Balance sheet vs. off-balance sheet instruments

Market risk on specific financial instruments

Market risk management

Market risk management best practice guidelines

Value at risk (VAR)

INTRODUCTION

Market risk is the potential loss on investment due to fluctuations in the market value of assets involved. Specifically, for derivatives products it is the negative impact that the fluctuations in the underlying security market value would have on the value of the derivative. The uncertainty is implicit in all derivative securities. It is the driving force behind their trading and development. However, some of the risk associated with it can be diversified away or hedged. The remaining factors that could potentially incur losses on investment are market risk. It arises from the characteristics of the instrument as well as unforeseen circumstances in the market as a whole. Whilst there is no way of knowing with certainty where the FTSE 100 level will be at expiry of the corresponding futures contract, this is implicit in the definition of the product itself. However, the impact that a tsunami or an earthquake would have on the option value is impossible to incorporate into trading strategy. Since ‘playing safe’ is not an option for an active investor, the potential for losses is always present. Another important concept that arises within this context is non-traded market risk. It is the risk associated with interest rate fluctuations that impact on the banks’ balance sheet. All open positions are repriced daily for the purpose of P&L reporting, and thus are indirectly affected by the interest rate movement regardless of their underlying market. The impact is most evident in the wide mix of assets and liabilities resulting from the investment bank’s role as an intermediary. Hence market risk management focuses on the calculation of probability of adverse circumstances and the financial impact they would have. Risk mitigation is a complex subject that could have an entire book devoted to it, but will be briefly discussed further in the chapter. Typical approaches are: active portfolio management enabling hedging risk exposure in different sectors and reserving policy. Reserving sufficient funds to cover potential losses, thus avoiding default, is the legal and regulatory requirement for all market participants.

BALANCE SHEET VS. OFF-BALANCE SHEET INSTRUMENTS

As discussed in previous chapters, financial instruments that involve the transfer or exchange of principal (deposits, loans, swaps etc.) impact on a bank’s available assets, and thus appear on the company balance sheet. In contrast, derivative instruments that either do not require up-front payment, or where only a fraction of the underlying is involved (such as option margin), are off-balance sheet instruments. Even though their initial funding requirement is low, their market exposure is significant. Care must be taken to assess the exposure and reserve sufficient funds to cover potential losses due to unforeseen circumstances or market fluctuations that cannot otherwise be mitigated.

MARKET RISK ON SPECIFIC FINANCIAL INSTRUMENTS

Risks and benefits of various classes of products were already discussed in more detail in their corresponding chapters. They will be briefly re-visited here for completeness and clarity. Furthermore, it should be stated that market risk exposure is in many instances desirable, as it is a source of profit in correctly anticipated market conditions. Hence banks and other financial institutions, as a management decision, in some instances intentionally leave open positions that are part of their business strategy and in line with their view of the financial markets and economic conditions.

Money market products

Money market products are used for short-term lending and borrowing. Their underlying price driver is the short-term interest rate. As banks tend to have access to funds at interbank rate (e.g. Libor), whilst transacting with clients at less favourable rates, hedging money market positions is relatively easy and thus they are perceived as virtually riskless. As maturities are short and markets very liquid, no concentrations, maturity gaps or other mismatches should remain, leaving a fully balanced portfolio.

Capital market products

Capital market instruments are used for long-term lending and borrowing, thus their price is affected by long-term interest rates. Akin to the above, as banks tend to have access to funds at the interbank rate (e.g. Libor), whilst transacting with clients at less favourable rates, hedging these positions is relatively easy and thus they are perceived as virtually riskless. As these products are very liquid, no concentrations, maturity gaps or other mismatches should occur. However, an important difference between long- and short-term funding is in the repayment structures, whereby the former includes periodic interest payments and the latter does not. Depending on the contractual specifications, repayment schedules in OTC products may include non-standard terms and features, making them potentially difficult to offset exactly. But overall the inherent market risk is very low for this class of instruments.

