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FOUNDATIONS OF RISK
MANAGEMENT
Types of Risk
Key classes of risk include marker risk, credir
risk, liquidity risk, operarional risk, legal and
regulatory risk, business risk, srraregic risk, and
repuracion risk.
Market risk includes interest race risk, equity price
risk, foreign exchange risk, and commodity price risk.
Credit risk inc ludes default risk, bankruptcy risk,
downgrade risk, and sctdcmcnt risk.
Liquidity risk includes fundin g liquidiry risk and
crading liquidity risk.
Enterprise Risk Management (ERM)
Comprehensive and integraced framework for
managing firm risks in order co meec business
objeccives, minimize unexpecred earnings
volacility, and maximize firm value. Benefits
include (I) increased organizarional effecciveness,
(2) beccer risk reporting, and (3) improved
business performance.
Determining Optimal Risk Exposure
Target certain default probability or specific credit
rating-. high credit racing may have opporcunity
coses (e.g., forego risky/proficable projeccs).
i
Sensitivity or scenario analys s: examine adverse
impaccs on value from specific shocks.
Diversifiable and Systematic Risk
The pare of the volacility of a single security's
recurns chac is uncorrelaced wich che volatility of
the markec porcfolio is chat securicy's diversifiable
risk.
The pare of an individual securicy's risk char
arises because of the posirive covariance of thac
securicy's recurns with overall marker recurns is
called its systematic risk.
A standardized measure of systematic risk is beta:
Cov(R;.RM)
beta=
I
2
OM
Capital Asset Pricing Model (CAPM)
In equilibrium, all investors hold a porcfolio
of risky assecs thac has the same weigh rs as rhe
market porcfolio. The CAPM is expressed in che
equacion of the security market line (SML). For
any single security or portfolio of securicies i, the
expected return in equilibrium, is:
E(R;) = Ri= + b eca ; [E(RM )- RF)
CAPM Assumptions
Investors seek to maximize the expected utility
of thei r wealth at the end of the period, and all
investors have the same inv estment horizon.
Investors are risk averse.
Investors o nly consider the mean and standard
asset returns are normally distrib uted .)
deviation of returns (which impli cic ly assumes the
Inv estors can borrow and lend at the same risk-free
rate.
Investors have the same expectations con c ernin g
ret urns .
CFA FRM+
There are neither raxes nor transactions costs, and co hide crading losses; lessons include separacion
asse tsare infinitely divisible. This is often referred of ducies and managemenc oversighc.
to as "perfect markets." Allied Irish Bank: currency crader, John Rusnak,
Arbitrage Pricing Theory (APT) hid $691 million in losses; Rusnak bullied back
office workers inco not following-up on crade
The APT describes expecced recurns as a linear
function of exposures to common risk factors: confirmations for fake trades.
E(R) R,. + G;iRP, + G;iRP l + ... + 0,kRP k UBS: equicy derivacives business lose millions due
=
where: co incorrecc modeling of long-daced opcions and
0, = /' fac tor beta for stock i ics srake in Long-Term Capical Managemenc.
i
RP = risk premium associated with risk factor j Sociite Genemle: junior crader, Jerome Kerviel,
i parcicipaced in unauthorized crading accivicy and
The APT defines the scruccure of rerurns but
hid accivicy with fake ofsT eccing cransaccions;
does noc define which faccors should be used in
fraud resulred in losses of $7. I billion.
the model.
Metal!gesellscha.ft: shorc-cerm futures concracts
The CAPM is a special case of APT with only one
used co hedge long-cerm exposure in che
factor exposure-che market risk premium.
pecroleum markecs; scack-and-roll hedging
The Fama-French three-factor model describes
scrategy; marking co markec on fucures caused
recurns as a linear funccion of che markec index
huge cash Row problems.
recurn, firm size, and book-co-markec faccors.
Long-Term Capital Management: hedge fund
Measures of Performance that used relative value stracegies with enormous
The Treynor measure is equal co che risk amouncs of leverage; when Russia defaulced on
measure -[
premium divided by beta, or systemacic risk:
Treynor
E(Rp) - RF ] ics debt in 1998, the increase in yield spreads
caused huge losses and enormous cash Row
problems from realizing marking co market
(3 p
losses; lessons include lack of diversificacion,
The Sharpe measure is equal co che risk premium model risk, leverage, and funding and crading
Sharpe measure -
[E(Rp)-RF]
divided by che standard deviation, or coral risk:
Op
liquidity risks.
Banker's Trust: developed derivacive scruccures
that were incencionally complex; in caped phone
The Jensen measure (a.k.a. Jensen's alpha or jusc conversations, staff bragged abouc how badly
alpha), is the asset's excess return over the return chey fooled clients.
JPMorgan and Citigroup: main councerparcies in
predicred by the CAPM:
Jensen measure -
Enron's derivatives transaccions; agreed to pay a
o.p = E(Rp)-{Ri= + 13p[E(RM)- RF)} $286 million fine for assiscing wich fraud against
Enron investors.
The information ratio is essentially the alpha of
the managed porcfolio relative co its benchmark Role of Risk Management
I. Assess all risks faced by che firm.
IR =
[
divided by che cracking error.
E(Rp)-E(Rs)
crackmg error
] 2. Communicace these risks co risk-caking
decision makers.
3. Monicor and manage these risks.
The Sortino ratio is similar co the Sharpe Objeccive of risk managemenc is co recognize
ratio excepc we replace the risk-free race wich a chat large losses are possible and co develop
minimum acceptable return, denoted Rm,. and conti ngenc y plans that de al with such losses if
we replace the scandard deviarion wich a cype of they should occur.
semi-srandard deviation. Risk Data Aggregation
Sortino racio E_(_ p_)_-_R
R _,_ _..,_
m 1
ir ,_
"' Defining, gathering, and processing risk daca for
-
- __
semi- standard deviation measuring performance againsc risk colerance.
Financial Disasters Benefics of effeccive risk daca aggregacion and
Drysdale Securities: borrowed $300 million in reporcing systems:
unsecured funds from Chase Manhaccan by Incre ases abiliry to anticipate problems.
Ide ntifies rouces to financial he alth.
exploiting a Raw in che syscem for compucing che
Impr oves resolvabilicy in event of bank stress.
value of collateral.
I ncreases efficiency, reduces chance of loss, and
Kit.Ukr Peabody: Joseph Jett reporced subscancial
increases profitability.
arcificial profits; afcer the fake profics were
GARP Code of Conduct
dececced, $350 million in previously reporced
Secs forth principles relaced co echical behavior
gains had co be reversed.
Barinf(s: rogue crader, Nick Leeson, cook
speculative derivative posicions (Nikkei 225
wirhin che risk managemenc profession.
It scresses ethical behavior in che following areas:
Principles
fucures) in an actempc co cover crading losses;
Leeson had dual responsibilicies of crading and Professional integrity and cchical con duct
Con A ices of interest
supervising settlement operacions, allowing him
Confidentiality
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Professional Standards Kurtosis is a measure of the degree to which distribution with mean and variance equal to
Fundamental responsibilities a distribution is more or less "peaked" than a CJ2/n as the sample size becomes large.
Adherence to best practices normal distribution. Excess kurtosis = kurtosis-3.
Population and Sample Mean
Violations of the Code of Conduct may result Leptolwnic describes a distribution chat is more
m ean
in tempor:iry <n<pen<ion or permanent removal peaked than a normal di<trihution.
The population sums all observed values
in the population and divides by the number of
from GARP membership. In addition, violations Platykunic refers to a distribution chat is less
observations in the population, N.
could lead to a revocation of the right to use the peaked, or flatter, than a normal distribution.
N
FRM designation.
Exi
Desirable Properties of an Estimator
An unbiased estimator is one for which the
= i=l

