments are commonly used to hedge floating-rate loans in which the rate is set on a given day but the interest is paid later.
Note that the difference between the underlying rate and the exercise rate is multiplied by 1801360 to reflect the fact that the rate quoted is a 180-day rate but is stated as an annual rate. Also, the interest calculation is multiplied by the notional principal.
In general, the payoff of an interest rate call is
Days in underlying rate
(Notional Principal)Max(O,Underlying rate at expiration – Exercise rate) 360 ) (4-1)
The expression Max(0,Underlying rate at expiration – Exercise rate) is similar to a form that we shall commonly see throughout this post for all options. The payoff of a call option at expiration is based on the maximum of zero or the underlying minus the exercise rate. If the option expires out-of-the-money, then “Underlying rate at expiration – Exercise rate” is negative; consequently, zero is greater. Thus, the option expires with no value. If the option expires in-the-money, “Underlying rate at expiration – Exercise rate” is positive. Thus, the option expires worth this difference (multiplied by the notional principal and the Days1360 adjustment). The expression “Days in underlying rate,” which we used in earlier posts, refers to the fact that the rate is specified as the rate on an instrument of a specific number of days to maturity, such as a 90-day or 180-day rate, thereby requiring that we multiply by 901360 or 1801360 or some similar adjustment.
For an interest rate put option, the general formula is Days in underlying rate
(Notional Principal)Max(O,Exercise rate – Underlying rate at expiration)
For an exercise rate of 5.5 percent and an underlying rate at expiration of 6 percent, an interest rate put expires out-of-the-money. Only if the underlying rate is less than the exer- cise rate does the put option expire in-the-money.
As noted above, borrowers often use interest rate call options to hedge the risk of rising rates on floating-rate loans. Lenders often use interest rate put options to hedge the risk of falling rates on floating-rate loans. The form we have seen here, in which the option expires with a single payoff, is not the more commonly used variety of interest rate option. Floating-rate loans usually involve multiple interest payments. Each of those payments is set on a given date. To hedge the risk of interest rates increasing, the borrower would need options expiring on each rate reset date. Thus, the borrower would require a combination of interest rate call options. Likewise, a lender needing to hedge the risk of falling rates on a multiple-payment floating-rate loan would need a combination of interest rate put options.
A combination of interest rate calls is referred to as an interest rate cap or sometimes just a cap. A combination of interest rate puts is called an interest rate floor or sometimes just a floor.8 Specifically, an interest rate cap is a series of call options on an interest rate, with each option expiring at the date on which the floating loan rate will be reset, and with each option having the same exercise rate.9 Each option is independent of the others; thus, exercise of one option does not affect the right to exercise any of the others. Each component call option is called a caplet. An interest ratefloor is a series of put options on an interest rate, with each option expiring at the date on which thefloating loan rate will be reset, and with each option having the same exercise rate. Each component put option is called a floorlet. The price of an interest rate cap or floor is the sum of the prices of the options that make up the cap or floor.
A special combination of caps and floors is called an interest rate collar. An interest rate collar is a combination of a long cap and a short floor or a short cap and a long floor. Consider a borrower in a floating rate loan who wants to hedge the risk of rising interest rates but is concerned about the requirement that this hedge must have a cash outlay up front: the option premium. A collar, which adds a short floor to a long cap, is a way of reducing and even eliminating the up-front cost of the cap. The sale of the floor brings in cash that reduces the cost of the cap. It is possible to set the exercise rates such that the price received for the sale of the floor precisely offsets the price paid for the cap, thereby completely eliminating the up-front cost. This transaction is sometimes called a zero-cost collar. The term is a bit misleading, however, and brings to mind the importance of noting the true cost of a collar. Although the cap allows the borrower to be paid from the call options when rates are high, the sale of the floor requires the borrower to pay the counterparty when rates are low. Thus, the cost of protection against rising rates is the loss of the advantage of falling rates. Caps, floors, and collars are popular instruments in the interest rate markets.
Although interest rate options are primarily written on such rates as LIBOR, Euribor, and Euroyen, the underlying can be any interest rate.

Options on bonds, usually called bond options, are primarily traded in the over-the-counter markets. Options exchanges have attempted to generate interest in options on bonds, but have not been very successful. Corporate bonds are not very actively traded; most are purchased and held to expiration. Government bonds, however, are very actively traded; nevertheless, options on them have not gained widespread acceptance on options exchanges. Options exchanges generate much of their trading volume from individual investors, who have far more interest in and understanding of stocks than bonds. Thus, bond options are found almost exclusively in the over-the-counter market and are almost always options on government bonds. Consider, for example, a U.S. Treasury bond maturing in 27 years. The bond has a coupon of 5.50 percent, a yield of 5.75 percent, and is selling for $0.9659 per $1 par. An over-the-counter options dealer might sell a put or call option on the bond with an exercise price of $0.98 per $1.00 par. The option could be European or American. Its expiration day must be significantly before the maturity date of the bond. Otherwise, as the bond approaches maturity, its price will move toward par, thereby removing much of the uncertainty in its price. The option could be specified to settle with actual delivery of the bond or with a cash settlement. The parties would also specify that the contract covered a given notional principal, expressed in terms of a face value of the underlying bond.
Continuing our example, let us assume that the contract covers $5 million face value of bonds and is cash settled. Suppose the buyer exercises a call option when the bond priceis at $0.995. Then the option is in-the-money by $0.995 – $0.98 = $0.015 per $1 par. The seller pays the buyer 0.015($5,000,000) = $75,000. If instead the contract called for delivery, the seller would deliver $5 million face value of bonds, which would be worth $5,000,000($0.995) = $4,975,000. The buyer would pay $5,000,000($0.98) = $4,900,000. Because the option is created in the over-the-counter market, the option buyer would assume the risk of the seller defaulting.
Even though bond options are not very widely traded, another type of related option is widely used, especially by corporations. This family of options is called interest rate options. These are quite different from the options we have previously discussed, because the underlying is not a particular financial instrument