Derivatives in Plain Words by Frederic Lau, with a ... - HKU Libraries

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needs to take the necessary business risk. What is important to a bank isits ability to manage the risk and to measure risk and profit properly.Derivative in itself is only a tool either to manage risk or enhance earnings.Similar to home appliances, there should not be any problem to keep thefridge and washer at home so long as the former is used to keep the foodand the latter is used to wash the clothes — and not vice versa. Even forsimple tools like these, you are advised to test the machines, check thevoltage settings, fill out the warranty certificates, read the user manuals andask your children not to play with them improperly.What the regulators would do is to understand how banks in Hong Kongare using derivatives to manage their risks and to ensure that they are usingthe tools properly. In order for us to achieve the goal, the HKMA issuedthe guideline 12.2 in 1996 to all authorised institutions in Hong Kong,which is reprinted in the Appendix of this book. This guideline serves toestablish a risk management framework. The framework helps set a minimumstandard — we would like to stress the words "minimum standard" — forus to evaluate the adequacy and quality of the risk management system inplace. The document addresses four main areas.First and foremost, the Board of Directors and senior management mustfully understand the nature and risks involved in the institution's activities.It is their duty to establish risk management framework to identify, measure,control and report such risks.The next focus would be to look into the actual market risk and credit riskmanagement system in place. To evaluate the quality in these two areas, thelevel of risk, complexity and volume of derivative activities would always betaken into account. By this, it means that the risk management system ofa bank which is an active dealer in derivatives should be much moresophisticated than what one would expect from a bank which only usesderivatives for the purpose of asset/liability management.Managing Risks in Banks
Operational risk management is another area of concern - a vital area infact In the past, cases of colossal financial loss were reported, and themedia liked to attribute these losses to the trading of derivatives. In substance,the true villain in many of the cases was inadequate internal controls, lackof segregation of duties, improper procedures, human error, system failureor fraud.THE IMPORTANCE OF SENIOR MANAGEMENT'S INVOLVEMENTWhilst the management of market risk, credit risk and operational risk havebeen widely discussed in the industry, we would discuss more about seniormanagement oversight in the following section.Earnings, earnings per share to be more exact, is very important to a bank.Thus, it is not surprising that when senior management receive themanagement reports, the first thing, if not the only thing, they look at arethe profit and loss figures.However, there are at least two more basic issues which the senior executivesshould pay attention to. Is the profit generated from activities whichthey and the shareholders approve? Is the profit a real and normal one?These two seemingly easy questions are, in reality, great challenges to thesenior executives - especially when it comes to derivative activities.The first rule to successful risk management is for the Board of Directorsand senior management to realise that it is their duty to fully understand thenature and risks involved in the institution's activities, and to establish a riskmanagement framework to identify, measure, control and report such risks.In the previous chapters, we have only talked about market risk and creditrisk. However, real life is much more complicated and management needto oversee other types of risk which are difficult to quantify. Examples areregulatory risk, legal risk, liquidity risk, reputation risk and operational risk.The establishment of a set of comprehensively written policies and proceduresis always the starting point for high quality senior management oversight. InManaging Risks in Banks(Eft!
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THE UNIVERSITY OF HONG KONGLIBRARIE
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VI- . .7 « i8^p ! ««^^OOSHSlVCJ
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Ever since derivatives took centre-
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denominator, value at risk, which c
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the kind of information that superv
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This book is a team effort of the H
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While most market participants defi
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of this investment is 6.32 percent
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Mathematically, the relation betwee
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$10,000. (For simplification of pre
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Hong Kong does go up and the HSI ri
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3OF ATHEPRICING OF A FORWARD CONTRA
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COST OF CARRYIn the above example,
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interest rate swap rates. From thes
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Borrowers, on the other hand, usual
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Again we use our method of having t
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ates, the forward rate for the peri
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5In this chapter, we will discuss w
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often complain that there is too mu
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ABC also has three cash flows:1. It
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Assuming that there is no transacti
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simulation techniques and mathemati
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The calculation of credit risk proc
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The payments are exchanged every th
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the reference rate. When this type
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Effectively this is just a 2-year s
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This measure of duration is referre
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analysis, it also has its shortcomi
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Percentage change in price due to d
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8OFOptions are generally perceived
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OPTION'S PAYOFF PATTERNWhat about a
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Volatility is the most important fa
Page 66 and 67: fANDTrading options becomes more po
Page 68 and 69: You need to hold 7 shares of stock
Page 70 and 71: di = [ln(IOO/IOO) + (0.06 + O.P/2)
Page 72 and 73: is10In the previous chapter, we dis
Page 74 and 75: stock will go up in the near future
Page 76 and 77: If the stock price of A continues t
Page 78 and 79: OF AN11In the previous two chapters
Page 80 and 81: at-the-money option approaches its
Page 82 and 83: 12Mortgage-backed securities (MBS)
Page 84 and 85: NEGATIVE CONVEXITYFor MBS, there is
Page 86 and 87: MULTI-CLASSIn 1983, Freddie Mac int
Page 88 and 89: 13What is a hedge? According to the
Page 90 and 91: management to enter into swap and o
Page 92 and 93: transaction. For this criterion to
Page 94 and 95: CREDIT DEFAULT SWAPThe simplest for
Page 96 and 97: APPLICATION OF CREDIT DERIVATIVESYo
Page 98 and 99: in the US. Equally innovative, cred
Page 100 and 101: THE VARIANCE-COVARIANCE METHODThe t
Page 102 and 103: "cell" would have a cash flow expos
Page 104 and 105: Daily profit and loss ranked in asc
Page 106 and 107: of the market factor. Through this
Page 108 and 109: 3. Most value at risk models use hi
Page 110 and 111: 16ANDIn Chapter 5, we talked about
Page 112 and 113: price) of 9,000. For this transacti
Page 114 and 115: and the June 3-month futures rate i
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Page 120 and 121: The derivatives industry can be com
Page 122 and 123: ANDONOFINTRODUCTION1. The Monetary
Page 124 and 125: MANAGEMENT AND CORPORATE5. As the B
Page 126 and 127: ensure that there is sufficient awa
Page 128 and 129: 15. Branches of foreign banks which
Page 130 and 131: 20. Where the institution considers
Page 132 and 133: RISK MEASUREMENT25. Having identifi
Page 134 and 135: ) the tendency of the relevant mark
Page 136 and 137: 38. The measurement of the market r
Page 138 and 139: market, credit and liquidity risk o
Page 140 and 141: Consideration must be given to the
Page 142 and 143: 55. As noted earlier, the market or
Page 144 and 145: changes in portfolio value;d) the r
Page 146 and 147: 66. A basic and essential safeguard
Page 148 and 149: 73. It is essential that the intern
Page 150 and 151: Market liquidity risk is the risk t
Page 152 and 153: Furthermore, contracts with the sam
Page 154 and 155: There are three main VAR approaches
Page 156 and 157: Options risk should be captured; ri
Page 158 and 159: Annex D1. NOTIONAL OR VOLUME LIMITS
Page 160 and 161: assumptions on which they are based
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addition and deletion of operators,
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• Profits and losses resulting fr
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This book is due for return or rene
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