expected value of the estimator is equal to the

QUANTITATIVE ANALYSIS parameter you are trying to estimate.
An unbiased estimator is also efficient if the
variance of its sampling distribution is smaller than
Probabilities all the ocher unbiased estimators of the parameter
Unconditional probability (marginal probability) is you are trying to estimate.
the probability of an event occurring. A consistent estimator is one for which the accuracy
Gmditiona/ probability, P( A J B), is the probability of
N
The sample mean is the sum of all values in
a sample of a population, EX, divided by the
number of observations in the sample, n. It is used
to make informces about the population mean.
Population and Sample Variance

of the parameter estimate increases as the sample

an event A occurring given that event B has occur.red
The population variance is defined as the average
size increases.
of the squared deviations from the mean. The
Bayes' Theorem A point estimate should be a linear estimator when
population standard deviation is the square root
it can be used as a linear function of sample data.
Updates the prior probability for an event in of the population variance.
response to the arrival of new information. Continuous Uniform Distribution N
P(O I) Distribution where the probability of X occurring
E(xi -) 2
P(IIO)= J xP(I)
P(O)
in a possible range is the length of the range
c? = i=l--
relative to the total of all possible values. Letting N
Expected Value a and b be the lower and upper limits of the
The sample variance, r, is the measure of
Weighted average of the possible outcomes of uniform distribution, respectively, then for
dispersion that applies when we are evaluating a
a random variable, where the weights are the a x1 <is b:
sample of n observations from a population. Using
probabilities that the outcomes will occur. (x2
- xi)
E(X)= P (x1 -
<X<x
- 2) = - n - 1 instead of n in the denominator improves the
(b-a) statistical properties of i2 as an estimator of CJ2
EP(xi)Xi = P(x1)x1 +P(x2 )x2 + .. . + P(x0)x0 n
-
Binomial Distribution i -X)2
L--(X
Variance Evaluates a random variable with two possible s2 = i= l
____

