HWESER'
C r it ic a l C o n c e pt s
FOUNDATIONS OF RISK
MANAGEMENT
Types of Risk
Key classes o f risk include market risk, credit risk,
liquidity risk, operational risk, legal and regulatory
risk, business risk, strategic risk, and reputation risk.
Market risk includes interest rate risk, equity price
risk, foreign exchange risk, and commodity price risk.
Credit risk includes default risk, bankruptcy risk,
downgrade risk, and settlement risk.
Liquidity risk includes funding liquidity risk and
trading liquidity risk.
Enterprise Risk Management (ERM)
Comprehensive and integrated framework for
managing firm risks in order to meet business
objectives, minimize unexpected earnings
volatility, and maximize firm value. Benefits
include (1) increased organizational effectiveness,
(2) better risk reporting, and (3) improved
business performance.
Determining Optimal Risk Exposure
Target certain default probability or specific credit
rating, high credit rating may have opportunity
costs (e.g., forego risky/profitable projects).
Sensitivity or scenario analysis: examine adverse
impacts on value from specific shocks.
Financial Disasters
Drysdale Securities: borrowed $30 0 million in
unsecured funds from Chase Manhattan by
exploiting a flaw in the system for computing the
value o f collateral.
K idder Peabody: Joseph Jett reported substantial
artificial profits; after the fake profits were
detected, $330 million in previously reported
gains had to be reversed.
Barings: rogue trader, Nick Leeson, took
speculative derivative positions (Nikkei 225
futures) in an attempt to cover trading losses;
Leeson had dual responsibilities o f trading and
supervising settlement operations, allowing him
to hide trading losses; lessons include separation
o f duties and management oversight.
A llied Irish Bank: currency trader, John Rusnak,
hid $691 million in losses; Rusnak bullied back-
office workers into not following-up on trade
confirmations for fake trades.
UBS: equity derivatives business lost millions due
to incorrect modeling o f long-dated options and
its stake in Long-Term Capital Management.
Societe Generale: junior trader, Jerome Kerviel,
participated in unauthorized trading activity and
hid activity with fake offsetting transactions;
fraud resulted in losses o f $7.1 billion.
M etallgesellschafi: short-term futures contracts
used to hedge long-term exposure in the
petroleum markets; stack-and-roll hedging
strategy; marking to market on futures caused
huge cash flow problems.
Long-Term C apital M anagement: hedge fund that
used relative value strategies with enormous
fo r t h e 2017 FRM E x a m
amounts o f leverage; when Russia defaulted on
its debt in 1998, the increase in yield spreads
caused huge losses and enormous cash flow
problems from realizing marking to market
losses; lessons include lack o f diversification,
model risk, leverage, and funding and trading
liquidity risks.
Banker's Trust developed derivative structures
that were intentionally complex; in taped phone
conversations, staff bragged about how badly they
fooled clients.
JPM organ an d Citigroup: main counterparties in
Enrons derivatives transactions; agreed to pay a
$ 2 8 6 million fine for assisting with fraud against
Enron investors.
Role of Risk Management
1. Assess all risks faced by the firm.
2. Communicate these risks to risk-taking
decision makers.
3. M onitor and manage these risks.
Objective o f risk management is to recognize that
large losses are possible and to develop contingency
plans that deal with such losses if they should occur.
Systematic Risk
A standardized measure o f systematic risk is beta:
ben, = C o v ( R ,.R m )
gm
Capital Asset Pricing Model (CAPM)
In equilibrium, all investors hold a portfolio
o f risky assets that has the same weights as the
market portfolio. T he CAPM is expressed in the
equation o f the security market line (SM L). For
any single security or portfolio o f securities /, the
expected return in equilibrium, is:
E (R j) = Rp + b etai[E (R M) Rp]
CAPM Assumptions
Investors seek to maximize the expected utility
of their wealth at the end of the period, and all
investors have the same investment horizon.
Investors are risk averse.
Investors only consider the mean and standard
deviation of returns (which implicitly assumes the
asset returns are normally distributed).
Investors can borrow and lend at the same
risk-free rate.
Investors have the same expectations concerning
returns.
There are neither taxes nor transactions costs, and
assets are infinitely divisible. This is often referred
to as perfect markets.
Measures o f Performance
T he Treynor measure is equal to the risk
premium divided by beta, or systematic risk:
E (R P) - R p
Treynor measure =
f3P
T he Sharpe measure is equal to the risk premium
divided by the standard deviation, or total risk:
cl E(Rp) Rp
oharpe measure = ---------------
Op
T he Jensen measure (a.k.a. Jensens alpha or just
alpha), is the assets excess return over the return
predicted by the CAPM:
Jensen measure =
a p = E ( R p ) - { R F + ( 3 p [ E ( R M) - R F]}
T h e information ratio is essentially the alpha o f
the managed portfolio relative to its benchmark
divided by the tracking error.
