Risk Management (Best Tutorial 2019)

Risk Management

Risk Management

Historically, many failures led risk management to the forefront in financial and nonfinancial institutions. Corporations have been adopting a number of approaches and tools to manage and reduce various types of risks. The risk management function spreads across the organization and all business activities.

 

Although derivatives are typically used to manage risk, derivatives themselves introduce a new set of risks. Like other instruments, a derivatives contract is also exposed to typical market parameters, and the contract value is subject to change.

 

This value change may impact the hedge being used and require a rebalance. Since the change is continuous, the risk management process becomes an iterative process. In addition to market risk, derivatives also introduce other risks such as credit risk, liquidity risk, and operations risk.

 

The preceding blogs introduced respectively the derivatives market and its various products. This blog introduces the risk management function. Risk management is a broad area, and this blog does not describe it in detail but rather provides an overview.

 

This blog starts with the definition of risk and the context of risk management. It proceeds to explain enterprise risk management and risk management function, giving insight into how risk management works in an organization at different levels.

 

It next defines various types of risk that are faced by financial and nonfinancial firms and shows how derivatives are used to manage financial risks. Finally, this blog briefly explains some key risk measures and tools. This blog treats the following risk management topics:

 

  • the various types of risks financial and nonfinancial corporations face
  • how derivatives are used to manage financial risk
  • risk introduced by derivatives
  • enterprise risk management
  • the risk management process and various risk measurements and tools
  • various measures used to mitigate operations risk in managing derivative contracts

 

What Is Risk

What Is Risk

Risk pertains to anything that may prevent a company from achieving its objectives or that may have an adverse impact on the company’s performance.

 

All financial and nonfinancial corporations are exposed to risks in their everyday business activities from adverse movements and events in various contingencies, such as interest rates, foreign exchange rates, commodity prices, credit, liquidity, theft, weather, health, catastrophe, and competition.

 

The risk may arise on different levels of an organization due to business activities, specific investments, internal operations, or other sources.

 

The risk that companies face can be broadly divided into two categories: financial and nonfinancial. Financial risk is associated with financial market variables such as interest rates, exchange rates, stock prices, commodity prices, credit, and liquidity. The major financial risk types are a market risk, credit risk, and liquidity risk.

 

Types of nonfinancial risk include operations risk, legal risk, model risk, settlement risk, regulatory risk, and other business risks. Each of these types of risk is treated separately in the “Types of Risk” section of this blog.

 

Why Manage Risk

Why Manage Risk

Although risk-taking is an inevitable condition of doing business, not all risks that a business faces can be treated the same. Some risks must be differentially controlled to protect the business.

 

Firms must control—or hedge—certain risks whose probabilities or possible costs they judge to be unacceptably high. Risk management aims to reduce preexisting or future risks, avoid financial distress costs, maintain an optimal capital budget, increase the debt capacity, stabilize cash flows, protect the company, and comply with regulations.

 

Risk Management Process

Risk management is the continuous process of identifying the acceptable level of risk (risk tolerance), measuring the level of risk that an entity currently has (actual risk) and taking actions that bring the actual level of risk to the acceptable level of risk.

 

Other components of this process are continuously monitoring the new actual risk level and adjusting actions so that the current risk level remains aligned with the desired or acceptable level of risk.

 

Risk Management Process

 

Risk management is a proactive, anticipative, and reactive process that continuously monitors and controls the risk. Although hedging strictly reduces risk, risk can sometimes be increased to achieve business objectives.

 

Risk management is thus a general practice that involves both reducing and increasing the risk, as required. It involves answering the following questions by reference to the following risk measures, which shall be explained in the course of this blog:

 

What is the current trading position by trader, desk or portfolio, or firm level? The answer is framed by reference to positions, instruments, key measures such as national, risk measures such as duration, and delta that describe various aspects of positions or portfolios.

 

How is day-over-day profit and loss (P&L) moving and why? The answer involves the identification of the various market factors that are driving those market value changes.

 

What could happen to positions or portfolios and the P&L if the market moves in different directions in the future? The answer includes modeling various scenarios and their respective impacts on positions or portfolios.

What would be the effects of severe market movements on portfolios? The answers are derived from appropriate stress tests.

 

Risk from Derivatives

Although the primary use of derivatives is to hedge the risk, derivatives them-selves introduce a completely new risk. Like all other products, derivatives are also exposed to various market variables and operational issues. Derivatives are exposed to various risks similar to other financial instruments.

 

In addition, if the derivatives contract is used for hedging, the change in the value of the contract itself would affect the hedge. The process of balancing the resulting imperfect hedge is a critical part of the risk management function.

 

Moreover, risks introduced by derivatives are complex and difficult to understand, and they may be dangerous at times. Another component of derivatives is that they require a low investment, allowing firms to take greater risks. The misunderstanding of these risks or any unexpected market events may cause a much larger loss than first hypothetically envisaged.

 

Hedging

Hedging is the process of reducing or eliminating the risk. In practice, it could be described as simply balancing the level of existing risk to the desired level of risk. Most financial risks are hedged using financial derivatives. Later parts of this blog explain how derivatives can be used to hedge risk.

 

This section, however, considers only the hedger who transfers risk to another party—whether a speculator or another hedger with the opposite belief or risk exposure.

 

The ideal hedging instrument is one that has a perfect negative correlation with the asset being hedged. In reality, there may not be such an instrument available for hedging. The market price of both assets being hedged and the value of the hedging instrument are subject to change.

 

As one or both of these change, the hedge will also change, resulting in an ineffective or imperfect hedge. To maintain the perfect hedge, the portfolio (or the hedge position) must be rebalanced continuously. The risk of loss from an imperfect hedge is known as a basis risk or hedge risk.

 

Enterprise Risk Management

Enterprise Risk Management

 

Enterprise risk management (ERM) is the process of managing the risk that the firm faces at an organization level, as well as the combined risk from the organization’s individual departments or groups. In financial markets, it is also referred to as corporate risk management, enterprise-wide risk management, or firm-wide risk management.

 

ERM is a structured and disciplined approach of aligning strategy, processes, people, technology, and knowledge with the purpose of assessing and managing the risks that a company faces as it performs its business activity.

 

It provides an organization with a holistic view of risk, compliance, and governance—one that allows the organization to add value to its operations and create a competitive advantage while also addressing bottom-line efficiencies and redundancies.

 

In addition, ERM places responsibility on a level closer to senior management, giving senior management an overall view of the company’s risk position. Strategically, ERM is a key component of corporate governance.

 

Typical ERM functions include the management of different types of risks—such as market risk, credit risk, liquidity risk, operational risk, and settlement risk—capital requirements reporting, limits monitoring and control, enterprise collateral management, compliance monitoring and control, and enterprise reporting and audit.

 

The ERM function is performed by a single risk management group that monitors and controls all of the risk-taking activities of the organization, but may also have various subgroups that perform risk management activities at different levels throughout the organization. This group is responsible for the design, oversight, and implementation of risk planning, policies, procedures and control processes.

