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CORE - CloseOut Risk Evaluation October /2012

CORE - CloseOut Risk Evaluation October /2012. CLASSIFICATION OF INFORMATION (CHECK WITH AN “X”):. CONFIDENTIAL AND RESTRICTED. CONFIDENTIAL. INTERNAL USE. PUBLIC. X. AGENDA. RISK MODELING IN MULTI-ASSET CLASS AND MULTIMARKET CLEARINGHOUSES.

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CORE - CloseOut Risk Evaluation October /2012

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  1. CORE - CloseOutRiskEvaluation 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

  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

  4. RISK MODELING IN MULTI-ASSET CLASS CLEARINGHOUSES • DEFINING A ROBUST & EFFICIENT RISK MODEL MULTI-ASSETCLASSANDMULTIMARKETCLEARINGHOUSES OPPORTUNITY TO INCREASE EFFICIENCY VIARISK-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 GAINSARE ROBUST? NEED TO BUILD A RISK MODEL THAT REFLECTS, IN A REALISTIC WAY, THE RISK MANAGEMENT PROBLEM FACED BY A CLEARINGHOUSE

  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 PORTFOLIO CLOSEOUT PROCESS ... T+0 T+2 T+3 T+4 T+N T+1 MAJOR ASPECTS THAT SHOULD BE TAKEN INTO ACCOUNT BY THE MODEL TRADING MODEL – ELECTRONIC VS OTC 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 SETTLEMENT MODEL – RTGS VS DNS LIQUIDITY/MARKET DEPTH FRICTIONS, RESTRICTIONS AND OPERATIONAL FEATURES ASSOCIATED WITH EACH ASSET INCLUDED IN THE PORTFOLIO CASH FLOW STRUCTURE OF THE ASSET POSSIBILITY OF A FRACTIONAL SETTLEMENT

  6. 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&LCALCULATION • DYNAMIC PROCESS WITH FRICTIONS ... T+0 T+2 T+3 T+4 T+N T+1 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 • P&LCALCULATION • STATIC PROCESS WITHOUT FRICTIONS T+0 T+N

  7. 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 • UNDERLYING HYPOTHESIS: ALL ASSETS & CONTRACTS ARE TO BE SETTLED AT THE SAME TIME WITHOUT ANY FRICTIONS, WITH FULLY COINCIDING CASH FLOWS T+0 T+N 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 • SUM OF RISKS T+0 T+0 T+0 T+N T+N T+N • ... • SILO 1 • SILO 2 • SILO 3

  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” • COLLATERAL (RISK) = 100 T+0 T+0 T+N T+N • SILO 1 • SILO 2 INCREASED MARKET VOLATILITY DISINCENTIVE TOWARDS A DILIGENT BEHAVIOR AGENT “A” HEDGES SILO 2 RISK ON THE MARKET • COLLATERAL(RISK) = 200 LIQUIDITY RISK INCREASES IN THE SYSTEM T+0 T+0 T+N T+N • SILO 1 • SILO 2 AGENT “B” DOES NOT HEDGE AT ALL LTCM SCENARIOS (1998) & NTN-D CRISIS (2002) • COLLATERAL (RISK) = 100 T+0 T+0 T+N T+N • SILO 1 • SILO 2

  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

  10. 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

  11. THE CORE MODEL FOR RISK CALCULATION • OVERVIEW: CLOSEOUT RISK CALCULATION IN THREE STEPS 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 1. DETERMINING THE CLOSEOUT STRATEGY ... T+0 T+2 T+3 T+4 T+N T+1 2. RISK EVALUATION 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). ... T+0 T+2 T+3 T+4 T+N T+1 3. POTENTIAL P&L CALCULATION Calculates and aggregates intertemporallyP&L associated with each scenario, considering the defined closeout strategy ... T+0 T+2 T+3 T+4 T+N T+1 CLOSEOUT RISK PERMANENT LOSS TRANSIENT LOSS Result: Two risk measures—market and liquidity—that are estimated both jointly and consistently

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

  13. THE CORE MODEL FOR RISK CALCULATION • DETAIL: CLOSEOUT STRATEGY DEFINITION T+0 T+5 T+1 T+2 T+3 T+4 CLOSEOUT PORTFOLIO 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 3 OPTIMAL STRATEGY ITERATION

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

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

  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 POSITIVE FLOW SCENARIOS T+2 T+1 T+3 T+4 T+5 T+6 NEGATIVE FLOW

  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

  18. 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+2 T+3 T+4 T+N T+1 CURRENT MODEL • SUM OF RISKS T+0 T+0 T+0 T+N T+T T+T • SILO 2 • LISTED DERIVATIVES • SILO 1 • OTC POSITION • 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)

  19. 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+2 T+3 T+4 T+N T+1 CURRENT MODEL • SUM OF RISKS T+0 T+0 T+T T+N • SILO 2 • COLLATERAL • SILO 1 • LISTED DERIVATIVES 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)

  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+2 T+3 T+4 T+N T+1 CURRENT MODEL • SUM OF RISKS T+0 T+0 T+T T+N • SILO 2 • COLLATERAL • SILO 1 • EQUITIES LENDING 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)

  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

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

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

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

  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

  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

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