Trading and Risk Management

1
Trading and Risk Management

• Dr. Jack Yeager, Associate Partner
• Eric Penney, Associate Partner

2
Agenda

• Introduction
• Overview of the Trading Organization
• Front Office
• Middle Office
• Back Office
• QA

ü
3
Introduction - Accenture

• Broad and deep global resources
• More than 75,000 people in 47 countries
• Expertise in 18 industries across all areas
• We quickly mobilize our resources to accelerate
  results
• Drive innovation through network of consulting,
  outsourcing, affiliates and alliances
• Strong heritage of technology innovation and
  delivery excellence
• Proven history of identifying and seizing
  industry trends

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Accenture offers an integrated, holistic approach
to enable trading and risk management
capabilities.

• Strategy
• Development of strategic vision and approach to
  increase shareholder value through TRM
  capabilities
• Market assessments and entry strategies
• Development of corporate trading and risk policies

• Process
• Business process design and reengineering to
  execute on strategy
• Robust and consistent approach for decomposing /
  modeling assets
• Implementation of risk measures and analysis
  required to make business decisions

• People
• Organization design and policy development
• Performance measurement design and implementation
• Change management and business readiness related
  to new capabilities

• Technology
• Integration of best of breed applications to
  create powerful TRM solutions
• Design / development of data warehousing and
  middleware capabilities
• Flexible and scalable technical architectures and
  analytics

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Introduction - Accenture
Accentures Trading and Risk Management (TRM)
group has worked with leading energy marketing
and trading organizations to design, develop, and
implement business strategies and solutions. The
breadth of our experience includes, but is not
limited to

• Strategic Planning
• Market assessments
• Market entry strategies
• Business model practices
• Business diagnostics

• Trading policy and procedure creation
• Process reengineering
• Packaged system implementation
• Custom development of complex risk management
  and back office capabilities

We have deep vendor relationships to facilitate
technology solution selection, design, and
implementation efforts.
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Agenda

• Introduction
• Overview of the Trading Organization
• Front Office
• Middle Office
• Back Office
• QA

ü
7
What is Risk?

• Risk Uncertainty x Exposure

• Business Risks No control over uncertainty, so
  manage exposure

• Operational Risks Some control over
  uncertainty, exposure often difficult to
  quantify.

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How do you manage Risk?

• Business Risks Change exposure
• Operational Risks Organizational
  Structure

• Trading
• Origination and Development
• M A
• Contract Terms

• Process
• Information
• Technology

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Risks in commodity trading

• Operational Risk
• Market Risk
• Counterparty Risk
• Other

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Operational Risk

• What is operational risk?
• What are the consequences of not managing it?
• How do you manage it?

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What is Operational Risk?

• Performance failure within own organization
• Failure of machinery
• Transmission errors
• Misunderstanding
• Quality problems

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Operational Risk Consequences

• Union Bank of Switzerland
• Area Derivatives Desk
• Loss 700m
• Risk Mathematical pricing models inaccurate
• Operational weaknesses
• Conflict of Responsibilities
• Risk Manager also responsible for P/L
• Sales Manager also responsible for financial
  market risk assessment
• No effective daily marking to market
• Risk Manager failed to monitor derivatives desk
• Market signals ignored - relative pricing of UBS
  to other Banks

• Barings
• Area Singapore Equity Derivatives Operation
• Loss 1bn, Firm Bankruptcy
• Risk Huge exposure to market falls
• Operational weaknesses
• Conflict of responsibilities - Head of Trading
  also Head of Back Office
• No effective Monitoring Limits, Customer
  accounts and Marking to market
• Lack of understanding - senior managers unaware
  of products and real risks involved in their
  trading
• Ineffective Limit setting - cash flow limits not
  coordinated with capital limits

• Louisville Gas Electric (LGE)
• Area Merchant Power Trading
• Loss 225m
• Risk Long term fixed price contracts not hedged
• Operational weaknesses
• Lack of effective Risk Management
• Poor market understanding - did not understand
  volatility of the market
• Did not hedge fixed price sale contracts
  effectively - forced to close position in spot
  market

• Metallgesellschaft
• Area Refining and Marketing
• Loss 1.3bn
• Risk Strategy was reliant on stable oil prices
• Operational weaknesses
• Inappropriate responsibilities - CFO controlled
  trading decisions
• No monitoring - CFOs trading activity not
  monitored
• Lack of Product understanding - hedging of long
  term commitments with short term futures created
  exposure to volatile oil prices

