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PRM_Exam_Handbook

PRM_Exam_Handbook

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The Professional Risk Managers\u2019 Handbook
A Comprehensive Guide to Current Theory and Best Practices
___________________________________________________
Edited by Carol Alexander and Elizabeth Sheedy
Introduced by David R. Koenig
The Official Handbook for the PRM Certification
The PRM Handbook
Contents
Author Biographies

IntroductionDavid R. Koenig
SECTION I - FINANCE THEORY, FINANCIAL INSTRUMENTS AND MARKETS
Preface I

Zvi Wiener
A \u2013 FINANCE THEORY
I.A.1 Risk and Risk Aversion
Jacques Pezier

I.A.1.1 Introduction
I.A.1.2 Mathematical Expectations: Prices or Utilities?
I.A.1.3 The Axiom of Independence of Choice

I.A.1.4 Maximising Expected Utility
I.A.1.4.1 The Four Basic Axioms
I.A.1.4.2 Introducing the Utility Function
I.A.1.4.3 Risk Aversion (and Risk Tolerance)
I.A.1.4.4 Certain Equivalence
I.A.1.4.5 Summary

I.A.1.5 Encoding a Utility Function
I.A.1.5.1 For an Individual
I.A.1.5.2 For a Firm
I.A.1.5.3 Ironing out Anomalies

I.A.1.6 The Mean\u2013Variance Criterion
I.A.1.6.1 The Criterion
I.A.1.6.2 Estimating Risk Tolerance
I.A.1.6.3 Applications of the Mean\u2013Variance Criterion

I.A.1.7 Risk-Adjusted Performance Measures
I.A.1.7.1 The Sharpe Ratio

I.A.1.7.2 RAPMs in an Equilibrium Market
I.A.1.7.2.1 The Treynor Ratio and Jensen\u2019s Alpha
I.A.1.7.2.2 Application of the Treynor Ratio
I.A.1.7.2.3 Application of Jensen\u2019s Alpha

I.A.1.7.3 Generalising Sharpe Ratios
I.A.1.7.3.1 The Generalised Sharpe Ratio
I.A.1.7.3.2 The Adjusted Sharpe Ratio

I.A.1.7.4 Downside RAPMs
I.A.1.7.4.1 RAROC
I.A.1.7.4.2 Sortino Ratio, Omega Index and other Kappa indices

I.A.1.8 Summary
Appendix I.A.1.A: Terminology

Appendix I.A.1.B: Utility Functions
I.A.1.B.1 The Exponential Utility Function
I.A.1.B.2 The Logarithmic Utility Function
I.A.1.B.3 The Quadratic Utility Function
I.A.1.B.4 The Power Utility Function

I.A.2 Portfolio Mathematics
Paul Glasserman
I.A.2.1 Means and Variances of Past Returns
2004 \u00a9 The Professional Risk Managers\u2019 International Association
ii
The PRM Handbook

I.A.2.1.1 Returns
I.A.2.1.2 Mean, Variance and Standard Deviation
I.A.2.1.3 Portfolio Mean, Variance and Standard Deviation
I.A.2.1.4 Correlation
I.A.2.1.5 Correlation and Portfolio Variance
I.A.2.1.6 Portfolio Standard Deviation

I.A.2.2 Mean and Variance of Future Returns
I.A.2.2.1 Single Asset
I.A.2.2.2 Covariance and Correlation
I.A.2.2.3 Mean and Variance of a Linear Combination
I.A.2.2.4 Example: Portfolio Return
I.A.2.2.5 Example: Portfolio Profit
I.A.2.2.6 Example: Long and Short Positions
I.A.2.2.7 Example: Correlation

I.A.2.3 Mean-Variance Tradeoffs
I.A.2.3.1 Achievable Expected Returns
I.A.2.3.2 Achievable Variance and Standard Deviation
I.A.2.3.3 Achievable Combinations of Mean and Standard Deviation
I.A.2.3.4 Efficient Frontier
I.A.2.3.5 Utility Maximization
I.A.2.3.6 Varying the Correlation Parameter

I.A.2.4 Multiple Assets
I.A.2.4.1 Portfolio Mean and Variance
I.A.2.4.2 Vector Matrix Notation
I.A.2.4.3 Efficient Frontier

I.A.2.5 A Hedging Example
I.A.2.5.1 Problem Formulation
I.A.2.5.2 Gallon-for-Gallon Hedge
I.A.2.5.3 Minimum-Variance Hedge
I.A.2.5.4 Effectiveness of the Optimal Hedge
I.A.2.5.5 Connection with Regression

I.A.2.6 Serial Correlation

I.A.2.7 Normally Distributed Returns
I.A.2.7.1 The Distribution of Portfolio Returns
I.A.2.7.2 Value-at-Risk
I.A.2.7.3 Probability of Reaching a Target
I.A.2.7.4 Probability of Beating a Benchmark

I.A.3 Capital Allocation
Keith Cuthbertson, Dirk Nitzsche

I.A.3.1 An Overview
I.A.3.1.1 Portfolio Diversification
I.A.3.1.2 Tastes and Preferences for Risk versus Return

I.A.3.2 Mean\u2013Variance Criterion
I.A.3.3 Efficient Frontier: Two Risky Assets
I.A.3.3.1 Different Values of the Correlation Coefficient
I.A.3.4 Asset Allocation

I.A.3.4.1 The efficient frontier: n risky assets
I.A.3.5 Combining the Risk-Free Asset with Risky Assets
I.A.3.6 The Market Portfolio and the CML
I.A.3.7 The Market Price of Risk and the Sharpe Ratio
I.A.3.8 Separation Principle
I.A.3.9 Summary
Appendix: Mathematics of the Mean\u2013Variance Model

2004 \u00a9 The Professional Risk Managers\u2019 International Association
iii