Eurex Clearing Prisma Portfolio-based risk management

www.eurexclearing.com

Table of contents

03 Eurex Clearing Prisma: Delivering innovation with portfolio-based risk management

04 Introduction to Eurex Clearing Prisma• Liquidation Groups • Default management

10 Products covered• Futures• Options

- Premium-style options- Futures-style options

• Swaps products- Interest rate swaps- Overnight index swaps- Forward rate agreements

12 Margin components• Backward-looking components – mark-to-market margin

- Premium margin- Variation margin

• Forward-looking components – initial margin- Market risk component- Liquidity risk component

• Cross margining allocation algorithm for interest rate derivatives • Aggregating forward-looking components

20 Contacts

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Eurex Clearing Prisma: Delivering innovation with portfolio-based risk management Eurex Clearing is a leader in clearing technology and state-of-the-art customer solutions. We were first to introduce both real-time risk calculation and real-timerisk-data provision, and we continue to set industry standards in risk management.

With our portfolio-based risk management approach – Eurex Clearing Prisma – we offer an innovative way to help customers maximize collateral efficiency.

Eurex Clearing Prisma maintains reliablecounter cyclical margin levels in eventhe most challenging situations througha transparent and risk-sensitive metho-dology. It also delivers synergies throughrisk netting effects for listed, OTC andbetween listed and OTC positions.

It also promises flexibility when intro-ducing new products as well as oppor-tunities for greater capital efficiency,all with the robustness and reliabilitythe market has come to expect fromEurex Clearing. As with everything we do, Eurex Clearing Prisma has beendeveloped in conjunction with cus-tomers around the world to enablemaximum benefits – and to ensure regulatory compliance – for all marketparticipants. It is a solution that prioritizes safety, efficiency and integrity.

Eurex Clearing Prisma calculates com-bined risks across all markets clearedby Eurex Clearing. Cleared productsthat share similar risk characteristicsare assigned to the same so-called

Liquidation Group, which results inmore comprehensive risk calculationsenabling cross margining across posi-tions within any Liquidation Group. Ourmargining method and default manage-ment process are closely aligned.

Eurex Clearing is optimizing post-tradeactivity for all market participants – so you can be prepared for new regu-lations, respond faster to challengingmarket conditions and feel confidentthat you are clear to trade.

About Eurex Clearing

Eurex Clearing is one of the leading central counterparties globally –assuring the safety and integrity of markets while providing innovation in risk management, clearing technology and client asset protection. We clear the broadest scope of products under a single framework in Europe – both listed products and OTC – and offer the world’s widest spectrum of eligible collateral.

Eurex Clearing serves more than 170 Clearing Members in 16 countries,managing a collateral pool of around 51 billion euros and processing gross risks valued at almost 15.7 trillion euros every month. In the first four months of 2014 we cleared over 0.5 billion derivatives contracts.

Eurex Group is comprised of Eurex Exchange, the International SecuritiesExchange, the European Energy Exchange, Eurex Clearing, Eurex Bonds and Eurex Repo.

Eurex Group is owned by Deutsche Börse AG (Xetra: DB1).

www.eurexclearing.com

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1 Please visit the Eurex Clearing Prisma User Guide, which is available on Eurex Clearing’s website www.eurexclearing.com, for more detailed information on specific topics.

Introduction to Eurex Clearing Prisma

In order to facilitate the transition to Eurex Clearing Prisma, we are intro-ducing the new margin method inmultiple steps.

During the migration period, EurexClearing Prisma and the Risk-basedMargining method will run in parallel,allowing Clearing Members to migrateto the new risk method at their ownpace. Throughout this period, ClearingMembers will be able to decide individ-ually when to migrate their portfolioson a Liquidation Group and positionaccount basis.

Eurex Clearing’s Prisma methodology1

features concepts that build on existingprinciples and procedures in order toachieve enhanced precision and maxi-mize use of collateral. The followingsection explains, among others, Liquidation Groups, a key element of the portfolio-based margining systemthat enables Eurex Clearing to deliversynergies such as cross margining. It also describes how the default management process is designed toaccommodate the concept of Liqui-dation Groups. In a subsequent sectionthe brochure explains the margin calculation method.

Liquidation GroupsA Clearing Member’s portfolio typicallyfeatures a heterogeneous structure,size and/or complexity. Given thiscomplexity, and due to the generalhandling principles laid out in our default management process, it is usually impossible to liquidate an entire portfolio in one single transaction. Therefore, Eurex Clearing has introduced the concept ofLiquidation Groups.

A Liquidation Group combines productsthat share similar risk characteristicsacross all markets cleared by EurexClearing. Liquidation Groups serve as a cornerstone of the Eurex ClearingPrisma portfolio-based risk manage-ment method. The composition ofeach Liquidation Group is reviewedon a regular basis and adjusted due tomarket requirements. Together with its Clearing Members, Eurex Clearingdecides on the composition of Liqui-dation Groups.

