Mod 27: Management of market risk Flashcards
Outline the main strategies used to manage market risk
Strategies to manage market risk
- diversification:
1. holding a range of assets to limit losses within a portfolio - investment strategy:
1. ensuring it is appropriate for the liabilities of the organisation (subject to constraints, eg regulatory restrictions) - hedging:
1. using derivatives to manage risk
List the key elements of market risk management ©
Elements of market risk management
* policies
* limits
* reporting
* economic capital management
* portfolio strategies
Outline the issues that should be covered by market risk policies
Market risk policies
* roles and responsibilities – who is responsible within the company for developing, implementing, monitoring and reviewing policies
* delegation of authority and limits – who, to what extent, segregated trading (front-office) and settlement (back-office)
* risk measurement and reporting – the metrics used for measurement and reporting critical issues (especially limit violation)
* valuation and back-testing – how positions are valued
* hedging policy – what risks are to be hedged, the products, limits and strategies, measures of effectiveness
* liquidity policy – measures, contingency plans
* exception management – handling and reporting
Describe ‘best practice’ market risk management practices
‘Best practice’ market risk management practices
* Market risk factors −
seek competitive advantage by exploiting mispriced securities and better intelligence
* Modelling −
sophisticated tools, eg hot-spot analysis, best hedge analysis, best replicating portfolio and implied view
* Market risk function −
corporate control and profit centre – seeks to maximise profits within risk limits
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Outline the key features of exchange-traded derivatives
Exchange-traded derivatives
* futures (and some options) are exchange-traded contracts
* contracts are standardised – available only on certain assets and indices and only for specific delivery dates (or date ranges)
* trading is done through the exchange based on market prices (which may be subject to a minimum price movement or tick)
* deals are settled through a clearing-house clearing-house takes on two-sided counterparty risk
* counterparty risk is reduced, for the clearing-house, by the pooling of many contracts and is managed by requiring the trading parties to provide margin and by daily marking to market
* above features result in a highly liquid market with comparatively low transaction costs
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Outline the key features of over-the-counter derivatives ©
Over-the-counter (OTC) derivatives
* forwards, swaps and some options are OTC contracts
* trading is done at the convenience of the parties
* pricing is by negotiation between the parties who take on counterparty risk
* counterparty risk may be mitigated by the transfer of acceptable collateral
* very flexible in terms of the choice of both the underlying and the delivery date – generally provided by banks to address the specific needs of a company, or other institution
* documentation is usually based on standard terms and conditions, such as those published by the International Swaps and Derivatives Association (ISDA)
State what determines the forms of collateral that can/must be held by one or both parties to a contract to provide protection from any potential default
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Forms of collateral
1. exchange-traded contracts −
* cash – initial margin, adjustments to the margin account through marking-to-market, variation margin payments when the account falls below the maintenance margin
* securities (rather than cash) – the exchange specifying what securities are acceptable and the proportion of face value that counts as collateral
over-the-counter contracts −
* acceptable securities will typically be specified in a credit support annex (CSA) to the contract, along with statements of when collateral transfers are required and how they are to be calculated, and the minimum transfer amount
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List the advantages and disadvantages of using derivatives to manage market risk
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Advantages and disadvantages of derivatives in managing market risk
Advantages:
* can be cheaper and easier than using underlying asset
* flexibility (can be tailored)
* speed (of exposure changes)
Disadvantages:
* derivative hedges can prove to be ineffective and result in losses
* loss of upside
* can be costly
* requires management time and effort
* requires knowledge, skills and experience
associated risks, including:
- counterparty, including settlement
- aggregation and concentration
- operational, legal, reputational
- liquidity and basis
Describe basis and basis risk (relating to futures contracts) ©
Basis and basis risk
Basis = the difference between the futures price and the spot price of the reference asset. Basis risk is the risk of loss arising from changes in the basis over time. Basis risk may arise if:
* a hedger is uncertain as to the exact date for trading the underlying
* a hedger requires the futures position to be rolled over early
* a speculator is expecting to close out a futures contract early
* differences in income, benefits and/or costs between the futures contract and the underlying asset are not known precisely in advance
* the asset whose price is to be hedged is not exactly the same as the asset underlying the futures contract (the resulting price risk is known as cross hedging risk which is a component of basis risk).
