Credit Derivatives: Trading, Investing and Risk Management, Second Edition

27

Mathematical Model and Systems Validation

27.1 TESTING PROCEDURES

The following describes current practice within risk-control departments of banks and large hedge funds and is commonly used with regard to internal (self-written) and external (off-the-shelf or bespoke) systems and models used for valuation and risk reporting. Without approval at this level, trading desks, for example, are generally not allowed to trade using the trading desks systems and models. An exception applies at start-up of a new desk - generally a limited trading approval is given which may restrict the number of deals, their size, duration of trading period, and other aspects of the transactions. This limited trading approval gives the desk and other departments within the bank time and experience to set up management procedures and ensure that transactions are properly booked, reported and controlled throughout all aspects of the deal. It should also be borne in mind that the testing process is not an attempt to annoy traders and stand in the way of product development - although it may seem so from the point of view of the trading desk - it is a response to requirements imposed by regulators and a responsibility to shareholders and investors.

The testing process typically takes 3 to 6 months for a new ‘product’ of some complexity (such as a bank starting in CDS or CDO products). This process is usually (but not necessarily) undertaken by someone remote from the trading desk - such as a risk ...