 

The ERM group defines the enterprise-level risk management framework that includes a risk framework for all its individual business units, divisions, and subsidiaries.

 

The ERM framework essentially explains an approach to identify, assess or measure, manage, monitor, and report risks. It defines procedures and processes for each of these activities to be used by an organization at different levels. It also identifies the strategy used to respond to the identified risks. 

 

ERM uses various enterprise-level risk measures such as value-at-risk (VaR), potential future exposure (PFE), credit valuation adjustments (CVA), economic capital, and regulatory capital, and various tools such as stress tests, scenario tests, and collateralization. These various risk measures and tools are discussed in subsequent sections of this blog.

 

Risk Management Function

Risk Management Function

The risk management function involves setting policies and procedures, defining the level of risk tolerance, identifying the risk, measuring the risk, and adjusting the level of risk.

 

The whole process is defined in a firm’s risk management framework. The risk management framework is comprised of risk management environment, risk strategy, risk management procedures and processes, and enterprise reporting, which are explained below.

 

Risk Management Environment

The risk management environment includes the risk philosophy, risk appetite, governance structure, policies, procedures, people, and other resources.

 

Risk Strategy

Risk strategy is a concise, high-level plan that articulates the vision and direction for risk management within the organization. The plan includes risk tolerance guidance, risk processes, and expectations for the risk management function.

 

Risk Management Process

Risk Management Process

The risk management process refers to the process of implementing the framework and executing the strategy. It includes processes and operational procedures that represent the execution of the risk management program.

 

The key steps in the risk management process are risk identification, risk measurement, risk management, and monitoring the risk. 

 

Risk identification. The ongoing process of recognizing the risk, its sources, and its nature.

 

Risk measurement. The process of assessing the magnitude of risk and its impact on the achievement of business objectives.

 

Risk strategy. The plan for how a firm would respond to a specific risk.

Firms may respond to each risk using one of the following strategies:

 

Risk transfer. The shift or transfer of risk exposure to another party or entity by, for example, a “hold harmless” contract.

 

Risk acceptanceThe acceptance of the likelihood and consequences of a particular risk. In terms of best practice, risk can only be accepted if it is within set risk appetite limits.

 

Risk reduction or mitigation. The strategy used to measure in order to control or prevent an issue or adverse event from causing harm and thereby reduce the risk to an acceptable level.

 

Risk insurance. An insurance policy that would prevent a loss of benefits in case covered losses does occur. However, not all risks can be insured, as it is either too expensive or such policies may not be available on the market.

 

Risk avoidance. Avoidance of activities that expose the firm to selected risks.

 

Risk monitoring and performance valuation. The process of ongoing and systematic tracking and evaluation of risk management decisions and actions against strategies, risk appetite, policies, limits, and key risk indicators.

 

Based on the assessed results, the process may loop back into any of the previous steps—risk identification, measurement, or management.

 

Risk reporting. Another important function of risk management is reporting. Reporting is the communication of risk information in all phases of the risk management function.

 

Risk reporting includes various details such as aggregate exposures and targets at different levels, compliance reports, key risk measures, evaluation results, and others.

 

Enterprise Reporting

Enterprise reporting provides a holistic view of overall risk management, including dashboards, various risk measures, and other details at an enterprise level.

 

Risk Management Team

The overall risk management function typically includes risk managers, compliance officers, regulators, auditors, supervisors, and ERM managers. The actual risk management organization structure varies by the type and size of a firm.

 

Types of Risk

Types of Risk

Of the many types of risk described in the following sections, the most common are a market risk, credit risk, and operations risk.

 

Market Risk

Market risk is the risk of a loss as a result of unfavorable changes in market prices such as foreign exchange rates, interest rates, equity prices, credit spreads, and commodity prices.

 

In other words, market risk is the sensitivity of the price (value) of an asset or derivative to a change in the market price (source of risk). Based on the sources of risk, market risk can be refined into risk categories such as interest rate risk and equity price risk.

 

Many factors can cause market risk exposure. At each positional level, market risk is calculated using measures such as beta for stocks, duration, and convexity for bonds, and delta and gamma, which reflect the price sensitivity of the derivative to movements in the underlying asset.

 

Typically, the market risk at a portfolio level is measured using the statistical measure value at risk (VaR). VaR is a single estimated number that represents the potential loss of a portfolio over a given time interval at a given confidence interval under normal market conditions.

 

The market risk for a derivative comes from the price movements of the underlying. The relationship between the change in the value of a derivative and the change in the underlying asset is complex. Assessing and managing the market risk of derivative contracts is consequently a relatively complex process.

 

Credit Risk

Credit Risk

Credit risk is the risk of loss from a change in the credit quality of the counterparty to a contractor of a security issuer. Credit quality may include a simple downgrade of a rating agency or, in extreme cases, a default.

 

Credit risk is typically measured by credit exposure, which is a potential loss in case of an adverse event. Credit exposure at any point in time is the replacement cost of the contract or asset.

 

In derivatives, the primary method for managing credit risk is through monitoring the net exposure to the counterparties to contracts. Limiting exposure to a particular counterparty requires the trading activity to be conducted with multiple partners. It ensures that the firm is not taking too much risk from a single counterparty.

 

Credit risk exists in most financial instruments from simple loans to complex derivative contracts. The source of risk and total credit exposure varies by type of instrument. For instance, in a simple loan, there is a risk of loss of interest, principal, or both.

 

Counterparty Credit Risk

In derivative transactions, a major form of credit exposure is counterparty credit risk (counterparty risk for short). A counterparty risk is a potential loss in the event the counterparty does not honor its obligations because of a default or other event. The recent financial crisis has re-emphasized the importance of counterparty credit risk.

 

The reforms have addressed most shortcomings of the OTC market. Reforms have introduced the central clearing of some of the OTC contracts, rules to improve transparency, and rules to reduce counterparty risk.

 

Counterparty exposure is generally defined as the amount that is lost in the event of counterparty default. So, sometimes the counterparty risk is referred to as default risk. In simple terms, the credit exposure from any contract is the cost of replacing the contract.

 

In addition, there are three major components of counterparty risk. First, the current credit risk (current exposure) is a risk that the counterparty will not pay if an amount is already currently due.

 

Second, potential credit risk or potential future exposure (PFE) is the risk that the counterparty will not pay the amount due in the future. Third, the counterparty might owe nothing now but could declare bankruptcy in the future because of liabilities currently owed to other parties.

 

Concentration Risk

Another form of credit risk is concentration risk, which is the potential loss from having investments or contracts with only a single source, such as counterparty or in a particular industry (market segment).

 

Operations Risk

Operations Risk

By definition, operations risk (also known as operational risk) represents the risk of loss resulting from inadequate or failed internal processes, people, and systems, or external events. This includes legal risk but excludes strategic risk and reputational risk.

