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Derivatives Compass

PractitionerAdvanced

Middle Office (Risk Management)

Who this is for
For people who measure market, credit and liquidity risk and run limits and valuation controls.
How to read it
Newcomers read the foundations first. Practitioners start at stage 1. If you already measure VaR and exposure, start at stage 3.

  1. Stage 1Measuring riskPractitioner

    Greeks and sensitivities, VaR and expected shortfall, stress testing and backtesting: how market risk is counted.

    1. IntroductoryThe GreeksA hypothetical call (price 8.43) has a delta of 0.5596, so its price is estimated to rise about 0.56 when the underlying price rises by 1.Valuation
    2. PractitionerSensitivities: DV01, Vega and Key Rate SensitivitiesRisk factors depend on the product, and each maturity's interest rate is treated as a separate risk factor.Market Risk
    3. IntroductoryValue at Risk (VaR)VaR at a 99% confidence level is the amount that losses exceed with a probability of 1%.Market Risk
    4. PractitionerExpected ShortfallEven with the same VaR, a position with larger losses beyond VaR has a larger expected shortfall.Market Risk
    5. PractitionerStress TestingVaR is based on past data and cannot show environment changes or tail losses, so stress testing fills the gap.Market Risk
    6. PractitionerBacktestingVaR is an estimate that can be wrong, so each day's VaR is compared with the next business day's profit or loss and the exceptions over the most recent 250 business days are counted.Market Risk

  2. Stage 2Counterparty exposurePractitioner

    How losses arise when a counterparty fails, how netting and collateral reduce them, and how credit limits and margin funding work.

    1. IntroductoryWhat Is Counterparty Credit Risk?When a counterparty fails, only the party for which the transaction has a positive value can lose that amount.Counterparty Credit Risk
    2. PractitionerExposure Measures: CE, PFE, EE/EPE and EADCE is the positive part of today's market value, PFE a high percentile of the future distribution of exposure, EE its mean, and EPE the average of EE.Counterparty Credit Risk
    3. PractitionerExposure Profiles by ProductThe shape of exposure comes from combining the widening range of market moves with the shrinking amount of remaining payments.Counterparty Credit Risk
    4. PractitionerRisk Reduction through Netting and CollateralWith close-out netting, exposure is the positive part of the total market value of the trades, not the sum of each trade's positive market value.Counterparty Credit Risk
    5. PractitionerCredit Limit ManagementA credit limit is a cap, set for each counterparty, on the amount that could be lost if that counterparty failed.Counterparty Credit Risk
    6. PractitionerFunding Variation and Initial MarginFunding liquidity risk is the risk of being unable to find the cash for payments or collateral, and demands for additional collateral are one cause in derivatives.Liquidity and Funding Risk
    7. PractitionerHandling Margin CallsIn bilateral trades, a call runs in order through valuation, calculation of the required amount, the call, agreement on the amount, and delivery, and each party calculates the amount itself.Liquidity and Funding Risk

  3. Stage 3Valuation control and governancePractitioner

    How volatility and collateral move valuations, then daily routines, P&L attribution, the three lines model, limits, independent price verification and model risk.

    1. PractitionerImplied VolatilityImplied volatility restates an option's price as a volatility, much as a yield restates the price of a bond.Valuation
    2. PractitionerVolatility Smiles and SurfacesEquity options usually show a downward-sloping shape (a skew): implied volatility is higher at lower strikes, and the slope is steeper at shorter expiries.Valuation
    3. PractitionerCollateral and DiscountingThe collateral currency, the interest rate on collateral, the transfer frequency, and the threshold are set in the credit support annex (CSA), and the discount rate changes with these terms.Valuation
    4. PractitionerDaily Risk Management OperationsFor the risk management department to act as a check on the front office, the work of measuring risk and preparing reports must be independent of the front office.Internal Operations
    5. PractitionerP&L AttributionP&L is split by risk factor to show where it came from and to notice valuation errors or risks that are not captured.Capital and Profitability
    6. IntroductoryThe Three Lines ModelThe three lines model assigns the role of managing risk and the role of checking that the management works to separate parts of the organization.Governance and Controls
    7. PractitionerLimit FrameworksRisk appetite is the types and amount of risk management accepts, and a limit is a numerical upper bound that allocates it to units and risk types.Governance and Controls
    8. PractitionerIndependent Price Verification (IPV)IPV is a control in which people or units independent of the front office recheck valuations against independent prices, guarding against bias toward the front office's estimates.Governance and Controls
    9. PractitionerModel Risk Management: SR 11-7 and the JFSA PrinciplesModel risk is the risk that a decision based on a model error or inappropriate model use leads to an undesirable outcome.Governance and Controls