Provides a measure of the extent of the dispersion outcomes over a series of n trials. The probability n-1
in the values of the random variable around the of"success" on each trial equals:
mean. The square root of the variance is called p(x) = (number of ways to choose x from n ) Sample Covariance
. n (X1
the standard deviation. p'(l- p)n- X)(Y1 -Y)
covariance = E
variance(X) = EHX -)2 ]
-

For a binomial random variable:

i=l n-1
expected value = np
Covariance variance= np(l- p)
Expected value of the product of the deviations
Standard Error
Poisson Distribution The standard error of the sample mean is the
of two random variables from their respective
Poisson random variable X refers to the number standard deviation of the distribution of the
expected values.
of successes per unit. The parameter lambda (X) sample means. When the standard deviation of
Cov(Ri,Rj) = E{[R i -E(Ri)] x [R j - E(R j )])
refers to the average number of successes per unit. the population, CJ, is known, the standard error of
For the distribution, both its mean and variance the sample mean is calculated as:
Correlation
X. CJ
CJx =
are equal to the parameter,
Measures the strength of the linear relationship
Axe-
}.
Fa_
between two random variables. It ranges from-1 P(X=x)=-
to +l. x!
Confidence Interval
Cov (Ri,R j) Normal Distribution If the population has a normal distribution with
Corr (Ri,Rj)-
Normal distrihurion i< complere ly de...crihed hy
-
o(Ri)o Rj)
a known variance, a confidence interval for the
( its mean and variance. population mean is:
68% of observations fall within ls. CJ
Sums of Random Variables -
X Zo./2 Fa_

90% of observations fall within l.65s.

If X and Y are any random variables:

95% of observations fall within l.96s.

z

+
99% of observations fall within 2.58s.
E(X + Y) = E(X) E(Y) <>ll
= 1.65 for 90% confidence intervals

(significance level 10%, 5% in each tail)

If X and Y are independent random variables:
Var(X + Y) = Var(X) + Var(Y)
If X and Y are NOT 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. The skewness of
a normal distribution is equal to zero.
A positively skewed distribution is characterized by
many outliers in the upper region, or right tail.
A negatively skewed distribution has a
disproportionately large amount of outliers that
Standardized Random Variables
A standardi:ud random variable is normalized
so that it has a mean of zero and a standard
deviation of 1.
z-scort: represents number of standard deviations
a given observation is from a population mean.
x -
z= = --
observation -population mean
standard deviation
Central Limit Theorem
When selecting simple random samples of size
n from a population with mean and finite
z = 1.96 for 95% confidence intervals
a12
(significance level 5%, 2.5% in each tail)
z<>ll= 2.58 for 99% confidence intervals
tail)
(significance level 1%, 0.5% in each
Hypothesis Testing
Null hypothesis (HJ: hypothesis
the researcher
wants to reject; hypothesis that is actually tested;
CJ
the basis for selection of the test statistics.
Al.ternatiVt: hypothesis (H A): what is concluded
if there is significant evidence to reject the null
hypothesis.

variance CJ2, the sampling distribution of sample One-tailed test: tests whether value is greater than
fall within its lower (left) tail. means approaches the normal probability or less than another value. For example:
H0: 0 versus HA: 11>0
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Two-tailed test: tests whether value is different The variance of the error term is constant for all assumption results in a specific relationship for
from another value. For example: independent variables. variance in the model:
H0: = 0 versus HA: 0 No serial correlation of the error terms.
=(1- >..)r;_, + )..cr-1