 

Operations risk is very broad in nature and may originate from many sources, including the following:

  • People. Employee fraud, unauthorized activities, employment laws, loss of key employees, workforce disruption, and others.

 

  • Processes. Valuation and pricing (mathematically modeled risk), settlement risk, documentation, change management, reporting, compliance, and others.

 

  • Systems. Systems development and implementation, systems failures, security breaches, capacity, technology choices, and others.

 

  • External. Political and government risks, legal risks, disaster and infrastructure failures, and others.

 

Liquidity Risk

Liquidity is the ability of a firm to fund its obligations as they become due without incurring unacceptable losses. There are two types of liquidity risks. Market liquidity risk is the risk that the firm cannot easily offset or eliminate a position without taking a significant loss (trading below market price).

 

Funding liquidity risk is the risk that the firm will not be able to efficiently meet both the expected and unexpected current and future cash flow and collateral needs without affecting the firm’s financial condition or business activity.

 

It is difficult to measure liquidity risk. Derivative contracts can sometimes give rise to large and unpredictable cash flows, particularly margin calls for cleared products and collateral calls for bilateral products. This may create a liquidity crisis when there are drastic market movements or when the firm does not have a proper liquidity management plan.

 

Funding liquidity risk is typically managed at a corporate level by the finance department. Market liquidity risk is managed by individual risk management departments.

 

Legal Risk

Legal risk is the risk of loss from the unexpected application of a law or regulation or from a contract with a counterparty that cannot be enforced owing to legal limitations.

 

The legal risk of listed products is relatively small because operations are well defined and governed by exchanges, clearinghouses, and market associations. By contrast, the legal risks associated with products on OTC bilateral markets—even those covered by ISDA agreements—are considerable.

 

Model Risk

Model risk is the risk of loss from using mathematical (financial) models that do not produce the expected results or produce misleading numbers. Risk calculation and valuation of derivative instruments depend implicitly on the mathematical models selected for the computations.

 

Some models are simple, while others are highly complex and factor in many variables with multiple limitations. Selecting the wrong model or inputting the wrong data entails the risk of acting on misleading results.

 

Settlement Risk

Settlement Risk

Settlement risk is the risk of loss from the failure of the counterparty after the transaction date (trade date or valuation date) but before the final settlement.

 

The most common form of settlement risk is the Herstal risk. In many transactions, the settlements are two-way, meaning each party pays the other. This situation creates a problem when one party is paying while the other is declaring bankruptcy and the paying party is not aware of that fact due to time zone differences.

 

This type of settlement risk is known as a Herstaatt risk after the Herstal Bank in Germany, which failed in 1974 when its counterparties from foreign countries were sending money to it but it did not reciprocate the payments as it should have done.

 

Currency swaps often involve trading partners from different countries operating in different time zones. Payments from both parties are not settled simultaneously.

 

While one party that has sent irrevocable payment instructions to its financial institution is waiting for the payment to clear, the counterparty might declare bankruptcy. Such transactions are understandably exposed to settlement risk.

 

The market has, however, adapted many procedures and controls to reduce and eliminate the settlement risk for most types of situations.

 

For example, netting (whereby only net cash flows are payable) reduces this problem for single-currency transactions such as simple interest rate derivatives. Settlement risk persists, however, in cross-currency transactions between parties operating in different time zones.

 

Systemic Risk

Systemic risk is a risk of collapse of the entire financial system or a major market induced by the failure of one institution or a small group of institutions that are significantly interconnected with the whole system.

 

Derivatives are a source of systemic risk because of the large notional involved in a derivatives market and the fact that most large financial institutions around the world are heavily involved in derivative transactions.

 

The financial crisis of 2007–2008 is a classic example of the triggering of systemic risk. The market reforms that followed are primarily focused on reducing or eliminating the systemic risk through a broad set of rules.

 

Compliance Risk

Compliance risk (also called regulatory risk) is a risk of loss from employee actions or business practices that violate government regulations, exchange rules, clearinghouse rules, or mandatory market practices. Compliance risk is managed through strategies that promote operational transparency, continuous monitoring, and other procedures.

 

Reputational Risk

Reputational risk is a risk of loss from damage to the firm’s image caused by factors such as actions of company personnel that adversely affect public perception of the firm’s performance, strategy execution, integrity, product quality, commitment to safety, or ability to create shareholder value.

 

Such risky actions may cause loss of business and/or legal actions against the firm. Even if the firm escapes direct financial loss, reputational damage may hurt its future business and growth.

 

Derivatives and Operations Risk

Derivatives and Operations Risk

Operational risk management is an important part of managing derivative contracts. Operational risk exposure exists throughout the life of the contract including pre-trade, trading, post-trade processing, and settlement.

 

Operational failures may occur at any step resulting in consequent losses. The following list explains some key operational failures that may occur.

 

  • System failures. Failures such as IT infrastructure failures— including software and hardware malfunctions, telecommunication problems, and utility outages—that can disrupt the business causing subsequent losses.

 

  • Process or operational failures. Losses from failed operations such as errors in transaction processing, data entry errors, validation errors, collateral management failures, missing legal documentation, and access controls failures.

 

  • Internal fraud. Actions such as violating regulations and abuse of processes or fraud by employees, including theft, hiding transactions from internal or external regulators, insider trading, and manipulation of data and reports.

 

Operations risk is addressed at all stages of the contract and all parts of the derivatives business. In addition to regulatory controls, operations risk controls also include the firm’s internal risk controls.

 

The Basel Accords (in particular, Basel II and Basel III) prescribe a comprehensive operations risk management framework for all banks. This framework defines operations risk and provides guidelines for operations risk management.

 

The following list explains some procedures and controls used in the derivatives contract management function.

Access controls. Derivative systems include various features such as access control, audit, and reporting to eliminate or reduce any potential fraud.

 

  • Four-eye validation.

Critical operations designed to be reviewed by at least two people. For instance, every trade that is captured goes through at least two people (one person enters the trade and another person verifies and approves the trade).

 

It is known as the four-eye principle. Similarly, every settlement is reviewed by at least two or more people before final processing.

 

  • Workflow automation.

Most firms use end-to-end automation (or most operations) to avoid operational failures such as fraud or human errors. Automation also improves operational efficiency and compliance with regulations.

 

  • Independent risk group.

The risk management function is carried out by an independent group that is separate from a business group and that reports to senior management. Its compensation is not linked to the performance of any specific trading or business group. Such separation is expected to reduce or avoid any internal fraud.

 

  • Regular audit.

Internal risk controllers or auditors closely monitor derivative operations and trading activity at trading desks as well as treasuries. They also review all models used for activities such as pricing, risk management, and reporting.

Training. Regularly, mandatory training programs are provided to most operations staff in appropriate subjects that help to control operational risk exposure.

 

Note The Barings Bank Failure, which occurred in 1995, is a classic example of operational failure. A derivatives trader, Nick Leeson, single-handedly precipitated the collapse of this bank founded in 1762.