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Operational Risk Consequences

• Enrons commodities trading probed
• Investigation indicates breadth of U.S. digging
  into collapse
• also looking at the Houston companys derivatives
  trading through its EnronOnline business, an
  electronic trading system
• CFTC is probing whether Enron committed fraud or
  manipulated markets through improper trading on
  commodity exchanges

Enron
Senator Enron collapse shows power markets need
oversight Although Enrons fiscal flameout
eclipsed billions in wealth from stock portfolios
and retirement accounts, it hasnt damaged the
nations energy trading markets or supply
Source MSNBC
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Managing Operational Risk

• Organizational Structure
• Processes
• Technology
• Information

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Organizational Structure
Organizational Structure to manage operational
Risk
BOARD or CEO/CFO
Head of Risk Control
Head of Trading Operations
Head of Back Office Operations
Risk Control
Marketing
Structuring
Trading Cash/Derivatives
Settlement
Confirmation
Contract Admin
Legal Compliance
Position Financing
Information Analysis
Scheduling
Front Office
Back Office
Middle Office
Systems Support
While these offices of a trading organization
need to work closely together, it is important
that there remains an organisational reporting
separation
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Operational Risk Processes
17
Operational Risk Processes
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Operational Risk Processes
New Trade Requirement
Change Portfolio?
Yes
Determine Approach to Address
Exposure / Stress Analysis
Portfolio
No
Change Limits?
Yes
MTM Analysis
Set Trading Limits
No
Is Portfolio within Limits
No
VaR Analysis
Yes
Did Trader violate trading policy?
Credit Analysis
Yes
Discipline Trader
No
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Agenda

• Introduction
• Overview of the Trading Organization
• Front Office
• Middle Office
• Back Office
• QA

ü
20
Front Office
Front Office
Back Office
Middle Office
Head of Trading Operations
Head of Back Office Operations
Head of Risk Control
Risk Control
Marketing
Structuring
Trading Cash/Derivatives
Settlement
Confirmation
Contract Admin
Position Financing
Legal Compliance
Information Analysis
Scheduling
Systems Support
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Front Office Functions

• Trading
• Structuring
• Marketing
• Information and Analysis
• Scheduling ???
• Risk Management ???

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Trade Execution Process
No
Is Portfolio structure consistent
with market view?
No
Deal Struck?
Portfolio
New Trade Requirement
Talk to Trading Partners
Talk to Brokers
Talk to Trading Partner
Negotiate Deal
Yes
Yes
OTC
Market View
Trade Exchange or OTC?
EnterDeal
Exchange
Yes
Yes
Can short term physical obligations be met?
No
Order Filled?
Analyze Market News
Analyze Market Prices
Talk to Exchange Broker
Place Order
No
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Agenda

• Introduction
• Overview of the Trading Organization
• Front Office
• Middle Office
• Back Office
• QA

ü
24
Middle Office
Front Office
Back Office
Middle Office
Head of Trading Operations
Head of Back Office Operations
Head of Risk Control
Risk Control
Marketing
Structuring
Trading Cash/Derivatives
Settlement
Confirmation
Contract Admin
Position Financing
Legal Compliance
Information Analysis
Scheduling
Systems Support
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Credit risk

• As buyers
• Is my counterparty creditworthy?
• (credit risk)
• As sellers
• Will they/can they perform
• (performance risk)
• As either
• Is my counterpart
• operationally competent?
• (operational risk)

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Recent events have underlined the importance of
managing credit well in the energy sector.
Dow Jones Utility Index vs. SP 500 vs. Dow
Jones industrials
Market Capitalization (Billion)
27
An analysis of 500 banks over 10 years indicates
that credit risk management performance impacts
shareholder value.
The market discounts credit losses at a 21
multiple
(0)
For the average bank
(50)
-1.92
(100)
Market Value Impact

• Realizing 50 million in annual net charge-offs
  reduces market value by 100 million
• 5 million year-to-year swings in annual net
  charge-offs reduces market value by 150 million

(150)
(200)
0.00
2.00
4.00
6.00
8.00
10.00
Net Charge-Offs
But discounts loss volatility at more than a 201
multiple
(0)
(50)
Market Value Impact
(100)
(150)
(200)
0.00
2.00
4.00
6.00
8.00
10.00
Net Charge-Offs Volatility (Average NCO 5.00)
28
Credit and liquidity practices in the energy
sector have created a fragile industry structure
that is poised for collapse.
The Outcomes
The Problem

