1. CORE - CloseOut Risk Evaluation
October/2012
CLASSIFICATION OF INFORMATION (CHECK WITH AN “X”):
CONFIDENTIAL AND RESTRICTED
CONFIDENTIAL
INTERNAL USE
PUBLIC X

2. AGENDA
RISK MODELING IN MULTI-ASSET CLASS AND MULTIMARKET CLEARINGHOUSES
THE CORE MODEL FOR CLEARINGHOUSE RISK CALCULATION
HEDGING STRATEGIES THAT BENEFIT FROM THE CORE MODEL
CORE MODEL IMPLEMENTATION
KEY BENEFITS DERIVED FROM THE CORE MODEL IMPLEMENTATION 2

3. AGENDA
RISK MODELING IN MULTI-ASSET CLASS AND MULTIMARKET CLEARINGHOUSES
THE CORE MODEL FOR CLEARINGHOUSE RISK CALCULATION
HEDGING STRATEGIES THAT BENEFIT FROM THE CORE MODEL
CORE MODEL IMPLEMENTATION
KEY BENEFITS DERIVED FROM THE CORE MODEL IMPLEMENTATION 3

4. RISK MODELING IN MULTI-ASSET CLASS CLEARINGHOUSES
DEFINING A ROBUST & EFFICIENT RISK MODEL
MULTI-ASSET CLASS AND MULTIMARKET CLEARINGHOUSES
OPPORTUNITY TO INCREASE EFFICIENCY VIA RISK-OFFSETTING
Efficiency gains are not considered robust when the assumptions employed by the risk-offsetting model have a low level of adherence to reality, resulting in insufficient resources for the clearinghouse to fulfill its obligations
BUT HOW TO ENSURE THAT EFFICIENCY GAINS ARE ROBUST?
NEED TO BUILD A RISK MODEL THAT REFLECTS, IN A REALISTIC WAY, THE RISK MANAGEMENT PROBLEM FACED BY A CLEARINGHOUSE 4

5. RISK MODELING IN MULTI-ASSET CLASS CLEARINGHOUSES
THE RISK MANAGEMENT PROBLEM FACED BY A CLEARINGHOUSE
IN THE EVENT OF A PARTICIPANT DEFAULT, THE RISK MANAGEMENT PROBLEM OF FACED BY A CLEARINGHOUSE IS TO HAVE THE RESOURCES AND LIQUIDITY NEEDED TO PROVIDE AN ORDERLY CLOSEOUT FOR THE SET OF POSITIONS HELD BY THE PARTICIPANT, UNDER CURRENT MARKET CONDITIONS, CONSIDERING A MINIMUM HOLDING PERIOD
T+0
T+1
T+2
T+3
T+4
T+N
...
PORTFOLIO CLOSEOUT PROCESS
MAJOR ASPECTS THAT SHOULD BE TAKEN INTO ACCOUNT BY THE MODEL
EVOLUTION (INTERTEMPORAL DYNAMICS) OF THE RISK FACTORS THAT DEFINE THE VALUE OF THE ASSETS AND CONTRACTS INCLUDED IN THE PORTFOLIO, AS WELL AS OF THE PORTFOLIO COMPOSITION ITSELF
FRICTIONS, RESTRICTIONS AND OPERATIONAL FEATURES ASSOCIATED WITH EACH ASSET INCLUDED IN THE PORTFOLIO
TRADING MODEL – ELECTRONIC VS OTC
LIQUIDITY/MARKET DEPTH
POSSIBILITY OF A FRACTIONAL SETTLEMENT
SETTLEMENT MODEL – RTGS VS DNS
CASH FLOW STRUCTURE OF THE ASSET 5