The model is correctly specified (does not omit

T-Distribution variables). where:
The t-distribution is a bell-shaped probability RegressionAssumptionV iolations )..= weight on previous volatility estimate
(between zero and one)
distribution that is symmetrical about its mean. Heteroskedasticity occurs when the variance of the
It is the appropriate distribution to use when residuals is not the same across all observations in High values of>. will minimize the effect of daily
constructing confidence intervals based on the sample. percentage returns, whereas low values of).. will
small samples from populations with unknown MulticoOinearity refers to the condition when two tend to increase the effect of daily percentage
variance and a normal, or approximately normal, or more of the independent variables, or linear returns on the current volatility estimate.
distribution. combinations of the independent variables, in GARCHModd
a multiple regression are highly correlated with A GARCH(l,1) model incorporates the most
t-test: t= x - .
st ..In each other. recent estimates of variance and squared return,
Serial cornlation refers to the situation in which the and also includes a variable that accounts for a
Chi-Square Distribution residual terms are correlated with one another. long-run average level of variance.
The chi-square test is used for hypothesis tests
concerning the variance of a normally distributed Multiple Linear Regression er =w+nr;_, +0cr-l
population. A simple "gression is the two-variable regression
with one dependent variable, Yi, and one where:
. 2 (n -l)s 2 Ct=weighting on previous period's return
chi-square test: X = independent variable, X. A multivariate regression 0 = weighting on previous volatility estimate
has more than one independent variable. w = weighted long-run variance
w
F-Distribution Yi=Bo +B 1 xX1i +B 2 xX2i +ei VL = long-run average variance =
l-et-0
The F-test is used for hypotheses tests concerning Ct+ 0 < 1 for stability
Adjusted. R-Squared
the equality of the variances of two populations.
Adjusted R 2 is used to analyze the imporrance of The EWMA is nothing other than a special case
s2
F-test: F= 1- an added independent variable to a regression. of a GARCH(l,1) volatility process, with w = 0,
s2 n-1 o. = 1 ->., and 0 = >..
adjusted R2 = 1- (1 - R2 ) x ---
n - k-l The sum Ct + 0 is called the persistence, and if the
SimpleLinear Regression
model is to be stationary over time (with reversion
Yi= B0 + B1 x X i + Ei TheF-Statistic
to the mean), the sum must be less than one.
where: The F-stat is used to test whether at least one of
Y i = dependent or explained variable the independent variables explains a significant SimulationMethods
portion of the variation of the dependent variable. Monte Carlo simulations can model complex
independent or explanatory variable
=

The homoskedasticity-only F-stat can only be problems or estimate variables when there are
B0 intercept coefficient
=

B1 =slope cocfficicnc clerivecl from R2 when the error rerms clisplay small sample sizes. Basic steps are: (1) specify
Ei = error term homoskedasticity. data generating process, (2) estimate unknown
variable, (3) save estimate from step 2, and (4) go
TotalSum of Squares ForecastingModelSelection
back to step 1 and repeat process N times.
For the dependent variable in a regression model, Model selection criteria takes the form of penalty
Bootstrapping simulations repeatedly draw data
there is a total sum of squares (TSS) around the factor times mean squa"d error (MSE).
from historical data sets and replace data so it
sample mean. MSE is computed as:
can be re-drawn. Requires no assumptions with
total sum of squares = explained sum of squares + T

sum of squared residuals E e;/T respect to the true distribution of parameter

t=l
estimates. However, it is ineffective when there are
TSS = ESS + SSR outliers or when data is non-independent.
Penalty factors for unbiased MSE (s2), Akaike
information criterion (AIC), and Schwan

Coefficient of Detennination
Represented by R 2, it is a measure of the
"goodness of fit" of the regression.
ESS
R2 = = l SSR_
TSS TSS
In a simple two-variable regression, the square root
of R 2 is the correlation coeffi cient (r) between X'
and Y, If the relationship is positive, then:
r= JR2
Standard Error of theRegression (SER)
Measures the degree of variability of the actual
Y-values relative to the estimated Y-values from
a regression equation. The SER gauges the "fit"
of the regression line. The smaller the standard
error, the better the fit.
Linear RegressionAssumptions
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.
information criterion (SIC) are: (T IT - k),
e<2 kl11, and T(IUI), respectively.
SIC has the largest penalty factor and is the most
consistent selection criteria.
CovarianceStationary
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(l)] is
specified as a variable regressed against itself in
lagged form. It has a mean of zero and a constant
variance.
Yt =1-1 +et
EWMAModel
The exponentially weighted moving average
(EWMA) model assumes weights decline
exponentially back through time. This
FINANCIAL MARKETS AND
PRODUCTS
Option andForwardContract Payoffs
The payoff on a call option to the option buyer is
calculated as follows: CT=max(O, ST- X)
The price paid for the call option, C0, is referred
to as the call premium. Thus, the profit to the
option buyer is calculated as follows:
profit= CT- C0
The payoff on a put option is calculated as follows:
PT= max(O, X- ST )
The 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
Hedgers: lock-in a fixed price in advance.
Speculators: accept the price risk that hedgers are
unwilling to bear.
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Arbitrageurs: in te rested in marker inefficiencies co Forward price wich convenience yield, c: OptionPricing Bounds
F. -
obtain riskless profic. o - Soe (r -c)T Upper bound European/American call:
Basis c :$ S0; C :$ S0
Forward foreign exchange rate using interest rate
The basis in a hedge is defined as che difference
paricy ORP): Upper bound European/American put:
between che spoc price on a hedged assec and
i:; -S e <i:.i-rr )T p :$ Xe-rT; p :$ x
che futures price of che hedging inscrument o - o
{e.g., furures concracc). When che hedged asset Arbitrage. Remember to buy low, sell high. Lower bound European call on non-dividend
and che asset underlying che hedging inscrument If Fo > S0erT ,borrow, buy spot, sell forward paying stock:
.

