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Trading and
Capital-Markets Activities Manual
Trading
Activities: Financial Performance
Source: Federal Reserve System
(The complete Activities
Manual (pdf format) can be downloaded from the Federal Reserve's web
site)
The evaluation of financial performance,
or profitability analysis, is a powerful and necessary tool for managing
a financial institution and is particularly important in the control and
operation of trading activities. Profitability analysis identifies the
amount and variability of earnings, evaluates earnings in relation to
the nature and size of risks taken, and enables senior management to judge
whether the financial performance of business units justifies the risks
taken. Moreover, profitability analysis is often used to determine individual
or team compensation for marketing, trading, and other business-line staff
engaged in trading activities. The following four elements are necessary
to effectively assess and manage the financial performance of trading
operations:
• valuing or marking positions to market prices
• assigning appropriate reserves for activities and risks
• reporting results through appropriate chains of command
• attributing income to various sources and products
Valuation of the trading portfolio is critical to effective performance
measurement since the accuracy and integrity of performance reports are
based primarily on the market price or fair value of an institution's
holdings and the process used to determine those prices. The valuation
process is often complex, as the pricing of certain financial instruments
can require the use of highly sophisticated pricing models and other estimators
of fair value. The chief financial officer (CFO) and other senior officers
of the bank must receive comprehensive and accurate information on capital-markets
and trading activities to accurately measure financial performance, assess
risks, and make informed business decisions. Internal profitability reports
should indicate to the CFO and other senior management the sources of
capital-markets and trading income, and assign profits and losses to the
appropriate business units or products (for example, foreign exchange,
corporate bond trading or interest-rate swaps). To prepare these reports,
an institution should specify its methodologies for attributing both earnings
and risks to their appropriate sources such as interest income, bid/offer
spreads, customer mark-up, time decay, or other appropriate factors. Similar
methodologies for allocating reserves should also be established where
appropriate.
Proper segregation of duties and clear reporting lines help ensure the
integrity of profitability and performance reports. Accordingly, the measurement
and analysis of financial performance and the preparation of management
reports are usually the responsibility of a financial-control or other
non-trading function. This responsibility includes revaluing or marking
to market the trading portfolio and identifying the various sources of
revenue. Some banks have begun to place operations and some other control
staff in the business line, with separate reporting to the business head.
Examiners should satisfy themselves that duties are adequately segregated
and that the operations staff is sufficiently independent from trading
and risk-taking functions.
VALUATION
The valuation process involves the initial
and ongoing pricing or ''marking to market'' of positions using either
observable market prices or, for less liquid instruments, fair-value pricing
conventions and models. An institution's written policies and procedures
should detail the range of acceptable practices for the initial pricing,
daily mark-to-market, and periodic independent revaluation of trading
positions. At a minimum, the bank's policies should specifically define
the responsibilities of the participants involved in the trading function
(for example, trading operations, financial-control, and risk-management
staff) to ensure reliable and consistent financial reporting. Pricing
methodologies should be clearly defined and documented to ensure that
they are consistently applied across financial products and business lines.
Proper controls should be in place to ensure that pricing feeds are accurate,
timely, and not subject to unauthorized revisions. Additionally, the firm
should have comprehensive policies and procedures specifically for creating,
validating, revising, and reviewing the pricing models used in the valuation
process. Inadequate policies and procedures raise doubts about the institution's
trading profits and its ability to manage the risks of its trading activities.
Initial Pricing
The initial pricing of positions or transactions is generally the responsibility
of the trader who originates the deal, although a marketer will often
be involved in the process. For those instruments that trade in fairly
liquid markets, the price is usually based on the quoted bid/offer price
plus an origination ''value-added'' spread that may include, for example,
a credit premium or estimated hedge cost, depending on the characteristics
of the product. The prices of less liquid instruments are generally priced
at theoretical market prices, usually determined by pricing models. Regardless
of the type of transaction, an independent control function should review
all new-deal pricing for reasonableness and ensure that pricing mechanics
are consistent with those of existing transactions and approved methodologies.
Significant differences, as defined in written policies, should be investigated
by the control function.
Daily Mark-to-Market Process
Trading accounts should be revalued, or ''marked to market,'' at least
daily to reflect fair value and determine the profit or loss on the portfolio
for financial-reporting and risk-management purposes. Trading positions
are usually marked to market as of the close of business using independent
market quotes. Most institutions are able to determine independent market
prices daily for most positions, including many exotic and illiquid products.
