Why trading portfolios need IPV?
We have explained earlier that the all positions in Trading books uses market data to generate generate NPV (value) and Risks of derivatives and cash products. FO or Middle office team (or both) determine the source and update daily at the end of the day. The Valuation Control Group(VCG) whose primary responsibility is to ensure that the valuation feed into the general ledger should be reflecting accurate market valuation. Hence, the VCG independently gather market data (e.g. FX spot, FX Forward data, interest rate curves, CDS curves, bond and equity prices) and applied to the complete portfolios. This process is called IPV – Independent Price Verification. The IPV can be gain or loss. That means VCG new positive NPV can be higher than production positive NPV which generates gain and vice versa. This applies to risk based IPV as well. Finally, total IPV amount is adjusted to General Ledger by accounting team.
There are basically two approaches:
A. Risk Based IPV: The trade can have multiple risks, For example, FX spot risk, Interest rate curves risk etc. Hence, each risk and data point is multiplied with new market data and subtracted by risk multiplied by production (FO sourced) market data. The difference in valuation is IPV amount.
Risk based IPV = risk x VCG market data – risk x FO- Production market data
For example : FX forward trade MXN vs USD. We need FX spot rate, MXN zero and basis curve. The risks are basically FX exposure and PV01 for MXN zero and cross currency basis curve. Even though the valuation is using FX forward curve , the risks are PV01 on interest rate curves which are derived from FX forward curve.
FX spot IPV = FX exposure x VCG FX spot – FX exposure x Production FX spot
3M zero curve PV01 IPV = 3M PV01 x VCG 3M MXN zero curve quote – 3M x Production 3M MXN zero curve quote
B. Full Valuation Approach IPV : The complete portfolio is fully revalued using VCG market data. Each trade production NPV is subtracted from new VCG new NPV. The difference is IPV.
IPV = New VCG NPV – Production NPV
For example : EUR mono currency interest rate swap trade. We need EUR FX spot rate, EUR zero curve and cross currency basis curve. VCG gathers these 3 items. They are in the same format as FO-Production market data which feed into the system. The system produced new NPV. These new NPV is compared with production NPV.
There are few things need consideration:
1. Completeness in terms of trades – The desk can have different asset class products which are booked in different systems.
2. Risk Based IPV – completeness in terms of all risks types. For example, Fx delta, IR delta, CS01 etc.
3. Independently sourced market data quality – For example vendors consensus market data should be gathered from prominent banks and processed/refined with time tested methods. If our own bank FO market data received via vendor would not be good. That defeat the IPV purpose itself.
4. Gathering , cleaning and calibration of market data – Volatility like ATM, RR and ST FX options market data are used to generate the complete volatility surface which eventually used in valuation and risk generation. The products which uses more complex market data, it is better to use Full Revaluation approach. The risks may not appropriately capturing any gap in valuation.