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

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Market liquidity risk is the risk that an institution may not be able toexit or offset positions quickly, and in sufficient quantities, at a reasonableprice. This inability may be due to inadequate market depth in certainproducts (e.g. exotic derivatives, long-dated options), market disruption,or inability of the bank to access the market (e.g. credit down-gradingof the institution or of a major counterparty).Funding liquidity risk is the potential inability of the institution tomeet funding requirements, because of cash flow mismatches, at areasonable cost. Such funding requirements may arise from cash flowmismatches in swap books, exercise of options, and the implementationof dynamic hedging strategies.4.Operational risk is the risk of loss occurring as a result of inadequatesystems and control, deficiencies in information systems, human error, ormanagement failure. Derivatives activities can pose challenging operationalrisk issues because of the complexity of certain products and their continualevolution.5. LEGALLegal risk is the risk of loss arising from contracts which are not legallyenforceable (e.g. the counterparty does not have the power or authority toenter into a particular type of derivatives transaction) or documentedcorrectly.6.Regulatory risk is the risk of loss arising from failure to comply with regulatoryor legal requirements.7. REPUTATION RISKReputation risk is the risk of loss arising from adverse public opinion anddamage to reputation.Guideline on Risk Management of Derivatives and Other Traded Instruments
Annex BI. OR OFThis simply refers to the notional amount of the contract and is the mostbasic form of risk measurement. The main advantage of this measure is itssimplicity which allows net and gross positions to be computed easily andquickly. It is useful as one of the means for limiting business volume, andliquidity and settlement risks.However, the notional amount only provides an indication of the volume ofbusiness outstanding and bear little relation to the underlying risks of theexposure as it does not take account of cash flows, price sensitivity or pricevolatility. Also, for sophisticated institutions, the nominal measurement methoddoes not allow an accurate aggregation of risks across all instruments.Thismethod should not be used on a stand-alone basis.2.This is the product of the notional amount of the contract expressed inmillions and the remaining term of the contract expressed in number of months.For example, the month-million of an interest rate contract with an amount of$60 million and a remaining term of three months is calculated as follows:3 months x $60 million = $180 month-million.This method is commonly used by market participants for measuring exposurein interest rate products. It is simple in nature and is better than thenotional amount as it also takes account of the remaining maturity of thecontract which is a relevant factor in assessing the market risk of interestrate products. However, similar to the nominal measurement method, itdoes not take account of the underlying instrument's cash flow, price sensitivityor price volatility.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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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
Page 100 and 101: THE VARIANCE-COVARIANCE METHODThe t
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Page 122 and 123: ANDONOFINTRODUCTION1. The Monetary
Page 124 and 125: MANAGEMENT AND CORPORATE5. As the B
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Page 132 and 133: RISK MEASUREMENT25. Having identifi
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Page 136 and 137: 38. The measurement of the market r
Page 138 and 139: market, credit and liquidity risk o
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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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Page 152 and 153: Furthermore, contracts with the sam
Page 154 and 155: There are three main VAR approaches
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Page 158 and 159: Annex D1. NOTIONAL OR VOLUME LIMITS
Page 160 and 161: assumptions on which they are based
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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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