Many complex instruments can be valued using the independent market prices
of various elementary components or risk factors. Automatic pricing feeds
should be used to update positions whenever feasible. When automatic pricing
feeds are not feasible, a separate control function (for example, the
middle- or back-office function) should be responsible for inputting appropriate
pricing data or parameters into the appropriate accounting and measurement
systems, even though traders may have some responsibility for determining
those prices and parameters.
Daily revaluation may not be feasible for some illiquid instruments, particularly
those that are extremely difficult to model or not widely traded. Institutions
may revalue these types of transactions less often, possibly weekly or
monthly. In these cases, written policies should specify which types of
transactions, if any, are exempt from daily revaluation and how often
these transactions must be marked to market.
Independent Price Testing and Revaluation
In addition to the mark-to-market process performed daily, banks should
perform an independent review and revaluation of the trading portfolio
periodically to verify that trading positions reflect fair value, check
the reasonableness of pricing inputs, and assess profitability. The review
must be performed by a control function that is independent from the trading
function. Usually this independent revaluation process is performed monthly;
however, it may be prudent to independently revalue certain illiquid and
harder-to-price transactions, and transactions that are not marked to
market daily, more frequently.
The scope of the testing process will differ across institutions depending
on the size and sophistication of the trading activities conducted. In
many institutions, revaluation of an entire portfolio of relatively simple,
generic instruments may be too time consuming to be efficient, and price
validation may be conducted on a sampling basis. In contrast, more complex
transactions may be revalued in their entirety. Alternatively, an institution
may choose to revalue holdings based on materiality (for example, all
transactions over a dollar threshold). An institution's policies should
clearly define the scope of its periodic valuation-testing process, and
reasonable justification should be provided for excluding certain transactions
from the testing process.
If the value of the portfolios as determined by the periodic (for example,
monthly) independent revaluation is significantly different from the book
value of these portfolios, further investigation is warranted. The materiality
threshold for investigation should be specifically defined in written
policies (such as ''all discrepancies above $x thousand must be investigated
to determine the source of the difference''). When the reason for the
discrepancy is discovered, the institution should determine whether the
financial reports need to be adjusted. Based on the magnitude and pattern
of the pricing inconsistencies, changes to the pricing process or pricing
models may be required.
Results of the month-end valuation process should be formally documented
in sufficient detail to provide a complete audit trail. In addition, a
summary of the results of the independent revaluation should be communicated
to appropriate management and control functions. Reports should be generated
to inform management of the results of the periodic price-testing process
and include, at a minimum, the scope of the testing process, any material
discrepancies between the independent valuations and the reported valuations,
and any actions taken in response to them.
Liquid Instruments and Transactions
For transactions that trade on organized exchanges or in liquid over-the-counter
(OTC) markets, market prices are relatively easy to determine. Trading
positions are simply updated to reflect observable market prices obtained
from either the exchange on which the instrument is listed or, in the
case of OTC transactions, from automated pricing services or as quotes
from brokers or dealers that trade the product. When observable market
prices are available for a transaction, two pricing methodologies are
primarily used-bid/offer or mid-market. Bid/offer pricing involves assigning
the lower of bid or offer prices to a long position and the higher of
bid or offer prices to short positions. Mid-market pricing involves assigning
the price that is midway between bid and offer prices. Most institutions
use mid-market pricing schemes, although some firms may still use bid/offer
pricing for some products or types of trading. Mid-market pricing is the
method recommended by the accounting and reporting subcommittee of the
Group of Thirty's Global Derivatives Study Group, and is the method market
practitioners currently consider the most sound.
Some institutions may use bid/offer pricing for some transactions and
mid-market pricing for others. For example, bid/offer pricing may be used
for proprietary and arbitrage transactions in which the difference between
bid and offer prices and the mid-market price is assumed not to be earned.
Mid-market pricing may be used for transactions in which the firm is a
market maker, and the bid/offer to mid-market spread is earned. Also,
some organizations may value positions on the conservative side of mid-market
by taking a discount or adding a premium to the mid-market price to act
as a ''holdback reserve.'' Firms that use a conservative mid-market valuation
system may mark all positions in this manner or may only value some less
liquid positions this way. Bank policies should clearly specify which
valuation methodologies are appropriate for different types of transactions.
