Fpml Pricing and Risk

FpML Pricing and Risk

Phase 1 Architecture

Table of Contents

1.Introduction

2.Derivatives Pricing and Risk

2.1.Pricing

2.2.Valuation and Risk Reporting

3.Scope

4.Requirements

4.1.Introduction

4.2.Usage Scenarios

4.3.Product Coverage

4.4.Valuation and Risk Measures

4.5.Market and Pricing Data

4.6.Valuation Scenarios

4.7.Portfolios

5.Overview of design

5.1.Overview

5.2.Shared Types

5.2.1.Introduction

5.2.2.Quotation Characteristics

5.2.3.Measure Types

5.2.4.BasicQuotations

5.2.5.Valuation

5.2.6.Basic Asset Valuation

5.3.Valuation Sets and related definitions

5.3.1.Quotation

5.3.2.AssetValuation

5.3.3.Sensitivity Set

5.3.4.Sensitivity

5.3.5.ValuationSet

5.3.6.Valuation Scenarios

5.3.7.Summary

5.4.Pricing Inputs

5.4.1.Overview

5.4.2.Abstract Structures

5.4.3.Term Points and Curves

5.4.4.Underlying Assets

5.4.5.Quoted Asset Sets

5.4.6.Yield Curves

5.4.7.FX Forward Curves

5.4.8.Credit Curves

5.4.9.Multi-dimensional Pricing Data

5.4.10.Markets

5.5.Risk Definition

5.5.1.Overview

5.5.2.Sensitivity Set Definitions

5.5.3.Sensitivity Definitions

5.5.4.Pricing Parameter Derivative

5.5.5.Derivative Formula

5.5.6.Derived Valuation Scenario

5.5.7.Pricing Parameter Shift

5.6.Valuation Messaging

5.6.1.Introduction

5.6.2.TradeValuationItem

5.6.3.PortfolioValuationItem

5.6.4.RequestValuationReport

5.6.5.ValuationReport

6.Use Cases/Examples

6.1.Terminology:

6.2.Request/Response scenarios:

6.2.1.Scenario 1 – Request Trade Value

6.2.2.Scenario 2 – Request Portfolio Value

6.2.3.Scenario 3 – Request New Trade Impact

6.2.4.Scenario 4 – Request Sensitivities

6.2.5.Scenario 5 – Perform Analyses

6.2.6.Scenario 6 – Request Pricing Inputs

6.3.Notification Scenarios

6.3.1.Use Case 7:

6.3.2.Use Case 8:

7.Glossary

7.1.Valuation

7.2.Risk

7.3.Valuation Measure

7.4.Risk Measure

7.5.Market Environment

7.6.Market Data

7.7.Market Data Value

7.8.Pricing Data

7.9.Portfolio

7.10.Scenario

7.11.Sensitivity

7.12.Shock

8.Validation Rules

8.1.Introduction

8.2.Reference Integrity

8.3.Date uniqueness

8.4.Optionality

8.5.Names/Definitions

8.6.Consistency of definitions/references

9.Appendix – Design Decisions

9.1.Abstract vs. Actual Products

9.2.Product and Trade Identification and Description

9.3.Pricing Inputs

9.4.4.6.4 Valuation Reporting

9.5.4.6.5 Risk Types and Measures

Edit History

Version / Date / Author / Comment
0.1 / 21 May 2004 / B. Lynn / Initial version - Adapted from version 10 of the FpML Pricing and Risk Requirements document.
0.2 / 31 May 2004 / B. Lynn / Reorganized per PRWG suggestions.
0.3 / 5 June 2004 / B. Lynn / Added coverage of market environments and risk definitions.
0.4 / 15 June 2004 / B. Lynn / Updated diagrams to cover latest version of schema.
0.5 / 15 June 2004 / B. Lynn / Added coverage of credit and FX curves

1.Introduction

This document thethe initial deliverable of the FpML Pricing and Risk Working Group (PRWG).

Included in this documentIt discusse ares:

A very brief introduction to derivatives pricing and risk, and how this specification relates to those processes.
The scope of the initial deliverable
The requirements to address that scope
A high-level overview of the structures in the schema used to address the requirements.
A more detailed explanation of the usage scenarios together with examples
A short glossary

2.Derivatives Pricing and Risk

2.1.Pricing

Interest rate derivatives are typically priced (a.k.a. “valued”) by forecasting the future price and price evolution of the assets that underlie the derivative, using these forecasts to estimate the future cash flows of the derivative instrument, and then discounting these cash flows to the preset.

