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:
beta=
I

Cov(R;.RM)
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
deviation of returns (which impli cic ly assumes the
asset returns are normally distrib uted .
Inv estors can borrow and lend at the same risk-free

rate.

Investors have the same expectations con c ernin g

ret urns .

are neither raxes nor transactions costs, and

are infinitely divisible. This is often referred
to as "perfect markets."

There

asse ts

Arbitrage Pricing Theory (APT)

The APT describes expecced recurns as a linear
function of exposures to common risk factors:
E(R) R,. + G;iRP, + G;iRP l + ... + 0,kRP k
where:
0, = /' fac tor beta for stock i
i
RP = risk premium associated with risk factor j
i
The APT defines the scruccure of rerurns but
does noc define which faccors should be used in
the model.
The CAPM is a special case of APT with only one
factor exposure-che market risk premium.
The Fama-French three-factor model describes
recurns as a linear funccion of che markec index
recurn, firm size, and book-co-markec faccors.
=

Measures of Performance
The Treynor measure is equal co che risk
premium divided by beta, or systemacic risk:
Treynor

measure -[

E(Rp) - RF

(3 p

The Sharpe measure is equal co che risk premium

divided by che standard deviation, or coral risk:
Sharpe measure -

[E(Rp)-RF]
Op

The Jensen measure (a.k.a. Jensen's alpha or jusc

alpha), is the asset's excess return over the return
predicred by the CAPM:
Jensen measure o.p = E(Rp)-{Ri= + 13p[E(RM)- RF)}

The information ratio is essentially the alpha of

the managed porcfolio relative co its benchmark
divided by che cracking error.
IR =

E(Rp)-E(Rs)

crackmg error

The Sortino ratio is similar co the Sharpe

ratio excepc we replace the risk-free race wich a
minimum acceptable return, denoted Rm,. and
we replace the scandard deviarion wich a cype of
semi-srandard deviation.
Sortino racio

1
ir ,_
"'
m
_..,_
p_)_-_R
R _,_
E_(_

_
- _

semi- standard deviation

Financial Disasters

Drysdale Securities: borrowed $300 million in

unsecured funds from Chase Manhaccan by

exploiting a Raw in che syscem for compucing che
value of collateral.
Kit.Ukr Peabody: Joseph Jett reporced subscancial
arcificial profits; afcer the fake profics were
dececced, $350 million in previously reporced
gains had co be reversed.
Barinf(s: rogue crader, Nick Leeson, cook
speculative derivative posicions (Nikkei 225
fucures) in an actempc co cover crading losses;
Leeson had dual responsibilicies of crading and
supervising settlement operacions, allowing him

co hide crading losses; lessons include separacion

of ducies and managemenc oversighc.
Allied Irish Bank: currency crader, John Rusnak,
hid $691 million in losses; Rusnak bullied back
office workers inco not following-up on crade
confirmations for fake trades.
UBS: equicy derivacives business lose millions due
co incorrecc modeling of long-daced opcions and
ics srake in Long-Term Capical Managemenc.
Sociite Genemle: junior crader, Jerome Kerviel,
parcicipaced in unauthorized crading accivicy and
hid accivicy with fake ofsT eccing cransaccions;
fraud resulred in losses of $7. I billion.
Metal!gesellscha.ft: shorc-cerm futures concracts
used co hedge long-cerm exposure in che
pecroleum markecs; scack-and-roll hedging
scrategy; marking co markec on fucures caused
huge cash Row problems.
Long-Term Capital Management: hedge fund
that used relative value stracegies with enormous
amouncs of leverage; when Russia defaulced on
ics debt in 1998, the increase in yield spreads
caused huge losses and enormous cash Row
problems from realizing marking co market
losses; lessons include lack of diversificacion,
model risk, leverage, and funding and crading
liquidity risks.
Banker's Trust: developed derivacive scruccures
that were incencionally complex; in caped phone
conversations, staff bragged abouc how badly
chey fooled clients.
JPMorgan and Citigroup: main councerparcies in
Enron's derivatives transaccions; agreed to pay a
$286 million fine for assiscing wich fraud against
Enron investors.

