20 March 2014

Training Manager's Guide To... Derivatives

Our derivatives expert guides you through the key terms, latest developments and skills required for staff working in this area...

What are derivatives?

Derivatives are financial instruments whose values are contractually linked to the prices of other financial market variables such as interest rates, FX rates, credit, equity indices and other asset classes.

Developed to provide an efficient means of transfer for different types of risk, now more than 90% of the world’s largest corporations and all major financial institutions actively use derivatives to manage their financial risk exposures. Derivatives can also be used for trading and investment purposes, offering alternative ways for traders, money managers and other types of investor to gain exposure to market risk.

here is enormous diversity within derivative markets, that ranges from exchange traded listed derivatives to the (larger) over-the-counter (OTC) markets, and across a broad spectrum of products, from simple futures and forward contracts to options and highly complex exotic derivatives.

What are the need to know terms?

CVA – Credit Valuation Adjustment (also DVA – Debit Valuation Adjustment)
CVA represents the estimated market value of counterparty credit risk exposure, arising from uncollateralised OTC derivative transactions. Now required under accounting and regulatory standards, CVA and DVA measurement represent an additional burden for the OTC derivatives industry, and additionally creates a new source of market risk, leading to the establishment of CVA hedging desks to measure and manage such exposures.

OTC – Over the Counter
Derivative instruments can exist as as over the counter (OTC) derivatives, privately negotiated contracts traded bilaterally but increasingly via organised electronic trading platforms (swap exchange facilities (SEFs) or Organised Trading Facilities (OTFs)). The OTC derivatives market dwarfs the listed derivatives markets, with a total volume (notional principal) approaching USD 600 trillion,

ISDA Documentation
The International Swaps and Derivatives Association fulfils a number of critical roles in relation to the global OTC derivatives industry, most notably in the drafting and generation of a legal documentation to facilitate trading of over the counter derivatives. This centres on the ISDA Master Agreement, a bilateral master agreement governing the contractual basis of all OTC derivative transactions.

OIS Discounting
Also referred to as dual curve pricing or CSA discounting, the subject of OIS discounting refers to recent modifications in OTC derivatives valuation models to better reflect changes in market pricing and to recognise the greater use of collateralisation in bilateral transactions and centrally cleared transactions.

Structured Products
Structured products represent a synthesis of derivative instruments and more conventional securities, and provide a means for investors of all types to gain access to a wider range of markets, risk and return characteristics than offered by more conventional investment vehicles.

What's important to know now?

The global derivatives market is going through a period of enormous change, principally from a number of regulatory perspectives that have significant implications for the legal and operational infrastructure of the marketplace, as well as modifications to industry standard pricing and valuation models.

Regulatory changes

As the rules stemming from Dodd-Frank Act (US) and EMIR (European Market Infrastructure Regulations) start to take full effect on the OTC derivatives markets, the requirements for mandatory registration by market participants, trading via organised exchanges or similar facilities, centralised clearing, trade data reporting, are consuming the attention of banks and other users of OTC derivatives.

Compliance with new capital requirements that are currently being implemented in accordance with the recommendations of the Basel 3 Accord is also leading to an additional burden for OTC derivatives industry participants.

Pricing and Valuation Methodologies

The changes in markets resulting from the financial crisis, in conjunction with the growth of collateralisation of OTC derivatives – both bilaterally and via centralised clearing mechanisms - have led to subtle but important changes to OTC derivative valuation models. The shift to incorporate OIS discounting or multi-curve valuation represents an enormous challenge for market participants, as they strive to make the necessary adjustments to systems, valuation and risk models.

In some of these new issues, there being as yet no standard industry wide agreed methodology, institutions are faced with a complex range of choices with regard to the best approaches to adopt.

Who works in derivatives and what are the skills they need?

The principal responsibilities of the role of derivative trader, similar to other trading positions, are to quote prices to clients and to other market participants for the derivative instruments that they are responsible for, and to manage the risks of the portfolio of positions (‘trading book’) that they have previously transacted, within pre-agreed guidelines and risk limits.

Skills - As OTC derivatives are often highly customised, tailored transactions, traders can often spend significant time pricing client transactions, although this may depend on the size of the institution and the differentiation of job roles.

As with other financial instruments e.g. equity sales, bond sales, many banks have dedicated derivatives sales personnel, or derivatives products may represent part of a broader range of instruments sold to corporate and institutional clients e.g. money market sales, alongside closely related instruments e.g. spot FX, money market instruments.

Skills - The sales role can encompass everything from simple flow products, through to more complex or tailored client transactions, which may involve significantly greater structuring responsibilities placed on the sales person. In some institutions, such a role may be split between broader generalist sales, responsible for day to day contact with clients on a broad range of products and services, and specialists, who have greater technical understanding and who would typically be called upon when more structured transactions are being evaluated.

Product Control
Between the traditional Front Office (trading and sales) and Back Office (clearing and settlement) functions Middle Office covers a number of roles vital in supporting the derivatives business. Because of the nature of OTC derivative markets i.e. as they are not yet standardised products universally traded on exchanges and via central clearing houses, many post-trade functions are fulfilled manually by the contracting counterparties. This creates a number of critically important roles that inhabit the Middle Office.

Of these, Product Control represents the most technical role, with principal responsibility for the accounting i.e. valuation and reporting in respect of derivative trading desks, and the preparation of risk reports.

Skills - The product control role covers areas of technical complexity that requires acquaintance with appropriate valuation models to prepare p/l, and understanding of derivative risks, for the preparation and understanding of a wide range of different risk reports.

The role of structurer, like that of the specialist sales role (above), involves responsibilities that may lie between an entirely client facing pure sales role at one extreme to a more technical quasi-trader role at the other. Structurers typically have direct access to suites of derivative pricing models, which are used to structure and engineer different transaction types, in response to client requests or in anticipation of client demand.

Skills - The disciplines and skill sets required within this business area are wide ranging, and within which the role of structurer is a vital component in designing and creating products in response to or in anticipation of client demand, and involves many of the technical skills required by traders, but without the trading book responsibilities.

Now take a look at Euromoney Training's entire range of derivatives training courses.


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