Valuation and Risk Models Focus Review Video 1

2012 FRM P1 Focus Review
6th of 8: Valuation & Risk Models
Hosted by David Harper

CFA, FRM, CIPM
October 22nd, 2012
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P1 Focus Review: 6th of 8th (Valuation)
Key ideas, Valuation & Risk Models

• Parametric value at risk (VaR)
• Historical simulation (HS) Valuation at Risk (VaR)
• Fixed income valuation
2
Parametric Value at Risk (VaR)
3
2012 FRM Valuation and Risk Models 4.a Allen, Understanding Market: Chapter 3
Taylor Series Approximation

Y 1  2Y
Y  X  X 2
...
X 2 X 2
VaR Linear Derivative    VaR Underlying Risk Factor

VaR S&P 500 Futures Contract  $250  VaR Index
• The Taylor approximation is not helpful when the derivative

exhibits extreme non-linearities.
– Mortgage-backed securities (MBS)
– Fixed income securities with embedded options
4
2012 FRM Valuation and Risk Models 4.a Allen, Understanding Market: Chapter 3
Describe the delta‐normal approach to calculating VaR

for non‐linear derivatives.
First-second derivative: Delta-gamma, duration-convexity
European call option price Bond Price versus Yield (YTM)

vs. stock price $70
$6
$60 Price Duration
$5
$50
Option price
$4
$40
$3
$30
$2 $20
$1 $10
$- $-
$- $5 $10 $15 $20 0% 5% 10%
Stock Price Yield
5
Question [Two-asset portfolio VaR]

GARP 2010.P1.16 (modified and corrected for error)
Given a portfolio consisting of two zero-coupon bonds:
Bond Yield Maturity (yrs) StdDev (Yield) Exposure

A 5.0% 2 5.0% $25.00
B 3.0% 13 12% $75.00
What is the portfolio’s 10-day diversified VaR?
6
Answer!
Two Currency Port: Bond A Bond B Portfolio

Position $25 $75 $100
Weight 25% 75% 100%
Maturity (years) 2.0 13.0
Yield 5.00% 3.00%
Duration (Mod), s.a. 1.95 12.81
Std Dev (yield) 5.00% 12.00%
Volatility (Price) 9.76% 153.7% 115.90%
Individual 95% VaR, 10-day $0.80 $37.92
Correlation 0.25
Portfolio Volatility, $ $115.90
Diversified 95% VaR, 10-day $38.1293
7

GARP 2009.E1.1.
Given the information provided in the table below, what is the portfolio VaR, at the
99% confidence level, of the following 100 million CHF (Swiss francs) equally weighted
investment portfolio?
Correlation
Asset E[return] Volatility Stocks Bonds
Stocks 24.0% 18.0% 1.00 0.10
Bonds 15.0% 6.0% 0.10 1.00
a. 27.96 million CHF

b. 22.77 million CHF
c. 20.97 million CHF
d. 13.98 million CHF
8
Answer!
GARP 2009.E1.1.
Given the information provided in the table below, what is the portfolio VaR, at the
99% confidence level, of the following 100 million CHF (Swiss francs) equally weighted
investment portfolio?
Correlation
Asset E[return] Volatility Stocks Bonds
Stocks 24.0% 18.0% 1.00 0.10
Bonds 15.0% 6.0% 0.10 1.00
Answer: Variance of equally weighted portfolio =

0.5^2*0.18^2 + 0.5^2*0.06^2 + 2*0.5*0.5*0.1* 0.18*0.06 = 0.0081+0.0009+0.0005
= 0.00954.
Volatility = 9.77%.
Portfolio VaR = 2.33 * 9.77% * 100 million CHF = 22.77 million CHF.
9
Question [Delta‐normal valuation, full revaluation,

historical simulation, Monte Carlo simulation methods]
GARP 2012.P1.1.
You have been asked to estimate the VaR of an investment in Big Pharma Inc. The
company’s stock is trading at USD 23 and the stock has a daily volatility of 1.5%. Using
the delta-normal method, the VaR at the 95% confidence level of a long position in an
at-the-money put on this stock with a delta of -0.5 over a 1-day holding period is
closest to which of the following choices?
a) USD 0.28
b) USD 0.40
c) USD 0.57
d) USD 2.84
10
Question [Delta‐normal valuation, full revaluation, Answer!

