Crriticat Concerts For Exam SUCCESS PU ON NAa Ue Case Studies hafe shorter fates contracts ong-ttin expose in the petoleuin markets sack-anid-ol hedging sxrategy; marking to market om futures eased hag cash low problems, Sumsitore rade atempod 0 market by buyin copper an long future posions; copper prices plunged, causing huge losses lesson isthe lack operational and isk contol that allowed thi amounts of leverage; ite debt in 1998, the in n Russa defatted on Toees and enormous cash ow problems from realizing marking to market loses; lessons include ack of diversification, es and funding and trading Tigi iss. Baringr rogue tener, Nick Lec P ons (Niki Fuuzes) in an atempe to cover tad leivavep Lscsom had ual responsibilities of trang and supervising seeement operations allowing him o hie train Risk and Return of a Portfolio Expected eta ER.) = SOWELR,) from divecsicaion : Capital Maske Theory Security Market Line (SML) Investors should only be compensated for risk relative to the matke. Unsytematc rik i lives aways investors are compensated fs systematic rik. The equation of the SML is the CAPM, which ea star syste uilibrium relation CAPM: E(R,)=Ry +3 ]E(R yu) R, Forms of Market Efficiency Weak form: al pas patterns are incorporated into marke price incorprated into market prices Capital Market Line Measures of Risk-Adjusted Performance H(R,)-R E(R,)-R, Sharpe csi SR = op = E(Ry) Ry ERRy)-Re ja Teaching ror 0, «is the sandard deviation of the difference berwcenrewins ofthe portfolio and returns of the benchmark. E(RnI-ELR4)] Axbitrage Pricing Theory (APT) The CAPM is aspecial cas of ADT with only one acto ‘which factors shouldbe sed cexposire—the market risk premium, Re = Nath et Nau by + GARP Code of Conduct related vo ethical behavior within the rk behavior inthe following aes: (1) Profesional intetty and ethical conduct. (2) Conicts of interest (3) Contin 1) Fundamental esponsibiliis 2) Adherence to best practices DU See Standardized Random Variables A mandardied none 84 mean of zero and a sandand deviation of Zan represents #of standard deviations a Correlation Coefficient, + The is bounded by—1 and +1 fhe conelation is er, the variable and y ae uncorrelated ‘Measures of Central Tendency Avid us Made vale that ocean fsquety ina dataset. Medio: mnidpine ofa dataset when dhs aangedin an aeading or deceit Variance and Standard Deviation Variance average of squared deviations fom Eps Normal Distributions Normal dsributon s completly des 6 ations fl within + 1, tos fll within + 1.650 + Leptokutc: more peaked hana norm Standard Error Confidence Intervals The confidence interval gives the range of values the mean val wet, with a cetain probability ( 0), With ko ariance, dl confidence intervals 2qj2 =2.58 for 9% confidence interval (gniicance level 1%, 0.5% in each el Hypothesis Testing N hei (H.): hypohesi the research‘want to reject; hyposbesis that i actly tested, the basis for selection ofthe tes statisti, Alternative hypetesis(H what conclaed ire Issigniicant evidence wo sejet the ull hypothesis Oneal tee tests whether valu is greater than corles than 0. Hyp Overs Hy 30 Tita see tests whether value i ifrent from 20 Hyp = Overs Hy: p20 Tipe Leon sjecton of ll hyper when i isaculy re Tipe er ae to ej the nl bypass when eat fle. ‘Central Limit Theorem Cental imi shore: hen seeing simple random samples of az ram population with ‘mean and ite variance othe sampling dieribution of sample mean approaches nemal baby dsrbtion with ean wand variance tal ton asthe sample se becomes lage Probability Functions 1A pb cin ck, probly mss fimeion) specs the probaly tht random vate equal a rete ale A pbb deny fain pi) canbe wed to generate he poably chi utcome continuous dition le within paricuar tang of ucomes: ‘Aesmudatie dirt foto) ies the probabiy tha random variable X hes fon ale oa oor os than a spec abe ‘Snrmal bio ebb diy anion isarype of cif wre Xs normaly dtbaed seth ean p and varancs ‘T-Distribution The ediribtion ia bl shaped probability liaibution hati eymmercl bouts mean Ieiethe appropriate dstibuion rouse when constructing confidence intervals based on all mpl from popaltions with noun rane and 2 normal, oF approximately