Introduction
Deep insight into valuation and risks of Financial Derivatives
Financial derivatives are traded globally. Valuation and Risks are the inherent part of them. Quantitative Tool is created to accurately value and capture the risks. The tool is a combination of robust knowledge of Financial Products, computer programming (C++, Python) and Mathematics. Practical application of the valuation and risks methodology is crucial for financial professionals at all stages of their career.
Valuation and Risks: Institutions are pricing their trading portfolios daily which generates Net Present Value (NPV) for each trade using closing market data. NPV is discounted future cash flows. So, we need to determine the future cash flows and discount factors for each cash flows. Market data used for both determining cash flows and discounts factors. The change in trade NPV due to change in each unit of market data used in the valuation is the market risk. Hence, risk is due to change in different types of market data (e.g. FX spot rate, interest swap points, volatility etc.) and different usage impacting future cash flow as well discount factors simultaneously.
Mostly derivatives are traded at market level and hence there is theoretical zero NPV when the trade is entered. There can be exceptions mainly in credit default swaps. As the time passes, the NPV changes on a daily basis and which determines Life to date Profit/Loss (NPV) as well daily P&L (Current NPV – Previous NPV +- Cashflows).
Derivatives valuation-NPV has mainly two parts.
- Determining Future Cash Flows: There are different kinds of derivatives and their cash flows streams are unique as per the OTC trade details and market terms. The process of determining future cash flows has to be accurate and hence we need quantitative (Quant) library. This Quant Library uses not just trade information and market data but exact daycount basis, holidays and other minor detailing which generate the exact cashflows with their payment/receipt dates. Derivatives can have single cash flow (e.g. FX Forward) or multiple cash flows (e.g. Swaps). The cash flows can be linear or non-linear (e.g. options, swaptions – cash flows depend on volatility). The valuation process uses different kinds of market data. If the trading team (Front Office) determines the closing market data for valuation then independent valuation team has to calculate IPV (Independent Price Verification). Mid – (Bid + offer)/2 is used to value to the trades in normal practice. If we need to close the trade, we face bid offer spread. That means, if we are long (bought) and we need to short(sell), we may be getting less than Mid value (based on the valuation happened). This gap in valuation is captured using bid offer reserve for each market data.
Fair Value Adjustment (FVA): Bid offer reserve, market data uncertainty reserves, model reserve (Quant Library limitation) etc.
Independent Price Verification (IPV)
- Discount Factors: Each future cash flow has to be discounted using appropriate discount factor. The discount factor is decided based on Currency, cash flow stream, market practice etc. Discounting factor is as crucial as the determining future cash flows. Each currency cash flow is discounted using their currency risk free interest rate curve. This is the just the beginning. Non-USD currency cash flows has to consider cross currency basis curve. In OTC market, due to counterparty risk the risk-free discount rate triggers CVA (Credit Valuation Adjustment) and DVA (Debit Valuation Adjustment)- our own credit risk to our counterparties. As per funding curve of the institution which triggers again Funding Valuation Adjustment. In nutshell, derivatives future cash flows discount factor determines all other valuation adjustments.
CVA – Credit Valuation Adjustment => Counterparty Risk Reserve
DVA -Debit Valuation Adjustment on trades/ counterparties where we owe to counterparty
Funding VA – Funding Valuation Adjustment – OTC trades are collateralized or uncollateralized. Usually, the collaterals are generating only risk-free rate. But the institutions have funding spread on top of risk-free rate. When the counterparty owes us (Positive NPV – Assets). We are funding those assets using (Risk free rate + Funding spread unique to our Institutions). But we are only generating risk free rate on collateral received for those positive NPV. Hence, the assets are generating loss on funding spreads. This reciprocally applies to Negative NPV – Liabilities. We owe to the counterparty and we have delayed payment, saving funding cost. Assets generate funding loss and Liabilities funding gain.
Traded Risks
- Market Risk-> Valuation of trades need market data. The change in the NPV(Net Present Value) due to change in one unit of all kinds of market data used. For example: PV01- Interest Rate Risk, FX Delta Risk – FX Spot rate change , Vega – Change in ATM and Skew Volatility.
- Credit Risk-> Loss due to counterparty default. CS01 – Credit Spread Risk.
Financial Derivatives Types
- OTC (Over The Counter)-> The contract between two counterparties using agreed terms of trade which is flexible as per the counterparties needs. Significant counterparty risk.
- Exchange Listed-> The specific products, maturity and other terms of trades directly traded on exchange. No counterparty risk.
Financial Derivatives Categories
- Linear-> The trade date to maturity date journey of the trade is predictable without considering volatility. For example: Spot, Forwards, Swaps etc. Volatility is not needed to value the trade.
- Non-Linear-> Volatility is crucial market data to value the trade. For example: Options, Swaptions, Cap-Floor etc
Trades Levelling Types
There are different market data availability and usage in trades valuation. Each trade NPV is categorized based on the market data Observability. Institution has to present their trading balance sheet into these 3 categories. Levelling is additional point of view to review trading portfolios. Hence, regular FVA, IPV and XVA adjustments are considered on all of them. Level III trades may need further valuation adjustments. Level III trades and movement of trades from one levelling to another are analyzed, discussed and documented appropriately in Senior Management meeting.
- Level I -> Readily price available for value the trades. For example , Equity spot price, futures prices. This does not mean that the position is liquid enough. Level I trades can have wider bid offer spread. Institutions globally opt to use model price instead future price(readily available). Then those trades categorized under Level II.
- Level II -> The trades valuation is derived using market data readily available. For example, Swaps valuation uses interest rate curves , Credit default swaps valuation uses CDS curves. But the market data are being cleaned, calibrated, interpolated and extrapolated using models or best practice to determine the final valuation of the trades. Hence, there is no direct price but value can be derived and accepted in normal market conditions.
- Level III -> Market data are neither readily available nor derived. There are exotic options, hybrid trades (combination of different asset classes) need volatilities, correlation, etc. to value them. These volatilities or correlations are calculated using mathematical model driven and/or approximate market data. There are vanilla trades like forward, swaps could be categorized in Level III due to unavailability of market for example longer tenors, EM countries etc.
Derivatives
Financial Derivatives
Equity
Equity Swap, Equity Options
Foreign Exchange
FX spot, FX Forward, FX NDF, FX Options
Credit
Credit Default Swap, Total Return Swap
Interest Rate
IR Swap, XccySwap, Swaption, Cap/Floor
Banks
Insight into Bank's Financials
QuantPie
