Valuation, Model and Data Risk Management

“Only the curious will learn”

GARP Caribbean Chapter Meeting, March 28

th

₂₀₀₈

By Philippe Carrel, Reuters,

Executive Vice President

[email protected]

"It was the failure to properly price these risky assets that set off the

tidal wave of risk contamination" .

Growth, competition lead to accelerated innovation

•

Hedge Funds / Prop trading develop absolute return strategies

•

Cross-asset strategies

•

Combination of loans, securities, OTC instruments,hybrids

Assumptions, Correlations, Proxies, Models

The quest for alpha leads to innovation

Fast growth, competitive markets, accelerated innovation

Risk increasingly managed from front office

Fast growth, competitive markets, accelerated innovation

•

Securitisation boom (US$1.2 tn in 2006)

•

Liability driven structuring

Assumptions become usual practice

Liquidity produces liquidity

Uncontrolled automation lead to systematic risk

Of the dangers of uncontrolled automation

•

Program trading

•

Automated arbitrage and order generation

Loss of confidence lead to systemic risk

•

Automated arbitrage and order generation

•

Implied volatilities and correlations

•

Automated feed of reference data

Risk is increasingly managed from front office, model driven, assumption based

•

Sub-Prime

•

Credit crunch

Greed, Fear and Regulations

Innovation

Regulators’ obsessive focus on risk…

•

Basle II

•

Mifid/NMS

Triggered massive transfers of assets to special purpose vehicles

Freed capital

Multiplication of trading venues

Data repositories, analytics platforms

Innovation

Competition

•

UCITS III

•

SFAS 157

Generalise use of derivatives and OTC instruments

Valuation-based compliance

Defines fair value as sell value

Establish 3-level hierarchy based on valuation

Market Risk

Credit Risk

Operational Risks

A new risk class

Data Acquisition

Data Processing

_Identify

Assess

Mitigate

Data Risk

Valuation

(Process)

Risk

Model Risk

Orders

Static Data

OTC Data

For…

Execution

Position/PL

Analytics

..we need to…

..the following

risks :

Data + Models + Processes + Control = Valuation risk

Mitigate

Monitor

Report

Sensitivities

(Mkt/Crdt)

Collateral

Liquidity

Reporting

Data Distribution

Compliance

Pricing

Valuations

Contribution

Portfolio

Risk

Performance

Regulatory

Audit control

Reporting

Valuation risk

Data

•

Prices

•

Reference data

•

Models and hierarchy

•

Formats / Taxonomy

Which data for which purpose?

Processes

•

Compatibility of models and data, consistency in use

•

Data quality management (rating on availability, reliability, updates)

•

Data hierarchy (dependencies on imported, existing, calculated data)

How does the firm use data, rely on processes and assumptions?

Workflow analysis

•

Data hierarchy (dependencies on imported, existing, calculated data)

•

Process hierarchy (critical path, dependence on assumptions)

•

Workflow analysis (potential domino effect)

•

Vulnerabilities (latency, breakdown)

•

Connectivity (Synchronicity, external communications)

Organisation

•

Sponsorship, hierarchy, culture

•

Governance

•

Dashboard / warnings, alerts

OMS Providers

FX

FX OTC deriv Futures

Fix Inc

CDS

Fix Inc Deriv, Equ, CFDs, Cmdts

Exchanges

Securities

Futures & Opt

OTC Markets

Loans

Derivatives

Exchanges

Securities

Futures & Opt

Exchanges

Securities

Futures & Opt

OTC Markets

Loans

Derivatives

OTC Markets

Loans

OTC Derivatives

Execution Venues

Brokers

Golden copies and set-in-stone analytics…

Position Analytics and Valuations

Front

Office

Office

Back

Admin &

Accntg

Asset

Mgt

Custody

Adhoc Reporting for Communities

Real-time

export

Orders

OMS Providers

Exchanges

OTC

Markets

Electronic Execution

Brokers Others

Cash / Fx / Fwd / Opt / MM / STIR Deriv / Bills / Credit / Fix Inc/ MBS / CDOs Futures / Fut Opt / Equities / CFDs / OTC Deriv Metals / Energy / Softs

Market Makers Distributors

Order Processing

Position Management

Trade blotter Trade allocation Position Record Book Structure Exception Mgt Amendment forms

M

A

R

K

E

T

D

A

T

A

Drill-Down Position Analysis Inventory Analysis Funding Input verification Trade Entry

OMS Providers

Exchanges

OTC

Markets

Exchanges

OTC

Markets

Electronic Execution

Brokers Others

Cash / Fx / Fwd / Opt / MM / STIR Deriv / Bills / Credit / Fix Inc/ MBS / CDOs Futures / Fut Opt / Equities / CFDs / OTC Deriv Metals / Energy / Softs

Cash / Fx / Fwd / Opt / MM / STIR Deriv / Bills / Credit / Fix Inc/ MBS / CDOs Futures / Fut Opt / Equities / CFDs / OTC Deriv Metals / Energy / Softs

Market Makers Distributors

Order Processing

Position Management

Order Processing

Position Management

Trade blotter Trade allocation Position Record Book Structure Exception Mgt Amendment forms

M

A

R

K

E

T

D

A

T

A

M

A

R

K

E

T

D

A

T

A

M

A

R

K

E

T

D

A

T

A

Drill-Down Position Analysis Inventory Analysis Funding Input verification Trade Entry

..quickly reveal their own limitations.

