Crash Course in Risk Management

  1. Operational Risk
  2. Counterparty/Credit Risk

Market Risk

Market risk is probably somewhat intuitive to us. When carrying out positions we are exposed to many risks associated with the underlying assets that we trade (direction, volatility, correlation, etc.). Any practitioner knows the risks he/she is exposed to (directional risk, volatility/skew/ correlation, and basis risk are only a few examples of market risk), so it’s relatively easy to quantify these risks and manage them.

A typical Delta matrix (x-axis = vol level, y-axis = spot level) of a Long 1-month EURUSD 1.20 Call.
  1. Historical VaR
  2. Monte Carlo Simulation
  1. Confidence Level
Credit: Fernando Caio Galdi, L.M Pereira
MC Simulation (1-day, vol = 16% , paths=500 , steps = 1000)

Operational Risk

Operational Risk is often being overlooked by practitioners, as it’s the unsexy side of risk management, which deals with technical aspects of trading (execution, post-trade lifecycle, and settlement).

  1. Post-Trade (trade lifecycle)
  2. Backoffice and cashflow
  1. Risk Management —Once fed into the risk management system, the order is being assessed for margin and available equity in the account to withstand the risk level. After all, checks are done and cleared the trade is sent to the exchange.
  2. Matching at the exchange — After the trade is sent to the exchange it’s placed in the exchange order book, waiting for a match on the other side. Once a matching order is available, the client’s order is matched against that.
  3. Trade made — A new trade is born, now the exciting stage of post-trade begins with the exchange sending both parties’ brokerage firms a confirmation of the trade (so they could inform their clients).
  4. Trade confirmation — Now that the trade is done, both parties need to confirm the trade’s details in order for the process to continue. Without a matching of the details from both sides the trade will not be able to be processed to clearing at the clearinghouse. Usually, trade needs to be confirmed until T+1 (1-day ) from the moment it’s matched.
  5. Clearing — Once the trade is confirmed by both parties it needs to be cleared by the clearinghouse. The purpose of the clearinghouse is to make sure both parties meet their obligations. Trades are usually referred to as T+1, T+2 or T+3, where the ‘T’ referred to the transaction date (the date on which the trade was executed). On the settlement date, the sell-side must have transferred their security and the buy-side must have transferred the money for their purchase.
  6. Settlement — At the end of the trade life cycle process the day of settlement arrives. The settlement process is done within the clearinghouse, where the cash and securities are transferred between the parties’ accounts. At the end of the trade date, the clearinghouse will provide reports on settled trades to the exchanges and custodians.
Credit : Quora

Credit (Counterparty) Risk

The aftermath of the subprime crisis emphasized the importance of credit risk management. We rarely think that our biggest risk in the market is credit, but back in 2008, this risk almost singlehanded brought the entire financial market to a halt.

Credit risk remedies — XVA

In an attempt to tackle the credit risk banks developed a framework to account for counterparty risk, as well as funding risk. The two valuation adjustments are CVA (Credit Valuation Adjustment) and FVA (Funding Valuation adjustment). In short, when pricing an instrument, the trading desk will adjust the price according to the risk of its counterpart to reflect the default probability and funding cost.

credit: Wikipedia
Credit : Bloomberg

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