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

More documents

Recommendations

Info

transaction. For this criterion to be met, at the inception of thehedge and throughout the hedge period, high correlation of changesin (a) the market value of the hedging instrument and (b) the fair valueof, or interest income or expense associated with, the hedged itemshall be probable so that the result of the hedging instrument willsubstantially offset the effects of price and interest rate changes on theexposed item. However, the accounting standard falls short of sayingwhat "high correlation" is. The "hedge" in our example does not meetthis criterion because when interest rates rise, the values of both thehedging instrument and the instrument being hedged decrease.For a transaction qualified as a hedge, the recognition of a change in thehedging instrument's market value is not required until the reporting periodin which the change in market value of the hedged item is ultimatelyrecognised. This accounting treatment allows the delay of recognition ofprofits and losses for instruments designated as hedge, and opens the doorfor abuses by companies which want to hide their derivatives losses. Becausethe traditional accounting standards are incomplete, it is difficult to policeabuses. On the other hand, it is not that difficult to find some correlationbetween two items in a multi-billion dollar assets and liabilities portfoliosand call them a hedge, even though the so called "hedge" may not make anysense to the institution's existing asset/liability structure.Several international accounting bodies, including the Hong Kong Society ofAccountants, are currently addressing this issue. Until the new standardsbecome effective, policing accounting abuses in derivatives transactionsremains a difficult job.Hedging with Derivatives
14One of the most popular topics in the derivatives and risk management circlethese days is credit derivatives. This latest financial innovation may havetremendous impact on how banks and financial institutions operate in the future.The most important characteristic of derivatives is its ability of "bundling"or "unbundling" risk and return. For example, buying an index futurescontract means participating in the ups or downs of all the underlyingstocks in the index. On the other hand, a pool of mortgage loans can be"unbundled" into several different tranches of mortgage-backed securitiesor collateral mortgage obligations (CMO) and sold to different types ofinvestors who have different risk and return requirements. Credit derivativesare under the concept of "unbundling".The return on any financial instrument depends on the risk level of thefinancial instrument. Many financial instruments have more than one typeof risk. For example, a corporate bond has its credit, interest rate andliquidity risk components, and may even have additional tax and legal riskcomponents. An investor may find that a particular corporate bond issuitable for his risk/return requirement except for the credit risk. In thepast, he might just forget about buying that bond because there was no wayfor him to get rid of the credit risk component of this investment. Withcredit derivatives, he can now buy this bond and "unbundle" away thespecific credit risk of the subject company.There are three common forms of credit derivatives, namely, credit defaultswap, credit linked note and total return swap.Credit Derivatives
Page 2 and 3:
THE UNIVERSITY OF HONG KONGLIBRARIE
Page 4 and 5:
VI- . .7 « i8^p ! ««^^OOSHSlVCJ
Page 6 and 7:
Ever since derivatives took centre-
Page 8 and 9:
denominator, value at risk, which c
Page 10 and 11:
the kind of information that superv
Page 12 and 13:
This book is a team effort of the H
Page 14 and 15:
While most market participants defi
Page 16 and 17:
of this investment is 6.32 percent
Page 18 and 19:
Mathematically, the relation betwee
Page 20 and 21:
$10,000. (For simplification of pre
Page 22 and 23:
Hong Kong does go up and the HSI ri
Page 24 and 25:
3OF ATHEPRICING OF A FORWARD CONTRA
Page 26 and 27:
COST OF CARRYIn the above example,
Page 28 and 29:
interest rate swap rates. From thes
Page 30 and 31:
Borrowers, on the other hand, usual
Page 32 and 33:
Again we use our method of having t
Page 34 and 35:
ates, the forward rate for the peri
Page 36 and 37:
5In this chapter, we will discuss w
Page 38 and 39:
often complain that there is too mu
Page 40 and 41:
ABC also has three cash flows:1. It
Page 42 and 43: Assuming that there is no transacti
Page 44 and 45: simulation techniques and mathemati
Page 46 and 47: The calculation of credit risk proc
Page 48 and 49: The payments are exchanged every th
Page 50 and 51: the reference rate. When this type
Page 52 and 53: Effectively this is just a 2-year s
Page 54 and 55: This measure of duration is referre
Page 56 and 57: analysis, it also has its shortcomi
Page 58 and 59: Percentage change in price due to d
Page 60 and 61: 8OFOptions are generally perceived
Page 62 and 63: OPTION'S PAYOFF PATTERNWhat about a
Page 64 and 65: 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 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 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
show all

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

Create successful ePaper yourself

Delete template?

Save as template?