Deutsche Bank
Risk
Credit Risk of Derivatives
Exposure Management Group
Exposure Management: Roles & Responsibilities
1. Introduction to Exposure
Management
2. Exposure Modelling &
Measurement
 Analysis of derivatives risk of structured transactions, impact of new trades on
existing portfolios.
 Counterparty portfolio analysis: monitoring of critical portfolios and analysis of
unprocessed trades.
3. Simple Derivative Products
 Advise and support CRM and business on risk mitigation.
4. Risk Reducing Techniques
 Development of pre-deal check tools.
5. Stress Tests
 Development of risk methodology together with MRM Derivatives Exposure
and review of internal and external margining methodologies (e.g. Clearing
Houses).
 Bank portfolio (and sub-portfolio) analysis: exposure reports for targeted
products or regions (e.g. commodities or Emerging markets) via derivatives
stress test analysis.
 Risk assessment within the New Product Approval (NPA) process.
 Ultimate Goal: optimize the credit risk within the parameters set by the credit
officers, i.e. maximize the return on the risk at the firm-wide portfolio level.
Deutsche Bank
Risk
Exposure Management Group
1
Overview of Credit Risk/ Exposure
1. Introduction to Exposure
Management
2. Exposure Modelling &
Measurement
 Credit Risk: risk of a loss, arising from counterparty’s inability to meet
its obligations on a financial contract
 Credit Exposure: is a measure of the amount that would be lost if a
counterparty to a financial contract defaults
3. Simple Derivative Products
 Credit exposure on a straight loan ~ loan notional
4. Risk Reducing Techniques
 Credit exposure on a derivative instrument = Replacement value, if
positive.
5. Stress Tests
 Credit Exposure of traded products is measured via two concepts:
 Current Credit Exposure (CCE)
 Potential Future Exposure (PFE)
 For collateralized counterparties (except HF) → short-term PFE
(VaR), the risk is calculated over the respective call frequency
period + liquidation period (usually 10 business days)
 For Hedge Funds monitoring is based on stress test shortfall
Deutsche Bank
Risk
Exposure Management Group
2
Measuring counterparty exposure: CCE
1. Introduction to Exposure
Current Credit Exposure (CCE):
Management
2. Exposure Modelling &
Measurement
3. Simple Derivative Products
4. Risk Reducing Techniques
5. Stress Tests
 CCE is calculated as a replacement value of the derivative, applying
enforceable netting rules (Credit Line Netting) and collateral, if
applicable.
 CCE depends on current market conditions (IRs, FX rates, equity
prices, credit spreads, inflation, volatility, hidden market conditions as
liquidity).
 CCE is monitored under the CCE Limit, set by each credit officer in
accordance to the present credit risk appetite;
 CCE is the legally binding exposure in case of counterparty’s
default.
Deutsche Bank
Risk
Exposure Management Group
3
CCE: Impact of Credit Line Netting (“Close Out” Netting)
1. Introduction to Exposure
Example: all numbers from DB perspective
Management
2. Exposure Modelling &
Measurement
DB has entered into two derivative transactions with a counterparty. 1st transaction has a
MtM of + 32 (i.e. the counterparty owes DB) and 2nd transaction has a MtM of -10 (i.e. DB
owes the counterparty).
3. Simple Derivative Products
4. Risk Reducing Techniques
CCE with netting:
5. Stress Tests
CCE without netting:
+ 32 - 10
= 22
= 32
Without netting in the case of ctpy’s default, DB will still have the obligation to pay 10 (DB
owes it to the counterparty), but the 32 would go into the bankrupt’s liabilities.
Deutsche Bank
Risk
Exposure Management Group
4
Measuring counterparty exposure: PFE
1. Introduction to Exposure
Potential Future Exposure (PFE):
Management
2. Exposure Modelling &
Measurement
3. Risk Systems Overview
4. Simple Derivative Products
5. Case Study
6. Risk Reducing Techniques
7. Stress Tests
8. Policy Overview
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Risk
 PFE quantifies the potential adverse movement of the trade/ portfolio
CCE due to changes in the underlying asset (IR, FX, equity, etc.);
 PFE varies over time as the market conditions might alter and the
trade gets closer to maturity (aging effect);
 The PFE utilisation is calculated over the lifetime of the trade, i.e.
PFE Profile.
 PFE is monitored under the PFE limit for the respective future tenor
point , i.e. PFE Limit Structure;
Exposure Management Group
5
PFE Considerations
1. Introduction to Exposure
Management
2. Exposure Modelling &
Measurement
3. Simple Derivative Products
4. Risk Reducing Techniques
5. Stress Tests
 The PFE gives a „reasonable worst case“ exposure, considering
counterparty’s default and adverse market scenario.
 The PFE utilisation is calculated over the lifetime of the trade, i.e. PFE
Profile.
 It is measured at 95% confidence level → 95% probability that the exposure
of a trade/ portfolio will stay below the PFE number.
 Tail risk: up to 5% probability the trade/ portfolio exposure to exceed the PFE
number due to extreme market movements (e.g. Global Crisis in 2008/ 2009).
 The PFE calculation approach should be:
 conservative enough to protect the bank;
 backed up by historical analysis (backtesting); macroeconomic analysis
& product expertise are considered by the scenario definition;
 consistent over different product classes (e.g. FX Forwards &
CCSwaps);
 take into account the tenor of the transaction;
 consider the specifics of the underlying, e.g. distinguish between high/
low volatility assets (DM vs. EM underlying), liquid/ illiquid assets.
Deutsche Bank
Risk
Exposure Management Group
6
PFE Profile Example: 5Y “at the money” IRS
1. Introduction to Exposure
Management
2. Exposure Modelling &

