Framework of derivatives risk

management and case

analysis

Wang Yong, PhD, CFA, FRM

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免责声明

本课件内容系个人观点表达，不代表我所在公司或其他组织。

All the views expressed in this presentation are those of

my own and do not necessarily represent the views of my

company and other institutions.

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金融

系统性

systemic

监督机制和法律

Regulatory & Legal

竞争

Competition

策略 Strategic

名誉 Reputation

操作 Operational

信用

Credit

资金及流动性

Liquidity and Fund

其他

Other

金融中介机构所面临的风险类型

市场

Market

Types of risks

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Risk appetite

Spontaneous constrains

Risk appetite

Regulatory constrains

Risk control & tolerance

Profile measurement

Regulatory constrains, which are mandatory and must be followed,

define the risks acceptable for financial institutions.

Through spontaneous constrains, the financial institutions can determine

the risk scale acceptable for us.

Risk control and tolerance turn the risk appetite into a series of

executable statements and constrains as the guidance of business.

Profile measurement is a timely control over special risks of the

company.

Risk appetite of financial institutions

Regulatory constrains

F i n

a n

c i a

l

spontaneous - constrains

F i n

a n

c i a

l

Risk limits

& tolerance

F i n

a n

c i a

l

Risk

image

Source：IIF – Implementing Robust Risk Appetite Framework to Strengthen Financial Institutions – Annex I：Case Studies McKinsey & Company

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Transaction management framework

风险管理和审计

Risk Management &

Audit

后台 Back Office

中台 Middle Office

前台 Front Office

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Different lines of defenses in risk management

Board of directors

Ensure adequate resource and investment to be put into risk management

Company’s management and risk management committee

Risk owners

• Business departments

and business support

• Responsibility

• Follow risk policy

risk identification

risk measurement

risk response

risk report

Risk supervision

•Risk dept., capital dept.,

compliance

•Set up corresponding

risk management framework

•Guide implementation of

risk management

•Have independent say in

situation of risk management

(work out independent report)

Independent guarantee

• internal and external audit

• confirm independently

the effective implementation

of risk management ( to

senior management and

the Board)

• Present independent report

on major risky affairs

Personnel

committee

Risk

committee

Other

committees

Audit

committee

First line of defense Second line of defense Third line of defense

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前台 前台

Management of product transaction process

Audit targets

Back office

accounting system

Middle office

& monitoring

of limit approval

in risk management

Front office

Payment system

Capital market

customers

Risk management

system

Customer transaction

collection of transaction information

Transaction information

approval

Two-way

Audit targets

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Key links in derivatives management

The pricing of derivatives involved four key links:1）confirmation of trade clauses 2）independent

pricing 3）model checking 4）adjustment and confirmation of price

trade clauses

Model input

model interest rate

stock price

volatility

model + price = fair

exchange rate price adjustment price

others

Independent check of

model by model

checking team

Final adjustment of price by

pricing team with guaranteed

independence

Confirmation of trade by operation team is required

Independent confirmation

of model input by pricing team

1 1

2

3 4

),...,,( 21 NRRRf

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Trade limit framework

global

strategic

tactical

Operational

Trading platform

The limit of the whole bank is determined by the Board and

executed under the supervision of chief risk officer.

The limit of whole bank is set up based on VaR and pressure test.

The extra part of limit needs to be checked and approved by the Board.

Strategic limit is determined by chief risk officer.

Tactical limit is in the hands business managers

Tactical limit includes VaR, sensitivity, pressure test and

others

The limit at operational level is executed and supervised

by regional market risk manager.

It is usually the showdown of tactical limit.

Platform limit is controlled by director of

trading platform.

It is executed and supervised by market risk manager.

Case: Analysis of huge losses

of London Whale

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Background

• Composite credit portfolio is mainly targeted at benefiting under

pressured credit environment.

–Designed to hedge some credit risks

–Include some long positions to reduce the cost of credit

protection

–Adjust timely to reflect the changes in macro market view.

• Composite credit portfolio performed as good as expected from

2007 to 2011.

–The portfolio generated a profit about 2 billion dollars

between 2007 and 2011.

–This portfolio makes profits every year.

• It earned 400 million dollars because of bankruptcy of American

Airlines on Nov. 29 2011but suffered 50 million losses because

of cut-down default protection positions in the bankruptcy of

Kodak on Jan. 29 2012. *

*Investigation report of U.S. Congress dated May 15: based on 90000 relevant documents, 200 phone records, 25

interviews with senior managers and 25 hearings.

Year Profit and

cost of SPC

2008 $170 million

2009 $1.05 billion

2010 $149 million

2011 $ 453 million

2012 -$ 6.2 billion

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Changes of investment portfolio • At the end of 2011, the management informed the CIO to reduce risk-weighted asset as part of

annual budget.

–According to Basel I，RWA of JP Morgan chase CIO was 20 billion dollars. But according to

Basel II.5 /III , RWA of CIO would rise to 60 billion dollars.

–The liquidation of CIO positions would be very expensive. As estimated by some traders, the

cost of reducing 10 billion RWA by liquidation would be 500 million dollars.

