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

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38. The measurement of the market risk in options involves specialconsiderations because of their non-linear price characteristics. Thismeans that the price of an option does not necessarily move in aproportionate relationship with that of the underlying instrument,principally because of gamma and volatility risk. (A description of theserisks and the other risks in options is given in Annex D.) Measurementof risk exposure of an options portfolio may therefore require the useof simulation techniques to calculate, for example, changes in the valueof the options portfolio for various combinations of changes in theprices of the underlying instruments and changes in volatility. The riskexposure would be calculated from that combination of price and volatilitychange that produced the largest loss in the portfolio. Other moreelaborate simulation techniques may be used. In general, given theadditional complexity of risk measurement and management of options,the MA would expect active trading in options to be confined to themore sophisticated authorized institutions.Measuring credit risk39. The credit risks of derivatives products have two components: presettlementrisk and settlement risk. They should be monitored andmanaged separately. A number of authorized institutions have not donethis in respect of settlement risk.40. Pre-settlement risk is the risk of loss due to a counterparty defaultingon a contract during the life of a transaction. It varies throughout thelife of the contract and the extent of loss will only be known at the timeof default. To measure pre-settlement risk, authorized institutions shouldnot rely solely on the notional amounts of derivatives contracts whichprovide only an indication of the volume of business outstanding andbear little relation to the underlying risk of the exposure. That risk isconditional on the counterparty defaulting and the contract having positivemark-to-market value to the institution at the time of default. However,Guideline on Risk Management of Derivatives and Other Traded Instruments
even contracts which presently have a zero or negative mark-to-marketvalue to the institution (and where there is thus no current loss exposure)have potential credit risk because the value of the contract can becomepositive at any time prior to maturity as a result of market movements.41. All authorized institutions are encouraged to calculate pre-settlementrisk by summing the current exposure of a contract (i.e. the mark-tomarketvalue, if positive) and an estimate of the potential change in valueover the remaining life of the contract (the "add-on"). Where legallyenforceable netting agreements are in place, the current exposure for agiven counterparty may be calculated by netting contracts with thatcounterparty which have negative mark-to-market value against thosewhich have positive value. The Guideline on Amendment to the 1988Capital Accord for Bilateral Netting issued by the MA in February 1995sets out the conditions under which the MA will be prepared to recognizenetting arrangements for capital adequacy purposes.42. Active dealers and active position-takers may use their own simulationtechniques to measure potential future exposure, or else may use theadd-ons specified by the Basle Committee for capital adequacy purposes.A less sophisticated approach is to measure the total pre-settlementrisk by multiplying the notional amount of the contract by percentagefactors which depend on the numbers of years of the contract (the"original exposure" method). This method is not recommended forauthorized institutions.43. Settlement risk arises where securities or cash are exchanged and canamount to the full value of the amounts exchanged. In general, the timeframefor this risk is quite short and arises only where there is nodelivery against payment.LIMITS44. A comprehensive set of limits should be put in place to control theGuideline 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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at-the-money option approaches its
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12Mortgage-backed securities (MBS)
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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 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 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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