Increased Availability of Financial Risk Management Products

Another technical development that was to lead to the modern approach to financial risk management was the introduction in the US by the Chicago Board Options Exchange (CBOE) of exchange-traded options on common stocks (or ordinary shares, as they are known in the UK). At the same time the Chicago Mercantile Exchange (CME) started trading financial futures contracts on both currencies and interest rates. While over-the-counter options and forward contracts had long existed, they had many disadvantages; exchange-traded instruments promised much greater liquidity, since the risk of default by one of the parties to a transaction was negligible. Because of the methods used to manage trading on these exchanges, these markets are open to all parties, with both firms and individuals able to transact. In addition, exchanges, with their large number of competing bids and offers, established robust trading mechanisms. Equally, immediate price dissemination provides transparent and efficient pricing.*

An unrelated but equally important development that was occurring at the same time was the seminal work by Fisher Black and Myron Scholes (1972) on providing a model for option pricing.† Their work and that of others in this area has provided practitioners with accurate analytical models for pricing complex, probabilistic products.

The combination of increased market volatility and the availability of financial instruments for hedging purposes (latterly called derivatives) has led to the development of modern financial risk management techniques. A related development has been the proliferation of new financial instruments, many incorporating one, or more than one, derivative to alter the pattern of the return offered. The longestablished instruments, namely traditional bonds and ordinary shares, have some drawbacks, and structured products, as these new instruments are called, aim to address these. Some of the new structured securities have been ‘seven-day wonders’; others have created new possibilities for asset and liability managers. The process of building new financial instruments continues, although there is some evidence that the spurt in financial innovation that took place in the 1970s and particularly the 1980s has abated somewhat.§ Nevertheless, securities that have special features can be an important way to manage certain risks. Even governments recognise this. For instance, while the UK has had inflation-protected government bonds for a long time, the US has not. Yet in the late 1990s the US introduced similar securities, and other countries, such as France, have also in recent years begun to issue similar securities. Other securities offer exposure or protection to currencies, commodities and even equities.

As a consequence of the increased volatility and uncertainty, industrial and commercial firms have responded to the increased financial risks by seeking better methods to manage their risks. At the same time, reacting to the increased demand for risk management instruments, financial intermediaries have sought better ways of helping their clients to reduce or eliminate such risks. It is an ongoing dynamic and interactive process where participants’ understanding of risk has led to the evolution of new, more specific hedging methods. Over time, increased technical expertise and experience have allowed financial engineers to more fully understand these risks and develop ways of breaking them down into their constituent parts. Complex exposures can then be reassembled with the undesirable or unacceptable elements removed. As mentioned earlier, airlines face a range of risks in their business: fuel prices, interest rates, currency movements, passenger load factors and political events. Some or all of these risks need to be managed. In response, financial intermediaries put together special hedge programmes, such as jet fuel swaps or currency swaps, to provide tailor-made solutions to these and other uncertainties.

New Developments in Technology

In the mid-1960s, International Business Machines (IBM) introduced its 360 series of computers, heralding increased computing power and greater ease of use. Many data-processing tasks that hitherto had to be handled manually were now automated. In 2001, Microsoft, along with computer manufacturers and other software firms, celebrated the twenty-fifth anniversary of the introduction of the PC. New developments in information technology (IT) have occurred hand in hand with the need for more extensive risk management activity. Many of the developments in financial methodology are dependent on the availability of cheap and fast processing power. Pricing many kinds of derivatives requires the high-speed ability of computers to crunch the numbers. This applies to virtually all aspects of financial intermediaries’ ability to deliver risk management products. Even an established financial derivative like a foreign exchange forward contract cannot be managed without the support of IT systems. More exotic derivatives require computers to perform iterative simulation or optimisation in deriving a price or the instrument’s risk characteristics. A side product to the availability of IT systems has been the collection of enormous quantities of financial data with which to test the new instruments and develop quantified risk estimates for the sources of risk.