normal, disubuion. xu ress Chi-Square Distribution The chisquate tet ised fr hypothesis tests concerning the vaiance ofa normally dsibuted popltion »_(o=Ws chiaquate rests? = 2 E-Distribution The Fest sed for hypotheses fess concen the ua of the vatances of wo popelatons Fee F= 5 Simple Linear Regression Y, =By +B, xX; #5, 1, «dependent or eplined variable +X sindependen o explanatory varible + tree coefficient + Bs dope cocticient Jarque-Bera Test “The Jang Bova ris a method for resting ite somali sumption i easanble ype 2feK—3F “6 4 Ordinary Least Squares Regression (OLS rgesion: a proces that estimates the population parameters B, with corresponding ‘aluc for b, sample coeffi) that minimize the squared ero terms ‘Total Sum of Squares “oral wu of se = pine su of ses Coefficient of Determination The nfo cermin, rps by Bs amessue of the odes ffi ofthe gression, Multiple Linear Regression Asinple rein ste eval regression ‘with one dependent variable, Y, and one independen variable, X,A murat resin able hax more than onc independent vl Y, = By +B xX, + By xX. ‘The F-statistic “The Ftc allows forthe vesting ofthe joint hypathesis tha boh slope coecents eal zero, lean beclculted a5 follows ESS af BS af Adjusted R-Squared AUjuced Bis seo analyze the importance of F an added independent variable to a regresion, adjusted R21 - (1 -R?)x2=" a-k-l ‘The Binomial Distribution Evaluates random variable wth two posible outcomes ver series of mati. The probability of access” om each til equal ‘pls = (aumber of ways to choose x from a} pil-py Fora binomial nradon variable expected vale = np variance = apt p) ‘The Poisson Distribution Poisson random variable X refers to the number ofsueceses per unt. The paramece lambda (X) tefers ro the average number oF suceses pet tit For the distebusion, both ts mean and variance ae equal the parameter, we Px=8)= Exponentially Weighted Moving Average Model oh = Nol, HO-Nu where = weight on previous volatility evimate (between eto and one) GARCH Estimation Model == ou) +80 + Tp umes vane reves ong un area ee + Sam (a) mst Be ks than ofr he ae FINANCIAL MARKETS AND PRODUCTS Foreign Currency Risk ‘Ant ing (shor) currency position means a Bank fies hess chat the FX at wl al ise) Orble she edging matched maesty and curcncy frcga ase-aily book Offline se eng: ene poition a forward conc. Forward Prices Basic formula: = Sye Forward price with carrying cows Re(-ne Forward price with continuous dividend yd hese Forward price with storage costs: Fy=[Sue Ule” or Fi se Arb: Remember buy los sl high! IF > Sie", orzo, bu spots forward today: dlver ast, repay-loan tend AFF < Se, shre po, invest by forward today collec oan buy asunder fates one, dlr 0 coer shor Hedging With Stock Index Futures offer = ontalo Prete of Fares Interest Rate Parity Interest Rate Swaps Plain wail ase ate swap exchanges fed for flsvng rate payments ost the ife of the swap. AL inception, the value of swap i 20 ‘Ae inception, the vale ofthe swap isthe dliference berwecn che present value ofthe remaining fixed and Roating-ite payin: = tot 8 sia tiat™ Bis Bo Bet = (PMTs, xe") (Ota, xe!) tional + PMTget, sional + noon Gareng sap: exchanges payenss in two dierent snrencies: payments canbe fixed or floating, fa swap has positive value to one counterpaty shat pay is exposed to cei ris,Factors Affecting an Option’s Price a el ee x ae) ees ere tT)? |?]-|- ye : Option Pricing Bounds Upper bound EuropeantAmercan cal eSSICSS, Upper bound EuropeantAmerican put psxe"i Pex Lower bound Europsn cll on no dividend paying stock snax(S,—Xe-.0) Lower bound Europsin pu on nondiviend ying sock p2ma[Xe"" ~S.0) Rules for Exercising American Options + Irisneet opima w exceie an Amin cll con-anonsdvden.paing tick ble “Arian puts can be opimaly exec ery they ae sfieninahesmoney. ‘An American al on didend-paying stock ‘muy be exerci ef the dividend ence the Put-Call Parity P48 2C4Xe Option Trading Strategies + Cred al Long ck pls shot al. + ee pe Long tock pls lng put ‘Aso elle portfolio insurance + Bui prod Purchase el option with bw exercise vice and subse the purchase wih se of 3 Call opion wih higher execs pric, + Bear pred. Shore all spend. Patchass call wth high sik pice and