The bid/offer price should be considered a limit on instrument values,
net of any reserves. Net instrument values recorded on the books at market
value should not be below or above the market's bid/offer price, as these
are the values at which a position can be closed. Some institutions have
automated programs that use prices obtained from traders to check whether
the fair values recorded on the firm's financial statements fall within
the bid/offer price. While these programs can help ensure appropriate
pricing regardless of the specific method used, a firm should still have
a sound, independent daily revaluation that does not rely solely on traders
marking their positions to market.
Whether bid/offer or mid-market pricing is used, it is important that
banks use consistent time-of-day cut-offs when valuing transactions. For
example, instruments and their related hedges should be priced as of the
same time even if the hedging item trades on an exchange with a different
closing time than the exchange on which the hedged item trades. Also,
all instruments in the same trading portfolio should be valued at the
same time even if they are traded at different locations. Price quotes
should be current as of the time of pricing and should be consistent with
other trades that were transacted close to the same time.
For liquid exchange-traded or OTC products, the monthly revaluation process
may simply entail a comparison of book values with exchange or broker-dealer
quotations. In these cases, it should be known whether the party providing
the valuation is a counterparty to the transaction that generated the
holding or is being paid for providing the valuation as an independent
pricing service. Firms should be aware that broker-dealer quotes may not
necessarily be the same values used by that dealer for its internal purposes
and may not be representative of other ''market'' or model-based valuations.
Therefore, institutions should satisfy themselves that the external valuations
provided are appropriate.
Illiquid Instruments and Transactions
Illiquid, non-traditional, and user-specific or customized transactions
pose particular pricing challenges because independent third-party prices
are generally unavailable. For illiquid products that are traded on organized
exchanges, but where trades occur infrequently and available quotes are
often not current, mark-to-market valuations based on the illiquid market
quotes may be adjusted by a holdback reserve that is created to reflect
the product's reduced liquidity (see ''Holdback Reserves'' below). For
illiquid OTC transactions, broker quotes may be available, albeit infrequently.
When broker quotes are available, the bank may use several quotes to determine
a final representative valuation. For example, they may compute a simple
average of quotes or eliminate extreme prices and average the remaining
quotes. In such cases, internal policies should clearly identify the methodology
to be used.
When the middle or back office is responsible for inputting broker quotes
directly, the traders should also be responsible for reporting their positions
to the middle- or back-office function as an added control. Any differences
in pricing should be reconciled. When brokers are responsible for inputting
data directly, it is crucial that these data are verified for accuracy
and appropriateness by the middle or back office.
For many illiquid or customized transactions, such as highly structured
or leveraged instruments and more complex, non-standard notes or securities,
reliable independent market quotes are usually not available, even infrequently.
In such instances, other valuation techniques must be used to determine
a theoretical, end-of-day market value. These techniques may involve assuming
a constant spread over a reference rate or comparing the transaction in
question with similar transactions that have readily available prices
(for example, comparable or similar transactions done with different counterparties).
More likely, though, pricing models will be used to price these types
of customized transactions. Even when exchange prices exist for a financial
instrument, market anomalies in the pricing may exist, making consistent
pricing across the instrument difficult. For example, timing differences
may exist between close of the cash market and futures markets causing
a divergence in pricing. In these cases, it may be appropriate to use
theoretical pricing, and again, pricing models may be used for this purpose.
When conducting the monthly revaluation, the validity of portfolio prices
can be tested by reviewing them for historical consistency or by comparing
actual close-out prices or the performance of hedge positions to model
predictions. In some instances, controllers may run parallel pricing models
as a check on the valuations derived by trader models. This method is
usually only used for the more exotic, harder-to-price products.
Pricing Models
Pricing models can either be purchased from vendors or developed internally
and they can be mainframe or PC-based. Internally developed models are
either built from scratch or developed using existing customized models
that traders modify and manipulate to incorporate the specific characteristics
of a transaction.
The use of pricing models introduces the potential for model risk into
the valuation process. Model risk is the risk that faulty pricing models
will result in inaccurate valuations of holdings, which results in trading
losses to the institution. Model risk can result from inadequate development
or application of a model, the assumptions used in running a model, or
the specific mathematical algorithms on which a model is based. Accordingly,
effective policies and procedures related to model development, model
validation and model control are necessary to limit model risk. At a minimum,
policies for controlling model risk should address the institution's process
for developing, implementing, and revising pricing models. The responsibilities
of staff involved in the model-development and model-validation process
should be clearly defined.
