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

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RISK MEASUREMENT25. Having identified the various types of risk, the authorized institutionshould as far as possible attempt to measure and aggregate them acrossall the various trading and non-trading activities in which it is engaged.26. The risk of loss can be most directly quantified in relation to market riskand credit risk (though other risks may have an equally or even greateradverse impact on earnings or capital if not properly controlled). Thesetwo types of risks are clearly related since the extent to which a derivativescontract is "in the money" as a result of market price movements willdetermine the degree of credit risk. This illustrates the need for anintegrated approach to the risk management of derivatives. The methodsused to measure market and credit risk should be related to:a) the nature, scale and complexity of the derivatives operation;b) the capability of the data collection systems; andc) the ability of management to understand the nature, limitations andmeaning of the results produced by the measurement system.27. The MA has observed that the risk measurement methodologies of anumber of authorized institutions are relatively simple and unsophisticateddespite the fact that they are quite active market participants. In particular,the use of notional contract amounts to measure the size of market orcredit risk (and to set limits) is insufficient in itself and should beconfined to limited end-users (and even then only on a temporary basisuntil a more sophisticated risk measurement system has been devised).It should be noted however that although more sophisticatedmethodologies measure risk more accurately, they also introduce addedassumption and model risk. In particular, the assumption in u value-atrisk"models (see below) that changes in market risk factors (such asinterest rates) are normally distributed, may not hold good in practice.Guideline on Risk Management of Derivatives and Other Traded Instruments
Mark-to-market28. The measurement process starts with marking to market of positions.This is necessary to establish the current value of positions and torecord profits and losses in the bank's books. It is essential that therevaluation process is carried out by an independent risk control unitor by back office staff which are independent of the risk-takers in thefront office, and that the pricing factors used for revaluation are obtainedfrom a source which is independent of the front office or areindependently verified. A number of authorized institutions have notadopted this practice. (Ideally, the methodologies and assumptions usedby the front and back offices for valuing positions should be consistent,but if not there should be a means of reconciling differences.) For activedealers and active position-takers, positions should be marked to marketon a daily basis. Where appropriate, intra-day or real-time valuationshould be used for options and complex derivatives portfolios (this maybe performed by dealing room staff provided that the end-of-day positionsare subject to independent revaluations).29. To ensure that trading portfolios are not overvalued, active dealers andactive position-takers should value their trading portfolios based onmid-market prices less specific adjustments for expected future costssuch as close-out costs and funding costs. Limited end-users may usebid and offer prices, applying bid price for long positions and offer pricefor short positions.Measuring market risk30. The risk measurement system should attempt to assess the probabilityof future loss in derivative positions. In order to achieve this objective,the system should attempt to estimate:a) the sensitivity of the instruments in the portfolio to changes in themarket factors which affect their value (e.g. interest rates, exchangerates, equity prices, commodity prices and volatilities); andGuideline 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
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If the stock price of A continues t
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OF AN11In the previous two chapters
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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
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 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 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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