DRAFT ASIAN DEVELOPMENT BANK Office of the General Auditor FOR INTERNAL USE ONLY (Do Not Reproduce Return to OGA After Use) AUDIT REPORT ON FINANCIAL DERIVATIVES This Copy: Draft Report No.4 19 May 1999 ASIAN DEVELOPMENT BANK Office of the General Auditor REPORT ON AN AUDIT OF FINANCIAL DERIVATIVES TABLE OF CONTENTS Para. Nos. HIGHLIGHTS IBACKGROUND1-7 IIOBJECTIVES OF THE AUDIT8 IIISCOPE OF AUDIT9 IVFINDINGS, RECOMMENDATIONS AND COMMENTS A.Duration10-15 B.Relationship Between Duration and Futures Trading16-24 C.Portfolio Risk Profile25-39 D.Authentication of Trades Data40 E.Distribution of Trades41-48 Appendices 1.Table of Audit Recommendations 2.US Dollar Portfolio Duration vs. Futures Transactions 3.French Franc Portfolio Duration vs. Futures Transactions 4.US Dollar Profit and Loss Analysis 5.Japanese Yen Profit and Loss Analysis 6.French Franc Profit and Loss Analysis 7.Authentication of Trades Data ASIAN DEVELOPMENT BANK Office of the General Auditor - i - REPORT ON AN AUDIT OF FINANCIAL DERIVATIVES HIGHLIGHTS BACKGROUND 1.The Expanded Investment Authority of the Treasurers Department (TD), which was approved by the Asian Development Banks (Bank) Board of Directors on 24 October 1991, allows the Bank to trade exchange-traded financial futures and options contracts for the purpose of managing market risk of the Banks investment portfolio (Portfolio). 2.The Portfolio is maintained primarily as part of the Banks cash flow management process to allow the Bank to continue to function should its borrowing operations be interrupted. Given that the key aim of maintaining the Portfolio is to manage the cash flow of the Bank, more consideration is accorded to the security and liquidity of investments rather than the income they generate. Hence funds are invested to achieve the principal objectives of security and liquidity, and maximising return on the Portfolio is only an ancillary objective. This implies that the primary investment strategy of the Portfolio is minimisation of the Portfolios risk before optimisation of the Portfolios income or return. 3.Paragraph 13 of the Expanded Investment Authority document states that the Bank can use financial futures and options contracts to have more control over the market risk of its Portfolio. In line with the Banks investment strategy and Paragraph 13, ASIAN DEVELOPMENT BANK Office of the General Auditor - ii - the Banks key objective of using financial futures and options should therefore be to minimise the risk of the Portfolio rather than to generate income. In other words, the Bank is allowed to use financial futures and options generally as hedging instruments, in contrast for example to an investment bank that might use these for pure trading/speculative purposes, i.e., to enhance the Portfolios return by taking a view on the market. 4.The Bank began its financial derivatives trading activities in 1994. The Banks financial derivatives trading activities have been concentrated primarily in interest rate futures contracts. 5.An audit was requested by the Audit Committee of the Board to evaluate whether the derivatives transactions undertaken by the Bank were conducted in accordance with the Banks policy on derivatives trading. The Office of the General Auditor (OGA) engaged KPMG Consulting (Asia Pacific) to assist in this audit (the Audit). 6.The objectives of this Audit were to: (i) analyse the hedging activities in financial derivatives; (ii) analyse the derivatives transactions and determine the existence of abnormal trends; and (iii) identify essential and practical risk management measures necessary to mitigate the Banks exposure to risks identified from the above analyses as well as any weaknesses in the existing internal control systems. ASIAN DEVELOPMENT BANK Office of the General Auditor - iii - OVERALL CONCLUSION 7.The Audit revealed the following: i.Analyses of the Banks derivatives trading activities showed that the Bank used derivatives mainly for income optimisation rather than to manage the Banks Portfolio Duration, i.e., market risk management. These activities appear somewhat inconsistent with the Banks overall investment strategy, which primary objectives are security and liquidity rather than income generation. Most of the futures trades were extremely short-term in nature or intra-day. These kind of trades are more speculative in nature, and hence, actually increased the Banks market risk exposure as evidenced by the risk analyses conducted on selected Portfolios. ii.The setting of risk limits, i.e., Duration targets, are left too broadly to TD. Management only defines broad Duration band targets. This effectively allows TD to set its own trading and risk limits with little management involvement, which is not “best practice”. Furthermore, the Duration target bands set by TD are too wide, and there is no stop-loss limit established for the Banks derivatives trading activities. iii.There appears to be a concentration of futu