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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
3 | © 2014 Global Association of Risk Professionals. All rights reserved.
Bank vs. Proprietary Trading
4 | © 2014 Global Association of Risk Professionals. All rights reserved.
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
5 | © 2014 Global Association of Risk Professionals. All rights reserved.
Rewards and Responsibilities Dictate Decisions
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
6 | © 2014 Global Association of Risk Professionals. All rights reserved.
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
7 | © 2014 Global Association of Risk Professionals. All rights reserved.
Volatility Curve for Commodity
8 | © 2014 Global Association of Risk Professionals. All rights reserved.
Commodity Distribution
9 | © 2014 Global Association of Risk Professionals. All rights reserved.
Rewards and Responsibilities Dictate Decisions
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.
10 | © 2014 Global Association of Risk Professionals. All rights reserved.
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.
11 | © 2014 Global Association of Risk Professionals. All rights reserved.
Margin and Haircut Requirements
12 | © 2014 Global Association of Risk Professionals. All rights reserved.
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
13 | © 2014 Global Association of Risk Professionals. All rights reserved.
SPAN (continued)
16 Different Scenarios of Risk
Price Scan Range
$86.50
Volatility Scan Range
7%
14 | © 2014 Global Association of Risk Professionals. All rights reserved.
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)
15 | © 2014 Global Association of Risk Professionals. All rights reserved.
SEC vs. CFTC Risk Shocks to Underlyings
16 | © 2014 Global Association of Risk Professionals. All rights reserved.
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)
17 | © 2014 Global Association of Risk Professionals. All rights reserved.
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/
18 | © 2014 Global Association of Risk Professionals. All rights reserved.
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
19 | © 2014 Global Association of Risk Professionals. All rights reserved.
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
20 | © 2014 Global Association of Risk Professionals. All rights reserved.
Preparing for the Unexpected
My Nightmares
Accidentally falling asleep on buy button
Catastrophic events
Regulatory environment becoming overwhelming
21 | © 2014 Global Association of Risk Professionals. All rights reserved.
Preparing for the Unexpected
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 ®
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Risk Professionals
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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.
22 | © 2014 Global Association of Risk Professionals. All rights reserved.