Role of Risk Management

I. Assess all risks faced by che firm.
2. Communicace these risks co risk-caking
decision makers.
3. Monicor and manage these risks.
Objeccive of risk managemenc is co recognize
chat large losses are possible and co develop
conti ngenc y plans that de al with such losses if
they should occur.
Risk Data Aggregation
Defining, gathering, and processing risk daca for
measuring performance againsc risk colerance.
Benefics of effeccive risk daca aggregacion and
reporcing systems:
Incre ases abiliry to anticipate problems.
Ide ntifies rouces to financial he alth.
Impr oves resolvabilicy in event of bank stress.
I ncreases efficiency, reduces chance of loss, and

increases profitability.

GARP Code of Conduct

Secs forth principles relaced co echical behavior

wirhin che risk managemenc profession.
It scresses ethical behavior in che following areas:

Principles

Professional

integrity and cchical con duct

Con A ices of interest

Confidentiality

Professional Standards

Fundamental responsibilities
Adherence to best practices

Violations of the Code of Conduct may result

in tempor:iry <n<pen<ion or permanent removal

Kurtosis is a measure of the degree to which

distribution with mean and variance equal to

a distribution is more or less "peaked" than a

CJ2/n as the sample size becomes large.

normal distribution. Excess kurtosis = kurtosis-3.

Leptolwnic describes a distribution chat is more

peaked than a normal di<trihution.

from GARP membership. In addition, violations

FRM designation.

Desirable Properties of an Estimator

could lead to a revocation of the right to use the

QUANTITATIVE ANALYSIS
Probabilities
Unconditional probability (marginal probability) is
the probability of an event occurring.

Gmditiona/ probability, P( A J B), is the probability of

an event A occurring given that event B has occur.red

Bayes' Theorem
response to the arrival of new information.

P(IIO)=

P(O I)
J xP(I)
P(O)

An unbiased estimator is one for which the

expected value of the estimator is equal to the

parameter you are trying to estimate.

An unbiased estimator is also efficient if the

variance of its sampling distribution is smaller than
all the ocher unbiased estimators of the parameter
you are trying to estimate.

Updates the prior probability for an event in

Platykunic refers to a distribution chat is less

peaked, or flatter, than a normal distribution.

A consistent estimator is one for which the accuracy

of the parameter estimate increases as the sample

size increases.
A point estimate should be a linear estimator when
it can be used as a linear function of sample data.

Continuous Uniform Distribution

Distribution where the probability of X occurring

in a possible range is the length of the range

relative to the total of all possible values. Letting

Expected Value

a and b be the lower and upper limits of the

Weighted average of the possible outcomes of

uniform distribution, respectively, then for

a random variable, where the weights are the

probabilities that the outcomes will occur.

Variance
Provides a measure of the extent of the dispersion
in the values of the random variable around the
mean. The square root of the variance is called

of two random variables from their respective

expected values.

Cov(Ri,Rj) = E{[R i -E(Ri)] x [R j - E(R j )])

Correlation
Measures the strength of the linear relationship
between two random variables. It ranges from-1

Cov (Ri,R j)

p(x) = (number of ways to choose

Sums of Random Variables

Var(X + Y) = Var(X) + Var(Y) + 2

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

(X)

disproportionately large amount of outliers that

fall within its lower (left) tail.

The

population variance is defined as the average

of the squared deviations from the mean. The

population standard deviation is the square root
of the population variance.
N

E(xi -) 2

c? = i=l--

s2 =

i -X)2
L--(X
i= l

_
___

n-1

Sample Covariance
n (X1

i=l

X)(Y1 -Y)

n-1

The standard error of the

sample

mean

is the

standard deviation of the distribution of the

sample means. When the standard deviation of
the population, CJ, is known, the standard error of

For the distribution, both its mean and variance

the sample mean is calculated

are equal to the parameter,

}.
Axe-

X.

CJx =

P(X=x)=-
x!

