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Derivatives Compass

PractitionerAdvanced

Systems and IT

Who this is for
For IT departments, system integrators and package vendors who build and run trade management and risk systems.
How to read it
Newcomers read the foundations first. Practitioners start at stage 1. If you have worked on a trade management system, start at stage 2. Stage 6 is for people building valuation engines.

  1. Stage 1Business and system landscapePractitioner

    Who does what, the systems from front to back office, vendor products, and the data behind trade capture and lifecycle events.

    1. IntroductoryFront, Middle and Back Office RolesUnits are separated because, if the people who trade also keep the records and make the payments, no one else can notice hidden losses or misappropriated assets.Internal Operations
    2. IntroductoryFront-to-Back System ArchitectureSystems are often divided by function (trading; risk management; confirmation, settlement and collateral; and accounting), and their users span several departments.Data and Systems
    3. PractitionerTrading System Types and Vendor ExamplesTrading systems are viewed in three groups by how they are obtained: packaged integrated systems, specialist systems, and in-house builds.Data and Systems
    4. IntroductoryTrade Capture and ApprovalA unit other than the one that did the trade checks the entry, errors are corrected, and checked trades are passed on for reconciliation with the counterparty.Internal Operations
    5. PractitionerLifecycle Event ProcessingA lifecycle event determines whether a trade continues, ends, or is replaced by another trade.Internal Operations
    6. PractitionerLifecycle Event DataReporting data separates the action taken on a trade from the event behind it, and distinguishes 12 event types.Data and Systems

  2. Stage 2Conventions behind the calculationsPractitioner

    Day count and business day conventions, compounding and discounting, zero and forward rates, curve building and in-arrears compounding: the rules implementations get wrong.

    1. IntroductoryDay Count ConventionsInterest is the principal times the rate times "days in the period ÷ days in a year," and the days in the period include the start date but not the end date.Core Concepts
    2. IntroductoryBusiness Day Conventions and Holiday CalendarsIn Japan, banks are closed on Sundays, Saturdays, holidays under the Act on National Holidays, and from December 31 to January 3.Core Concepts
    3. IntroductoryCompounding and DiscountingIf you deposit 100 yen for three years at 2%, you end up with 106 yen under simple interest, which pays interest only on the principal, and 106.12 yen with annual compounding.Core Concepts
    4. IntroductoryPresent Value and Discount FactorsAt an interest rate of 2%, the present value of 102 yen received in one year is 100 yen.Core Concepts
    5. PractitionerZero Rates and Forward RatesA spot rate is the compound yield on a discount bond that pays no interest before maturity.Core Concepts
    6. PractitionerBootstrapping a Yield CurveSwap fixed rates do not show discount factors directly, so you solve for them in order of maturity, starting with the shortest.Core Concepts
    7. PractitionerThe Multi-Curve FrameworkDiscounting uses an OIS curve, projection uses a curve for each reference rate and tenor, and the projection curve is solved from the condition that market swaps have zero value.Core Concepts
    8. PractitionerCompounding in ArrearsThe rate compounded in arrears annualizes the growth from reinvesting overnight funds every day together with the interest, and it is set at the end of the period.Benchmark Rates
    9. PractitionerLookback, Lockout and Payment DelayWith a five-business-day lookback, the rate is known five business days before the end of the period.Benchmark Rates

  3. Stage 3Data and standardsPractitioner

    Market data management, end-of-day batches, FpML and the ISDA CDM, identifiers, and connections to trading platforms and post-trade services.