6. PORTFOLIO CLOSEOUT RISK
RISK MODELING IN MULTI-ASSET CLASS CLEARINGHOUSES
A MORE COMPLEX APPROACH THAN THAT OF MODELS BASED ON VAR
WHEN MODELLING THE RISK MANAGEMENT PROBLEM FACED BY A CLEARINGHOUSE, ONE MUST CONSIDER, IN A JOINT FASHION, THE EVOLUTION OF THE MARKET VARIABLES (PRICES & RATES) AND THAT OF THE PORTFOLIO COMPOSITION, RESPECTING A SET OF SIGNIFICANT RESTRICTIONS IMPOSED BY THE CHARACTERISTICS OF EACH ASSET UNDER CONSIDERATION
PORTFOLIO CLOSEOUT RISK
P&L CALCULATION
...
DYNAMIC PROCESS WITH FRICTIONS
T+0
T+1
T+2
T+3
T+4
T+N
THIS TYPE OF MODELLING REQUIRES CONCEPTS AND TOOLS MORE COMPLEX THAN THOSE TYPICALLY EMPLOYED BY THE FINANCIAL INDUSTRY (I.E. MODELS BASED ON VAR). IN FACT, THESE MODELS OFTEN FOCUS ON MEASURING THE POTENTIAL VALUE OF A STATIC PORTFOLIO, WITHOUT TAKING INTO ACCOUNT A DYNAMIC CLOSEOUT PROCESS WITH FRICTIONS
VARIATION RISK OF THE PORTFOLIO VALUE
T+0
T+N
P&L CALCULATION
STATIC PROCESS WITHOUT FRICTIONS 6

7. IMPLICIT CLOSEOUT MODEL IMPLICIT CLOSEOUT MODEL
RISK MODELING IN MULTI-ASSET CLASS CLEARINGHOUSES
A MORE COMPLEX APPROACH THAN THAT OF MODELS BASED ON VAR (CONT’D)
ALTHOUGH THE MODELS BASED ON VAR MAY BE ADAPTED TO ESTIMATE THE CLOSEOUT RISK, THEIR PLAUSIBILITY IS COMPROMISED WHEN MULTI-ASSET AND MULTIMARKET PORTFOLIOS (I.E. HIGHLY HETEROGENEOUS) ARE CONSIDERED
IMPLICIT CLOSEOUT MODEL
T+0
T+N
UNDERLYING HYPOTHESIS: ALL ASSETS & CONTRACTS ARE TO BE SETTLED AT THE SAME TIME WITHOUT ANY FRICTIONS, WITH FULLY COINCIDING CASH FLOWS
AN ALTERNATIVE APPROACH CONSISTS IN THE USE OF A MODEL BASED ON MULTIPLE SILOS, WHERE EACH SILO CONTAINS ONLY ASSETS AND/OR CONTRACTS WITH COMMON FEATURES (I.E. HOMOGENEOUS). IN THIS CASE, THE TOTAL PORTFOLIO RISK IS GIVEN BY THE ALGEBRAIC SUM OF EACH SILO.
IMPLICIT CLOSEOUT MODEL
T+0
T+N
SUM OF RISKS
SILO 1
SILO 2
SILO 3
... 7

8. RISK MODELING IN MULTI-ASSET CLASS CLEARINGHOUSES
SILO MODELLING & SYSTEMIC RISK INCREASE
EVEN A MODEL BASED ON SILOS, WITH SUPERCOLLATERALIZATION VIA SUM OF RISKS, DOES NOT NECESSARILY ENSURE A MORE ROBUST SYSTEM. IN FACT, A MODEL BASED ON SILOS MAY HIDE IMPORTANT RISKS OF LIQUIDITY FRAGMENTATION AND REDUCE INCENTIVES TOWARDS THE ADOPTION OF A DILIGENT BEHAVIOR IN TIMES OF CRISIS.
ORIGINAL SITUATION, AGENTS “A” & “B”
T+0
T+N
COLLATERAL (RISK) = 100
SILO 1
AGENT “A” HEDGES SILO 2 RISK ON THE MARKET
SILO 2
AGENT “B” DOES NOT HEDGE AT ALL
INCREASED MARKET VOLATILITY
COLLATERAL(RISK) = 200
DISINCENTIVE TOWARDS A DILIGENT BEHAVIOR
LIQUIDITY RISK INCREASES IN THE SYSTEM
LTCM SCENARIOS (1998) & NTN-D CRISIS (2002)
SILO 1
SILO 2 8

9. AGENDA
RISK MODELING IN MULTI-ASSET CLASS AND MULTIMARKET CLEARINGHOUSES
THE CORE MODEL FOR CLEARINGHOUSE RISK CALCULATION
HEDGING STRATEGIES THAT BENEFIT FROM THE CORE MODEL
CORE MODEL IMPLEMENTATION
KEY BENEFITS DERIVED FROM THE CORE MODEL IMPLEMENTATION 9

