Lunch and Learn #4: Risk-Based P&L

20 May 2015
What is Risk-Based P&L?
A method for understanding the P&L from books exposed to market risk, carried
out through the following daily processes:
• Decomposing the actual P&L into the contributions from new deals, changes
in the risk factors, and the passage of time (waterfall attribution)
• Predicting the P&L from the known risk sensitivities (measured at the close
of the previous day) and the changes in the risk factors (risk-based or
sensitivity-based prediction or estimation)
• Comparing the predicted and actual P&L and investigating and escalating
differences above prescribed thresholds
• Investigating and escalating the contributions from new deals above
prescribed thresholds

Note: all books valued using Fair Value Accounting are exposed to market risk!

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Daily Profit and Loss Reporting [PC Mandate]
The respective Product Control group should produce a daily P&L report, containing the actual P&L in local
currency and in Canadian dollar (CAD) equivalent. The P&L report should also show month-to-date (MTD)
and year-to-date (YTD) figures.
The daily P&L report should contain decomposition of the daily P&L to resident risk profile (ideally as both
waterfall and risk based estimates), and comparison to an estimate provided by the Front Office.

The following thresholds will apply for escalation of P&L differences and review of new deals and
amendments:-
• Differences between predicted or estimated P&L and actual P&L, escalation to local head of
Product Control – C$10,000 ; escalation to global head – $25,000
• Trader estimate differences – any differences above $250,000 to be escalated to global head.
• New deals and amendments, escalation to local head – $50,000; escalation to global head -
$500,000
The Global Head of Product Control will determine if further escalation or discussion, as applicable, is
required with the Front Office.
On a monthly basis, the respective PC group should provide tracking details of trader sign-off for P&L. Lack
of sign-off should be escalated to local head of PC, with escalation to global head if sign-off is still not
forthcoming.

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Why do we need Risk-Based P&L?
Five reasons:
1. Decomposing the actual P&L into contributions from different risk factors
helps us explain the P&L
2. Predicting the P&L from the known risk sensitivities and the changes in the
risk factors gives us a way to check the P&L
3. Predicting the P&L and comparing this with the actual P&L also gives us a
way to check the risk sensitivities
4. Measuring the contribution from new deals helps us detect valuation
problems and inappropriate trading activity
5. Watching the P&L attribution over time gives us insight into how a trading
desk is making money and whether they are effectively hedging risks that
they don’t want to take

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What’s in this presentation
Sensitivity-based prediction and waterfall attribution
• The mathematics behind sensitivity-based prediction
• A textbook example: a call option valued with Black Scholes
• Comparing the prediction with waterfall attribution
• How it works for real deals

Applying the prediction and waterfall attribution to a book

• How we account for new deals and deal unwinds

Risk-Based P&L in practice: examples of what we can learn

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Risk-based prediction: the Taylor series expansion
For a function f(x) depending on a single variable x, the Taylor Series can be used
to predict the change in f(x) from a small change in x:

For us:
f(x) = value of a forward, swap, option, or other financial derivative
x = risk factor affecting the value of f()
df/dx = linear sensitivity (“delta”) of f() to the risk factor
d2f/dx2 = second-order sensitivity (“gamma”)

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The Taylor Series with more than one variable
For a function f(xi) depending on a n variables x1, x2, …, xn, the Taylor Series
requires partial derivatives of f(x) with respect to each of the xi:

Now there are n first-order derivatives (“deltas”) and n2 second-order derivatives

(“gammas”)
In risk-based P&L prediction we don’t use all these gammas but we may use
some of them if they are expected to be important

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A simple example: a Black-Scholes stock option

C(S,t) is the value of a call option on a stock that does not pay dividends. It
depends on three risk factors (S, r, ) plus the time (t).

