Manufacturing and Managing Customer-Driven Derivatives. Qu Dong

to the quantitative profession is impressive. I also very much enjoyed my professional interactions with Paul Wilmott, Fabio Mercurio, Han Lee, Lane Hughston, Ken Yan, Marek Lusztyn and Juliusz Jabłecki.

      Finally, I'd like to thank my families in UK, China and Poland for their continuous support, which have made my day-to-day professional life and book-writing enjoyable and sustainable.

      About the Author

      Dong Qu (

) obtained a BSc in Physics in China. He came to the UK to pursue a higher degree and completed a PhD in Statistical Laser Optics from Imperial College London. He started working in the City of London in the mid-1990s.

      In the late-1990s, working with colleagues, Dong was instrumental in industrializing barrier reverse convertibles, which have since become one of the most popular structured products. The barrier protection mechanism designed to reduce the risk of capital loss is now an industry-standard risk-reduction tool. It has become a stalwart of the structured product markets and is embedded in many products such as autocallables.

      Dong is currently the global head of the quantitative product group at UniCredit, having previously worked at banks including HSBC, Nikko and Abbey/Santander. He has in-depth knowledge of customer-driven derivatives across major asset classes, including equity, interest rate, FX, credit and real estate. He has spent many years on derivative pricing and hedging models, associated trading and risk management infrastructures, and has first-hand experience of how the customer-driven derivatives industry is operating in the competitive business and regulatory environments.

      Part One

      Overview of Customer-driven Derivative Business

      The derivative business environment has evolved and changed dramatically. Many lessons have been learned, and financial regulations have become more sophisticated and demanding. Product offerings bearing geographic features reflect the importance of the customer-driven derivative business. In order to cope with the evolving business environment and optimize business efficiency and safety, executives need to create an effective organizational structure, streamline the development process for new products and modernize product distribution techniques.

      Financial risk management and the banking global rule book Basel III are the generic parts of the business. Executives must manage economic and regulatory capital requirements along with leverage and liquidity, all of which attribute significantly to the business's bottom line.

      Chapter 1

      Evolving Derivative Business Environment

      The derivatives business has evolved in terms of customer needs, product ranges and models and infrastructure required for managing the derivatives products. It is a business that requires comprehensive understanding of the quantitative and organizational setup, and one must pay attention to the overall picture, as well as individual components.

      Customer-Driven Derivative Product Categories

      Derivative products are explicitly or implicitly embedded in many financial product types:

      • retail structured products;

      • insurance investment products;

      • pension products;

      • securitization products;

      • real estate (property) products;

      • etc.

There are many different ways to categorize customer-driven derivative products: by asset classes, by payoffs, by client sectors, etc. At the high level, they can also be categorized by the intended purposes of the derivative products, as seen in Table 1.1.

Table 1.1 Customer-driven derivative products

      Retail structured derivative products are by far the most varied in product types and payoffs innovation across all major asset classes, including equity, commodity, interest rate, FX and credit. Structured derivative products modify the risk/reward profile and hence the risk-adjusted returns. Their returns can therefore be better defined and clarified. One can also incorporate protection barrier features into many types of product to reduce the risk of losing capital.

      Structured life insurance products also become popular in the low interest rate environment, whereby insurance companies look into new investment areas and products, in order to fulfil the promised coupons embedded in certain products. As life insurance institutions will be subject to Solvency II capital requirement, the products with low guarantee will attract lower capital requirement.

      Structured derivative business has undergone profound changes over the years, in manufacturing processes and distribution mechanisms. The products become more tailor-made, coupled with the fact that distribution channels are moving towards e-platforms, which in turn encourages more individual product features. The manufacturing process encompasses product design, quantitative modelling, trading and risk systems integration, and validation. The overall process has become much more complex and infrastructures must also build in various required regulatory constraints. Therefore an integrated comprehensive manufacturing approach is vital to keep the whole process economically viable. The products' competitions have also been extended towards the longer end, from traditional short-dated (e.g. typically < 5 years) products to long-dated products, including pension products serving the ageing population.

      Financial promotions of derivative products not only require the sell sides to get facts right, i.e. what the product does, what the cash and tenure commitment is it is also a compliant requirement to explain clearly to the customers the risks involved. Setting a strict and high standard on products and their risk management ensures a sustainable product design process which is vital for the long-term success of the derivative business.

      Lessons in Derivatives and Crises

Financial derivatives are a double-edged sword. Understanding and using them well, derivatives can be valuable investment tools, and effective risk management and mitigation instruments. Misunderstanding and misusing them can lead to amplified losses. Over the decades, there have been many documented and undocumented derivative losses. Table 1.2 lists some of the well-known and high profile cases dating back to early 1990s. These derivative losses resulted either from outright wrong and misunderstood positions or from unwinding losses because of forced margin calls.

Table 1.2 Sample derivative losses

      Derivative Losses

      As can be seen in Table 1.2, derivative losses have happened frequently in the past. While the frequency of these occurrences may have become less on average, the individual loss amount has actually become larger. This indicates that lessons have not been learned fully. Derivatives are highly leveraged instruments. One must fully understand the risky nature of the derivatives as well as their practical operational details. It is essential to build adequate technical and operational frameworks before embarking on highly leveraged activities. Derivatives business should consist of a comprehensive set of technical, risk management and operational control tools.

Table 1.2 does not include rogue trading that occurred at Barings, Société Générale and UBS. For completeness, they are listed in Table 1.3 and it is striking to see how similar they all look. The last column shows one of the common features of rogue trading; they all involved liquid index futures. Strong internal operational control is the key to prevent such rogue trading activities.

Table 1.3 Derivative rogue trading losses

      Credit Crunch and European Debt Crisis

The banking landscape has changed forever following two major financial