Document

Report
THE DERIVATIVES BUSINESS

The Derivatives Business:
Focus on Financial Risk
and Control Systems
1
MILAN, 30 JUNE 2004
THE DERIVATIVES BUSINESS
Key Facts
COMPANY PROFILE (December 2003)
Conceived in 1998, formally spun off in 2000
569 employees, average age 35
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S&P Rating:
Total Assets:
Gross Revenues:
Net income:
Average daily VaR:
Cost/Income:
ROE:
Net revenues/employee:
AAEUR 47b
EUR 770m
EUR 340m
EUR 4.4m
24%
61%
EUR 598k
Regulatory Capital Requirements
1,200
1,000
800
EUR/m
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600
400
200
Mar-03
SOME TRADING BOOK STATISTICS
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Derivatives portfolio’s outstanding notional > € 1,000b
Outstanding trades > 200,000
Total risk factors > 40,000
Total web transactions on capital guaranteed products > 500,000
Number of daily trade revaluations > 15m
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Jun-03
Sep-03
Dec-03
THE DERIVATIVES BUSINESS
Executive Summary
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Over 80% of UBM’s gross revenues are generated from Financial Products – sales & trading (FP)
FP includes institutional and corporate derivatives as well as fixed income and equity trading
Over 85% of FP’s gross revenues are generated from derivatives
In total approximately 75% of UBM’s gross revenues are generated from derivatives
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The purpose of this presentation is to illustrate the risk management framework behind this activity
Four main risk classes are analysed:
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Market risk
Model risk
Counterparty risk
Operational risk
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THE DERIVATIVES BUSINESS
Financial Products - sales and trading
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From the beginning of operations, market risk management has been a distinctive element in UBM
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Derivative products are traded on all asset classes
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Ability to address a broad segment of corporate and institutional customers with innovative financial
products
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Core skills in pricing, hedging and trading
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Products are unbundled into elementary risk components by proprietary pricing models and hedged
through wholesale markets
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Limited back-to-back trading
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Industrial approach: large volumes, high throughput, efficient time-to-market
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UBM transforms derivatives risks into market, model, counterparty and operational risks
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THE DERIVATIVES BUSINESS
The Risk Management Stages
DERIVATIVE PRODUCT
CLIENT
OPERATIONAL
MARKET
MODEL
COUNTERPARTY
RISK
RISK
RISK
RISK
CTPY
1
CTPY
CLIENT
CLIENT
2
UBM
n
SALES
CTPY
CTPY
RISK
MANAGEMENT
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TRADING
1
2
3
m
THE DERIVATIVES BUSINESS
Market Risk: daily Value-at-Risk …
Value-at-Risk (VaR)
UBM’s portfolio affected by more than 40,000 risk factors
VaR calculated daily through a proprietary VaR engine via historical simulation
VaR parameters: 99% double-tail confidence level, 1-day holding period, daily update of time series
VaR model has been validated by Italian regulators for capital requirement purposes
UBM daily VaR limit is €7m, against a one-year average of €4.4m (max €6.6m)
Daily back-testing against “clean” P&L series
Daily VaR vs P&L
PL
VaR
7
P&L (EUR/m)
5
3
1
-1
-3
-5
-7
Ja
n
Ja - 03
n
Ja - 03
n
Fe - 0
b- 3
Fe 03
b
M -03
ar
M - 03
ar
A - 03
pr
A -03
pr
A -03
pr
M -0
ay 3
M -0
ay 3
Ju -03
n
Ju -03
nJu 03
lJu 03
lJu 03
A l-03
ug
A -0
ug 3
Se -0
p 3
Se -03
p
Se -03
p
O -03
ct
O -03
c
N t-0
ov 3
N -0
ov 3
D -0
ec 3
D -03
ec
D -03
ec
-0
3
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Date
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THE DERIVATIVES BUSINESS
… and daily Stress and Crash Tests
Stress Tests
•A total of 8 stress scenarios are evaluated and the worst outcome is selected
•Stress test (as of 14 May 2004): €14.8m
Crash Tests
•A total of 8 crash scenarios are evaluated and the worst outcome is selected
•The last scenario is calculated as a combination of the the worst event for each asset class
•Credit spread scenarios have been obtain using telecom industry and South America as benchmarks
•Crash test (as of 14 may 2004): €13.7m
STRESS
CRASH
ASSET CLASSES
INTEREST RATES
RISK FACTORS
Scenario 1 Scenario 2 Scenario 3 Scenario 4 Scenario 5 Scenario 6 Scenario 7 Scenario 8
Interest rate curve
-40%
-30%
-20%
-10%
10%
20%
30%
40%
buckets
CREDIT SPREADS Credit spread curve
40%
30%
20%
10%
-10%
-20%
-30%
-40%
buckets
COMMODITY
Commodity prices
-40%
-30%
-20%
-10%
10%
20%
30%
40%
FX
Fx rates
-40%
-30%
-20%
-10%
10%
20%
30%
40%
EQUITY
Equity prices
-40%
-30%
-20%
-10%
10%
20%
30%
40%
INDEX
Index prices
-40%
-30%
-20%
-10%
10%
20%
30%
40%
VOLATILITY
Equity volatility,
40%
30%
20%
10%
-10%
-20%
-30%
-40%
Index volatility,
Interest rete
volatility, Fx
volatility
DEFAULT
Other risk factors
