27. Managing market risk Flashcards
1
Q
Outline the key activities involved in managing market risk
A
- Set and monitor policies
- Set and monitor limits
- Reporting
- Capital management
- Implementing risk-portfolio strategies
2
Q
Outline what the market risk policy must cover
A
- Roles and responsibilities – who’s responsible within co for developing, implementing, monitoring and reviewing policies
- Delegation of authority and limits – who’s permitted to execute market risk positions and to what extent, segregation of trading (front-office) and settlement (back-office) functions
- Risk measurement and reporting – metrics for measurement and reporting, esp NB issues such as limit violation
- Valuation / back-testing – how positions are valued esp if no market price
- Hedging policy – risks that are hedged, products, limits and hedging strategies and how effectiveness is measured
- Liquidity policy – how liquidity is to be measured and contingency plans in place
- Exception management – how handled and reported
3
Q
List market risk management strategies
A
- Reduce volatility
- Reduce duration
- Diversification
- Match expenses to revenue
- Delay- wait before taking on risk
- Avoid
- Access foreign markets
- Retain
- Bank overdraft
- Pre-sell (similar to derivative)
- Hedging/ derivatives
4
Q
List 4 examples of derivatives
A
- Forwards
- Futures
- Options
- Swaps
5
Q
What are the characteristics of exchange traded derivatives
A
- Standardised
- Trading is done through exchange based on market prices
- Deals are settles through a clearing house
- Clearing-house acts as counterparty to long and short party to the contract and therefore takes on counterparty risk
- Counterparty risk is reduced for the clearing house by pooling many contracts. It is managed by requiring the trading parties to provide the clearing house with collateral (margin) and by (daily) marking to market**
- Very liquid market
6
Q
Explain the marking-to-market process
A
- Start of contract – counterparty deposits cash (initial margin) into margin account.
o The initial margin is determined using the size and expected volatility of contract - Subsequently, clearing house periodically considers whether to add / remove amounts from margin account based on the underlying’s price movements.
o Additions / deductions reflect respective profit or loss position of counterpart – a process known as marking-to-market - If margin drops below specified level, maintenance margin, counterparty must top-up the account to starting by adding a variation margin to the margin account
7
Q
What are the characteristics of OTC derivatives?
A
- Trading done at convenience of parties
- Pricing is by negotiation between parties taking on the default risk
- Contracts have very flexible choice of underlying and delivery dates.
- Usually provided by banks to address needs of company/other org usually swap/option
- Documentation usually standard t+cs like those in International Swaps and Derivatives Association (ISDA)
8
Q
What are the advantages of dealing in derivatives
A
- Deals might be cheaper and easier
- Can be flexible and exposure can change quickly without need to deal in underlying, e.g. can change investment allocation quickly while holding assets
9
Q
What are the disadvantages of dealing in derivatives
A
- Hedging strategies can be ineffective + may lead to losses
- Hedging risk = gains and losses may be eliminated
- Involves transaction costs, spreads, premiums and management time + effort
- Exposes parties involved to increased levels of risk
10
Q
List the risks inherent in derivatives
A
- Credit risk
- Settlement risk
- Aggregation risk
- Operational risk
- Liquidity risk
- Legal risk
- Reputation risk
- Concentration risk
- Basis risk
11
Q
What is normal backwardation?
A
- Describes relationship between future and spot prices
o future price < spot price
o Arises if market thinks income from A will outweigh the carry it or …
o … High demand for short positions in the future
12
Q
What is contango?
A
- Describes relationship between future and spot prices
o future price > spot price
o Due to demand for long positions in the future, e.g. if storage cost is high
13
Q
Outline ways in which basis risk can arise
A
- Hedger uncertain on date underlying / ref asset will be bought or sold
- Speculator expecting to close out a future contract before expiration rate
- Hedger requiring position to be rolled over at/prior to expiration (because futures contract shorter than desired period for the hedge)
- Differences in income, benefits and/or costs between futures contract and underlying aren’t known precisely in advance
- Cross hedging risk – arises if price of assets used to hedge isn’t exactly same as underlying
14
Q
What is the obtimal hedge ratio?
A
Optimal hedge ratio= ρ*σ_security/σ_Future
15
Q
List ways to manage FX risk
A
- Currency forward
- Currency future
- Currency swap
- Currency option
- Netting
- Leading and lagging