Collateral Management

Data Management

Network Communications

Order Generation

M

A

R

K

E

T

D

A

T

A

Drill-Down Ticket/Pricing/Order Scenario Builder Parameters Collateralizing deals Collateral reports Instrument search Derivatives Pricing Curves / Surfaces Instrument Requests New bond forms

CA Event forms OTC inst forms

Instrument analytics Export to Admin / PB Maturity Option expiry Terminations Cash events Notifications

Hedge effectiveness End of Day/Month

Exception Mgt

Collateral Management

Data Management

Network Communications

Order Generation

Collateral Management

Data Management

Network Communications

Order Generation

M

A

R

K

E

T

D

A

T

A

M

A

R

K

E

T

D

A

T

A

M

A

R

K

E

T

D

A

T

A

Drill-Down Ticket/Pricing/Order Scenario Builder Parameters Collateralizing deals Collateral reports Instrument search Derivatives Pricing Curves / Surfaces Instrument Requests New bond forms

CA Event forms OTC inst forms

Instrument analytics Export to Admin / PB Maturity Option expiry Terminations Cash events Notifications

Hedge effectiveness End of Day/Month

Data Acquisition

Data Processing

Input &

Visualisation

Calibration

Pricing

Pre-Trade Analytics

Position Analytics

Portfolio Reports

Corporate actions

Issuer Data

T&Cs

Market Data

Valuations

Projections

Risk aggregation

Yield Curves

Vol Surfaces

Input Services

Interactive

Platform

Data Acquisition

Data Processing

Input &

Visualisation

Calibration

Pricing

Pre-Trade Analytics

Position Analytics

Portfolio Reports

Corporate actions

Issuer Data

T&Cs

Market Data

Valuations

Projections

Risk aggregation

Yield Curves

Vol Surfaces

Input Services

Interactive

Platform

Open models, dynamic, adaptable workflow…

Data Distribution

Scenario-based

analytics

P/L & Risk

Limits &

Compliance

Margin & Collateral

Back-Office

Records

History & Audit

Risk & Compliance Reports

Performance

Portfolio modelling

Decomposition

VaR & Stress Test

Scenarios

X-Asset Aggregation

Correlations

Ratings

Interactive

Services

Communication

Services

External connections

Data Distribution

Scenario-based

analytics

P/L & Risk

Limits &

Compliance

Margin & Collateral

Back-Office

Records

History & Audit

Risk & Compliance Reports

Performance

Portfolio modelling

Decomposition

VaR & Stress Test

Scenarios

X-Asset Aggregation

Correlations

Ratings

Interactive

Services

Communication

Services

External connections

..dynamic adaptable processes,…

Scenario based risk analysis

Workflow and hierarchy

•

Contingencies in processes

•

Data dependencies

•

Defining Key Risk Factors (feed, curves, surfaces, matrices, diffusion model) for concentrations

•

Sensitivity to chosen factors, observable input, economic factors

•

Interdependence of risk factors (volatility, spreads, correlations)

•

Impact on collateral, covenants (rule-based)

•

Multiple model approach (highly recommended by most professional associations)

•

Volume processing, scalability

•

Connectivity, external contingencies

Alternative procedures

Triggers and alerts

•

Swappable, adjustable analytics

•

Alternative data sets

•

Alternative processes

•

Connectivity, external contingencies

•

Establish triggers (intra-day vol, price gaps, default event)

•

Measure impact immediately

•

Huge volumes to be analysed and visualised almost instantly

•

Multiple views, interactive queries, filtering

•

Multiple data sources –aggregated an reconciled automatically

•

Multiple pricing models

•

On-demand variables and risk factors aggregation

•

Permanent compliance check against investment policies, risk limits

..interactive data models… will make the firm more agile.

Insights

Open Model Approach

•

Multiple (alternative) models

•

Scenario-based, cross-asset

•

Scenario-based, cross-asset

Combining the management of data, models and

processes into a set of adaptable and

interchangeable procedures for pricing, valuing and

reporting, P/L, exposure and performance.

How agile a firm can be in adapting to a new

business environment.

Policy/Strategy

Organisation and corporate culture

Structure

•

Risk culture acknowledging Valuation Risk as a standalone risk to be managed

•

Risk committee

•

Hierarchy, Empowerment

•

Independence

•

Governance and acountability (process owners)

Audit and control

•

Openess

•

Disclosure of data, results, methodologies

•

“Democratised access to data (user interface)

•

Governance and acountability (process owners)

•

Taxonomy

“As far as mathematics refer to reality they are not certain, as

far as they are certain they do not refer to reality”

Albert Einstein

GARP Caribbean Chapter Meeting, March 28

th

₂₀₀₈

By Philippe Carrel, Reuters,

Executive Vice President

[email protected]

Valuation, Model and Data Risk Management