 

He managed to hide his risky transactions, which caused the collapse of the entire bank when his bets failed. This collapse could have been avoided if the bank had had adequate internal controls and modest oversight in place.

 

Derivatives are crucial for corporations to manage the various risks that they face. In addition to the low cost of transactions, derivative contracts provide flexibility, liquidity, and quick access. Financial derivatives are key tools for corporations to manage financial risk.

 

Hedging in this context refers primarily to the process of offsetting a preexisting risk through additional derivative transactions. Financial risks such as interest rate, currency, equity, commodity price, and credit risk can simply be hedged or traded with other parties who are more willing, or better suited, to take or manage these risks.

 

Most derivatives, including exotics, are of one of these types or are a combination of two or more of these types. The following sections briefly explain how these different types of derivative contracts can be used to manage risk.

 

However, the use of derivatives is not limited to the description provided below. Complex contracts and strategies can be designed and used by participants to address a variety of risks at various levels.

 

Even if the derivatives are traded for speculation, a better understanding of risk from the derivatives that are being used is critical for all market participants. If a speculative bet fails or the risk is misunderstood, it may cause serious loss to the contract holder.

 

Futures and Forwards

Futures and Forwards

Futures contracts are widely used in hedging preexisting risk. They can be used to reduce the overall risk as well as match expected returns.  These varieties of futures contracts can be used for hedging purposes in the following ways:

 

IR futures. Interest rate futures can be used to hedge risks posed by fluctuating interest rates. For instance, banks can efficiently manage the asset-liability mismatches inherent in their funding of long-term assets consequent on the difference between the rate that it pays on deposits (liabilities) and the rate that it receives on its assets.

 

This mismatch (also known as interest rate sensitivity) is alleviated by use of interest rate futures and other derivatives.

 

Equity index futures. Equity fund managers can reduce their market exposure easily with low-cost stock index futures.

FX futures. Multinational corporations, importers, and exporters can manage their foreign exchange risk using foreign currency futures.

 

As explained in the preceding blog, forwards are quite similar to futures but differ in that they trade in the OTC market and are customized. Like futures, forwards are used to hedge preexisting risk. The ability to customize forward contracts to suit the specific needs of counterparties may reduce the overall transaction costs.

 

Options

Option contracts are widely used instruments in hedging portfolio risks. The option sensitivity measures (Greeks) that are explained in a later section will provide an important insight into constructing portfolio hedges with options.

 

They not only characterize an individual option, but they can also characterize the risk exposure of a portfolio that includes options and other assets.

 

Although options are typically regarded as very risky instruments, in using complex strategies it is possible to create option positions that have a substantially lower risk than an outright position in an option.

 

There are many options strategies that can create a variety of new payoff profiles. Typically, option contracts can be used to neutralize the changes in the portfolio value from the underlying asset value changes (known as delta neutral hedging).

 

In another strategy known as portfolio insurance, the portfolio value can be kept at a certain minimum amount using an options contract.

 

This strategy combines the long position (by position) in a put option with a long position in the underlying asset, ensuring that the value of the combined portfolio cannot fall below a given level.

 

Swaps

Like other financial derivatives, swaps can eliminate, decrease, or increase the risk. There are many types of swaps including interest rate swaps, equity swaps, currency swaps, credit default swaps, and exotics—each with specific risk characteristics, described in the following list.

 

In addition to simple swaps, there are many exotics used by market participants to serve their risk management and other needs.

 

  • Interest rate swaps.

Interest rate swaps can be used to manage the interest rate risk of a firm. For instance, a firm borrowing at the floating rate can convert it to a fixed rate if it decides to limit exposure from interest rate changes. Thus, a swap can easily align a firm’s risk with the risk it desires.

 

  • Equity swaps.

Equity swaps can be used to avoid risk from fluctuations in equity prices. For instance, a portfolio manager holding a long-term equity portfolio would like to avoid the risk of short-term price fluctuations.

 

An equity swap to pay a floating rate on the equity side and to receive a fixed interest payment for a year can hedge the short-term risk—a year, in this case.

 

  • Amortizing swaps.

An amortizing swap is a popular exotic swap in which the notional principal is reduced over time. This replicates the mortgage loan. In this structure, the interest payments will become smaller during the life of the swap, thus providing a useful tool for managing the interest rate risk associated with mortgages.

 

  • Swaption.

This is another popular swap product. It is a combination of option and swap. The holder of a swaption has the option to enter into a swap in the future.

 

For instance, a receiver swaption gives the holder the right to enter into a swap as the fixed-rate receiver. It is like a put option on an interest rate. The holder can exercise the right to enter into a receive fixed-rate swap if the floating rate declines.

 

Credit Derivatives

Credit Derivatives

The credit market provides a wide variety of contracts, including credit default swaps on a single name, as well as a basket (index) of reference entities with various maturity periods. This allows market participants to manage their credit risk efficiently.

 

While the purchase of a corporate bond represents various risks, including interest rate, credit risk, and potentially other risks, credit derivatives represent pure credit risk.

 

Thus, a credit contract allows participants to separate credit risk from other risks, enabling easier credit risk management. Furthermore, because of the separation of credit risk, one can trade (assume or transfer) credit risk easily.

 

Credit derivatives are key for banks to reduce their credit risk exposure to companies they deal with through loans and other transactions. Banks can hedge their credit risk through contracts such as single-name credit default swaps, basket credit default swaps, and loan credit default swaps. Credit contracts also help banks to maintain capital requirements mandated by regulators.

 

Similarly, other institutions such as hedge funds, asset managers, and insurance companies use credit derivatives to manage their credit risk as well as to trade risk for profit.

 

Risk Measures

Risk Measures

There are many different measures used in practice to assess the risks from derivative and nonderivative positions. Risk measures are sometimes referred to as sensitivities. The following sections describe some of the common measures.

  • Greeks

Option sensitivities or risks are also known as Greeks. Greeks explain how the value of an option position changes in response to changes in the price of underlying, the passage of time, the risk-free rate, and volatility. These are key risk measures of all types of options positions:

  • Delta.

The rate of change of the portfolio value with respect to the price of the underlying. Assume that the delta of the portfolio is 0.6. This means if the underlying asset prices change by $1, the portfolio value changes by $0.60. Delta is widely used to measure market risk.

  • Gamma.

The rate of change of the portfolio’s delta with respect to the price of the underlying asset. In other words, gamma is the second derivative referenced with respect to the underlying asset price.

  • Vega.

The rate of change of portfolio value with respect to the volatility of the underlying asset. Higher absolute vega means the portfolio value is very sensitive to small changes in the asset volatility. Lower absolute vega means the portfolio value has little impact from underlying asset volatility.

  • Theta.

The rate of change of the value of the portfolio with respect to the passage of time, with all else remaining constant. Rho. The measure of the rate of change of the value of a position with respect to the interest rate, with all else remaining constant.