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Black-Scholes risk sensitivities (the “greeks”)

• The Black-Scholes model gives formulas for the risk sensitivities

• Most pricing models require numerical calculation of the sensitivities
• Fixed-Income people have other names for “Rho” (IR delta or DV01 or PV01)

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Call-option dependence on stock price (nonlinearity)

The black (middle) line shows the exact dependence of a call option on the stock price
when T-t=0.1, r=10%, =30%, and K=60. The green (lower) and blue (upper) lines
show the predicted dependence calculated from the option value at S=60 and the
delta (green) and delta and gamma (blue) sensitivities at S=60.
Gamma is needed to make accurate predictions for nonlinear products like options.

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Black-Scholes example: risk-based P&L estimate
Risk Fa cto r Da y 0 Da y 1 Da y 1 - Da y 0
S trike 60 60
Time to expiry 0.1 0.09603 -0.00397
Ris k-free rate 1.00% 0.90% -0.001
Volatility 30% 35% 0.05
S tock price 60 57 -3
Ca ll Price 2.29894 1.32304 -0.97591

Risk S e nsitivity (Gre e k) Da y 0 Gre e k * (Risk Fa cto r Cha ng e )

Theta* -11.6259 -0.0461
Rho 2.9088 -0.0029
Vega 7.5567 0.3778
Delta 0.52312 -1.56935
Gamma 0.06997 0.31486 Une x pla ine d P&L
Theta-Rho-Vega-Delta s um: -1.2406 0.2646
Theta-Rho-Vega-Delta-Gamma s um: -0.9257 -0.0502
*(multiply The ta by the c ha nge in time , not the time to e xpiry)

• Using just Delta, we predict a P&L of -1.2406, giving an unexplained P&L of 0.2646
• Using Delta and Gamma, the unexplained P&L is lower, -0.0502
• With sensitivity-based estimates there is always some unexplained P&L

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Black-Scholes example: waterfall attribution
Wa te rfa ll Ne w Ca ll Wa te rfa ll Risk-Ba se d
Risk Fa cto r Da y 0 Da y 1
S te p Price Attributio n Attributio n
S trike 60 60 day-0 values 2.29894
Time to expiry 0.1 0.09603 change time 2.25235 -0.04659 -0.04613
Ris k-free rate 1.00% 0.90% next change r 2.24956 -0.00279 -0.00291
Volatility 30% 35% next change s 2.61980 0.37024 0.37783
S tock price 60 57 next change S 1.32304 -1.29676 -1.25449
Ca ll Price 2.29894 1.32304 Attributio n S um: -0.97591 -0.92569
Actua l P&L -0.97591 Une x pla ine d P&L: 0.00000 -0.05021

• With the waterfall there is no unexplained P&L: the attribution adds exactly to the
Actual P&L
• The amounts attributed to each risk factor are similar to those given by the risk-
based attribution, but slightly different at each step
• The exact amount the waterfall attributes in each step depends on the order of the
steps

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Comparing the risk-based and waterfall methods
Advantage Disadvantage
Risk-Based P&L Estimate
 Shows delta & gamma  Usually includes only linear
contributions separately if both are sensitivities; ignores nonlinear terms
used
 Can give detailed results (e.g.,  Does not match the Actual P&L
contribution from each curve point) exactly
 Easy to understand
 Can reveal P&L errors if the Actual
P&L is wrong
Waterfall Attribution
 Matches the Actual P&L exactly,  Cannot divide attribution into linear
even if there are large changes in (delta) and nonlinear (gamma)
the risk factors contributions
 Good to use for P&L attribution as  Cannot show as much detail as a risk-
there is no unexplained P&L based estimate can
 Cannot reveal P&L errors when the
Actual P&L is wrong

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Making risk-based predictions for real deals
The risk-based P&L estimates that we make for real deals differ from our textbook
Black-Scholes example in the following ways:
• The sensitivities are calculated numerically by “bumping” the risk factors
• When gamma is required it is handled by recalculating delta using larger
bumps of the risk factor
• The risk factors are sometimes curves with many points, each one becoming
a risk factor
• Time is handled in the risk-based estimate in the same way that it is in the
waterfall

