Risk Manager's VaR Analysis and configuration

In our recent blog post, we took a look at the challenges facing derivatives risk management. Following on from this summary, we take a look at how stress testing and scenario analysis has become a hot topic, and how the Risk Manager provides help in this area.

The derivatives market is inherently sensitive to a myriad of factors – geopolitical events, economic indicators, and sudden shifts in investor sentiment. Stress testing, in essence, involves subjecting a portfolio to simulated adverse conditions to evaluate its performance under duress. This goes beyond the routine risk metrics and provides traders with a nuanced understanding of how their portfolios might behave in the face of extreme market movements or unforeseen events.

The challenge lies in the complexity of derivatives and the need for a comprehensive historical lookback to inform stress testing accurately. Traditional risk management systems, often designed for simplicity and efficiency, may fall short in capturing the intricate interplay of variables in derivatives trading. Traders relying on rudimentary stress tests risk overlooking potential vulnerabilities that could manifest in turbulent market conditions. This gap in stress testing capabilities can lead to suboptimal risk mitigation strategies and, in the worst-case scenario, expose portfolios to significant financial losses.

Risk Manager is a comprehensive solution designed to tackle the nuances of stress testing and scenario analysis in the derivatives space. The system stores risk calculations in an AWS Time Series database, providing traders with a rich repository of historical data. This historical lookback capability empowers traders to create detailed risk profiles and establish trend analyses, allowing them to identify patterns and anticipate potential challenges based on past performance.

Risk Manager's VaR Analysis and configuration

Simple VaR and Stress management

Risk Manager doesn’t stop at historical analysis; it goes further by facilitating custom calculations and rankings. Traders can define their own risk parameters and establish a hierarchy of actions based on the outcomes of stress tests. This flexibility is crucial in a market where standardized approaches may not capture the intricacies of individual trading strategies. Custom calculations and rankings empower traders to tailor stress tests to their specific needs, ensuring a more accurate reflection of their portfolio’s response to adverse conditions.

However, stress testing is not solely about identifying weaknesses; it also encompasses fortifying the portfolio against potential risks. Risk Manager’s integrated approach, combining P&L, VaR, Margin, and Stress in a consolidated view, provides traders with a holistic understanding of their portfolio’s risk exposure. This unified view is invaluable in decision-making, offering a comprehensive analysis that goes beyond isolated risk metrics.

Risk Manager's VaR Analysis and configuration

See P&L, VaR, Margin and Stress combined in one chart

In conclusion, stress testing and scenario analysis are indispensable tools in the derivatives trader’s toolkit. In the face of increased market volatility and the unpredictability inherent in derivatives, a robust risk management system that encompasses historical lookback, custom calculations, and comprehensive risk analytics is not just a necessity—it’s a strategic advantage. Risk Manager is a unique system aimed at empowering traders to navigate the stormy seas of derivatives trading with confidence, armed with insights derived from thorough stress testing and scenario analysis.

VaR histogram for derivatives scenario analysis

Market conditions in derivatives trading can change in the blink of an eye. These rapid advances have meant that effective risk management paramount to a firms ability to run and make profits. At KRM22, we see four key problems facing the industry in terms of risk management;

  1. Addressing increased market volatility
  2. A heighted focus on liquidity risk management
  3. Implementing stress testing and scenario analysis
  4. The push to real-time monitoring

Our  comprehensive Trading Risk toolset, delivered through Limits Manager and Risk Manager modules, is a beacon of stability for traders navigating the seas of increased market volatility, liquidity risk management, stress testing, and real-time monitoring.

Addressing Increased Market Volatility

The derivatives market is no stranger to heightened volatility. In the last decade,  this phenomenon has been intensified by a variety of factors such as extreme geopolitical events, economic uncertainties, and sudden market shocks.

Increased market volatility poses a substantial challenge for traders and risk managers, as it can lead to rapid and unpredictable price movements. Traditional risk management systems often struggle to adapt to the accelerated pace and magnitude of these market fluctuations.

Traders need a solution that not only consolidates key risk metrics but also provides a real-time, holistic view of their portfolio’s performance. Without effective risk analytics and margin management, navigating through periods of increased market volatility becomes a daunting task, with the potential for significant financial losses and disruptions to trading strategies.

