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

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management to enter into swap and other derivative transactions only forthe purposes of hedging or reducing the bank's interest rate exposure. Justlike other messy transactions, there were no documented analysis and recordon this swap transaction. Management admitted that it was a mistake, andtold the examiners that the analyst was no longer working for the bank andnobody knew the reasoning behind that transaction.What happened to this transaction was amazing. In the early 90's, the USshort-term interest rates continued to drop. This reverse swap actuallymade a lot of money for the bank.So the young analyst won his bet. But the question is - was it a hedge? Theanswer is no. This was a bet on interest rates. Management probably knewand endorsed the transaction, but was afraid that the regulators mightcriticise the institution of betting on interest rates. Therefore, no documentedanalysis was retained. This happened quite often during the banking crisisin the US several years ago because of the federal deposit insurance system- if the bet was right, the institution would be saved and management wouldbe rewarded handsomely; if the bet was wrong, the government wouldhave to pay for the damages.Hedging is a complicated issue. To hedge a position can reduce risk, but italso implies foregoing of business opportunity and potential profit. Forexample, a back-to-back transaction can reduce your price risk to a minimumlevel. However, it also means that the institution will not be able to enjoyany gain. (Even a back-to-back transaction cannot eliminate risk entirelybecause it introduces additional credit risk and liquidity risk.)How much risk a bank is willing to take depends on the institution's capitallevel, business strategy, expertise, sophistication of systems, etc.In ourexample, if the institution leaves this $50 million loan totally unhedged,there may not be too much problem if the institution has a strong capitalposition which can tolerate this kind of risk, provided that proper analysishas been performed and documented.Hedging with Derivatives
In reviewing a hedge transaction, examiners usually look at the entire process,the oversight by management, the analysis and the documentation. To hedgeor not to hedge is a management decision. It should be part of theinstitution's entire asset/liability management process. It should be properlyanalysed and documented. In addition, the analysis should be reviewed andapproved by management, and even by the board if the transaction isconsidered significant to the institution.The current rules governing the accounting treatment for derivatives arequite weak. They do not adequately cover some of the most basic typesof derivative products. Accounting for end-user hedging activities is themost problematic derivatives accounting issue. Accounting rules for theseactivities are incomplete and could easily be mis-applied. This situationexists in Hong Kong, the US and the UK.Traditional accounting standards only cover certain derivatives instruments.For example, in the US, SFAS 52 covers foreign currency transactions, andSFAS 80 covers futures contracts. These accounting standards may not coverother derivatives transactions such as swaps, options, structured notes.The traditional practice in hedge accounting is to treat a transaction as ahedge if it meets the following general criteria:1. The item to be hedged exposed the enterprise to price for interestrate) risk. In our example, there definitely is an interest rate risk. Ifinterest rates rise, the institution will suffer a loss on this loan.Therefore, this criterion is met. To fulfil this requirement, certainanalytical work must be performed and documented by management.2. The item being hedged and the hedging instrument are specificallyidentified by management and the relationship between them isdesignated as hedge. This criterion is also met in our example.Again, proper documentation is required.3. The hedging instrument is expected to reduce such exposureeffectively and continue to do so throughout the life of theHedging with Derivatives
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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
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 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
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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
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
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Consideration must be given to the
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55. As noted earlier, the market or
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changes in portfolio value;d) the r
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66. A basic and essential safeguard
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73. It is essential that the intern
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Market liquidity risk is the risk t
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Furthermore, contracts with the sam
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There are three main VAR approaches
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Options risk should be captured; ri
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Annex D1. NOTIONAL OR VOLUME LIMITS
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assumptions on which they are based
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* There should be a unit independen
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- the customer had specifically req
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addition and deletion of operators,
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• Profits and losses resulting fr
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This book is due for return or rene
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