Market Risk Management Certification

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SECTION 1
Introduction to Bank Risk Management
• Risk Classification
• The Objectives of Risk Management
• Risk Management Failures
• Organizational Structure of Risk
• Management in Banks
• Organization of this Volume
• Summary
SECTION 2
Foreign Exchange Markets, Instruments
and Risks
• The Foreign Exchange Market
• Sport Foreign Exchange Transactions
• Forward Foreign Exchange Transactions
• Currency Futures
• Currency Swaps
• Currency Options
• Exotic Options
• A Nested Risk Model for FX Instruments
• Summary
SECTION 3
Interest Rate Markets,
Instruments and Risks
• The Importance of Fixed Income Instruments
• Cash Fixed Income Instruments
• Pricing Cash Fixed Income Instruments
• Risk in Cash Fixed Income Instruments
• Fixed Income Derivatives
• Option and Exotic Fixed Income Instruments
• Fixed Income Risk Map
SECTION 4
Equity and Commodity Markets, Instruments
and Risks
• Equity Instruments
• Equity Derivatives
• Commodities
• Commodity Derivative Instruments
• Risk Maps
SECTION 5
The Risk Measurement Process
• Value at Risk
• Critiques of VaR
• Nonparametric Methods and Historical
Simulation
• VaR for Multiple Factors
• Position Mapping and Aggregation
• The Daily VaR Process
• Quality Control in VaR
• Summary
SECTION 6
Risks in Bank Trading Strategies
• Overview of Bank Trading Strategies
• Bank Trading Strategies
• External Risks in Bank Trading
• Summary
SECTION 7
Market Risk Organization and Reporting
• Components of Market Risk
• Governance of Market Risk
• Tools Used to Measure Market Risk
• Risk Monitoring and Control Uses and Users
of Market Risk Reports
Market Risk Management
Table of Contents
2
This chapter expands on the introductory treatment of
traded foreign exchange (FX or forex) instruments in the
FBR. Most traded financial instruments can be classified
by market and type. Market instruments include currency,
interest rates, equity and commodities. Types of instru-
ments include cash (or spot), forward/futures, swaps,
options and exotics. This chapter discusses all instrument
classifications for the foreign exchange market. The FX
market is used to introduce market risks in this volume
because most large, internationally active banks have
significant exposure to foreign exchange trading and the
financial instruments in the FX markets. While many smaller
banks are active in the FX markets—buying and selling
foreign currency to provide services for their clients—it is
the large global banks such as HSBC, Citibank, and RBS,
to name three, with their wide-spread branch networks
and well-established international linkage who play a sig-
nificant, if not dominating role, in the foreign exchange
markets. Also, many of the instruments used in the FX
markets have risk profiles that resemble instruments used
in other markets.
With this chapter as background, the student can read-
ily explore more sophisticated financial instruments used
in the interest rate, equity and commodity markets. The
chapter does not cover advanced issues such as complex
valuation formulas. The emphasis is on understanding the
primary traded FX products and their risks. In later chap-
ters, the discussions of these risks will lay the groundwork
for more intense analysis and discussion of complex risks
and risk management practices.
On completion of this chapter, the reader will have an
improved understanding of:
• Cash transactions in the foreign exchange market
• Drivers of the value and risk of cash instruments
• FX forward instruments
• Differences between forwards and futures contracts
• Currency swaps
• Risk drivers in forward markets
• Option instruments
• Exotics
• Risk factors for options and exotics
This chapter is extremely important because it sets the
framework for the chapters that follow. Chapters 3 and 4
explore the other major bank markets using the same trans-
action type structure.
2.1 THE FOREIGN EXCHANGE MARKET
Trading instruments come in many types and “flavors.”
The common products, in terms of volume, are the main
instruments traded globally; they are commonly called
“plain vanilla” products because they are plain with nothing
complex added. For every standard product, however, there
is also likely to be a complex version. What is more, new
products are continually being developed to meet customer
demand. For all the instruments discussed below, the main
currencies traded are the US dollar (USD), euro (EUR),
Japanese yen (JPY) and the British pound (GBP). Other cur-
rencies discussed in this section are the Swiss franc (CHF),
the Canadian dollar (CAD), the Australian dollar (AUD) and
the Hong Kong dollar (HKD). Nevertheless, the principles dis-
cussed in this chapter apply to any freely traded currency.
Innovation in the financial markets is expanding the num-
ber of financial instruments traded in these markets to fit the
needs of market participants. As the financial markets adopt
new instruments, old instruments that fail to meet partici-
pants’ needs are abandoned.
