Derivatives trading is supported by numerous computer systems to manage risk, account for positions on a mark-to-market basis and measure value-at-risk.
A critical but often overlooked aspect of a competent derivatives trading operation is the computer system used to manage the 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.
If you’ve read some of the articles in the Derivatives section of the Financial Pipeline, you will realize how quickly a portfolio of transactions can become complicated.
In the section on hedging swaps, we discussed some of these complications including the problems associated with mismatched short term cash flows and maturity bucket grouping.
Options produce their own problems because of the convexity of these products. Taking snapshots of delta, gamma and vega at an instantaneous specification of prices is insufficient (although necessary) for competent financial risk management.
One must also have an appreciation of how these risks change with the progress of time and the evolution of prices. In the first edition of Risk Professional magazine published by the Global Association of Risk Professionals (see http://www.garp.com), Geoff Kates establishes a framework for evaluating a financial risk management system and he uses this framework to assess some of the more common off-the-shelf products on the market. This article will discuss those criteria and it will explain the importance.
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. For many banks, this is still the case.
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 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. It is not something you’re likely to learn from a book or a classroom. You have to have experience.
To buy or to build
The next question the bank’s senior management must ask itself is whether or not the bank should buy an off-the-shelf system 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. That is, 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 user permits. Many of the companies that sell these systems make it easy for the user to customize reports, batch files, pricing modules, etc.
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. Let’s say you are the head of trading at ABC Bank and you commission your risk management department, all of three people (Larry, Curly and Moe) to design and implement your interest rate risk management system. If Larry, Curly and Moe leave to go as a team to DEF Bank, you will have lost all of your core knowledge base and you will have to start from scratch. There is also the possibility that Larry, Curly or Moe designed secret entrances into the system for themselves so that they could manipulate tickets and positions and profit and loss statements.
In order to be effective, risk management information must be at least as fast as the markets to which it refers. On the face of it, for most people using applications designed for home use, this is not problematic. However, for financial institutions with portfolios consisting of thousands of different instruments, some of which use very complicated formulae, and arrays of parameters to revalue, this is a serious database design problem.
One of the key aspects of a well-designed system is its flexibility. A good risk management system will have a user interface that is customizable. Many of them are beginning to use the Internet as their interface platform. The interface is also the mechanism in which reports are designed. For an example of the kinds of reports dealers and risk managers require, see our earlier article entitled “How Do Options Traders Look At Their Portfolios”.
Asset Class Coverage
Further to our discussion of the integration of asset classes in the management of derivatives sales and trading operations at leading financial institutions, a good risk management system 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.
It is not uncommon for banks to have systems in place that enable their management to take a snapshot of the firm’s financial price risk with the simple click of a button at any point during the trading day, in real-time.
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 a controversial one. A good risk management system will allow management to pick and choose the pricing model it prefers for a particular instrument and it will also allow management to compare the model risk in different market environments associated with individual pricing models.
Ability to Link to Other Systems
The derivatives risk management system is 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 an operational risk issue as well. 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.
The key point here is that technological sophistication leads to better management.
These are just some of the criteria that a financial institution risk manager may choose to apply to the selection of a financial risk management computer system. In the next wave of development, risk management platforms will be entirely web-based. Already, Goldman Sachs and other leading American investment banks are offering web-based risk management systems, including pricing models, to their clients. Helping their clients understand the financial price risk they face makes it easier for the client to understand the efficacy of financial products.