The result of the PFE calculation is a whole pattern, i.e. PFE profile

The calculation considers the maturity of the trade and the so called “aging effect” (the
exposure decreases with each coupon payment)
Measurement
3. Risk Systems Overview
4. Simple Derivative Products
5. Case Study
6. Risk Reducing Techniques
7. Stress Tests
8. Policy Overview
Deutsche Bank
Risk
Exposure Management Group
7
Risk Measurement for Collateralized Counterparties (1)
The most fundamental evaluation of the risk is the CCE.
1. Introduction to Exposure
CCE = Portfolio MtM (netting applied) + Collateral posted – Collateral held
Management
2. Exposure Modelling &
Measurement
3. Simple Derivative Products
4. Risk Reducing Techniques
5. Stress Tests
 Collateral is valued at its current market value pre-haircut.
 Accordingly, a PFE estimate is needed to value the market movements
impact on the CCE in the future.
 The PFE estimate, called short-term PFE (VaR), should reflect changes in
DB’s exposure.
 The short-term PFE (VaR) is monitored vs. PFE (VaR) Limit.
 The PFE calculation should also reflect potential changes in the value of the
collateral taking into account correlation.
 The risk horizon for the exposure calculation depends on the call frequency, it
is usually calculated as:
Risk horizon = Call frequency + 10 bdays (liquidation period)
Deutsche Bank
Risk
Exposure Management Group
8
Risk Measurement for Collateralized Counterparties (2)
 Time Horizon for a PFE calculation with daily margining: 10 bdays/ 14 calendar days
 In DB Risk systems the calculation is done over the immediate next 10 business days
(i.e. 14 calendar days by daily margining).
 Short-term PFE (VaR) = 10bdays PFE – CCE after Collateral
 However, the risk over any 10 bdays period in the life of the portfolio should be
considered.
Deutsche Bank
Risk
[
TODAY
10 DAYS
10 DAYS
10 DAYS
[
[
[
10 DAYS
MATURITY
Exposure Management Group
9
Simple Derivatives Products: Overview
1. Introduction to Exposure
 Forward
Management
2. Exposure Modelling &
Measurement
 Interest Rate Swap (IRS)
 Swaption
3. Simple Derivative
Products
 Options
4. Risk Reducing Techniques
5. Stress Tests
Deutsche Bank
Risk
Exposure Management Group
10
Simple Derivatives Products: Introduction to Exposure Calculation
1. Introduction to Exposure
The exposure calculation involves always the following steps:
Management
2. Exposure Modelling &
Measurement
3. Simple Derivative
Step 1: Understand the trade structure and identify the main risk drivers
 Trade cashflows and respective risk driver, e.g. FX spot rates, equity prices,
IRs, CS, etc.
Products
4. Risk Reducing Techniques
Step 2: Identify the trade sensitivity (impact of the underlying on the CCE)
5. Stress Tests
 Appreciation/ depreciation of base currency, increasing/ decreasing stock
prices, increasing/ decreasing IRs, credit spreads widening/ tightening
Step 3: Model the underlying (simulate future levels)
 E.g. FX rates are assumed to be log-normally distributed
Step 4: Re-price the product using the simulated levels of the underlying,
determine CCE & PFE
Deutsche Bank
Risk
Exposure Management Group
11
Forwards
1. Introduction to Exposure