• Large, deadweight working capital costs that hurt
  company performance and stock price
• High bankruptcy costs
• Collateral management behavior that becomes
  unpredictable in a industry liquidity crisis
• Capital costs so high that valuable investments
  and growth opportunities must be curtailed

• Bilateral credit arrangements that are costly and
  informal
• Custom post-default loss mitigation arrangements
• Retention of credit exposure on energy company
  balance sheets ill-suited to carry the risk
• Aggregate, net credit exposure that exceeds
  aggregate, industry credit capacity
• An OTC market structure lacking an historical
  clearinghouse model

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The fact is that many major energy companies have
more credit exposure on their balance sheet than
a typical commercial bank.
Credit Exposure ( Millions)
1,750.4
Regional Bank A
2,156.7
Regional Bank B
4,162.8
Energy Marketer A
1,945.0
BP North America
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Yet the range of credit risk management practices
among energy companies falls well short of
standard banking practices.
Energy Company A
Energy Company B
Energy Company C
Energy Company D
Energy Company E
Standard Bank
The Credit Process
Credit Risk Strategy and Planning

• Business objectives
• Credit performance objectives
• TMDs and RACs
• Customer selection

• Origination
• Underwriting and structuring
• Booking and servicing
• Credit enhancement
• Distribution

Credit Transaction Management
Credit Performance Monitoring and Management

• Credit portfolio and transaction performance
  monitoring
• Portfolio management
• Credit risk capacity management

Checks and Balances

• Credit culture
• Organization
• Rewards
• Controls

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What is needed are higher quality credit
practices supported by a complete set of industry
features.
Credit Practices
Industry Features

• More transparency in external reporting
• Deeper industry knowledge and rating acumen at
  rating agencies
• Enhanced master agreement language
• Enhanced bilateral netting arrangements
• Multilateral netting through a central
  counterparty

• Planning and managing the credit capacity that
  the businesses require
• Credit scoring, loss forecasting, credit
  structuring
• Counterparty-specific credit covenants
• Knowing the cost of credit
• Single-name credit aggregation
• Management of volatile liquidity positions

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If energy companies choose to adopt the banking
model, credit risk management would be shared
across three functions.
One Face to the Business
One Face to the Customer

• Credit Line Management
• CP Approval
• Collateral Management

Deal Origination Business Units
CP Management and Fulfillment BU Credit
Credit Risk Management
Day-to-day Operational Interactions

• Credit Risk Mitigation
• Strategies
• Forward Credit Views
• Portfolio Mix Guidance
• Credit Structuring Guidance

• Cost of Credit
• Recommend Credit Modeling Approach

Deal Origination Information
Portfolio Management ERM
One Face to the Credit Markets
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Credit risk transfer prices would be used to
communicate the costof credit to business
functions.
Example of One-Year and Two-Year Loss Rates for a
Bank Client
Internal Risk Rating
One-Year Loss Transfer Rates
Two-Year Transfer Rate
1
2
0.04
0.06
3
0.14
0.56
4
1.34
1.83
5
1.40
2.59
6
8.50
11.40
7
17.20
33.00
34
Generally, this transfer price is based on a
comprehensive measure of current credit exposure.
Receivables for products services rendered in
prior month(s). Receivables for products
services rendered in the current month. Amount
that would become collectible due to performance
requirements of contract termination
terms. The current replacement cost, or
mark-to-market value, of a contract. This
exposure only exists when the mark-to-market
value is positive. Reflects the uncertainty
in MTM credit exposure for future periods.
Utilizes forward market price levels,
volatilities, and correlations as inputs to
either a formulaic or simulation defined
statistical distribution.
Accounts Receivable Exposure

