Chapter 23 - Market risk management Flashcards
What should market risk policies cover?
Roles and responsibilities Delegation of authority and limits Risk measurements and reporting Valuation and back-testing Hedging policy Liquidity policy Exception management
Main types of derivatives
Options - right for one party to exercise contract in return for premium to counterparty
Forwards - Obligation for parties to complete transaction on future date at known price
Futures - Like forward, but standardised contract traded on exchange
Swaps - Obligation for parties to exchange a series of cashflows
Differences between Exchange Traded and OTC
Exchange vs OTC
Standardised contracts vs Variety
Market prices vs Price by negotiation
Exchange traded through clearing house
Exhange traded collateral in form of margin account, adjusted by clearing house as experience emerges
OTC collateral is specified in credit support annex (CSA)
Optimal hedge ratio
Optimal hedge ratio =
(stad dev of spot prices) / (std dev of future prices) * (correlation between the two)
h=p.(Os/Of)
Delat, gamma and vega hedging
Delta: First partial derivative of derivative/portfolio with respect to underlying asset value
Gamma: Second partial derivative (rate of change)
Vega: Partial derivative with respect to volatility (rate of change of delta)
Sum of above by each underlying asset must equal zero
Practical difficulties:
Number of required derivatives may be large
Delta can be easily neutralised, but gamma and vega less frequently adjusted
Dynamic hedging
Used to manage the risk of from writing options (put/call).
A trader will rebalance the option portfolio using forwards, futures and asset holdings in order to remain delta neutral.
Dyanmic due to need to rebalance constantly (impractical and costly)
Exposed to Gamma risk - high gamma means more need for rebalancing
Liquidity of derivatives restricts ability to remain gama neutral (managed through limits)
Two types of interest rate exposures?
Direct exposure - size of cashflows affected
Indirect - affects value of future cashflows
Hedging direct interest rate risk
Forward Rate Agreement (FRA)
OTC contract
Two parties committ to exchange interest rate dependent payments
Caps and floors
OTC option
Provides insurance against rate of interest rising/falling above.below cap rate
Hedging against indirect interest rate risk
Cashflow matching
Match AL by term, nature,currency
Difficult due to availability of assets, uncertainty of future assets, changes in expected cashflows
May not be desirable to remove all risk
Immunisation Used where pure matching not possible PV of DMT of AL must be equal Convexity of assets must exceed that of Liabilities Significnat practical difficults
Hedging using model points
Hedge cashflows at key reference points (eg 5, 10, 15 years)
