Derivatives are financialinstrumentswhosevaluedependontheunderlying.

Derivativescan
be used to transfer risk to other entities. These are risky investments with very high
leverage improper understanding of these instruments may result in severe liquidity
problems. Derivatives instrumentsarebothtradedonanexchange(futures,options)orOTC
(forwards, swaps). Differenttypesofinvestorsormarketparticipantstradederivativestoadd
liquidity to the market. Hedgers try to reduce the risk oftheirpositions,whilespeculatorstry
to benefit from their marketviewsandarbitrageurstrytoprofitfrompriceimparityindifferent
markets.

Futures contracts require maintaining a margin with the clearinghouse (initial margin,
maintenance margin and variation margin). In effect a new futures contract is re written
every day and thus the value of the contract is made zero every day. Obviously, as the
deliverydataapproaches,priceoffuturesconvergestothatoftheunderlyingspotprice.

The party with the short position delivers an intention to deliver notice prior to delivery and
alsospecifiestheplaceofdelivery.

Trading volume is the total number of contracts traded, whereas Open Interest is the total
outstandingcontracts(nooflongorshortcontractsoutstanding).

Derivatives are majorly used in hedging the risks that one is exposed. But before hedging,
oneneedstolookatthebigpictureliketheindustryoperatingin,commonpracticesinthe
industry etc. else, hedging mayresultinundesirableoutcomes(likeincreasedfluctuationsin
margins).Hedginghelpstolockinaprice,itmaynotguaranteethebestoutcome.

Short hedge is taking a short position in the derivatives contract (you dothiswhenyouown
the asset and wants to sell it at a later date). Long hedge is taking a long position in the
derivativescontract.

The asset you want tohedgeandthefuturescontractmaybedifferentyoumaynotknowin

advance the exact day whenyouwillbuy/selltheassetthefuturescontractthatyouusedto
hedge may need to be closed before its delivery month. All the above scenarios lead to a
riskcalledBasisrisk. .

Strengthening of the basis (increase in basis) improves the hedgers position in a short
hedge.Viceversaincaseofalonghedge.

We should always choose the futures contract such that its delivery month is after (but
closestto)ourhedgingperiod.

When the asset we want to hedge and the available futures contract are different, then itis
called Cross hedging. Hedge ratio becomes paramount here, because the change in the
spot price and change in futures contract may not be same in cross hedging. Thus hedge
ratio depends on the standard deviations of boththechangeinspotpriceandthechangein

forward price and the correlation between the two. and thus the optimal

1
number of contractsrequiredis .Whenfuturescontractsareusedtohedge,then
an adjustment called tailing the hedge is to be made to adjustforthedailysettlementofthe

futures. In effect, we are just multiplying the hedge ratio by theratioofspotprice

tofuturesprice.

Similarly, we can also hedge our positions in stock market using index futures.
Here, we are in effect reducing the beta of our portfolio to 0. Why to hedge the portfolio
instead of just selling it? We may just want to withstandthevolatilityforaspecificperiodof
time. Or we assume that our portfolio will do better than that of the well diversified portfolio
(index). In other words, we only want to take away the market risk or systematic risk but
wouldliketotakeadvantageofthecompanyspecificrisk.

Stack and roll the contracts

forward is one way of entering into a long term hedge using short term contracts. But,
beware of the liquidity constraints (owing to daily settlement of futures!) when following this
strategy.

Interest rates (or discount rates or opportunity costs) equate present value of the money to

its future value and vice versa. The frequency of the compounding is a major
factor of this formula. Also, always note that the we cannot compare two interest rates with
different compounding frequencies. The formula to find future value of money with

continuouscompoundingisgivenby .

Treasury rates are the interest rates provided by the sovereign governments when they
borrow funds in their own currency. This is virtually risk free, as thegovernmentcanalways
print money torepayitsdebt.However,duetoregulatoryandtaximplications,treasuryrates
are artificially low. Hence, derivatives dealers use a better risk free rate measure LIBOR.
LIBOR is the inter bank offered rate (to a AA rated bank) for a specified period of time.
LIBOR rates are quote in all major currencies for periods less than 12 months. This
interbank market is known as eurocurrency market. To extend the LIBOR risk free yield
curve beyond 12 months, Eurodollar futures and interest rate swaps are used. Repo rates
are the repurchase agreements for a short period of time between banks. If structured
properly, these are also close to risk free.After2007crisis,derivativesdealersstartedusing
OvernightIndexedSwap(OIS)ratesastheriskfreerates.