10. CONSIDERS THE INTERTEMPORAL DYNAMICS OF THE PORTFOLIO CLOSEOUT PROCESS
THE CORE MODEL FOR RISK CALCULATION
THE CORE MODEL
THE CORE MODEL WAS SPECIFICALLY DEVELOPED BY BM&FBOVESPA TO ALLOW FOR ROBUST AND EFFICIENT RISK ESTIMATION IN A MULTI-ASSET CLASS, MULTIMARKET CLEARINGHOUSE
MAJOR FEATURES
CONSIDERS THE INTERTEMPORAL DYNAMICS OF THE PORTFOLIO CLOSEOUT PROCESS
CONTEMPLATES IMPORTANT FRICTIONS & RESTRICTIONS ASSOCIATED WITH THE SETTLEMENT PROCESS OF ASSETS AND CONTRACTS – TRADING DYNAMICS, MARKET LIQUIDITY AND DEPTH, CASH FLOW STRUCTURE, ETC
ESTIMATES, IN BOTH A JOINT AND A CONSISTENT MANNER, THE MARKET AND LIQUIDITY RISKS ASSOCIATED WITH A PORTFOLIO CLOSEOUT PROCESS 10

11. 1. DETERMINING THE CLOSEOUT STRATEGY 3. POTENTIAL P&L CALCULATION
THE CORE MODEL FOR RISK CALCULATION
OVERVIEW: CLOSEOUT RISK CALCULATION IN THREE STEPS
1. DETERMINING THE CLOSEOUT STRATEGY
T+0
T+1
T+2
T+3
T+4
T+N
...
Defines the portfolio closeout strategy which, respecting the settlement restrictions of the portfolio of assets/markets, should minimize the risk of a loss associated with the closeout process, preserving existing hedge strategies
2. RISK EVALUATION
T+0
T+1
T+2
T+3
T+4
T+N
...
Defines the (stress) scenarios associated with the dynamics of each risk factor relevant to the portfolio. All assets and contracts are reevaluated considering the scenarios defined in this step (full valuation).
3. POTENTIAL P&L CALCULATION
T+0
T+1
T+2
T+3
T+4
T+N
...
Calculates and aggregates intertemporally P&L associated with each scenario, considering the defined closeout strategy
CLOSEOUT RISK
Result: Two risk measures—market and liquidity—that are estimated both jointly and consistently
PERMANENT LOSS
TRANSIENT LOSS 11

12. 3. POTENTIAL P&L DETERMINATION
THE CORE MODEL FOR RISK CALCULATION
OVERVIEW: PERMANENT & TRANSIENT LOSS
T+0
T+1
T+2
T+3
T+4
T+N
...
3. POTENTIAL P&L DETERMINATION
CASH NEED BY T+N
PERMANENT LOSS V0 + V1 V2 V3 V4 VN
CASH NEED BY T+4
CASH NEED BY T+3
CASH NEED BY T+2
CASH NEED BY T+1
CASH NEED BY T+0
CASH FLOW AMOUNTS
CASH NEED ON T+N
MAXIMUM BETWEEN
TRANSIENT LOSS
EQUALS 12

13. OPTIMAL STRATEGY DEFINITION
THE CORE MODEL FOR RISK CALCULATION
DETAIL: CLOSEOUT STRATEGY DEFINITION
T+0
T+1
T+2
T+3
T+4
T+5
PORTFOLIO
CLOSEOUT
FUTURES, BUY, IMMEDIATE SETTLEMENT
OPTIONS, SELL, SETTLEMENT ON T+3 ONLY
SWAP, SELL, SETTLEMENT ON T+5 ONLY 1
NAIVE STRATEGY
RISK
MINIMUM RISK 2
OPTIMAL STRATEGY DEFINITION
OPTIMAL STRATEGY 3
ITERATION 13

14. THE CORE MODEL FOR RISK CALCULATION
DETAIL: PORTFOLIO COMPOSITION & RISK FACTOR EVOLUTION
P&L ALONG THE PROCESS
T+0
T+1
T+2
T+3
T+4
T+5
T+6
PORTFOLIO
CLOSEOUT
FACTOR 1
FACTOR 2
FACTOR n
T+0
T+1
T+2
T+3
T+4
T+5
T+6
MARKET
RISK FACTOR EVOLUTION 14

