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

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the kind of information that supervisors should seek from their institutions.The HKMA will take account of this framework in further developing thereporting regime in Hong Kong.Second, banks and securities companies are being encouraged to expand theamount of public disclosure which they make about their overall involvementin the derivatives market and trading, the impact of these activities onprofitability and their performance in managing the risks. If provided withmeaningful information, the market should be able to exert its own disciplineon institutions to manage their derivatives business in a prudent fashion. Ifso, this should complement the efforts of the supervisors. In Hong Kong,the information published by banks in their annual reports about theirinvolvement in derivatives and trading activities has increased greatly inrecent years. This policy of more transparency will continue.Third, central banks are trying to obtain more statistics about activity inglobal derivatives markets so that they can better monitor the macroeconomicas well as the prudential aspects of this business. Hong Kong is participatingin this exercise.About this bookAs part of our efforts to raise the level of awareness of our staff onderivatives and to keep abreast of market developments, Mr Frederic Lau,the leader of the HKMA Derivatives Team started to write a series ofarticles on the subject. Other past and present members of the Team,Dr Chau Ka-lok, Dr Hui Cho-hoi, Mr Cedric Wong, Mr Henry Cheng andMr Adrian Pang, also contributed to the series. The articles, circulatedwithin the HKMA, were intended to augment the various seminars andtraining programmes on derivatives organised in-house or by outsideorganisations for banking supervisory staff.We believe the series have grown to such a size that it is worth publishingthem in the form of a book to make them accessible to a larger audience.Preface
There is no shortage of books on derivatives available in bookstores. Thisbook is not intended for traders or market professionals or academics whowish to acquire advanced knowledge of derivatives. Rather, it is what itstitle suggests — a guide to derivatives in plain words intended for a wideaudience of non-experts. The book focuses on the underlying concepts ofderivatives, the nature and risks of different derivatives products and theappropriate risk measurement and management techniques. Also coveredare new market developments such as credit derivatives.I hope that this book will help to demystify derivatives and contribute tothe healthy growth of the market in Hong Kong.David CarseDeputy Chief ExecutiveHong Kong Monetary AuthorityPreface
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 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
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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
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12Mortgage-backed securities (MBS)
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NEGATIVE CONVEXITYFor MBS, there is
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MULTI-CLASSIn 1983, Freddie Mac int
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13What is a hedge? According to the
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management to enter into swap and o
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transaction. For this criterion to
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CREDIT DEFAULT SWAPThe simplest for
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APPLICATION OF CREDIT DERIVATIVESYo
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in the US. Equally innovative, cred
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THE VARIANCE-COVARIANCE METHODThe t
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"cell" would have a cash flow expos
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Daily profit and loss ranked in asc
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of the market factor. Through this
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3. Most value at risk models use hi
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16ANDIn Chapter 5, we talked about
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price) of 9,000. For this transacti
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and the June 3-month futures rate i
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needs to take the necessary busines
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ief, the policies and procedures sh
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The derivatives industry can be com
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ANDONOFINTRODUCTION1. The Monetary
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MANAGEMENT AND CORPORATE5. As the B
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ensure that there is sufficient awa
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15. Branches of foreign banks which
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20. Where the institution considers
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RISK MEASUREMENT25. Having identifi
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) the tendency of the relevant mark
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38. The measurement of the market r
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market, credit and liquidity risk o
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Consideration must be given to the
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55. As noted earlier, the market or
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changes in portfolio value;d) the r
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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
Page 170 and 171:
This book is due for return or rene
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