risk management lessons from a proprietary derivatives ... · risk management lessons from a...

Risk Management Lessons from a Proprietary Derivatives Trading Firm

Tom Hutchinson

President

Belvedere Trading

May 15, 2014

2 | © 2014 Global Association of Risk Professionals. All rights reserved.

Contents

Rolling the dice to playing it safe: Rewards dictate decisions

Haircuts, margin, and risk: Evaluating risk takes several approaches

System failures and fraud: Preparing for the unexpected


Bank vs. Proprietary Trading


Rewards and Responsibilities Dictate Decisions

Trading arm of bank

Incredible learning experience

Vast resources and opportunities

Adjustable risk capital

Extremely high cash available

Access to other trading venues

Lower percentage split

50/50 Split

Perfect for career milestones and

scalable strategies



Backed proprietary trading firm

Invested life savings

Early stages of career

Low lifestyle expectations

Higher split

Participated in capital side

– 50% of profits for trading

– 40% of capital or 20% of profits

– Net 70% of profits

Efficient capital usage which meant riskier positions


Volatility Curve of Equity Index

0

5

10

15

20

25

30

35

40

45

-30 -20 -10 0 10 20 30

Implied Volatility

Implie

d V

ola

tilit

y

Percentage Move


Volatility Curve for Commodity


Commodity Distribution



Proprietary trading firm

Transitioned to fully self-backing

Market making is not scalable

Committed to options trading

Risk numbers reduced

Diversified trading groups

About 200 Belvedere team members

Several partners with large contributions

Responsibility and diversification leads to more consistent but lower returns.


Margin and Haircut

Overall margin limits are set by Government Regulators and enforced by Exchanges

and/or Clearing Firms.

CFTC- Commodity Futures Trading Commission

Independent agency of the United States government that regulates futures and option markets

CFTC- Commodity Futures Trading Commission

Holds primary responsibility for enforcing the federal securities laws and regulating the securities

industry, the nation's stock and options exchanges, and other activities and organizations, including

the electronic securities markets in the United States.


Margin and Haircut Requirements


Standard Portfolio of Risk (SPAN – CFTC)

CFTC regulated exchanges use SPAN to set margin requirements

Developed and implemented in 1988 by the Chicago Mercantile Exchange

SPAN calculates the worst possible loss that a portfolio of derivative and physical instruments might

reasonably incur over a specified time period (typically one trading day) This is done by computing the

gains and losses under different market conditions

Each market condition is called a risk scenario. The numeric value for each risk scenario represents

the P&L that a particular contract will experience for a particular combination of price change, volatility

change, and decrease in time to expiration


SPAN (continued)

16 Different Scenarios of Risk

Price Scan Range

$86.50

Volatility Scan Range

7%


Haircut - SEC

OCC utilizes a proprietary derivation of the Cox-Ross-Rubinstein binomial option pricing model to

calculate projected liquidating prices.

– Projected prices are calculated based upon the closing underlying asset price for each day plus and minus

price moves at ten equidistant data points over a broad range of market movements

For market makers, the percentages of the daily market price of the underlying are +6/-8% for high

capitalization diversified indexes, +/-10% for non-high capitalization indexes and +/-4.5% for major

market foreign currencies

A minimum charge of 1/4 point per contract times the appropriate multiplier is applied when the class,

product or portfolio group reflects little or no market exposure (or $25.00 per option contract assuming

that option contract covers 100 shares)


SEC vs. CFTC Risk Shocks to Underlyings


Haircut - SEC

OCC utilizes a proprietary derivation of the Cox-Ross-Rubinstein binomial option pricing model to

calculate projected liquidating prices.

– Projected prices are calculated based upon the closing underlying asset price for each day plus and minus

price moves at ten equidistant data points over a broad range of market movements

For market makers, the percentages of the daily market price of the underlying are +6/-8% for high

capitalization diversified indexes, +/-10% for non-high capitalization indexes and +/-4.5% for major

market foreign currencies

A minimum charge of 1/4 point per contract times the appropriate multiplier is applied when the class,

product or portfolio group reflects little or no market exposure (or $25.00 per option contract assuming

that option contract covers 100 shares)


Questions/ Comments?

Web links used for the presentation

http://www.cmegroup.com/clearing/risk-management/

http://www.cftc.gov/About/MissionResponsibilities/index.htm

http://www.sec.gov/about/whatwedo.shtml#.U3S82PldXAQ

http://www.cmegroup.com/clearing/margins/#e=all&a=all&p=all

http://www.optionsclearing.com/risk-management/rbh/

http://www.cmegroup.com/clearing/risk-management/

http://www.cftc.gov/About/MissionResponsibilities/index.htm

http://www.sec.gov/about/whatwedo.shtml

http://www.cmegroup.com/clearing/margins/

http://www.optionsclearing.com/risk-management/rbh/


Evaluating Risk Takes Several Approaches

Percent Risk Runs- Determined by the firms proprietary options volatility models.

– For S&P 500 Down 30%, 20% and 10% Up 10% and 15%

– Vol Shocks after the move given bounded parameters

– Changes in skew and other derivatives can be altered

Theoretical Option Pricing- Combining the Black-Scholes world with reality.

– Unit options have small dollar values as well as vegas

– Simulations and jump models can be calculation intensive

– Smoothing in the price changes in units with larger valued options

– Educating traders used to looking at vol surfaces on functionality

> Traders acknowledge large jumps in underlying

> The values aren’t intuitive when brought into the BS space


Preparing for the Unexpected

Electronic Failures

Several large firms have had documented system failures

Intermittent or persistent divergence could be more damaging

Automated testing

Small scale betas

Patience in the development process



My Nightmares

Accidentally falling asleep on buy button

Catastrophic events

Regulatory environment becoming overwhelming



Limiting Back Office Mistakes

Checks by individual trading groups and by firm totals

PNL balancing and reconciliation

Appropriate environment to admit mistakes

Team members who are threatened with termination can make irrational decisions.

Allowing risk managers the time and authority to oversee other trading teams.

C r e a t i n g a c u l t u r e o f

r i s k a w a r e n e s s ®

Global Association of

Risk Professionals

111 Town Square Place

14th Floor

Jersey City, New Jersey 07310

U.S.A.

+ 1 201.719.7210

2nd Floor

Bengal Wing

9A Devonshire Square

London, EC2M 4YN

U.K.

+ 44 (0) 20 7397 9630

www.garp.org

About GARP | The Global Association of Risk Professionals (GARP) is a not-for-profit global membership organization dedicated to preparing professionals and organizations to make

better informed risk decisions. Membership represents over 150,000 risk management practitioners and researchers from banks, investment management firms, government agencies,

academic institutions, and corporations from more than 195 countries and territories. GARP administers the Financial Risk Manager (FRM®) and the Energy Risk Professional (ERP®)

Exams; certifications recognized by risk professionals worldwide. GARP also helps advance the role of risk management via comprehensive professional education and training for

professionals of all levels. www.garp.org.


risk management lessons from a proprietary derivatives ... · risk management lessons from a...

Documents