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

More documents

Recommendations

Info

denominator, value at risk, which can be more intuitively understood by theboard and senior management. This approach has been developed in relationto the measurement of market risk, but it also has application in measuringcredit risk across a portfolio.The HKMA welcomes the use of value at risk and other statistical models.However, there are important caveats. First, it is possible for seniormanagement to be lulled into a false sense of security by such models.While on the face of it the mathematics of the models may be quitecomplex, they are in fact based on a set of simplifying assumptions, includingthat changes in prices or rates are normally distributed and that positionscan be traded out within the assumed holding period. It is importanttherefore that models should not be seen as supplying the right answerunder all circumstances. If volatilities change dramatically and if marketliquidity dries up, the potential for loss may be greater than that predictedby the model. This means that stress tests should also be used to calculatethe exposure under worst case market scenarios, which may not be probablebut which are certainly possible. This may then lead management to setmore conservative limits than the value at risk model would otherwiseimply. Thus, subjective judgement still matters.The second point is that, as the Basle Committee has emphasised, thequalitative controls surrounding how models are used are just as importantas the mathematics. In particular, as recent events have demonstrated, it isvital that the data on prices and volatilities which are fed into models areaccurate and are regularly checked by an independent risk control unit. Themodels themselves should be subject to regular independent review andback-testing. This principle of checks and balances and segregation of dutiesis absolutely vital for all aspects of a trading operation.Supervisors need to have the capability to evaluate risk management systemsand the way in which models are used. In Hong Kong, we have set up aSpecialist Derivatives Team to help in formulating regulatory policies and practices,conducting examinations of treasury operations and reviewing in-house models.Preface
Sufficient capital to withstand lossesHowever, risk management is not the whole story. Even in well-run tradingoperations it is possible that losses may occur as a result of unexpectedmarket movements and it is thus necessary to ensure that banks havesufficient capital to be able to withstand such losses. The existing capitaladequacy framework in Hong Kong is based on the 1988 Basle CapitalAccord which almost exclusively deals with credit risk. In 1996, the BasleCommittee amended the Accord to take account of market risk. By theend of 1997 we shall have changed our capital adequacy rules in Hong Kongto take account of this.It does not appear that the introduction of market risk will have a greatimpact on the capital ratios of most local authorised institutions using the"standardised approach" of the Basle Committee. Even so, in line with theBasle recommendations, we propose to give institutions the opportunity toeconomise still further on the use of capital by allowing those who arequalified to do so the alternative of using their own internal statisticalmodels to calculate the capital requirement. This is in keeping with theBasle Committee's objective of giving banks every opportunity to improvetheir own internal risk management. However, as modelling is still not anexact science, the Basle Committee has insisted that the value at riskproduced by a model should be multiplied by a factor of at least three inorder to arrive at the capital requirement.Increased market transparencyThe final leg of the supervisory approach is to try to improve the qualityof information about the derivatives activity being conducted in marketsaround the world and by individual market participants.First, supervisors are trying to improve their understanding of how derivativesaffect the overall risk profile and profitability of banks and securities firms.The Basle Committee and the International Organisation of SecuritiesCommissions (IOSCO) have therefore jointly developed a framework forPreface
Page 2 and 3: THE UNIVERSITY OF HONG KONGLIBRARIE
Page 4 and 5: VI- . .7 « i8^p ! ««^^OOSHSlVCJ
Page 6 and 7: Ever since derivatives took centre-
Page 10 and 11: the kind of information that superv
Page 12 and 13: This book is a team effort of the H
Page 14 and 15: While most market participants defi
Page 16 and 17: of this investment is 6.32 percent
Page 18 and 19: Mathematically, the relation betwee
Page 20 and 21: $10,000. (For simplification of pre
Page 22 and 23: Hong Kong does go up and the HSI ri
Page 24 and 25: 3OF ATHEPRICING OF A FORWARD CONTRA
Page 26 and 27: COST OF CARRYIn the above example,
Page 28 and 29: interest rate swap rates. From thes
Page 30 and 31: Borrowers, on the other hand, usual
Page 32 and 33: Again we use our method of having t
Page 34 and 35: ates, the forward rate for the peri
Page 36 and 37: 5In this chapter, we will discuss w
Page 38 and 39: often complain that there is too mu
Page 40 and 41: ABC also has three cash flows:1. It
Page 42 and 43: Assuming that there is no transacti
Page 44 and 45: simulation techniques and mathemati
Page 46 and 47: The calculation of credit risk proc
Page 48 and 49: The payments are exchanged every th
Page 50 and 51: the reference rate. When this type
Page 52 and 53: Effectively this is just a 2-year s
Page 54 and 55: This measure of duration is referre
Page 56 and 57: analysis, it also has its shortcomi
Page 58 and 59:
Percentage change in price due to d
Page 60 and 61:
8OFOptions are generally perceived
Page 62 and 63:
OPTION'S PAYOFF PATTERNWhat about a
Page 64 and 65:
Volatility is the most important fa
Page 66 and 67:
fANDTrading options becomes more po
Page 68 and 69:
You need to hold 7 shares of stock
Page 70 and 71:
di = [ln(IOO/IOO) + (0.06 + O.P/2)
Page 72 and 73:
is10In the previous chapter, we dis
Page 74 and 75:
stock will go up in the near future
Page 76 and 77:
If the stock price of A continues t
Page 78 and 79:
OF AN11In the previous two chapters
Page 80 and 81:
at-the-money option approaches its
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 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 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
show all

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

Create successful ePaper yourself

Delete template?

Save as template?