Managing financial risk A London International Financial Futures and Options Exchange case study
Page 1: Introduction
There is an element of risk in an activity when the outcome cannot be predicted with any certainty, or when the outcome is known but its full consequences are not. As individuals we have widely different attitudes to taking risks. For example, it is possible to identify three different positions.
The risk lover - Someone who enjoys a gamble, even when mathematical analysis shows that the odds are unfavourable.
The risk-neutral person - Will gamble only if the odds on a gain are favourable. The person will not be concerned with the range of possible outcomes, only with the odds being in their favour.
The risk-averse person - Will gamble only if the odds are strongly favourable.
Organisations also take risks. Some are prepared to take large risks and stand or fall by their ability to choose the right outcome - many of them fail. More typical organisations will take calculated risks. For example, insurance companies calculate insurance premiums on the basis of detailed statistical tables.
Financial institutions have to be very careful because they are dealing with funds which have been entrusted to them for safe keeping. For example, customers who deposit money in a bank account would be horrified if they found that a large proportion of this money was being used for speculative purposes. Generally speaking, therefore, financial institutions lean towards the risk-averse position.
Focusing on the way that Building Societies reduce their risk
This case study focuses on the way in which a particular type of financial institution, Building Societies, are able to reduce their financial risks today by using the London International Financial Futures and Options Exchange (LIFFE).
LIFFE carries out a range of financial activities and is Europe’s leading futures and options exchange and the third largest exchange of its type in the world. LIFFE opened for trading in 1982 and in each successive year its business has gone from strength to strength. Its principal function is to enable organisations and individuals to reduce their risks to either interest rates or share prices. This form of activity is known as hedging. LIFFE has over 200 member firms, over 70% of which are foreign-owned and include most of the world’s leading financial institutions.
Using the case of Building Societies will give a good understanding of the general principles involved in reducing risks through LIFFE. In this way, the Building Societies were able to operate comfortably for many years. Interest rates tended to move up and down during this period. However, this did not present a problem for Building Societies. They simply charged variable interest rates to borrowers and offered variable rates to depositors. They made sure that the interest rate charged to borrowers was always higher than that paid out to depositors.
London International Financial Futures and Options Exchange | Managing financial risk