The Volcker metric known as inventory aging… and thoughts of Whisky
Inventory Aging is a rather innocuous looking member of the band of (now) seven metrics that, under the Volcker rule, banking entities with significant trading assets and liabilities are required to calculate daily and report monthly.
As written, the metric description seems straightforward enough:
Inventory Aging generally describes a schedule of the trading desk’s aggregate assets and liabilities and the amount of time that those assets and liabilities have been held. [It] should measure the age profile of the trading desk’s assets and liabilities and must include two schedules, an asset- aging schedule and a liability-aging schedule.
The graphic below broadly outlines the processes of asset/liability tagging, matching, sorting and netting of trades involved in generating an inventory aging schedule.
Straightforward enough for standardized instruments where the product can be unambiguously described such that its quantities (i.e. how much is held and for how long it has been held) can be reasonably easily established. For OTC derivatives not so much; and for complex OTC derivatives, well that is when one’s thoughts wander to Whisky.
And an analogy…
© Acuity Derivatives LLC, 2014
A complex OTC derivative represents a complex composite of stochastic interactions between a great many variables, that together unambiguously describe it. Not unlike Whisky. And like Whisky, an unambiguous description is almost impossible to be had; but is best approximated via a robust classification scheme. At the TSAM Technology and Operational Strategy conference in June this Whisky analogy was used — perhaps to distraction in a late presentation session on a hot summer afternoon.
The TSAM presentation itself may be viewed and downloaded below.
As has been described in earlier discussions of the topic, classification attempts to arrange traded financial derivatives into product classes or groups based on similar or related properties (similarity of properties as meaningful within some context). Here, risk and valuation materiality form the classification context.
In this context, classification is less about a normative way of naming products and more about a framework for ordering the properties of financial derivative contracts in such a way that they can be grouped around the types of risk sensitive behavior they are likely to exhibit; so risk similar products are treated consistently e.g. for netting within a Volcker metrics or similar risk reporting framework that relies on aggregation and similarity.
Inventory Aging is a metric that teases out the subtlety of this complexity. In the post-regulatory world of aggregated risk, there are several more.