Fundamentals of Derivatives Risk
The aim of this two-day workshop is to give participants an overview of the different risks encountered in derivatives transactions, how they inter-relate and how they can be measured and monitored.
Key Learning Outcomes:
- Understand how risks in derivatives transactions differ from traditional banking products and why special care needs to be taken in measuring and monitoring these risks
- Distinguish market, credit, operational, liquidity and reputation risk in derivatives products and understand how they inter-relate
- Identify the different types of exposure within each risk group and derivative type and review how these exposures can be measured
- Review lessons learned from risk management failures in derivatives transactions in order to establish best practice in the monitoring and mitigation of risks.
Derivative Product Overview
The aim of this section is to review the key features and risk profiles of different types of derivatives transactions.
Key features of derivatives
- Market dynamics: history, size and development of derivatives markets
- Derivatives building blocks: forwards, futures, swaps and options; simple and compound structures
- Exercise: review of main features of key derivative products e.g. interest rate swap, FX forward and credit default swap
- Markets: interest rate, foreign exchange, credit, equity, commodity and exotic products
- Settlement and clearing mechanisms: exchange traded versus over the counter; role of central clearing parties.
- Key features of derivative transactions and how the risks differ from other banking transactions
- Purpose of derivatives transactions: hedging, trading, investing
- Risk perspectives of different types of parties: banks, companies, public sector entities, pensions and other investment funds
- Exercise: how and why different counterparties use derivatives.
- Identifying and defining major risk groups and how they arise in the derivatives business: market, credit, liquidity, operational and reputation
- Lessons learned from risk management failures in derivatives
- Exercise: Company failures caused by derivatives.
This segment reviews how market risk arises in derivatives and how this can be measured and controlled.
Types of market risk
- Types of market risk in derivatives: position (net long or short), relative (basis, spread, correlation), optionality, complexity
- Trading book vs banking book derivatives risk.
Measuring and managing the risk
- Differing methods of measuring and monitoring derivatives: how and where they are used, benefits and shortcomings of each
- Value at Risk (VaR): definition and key concepts: holding periods, confidence levels and disclosure, backtesting
- Exercise: Calculating VaR on a simple derivative transaction
- Greeks: uses of delta, gamma, vega and theta to measure risk in the dealing room
- Limit structures in the dealing room
- Stress testing, scenario testing and simulation modelling.
Credit / Counterparty Risk
This segment reviews the main types of counterparty risk in derivatives and how they are measured and mitigated. Derivatives from the main product groups (interest rate and foreign exchange) will be used as examples.
Types of counterparty risk
- Differentiating derivative credit risk from other forms of credit risk
- Different types of counterparty risk: pre-settlement and settlement and other risks.
Failure due to poorly managed counterparty risk.
Measuring and mitigating the risk
- Challenges of predicting exposure at default
- Exercise: Compare pre-settlement risk on two transactions e.g. an interest rate swap and FX forward
- Basics of credit mitigation techniques and documentation.
Liquidity, Operational and Reputation Risk
This segment reviews how liquidity, operational and reputation risk arise in derivatives and how these risks can be measured and controlled.
Types of risks
- Transactional liquidity risk in derivatives: secondary market, contingent outflows from collateralisation
- Reputation risk: ensuring derivative transactions are appropriate for the client
- Operational risk: key challenges with derivative risk models and mitigation techniques.
Managing the risks
- Lessons learned from risk management failures
- Best practice in managing liquidity, operational and reputation risk within banks
- Regulatory requirements and impact of moves to central counterparties.
Who should attend
A foundation level risk-focused course for capital markets, risk, credit analysts, origination, corporate and bank treasurers, investment management and regulatory professionals who need a better understanding of the practical day to day risks involved in different types of derivatives. The risk focus of the workshop makes it complementary to product skills learned elsewhere.