E (R P) E (R b )
IR =
tracking error
T h e Sortino ratio is similar to the Sharpe
ratio except we replace the risk-free rate with a
minimum acceptable return, denoted R min, and
we replace the standard deviation with a type o f
semi-standard deviation.
E (R P) R,min
Sortino ratio =
semi-standard deviation
Arbitrage Pricing Theory (APT)
T h e A PT describes expected returns as a linear
function o f exposures to common risk factors:
E (R i) = R F + (3ilR P 1 + |3i2RP2 + . . . + (3ikRPk
where:
(3.. = / factor beta for stock i
RP. = risk premium associated with risk factor j
T h e A PT defines the structure o f returns but
does not define which factors should be used in
the model.
T h e CAPM is a special case o f A PT with only
one factor exposure the market risk premium.
T h e Fama-French three-factor m odel describes
returns as a linear function o f the market index
return, firm size, and book-to-market factors.
Risk Data Aggregation
Defining, gathering, and processing risk data for
measuring performance against risk tolerance.
Benefits o f effective risk data aggregation and
reporting systems:
Increases ability to anticipate problems.
Identifies routes to financial health.
Improves resolvability in event o f bank stress.
Increases efficiency, reduces chance of loss, and
increases profitability.
GARP Code o f Conduct
Sets forth principles related to ethical behavior
within the risk management profession.
It stresses ethical behavior in the following areas:
Principl es
Professional integrity and ethical conduct
Conflicts o f interest
Confidentiality
Professional Standards
Fundamental responsibilities
Adherence to best practices
Violations o f the Code o f Conduct may result
in temporary suspension or permanent removal
from GARP membership. In addition, violations
could lead to a revocation o f the right to use the
FR M designation.

QUANTITATIVE ANALYSIS
Probabilities
U nconditional probability (marginal probability) is
the probability o f an event occurring.
Conditionalprobability, P(A |B), is the probability o f
an event A occurring given that event B has occurred.
Bayes Theorem
Updates the prior probability for an event in
response to the arrival o f new information.
P ( I | 0 ) = P (Q | I) X P(I)
V P(O)
Expected Value
Weighted average o f the possible outcomes o f
a random variable, where the weights are the
probabilities that the outcomes will occur.
E(X) =
P(Xi ) x [ = P(xj )x1 + P(x2 )x2 + ... + P(xn)xn
Variance
Provides a measure o f the extent o f the dispersion
in the values o f the random variable around the
mean. T he square root o f the variance is called
the standard deviation.
variance(X) = E[(X p)2 ]
Covariance
Expected value o f the product o f the deviations
o f two random variables from their respective
expected values.
Cov(Ri,Rj) = E{[Ri - E(Ri)] x[R j - E(Rj)]}
Correlation
Measures the strength o f the linear relationship
between two random variables. It ranges from
- 1 to +1.
Cov^Rp Rj j
Sums o f Random Variables
If X and Y are any random variables:
E (X + Y) = E(X) + E(Y)
If X and Y are independent random variables:
Var(X + Y) = Var(X) + Var(Y)
If X and Y are N O T independent:
Var(X + Y) = Var(X) + Var(Y) + 2 x Cov(X,Y)
Skewness and Kurtosis
Skewness, or skew, refers to the extent to which a
distribution is not symmetrical. T he skewness o f
a normal distribution is equal to zero.
A positively skewed distribution is characterized by
many oudiers in the upper region, or right tail.
A negatively skewed distribution has a
disproportionately large amount of outliers that
fall within its lower (left) tail.
Kurtosis is a measure o f the degree to which
a distribution is more or less peaked than a
normal distribution. Excess kurtosis = kurtosis - 3.
Leptokurtic describes a distribution that is more
peaked than a normal distribution.
Platykurtic refers to a distribution that is less
peaked, or flatter, than a normal distribution.
Desirable Properties of an Estimator
An unbiased estimator is one for which the
expected value of the estimator is equal to the
parameter you are trying to estimate.
An unbiased estimator is also efficient if
the variance of its sampling distribution is smaller
than all the other unbiased estimators of the
parameter you are trying to estimate.
A consistent estimator is one for which the accuracy
of the parameter estimate increases as the sample
size increases.
A point estimate should be a linear estimator when
it can be used as a linear function of sample data.
Continuous Uniform Distribution
Distribution where the probability o f X occurring
in a possible range is the length o f the range
relative to the total o f all possible values. Letting a
and b be the lower and upper limits o f the uniform
distribution, respectively, then for a < x } < x2 < b:
(x 2 X1
P(xj < X < x 2)
~
(b-a)
Binomial Distribution
Evaluates a random variable with two possible
outcomes over a series o f n trials. T he probability
o f success on each trial equals:
p(x) = (number o f ways to choose x from n)
px( l - p ) nx
For a binom ial random variable:
expected value = np
variance = n p (l - p)
Poisson Distribution
Poisson random variable X refers to the number
o f successes per unit. T he parameter lambda (X)
refers to the average number o f successes per unit.
