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What We Do

We provide insight into financial derivatives.

Usually, we get the definition of financial derivatives or mathematical detail paper. We have shortage of information on this subject where we need more details without dwelling into very technical or mathematical details. This information is not meant for trading. The information would be helpful to students, job hunters and established professionals.

Quantitative Tool:

The tool is the application of financial and mathematical knowledge to value and calculate risks for trades.

There are mainly two purposes:

  • Calibration of market data: Using actual quotes from the market like FX Spot, forward points, Money Market, Swap, Futures, ATM Volatility, Risk Reversal, Strangle, Cap-Floor and Swaptions volatility.
  • Calculating Risks and Valuation of Trades: Using calibrated market data with trade information

Services

Financial Derivatives

EQUITY

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  • Equity Spot
  • Equity Forward
  • Equity Index
  • Equity Swap
  • Equity Options

INTEREST RATES

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  • Mono Currency Swap
  • Cross Currency Swap
  • Swaption
  • Cap-Floor

FOREIGN EXCHANGE

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  • FX Spot
  • FX Forward
  • FX Non Deliverable Forward
  • FX  Options

CREDIT

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  • Credit Default Swap
  • Credit Default Index
  • Total Return Swap
  • Credit Linked Note

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BONDS

Bonds are integral part of Fixed Income asset class. There are  many types of bonds.

  • Zero Coupon vs  Normal bonds with coupons mainly semi-annually. Zero coupon bonds has initial investment and final payment of notional. Initial price is discounted price. For example, if we buy the 1 Year zero coupon bond  @ $95 and we get $100 on maturity. Based on the Daycount Basis, holiday schedule and market terms, the interest rate is derived. The interest rate is >5%. ( $5 on $95 initial investment). 
  • Callable/Putable Bonds: The issuer of the bond can called up the bond, pay all dues and terminate bonds as per the term sheet. Putable bonds are put by investors when the terms of the market goes in their favor.  The bond is properly documented so there is no room for ambiguity. These bonds are considered Simple Bond + Embedded Options(call or put). If we long the simple bond and short callable bond with same or close maturity we left with option value. 
  • G7 Bonds (e.g. USD, EUR etc.) and Currency Bonds (Mexico Govt issues bonds in MXN currency).  EM country Sovereign or Corporate  bonds denominated in USD faced Credit risk mainly. EM  country bonds in their own currency is opt out from credit risk assuming the Govt would easily pay of the dues even printing money.  That is not possible in USD or EUR currency denominated bonds.

Bonds prices are usually readily available. So the institutions reaped the yield curve from the series of bonds with different maturity of the same entity. All cash flows of the bonds are discounted with ( Risk Free Rate + CDS Curve + Bond Basis curve) to derive the market price. Usually Bond prices, risk free rate, and CDS curves are available. Bond Basis curve is missing component to arrive at Market price of the bond.  This information helps to evaluate the bond profitability picture. Deriving the bond basis curve is not simple calculation. The quant library does it meticulousl

Accounting of Financial Derivatives

Brief details of Accounting Treatment of Financial Products:

  1. Derivatives: Every derivative trade irrespective of their valuation complexities, mainly has Net Present Value (NPV). This can be positive (gain) or negative (loss).  The NPV amount is credited to P&L Account and Debited to Balance Sheet Account if it is gain(credit) and vice versa. This means gain is increasing the P&L. But the cash is not exchanged yet it will be reported as assets on Balance Sheet. The loss will be reported as liabilities.
  2. Linked Note: The note trade where the notional is exchanged between the counterparties at the beginning and end of the trade. Usually, the note is linked to derivatives (FX, Equity, Credit etc.).  Hence, there are two sections of the trade-Note (Notional) and Derivative (NPV). In normal business, banks issues notes, that means the bank accepts notional in the beginning of the transaction. This notional amount is recorded as liability (Credit Balance Sheet account and Debit Cash account). When the notional is returned to the counterparty, the entry is reversed. The notional amount is subject to marked to market where underlying zero curve + credit component of the bank needed. Derivative part is same as explained in (1).
  3. Bond: There are settled and unsettled positions of bond for each unique ISIN. Settled positions accounting is slightly complicated due to premium and amortization accounting.  Unsettled bond positions accounting treatment is similar to derivatives as there is no cash exchange happened. If the gap between trade date and settlement date is more than usual (~2 to 3 days) then it is accounted as Bond Forward trade.

