CALYPSO ENTERPRISE RISK SYSTEM - Dr Philip Symes' Website

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© Philip Symes, 2006

CALYPSO ENTERPRISE RISK SYSTEM Dr Philip Symes

Introduction  Calypso's Enterprise Risk Service (ERS) is part of their Front-to-Back software system.


 Calypso ERS provides the Middle Office risk function. – Risk control and risk management solution.  The system is designed to manage: – market risk; – credit risk; – limits.  The back testing functionality included in the system meets the requirements from Basel2 IRB approach.  Operational risk is on the roadmap to be integrated.

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Contents  Brief overview of the Calypso suite of products.  Brief overview of functionality of Calypso ERS.  Technical overview of Calypso ERS (how it works).


 Integrating ERS with other Front Office solutions (Calypso and other systems).  Scenario methodology: – Application of methodologies in Calypso ERS; – Historical simulations (detailed); – Stress testing.  Watchpoints for risk implementation.

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Calypso ERS Areas  Calypso ERS is Calypso's new Middle Office risk management solution.  Market risk areas: – Risk factor sensitivities; – Historical Value at Risk simulation; – Stress testing; – Back testing.  Limits: – Market risk; – Counterparty credit risk.  Credit Risk: – Counterparty credit exposure.

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The Calypso Product Suite  Calypso is a cross asset Front-to-Back Office banking software system.

 Calypso is designed to work “out of the box” and is configurable for specific environments.


 Calypso's system architecture makes it highly configurable and extendable: – Pricing libraries can be added in Java and C++; – External databases can be referenced; – This makes it appropriate for dynamic environments.  Calypso interacts with other Front and Back Office systems through information feeds.

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The Calypso Product Suite (cont.)


 Summary of Calypso “solutions”:

© Calypso

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Front-to-Back Integration  Calypso ERS integrates with Calypso’s front-to-back software system.  This gives considerable advantages when integrating risk systems for compliance and cost.


 Cost savings arise from: – – – – –

IT department specialising in fewer systems; Lower licence and support costs; Less infrastructure; Lower setup costs; A simplified systems that reduces operational risk.

 The system also requires less training for users who only have to learn one system.

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Calypso ERS Architecture

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 Calypso ERS separates the user interfaces and back end processes.

 The user interface is the ERS Web Browser: – Thin-client presentation layer; – Web services – DHTML, XML, etc.


 The back end works using ERS engines: – –

A distributed computing GRID; Service-oriented architecture.

 The ERS engines: – Manage portfolio risk analysis; – Use existing FO pricing libraries to create P&L vectors.

Calypso ERS Architecture (cont.)

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Browser DHTML XML / AJAX

Web Server SOAP

Web Services (Apache Tomcat)


JDBC

Ad-hoc Requests

Risk Risk Engines ERS Engines Engines

© Calypso

Java RMI TCP/IP or Multicast

JDBC

Data Server

Java RMI

JDBC

ERS Results

Database

Event Server


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 The Calypso ERS Results service acts as a warehouse of official risk numbers: – ERS can run on Sybase and Oracle databases; – Can even run on a different database to Calypso.


 The service can work with numbers from within Calypso or from an external database.  Historical scenarios are accessed directly from the database – Better performance than using the Data Server  The results can be exported to different formats – E.g. MS Excel for spreadsheet analysis.


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 Runs off a batch job overnight – This takes about 5 hours to perform simulations for 100,000 trades; – System does not run in real-time.  ERS can run in distributed computing or GRID environment – Using Calypso Dispatcher (DC) or Data Synapse (GRID).  P&L vectors are used as the main building blocks of risk analysis – This is because VAR is not a coherent risk measure (see RiskMetrics presentation); – In particular, VAR is not subadditive.

Calypso & ERS Integration


 Calypso ERS uses the same pricing environment as Calypso – This means that the same pricing libraries are used – Therefore ERS does not need a separate pricing methodology  ERS could be accessed from the Calypso GUI – This would require development work – The API allows ERS extensions  The bucket hedge function is available – More work on this is on the “roadmap” – But ERS is not a FO system

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Simulation Methodology

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 ERS deals is mainly a historical simulation VAR engine.  Portfolios are repriced based on the simulated results – This revaluation is done by creating a new pricing environment (PE).


