The Present Value

ISDA highlights a selection of research papers on derivatives and risk management         


Risk Appetite and Intermediation by Swap Dealers

Commodity Futures Trading Commission Research Papers
By Scott Mixon and Esen Onur

This study examines the behavior of swap dealers, and demonstrates that dealer risk appetite affects the real economy through dealer hedging activity.

The analysis covers the West Texas Intermediate (WTI) crude oil derivatives market during the period between 2007 and 2015. It is based on futures and swap positions data, which was aggregated across a broad sample of large dealers in WTI-related swaps.

Dealers provide customized swap contracts to real-economy firms that want to hedge their exposure. Subsequently, the dealers imperfectly hedge their risks because they use standard, liquid instruments to hedge bespoke contracts.

The majority of dealer hedging activity in futures is in near-dated contracts when hedging commodity index exposures, although hedging activity for single commodity swaps in WTI is more dispersed across the term structure. Most of the dealer activity in futures appears to take place in nearby, liquid contracts, supporting the idea that dealers face basis risk in hedging.

The authors present evidence that dealers hedge swap exposures more tightly (ie, take on less basis risk) when balance sheet constraints are tighter (ie, risk appetite is lower). The study concludes that dealers’ propensity to provide swap exposure and the amount of hedging executed by real-economy firms is strongly related to dealers’ risk appetite.

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Our Lessons Have Returned: Insights into Post-crisis Financial Regulation from Mandatory OTC Derivatives Clearing Policy

LSE Legal Studies Working Paper No. 6/2020
By David Murphy

This paper uses mandatory clearing of over-the-counter (OTC) derivatives as a case study of the review of post-crisis regulation. When OTC derivatives regulations were designed immediately after the financial crisis, information on their likely impact was difficult to obtain and was often of poor quality. As more information is currently available, regulatory review and revision can be better informed by this data.

The report highlights a number of questions that any regulatory review should address, including: the goal of the regulation; its proportionality; whether alternative policies could meet the same goal with lower cost, higher benefit, more certainty and/or fewer side effects; and the calibration of the policy.

In the case of mandatory clearing of OTC derivatives, some suggestions for the redesign and potential improvements of the policy include: rephrasing the threshold for mandatory clearing in terms of risk (ie, initial margin) rather than notional amount; setting the threshold so it only captures clients that pose a plausible risk to financial stability; and considering whether very large end users should be direct members of central counterparties rather than accessing them as clients.

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Derivatives Use and its Consequences for Management Earnings Forecasts

By John L. Campbell, Sean S. Cao, Hye Sun Chang and Raluca Chiorean

This study examines the relationship between firms’ use of derivatives to hedge risk and the frequency of management earnings forecasts and how informative they are. The analysis is based on a sample of 21,880 observations from derivatives users and non-users.

The authors find that derivatives users provide more earnings guidance than non-users. As firms initiate derivatives programs, the frequency of management earnings forecasts increases. However, the increase only occurs when managers use derivatives to reduce the volatility of earnings and managers have less pronounced personal disclosure costs.

Effective hedging using derivatives should reduce the future volatility of a firm’s performance. This makes it easier to predict earnings, as well as meet or beat predicted earnings, and it lowers managers’ costs of making forecast disclosures. However, ineffective or speculative derivatives use increases the uncertainty of future performance, increasing managers’ disclosure costs.

The study also points out that managerial costs in the form of career concerns affects the association between derivatives use and the frequency of management earnings forecasts.
When making earnings forecasts, managers face significant personal costs associated with disclosure. Managers with high career concerns (ie, young CEOs and those with short tenure) increase earnings forecast frequency only when derivatives use makes it easier to forecast future earnings.

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