All financial products and instruments, no matter what
their level of complexity, can be approximated by combi-
nations of positions in simpler instruments. The risk of the
simpler instruments provides a clue as to the risk of the com-
plex product. Also, any pricing model for a product gives
us a clue how to understand the risks of the product. Any
input to the pricing model that can fluctuate is called a risk
factor. For bonds, for example, market interest rates are a
risk factor. Exchange rates in forward and futures contracts,
typically determined by market interest rates and inflation
differentials, are considered risk factors, as will be explained
more fully below. The importance of any risk factor can be
determined by measuring its effects on financial instrument
pricing.
Chapter 2: Foreign Exchange Markets, Instruments and Risks
3
The definitions of the various instruments provided
throughout the rest of this chapter describe the risks gen-
erated by each instrument, regardless of the underlying
currency. However, all instruments valued in a currency
other than a bank’s reporting currency will generate foreign
exchange risk for the bank. Even if the values of those instru-
ments do not change in foreign currency terms, the values
change in domestic currency terms.
A bank’s risk management problems are large and com-
plex, and it is difficult to tackle them all at once. We begin by
focusing on the FX markets first, for several reasons:
• Foreign exchange is a large part of trading activity for
many banks
• Global volumes of foreign exchange trading are high
• The foreign exchange market is geographically diverse
and trades 24 hours a day, except weekends
• The foreign exchange market is considered the most
liquid in the world
• Foreign equity, fixed income and commodity markets cre-
ate foreign exchange opportunities and challenges for banks
Foreign Exchange Trading and Market Trading Activity
According to the Bank for International Settlements,1 the
average daily trading in global foreign exchange markets
was about USD 4.0 trillion in 2007. Trading in the world’s
main financial markets accounted for the vast majority of
this total. The transactions can be broken down as follows:
• USD 1.0 trillion in spot transactions
• USD 0.4 trillion in outright forwards
• USD 1.7 trillion in foreign exchange swaps
The most widely traded currencies, as of April 2007, were
the USD (86%), the EUR (37%), the JPY (17%) and the GBP
(15%). No other single currency had more than a 7% share of
the traded market. When trading activity is recorded in for-
eign exchange, it is recorded twice, since it is a simultaneous
purchase of one currency and a sale of another. Because
each currency trade is recorded twice, the total percentages
add up to 200%, not 100%. Therefore, these four currencies
account for 155% out of 200% of trading volume, or more
than three quarters of all bank trading in FX.
The most active banks in the foreign exchange market
can be assessed from survey data. In May 2008, Deutsche
Bank accounted for 22% of foreign exchange trading by
banks, UBS AG 16%, Barclays Capital 9%, Citibank 7.5%, and
RBS 7.5%. No other single bank was responsible for more
than 5% in trading volume.
In the United States, during the second quarter 2009,
foreign exchange derivative contracts account for appro-
ximately 7% of all derivatives transactions. Although
approximately 12% of all U.S. commercial banks engage
in derivatives trading, these transactions occur mainly
between a few large internationally active banks, where
the risks are also concentrated.
2.2 SPOT FOREIGN EXCHANGE TRANSACTIONS
The market for spot transactions is perhaps the most liquid
market in the world. In the spot foreign exchange market,
one currency is exchanged for another (i.e. bought and sold).
EXAMPLE
On behalf of a client, a German bank needs to buy JPY.
The German bank sells EUR and, in exchange for the EUR,
receives JPY.
Spot transaction deals generate foreign exchange risk,
since the relative value of the two currencies in the spot
transaction may change. By convention, spot foreign
exchange transactions are to be exchanged two business
days in the future, which is known as the spot date. The
two-day timeframe came into practice when settlement
instructions between banks were affected by telegraph and
banks needed two days to ensure that instructions could be
issued and acted upon. Although settlement is now carried
out electronically, the two-day rule for settlement remains.
2.2.1
Exchange Rates for Major Currencies
prices at a point in time in order to study reporting conven-
tions and pricing relationships. As an example, the spot
exchange rates for eight major world currencies are shown
below. At that time, it would have cost HKD 7.75 to buy
USD 1, or AUD 0.129 to buy USD 1.
Chapter 2: Foreign Exchange Markets, Instruments and Risks
4
2.2.2
Drivers of Foreign Exchange Rates
Banks often engage in significant foreign exchange transac-
tion activity, and the risks of those transactions are fairly
well understood. The usual approach to risk is to examine
the historical variability in exchange rates, but this approach
does not explain the drivers of foreign exchange risk.
Broadly speaking, foreign exchange rates are driven by
economic factors, international political factors and market
psychology. To understand the economic forces affecting
exchange rates, it is best to think of currency itself as a
product. For example, if a Hong Kong investor sees a USD 1
bill as a product, its price in HKD is 7.75; the product
benefits him because he can purchase other goods and
services with the USD 1, or earn USD interest.
