Portfolio Margining: Strategy vs Risk

This paper presents the results of a novel mathematical and experimental analysis of two approaches to margining customer accounts, strategy-based and risk-based. Building combinatorial models of hedging mechanisms of these approaches, we show that the strategy-based approach is, at this point, the most appropriate one for margining security portfolios in customer margin accounts, while the risk-based approach can work efficiently for margining only index portfolios in customer mar-gin accounts and inventory portfolios of brokers. We also show that the application of the risk-based approach to security portfolios in customer margin accounts is very risky and can result in the pyramid of debt in the bullish market and the pyramid of loss in the bearish market. The results of this paper support the thesis that the use of the risk-based approach to margining customer accounts with positions in stocks and stock options since April 2007 influenced and triggered the U.S. stock market crash in October 2008. We also provide recommendations on ways to set appropriate margin requirements to help avoid such failures in the future

Margining Option Portfolios by Network Flows

As shown in [Rudd and Schroeder, 1982], the problem of margining option portfolios where option spreads with two legs are used for offsetting can be solved in polynomial time by network flow algorithms. However, spreads with only two legs do not provide sufficient accuracy in measuring risk. Therefore, margining practice also employs spreads with three and four legs. A polynomial time solution to the extension of the problem where option spreads with three and four legs are also used for offsetting is not known. In this paper we propose a heuristic network flow algorithm for this extension and present a computational study that proves high efficiency of this algorithm in margining practice

Combinatorics of Option Spreads: The Margining Aspect

In December 2005, the U.S. Securities and Exchange Commission approved margin rules for complex option spreads with 5, 6, 7, 8, 9, 10 and 12 legs. Only option spreads with 2, 3 or 4 legs were recognized before. Taking advantage of option spreads with a large number of legs substantially reduces margin requirements and, at the same time, adequately estimates risk for margin accounts with positions in options. In this paper we present combinatorial models for known and newly discovered option spreads with up to 134 legs. We propose their full characterization in terms of matchings, alternating cycles and chains in graphs with bicolored edges. We show that the combinatorial analysis of option spreads reveals powerful hedging mechanisms in the structure of margin accounts, and that the problem of minimizing the margin requirement for a portfolio of option spreads can be solved in polynomial time using network flow algorithms. We also give recommendations on how to create more efficient margin rules for options

Using financial futures in trading and risk management

The authors explain the features of an array of futures contracts and their basic pricing relationships and describe a few applications to show how investors and risk managers can use these contracts. Futures - and derivatives generally - allow economic agents to fine-tune the structure of their assets and liabilities to suit their risk preferences and market expectations. Futures are not a financing or investment vehicle per se, but a tool for transferring price risks associated with fluctuations in asset values. Some may use them to spread risk, others to take on risk. Financial futures (along with options) are best viewed as building blocks. Futures have facilitated the modern trend of separating conventional financial products into their basic components. They allow not only the reduction of transformation of investment risk but also the understanding and measurement of risk. The market for derivatives has grown enormously over the past decade. The value of exchange-traded eurodollar derivatives (futures and options) is equal to roughly 13 times the value of the underlying market. The volume of trading in financial futures now dwarfs the volume in traditional agricultural contracts. As emerging markets develop, given their inherently risky nature, expect financial futures to play a prominent role in risk management.Payment Systems&Infrastructure,Economic Theory&Research,International Terrorism&Counterterrorism,Banks&Banking Reform,Securities Markets Policy&Regulation,Commodities,Banks&Banking Reform,International Terrorism&Counterterrorism,Non Bank Financial Institutions,Economic Theory&Research

CCPs, Central Clearing, CSA, Credit Collateral and Funding Costs Valuation FAQ: Re-hypothecation, CVA, Closeout, Netting, WWR, Gap-Risk, Initial and Variation Margins, Multiple Discount Curves, FVA?

We present a dialogue on Funding Costs and Counterparty Credit Risk modeling, inclusive of collateral, wrong way risk, gap risk and possible Central Clearing implementation through CCPs. This framework is important following the fact that derivatives valuation and risk analysis has moved from exotic derivatives managed on simple single asset classes to simple derivatives embedding the new or previously neglected types of complex and interconnected nonlinear risks we address here. This dialogue is the continuation of the "Counterparty Risk, Collateral and Funding FAQ" by Brigo (2011). In this dialogue we focus more on funding costs for the hedging strategy of a portfolio of trades, on the non-linearities emerging from assuming borrowing and lending rates to be different, on the resulting aggregation-dependent valuation process and its operational challenges, on the implications of the onset of central clearing, on the macro and micro effects on valuation and risk of the onset of CCPs, on initial and variation margins impact on valuation, and on multiple discount curves. Through questions and answers (Q&A) between a senior expert and a junior colleague, and by referring to the growing body of literature on the subject, we present a unified view of valuation (and risk) that takes all such aspects into account

