February 8, 2016

The Profit and Loss Equation in Compressions | A Short Video

This video explains “Realised” and “Unrealised” profits and losses, key concepts in derivatives trading. Furthermore, this equation drives portfolio compressions.

Shrinking a portfolio of transactions is about keeping the same profits and price risk while reducing those side effects that derivative trading firms have to deal with after a transaction is executed: operational, credit and regulatory risks. The profit and losses (P&L) that happened in the past, is usually referred to as the "Realised P&L". Earnings to be made in the future are called "Unrealised P&L". These two components add up to the total profits and losses in a portfolio.

[Realised P&L + Unrealised P&L]Before compression ≈ [Realised P&L + Unrealised P&L]After compression

Source: The Profit and Loss equation is explained in Chapter 6 of the book Portfolio Compression (see link below for a 20% discount offer for OTC Space readers)

This video explains the equation that should be kept in the minds of those involved in compressions. The equation ensures that profits stay the same before and after reducing transactions in a portfolio. The following timeline should help viewers to follow the parts they are most interested on.

The Profit and Loss Equation in Compressions

Click to open the Video by Risk Books and Incisive Media in a new window

  • 00:00 Part I: The Profit and Loss Equation in Compressions: Definition
  • 00:00 – Compressions reducing global derivatives
  • 00:40 – Profit and Loss equation in compressions
  • 00:54 – Describing the beginning and the end of a derivative transaction
  • 1:10 – Realised Profit and Loss (P&L)
  • 1:30 – Unrealised Profit and Loss (P&L)
  • 2:00 – Defining the total Profit of a portfolio
  • 2:18 – Cost of capital in a portfolio
  • 2:26 – Profit and Loss before and after the compression
  • 3:00 – Balancing Realised and Unrealised P&L before and after the compression
  • 3:29 – Profit and Loss tolerance in compressions

3:43 – Part II: Before and after a compression: Example with a commodity derivative

  • 3:43 – Example with a commodity derivative involving physical delivery of gas
  • 3:50 – Volume, price and tenor terms of a gas deal
  • 4:20 – Market prices of gas in the previous days
  • 4:27 – Calculating the Realised Profit and Loss
  • 4:50 – Future prices of gas
  • 5:11 – Calculating the Unrealised Profit and Loss
  • 5:37 – Compression in this deal: change of end date
  • 6:01 – Payment for the Unrealised Profit and Loss as a result of the compression
  • 6:13 – Urealised P&L becoming Realised P&L after the compression
  • 6:28 – Total Realised P&L after the compression
  • 6:53 – Unrealised P&L after the compression
  • 7:03 – Equation in compressions: the total Profit & Loss does not change

7:18 – Part III: Reasons to compress

  • 7:18 – Type of companies applying compressions
  • 7:22 – Regulations
  • 7:40 – Credit risk management
  • 7:44 – Operational risk managed with compressions
  • 7:55 – Credit risk in energy trading
  • 7:58 – Step by step guide for execution
  • 8:03 – People and companies involved in compressions
  • 8:20 – New developments in the derivatives market

Diana Higgins, author of Portfolio Compression, a technique to reduce various risks while keeping the same profits. Order through OTC Space and get a 20% discount plus free delivery! For more information or to order your discounted copy visit (the discount is automatically applied)

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