are che same, che basis will be zero ac maruricy
Minimum Variance Hedge Ratio
The hedge ratio minimizes che variance of che
combined hedge position. This is also che beca of
Backwardation and Contango
spoc prices wich respecc co furures concracc prices.
HR = Ps,F
crp
today; deliver asset, repay loan at end. c max(S0 -Xe-rT ,0)
If lb < S0e rT , shon spot, invest, buy forward
today; collecc loan, buy asset under fucures Lower bound European put on non-dividend
concracc, deliver to cover shon sale. paying stock:
T
p max(Xe-r -S o ,O)
Backwardation re!Crs to a situation where the futures
price is below the spot price. For this to occur, there Exercising AmericanOptions
must be a significant benefit to holding the asset. It is never optimal to exercise an American call on a

HedgingWith Stock Index Futures Contango refers to a situation where the fucures non-dividend-paying stock before ics expiration date.
price is above the spot price. If there are no benefits American puts can be optimally exercised early if

porcfolio value to holding the asset (e.g., dividends, coupons, or the y are sufficiently in-the-money.
# of cont racts =i3r x convenience yield), cont ango will occur because the An American call on a dividend-paying stock
fucures price x furures price will be greater than the spot price. may be exercised early if the dividend exceeds the
concracc multiplier
amount of forgone interest.
Treasury BondFutures
AdjustingPortfolio Beta In a T-bond futures concracc, any government Put-CallParity
If che beta of che capital asset pricing model is bond with more chan 15 years to maruricy on p = c - S +Xe-rT
used as che systematic risk measure, chen hedging che fuse of che delivery monch {and noc callable
boils down co a reduction of che porcfolio beta. wichin 15 years) is d eliverable on che concracc. c= p+S-Xe-rT
# of contracts= The procedu re to determine which bond is che
folio value cheapest-to-deliver (CID) is as follows: Covered Call andProtective Put
(target beta-portfioIio beta) pon
underlying asset Covered call: Long scock plus short call.
cash received by che s hore = {QFP x CF)+AI
Protective pur. Long stock plus long put. Also
cost to purchase bo nd=QB P+AI
ForwardInterest Rates called portfolio insurance.
Forward rates are interest rates implied by che spot where: OptionSpread Strategies
curve for a speci fie d furure period. The forward QFP =quoted futures price
Bull sprrad: Purchase call option wich low exercise
rate between T1 and T2 can be calculated as: CF = conversion factor
QB P =quoted bond price price and subsidize the purchase with sale of a call
R
R forward - 1T2-R1T1 AI =accrued interest option with a higher exercise pri ce .
T2 - TI
=R 1 + (R 2 - R 1 ) x (_Ii_)
T1 -T1
T he CTD is che bond that minimizes che
foll owing: Q B P- (QFP x CF). This formula
calculates the cost of delivering che bond.
Bear sprrad: Purchase call with high strike price
and shon call wich low strike price.
Investor keeps difference in price of che options
if stock price falls. B e ar spread wich puts involves
Forward RateAgreement (FRA) Duration-Based Hedge Ratio
buying puc wich high exercise price and selling
T he obje ccive of a duration-based hedge is to create
CashFlows
a combined position char does not change in i
put wich low exercise pr ce.
An FRA is a forward ooncract obligacing two Buttnft.y spmui: Three different options: buy one
parries to agree chat a certain interest rate will value when yields change by a small amounc.
call with low exercise price, buy another with a high
apply to a principal amount during a specified ponfolio value x durarionp
#of contracts= exercise price, and shon two calls with an exercise
fucure rime. The T2 cash Bow of an FRA chat fucures value x durationp price in between. Butterfly buyer is hecring the scock
promises che receipt or payment of RK is: price will stay near the price of the written calls.
cash flow (if receiving R!<) =
Interest RateSwaps
Plain vanilla interest rat e swap: exchanges fixed for Calendar sprrad: Two options with different
Lx(RK-R)x(T2 - T1J
float ing -race payments over che life of the swap .
expirations. Sell a shore-dated option and buy a
cash flow (if paying RK ) = At inception, the value of che swap is zero. After long-dated option. Investor profits if stock price
T. x (R - RK)x (Tz - Ti) inception, the value of the swap is the difference stays in a n arrow range.