For the distribution, both its mean and variance
are equal to the parameter, X.
\xp-\
P(X = x) =
x!
Normal Distribution
Normal distribution is completely described by
its mean and variance.
90% o f observations fall within 1.65s.
95% o f observations fall within 1.96s.
99% of observations fall within 2.58s.
Standardized Random Variables
A standardized random variable is normalized so that
it has a mean o f zero and a standard deviation o f 1.
z-score: represents number o f standard deviations
a given observation is from a population mean,
observation population mean _ x p
standard deviation a
Central Limit Theorem
W hen selecting simple random samples o f size
n from a population with mean p and finite
variance a 2, the sampling distribution o f sample
means approaches the normal probability
distribution with mean p and variance equal to
&2ln as the sample size becomes large.
Population and Sample Mean
T h e population mean sums all observed values
in the population and divides by the number o f
observations in the population, N.
T he t-distribution is a bell-shaped probability
N
T he sample mean is the sum o f all values in
a sample o f a population, E X , divided by the
number o f observations in the sample, n. It is used
to make inferences about the population mean.
Population and Sample Variance
T he population variance is defined as the average
o f the squared deviations from the mean. The
population standard deviation is the square root
o f the population variance.
N
E > i-^ )2
a 2 = ^ --------------
N
T he sample variance, si1, is the measure o f
dispersion that applies when we are evaluating a
sample o f n observations from a population. Using
n - 1 instead o f n in the denominator improves the
statistical properties o f s2 as an estimator o f a 2.
S2 = i ^ ---------------
n 1
Sample Covariance
_ (Xj X)(Yj Y)
covariance
n 1
i=l
Standard Error
T he standard error o f the sample mean is the
standard deviation o f the distribution o f the
sample means. W hen the standard deviation of
the population, a , is known , the standard error o f
the sample mean is calculated as:
a
Confidence Interval
I f the population has a norm al distribution with
a known variance, a confidence interval for the
population mean is:
x ^ za /2 f
Vn
ztt/2 = 1.65 for 9 0% confidence intervals
(significance level 10% , 5% in each tail)
zcx/2 = 1.96 for 9 5% confidence intervals
(significance level 5% , 2 .5 % in each tail)
za/2 = 2 .5 8 for 9 9 % confidence intervals
(significance level 1% , 0 .5 % in each tail)
Hypothesis Testing
N ull hypothesis (H ()): hypothesis the researcher
wants to reject; hypothesis that is actually tested;
the basis for selection o f the test statistics.
Alternative hypothesis (HA): what is concluded
if there is significant evidence to reject the null
hypothesis.
O ne-tailed test tests whether value is greater than
or less than another value. For example:
H q: p < 0 versus H^: p > 0
Two-tailed test tests whether value is different
from another value. For example:
H q: p = 0 versus H A: p ^ 0
T-Distribution
distribution that is symmetrical about its mean.
It is the appropriate distribution to use when
constructing confidence intervals based on
small samples from populations with unknown
variance and a normal, or approximately normal,
distribution.
x p
Chi-Square Distribution
T he chi-square test is used for hypothesis tests
concerning the variance o f a normally distributed
population.
u.
chi-square test: \ 2 -----
(n -l)s 2
5----
CT0
F-Distribution
T h e F-test is used for hypotheses tests concerning
the equality o f the variances o f two populations.
2 GARCH Model
F-test: F = \ n k 1
4 recent estimates o f variance and squared return,
Simple Linear Regression
Y.=
l B 0.+ B,1 x X .i +i e.
where:
Y. = dependent or explained variable
X = independent or explanatory variable
B Q = intercept coefficient
B j = slope coefficient
6.I = error term
Total Sum o f Squares
For the dependent variable in a regression model,
there is a total sum o f squares (TSS) around the
sample mean.
total sum o f squares = explained sum o f squares +
sum o f squared residuals
T S S = ESS + SSR
E ft - Y
)2=E ( Y- Yf +E f t - Yf
Coefficient of Determination
Represented by R 2, it is a measure o f the
goodness o f fit o f the regression.
2 ESS , SSR
R = ------= 1----------
TSS TSS
In a simple two-variable regression, the square root
o f R 2 is the correlation coefficient (r) between X
and Y . I f the relationship is positive, then:
Standard Error of the Regression (SER)
Measures the degree o f variability o f the actual
lv alu es relative to the estimated lv a lu es from
a regression equation. T he S E R gauges the fit
o f the regression line. T he smaller the standard
error, the better the fit.
Linear Regression Assumptions
A linear relationship exists between the dependent
and the independent variable.
The independent variable is uncorrelated with the
error terms.
The expected value of the error term is zero.
The variance of the error term is constant for all
independent variables.
No serial correlation of the error terms.
The model is correctly specified (does not omit
variables).
