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    8 views6 pages

    2012FRM QuickSheet Part2

    Uploaded by

    Prashant Wani
    frm

    Copyright:

    © All Rights Reserved
    Download as PDF or read online from Scribd
    Flag for inappropriate content
    of 6
    MARKET RISK MEASUREMENT Cae Estimating VaR VaR for a given confidence level occus at the cutoff point that separates the el losses from the remaining distribution Heil mulation approach oes eet abservations and find the observation that corresponds tothe VaR los eve. Paranetric estimation approach: assumes & distibution for the undedying observations + Normal dsuibution assumption VaR= (i, +6, <2n) + Lognoral dixon sumption: VaR =(-¢ Expected Shortfall Provides an entimateof til loss by averaging the VaRs for increasing confidence levels inthe el Weighted Historical Simulation Approaches + Ageecghedadjuss the most cet (dant) ‘hnervations tobe more (le) heavily weighted Volare replaces histori urns with solaily-adjsted retens: actual procedure of cotimating VaR i unchanged relatonscighed: updates the vatance covariance matrix between ast inthe porto, Fle bir simalaion: es on boorrapping of standardized reruns based om voli forecasts able to capare conditional vob, oat chaerng, anor data Peaks-Over-Threshold (POT) Application of extreme vale theory (EV) to the disibution of exces loses over a high threshold. One ofthe goals of using POT approach is to compute VaR. From estimates of VaR. we can derive the expected shorfall (ES) ‘The expression for VaR and ES using POT parameters 2%) . (0 confidence |” —1 level. van =u+2 | u threshold (in percentage terms) 2 number of observations N, number of observations cha exceed threshold Band € = scale and shape parameters, respectively Backtesting VaR CComperes the numberof instances when loses acer the VaR level (exceptions) with the ‘umber predicted by the model tthe chosen level of confidence Faire mate waives of exceptionstaumber of observations. The Basel Committee requires backteting 3 the 9986 confidence level over 1 yeat establishes ones forthe numberof exceptions with corresponding penalties (increases in the capital mull) Mapping ‘Mapping involves finding common cs factors mong pesiions in a given porto maybe dificult and time consuming to manage the isk ofeach individual position. One can evaluate the ‘alse of portale positions by mapping them Yield-Based DVO1 Similar othe dollar value ofa basis pine (DVO1), bu explicdly assumes tha the yield of 2 scucg isthe interest rate factor and shat the Pricing function isthe price-yeld lationship. 1 (ora reac sum of time-weighted present values) lof the bond's cash flows yld-based DVOI = Macaulay and Modified Duration Maceuley duration: weighted average erm ‘0 yy ofa bond’ cath flows. The Macaulay duration ofa zero coupon bond i equal 0 its “Modified duration: approximate percentage price change in a bond from a given change in yield. terial) modified yi uration duration Characteristics of Duration + Maturiy increases, duration increases. * Coupon increases, dation decreases. + ek decease (price increase), duration + Yield increases (rice decrease), duration decreases Bond Portfolio Structures Barbell. manages uses bonds with short and long Buller: manager buys bonds concentrated in the intermediate maturity range fa bullec and barbell have the same duration, the barbell poreoio will have greater convexity because convert is related tothe square of Key Rate Duration + Duration assumes a parallel sift the yckd + Key ate duration adresesnonparlel shifts in the yield curve by allowing for changes inal ates be determined by change in key ttes + Changes in each hey rate wl afer the erm of the previous and subsequent hey rates in a linear fshion, Key rte 01 (8): dollar change of a one-basis- point shift around each key rate on the value of the secur: Key rate duration: iterpteved asthe approximate percentage change in the value of a bond or bond portfolio in response to 2 100-bast-point change in a given key rate, holding all other rates constant, The sum of the key ate durations for ‘abond will equal the effective duration ofthat bond. bey ater ‘gest’ Inia vale Bond Valuation Using Binomial Tree Using backward induction, the value ofa bond ata given node in a binomial tee isthe average ‘of the present values ofthe two posible values from the next period. The appropriate discount rate is the forward rate asocited with the node kee rate duration, years = 10,000 tunder analysis, ‘There ate thtee basic steps to valuing an option ‘on a fixed-income instrument using a binomial Sucp