KRM22’s Risk Manager assists firms with these issues in two key areas;

Combined Risk Analytics

Risk Manager brings together P&L, VaR, Margin, and Stress in a consolidated view. This integration of risk metrics provides traders and risk managers with valuable insights into their portfolio’s performance, helping them navigate the storm of increased market volatility. These metrics can then be combined into a customized risk score, allowing teams to focus on the firms presenting the biggest problems.

Risk-Based Margin Financing

In times of market turbulence, managing margin requirements becomes critical. Risk Manager not only calculates the margin based on exchange requirements but also employs risk-based margin financing. This ensures that traders have a clear understanding of the financial commitments required to weather market storms. KRM22 actively works with all major exchanges to ensure the current methodologies are available.

Heighted Focus on Liquidity Risk Management

Liquidity risk management is a critical concern for derivatives traders, especially during times of market stress. Liquidity risk arises when there is a mismatch between the ability to execute trades and the demand for liquidity. This challenge is amplified in the derivatives space, where products can be highly specialized and liquidity may vary significantly across different instruments.

Traders face the risk of being unable to exit positions at desired prices, leading to increased transaction costs and potential losses. In the absence of centralized and efficient systems for monitoring liquidity exposure across multiple trading platforms, traders may find it challenging to proactively manage and mitigate liquidity risks.

This lack of visibility into liquidity needs and the absence of streamlined workflows for rapid decision-making can impede the ability to seize opportunities or protect against adverse market movements, undermining overall portfolio performance.

Our Limits Manager has been designed to tackle this issue head on.

Centralized Database and Efficient Reporting

Limits Manager centralizes active limits across all trading platforms. This not only streamlines regulatory reporting to individual exchanges but also facilitates real-time monitoring of liquidity exposure. The product search functionality enables immediate identification of liquidity needs across various ISVs, supporting quick decision-making.

Simplified Workflow and Accountability

Customizable workflows ensure accountability in the limit change request process. The system’s audit trail, complete with risk calculations, user remarks, and timestamps, provides an unambiguous record of every action taken. This level of transparency enhances accountability and aids in tracking liquidity risk management decisions.

Stress Testing and Scenario Analysis

Stress testing and scenario analysis are indispensable components of risk management in derivatives trading, serving as the litmus test for a portfolio’s resilience under adverse conditions.

As we have described, the derivatives market is highly sensitive to unexpected events, and stress testing is crucial for assessing how a portfolio would perform under extreme market conditions. Traders need to anticipate and understand the potential impact of significant market movements, black swan events, or sudden economic shifts.

Traditional risk systems may fall short in providing a comprehensive historical lookback and the ability to create risk profiles, leaving traders vulnerable to unforeseen risks. Without the ability to conduct robust stress testing and scenario analysis, traders risk being blindsided by market dynamics, leading to suboptimal decision-making and exposure to heightened financial risks.

Risk Manager has two key areas of functionality aimed at solving this issue

Historical Lookback and Trend Analysis

The At/Post Trade Risk Management module stores all risk calculations in an time series database. This historical lookback capability allows traders to create risk profiles and establish trend analyses. Understanding historical performance equips traders to anticipate and respond to potential future challenges proactively.

Custom Calculations and Ranking

The system empowers users with custom calculations, letting them define their own risk parameters. Rankings, coupled with described actions like notifications or limit changes, enable traders to prioritize and address potential risk scenarios based on their unique strategies and risk tolerance.

Real-time Monitoring

In the fast-paced world of derivatives trading, where milliseconds can make a significant difference, real-time monitoring is the linchpin of effective risk management. The derivatives market operates around the clock, and market conditions can change swiftly. Without timely insights into portfolio performance, traders face the risk of making decisions based on outdated information, exposing them to unnecessary risks. In the absence of a system that facilitates immediate product searches and provides up-to-the-minute risk analytics, traders may struggle to adapt swiftly to changing market dynamics. Real-time monitoring is not merely a convenience but a necessity for derivatives traders aiming to stay ahead of the curve and respond promptly to emerging opportunities or threats in the market. A lack of real-time monitoring capabilities can undermine the agility required to navigate through volatile conditions, potentially resulting in missed opportunities or unintended exposures.

Efficient Limit Change Request Processing

Limits Management ensures efficient processing of limit change requests. This not only aids in real-time decision-making but also supports growth facilitation by reducing the time required for generating essential reports.

Immediate Product Search

The ability to search for individual products across all ISVs in real-time is a game-changer. It allows traders to respond promptly to evolving market conditions and make necessary adjustments to their portfolios.

