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

Federal Reserve Bank of New York - Quarterly Review, Summer-Fall, 1994 by Arturo Estrella, Darryll Hendricks, John Kambhu, Soo Shin, Stefan Walter

Global markets for option products, both change-traded and over-the-counter, have expanded rapidly in recent years. The Bank for International Settlements (1994) reports that outstanding options now exist on notional principal amounts totaling at least $3.3 trillion. In the last four years, the outstanding interest rate, commodity, and equity-related options of U.S. commercial banks have grown more than 40 percent annually and the banks' foreign exchange options more than 16 percent per year.

The expansion of options markets underscores the need for supervisors to develop 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 methods for measuring the market risk of options positions examined in the article fall into two broad categories: simple strategy methods and value-at-risk (or price sensitivity) methods. We compare the performance of the different methods in providing capital coverage for potential losses on a series of option portfolios.

We find that the simple strategy methods provide only a rough measure of potential losses. Moreover, for market participants with large option positions, the simple strategy approach could lead to an excessive reporting burden. The value-at-risk methods, which are based on 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 found to be significantly enhanced by adjustments for gamma risk, the risk that an option's price changes in a nonlinear fashion as a result of large movements in the price of the underlying instrument.(1)

BACKGROUND AND METHODOLOGY THE UNIQUE Risks OF OPTIONS

Like most other instruments, options contracts entail both 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. On some occasions, intermediaries will attempt to eliminate such risk by engaging in offsetting transactions; that is, they attempt to "hedge" the market risk away. On other occasions, however, intermediaries may attempt to earn a risk premium for bearing the market risk. Credit risk arises because a financial asset, such as a purchased option or a business loan, could become worthless if the counterparty to the asset does not make good on its obligations. This article focuses on market risk.

The form that market risk takes in options markets can be quite different from its form in other markets. This is true 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 result from market movements. This task can be particularly difficult in periods of great market stress and lowered liquidity, such as that experienced in the market for European currency options in September 1992.

Alert to these difficulties, supervisors must consider carefully how supervisory capital can best reduce 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 level of prudence could probably be achieved by simply setting very high standards without regard to how the risks change in response to changing market conditions. This approach could, however, require far more capital than is actually needed. 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 such 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 compute 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 movements in the risk factors. To process such 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. Complex supervisory charges may be difficult to implement uniformly. Moreover, the more specific the rule, the greater the opportunities for finding exceptions or exclusions that were not intended. Nevertheless, complex calculations could lead to more accurate and efficient charges, thereby lessening the regulatory burden on the options market.