A forward contract is an agreement between two counterparties that fixes
the terms of an exchange that will take place between them at some future
date.

The contract specifies the underlying, the price at which the exchange
takes place (strike) and the date (or range of dates) in the future when the
exchange will take place.

A forward contract is a contract for forward delivery. No intermediate
cashflows until delivery.

Forward contracts are tailor made - both the size of the transaction and
the date of forward delivery are agreed between the counterparties.

Compare to Futures!
Management
2. Exposure Modelling &
Measurement
3. Simple Derivative
Products
4. Risk Reducing Techniques
5. Stress Tests
Deutsche Bank
Risk
Exposure Management Group
12
Forwards: Specifics
1. Introduction to Exposure
Settlement risk considerations for FX:
Management
2. Exposure Modelling &
Measurement
3. Simple Derivative
Products
4. Risk Reducing Techniques

In an FX forward both parties exchange a currency amount.

This exchange is mostly free of delivery, i.e. unsafe settlement.

If the settlement fails, the full amount DB expects is at risk.

Due to the global nature of the business and time lags between different locations, a
whole time window has to be monitored (extended liquidation period).

FX Settlement Limit in Paragon should be set up!
5. Stress Tests
Forward on equity: forward on counterparty’s own shares
Basic assumption of each PFE calculation in such cases: the counterparty has defaulted!
Deutsche Bank
Risk

In this case the share price can be assumed to drop to zero!

In a forward sale the MtM and therefore the PFE is 100% of the notional!

We call this Wrong-Way Risk!
Exposure Management Group
13
FX Forward*: Example
1. Introduction to Exposure
Example: DB buys EUR 10 mn vs. USD @ a strike of 1.3633 USD/ EUR in 12M
Management
2. Exposure Modelling &
Measurement
USD 13.63 mn
3. Simple Derivative
Products
DB
4. Risk Reducing Techniques
5. Stress Tests
EUR 10 mn

Main risk driver: EUR/ USD FX rate

Trade sensitivity: USD depreciation vs. EUR

Deutsche Bank
Risk
Ctpy

Assume USD depreciates vs. EUR to 1.42 USD/ EUR

Then the MtM of the trade will be positive for DB as under the Forward DB is
supposed to pay only 1.3633 USD for 1 EUR instead of the market rate of 1.42
USD/ EUR (i.e. less than market)
Note that a series of FX Forwards is called a “Strip”.
Exposure Management Group
*FX = Foreign Exchange
14
FX Forward: Modelling the Underlying Risk Factor (1)
1. Introduction to Exposure

The model assumes that financial assets follow a random walk without
drift for Developed markets; for Emerging markets jump factors may be
included.

Efficient market hypothesis (weak form): the current security price
instantaneously and fully reflects all information contained in the past
history of the security price.

For exposure purposes in closed form this translates to the log-normal
distribution.

