Risk Management and Financial Institutions, + Web Site, 3rd Edition

CHAPTER 7

How Traders Manage Their Risks

The trading function within a financial institution is referred to as the front office; the part of the financial institution that is concerned with the overall level of the risks being taken, capital adequacy, and regulatory compliance is referred to as the middle office; the record keeping function is referred to as the back office. As explained in Section 1.6, there are two levels within a financial institution at which trading risks are managed. First, the front office hedges risks by ensuring that exposures to individual market variables are not too great. Second, the middle office aggregates the exposures of all traders to determine whether the total risk is acceptable. In this chapter we focus on the hedging activities of the front office. In later chapters we will consider how risks are aggregated in the middle office.

This chapter explains what are termed the “Greek letters” or simply the Greeks. Each of the Greeks measures a different aspect of the risk in a trading position. Traders calculate their Greeks at the end of each day and are required to take action if the internal risk limits of the financial institution they work for are exceeded. Failure to take this action is liable to lead to immediate dismissal.

7.1 DELTA

Imagine that you are a trader working for a U.S. bank and responsible for all trades involving gold. The current price of gold is $1,800 per ounce. Table 7.1 shows a summary of your portfolio (known as your “book”). ...