Quiz: Daily Operations

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6 questions to check your understanding of the chapter “Daily Operations”. Choose an answer and select “Check answer” to see the answer and explanation. You can also open “Answer and explanation” to see the answer first.

1. Question 1

   As a hypothetical example, a financial institution enters into an interest rate swap with a notional amount of 20 billion yen and agrees to pay a fixed rate of 1.5% a year. In trade capture, however, the notional amount is entered as 2 billion yen. How much lower each year is the fixed payment in the institution's internal records, and which unit does the 1998 examination manual of the US Federal Reserve Board treat as the place that detects errors and reports them to traders?

   1. A.270 million yen lower a year; the back office (operations and settlement) detects and reports the error
   2. B.270 million yen lower a year; the middle office (risk management and similar functions) detects and reports the error
   3. C.30 million yen lower a year; the back office (operations and settlement) detects and reports the error
   4. D.30 million yen lower a year; the middle office (risk management and similar functions) detects and reports the error
   Answer and explanation

   Answer: A

   The system calculates with the terms that were entered. From the notional amount entered, the fixed payment is recorded as 2 billion yen × 1.5% = 30 million yen. Under the contracted terms, it would be 20 billion yen × 1.5% = 300 million yen. The record is lower than the contracted amount by 300 million yen − 30 million yen = 270 million yen a year. The 30 million yen is the payment that was recorded, not the amount by which it falls short.

   The entered record is the basis not just for one task but for the operations that follow. Financial institutions use the trade record for accounting entries and for settlement through maturity. Recorded trades are revalued periodically, and the instructions for payments at maturity are also generated from this record. So the market value and the position, not only the payments, are calculated as if the trade were one-tenth the size.

   The 1998 examination manual separates the duties of the front office (sales and trading) and the back office (operations and settlement), and treats the back office as the place where entry errors are detected and reported to front-office traders. Where the middle office (risk management and similar functions) checks limits, it checks whether the entered trade stays within limits, and it is the back office that checks the entry against the trade records (who checks limits varies between institutions).

   Learn more: Trade Capture and Approval

2. Question 2

   Among the events that occur during the life of an OTC derivative trade (lifecycle events), which one leaves the original trade in place rather than ending it?

   1. A.One party transfers the whole trade to a third party, which takes its place
   2. B.A central counterparty (CCP) steps in between the parties to the trade
   3. C.The buyer of a swaption exercises its right
   4. D.The parties negotiate and change the terms of the trade
   Answer and explanation

   Answer: D

   When the parties negotiate a change to the terms, the trade continues and only the terms are updated. Other events after which the trade continues are the rate fixing for each interest period and the interest payment.

   In the other three, the original trade ends and is replaced by another trade. In a novation, where the whole trade is transferred to a third party, the original trade ends and a new trade is formed between the remaining party and the party that stepped in. Submitting a trade to a central counterparty ends the trade between the original parties and replaces it with trades against the central counterparty. Exercising a swaption creates the underlying interest rate swap as a new trade. Because a swap starts, it can look as if the trade continues, but the swaption trade itself ends.

   Learn more: Lifecycle Event Processing

3. Question 3

   As a hypothetical example, a desk that trades interest rate swaps has decided that, in P&L explain, it investigates the cause whenever the size of unexplained P&L (whether positive or negative) exceeds 1 million yen. One day, the P&L broken down by source is −7 million yen from market moves, 1 million yen from the passage of time, and 2 million yen from new trades, and the actual P&L is −5.5 million yen. Which combination gives the day's unexplained P&L and how it is handled?

   1. A.0.5 million yen; within the threshold, so the cause is not investigated
   2. B.−1.5 million yen; beyond the threshold, so the cause is investigated
   3. C.1.5 million yen; beyond the threshold, so the cause is investigated
   4. D.−0.5 million yen; within the threshold, so the cause is not investigated
   Answer and explanation

   Answer: B

   Unexplained P&L is actual P&L minus the P&L attributed to sources (explained P&L). Explained P&L is −7 million + 1 million + 2 million = −4 million yen. Unexplained P&L is −5.5 million − (−4 million) = −1.5 million yen. Its size, 1.5 million yen, exceeds the 1 million yen threshold, so the cause is investigated.

   Subtracting actual P&L from explained P&L gives 1.5 million yen, with the opposite sign. Leaving out the 2 million yen from new trades makes explained P&L −6 million yen, so unexplained P&L appears to be 0.5 million yen. Leaving out the 1 million yen from the passage of time makes explained P&L −5 million yen, so unexplained P&L appears to be −0.5 million yen.

   In the April 2003 examination manual of the US Federal Reserve Board, a large unexplained P&L may mean that the valuation process is flawed and that reported profit is overstated or understated. Depending on the findings, the valuation model may be changed or the choice of valuation inputs reviewed. Unexplained P&L on the profit side is investigated just as it is on the loss side.