Within each of these LiquidationGroups, positions can further be divided into so-called “LiquidationGroup splits” in the event that somepositions must follow a different liquidation timeline. The need forvarying timelines is related to one ofthese factors:

• Positions that are near to expiration(i.e. options or near-to-maturityfutures or bonds) might have to beliquidated with priority in case of a Clearing Member default.

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Liquidation Group equity derivatives – potential splits

Equity and equity index derivatives positions

Positions with remaining maturity: ≤ 4 days

Equity and equity index derivatives positions

Holding period: 4 days (for positions with remaining maturity

of >4 days)

• Interest rate positions in the listedarea (i.e. Euro-Bund Futures orEURIBOR futures) can follow differ-ent liquidation timelines dependingon whether they are used to hedgeinterest rate swaps positions or notby applying the Margin Optimizer.This optional feature allows for reducing the overall risk and achieves margin and collateral effi-ciency (please visit page 17 for further details).

A complete Liquidation Group split canbe hedged by Eurex Clearing, pricedby Clearing Members and then beauctioned within a reasonable periodof time.

General principles for Liquidation Groups:• Portfolio risk margin offsets are

only granted within pre-definedLiquidation Groups.

• Each Liquidation Group has a fixed holding period that reflectsthe time estimated to analyze,hedge and liquidate the respectiveproducts. A pre-defined holding period can be between two to fivedays, depending on the LiquidationGroup, and is at the same time the basis for the margin calculation.

The diagram below illustrates the currently existing Liquidation Groupsacross some markets cleared by Eurex Clearing.

Currently available Liquidation Groups

Liquidation Group

Liquidation Group Equity

Liquidation Group Fixed Income

Products

Equity (index) derivatives

Interest rate swapsListed fixed income derivativesListed money market derivatives

Currency

EUR, CHF, GBP, USD

EUR, CHF, GBP, USD, JPY

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Despite the individual nature of every situation, explicit trigger eventsfor a Clearing Member’s default havebeen defined, regardless of product or cleared market. In the case that a Clearing Member has been declaredto be in default, the Clearing Member’sproprietary positions and its clientpositions may be treated differently.

Client positions

When a Clearing Member defaults, oneof our principle objectives is to protectcustomers and to minimize the impacton clients and their positions. We arecommitted to ensuring that clients andtheir positions can be transferred to a new, solvent Clearing Member quicklyand smoothly, wherever possible.

Our risk management and clearingprocedures have proved to be robusteven in times of acute distress infinancial markets. However, the recentcrisis also highlighted that in the eventof a Clearing Member default greatertransparency and legal certainty withrespect to the treatment of client posi-tions and assets are critical to ensurethe highest degree of protection for our Clearing Members and their cus-tomers. As one part of our continuousefforts to optimize our default man-agement processes, we address thesegregation and portability needs ofour customers to help better preparefor a default event.

Default managementAs one of the world’s leading ClearingHouses, we play an important role inthe global effort to maintain stabilityin financial markets. We recognize ourresponsibility to help mitigate systemicrisks should the default of a ClearingMember occur. We managed the recentfinancial crisis effectively, not leastbecause we had robust procedures inplace to deal with a Clearing Memberdefault and were prepared to act whenthe need arose. We maintain our readiness to act in similar situations bycontinuously updating our safeguardsand introducing innovative productofferings that increase the safety ofour clients and of the Clearing House.

Default procedures

Aware that each default scenario isunique, we maintain flexibility in ourprocedures in order to accommodatethe individual features of each defaultconsistent with local and global regu-latory standards. Our procedures provide a transparent and adjustableframework that is applied dependingon the circumstances of the scenarioat hand.

The default management process isdesigned in a way which enables EurexClearing to handle portfolios in differentLiquidation Groups individually. Whileit is likely that the liquidation with respect to different Liquidation Groupsis likely to be conducted overlappingin time, the concrete measures appliedcan differ.

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Default management process

Our default management process iscomprised of set procedures designedto facilitate the orderly liquidation of even large and complex portfolios.

The following briefly describes keycomponents of the default manage-ment process:

• Default Management Committees:

Default Management Committees(DMCs) advise and assist the ClearingHouse with respect to any relevantmatter of the default managementprocess, most importantly hedgingand the preparation of auctions.Each DMC is staffed with professionalemployees of pre-selected ClearingMembers. They have sufficient tradingand risk expertise in the productsbelonging to the respective Liquida-tion Group(s) for which the DefaultManagement Committee is convened.Default Management Committees willbe convened in case of a ClearingMember default and for regulardefault simulations (once or twiceper year).

• Hedging: The purpose of hedgingwithin the default management process is to enable Eurex Clearingto reduce market and potential cash-flow risks. Furthermore, hedgingreduces the portfolio’s sensitivity to market moves and stabilizes it for auctions.

• Independent sale: In order to grantsufficient flexibility during a defaultsituation, positions or groups of posi-tions can be sold independently toindividual Members, i.e. positions ofthe defaulted Clearing Member arere-established by the Clearing Houseeither on-exchange or OTC, as an alternative to the auction process.