Financial futures

Financial futures are exchange-traded products and thus are subject to a margining system. Whilst the exposure to the underlying security market remains, all daily profits and losses are incorporated into the margin payments. Furthermore, an initial margin is placed as a collateral at the inception of the contract, as a buffer against large market fluctuations or counterparty default. Hence no large, sudden losses resulting from underlying market moves should arise from futures contracts. They are typically hedged using FRAs, accounting for convexity adjustments, as discussed in Chapter 6.

FRAs

FRAs are short- to medium-term interest rate derivatives, hence they are primarily affected by interest rate fluctuations. They can be hedged either by futures (accounting for convexity adjustments), or strips of FRAs can be hedged using swaps of corresponding maturity and payment frequency. As FRAs are the OTC equivalent to futures, they are bespoke instruments with varied notional amounts, start and end dates, hence offsetting them exactly might potentially be a problem. But overall their market risk management is deemed straightforward, as the product structure and pricing is simple and the market is liquid.

Swaps

In most swap trades the investment bank acts as an intermediary between two counterparties, guaranteeing each side of the swap and earning the spread between the quoted rates. In such a scenario, there is no market risk implicit in the transaction, as the spread is earned regardless of the rate fluctuations and the counterparties to the swap are bearers of the full extent of the market exposure. Interest rate swap positions can also be hedged using strips of futures or FRAs, making their risk management straightforward. Other swap structures expose the bank to market risk in the underlying instrument (equity, commodity, FX etc.) requiring hedging with suitable product classes.

As swap maturities sometimes extend up to 50 years, liquidity becomes an issue, hence finding willing counterparties for a hedging transaction might be an issue.

Options

Exchange-traded options, just like futures, are margined. Whilst exposure to the underlying security market remains, all daily profits and losses are incorporated into the margin payments. Furthermore, the initial margin is placed as a collateral at the inception of the contract, as a buffer against large market fluctuations or counterparty default. However, the market exposure of the option buyer and seller are markedly different. Whilst the potential loss incurred by the buyer is the option premium, the seller is exposed to the full value of the underlying security. Option sensitivities (Greeks, discussed in Chapter 9) are important factors in consideration of suitable hedges, as very volatile positions can render a previously suitable hedge worthless under changed market conditions.

Foreign exchange instruments

Any type of financial instrument can be structured to involve foreign currency. Thus the market risks inherent in the basic product (option, future, swap etc.) are further enhanced by the incorporation of more than one currency in the deal. Not only is the fluctuation of the FX rate crucial in determining the market risk, the interest rates in both currencies further compound the exposure. As this exposure arises in different markets, potential hedging issues may arise in accessing foreign markets and the rates thus achieved. This is particularly true for long-dated FX instruments, where the liquidity may render the appropriate hedging strategy impossible.

Bonds

Market risk on bonds is the risk that the bond market as a whole could decline, reducing the value of individual securities regardless of their individual characteristics. It is further compounded by the timing risk, i.e. that the bond would underperform after its purchase. There is also a liquidity risk, i.e. difficulty finding buyers for some bonds that may result in an unfavourable selling price. Further market risk arises in bonds with special features, such as callable, puttable and convertible bonds, as the timing and effect of exercising such options is hard to predict. Declining interest rates may accelerate the redemption of a callable bond, causing the principal to be repaid sooner than expected and thus reinvested at less favourable interest rates. As bonds are typically called at or close to par value, investors who paid a premium for their bond also risk a loss of principal. However, bonds are typically issued directly in the market, i.e. without banks acting as intermediaries. They nevertheless feature in investment banks’ portfolios, typically as part of asset-backed securities or other credit derivatives, where their market risk is further complicated by the structure they are part of.

Equity derivatives

Equity derivatives offer exposure to equity markets without actual market participation. However, that does not insulate the investor from the equity market trends. On the contrary, the effect of gearing (whereby a relatively low capital investment results in large market exposure) associated with some products, makes the positions extremely risky. This is particularly the case when investing in single stocks or very specific equity sectors, whereby the price volatility can be significant without any means of diversification. Prudent hedging strategies employing diversified portfolios are mandatory market risk management practice.

