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15. Branches of foreign banks which trade in derivatives in Hong Kongshould operate within policies and procedures which are approved byhead office and which are consistent with those approved by the boardfor the bank as a whole. Regular reports on risk exposure, positionsand profitability should be submitted to head office.THE IDENTIFICATION OF16. Institutions should identify the various types of risk to which they areexposed in their derivatives activities. As set out in the December 1994Guideline, the main types of risk are:• credit risk• market risk• liquidity risk• operational risk• legal riskDefinitions of these are set out in Annex A.17. Operational risk, involving the risk of loss from inadequate systems ofcontrol, was a key feature of the Barings and Daiwa Bank cases. TheDaiwa Bank case also demonstrated how an initial loss arising fromfailure of controls can be compounded by regulatory r/sk, i.e. the risk ofloss arising from failure to comply with regulatory or legal requirements,and reputation risk, i.e. the risk of loss arising from adverse public opinionand damage to reputation. In this context, institution should promptlyinform the MA of any fraud or trading malpractices by staff, particularlythose which could result in financial or reputational loss by the institutionconcerned.Reputation risk and appraisal of counterparties18. The complexity of some derivatives products and the amount of leverageinvolved (which increases the potential for loss as well as profit) mayexpose authorized institutions to an additional element of reputationGuideline on Risk Management of Derivatives and Other Traded Instruments
isk if counterparties who have lost money on derivatives contractscomplain publicly that they were misled about the risks or take legalaction. The authorized institution may also be exposed to credit risk ifthe counterparty fails to meet his financial obligations under the contract.This risk can arise in respect of both corporate and personal customers(particularly in the private banking area). The MA has come across anumber of the latter cases in 1995.19. For the institution's own protection, the board should approve clearwritten policies to address the issues of selection and appraisal ofcounterparties, risk disclosure and handling of disputes and complaints.Such policies and procedures were lacking in a number of authorizedinstitutions whose controls were reviewed in 1995. The objective ofsuch policies and procedures is prudential in nature : to protect anauthorized institution against the credit, reputation and litigation risks thatmay arise from a counterparty's inadequate understanding of the natureand risks of the derivatives transaction. Such counterparties may notfully understand their obligations under the derivatives contracts andtherefore may be unable to anticipate and plan for the risks these obligationsentail. This gives rise to a higher than normal risk of default and agreater potential for litigation and damage to the authorized institution'sreputation. As in the case of an ordinary credit facility, the MA expectsthat, as part of its credit analysis, an authorized institution will :a) analyze the expected impact of the proposed derivatives transactionon the counterparty;b) identify whether the proposed transaction is consistent with thecounterparty's policies and procedures with respect to derivativestransactions, as they are known to the institution; andc) ensure that the terms of the contract are clear and assess whetherthe counterparty is capable of understanding the terms of the contractand of fulfilling its obligations under the contract.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
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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 126 and 127: ensure that there is sufficient awa
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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