 Trades are revalued using this PE to get a P&L vector of changes in the trade's net present value – Each vector element is the P&L for one day in the simulation period.

 VAR is calculated from these P&L vectors – They are stored for trades and portfolios.



 The risk factors used are the same as the underlying market data factors used for pricing: – Interest rates – Credit spreads – Equity prices – Foreign exchange rates – Volatility  These are not correlated – the portfolios are just revalued based on RF changes from feeds  They are then fed into a set of historical simulation vectors.

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 Extreme returns are modelled in the same way as other returns if they occur in the historical period.  No time-based scaling is done at the moment, but functionality for this will be added.


 With exponential weighting added to the volatility, for example, the decay factor λ moves away from 0:


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 The implied return on the risk factors is used to change the yield curve with an: – Absolute change (i.e. ±x bps) – Relative (fractional) change – Weighted percentage change  The Calypso pricing model is then used to price the product off the new change in underlying factors – A warning is given if there is not enough historical data for the period required  No drift is modelled in these scenarios – 1-day or 10-day VAR is the main result – Drift is not sensible below ~3 month horizon

Simulation Methodology (cont.)

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Time Series DB

Mkt Data EOD

Scenarios


Generate Scenarios

Trades from GUI

Trades Feed

Scenarios Market Data Trades

ERS Engines

Calypso DS/DB

Scenarios

PnL Vectors

VaR

Results XML

VaR

Total Total

Scenarios

Org. Org.

VaR

Org.

Group Group Group Group Group VaR

Excel

External System

PnL Vectors

© Calypso

Desk

Aggregate

Desk

Desk Desk

Desk

Desk

VaR

Desk

PnL1 PnL1 PnL1 PnL1 PnL1 PnL1 PnL1 P&L PnL11 PnL1 PnL1 PnL1 PnL1 PnL1 PnL1 PnL1 PnL1 PnL1 PnL1 PnL2 PnL2 PnL2 PnL2 PnL2 PnL2 PnL2 P&L PnL22 PnL2 PnL2 PnL2 PnL2 PnL2 PnL2 PnL2 PnL2 PnL2 PnL2 PnL3 PnL3 PnL3 PnL3 PnL3 PnL3 PnL3 P&L PnL33 PnL3 PnL3 PnL3 PnL3 PnL3 PnL3 PnL3 PnL3 PnL3 PnL3 .

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PnLn PnLn PnLn PnLn PnLn PnLn PnLn P&L PnLnn PnLn PnLn PnLn PnLn PnLn PnLn PnLn PnLn PnLn PnLn

Portfolio Hierarchy Leaf Nodes

PnL Vectors

Historical Simulation

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 Calypso ERS takes historical data from an external price history database – Input can be fractional, relative or absolute.


 From these prices, the shifts in risk factors are calculated.  The period for collecting the historical data can be specified: 1 year, 4 years, etc.  Forecast horizons are configurable: 1 day, 10 day, etc.  The historical data set can be updated at customisable periods: daily, monthly, etc.

Credit Risk Simulation


 Credit risk is done through credit exposures: – The Mark-to-Market Plus Add-on method is used; – This is a standard technique (Basel I).  Marking to market is done using the Calypso pricing libraries applicable to each product: – This gives the current value of the credit exposure; – Can use the same pricing environment as the Front Office; – This means that no approximations or price mismatches come from the risk system.

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 An add-on is made for potential future exposure market – I.e., the add-on accounts for the volatility of the product; – It accounts for the risk that exposure may increase over time.  This add-on is time and product dependent typically varies between: – 0-2% for IR products; – 1-8% for FX products; – 5-10% for equities.


