UNDERSTANDING TRADES FROM A RISK PERSPECTIVE

WHOLESALE BANKING & MARKETS UNDERSTANDING TRADES FROM A RISK PERSPECTIVE Michael Timmins Head of Rates Structuring Let’s look at product from the B...
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WHOLESALE BANKING & MARKETS

UNDERSTANDING TRADES FROM A RISK PERSPECTIVE Michael Timmins Head of Rates Structuring

Let’s look at product from the Bank’s perspective

Client

Bank

How does the Bank ‘manufacture’ derivatives?

Why should I care?

How does the Bank ‘manufacture’ derivatives?

Source: www.ronainnes.co.uk/digital_illustrations.html

A stylised view of the Bank business model 1

The Bank originates Client business (bespoke derivatives transactions typically uncollateralised)

2

Principal market risks are offset using standardised market instruments (whose credit risk is mitigated via collateral / margin) or via other client business

3

Other risks are retained (esp. credit risk, funding risk, secondary trading risks) The Bank needs to hold capital against the risks is retains (esp. credit exposure).

Client 1

Client 2



Bank

Market

A more detailed view

Client

Client

Client

Sales, structuring, advisory, etc

FX Etc.

Options

Swaps

Counterparty exposure

Etc.

Funding Capital and RWAs

Market

Understanding the market risks

• The job of the trading desks is to understand, price and manage the risks of client transactions

Whereas a client may focus on cash flows…

…the trader will focus on mark-to-market

PV 2.5 2.0

Client

Swap Bank

1.5 1.0 PV

Lending Bank

0.5 0.0 -0.5 -1.0 -1.5 -2.0 -4%

-2%

0% Curve shift

2%

4%

How does the swaps trader manage his risk?

Example: 5y swap (client pays fixed)

-50

0

50

-50

1y

1y

2y

2y

3y

3y

4y

4y

5y

5y

6y

6y

7y

7y

8y

8y

9y

9y

10y

10y Client trade

0

Client trade

50

Hedge

How does the swaps trader manage his risk?

Example: 10y amortising swap (client pays fixed)

-50

0

50

-50

1y

1y

2y

2y

3y

3y

4y

4y

5y

5y

6y

6y

7y

7y

8y

8y

9y

9y

10y

10y Client trade

0

Client trade

50

Hedge

Example: a restructure

A client has an existing 3y GBP swap at 4%

Alternatively could blend into a single fixed rate

…and wishes to extend by further 3 yrs

4% 3% 2%

3y

6y

6y

What are the traders’ risks?

Existing GBP rates position… -100

-50

0

50

100

replaced by new position… -100

-50

0

50

100

to give net position

-100

1y

1y

1y

2y

2y

2y

3y

3y

3y

4y

4y

4y

5y

5y

5y

6y

6y

6y

7y

7y

7y

8y

8y

8y

9y

9y

9y

10y

10y

10y

Client trade

Client trade

-50

0

Client trade

50

100

A more detailed view

Client

Client

Client

Sales, structuring, advisory, etc

FX Etc.

Options

Swaps

Counterparty exposure

Etc.

Funding Capital and RWAs

Market

Understanding credit, funding and RWA risks

• Credit exposure: the Bank is exposed to a loss if counterparty defaults and MTM is positive

Scenario 1 – positive MTM Potential loss in event of default

• Funding: the Bank needs to fund collateral position on its hedges

M TM

Embedded loan

Time

• Capital / RWAs: the Bank is required to hold Capital against derivative exposure, and needs to earn a sufficient return on this capital

Time

Scenario 2 – negative MTM

• However, all these quantities depend on market rates (and in particular the PV of the trade) M TM

Time

Embedded deposit No loss in event of counterparty default Time

Calculating credit, funding and RWA position

• Credit charge is the expected loss over the life of the trade – measured at counterparty (netting set) level, depends on trade(s), counterparty, market • Funding charge is the expected funding cost over the life of the trade – measured at counterparty level, depends on trade(s), bank funding levels, market • The RWA charge is the expected required return on capital over the life of trade – measured at counterparty and portfolio level; depends on regulations (esp. Basel), trade(s), counterparty, market, required returns

• “Monte Carlo” techniques are used to simulate large numbers of outcomes.

MTM

Calculating credit, funding and RWA position

Time

• The simulation outcomes are combined with relevant credit, funding and RWA parameters to determine expected credit, funding, and RWAs.

M TM

• In particular, we are interested in the “Expected Positive Exposure”.

Time

Blend and extend restructure revisited

Expected RWA

Expected positive exposure Original 3y swap Original 3y swap & new 3y3y swap Blend and extend 6y swap

2012

2013

2014

2015

2016

2017

Original 3y swap Original 3y swap & new 3y3y swap Blend and extend 6y swap

2018

2012

2013

2014

2015

2016

2017

2018

Source: www.ronainnes.co.uk/digital_illustrations.html