• Auction process: The LiquidationGroup-specific auction process is the main component of the defaultmanagement process. An auctionenables Eurex Clearing to rapidlytransfer risk in bulk to willing ab-sorbers, establishing fair market prices for the particular portfolios.

Overview – default management process

Preliminarymeasures Hedging Independent

sale Auction

• Convention of DefaultManagementCommittees to supportEurex Clearing through-out the whole DMP

• To protect client assets,positions and collateralare transferred wher ever possible

• Portfolio and marketevaluation in prepara -tion of liquidation

• Handling positions thatexpire shortly

• Hedging of the de-faulting ClearingMember’s portfolio is executed as early as possible, to limit losses immediately

• Hedged portfolio islikely to receive betterprices in the auction

• If the portfolio is smallor only few ClearingMembers are active inthe involved productsthen bilateral or on-exchange trades canensure a timely liquida -tion

• Mutual Clearing Fundwill not be utilized,unless all Clearing Mem bers have thechance to provide a price in the auction

• Participation in auctionsis generally mandatoryfor those ClearingMembers who areactive in the respectiveLiquidation Group

• Clients are allowed to bid

• Clearing Fund juniori-zation and penalty fee set incentives forcompetitive bidding

Holding period serves as basis for risk calculation within Eurex Clearing

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Lines of defense

We guarantee the fulfillment of everytransaction in every market for whichwe provide clearing services. To ensurethat we are able to keep this promise,we set up a multi-level safety systemcalled our “lines of defense”. Whilethe mainstay of this safety system isthe margin which Clearing Membershave deposited as collateral for openpositions, our lines of defense consistof several additional layers of financialresources, namely:

• the defaulted Clearing Member’sClearing Fund contribution,

• own resources of Eurex Clearing and the

• Clearing Fund contributions of all other non-defaulted ClearingMembers.

Segmented Clearing Fund

Eurex Clearing maintains a segmentedClearing Fund, consisting of multipleLiquidation Group-specific ClearingFund segments (CFS), and the sum ofall CFSs is the overall Clearing Fund.

When liquidating a particular portfolio,only funds of the CFS assigned to the respective Liquidation Group canbe used to cover losses, unless there isa known surplus from other LiquidationGroups for which the default manage-ment process has already been finished. As such, the segmentation of the Clear-ing Fund ensures that those ClearingMembers’ contributions are used first,which have been active in the Liqui-dation Group(s) that losses arise from.

Meanwhile, the segmentation stillmaintains the capital efficiencies of one joint Clearing Fund, as com-pared to multiple asset class specificClearing Funds.

Assessments

Eurex Clearing ensures that the lia-bility of a Clearing Member towardsthe Clearing House is limited. As such,Eurex Clearing’s right to assess theClearing Fund, i.e. Eurex Clearing’sright to request Clearing Members tore-fill their Clearing Fund contributionsonce they have been utilized, is capped.In any crisis situation, each ClearingMember is only obliged to provideadditional funds, up to an amount of two times its pre-funded ClearingFund contribution.

In the event of a default, these layersare applied in the order illustrated onthe next page. This way, the lines ofdefense help protect the marketplaceas a whole and play an importantrole in preventing a domino effect.

As a matter of last resort, EurexClearing intends to implement the possibility for one LiquidationGroup to be closed at the end of the lines of defense, while all otherLiquidation Groups remain unaffected.This additional recovery option serves to minimize contagion risk tothe maximum possible extent.

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Lines of defense – sequence of usage by Liquidation Group

* Listed interest rate derivatives and OTC interest rate swaps

Liquidation Groupequity derivatives

Defaulter’s contributions

Remaining contributions from defaulted Members

Liquidation Groupfixed income*

Defaulter’s contributions

Liquidation Group n

Defaulter’s contributions

Dedicated amount of Eurex Clearing

Remaining dedicated amount from Eurex Clearing

Dedicated amount of Eurex Clearing

Dedicated amount of Eurex Clearing

CFS

Remaining Clearing Fund contributions from non-defaulting Members

CFS CFS

CFS assessments

Sequ

ence

ofus

age

▼Se

quen

ceof

usag

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Guarantee by Deutsche Börse AG (“Patronatserklärung“)

Remaining capital of Eurex Clearing

Setting new standards in transparency

When a Clearing Member defaults,we are careful to ensure that we takeall possible steps to protect confiden-tiality, while we simultaneously rec-ognize our responsibility to inform our stakeholders and the generalpublic of the incident. In the event ofa Clearing Member default we have

implemented a clear communicationguideline that is strictly supervised by Eurex Clearing’s management anda policy to keep stakeholders informedat all times.

Key aspects of our policy include the immediate creation of a systemaccessible news board message after

an official regulator announcement or a self-declaration by the defaultingMember. It consists of publishinginformation on the Eurex Clearingwebsite, daily press statements, the distribution of circulars, and con-ference calls held with the members of our clearing committees and the risk committee.