share with lw sike pre Investor he ieee in rc of he ‘pions if ck prc ll Bear spread with pus fnvolses buying put with high exercise pric and put wth kw ext rc Bucy rca. Vase ice opions Buy one cal wih ew ener rice, buy another with thigh exes pie an shore al with tm exercise price in erwoon, Bute buyer is tasting the ck pie wil ay near the pc the writen call, Glenda pred. options with difzent expiration. Slla shored option and buy 3 long-dacd prion, lvesor profs if sock price Ling stele Bet on wat Buy ill anda pur with the sae eve price an expiestion at. Profits earned if stock pice as 3 Lge change in citer discon ‘Sort rade Sell spt ad cll with the ‘ame eerie price and epiation dite If soe, Price remains unchangs eller kspsopion premiums. Unlimited poten ks Single Sina sale xe parsed opin Jou he mong sis cheaper eo implement Sock price ha to mowe more to be pofiale + Soa sys, an abo pa ip ‘al rap) rade rt (Clean and Dirty Prices Gan price bond price wih accrued interes. int price inludes accrue interes; price the eller ofthe bond must be paid w ive ‘up ownership. Hedging Strategies Using Futures as rik difenc baw spox pric of heed asset an futures rie of contact ted ined Optil (nino arian) ee rt he pay Concessionality Concesinalinys the net cost ofa multiyeat structuring aprement. concessional = (PV of origina loan) ~ (PV of restructured loan) The lower the PV ofthe restructured loan in relation w the orginal laa, the more the bank dns given up, and dhe greater dhe ens of loan restating. DET Ey Binomial Option Pricing Supt: Cleat option payee inl sates Sep 2: Caleulateoprion valves using rkeneutral probabil. sine of up move» U =e sicof down mos Sep 3: Discount today sing sfc ae Black-Scholes-Merton Option Pricing Model Nid} Xe"T NU) peXe "Nd Si Greeks Deletes the change inva for a option fora one-unit change in stock pice {all dca beren and sere as stock CCl eles hn or out of money cals lose wT for dep inthe money cls Dur dees bowen 1 and 0: nce fom to (as sock price incre Pat dele chow ofr Fr out othe money puts loge =I for dep in-the-money ps ‘Trt: vm deca; mos native when option Gn of changin eke stderr tock price changes lage when opcon atthe sone Vga sensivgy ofan option’ price to changes in slays gest when opion is acahe money; close 00 when option is dsp in- oF ou-of the-money. Delta-Neutral Hedging + Tocompletedy hole along oso all porn, pchae sates of sock xl vo dca + Only apprepriate for sll change inthe alae ofthe undeyingasee + Gamma can comet hedging cor by proecting aguas lege movements in ast pric + Camma-neucal postion are erated by marching porflio gamma wth an offating option poston, Value at Risk (VAR) “Minimum amoune one could expect to lose with given probability over a specific period of time VAR(X96), Use the square mot of time to change daily 0 vom or annual VAR, VAR(X90), Joy = VAR) sap Stress Testing YAR tells the prababily of exceoding a given los ‘ut ils wo inconporate the posible aroun fa Jon that ress from an extreme amount Sie ting conperens VAR by providing ‘infomation abou the magatud of les that ‘may occur in extreme market conditions Relationship Among Coupon, YTM, and Price ITenapon at > YFM, bol price wl be greater than par valu: premium bond. eoupon tate YTM, bond price wil be ss than par valu: dicount bond IF eoupon tate = YM, bon price will be equ to par ale: par ond, Duration and Convexity ‘Drs Fis deri ofthe priced slaonsip, ose widly wed measure of bond price vous che longer shore duration, the _more es) sestive the bonds price to changes in one pice chang BY_a, BV sy 2xBV, x Ay Goes: meas fhe degre of are (cor deat) ofthe peli elaionshp serous for corn pi changs ema fon cffecrive duration = BY_, +BV. yy -2xBV, BY, x34 Parentage price ne etna sing dein aud convexity Trion p10] [4 xcomesiera( ayy so] ‘Convexiy always ha favorable impact on bond price Bonds With Embedded Options Callable bond issuer has the right to by back the bond in the fate tt pie sell, bond likely to heeled prices wil teat a decreasing raenegarne come Parable bond: bondholder has the tght sll bond back othe ise at price. ‘VAR Methods “The dlanarmal method (aka. the vince: covariance method or the analytical method) for