In some institutions, only one department or group may be authorized to
develop pricing models. In others, model development may be initiated
in any of several areas related to trading. Regardless of the bank function
responsible for model development and control, institutions should ensure
that modeling techniques and assumptions are consistent with widely acceptable
financial theories and market practices. When modeling activities are
conducted in separate business units or are decentralized, business-unit
polices governing model development and use should be consistent with
overall corporate polices on model-risk management. As part of these policies,
institutions should ensure that models are properly documented. Documentation
should be created and maintained for all models used, and a model-inventory
database should be maintained on a corporate-wide or business-line basis.
Before models are authorized for use, they should be validated by individuals
who are not directly involved in the development process or do not have
methodological input to the model. Ideally, models should be validated
by an independent financial-control or risk-management function. Independent
model validation is a key control in the model-development process and
should be specifically addressed in a firm's policies. Management should
be satisfied that the underlying methodologies for all models are conceptually
sound, mathematically and statistically correct, and appropriate for the
model's purpose. Pricing methodologies should be consistent across business
lines. In addition, the technical expertise of the model validators should
be sufficient to ensure that the basic approach of the model is appropriate.
All model revisions should be performed in a controlled environment, with
changes either made or verified by a control function. When traders are
able to make changes to models outside of a controlled environment, an
inappropriate change may result in inaccurate valuation. Under no circumstances
should traders be able to determine valuations of trading positions by
making changes to a model unless those changes are subject to the same
review process as a new type of transaction. Accordingly, written policies
should specify when changes to models are acceptable and how those revisions
should be accomplished. Controls should be in place to prevent inappropriate
changes to models by traders or other unauthorized personnel. For example,
models can be coded or date marked so that it is obvious when changes
are made to those models. Rigorous controls on spreadsheet-based models
should ensure their integrity and prevent unauthorized revisions. The
control function should maintain copies of all models used by the traders
in case those used on the trading floor are corrupted.
Models should be reviewed or reassessed at some specified frequency, with
the most important or complex models reviewed at least once a year. In
addition, models should be reviewed whenever major changes are made to
them. The review process should be performed by a group independent from
the traders, such as a control or risk-analysis function. As appropriate,
model reviews should consider changes in the types of transactions handled
by the model, as well as changes in generally accepted modeling conventions
and techniques. Model reviews should incorporate an investigation of actual
verses expected performance and fully incorporate assessment of any hedging
activity. Significant deviation in expected versus actual performance
and unexplainable volatility in the profits and losses of trading activities
may indicate that market-defined hedging and pricing relationships are
not being adequately captured in a model. The model-review process should
be clearly defined and documented, and these policies should be communicated
to the appropriate parties throughout the organization.
In addition to the periodic scheduled reviews, models should always be
reviewed when new products are introduced or changes in valuations are
proposed. Model review may also be prompted by a trader who feels that
a model should be updated to reflect the significant development or maEagle
Tradersg of a market. In some cases, models may start out as a PC-based
spreadsheet model and are subsequently transformed to a mainframe model.
Whenever this occurs, the model should be reviewed and any resulting changes
in valuation should be monitored. Banks should continually monitor and
compare their actual cash flows versus model projections, and significant
discrepancies should prompt a model review.
Pricing-Model Inputs
Pricing models require various types of inputs, including hard data, readily
observable parameters such as spot or futures prices, and both quantitatively
and qualitatively derived assumptions. All inputs should be subject to
controls that ensure that they are reasonable and consistent across business
lines, products, and geographic locations. Assumptions and inputs regarding
expected future volatilities and correlations, and the specification of
model-risk factors such as yield curves, should be subject to specific
control and oversight. Important considerations in each of these areas
are as follows:
• Volatilities. Both historically determined and implied volatilities
should be derived using generally accepted and appropriately documented
techniques. Implied volatilities should be reviewed for reasonableness
and derived from closely related instruments.
• Correlations. Correlations should be well documented and estimated
as consistently as practicable across products and business lines. If
an institution relies on broker quotes, it should have an established
methodology for determining the input to be used from multiple quotes
(such as the average or median).
• Risk factors. Pricing models generally decompose instruments
into elementary components, such as specific interest rates, currencies,
commodities, and equity types. Interest rates and yield curves are particularly
important pricing-model-risk factors. Institutions should ensure that
the risk factors in general, and the yield curves in particular, used
in pricing instruments are sufficiently robust (have sufficient estimation
points). Moreover, the same types of yield curves (spot, forward, yield-to-maturity)
should be used to price similar products.
