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

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Annex D1. NOTIONAL OR VOLUME LIMITSLimits based on the notional amount of derivatives contracts are the mostbasic and simplest form of limits for controlling the risks of derivativestransactions. They are useful in limiting transaction volume, and liquidity andsettlement risks. However, these limits cannot take account of price sensitivityand volatility and say nothing about the actual level of risk (in capital orearnings terms) faced by the institution. Derivatives participants should nottherefore use these limits as a stand-alone tool to control market risk.2. STOP LOSS LIMITSThese limits are established to avoid unrealized loss in a position fromexceeding a specified level. When these limits are reached, the position willeither be liquidated or hedged. Typical stop loss limits include those relatingto accumulated unrealized losses for a day, a week or a month.Some institutions also establish management action trigger (MAT) limits inaddition to stop loss limits. These are for early warning purposes. Forexample, management may establish a MAT limit at 75 percent of the stoploss limit. When the unrealized loss reaches 75 percent of the stop losslimit, management will be alerted of the position and may trigger certainmanagement actions, such as close monitoring of the position, reducing orearly closing out the position before it reaches the stop loss limits.The above loss triggers complement other limits, but they are generally notsufficient by themselves. They are not anticipatory; they are based onunrealized losses to date and do not measure the potential earnings at riskbased on market characteristics. They will not prevent losses larger thanthe stop loss limits if ft becomes impossible to close out positions, e.g.because of market illiquidity.yygGuideline on Risk Management of Derivatives and Other Traded Instruments
3. GAP OR MATURITY BAND LIMITSThese limits are designed to control loss exposure by controlling the volumeor amount of the derivatives that mature or are repriced in a given timeperiod. For example, management can establish gap limits for each maturityband of 3 months, 6 months, 9 months, one year, etc. to avoid maturitiesconcentrating in certain maturity bands. Such limits can be used to reducethe volatility of derivatives revenue by staggering the maturity and/or repricingand thereby smoothing the effect of changes in market factors affectingprice. Maturity limits can also be useful for liquidity risk control and therepricing limits can be used for interest rate management.Similar to notional and stop loss limits, gap limits can be useful to supplementother limits, but are not sufficient to be used in isolation as they do notprovide a reasonable proxy for the market risk exposure which a particularderivatives position may present to the institution.4. VALUE AT RISK LIMITSThese limits are designed to restrict the amount of potential loss fromcertain types of derivatives products or the whole trading book to levels(or percentages of capital or earnings) approved by the board and seniormanagement. To monitor compliance with the limits, management calculatesthe current market value of positions and then uses statistical modellingtechniques to assess the probable loss (within a certain level of confidence)given historical changes in market factors (details are set out in Annex B).The advantage of value at risk (VAR) limits is that they are related directlyto the amount of capital or earnings which are at risk Among other things,they are therefore more readily understood by the board and seniormanagement. The level ofVAR limits should reflect the maximum exposuresauthorized by the board and senior management, the quality and sophisticationof the risk measurement systems and the performance of the models usedin assessing potential loss by comparing projected and actual results. Onedrawback in the use of such models is that they are only as good as 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
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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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"cell" would have a cash flow expos
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Daily profit and loss ranked in asc
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of the market factor. Through this
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Page 120 and 121: The derivatives industry can be com
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Page 124 and 125: MANAGEMENT AND CORPORATE5. As the B
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Page 150 and 151: Market liquidity risk is the risk t
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Page 160 and 161: assumptions on which they are based
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Page 168 and 169: • Profits and losses resulting fr
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