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Calculating sensitivities by bumping the risk factors
For a product F depending on a risk factor X, the sensitivity of F to changes in X is
calculated by choosing a suitable (small) X and calculating the sensitivity by
Delta = F(X+X) – F(X)
The generic name for this sensitivity is Delta, but special names are used for
special risk factors. Some examples:
• For interest rates and credit spreads we use a -1 bp bump (DV01, CS01)*
• For volatilities we use a +1% (absolute) bump (Vega)
• For stock prices we use a +1% (relative) bump (Delta)
In some cases sensitivities are measured for both positive and negative bumps. To
use the sensitivities correctly you must know how X was chosen. The bump
size, the sign, and whether it is an absolute or relative bump are all important.
If gamma is important then more than one bump size will be used. We first look
at an example without gamma.
*For minor IR curves delta is sometimes measured using a positive bump

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Example: a credit default swap (CDS)
K2 deal D40857 is a single-name default swap in which BNS buys credit
protection on the obligor Wyndham WC. The maturity is 3.25yr in the future
according to the way dates are counted in the credit curves.
Date K2 ID Book Trade Type Notional MTM Maturity K2 Obligor
5/6/2015 D40857 CCRCAPHEDGE CDS Single Name (4,000,000) (67,096) 9/20/2018 WYNDHAM WC

This is the only CDS deal in the CCRCAPHEDGE book. The NPV GUI shows the
waterfall analysis for the P&L on May 7th:
Portfolio Time Yield Curve Credit - Credit - Credit - Risk
Product Change Value Rate Spreads OIS General Specific Total Subtotal
Credit Default Swap 2,284.23 (61.15) (2.84) 0.17 - (3,619.91) 5,967.96 2,348.05 2,284.23

The waterfall attributes nearly all (2,348.05) of the 2,284.23 actual P&L to the
change in credit spreads, which is split into General and Specific contributions (I
added them to give a Credit-Total change). Let’s see how we calculate this with a
risk-based estimate.

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Example: a CDS (the credit curve estimate)
The credit risk factor we need is the CDS spread for the K2 obligor WYNDHAM
WC. The CDS spread is not a single number; it is a curve with nine points. The
table shows these spreads (in bp) on May 6 and May 7, the spread changes from
the 6th to the 7th, and the sensitivity (calculated on May 6) of the D40857 MTM to
a -1 bp spread change at each of the curve points:

CDS Curve 0m 6m 12m 2y 3y 4y 5y 7y 10y

5/6/2015 11 11 16.01 29.01 48.01 70.01 94 128.98 141.98
5/7/2015 11 11 16.01 31.01 50.01 71 96 128.98 141.98
Change 0 0 0 2 2 0.99 2 0 0
CS01 -0.18 -1.01 -2.96 -6.48 -999.74 -339.90 0 0 0 Total P&L
P&L 0 0 0 12.96 1999.48 336.50 0 0 0 2348.94

The P&L contribution from each point is calculated as (Change/(-1)) * CS01. The
P&L estimate (2348.94) is almost exactly the 2348.05 waterfall credit attribution.
The waterfall does not show the contribution from each point on the curve; we
get just a total for the change in the credit curve.

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Example: an index stock option
This example is a listed call option on the S&P 500 stock index. What is of interest
to us here is how “gamma” is included in the risk-based estimate.
The option is a short position in 650 contracts of the 12/19/2015-expiry call
option with a 2050 strike. We consider the P&L on May 8. The Risk Watch
waterfall gave the following attribution (not all of it is shown here):

day0Posn day1Posn Carry Yield DivFlow DivRisk BorrowCurve Asset Vols

(650) (650) 18,744 4,842 (4,262) - - (1,050,749) 135,792

Most of the P&L comes from the change in volatility and the change in the
underlying asset – the S&P 500 index. Let’s see how a risk-based P&L estimate is
made for the asset contribution.

