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

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Furthermore, contracts with the same month-million may have significantlydifferent risk exposures. For example, an interest rate contract with anamount of $60 million and a remaining term of three months (3 months x$60 million = $180 month-million) has the same month-million of anotherinterest rate instrument with an amount of $3 million and a remaining termof five years (60 months x $3 million = $180 month-million). Althoughthese two instruments have the same month-million, their risk profiles (shorttermvs long term) are quite different and should be managed differently.This method should not therefore be used on a stand-alone basis by activederivatives participants.3. DURATIONDuration is a measure of the sensitivity of the present value or price of afinancial instrument to a change in interest rates. Conceptually, duration isthe average time to the receipt of cash flows weighted by the present valueof each of the cash flows in the series. This measurement technique calculatesprice sensitivities across different instruments and converts them to acommon denominator. Duration analysis can estimate the impact of interestrate changes on the present value of the cash flows generated by a financialinstitution's portfolio. For example, if the modified duration (duration dividedby I + yield) of a security is 5, the price of the security will decrease by5 percent approximately, if the related yield increases by one percent.The Price Value Basis Point (PVBP) measurement is a common applicationof the duration concept. This methodology assesses the change in presentvalue of a financial instrument or a portfolio of instruments due to a onebasis point change in interest rates. PVBP is calculated by multiplying theprice of the instrument by its modified duration and then by a factor of0.0001. For example, a one basis point increase in yield would decrease theprice of a bond with a modified duration of 5 from 100 to 99.95. PVBP isa useful tool for sensitivity analysis of a position or a portfolio. It alsoprovides a quick tool for traders to evaluate their profit and loss due to abasis point movement in interest rates.Guideline on Risk Management of Derivatives and Other Traded Instruments
However, the duration method also has certain limitations. Duration methodsfocus on sensitivity analysis but not probability analysis. They do not tellhow the value of a security or a portfolio of securities would be likely tochange based on past experience. Also, for large rate movements (by morethan one percent), duration tends to provide inaccurate results as the truerelationship between a change in price and a change in interest rate is notlinear.This can be remedied to some extent by combining duration measureswith convexity measures (measuring the rate of change of duration as yieldchanges).4. VALUE ATThis is a sophisticated method increasingly used by major market participantsto assess the risk of their whole trading book. The "value at risk" (VAR)approach uses probability analysis based on historical price movements ofthe relevant financial instruments and an appropriate confidence interval toassess the likely loss that the institution may experience given a specifiedholding period. It combines both probability analysis and sensitivity analysis.The following is a simplified illustration of the concept:A bank has an open USD/DEM position of $ I million.The historical data indicatesthat the one-day volatility during an adverse USD/DEM exchange rate movementis 0.08 percent. The value at risk based on one standard deviation is:$1 million x 1(0.08 percent) = $800The value at risk based on three standard deviations is:$1 million x 3(0.08 percent) = $2,400This example can be interpreted that there is an approximately 16 percentprobability (one standard deviation) based on the past price movementexperience that the bank may lose $800 or more overnight, and approximately0.14 percent probability (three standard deviation) the bank may lose $2,400or more. Additionally, the longer the holding period that is used, for example,five or ten days instead of overnight, the larger the value at risk.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
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THE VARIANCE-COVARIANCE METHODThe t
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Page 112 and 113: price) of 9,000. For this transacti
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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
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Page 128 and 129: 15. Branches of foreign banks which
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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
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Page 150 and 151: Market liquidity risk is the risk t
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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
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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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