    1. PractitionerMarket Data ManagementDiffering assumptions between departments can distort financial reporting and market risk assessment.Data and Systems
    2. PractitionerEnd-of-Day Batch ProcessingEnd-of-day batch processing runs the jobs that use end-of-day values together, and is treated separately from online processing that runs on the spot.Data and Systems
    3. PractitionerFpMLFpML can be integrated with ISO 20022 and is also a target of CDM mappings.Data and Systems
    4. PractitionerThe ISDA Common Domain Model (CDM)The CDM is a data model that aligns how financial products, trades and lifecycle events are represented, in a machine-readable and machine-executable form.Data and Systems
    5. PractitionerIdentifiers: LEI, UTI, and UPIThe LEI identifies the legal entity, the UTI the trade, and the UPI the product, and an ISO standard sets the form of each.Data and Systems
    6. PractitionerElectronic Trading Platforms such as SEFsThe aims of the rules differ by country. The US states pre-trade price transparency, and Japan states disclosure of the outline of trades to ensure fair trading.Market Infrastructure
    7. PractitionerPost-Trade Confirmation and Matching ServicesIn electronic confirmation, the confirmation is established when the terms agree or the parties accept them.Market Infrastructure

  4. Stage 4Valuation and risk processingPractitioner

    Swap and option valuation, Greeks, collateral discounting, sensitivities and VaR, Monte Carlo and the daily valuation and P&L run, seen as processing steps.

    1. PractitionerValuing an Interest Rate SwapThe value is the present value of what you receive minus the present value of what you pay, and it is zero at the time the swap is traded at market rates.Interest Rate Derivatives
    2. PractitionerThe Black-Scholes ModelThe model assumes that the underlying price follows geometric Brownian motion, that volatility and interest rates are constant, and that trading is continuous and free of costs.Valuation
    3. 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
    4. 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
    5. 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
    6. IntroductoryValue at Risk (VaR)VaR at a 99% confidence level is the amount that losses exceed with a probability of 1%.Market Risk
    7. 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
    8. PractitionerDaily Valuation and P&L Sign-OffErrors and fraud could hide in P&L that traders set themselves, so a unit that does not trade checks the front office's figures.Internal Operations

  5. Stage 5Reporting and regulatory requirementsPractitioner

    Regulatory reporting, the trade reporting regime, the electronic trading mandate, record keeping and booking entities: the requirements systems must meet.

    1. PractitionerRegulatory ReportingTrade information is sent to a trade repository trade by trade, while capital ratios and the state of risks are sent to the authorities at set times.Internal Operations
    2. PractitionerTrade ReportingThe legal basis is Articles 156-63 to 156-66 of the Financial Instruments and Exchange Act and a Cabinet Office Order.Regulation: Japan
    3. PractitionerElectronic Trading Platform MandateThe notice as amended covers transactions that meet all its requirements. These include yen swaps with a compounded-in-arrears TONA floating rate.Regulation: Japan
    4. PractitionerRecord keepingJapan requires financial instruments business operators to create and retain books and records of their business, and a Cabinet Office Order sets the types and periods.Regulation: Cross-Border Themes
    5. PractitionerChoosing the Booking EntityThe sales entity that deals with the client and the booking entity that carries the trade are not always the same.Booking Models

  6. Stage 6Numerical methods for valuation enginesAdvanced

    Curve interpolation, calibration, finite differences, AAD, the Hull-White model and XVA computation, and the digitalization of trading.

    1. AdvancedCurve InterpolationThe quantity you interpolate is the discount factor, its logarithm, or the zero rate, and the quantity you choose sets the shape of the forward rate between the points.Core Concepts
    2. AdvancedModel CalibrationA model used for valuation is fitted to the current prices of instruments that have observable market prices and are also used for hedging.Valuation
    3. AdvancedFinite Difference MethodsReplacing derivatives with differences between grid points lets the explicit method write one time step as a weighted sum of three neighboring values.Valuation
    4. AdvancedAdjoint Algorithmic Differentiation (AAD)Bumping, which moves the inputs one at a time, needs more recomputation as the number of sensitivities grows, and the choice of step size adds error.Valuation
    5. AdvancedThe Hull-White ModelThe short rate moves according to two parameters, the speed of mean reversion and the volatility. It is normally distributed, so it can take negative values.Valuation
    6. PractitionerOverview of XVACVA, FVA, MVA, and KVA lower the value, and DVA raises it.Valuation
    7. PractitionerDigitalization: CDM and TokenizationAdoption has been announced for the CDM and trade reporting, while tokenization is mostly surveys and experiments.New Trends

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