Senior managers of organizations that successfully engage in structuring and trading derivative products are committed to and support derivative trading and structuring activities as an integrated component of their strategic business plans. Such support is provided with the knowledge that operational procedures exist to provide management with the requisite understanding and control over those aspects of derivative structuring, hedging, and trading in which the firm is involved. (See the sample management presentations in the Resource Guide.)
The following information includes brief descriptions of certain derivative risks, certain minimum standards of management oversight for officers, directors, and others in positions of authority, and regulatory proposals concerning derivative and structured product transactions. It is not intended as a substitute for legal advice concerning specific management oversight issues, transactions, regulatory, tax, risk management, or operational matters.
Key Risks in Derivatives and Structured Financial Products
The following broad categories of risk are involved in derivatives and structured products for issuers, dealers, and end users. While not unlike risks present in most financial instruments, the management of these risks presents unique challenges due principally to the customized nature of many derivative and structured financial products. It is these risks that boards of directors and senior managers must control in order to maintain effective derivatives and structured product programs.
Credit Risk. The risk of loss should a counterparty fail to perform pursuant to the terms of an agreement. The loss is the cost of replacement, which is usually equal to the present value of expected cash flows at the time of default or the notional value of outstanding positions.
Legal Risk. The risk of loss if an agreement is not enforceable due to insufficient documentation, lack of capacity, or unenforceability in bankruptcy or insolvency.
Liquidity Risk. The risk of loss from either the inability to unwind, offset, or hedge a particular transaction (or the inability to do so without adversely affecting the market price) or the inability to meet payment obligations or collateral requirements.
Market Risk. The risk of loss from an instrument resulting from adverse price movements or market conditions that should generally be viewed from the net or residual exposure of the entire portfolio.
Operational Risk. The risk of loss from deficient or inadequate systems, internal controls of management oversight, or other failures.
Legal Obligations of Officers and Directors
Directors and officers are obligated to refrain from using their positions for personal profit at the corporation's expense and to make well-informed decisions. The obligations of officers and directors can only be met through the exercise of personal judgment on a daily basis. These legal obligations of officers and directors fall into two broad categories: duty of care and duty of loyalty.
Recommendations For UseSelected Recommendations from the Group of Thirty's Report: Derivatives: Practices and Principles
Framework for Voluntary Oversight, Derivatives Policy Group (Group of Six Report)
Overview Of Proposed, Pending, and Existing Derivative Securities Studies, Recommendations, and Regulations
The complexity and proliferation of derivatives and structured financial
instruments have increased at a faster pace than the controversies surrounding
their use and alleged abuse. Inevitably the responsibilities of senior managers
and directors of organizations engaged in the origination and risk management
of structured financial instruments have increased. Their oversight is also the
subject of a great deal of scrutiny by regulators, shareholders, and courts of
turns the discussion toward the activities involved in structured
product creation, development, and marketing. It includes a review of how to
identify investor demand for new structured products; the idea generation and
structuring process; and the legal and regulatory review and registration
procedures that are necessary when engaging in the underwriting, syndicating,
and marketing of structured products.
Chapter 3 turns the discussion toward the activities involved in structured product creation, development, and marketing. It includes a review of how to identify investor demand for new structured products; the idea generation and structuring process; and the legal and regulatory review and registration procedures that are necessary when engaging in the underwriting, syndicating, and marketing of structured products.
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