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Slide 1
Neil Walter
Terminology
Three reasons why this presentation matters
Additional considerations for physical deals
A framework for measurement
Insights
References
Slide 3
Neil Walter
Terminology
Finance
Concerned with monthly accrued changes. Errors crossing
reporting periods (monthly or quarterly) may be the most relevant
to this constituency.
Accounting
Concerned with settlement and reconciliation. Errors persisting to
settlement (physical or financial) may be the most relevant metric
to this constituency.
Slide 4
Neil Walter
Terminology
Error/Correction
Change to any portion of the trade after the day it was entered into
the system.
Rebook
Change to the trade so that the risk exposure is altered after the
day it was entered into the system (a subset of error).
Nostro Break
Discrepancy between expected and actual cash settlements.
Slide 5
Neil Walter
2003
8
15
6
10%
2004
14
7
12
10%
2003
11
6
3
7%
2004
14
7
12
8%
Slide 6
Neil Walter
93%
3.4
2.5
83%
78%
73%
63%
59%
+
5.9
30%
15%
Trade Date
2003
T+1
T+2
T+3
T+4
T+5
2004
Slide 7
Neil Walter
0
89%
15%
8.9%
0
1
100%
59%
1.1%
0
2
100%
78%
0%
0
3.4
2.5
6
10%
3
100%
89%
0%
0
5
100%
100%
0%
0
6
100%
7
100%
8
100%
9
100%
10
100%
11
100%
0%
1.5%
0%
4.4%
0%
1.9%
0%
1.1%
0%
0.4%
0%
0.7%
8.5%
4.1%
2.2%
1.1%
0.7%
0.0%
4
100%
93%
0%
0
Trade entered
into system
Confirmation is
sent out
Expiry
Trade is
executed by
trader
Confirmation is primary
control as parties indicate
they agree the terms are
correct.
Slide 9
Neil Walter
Trade
entered into
system
Confirmation
is sent out
Schedule
gas on EBB
Delivery
Trade is
executed
by trader
Balance
pipeline
Invoice
generated
Pay/receive
cash
Slide 10
Neil Walter
Delivery start
Delivery End
Fixed transportation charges
Variable transportation charges
Transportation path
Additional balancing transactions
Slide 11
Neil Walter
Value1-Value0=mark-to-market
Value1
P1
Mark-to-market is actually:
Q0(P1-P0)
P0
Value0
Quantity
Q0 Q1
+ Qi (P1-Pi)
+ Qi (P1-Pi)
+ Qi-new(P1-Pi-new)
Qi-old(P1-Pi-old)
corrected
Mark-to-market
Slide 12
Neil Walter
-2
-1.5
-1
-0.5
0.5
1.5
2.5
Slide 13
Neil Walter
Slide 14
Neil Walter
3.
4.
Model the MTM impact of each error given the number of days it
took to get corrected. (Normal dist)
Infer an aggregate distribution for the errors.
For this example, assumptions are consistent with the ISDA data
provided on OTC commodity derivatives.
For more information on aggregate distributions and the generalized methodology used here
Klugman, Panjer and Willmot. Loss Models: From Data to Decisions. New York: Wiley, 1998. Chapter 4
A sample model similar to the one used for this presentation is available upon request. Please contact Xianqiao
Chen at xianqiao.chen@conocophillips.com
Sahay and Dev A Forward-Looking Adjustment for Operational Risk Quantification Risk, April 2005 Vol. 18, No 4
Samad-Khan, Ali Why COSO is Flawed Operational Risk Magazine, January 2005
Slide 15
Neil Walter
12%
10%
8%
6%
Assumptions
Mean errors (per 100 trades)
Stdev errors
mean # days to correct (per trade)
Stdev # days
mean MTM impact (per trade)
Stdev MTM impact
Sample Mean
p-value (H0: Mean=0)
Sample Stdev
-1.65 * Sample Stdev
Poisson
Negative Binomial
10.0
10.0
3.2
6.0
7.6
7.6
2.8
5.0
25,000
25,000
Poisson
Negative Binomial
1,169
110
67%
60%
189,512
210,903
(312,696)
(347,991)
4%
2%
42
,9
00
12
6,
36
3
20
9,
82
5
29
3,
28
8
37
6,
75
0
46
0,
21
3
54
3,
67
6
62
7,
13
8
71
0,
60
1
79
4,
06
4
87
7,
52
6
0%
(8
75
,1
89
)
(7
91
,7
26
)
(7
08
,2
64
)
(6
24
,8
01
)
(5
41
,3
39
)
(4
57
,8
76
)
(3
74
,4
13
)
(2
90
,9
51
)
(2
07
,4
88
)
(1
24
,0
25
)
(4
0,
56
3)
Slide 16
Neil Walter
Insights
Error rates are higher for commodities than for other derivatives. Physical
deals increase the propensity for error.
Errors can persist for long periods of time. Monitoring provides a systematic
methodology for reducing errors and improving business processes.
Portfolio variance is more than price risk. Explaining daily or periodic MTM
changes necessitates assigning variance to corrective actions.
Although the MTM impact of an error for any given trade may be smalland
may even be expected to be 0 over timethe variance for any given day as a
result of errors can represent a significant portion of the total variance and
ought to be explained as such.
The modeling approach can be extended to other types of operational risk
such as nostro breaks (also a frequency/severity problem).
Other disciplines such as operations management and actuarial science
contain valuable methodologies for improving estimation of exposure and
reducing risk over time.
Slide 17
Neil Walter
References
1. Basel Committee on Banking Supervision. International Convergence of Capital Measurements and
Capital Standard: A Revised Framework, June 2004, P. 137
2. International Swaps and Derivatives Association. ISDA 2004 Operations Benchmarking Survey, P. 6-7
http://www.isda.org/c_and_a/pdf/ISDA-Operations-Survey-2004.pdf
For more information on aggregate distributions and the generalized methodology used here
Klugman, Panjer and Willmot. Loss Models: From Data to Decisions. New York: Wiley, 1998. Chapter 4
For more information on modeling operational risk
Kindall, Walter, and Chen. The Operational Impact of Belated Trades GARP Risk Review
November/December 04, Issue 21, P.6
A sample model similar to the one used for this presentation is available upon request. Please contact
Xianqiao Chen at xianqiao.chen@conocophillips.com
See the Basel Committee guidelines for operational risk. Basel Committee on Banking Supervision.
International Convergence of Capital Measurements and Capital Standard: A Revised Framework,
June 2004
Sahay and Dev A Forward-Looking Adjustment for Operational Risk Quantification Risk, April 2005
Vol. 18, No 4
Samad-Khan, Ali Why COSO is Flawed Operational Risk Magazine, January 2005
Slide 18
Neil Walter