Chapter 7 notes 2012 08 06


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Chapter 7 notes 2012 08 06

  1. 1. finlogIQ Knowledge for financial IQ STRICTLY PRIVATE AND CONFIDENTIALChapter 7Trading Risk Control and ManagementAugust 2012
  2. 2. Chapter summary and outlineThis chapter describes the controls, measures and accountingprocedures that are used to manage the risks involved in futuresand options trading, i.e. market risk, credit risk and settlementrisk. The chapter also highlights the importance of segregation ofresponsibilities throughout the bank to manage potential conflictsof interest.Chapter outline:• Categories of risks and measurement• Segregation of responsibilities• Accounting proceduresfinlogIQ 2
  3. 3. Categories of Risks and MeasurementThree types of risks involved in trading• Market risk• Credit risks• Settlement risksfinlogIQ 3
  4. 4. Market Risk• Exposure to a change in value of some market variables, such as interest rates, foreign exchange rates, equity, or commodity prices, is termed as market risk.• Limits that can be set to control the level of market risk• Open contract limit – Based on volatility of the contracts and estimated expected maximum loss – More volatile contracts are therefore subject to a smaller open contract limit• DV01 (dollar value per basis point) – DV01 is a better measure of interest rates risk as it reflects the greater risks of longer-dated exposures compared to shorter-dated ones.• Value at Risk (VaR) – Value at risk is widely used for risk measurement on a specific portfolio of financial assets. – Incorporates volatility & correlation => potential loss amount or value-at-risk. – It measures the threshold value such that the probability that the mark-to-market loss on the portfolio over the given time horizon exceeds this value. – Setting a lower VaR, the portfolio size would need to be lowered as well or highly correlated risks would have to be reduced.finlogIQ 4
  5. 5. Market Risk - 2• Total overall open contracts – Total overall open contracts that can be held by one firm or entity should be limited to a certain percentage of the Gross Open Interest – Avoid potential liquidity problems• Maximum loss limit is set for trader/trading group − Weekly and monthly maximum losses − Once loss limit triggered the trader/group will be suspended• Maturity limit is set for trading purposes – limit the possible losses that can arise as the result of poor liquidity – Liquidity normally better for near-month contracts and worse for further months – Further contracts normally have lower liquidity and are hence more volatile – Under adverse conditions, difficult to unwind further month contractsfinlogIQ 5
  6. 6. Market Risk - 3• Options carry multiple risk parameters – Limits for Greeks, i.e. delta, gamma, vega, theta and rho.• Delta limits are normally set in terms of USD or the local currency amount.• Gamma is usually measured against a specified movement in the spot FX rate of say, one standard deviation.• Vega is the major trading risk in options and is usually measured by the change in value of an option, i.e. the premium over a 1% change in market volatility• Theta, which measures the potential loss through time decay, is limited by potential loss over a 1-day period.• Gamma, vega and theta are sometimes controlled together by setting the maximum loss for all three combined.• Positive effects of theta are automatically offset against the negative effects of gamma.• Executing a FX swap transaction can reduce rho risksfinlogIQ 6
  7. 7. Credit Risk• Exchange risk – exchange and its associated clearing house is the counterparty to any exchange- traded futures contract. – Committed lines of credit from commercial banks, its own capitalization, and mutual liability arrangements among the clearing members, it nevertheless has to make good any contractual demands even if its counterparties fail.• Clearing broker risk – Margins must be maintained with the clearing broker, the credit risk arises from the placement of such funds with the broker• Counterparties’ credit risks – Greater for OTC options and are set for individual counterparties. – Limits are set according to the credit rating of the institution in terms of settlement amount and contract tenor. – Premium payment limits to avoid institutions from constructing a synthetic loan through options • Corporate institutions raise capital by selling deep in-the-money options, covering the FX risk by forward purchase of the deliverable currency and purchase of out-of-money options. • Large premium paid upfront to the client would thus create a credit exposure for the institution that purchases the option from the corporate client.finlogIQ 7
  8. 8. Settlement Risk• Primarily the domain of back office• Timely and accurate confirmations of trades done by the traders are essential to help ensure there is prompt settlement of transactions.• OTC options – confirmation should include details like the style of option, call currency and amount, put currency and amount, expiry date and time, premium payment date, settlement date and strike price.finlogIQ 8
  9. 9. Segregation of Responsibilities• Clear lines of reporting and segregation of responsibilities to avoid situations where conflict of interest s may arise.• The middle office (that controls and monitors risk limits) and the back office (which reconciles payments with confirmations) should detect any limits excess or breach of control procedures promptly to avoid financial disasterTransaction Authorization• Before any new instrument can be traded, it must first be approved• Proper transaction authorisation or an approval process• Trading Manager – provide input on the market limits required consistent with his business objectives and risk tolerance allowed. – work closely with the middle office manager on risk limits, mark-to-market process and other system requirements. – trading in the exchanges and contracts to be traded. – In the case of OTC options, the various limits like VaR and the Greeks are also discussed.finlogIQ 9
