Figure 3-9 Group of Thirty Derivatives Project Good Practice Recommendations

Recommendation 1: The Role of Senior Man- exposure ). by the measure of market risk.
agement • Components of market risk that should be con- • The review and approval of pricing models and
Dealers and end users should use derivatives in a sidered across the term structure include: valuation systems used by front and back-office
manner consistent with the overall risk manage- aQsolute price or rate change (delta); convexity personnel, and the development of reconcilia-
ment and capital policies approved by their (gamma); volatility (vega); time decay (theta); tion procedures if different systems are used.
boards of directors. These policies should be basis or correlation; and discount rate (rho).
reviewed as business and market circumstances Recommendation 9: Practices by End Users'
change. Policies governing derivatives use should Recommendation 6: Stress Simulations As appropriate to the nature, size, and complexity
be clearly defined, including the purposes for Dealers should regularly perform simulations to of their derivative~ activities, end users should
which these transactions are to be undertaken. l determine how their portfolios would perform adopt the same valuation and market risk man-
Senior management should approve procedures under stress conditions. agement practices that are recommended for deal-
and controls to implement these policies, and ers. Specifically, they should consider: regularly
management at all levels should enforce them. Recommendation 7: Investing and Funding marking to market their derivatives transactions
Forecasts for risk management purposes; periodically fore-
Recommendation 2: Marking to Market Dealers should periodically forecast thc cash casting the cash investing and funding require-
Dealers should mark their derivatives positions to ~investing and funding requirements arising from ments arising from their derivatives transactions;
market, on at least a daily basis, for risk manage- their derivatives portfolios. and establishing a clearly independent and
ment purposes. authoritative function to design and assure adher-
Recommendation 8: Independent Market Risk
ence to prudent risk limits.
Recommendation 3: Market Valuation Methods Management
Derivatives portfolios of dealers should be valued Dealers should have a market risk management Recommendation 10: Measuring Credit
based on mid-market levels less specific adjust- function, with clear independence and authority, Exposure
ments, or on appropriate bid or offer levels. Mid- to ensure that the following responsibilities are Dealers and end users should measure credit
market valuation adjustments should allow for carried out:
exposure on derivatives in two ways:
expected future costs. such as unearned credit
• The development of risk limit policies and the • Cun"ent exposure, which is the replacement
spread, close-out costs, investing and funding
monitoring of transactions and positions for cost of derivativcs transactions, that is, their
costs, and administrative costs.
adherence to these policies (See Recommcnda- market value.
Recommendation 4: Identifying Revenue tion 5.)
• Potential exposure, which is an estimate of the
Sources • The design of stress sccnarios to nlcasurc the future rcplacement cost of derivatives trans~c-
Dealers should measure the components of rev- impact of market conditions, however improba- lions. It should be calculated using probability
enue regularly and in sufficient detail to under- ble, that might cause markct gaps, volatility analysis bascd upon broad confidence intervals
stand the sources of risk. swings, or disruptions of major relationships, or (e.g., two standard deviations) over the remain-
might reduce liquidity in the facc of unfavorable ing terms of the transactions.
Recommendation 5: Measuring Market Risk market linkages, concentrated market making,
Dealers should use a consistent measure to calcu- or credit exhaustion. (See Recommcndation 6.) Recommendation 11: Aggregating Credit
late daily the market risk of their derivatives posi- • The design of revenue reports quantifying the Exposures
tions and compare it to market risk limits. contribution of various risk components, and of Credit exposures on derivatives, and all other
• Market risk is best measured as "value at risk" market risk measures such as value at risk. (See credit exposures to a counterparty, should be
Recommendations 4 and 5.) aggregated taking into consideration enforceable
using probability analysis based upon a com-
• Thc monitoring of variance bctwecn thc actual nctting arrangements. Credit exposures should be
mon confidence interval (e.g., two standard
calculated regularly and compared to crcdit limits.