• At the beginning of 2012, CIO tried to reduce credit short positions and RWA while hoping to

maintain the benefits from defaults by enterprises and to optimize its balance sheet.

− Increased the net long positions of investment grade index (i.e. holding long positions of credit

risk),

− Increased the short positions of some junior securities for further default protection.

Enterprise bonds Buying credit protection Low-risk bonds

Risk-free bonds Selling credit protection Enterprise bonds

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Rapid growth of portfolio scale

and increasingly complicated risks

• CIO increased the portfolio scale, complexity and various risk exposure sharply including:

–Risk exposure to relationship between investment grade index and high-yield index

–Default correlation between assets structure(e.g. highest level vs. middle level )

–Basis between new and old index

• The changes of portfolio scale, complexity and risks were not fully reported to the management.

• On April 12, 2012 OCC began to address inquiries only after Little Morgan SCP was exposed. With

the bank’s guarantee OCC did not go into details of SCP risks * • Investigation report of U.S. Congress

dated March15 Scale Growth in scale of portfolio (nominal)

Nominal net

Total of long

position

Total of short

position

Dec 30 Mar 30

3 times

Growth of second-tier position (nominal)

Growth old index position (nominal)

Nominal net

Nominal net

Dec 30 Mar 30

2 times

3 times

Complexity

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Transaction scale of London Whale

• SCP position: Position of credit deriviates reached 100 billion dollars.

• Regarded as a company, London Whale’s bond credit index ranked the 7th in the world, behind JP

Morgan chase(excluding London whale position), Morgan Stanley, Goldman Sachs, Bank of

America, Citigroup and HSBC.

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Key events in the establishment of positions

• At the beginning of 2012, some risk limits at CIO level were breached

–Related to expansion of premium difference. The risk limit time breaches had been mentioned

inside the company.

• Model checking department approved the new composite credit model VaR at the end of January.

–The management estimated that the company of new credit model would work out a small

VaR. Therefore, they raised VaR limit at company level as a provisional measure to deal with

the breached VaR limit.

• CIO held a business review meeting with the company’s management in February.

–Discussed the composite credit portfolio to limited extent.

–CIO thought the position of portfolio was sound and RWA was decreasing.

VaR

Jan. 16, 2012 Jan. 26, 2012

CS01 CRM

Feb. 22, 2012

CSW10%

March 22, 2012

loss from pressure

March 29, 2012

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Key events in the establishment of positions

• Macris (director of CIO’s equity and margin trading) compared the management of composite credit

portfolio to flying a airline. The statement of Jimmy Damon(CEO of JP Morgan chase) indicates the

alarm on the plane sounded too late.

• However, the risk control indicator told a completely different story:

–From Jan. 2012 to 2012, the CIO limit was breached more than 330 times.

–CS01 and VaR alarms sounded in January.

–CRM alarm sounded in February. (When CRM showed a loss up to 6.3 billion, the management regarded it as

“rubbish”!)

–CSW 10% alarm sounded in March.

– The alarm of pressure loss limit sounded in late March.

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Importance of independent pricing

The pricing of derivatives involved four key links:1）confirmation of trade clauses 2）independent

pricing 3）model checking 4）adjustment and confirmation of price

trade clauses

Model input

model interest rate

stock price

volatility

model + price = fair

exchange rate price adjustment price

others

Independent check of

model by model

checking team

Final adjustment of price by

pricing team with guaranteed

independence

Confirmation of trade by operation team is required

Independent confirmation

of model input by pricing team

1 1

2

3 4

),...,,( 21 NRRRf

Independency!

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Problems concerning CIO evaluation

• Valuation of CIO at the end of each quarter

–CIO trader had been evaluating SCP before the first quarter of 2012

–CIO’s evaluation control department confirmed that the trader’s evaluation was within the

predetermined critical range (the gap between buying and selling prices on market was taken

into account in the critical range)；The evaluation outside the range was adjusted.

• The review by management revealed doubts about the trader’s valuation.

–By interviews, E-mails, voice recording and other documents, there were signs that the trader

did not try to evaluate all long positions they thought executable.

–The trader might have tried to avoid the disclosure of all losses.

–Taking liquidity into account, the company decided to take external intermediate

–market as the standard price.

• significant deficiency in the 1st quarter of 2012

• There was a significant deficiency in the valuation of the composite credit portfolio in the 1st

quarter of 2012 by CIO evaluation control department.

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Treatment of responsible management personnel involved

• All management personnel of CIO London responsible for the composite

credit portfolio have left the company

–Without severance pay or incentive compensation of 2012

–The salary of each person concerned must be retrieved.

• Triggered the largest recourse of compensation within allowed scope

–Equivalent to the sum of two years’ compensation of each person

concerned

–Including recourse of restricted stock and cancellation of equity incentive

• Various factors were considered in the decision-making of compensation

recourse

–Different factors in each case were weighed.

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conclusion：lesson from London whale

Clearly-defined trading responsibilities

Performance must be target-dependent to identify reduced RWA or profits.

Trading strategy

No free lunch

Emphasis on liquidity management：Destruction pursues the great

Risk management culture

To be implemented comprehensively

The judgment of “pilot” is more important than “warning”.

Regulatory authority

Timely intervention, independent supervision.

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