historical simulation, Monte Carlo simulation methods]
You have been asked to estimate the VaR of an investment in Big Pharma Inc. The
company’s stock is trading at USD 23 and the stock has a daily volatility of 1.5%. Using
the delta-normal method, the VaR at the 95% confidence level of a long position in an
at-the-money put on this stock with a delta of -0.5 over a 1-day holding period is
closest to which of the following choices?
a. USD 0.28
b. USD 0.40
c. USD 0.57
d. USD 2.84
VaR = |delta| * 1.645 * sigma * S = 0.5 * 1.645 * 0.015 * 23 = 0.28.

The delta of an at-the-money put is -0.5 and the absolute value of the delta is 0.5.
11
Question [Value-at-Risk (VaR)]

GARP 2012.P1.12.
Howard Freeman manages a portfolio of investment securities for a regional bank. The
portfolio has a current market value equal to USD 6,247,000 with a daily variance of
0.0002. Assuming there are 250 trading days in a year and that the portfolio returns
follow a normal distribution, the estimate of the annual VaR at the 95% confidence
level is closest to which of the following?
a. USD 32,595
b. USD 145,770
c. USD 2,297,854
d. USD 2,737,868
12
Answer!
Question [Value-at-Risk (VaR)]
Howard Freeman manages a portfolio of investment securities for a regional bank. The portfolio
has a current market value equal to USD 6,247,000 with a daily variance of 0.0002. Assuming
there are 250 trading days in a year and that the portfolio returns follow a normal distribution,
the estimate of the annual VaR at the 95% confidence level is closest to which of the following?
a. USD 32,595
b. USD 145,770
c. USD 2,297,854
d. USD 2,737,868
Daily standard deviation = sqrt(0.0002) = 0.01414.

Annual VaR = 6,247,000 x sqrt(250) x 0.01414 x 1.645 = 2,297,854.
13
Question [Value‐at‐Risk (VaR) Definition and methods]

GARP 2011.P1.E1.24.
Assume that portfolio daily returns are independently and identically normally distributed. Sam
Neil, a new quantitative analyst, has been asked by the portfolio manager to calculate the
portfolio Value-at-Risk (VaR) measure for 10, 15, 20 and 25 day periods. The portfolio manager
notices something amiss with Sam’s calculations displayed below. Which one of following VARs on
this portfolio is inconsistent with the others?
a. VAR(10-day) = USD 316M

b. VAR(15-day) = USD 465M
c. VAR(20-day) = USD 537M
d. VAR(25-day) = USD 600M
14
Answer!
Assume that portfolio daily returns are independently and identically normally distributed. Sam Neil, a
new quantitative analyst, has been asked by the portfolio manager to calculate the portfolio Value-at-
Risk (VaR) measure for 10, 15, 20 and 25 day periods. The portfolio manager notices something amiss
with Sam’s calculations displayed below. Which one of following VARs on this portfolio is inconsistent
with the others?
a. VAR(10-day) = USD 316M

b. VAR(15-day) = USD 465M
c. VAR(20-day) = USD 537M
d. VAR(25-day) = USD 600M
Calculate VAR(1-day) from each choice:

VAR(10-day) = 316 → VAR(1-day) = 316/sqrt(10) = 100 Please
VAR(15-day) = 465 → VAR(1-day) = 465/sqrt(15) = 120 Practice!
VAR(20-day) = 537 → VAR(1-day) = 537/sqrt(20) = 120
VAR(25-day) = 600 → VAR(1-day) = 600/sqrt(25) = 120
VAR(1-day) from Answer A is different from those from other answers. Thus, VAR from answer A is
inconsistent.
15
VaR (HS)
16

