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

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20. Where the institution considers that a proposed derivatives transactionis inappropriate for a counterparty, it should inform the counterparty ofits opinion. If the counterparty nonetheless wishes to proceed, theinstitution should document its analysis and its discussions with thecounterparty in its files to lessen the chances of litigation in case thetransaction proves unprofitable to the counterparty. If the institutionconsiders that the counterparty may be financially incapable of meetingits obligations, or that undue reputation risk may arise from adversepublicity if the counterparty loses money, the institution should considervery carefully whether it should enter into the transaction at all.Institutions should exercise extra care in respect of complicatedderivatives transactions in view of the additional credit, reputation andlitigation risks to which they may give rise.21. It is important that the institution understands clearly the nature of itsrelationship with the counterparty and the obligations which may flowfrom that The issue of whether the transaction is an appropriate onefor the counterparty to undertake does not generally arise in respectof transactions where the institution acts on the instructions of theclient in the capacity of broker or agent. For transactions which theinstitution entered into on a principal-to-principal basis, it is recognizedthat the transaction is essentially on an arm's length basis and thatcounterparties are ultimately responsible for the transactions they chooseto make. However, as noted in paragraph 19 above, the MA considersthat internal policies and procedures are still required to guard againstthe credit risk that may arise from the counterparty's inadequateunderstanding of the nature and risks of the transaction and to protectthe institution against complaints or litigation on the ground ofmisrepresentation in respect of any information which it chooses toprovide to the counterparty. For transactions where an institution hasagreed to assume the role of an advisor, the institution needs to beaware that it owes the client a duty to tender its advice fully, accuratelyand properly.Guideline on Risk Management of Derivatives and Other Traded Instruments
22. Authorized institutions should also be aware that the degree of complexityof the transaction and the level of sophistication of the counterparty arefactors which a court may take into account in considering whether theinstitution has in practice assumed an advisory role in relation to thecounterparty (even if no explicit agreement to that effect has beenentered into). A wider duty of care may be allowed by the courts ina- case involving a highly sophisticated transaction and a relativelyunsophisticated counterparty. In those circumstances, there is a possibilitythat the courts may be more likely to accept evidence that an authorizedinstitution had assumed a responsibility to advise the counterparty onissues such as risk and suitability. It is also noted that where an institutionprovides information to enable its counterparties to understand thenature and risks of a transaction, it should:a) ensure that the information is accurate;b) ensure that information in any economic forecast is reasonable, basedon proper research and reasonable grounds; andc) present the downside and upside of the proposal in a fair andbalanced fashion.23. To guard against the possibility of misunderstandings, particularly withprivate banking customers, all significant communications between theinstitution and its customers should be in writing or recorded in meetingnotes. Where it is necessary for an account manager to speak to thecustomer by telephone, such conversations should be tape-recorded.24. Institutions should establish internal procedures for handling customerdisputes and complaints. They should be investigated thoroughly andhandled fairly and promptly. Senior management and the ComplianceDepartment/Officer should be informed of all customer disputes andcomplaints at a regular interval. Cases which are considered material,e.g. the amount involved is very substantial, should be reported to theboard and the MA.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
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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 128 and 129: 15. Branches of foreign banks which
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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