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

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ensure that there is sufficient awareness of the risks and the size of exposureof the trading activities conducted in overseas operations.The local countrymanager also needs to have sufficient understanding of the business in histerritory and the formal authority to ensure that proper standards ofcontrol are applied (including segregation of duties between the front andback offices). This is also necessary so that he can communicate effectivelywith the local regulators. In the case of Hong Kong, the chief executive ofthe local branch of a foreign bank is fully accountable to the MA for theconduct of all the business conducted by the branch in Hong Kong, evenif he is not functionally responsible for certain parts of the business.BOARD AND SENIOR HANAGEMENT OVERSIGHT12. Consistent with its general responsibility for corporate governance, theboard should approve written policies which define the overall frameworkwithin which derivatives activities should be conducted and the riskscontrolled. The MA's observations over the last year are that acomprehensive set of such policies have been lacking in some institutions.This should be rectified if it has not already been done.13. The policy framework for derivatives approved by the board may begeneral in nature (with the detail to be filled in by senior management).But the framework should, among other things:a) establish the institution's overall appetite for taking risk and ensurethat it is consistent with its strategic objectives, capital strength andmanagement capability. (Appetite for risk can be expressed in termsof the amount of earnings or capital which the institution is preparedto put at risk, and the degree of fluctuation in earnings, e.g. fromposition-taking, which it is willing to accept);b) towards this end, define the approved derivatives products and theauthorized derivatives activities, e.g. market-making, position-taking,arbitrage, hedging. (The nature of such exposure should be carefullydefined to ensure, for example, that activities described as arbitragedo not in practice involve the taking of outright positions);Guideline on Risk Management of Derivatives and Other Traded Instruments
c) detail requirements for the evaluation and approval of new productsor activities. (This requires the board to approve the definition ofwhat is meant by a "new" product, e.g. a change in the underlyinginstrument and hence in the risk, or a change in the capacity inwhich the institution trades the product, e.g. as dealer or end-user);d) provide for sufficient staff resources and other resources to enablethe approved derivatives activities to be conducted in a prudentmanner;e) ensure appropriate structure and staffing for the key risk controlfunctions, including internal audit;f) establish management responsibilities;g) identify the various types of risk faced by the institution and establisha clear and comprehensive set of limits to control these;h) establish risk measurement methodologies which are consistent withthe nature and scale of the derivatives activities;i) require stress testing of positions; andj) detail the type and frequency of reports which are to be made tothe board (or committees of the board).14. The type of reports to be received by the board should include thosewhich indicate the levels of risk being undertaken by the institution, thedegree of compliance with policies, procedures and limits, and the financialperformance of the various derivatives and trading activities. Internaland external audit reports should be reviewed by a board level AuditCommittee and significant issues of concern should be drawn to theattention of the board. More detailed information should be suppliedto senior management, including that which splits risk exposure, positionsand profitability by regions, business units and products and which analysesexposure to the various market variables (interest rates, exchange ratesetc.).Guideline on Risk Management of Derivatives and Other Traded Instruments
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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
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fANDTrading options becomes more po
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You need to hold 7 shares of stock
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di = [ln(IOO/IOO) + (0.06 + O.P/2)
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is10In the previous chapter, we dis
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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
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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
Page 116 and 117: needs to take the necessary busines
Page 118 and 119: ief, the policies and procedures sh
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 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
Page 162 and 163: * There should be a unit independen
Page 164 and 165: - the customer had specifically req
Page 166 and 167: addition and deletion of operators,
Page 168 and 169: • Profits and losses resulting fr
Page 170 and 171: This book is due for return or rene
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