N year zero coupon interest rate is also called as thenyearzerorateornyearspotrate

or n year zero. We useatechniquecalledbootstrappingtocalculatethezerorates.While

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pricing a bond, each cash flow should bediscountedbyitscorrespondingzerorate.Sohow
do you compare bonds? Yield of the bond is the single discount factor which equates the
bonds discounted cash flows to its quoted market price. Par yield is the coupon rate which
equates the bonds cash flows discounted at their corresponding zero rates to its quoted
marketprice.Yieldcurveshowsthezerorates(yaxis)fordifferentmaturities(xaxis).

Forward rates are the interest rates implied by the current zero rates for a future period of
time. Forward Rate Agreements (FRA) have a value of zero when Else, value of

FRAis .

Arguments of arbitrage will only hold for the investment assets because for consumption
assets there is a convenience in holding the assets. Using thearbitragearguments,wecan

findtheforwardprices(andthusfuturespriceaswell). Here I is

the PV oftheincomesreceivedfromthatunderlyingasset. Hereqistheknown

income yield as a percentage of the asset's price at the time the income is paid.

Here,yistheconvenienceyieldanduisthePVofstoragecosts.

Futures and forward contractsdifferabitintheirsettlements.Infutures,becauseofthedaily

settlements, a profit (or loss) is immediately realised. Whereas, in forwards one has to wait
till the contracted maturity period to receive the profit (orloss).Thus,whenvaluingforwards
ataparticularpointintime,weneedtodiscountthepayoffsfromthestatedmaturitydate.

The value of forward contract changes as time passess, because the stated strike price of
the contract remains the same but the forward (because of the change ininterestratesand
assetprice)pricechanges.Initially,thevalueoftheforwardcontractisalwayssetzero.

The value offuturesandforwardswillbethesamewhentheshortterminterestratesremain

constant or deterministic. When the asset price is positivelycorrelatedwiththeinterestrate,
thefuturespriceishigherthanthatoftheforwardprice.

Interest Rate Parity shows the relationship between the spot exchange rate and forward

exchangerate.

When the futures price is below the expected future spot price (or current spot price), then
suchasituationiscalledbackwardation.Itscalledcontango,ifotherwise.

Day count conventions defines how the interest gets accrued. Treasury bonds have a day
count convention of actual/actual 30/360 is used for corporate and municipal bonds
actual/360(actual/365inAustralia)formoneymarketinstruments.

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Price is quoted as a discount rate on Treasury bills.Forexample,ifthepriceof91dayTbill
is quoted as 8, then it means interest earned on Face value for 360 days is 8%. Treasury
bond prices are quoted as dollars and 32 seconds of a dollar. Accruedinterestistobepaid
whilebuyingthebond(dirtyprice).

In treasury bond futures, one can deliver any government bond withaminimumof15years
remaining to maturity and isnotcallablefor15years.Hence,thecheapesttodeliverbondis
to be identified. A conversion factor, which is the quoted price the bond would have per
dollar of principal with interest rates assumed at 6% for all maturities with semi annual

compounding.

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Eurodollar is a dollar deposited outside US. Eurodollar interest rate is the rate interbank
dollar deposit rate. It is similar to LIBOR. The contract is designed in such a way that one
basis point change in interest rates result in $25 change per contract. Similar to Forward
Rate Agreement, except that the daily settlement in Eurodollar futures results in the price
difference between the two. A convexity adjustment is made to account forthedifferencein

therates. .

P is portfolio value, Dp is duration

of portfolio, Vf is value of futures, Df is the duration of futures. This is the duration based
hedgeratio.

Swaps are a series of forward contracts. Swaps can be used to transform assets or
liabilities, fixed or floating rates. One advantage of swaps is comparative advantage
(difference between two fixed rates and two floating rates). But, a counter argument to this
advantage is that in a floating rate the money is given only for single period and is rolled
over till the maturity, providedthecounterpartysriskprofile(creditrating)remainsthesame.
This is different from a fixed loan given to a counterparty till maturity, where the
counterpartyscreditprofilecandeteriorateduringthetenure.

Market makersintheswapmarketprovideliquidity.Swaprateistheaverageofbidandoffer
fixed rates of a swap. In other words, swap rate is the average of fixed rate that a swap
market makerispreparedtopayinexchangeforreceivingLIBOR(itsbidrate)andfixedrate
that it is prepared to receive in return for payingLIBOR(itsofferrate).Swapratesarelower
thanthecorrespondingmaturityAArates.

Value of a swap iszerowhenitisenteredinto.Swapscanbevaluedintwoways.Inthefirst

method, swaps are valued as the difference betweenfixedratebondandfloatingratebond.
The fixed rate bond value is relatively straightforward. The floating rate bond value can be
calculated usingthetherulethebondisworththenotionalprincipalimmediatelyafterpaying
an interest payment. The other method to value swaps is by assuming a series of forward
contracts (FRAs). In this method, the swap is valued assuming the forward rates are
realised.