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The qualification of product relatedrisk is another important componentof the Eurex Clearing Prisma process.This allows the Clearing House toaccurately assess the overall risk of an open position as well as to determinepotential cross margining synergies. As Eurex Clearing Prisma permitscross margining between products (traded on- and off-exchange) as wellas across markets cleared by EurexClearing, this section provides an over-view of the products covered underthe Eurex Clearing Prisma methodologyand their general characteristics.

FuturesFinancial futures are always based onthe firm contractual agreement- To purchase (buyer of a futures

contract)- Or to deliver (seller of a futures

contract)- A standardized quantity of a par-

ticular financial asset (underlyinginstrument)2

- At a pre-determined price (price ofthe futures contract)

- At a standardized future point in time(delivery date)

Both parties to a financial futures contract, i.e. the buyer as well as the seller, have assumed an obligation.However, neither the buyer nor the seller is obliged to keep his positionuntil the end of the contract’s term and,consequently, to fulfill the obligation.Both have the possibility to eliminate

their risk exposure by executing an off-setting (closing) transaction. The actualfulfillment of the contract, i.e. the delivery or purchase of the underlyinginstrument, can therefore be avoided.Only the profit or loss arising from the difference between the entry andexit price remains. This difference ischarged or credited to a cash clearingaccount on a daily basis by the ClearingHouse. This offsetting of profits and losses is called variation margin.In contrast to other kinds of margin,variation margin can only be depositedin cash. It is settled on a daily basis.

OptionsThe purchaser of an options contract(buyer) acquires, against payment of a premium, the right- To buy (call option) or- To sell (put option)- A pre-determined amount

(contract size)- A standardized quantity of a par-

ticular financial asset (underlyinginstrument)2

- On (European & American style) orbefore (American style) a specifieddate (expiration)

- At a pre-determined price (strike orexercise price)

Our margin process distinguishes between two different options typesand sets different margin requirementsfor each:• Premium-style options • Futures-style options

Premium-style options

For premium-style options (e.g. equityoptions), where the premium of an options transaction is exchangedupfront between the buyer and the seller, the seller of the option must deposit collateral to cover the risk of his position – known aspremium margin.

The options buyer receives a premiummargin credit which can be used tooffset a margin requirement arisingfrom his entire position.

Futures-style options

In the case of futures-style options(e.g. options on fixed income futures),both the buyer and the seller of the option are required to depositcollateral, as no premium is exchangedbetween the buyer and the seller when the transaction is entered.

With futures-style derivatives, the posi-tions are marked-to-market on a dailybasis. Profits and losses of futures-stylederivatives positions are calculated andsettled every day based on the providedvariation margin.

Swaps productsEurex Clearing’s EurexOTC Clear offering includes different types ofswaps products: • Interest rate swaps (IRS) • Overnight index swaps (OIS)• Forward rate agreements (FRAs)

Products covered

2 In case a futures or options product is designed that a physical exchange of the underlying is excluded, such contracts are settled in cash.

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All three are margined in a similarmanner as they share certain characteristics, which are brieflydescribed below.

Interest rate swaps

An interest rate swap (IRS) is a deriva-tive in which one party exchanges an agreed series of interest paymentsfor another party’s series of interestpayments. Interest rate swaps allowmarket participants to lock in interestrates and payments.

In an interest rate swap, each counter-party agrees to pay either a fixed orfloating rate denominated in a particu-lar currency to the other counterparty.The fixed or floating rate is multipliedby a notional principal amount. Thisnotional amount is not exchangedbetween counterparties, but is usedonly for calculating the size of cashflows to be exchanged.

A so-called plain vanilla interest rateswap is an instrument where onecounterparty pays a fixed rate (the swaprate) to another counterparty, whilereceiving a floating rate (linked to a reference rate such as the EURIBOR).With such instruments, fixed interestrate payments received/paid out of an underlying security/loan can beswapped into floating interest pay-ments received/paid and vice versa.

According to usual market convention,the counterparty paying the fixed rate is called the “payer”, and thecounterparty receiving the fixed rate is called the “receiver”.

A tenor basis swap is an instrumentwhere one counterparty pays a floatingrate linked to a reference rate withone reset frequency (e.g. Three MonthEURIBOR) plus a spread to anothercounterparty, while receiving a floatingrate linked to a reference rate with an other reset frequency (e.g. SixMonth EURIBOR).

Usually, interest rate calculations arebased on a constant “notional” prin-cipal amount, but variable notionals,variable fixed rates and variable floatingrate spreads are supported, too.Compounding and zero coupon swapsare also supported.

An interest rate swap can be spot orforward starting. Supported IRS are ina single currency; the reset is inadvance, the payment in arrears andinterest payments are settled net.