-10%
-8%
-6%
-4%
4%
6%
8%
10%
EVENT
Black Monday
Gulf War
ERM Crisis
Bond market crash
Japanese Banks Crisis
LTCM Crash
Twin Towers
Combination
DATE
1 oct '87 - 1 dec '87
1 aug '90 - 1 oct '90
1 aug '92 - 1 nov '92
1 jan '94 - 1 jan '94
1 mar '98 - 1 sep '98
14 aug '98 - 14 nov '98
1 sep '01 - 1 nov '01
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THE DERIVATIVES BUSINESS
Model Risk
The structure
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Team of dedicated professionals developing and implementing pricing models for
exotic derivatives
Implementation and maintenance of a large, high-throughput risk management
system
Over 200 proprietary pricing models deployed
Dedicated Model Testing team based in London
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Some examples
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Front-office booking system with over 200,000 trades
Proprietary technology for capital guaranteed products with more than 500,000 webbased transactions executed, with real time tracking and stress tests
Ubiquitous computing: Enterprise-wide Parallel Processing (over 500 CPUs)
Skew/smile proprietary pricing models based on stochastic volatility
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Market Surface
1
TCP
9
7
5
3
TCP, FTP
12
3.0%
3.5%
4.0%
4.5%
4.8%
5.0%
5.5%
6.0%
7.0%
8.0%
9.0%
10.0%
25%
24%
23%
22%
21%
20%
19%
18%
17%
16%
15%
14%
13%
12%
11%
10%
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THE DERIVATIVES BUSINESS
Counterparty Risk
Measuring Counterparty Risk
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Derivative portfolio size > €1,000b
Market risks are hedged through OTC trades with other market counterparties
Traditionally counterparty risk has been monitored using fixed coefficients
Need to quantify the effective cost of substitution
The cost of substitution is the value of each trade increased by the potential variation that may occur
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Estimate the cost of substitution as the marked-to-market valuation plus a simple add-on
Method’s advantages
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Quantifies more accurately the effective counterparty risk
Uses standard product control techniques
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Can be used with risk mitigation tools such as close-out netting and collateral agreements
When using netting, portfolio diversification is captured
Dynamic methodology in line with market variations
More in line with market practice and central bank models
Can bring in market risk techniques (substitution of the simple add-on with VaR)
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THE DERIVATIVES BUSINESS
Counterparty risk : a practical example
Monitoring and analysis of historical data
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All counterparty information is stored in a database
Marked-to-market valuations are available at individual deal level
Simple add-on is compared with realized 10-day marked-to-market valuation moves
There is evidence that current method overestimates effective exposure
Currently implementing 10-day VaR in place of simple additive add-on
This will factor in portfolio diversification and will bring a uniform methodology to exposure valuation
Simple Add-on vs 10-day delta MTM
Counterparty Risk – an example
1,400
2,000
1,200
1,500
1,000
LIMIT
EXPOSURE
MTM
COLLATERAL
Value (€/m)
Exposure (€/m)
1,000
800
DELTA MTM
ADD_ON
600
500
400
-
200
-500
-200
13-Feb-03
Date
10
06-Mar-03
27-Mar-03
17-Apr-03
Date
09-May-03
30-May-03
THE DERIVATIVES BUSINESS
Operational Risk
Assessing and controlling operational risk
• Operational risk is defined as the risk of losses resulting from inadequate or failed internal processes, people
and systems or from external events. This definition includes legal risk, but excludes strategic and
reputational risk (Basel, September 2001)
• Risk control is achieved through process mapping, risk assessment and business process reengineering
• The “Operational risk control” project is an on-going activity that advances by gradual improvements
• Main steps:
• Definition of roles and responsibility
• Implementation of techniques of process analysis and representation
• Application development to support historical loss data collection
• Study of risk assessment methodology to influence business process and control reengineering
• Banking activity is so heterogeneous and specialised that only process owners are able to effectively control,
process and assess risk
• Internal workgroups have been constituted with line managers and Internal Audit
• These workgroups have permanent responsibility on process design, operational risk assessment and
reengineering solution identification
• Processes are targeted and mapped out to workflow charts
• Workflow charts illustrate the role of every actor in the process both internal and external, as well as
systems contribution
• Identification of critical process activities and improvements (e.g. by introducing new control points)
• Development of in-house database to support a structured collection of historical data describing operational
accidents, related losses and recovery
• Implementation of reporting tools both internal and regulatory
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