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What is the point, for a bank, of engaging in derivatives trading to cover risk if the intent is to reduce "net exposure" to zero, or as close thereto as possible? If the best case scenario is that you come out with zero gained, zero lost, why do this if there is no desire to make a profit? Doesn't all effort to profit involve some risk? If you write risk out of a transaction, thus have no expectation of profit, then why go to all the trouble? And, in any case, there is always some risk that a counter party might be unable to pay, despite putting up collateral. Sorry if this question is stupid, but I'd really like to understand this.

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The main roles of banks are taking deposits, transmitting and changing money, making loans, and perhaps more generally providing liquidity for their customers.

So if a customer wants to change yen for dollars, the bank does not consider whether its buying yen would be a good medium-term investment for the bank. Instead it considers whether it can sell the yen back to dollars in the short-term at a better price either to other customers or in the wholesale market. It sets the price (and any fees) to the original customer so that it can expect to make a margin on the overall transaction, at little or no risk to the bank.

Similarly with taking deposits and making loans, the profit for the bank is in the margin between the two interest rates (allowing for credit defaults), and the bank earns this because it is cheaper and more convenient for the customers than trying to act without the bank as an intermediary. And if a customer wants to buy or sell bonds immediately, the bank acts as a dealer with the aim of re-selling those bonds to or buying them from somebody else at another time with a profit from the margin rather than from possible future changes in value.

With derivatives, if say a customer wants to buy a call option, then the bank may write one, not with the aim of taking the full premium and hoping things turn out right but with the aim buying another or of other balancing transactions (e.g. a put and the underlying security) and taking a margin based on providing the customer with an immediate contract in what otherwise may be an illiquid market.

The best case for the bank is that it profits from being an intermediary in these transactions, not as a speculator taking a view on how markets will move. If it gets into an unbalanced position overall, the bank will want to hedge its position to reduce risk, as this makes it more likely that the bank will survive to make profits in the future.

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  • $\begingroup$ Excellent answer: could you please also add some remarks about the willingness to bear a particular type of risk, leading to hedging on those risks where there is non-willingness. $\endgroup$ – Gspia Oct 3 '16 at 15:02

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