The price risk of options positions: measurement and capital requirements - includes appendix describing value-at-risk rules

Global markets for option outcomes both change-traded and over-the-counter, have expanded rapidly in new years. The Bank for International adjustments (1994) reports that outstanding options now exist upon notional principal amounts totaling at least $33 trillion. In the last four years, the outstanding interest rate, commodity, and equity-related options of U commercial banks have grown more than 40 percent annually and the banks' foreign exchange options more than 16 percent by year.

The expansion of options markets underscores the ne for supervisors to exhibit sound methods of monitoring the risks associated with these markets. This article assesses different supervisory approaches to the measurement and capital treatment of the market risk of options--the risk that an options contract will decline in value with changes in market prices or rates. The [i]modus operandi[/i]s for measuring the market risk of options positions examined in the article fall into sum of two units broad categories: simple strategy meanss and value-at-risk (or price sensitivity) courses We compare the performance of the different meanss in providing capital coverage for potential losse upon a series of option portfolios.

We find that the simple strategy rules provide only a rough measure of potential losse Moreover, for market participants with large option positions, the simple strategy approach could lead to an excessive reporting load The value-at-risk methods, which are based upon option pricing models, tend to provide better estimates of the market risk inherent in a position. The accuracy of the value-at-risk approach is also ground to be significantly enhanced by dint of adjustments for gamma risk, the risk that an option's price changes in a nonlinear fashion as a ensue of large movements in the price of the underlying instrument.(1)

BACKGROUND AND METHODOLOGY THE UNIQUE Risks OF OPTIONS

Like greatest in quantity other instruments, options contracts entail the pair price (or market) risk and credit risk. Market risk arises when the value of the intermediary's portfolio is sensitive to changes in market prices or rates. upon some occasions, intermediaries will attempt to eliminate similar risk by engaging in offsetting transactions; that is, they attempt to "hedge" the market risk away. upon other occasions, however, intermediaries may attempt to earn a risk premium for bearing the market risk. Credit risk arises because a financial asset, like as a purchased option or a business loan, could become worthless if the counterparty to the asset does not make profitable on its obligations. This article focuses upon market risk.

The form that market risk takes in options markets can be quite different from its form in other markets. This is pure in part because the values of options contracts can change extremely rapidly--often far more rapidly as a percentage of their value than do the assets that underlie options contracts. In addition, the price sensitivity and volatility of a position can themselves change quickly, further complicating the risk management of options positions. An intermediary must constantly track the changes in the volatility of its portfolio that spring from market movements. This task can be particularly difficult in periods of great market stres and lowered liquidity, similar as that experienced in the market for European publicity options in September 1992.

Alert to these difficulties, supervisors must consider carefully in what manner supervisory capital can best bring the detrimental impact of options risks in the financial markets.

CONSIDERATIONS IN SETTING SUPERVISORY CAPITAL REQUIREMENTS

Determining appropriate supervisory capital standards for options positions involves several choices. A sufficient horizontal of prudence could probably be achieved through simply setting very high standards without regard to by what mode the risks change in replication to changing market conditions. This approach could however, require far more capital than is actually emergencyed The costs of this excessive safety would then translate into a slowdown in potentially beneficial options trading or perhaps a relocation of this trading to jurisdictions not imposing of that kind onerous standards.

More accurate measures of the risks of an options portfolio require more information about the composition of the portfolio and more calculations. As the analysis below makes clear, there is a definite trade-off between the efficiency of the capital charge and the resources required to cast up the charge. The most efficient charges would, for example, require substantial data about the composition of the options portfolio and the risk factors affecting the portfolio's value, as well as estimates of the sensitivities of the portfolio's value to moves in the risk factors. To proces like information in a timely fashion, an institution must be willing to commit significant resources.

The complexity of the capital calculation itself is also an important consideration. mingled supervisory charges may be difficult to implement uniformly. Moreover, the more specific the domination the greater the opportunities for finding exceptions or exclusions that were not intended. Nevertheless, composed of several elements calculations could lead to more accurate and efficient charges, thereby lessening the regulatory weight on the options market.