Collateral of Financial Derivatives

Mainly OTC (over the counter) trades are specific and the valuation is not readily available as exchange trade price. Each counterparty is valuing based on their internal model using their market data. This creates inherent counterparty risks if we have positive Net Present Value (NPV). Hence the collateral amount is exchanged as per CSA. There are netting agreements that trades under different desks/entities are netted. As per the agreement, the cash or equivalent to Cash are exchanged between the counterparties on net positions. For example, after netting if counterparty A owes $12MM to counterparty B. If the agreement has threshold, the exchange of collateral only happens if the net position is greater than the amount. In above case, if the threshold amount is $10MM, then the collateral is transferred from A to B as per agreement (it can be $2MM or $12MM). 

New Trades P&L

What is New Trade?  The very first day of the trade when it is entered into the system.

At the end of the day with closing market data,  the NPV is calculated like all other existing trades. The normal new trade NPV has two components.  

a. New trade P&L: At the moment when the trade is entered with the counterparty. This is mainly bid offer spread P&L. Big Banks are market maker and hence earned immediately for taking opposite positions for their clients.  This P&L depends on the liquidity of the market data underlying . EUR/USD FX spot may have very minimal new trade P&L vs Credit Default Swap on EM corporate entity can significant P&L due to illiquidity in the market.

b. Intra-day P&L: This is the P&L from the time when the trade entered into the system till the closing of the day. This P&L can be gain or loss depends on market data movement in that period.

There can be additional flavor to this new trades P&L. Off Market Trade and Day 1 P&L.

  • Off-Market Trade: When the trade is entered, the trade is in favor or against of one counterparty unreasonably. That creates significant gain or loss to the one of the two counterparties. The trade strike price is not reasonably explained by bid offer spread in normal conditions.  Off-market trades can be valid when the market is very volatile and bid offer spreads are wider than normal. Regulators keep close eyes on these trades to ensure that the Big Institutions are not exploiting the market in their favor or harming client’s interest due to market dominance.
  • Day 1 P&L: Day 1 P&L is the term used in Banks where the huge gain/loss is made on some specific transactions. These trades may have significant valuation deficiencies due to Market data unobservability and/or unstable valuation model. Day 1 P&L is calculated normally with available market data, made up market data (e.g. Historical Correlations and volatility – standard deviation) and with existing models.  As mentioned early, the first day of the NPV  may be big gain or loss. This NPV is adjusted further for FVA , IPV and XVA adjustments. Day 1 P&L  = First Day NPV –  FVA – IPV -XVA.  Once Day 1 P&L is accurately determined then it is moved from P&L account to Balance Sheet account.  As per  management’s discretion the Day 1 P&L is reviewed, released/amortized periodically.

Market Data Vendors

We have repeated multiple time about market data usage and their impact on valuation and risks.  Hence, it is obvious that the source of market data has to be reliable. We also have to understand the gathering process of market data by each vendor.  Market data can be indicative as per vendors models or real traded price. The market data can be consensus or average of different institutions prices. Each vendor has their own policy.  It is important to note that each market data can have different methods. US Treasury bonds prices are reliable and similar across vendors vs EM corporate bonds reflect different prices by different vendors. Hence, choosing right vendor for right market data is very crucial for valuation and risks of Derivatives.

  • Bloomberg: We all know bloomberg which is very user friendly. Bloomberg has multiple services
  • Reuters: Similar to Bloomberg but not as wide coverage of market data.
  • Markit-Totem: Totem is expanding in different asset classes and types of market data.  They first gather market data from institutions  in specific template. The market data are  analyzed and the consensus reports are generated based on the pre-approved process. Outer bound market data are rejected. The process is controlled which ensures the consensus market data are more reflective of current market.  The institutions get back the same market data with consensus and other parameters e.g. standard deviation of  all contributions.  Institutions contributed marks are accepted or rejected. If they constantly rejected then Totem team discontinue providing consensus market data.  Rejection market data has to be analyzed and reviewed periodically.
  • Brokers: Small or big Institutions trade with brokers. Hence, brokers has immense information of the market.  They process the market data and provide the service to the institutions.  Brokers are very famous and reliable in EM markets.