Commodity derivatives

As commodities are physical goods traded for profit (arbitrage and speculation) as well as for hedging and delivery, pricing considerations as well as market risk associated with their derivative securities are different to other product classes. Prices of some commodity securities, energy derivatives in particular, are affected by a broad range of political and economic factors, government and regulatory policies and a host of issues difficult for market practitioners to foresee. Considerations of seasonality, convenience premiums and liquidity of more scarce products have to be weighed carefully in assessment of market risk. Hedging with equal and opposite transactions might not always be possible and finding a willing counterparty to accept a contract for delivery might prove difficult. Active market risk management by way of portfolio diversification and product, sector and maturity balancing is difficult to achieve, hence prudent reserving policy should be a cornerstone of commodity derivative market risk mitigation.

Credit derivatives

Credit derivatives are relative newcomers to the derivatives markets. As recent developments have shown, their impact on the world economy and the financial markets as a whole is far-reaching. In offering credit protection in the event of a third party or a reference asset default, credit derivatives affect several otherwise uncorrelated markets, extending the market risk across a wide range of factors. Examples of reference entities could be bonds, pools of commercial or residential mortgages, credit card or student loan debt, all with their associated risk of default (affected by a rise in interest rates, housing market decline, unemployment and a host of other issues). Their impact on the market value of the derivative security is difficult to estimate and hence mitigate. Again, prudent reserves should be put in place and careful monitoring of all open positions should be a standard practice.

MARKET RISK MANAGEMENT

As previously stated, market risk arises from trading activities as well as from indirect sources, such as interest rate fluctuation, that impact on the value of open positions and balance sheet. The first step in market risk management is its identification, followed by assessment. The simplest way of quantifying market risk exposure is marking to market. Marking to market is valuation of financial instruments compared to the prevailing market prices. It is used as a measure of current exposure to market fluctuations. In order to react to any unfavourable changes in the value of an investment portfolio, marking to market is done at regular intervals. In investment banks, this function is performed by the finance department. This process is called independent pricing, as it is done separately from valuation on the trading floor. If that were not the case, there would be the potential for misuse, as traders whose bonuses depend on the profit they are making could potentially underestimate losses.

Independent pricing involves valuation of all open positions. They are valued daily, weekly, monthly and annually. In order to have meaningful exposure assessment for any particular instrument, the price used for comparison has to be relevant. It is typically taken to be the cost of closing out the position. For example, if a company has purchased a cross-currency future that is making losses, the value of that open position is equal to the price it would achieve in the market by closing it out immediately.

For some product classes, such as money market instruments, performing the above calculation is an easy task, as there is sufficient liquidity and market prices are readily available. In contrast, exotic OTC securities, which are tailor-made to meet the clients’ needs, will not have a comparable product in the market. Sometimes the structure is so specific that finding a counterparty to take the opposite side in a close-out deal is impossible. Hence marking to market cannot be done on a like-for-like basis.

In such circumstances the security valuation is done in stages. The factors that are used in pricing models are marked to market separately and then used to derive the ‘market value’ of the security. For example, if the exotic option model requires inputs for volatility, market-implied volatility for the closest matching instruments would be used with possible adjustment.

Another responsibility of the investment bank finance department is reserve policy. This is the mandate on the funds that have to be set aside for each class of products, or on individual trades. These funds are kept away from the trading books, to be used to cover potential losses on closing out unprofitable trades. Once the contract matures, or is terminated in a different way, the funds are released. The reserve calculation involves inputs from:

• Quantitative analysts – as they develop pricing models, they are aware of their limitations and the approximations used. Hence they can assess the impact the market fluctuations would have on validity of the prices derived from the models and the margins of error they would introduce.
• Market risk department – their responsibility is quantification of market risk for all open positions using standardised measures. They provide their expertise in assessment of potential losses on various types of trades.