15. SCENARIOS TO DETERMINE P&L DURING THE CLOSEOUT PROCESS
THE CORE MODEL FOR RISK CALCULATION
DETAIL: RISK FACTOR EVOLUTION & MULTIVARIATE SCENARIO GENERATION
...
FACTOR 1
...
...
...
...
...
...
FACTOR 1
MULTIVARIATE
SCENARIO
GENERATOR
FACTOR 2
FACTOR 2
...
...
FACTOR n
FACTOR n
SCENARIOS TO DETERMINE P&L DURING THE CLOSEOUT PROCESS
T+0 – T+1 – T – T+N
T+0 – T+1 – T – T+N
...
...
...
...
...
...
...
# SCENARIO
RISK FACTOR
T+0 – T+1 – T+2 – ... – T+N 15

16. THE CORE MODEL FOR RISK CALCULATION
DETAIL: P&L DETERMINATION DURING THE CLOSEOUT PROCESS
WORST CASE SCENARIO
PERMANENT LOSS
TRANSIENT LOSS #1
PERMANENT LOSS
TRANSIENT LOSS #2
PERMANENT LOSS
TRANSIENT LOSS #3
...
...
...
...
...
PERMANENT LOSS
TRANSIENT LOSS
#nSCN
SCENARIOS
T+1
T+2
T+3
T+4
T+5
T+6
POSITIVE FLOW
NEGATIVE FLOW 16

17. AGENDA
RISK MODELING IN MULTI-ASSET CLASS AND MULTIMARKET CLEARINGHOUSES
THE CORE MODEL FOR CLEARINGHOUSE RISK CALCULATION
HEDGING STRATEGIES THAT BENEFIT FROM THE CORE MODEL
CORE MODEL IMPLEMENTATION
KEY BENEFITS DERIVED FROM THE CORE MODEL IMPLEMENTATION 17

18. HEDGING AN OTC DERIVATIVES POSITION ON THE LISTED DERIVATIVES MARKET
HEDGING STRATEGIES BENEFITING FROM THE CORE MODEL
MAIN EXAMPLES
HEDGING AN OTC DERIVATIVES POSITION ON THE LISTED DERIVATIVES MARKET
CORE RISK
CLOSEOUT RISK
...
T+0
T+1
T+2
T+3
T+4
T+N
CURRENT MODEL
SUM OF RISKS
T+0
T+T
T+0
T+T
T+0
T+N
SILO 1
OTC POSITION
SILO 2
LISTED DERIVATIVES
SILO 3
COLLATERAL
CORE RISK: PORTFOLIO CLOSEOUT COST (POSITIONS + COLLATERAL) MUST BE EQUAL TO OR LESS THAN ZERO
CURRENT MODEL: COLLATERAL-HAIRCUT EQUAL TO OR GREATER THAN RISK (OTC) + RISK (LISTED DERIVATIVES) 18

19. ASSET BEING HEDGED IS POSTED AS COLLATERAL
HEDGING STRATEGIES BENEFITING FROM THE CORE MODEL
MAIN EXAMPLES (CONT’D)
ASSET BEING HEDGED IS POSTED AS COLLATERAL
CORE RISK
CLOSEOUT RISK
...
T+0
T+1
T+2
T+3
T+4
T+N
CURRENT MODEL
SUM OF RISKS
T+0
T+T
T+0
T+N
SILO 1
LISTED DERIVATIVES
SILO 2
COLLATERAL
CORE RISK: PORTFOLIO CLOSEOUT COST (POSITIONS + COLLATERAL) MUST BE EQUAL TO OR LESS THAN ZERO
CURRENT MODEL: COLLATERAL-HAIRCUT EQUAL TO OR GREATER THAN RISK (LISTED DERIVATIVES) 19