Overnight IndexedSwap(OIS)isaswapwhereafixedrateforaperiodisexchangedforthe
geometric average of the overnight rates during that period. Its lower than LIBOR and is
currently used universallyasariskfreerateinderivativescalculations.LIBOROISspreadis
oneindicatorofstressinthefinancialmarkets.

There are many types of swaps. Currency swaps, amortizing swaps (where the notional
principal decreases gradually), step up swaps (where the notional principal increases
gradually), deferred swaps or forward swaps, Constant Maturity Swaps (CMS Swap:
exchange LIBOR rate for a swap rate), Constant Maturity Treasury Swaps (CMT Swap:
exchange LIBOR rate for a particular treasury rate), Compounding swap (interest is

5
compounded and thus only one payment at the end of the life of the swap), accrual swap
(interest on one side of the swap accrues only when the floating reference rate is in the
specified range), diff swap or quanto (rate observed in onecurrencyisappliedtoaprincipal
amount in another currency), equity swaps, extendable swap, puttable swap, swaptions
(option to enter into a swap), commodity swap, volatility swap (prespecified volatility
exchangedforhistoricalvolatilityrealisedintheperiod).

Derivatives are widely used to transfer risks from one party to the other. Securitization of
cash flow producing assets is another way to transfer risk. It played a significant role in the
US financial crisis of 2008, which trickled down to the entire world. Why did this happen?
Why was it overlooked? Irrational exuberance! Lower interest rates helped surge in the
housing demand. However, its the relaxed mortgage lending practices which contributed to
this downfall. NINJA loans were given out. Everyone was only banking on the underlying
mortgage rates to increase. Banks or originators of loans only wanted to get rid off these
dangerous loans off their books so they are only interested whether a loan could be
securitized and sold off subsequently or not. Also, in the US, the mortgage loans have non
recoursefeature.ThusineffecttheborrowerspossessafreeAmericanstyleputoption.

Once the originators sell their loans to SPVs, they are securitized and sold to investors in
two ways either as pass through securities or as CMOs or CDOs with tranches followinga
waterfall model. The assets are tranched to achieve the rating of theirchoice.Forexample,
consider anABSwith65%AAA,25%BBBand10%equitytranche.Toboostthepercentage
of AAA rated securities, the BBB rated are further pooled to create another ABS CDO.The
new ABS CDO would have 60% AAA 30% BBB and 10% equity. Thus the percentage of
AAA rated could be pushedevenhigher.ABXindextracksthevalueofABStranchecreated
from subprime mortgages. TABX index tracks the ABS CDO tranches created from BBB
rated tranches. Why would the rating agencies give the same AAA rating even when the
underlyingsecuritiesarefromaBBBratedABS.Theansweriscorrelation.But,evenaslight
increase in correlation would bring havoc to these securities and correlation increases
especially during the times of stress. Also, rating agencies only equated one particular risk
characteristic of the bonds to those of these securities. For example, S&P and Fitch gave
ratings based on the probability of tranche experiencing a loss relative to similarly rated
bonds. Moodys provided rating based on the expected loss. The rating agencies should
have come up with a different rating framework and ratings to these securities. This would
have averted regulatory arbitrage and most of the shit that happened. Also, the differences
betweenbondsandtrancheswereaccentuatedbythefactthatthetranchesareverythin.

Goldman Sachs and Morgan Stanley were rechristened as BHC instead of investment
banks.

Forwards and futures have linear payoffs, whereas options have nonlinear payoffs. All of
these are zero sum games. Options terminology: long/short call/put option, option premium
or option price, strike price or exercise price, expiration date or maturity date, American
options, European Options. The precise exercise day of the option is the Saturday
immediately following the third Friday in the option expiration month. Options of the same
type (puts or calls) are called Option Class (eg. IBM calls are one class). Option Series

6
consists of the options in a given class with the same expiration date and strike price.
Exchange traded options prices are usually adjusted for stock splits, but not for dividends
(large dividends areanexception).Anakedoptionisanoptionthatisnotcombinedwithany
offsettingpositioni.e.nohedgingdone.

Its never optimal to exercise a non dividend paying American call option before expiration,
especially when you are planning to hold the security till the option maturity, because you
loose on the optionality (the chance of optionbeingevendeeperinthemoney)andthetime
value of money (paying the strike price now as against later). Even when you dont wantto
hold the underlying, its better to selltheoption,ratherthanexercisingit,becausetheoption
will be more valuable to others who are planning to hold the security till/beyond the option
maturity. Hence, non dividend paying American call options are like European call options.

