27. Managing market risk Flashcards
Outline the key activities involved in managing market risk
- Set and monitor policies
- Set and monitor limits
- Reporting
- Capital management
- Implementing risk-portfolio strategies
Outline what the market risk policy must cover
- 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
List market risk management strategies
- 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
List 4 examples of derivatives
- Forwards
- Futures
- Options
- Swaps
What are the characteristics of exchange traded derivatives
- 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
Explain the marking-to-market process
- 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
What are the characteristics of OTC derivatives?
- 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)
What are the advantages of dealing in derivatives
- 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
What are the disadvantages of dealing in derivatives
- 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
List the risks inherent in derivatives
- Credit risk
- Settlement risk
- Aggregation risk
- Operational risk
- Liquidity risk
- Legal risk
- Reputation risk
- Concentration risk
- Basis risk
What is normal backwardation?
- 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
What is contango?
- 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
Outline ways in which basis risk can arise
- 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
What is the obtimal hedge ratio?
Optimal hedge ratio= ρ*σ_security/σ_Future
List ways to manage FX risk
- Currency forward
- Currency future
- Currency swap
- Currency option
- Netting
- Leading and lagging
What is netting
o Use revenue in one currency to meet amounts owing in that currency.
o Cashflows unlikely to match exactly …
o + any residual amount might need hedging
What is leading and lagging?
o May attempt to bring forward (lead) or delay(lag) foreign cashflows to exploit expected movements in exchange rates
How would you hedge your exposure to options
- Use Greeks
- Impracticalities have led to Greeks being managed to be given limits to effectively limit volume written by trader and org
- May use dynamic delta-hedging to become delta neutral
Why might it be impractical to maintain gamma and vega neutrality?
o # of derivatives needed may be too large (> m^2)
o Significant cost of rebalancing limits frequency of adjusting higher “Greeks”
o Availability of suitable traded derivatives or poor liquidity
o Resposnsibility for managing limits on greeks usually separated from that of managing the overall portfolio of the Greeks
Explain dynamic hedging
- Day-to-day hedging activity undertaken by option writers. Used to manage risk from writing options
- Institutions employ traders to ensure portfolios stay delta neutral
- Trader may rebalance option portfolio using forwards, futures and asset holdings to stay delta neutral
o Impractical to balance portfolio continuously
o Rebalancing occurs daily instead, …
o … institution remains exposed to risk ; can make losses between rebalancing points
o Dealing costs with rebalancing
o Can be gamma and vega neutral. But difficult to achieve, so gamma and vega risk usually managed by limiting # of options written
What are the two types of interest rate risks
- Direct exposure – direct effect on cashflows e.g. rise in interest rate»_space; cost of floating rate loan
- Indirect exposure – affect value of future cashflows e.g. change in interest rates changing PV of future payments
How would you manage direct interest rate risk?
- FRA
- Caps and floors
How would you manage indirect interest rate risk?
Cashflow matching
- interest rate swaps
- swaptions
Immunisation
Hedging using model points