20. HEDGING STRATEGIES BENEFITING FROM THE CORE MODEL
MAIN EXAMPLES (CONT’D)
EQUITIES BORROWER HOLDING COLLATERAL IN SHARES OF THE SAME COMPANY, BUT OF A DIFFERENT TYPE (PREFERRED VS COMMON)
CORE RISK
CLOSEOUT RISK
...
T+0
T+1
T+2
T+3
T+4
T+N
CURRENT MODEL
SUM OF RISKS
T+0
T+T
T+0
T+N
SILO 1
EQUITIES LENDING
SILO 2
COLLATERAL
CORE RISK: PORTFOLIO CLOSEOUT COST (POSITIONS + COLLATERAL) MUST BE EQUAL TO OR LESS THAN ZERO
CURRENT MODEL: COLLATERAL-HAIRCUT EQUAL TO OR GREATER THAN RISK (LENDING) 20

21. AGENDA
RISK MODELING IN MULTI-ASSET CLASS AND MULTIMARKET CLEARINGHOUSES
THE CORE MODEL FOR CLEARINGHOUSE RISK CALCULATION
HEDGING STRATEGIES THAT BENEFIT FROM THE CORE MODEL
CORE MODEL IMPLEMENTATION
KEY BENEFITS DERIVED FROM THE CORE MODEL IMPLEMENTATION 21

22. CORE MODEL IMPLEMENTATION
MODEL COMPONENTS & IT ARCHITECTURE
OPTIMAL CLOSEOUT STRATEGY DEFINITION
PRICE GENERATION BASED ON MULTIVARIATE SCENARIOS
RISK AGGREGATION & CONTROL
INTERFACE WITH THE RTC PLATFORM (CINNOBER)
SPECIFIC SOFTWARE TO DEAL WITH OPTIMIZATION ISSUES
VERY HIGH PERFORMANCE PARALLEL ARCHITECTURE USING GRAPHIC UNITS WITH MULTIPLE PROCESSORS (GPUs)
HIGH PERFORMANCE SOFTWARE DEVELOPED IN C++ BY BM&FBOVESPA
RISK PLUG-IN DEVELOPED BY BM&FBOVESPA IN TANDEM WITH CINNOBER 22

23. CORE MODEL IMPLEMENTATION
TEAMS INVOLVED
RISK MANAGEMENT OFFICE
FINANCE CONCEPTS (MR. MARCO AVELLANEDA/NYU & MR. RAMA CONT/COLUMBIA)
IT OFFICE POST-TRADING
INDEPENDENT ASSESMENT, FEASIBILITY ANALYSIS, SUPPORT TO MODEL DEFINITION
MODEL DEFINITION, PROTOTYPE CONSTRUCTION, DEFINITIVE MODEL TESTING
CORE MODEL DEVELOPMENT 23

24. PROTOTYPE PRESENTATION
CORE MODEL IMPLEMENTATION
PROJECT STATUS - MACRO
CONCEPTUAL MODEL
MATHEMATICAL MODEL
PROTOTYPE
RISK PLUG-IN/CORE
DEC2010
JUL2010
DEC2011
JUL2011
DEC2012
MAR2013
PROTOTYPE PRESENTATION 24

25. AGENDA
RISK MODELING IN MULTI-ASSET CLASS AND MULTIMARKET CLEARINGHOUSES
THE CORE MODEL FOR CLEARINGHOUSE RISK CALCULATION
HEDGING STRATEGIES THAT BENEFIT FROM THE CORE MODEL
CORE MODEL IMPLEMENTATION
KEY BENEFITS DERIVED FROM THE CORE MODEL IMPLEMENTATION 25

26. KEY BENEFITS DERIVED FROM THE CORE MODEL IMPLEMENTATION
DEVELOPED SPECIFICALLY TO DEAL WITH THE RISK MANAGEMENT PROBLEM FACED BY CLEARINGHOUSES
ROBUST MODELLING PROVIDING EFFICIENCY GAINS WITHOUT GIVING UP SAFETY
TRANSPARENT & INTUITIVE MODEL – ASSUMPTIONS CA BE EASILY VALIDATED
MARKET & LIQUIDITY RISKS ARE TREATED IN BOTH A JOINT AND A CONSISTENT MANNER
GREATER EFFICIENCY IN CAPITAL ALLOCATION FOR PORTFOLIOS WITH RISK MITIGATION STRATEGIES (HEDGE)
INCENTIVES TO THE ADOPTION OF PRUDENTIAL MEASURES TO MITIGATE RISKS
CIRCUMVENTS THE SILO APPROACH, SO LIQUIDITY FRAGMENTATION IS AVOIDED AND SYSTEMIC RISK MITIGATED 26