. . .
However, when the stock issues dividends, it may be optimal to exercise American call
options immediately before exdividend date. An option has both intrinsic value and time
value.

Putcall parity for non dividend paying European options is given by . A

companys assets and liabilities can also be thought of as holding options (equity holder is
like longEuropeancall)andcanbeusedtoproveputcallparity(usingtheequationassets=
liabilities). For American non dividend paying stocks, the put call parity is given by

. With dividends, put call parity equation becomes

and .

There are a number of trading strategies with options. Principalprotectednotesarecreated

by banks wherein the banks sell zero coupon bonds and a call/put option. The interest on
the zero coupon is used by the banks to purchase option providing a dividend yield. Thus,
thisstrategydependsalotontheinterestratesandvolatilityoftheunderlyingstocks.

To make money from any investment strategy, youve to take a view that is different from
mostoftherestofthemarketandyoumustberightaswell!

Covered call (long stock + short European call). Protective put (long stock + short put).
Taking a trading position in two or more options of the same type (puts or calls) is called
Spreadtradingstrategy.

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Bull spread (buy European call at a certain strike price and sell call on the same stock at a

higher strike) (buy European put with low strike

price and sell put at a higher strike price). An investor entering into a bull spread is hoping
that the price increases and investor entering into bear spread is hoping that the price will
decrease.

Bear spread (buy put at higher strike price and sell put at lower strike price) or buy call at
higherstrikepriceandsellcallwithlowerstrikeprice)

Box spread is a combination of bull call spread with strike prices K1 and K2 andabearput
spread with the same two strike prices. The payoff from a box spread is always K2K1.

WorksonlywithEuropeanoptions.

Butterfly spread (buy European call at low strike price K1, buy call at relatively highK3and

selltwocallswithK2=(K1+K3)/2.

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Calendar spread (sell Europeancallatacertainstrikepriceandbuylongermaturitycallwith

samestrike).

Combinationstrategiesinvolvetakingpositionsinbothputsandcallsonthesamestock.

Straddle (buy call and put with same strike price and expiration date). A straddle is
appropriate when theinvestorexpectsalargemoveinthestock,butdoesnotknowinwhich

directionthemovewillbe.

Strip (long call and2longputswithsamestrikeandexpiration).Expectsbigstockmove,but

expectsdecreaseofpricemorelikely.
Strap(long in 2 calls and 1 putwithsamestrikeandexpiration).Expectsbigstockmove,but

expectsincreaseofpricemorelikely.

Strangle (buyputandcallwithsameexpirationbutdifferentstrikescallstrike>putstrike).A
straddle is appropriate when the investor expects a large move in the stock, but does not
know in which direction the move will be. Stock price has to move farther inastranglethan

inastraddlefortheinvestortomakeaprofit.

Stock prices are assumed to follow random walks. Binomial models. Trinomial models are
very elegant lattice models to price options. When the time step becomes smaller, in fact,
binomial model converges to black scholes model. No arbitrage arguments are used in the

9
pricing of options. Also, there are no analytical models like BS to price American options.
Binomial lattice can be usedtopricetheseoptions.Controlvariatetechniquecanbeusedto
improve the price of the American option (the error between BS option price
and binomial tree european option is assumed to be the same for American option value
calculatedusingtrees).

The probability of stock pricegoingupordownisirrelevanthere,becauseitsalreadypriced

in the stock price. Were valuing the option in terms of price of underlying stock, not in
absolute terms. Risk neutral valuation states that when we are pricing an option in termsof
thepriceofunderlyingstock,riskpreferencesareunimportant.

When constructing binomialtreetorepresentmovementsinthestockprice,wevetochoose
parametersuanddtomatchthevolatilityofthestockprice.

When we move from real world to risk neutral world, expected returnonthestockchanges,

but its volatility remains the same.

(u=1/d).

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Start from theendofthetreeandworkbackwardfindingthepayoffsateachnode.Calculate
the option value at each node by using the expected value(probability*payoffs)conceptat
eachnode.

A random variable is said to follow stochastic process. The randomness could be either in
time (discrete time or continuous time) or in the variable itself (discrete variable or
continuous variable). Markov process is a memory less process. It is a particular type of
stochastic process where only the present value of variable is needed for predicting the
future. This implies that the market is weak form efficient. Since, predicting the future is
uncertain, it is expressed in probability distributions. When Markov processes are
considered,meanandvariancesareadditive,notstandarddeviations.

Wiener process is a particular Markov stochastic process with a mean change of 0 and

variancerateof1peryear.

Drift Rate (mean change per unit time for a stochastic process).Variancerate(varianceper
unittime).ThebasicWienerprocessd
zhasadriftrateof0andvariancerateof1.
A Generalized Wiener Process for variable x is given by

Itos process is a Generalized Wiener Process in which the parametersaandbfunctionsof

theunderlyingvariablesxandT.