  4. Stage 4Regulatory capitalPractitioner

    The Basel framework and risk-weighted assets, the regulatory treatment of counterparty risk, margin rules and SIMM, and the leverage ratio.

    1. IntroductoryThe Basel Framework and DerivativesThe Basel Framework is the set of international standards developed by the BCBS, and it rests on three pillars (minimum capital requirements, banks' own risk management and supervisory review, and disclosure).Regulation: International Standards
    2. IntroductoryRisk-Weighted Assets (RWA)RWA is the size of a bank's risks expressed as an amount, and it is the denominator of the capital adequacy ratio.Capital and Profitability
    3. PractitionerOverview of the Regulatory Treatment of Counterparty RiskThe regulation requires two kinds of capital, one against counterparty default and one against changes in the market value of CVA.Counterparty Credit Risk
    4. PractitionerBCBS-IOSCO Margin Requirements for Uncleared DerivativesThe framework aims to reduce the systemic risk of uncleared trades and to encourage central clearing.Regulation: International Standards
    5. PractitionerISDA SIMM: The Standard Model for Initial MarginInitial margin for OTC derivatives not cleared through a central counterparty uses the standardized schedule or, in Japan, a notified quantitative model.Valuation
    6. PractitionerThe Leverage RatioThe numerator is Tier 1 capital and the denominator is assets and transactions measured without risk weights, so the ratio complements the risk-based capital adequacy ratio.Capital and Profitability

  5. Stage 5XVA and advanced capital rulesAdvanced

    From Monte Carlo and an overview of XVA to CVA and DVA, FVA and MVA, wrong-way risk, SA-CCR, FRTB, the CVA capital charge and KVA.

    1. PractitionerMonte Carlo SimulationPaths are generated under risk-neutral dynamics, in which the expected return of the underlying is set to the risk-free rate.Valuation
    2. PractitionerOverview of XVACVA, FVA, MVA, and KVA lower the value, and DVA raises it.Valuation
    3. AdvancedCVA and DVAIf the counterparty's default is independent of market moves, CVA is the sum, over time intervals, of the discount factor times expected exposure times default probability times loss given default.Valuation
    4. AdvancedFVA and MVAFVA reflects the cost of funding collateral between an uncollateralized trade and its collateralized offsetting trade.Valuation
    5. AdvancedWrong-Way RiskIn a CVA valuation, estimating exposure and the counterparty's default separately understates the loss when the risk is wrong-way.Counterparty Credit Risk
    6. AdvancedThe Standardized Approach for Counterparty Credit Risk (SA-CCR)The exposure is 1.4 times the sum of replacement cost and PFE, calculated for each netting set.Regulation: International Standards
    7. AdvancedThe Fundamental Review of the Trading Book (FRTB)The FRTB is the market risk capital regulation that the BCBS published and later revised to address issues left over from Basel 2.5.Regulation: International Standards
    8. AdvancedThe CVA Risk Capital ChargeThe CVA risk capital charge requires capital for changes in CVA, separate from the capital held against default.Regulation: International Standards
    9. AdvancedCapital Valuation Adjustment (KVA)KVA is the present value of the cost of the regulatory capital held until maturity, and it lowers the value.Capital and Profitability

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