Model simplification (stress formula):
Management
2. Exposure Modelling &
Measurement
3. Simple Derivative
Products
4. Risk Reducing Techniques
5. Stress Tests
Stressed Spot = Spot * exp( ±1,645 * Vol * √ Time )
From statistics:
±1,645 is the z-value of the normal distribution (Gauss’ bell curve) – representing the
confidence level of 95 %
Vol = Volatility: based on historical data, the volatility measures the fluctuation
√ Time = square root of time in years
Deutsche Bank
Risk
Exposure Management Group
15
FX Forward: Modelling the Underlying Risk Factor (2)
1. Introduction to Exposure
Exercise:
Management
2. Exposure Modelling &
Measurement
What would be the stressed EUR/ USD level in 12 months considering
the following input values?
3. Risk Systems Overview
4. Simple Derivative
Products
Hint: use the stress formula!
5. Case Study
6. Risk Reducing Techniques
7. Stress Tests
8. Policy Overview
 Spot level: 1.3647 USD/ EUR
 Z-value: 1.645
 Volatility: 9.8%
 Time to maturity: 12 months
Deutsche Bank
Risk
Exposure Management Group
16
EUR/ USD FX Simulation: Example
Application of the model to the EUR/ USD FX rate, trading at 1.3647 USD/ EUR
EUR / USD FX Rate
1.70
1.60
1.50
1.40
95th percentile
5th percentile
1.30
1.20
364 D
334 D
303 D
273 D
242 D
212 D
181 D
151 D
135 D
121 D
104 D
90 D
75 D
61 D
Today
1
D
2
3
D
5
D
7D
10
14 D
21 D
30 D
37 D
44 D
1.10
Simulation time points: more narrow at the beginning, more spread out in the future
Advantage of the log-normal model:
Simulated levels of the underlying risk factor are always positive!
Deutsche Bank
Risk
Exposure Management Group
17
FX Forward: Quick PFE Calculation
1. Introduction to Exposure
Management
2. Exposure Modelling &
 To get a PFE number, the simulated levels of the EUR/ USD FX are used.
 For a quick proxy, the stress formula could be used to “simulate” the FX rate
at maturity:
Measurement
3. Simple Derivative
Simulated EUR/ USD FX: 1.3633 * exp(1.645 * 9.8% * √1)) = 1.6034
Products
4. Risk Reducing Techniques
5. Stress Tests
 Peak PFE is then calculated by re-pricing the trade at the potential future FX
rate:
6. Policy Overview
Peak PFE in EUR = EUR 10 mn – USD 13.633 mn/ 1.6034 = EUR 1.4975 mn

PROs: very quick, gives a good proxy of the FX risk for short-term DM currencies

CONs: only Peak PFE, no PFE profile, not appropriate for EM nor trades with peak
not at maturity
 For a PFE Profile on plain vanilla trades cEIS Pre-Deal Checker to be used: a
full simulation of the FX rate by Matrix, re-pricing at each timepoint on the grid
Deutsche Bank
Risk
Exposure Management Group
18
Interest Rate Swap (IRS)
1. Introduction to Exposure
Management
Role of the swap market:

2. Exposure Modelling &
attracting investors with certain characteristics.
Measurement
3. Risk Systems Overview
4. Simple Derivative
The swap market helps issuers to find a financing corresponding to their specific needs by

Banks act as mediator between issuers and investors vs. compensation.

The swap market is used to transformed fixed to floating coupons and vice versa.
Products
5. Risk Reducing Techniques
6. Stress Tests
Issuers with
specific financing
needs
Deutsche Bank
Risk
Exposure Management Group
Swap
market
Investors with
specific debt
requirements
19
Interest Rate Swap (IRS): Example
1. Introduction to Exposure
Management
2. Exposure Modelling &
Notional:
EUR 100 mn
Tenor:
spot – 5Y
DB pays:
3M Euribor, QTR, act/ 360
DB receives:
0.75% p.a., QTR, act/ 360
Trade sensitivity:
falling EUR interest rates
Measurement
3. Risk Systems Overview
4. Simple Derivative
Products
5. Risk Reducing Techniques
6. Stress Tests
Interpretation:
DB receives a fixed rate, hence if the EUR IRs fall, DB will receive a higher than the market
implied rate, meaning the value of the swap will increase
3M Euribor
DB
Ctpy
0.75% p.a.
Deutsche Bank
Risk
Exposure Management Group
20
Options: Definitions
1. Introduction to Exposure

Definition: an option is a contract that gives the holder the right, but not the obligation to
buy (call) from / sell (put) to the option writer a certain asset (here FX amount) at a
pre-determined price (strike) on a future time point (exercise date).