During the periodic revaluation process, many institutions may perform
a formal verification of model-pricing inputs, including volatilities,
correlation matrices, and yield curves.
HOLDBACK RESERVES
Mark-to-market gains and losses on trading
and derivatives portfolios are recognized in the unit's profits and losses
and incorporated into the value of trading assets and liabilities. Often
a bank will ''hold back,'' or defer, the recognition of a certain portion
of first-day profits on a transaction for some period of time. Holdback
reserves are usually taken to reflect uncertainty about the pricing of
a transaction or the risks entailed in actively managing the position.
These reserves represent deferred gains that may or may not be realized,
and they are usually not released into income until the close or maturity
of the contract.
Holdback reserves can also be taken to better match trading revenues with
expenses. Certain costs associated with derivatives transactions, such
as credit, operational, and administrative costs, may be incurred over
the entire lives of the instruments involved. In an effort to match revenue
with expenses, an institution may defer a certain portion of initial profit
or loss generated by a transaction and then release the reserve into income
over time. By deferring a portion of the profits or losses, holdback reserves
may avoid earnings overstatement and more accurately match revenues and
expenses.
Reserving methodologies and the types of reserves created vary among institutions.
Even within firms, the reserving concept may not be consistent across
business lines, or the concept may not be applied consistently. At a minimum,
policies regarding holdback reserves should define (1) the universe of
risks and costs that are to be considered when creating holdback reserves,
(2) the methodologies to be used to calculate them, and (3) acceptable
practices for recognizing the reserves into the profits and losses of
the institution.
General policies for holdback reserves should be developed by a group
independent from the business units, such as the financial-control area.
This group may also be responsible for developing and implementing the
policy. Alternatively, individual business lines may be given responsibility
for developing an implementation policy. If implementation policies are
developed by individual business lines, they should be periodically reviewed
and approved by an independent operating group. Most importantly, the
traders or business units should not be able to determine the level of
holdback reserves and, hence, be able to determine the fair value of trading
positions. In general, reserving policies should be formula-based or have
well-specified procedures to limit subjectivity in the determination of
fair value. Reserve policies should be reviewed periodically and revised
as necessary.
Reserve Adequacy
An insufficient level of holdback reserves may cause current earnings
to be overstated. However, excess holdback reserves may cause current
earnings to be understated and subject to manipulation. Accordingly, institutions
should develop policies detailing acceptable practices for the creation,
maintenance, and release of holdback reserves. The level of holdback reserves
should be periodically reviewed for appropriateness and reasonableness
by an independent control function and, if deemed necessary, the level
should be adjusted to reflect changing market conditions. Often, the reasonableness
of reserves will be checked in conjunction with the month-end revaluation
process.
Creating Reserves
All holdback reserves should be recognized in the internal reports and
financial statements of the institution, whether they are represented
as ''pricing adjustments'' or as a specified holdback of a transaction's
profit or loss. Any type of holdback reserve that is not recorded in the
financial records should be avoided. Reserves may be taken either on a
transaction-by-transaction basis or on an overall portfolio basis. Written
policies should clearly specify the types of holdback reserves that are
appropriate for different portfolios and transactions.
While holdback reserves may be created for a variety of risks and costs,
the following are the most common types:
• Administrative-cost reserves. These reserves are intended to
cover the estimated future costs of maintaining portfolio positions to
maturity. Administrative-cost reserves are typically determined as a set
amount per transaction based on historical trends.
• Credit-cost reserves. These reserves provide for the potential
change in value associated with general credit deterioration in the portfolio
and with counterparty defaults. They are typically calculated by formulas
based on the counterparty credit rating, maturity of the transaction,
collateral, netting arrangements, and other credit factors.
• Servicing-cost reserves. These reserves provide for anticipated
operational costs related to servicing the existing trading positions.
• Market-risk reserves. These reserves are created to reflect a
potential loss on the open risk position given adverse market movements
and an inability to hedge (or the high cost of hedging) the position.
This includes dynamic hedging costs for options.
• Liquidity-risk reserves. These reserves are usually a subjective
estimate of potential liquidity losses (given an assumed change in value
of a position) due to the bank's inability to obtain bid/offer in the
market. They are intended to cover the expected cost of liquidating a
particular transaction or portfolio or of arranging hedges that would
eliminate any residual market risk from that transaction or portfolio.