For example, interest rate swap cash flows are typically calculated based in part on an floating interest rate index (such as US Dollar 3 month LIBOR). An interest rate swap’s value is usually estimated by forecasting the floating rate (in this example, USD-LIBOR-3M), calculating the forecast cash flows, and then discounting them to the present using a discount curve.

More complex products such as option products frequently use a similar process, but price the instrument under a variety of forecasts and estimate the value of the derivative by averaging or otherwise combining the various forecasts.

This specification describes ways to represent the data that is needed for generating these forecasts, if required for valuation reporting.

2.2.Valuation and Risk Reporting

A series of values (“measures”) can be computed about derivatives. The measures include:

a variety of price-like values (e.g. Net Present Value, Clean Price, Dirty Price, Accrued Interest, Cash Payable, etc.),
the sensitivities of some of the above values (particularly the NPV) to changes in pricing assumptions
other risk measures, such as Potential Exposure, Value At Risk, etc.

The specification provides way to represent these measures and if desired to describe them in some detail.

3.Scope

The product scope for this documentis:

Valuation and basic risk on the following products:

1Vanilla IR Swaps (single and dual currency fix/float swaps, non-CMS/CMT)

Valuation reporting (trades only)
Market Data (Yield Curves, FX spot rates)
Market risk reporting (Delta Risk vs. Curve Inputs, FX exposures) for trades

2Credit Default Swaps

Valuation reporting for trades
Market Data (ir curves, credit spread, recovery rate, probability of default)
Market risk reporting (risk with respect to. the above variables) for trades

3IR Caps/Floors/ EuropeanSwaptions, and corresponding risk types

Valuation reporting for trades
Market data (volatility surfaces)
Market risk reporting
Volatility/Vega Risk
Convexity/Gamma Risk (applies to all products).
Time Decay/Theta (applies to all products)

4Portfolio level valuation and risk

Valuation
Risk reporting

We have also provided some definitions that might be useful for other types of valuation and risk reporting.

4.Requirements

4.1.Introduction

The aim of the FpML Pricing and Valuations Working Group (PRWG) is to define a set of extensions to the FpML schema that allow the description of:

i)A request to provide valuation and risk information about a trade or group of trades, henceforth referred to as a Valuation Request.

ii)A report providing valuation and risk information about a trade or group trades, henceforth referred to as a Valuation Report.

4.2.Usage Scenarios

The intended uses of this specification include:

Submitting valuation requests by relatively unsophisticated clients to more sophisticated providers, and returning the results.
Submitting valuation requests from sophisticated trading users or applications to a valuation engine or system.
Providing sensitivity results with a variety of levels of rigor and definitional detail
Communicating market data between clients and providers for the purposes of either requesting valuations or explaining how valuation results were obtained.

These scenarios are described below in more detail in the “Use Cases and Examples” section.

4.3.Product Coverage

The products to be supported are those covered by the FpML 4.0 specification. However, we will in particular focus on the following product groupings:

i)Vanilla IR Swaps (single and dual currency fix/float swaps, non CMS/CMT)

ii)Credit Default Swaps

iii)IR Caps/Floors and European Swaptions.

4.4.Valuation and Risk Measures

The specification and reporting of following valuation and risk measures are to be supported:

i)Net Present Value

ii)Market Risk Sensitivities, including, but not limited to:

a)Interest Rate Delta (Sensitivity to Curve Inputs)

b)Interest Rate Delta (Sensitivity to Forward Rates)

c)Interest Rate Vega

d)Interest Rate Gamma

e)FX Spot Sensitivity

f)Credit Spread Sensitivity

g)Sensitivity to Probability of Default

h)Recovery Rate sensitivity

In addition, the schema should be easily extensible to allow additional valuation or risk measures to specified and reported.

4.5.Market and Pricing Data

The schema should allow the description of market or pricing data. Here we refer to market data as observable market rates or prices in some structured form (e.g. a yield curve of interest rates), and pricing data as market data that has been processed in some way (e.g. a term structure of discount factors).

This market and pricing data may be referred to by the Valuation Request as data to be used in calculating the requested valuation and risk measures, or can be included in the Valuation Report as data used to produce the reported valuation and risk measures.