Counterparty Credit Risk in OTC Derivatives under Basel III

International audienceRecent financial crises were the root of many changes in regulatory implementations in the banking sector. Basel previously covered the default capital charge for counterparty exposures however, the crisis showed that more than two third of the losses related to this risk emerged from the exposure to the movement of the counterparty's credit quality and not its actual default therefore, Basel III divided the required counterparty risk capital into two categories: The traditional default capital charge and an additional counter-party credit valuation adjustment (CVA) capital charge. In this article, we explain the new methodologies to compute these capital charges on the OTC market: The standardized approach for default capital charge (SA-CCR) and the basic approach for CVA (BA-CVA). Based on historical calibration and future estimations, we built internal models in order to compare them with the amended standardized approach. Up till June 2015, interest rate and FX derivatives constituted more than 90% of the traded total OTC notional amount; we constructed our application on such portfolios containing and computed their total counterparty capital charge. The analysis reflected different impacts of the netting and collateral agreements on the regulatory capital depending on the instruments' typologies. Moreover, results showed an important increase in the capital charge due to the CVA addition doubling it in some cases

Structural pricing of XVA metrics for energy commodities OTC trades

The aim of the present Chapter is to improve of the structural rst-passage framework built in Chapter 1 along several directions as well as test its robustness. Since typically commodity trades are not clearable under Central Clearing Counterparts (CCPs), it is worthy to assess the eect of bilateral Collateral Support Annex (CSA) agreements on CVA/DVA metrics. Moreover I introduce within my CCR modelling, the impact of state-dependent stochastic recovery rates. Furthermore, in order to stress-test my framework, I investigate the eects on CCR measures of multiplicative shocks to the two major drivers in the game: credit and volatility. Finally I propose an alternative balance-sheet calibration based on hybrid market/accounting data which is well suited in the commodity context in the light of small and medium size of corporations usually operating in the EU commodity derivatives market for risk-management purposes.The global nancial crisis revealed that no economic entity can be considered default-free any more. Because of that, both banks and corporations have to deal with bilateral Counterparty Credit Risk (CCR) in their OTC derivatives trades. Such evidence implies the fair pricing of these risks, namely the Credit Valuation Adjustment (CVA) and its counterpart, the Debt Valuation Adjustment (DVA). Despite the more commonly used reduced-form approach, in this work the random default time is addressed via a structural approach a la Black and Cox (1976), so that the bankruptcy of a given rm is modelled as the rst-passage time of its equity value from a predetermined lower barrier. As in Ballotta et al. (2015), I make use of a time-changed Levy process as underlying source of both market and credit risk. The main advantage of this setup relies on its superior capability to replicate non null short-term default probabilities, unlike pure diusion models. Moreover, a numerical computation of the valuation adjustments for bilateral CCR in the context of energy commodities OTC derivatives contracts has been performed.The global nancial crisis revealed that no economic entity can be considered default-free any more, so that both banks and corporate rms have to cope with bilateral Counterparty Credit Risk (CCR) when negotiating OTC derivatives. Since the mainstream approach typically used in practical settings is to evaluate derivatives in terms of the cost of their respective hedging strategies, the pricing of CCR metrics implicitly relates to the way these strategies are nanced. Within the numerical section of the present work, the valuation adjustments for CCR have been computed. Moreover, the role played by funding costs and their impact in widening bid-ask spreads have been assessed. A similar reasoning has been applied for the investigation of the cost of funding Initial Margins (IM), typically eective on top of Variation Margins (VM) when trading under Central Clearing Counterparties (CCPs). As the Initial Margin Valuation Adjustment (MVA) is concerned, it is here showed that, dierently from what can happen for FVAs, no osetting eect can materialize. As a consequence, in aggregate terms IMs can cause systemic liquidity eects. The computed XVA metrics are relative to energy commodities OTC derivative trades

The Globalization of Stock Index Futures: A Summary of the Market and Regulatory Developments in Stock Index Futures and the Regulatory Hurdles which Exist for Foreign Stock Index Futures in the United States

The twelve-year history of stock index futures contracts has been marked by great success both in the United States and in many other countries. Two years after the product was introduced in 1982, the notional, i.e., underlying, or dollar value of trading on the Chicago Mercantile Exchange (CME) S&P 500 Stock Price Index futures contract surpassed the dollar volume of trading at the New York Stock Exchange (NYSE).\u27 Moreover, as investors go increasingly global and market turbulence grows, stock index futures are emerging as the favorite way for nimble money managers to deploy their funds. Indeed, in most major markets, trading in stock index futures now exceeds the buying and selling of actual shares. This article presents an overview of the history of stock index futures products, including an examination of their role in the market decline of 1987 and their broad acceptance in international markets. It concludes with a review of the current regulatory impediments to stock index futures trading