 

Duration and Convexity

Durations and Convexity

Duration and convexity are key interest rate risk measures that describe exposure to change in market interest rates. They can be calculated for an individual position or entire portfolios that hold interest rate products. With single numbers, they summarize a bond’s or a portfolio’s sensitivity to changes in interest rates.

 

Duration and convexity are tools for asset liability management. Duration is the first derivative and convexity is the second derivative of that curvature of change in market interest rates. Since convexity is a second-degree derivative, it is a better approximation than duration.

 

Volatility

In general, volatility is a measure of the uncertainty of change in the value of a variable, such as security price or the return on an asset. It is typically measured using such statistical measures as standard deviation and variance.

Another form of volatility is the implied volatility of an option, which is the volatility that gives the market price of the option when substituted in the pricing model.

 

Value at Risk

Value at Risk

Value at risk (VaR) is the worst-case loss at a specific confidence level over a certain period of time. In other words,VaR is the maximum loss that a portfolio or a firm can face over a specified period with a given probability.

 

Assume, for example, that the one-day VaR of a firm at a 95%-confidence level is estimated at $50 million. That means that with a 95%-confidence level, the firm might lose a maximum of $50 million owing to adverse market movements over the course of a day.

 

VaR is also computed at different levels in organizational structure to understand the risk at different levels. VaR is commonly used to measure market risk.

 

Expected Shortfall

Expected Shortfall (ES)—also known as conditional VaR (CVaR), average value at risk (Avar), expected tail loss (ETL), or simply tail loss—is an alternative risk measure to VaR. VAR answers the question, “How bad can things get?” ES answers the question, “If things do get bad, what is the expected loss?”

 

VaR is the maximum loss over a specified period with a given confidence level (p), whereas ES is the average loss in the worst (1-p)% cases. In other words, ES is the average of all losses that are equal or greater than VaR.

 

Potential Future Exposure

Potential Future Exposure (PFE) is the maximum expected credit exposure over a specified period of time calculated at a certain level of confidence. PFE is primarily a counterparty credit risk measurement used to assess the expected exposure to the counterparty over a certain time horizon.

 

PFE is similar but not identical to VaR. VaR is an exposure due to market risk, whereas PFE is a credit exposure due to the increase in the value of a contract. VaR is typically computed for short-term horizon (in days), whereas PFE is computed for long-term horizon (in years).

 

Credit Value Adjustment

Credit value adjustment (CVA) is the difference between the risk-free portfolio value and the true portfolio value that takes into account the possibility of counterparty default. Essentially, it is the market value of the counterparty credit risk. It is one of the key measures used in credit risk assessment.

 

Economic Capital

Economic Capital

Economic capital (also known as risk capital) represents the required capital amount that ensures that the firm stays solvent even in the worst-case scenario. It is the capital required to support the risk that the firm—generally, a financial institution such as a bank—is taking.

 

Economic capital is used by firms to manage their own risk, whereas regulatory capital is the minimum required capital by regulators. For banks, the regulatory capital calculation framework is prescribed by the applicable Basel accord (Basel II or Basel III).

 

Liquidity Coverage Ratio

The liquidity coverage ratio represents the proportion of highly liquid assets that must be held by a financial institution in order to meet short-term obligations. It is a regulatory requirement that mitigates the liquidity risks that firms face and is part of the latest Basel III accord.

 

Risk Management Tools

In addition to different risk measures, there are various tools or methods used in risk management practice. The following sections describe some of the common tools and techniques used in risk management.

 

Stress Testing

Stress testing is the process of estimating losses in case of abnormal market conditions. Abnormal conditions include historically worse market events or hypothetically worse market conditions. Stress tests are performed at different levels, such as those of the portfolio or the overall firm.

 

Scenario Analysis

Scenario analysis is the process of studying the impact of market data movements on returns (profit and loss) and the sensitivities (risk measures) of portfolios. In this process, various simple and complex scenarios that represent the best and worst market conditions such as rates and prices are used to compute the profit, losses, and sensitivities of portfolios.

 

P&L Variance Analysis

Profit and loss variance analysis is the process used to study daily profit-and-loss changes from various events on a trade-by-trade basis. It is similar to scenario analysis but with a focus on trades and events such as the profit-and-loss contribution of each position, the contribution from a new position, or the unwinding a current position.

 

Sensitivity Analysis

Sensitivity analysis is the process of studying the impact on the target variable such as the portfolio value from different values of a single variable. For instance, sensitivity analysis includes the computing of the impact of interest rate changes on portfolio value.

 

Limits Management

Limits management is a key risk control tool used by firms. It is the monitoring and controlling of the limits of various trading and nontrading activities by variables such as trading notional, credit exposure, market risk exposure (VaR, Greeks), and settlement risk exposure.

 

Firms may monitor and control limits either in real time or in periodic intra-day intervals. Typically, various limits are set at different levels such as trader, desk, portfolio, department, issuer, counterparty, and others.

 

Backtesting

Backtesting is the process of validating the models used to calculate various measures such as VaR. Backtesting is performed after the fact on historical data. In backtesting, typically historical data is used to compute the target using the model; this output is compared with real numbers from the market.

 

Netting

The most common tools used to mitigate counterparty risk are netting and collateralization. While netting helps to mitigate the current exposure, collateralization mitigates the potential future exposure.

 

In netting, counterparty exposure is reduced by offsetting amounts owed from each party to the net difference, wherein one party pays the other only a single amount.

 

Netting is a common feature used in two-way contracts such as forwards and swaps. It reduces credit exposure in swaps such as interest rate derivatives, but not in currency derivatives. Currency swaps often involve two parties in different countries and do not have a netting feature. 

 

Periodic payments in two-way derivative contracts with a netting feature are netted. The party that owes the greater amount deducts the amount due from the other party and pays the net to the other party. This is also referred to as payment netting.

 

Netting also reduces the risk in case one of the parties defaults. All outstanding transactions between the two parties are netted to find the net exposure. This type of netting is referred to as closeout netting.

 

Central Clearing

Central clearing is a key player in reducing the credit risk in derivatives transactions. As discussed earlier, central counterparties (CCPs) clear all the listed and OTC cleared contracts.

 

CCPs are well protected against the default as they use several lines of defense against their counterparty risk exposure. In addition, they use collateral to reduce their exposure by processes.

 

Collateralization

Collateralization is an effective credit risk mitigation technique used in derivatives and many other financial transactions. It is a practice in which market participants collect funds from counterparties as a security deposit and use them to recover losses in case of counterparty failures.

 

The Derivatives Contract

Derivatives Contract

This blog section introduces the derivatives contract, which is a legal agreement­ between its holders. The protean variety and inherent complexity of derivatives­ make the trading and managing of their contracts challenging.

 

This blog begins with an explanation of the general characteristics of a derivatives­ contract and an account of the successive phases of the contract lifecycle.

 

The various functional units of an organization involved in contract management and the role of each unit are also discussed. Finally, this blog touches on contract lifecycle variations across the major product types.