In addition, a Valuation Request may refer to market and pricing data (as a group) by reference (e.g. an identifier denoting ‘use current market data’ or ‘use yesterday’s end-of-day market data).

4.6.Valuation Scenarios

The schema should allow the specification of shocks to one or more market data elements, collectively referred to as a Scenario, and the calculation and reporting of all applicable valuation and risk measures in the context of the Scenario rather than the base market data.

4.7.Portfolios

The schema should allow specification of a Valuation Request for a single trade or group of trades, henceforth referred to as a Portfolio. A trade may be defined ‘in place’, i.e. as a complete FpML trade representation, or by reference (e.g. a trade identifier). A portfolio may be specified in the following ways:

i)A list of trades defined ‘in place’

ii)A list of trade references

iii)A portfolio reference (e.g. a portfolio identifier)

iv)A query or logical definition (e.g. all trades with counterparty x)

5.Overview of design

5.1.Overview

The Pricing and Risk schema is intended to meet the requirements described above. Because the requirements include both high-level, simplified representations as well as sophisticated, detailed definitions, the schema has been designed to allow a variety of amounts of detail to be provided. It will be up to the client and the provider to negotiate minimum requirements for data as well as well as the list of maximum supported elements.

The schema has been subdivided into several subschema files, corresponding to different topic areas, to reduce the number of definitions that a user needs to review and understand to be able to use the schema. These subschema include (where x-y is the FpML version number):

Fpml-pr-shared-x-y.xsd – This includes base types used throughout the pricing and risk schema, such as quotations characteristics, measure types, etc.
Fpml-pr-x-y.xsd – This includes valuation result sets and related definitions.
Fpml-reporting-x-y.xsd – This include messages used for requesting and providing valuation reporting results.
Fpml-mktenv-x-y.xsd – This include definitions of market environment data structures such as yield curves, volatility matrices, and the like. It contains the largest set of definitions, but is not necessary for simple uses of the standard.
Fpml-riskdef-x-y.xsd – This includes detailed definitions of valuation and sensitivity results. They include detailed definitions of sensitivity calculations and are intended to be used by sophisticated users.

5.2.SharedTypes

5.2.1.Introduction

The Pricing and Risk shared types include ways to represent valuations about single objects, such as assets or pricing inputs. They include quotation characteristics, measure types, and base level valuation structures.

5.2.2.Quotation Characteristics

The QuotationCharacteristics.model model group, and the corresponding type QuotationCharacteristics, allow a variety of descriptors to be applied to any particular quotation. These descriptors include items such as:

The measure reported (ie. The type or purpose of the quotation)
The units of measure
Which point of view the quotation is expressed for (buyer, seller, mid-market)
The currency of the quotation
Whether the quotation is for opening of business, daily high/low/mid, close of day.
The time the quotation was recorded.
How long the quotation remains valid
For cash flow quotations, the type of cash flow. (This is a sub-measure; in a future draft this may be generalized further).

The Quotation Characteristics structures are used relatively consistently throughout the schema to describe values that may be reported.

5.2.3.Measure Types

“Measure Types” are represented by the “AssetMeasureType” type, which is an FpML scheme. A wide variety of measures have been defined (see “scheme values” for more information), but additional ones could also be defined. Current measures are divided into three broad categories:

Valuation measures, such as NPV, cash, accrued interest.
Sensitivity measures, such as InterestRateBucketedSensitivity
Risk measures, such as Value at Risk.

Please see the FpML “schemes” documentation for a complete list of the measures.

A number of measure types have been defined for areas beyond the current scope of this working group.

5.2.4.BasicQuotations

A BasicQuotation is a type that provides a value with a set of QuotationCharacteristics as defined above.

A BasicQuotation is provided for quoting simple assets where sensitivities are not required, e.g. for quotes for input instruments in curves

5.2.5.Valuation

Valuation is a type used as a base for types that represent valuations, i.e. quotations associated with objects for a particular valuation scenario.

It includes:

An optional definition reference, which allows a reference to the definition of this valuation to be provided [??? – needs to be reviewed, provide an example]
An object reference, which identifies the object that is valued.
An optional valuation scenario reference, which identifies the valuation scenario that this valuation is for.

Valuation is extended for objects such as assets and pricing structures.

