PRE-TRADE RISK ANALYTICS
Figure 2: Trade Risk Profile for John’s Trading Book Trade Risk Profile
$250,000 $200,000 $150,000 $100,000 $50,000 $- - 200,000 400,000 600,000 800,000 1,000,000 1,200,000 1,400,000 1,600,000 1,800,000 2,000,000 Henry Hub Position (MMBTUs) Source: NQuantX
Table 2: Best Hedge Report For John’s Trading Book Existing VaR
VaR Limit
Minimum VaR VaR Reduction Existing Position Best Hedge Adjustment
Optimal VaR Action
$ 97,619 $ 100,000 $ 63,530 $ 34,089 1,200,000 760,000
(440,000) Short 44 NYMEX March 2013 Contracts
ask her why his VaR jumped overnight. Anne looks at him condescendingly and answers that she does not have time to explain to him how the internal models work and reminds John that he chose not to attend any of the training sessions she set up to explain the firm’s VaR model. John then asks her if she has any suggestions regarding what trades would be most effective reducing the risk of his portfolio, but Anne responds that she is not familiar enough with John’s book to make such recommendations. Anne also points out that her job is to calculate the risk of the individual books every day, not to manage them.
Trade risk profiles are particularly useful
to identify macro hedges that can have the largest VaR reduction at the portfolio level John knows that his actual overnight risk is considerably
lower than $100,000, but he also understands that there is little point in arguing the VaR model results based on historical volatilities and correlations of risk factors as the risk group is using the company approved risk model which is showing otherwise. Based on his experience and intuition, he knows
that he is overall position is long gas price risk and he could likely reduce the risk of his book by adjusting his NYMEX Henry Hub position with minimal transaction
54 March 2013 • •
costs. The problem is that he does not know exactly what is the VaR minimizing position according to the firm’s risk model and any new trades could actually end up increasing the risk of the book instead of decreasing it. Suddenly, John remembers that he
learned how to create trade risk profiles in Excel in an energy risk management workshop he attended the prior year. His firm calculates VaR overnight, but he could perform his own VaR calculations on real-time and conduct what-if analysis for new hypothetical trades. To create a trade risk profile, he just needs his main exposures by underlying market, as well as the volatility and correlation matrix of the risk factors he is exposed to.
Trade Risk Profiles A trade risk profile is a chart that shows
how increasing or decreasing the exposure to a particular risk
MMBTUs MMBTUs MMBTUs
factor increases or decreases
portfolio VaR after taking into account the interaction between all the portfolio constituents. Trade risk profiles are particularly useful to identify macro hedges that can have the largest VaR reduction at the portfolio level. For example, Figure 2 shows the trade risk
profile using Henry Hub March 2013 futures as a hedge. The X-axis shows the net Henry Hub
position assuming that all other portfolio exposures remain constant, while the Y-axis shows the portfolio VaR for each hypothetical net position in Henry Hub. The red circle shows John’s original net exposure
to Henry Hub in MMBTUs and its associated VaR in the y-axis. The yellow circle shows the exposure that would minimize the portfolio VaR and the associated VaR reduction. Table 2 provides a series of summary risk statistics, including the optimal VaR trade recommendation. By adjusting his Henry Hub Natural Gas exposure,
John could reduce his book VaR from $97,619 to $63,530, which represents a reduction of $34,089. The reason that liquidating part of the long Natural Gas March 2013 futures contract position would reduce portfolio VaR is that the implied risk view on the original Henry Hub exposure was substantially long. To be in a risk neutral position that would correspond with the minimum portfolio VaR, assuming all other positions remain constant, John could sell 44 NYMEX April 2013 Henry Hub contracts to reduce his original position of long 120 lots. After careful consideration, John decides to execute the optimal VaR trade before the market close. The following day, after receiving his daily risk report, he sees that his VaR number is down to $65,000, way
Portfolio VaR
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