 

The topics and terminology presented in this blog serve as the foundation for more detailed discussion in corresponding blogs about specific product types.

 

The objectives of this blog section are to

  • define and distinguish the terms order, trade, contract, deal, and position
  • describe the general characteristics of a derivatives contract
  • explain the marketwide derivatives contract workflow
  • understand the various phases of a contract lifecycle
  • discuss the various organizational units and the functions they perform throughout the life of a contract

 

Contract Terminology

Each derivatives contract is made up of the elements presented in the following sections. Each element is associated with distinct terminology.

 

Order, Trade, and Contract

An order is a request or intention to purchase a financial derivative or enter into a contract. The order normally originates in a portfolio or from an investment management group.

 

After its origin, it may go through an approval process before being sent to a trading desk for execution. The order is executed by a derivatives trader. This execution agreement is known as a trade. A trade is only an agreement of execution, and it is not valid or legally binding until the trade is fully processed.

 

The trade becomes an effective (live) agreement between counterparties after it is fully processed. This agreement is known as a contract. The contract life begins from the effective date of the contract and ends on its maturity date or date of termination. 

 

The terms contract and trade are sometimes used synonymously, although this is not technically accurate. Other terms commonly used to refer to a contract are deal and agreement.

 

Position

Position refers to an investment (contracts) held by an institution or investor, and it can be either a financial security or derivatives contract. This is an aggregation (net) of all similar assets or contracts.

 

For instance, if there are two similar swap contracts worth $100 million and $50 million, it results in a swap position worth $150 million. If the situation is opposite (long and short), then it will result in a swap position worth $50 million ($100–$50).

 

Financial Instrument and Product

A financial instrument refers to the financial contract that is actually being traded. Generally, the product is used to refer to the category of the instrument. For example, while the equity option is a product, the specific stock option is an instrument. These two terms are also often used synonymously.

 

Characteristics of Derivatives Contracts

Characteristics of Derivatives Contracts

Derivatives contracts are complex and comprise many characteristics. This section describes common characteristics of derivatives contracts.

 

National

Notional refers to the principal amount of the contract. It is the amount used to calculate cash flow, but not necessarily the value of the contract. This amount is not necessarily exchanged between the two parties. Take, for example, a simple interest rate swap (IRS) with a $1 million notional amount.

 

This amount is not exchanged between the two parties, but all cash flow exchanged between the parties is calculated based on a $1 million principal, which is considered the notional amount of the contract.

 

A contract that has a notional transfer between counterparties is known as a funded contract. Other terms used are a notional principal, notional value, nominal amount, notional sum, and face amount.

 

Effective Date

The effective date, or start date, is the date on which a contract term begins. All obligations of agreement take effect from that date.

Termination Date

The termination date (also called maturity date) is the date on which a contract term expires. Contract obligations end after this date.

Tenor

The tenor (also known as the duration or length) is the period through which the contract terms are effective.

 

Counterparty

A contract is between two parties, such that each party is the counterparty to the other. Other frequently used terms for this arrangement are another party, trading partner, and contra. In general, the counterparty is used to refer to each holder of a contract.

 

Currency

The base currency of a contract notional is generally the currency of the contract.

 

Legs

Many derivative contracts are comprised of multiple components, each ­resulting in an independent series of cash flow. These components are generally­ referred to as legs. For example, in an interest rate swap, there are two components. First, a fixed interest component, which results in a series of cash flow events based on a fixed interest rate.

 

Second, a floating-rate component, which results in a series of cash flow events based on a floating interest rate. These components are the two legs of the contract. In a trading strategy, there are normally multiple trades involved where each trade is a leg of the strategy.

 

Settlement

The settlement is the fulfillment of the obligation of a contract holder. The ­obligation might be in the form of cash, securities, or underlying assets. Essentially, a contract holder that has an obligation transfers the asset or cash to its counterparty­.

 

Usually, the transfer of cash or assets is done between the custodians of the two parties. In derivatives, there may be multiple settlements­ through the term (life) of a contract.

 

For instance, a swap contract involves periodic payments to be made between two parties. There is a settlement each time a payment is made by any party. In another example, the margin is paid on futures contracts every trading day; hence, a settlement takes place every trading day.

 

Settlement Date

The settlement date is the date on which the settlement of a specific obligation takes place.

Cashflow Schedule

Cash flow is the obligation stipulated in a derivatives contract. Many ­contract types undergo multiple cashflow events in their lifetime. The pay dates, amount, and other cashflow details are known as the cash flow schedule.

 

Third Parties

Apart from the two contract participants, there may be other entities involved in a contract such as the execution broker and the clearing broker. All entities other than the contract holders (counterparties) are known as third parties.

 

Portfolio

The portfolio is a collection of investments held by an institution. The collection­ may include securities, derivatives, or any other type of financial ­instrument. Normally, derivative contracts are organized and managed through a portfolio.

 

Legal Entity

A legal entity is the name of the entity registered with the local government. The legal entity’s name of the contract holder is used in all official agreements.

 

Transaction Date and Value Dates

Transaction Date and Value Dates

Although settlements are supposed to happen on a date specified in the contract,­ the actual transaction may not happen on that exact date. In such scenarios, there are two different dates that are in use. The date on which an actual transaction settles is referred to as transaction date.

 

The date on which a transaction is intended to settle according to the contract­ terms is referred to as the value date. Cash flows are computed as they are settled on value date.

 

Contract workflow:

Contract workflow

 

A derivatives contract life cycle starts with trade execution and ends with its maturity or termination. This section briefly describes various phases in the life cycle along with stages of each phase. 

 

In fact, the pre-trade phase which is related to the origination is also an important phase of a derivatives contract. This is why the pre-trade phase is also included in the life cycle of the contract.

 

The following steps summarize the contract workflow:

 

  • Pre-trade. During the pre-trade phase, market participants establish the trading relationship among each other, including the establishment of service providers.

 

  • Trade execution. Market participants execute their trade either bilaterally or on execution venue.

 

  • Matching and confirmation. After execution, trade details are matched from both sides to avoid any recording of other errors.
  • Clearing. Cleared contract trades are sent to CCPs for clearing.

 

  • Live contract. After clearing, the contract becomes live until either expired or terminated. During this period, both counterparties must fulfill their obligations. Derivative contracts may involve multiple settlements.

 

  • Expiry. Finally, a contract expires at the end of its term or early if formally terminated.

 

Bilateral contracts are between two end clients or between an end client and a dealer. Listed and cleared contracts are between a CCP and an end client or dealer. The following section divides the whole life cycle of a contract into multiple phases and stages and elaborates on each of them.

 

The Phases of a Contract Life Cycle

Phases of a Contract Life Cycle

The life cycle of a contract is divided into five major phases, and each phase is further divided into multiple stages. Figure 4-3 shows the different phases and stages (activities) under each phase.

 

The following sections describe each phase of a contract lifecycle and the various stages of each phase.

