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Derivatives have long diffused into the financial systems as trading, hedging and risk management instruments, on and off balance sheets, embedded in assets and liabilities. In an industry that is increasingly focusing on value-added activities, customer-driven derivatives will continue to play key roles in the retail, private, corporate and institutional derivatives markets.

Managed properly, customer-driven derivatives business can be a rewarding business with high capital efficiency. It offers tailor-made investment and hedging solutions to the customers, and can be a very valuable source of funding for banks, even in a time of crises. The capital efficiency mainly comes from the fact that the bulk of the business is customer-driven. By its nature, this business requires efficiency and flexibility in product offering.

While it is true that the customer-driven derivative products have overall become simpler, manufacturing and managing these products has actually become more complex, due to macro factors such as the multi-curve environments triggered by the recent financial crises, stricter regulatory requirements of consistent modelling and managing frameworks, and the needs to optimize risk/reward profiles.

This book aims to present a holistic view of the customer-driven derivatives business, coupled with forensic quantitative model analyses from a practical perspective:

• It explains the life cycle of the derivative products, the manufacturing process of turning models into products, the key pillars of the business infrastructure and the regulatory framework, including Basel III and beyond.

• It explores quantitative pricing models and their applications, explaining various model paradigms and non-arbitrage models used in real equity and interest rate derivatives business. Smile/skew topics are examined in depth. The multi-curve environment and its practical impact on interest rate derivatives pricing are discussed extensively. Key derivative risks are also highlighted, and the focus is on combining or balancing the model simplicity with the necessity to capture the risks.

• It examines a wide range of customer-driven structured derivative products, their investment or hedging payoff features and associated risk exposures.

• It analyses a number of real-life derivatives embedded in real-life financial products, zooming into their risk characteristics.

Customer-driven derivatives business is a complex business, and it is often surrounded by some mystery. Certain derivatives may look simple, but are actually complex, others may look complex, but are actually simple. Complexity/simplicity does not necessarily equate to or explain the riskiness. This book hopes to demystify some aspects of the customer-driven derivatives and increase the transparency.

The book pays attention to risks and raises risk awareness. The customer-driven derivatives business is always an evolving business. Risks evolve with the business offerings, driven by customers' and banks' risk appetites. Better understanding of derivatives risks and how such risks should be captured and quantified can help managers and practitioners to adopt better organizational setup and control framework.