Receivables Credit Exposure
Current Unbilled Exposure

Provisional Unbilled Exposure
Expected Credit Exposure

Current MTM Credit Exposure
Forward Credit Exposure

Potential MTM Credit Exposure
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In addition to current exposures, potential
credit exposures are estimated probabilistically.
Loss Distribution Curve
CVaR Confidence Interval (Credit Economic Capital)
Mean (m) Exposure x EDF x (1-Recovery)
0
Increasing Losses
Recovery Rate (RR)
Exposure
Expected Default Frequency (EDF)
Mean (m)
Standard Poors / Moodys credit rating, and
associated default probability (I.e., BBB
0.13 annual probability of default)
Standard Poors / Moodys historical recovery
of obligation once default has occurred (I.e.,
45 for senior unsecured obligations)
Expected Credit Exposure
Variance (s2)
EDF x (1-EDF)
RR x (1-RR)/4
Volatility of Expected Credit Exposure
36
These exposures are then converted into economic
capital measures for which a cost of carry is
assigned.
Credit Exposure
Economic Capital
Company A
78K
67 mm
(AA)
Company B
67 mm
350k
(A)
Company C
67 mm
500k
(A-)
37
It is more simple than it appears.
Expected Credit Exposure
Exposure Metrics
Expected Default Frequency (Rated by SP or
credit score)
(1 - Recovery Rate )
Model Parameters
Statistical Confidence Interval
Risk Metrics
Credit Risk
38
In summary, if energy companies choose to adopt
the banking model for credit risk management they
must learn to do several things well

• Consider the cost of credit in account planning,
  budgeting and resource planning
• Setting and enforcing hard limits on counterparty
  and deal credit risk and enforcing
• Automated financial and behavioral credit scoring
  as part of underwriting and portfolio management
  process
• Credit performance monitoring, portfolio analysis
  and limit compliance

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Market Risk

• Combination of
• Price Risk
• Liquidity Risk
• Volume Risk

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Market Risk
Price risk exists where a company makes or loses
money as a result of changes in commodity market
prices.
Liquidity Risk is being able to buy or sell the
volume you want at the time you want without
moving the market.

• Volume risk exists where the other party to the
  contract has an option in the volume to be
  delivered/received.

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Price Risk Management Tools

• Futures
• Forwards
• Swaps
• Options
• Exchange-based and over the counter markets
• We will define each of these in detail

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Operational Risk Processes
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Trading performance - P L

Mark to Market Valuation of the portfolio at
current market prices.
44
Mark to Market vs. PL
What is MtM?
45
Measuring Risk Exposure
Exposure The portfolios relative sensitivities
to market price changes. Example Exposure of
1,000 barrels to April Brent price means -if
April Brent price increases by 1/bbl, then
portfolio value increases by 1,000.
46

Measuring risk - Value at Risk (VaR)
Value at Risk The portfolios sensitivity to
changes in underlying market prices.
Value at Risk is the expected loss for an adverse
market movement in a specified probability(e.g.
95) over a particular period of time(e.g. a
day).
47

Measuring risk - Value at Risk (VaR)
48
Measuring risk - Value at Risk (VaR) example

Position 1,000 bbls Price 20 /
bbl Volatility 10 Correlations N/A (1
position)

• Parametric
• 1 day horizon
• 95 confidence
• single position.
• VaRPositionPriceVolatility1.65

VaR 1,000 20 0.10 1.65 3,300
49

Measuring risk - Value at Risk (VaR)
Example
PORTFOLIO VaR LIMIT GLOBAL (4,030,745) (16,000,00
0) BELGIAN POWER (3,752,609) (5,000,000) Power
Trader 1 (182,341) (200,000) Power Trader
2 (203,949) (250,000) HOUSTON
POWER (3,058,006) (3,000,000) One day
horizon, 95 confidence
50
Measuring risks - Stress Testing
Stress Testing The change in a portfolios value
based on a change in a single risk
factor. Parameter choices PORTFOLIO PRICE OR
VOLATILITY COMMODITY
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Other Business Risks

• Sovereign
• Legal/Regulatory
• Force Majeure
• Competition Threat
• .

52
Beyond VaR

• Economic Capital
• The Underpinnings of RAROC
• Measures capital held against risks (cost of
  risks)
• Links risk taking to capital adequacy

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Agenda

• Introduction
• Overview of the Trading Organization
• Front Office
• Middle Office
• Back Office
• QA

ü
54
Back Office
Front Office
Back Office
Middle Office
Head of Trading Operations
Head of Back Office Operations
Head of Risk Control
Risk Control
Marketing
Structuring
Trading Cash/Derivatives
Settlement
Confirmation
Contract Admin
Position Financing
Legal Compliance
Information Analysis
Scheduling
Systems Support
55
Back Office Processes

• Settlement and Invoicing
• Checkout with Counterparties
• Broker Reconciliation
• Volume and Price Actualization
• Contract Administration
• Trades without Contracts
• Netting Agreements
• Confirmation
• Monthly Accounting
• Accrual
• MtM
• FAS 133

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Key Back Office Processes
Invoicing Close Account
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• Q A