1. finlogIQ
Knowledge for financial IQ
STRICTLY PRIVATE AND CONFIDENTIAL
Chapter 7
Trading Risk Control and Management
August 2012

2. Chapter summary and outline
This chapter describes the controls, measures and accounting
procedures that are used to manage the risks involved in futures
and options trading, i.e. market risk, credit risk and settlement
risk. The chapter also highlights the importance of segregation of
responsibilities throughout the bank to manage potential conflicts
of interest.
Chapter outline:
• Categories of risks and measurement
• Segregation of responsibilities
• Accounting procedures
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3. Categories of Risks and Measurement
Three types of risks involved in trading
• Market risk
• Credit risks
• Settlement risks
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4. Market Risk
• Exposure to a change in value of some market variables, such as interest
rates, foreign exchange rates, equity, or commodity prices, is termed as
market risk.
• Limits that can be set to control the level of market risk
• Open contract limit
– Based on volatility of the contracts and estimated expected maximum loss
– More volatile contracts are therefore subject to a smaller open contract limit
• DV01 (dollar value per basis point)
– DV01 is a better measure of interest rates risk as it reflects the greater risks of
longer-dated exposures compared to shorter-dated ones.
• Value at Risk (VaR)
– Value at risk is widely used for risk measurement on a specific portfolio of
financial assets.
– Incorporates volatility & correlation => potential loss amount or value-at-risk.
– It measures the threshold value such that the probability that the mark-to-market
loss on the portfolio over the given time horizon exceeds this value.
– Setting a lower VaR, the portfolio size would need to be lowered as well or highly
correlated risks would have to be reduced.
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5. Market Risk - 2
• Total overall open contracts
– Total overall open contracts that can be held by one firm or entity should be
limited to a certain percentage of the Gross Open Interest
– Avoid potential liquidity problems
• Maximum loss limit is set for trader/trading group
− Weekly and monthly maximum losses
− Once loss limit triggered the trader/group will be suspended
• Maturity limit is set for trading purposes
– limit the possible losses that can arise as the result of poor liquidity
– Liquidity normally better for near-month contracts and worse for further months
– Further contracts normally have lower liquidity and are hence more volatile
– Under adverse conditions, difficult to unwind further month contracts
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6. Market Risk - 3
• Options carry multiple risk parameters
– Limits for Greeks, i.e. delta, gamma, vega, theta and rho.
• Delta limits are normally set in terms of USD or the local currency amount.
• Gamma is usually measured against a specified movement in the spot FX
rate of say, one standard deviation.
• Vega is the major trading risk in options and is usually measured by the
change in value of an option, i.e. the premium over a 1% change in market
volatility
• Theta, which measures the potential loss through time decay, is limited by
potential loss over a 1-day period.
• Gamma, vega and theta are sometimes controlled together by setting the
maximum loss for all three combined.
• Positive effects of theta are automatically offset against the negative effects
of gamma.
• Executing a FX swap transaction can reduce rho risks
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7. Credit Risk
• Exchange risk
– exchange and its associated clearing house is the counterparty to any exchange-
traded futures contract.
– Committed lines of credit from commercial banks, its own capitalization, and
mutual liability arrangements among the clearing members, it nevertheless has
to make good any contractual demands even if its counterparties fail.
• Clearing broker risk
– Margins must be maintained with the clearing broker, the credit risk arises from
the placement of such funds with the broker
• Counterparties’ credit risks
– Greater for OTC options and are set for individual counterparties.
– Limits are set according to the credit rating of the institution in terms of
settlement amount and contract tenor.
– Premium payment limits to avoid institutions from constructing a synthetic loan
through options
• Corporate institutions raise capital by selling deep in-the-money
options, covering the FX risk by forward purchase of the deliverable currency
and purchase of out-of-money options.
• Large premium paid upfront to the client would thus create a credit exposure
for the institution that purchases the option from the corporate client.
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8. Settlement Risk
• Primarily the domain of back office
• Timely and accurate confirmations of trades done by the traders are
essential to help ensure there is prompt settlement of transactions.
• OTC options
– confirmation should include details like the style of option, call currency and
amount, put currency and amount, expiry date and time, premium payment date,
settlement date and strike price.
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9. Segregation of Responsibilities
• Clear lines of reporting and segregation of responsibilities to avoid
situations where conflict of interest s may arise.
• The middle office (that controls and monitors risk limits) and the back office
(which reconciles payments with confirmations) should detect any limits
excess or breach of control procedures promptly to avoid financial disaster
Transaction Authorization
• Before any new instrument can be traded, it must first be approved
• Proper transaction authorisation or an approval process
• Trading Manager
– provide input on the market limits required consistent with his business
objectives and risk tolerance allowed.
