Since the introduction of the Treasury bill and Treasury bond futures in the U.S. in the mid 70’s, many innovative interest-rate derivatives were invented all over the world. Usually these derivatives are sold by a financial institution or trader to one of its clients over-the-counter. If they are traded at an exchange the financial institution or trader can neutralize or hedge the position by buying the same instrument at the exchange. The resulting position is called covered. Unfortunately, most of these derivatives are tailored to the specific needs of a client with no equivalent exchange-traded product available for hedging purposes. This significantly complicates the hedging process. The trader has to buy or sell other financial instruments to synthetically create the same exposure as the derivative generates, which he or the financial institution sold to the client. If, and that is the predominating case, both portfolios do not fully coincide the trader is exposed to the risk that both positions evolve differently over time. This risk has to be quantified and updated by an adequate risk-management system. The main problem such a system has to solve is to supply the trader or risk manager with adequate risk numbers and, if advanced, to give assistance within the process of structuring and restructuring the portfolio according to the desired exposure or level of risk. Before we approach the question of how to define an adequate risk number we have to define the risk we are talking about a little more closely.
KeywordsRisk Measure Risk Position Financial Instrument Portfolio Return Short Rate
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