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