Regression Assumption Violations
Heteroskedasticity occurs when the variance o f the
residuals is not the same across all observations in
the sample.
M ulticollinearity refers to the condition when two
or more o f the independent variables, or linear
combinations o f the independent variables, in
a multiple regression are highly correlated with
each other.
Serial correlation refers to the situation in which the
residual terms are correlated with one another.
Multiple Linear Regression
A simple regression is the two-variable regression
with one dependent variable, Y., and one
independent variable, X . A m ultivariate regression
has more than one independent variable.
Yi = B0 + x X jj + B 2 x X 21 + E[
Adjusted R-Squared
Adjusted R 2 is used to analyze the importance o f
an added independent variable to a regression.
adjusted R 2 = 1 - ( 1 - R 2 )X n_1
A G A R C H (1,1) model incorporates the most
Forecasting Model Selection
Model selection criteria takes the form o f penalty
factor times mean squared error (MSE).
M S E is computed as:
T where:
t=l
Penalty factors for unbiased M SE (s2), Akaike
information criterion (AIC), and Schwarz
information criterion (SIC) are: (T / T - k),
e(2k/1), a n d T (kn), respectively.
S IC has the largest penalty factor and is the most
consistent selection criteria.
Trend Models
A linear trend is a time series pattern that can be
graphed with a straight line:
yt = Po + P i(t)
A nonlinear trend is a time series pattern that
can be graphed with a curve. It can be modeled
using either quadratic or exponential (log-linear)
functions, respectively:
y t = 3o + P i(0 + P2 (O2
Yt = 0oe(3l(t);ln (yt) = in(30 ) + Pi(t)
Seasonality
Seasonality in a time series is a pattern that tends
to repeat from year to year.
There are two approaches for modeling and
forecasting a time series impacted by seasonality:
(1) using a seasonally adjusted time series and (2)
regression analysis with seasonal dummy variables.
Combining a trend with a pure seasonal dummy
model produces the following model:
s - investment income
Yt = Pi (0 + TTHfi ) + t
i=l
Covariance Stationary
A time series is covariance stationary if its
mean, variance, and covariances with lagged
and leading values do not change over time.
Covariance stationarity is a requirement for using
autoregressive (AR) models. Models that lack
covariance stationarity are unstable and do not
lend themselves to meaningful forecasting.
Autoregressive (AR) Process
The first-order autoregressive process [AR(1)] is
specified as a variable regressed against itself in
lagged form. Mean is 0 and variance is constant.
Yt = W t-1 + et
EWMA Model
T he exponentially weighted moving average
(EW MA) model assumes weights decline
exponentially back through time. This
assumption results in a specific relationship for
variance in the model:
a2 = (1 - \)r2_! + Xa2_!
where:
X = weight on previous volatility estimate
(between zero and one)
High values o f X will minimize the effect o f daily
percentage returns, whereas low values o f X will
tend to increase the effect o f daily percentage
returns on the current volatility estimate.
and also includes a variable that accounts for a
long-run average level o f variance.
a2 = w + ar2_! + 0a2_j
a = weighting on previous periods return
0 = weighting on previous volatility estimate
u; = weighted long-run variance
to
V l = long-run average variance =
1 a (3
a + (3 < 1 for stability
T h e EW M A is nothing other than a special case
o f a G A R C H (1,1) volatility process, with u = 0,
a = 1 - X, and 0 = X.
T he sum a + 0 is called the persistence, and if the
model is to be stationary over time (with reversion
to the mean), the sum must be less than one.
Simulation Methods
M onte Carlo simulations can model complex
problems or estimate variables when there are
small sample sizes. Basic steps are: (1) specify
data generating process, (2) estimate unknown
variable, (3) save estimate from step 2, and (4) go
back to step 1 and repeat process N times.
FINANCIAL MARKETS AND
PRODUCTS
P&C Insurance Company Ratios
combined ratio = loss ratio + expense ratio
combined ratio after dividends = combined ratio
+ dividends
operating ratio = combined ratio after dividends
Net Asset Value (NAV)
Open-end mutual funds trade at the fund s NAV:
Fund Assets - Fund Liabilities
NAV =
Total Shares Outstanding
Option and Forward Contract Payoffis
T h e payoff on a call option to the option buyer is
calculated as follows: C.r = max(0, STX)
T h e price paid for the call option, C{), is referred
to as the call premium. Thus, the profit to the
option buyer is calculated as follows:
profit = C T - C 0
T he payoff on a put option is calculated as follows:
R r = max(0, X - ST)
T h e payoff to a long position in a forward
contract is calculated as follows:
payoff = ST - K
where:
ST = spot price at maturity
K = delivery price
Futures Market Participants Forward price with continuous dividend yield, q : positive value to one counterparty, that party is
Hedgers: lock-in a fixed price in advance. exposed to credit risk.
F0 = S0e ^ > T
Speculators: accept the price risk that hedgers are Vswap (D C ) = B d c (S0 X B FC)
Forward price with storage costs, u:
unwilling to bear.