Overnight index swaps

An overnight index swap (OIS) is an interest rate swap where the fixedrate of the swap is exchanged for the weighted (geometric) average of

3 All margin components are described in-depth in the next chapter.

Applicable margin components

Premium-style options

Futures

Futures-style options

Interest rate swaps

Forward rate agreements

Overnight index swaps

Premium margin

Price align-ment interest

Variation margin

Market risk Correlationbreak

Compression Liquidityrisk

Backward-looking components

Forward-looking components

Model adjustments

Long optioncredit

Applicable Not applicable

an overnight index (i.e. a publishedinterest rate) over every day of thepayment period. The index is typicallyan interest rate for overnight call-money in euro (EONIA) or U.S. dollar(Fed Funds) etc. It will not be paid dailybut compounded and typically paid at maturity or annually for calculationperiods exceeding one year.

Forward rate agreements

A forward rate agreement (FRA) is a contract that starts in the future and whose final payoff depends on an interest rate fixing on that date.The difference between a swap andan FRA is that only one paymentoccurs and that typically the paymentis settled on the effective date.

Two types of backward-looking com-ponents are applicable for the swapsproducts described above.3 They arevariation margin and price alignmentinterest (PAI). Marking-to-market is carried out as well for all swaps products. Profits and losses that arisedue to the price fluctuations of openpositions are offset daily via variationmargin, as in the case of financialfutures. Price alignment interest (PAI)serves as a further cash-based margincomponent. It is the interest paid onthe variation margin, which aligns thepayoff of a cleared interest rate swapwith that of an OTC interest rate swap.

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The Eurex Clearing Prisma methodologycalculates the actual liquidation cost ofa portfolio as well as estimates the worstcase losses that a Liquidation Groupcan incur during its holding period.This ensures that risk is covered pru-dently without tying up unnecessaryliquidity. Risk is calculated using different margin components that arethe essential elements of the EurexClearing Prisma computation process.When determining appropriate marginrequirements and risk offsets, EurexClearing considers two margin types: • Mark-to-market margin (backward-

looking margin components)• Initial margin (forward-looking

margin components)

Both the backward- and forward-looking margin components aredescribed in detail in this section. After providing an in-depth discussionof each margin component, this section then proceeds to describe how

Eurex Clearing Prisma aggregates the different forward-looking com-ponents to create a comprehensiverisk profile for determining the initialmargin requirement of each ClearingMember.

Backward-looking components:mark-to-market marginThe Eurex Clearing Prisma calculationapproach begins by considering twobackward-looking margin components:the premium margin which allows forthe deposit of collateral and the varia-tion margin (including price alignmentinterest for swaps) that is calculated ona daily basis to exchange profits andlosses and which has to be deposited in cash.

Premium margin

Premium margin must be deposited bythe seller of an option, if the transactionresults in an open position. It coversthe potential loss that could be incurred

Margin components

Backward-looking Present Forward-looking

▼

Premium margin

Variation margin

Price alignment interest

Market risk based on filtered historical simulation

Liquidity risk component

Market risk based on stress period scenarios

Model adjustments

Mar

ket

risk

Initi

al m

argi

n

Eurex Clearing Prisma margin components

Mar

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-mar

ket

mar

gin

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if the seller was forced to liquidate the position today. The premium marginis continuously adjusted, i.e. if pricesfluctuate so that the potential lossupon liquidation increases, the sellerwill be obliged to deposit additionalpremium margin.

Premium margin is calculated for all positions in options products thatare subject to the procedure known as “premium-style margining”. This involves those options for which the premium is paid in full atthe time of purchase (e.g. equity options). The premium margin coversthe costs or profits that would ariseupon liquidating all positions of a specific product at their respectiveclosing prices.

Variation margin

On a mark-to-market basis, EurexClearing settles the trading day’s profits and losses of all open positionsheld in a position account in cash. This approach applies to futures, futures-style options and swaps products. To exchange profits and losses that arise due to the price fluctuations of open positions EurexClearing asks for cash collateral that is settled on a daily basis in the respective product currency, also known as variation margin.

The owner of a long position that was purchased at a lower price thanthe daily closing price (settlement price)is credited with the difference betweenthe two prices, whereas the owner ofthe related short position must pay

that difference. When the variationmargin for futures-style options isdetermined, calculation of the appro-priate credits and debits depends onhow the value of a call or put positionchanged during the trading day.

The variation margin procedure ensuresthat each position is revalued at thedaily settlement price. The differencebetween today’s and the previous day’sclosing price is offset by daily com-pensating payments. Thus, all that hasto be done on the final settlement day is to value all open positions attheir respective final settlement prices.

In the case of futures-style options,the final valuation is made at the settle-ment price on either the expirationdate of the option or the day on whichit is exercised.

Price alignment interest

Price alignment interest (PAI) serves as a further cash-based margin component in addition to variationmargin and is only applicable to products within our swaps offering. It minimizes the impact of daily cash variation margin payments onthe pricing of swaps.

Eurex Clearing will charge/pay interestusing the overnight interest rate of the corresponding currency on cumu-lative variation margin received/paidfor products.