5.2.6.Basic Asset Valuation

A BasicAssetValuation object extends the Valuation type with a BasicQuotation. It is used for representing basic valuations of assets such as benchmarks assets used as inputs to a yield curve. It is not typically used for reporting values of derivative instruments.

5.3.Valuation Sets and related definitions

The following types are used to represent valuations of assets and the corresponding sensitivity valuations. These definitions are mostly contained in the fpml-pr-x-y.xsd subschema file.

5.3.1.Quotation

The Quotation type is similar to the BasicQuotation but also allows a collection of sensitivities to be added. This allows sensitivities to be associated directly with a specific measure, to provide a precise relationship between the sensitivities and the base value. (Note that both the base value and the sensitivities are optional, so that only one or the other could be reported.)

5.3.2.AssetValuation

The AssetValuation type extends the Valuation types with a full Quotation. It allows values (and the associated sensitivities) to be represented for a single asset, such as a trade or a portfolio.

5.3.3.Sensitivity Set

A Sensitivity Set is collection of sensitivities, normally related somehow. It is used for containing a mini “risk report” for a single asset, e.g. bucketed interest rate delta risk for a trade or portfolio.

It can contain:

The name of the sensitivity sets, used to describe its purpose to a human.
A reference to the definition of the sensitivity set, used to fully explain the meaning of the sensitivities
A collection of sensitivities.

5.3.4.Sensitivity

A sensitivity is a structure that contains a numerical result for the sensitivity of a valuation to a pricing input change:

It contains only a single numeric value. The associated valuation is obtained via containment (i.e. the sensitivity is directly under the same quotation structure). It has two optional attributes: A name, which is a human-readable description of the sensitivity value (e.g the “2Y” point on an interest rate delta curve), and a definitionRef, which is a reference to a Sensitivity Defintion (described in detail below). At least one of these two attributes must be filled it.

The units of the sensitivity (and other quotation characteristics) can be provided via the Sensitivity Definition or the Sensitivity Set definition. If a quotation characteristic is provided at both levels, the finer grained one (ie. that applying to the SensitivityDefinition) prevails.

5.3.5.ValuationSet

The valuation set, in effect a short “risk report” or “valuation report”, is a collection of valuations, together with some identifying and descriptive information.

Contents include:

The name of the valuation set, for human readers
The valuation scenario that was applied (this describes items such as valuation date, the base counterparty, and the market environment).
The base party, from which point of view the valuations are computed.
The default quotation characteristics (used to abbreviate large valuation sets containing many similar quotations, such as NPVs).
The definitions of any sensitivity sets, ie. definitions of the sensitivity risk reports provided.
A flag indicating whether the market environment is or should be included.
A collection of asset valuations, as described above.

5.3.6.Valuation Scenarios

The Valuation Scenario is a type that is used to define how the valuation was (or is to be) computed. It specifies the input assumptions for the valuations.

It includes, or can include:

A name, for humans to understand the purpose.
The date for which the valuation is performed.
A reference to the market environment (see below).
Constructs for defining how the base market environment is to be adjusted prior to valuation. (See below in risk definitions for more detail.)

5.3.7.Summary

Following is an overview diagram showing many of the structures described above.

5.4.Pricing Inputs

5.4.1.Overview

This section describes representations for market inputs, such as yield curves and volatility matrices. These market inputs may be shared for the purpose of requesting a valuation or of reporting how a valuation was obtained.

Market inputs are divided into two main types:

Pricing Structures provide a name/identifier to allow the pricing input to be referenced and identified, but provide no values.
Pricing Structure Valuations provide values (inputs and/or outputs) for a pricing structure. They are typically associated with a particular valuation scenario.

Each of these is specialized into a variety of pricing input structures, which are in turn built out of building blocks such as TermCurves (for representing term structures) and Underlying Assets with quotations.

A collection of pricing inputs is defined by a “market” or “market Environment.”

5.4.2.Abstract Structures

The Pricing Structure type is used as a placeholder for identifying a pricing input, such as a curve or matrix. It is extended for particular pricing structures.

The Pricing Structure Valuation type is used to hold valuations associated with the pricing structure. It includes

A reference to the pricing structure that is valued.
A reference to the valuation scenario that this is for
A variety of pieces of date information to describe the valuation.

5.4.3.Term Points and Curves

A term curve is a building block structure used to represent a set of market values over a term structure. It contains a set of Term Points, as well as some information about interpolation and extrapolation. It is used for representing term structures such as discount factor curves.