– work closely with the middle office manager on risk limits, mark-to-market
process and other system requirements.
– trading in the exchanges and contracts to be traded.
– In the case of OTC options, the various limits like VaR and the Greeks are also
discussed.
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10. Segregation of Responsibilities - 2
Transaction Authorization(cont)
• Middle Office Manager
– Setting limits control, mark-to-market process, profit and loss reporting
– Certification of pricing tools to be used
• Operations Manager
– Necessary system support, confirmation procedures, settlement requirements,
and monitoring of brokerage fees according to the brokerage schedule after it
has been negotiated by the front office.
• Compliance Officer/ Legal Officer
– provide input with regards to local banking laws and regulations as well as those
of the country of incorporation of the bank.
• Finance Officer and Tax Officer
– accounting procedures for local tax and the tax authority requirements of the
country in which the local exchange is located.
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11. Segregation of Responsibilities - 3
Trading Manager’s Responsibilities
• Sets transaction and position limits, daily and monthly stop loss limits
– Ensures traders maintain continuous records of their positions throughout the day
• Ensure trade input should include the transaction date, settlement
date, contract type, number of contracts, delivery
month, price, exchange, broker, trader’s name and signature.
– Accounting hedges to be identified
• Daily review of trading activity
– reasonableness of pricing, unusual activity at month-end that has a material effect
on profit and loss, frequent cancellations/revisions and concentrated use of
specific brokers without good cause.
• Reconcile trading profit and loss reports
• Perform trading and unit management to ensure intended results are
achieved, and to review trading and hedging activities on a regular basis.
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12. Segregation of Responsibilities - 4
Back Office Responsibilities
• Consists of different operating units such as processing, accounting , and/or
internal audit, which may perform certain functions described below.
• Trading, processing, accounting, internal audit, and settlements/payments
functions.
• Review daily all trade tickets for completeness and proper approval prior to
input into the computer system of record.
– Tickets received after cut-off time should be recorded in a separate holdover log
and entered the following day (the actual trade date must be recorded in
system).
• Verify daily the accuracy of all future transactions
• Verify daily the accuracy of data provided by external brokers, exchanges
and clearing houses concerning open positions, money balances and net
equity
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13. Segregation of Responsibilities - 5
Back Office Responsibilities (cont..)
• Provide the information necessary to the Trading Manager to facilitate
effective management of the positions.
• Verify daily that outstanding positions have not exceeded authorised
positions and exchange limits.
• Prepare and pass daily the required general ledger accounting entries
regarding margin deposits, commission payments and other items.
• Monthly certifications of all outstanding futures contracts and fees paid
against all applicable general ledger accounts.
• Monitor all margin deposits
• Records:
– Accounting and/ or custodial records
– Local tax reporting purposes
– reports required by futures exchanges or other local regulatory bodies. If local
reporting requirements deviate from the accounting policies explained above,
parallel procedures should be adopted
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14. Accounting Procedures
• Essential to ensure proper management of risks
– Futures contracts are marked-to-market daily
– OTC options, independent sources of most recently available prices should be
used for daily mark-to-market purposes.
• Balance needed between flexibility, risk control and profitability.
– A flexible accounting system will expose the institution to a greater degree of risk
but will increase its profit potential.
• Mark-to-Market Accounting
– All futures contracts must be marked-to-market for accounting purposes.
– For hedges, they will be given the deferral accounting treatment.
• Gains or losses, including fees and commissions received or paid are
amortized as an adjustment to the interest account for the item being
hedged over its expected weighted average life and must be recorded as an
adjustment to its carrying value.
– hedges where correlation is not achieved, deferral accounting must be
terminated.
– Any trading gain or loss, recognized immediately
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15. Accounting Procedures - 2
Mark-to-Market Accounting (cont.)
• Where futures are used for hedging
– Underlying instrument that is being hedged can be identified and matched.
– Same accounting system must be applied to both the target security and the
hedge.
– Improper to use mark-to-market for one and we use accrual basis for the other.
• Uplifting a hedge must be explicitly.
– Prevent traders from using lousy positions as hedge and good positions as
trading.
– If the hedge is to reduce the overall risk position of existing assets and liabilities
or firm commitments or anticipated transactions;
– The items that are to be hedged must be identified, and
– The design of the hedge must be specified.
• Hedge management process ensures correlation between changes in the
value of the futures hedge(s) and the changes in the value of the hedged
item(s) is still achieved.
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