The price alignment interest is appliedseparately to each trading currencyon a portfolio basis and is settleddaily, analogous to variation margin.

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Forward-looking components:initial marginThe Eurex Clearing Prisma marginmethodology is based on a completeview of each Clearing Member’s portfolio and takes advantage ofcross-correlation effects and accountsfor hedging. In this way, it determinesthe initial margin requirement on a portfolio level as opposed to a product-by-product view.

The methodology is designed for the adequate and stable computationof initial margin figures, thus creatinga forward-looking risk model that is able to cope with a high degree ofuncertainty in the financial marketsand yet at the same time is sufficientlyflexible to be able to adapt to changesin the risk environment.

The Eurex Clearing Prisma initial margincalculation is the result of a simulation-based, value-at-risk (VaR) methodologythat uses • Filtered historical scenarios • Stress period scenarios • Adjustments to account for

correlation breaks, compression and illiquidity

As the initial margin is a forward-lookingmargin component, it quantifies an estimate of future potential lossesover the holding period of all ClearingMembers’ Liquidation Groups at a pre-defined and appropriate confidencelevel. The initial margin is calculatedby taking into account potential corre-lation and netting effects for positionswithin a Liquidation Group. Initialmargin figures for different Liquidation

Group splits and Clearing Memberposition accounts are then aggregatedto a single margin amount.

The initial margin consists of two mainsubcomponents: • Market risk• Liquidity risk

Both components are calculated using profit and loss distributions for the Liquidation Group based on a set of different scenario prices forthe underlying instruments.

Methodology overview

…

Scenario pricesby instrument

Cross product scenarios

Scenario12…S

e.g. equity prices

1 …47.3445.01

47.76

M51.1948.14

49.09

Pure market risk component

Modeladjustments

Liquidity riskcomponent

Initial margin for Liquidation Groups

Theo

retic

al p

rices

Portfolio data fromClearing Member

Position 1Position 2

Position N

▼ ▼

Profit and loss distributions for LiquidationGroup splits

…

Margin Optimizer – Determination (optional) of ideal portfolio structure for FI LQ

Definition of Liquidation Groups & LiquidationGroup splits

Margin optimization for listed

and OTC interest rates derivatives

Before calculating the individual margin components within the fixedincome derivatives Liquidation Group,the Clearing House uses a MarginOptimizer process to determine theideal portfolio structure by optionallycombining fixed income and moneymarket derivatives and IRS, therebyenabling cross margining. Fixed incomederivatives (e.g. Euro-Bund Futures)and money market derivatives (e.g.EURIBOR Futures), which hedge the interest rate risk of the IRS positions,are allocated to the IRS LiquidationGroup split which is correspondinglyalso called “IRS+FI split”. This allocationaims to reduce the interest rate sensi-tivities of the IRS portfolio as far aspossible. Some product types like tenorswaps are not considered for this allocation, as they are not generallysensitive to interest rates. The MarginOptimizer also ensures that based onthis allocation no adverse effects fromthe increased liquidation horizon occur.

Market risk component

The pure market risk component, i.e.without the model adjustments, is calculated based on tail risk measuresin the form of value-at-risk figures. It utilizes profit and loss distributionson a Liquidation Group split level that in turn uses historical and stressperiod scenarios.

Filtered historical scenarios

A set of 750 filtered historical scenariosis used to calculate potential profits and losses for every instrument cleared

by Eurex Clearing. The filtered his-torical scenarios are amongst othersconsidering the following risk factors:• Underlying settlement prices for all

other instruments cleared• Implied volatility surfaces• Interest curves• FX rates

The potential profits and losses shallcover the maximum loss that couldoccur during the holding period of a Liquidation Group. Therefore, thesemaximum levels are calculated for anyinstrument by applying 750 historicallogarithmic returns of the underlyinginstrument over the respective holdingperiod to its risk factors and revaluatingthe instrument leading to 750 differenthistorical scenario prices. Instead ofusing a straightforward historical simu-lation, a filtered historical simulation isused to calculate the different scenarioprices. The filtered historical simulationuses dynamic volatility modeling, wherethe levels of margin requirements aredynamically increased when marketvolatility increases. In practice this meansthat the historical volatility is replacedby the current volatility of the instru-ment because current volatilities exhibithighly accurate forward-looking properties and reflect the current market conditions.

All historical scenarios are updated ona daily basis with the latest risk factorreturns and the new current priceinformation available leading to a newset of 750 historical prices every day.

Stress period scenarios

In order to introduce a countercyclicalmargin component by taking intoaccount periods of high financial distress

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and extreme events, 250 stress scenarios are also used as input for the calculation of risk figures such asvolatility, interest rates, etc. Thesescenarios are obtained by jointly simulating respective returns for allinstruments of a Liquidation Groupbased on periods with exceptionallyhigh fluctuations of the correspondingrisk factors. In contrast to the calcula-tion of historical scenarios, no filteringis used for the stress scenarios.