CJ

as:

Fa_

Confidence Interval

Normal Distribution

If the population has a normal distribution with

its mean and variance.

68% of observations fall within ls.

population mean is:

a known variance, a confidence interval for the

-
Zo./2
X

90% of observations fall within l.65s.

95% of observations fall within l.96s.

99% of observations fall within 2.58s.

Standardized Random Variables

A standardi:ud random variable is normalized

Cov(X,Y)

Population and Sample Variance

refers to the average number of successes per unit.

so that it has a mean of zero and a

x

It is used

to make informces about the population mean.

Standard Error

of successes per unit. The parameter lambda

Y) = Var(X) + Var(Y)

a sample of a population, EX, divided by the

number of observations in the sample, n.

np

Poisson random variable X refers to the number

If X and Y are independent random variables:

The sample mean is the sum of all values in

covariance = E

Poisson Distribution

E(Y)

If X and Y are NOT independent:

from n )

variance= np(l- p)

If X and Y are any random variables:

Var(X +

Normal distrihurion i< complere ly de...crihed hy

o(Ri)o Rj)

Exi
= i=l

For a binomial random variable:

Expected value of the product of the deviations

(b-a)

of"success" on each trial equals:

n - 1 instead of n in the denominator improves the

statistical properties of i2 as an estimator of CJ2

outcomes over a series of n trials. The probability

expected value

observations in the population, N.

sample of n observations from a population. Using

- xi)

Evaluates a random variable with two possible

Covariance

E(X + Y) = E(X)

sums all observed values

dispersion that applies when we are evaluating a

(x2

p'(l- p)n-

variance(X) = EHX -)2 ]

Corr (Ri,Rj)-

b:

m ean

in the population and divides by the number of

The sample variance, r, is the measure of

Binomial Distribution

the standard deviation.

to +l.

<is

<X<x
P (x1 - 2)

E(X)=

EP(xi)Xi = P(x1)x1 +P(x2 )x2 + .. . + P(x0)x0

x1

Population and Sample Mean

The population

standard

deviation of 1.

z-scort: represents number of standard deviations

a given observation is from a population mean.

z=

observation -population mean

standard deviation

x -
= -CJ

Central Limit Theorem

When selecting simple random samples of size

n from a population with mean and finite

variance CJ2, the sampling distribution of sample

means approaches the normal probability

CJ

Fa_

<>ll

= 1.65 for 90% confidence intervals

a12

= 1.96 for 95% confidence intervals

(significance level 10%, 5% in each

z<>ll=

tail)

(significance level 5%, 2.5% in each tail)

2.58 for 99% confidence intervals

(significance level 1%, 0.5% in each

Hypothesis Testing
Null hypothesis (HJ: hypothesis

tail)

the researcher

wants to reject; hypothesis that is actually tested;

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.

One-tailed test: tests whether value is greater than

or less than another value. For example:

H0: 0 versus HA:

11>0

Two-tailed test: tests whether value is different

from another value. For example:

H0: = 0 versus HA: 0

T-Distribution
The t-distribution is a bell-shaped probability
distribution that is symmetrical about its mean.
It is the appropriate distribution to use when
constructing confidence intervals based on
small samples from populations with unknown
variance and a normal, or approximately normal,
distribution.
t-test: t= x - .
st ..In

Chi-Square Distribution
The chi-square test is used for hypothesis tests
concerning the variance of a normally distributed
population.
.
2
(n -l)s 2
chi-square test: X =

F-Distribution
The F-test is used for hypotheses tests concerning
the equality of the variances of two populations.
s2
F-test: F= 1s2
SimpleLinear Regression
Yi=

B0 + B1 x X i + Ei
where:
Y i = dependent or explained variable

independent or explanatory variable

B0 intercept coefficient
B1 =slope cocfficicnc
Ei = error term
=

TotalSum of Squares
For the dependent variable in a regression model,
there is a total sum of squares (TSS) around the
sample mean.
total sum of squares = explained sum of squares +
sum of squared residuals
TSS = ESS + SSR

Coefficient of Detennination
Represented by R 2, it is a measure of the
"goodness of fit" of the regression.
ESS
= l SSR
R2 =
_

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.