• Model-risk reserves. These reserves are created for the expected
profit and loss impact of unforeseen inaccuracies in existing models.
For new models, reserves are usually based on an assessment of the level
of model sophistication.
Recording Reserves
Holdback reserves may be separately recorded in the general-ledger accounts
of each business entity, or they may be tracked on a corporate-wide basis.
These reserves are usually recorded on the general-ledger account as a
contra trading asset (representing a reduction in unrealized gains), but
some banks record them as a liability. Alternatively, reserves for some
risks may be recorded as a contra asset and reserves for other risks recorded
as a liability. Holdback reserves can be netted against ''trading assets,''
included in ''other liabilities,'' or disclosed separately in the published
financial statements. Institutions should ensure that they have clear
policies indicating the method to be used in portraying reserves in reports
and financial statements.
Releasing Reserves
An institution's policies should clearly indicate the appropriate procedure
for releasing reserves as profits or losses. Holdback reserves created
as a means of matching revenues and expenses are usually amortized into
income over the lives of the individual derivative contracts. Reserves
that are created to reflect the risk that recognized gains may not be
realized due to mispricing or unexpected hedging costs are usually released
in their entirety at the close or maturity of the contract, or as the
portfolio changes in structure. If reserves are amortized over time, a
straight-line amortization schedule may be followed, with reserves being
released in equal amounts over the life of the transaction or the life
of the risk. Alternatively, individual amortization schedules may be determined
for each transaction.
INCOME ATTRIBUTION
Profits and losses (P&L's) from trading
accounts can arise from several factors. Firms attempt to determine the
underlying reasons for value changes in their trading portfolios by attributing
the profits and losses on each transaction to various sources. For example,
profits and losses can be attributed to the ''capture'' of the bid/offer
spread-the primary aim of market making. Another example is the attribution
of profit to ''origination,'' the difference between the fair value of
the created instrument and the contracted transaction price. Profit and
loss can also result from proprietary position-taking. Proper attribution
of trading revenues is crucial to understanding the risk profile of trading
activities. The ability of an institution to accurately determine the
sources of daily P&L on different types of financial instruments is
considered a key control to ensure that trading-portfolio valuations are
reasonable. The discipline of measuring and attributing P&L performance
also ensures that risks are accurately measured and monitored.
The income-attribution process should be carried out by a group independent
from the traders; in most larger institutions, attribution is the responsibility
of the risk-management or middleoffice function. The designated group
is responsible for conducting analysis of the institution's transactions
and identifying the various sources of trading P&L for each product
or business line. These analyses may cover only certain types of transactions,
but increasingly they are being applied to all products. The income-attribution
process should be standardized and consistently applied across all business
units. The goal of income-attribution analyses is to attribute, or ''explain,''
as much of the daily trading P&L as possible. A significant level
of ''unexplained'' P&L or an unusual pattern of attribution may indicate
that the valuation process is flawed, implying that the bank's reported
income may be either under- or overstated. It may also point to unexplained
risks that are not adequately identified and estimated.
Explained Profits and Losses
Profits and losses that can be attributed to a risk source are considered
''explained P&L.'' Institutions with significant trading activities
should ensure they have appropriate methodologies and policies to attribute
as much revenue as practicable. For example, some institutions may define
first-day profit as the difference between the mid-market or bid/offer
price and the price at which the transaction was executed. This first-day
profit may then be allocated among sources such as the sales desk, origination
desk, and proprietary trading desk, as well as to holdback reserves. Any
balance in the first-day profit may then be assigned to the business or
product line that acquired the position. As the position is managed over
time, subsequent P&L attributions are made based on the effectiveness
of a trading desk's management of the position. In turn, the trading desk
may further attribute P&L to risk sources and other factors such as
spread movements, tax sensitivity, time decay, or basis carry. Many trading
desks go on to break out their daily P&L with reference to the actual
risks being managed-for example delta, gamma, theta, rho, and vega. Institutions
should ensure that they provide an independent review for the reasonableness
of all revenue splits.
Unexplained Profits and Losses
Unexplained profits and losses is defined as the difference between actual
P&L and explained P&L. If the level of unexplained P&L is
considered significant, the control function should investigate the reason
for the discrepancy. It may be necessary to make changes to the pricing
process as a result of the investigation. For example, models may be modified
or the choice of pricing inputs, such as volatilities and correlations,
may be challenged. The level of unexplained P&L considered significant
will vary among institutions, with some firms specifically defining a
threshold for investigation (for example, ''unexplained P&L above
$x thousand dollars will be investigated''). Some institutions permit
risk-control units to decide what is significant on a case-by-case basis.