Expected return of a stock price is given by expected drift divided by the stock price.

This is the most widely used model for stock behaviour. Mu is the
expected return of the stock and mu*S is the drift rate. This is also known as geometric

brownian motion. The discrete time version of the model is given by

11
 . We can use Monte Carlo simulation to find the normal distribution
term.

The value of the derivative dependent on the stock is independent of mu. The parameter
sigma,incontrast,isveryimportantthough.

Itoslemma

Thestocksreturnsareassumedtofollowlognormalprocess. .

BlackScholesMertondifferentialequation
We can set theboundaryconditionsandsolvetheabovedifferentialequationtoarriveatthe
options prices of European puts and calls. Note that the above equation does not have
expectedreturnasaparameter.

Implied volatility is calculated based on the market price of the option and using the BS
formula. VIX is an index of implied volatility of 30day options on the S&P 500 calculated
fromawiderangeofcallsandputs.

Employeestockoptionsconstituteamajorcomponentofthecompensationoftopexecutives
and start up employees. On the flip side, these options are infamous for their asymmetric
payoffsgetrewardedwhenthingsgowellandgounpunishedwhenthingsgosoar.

There are many ways of pricing these employee stock options. In the quick and dirty
approach, the expected life of the option (based on the historical data) is calculated and
then BS model is used to price the option. Using Binomial Tree approach is another
method of calculating the option price. Here, the volatility of stock price is calculated using
the historical data. Exercise multiple approach (defining a multiple (stock price/strike price)
12
based on historical data and using binomial or trinomial trees to price the option is another
method. Market based approach is another method, though difficult. Backdating scandals
areprevalentinemployeestockoptionprograms.

Options on stock indices and currencies are used for hedging risks. A range forward
contract(set up with 0 CF initially) is also usedtohedgeforeignexchangerisk.(Buyoneput
with strike K1 and sell a call with strike K2, such that K1<So<K2 or sell put at K1 and buy
callatK2)

For a known dividend yield, the stock price is first discounted with the dividend yield and
thentheoptionisvaluedasthoughthestockpaysnodividends.

This technique can be used to value options, find the lower bounds of options etc. Foreign
currency is analogoustoastockpayingaknowndividendyield(whichistheforeignriskfree
rate).Also,abinomialtreecanbeusedtovalueallthese.

Futures options or options non futures are generally American. Interest rate futures prices
increase when bond prices increase (rates fall) and vice versa. Thus, if youbelievethatthe
rates would fall, you will buy call options on eurodollar futures. If you believe that the rates
will rise, youll buy put options on eurodollar futures. Futures options are more liquid and
easiertotradethantheunderlyingassets.

Hedging options is important to ward off any unpleasant payoffs. You can either take a
naked position or take a covered position (with a position in the underlying) depending on
many factors.Stoplossstrategyisonewayofhedgingbybuyingthestockatthestrikeprice
every time the stock moves up/down the strike price. This can be a very costly strategy,
especiallywhenthestockpricehasalotofvolatilityaroundthestrike.

Delta is the rate of change of option price with respect to the price of the underlying asset.

. A portfolio can be made delta neutral by taking an opposite position in the

underlying stocks. Rebalancing is required to maintain the portfolio delta hedged always
(dynamic hedging as againststatichedging).Blackscholesequationisderivedbysettingup
arisklessportfolioconsistingofoptiononastockandapositioninthestock.

ThedeltaofshortcallisN(d1).

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 Delta of a portfolio is the weighted
average deltas of the individual options (long call is+ve,shortcallisve,longputisveand
shortputis+ve).

Theta (Time Decay) is the rate of change of value ofanoptionwithpassageoftime,ceteris

paribus. Itisusuallynegativeforanoption(exceptions:inthemoneyputorinthemoneycall

with veryhighinterestrate). Doesntmakemuch

sensetomakeaportfoliothetaneutral,becausepassageoftimeiscertain.

Gamma is rate of change of delta w.r.t the underlying asset price. It is the second partial

derivative of portfolio w.r.t to asset price. It measures the curvature. .

A position in the underlying asset

has a gamma of 0, so we cant use it for gamma hedging. We require a position in an
instrument (like a traded option) that is nonlinearlydependentonunderlyingasset.Gamma
neutrality protects the portfolio against large movements in the stock price between hedge
rebalancing. When we make a portfoliogammaneutral,thedeltaoftheportfolioischanged

so we need to make the portfolio back to delta neutral. .

14
 . For a delta neutral

portfolio,

Vega is the rate of change of value of the portfolio w.r.t thevolatilityoftheunderlyingasset.