eaimating VAR requires the asuinpion of 4 normal dtibution. The method wees the cxpected return an scndard deviation ofretors The hive! simulation mest for exinatig‘VAR uses historical dita. For example to calculate the 59% daly VAR, you accumulate a number of pas aly recurs, ankthe returns fiom highest to lowest, and chen deny the lowes 59% of returns ‘The Mont Carl simuation method ees to computer sofware that generates many posible outcomes rom the ditibutons of Inputs specified by the usr. All ofthe examined ponfli eurns wil form a distribution, which wil approximate the nom dsibuion, VAR is then ealulted in the same way as with the delt-normal method Sovereign risk Serge rks the isk that ori govcenmeat may defaule on alan fil to honor busines «commitments duet a change in national poi ‘When exposed sovereign isk the lene’ egal remedies a ery lit Creditor should + Taamin the soversgn sk quality ofthe county in which he rm ese. + Asses the cre qualtyof he firm, Internal Credit Ratings Avshe pein approach: oa so prec the credit. ‘quality over aelaively shor orion of few ‘months of, more genet a yes. Tioughtheyee approach: Fuses on a longer time horizon and includes the ees of forecasted cycles. Expected Loss “The epee de (EL) represents the decease fn value ofan ast (portale) with a given exposure subject toa postive probability of defaule expected loss = exposure x os given etary ait. Risk-Adjusted Return on Capital Dafne a tikadjutexurcadstd capil revenues [=] er rac “leaner The ARAROC approach iss RAROCs aw of asuning he patil fds conca (RAKOC= Rp) ARAROC = Basel II: 3 Pillars |. Minin capital requirements 2 Supersiory review proces 3, Marke dxipline Basel II: Forms of Capital Ter I: shacholders equity retained earings nonredeemable, noneunulative prefered stock. Tier 2 cumulative prefered sock, guns on LT investments, oan loss eserves, Tier 3: short-term subordinated debs, can only be used to offer make is Basel II: Credit Capital Requirements Suandardied appro bsed on extemal credic Interna ings bse (IRB) approaches: «Foundation: hak evi + Abaca: bark eins PD, LGD, EAD, and ML Basel II: Operational Risk Bs indatrapprnl capilcharge mesure on Gm bas + Sedaris approach banks divide activites among busines lise capital charge = um fo ‘ach busines ine ene aa7aaeni, ISBN 1427788665, IM rea? mu + Advanced mezuremenapproue asks we ais ‘wm methnolge for sein operatina ik Justifications for Banking Regulation Phe bank deposi fm x ake + Provide stabi for ransactions + Avo domino fos om he king sem, Model The sik associated with wing nancial models to simulate complex telatonships. Sources of model rk include incor mel aplication, implementation tk, calibration eros programing eros, and data pbs Capital Management The problem of eapital adquacy for Financial conglomerates ean be rool by detecnining 1 Poli singhfctr vik + Thebusnes unis crs cor Risk actors across the busines unit a che holding apa ee Loss Distribution Approach The loss distebuion approach (LDA) i used co meet the Base Il standards for economic and regulary capital. The LDA has several steps + Onanze a gp os dit into asin li! ‘Weishe every dat point in the matric Mole lo dsb in ech el ofthe mat Devermine the operating rk capil rsirements foreach busines ne Liquidity-Adjusted VAR “The liuidty-adjusted VAR (LVAR) incorporates liquidity sk int thereon VAR messare LVAR = VAR + L(V xspread) Causes of Liquidity Risk. (1) From ably side: depositor or policyholders demand payment. Can be managed with purchased o stored iqity management (2) From aie side inthe farm of loan commitments eters of ered andor fan purchase obligations Saat FINANCIAL MARKETS Credit Crises Characteristics + Complacency dvi pesods of posptiy Desite for profs, dined fr ek + Unsable investor bebo + Underimaton of risk ABX Index The fst transpatent marke where investors could gauge vation of subprime mor Northern Rock Large UK bank was nationalize, blamed largely on che fale of FSA to properly monitor the bank ‘Market Frictions 1. Disaster myopia 2. Nawwork externalities 3. Misaligned incentives UBS Write-Downs Incetnal pressure and ineffective oversight led to large amounts of subprime rsk exposure