GARP 2011.P1.E1.22.
You are the risk manager of a fund. You are using the historical method to estimate VaR. You find
that the worst 10 daily returns for the fund over the period of last 100 trading days are -1.0%, -
.3%, -0.6%, -0.2%, -2.7%, -0.7%, -2.9%, 0.1%, -1.1%, -3.0%. What is the daily VaR for the portfolio
at the 95% confidence level?
a. -0.6%
b. -0.7%
c. -1.0%
d. -3.0%
17
Answer!
You are the risk manager of a fund. You are using the historical method to estimate VaR. You find
that the worst 10 daily returns for the fund over the period of last 100 trading days are
-1.0%, -.3%, -0.6%, -0.2%, -2.7%, -0.7%, -2.9%, 0.1%, -1.1%, -3.0%. What is the daily VaR for the
portfolio at the 95% confidence level?
a. -0.6%
b. -0.7%
c. -1.0%
d. -3.0%
The daily VaR at 95% confidence level is given by the fifth worst loss over the period which is -1%.
18

GARP 2010.P1.20
20. Rational Investment Inc. is estimating a daily VaR for its fixed income portfolio currently
valued at USD 800 million. Using returns for the last 400 days (ordered in decreasing order, from
highest daily return to lowest daily return), the daily returns are the following: 1.99%, 1.89%,
1.88%, 1.87%,…, -1.76%, -1.82%, -1.84%, -1.87%, -1.91%.
At the 99% confidence level, what is your estimate of the daily dollar VaR using the historical
simulation method?
a. USD 14.08mm
b. USD 14.56mm
c. USD 14.72mm
d. USD 15.04mm
19
Answer!
GARP 2010.P1.20
20. Rational Investment Inc. is estimating a daily VaR for its fixed income portfolio currently
valued at USD 800 million. Using returns for the last 400 days (ordered in decreasing order, from
highest daily return to lowest daily return), the daily returns are the following: 1.99%, 1.89%,
1.88%, 1.87%,…, -1.76%, -1.82%, -1.84%, -1.87%, -1.91%.
At the 99% confidence level, what is your estimate of the daily dollar VaR using the historical
simulation method?
Answer:
20. B. $14.56 million
Explanation: VaR = 1.82% * 800 = 14.56 million
20
Fixed Income Valuation
21
2012 FRM Valuation and Risk Models 4.c Tuckman, Fixed Income Securities: Chapter 2
Calculate the value of a bond using spot rates.

Par $100.00
Coupon 6.00%
Yield to maturity (YTM) 4.88%
Years to Maturity 0.5 1.0 1.5 2.0 2.5

Cash flows $3.0 $3.0 $3.0 $3.0 $103.0
Spot rates 1.00% 2.00% 3.00% 4.00% 5.00%
Discounted (spot) $2.99 $2.94 $2.87 $2.77 $91.04 $102.60
22
Define, compute, and interpret the effective duration …

Par value $1,000.00 Semiannual equivalents:
Years to Maturity 10 Coupon, % 2.0%
Coupon, % 4.0% coupon, $ $20.00
Yield 6.0% Periods 20
Semiannual Yield 3.0%
Bond Price (PV) $851.23
Modified Duration
Py  Py 1
Deffective  Shock, bps 10
2y P Shock, % 0.10%
Yield up 6.10%
Price (Shock up) $844.51
Yield down 5.90%
Price (Shock down) $858.01
Duration 7.931
23
Define and compute the DV01 of a fixed income security given a

change in yield and the resulting change in price.
Dollar value of an 01 (DV01; aka, price value of a basis point)
Par $100.00 $100.00

Coupon 5.00% 5.00%
Maturity (yrs) 5.0 30.0
Initial Yield 5.00% 5.00%
Initial price $100.0000 $100.0000
Shock up - 1 bps
Yield 4.99% 4.99%
Price $100.0438 $100.1547
DV01 $0.0438 $0.1547
P  DMod
Key
Formula
DV 01 
10,000
24
Question [Discount factors, arbitrage, yield curves]