. A position in the underlying assethas0vega,sowecantuseforvegahedging.A

portfolio that is gamma neutral will not beveganeutral.Wedneed2tradedoptionstomake
a portfolio gamma and vega neutral. Vega is alwayspositiveforalongpositioninanoption.

Rho of the portfolio is the rate of change of portfolio value w.r.t the interest rate. .
Options are often close to money at issuance, so they have relatively high gammas and
vegas. After some time, the options will be in or out of money, in which case the gammas
and vegas will be small and thus of little consequence. A nightmare would be when the
optionsremainatthemoneyasthematuritydateisapproached.

Scenario analysis is another way of dealing with the risks of the options. The timeperiodis
chosendependsontheliquidityoftheinstruments.

Taylor series expansion when the volatility of the underlying asset is assumed to be

constant.

Whenthevolatilityisstochastic,

While pricing options using BS model, volatility is assumed to be constant. But in reality,
traders allow volatility to depend on strike price and time to maturity. Volatility Smile is the
plot of implied volatility of an option with certain life as a function of itsstrikeprice.Volatility

15
smile is the same for puts and calls. This is because the error in market pricing and model

pricingshouldbesameforbothputsandcalls. .

For asset rate to be lognormally distributed, it is assumed that the volatility of asset is
constant and there are no sudden jumps in prices. BS assumes lognormal distribution of
prices, whereas in reality, the prices are skewed with fat tails. Thus, rare events are more
likelytooccur.Optionpricingshouldtakeintoaccountthisvolatilitysmile.

One reason fro

volatilitysmile(orskew)inequitiesisleverage.
For the smile to be more stable, volatility smile often calculated astherelationshipbetween
implied volatility and K/So. Volatility Surface combines volatility smiles with volatility term
structure(tablewithK/Soandtime).

Value at Risk (VaR) is the single measure of risk which answers the questionhowmuchof
my capital is at risk? It involves both confidence levels and time frame. I am X percent
confident that the loss in this portfolio will not exceed so much (VaR) in the next N days.
Basel committee requires calculating VaR for the trading book of banks using N= 10 days
and at 99% confidence levels. Expected shortfall is the expected value of VaR. It answers
thequestionifthingsdogobad,thenwhatismyexpectedloss?

There are two ways of calculating Var Historical simulation method and model building
approach. Historicalmethodinvolvesrankingtheportfolioreturnsintheascendingorderand
choosingthe5%or1%value.
16

In the model building approach, it is assumed that the expected change in the market
variable over the time period considered is zero. The correlation between the assets in the
portfolio is considered to calculate the portfolios standard deviation which is thenmultiplied
by the square root of the number of days and portfolio value to calculate the portfolio VaR.
MontecarlosimulationcanalsobeusedtocalculateVaR.

Daily volatility is much greater when compared to daily returns so we can ignore daily
returns but not daily volatility. Also, in real world, asset returns have fat tails, unlike the
assumed normal distribution. Thus, rare and heavy losses are more likely in the real world.
Thus, using stress testing and scenario analysis is now mandated by the regulators.Back
testingisanimportanttooltodoarealitycheck.

Volatilities and correlations are estimated using their historical numbers.

Simplifyingweget,
ARCH model assumes mean reversion with long run average variance rate of V.

. EWMA model isknownforitssimplicityanddoesnotassumemean

reversion u(n1) is the most recent daily percentage change in the

variable.GARCHmodel .

VaRandgreeklettershelpquantifythemarketriskoftheportfolio.

Ratings (investment grade orspeculativegrade) providedbytheratingagenciesareagood

indicator of credit risk of the company's/securities. Generally, for investment grade bonds,
probability of default is an increasing function of time, whereas for bonds with poor credit
ratingitisgenerallyadecreasingfunctionoftime.

When a company defaults on its obligations or bonds,noteverythingislost.Aportionofthe
total exposure is recovered. But recovery rates are significantly negatively correlated with
defaultrisks.

17
Bond prices can be used to calculate the probability of defaults. Because the assumption
here is that it's only because of the credit risk that the yields of a bond is more than a
comparable risk free bond (treasury bond). If a bond is priced 200 bps more than its
comparable treasury bond, then the issuer expects the bond loose 200 bps per year from
defaults.Also,noteverythingislostwehaverecoveryrates.
Therefore, the probability of default per year conditional on no earlier default is given by

, where lambda bar is the average hazard rate per year,sisthespreadandRis

therecoveryrate.