where : between che present value of che remaining fixed Diagonal sprrad: Similar co a calendar spread

L = princi pal and floating-rate payments: except chat the options can have different strike
RK = annualized rate on L Vswap to pay rlXcd = Bfloat - Brix prices in addition to different expirations.
R = annualized actual rate Vswap to n:ccive fixed = B rix - Bfloat Box spread: Combination of bull call spread and
Ti = time i expressed in years
B rixcd = (PMTfixcd,t, x e-re, )
bear put spre ad on che same assec. This strategy
will produce a constant payoff chat is equal to che
Cost-of- Carry Model + (PMT fixcd,t2x e -rc2 ) + ...
Forward price when underlying asset does not high exercise price minus che low exercise price.
+ [{notional + PMTfixcd t ) xe-n" J
have cash flows: Option Combination Strategies
Fo = SoerT [
Bfloating = notional + ( notional x )J x e -n, Long straddle. Bee on volarilicy. Buy a call and a
put wich the same exercise price and expiration
Forward price when underlying asset has cash Currency Swaps date. Profit is earned if scock price has a large
Bows,/: Exchanges payments in two different currencies;
change in either direction.
T payments can be fixed or Boating. If a swap has
lb = (S0 - I)er Short straddlr. Sell a put and a call with the
a positive value to one oounterparcy, chat parry is
same exercise price and ex.pirarion date. If stock
Forward price wich continuous dividend yield, q: exposed to credit risk.
price remains unchanged, seller keeps option
Fo = Soe (r-q )T Vswap(DC) =Boe -(S0 x Bpc ) premiums. Unlimited potential losses.
Forward price wich storage co sts , u: Stranglr. Similar to straddle except purchased option
where:
T u)T is out-of-the-money; so it is cheaper to implement.
lb =(So + U )er or lb = Soe(r+ So = spot rate in DC per FC
Stock price has to move more to be profitable.
 www.mxkaozi.com
Strips and straps: Add an additional put (strip) or
call (strap) to a straddle strategy.
Exotic Options
Gap optWn: payoff is increased or decreased by the
difference between two strike prices.
Compound optron: 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 optron: payoff depends on the maximum
(call) or minimum (put) value of the underlying
asset over the life of the option. This can be fixed
or floating depending on the specification of 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 of the
underlying asset price over the life of the option;
less volatile than standard option.
Basket options: options to purchase or sell baskets
of securities. These baskets may be defined
specifically for the individual investor and may
be composed of specific stocks, indices, or
currencies. Any exotic options that involve several
different assets are more generally referred to as
rainbow optWns.
Foreign Currency Risk
A net long (short) currency position means a
bank faces the risk that the FX rate will fall (rise)
versus the domestic currency.
net currency exposure (assets - liabilities) +
= lowest, and then identify the lowest 5% of returns.
(bought - sold)
On-balance shut hedging. matched maturity and
currency foreign asset-liability book.
Off-balance sheet hedging. enter into a position in
a forward contract.
Central Counterparties (CCPs)
When trades are centrally cleared, a CCP becomes
the seller to a buyer and the buyer to a seller.
Advantages ofCCPs: transparency, offsetting, loss
mutualizacion, legal and operational efficiency,
liquidity, and default management.
Disadvantages ofCCPs: moral hazard, adverse
selection, separation of cleared and non-cleared
products, and margin procyclicality.
Risks faced by CCPs: default risk, model risk,
liquidity risk, operational risk, and legal risk.
Default of a clearing member and its flow through
effects is the most significant risk for a CCP.
MBSPrepay ment Risk
Factors that affect prepayments:
Prevailing mortgage rates, including (l) spread
of current versus o riginal mortgage rates, (2)
mortgage rate path (refinancing burnout), and (3)
level of mortgage rates.
Underlying mortgage characteristics.
Seasonal f.ictors.
General economic activity.
Conditional Prepay ment Rate (CPR)
Annual rate at which a mortgage pool balance
is assumed to be prepaid during the life of the
pool. The single monthly mortality (SMM) rate is
derived from CPR and used to estimate monthly
prepayments for a mortgage pool:
SMM l -(l -CPR) 1112
= _
QQ106454842 CFA FRM+
Option-Adjusted Spre ad (OAS)
Spread after the "optionality" of the cash flows is
taken into account.
Expresses the difference between price and
theoretic:al value.
When comparing two MBSs of similar credit
quality, buy the bond with the biggest OAS.
OAS zero-volatility spread-option cost.
=
''4'll!:ii''':''';11i1ti:1r''',jf1
. .
Value at Risk (VaR)
Minimum amount one could expect to lose with
a given probability over a specific period of time.