GARP 2011.P1.E1.23.
Consider a bond with par value of EUR 1,000, maturity in 3 years, and that pays a coupon of 5%
annually.
Term Annual Spot Interest Rates

1 6%
2 7%
3 8%
The value of the bond is closest to:
a. EUR 904
b. EUR 924
c. EUR 930
d. EUR 950
25
Answer!
Consider a bond with par value of EUR 1,000, maturity in 3 years, and that pays a coupon of 5%
annually.

1 6%
2 7%
3 8%
a. EUR 904
b. EUR 924
c. EUR 930
d. EUR 950
Using spot rates, the value of the bond is:

50/(1.06) + 50/[(1.07)^2] + 1,050/[(1.08)^3] = 924.37
26

GARP 2011.P1.E2.23.
A bond with par value of USD 100 and 3 years to maturity pays 7% annual coupons. The spot rate
curve is as follows:

1 6%
2 7%
3 8%
a. USD 95.25
b. USD 97.66
c. USD 99.25
d. USD 101.52
27
Answer!
A bond with par value of USD 100 and 3 years to maturity pays 7% annual coupons. The spot rate
curve is as follows:

1 6%
2 7%
3 8%
a. USD 95.25
b. USD 97.66
c. USD 99.25
d. USD 101.52
Using spot rates, the value of the bond is: 7/(1.06) + 7/[(1.07)^2] + 107/[(1.08)^3] = 97.66
28
Question [DV01, duration and convexity, duration based

hedging]
GARP 2012.P1.4.
A trading portfolio consists of two bonds, A and B. Both have modified duration of
three years and face value of USD 1000, but A is a zero-coupon bond and its current
price is USD 900, and bond B pays annual coupons and is priced at par. What do you
expect will happen to the market prices of A and B if the risk-free yield curve moves up
by 1 basis point?
a. Both bond prices will move up by roughly the same amount.

b. Both bond prices will move up, but bond B will gain more than bond A.
c. Both bond prices will move down by roughly equal amounts.
d. Both bond prices will move down, but bond B will lose more than bond A.
29
Question [DV01, duration and convexity, duration based Answer!

hedging]
A trading portfolio consists of two bonds, A and B. Both have modified duration of three years
and face value of USD 1000, but A is a zero-coupon bond and its current price is USD 900, and
bond B pays annual coupons and is priced at par. What do you expect will happen to the market
prices of A and B if the risk-free yield curve moves up by 1 basis point?
a. Both bond prices will move up by roughly the same amount.

b. Both bond prices will move up, but bond B will gain more than bond A.
c. Both bond prices will move down by roughly equal amounts.
d. Both bond prices will move down, but bond B will lose more than bond A.
Assuming parallel movements to the yield curve, the expected price change is:
ΔP = -PΔy * D
where P is the current price or net present value
Δy is the yield change
D is duration
All else equal, a negative impact of yield curve move is stronger in absolute terms at the bond
which is currently priced higher. Upward parallel curve movements makes bonds cheaper.
30
Question [Bond prices, spot prices, forward rates]

GARP 2012.P1.18.
A hedge fund has invested USD 100 million in mortgage backed securities. The risk
manager is concerned about prepayment risk if interest rates fall. Which of the
following strategies is an effective hedge against the potential loss due to a drop in
interest rates?
a. Short forward rate agreement (FRA), long T-bond futures

b. Long FRA, short T-bond futures
c. Long FRA, long T-bond futures
d. Short FRA, short T-bond futures
31
Answer!
Question [Bond prices, spot prices, forward rates]
A hedge fund has invested USD 100 million in mortgage backed securities. The risk manager is
concerned about prepayment risk if interest rates fall. Which of the following strategies is an
effective hedge against the potential loss due to a drop in interest rates?
a. Short forward rate agreement (FRA), long T-bond futures

b. Long FRA, short T-bond futures
c. Long FRA, long T-bond futures
d. Short FRA, short T-bond futures
When rates drop, the long position in the futures and the short position in the FRA both gain.
32
Question [Bond prices, spot rates, forward rates]