For a more exact calculation, take the difference of the bond prices which is the expected
loss from default over the life of the bond.Now,ateachpaymenttime,calculatethepresent
value(discounted at risk free rate) of the default amount (after subtracting the recovery rate
from the bonds value) multiplied by the unconditional probability of default per year. The
total expected loss is then equated to the difference of the bond prices, to calculate the
unconditional probability of default per year. Wecanusethismethodtocalculatethedefault
probabilities for all maturities by bootstrapping, similar to calculating zero rates for yield
curve.

Due to the flight to quality during stress times, the default probabilities calculated from
historicaldataareusuallymuchlessthanthosederivedfromthebondprices.

The default probabilities implied from bond yields are risk neutral probabilities of default.
Whereas,thedefaultprobabilitiesimpliedfromhistoricaldataarerealworldprobabilities.
Generally, defaults have a ripple effect. Credit Contagion is a situation where the default of
one company leads to the default of othercompanies.Unlikeequity,bondreturnsarehighly
skewed with limited upside. Default correlations means that the credit risk cannot be
completely diversified away, and this is a major reason why risk neutraldefaultprobabilities
are greater than realworlddefaultprobabilities.Reducedformmodelsandstructuralmodels
(Merton model) are used to calculate the default correlations. Gaussian copula is a very
useful way of representing the correlation structure between variables that are not normally
distributed.

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Credit risk in derivatives transactions is mitigated to an extent by using netting,
collateralisation, downward triggers and margin requirements. CVA is used to calculate the
exposure of credit risk for a party. The credit risk could alter during the life of the derivative
instrument.

Rightwayriskisasituationwherethecounterpartydefaultswhenthefinancialinstitutionhas
zero or low exposure. Wrong way risk is a situation where the counterparty defaults when
thefinancialinstitutionhasabigexposure.

Credit derivatives (CDS, TRS, Synthetic CDOs) are contracts where the payoffs dependon
the creditworthinessofoneormorecompaniesorcountries.Theyallowtradingofcreditrisk,
much similar to the trading of market risk. However, these credit derivatives have more
asymmetric information compared to derivatives with other underlyings (like interest rates,
currencies etc.) . Unlike in insurance contracts, in credit derivatives the party buying the
protectionneednotholdtheexposuretothecreditevent.

CDS is the most popular single name credit derivative contract. In this contract, one party
buys credit protection and the other sells protection. The total amount paid per year (as
percentage of notional amount) to buy protection is knownasCDSspread.Duetoarbitrage
arguments, the excess of an nyear bond yield over the riskfree rate should approximately

equal the nyear CDS spread. . Arbitrage

argumentssuggestthattheCDSbondbasisshouldbeclosetozero.

To value CDS, first calculate the unconditional default and survival probabilities. From the
perspective of seller of CDS, hell receive money from thebuyertillthetimethecreditevent
doesnt happen (i.e probability of survival*CDS spread). Also, sincethepaymentsaremade
in arrears, when the credit eventhappens,thebuyerwillhavetopaythespreadtillthatdate
(i.eprobabilityofdefault*expectedaccrualpayment).Thepresentvaluesofthesetwoshould
be equal to the present value of the cash outflow for the seller when the credit event
happens(probabilityofdefault*(1recoveryrate)).
The default probabilities used tovalueaCDSshouldberiskneutraldefaultprobabilities,not
realworld default probabilities. Also, note that the CDS spread is not very dependent on

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recovery rates (except in case of binary CDS), because hazard rates (unconditional
probabilities of default) are proportional to 1/(1R), whereas, value of CDSisproportionalto
R.

CDX NA IG and iTraxx Europe are the two CDS indices covering 125 investment grade
companiesinNorthAmericaandEurope.

Bermudan options, binary options. Asian options are options where the payoff depends on
the arithmetic average of the price of the underlying asset during the life of the option. A
shout option is a European option where the holder can shout to the writer at one time
during its life. At the end of the life of the option, the option holder receiveseithertheusual
payoff from a European option or the intrinsic value at the time of the shout, whichever is
greater. These barrier options can be classified as either knockout options or knockin
options. A knockout option ceases to exist when the underlying asset price reaches a
certain barrier a knockin option comes into existence only when theunderlyingassetprice
reaches a barrier. A cliquet option (which is also called a ratchet or strike reset option) is a
series of call or put options with rules for determining the strike price.Avolatilityswapisan
agreement to exchange the realized volatility of an asset between time 0 and time T for a
prespecified fixed volatility. A variance swap is an agreement to exchange the realized
variancerateVbetweentime0andtimeTforaprespecifiedvariancerate.