Under this paradigm, the USD strengthens—or costs
more in HKD—whenever the global demand for USD
increases. The USD will strengthen if one or more of the
following events occur (a similar logic can be applied to
any currency; this is just an example):
Outcomes That Would Strengthen the USD
• USD real interest rates rise (i.e. nominal rates net of
expected inflation)
• US expected inflation falls (purchasing power of the
dollar increases)
• US current account surpluses increase (the US exports
more goods than it imports—exports exceed imports)
Chapter 2: Foreign Exchange Markets, Instruments and Risks
• Demand for US products rises globally (increased
exports of US goods)
• Prices of US products fall in USD terms (decreasing
inflation)
• US reduces budget deficits and reduces its dependence
on debt
• US improves terms of trade to favor exports (demand
for foreign currency decreases)
• US political stability improves
• World political conditions cause a flight to quality,
causing emerging market investors to convert local
currencies into dollars
• Demand for dollars as a transactional currency increases
• US economic performance improves
The following outcomes, conversely, would weaken the
USD, and could be applied to any currency:
Outcomes That Would Weaken the USD
• USD real interest rates fall (i.e. nominal rates net of
expected inflation decline and may even fall below zero)
• US expected inflation increases (the purchasing power
of the dollar falls)
• US current account surpluses decrease (the US imports
more goods than it exports, making the demand for
foreign currency increase)
• Demand for US products fall globally (fewer exports of
US goods)
Table 1: Exchange Rates for Major Currencies
USD EUR JPY GBP CHF CAD AUD HKD
HKD 7.75 9.8565 0.0789 12.123 6.5751 6.5173 5.2243
AUD 1.4835 1.8867 0.0151 2.3205 1.2586 1.2475 0.1914
CAD 1.1892 1.5124 0.0121 1.8601 1.0089 0.8016 0.1534
CHF 1.1787 1.4991 0.012 1.8438 0.9912 0.7946 0.1521
GBP 0.6393 0.813 0.0065 0.5424 0.5376 0.4309 0.0825
JPY 98.235 124.9353 153.6641 83.3418 82.6094 66.2202 12.6754
EUR 0.7863 0.008 1.2299 0.6671 0.6612 0.53 0.1015
USD 1.2718 0.0102 1.5642 0.8484 0.8409 0.6741 0.129
Currency per unit of dollar reported by Bloomberg on Nov 8, 2008.
5
• Prices of US products increase in USD terms (increasing
inflation)
• US increases its budget deficits and increases depend-
ence on debt (the government borrows more which
increases the interest rates; reduced dependence drops
rates)
• US improves terms of trade to favor imports (the demand
for foreign currency increases)
• US political stability weakens
• World political conditions stabilize and emerging market
investors decide to hoard local currencies and not
exchange to dollars
• Demand for dollars as a transactional currency reduces
(and is replaced by other currencies, such as the euro)
• US economic performance weakens (recession)
Ironically, a strong currency discourages US exports
by making US goods more expensive abroad. This in turn
reduces the demand for US goods and USD, having a weak-
ening effect on the currency. Because of this natural balance
in the system, exchange rates are expected to trade in a
natural range, based on purchasing power parity (PPP). In
practice, foreign exchange rates differ substantially from
PPP. There are multiple reasons why market exchange rates
differ from the rates indicated by the PPP. Tariffs, for one,
limit international trade and impact import and export
prices; consequently, the price of similar goods is affected
differently across countries. Other factors include differ-
ences in demand and supply for various goods. Differences
in supply, demand, and consumption patterns may lead to
different price levels in different countries, which can skew
price levels, and the relationship indicated by PPP. When
exchange rates fall outside normal ranges and float freely,
or are managed by a central bank or similar entity, specula-
tors and central banks will often take positions anticipating
corrections to normal levels.
Chapter 2: Foreign Exchange Markets, Instruments and Risks
EXAMPLE
An intriguing and increasingly popular approach to quan-
tify the PPP and use the PPP as an indication of future
long-term changes in exchange rates is the Big Mac Index
created by The Economist magazine.
The Big Mac Index, or “Burgernomics,” builds on the PPP.
It argues that the same basket of goods—in this case a Big
Mac—should cost the same all around the world. While in
the short run, there might be differences in the purchasing
power of two currencies, in the long run the equilibrium
implied by the purchasing power differentials should pre-
vail. McDonald’s sells the Big Mac in about 120 countries;
it has identical ingredients anywhere it is sold, making the
cost of the hamburger comparable across different coun-
tries. The PPP implied by the cost of a single serving of Big
Mac determines what the value of hamburgers should be
in the long run. If there are deviations from the PPP, the
currency is either under- or overvalued relative to the USD,
which is at the base of “Burgernomics.”

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