V aR(Xo/o) =zx% x cr
Use the square root of time to change daily to
monthly or annual VaR
V aR(Xo/o)J-days = VaR(X%)1-day
VaRMethods
The delta-normal method (a.le.a. the variance
covariance method) for estimating VaR requires
the assumption of a normal distribution. The
method utilizes the expected return and standard
deviation of returns.
The historical simulation method for estimating
VaR uses historical data. For example, to calculate
the 5% daily VaR, you accumulate a number of
past daily returns, rank the returns from highest to
The Monte Carlo simulation method refers
to computer software that generates many
possible outcomes from the distributions of
inputs specified by the user. All of 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 (FS)
Average or expected value of all losses greater than
the VaR: E[4 I I,. > 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 PricingModel
A one-step binomial model is best described within
a two-state world where the price of a stock will
either go up once or down once, and the change
will occur one step ahead at the end of the
holding period.
In the two-period binomial model and multi
period models, the tree is expanded to provide for
a greater number of potential outcomes.
Step 1: Calculate option payoffs at the end of all
states.
Step 2: Calculate option values using risk-neutral
probabilities.
f
size of up move= U = ecr J
size of down move = D= _!._
u BondValuation
e'1- D
'ITup = ; 'ITdown = 1- 'rrup
U D
Step 3: Discount to today using risk-free rate.
-rr"P
can be altered so that the binomial model
can price options on stocks with dividends, stock
indices, currencies, and futures.
Stocks with dividends and stock indices: replace e'T
with tf.r-<i'JT, where q is the dividend yield of a stock
or stock index.
Currencies: replace t'T with tf.r--rT, where rr is the
foreign risk-free rate of interest.
Futurts: replace t'T with 1 since futures are
considered zero growth instruments.
Black-Scholes-MertonModel
x
c =So N(d1 )- Xe-rTN(d2)
p = Xe-rT N(-d2)-S0N(-d1)
where:
()
2
In [
+ r +0.5 xcr xT ]
axJf
d2 = d1 -(ox.ff)
T = rime to maturity
So = asset price
X = exercise price
r = risk-free rate
cr = stock return volatility
N() =cumulative normal probability
Gree ks
Delta: 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.
P ut delta between -1 and O; increases from -1 to 0
as stock price increases.
P ut 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 i s equal to 1.
The delta of a futures contract is equal to /T.
When the underlying asset pays a dividend, q, the
x
delta must be adjusted. If a di vidend yield exists,
delta of call equals riT N(d1), delta of put equals
riT x [N(d,)-1], delta of forward equals riT, and
delta of futures equals 1-T.
Theta: rime decay; change in value of an option
for a one-unit change in rime; more negative when
option is at-the-money and close to expiration.
Gamma: rate of change in delta as underlying stock
price changes; largest when option is at-the -money.
Vega: change in value of 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 of option's 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 valu e 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.
There are three steps in the bond valuation process:
Step 1: Estimate the cash flows. For a bond, there
 www.mxkaozi.com
are two types of cash flows: (1) the annual
or semiannual coupon payments and (2)
the recovery of principal at maturity, or
when the bond is retired.
Step 2: Determine the appropriate discount rate. The
approximate discount rate can be either the
bond's yield to maturity (YrM) or a series
of spot rates.
Step 3: Calculate the PVofthe estimated cash flows.
The PY is determined by discounting the
bond's cash fl.ow stream by the appropriate
QQ106454842 CFA FRM+
cash flows associated with the instrument to its Country Risk
price. The yield to maturity assumes cash flows Sources ofcountry risk-. (1) where the country is in
will be reinvested at the YfM and assumes that the economic growth life cycle, (2) political risks,
the bond will be held until maturity. (3) the legal systems of a country, including both
Relationship Among Coupon, YfM, the structure and the efficiency of legal systems,
and (4) the disproportionate reliance of a country
and Price
on one commodity or service.
If coupon rate > YTM, bond price will be greater
Factors influencing sovereign default risk-. (1) a
than par value: prmzium bond.
country's level of indebtedness, (2) obligations
If coupon rate < YTM, bond price will be less
such as pension and social service commitments,
than par value: discount bond.
(3) a country's level of and stability of tax receipts,
If coupon rate YTM, bond price will be equal
(4) political risks, and (5) backing from other
=

discount rate(s). to par value: par bond.