Option positions:
Management
2. Exposure Modelling &
Measurement
Option position
Trading name
Description
Buy Call
Long Call
Right to buy an asset
4. Risk Reducing Techniques
Sell Call
Short Call
Obligation to sell an asset
upon exercise to the holder
5. Stress Tests
Buy Put
Long Put
Right to sell an asset
Sell Put
Short Put
Obligation to buy an asset
upon exercise from the holder
3. Simple Derivative
Products
Option styles:

European style: exercise possible only on expiry date

American style: exercise at any time up to and including expiry date

Bermudan style: exercise at several pre-defined time points up to and including
expiry date

Asian style: the payoff depends on the average underlying price over a pre-set period
of time
Main risk driver: change in the market price of underlying, e.g. share price, FX rate, etc.
Deutsche Bank
Risk
Exposure Management Group
21
Payout Diagram of a Bought Call Option (Exposure Perspective)



Option premium ignored for simplicity!
Main risk driver: underlying asset price, sensitivity to increasing prices
Call options sold to non-collateralized counterparties are risk free, to collateralized counterparties bear
claw-back risk!
0.1
0.1
Exposure
0.0
0.1
1.30
1.35
1.40
USD/ EUR
1.45
1.50
“In the money”
“Out of the money”
-0.1
0.1
ATM*
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Risk
*ATM: „at the money“
Exposure Management Group
22
Payout Diagram of a Bought Put Option (Exposure Perspective)



Option premium ignored for simplicity!
Main risk driver: underlying asset price, sensitivity to falling prices
Put options sold to non-collateralized counterparties are risk free, to collateralized counterparties bear clawback risk!
0.1
0.1
Exposure
0.0
0.1
1.30
1.35
1.40
USD/ EUR
1.45
1.50
“Out of the money”
“In the money”
-0.1
0.1
ATM*
Deutsche Bank
Risk
*ATM: „at the money“
Exposure Management Group
23
Combined Option Positions (Exposure Perspective)
Combined Option Position = synthetic asset position without buying/ selling the asset
By European Options = Forward contract
Long Call
+
=
+
=
Short Call
Deutsche Bank
Risk
Synthetic
Long Asset
Short Put
Long Put
Synthetic Short
Asset
Exposure Management Group
24
Risk Reducing Techniques: Overview
1. Introduction to Exposure
Early Termination Clauses (ETCs)
Management

A technique to reduce the economic tenor of the transaction to a duration
proportional to the counterparty’s credit standing and CO’s risk appetite
3. Simple Derivative Products

The transaction is settled at the MtM on the exercise date;
4. Risk Reducing

Only mutual termination clauses are relevant for the exposure calculation;
2. Exposure Modelling &
Measurement
Techniques
5. Stress Tests
Collateral agreement (CSA: Collateral Support Annex): exposure calculation
over the relevant margin call frequency period and monitoring under the PFE
(VaR) limit.
Dynamic Credit Hedging
Deutsche Bank
Risk

The exposure is hedged via CDS contracts;

Objective: maintain the P&L impact of a counterparty’s default within the
pre-defined credit lines;
Exposure Management Group
25
Early Termination Clause (ETC): Definition
1. Introduction to Exposure

Management
2. Exposure Modelling &
Measurement
3. Simple Derivative Products

4. Risk Reducing
Longer dated trades should contain an ETC, in specific:

Trades with tenor > 10y for uncollateralized counterparties

Trades with tenor > 30y for collateralized counterparties
ETCs are defined as either:

Mandatory Cash Settlement Clause: settlement at current MtM at a specified
date

Optional Early Termination Clause (Mutual Termination Clause): right to call on
one or more dates to terminate the transaction vs. settlement at current MtM

Trigger based Optional Early Termination Clause: optional termination by the
non-affected party upon a trigger event (e.g. rating downgrade) vs. current MtM
Techniques
5. Stress Tests

Deutsche Bank
Risk
PFE and Limit tenors (system implementation since 2014):

For Mandatory Early Termination Clauses exposure is calculated till the first
termination date.

For Optional Early Termination Clauses exposure is calculated till maturity, tenor
breach if tenor of the limit is earlier than next ETC and maturity.

For Trigger based Optional ETC exposure is calculated till maturity.
Exposure Management Group
26
Collateral Agreement: Terms
1. Introduction to Exposure
The Credit Officer is responsible for defining the following parameters:
Management
2. Exposure Modelling &
Measurement
3. Simple Derivative Products

CCE Limit: represents DB’s risk appetite; generally a multi-product limit to cover all
products traded under the collateral agreement.