Pre-Trade

All steps before trade execution fall into the pre-trade phase. The following sections define each stage of this phase.

 

Onboarding

Onboarding is the process of establishing a trading relationship between trading­ partners and service agreements with all other market participants. These relationship agreements define the rules and regulations, type of relationship, trading limits, credit lines, and other legal matters. This process is also known as documentation.

 

Order Origination

Orders originate from financial institutions and other market participants (end users). The purpose of derivatives is explained in earlier blogs. Normally, trading decisions are made by a portfolio or asset management group.

 

Orders are forwarded to a trading department (front office) for execution. Although this depends on the organization’s structure, almost all requests go through a validation and approval process before execution (known as the pre-trade compliance).

 

Pre-Trade Compliance

Before execution, orders are checked to ensure adherence to internal and external compliance rules to protect the firm’s interest and avoid any violations.

 

Trading

Trading

Orders are sent to a trading desk for execution, where they are executed by professional traders who have the knowledge of the markets and ­products they are navigating. Trading involves the dealing and pricing of complex products.

 

Pricing

Pricing is the process of identifying the fair market value of an instrument. Listed products are liquid, and their market prices are easily available from trading venues. Complex OTC derivatives, however, are priced by traders using theoretical models.

 

Dealing and Execution

Execution is the agreement between two parties to enter into a contract. To find the best possible price, traders may check different venues or negotiate with dealers.

 

On an electronic exchange, trades are executed by an electronic matching system, but in bilateral trading, traders from both sides negotiate directly and execute the trade. Executing an order is also referred to as filling an order, and the execution is often referred to as a fill.

 

Allocation

Allocation is the process of assigning a trade to a legal entity (the firm that will legally own the position) or to sub-accounts of a legal entity. Allocation is a necessary step of execution. Allocation is done either before or right after execution. Post-trade processing begins after an allocation of a trade.

 

Post-Trade Processing

Post-Trade Processing

Trade execution is only the initial agreement between two counterparties. This agreement remains ineffective until it is fully confirmed by all parties involved (counterparties, clearing member, clearinghouse, and so on). The trade is confirmed during the post-trade processing phase.

 

After the trade execution, both parties forward the trade details to their respective middle offices (operations groups, as explained later in this blog) for processing.

 

The following steps explain all the stages of post-trade processing. At the end of successful post-trade processing, the trade becomes life, which is to say it is now a legally binding contract between two counterparties.

 

The duration of post-trade processing varies by the market. For instance, trades executed on the exchange (listed market) may get processed within ­minutes and, in the case of an OTC bilateral, it may take from few hours to a couple of days. However, the objective is to process the trade as quickly as possible in order to avoid trade failures.

 

Trade blogging

After the execution, trade details are captured in a post-trade processing system for further processing. The blogging can be done either manually or electronically. In electronic blogging, trade details are fed directly into a trade processing system from a trading system.

 

Trade Validation

After trade capture, the trade details are validated. Validation may include simple data validation to proprietary rules that enforce various trading practices.

 

Trade Enrichment

Trade execution records normally contain only the key details of a trade. In the post-trade processing phase, trade records are enriched with various other data such as market conventions, instrument details, calendars, and third parties. This additional information is necessary for further processing in the life of a contract.

 

Matching and Confirmation

Confirmation is the official agreement of both parties to the trade terms. Before confirmation, both parties compare and match trade terms to determine if their recorded terms are consistent.

 

This step eliminates any errors resulting from communication errors or from the trade capture. The official confirmation process establishes the contract as legally binding between both parties.

 

Clearing

In theory, clearing is the process of recording or registering and establishing­ the legal binding (legal obligation) between counterparties. This confirms the contractual obligations between the two parties.

 

There are two types of clearing: central clearing and bilateral clearing. In a central clearing, an agreement between the initial trading partners is transferred to a central counterparty (CCP, also known as clearinghouse).

 

In this case, the original contract between counterparties is replaced by two contracts on the same economic terms as the original trade, as well as standard CCP terms between the CCP and each participant.

 

After clearing, there is no contract between the original counterparties­. In a bilateral clearing, the initial trading partners interact with each other. Here there is no separate clearing step, as both parties face each other by default.

 

In practice, however, clearing typically refers to central clearing. Bilateral clearing is not a commonly used term; instead, those contracts are known as bilateral.

 

Clearing is the final step of post-trade processing. After clearing, a derivatives trade becomes a live contract. If a contract is bilateral, confirmation will be the final step. Listed and OTC cleared contracts are centrally cleared through a designated clearinghouse. All other OTC contracts are bilaterally cleared.

 

Live Contract

After post-trade processing, the contract becomes live. It is effective from the start date and expires on a maturity date or earlier if the contract is ­terminated.

 

A live contract may trigger periodic payments based on the terms of the contract. In addition, various other operations may be performed on a contract. Some of these operations may modify or terminate the contract itself.

 

Settlement

Settlement

The settlement is the process of fulfilling the obligations of a contract. Derivative contracts may involve multiple obligations (settlements) over the life of a ­contract.

 

These obligations can be cash or other asset transfers, according to the contract terms. Obligations are settled through financial institutions such as custodians, settlement agents, or a central bank.

 

Amendment

Contract terms can be modified during the life of a contract by mutual ­agreement. However, not all types of contracts are modifiable. For example, listed products cannot be modified, but the position itself can be closed by an offset trade.

 

After the amendment, a contract normally undergoes post-trade processing again to confirm the new terms of the contract.

 

Event Management

Events such as credit and corporate actions impact the life of a contract. These events are monitored, and impacted contracts are modified by ­counterparties to reflect these events.

 

Offset or Unwind

The offset is the process of terminating an existing contract through an offset trade (trade with the opposite direction). Centrally cleared (listed and cleared) contracts can be closed through offset before they mature at the end of the contract term. This way, contract holders can avoid any required delivery by offsetting their position.

 

Unwind is the process of terminating an existing contract with the original counterparty before its maturity. Bilateral contracts can be terminated through an unwind operation. This is also known as an early termination. This is the term commonly used in OTC bilateral contracts.

 

Partial Unwind

Partial unwind is the process of reducing the notional of a contract. A client can partially unwind a contract with the counterparty of the agreement. This operation will return the contract to post-trade processing. Note that not all types of contracts can be partially unwound.

 

Assignment or Novation

Assignment, or novation, is the process of transferring a contract from one party to another. This transfers all obligations to the new party.

 

Exercise

Exercise is the process in which an option holder claims the right (underlying­ asset or obligation) granted by an option. Based on the type of contract, the holder can exercise the contract either during the life of the contract or upon maturity. Exercise will trigger the settlement of underlying assets as per contract terms.

 

Expiry

The derivative contract has a limited life that starts on the effective date and ends on the maturity date. While certain types of contracts expire with ending ongoing obligations, others trigger the delivery on the expiry. The operations and events—such as unwind, offset, credit event, and exercise—all terminate the contract.