The variance of the error term is constant for all

independent variables.
No serial correlation of the error terms.
The model is correctly specified (does not omit
variables).

RegressionAssumptionV iolations
Heteroskedasticity occurs when the variance of the
residuals is not the same across all observations in
the sample.
MulticoOinearity refers to the condition when two
or more of the independent variables, or linear
combinations of the independent variables, in
a multiple regression are highly correlated with
each other.
Serial cornlation refers to the situation in which the
residual terms are correlated with one another.
Multiple Linear Regression
A simple "gression is the two-variable regression
with one dependent variable, Yi, and one
independent variable, X. A multivariate regression
has more than one independent variable.

Yi=Bo +B 1 xX1i +B 2 xX2i +ei

Adjusted. R-Squared

Adjusted R 2 is used to analyze the imporrance of

an added independent variable to a regression.

n-1
adjusted R2 = 1- (1 - R2 ) x --n - k-l

TheF-Statistic
The F-stat is used to test whether at least one of
the independent variables explains a significant
portion of the variation of the dependent variable.
The homoskedasticity-only F-stat can only be
clerivecl from R2 when the error rerms clisplay
homoskedasticity.
ForecastingModelSelection
Model selection criteria takes the form of penalty
factor times mean squa"d error (MSE).

MSE is computed as:

T

E e;/T
t=l

Penalty factors for unbiased MSE (s2), Akaike

information criterion (AIC), and Schwan
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

assumption results in a specific relationship for

variance in the model:

=(1- >..)r;_, + )..cr-1

where:

)..= weight on previous volatility estimate

(between zero and one)

High values of>. will minimize the effect of daily

percentage returns, whereas low values of).. will
tend to increase the effect of daily percentage
returns on the current volatility estimate.

GARCHModd
A GARCH(l,1) model incorporates the most
recent estimates of variance and squared return,
and also includes a variable that accounts for a
long-run average level of variance.

er =w+nr;_, +0cr-l
where:
=weighting on previous period's return
0 = weighting on previous volatility estimate
w = weighted long-run variance
Ct

VL = long-run average variance =

Ct+ 0 < 1 for stability

l-et-0

The EWMA is nothing other than a special case

of a GARCH(l,1) volatility process, with w = 0,
o. = 1 ->., and 0 = >..
The sum Ct + 0 is called the persistence, and if the
model is to be stationary over time (with reversion
to the mean), the sum must be less than one.

SimulationMethods

Monte Carlo simulations can model complex

problems or estimate variables when there are
small sample sizes. Basic steps are: (1) specify
data generating process, (2) estimate unknown
variable, (3) save estimate from step 2, and (4) go
back to step 1 and repeat process N times.
Bootstrapping simulations repeatedly draw data
from historical data sets and replace data so it
can be re-drawn. Requires no assumptions with
respect to the true distribution of parameter
estimates. However, it is ineffective when there are
outliers or when data is non-independent.

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.

Arbitrageurs: in te rested in marker inefficiencies co

obtain riskless profic.

Basis

The basis in a hedge is defined as che difference

between che spoc price on a hedged assec and

che futures price of che hedging inscrument

{e.g., furures concracc). When che hedged asset
and che asset underlying che hedging inscrument
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
spoc prices wich respecc co furures concracc prices.
HR = Ps,F
crp

HedgingWith Stock Index Futures

# of cont racts =i3r

porcfolio value
fucures price x
concracc multiplier

AdjustingPortfolio Beta
If che beta of che capital asset pricing model is
used as che systematic risk measure, chen hedging
boils down co a reduction of che porcfolio beta.
# of contracts=
folio value
(target beta-portfioIio beta) pon
underlying asset
ForwardInterest Rates
Forward rates are interest rates implied by che spot
curve for a speci fie d furure period. The forward
rate between T1 and T2 can be calculated as:
R
R forward - 1T2-R1T1
T2 - TI