Subsamples

The scenario prices are divided intoseveral subsamples to avoid artificialstatistical effects resulting from over-lapping time periods that would violatethe assumptions of the calculated riskfigures. Therefore each risk figure iscalculated on scenario subsample leveland subsequently aggregated to an overall risk figure. The number ofsubsamples depends on a LiquidationGroup’s holding period.

The graphic on page 16 illustrates howEurex Clearing calculates the marketrisk component of a portfolio by applying filtered historical and stressperiod scenarios.

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Based on the scenario prices of the filtered historical and stress periodscenarios, the profit or loss for eachproduct is calculated by comparing the calculated scenario price to thecurrent neutral price. The profit andloss figures for each product within a Liquidation Group are then aggre-gated for each scenario individually.Therefore, risk offsets within theLiquidation Groups are automaticallyconsidered.

Model adjustments

In order to mitigate model risk in-herent in the calculation of the tail riskmeasures, three model adjustmentsare calculated and added to the puremarket risk component:

• The correlation break adjustmentcompletes the simulation for theworst-case breaks in correlation.

• The compression adjustment amendsthe simulation by pricing effects wherea data compression approach hasbeen chosen applicable to productswhich are sensitive to volatility.

• The Long Option Credit compensatesa long option dominated portfolioand provides a credit in case the initialmargin exceeds the premium margin.

Liquidity risk component

The liquidity risk component is designedto capture the potential additional costswhen liquidating portfolios, includingpossible adverse price movements ofthe products cleared. The most im-portant characteristics are listed below:

• The liquidity risk componentdepends on the relative size of theposition. The liquidity risk com-ponent is a function of the positionsize and the total market capacity,which can be characterized by meansof daily traded volume or open interest of a financial instrument.

• The liquidity risk componentdepends on the current level of market risk in the respective product,i.e. the higher the volatility of an instrument’s price, the higher the premium.

• Even for small position sizes, the liquidity risk component is notzero. In reality, trading does notactually occur at mid prices, but atbid or ask prices. Therefore the minimum liquidity component isdefined by the liquidity premium.

Liquidation Group split’s P/Lbased on 1st n-day scenarios

▼

▼

▼

Overview – market risk calculation

Scenario pricesby instrument

Filtered historical scenarios

Stress period scenarios

P1

P750

Profit & lossdistributions

1 nP/L1 … P/L1

1 nP/L750/n…P/L750/n

1 nP/L1 … P/L1

1 nP/L250/n…P/L250/n

Scenario pricesby instrument

Profit & lossdistributions

P751

P1,000

Liquidation Group split’s P/Lbased on nth n-day scenarios

VaR

▼

Liquidation Group split’s P/Lbased on 1st n-day scenarios

▼

▼

▼

Liquidation Group split’s P/Lbased on nth n-day scenarios

VaR

▼

VaR1*

VaR2

VaRn

VaR1

VaR2

VaRn*

Liqu

idat

ion

Gro

up s

plit’

s m

arke

t ris

k co

mpo

nent

* The maximum of the filtered historical scenario and the adjusted stress period scenario is considered.

17

• Market capacities and liquidity riskcomponents are product-specific and unevenly distributed across product subgroups, i.e. for optionsthe market capacities and bid-askspreads depend on their moneynessand time to expiry.

The illustration below shows the liquid-ity risk component’s dependence onthe position size and the market riskof three positions with different riskprofiles. For all three positions the liquidity risk component is non-zero even for a small position size ( i.e. onthe left hand side of each graph) andgrows with an increasing position size.The liquidity risk component for a position carrying a higher marketrisk increases at a faster rate relative to the liquidity risk component forpositions with a smaller market risk.

Specific treatment for swaps products

Interest rate swaps are treated differ-ently from other instruments due to

product specific requirements andmarket conventions. The liquidity riskadjustment is calculated by currencyaccording to the expected transactioncosts of the swaps required to hedgethe Clearing Members’ portfolio.

Cross margining allocation algo-rithm for interest rate derivatives The cross margining allocation algo-rithm is based on the combination ofIRS positions, fixed income and moneymarket derivatives to offset interestrate sensitivities. This offset is calculatedfor each “maturity bucket” that assignsthe instruments to the respective partsof the yield curve. So, for each maturitybucket, the appropriate number offutures and/or options on futures iscalculated and – if such an amount is available – allocated to the IRS+FILiquidation Group split.

At each step, initial margin is calculatedfor both the IRS+FI and FI-only splits,before and after allocating the fixed

income and money market derivativesto the IRS+FI split. If the total initialmargin of both splits is not reduced atthis step, then the allocation is rejectedand the algorithm continues with the next step. This procedure continueswith each maturity bucket, workingtowards the shortest maturity bucketover time. In the first two maturitybuckets4 of the euro curve, moneymarket futures are considered. They areallocated to the maturity bucket inwhich their respective maturity falls.