  10. 10. Segregation of Responsibilities - 2Transaction Authorization(cont)• Middle Office Manager – Setting limits control, mark-to-market process, profit and loss reporting – Certification of pricing tools to be used• Operations Manager – Necessary system support, confirmation procedures, settlement requirements, and monitoring of brokerage fees according to the brokerage schedule after it has been negotiated by the front office.• Compliance Officer/ Legal Officer – provide input with regards to local banking laws and regulations as well as those of the country of incorporation of the bank.• Finance Officer and Tax Officer – accounting procedures for local tax and the tax authority requirements of the country in which the local exchange is located.finlogIQ 10
  11. 11. Segregation of Responsibilities - 3Trading Manager’s Responsibilities• Sets transaction and position limits, daily and monthly stop loss limits – Ensures traders maintain continuous records of their positions throughout the day• Ensure trade input should include the transaction date, settlement date, contract type, number of contracts, delivery month, price, exchange, broker, trader’s name and signature. – Accounting hedges to be identified• Daily review of trading activity – reasonableness of pricing, unusual activity at month-end that has a material effect on profit and loss, frequent cancellations/revisions and concentrated use of specific brokers without good cause.• Reconcile trading profit and loss reports• Perform trading and unit management to ensure intended results are achieved, and to review trading and hedging activities on a regular basis.finlogIQ 11
  12. 12. Segregation of Responsibilities - 4Back Office Responsibilities• Consists of different operating units such as processing, accounting , and/or internal audit, which may perform certain functions described below.• Trading, processing, accounting, internal audit, and settlements/payments functions.• Review daily all trade tickets for completeness and proper approval prior to input into the computer system of record. – Tickets received after cut-off time should be recorded in a separate holdover log and entered the following day (the actual trade date must be recorded in system).• Verify daily the accuracy of all future transactions• Verify daily the accuracy of data provided by external brokers, exchanges and clearing houses concerning open positions, money balances and net equityfinlogIQ 12
  13. 13. Segregation of Responsibilities - 5Back Office Responsibilities (cont..)• Provide the information necessary to the Trading Manager to facilitate effective management of the positions.• Verify daily that outstanding positions have not exceeded authorised positions and exchange limits.• Prepare and pass daily the required general ledger accounting entries regarding margin deposits, commission payments and other items.• Monthly certifications of all outstanding futures contracts and fees paid against all applicable general ledger accounts.• Monitor all margin deposits• Records: – Accounting and/ or custodial records – Local tax reporting purposes – reports required by futures exchanges or other local regulatory bodies. If local reporting requirements deviate from the accounting policies explained above, parallel procedures should be adoptedfinlogIQ 13
  14. 14. Accounting Procedures• Essential to ensure proper management of risks – Futures contracts are marked-to-market daily – OTC options, independent sources of most recently available prices should be used for daily mark-to-market purposes.• Balance needed between flexibility, risk control and profitability. – A flexible accounting system will expose the institution to a greater degree of risk but will increase its profit potential.• Mark-to-Market Accounting – All futures contracts must be marked-to-market for accounting purposes. – For hedges, they will be given the deferral accounting treatment. • Gains or losses, including fees and commissions received or paid are amortized as an adjustment to the interest account for the item being hedged over its expected weighted average life and must be recorded as an adjustment to its carrying value. – hedges where correlation is not achieved, deferral accounting must be terminated. – Any trading gain or loss, recognized immediatelyfinlogIQ 14
  15. 15. Accounting Procedures - 2Mark-to-Market Accounting (cont.)• Where futures are used for hedging – Underlying instrument that is being hedged can be identified and matched. – Same accounting system must be applied to both the target security and the hedge. – Improper to use mark-to-market for one and we use accrual basis for the other.• Uplifting a hedge must be explicitly. – Prevent traders from using lousy positions as hedge and good positions as trading. – If the hedge is to reduce the overall risk position of existing assets and liabilities or firm commitments or anticipated transactions; – The items that are to be hedged must be identified, and – The design of the hedge must be specified.• Hedge management process ensures correlation between changes in the value of the futures hedge(s) and the changes in the value of the hedged item(s) is still achieved.finlogIQ 15