 

In conclusion, our Trading Risk tools stand as robust solutions in the face of increased market volatility, liquidity risk, stress testing, and the need for real-time monitoring. By combining technological sophistication with a deep understanding of the challenges inherent in derivatives trading, we are empowering traders to navigate choppy waters with confidence, efficiency, and accountability.

Value at Risk showing historical analysis and figures

In the context of margining methodologies, a discussion has been ongoing regarding the comparison between SPAN and VaR approaches, revolving around the accuracy and effectiveness of these methodologies in capturing risk. Advocates of SPAN argue that it offers a more comprehensive assessment by considering various factors specific to individual contracts and portfolio interactions and believe that this approach provides a more accurate reflection of risk exposure. Meanwhile, proponents of VaR argue that it provides a simplified and transparent measure of risk, making it easier to understand and implement. VaR is widely used in financial institutions and offers a standardized framework for risk assessment.

The CME and ICE have taken a leadership position on this and are transitioning over to VaR at various points over the next 12 months. KRM22’s post trade functionality has always reflected the array based margins of these exchanges, a feature key to our customers. In response to the decisions made by the CME and ICE, KRM22 is updating our Trading Risk suite to more closely represent their account’s risk exposure. This will allow for the risk management communities to view their parameterized stress risk, margin requirement, and VaR calculations in the same view providing a wholistic risk profile associated to their accounts.

VaR calculations will include customizable confidence levels, expected shortfall, histogram, and product sector breakdown of each portfolio.

We are already working with the exchanges and customers to develop and test the new functionality. Traditional array based margining will continue to be supported as long as the exchanges make it available.

Contact us to discover more about migrating to historical VaR.

CME Span 2 Margin

The CME’s SPAN 2 margin methodology is going through testing and should begin to be implemented later this year.  The new margin methodology is not only a significant change to how margin is currently calculated but is being deployed as an “evolutionary” change rather than a “revolutionary” change.

The new margin rules are intended to co-exist with current SPAN margin methodology as opposed to replacing them. The current SPAN methodology has been highly effective for many years.  When SPAN 2 is put in place it means members of the exchange will have new set of margin calculations which incorporate more product correlations and historical data– not necessarily better or worse, but different.  

The reason for this is simple – different periods of volatility equate with different results under different margin methods.  The introduction of Historical risk views (hVaR) into SPAN 2 is just one major change to the existing SPAN model.  Yet hVaR may not always have enough of a time horizon to foresee anticipated price movements or “vol shocks”.   By leveraging multiple methods, the CME and its members will have a more “holistic” way to see an account’s true risk.  

These changes are not new to KRM22.  The combination of using an exchange’s internal margin methodology and combining those calculations with custom “stresses” and hVaR is the most fundamental aspect of KRM22’s market risk solution.  Our At Trade and Post Trade Stress system was first introduced in 2020 as a complete “end to end” product that combines the three major elements of SPAN 2 directly to our customers.  

We are currently working with the CME to ensure our independent margin calculations will be SPAN 2 compliant as well as provide direct access to the CME’s API-based SPAN 2 margin calculators.  

KRM22 has always been committed to bringing our customers the optionality of importing margin calculations directly from the exchanges they are members of as well as providing an independent valuation of their margin through our powerful margin calculation engine.  We look forward to continuing this level of service to our customers who rely on the CME to support clearing and trading activities throughout this introduction of SPAN 2.  

For more information on KRM22’s margin systems please contact Stephen Casner, President KRM22 (stephen@krm22.com)  or David Zurkowski, Director of Market Risk Products (Dave@KRM22.com).

Holy Cow! Over the past 15 months we have seen remarkable events in the medical field, in nature, politics, sports and the trading markets. The headliners include Covid-19, vaccine development, brush fires, freezing temperatures in warm climates, warm temperatures in freezing climates, political and social unrest around the globe, impeachment proceedings, senior Royals stepping down, the cancelling of the Olympics, the death of Kobe Bryant, a stock market crash and rebound, negative commodity prices in Crude Oil and a powerful stock squeeze. So many unpredictable events impacting our lives and our mental states and how we will perceive the future. Not even the finest ‘Magic 8 Ball’ device could have forecasted these events.

