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Market Risk Module

Market Risk Module

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Published by Chen Lee Kuen

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Categories:Types, School Work
Published by: Chen Lee Kuen on Jun 16, 2008
Copyright:Attribution Non-commercial

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04/09/2015

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II. Market Risk Module
II. 1. A. INTRODUCTION TO VAR 3
 
II. 1. B. PUTTING VAR TO WORK 9
 
II. 2. MECHANICS OF FUTURES MARKETS 13
 
II. 2. A. HEDGING STRATEGIES USING FUTURES 16
 
II. 2. B. DETERMINATION OF FORWARD &FUTURES PRICES 19
 
II. 2. C. INTEREST RATES 26
 
II. 2. D. SWAPS 35
 
II. 2. (NA). MECHANICS OF OPTION MARKETS 43
 
II. 2. E. PROPERTIES OF STOCK OPTIONS 45
 
II. 2. F. TRADING STRATEGIES INVOLVING OPTIONS 49
 
II. 2. G. BINOMIAL TREES 53
 
II. 2. H. THE BLACK 
SCHOLES MODEL 57
 
II. 2. I. THE GREEK LETTERS 65
 
II. 2. J. VOLATILITY SMILES 72
 
II. 2. K. EXOTIC OPTIONS 75
 
II. 3. A. VAR METHODS 85
 
II. 3. B. VAR MAPPING 87
 
 
2 / 166
II. 3. C. STRESS TESTING 94
 
II. 4. COMMODITY FORWARDS & FUTURES 98
 
II. 5. A. MARKET RISK 104
 
II. 5. B. FOREIGN EXCHANGE RISK 110
 
II. 6. A. FIRM-WIDE RISK MANAGEMENT 114
 
II. 6. B. CASH FLOW EXPOSURES 119
 
II. 6. C. THE DEMAND AND SUPPLY FOR DERIVATIVE PRODUCTS 125
 
II. 7. A. BOND PRICES, DISCOUNT FACTORS, AND ARBITRAGE 129
 
II. 7. B. BOND PRICES, SPOT RATES & FORWARD RATES 132
 
II. 7. C. YIELD-TO-MATURITY (YTM) 136
 
II. 7. D. GENERALIZATIONS AND CURVE FITTING 140
 
II. 7. E. ONE-FACTOR MEASURES OF PRICE SENSITIVITY 142
 
II. 7. F. MEASURES OF PRICE SENSITIVITY BASED ON PARALLEL YIELD SHIFTS 150
 
II. 7. G. KEY RATE AND BUCKET EXPOSURES 153
 
II. 7. H. THE SCIENCE OF TERM STRUCTURE MODELS 158
 
II. 7. I. MORTGAGE-BACKED SECURITIES 162
 
 
3 / 166
II. 1. A. Introduction to VaR
LO 7.1: Discuss reasons for the widespread adoption of VaR as a measure of risk.LO 7.2: Define value at risk and calculate VaR for a single asset on both a dollar and percentagebasis.LO 7.3: Convert a daily VaR measure into a weekly, monthly, or annual VaR measure.LO 7.4: Discuss assumptions underlying VaR calculations.LO 7.5: Explain why it is best to use continuously compounded rates of return when calculating VaR.LO 7.6: Calculate portfolio VaR and describe the primary factors that affect portfolio risk.
Background on value at risk (VaR)
Why it Became Popular
LO 7.1 Discuss reasons for the widespread adoption of VAR as a measure of risk
The capital asset pricing model (CAPM) is popular but controversial. CAPM divides (decomposes)risk into systemic (market) risk and residual (company-specific) risk. CAPM quantifies risk as
beta
  
 )
, but
beta
is controversial.Reasons for popular adoption of VAR include:The traditional approach has been the capital asset pricing model (CAPM), wherebeta is the risk metric. However, beta has a
“tenuous connection”
to actual returns.Further, as a one-factor model, CAPM is viewed as too simplistic by many practitioners
 JP Morgan created an “open architecture metric” (i.e., not proprietary) called
RiskMetricsBank for International Settlements (BIS) in 1998 started to allow banks to useinternal models such as VaR in order to calculate their capital requirements
 JP Morgan later said about the introduction of RiskMetrics in 1994, “we took thebold step of revealing the internal risk management methodology…and a free dataset…At the time, there was little standardization in the marketplace”.
 
What is VAR?
LO 7.2 Define value at risk (VaR)
 
 VaR answers a risk measurement
question (not a risk management question): “how much can welose in a given time frame, with a specified confidence level?”
 

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