as a result.
China's OTC Shibor-linked derivatives market is also expanding. Standardized Shibor-linked vanilla derivatives have also been rolling out. Standardized Shibor-linked derivatives can be used as interest rate hedging tools, and will facilitate interest rate liberalization in the country through enhanced market transparency. Some of the latest examples include 1-month OIS based on the overnight Shibor rate, 3-month swap based on the one-week Shibor rate, 3-month swap based on the seven-day repurchase rate and 3-month Shibor FRA. These provide standardized points of reference, catering for the growing demand for more efficient trading and hedging of interest rate risks from practitioners, including structured products issuers.
It is clear that structured products based on local currency and local underlyings will become popular in the future, when domestic market hedging capabilities are built up. As China is also undergoing interest rate liberalization, high-yield fixed income products may gradually lose their attraction. Sensibly designed structured products can be viable replacements in the long term.
China's financial markets are still evolving with its economic development and social needs. One example is how the country should handle its demographic situation and look after older people financially. There have been numerous discussions on the topic and new policies are emerging along the line of “utilizing houses to look after pensioners”. It is conceivable that equity release (reversion) products will be manufactured and distributed by the insurance companies. As these types of products often have embedded real estate derivatives, it is vital for the Chinese customers to understand the benefits as well as the risks in those products.
Chapter 2
Pillars in Structured Derivative Business
Structured derivative business encompasses exotic derivatives, in addition to vanillas. The key elements to understand in structured derivatives are Models, Risks, Applications and Hedges (MRAH). Given the risky nature of the structured derivatives, failing to understand MRAH, structured derivatives can backlash and HARM you. Grasping MRAH requires an effective and 201Csimpler” business value chain, with an efficient and well-functioning product development and distribution processes.
Derivative Business Value Chain
Structured derivatives business is not a stand-alone trading or stand-alone sales business. It is an integrated risk management business. A coherent and consistent risk management business value chain consists of the key pillars in Figure 2.1.
Figure 2.1 Key Pillars of Structured Derivatives Business
The pillars consist of:
• Trading: It is much more than just buying and selling. It is about understanding the risk characteristics of derivative products and hedging the risks. Risk management should be part of its DNA. In the process of risk managing the positions, trading is putting fingers onto the market pulses and making appropriate hedging decisions accordingly.
• Hedging derivatives requires deep understanding of potential pitfalls. “Gamma trap” is a classic example. To hedge short gamma and short volatility positions, traders have to buy the underlying when it goes up and sell when it goes down. If volatility suddenly spikes, the underlying will move rapidly against them and the dynamic hedging can exacerbate the underlying movement, in particular during the downward spiral. This type of “chasing own tails” hedging can lead to sharp V-shaped underlying movement known as “Gamma trap”, which can amplify losses of the short gamma positions. If large numbers of institutions hold similar short gamma positions and perform similar hedging, the “Gamma trap” can cause wider market distortion and stress, as observed many times in the past.
• Quanting: Quantitative modelling is the core part of derivative products development. In the modern day and age, the models need to be consistent front to back for pricing and risks, to ensure consistency and transparency across the value chain. Quants should play a driving role in the development of trading and risk infrastructures;
• Marketing: This client-facing function includes structuring and sales. Client-driven product design, distribution process and channels are constantly evolving. Clients and market feedbacks play important roles in the new products development and manufacture process.
• Risk controlling: This is a four-eyes principle-based independent risk management function that should work with the front office functions very closely, to identify and control risks including market, credit and operational risks.
• Trading/pricing/risk systems underpin day-to-day derivative activities. It is actually scandalous that the derivative industry has wasted many billions on IT systems spending due to lack of integrated vision and lack of coherent business and technological management.
The pillars illustrated in Figure 2.1 are fundamental to the structured derivatives business. The whole business value chain needs to function efficiently and coherently, to ensure an effective and safe business. The widely acclaimed IPD (Integrated Product Development) management philosophy can and should apply to the derivative products development, taking into account the business as a whole.
Model and Product Development Process
Financial derivative products are not tangible, and ultimately they are based on models. Quantitative analysts (quants) must be a risk-conscious business group. Its roles encompass developing derivative pricing and hedging models, providing quantitative supports, formulating and developing derivatives model-related trading and risk systems. Quants should be one of the drivers along the industrialized production line for derivatives.
Derivative pricing models are vital in the structured derivatives and risk management business. Many client-driven derivative products have no direct traded markets for bench-marking, and they will have to be marked to the models, although the vanilla markets are used for calibration. In such a (de facto) marking-to-model business environment, the quality of the models is paramount, as it not only impacts P&L, but also the day-to-day hedging and risk managing activities. Banks must establish and standardize a process for developing quality pricing and hedging models, as a key part of the efficient and reliable production line which can also minimize the model risks.
Principles of Model and Product Development
Model specification, its numerical implementation and development testing need to follow a number of critical principles. Independent model validation is also an essential part of the model and product development process.
Model Specification
Speculation is human, hedge is divine. The central part of the non-arbitrage derivative pricing framework rests on the divine principle of hedge. The model specification must comply with this general framework. The model mathematical formulation, scope, applicability range and any limitations should be clearly specified. Any model assumptions deviating from those defined in the model framework should be thoroughly assessed with the business. Assumptions and potential implications of hedging should be explicitly explained. The bank must seek to eliminate or minimize the model mis-specification risks at source.
It is very important that the models are specified and implemented as close as possible to the real world, and they are suitable for day-to-day business usage. Quants should be aware of the common and best market practices, remembering that the models are not only used for pricing, but also for risk analysis and hedging. As a general guideline, good model specifications