The result of the cross marginingaffects two splits of the fixed incomeLiquidation Group:

• One contains IRS, fixed income andmoney market positions that aremargined using a 5-day holdingperiod.

• A second one contains fixed incomeand money market derivatives only that are margined using a 2-dayholding period.

Low volatility High volatility

Position size

Liquidity risk depictions

Liqu

idity

com

pone

nt

Position size

Liqu

idity

com

pone

nt

Position size

Liqu

idity

com

pone

nt

4 Please visit the Eurex Clearing Prisma User Guide or the Eurex Clearing Prisma Cross Margining User Guide, which are available on Eurex Clearing’s websitewww.eurexclearing.com, for more detailed information about the applied maturity buckets.

18

As illustrated, for the fixed incomeLiquidation Group a total of fourLiquidation Group splits are available.

The IRS+FI split contains IRS positionsacross all currencies (EUR, CHF, USD,GBP, JPY) and the allocated EUR andCHF fixed income/money marketderiv-atives. Hence, cross margining is only applied to combined positionsdenominated in EUR and CHF. The FILiquidation Group split contains allremaining fixed income and moneymarket positions.

Listed derivatives positions and swapspositions which mature within the respective holding period are allocatedto seperate Liquidation Group splits.

Aggregating forward-looking componentsThe Eurex Clearing Prisma methodologytakes both backward- and forward- looking risk components into consider-ation in forming a complete risk picture.This section exclusively covers the elements of the forward-looking riskcomponents – the initial margin –

as backward-looking componentshave been covered previously and arepartly settled in cash on a daily basis.

The total initial margin component for a single Liquidation Group consistsof the aggregated market risk com-ponents over all scenario subsamples,including the respective model adjust-ments and Liquidation Group specificliquidity risk components.

The value-at-risk figures for each sub-sample of the filtered historical andthe stress scenarios are aggregated by taking the mean value-at-risk figuresof the subsamples separately for the filtered historical and the stressscenarios, including the relevant model adjustments.

The resulting two value-at-risk figuresfor the stress and the filtered historicalscenarios need to be aggregated aswell. This is done by taking the maxi-mum of the filtered historical value-at-risk and a scaled stress value-at-risk.The scaling ensures the appropriatestatistical confidence level of the stressvalue-at-risk.

The following table depicts how theinitial margin for a Clearing Memberis determined.

Liquidation Group fixed income derivatives – potential splits & Margin Optimizer

* For the Liquidation Group fixed income a total of four Liquidation Group splits are available. The Margin Optimizer optionally associates listed derivatives positions with swaps positions, enablingcollateral and margin efficiencies. Within each Liquidation Group split portfolio margin is applied.

Listed derivativespositions:remaining

maturity ≤ 2 days

Swaps positions:remaining maturity ≤ 5 days

Swapspositions:

IRSOISFRAs

FI splitholding period: 2 days

IRS + FI splitholding period: 5 days

Listed derivatives

positions:Euro-BundEuro-Bobl

Euro-SchatzEuro-Buxl®

EURIBORCONF

Margin Optimizer*

Aggregation

After the calculation of the two marketrisk components (filtered historicalscenarios and stress period scenarios),the results from the two componentsare aggregated per Liquidation Group,such that the filtered historical com-ponent is floored by the scaled stressperiod component.

This calculation is performed for eachLiquidation Group and the result candiffer by Clearing Member and position

account, i.e. in one instance it can bethe value from the filtered historicalscenario and in another instance it canbe the value from the stress periodscenarios. The value selected will bethe most favorable for the safety of theClearing House and the marketplace.

Initial margin

The initial margin per Liquidation Groupis determined by combining the marketrisk component with the liquidity riskcomponent. This approach is followed

19

for each individual Liquidation Groupthat is contained within the ClearingMember’s portfolio and is applied to an individual position account.

The consolidated initial margin foreach Clearing Member results fromthe sum of all initial margin results by Liquidation Group.

Initial margin calculation by Clearing Member and Liquidation Group

Filtered historical scenarios Stress period scenarios

▼

Aggregation

▼

Market risk

Liquidation Group 1

Value-at-riskMarket risk

Liquidation Group 2

Value-at-riskLiquidity risk

Liquidation Group n

Market riskLiquidation Group 1

Liquidation Group 2

Market riskLiquidation Group n

Market risk

Liquidation Group 1

Liquidation Group 2

Market riskLiquidation Group n

Initial margin

Initial margin Clearing Member

▼

Market risk

Liquidation Group 1

Market risk

Liquidation Group 2

Value-at-riskMarket risk

Liquidation Group n

Compression adjustment

Long optioncredit

Value-at-risk

Market risk

Liquidation Group 1

Market risk

Liquidation Group 2

Correlationbreak

Value-at-riskMarket risk

Liquidation Group n

Correlationbreak

adjustment

Compression adjustment

Long optioncredit

Value-at-risk

20

Business Development/Risk Management Alexander Rose T +49-69-211-149 75alexander.rose@eurexclearing.com

Contacts

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