deviations) and time horizon (e.g., a one-day volatility of portfolio value and that predicted
\'<~
) ) )
 ( ( (
Rccommcndation 12: Indepcndcnt Crcdit Risk sionals in sufficient number and with the appro- the risk being managed. Or, if the risk being
Managcment priate experience, skill levels, and degrees of spe- managed is marked to market with changes in
Dealers and end users should have a credit risk cialization. These professionals include value being taken to income, a qualifying risk
management function with clear independence specialists who transact and manage the risks management instrument should be treated in a
and authority, and with analytical capabilities in involved, their supervisors, and those responsible comparable fashion.
derivatives, responsible for: for processing, reporting, controlJing, and audit- o End users should account for derivatives not
o Approving credit exposure measurement ing the activities. qualifying for risk management treatment on a
standards. mark-to-market basis.
Rccommendation 17: Systems
o Setting credit limits and monitoring their use. o Amounts due to and from counterparties should
Dealers and end users must ensure that adequate
o Reviewing credits and concentrations of credit systems for data capture, processing, settlement, only be offset when there is a legal right to set
risk. and management reporting arc in place so that off or when enforceable netting arrangements
o Reviewing and monitoring risk reduction derivatives transactions are conducted in an are in place.
arrangements. orderly and efficient manner in compliance with
Where local regulations prevent adoption of these
management policies. Dealers should have risk
Recommendation 13: Master Agreements management systems that measure the risks practices, disclosure along these
lines is nevertheless recommended.
Dealers and end users are encouraged to use one incurred in their derivatives activities including
master agreement as widely as possible with each market and credit risks. End users should have
Recommendation 20: Disclosures
counterparty to document existing and future risk management systems that measure the risks Financial statements of dealers and end users
derivatives transactions, including foreign incurred in their derivatives activities based upon should contain sufficient information about their
exchange forwards and options. Master agree- their nature, size, and complexity. use of derivatives to provide an understanding of
ments should provide for payments netting and
Recommendation 18: Authority the purposes for which transactions are under-
c!ose-out'nelling, using a full two-way payments
Management of dealers and end users should des- taken, the extent of the transactions, the degree of
approach.
risk involved, and how the transactions have been
ignate who is authorized to commit their institu-
Recommendation 14: Credit Enhancement tions to derivatives transactions. accounted for. Pending the adoption of harmo-
Dealers and end users should assess both the ben- nized accounting standards, the following disclo-
efits and costs of credit enhancement and related Rccommendation 19: Accounting Practices sures are recommended:
risk-reduction arrangements. Where it is proposed International harmonization of accounting stan-
that credit downgrades would trigger early tenni- dardization for derivatives is desirable. Pending o Information about management's attitude to
the adoption of harmonized standards, the follow- financial risks, how instruments are used, and
nation or collatenil requirements, participants
ing accounting practices are recommended: how risks are monitored and controlled.
should carefully consider their own capacity and
that of their counterparties to meet the potentially o Dealers should account for derivatives transac- • Accounting policies.
substantial funding needs that might result.
tions by marking them to market, taking
o Analysis of the credit risk inherent to those
Recommendation 15: Promoting Enforcebility changes in value to income each period.
positions.
Dealers and end users should work together on a o End users should account for derivatives used
continuing basis to identify and recommend solu- to manage risks so as to achieve a consistency o Analysis of positions at the balance sheet date.
tions for issues of legal enforceability, both within of income recognition treatment between those
o For dealers only, additional information about
and across jurisdictions, as activities evolve and instruments and the risks being managed. Thus, the extent of their activities in financial instru-
new types of transactions are developed. if the risk being managed is accounted for at ments.
cost (or, in the case of an anticipatory hedge,
Rccommendation 16: Professional Expertise not yet recognize~ change!f in the value of a SOURCE: Derivatives: Practices and Principles. Global
Dealers and end users must ensure that their qualifying risk management instrument should Derivatives Study Group. Group of Thirty. Washington.
derivatives activities are undertaken by profes- be deferred until a gain or loss is recognized on D.C., July 1993
\j-.)