Alternatively, management ''triggers,'' such as contract limits, may identify
particular movements in P&L that should be reviewed.
REPORTS TO MANAGEMENT AND DISCLOSURES
TO CUSTOMERS
Reports to Management
An independent control function should prepare daily P&L breakout
reports and official month-end P&L breakout reports that are distributed
to senior management. Daily reports that identify the profits and losses
of new deals should be provided to appropriate management and staff, including
trading-desk managers. These reports should include P&L explanations
by source and risks for each trading book. New-deal reports may also be
generated periodically to provide information on all new deals transacted
during the period. This information may include the customer names, maturities,
notional amounts, portfolio values, holdback reserves, and new-deal profits
and losses. At a minimum, senior management should receive the formal
month-end P&L explanation reports.
Providing Valuations to Customers
Trading institutions are often asked to provide valuations of transacted
products to their customers. Quotes may be provided on a daily, weekly,
monthly, or less frequent basis at the customer's request. Even when valuations
are not requested by the client, sales personnel may follow the clients'
positions and notify them of changes in the valuation of their positions
due to market movements. Some firms will provide quotes for all of the
positions in their customers' portfolios-not just the transactions executed
with the firm. Firms may also formally offer to give valuations to certain
customers for certain lower-risk products.
Generally, price quotes are taken from the same systems or models used
to generate end-of-day mark-to-market values for the firm's own reports
and financial records, usually at mid-market. Holdback reserves are generally
not included in the valuation given to customers. In all cases, price
quotes should be accompanied by information that describes how the value
was derived. If internally validated models are used to determine a transaction
value, this fact should be made clear and the underlying valuation assumptions
provided.
In making any price quotes, institutions should include a disclaimer stating
the true nature of any quote-such as ''indication only'' or ''transaction
price.'' Disclosures should state the characteristics of any valuation
provided (for example, mid-market, indicative, or firm price). In markets
that have specific conventions for determining valuations, firms should
usually supply valuations using those conventions unless otherwise agreed
to by the customer.
Although traders and marketers should receive and review all valuations
distributed to customers, customer valuations should be provided primarily
by a back- or middle-office function to maintain segregation from the
front office. Internal auditors may review valuations provided to clients
to ensure consistency with the values derived from the independent pricing
models and consistency with internal mark-to-market processes.
Financial Performance
Examination Objectives
1. To review the institution's internal reporting of revenues and expenses
to ensure that these reports are prepared in a manner that accurately
measures capital-markets and trading results and are generally consistent
with industry norms.
2. To review management information reports for content, clarity, and
consistency. To ensure that reports contain adequate and accurate financial
data for sound decision making, particularly by the chief financial officer
and other senior management.
3. To assess whether the institution adequately attributes income to its
proper sources and risks. To assess whether the allocation methodology
is sufficient.
4. To review the level of profits, risk positions, and specific types
of transactions that result in revenues or losses (by month or quarter)
since the prior examination to ascertain-
a. reasonableness,
b. consistency,
c. consistency with management's stated strategy and budget assumptions,
d. the trend in earnings,
e. the volatility of earnings, and f. the risk-reward profile of specific
products and business units.
5. To review management's monitoring of capital-markets and trading volumes.
6. To assess whether the institution's market--risk-measuring system adequately
captures and reports to senior management the major risks of the capital-markets
and trading activities.
7. To determine the extent that capital-markets and trading activities
contribute to the overall profitability and risk profile of the institution.
8. To recommend corrective action when policies, procedures, practices,
or internal reports or controls are found to be deficient.
Financial Performance
Examination Procedures
These procedures represent a list of processes and activities that may
be reviewed during a full-scope examination. The examiner-in-charge will
establish the general scope of examination and work with the examination
staff to tailor specific areas for review as circumstances warrant. As
part of this process, the examiner reviewing a function or product will
analyze and evaluate internal-audit comments and previous examination
work-papers to assist in designing the scope of examination. In addition,
after a general review of a particular area to be examined, the examiner
should use these procedures, to the extent they are applicable, for further
guidance. Ultimately, it is the seasoned judgment of the examiner and
the examiner-in-charge as to which procedures are warranted in examining
any particular activity.