Arbitrageurs: interested in market inefficiencies to F0 = (S0 + U )erT or F0 = S0e(r+u)T where:
obtain riskless profit. S0 = spot rate in D C per FC
Forward price with convenience yield, c.
Basis Option Pricing Bounds
Ib -
T he basis in a hedge is defined as the difference Upper bound European/American call:
between the spot price on a hedged asset and Forward foreign exchange rate using interest rate
c < S 0; C < S 0
the futures price o f the hedging instrument parity (IRP):
(e.g., futures contract). W hen the hedged asset Upper bound European/American put:
Fq S0e(rd_rf)T
and the asset underlying the hedging instrument p < X e- r T ; P < X
Arbitrage*. Remember to buy low, sell high.
are the same, the basis will be zero at maturity.
I f Fq > Soer* , borrow, buy spot, sell forward Lower bound European call on non-dividend-
Minimum Variance Hedge Ratio today; deliver asset, repay loan at end. paying stock:
T he hedge ratio minimizes the variance o f the I f F o < S0er , short spot, invest, buy forward
c > max(SQ X e - r l ,0)
combined hedge position. This is also the beta o f today; collect loan, buy asset under futures
spot prices with respect to futures contract prices. contract, deliver to cover short sale. Lower bound European put on non-dividend-
Backwardation and Contango paying stock:
H R = pS)F
dp Backwardation refers to a situation where the futures p > m a x ( X e - r l SQ,0)
price is below the spot price. For this to occur, there
Hedging W ith Stock Index Futures must be a significant benefit to holding the asset. Exercising American Options
Contango refers to a situation where the futures It is never optimal to exercise an American call on a
portfolio value price is above the spot price. If there are no benefits non-dividend-paying stock before its expiration date.
# of contracts = (3p x
futures price X to holding the asset (e.g., dividends, coupons, or American puts can be optimally exercised early if
contract multiplier convenience yield), contango will occur because they are sufficiently in-the-money.
the futures price will be greater than the spot price. An American call on a dividend-paying stock
Adjusting Portfolio Beta Treasury Bond Futures may be exercised early if the dividend exceeds the
I f the beta o f the capital asset pricing model is amount of forgone interest.
In a T-bond futures contract, any government
used as the systematic risk measure, then hedging Put-Call Parity
bond with more than 15 years to maturity on
boils down to a reduction o f the portfolio beta.
the first o f the delivery month (and not callable p = c S + X e _rT
# o f contracts = r .. .
, . r i i \ portfolio value
(target beta portfolio beta)-*-------- :----------
within 15 years) is deliverable on the contract.
c = p + S X e_rT
underlying asset T h e procedure to determine which bond is the
cheapest-to-deliver (C T D ) is as follows:
Covered Call and Protective Put
Forward Interest Rates cash received by the short = (Q FP x C F) + AI Covered call: Long stock plus short call.
Forward rates are interest rates implied by the spot cost to purchase bond = Q B P + AI
Protective p u t Long stock plus long put. Also
curve for a specified future period. The forward
where: called portfolio insurance.
rate between T } and T 2 can be calculated as:
R 2T 2 R 11TA11
Q FP = quoted futures price Option Spread Strategies
R forward CF = conversion factor Bull spread: Purchase call option with low exercise
T2 - T ! Q BP = quoted bond price
Ti price and subsidize the purchase with sale o f a call
R 2 + (R 2 R j ) x AI = accrued interest
ToT1) option with a higher exercise price.
T h e C T D is the bond that minimizes the
B ear spread: Purchase call with high strike price
following: Q B P - (Q FP x CF). This formula
Forward Rate Agreement (FRA) and short call with low strike price.
calculates the cost o f delivering the bond.
Cash Flows Investor keeps difference in price o f the options
An FRA is a forward contract obligating two
Duration-Based Hedge Ratio if stock price falls. Bear spread with puts involves
T h e objective o f a duration-based hedge is to create buying put with high exercise price and selling
parties to agree that a certain interest rate will
a combined position that does not change in put with low exercise price.
apply to a principal amount during a specified
value when yields change by a small amount. Butterfly spread: Three different options: buy one
future time. T he 7 \ cash flow o f an FRA that
r portfolio value X durationp
# or contracts = -------------------------------;----- call with low exercise price, buy another with a high
promises the receipt or payment o f is:
futures value X durationp exercise price, and short two calls with an exercise
cash flow (if receiving R ^ ) =
L x ( R k - R ) x (T2 - T 1) price in between. Butterfly buyer is betting the stock
Interest Rate Swaps price will stay near the price o f the written calls.
cash flow (if paying R ^ ) = Plain vanilla interest rate swap: exchanges
fixed for floating-rate payments over the life o f Calendar spread: Two options with different
L x ( R - R k ) x (T2 - T 1)
the swap. At inception, the value o f the swap expirations. Sell a short-dated option and buy a
where: is zero. After inception, the value o f the swap is long-dated option. Investor profits if stock price
L = principal the difference between the present value o f the stays in a narrow range.