Reserving policy is a passive form of market risk management, as it only allocates funds that can be used to cover potential losses. More active market risk mitigation is achieved by active portfolio management whereby analysis of risks by sector, product and maturity enables identification of concentrations or gaps in exposure. Balancing assets and liabilities, so that to a large degree they offset each other, was previously a norm in market risk management. With a rise in derivatives trading there is also a potential for cross-market hedging, where balance sheet instrument exposures are covered by suitable offsetting positions in derivative securities. Whatever the choice, active market risk management is the only way of ensuring prudent business practice and reliance on the reserves should be viewed only as a last resort.

MARKET RISK MANAGEMENT BEST PRACTICE GUIDELINES

Investment banks, as well as all other financial institutions and market participants should have a well-defined set of market risk management principles. Whilst some are imposed by the regulatory structure (such as the previously discussed reserving policy, and implementation of VAR, described later), others should be followed as a part of prudent business operation. These include, but are not limited to:

• Establishing an appropriate market risk management environment
• Maintaining an appropriate market risk recognition, assessment and management
• Operating under a prudent and conservative market risk exposure limit policy
• Ensuring adequate market risk exposure controls and revisions.

Appropriate market risk management environment

Financial institutions should identify, evaluate and mange market risks inherent in all products and activities, as well as those arising from non-trading sources. Particular attention should be placed on new securities or activities, whereby suitable controls and management procedures need to be put in place, tested and approved. This is particularly true in relation to derivative and hybrid securities, whereby novel pricing techniques and complicated product structures make it hard, if not impossible, to adequately assess the true extent of market exposure. A market risk management strategy and policy should be developed and periodically reviewed at the highest level of seniority. Furthermore, all involved in identifying, measuring, monitoring and controlling market risks should be aware of and adhere to the policies.

Appropriate market risk recognition, assessment and management

A well-established, maintained and audited system for ongoing administration of all open positions as well as banking books should be in place at all financial institutions, investment banks in particular. Furthermore, a system for monitoring the extent of individual and overall breaches of market risk exposure limits should be established. Internal reserving and capital provision policies should be regularly revised in line with market moves and fluctuations in interest rates. In addition, the information on the overall portfolio composition and quality must be readily reproducible. In order to achieve this, information systems, applications and analytical models should be developed enabling analysis of present and potential market exposures by any classification (maturity, sector, product, or in various hypothetical scenarios). Concentrations and gaps should be identified and hedged away wherever possible to ensure active and dynamic mitigation of market risk exposure. Care should be taken to assess the boundaries of hedge validity, i.e. the range of market conditions under which the market risk exposure is effectively mitigated. Rehedging (or position rebalancing) should be done as frequently as is warranted by product class, practicality and cost-effectiveness.

Prudent and conservative market risk exposure limit policy

In addition to the market risk management methodologies enforced by regulatory requirements (such as VAR, described later), investment banks should employ their proprietary market risk management policies and models. This should be used when determining trading limits in individual securities, product classes and maturities, as well as to individual counterparties and groups of related counterparties. Particular care should be taken when extending existing trading limits or introducing new OTC products, where full assessment of pricing methodology, independent valuation, reserving policy and hedging potential should be established and stress-tested before introducing any changes.

Ensuring adequate market risk exposure controls and revisions

In line with the requirement for the proprietary market risk management methodology, investment banks should establish a system of continual independent review of market risk capture, measurement, management and control. Furthermore, internal controls and other monitoring activities should be employed to ensure that internal and external policies, procedures and limits are adhered to and any exceptions reported and addressed in a timely manner. Controls over trading limit extension and establishment of new trading activities should have priority within the control function. Finally, revision of all existing policies, procedures and the controls themselves should be done periodically to prevent problems and unforeseen losses due to unidentified or unmitigated market risk (both traded and non-traded) exposure.

VALUE AT RISK (VAR)

A standard measure of market risk, adopted by all financial market participants, is value at risk (VAR). It is a regulatory requirement and its definition is precisely defined. VAR is the amount by which the investment value may fall over a specified period of time at a given level of probability. For example, VAR of £50,000 at 1 per cent probability for one day implies that there is a 1 per cent chance that the investment would lose £50,000 in value in one day.