1. Obtain all profitability reports which are relevant to each business
line or group. For each line or group, identify the different subcategories
of income that are used in internal profit reports.
2. Assess the institution's methodology for attributing income to its
sources. Check whether the allocation methodology makes sufficient deductions
or holdbacks from the business line to account for the efforts of sales,
origination, and proprietary trading, and whether it properly adjusts
for hedging costs, credit risks, liquidity risks, and other risks incurred.
An adequate methodology should cover each of these factors, but an institution
need not make separate reserve categories for each risk incurred. However,
such institutions should be making efforts to allocate income more precisely
among these different income sources and risks.
3. Review management information reports for content, clarity, and consistency.
Determine if reports contain adequate financial data for sound decision
making.
4. Review internal trading-income reports to ensure that they accurately
reflect the earnings results of the business line or group. Check whether
internal profitability reports reflect all significant income and expenses
contributing to a business line or group's internally reported income.
5. Check whether internal reporting practices are in line with industry
norms and identify the rationale for any significant differences.
6. Check whether amortization and depreciation costs and other overhead
costs are appropriately allocated among the appropriate business areas.
7. Determine whether reserves for credit risk and other risks are sufficient
to cover any reasonably expectable losses and costs.
8. Review the institution's progress in implementing or updating the methodology
for attributing income to the appropriate sources.
9. Analyze the quality of earnings. Review the level of profits and specific
types of transactions that result in revenues or losses (by month or quarter)
since the prior examination to determine-
a. reasonableness,
b. consistency,
c. consistency with management's stated strategy and budgeted levels,
d. the trend in earnings,
e. the volatility of earnings, and
f. the risk/reward profile of specific products or business units.
10. Review the volume of transactions and positions taken by the institution
for reasonableness, and check that the institution has a system for effectively
monitoring its capital markets and trading volumes.
11. Determine whether the market-risk-measuring system provides the chief
financial officer and other senior management with a clear vision of the
financial institution's market portfolio and risk profile.
12. Determine the extent that trading activities contribute to the overall
profitability of the institution. Determine how the trend has changed
since the prior examination.
13. Recommend corrective action when methodologies, procedures, practices,
or internal reports or controls are found to be deficient.
Financial Performance
Internal Control Questionnaire
1. How does the institution define trading income? Does it cover interest,
overhead, and other expenses related to the business line in that line's
income reports? Do internal income reports accurately reflect the results
of the business line? Is the breakdown of business-line income into components
sufficient to identify the main sources of profitability and expenses?
What variations are there from the general market practice for internal
reporting of business-line income?
2. What is the methodology for allocating income to its sources? Do the
allocations make sufficient deductions or holdbacks to account for the
efforts of sales, origination, and proprietary trading? Do they properly
adjust for hedging costs, credit risks, liquidity risks, and other risks
incurred?
3. What steps is the institution taking to enhance its income-allocation
system?
4. How frequently are earnings reported to middle and senior management?
Are the reports comprehensive enough for the level of activity? Can they
be used for planning and trend analysis? How often and under what circumstances
are these reports sent to the chief financial officer, the president,
and members of the board of directors?
5. Evaluate the sources of earnings. Are earnings highly volatile? What
economic events or market conditions led to this volatility?
a. Are there any large, nonrecurring income/expense items? If so, why?
b. Is profitability of the business unit dependent on income generated
from one particular product? Is profitability of the business unit overly
dependent on income generated from one particular customer or related
group of customers? How diverse is the generation of product and customer
profitability?
c. Is the institution taking an undue amount of credit risk or market
risk to generate its profits? Is the institution ''intermediating'' in
transactions for a credit ''spread''? What is the credit quality of the
customers in which the institution is taking credit risk in the trading
unit?
6. How does the institution monitor and control its business-line and
overall volume of capital-markets and trading activities?
7. Does the market-risk-measuring system adequately capture and report
to the chief financial officer and senior management the major risks from
the capital-markets and trading activities?
8. Does the market-risk-measuring system provide the chief financial officer
and other senior management with a clear vision of the financial institution's
market portfolio and risk profile? How does management compare the profitability
of business lines with the underlying market risks?
9. What is the contribution of trading activities to the overall profitability
of the institution? How has the trend changed since the prior examination?
10. Evaluate the earnings of new-product or new-business initiatives.
What is the earnings performance and risk profile for these areas? What
are management's goals and plans for these areas?
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