PFE (VaR) Limit: should cover Threshold Amount + MTA + PFE (VaR)

Collateral Plan Type: unilateral (one-sided, i.e. supranational & international
institutions) or bilateral (both counterparties post collateral)

Call Frequency: preferred is daily, it depends on the client’s operational capacity to
value the portfolio and execute margin calls

Threshold Amount & rating triggers: preferred is zero threshold;
4. Risk Reducing
Techniques
5. Stress Tests
If CCE < Threshold → collateral is NOT required
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Risk

Independent Amount (Initial Margin), usually for Hedge Funds, upfront collateral to
cover potential MtM movements between collateral calls

Minimum Transfer Amount (MTA): collateral requirement must exceed the MTA prior
to any collateral exchange (minimize the number of collateral transfers)

Eligible Collateral: the collateral should be LIQUID (easy to liquidate in case of
default), preferred: Cash and Government bonds, see “Collateralized Trading Policy”
for details

Product Coverage

Rounding Increment (preferred: small, e. g. EUR 0.1m)
Exposure Management Group
27
Calculation of Collateral Calls (1)
1. Introduction to Exposure
Collateral calls are typically calculated as follows:
Management
MtM of all trades covered by the agreement (netting applied)
2. Exposure Modelling &
+ Independent Amount
Measurement
- Threshold Amount (uncollateralized exposure)
3. Simple Derivative Products
=
Credit Support Amount
4. Risk Reducing
- Collateral Held
Techniques
=
Delivery / Return Amount
5. Stress Tests
If Delivery/ Return Amount > MTA amount, it is rounded according to the Rounding
Increment to give the final Collateral Call Amount.
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Risk
Exposure
Threshold
MTA
Rounding
Increment
Action
23
20
5
2
No margin call
23
20
0
2
Call 4
23
20
2
2
Call 4
17
20
2
2
Return 2
Exposure Management Group
28
Calculation of Collateral Calls (2)
1. Introduction to Exposure
Exercise:
Management
2. Exposure Modelling &
Consider the following situation:
Measurement
3. Simple Derivative Products
 CCE:
EUR 16 mn
4. Risk Reducing
 Threshold:
EUR 15 mn
 MTA:
EUR 3 mn
 Rounding increment:
EUR 1 mn
Techniques
5. Stress Tests
Is DB entitled to execute a collateral call?
Deutsche Bank
Risk
Exposure Management Group
29
Eligible Collateral and Haircuts
Collateralized Trading Policy
1. Introduction to Exposure

Management
2. Exposure Modelling &
According to
includes:

Currencies of major developed markets: USD, GBP, EUR, JPY, CAD, AUD &
CHF

Highly liquid, easily priced, capital efficient marketable securities, currently
government bonds of: USA, UK, Germany, France, Japan, Canada,
Switzerland, Denmark, Netherlands
Measurement
3. Simple Derivative Products
4. Risk Reducing
Techniques

Cash and or securities should be held either by Deutsche Bank or preferred third
party custodians.