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 The MTM plus add-on method is fast and conservative in its risk assumptions: – But it is considered outdated by many banks; – Potential Future Exposure (PFE) is the proposed new method.  An improved credit risk handling system will be ready within the next few months – Development focus shifting towards credit risk  This new system will handle collateral through Calypso’s collateral management system  This will be Basel 2 compliant

Back Testing

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 Basel2 requires that banks back test their VAR models.  Calypso ERS meets this by showing: – The actual P&L; – The no-action (hypothetical) P&L.


 The VAR and P&L results are stored every day for each portfolio.  The back test analysis is performed automatically at the specified period.  The analysis checks for the number of times the actual P&L exceeds the VAR – Classification is in Basel2 colours: red, yellow or green.

Stress Tests  Stress testing scenarios are needed to complement simulations – See RiskMetrics presentation for more details.


 These are setup in Calypso using the Scenario Editor – Shocks to the portfolio, e.g. IR steepeners, are built into the Workspace of the main Calypso system.  The Calypso scenarios analyses are used in ERS – Less drilldown functionality is provided in ERS than Calypso  Portfolios can then be revalued based on these scenarios and the results can be summarised.

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Stress Tests


 A custom stress test in Calypso’s Scenario Editor:

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Limits

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 A new Calypso Limit Engine limits the risk of a portfolio – Other Calypso systems will be migrating to this; – Single engine will manage all limits in Calypso.  Limits can be placed on Market Risk factors: – Risk factor sensitivity; – VAR limits; – Stress limits.

Limits

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 Limits are placed on Credit Risk factors: – Exposure limits per counterparty; – Legal entity hierarchies are applied to counterparties; – Availability of assets (liquidity).  Limits can be configured: – Limits can be set at at different periods ●

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realtime, intra-day or end of day;

Limit exceptions are programmable in the Calypso workflow.

Simulation Reports

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 ERS has access to the Calypso Risk Reporting Tool via the Calypso GUI.  Results are summarised using VAR: – Different confidence levels can be selected, e.g. 99%; – VAR histograms are drawn; – Descriptive statistics are presented in the reports; – Risk and return measures, e.g. RAROC, are not included.  Risk amounts can be attributed to different factors – Risk can be shown due to FX, IR, etc.  Drill-down functionality shows risk by different criteria:

Advantages of ERS


ERS has several advantages over larger systems:  Speed – Fast system with little overhead that can run off existing architecture  Integration with existing Calypso FO and BO systems  Small infrastructure and resource overheads.  This makes the system suitable for banks with short term positions with hedge fund clients – Also suitable for larger hedge funds where infrastructure exists.

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Watchpoints


 Certain key parts of the project must be monitored – See the POC Kit for more details.  The next few slides deal with points in 3 key areas of project implementation from philipsymes.com’s experience: – Project level watchpoints; – Business level watchpoints; – Data watchpoints.

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Project Watchpoints  The scope of the project: – Must have detailed requirements documented; – Need to be aware of “scope creep”.


 Production release cycle: – Analyse testing requirements (POC); – Ensure the release is controlled (implementation).  All elements of the project should be properly documented.  Acceptance (success) criteria for the project must be pre-defined.

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Business Watchpoints

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 Business needs to understand the risk measures being presented: – This includes VAR, stress tests and expected shortfall; – Stakeholder involvement is essential.  Systems integration: – Software systems must be compatible; – Use banking and industry standards where possible.

Data Watchpoints


 Data requirements are always underestimated: – In house data sources preferable; – Need to analyse gaps in required data.  Data and systems must be integrated: – Calypso ERS uses FO pricing libraries; – Need the ability to drill-down on data provided; – Shared asset control across business units.

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Summary

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 ERS is Calypso's new risk service offering.


 It is designed to integrate with existing Calypso systems and other Front Office systems and pricing libraries.  ERS includes support for: – Historical simulation; – Basel 2; – Stress testing.  Results are summarised as reports: – Risk numbers are handled through P&L vectors; – VAR measures are calculated from these; – These meet regulatory requirements, e.g. Basel2.

CALYPSO ENTERPRISE RISK SYSTEM - Dr Philip Symes' Website

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