The world of finance is as big as it can be. One needs to take several nuances to enhance the financial position, be it for an individual or a company. Wrong are those people who think that finance is just about equalizing our balance sheets. No!
It’s about so much more! Capital markets, Trading, Shares, Bank Statements, and so much more. One such nuance is Profit and Loss Appropriation. No, it is not in the context of a company, but rather it is a term that is used by the trading markets. Using Profit and Loss Appropriation, one can back-test the risk management models for any given company. Here, we bring different components of Profit and Loss Account, observe and analyze to determine whether the given amount has risen out of a chance of due to a calculated, well thought-off strategy.
Stock markets are one of the most dynamic places to trade your money. It keeps on changing every single day. As it is essential to keep your tab on the trading part, it is also necessary to note the profit and losses of one’s trade. It is also essential to predict them to plan future things that might happen and compare the predicted profit or loss with the actual ones. This helps to ascertain the efficiency of planning done. Profit and Loss Attribution is definitely, one of the most important things for money matters.
Profit and Loss Attribution or P&L Attribution model is a testing method to measure a bank’s risk management models, which compares a bank’s predicted profit and loss with the actual profit and loss incurred. Risk managers use P&L Attribution to explain how a bank or company made or lost money.
The P&L Attribution model breaks down profit and loss into different components to ascertain the efficiency of operations. This is done by analyzing all the conditions that can affect the performance like time, prices of the commodities, applicable interest rates, market uncertainty, new contracts, cancellations, etc. it also helps the financial institutions to evaluate their decisions and justify their losses.
When was this model introduced?
The Profit and Loss Attribution (or P&L Attribution Model) was first introduced in October 2013 by the Basel Committee on Banking Supervision (BCBS), which was a part of their FRTB (Fundamental Review of the Trading Book). This test was drawn up as a new requirement for the trading desk’s accreditation to use the IMA (Internal Model Approach) to calculate the market risk capital.
What does the P&L Attribution Model aim to represent?
The Profit and Loss Attribution Model aims to ensure that the coverage of the risk factors used in a bank’s internal model approach calculation is adequate to fully capture the range of Profit and Loss variations that occur. As per the standard, every trading desk will have to make sure that it passes the P&L attribution to maintain accreditation to use the IMA for the capital calculations.
The P&L attribution compares two measures: A Hypothetical P&L and A Risk Theoretical P&L
A Hypothetical P&L is generated by the bank’s front office pricing models, and the bank’s own risk models generate the risk theoretical P&L. The gap between both is measured using a mean ratio and a variance ratio. The thing that is to be kept in mind by the revenue managers is that the ratios generated from the two P&L’s should always remain within the established thresholds for the test to be legitimate. Otherwise, a breach can occur if the desk surpasses the limit.
Why is the P&L Attribution Model so necessary?
A risk or a revenue manager should identify whether certain decisions of a company resulted in making or losing money. The only thing through which the company can measure its performance is by looking at their books of accounts. The way through which this is possible is by taking into account the decisions that the company has taken throughout the financial year and considering the profits and losses. This is where the P&L attribution Model comes into the picture. By taking into account all the factors such as performance, time, prices, etc., it helps to measure the company’s efficiency of operations and compare its performance with the predicted performance.
Methodologies for measuring the Profit and Loss Attribution model:
There are two methodologies for calculating the P&L Attribution:
- Sensitivities Method – This method involves calculating sensitivities known as the ‘Greeks’ because of the common practices of representing them using Greek Letters.
- Revaluation Method – This calculates values of trade on the current and prior day’s prices. The Formula for that is: Impact of Prices= Trade value for Today’s Price- Trade Values for Yesterday’s Prices.
In the following article, we came to know about the Profit and Loss Attribution method, its history, why this model is so necessary, the different methodologies used to measure the P&L attribution, and the different constituents of this method. So, from the following, we can understand that P&L Attribution is a very crucial part of the financial scenario.
It helps the financial institutions measure their performance with the hypothetical performance and allows the revenue managers to get an idea of the efficiency of operations and eradicate any shortcomings in their organization. The advantage of this method is that it considers all the factors such as prices and market uncertainty. Hence, it indeed is a really great method to measure financial performance and the institution’s efficiency.
So, now you know all about the Profit and Loss Attribution method!