There have always been, and will continue to be, unforeseen events that impact our behavior. However, we have no control over who, what, where, when and how these events appear. The same goes for the market; the risk that never leaves us is the unknown. The market listened and reacted to all the events listed above, but in differing magnitudes and intensities. Whether the reactions were rational/irrational, too big/too small, handled properly/poorly will be debated for a long time. The only certainty is that market reactions to newsworthy events will continue.

Managing the ‘event risk’ of known events like economic announcements, elections, crop reports, and energy supply data is a skill learned by looking at historical outcomes and outliers from prior announcements. Having industry experience in a particular sector is a great bonus. Applying market and correlation shocks that mirror past performance is a standard starting point for known events. In many cases, once the known event has passed, much of the uncertainty driving market behavior is temporarily removed and volatility is reduced. However, evaluating and managing the risks of unknown events involves some creativity. It is an art as much as it is science.

Two Scenarios (A and B) of unanticipated events and two different risk methodologies:

Short Term Spike Scenario

The takeaways: Violent Spike, Short-Term Impact and Certainty

A) The cold weather event in the Southern USA in February caught many people off guard. Electricity prices skyrocketed as temperatures dropped, demand rose exponentially, and the electricity grid became unstable. This created tremendous short-term uncertainty. But as unexpected and unfortunate as this was, this cold temperature pattern was not going to continue indefinitely. Weather forecasters pinpointed a return to normalcy relatively quickly.

Managing the risk to define the effects of this type of event involves applying extreme shocks to spot and front month prices (and related option volatilities and skews) while essentially leaving back month prices and volatilities static. It is wise to stress Implied option volatilities by a large multiple (2 to 5 times for example) of their current levels to expose ‘short-teeny’ risk (a position that is short out-of-the-money options). The weather event described is a ‘one and done’ occurrence and the practice of creating ‘front month’ price and volatility shock correlations for deliverable commodities should be a standard part of every risk manager’s tool kit. Even if the event you are trying to simulate/anticipate does not materialize for months or even years, it is critical to have the information available daily and assess the materiality of the outcome across an entire organization.

Long Term Uncertainty Scenario

The takeaways: Uncertainty, Safe vs. Risky and Breakdowns of ‘Normal’ Correlations

B) Using the Covid-19 pandemic as an example, most alive today never lived through a global pandemic. How long will it last? How contagious is it? Who is most at risk? Is there a cure? The emergence of Covid-19 as a global pandemic was slow and steady. There was conflicting information in the medical community about the cause and severity. Financial markets do not like uncertainty and as such, equity prices plummeted in March 2020 as the World Health Organization (WHO) announced a global emergency. Many countries followed the WHO announcement with travel bans put in place to stop the spread of the virus between countries. With tight restrictions in place for daily activities, industries like airlines, hospitality, entertainment, restaurant, energy, automotive, manufacturing and sports were all hit very hard. Unlike the weather example above, the was no clear guidance on how long we would be dealing with this issue (it is ongoing today). Unlike the “one and done” weather example above, the Covid-19 event has financial implications over a much longer term. How does a risk manager prepare for an event for which we have no reference data? We will explain potential scenarios to have at the ready.

Managing the risk to anticipate a scenario where industries and societies are slowed indefinitely demands some creative thinking. Some assumptions may assist in our process. Governments around the world will most likely seek to lessen the impacts of the event by providing liquidity (i.e., lower interest rates). Investors will look for some certainty by moving from riskier assets to less risky instruments (think of a ‘flight to quality’ toward government bonds, gold and silver and away from stocks for example). The yield or growth on investments will be less important than preservation of capital. ‘Safe’ assets will appreciate, and ‘risky’ instruments will depreciate. ‘Normal’ or ‘historical’ correlations across the yield curve and futures price curves breakdown. Unlike the weather example, the asset price movements affect tradeable assets 1 year, 2 years and even 3+ years into the future as there is no clear end to the societal disruption. Stock sectors like energy, transportation will suffer as daily demand for travel and daily commuting is reduced, while sectors providing services to help remedy the situation will expand.

A stress scenario that will provide a view into potential outcomes for this type of event applies equivalent price/yield movements (the same percentage or absolute price/yield shock across every expiration month of a product) to simulate real world market reaction. For example, applying the same basis point shock to all interest rate instruments on the yield curve will give a view into the P&L implications of a ‘flight to quality’. This estimate will not be perfect, but it will expose strengths or weaknesses of positions. Similarly, using the same absolute price shock and volatility change to all gold contract expirations is a starting point. On the negative price side, all stock sectors can be shocked by the same percentage move regardless of country, sector or market cap.