R ^ = annualized rate on L remaining fixed- and floating-rate payments:
\T _ T) _ T>
D iagonal spread: Similar to a calendar spread
R = annualized actual rate
Tj = time i expressed in years vswap to pay fixed Afloat fix except that the options can have different strike
Xswap to receive fixed fix Afloat prices in addition to different expirations.
Cost-of-Carry Model B fixed - (PM Tfixed,t, x e " ' ) Box spread: Combination o f bull call spread and
Forward price when underlying asset does not bear put spread on the same asset. This strategy
+ (PM Tflxaj )t2 x e " 2 ) + ...
have cash flows: will produce a constant payoff that is equal to the
r: _ r rT + [(notional + P M T rixedjt ) X e rt" ]
ho S qc high exercise price minus the low exercise price.
B floating = [notional + (notional X rfloat)] X e_rtl
Forward price when underlying asset has cash Option Combination Strategies
Long straddle: Bet on volatility. Buy a call and a
flows, I: Currency Swaps
put with the same exercise price and expiration
F0 - (S0 - I)erT Exchanges payments in two different currencies;
payments can be fixed or floating. I f a swap has a date. Profit is earned if stock price has a large
change in either direction.

Short straddle'. Sell a put and a call with the
same exercise price and expiration date. I f stock
price remains unchanged, seller keeps option
premiums. Unlimited potential losses.
Strangle'. Similar to straddle except purchased option
is out-of-the-money, so it is cheaper to implement.
Stock price has to move more to be profitable.
Strips an d straps: Add an additional put (strip) or
call (strap) to a straddle strategy.
Exotic Options
Gap option: payoff is increased or decreased by the
difference between two strike prices.
Compound option: option on another option.
Chooser option: owner chooses whether option is a
call or a put after initiation.
Barrier option: payoff and existence depend on
price reaching a certain barrier level.
Binary option: pay either nothing or a fixed amount.
Lookback option: payoff depends on the maximum
(call) or minimum (put) value o f the underlying
asset over the life o f the option. This can be fixed
or floating depending on the specification o f a
strike price.
Shout option: owner receives intrinsic value of option
at shout date or expiration, whichever is greater.
Asian option: payoff depends on average o f the
underlying asset price over the life o f the option;
less volatile than standard option.
Basket options: options to purchase or sell baskets o f
securities. These baskets may be defined specifically
for the individual investor and may be composed
o f specific stocks, indices, or currencies. Any exotic
options that involve several different assets are
more generally referred to as rainbow options.
Foreign Currency Risk
A net long (short) currency position means a
bank faces the risk that the F X rate will fall (rise)
versus the domestic currency,
net currency exposure = (assets - liabilities) +
(bought - sold)
O n-balance sheet hedging, matched maturity and
currency foreign asset-liability book.
O ff-balance sheet hedging, enter into a position in
a forward contract.
Central Counterparties (CCPs)
W hen trades are centrally cleared, a CCP becomes
the seller to a buyer and the buyer to a seller.
Advantages o f CCPs: transparency, offsetting, loss
mutualization, legal and operational efficiency,
liquidity, and default management.
Disadvantages o f CCPs: moral hazard, adverse
selection, separation o f cleared and non-cleared
products, and margin procyclicality.
Risksfaced by CCPs: default risk, model risk, liquidity
risk, operational risk, and legal risk. Default o f a
clearing member and its flow through effects is the
most significant risk for a CCP
MBS Prepayment Risk
Factors that affect prepayments:
Prevailing mortgage rates, including (1) spread
of current versus original mortgage rates, (2)
mortgage rate path (refinancing burnout), and (3)
level of mortgage rates.
Underlying mortgage characteristics.
Seasonal factors.
General economic activity.
Conditional Prepayment Rate (CPR)
Annual rate at which a mortgage pool balance is
assumed to be prepaid during the life o f the pool.
T he single monthly mortality (SM M ) rate is
derived from C P R and used to estimate monthly
prepayments for a mortgage pool:
SM M = 1 - (1 - C P R )1/12
Option-Adjusted Spread (OAS)
Spread after the optionality of the cash flows is
taken into account.
Expresses the difference between price and
theoretical value.
When comparing two MBSs of similar credit
quality, buy the bond with the biggest OAS.
OAS = zero-volatility spread - option cost.
VALUATION AND RISK MODELS
Value at Risk (VaR)
M inimum amount one could expect to lose with
a given probability over a specific period o f time.
V a R (X % ) = zXo/0 x a
Use the square root o f time to change daily to
monthly or annual VaR.
VaR Methods
T he delta-norm al m ethod (a.k.a. the variance-
covariance method) for estimating VaR requires
the assumption o f a normal distribution. The
method utilizes the expected return and standard
deviation o f returns.