Clean and Dirty Bond Prices
When a bond is purchased, the buyer must pay
any accrued interest (AI) earned through the
settlement date.
countries or entities.
Dollar Value of a Basis Point
The DVO 1 is the change in a fixed income
Internal Credit Ratings
At-the-point approach: goal is to predict the credit
security's value for every one basis point change in
quality over a relatively short horizon ofa few
interest rates.
months or, more generally, a year.
BV
DVOl = Through-the-cycle approach: focuses on a longer
10,000xy
time horizon and includes the effects of forecasted
DVOl = duration x 0.0001 x bond value cycles.

Clean price. bond price without accrued interest.
Dirty price. includes accrued interest; price
the seller of the bond must be paid to give up
ownership.
Effective Duration and Convexity
Duration: firsc derivative of the price-yield
relationship; most widely used measure of bond
Expected Loss
The expected loss (EL) represents the decrease in
value of an asset (ponfolio) with a given exposure
subject to a positive probability of default.

Compounding
price volatility; the longer (shoner) the duration,
the more (less) sensitive the bond's price is to
expected loss = exposure amount (EA)
x
x
probability ofdefault (PD)
loss rate (LR)

changes in interest rates; can be used for linear

Discrete compounding:

FVn = PV0 1 +
( )mxn estimates of bond price changes.
BV_Y - BV+Y
Unexpected Loss
Unexpected loss represents the variability of
effective duration = potential losses and can be modeled using the
2 x BV0 xy
definition of standard deviation.
where: Convexity: measure of the degree of curvature
r = annual rate
(second derivative) of the price/yield relationship;

UL = EA x PDxcr[R + LR2 x cr0
m = compounding periods per year
accounts for error in price change estimates from Operational Risk
11 = y ears
duration. Positive convexity always has a favorable Operational risk is defined as: The risk ofdirr:ct
Continuous compounding: impact on bond price. and indirect loss mu/ting.from inadequate or failed
rx n
FVn = PVoe . BV_y + BV+y - 2 x BV0 internal processes, people, and systems or from
convexity
external events.
=

BV0 x y2
Spot Rates
A t-period spot rate, denoted as z(t), is the yield
Operational Risk Capital Requirements
Bond Price Changes With Duration Basic indicator approach: capical charge measured
to maturity on a zero-coupon bond that matures
and Convexity on a 6rmwide basis as a percentage of annual gross
in t-years. It can be calculated using a financial
income.
percentage bond price change ::::: duration effect +
calculator or by using the following formula Standardized approach: banks divide activities
(assuming periods are semiannual), where d(t) is a convexity effect
among business lines; capical charge = sum for
discount factor:
B
= -duration x y + .!. x convexity x y2 each business ine.
l Capical for each business line

z(t) = 2
(-)
1 121
-1
B
Bonds With Embedded Options
2 determined with beta factors and annual gross
income.
d(t) Advanced measurement approach: banks use their
Callable bond: issuer has the right to buy back
own methodologies for assessing operational risk.
the bond in the future at a set price; as yields fall,
Capital allocation is based on the bank's
Forward Rates bond is likely to be called; prices will rise at a operational VaR.
Forward rates are interest rates that span future decreasing rate-negative convexity.
periods. Putable bond: bondholder has the right to sell
Loss Frequency and Loss Severity
Operational risk losses are classified along two
)1 (I __:. ic yield)'+!
+ period i
bond back to the ssuer at a set price.
(1 + ,.
rorward rate = _ __ _ _
____:. _;.__ independent dimensions:
(1 + periodic yield)1
Lossfrequency. the number of losses over a specific
time period (typically one year). Often modeled
Realized Return
with the Poisson distribution (a distribution that
The gross realized return for a bond is its end-of
models random events).
period total value minus its beginning-of-period
PPN: 32007227 Loss severity. value of financial loss suffered.
value divided by its beginning-of-period value.
ISBN-13: 9781475438192 Often modeled with the lognormal distribution
BV, + C, - BV,_1
Rc-1,c (distribution is asymmetrical and has fat tails).
_

-
BV1-l
The net realized return for a bond is its gross
realized return minus per period financing costs.
Yield to Maturity (YTM)
The YfM of a fixed-income security is equivalent
to its internal rate of return. The YTM is the
discount rate that equates the present value of all
U.S. $29.00 <Cl 2015 Kaplan, Inc. All Rights Reserved.
Stress Testing
VaR tells the probability of exceeding a given loss
but fails to incorporate the possible amount of a
loss that results from an extreme amount.
Stress testing complements VaR by providing
9 7 8 1 4 7 5 438 1 9 2 information about the magnitude of losses that
may occur in extreme market conditions.