 

Maturity or Expiration

All derivative contracts expire on their maturity date. Based on the type of contract, some contracts simply terminate all obligations upon maturity while others may trigger a final settlement.

 

Compression

Certain OTC contracts are compressed or netted to reduce the overall risk exposure. This will result in the termination of some live contracts that are similar and in an opposite direction.

 

Life Cycle by Category

The following section briefly explains the contract life cycle of each category. 

 

Listed Product Contract

Listed Product Contract

As discussed earlier, listed products are traded on exchanges and cleared by clearinghouses. These instruments are standardized, and processing procedures are well-defined. Listed contract trading is governed by trading exchanges; the clearing process is governed by the clearinghouse that clears the contract.

 

Listed contracts can be traded on some electronic platforms apart from the listed exchange. However, all off-exchange trading is reported to the exchange and are cleared by the designated clearinghouse. The overall life cycle is very similar for most products listed on the various exchanges. 

 

The following steps outline the life cycle of a listed contract. 

  • Pre-trade activity. Includes initial account setup and another legal agreement setup among clients, broker, exchange, clearinghouse, and other market participants before trading.

 

  • Trade execution. Clients send their orders to brokers; brokers, in turn, execute an order on an exchange or another execution venue. Execution details are sent back to the clients, and post-trade processing follows.

 

  • Matching and confirmation. Both parties (brokers) of the trade match trade details and confirm the trade execution through an exchange-provided confirmation platform.

 

  • Clearing. Confirmed trades are sent to the clearinghouse­. The clearinghouse clears the trades and becomes the central­ counterparty, creating two trades, one with each original party. Notification of the cleared trade status is sent to all the parties involved, and the contract becomes live.

 

  • Live contract. The live contract may generate multiple settlements and subject to various operations and events.
  • Settlement. Ongoing settlements including initial settlement,­ periodic obligations (daily), fee, and other deliverables are processed.

 

  • Exercise. Option contracts may be exercised by a contract­ holder when they become eligible.
  • Offset. Contracts can be terminated by an offset trade.

 

  • Margin management. Listed contracts require collateral­ to be maintained in a margin account. Margin payments are computed and collateral is posted daily.

 

  • Expiration. Listed contract expires on the maturity date or terminated by offset trade.

 

OTC Cleared Contract

The OTC cleared contracts are quite similar to listed contracts. These ­contracts can be traded on multiple trading venues such as exchanges and swap execution facilities (SEF). Regardless of the trading venue, the clearing CCP governs the lifecycle management of the contract. Part II of this blog provides more details. 

 

Pre-trade Activity

Dealing/Negotiation

The following steps outline the life cycle of an OTC cleared contract:

  • Pre-trade activity. Includes account setup and other activity between market participants before trading.

 

  • Trade execution. Market participants execute the trade over authorized execution facility and submit to affirmation platform for confirmation.

 

  • Matching and confirmation. Both parties match trade details and confirm the trade over an affirmation platform.

 

  • Clearing. The confirmed trade is sent to the CCP. The CCP clears the trade and becomes the counterparty creating two trades, one with each party. End clients clear their trades through a clearing member who is a member of the CCP.

 

  • Live contract. During the term of the life, contracts are evaluated, and obligations are settled between contract holders. A live contract is also subject to certain events and may get terminated through an offset trade.

 

  • Settlement. Ongoing settlements including initial settlement, periodic obligations (daily), fee, and other deliverables are processed.
  • Offset. Live trade can be terminated by an offset trade.

 

  • Event processing. Events that affect the contract are processed, and contracts are updated to reflect the impact.
  • Margin management. Cleared contracts require collateral to be maintained in a margin account.

 

  • Margin calls (initial margin and variation margin) are processed and collateral is posted daily.
  • Expiration. A cleared contract expired on the maturity date or was terminated by an offset trade.

 

OTC Bilateral Product Contract

OTC Bilateral Product Contract

An OTC bilateral contract is directly negotiated between two parties. Most bilateral contracts are arranged by dealers and, in most cases, dealers act as a counterparty.

 

The following steps outline the life cycle of an OTC bilateral product contract.

  • Pre-trade activity. The relationship between counterparties is established through an ISDA Master Agreement (market standard) and other documents.

 

  • Trade execution. An OTC bilateral trade is directly negotiated and executed between two parties or on an electronic platform.

 

  • Matching and confirmation. Both parties match trade details and confirm the trade on an affirmation platform. Since there is no central clearing, trade becomes live after confirmation.

 

  • Live contract. During the term of the contract, it is evaluated periodically for obligation settlement, collateral management, and other purposes. The live contract is also subject to operations such as early termination, amendment, assignment, or exercise if it is an option.

 

  • Settlement. Ongoing settlements including initial settlement, periodic obligations, fee, and other deliverables are processed.
  • Event processing. Events that affect the contract are processed, and contracts are updated to reflect their impact.
  • Expiration. The contract expires on the stated end date, early termination, or assignment.

 

Organizational Units

Having surveyed the different phases and steps of a contract life cycle, let us examine where these activities take place in a typical organization structure. In general, from the contract lifecycle perspective, an organization is divided into three major units: front office, middle office, and back office.

 

In addition, the middle office comprises multiple units such as operations, risk management, legal, and compliance units. The actual organizational structure may vary by type and size of the firm.

 

Contract Process Map

The following section briefly explains the roles and responsibilities of each unit. They are further discussed in greater detail in later blogs on the organizational structure of the different types of firms.

 

Front Office

Contract Process Map

The front office is primarily responsible for all trading-related activities.

The front office’s key responsibilities are the following:

  • pre-trade analysis such as pricing
  • negotiation and trade execution
  • amending live contracts, trading offsets, and contracts to terminate positions

 

Middle Office

The middle office is comprised of multiple groups such as operations, risk management, and compliance (corporate oversight).

The major responsibilities of middle office groups include the following:

  • validate, enrich, and confirm trades with counterparties or affirmation platforms as part of post-trade processing
  • monitor the clearing process and resolve any issues that arise in post-trade processing.
  • generate cash flows, validate and forward flows for processing­ by the back office

 

  • perform end-of-day activities such as load market data and rate resets (fixing of new interest rates)
  • generate all required reports: profit and loss, risk reports, activity reports, and so on

 

  • manage the life cycle of the contract, resolve any disputes or issues, and perform updates or adjustments
  • manage margin accounts and collateral with counterparties

 

  • assess and monitor risk and advise or take the appropriate­ action
  • develop and implement compliance framework for pre­-trade and post-trade compliance

 

Back Office

The major responsibilities of the back office are to manage the firm’s accounting and finances. With respect to derivatives processing, the back office’s key responsibilities include the following:

  • validate settlement instructions
  • process settlements and deliverables (cash and securities)

 

  • manage accounting and taxation
  • reconcile accounts and handling breaks, and resolve any disputes in payment processing

 

  • manage cash and liquidity
  • produce various financial reports

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