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

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in the US. Equally innovative, credit derivatives are poised for further growthSeveral years down the road, it will not be surprising to see a bank sellingsome or even most of its credit exposures in its asset portfolio and managingmainly the price risk component of these assets. It probably makes sensefor some banks to adopt this strategy because it is easier to manage pricerisk than credit risk. Although this strategy reduces the yield of these assets,it can increase the volume of lending activities to compensate for the yieldreduction. This is because this strategy may free up some of the bank'sregulatory capital relating to credit risk.Credit Derivatives
15ATIn the very first chapter of this book, we touched on the concept of value atrisk.Several years ago, the concept of value at risk was still relatively new. Sincethen, it has gained a lot of publicity on both the market and the regulatoryfronts.From the participants' point of view, value at risk is an extremely useful toolfor measuring market risk. It summarises the market risk exposure of allfinancial instruments in a bank's trading portfolio into a single number.Nowadays, if a dealer bank is not using value at risk or other similarmethodologies to measure market risk for its trading activities, it will beperceived to be lagging behind the best practice standard.The regulators also consider value at risk a useful tool in measuring marketrisk. The Basle Committee has issued an amendment to the 1988 CapitalAccord to incorporate market risk in which value at risk is an acceptableand preferred method for determining the required capital level for a bank'strading risk.In the first chapter, we defined value at risk as "the expected loss from anadverse market movement with a specified probability over a period oftime". We also made a simple illustration to demonstrate the concept ofvalue at risk. Although the concept of value at risk is quite simple and easyto understand, the implementation of value at risk is not an easy job. In thischapter, we will introduce some of the most commonly used value at riskapproaches and discuss the advantages and shortcomings of using value atrisk.Value at Risk
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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
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 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 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
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73. It is essential that the intern
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Market liquidity risk is the risk t
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Furthermore, contracts with the sam
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There are three main VAR approaches
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Options risk should be captured; ri
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Annex D1. NOTIONAL OR VOLUME LIMITS
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assumptions on which they are based
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* There should be a unit independen
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- the customer had specifically req
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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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