Hence the main VAR inputs are:

• Unit of measurement (index points, currency etc.)
• Time interval
• Probability.

Approved VAR models

According to the Basle agreement, investment banks are approved to use two types of VAR models:

• Standardised models, used by the general public
• Internal models, developed internally by the investment banks.

Internal VAR models have to adhere to strict qualitative and quantitative standards and be approved by regulatory authority. Those are:

Quantitative standards:

• One per cent probability level
• Two-week holding period on all trades
• Calculated VAR should be multiplied by three, to allow for error margin introduced by potential weaknesses in the internal model.

Qualitative standards:

• Independent validation of the VAR model by a third party
• Integration of the VAR model into risk management
• Internal control over data inputs and changes in the model
• Separation of trading business from risk management (introduction of ‘Chinese walls’)
• Senior management involvement in risk management.

VAR calculated in this way tends to be excessively high, thus it is typically breached only once every four years.

VAR measurement

Investment banks tend to have their internal VAR models, particulars of which are proprietary. Nevertheless, the approaches they take can be classified as:

• Parametric
• Historical
• Historical simulation
• Stochastic simulation.

Parametric VAR measurement

Parametric VAR measurement is very popular due to its ease of use and readily available market inputs. It assumes that the investment returns are normally distributed and therefore can be described using variances and co-variances of the underlying investments. It uses historical data to estimate variance and correlations of relevant investments, from which the investment returns are derived. This information is used in conjunction with current security prices to derive VAR. For example:

• Current market price for a bond future is 110, based on £100,000 notional amount. Historical estimates give value daily mean of 0.002 for future returns, with the standard deviation of 0.3.

From Chapter 13, we saw that 99 per cent of all normally distributed variables lie within 2.33 standard deviations from the mean. Hence, the point below 1 per cent of returns is given by:

1% of daily returns = 0.01 – 2.33 × 0.3 = −0.689

Hence the monetary value of VAR is:

VAR = 0.689 × 110/100 × £100,000 = £758

The main shortcomings of the parametric approach to VAR (also known as analytical or correlation method) are:

• Assumption of normal distribution of asset returns, which is in practice rarely observed
• Correlations between different variables impacting on investment returns are implicit in this model, even though the assets may be uncorrelated
• Volatility and correlation are assumed to be constant over a period of time.

Historical VAR measurement

Historical VAR measurement relies on taking a large sample of historical data and plotting the distribution. The bottom percentile can then be identified and VAR calculated using the same approach as above.

The pros and cons of this approach are:

• There is no implicit assumption about the distribution of investment returns
• No variance and co-variance estimates
• The shortcoming is that it is computationally extensive and requires complete recalculation on any change in VAR parameters.

Historical simulation (bootstrapping)

Historical simulation (bootstrapping) is used in the case of insufficient historical data on investments. Instead the historical data on parameters that impact on the value of investments is used. The investment performance through time is then simulated and VAR calculated as above.

The disadvantages of this approach are:

• Hard to identify the relevant price factors
• Needs extensive and reliable market data
• Extensive computational requirements, as the investments are evaluated using range of inputs many times in order to simulate their historical data.

Stochastic simulation

Stochastic simulation is similar to historical simulation, but instead of relying on historical market data for price factors, it constructs the distributions and parameters for each factor and then runs investment value simulations. It is popularly known as Monte Carlo simulation.

The main advantages of this approach are:

• No assumptions about the investment distribution
• No assumptions about asset returns
• Flexibility
• Ability to run a vast number of scenarios.

The disadvantages are:

• Excessive computational power is required
• Reliance on input parameters
• Reliance on sophisticated mathematical models.

Pros and cons of VAR

VAR is a market-standard measure of risk. However, it does have its disadvantages.

Its benefits are:

• Easy to understand
• Widely accepted
• A single measure of risk
• Easily applied.

Its shortcomings are:

• Does not account for risk in extreme circumstances
• Does not create reliable results for less frequently traded securities, as there isn’t enough information
• Uses a uniform measure for all securities, even though in practice their exposure varies (e.g. a two-week holding period is excessive for short-term instruments).