Basis reduces to zero as expiry approaches if the final two bullets don’t apply.
Describe what is meant by:
* normal backwardation
* contango
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Normal backwardation and contango
- normal backwardation:
- where the current futures price is below the expected future spot price
- may occur due to the market expecting the income on the asset to outweigh any cost of carry (hence a preference to hold the asset) or due to high demand for short positions in the future (from the asset holder protecting the value of their assets)
- contango:
- where the current futures price exceeds the expected future spot price
- may arise due to demand for long positions in the future (for example, where storage costs of the underlying commodity are particularly high)
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State the likely approach to be taken by a company with significant foreign exchange risk (or currency risk)
Managing foreign exchange (FX) risk
Purchasing power parity theory suggests that, in the long-term, exchange rates change track the relative inflation rates of the two relevant economies − thus mitigating the need to hedge currency risk.
Exposure to FX risk does not provide any additional systematic return. Hence, for overseas bonds, currency exposures are typically hedged. However, for overseas equities the situation is more complex and so hedging is either approximate or not attempted. Techniques for managing FX risk include use of:
* currency forwards and futures
* currency swaps currency options
* netting revenues and amounts owing in same currency
* leading and lagging cashflows to benefit from FX movements.
Outline the difficulties with gamma and vega hedging
Difficulties in gamma and vega hedging
* The number of derivatives required might be quite large. −achieving delta, gamma and vega neutrality on a portfolio whose value is linked to m underlyings can require over m^2 derivatives
* Responsibilities will be split between individual traders and the overall portfolio manager. individual traders tend to have responsibility for trading in all derivatives linked to a single underlying quantity only. They will be given limits on how far they can deviate from delta, gamma and vega neutrality. The overall portfolio manager then has responsibility for managing the total delta, gamma and vega.
* The gamma and vega can only be dynamically adjusted less frequently than the portfolio delta which can be easily neutralised at least daily and at low cost using, eg futures contracts.
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Discuss the activity of dynamic hedging ©
Dynamic hedging
- Dynamic hedging refers to the day-to-day hedging activity undertaken by writers of options.
- Option writing institutions will employ traders to rebalance the option portfolio using forwards, futures and asset holdings in order to remain delta neutral.
- This rebalancing will often occur on a daily basis – so called dynamic delta-hedging.
- There is a trade-off between the risk of not being delta-hedged and the cost of maintaining this hedge.
- Costs include not only the dealing costs in rebalancing, but also the exposure to the risk of losses between rebalancing points.
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Outline:
* the problems of a writer of options not being gamma and vega hedged
* the resulting approach to managing gamma and vega that is often taken as a result
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Managing a portfolio’s gamma and vega
- The gamma of a portfolio reflects its exposure to the risks associated with jumps in prices as well as to the risks of hedging at discrete time points rather than continuously.
- A high (un-hedged) gamma also means that the transaction costs of rebalancing (to achieve delta-neutrality) will be higher than a low gamma portfolio.
- The higher the portfolio’s (unhedged) vega, the greater the risk associated with an incorrectly specified volatility.
- A lack of traded derivatives or poor liquidity might make gamma and vega neutrality difficult to achieve in practice.
- As a result, the gamma and vega of a portfolio are often managed using limits that will effectively limit the volume of options that a trader can write. Limits would also be set for the whole institution.
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List the techniques used to manage direct and indirect interest rate risk
Managing interest rate risk
1. direct exposure
* forward rate agreements (FRAs)
* caps and floors
2. indirect exposure
* cashflow matching – removing all market risks
* interest rate swap or swaption – reducing interest rate risk
* swaption – one-sided protection
* immunisation – not matching cashflows but protecting present value
* hedging using model points ©
