RISK MANAGEMENT IN DERIVATIVES MARKET

Abstract

The use of financial derivatives requires special expertise, experience and rigorous controls. Critical management system be in place commensurate with each institution's use of derivative products. derivatives should not be executed without the proper system and internal controls necessary to monitor and analyze the performance of the instruments. An institution needs to ensure that the rewards associated with derivatives are commensurate with the risk being taken and that these risks are understood by the board of directors and senior management. This does not mean simply enumerating an endless list of theoretical possibilities, but quantifying risks so that the trivial and the significant are appropriately considered. In order to do this, there must exist real incentives that come form quantifying risks, tying these measures to compensation and business unit evaluation, and proper accountability. It is imperative that management understand what they are attempting to accomplish in making use of the various derivative products in the marketplace. when used properly, derivative products can become effective tools in managing business risks. In the marketplace, derivatives can be used to expand product offering to customers, manage capital and funding costs, and alter the risk-reward profile of a particular item or an entire balance sheet. Most importantly, derivative transactions offer the opportunity for financial institutions to reduce risks in the marketplace. An optimal risk management process works more at getting relevant risks on the radar screen than measuring what already appears on the radar screen more precisely. Derivatives have become an integral part of the financial markets because they can serve several economic functions. The counterparty must be an investment grade credit and the agreement must be marked to market no less frequently than monthly.