   Learn more: Daily Valuation and P&L Sign-Off

4. Question 4

   As a hypothetical example, a financial institution sets a VaR risk limit of 2 billion yen for its interest rate trading desk, with an alarm point at 75% of the limit. One day, the desk's VaR is 1.6 billion yen. Following the explanation in a 2019 Bank of Japan training document, which combination gives the day's limit usage and what is done that day?

   1. A.Usage is 125%; the limit has been exceeded, so the desk's positions are reduced by force
   2. B.Usage is 80%; as with a limit excess, written approval is obtained from senior management
   3. C.Usage is 80%; the alarm point has been crossed, so the position policy is discussed with the desk
   4. D.Usage is 80%; the alarm point has been crossed, so the desk's positions are reduced by force
   Answer and explanation

   Answer: C

   Usage is the day's value divided by the limit: 1.6 billion yen ÷ 2 billion yen = 80%. The alarm point is 75% of 2 billion yen, or 1.5 billion yen. VaR of 1.6 billion yen is above it but has not reached the 2 billion yen limit. An alarm point is set below the limit so that a problem is noticed before the limit is exceeded. Crossing it triggers a warning or a discussion of how to run the positions from now on.

   Dividing the limit by the day's value gives 2 ÷ 1.6 = 125%, which mistakes the situation for a limit excess. Reducing or closing positions by force is the rule when a hard limit is exceeded. With a hard limit, positions must be reduced as soon as the limit is exceeded, so once the alarm point is crossed, the institution can agree in advance on what to do if the limit is exceeded. Written approval from senior management was part of the procedure for exceeding a market risk limit in the 1998 examination manual of the US Federal Reserve Board.

   Learn more: Daily Risk Management Operations

5. Question 5

   As a hypothetical example, the threshold in a credit support annex (CSA) between an institution and its counterparty is 0 for both parties, the minimum transfer amount is 100 million yen, and the haircut on government bonds is 2% (2% is deducted from the market value). The institution holds, as collateral received from the counterparty, 300 million yen in cash and government bonds with a market value of 1 billion yen. On this day, the total market value of the trades from the institution's point of view is 1.5 billion yen. How is collateral transferred on this day?

   1. A.The institution returns 200 million yen of collateral to the counterparty
   2. B.The counterparty posts 120 million yen of collateral to the institution
   3. C.The institution returns 220 million yen of collateral to the counterparty
   4. D.The counterparty posts 220 million yen of collateral to the institution
   Answer and explanation

   Answer: D

   The government bonds are valued at their market value of 1 billion yen minus 2%: 1 billion yen − 1 billion yen × 0.02 = 980 million yen. Together with the cash, the collateral held is valued at 300 million yen + 980 million yen = 1.28 billion yen. With a threshold of 0, the full total market value is covered by collateral. The amount to transfer is 1.5 billion yen − 1.28 billion yen = 220 million yen. This exceeds the 100 million yen minimum transfer amount, so the counterparty posts 220 million yen to the institution.

   Forgetting the haircut values the collateral at 1.3 billion yen and gives an amount to transfer of 200 million yen. The minimum transfer amount decides whether collateral is transferred at all; it is not subtracted from the amount to transfer. So the answer is not 220 million − 100 million = 120 million yen. On days when the market value moves in the institution's favor, the counterparty provides collateral; on days when it moves against the institution, the institution returns collateral. If the total market value fell to 1.1 billion yen, the amount would be 1.1 billion yen − 1.28 billion yen = −180 million yen, and the institution would return 180 million yen to the counterparty.

   Learn more: Collateral Operations

6. Question 6

   A financial institution pays funds to a counterparty on the settlement date and receives funds from the same counterparty on the same day. Following how the 1999 examination manual of the US Federal Reserve Board measures it and the approach in the Bank of Japan's 2000 paper, over what period does the institution carry settlement risk to this counterparty?

   1. A.From when the payment instruction to the counterparty is sent to the bank until the counterparty's payment arrives in the account
   2. B.From when the payment instruction to the counterparty can no longer be canceled unilaterally until reconciliation of the counterparty's payment is complete
   3. C.From when the payment instruction to the counterparty is sent to the bank until reconciliation of the counterparty's payment is complete
   4. D.From when the payment instruction to the counterparty can no longer be canceled unilaterally until the counterparty's payment arrives in the account
   Answer and explanation

   Answer: B

   The 1999 examination manual measures settlement risk to a counterparty as the amount carried from the time a payment instruction can no longer be canceled unilaterally until reconciliation of the receipt is complete. A payment instruction can still be canceled after it has been sent, up to a set time. Right after sending it, the institution can still stop the payment, so it starts to carry the risk when the instruction can no longer be canceled.

   Under the Bank of Japan's 2000 paper, settlement risk is managed as ending not when funds arrive but when the receipt is confirmed. Late reconciliation lengthens the time for which the institution carries settlement risk. For example, if reconciliation cannot be done until the morning after the settlement date, the institution may send that day's payments, which it can no longer cancel, to a counterparty that failed to pay the day before.

   Learn more: Settlement