How Banks Manage Derivative Trading Risk

VOLUME NO. 16

HOW BANKS MANAGE DERIVATIVE THE CHALLENGE TRADING RISK

In this issue of Derivations we discuss how For years, financial institutions have been educating clients on the value of derivatives banks’ derivatives desks manage the as hedging and investing tools. Clients have learned how tailored financial products can market risk that arises from clients’ hedging be used to mitigate unwanted financial risks - interest rate, currency, commodity, equity, transactions. For simplicity, the discussion and credit - or to enhance specific investment objectives. However, hedgers generally will focus on the risks associated with know much less about how banks manage these risks after their transfer from the client to the bank. This has sometimes led to the simplistic misconception that the expert (the managing an interest rate swaps and bank) takes the other side of a derivatives trade because it believes the client is wrong. options trading book. In fact, it is the bank’s business to accept financial risk transfers from clients at a fair market price. The bank profits from managing large portfolios of risk in the most efficient and cost-effective manner.

Derivative trading desks divide risk between financial market risk and non-market risk. The bank’s exposure to financial market risk changes with each new client transaction. However, non-market risks (like model risk, counterparty credit risk, and operational risk) also need to be managed. Both types of risk are a normal consequence of market making in the derivatives business.

How Banks Disaggregate Market Risk Derivatives dealers typically break down market risk by: • Country/Currency • Product Swaps, FRAs, Caps, Floors, Swaptions, Cross Currency Swaps • Short-term vs. Long-term Risk with terms of less than 2 years vs. risk over 2 years.

Traders specializing in specific currencies, products, and maturity sectors are charged with actively monitoring the conditions of each market and sector, and dynamically managing the scale and shape of market risk within pre-established limits. Market Risk To manage interest rate swap exposure, market risk is usually further disaggregated into: • Delta Risk Exposure to directional changes in market interest rates

• Spread Risk Exposure to changes in swap spreads

• Vega Risk Exposure to changes in interest rate volatility

• Basis Risk Exposure to mismatched swap indices within the trading portfolio

• Reset Risk Exposure to mismatches in swap rate reset dates within the portfolio

The Disaggregation of Market Risk

Delta risk describes the potential for gain or loss in an interest rate swaps portfolio associated with a change in the general level of interest rates. Each new transaction changes the risk profile of the portfolio. The trader usually adjusts for the change by selling or buying treasury notes or money market futures contracts against the new swap risk. In certain situations, bond futures and options are also used to manage delta risk. Delta hedging directional interest rate risk with treasury securities leaves swap spread risk to be managed. Spread risk arises from changes in the relationship between swap rates and government bond yields. One way to manage it is to create offsetting spread positions from combinations of market swaps and treasury notes purchases and sales. Combinations of futures contracts (e.g. pairing a long eurodollar futures position with a short treasury bill futures position) or futures and cash trades can also be used to accomplish the same objective.

Vega risk is the label given to the price sensitivity of an option - like an interest rate cap or an option on a swap - to changes in the volatility of interest rates. The vega risk created by the purchase or sale of an option from a client can be managed by selling or buying a similar option in the market, e.g. hedging a long USD interest rate swaption volatility position by selling an offsetting USD swaption. However, managing risk, transaction by transaction, is unwieldy and expensive. More often, volatility risk is managed at the portfolio level, where the overall vega position is adjusted using straddles — the simultaneous purchase/sale of a put and a call with identical terms. Buying and selling straddles allows the trader to adjust the portfolio’s exposure to rate volatility without changing its exposure to other market risks.

Sometimes, lack of liquidity forces a dealer to look farther afield for a hedge, for the purpose of buying or selling options in instruments that are highly correlated with the underlying risk. For example, a dealer might use USD LIBOR Caps/Floors or UST bond options to hedge the volatility of USD interest rate swaptions. Or a dealer could use USD swaption volatility to hedge the vega risk arising from a CAD swaption. Cross hedging in this fashion leaves the dealer exposed to correlation risk, the risk that the relationship between the risk position and the hedge will change adversely.

Basis risk is created by transactions involving similar but not identical market instruments. For example, a swaps portfolio may have some swaps where the floating rate index is 3-month LIBOR, and offsetting positions where the basis is the A1P1 commercial paper index. To hedge the mismatch, dealers can use basis swaps (involving the exchange of one basis for another) to directly offset the risk, or use the futures market (where one exists) to offset it. If the basis swap or futures market is illiquid or non-existent, the dealer may be reduced to holding an open basis risk position for an extended period of time.

Reset risk is created by daily fluctuations in a specific reference index. Daily changes in LIBOR rates are a good example. Because transactions are customized to precisely suit client requirements, date mismatches build up over time between the floating legs of customer transactions. Reset mismatches in the portfolio are offset in the professional market with reset FRA switches (where dealers match off reset exposure by simultaneously buying and selling FRAs – forward rate agreements – against exposed dates). The FRA switch market allows for reset mismatches to be mitigated several months in advance of the actual reset. SUMMING UP

Managing market risk efficiently and cost effectively requires derivatives dealers to disaggregate the exposure that client trades create into component risks (delta, spread, vega, etc.) managed by traders specializing in managing each area. Each risk book is subject to specific exposure limits, and actual trading exposure is closely monitored against the limits. Traders seek to profit from the scale economies and diversification benefits of large aggregated risk portfolios, and by exploiting small and transitory market anomalies.

This material is for general information purposes only, and is not to be relied on as investment advice. Readers should consult their own financial advisors before making any investment decisions. Interest rates and figures are for illustrative purposes only, and do not constitute an offer to enter into any particular derivative transaction. Actual rates quoted at any time will vary.

GLOBAL FINANCIAL PRODUCTS GROUP TORONTO 416 867-6462 CHICAGO 312 845-4010 LONDON 44 20 7248-0207