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Example: an index stock option (the asset estimate)
Risk Watch gives us 53 deltas for the option calculated with different bump sizes
for the index. M30 is the delta for a -30% shift in the index, M1p5 is for a -1.5%
shift, P0p1 is for a +0.1% shift, and so on. Some of these deltas are shown here.
M30 …. M1p5 M1p25 M1 M0p75 M0p5 M0p25 M0p1 Zero
7,482,026 1,081,548 907,991 731,740 552,805 371,195 186,923 75,086 -

P0p1 P0p25 P0p5 P0p75 P1 P1p25 P1p5 P1p75 …. P30

(75,508) (189,560) (381,742) (576,531) (773,912) (973,868) (1,176,381) (1,381,432) (1,589,002) (34,598,136)

On May 8 the index changed by +1.34578%. In our risk-based estimate the delta
contribution is 1.34578 times the P1 delta for a +1% change:
Delta contribution = -1,041,520
For gamma we first interpolate between P1p25 and P1p5 to get a P&L estimate of
-1,051,459 for +1.34578%, and then subtract the delta contribution to get
P&L estimate = -1,051,459 (interpolated)
Gamma contribution = -9,939
The P&L estimate made here is close to the waterfall attribution (-1,050,749).

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Applying risk-based P&L to a book
Calculating the risk-based P&L estimate and the waterfall attribution for a whole
book introduces a few new complications:
• We must account for new deals added during the day and deals that were
unwound
• Some products or P&L contributions (bonds, cost of carry, …) are not
included in the standard waterfall, or else they are but we do not get a risk
attribution for the P&L (e.g., because the product is not valued by a model)
• Some trading desks have exposure to special risk factors (e.g., correlation
risk, basis risk) or products that require a custom Risk Watch batch process
for analysis.

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Accounting for new deals and deal unwinds
Risk-based P&L for a book is carried out through the following steps:
1. First, get the portfolio and market risk factors for the close of business on the
previous day (day_0); the sensitivities are calculated for the open of day_1
2. Make a risk-based P&L estimate (for day_1) using the day_0 portfolio
3. Revalue the day_0 portfolio changing the risk factors to get the waterfall
attribution
Steps 2 and 3 assume the day_0 portfolio does not change.
4. Add the P&L earned on day_1 from any new deals starting on day_1 to a
“new deals” total
5. For deals unwound on day_1, measure the difference between the unwind
value and the predicted day_1 value from steps 2 or 3 and add this to the
“unwinds” total
Note: the new deals & unwinds P&L measured in steps 4 and 5 is a lump-sum
P&L; it is not attributed to risk factors (although it can be split between products)

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Risk-based P&L for a book: a sample report
P&L Date 05/13/2015
Book/Currency: CREDIT - usd

A Waterfall P&L
Swap OIS
A Product Carry Curve Spread Spread Asset Credit New Deals Other Daily P&L
A Swaps (32,298) (1,648,672) (58,529) 128 - - - (0) (1,739,372)
A Total Return Swap 1,452 (318) - - 319,203 - (111,957) 45,663 254,042
A Credit Default Swap (162,769) (66,703) (591) (1) - (1,116,569) 1,428 (4,289) (1,349,495)
A Term Loans/Deposits (28,649) 5,218 (0) (0) - - 1,526 (0) (21,904)
A Repos (10,780) - - - - - - - (10,780)
A Cash (317) - - - - - - - (317)
A Bonds 768,837 1,804,524 - - - - 81,925 (205) 2,655,081
A Futures Options - 156,250 - - - - - (50) 156,200
- Summary Adjustment - - - - - - - - -
A Total: 535,476 250,299 (59,120) 127 319,203 (1,116,569) (27,078) 41,119 (56,544)

In this waterfall report for the USD CREDIT book, P&L from new deals and
unwinds is shown in the New Deals and Other columns.
The other columns show the P&L attributed to time change (Carry), major IR
curve changes (Curve), minor IR curve changes (Swap Spread and OIS Spread),
TRS asset price changes (Asset), and CDS curves (Credit).
The new deals and unwinds are identified in a similar way in the sensitivity-based
prediction.