I: Price the bond value at each node using the projected interest rates. Sup 2: Calculate the intrinsic value ofthe derivative a each node at matuity. Sep 3: Calculate the expected discounted value ofthe derivative at each node using the rsk- neutral probabilities and work backward through the tee, Constant Maturity Treasury Swap An agreement to swap a floating rate for a Treasury rate, such asthe 10-year rte. Put-Call Parity e=peS-XeT where ¢ = price ofa ell P = price ofa put S = price of the underlying security 1 tiskefee rate T = time lef to expiration expressed in yeats Volatility Smiles Gurren eptons:itmpliedvolatlicyis lower for atthe-money options than ies For away-fiome the-moncy options. I the implied volaiies for acwual currency options ate greater for away- fiom-the-money than at-the-money options currency traders must think chre i greater chance of extime price movements than predicted by a lognormal distribution. Equi aprons higher implied volatile for low sttke price options. The volatility smirk hal smile) exhibited by equity options translates {nto alef-skewed implied dstibuion of equity price changes Indicates that traders believe the probability of large down movements in price {s greater chan large up movements in price, 8 compared with a lognormal distribution. Exotic Options Compound option: option on another option. © Calon call: sight buy 3 call option at asc price for st peiod of tine Gallon a pu igh 0 buy apt option at 3 x¢ price frst period of me Pron a cal right sel acl option at ast price fora set period of time. + coma put ight wo sell pur option a ase price fora et period of time. Ghose option: owner chooses whether option is call or pu afer inition Barrer option: payof and existence depend on price reaching a certain bart level + Daanvond-out call ut ceases exis ifthe tndesyng ase price hits dhe baci level which inser below the current tock value Daanandin al (ut) only comes ato existence ifthe underying asset pie his che barrier level, wich ir se blow the cure tock ae Upeandeon cal pt) ceases to xs ifthe underving asc price hits a arr level, which set above the caren stock vale. Upand:in cal gu) only comes int existence if the underlying ast price hits the abowe-curent sock-pric barrier level Binary onion pay cher nothing ora fixed © Cabsornthing cal fed amount, Q, pid if the me ends up above the strike pice. N(Q) is the probably ofthe ase price being above the srk pie th ale ofa ash-or nothing ellis STNG), equal © Qe + Aucror-nshing all pays the vale ofthe sock when the contacts iniiated ifthe stock price nds up above the sik price a expiration, “The gorresponding value for this option is Se NG). Lookbackepton:payoft depends on the ‘maximum (call) or minimum (put) value of the undesying ast ovr the life ofthe option, Can he fixed ooating depending on the specification ofa strike price. Shout ption owner receives intrinsic value of option at shout date or expiration, whichever is eater Asian epion: payoff depends on average of the underlying asset price ovr the life of the option; les volatile than standard option. asker options options ro purchase or sll baskets of securities, These baskets may be defined specifically for the individual investor and. ray be composed of specifi stocks, indices, ‘orcurtencies. Any exotic options that involve several different asses are mote generally referred 1 a8 rainbow option. Mortgage Payment Factor ‘When amortizing a mortgage (with fxed rates ‘over the horizon), che payment each month is calculated with the following formula. This ‘ormula applies toll monthly payments over the Iie ofthe loan original FA a Pay poniy = x atoT=1 Joan balance where = monthly incre rate ‘MBS Prepayment Risk Factors that affect prepayments: + Prewaling morgage rate + Spread ofcurtent versus orginal mortgage ae. *+ Mortage rate path (financing burnoa) + Levelof mortgage rat + Underlying morgage characters + Seasonal faccors, + Genera economic active: CMO Prepayment Risk PAC mranche seceves cash lows according 0 4 predetermined schedule Sappore mance: reccives prepayment in exces Of PAC upper rate, diverts cash to PAC tranche ‘ifprepayments are slower than expected (Ceresiny of PAC bond eath flow comes atthe capenic of increased cisco the support canches, Stripped MBSs PO trip tesive principal payments sold ax discount from par ineeass in vale 8 prepayments increase inveretlationship with 10 rips ceive interest payments invertors want prepayments tobe sows postive relaconship with interest rates Option-Adjusted Spread (OAS) + Spread afer the “opeonalin” of the eth Bowes ‘ken into account + Expresses the eiferencebeewcen price ad theoretical vale + When comparing vo MBSe of sini «ual, buy the bond withthe biggest OAS, + OAS roby spread ~opson cout eT ae Eats Credit Mitigation Techniques _Netring legally binding agreement that enables counterparties with multiple derivative contracts to net their obligations (eg, Party A owes, Parry B $50 milion; Party B owes Paty A $40 nillion, so Party A pays net $10 milion to Party B Collaceralization: if the value of detivative ‘contracts is above a stated threshold, collateral ‘must equal the difference between the value of ‘the contract andthe threshold level Collateral agreements have wo major benefits: (1) expand thelist of potential counterparties boca credit rating is less important concern and (2) reduce cconomie capital requirements Downgrade rigger: used when the credit rating ‘of a counterparty falls below a certain level The trigger permits a counterparty 0 “closeout” 2 dlerivatives contrac at its curent market value Probability of Default ‘The probability of default (PD) ofa deb security «an be calculated by wing the fllowing equation: CS represent the credit spread, which isthe diference berween the yield on ssky debe and the rsk-fice rat. Loss given default (LGD) is ‘qual to one minus the recovery rate. Alternatively, probability of defaule can be calculated as follows: | iy ‘where y equals the yield on corporate debe an the risk-free ate is an observable T-bond rate, Forward Rate Since credit spreads change over time, the PD will change over time. A forward rat isthe period rate of intrest expecred on a bond issued at some time in the Future. One-yeat forward rates can be determined s follows: (+i? =045)x0 +4) where: (1+i,)°= the return from holding a 2-year bond for wo years 144i, = theretum on I-year bond 144) = theexpected 1-year rate in one yar (pat formed sr) eee Ds ina ven yar probaly of etka rl pect tee ea eee (1-PD.a)x0+6) Cumulative Probability of Default “Ths probabil of defaiog over maliple peice is equal w= 1 PD, bett—PDaDy cumulative PD. eres ‘The Merton Model + Avalue-based model where the value of the fis ‘oursanding debe (D) and equity (B) are equal the value of che firm (V). ‘The vale of the debs can serv a an indicate of fm df isk Since and Dare contingent claims, option ping «can be uc to determine thet values sfllow: payment ro shareholders: max(Vjq ~Dy. 0) payment co debtholders: Dyc—max(Dyy~ Vac 0) ‘+ aut siilae to along call option om the wake ofa firms ases where face value of debt isthe strike price of the option. + Debris similar to a Fisefice hond and short put ‘option on the vale ofa firm's aes where oe ‘alu of debe isthe sik price ofthe opsion ‘The KMV Model Built on the Merton model and tres to adjust for some of ic shortcomings. Assumes there are ‘only two debt iss. The defaue threshold is linear combination ofthese values and is equal to the par value ofthe fri abilities. A rule for determining the defaule threshold is: short-term liabilities + 0.5 x longc-term labile, ‘The distance to defaule (DD) caleulaes the ‘numberof standard deviations berwosn the mean of the asset distribution and the desu threshold expected asset return — default sheshold ‘standard deviation of expected asset return pp Once DD is compute, the probability of defals can be found by evaluating the DD of other fem tac have defaulted, Credit Scoring Models 1 Faker incr ditinnant anc segreges a lero to homogeneous ubsoups. + Deemer dcriminaton: sea ot funtion to deermine the mens ofthe soups, The ‘ene dtemines which group the seein is headin ely o- or nocd group). + Kcarst eghor catego» new entrant by bow lore trembles members lead in groupe + Support seco machin vies rer gop imo sabgroupe using hyperplanes Loss Given Default uctrs hat ead to suboptimal covery aes Ges higher loses given deal) 1. Debrstctre can le to neicin hsv. 2. Exe which the dbo staining power 3, Msenir det ha exestive tights contr 4. The pretence of ne or more hour banks (lose firm bank rations actos that affect the covery ate of traded bonde * Soir mote senior cians wll generally have 2 ighereorery ae + Caluco allocation, value, and quid of the aa wll determine the every tate. + Jaron dines defaulad optons fra frm in deal + Indwary some industries hae large amount of capital that an be sold in the event of deal + Busines le def probable il vary through the le Rate Functions Modeling the los given def alo called firing the recovery function. Thre functions estimate how mich the holder ofthe debe wll ‘inthe event of defile +The hw drbaion pase satis

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