Geometric Brownian Motion underlies theBSmodelinthepricingofmostoptions.Usingthe

volatility surfaces we canpricetheoptionsclosertotheirmarketprices.However,thismodel
fails when pricing exotics. Wed need more sophisticated or different methods (like Monte
Carlo) to price these. A model where stock prices change continuously is known as a
diffusion model. A model where continuous changes are overlaid with jumps is known as a
mixedjumpdiffusionmodel.Amodelwhereallstockpricechangesarejumpsisknownasa
purejumpmodel.ThesetypesofprocessesareknowncollectivelyasLevyprocesses.

One alternative to BlackScholesMerton is theconstantelasticityofvariance(CEV)model.

This is a diffusion model where the riskneutral process for a stock price S is

where r is the riskfree rate, q is the dividend yield, dz is a Wiener

process, is a volatility parameter, and is a positive constant. When alpha = 1, the CEV
model is the geometric Brownian motionmodelwehavebeenusinguptonow.When alpha
< 1, the volatility increases as the stock price decreases. This creates a probability
distribution similar to that observed forequitieswithaheavylefttailandlessheavyrighttail.
When alpha > 1, the volatility increases as the stock price increases. This creates a
probability distribution with a heavy right tail and a lessheavylefttail.Thiscorrespondstoa
volatility smile where the implied volatility is an increasing function of the strike price. This
type of volatility smile is sometimes observed for options on futures. The CEV model is
particularly useful for valuing exotic equity options. The parameters of the model can be
chosen to fit the prices of plain vanilla options as closely aspossiblebyminimizingthesum
ofthesquareddifferencesbetweenmodelpricesandmarketprices.

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A pathdependent derivative (or historydependent derivative) is a derivative where the
payoff depends on the path followed by the price of the underlying asset, not just its final
value.Asianoptionsandlookbackoptionsareexamplesofpathdependentderivatives.

Monte Carlo simulation is well suited to valuing pathdependent options and options where
there are many stochastic variables. Trees and finite difference methods are well suited to
valuing Americanstyle options. What happens if an option is both path dependent and
American? What happens if an American option depends on several stochastic variables?
Leastsquaresapproachandexerciseboundaryparametrizationapproach.

Martingales and measures are critical to a full understanding of risk neutral valuation. A
martingaleisazerodriftstochasticprocess.Ameasureistheunitinwhichwevaluesecurity
prices.Forallinvestmentassets,themarketpriceofriskisthesharperatio.

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A quanto or crosscurrency derivative is an instrument where two currencies are involved.
The payoff is definedintermsofavariablethatismeasuredinoneofthecurrenciesandthe
payoffismadeintheothercurrency.

A constant maturity swap (CMS) is an interest rate swap where the floating rate equals the
swap rate for a swap with a certain life.Forexample,thefloatingpaymentsonaCMSswap
mightbemadeevery6monthsatarateequaltothe5yearswaprate.
A constant maturity Treasury swap (CMT swap) works similarly to a CMS swap exceptthat
thefloatingrateistheyieldonaTreasurybondwithaspecifiedlife.
A differential swap, sometimes referred to as a diff swap, is an interest rate swap where a
floating interest rate is observed in one currency and applied to a principal in another
currency. Suppose that the LIBOR rate for the period between ti and ti+1 in currency Y is
appliedtoaprincipalincurrencyXwiththepaymenttakingplaceattimeti+1.

The volatility of the price of a commodity that is grown tends to be highest at preharvest
times and then declines when the size of thecropisknown.Duringthegrowingseason,the
priceprocessforanagriculturalcommodityisliabletoexhibitjumpsbecauseoftheweather.
stockstouse ratio this istheratiooftheyearendinventorytotheyearsusage.Typicallyit
is between 20% and 40%. It has an impact on price volatility. As the ratio for a commodity
becomes lower, the commoditys price becomes more sensitive to supply changes, so that
thevolatilityincreases.
Metals that are investment assets are not usually assumed to follow meanreverting
processesbecauseameanrevertingprocesswouldgiverisetoanarbitrageopportunity
fortheinvestor.
Energy products also generally follow mean reverting process, with the demandandsupply
adjustingtoeachother.
There are manygradesofcrudeoil,reflectingvariationsinthegravityandthesulfurcontent.
Two important benchmarks for pricing are Brent crude oil (which is sourced from the North

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Sea) and West TexasIntermediate(WTI)crudeoil.Crudeoilisrefinedintoproductssuchas
gasoline,heatingoil,fueloil,andkerosene.

The calculation of risk measures such as VaR should always be accompanied by scenario
analysesandstresstestingtoobtainanunderstandingofwhatcangowrong.

The front office in a financial institution consists of the traders who are executing trades,
taking positions, and so forth. The middle office consists of risk managers who are
monitoring the risks being taken. The back office is where the record keeping and
accounting takes place. Some of the worst derivatives disasters have occurred because
thesefunctionswerenotkeptseparate.

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