Shocking all months of Crude Oil or Copper in the same magnitude will expose weaknesses that would not appear under standard correlated stressing scenarios. For option positions, shocking the skew (the relationship between put and call volatilities) and the At-the-Money volatility in the same manner across multiple product expirations exposes the risk of a change in market sentiment. Products that traditionally had ‘bullish’ skew prior to the long-term disruption may now have a completely ‘bearish’ skew (and vice-versa). The P&L and Greeks associated with this change can be enormous. Adding the calculation of ‘extreme’ price and volatility shocks is also a necessary tool in the event of a ‘once in a lifetime’ occurrence (shocking prices by 10 -15 Sdev moves, whoa!.. but think about the explosive movement of Crypto Currencies and Game Stop stock over the past 15 months!)

Creating market stress scenarios to address the situations above should be normal operating procedure to identify weaknesses in trading positions. The goal is to expose risks not seen when using only current or historical price moves and correlations. While none of us has a crystal ball to predict future events, being prepared and having advance knowledge of potential financial outcomes prior to an unscheduled event is the key. The creative use of combinations of price curve stress, correlation breakdowns and volatility shocks allow a risk manager to “always expect the unexpected”.

While interest rates remain steady, change in Washington often means change in perspective and direction. If the stimulus bill is passed, what happens if the market starts to feel interest rate pressure again? Let’s look back to the a recent interest rate market event and how risk managers were able to react to it.  

The two months of June and July of 2019 brought unforeseen volatility into the interest rate arena. During this period, the Federal Reserve did an ‘about face’, regarding the direction of interest rates in the US. This came as an unwelcome surprise to market participants as most traders, speculators and hedgers were prepared for a rising or unchanged interest rate environment, with very little attention paid to the thought of declining interest rates. This group- think caused a ‘rush to exits’ to reverse or close out existing positions.  

Market risk managers are tasked with evaluating and diffusing these situations on a daily basis. A proactive risk manager will attempt to determine the outcome of potential events before they occur. They view the risk outside the ‘groupthink’ box and consider what happens if the market behaves in a manner 180 degrees removed from the consensus expectation.

The tools used to expose and mitigate these events are often known as ‘what if’ stressing scenarios. This practice allows risk managers to view the outcome of yield curve shifts and then determine if the risk exceeds the benefit of holding the position. Traders are famous for advocating on behalf of their positions and for stating “that won’t happen” when a risk manager poses an assumption that impact the trader’s position. However, it is imperative the risk manager know the answer to the question “what if it does happen?” prior to the event.

Market participants have an aggregate idea of the potential outcome when the market behaves ‘normally’. The key goal of risk management is to identify the outliers to ‘normal’ and then determine if the risk taken is warranted based on the probability of a ‘non-normal’ outcome.

Identifying the Negative Outcomes

Using post-trade stressing tools, risk managers create ‘what if’ scenarios to determine the potential profit/loss of: a steepening/flattening of the yield curve during rising/declining rate environments, an inverted yield curve during a rising/declining rate environment, a spike/dip in short-term rates due to a geopolitical event and/or eroding liquidity levels, but to name a few. These scenarios may be contrary to the current market wisdom at any point in time, but they must be evaluated daily as the associated risk needs to be identified before the ‘non-normal’ events are set in motion.

The examples given above pertain to positions containing only underlying securities. What happens if options are added to these positions or if these positions/strategies are created entirely out of options? This would introduce entirely new categories of risk and would require the risk manager to consider the following:

  • Shocking relative volatility levels of contracts in a particular segment of the yield curve (all of the monthly contracts of the 10yr T-note, for example), as well as across the entire yield curve (30yr,10yr, 5yr, 2yr, Eurodollars, Fed Funds)
  • Shocking volatility shapes (skew) on each piece of the yield curve as well as across the entire yield curve.
  • Calculating the theta of holding these positions each day and evaluating the effect of option expiration dates on the option behavior (for example, does this option expire before the upcoming Fed Meeting but others do not?).

The complexity of managing multi-dimensional risk (price/time/volatility/skew) calls for robust ‘what if’ tools that can simulate potential market events. These risks are real and should be evaluated as often as the ‘normal’ market expectation. Without the proper tools at his/her disposal, the risk manager is essentially driving while wearing a blindfold.