GARP 2011.P1.E1.20.
A 5-year corporate bond paying an annual coupon of 8% is sold at a price reflecting a
yield-to-maturity of 6% per year. One year passes and the interest rates remain
unchanged. Assuming a flat term structure and holding all other factors constant, the
bond’s price during this period will have
a. Increased
b. Decreased
c. Remained constant
d. Cannot be determined with the data given
33
Answer!
Question [Bond prices, spot rates, forward rates]
A 5-year corporate bond paying an annual coupon of 8% is sold at a price reflecting a yield-to-
maturity of 6% per year. One year passes and the interest rates remain unchanged. Assuming a
flat term structure and holding all other factors constant, the bond’s price during this period will
have
a. Increased
b. Decreased
c. Remained constant
d. Cannot be determined with the data given
Since yield-to-maturity < coupon, the bond is sold at a premium. As time passes, the bond price
will move towards par. Hence the price will decrease.
34
End of 2012 P1. Focus Review 6th/8
35

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2012 FRM P1 Focus Review

6th of 8: Valuation & Risk Models

Hosted by David Harper

Key ideas, Valuation & Risk Models

Taylor Series Approximation

VaR Linear Derivative    VaR Underlying Risk Factor

• The Taylor approximation is not helpful when the derivative

Describe the delta‐normal approach to calculating VaR

European call option price Bond Price versus Yield (YTM)

Question [Two-asset portfolio VaR]

Given a portfolio consisting of two zero-coupon bonds:

Bond Yield Maturity (yrs) StdDev (Yield) Exposure

What is the portfolio’s 10-day diversified VaR?

Two Currency Port: Bond A Bond B Portfolio

Question [Two-asset portfolio VaR]

a. 27.96 million CHF

Answer: Variance of equally weighted portfolio =

Question [Delta‐normal valuation, full revaluation,

Question [Delta‐normal valuation, full revaluation, Answer!

VaR = |delta| * 1.645 * sigma * S = 0.5 * 1.645 * 0.015 * 23 = 0.28.

Question [Value-at-Risk (VaR)]

Daily standard deviation = sqrt(0.0002) = 0.01414.

Question [Value‐at‐Risk (VaR) Definition and methods]

a. VAR(10-day) = USD 316M

a. VAR(10-day) = USD 316M

Calculate VAR(1-day) from each choice:

Question [Value‐at‐Risk (VaR) Definition and methods]

Question [Value‐at‐Risk (VaR) Definition and methods]

Calculate the value of a bond using spot rates.

Years to Maturity 0.5 1.0 1.5 2.0 2.5

Discounted (spot) $2.99 $2.94 $2.87 $2.77 $91.04 $102.60

Define, compute, and interpret the effective duration …

Define and compute the DV01 of a fixed income security given a

Dollar value of an 01 (DV01; aka, price value of a basis point)

Par $100.00 $100.00

Question [Discount factors, arbitrage, yield curves]

Term Annual Spot Interest Rates

The value of the bond is closest to:

Term Annual Spot Interest Rates

The value of the bond is closest to:

Using spot rates, the value of the bond is:

Question [Discount factors, arbitrage, yield curves]

Term Annual Spot Interest Rates

The value of the bond is closest to:

Term Annual Spot Interest Rates

The value of the bond is closest to:

Question [DV01, duration and convexity, duration based

a. Both bond prices will move up by roughly the same amount.

Question [DV01, duration and convexity, duration based Answer!

a. Both bond prices will move up by roughly the same amount.

Question [Bond prices, spot prices, forward rates]

a. Short forward rate agreement (FRA), long T-bond futures

a. Short forward rate agreement (FRA), long T-bond futures

Question [Bond prices, spot rates, forward rates]

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