Non-standard collateral is considered on a case by case basis subject to approval by
CM, Treasury, business, Legal and CRM (at least A2) with guidance from EMG.
5. Stress Tests
Deutsche Bank
Risk
the “Collateralized Trading Policy” (May 2014) eligible collateral
Exposure Management Group
30
Collateralized Counterparties: Practical Aspects
1. Introduction to Exposure
How much business could be done under a collateral plan?
Management
2. Exposure Modelling &
Measurement
3. Simple Derivative Products
4. Risk Reducing
Techniques
5. Stress Tests
 The potential trading volume depends on the difference between
PFE (VaR) Limit and (Threshold + MTA).
 The greater the room for potential CCE changes, the bigger the
business volume that could be accommodated under the limit.
 PFE (VaR) limit > Threshold + MTA, otherwise the relationship is
effectively uncollateralized.
 In addition to the portfolio PFE (VaR) in cEIS following is reported:
 Total Exposure = CCE after collateral + PFE (VaR)
 Availability under the PFE (VaR) limit calculated as:
PFE (VaR) Limit – { Max [(CCE after Collateral); (Threshold + MTA)] + PFE (VaR)}
 Variation Margin (Collateral): received or posted, direct feed from
dbMargin and Initial Margin (upfront collateral)
Deutsche Bank
Risk
Exposure Management Group
31
Stress Test: Overview
1. Introduction to Exposure
Management
2. Exposure Modelling &
Measurement
3. Risk Systems Overview
 Stress tests allow to identify the impact of large instantaneous
market moves on the portfolio exposure
 Stress tests are a complement to the PFE, but not a replacement of
it!
 Currently there is not a stress test limit framework in place!
4. Simple Derivative Products
5. Risk Reducing Techniques
Stress tests can be used for:
6. Stress Tests
 Visualisation of the trade/ portfolio sensitivity and risk drivers
identification
 Offsetting trade recommendations
 Comparison against limits/ appetite as a complement to the standard
PFE
 Communication with external clients (clients, regulators)
Deutsche Bank
Risk
Exposure Management Group
32
Types of Stress Tests
1. Introduction to Exposure
Management
2. Exposure Modelling &
Type of Scenario
 Portfolio composition may
be different
 Missing risk factors*
Single factor
 Readily available in cEIS
 Easy to understand
 Ignores correlations /
multi-factor effects
 Hard to compare against
limit/appetite
Expected / Economic
 Usually more relevant than
historical
 Useful for capital impact
planning and bank-wide
aggregation
 Not readily available
 Not flexible and can be
misleading at counterparty
level
Constructed
 Scenarios “custom” made for
each portfolio
 All sensitivities available, useful
for custom analysis
 Scenario may not be the
economically most relevant
 Expensive, less frequent
3. Simple Derivative
4. Risk Reducing
Techniques
5. Stress Tests
Cons
 Easy to design
 Easy to explain
 Explicitly includes correlation
Historical
Measurement
Products
Pros
* For example: CDS did not exist in 1994, so credit spreads were not included as a
risk factor into the analysis.
Deutsche Bank
Risk
Exposure Management Group
33
CRM Derivatives Stress Testing
1. Introduction to Exposure
Most stress tests currently are run by EMG or are system-generated:
Management
2. Exposure Modelling &
Measurement
1. Historical scenario:

EMG: designed/ custom scenarios run on an ad hoc basis
3. Simple Derivative
Products
4. Risk Reducing
2. Single-factor stress:

cEIS: default scenarios run daily
Techniques
5. Stress Tests
3. Expected scenario:

MRM: Global Downturn Scenario as part of quarterly capital stress;

EMG: ad hoc on request (e.g. EUR/USD parity or Greece restructuring scenarios
run in 2010)
4. Constructed scenario:

Deutsche Bank
Risk
EMG: monthly as part of global stress test released to each credit team, available
as Excel version and in dbState
Exposure Management Group
34
Stress Test: Example (1)
1. Introduction to Exposure
Suppose an interest rate swap portfolio has the following stress graph:
Management
2. Exposure Modelling &
Measurement
100
80
4. Risk Reducing Techniques
60
5. Stress Tests
EUR mn
3. Simple Derivative Products
40
Limit
20
Stressed CCE
0
-20
-40
-300 bp
-200 bp
-100 bp
0
100 bp
200 bp
300 bp
Change in EUR Interest Rates
Deutsche Bank
Risk
Exposure Management Group
35
Stress Test: Example (2)
1. Introduction to Exposure
Management
Conclusions from the graph:
2. Exposure Modelling &
Measurement
1.
The portfolio is sensitive to rising EUR interest rates
2.
Assuming an instantaneous increase by 100 bps, the CCE will increase
from EUR 23 mn to EUR 45 mn
3.
The CCE limit will be breached if the EUR interest rates rise by about 130
bps
3. Simple Derivative Products
4. Risk Reducing Techniques
5. Stress Tests
An offsetting trade would be: DB receives fixed and pays
floating on EUR 150 mn up to 10 years.
Deutsche Bank
Risk
Exposure Management Group
36
Stress Test: Example (3)
1. Introduction to Exposure
Management
With the recommended trade the stress graph changes
to:
2. Exposure Modelling &
Measurement
100
3. Simple Derivative Products
80
4. Risk Reducing Techniques
60
EUR mn
5. Stress Tests
40
Limit
20
New Stressed CCE
Old Stressed CCE
0
-20
-40
-300 bp
Deutsche Bank
Risk
-200 bp
-100 bp
0
100 bp 200 bp
Change in EUR Interest Rates
Exposure Management Group
300 bp
37