Derivatives as Risk Management Tools

Risk Assessment Tools

A critical but often overlooked aspect of a competent derivatives trading operation are the computer systems and risk assessment tools used to manage risk, account for the positions on a mark-to-market basis, track derivatives-related events (such as expiries and rollovers) and measure Value-at-Risk. Options produce their own problems because of the convexity of these products.

One must have an appreciation of how these risks change with the progress of time and the evolution of prices. It helps to establish a framework for evaluating a financial risk management system and use this framework to assess some of the more common off-the-shelf products on the market.

Using Derivatives Risk Assessment Tools

Integration

At the beginning of the global derivatives market’s development, almost every bank pursued derivatives in a stand-alone asset-class-by-asset-class fashion. That is to say, one group managed interest rate derivatives, another group managed equity derivatives and a third group managed foreign exchange derivatives.

However, an increasing number of financial institutions are turning to a more integrated approach, stripping the derivatives desks from each asset class’ cash group and combining them into a more efficient cross-marketing machine. Once you understand interest rate derivatives, it is fairly straightforward to understand equity derivatives or foreign exchange derivatives. Conversely, it is not necessarily the case that a manager who has spent his entire career overseeing spot foreign exchange salespeople will be able to understand the way in which a derivatives book works.

To Buy or to Build

The next question the bank’s senior management must ask itself is whether or not the bank should buy off-the-shelf risk assessment tools or build one using its own internal IT resources.

Buying a system is convenient, particularly if it is one that is in widespread use. Popular systems have been tested and have had all of the kinks worked out. The more popular the system, the less likely that it is vulnerable to internal control irregularities. The more popular the system, the less likely it is possible for individuals to manipulate the bank’s official records for fraudulent purposes. Systems are typically very expensive, with charges for both a site license and individual annual log-ins. Many of the companies that sell these systems make it easy for the user to customize reports, batch files, and pricing modules, among other things.

However, many financial institutions are reticent to relinquish the responsibility for risk management computer systems to a third party. The managers of these institutions would prefer to have their own internal risk management personnel design the system that is then implemented by the bank’s IT staff. Not only is this more expensive than buying an off-the-shelf system in terms of up-front dollar cost and delays in implementation, but the system is vulnerable to the expertise of a handful of individuals, who may not always be available or may choose to leave the company.

Interface

One of the key aspects of a well-designed system is its flexibility. Good risk assessment tools will have a user interface that is customizable. A vast majority use the Internet as their interface platform, as it allows for quick and efficient information exchange across multiple markets. The interface is also the mechanism in which reports are designed.

Asset Class Coverage

Good risk assessment tools will provide the senior management with the ability to immediately access information on all of the derivatives activities in which the financial institution is engaged, across all asset classes.

Covering all of the asset classes also allows for greater overall risk-taking because it allows for the portfolio effects of diversification of risk across the different asset classes.

Pricing Model Flexibility

Model risk refers to the problems associated with discrepancies between the theoretical pricing of a financial instrument and the way in which it actually trades in the market. The difference in price, for a given set of input parameters, is a result of the assumptions that are necessary for solution of the mathematical model of the price of the financial product in question.

For some financial products, particularly the more exotic or novel ones, the choice of pricing model is controversial. A good risk management system will allow management to pick and choose the pricing model it prefers for a particular instrument and compare the model risk in different market environments associated with individual pricing models.

Ability to Link to Other Systems

Derivatives risk assessment tools are only one of a handful of systems with which the dealer at a financial institution must be familiar. Other systems include ticketing systems for cash instruments, accounting systems, credit risk management systems and, possibly, spreadsheets tracking customer portfolios.

A dealer’s life is made much easier when the primary system he uses on a daily basis, the risk management system, can communicate its information to the other relevant systems automatically. Otherwise, the dealer (or more likely his assistant) will have to input multiple tickets for a single transaction. This is not just a question of personal effort. It is also an operational risk issue. Every time the dealer inputs a ticket, there is room for an error. Too many errors and the bank begins to lose customers as well as money.