The historical simulation m ethod for estimating
VaR uses historical data. For example, to calculate
the 5% daily VaR, you accumulate a number o f
)ast daily returns, rank the returns from highest to
owest, and then identify the lowest 5% o f returns.
T he M onte Carlo simulation m ethod refers to
computer software that generates many possible
outcomes from the distributions o f inputs specified
by the user. All o f the examined portfolio returns
will form a distribution, which will approximate
the normal distribution. VaR is then calculated in
the same way as with the delta-normal method.
Expected Shortfall (ES)
Average or expected value of all losses greater than
the VaR: E[Lp |Lp > VaR].
Popular measure to report along with VaR.
ES is also known as conditional VaR or expected
tail loss.
Unlike VaR, ES has the ability to satisfy the
coherent risk measure property of subadditivity.
Binomial Option Pricing Model
A one-step binom ial model is best described within a
two-state world where the price o f a stock will either
go up once or down once, and the change will occur
one step ahead at the end o f the holding period.
In the tw o-period binom ial m odel and multi-
period models, the tree is expanded to provide for
a greater number o f potential outcomes.
Step 1: Calculate option payoffs at the end o f all
states.
Step 2 : Calculate option values using risk-neutral
probabilities.
size o f up move = U = eav 1
size o f down move = D =
U
>^down 1 ^ up
U -D
Step 3 : Discount to today using risk-free rate.
up can be altered so that the binomial model
tt
can price options on stocks with dividends, stock
indices, currencies, and futures.
Stocks with dividends an d stock indices: replace
with ^(r~q)1, where q is the dividend yield o f a stock
or stock index.
Currencies: replace ef[ with where rf is the
foreign risk-free rate o f interest.
Futures: replace with 1 since futures are
considered zero growth instruments.
Black-Scholes-Merton Model
c = S0 x N ( d 1) - X e _rTN (d 2 )
p = X e - rTN ( - d 2 ) - S 0N ( - d 1)
where:
r + 0.5xa2 x T
d2 = dj | ax V T )
T = time to maturity
S0 = asset price
X = exercise price
r = risk-free rate
a = stock return volatility
N () = cumulative normal probability
Greeks
D elta: estimates the change in value for an option
for a one-unit change in stock price.
Call delta between 0 and +1; increases as stock
price increases.
Call delta close to 0 for far out-of-the-money calls;
close to 1 for deep in-the-money calls.
Put delta between - 1 and 0; increases from -1 to 0
as stock price increases.
Put delta close to 0 for far out-of-the-money puts;
close to -1 for deep in-the-money puts.
The delta of a forward contract is equal to 1.
The delta of a futures contract is equal to .
When the underlying asset pays a dividend, q , the
delta must be adjusted. I f a dividend yield exists,
delta of call equals r * v x N(dj), delta of put equals
e^Yx [N(dj) - 1], delta of forward equals e~*l\ and
delta of futures equals ^r_q)1.
Theta: time decay; change in value o f an option
for a one-unit change in time; more negative when
option is at-the-money and close to expiration.
Gamma: rate o f change in delta as underlying stock
price changes; largest when option is at-the-money.
Vega: change in value o f an option for a one-unit
change in volatility; largest when option is at-the-
money; close to 0 when option is deep in- or out-
of-the-money.
Rho: sensitivity o f options price to changes in the
risk-free rate; largest for in-the-money options.
Delta-Neutral Hedging
To completely hedge a long stock/short call
position, purchase shares of stock equal to delta x
number of options sold.
Only appropriate for small changes in the value of
the underlying asset.
Gamma can correct hedging error by protecting
against large movements in asset price.
Gamma-neutral positions are created by matching
portfolio gamma with an offsetting option position.
Bond Valuation Yield to Maturity (YTM) Country Risk
There are three steps in the bond valuation process: T he Y T M o f a fixed-income security is equivalent Sources o f country risk: (1) where the country is in
Step 1: Estimate the cash flow s. For a bond, there to its internal rate o f return. T he Y T M is the the economic growth life cycle, (2) political risks,
are two types o f cash flows: (1) the annual discount rate that equates the present value o f all (3) the legal systems o f a country, including both
or semiannual coupon payments and (2) cash flows associated with the instrument to its the structure and the efficiency o f legal systems,
the recovery o f principal at maturity, or price. T he yield to maturity assumes cash flows and (4) the disproportionate reliance o f a country
when the bond is retired. will be reinvested at the Y T M and assumes that on one commodity or service.
the bond will be held until maturity. Factors influencing sovereign default risk: (1) a
Step 2 : D eterm ine the appropriate discount rate. The
countrys level o f indebtedness, (2) obligations
approximate discount rate can be either the Relationship Among Coupon, YTM,
such as pension and social service commitments,
bonds yield to maturity (YTM ) or a series and Price (3) a countrys level o f and stability o f tax receipts,
o f spot rates. I f coupon rate > Y T M , bond price will be greater
(4) political risks, and (5) backing from other
Step 3 : Calculate the P V o f the estim ated cash flow s. than par value: prem ium bond.
countries or entities.
