● Stress scenarios, and
● Different add-ons.
All these bullets are used to supplement VAR measures. For example, stress tests have become useful sources of information on jump-to-default risk on credit prod- ucts, as well as in monitoring liquidity risk on exotic interest-rate instruments. In the judgement of banks participating in this 2005 Basel survey, marking to market can be a challenging task for positions where valuation is dependent on unobserved implied correlations or volatilities, as well as where liquidity of the market is an issue.
Underpinning dynamic hedging strategies, interest rate derivatives are a fre- quently used tool for hedging and profit making. Interest rate options and interest rate swaps are popular instruments. Two factors have contributed to the growth of interest rate swaps (IRS) and interest rate futures among credit institutions and investment banks:
● The significant growth of the market for fixed-income obligations, and
● The volatility of interest rates, which over the last 15 years has increased as they are now used for monetary policy reasons.
In the case of an interest rate swap, the counterparties swap interest payments on a given notional principal amount. This mainly involves fixed payments linked to a short-term interest rate. For central government, the advantage of using a swap contract is that it can separate the interest risk associated with issuing a bond from liquidity risk. This enables conversion of a ten-year fixed-rate bond into a debt at money market conditions.6
All players trading in interest rate futures and interest rate swaps need to per- fectly understand the yield relationship implicit in the term structure of interest rates, which underpins the yield curve. A yield curve is plotted against the default- free yield of government securities:
● At a given moment in time
● With different terms to maturity.
The market for interest rate options is flourishing, accounting for about 70% of financial options traded worldwide – and it is the largest segment of the entire derivative financial instruments market. (The term ‘interest rate options’ also covers options on bonds and on bond futures.) Their pricing is a challenging and often dangerous job, because they are based on estimates of future volatility, which may be subject to conflicts of interest. Other things being equal:
● The lower the projected future volatility, the lower will be the options price, and
● The lower is their price the better these options will sell, but if volatility is misjudged, then the options writer may face a torrent of red ink.
In trading jargon, this irrational expectation of lower volatility is known as volatility smile. It flourishes when volatility projections are guesswork, based on hope or are outright manipulations. A trading desk can use the volatility smile to
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distort the value of options, swaps and other instruments. The usual strategy is to convince management that one is documented in expecting that volatility will subside – hence, a cheering up.
Mispricing errors also happen because of organizational failures, such as building up firewalls that isolate different departments, and the opposite, the mixing up of duties. Everybody knows that those who trade should not also be responsible for back-office work, as happened with Nick Leeson at Barings, causing the venerable bank to go bankrupt. But few banks really establish and police the necessary sep- aration procedures between front desk and back office.
Companies that put deals together might be knowledgeable about current volatil- ity, but realistic estimates regarding future volatility are not always free of bias.
To assure that there is a separation between traders and accountants, several cen- tral banks have been promoting the creation of a middle office endowed with risk management functions. Sometimes, this middle office uses external agents to check pricing; this, however, is not foolproof.
In March 1997, NatWest Markets, the investment banking arm of National Westminster Bank, paid the volatility smile that led it to misprice its options. The bank’s controllers first found a £90 million ($170 million) hole in its accounts, which quickly grew to £300 million ($570 million) and beyond. As was stated at the time:
● Risk management in the middle office did not have good enough computer models, and
● The bank had accepted brokers’ estimates of volatility, which turned out to be overgenerous.
Eventually, NatWest sold bits and pieces of its investment banking subsidiary and was itself acquired by Royal Bank of Scotland. If financial institutions learned anything from what happened, it is that volatile instruments like derivatives produce exposure that may resonate throughout the entire enterprise. Management oversight can be very costly.
Market acceptance of interest rate derivatives documents that interest rate risk is manageable, provided one knows very well what he or she is doing. Additionally, to prognosticate adverse effects on their balance sheet, and therefore be able to act, companies must monitor their exposure to interest rate changes very care- fully, including the able use of stress tests.
Credit institutions may also be exposed to valuation risk on their investment and trading portfolio, as well as to the risk of an adverse impact of interest rate
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changes on the demand for credit. Credit quality and customers’ ability to service debt may also be affected by interest rate changes. Other exposures are:
● Optionality, such as prepayment of assets in the banking book or off- balance sheet items, and
● Basis risk, which arises from imperfect correlation in the adjustment of rates earned and paid on different instruments with otherwise similar repricing characteristics.
Measuring valuation risk in banking books requires detailed information on remain- ing maturities as well as purchasing prices. It is also necessary to assess valuation risks in fixed income trading portfolios. Both types of information are rather scarce at the present time, because institutions have not taken the necessary steps to restructure their accounting systems.