By PricewaterhouseCoopers, Risk Books
This can be an authoritative, step by step consultant throughout the practicalities of auditing derivatives. It comprises an advent to the designated features of some of the tools and terminology, and an up to date assessment of regulatory issues all over the world.
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Additional info for Derivatives and the Internal Auditor
For them, derivative contracts intended to risk manage underlying positions turned into near-lethal cocktails. For the 200-year-old British bank, Barings, the losses were indeed fatal - reminding us that the derivatives vendors and traders get burned too! Although serious derivatives losses have seemed to come in waves, appearing to peak in 1994, the fall of 1998 witnessed a series of sharp contractions in the US stock market, accompanied by a surge in the US bond market. The highly publicised forced rescue of the US hedge fund Long-Term Capital Management (LTCM), such a heavy user of derivatives that it has been characterised by some commentators as a kind of derivatives "reinsurer" for the risk management industry, sent chills down the spines not only of many investors but also of major lenders and regulators.
These contracts are binding and legally enforceable, but of course they are also subject to the possibility that the counterparty will default. There is usually no direct regulation of forward contracts, as they are private transactions, but agencies that regulate the participating firms do assert some modest influence over the use of these instruments. When the contract expires, the buyer pays the agreed-upon price and the seller delivers the asset - which might be anything from a bundle of bonds to supertankers full of crude oil.
The aim of this chapter, then, is to introduce auditors to the basic concepts of derivatives, what the instruments are, how they are used, and the special risks they create. Our task is not a simple one; derivatives can be quite complex and the language, albeit colourful, can be confusing. Like any new science, risk management abounds with buzz words. Terms such as delta, gamma, vega, value-at-risk, volatility smile, path-dependency, and quanto are sprinkled around by the "rocket scientists" (ie quantification specialists) working for derivatives vendors.