T he PV is determined by discounting the I f coupon rate < Y T M , bond price will be less
bonds cash flow stream by the appropriate than par value: discount bond. Internal Credit Ratings
I f coupon rate = Y T M , bond price will be equal A t-the-point approach: goal is to predict the credit
discount rate(s).
to par value: p a r bond. quality over a relatively short horizon o f a few
Clean and Dirty Bond Prices months or, more generally, a year.
W hen a bond is purchased, the buyer must pay Dollar Value of a Basis Point Through-the-cycle approach: focuses on a longer
any accrued interest (AI) earned through the T he DV01 is the change in a fixed income
time horizon and includes the effects o f forecasted
setdement date. securitys value for every one basis point change in
cycles.
# o f days from last coupon interest rates.
to the setdement date Expected Loss
AI = coupon x DV01 = ------- ------------ T he expected loss (EL) represents the decrease in
# o f days in coupon period 10,000 x Ay
value o f an asset (portfolio) with a given exposure
DVO1 = duration X 0 .0 0 0 1 X bond value subject to a positive probability o f default,
Clean price', bond price without accrued interest. expected loss = exposure amount (EA) x loss rate (LR)
Dirty price-, includes accrued interest; price Effective Duration and Convexity
x probability o f default (PD)
the seller o f the bond must be paid to give up Duration: first derivative o f the price-yield
relationship; most widely used measure o f bond Unexpected Loss
ownership.
price volatility; the longer (shorter) the duration, Unexpected loss represents the variability o f
Compounding the more (less) sensitive the bonds price is to potential losses and can be modeled using the
Discrete compounding: definition o f standard deviation.
changes in interest rates; can be used for linear
\ mxn
estimates o f bond price changes.
FVn = PV 0 1 + UL = EA x ^PD x o 2 r + L R 2 x app
mj B V a v ~ BVi a v
effective duration = ----------------------- Operational Risk
2 x BV 0 x A y
where: Operational risk is defined as: The risk o f direct
r = annual rate Convexity: measure o f the degree o f curvature an d indirect loss resultingfrom inadequate or fa ile d
m = compounding periods per year (second derivative) o f the price/yield relationship; internal processes, people , an d systems or from
n = years
accounts for error in price change estimates from external events.
Continuous compounding: duration. Positive convexity always has a favorable
Operational Risk Capital Requirements
impact on bond price.
FVn = PV0erXn Basic indicator approach: capital charge measured
BV_ Ay + BV|_a 2 x BV0 on a firmwide basis as a percentage of annual gross
convexity = ------------------------ -------------
Spot Rates BV q x A y2 income.
A /-period spot rate, denoted as z(t), is the yield Standardized approach: banks divide activities
to maturity on a zero-coupon bond that matures Bond Price Changes With Duration among business lines; capital charge = sum for
in /-years. It can be calculated using a financial each business line. Capital for each business line
and Convexity determined with beta factors and annual gross
calculator or by using the following formula
percentage bond price change duration effect + income.
(assuming periods are semiannual), where d(t) is a
convexity effect Advanced measurement approach: banks use their
discount factor:
AB 1 . 2 own methodologies for assessing operational risk.
-----= duration X Ay H X convexity X Ay Capital allocation is based on the banks
1 /2t B 2
z(t) = 2 1 operational VaR.
dW Bonds With Embedded Options Loss Frequency and Loss Severity
C allable bond: issuer has the right to buy back
Operational risk losses are classified along two
Forward Rates the bond in the future at a set price; as yields fall,
independent dimensions:
Forward rates are interest rates that span future bond is likely to be called; prices will rise at a
Loss frequency: the number o f losses over a specific
periods. decreasing rate negative convexity.
time period (typically one year). Often modeled
Putable bond: bondholder has the right to sell
(1 + forward rare)' = 1 periodic yidd)1+1 with the Poisson distribution (a distribution that
bond back to the issuer at a set price.
(1 + periodic yield)1 models random events).
Loss severity: value o f financial loss suffered.
Realized Return Often modeled with the lognorm al distribution
T h e gross realized return for a bond is its end-of- (distribution is asymmetrical and has fat tails).
IS B N :9 7 8 1 4 7 5 4 5 3 0 5 8
period total value minus its beginning-of-period
value divided by its beginning-of-period value.
Stress Testing
Stress testing shocks key input variables by large
BVt + C t - BVt_ 1
amounts to measure the impact on portfolio value.
R - u 5^ ; Key elements o f effective governance over stress
T h e net realized return for a bond is its gross testing include the governance structure, policies
realized return minus per period financing costs. and procedures, documentation, validation and
781475 453058 independent review, and internal audit.
U.S. $29.00 2017 Kaplan, Inc. All Rights Reserved.