Case Study Details

Overview

A qualified central counterparty clearing house (CCP) requested full validation of an initial margin model on FX Options under the CFTC regulation.

Purpose

A qualified CCP requested a full validation of an initial margin model on FX options. This validation effort played a key role in being able to get the approval of the regulator and start business on a new type of product.

As well as being recognised for performing in-depth applied validations, Risk Dynamics also has good knowledge of the client business model and validation methodology as it has been providing validation services for this client for more than three years. As a result, Risk Dynamics was tasked with validating this model.

Approach

The validation team consisted of team members with deep expertise in initial margin model validation. We defined a structured validation approach covering all regulatory requirements and articulating the in-depth expertise regarding the product and its related modelling aspects.

Conducted data quality checks: We started with data cleansing to ensure appropriateness and quality of the inputs. We then replicated all the data transformations and data processing steps. We then benchmarked the overall data quality against the best practices in the industry.

Reviewed and replicated the core model: We covered options on FX forwards for seven currency pairs with maturities up to two years. We performed a detailed review of the model’s compliance with regulatory guidelines and its methodological soundness. We challenged the model assumptions and expert judgement process, performed an independent review of the code and also replicated the pricing model and SABR calibration.

Performed independent back-testing: We implemented independent back-testing by building synthetic portfolios, both at single asset level and portfolio level. We considered coverage of the margin model, stability, mitigation of pro-cyclicality, sensitivity to a change in model parameters and model assumptions.

Outcome

We identified key modelling issues and set up of recommendations leading to an improvement of the model in the course of validation, eventually receiving approval from the regulator. We provided the client with a clear interpretation of the boundaries of the methodology and a proposed solution for enhanced control and monitoring of these portfolios exposures.

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SAM ISBISTER

Managing Director

ABOUT US

Why Risk Dynamics?

Our focus and dedication to model risk management and validation of risk models services, our independence and benchmarks, combined with our ability to provide unbiased views across regions and regulatory regimes, is unique in the market.

In MRM, our benchmarks are market-leading and based on annual surveys input of close to 100 leading financial institutions. Our proprietary model risk management framework allows us to follow our client along the entire path of a model risk management transformation.