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Examples from risk-based P&L in practice
1. The BOC interest rate cut causes surprising P&L in a “hedged” book,
explained to the traders by our risk-based analysis (explain the P&L)
2. Volatility on 15 Oct 2014 causes large losses, reported incorrectly by Product
Control but detected by somebody else’s risk-based estimate (check the P&L)
3. Risk-based estimate fails because of a large market move
4. Risk-based estimate fails because of a missing risk sensitivity
5. Risk-based estimate for the CREDIT book stops working well after the CDX.HY
index suffers defaults (check the risk sensitivities)
6. How we reported our “London Whale” exposure in 2011 using archived risk-
based estimates

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Example: surprising P&L from a “hedged” book
The PORTMGMTCUST book has bonds and bond TRS trades, some structured as
shown here:

Bond return TRS Counterparty

BNS
At the TRS maturity, receive the final bond value
Buy bonds (e.g., 10-
and pay the initial bond purchase price plus an
30yr maturities) “Floating” leg
interest charge that is our repo funding cost plus
Pass the return to the a spread
TRS counterparty (1yr
TRS deal, say)
Fund the bond Return cash plus interest
purchase by term repo Repo Counterparty
for the life of the TRS
Cash to buy bonds Gives funding to buy the bonds

The trader felt the book was hedged and did not require P&L estimates. But the
term repos are not fair valued (MTM) in our financial reporting, they are
accounted for on an accrual basis. Because of this the book is not hedged against
movements in short-term interest rates.

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P&L estimate on 21 Jan 2015 for PORTMGMTCUST
Term sCadMid IR Deltas P&L Estimate
• When the BOC made the Label Bonds Bond TRS Total Curve Change P&L
surprise IR cut on Jan 21 the 3 Month 1,349 43,658 45,007 -24.0 1,080,165
book gained more than 3 BAX1 690 10,471 11,161 -33.3 371,659

million dollars, most of it from BAX2 939 25,534 26,473 -35.0 926,566
BAX3 860 19,373 20,233 -35.0 708,146
the change in the CAD swap BAX4 -15 1,922 1,907 -34.5 65,782
curve (sCadMid). 2 Yr 55,725 -55,715 10 -31.3 309
3 Yr 135,854 -135,869 -15 -28.5 (426)
• There was a large drop in rates 4 Yr 44,082 -44,074 9 -25.0 216
at the short end of the curve. 5 Yr 1,363 -1,362 1 -21.4 15
This is where there is open risk 6 Yr 20,787 -20,787 0 -19.2 (7)

from the bond TRS, not hedged 7 Yr 6,850 -6,849 1 -15.7 13

8 Yr 80,686 -80,690 -4 -13.5 (52)
by the bonds. 9 Yr 41,419 -41,424 -5 -11.0 (56)

• The trading desk at first refused 10 Yr 42,677 -42,684 -7 -8.5 (56)

12 Yr 31,222 -31,150 72 -7.5 540
to accept the P&L, then 15 Yr 485,036 -484,812 224 -7.0 1,561
accepted it once shown this 20 Yr 1,506,433 -1,506,371 62 -6.1 379
risk-based estimate. 30 Yr 676,798 -676,912 -114 -3.4 (393)
40 Yr -20,388 20,461 73 -3.2 236
TOTAL 3,112,367 -3,007,281 105,087 3,154,598

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Example: risk-based P&L shows actual P&L is wrong
There was extreme volatility in the
rates markets on 15 Oct 2014.
A couple of the rates books suffered
large losses (millions) because of their
USD Libor/OIS exposure, but the losses
was hidden by inappropriate P&L
adjustments made by Product Control.
The ECA group knew from their VAR
back-testing that the books should
have lost money. They started asking
questions….
What they were doing was effectively
risk-based P&L!

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Product Control

Thank you for participating in PC’s Lunch and

Learn!!

Questions? Comments?

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