Risk Management Tutorial
The risk management function spreads across the organization and all business activities. This tutorial explains several techniques and tips to manage risk, and explores how derivatives themselves introduce a new set of risks. This tutorial starts with why we manage risk and the context of risk management.
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 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.
Types of Risk
Of the many types of risk described in the following sections, the most common is the market risk, credit risk, and operations 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 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 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 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.
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 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
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.
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.
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.
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.
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.
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 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 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 is the process of validating the models used to calculate various measures such as VaR. Backtesting is performed after the fact of 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.
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 net exposure. This type of netting is referred to as closeout netting.
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 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
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 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).
Characteristics of Derivatives Contracts
The base currency of a contract notional is generally the currency of the contract.
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.
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.
The settlement date is the date on which the settlement of a specific obligation takes place.
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.
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.
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
The life cycle of a contract is divided into five major phases, and each phase is further divided into multiple stages.
The following sections describe each phase of a contract lifecycle and the various stages of each phase.
All steps before trade execution fall into the pre-trade phase. The following sections define each stage of this phase.
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.
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).
Before execution, orders are checked to ensure adherence to internal and external compliance rules to protect the firm’s interest and avoid any violations.
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 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 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 allocation of a trade.
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 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.
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.
After trade capture, the trade details are validated. Validation may include simple data validation to proprietary rules that enforce various trading practices.
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.
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.
Listed Product 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.
Expiration. Listed contract expires on the maturity date or terminated by offset trade.
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.
Live contract. During the term of 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.
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.
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 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
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 a compliance framework for pre-trade and post-trade compliance
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