Trading desk P&L analysis: why does it makes losses?

Question

There is an invesment bank and the trading desk with negative cumulative P&L within some period of time (say, a 3-month one), and my common question why is it so?

The desk issues structured bonds with exotic options embedded, and the portfolio is rather diversified. They issue a structure, selling to clients, and hedge in the market. So, the desk persistenly makes losses (many small downjumps in daily historical observations), although the market is nearly stable this period. How can we establish the key reasons of losses?

How to begin the analysis of cumulative PL? What are the key questions to begin with? Thanks in advance!

Answer 1

Were the structured notes and their hedges meant to have zero P&L? An example of this not being true, the desk has large positive P&L when it sells a note to a client, then during the life of the note, the dessk has negative carry and/or costs of dynamically rehedging. In this case, negative P&L is by design. One of the reasons why the negative P&L is greater than expected might be that the bid-offer spread was greaster than expected, or the market was more volatile, and the re-hedging was more frequent than expected. The lesson learned is to charge clients more in the future.

If the notes and their hedges were meant to have near-zero net P&L, but have non-zero P&L, then, as Kermittfrog commented, a good P&L Explain tool would be very useful. If you're able to attribute most of the P&L to various deltas / gammas / cross-gammas and carry / rolldowns, with minimal unexplained P&L, then you should be able to read off right away what fails to net to zero. Some possible explanations are:

whoever structured this, forgot about some negative carry or financing costs that the desk pays and fails to pass on to the clients

The hedges don't exactly replicate the payoff of the note sold to the client, the desk retained some market risk. For example, they sell to the clients an embedded option with some strike and expiry, but hedge it with options with different strike and/or maturity.

It is also a good idea to look at the VaR. If the VaR is close to 0, but the P&L is not, then the VaR probably needs to be debugged. If the VaR is in line with the P&L, then if you have better than average VaR analysis tools, you can see what market scenarios caused the P&L in the tail, and what market factors drove it.

Answer 2

I am not too familiar with the structured bonds, but even for option hedging, it is imperfect with the Greeks. Usually options that are issued with investment banks are hedged daily for the first-order Greeks at a daily frequency, and the higher orders at a less frequent interval. But if you issue a large notional, it is possible for imperfect hedging (due to the discrete nature of hedging) and higher order Greeks to result in negative cumulative P&L.

Answer 3

1. Check "gamma vs theta" in PNL predict (Greek-based)
2. Bid offer spreads in delta hedging.
3. Transaction costs.
4. Marks of the observed parameters, e.g correlations or mean reversion speed s if any.

Some trades may have negative PNL, but other motivation, e.g. capital release, but perhaps not these ones.

Answer 4

Derivative portfolios PnL is completely dependent on statistical properties of the underlying (and any other risk factor). If realized vol is higher than implied vol, the call deltahedge leaks money.

Derivative portfolios take damage because the correct cost of hedging (i.e. correct dynamics of the underlying and all risk factors) is difficult to estimate day after day. Even if you estimate them correctly, the market might not agree with you, and so you MtM and take a loss.