=R 1 + (R 2 - R 1 ) x

(_Ii_)
T1 -T1

Forward RateAgreement (FRA)

CashFlows
a forward ooncract obligacing two
parries to agree chat a certain interest rate will
apply to a principal amount during a specified
fucure rime. The T2 cash Bow of an FRA chat
promises che receipt or payment of RK is:
cash flow (if receiving R!<) =
Lx(RK-R)x(T2 - T1J

An FRA is

where :
L = princi pal
RK = annualized rate on L
R = annualized actual rate
Ti = time i expressed in years

Cost-of- Carry Model

Forward price when underlying asset does not
have cash flows:
Fo = SoerT
Forward price when underlying asset has cash
lb = (S0 - I)er

Forward price wich continuous

Fo = Soe (r-q )T

c:

Forward foreign exchange rate using interest rate

paricy ORP):
i:; -S e <i:.i-rr )T
o - o

Arbitrage. Remember to buy low, sell high.

If Fo > S0erT ,borrow, buy spot, sell forward
today; deliver asset, repay loan at end.
If lb < S0e rT , shon spot, invest, buy forward

today; collecc loan, buy asset under fucures

concracc, deliver to cover shon sale.

Backwardation and Contango

Backwardation re!Crs to a situation where the futures
price is below the spot price. For this to occur, there
must be a significant benefit to holding the asset.
Contango refers to a situation where the fucures
price is above the spot price. If there are no benefits
to holding the asset (e.g., dividends, coupons, or
convenience yield), cont ango will occur because the
furures price will be greater than the spot price.

Treasury BondFutures
In a T-bond futures concracc, any government
bond with more chan 15 years to maruricy on
che fuse of che delivery monch {and noc callable
wichin 15 years) is d eliverable on che concracc.
The procedu re to determine which bond is che
cheapest-to-deliver (CID) is as follows:
cash received by che s hore = {QFP x CF)+AI
cost to purchase bo nd=QB P+AI
where:

dividend yield, q:

Forward price wich storage co sts , u:

T
u)T
lb =(So + U )er or lb = Soe(r+

Duration-Based Hedge Ratio

T he obje ccive of a duration-based hedge is to create
a combined position char does not change in
value when yields change by a small amounc.
ponfolio value x durarionp
#of contracts=
fucures value x durationp
Interest RateSwaps
Plain vanilla interest rat e swap: exchanges fixed for
float ing -race payments over che life of the swap
At inception, the value of che swap is zero. After
inception, the value of the swap is the difference
between che present value of che remaining fixed
and floating-rate payments:
Vswap to pay rlXcd = Bfloat - Brix
Vswap to n:ccive fixed = B rix - Bfloat
= (PMTfixcd,t, x e-re, )
B rixcd
x e -rc2 ) + ...
+ (PMT
fixcd,t2

+ [{notional + PMTfixcd t
x

Currency Swaps

) xe-n" J

)J x e

-n,

Exchanges payments in two different currencies;

payments can be fixed or Boating. If a swap has
a positive value to one oounterparcy, chat parry is
exposed to credit risk.

Vswap(DC) =Boe -(S0 x Bpc )

where:
So = spot rate in DC per FC

Lower bound European call on non-dividend

paying stock:
Lower bound European put on non-dividend
paying stock:
T
p max(Xe-r -S o ,O)

Exercising AmericanOptions
It is never optimal to exercise an American call on a
non-dividend-paying stock before ics expiration date.
American puts can be optimally exercised early if
the y are sufficiently in-the-money.
An American call on a dividend-paying stock
may be exercised early if the dividend exceeds the
amount of forgone interest.
Put-CallParity
p = c - S +Xe-rT

c= p+S-Xe-rT

Covered Call andProtective Put

call.
Protective pur. Long stock plus long put. Also
called portfolio insurance.
Covered call: Long scock plus short

price and subsidize the purchase with sale of a call

option with a higher exercise pri ce
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
buying puc wich high exercise price and selling
put wich low exercise pr ce.
Buttnft.y spmui: Three different options: buy one
call with low exercise price, buy another with a high
exercise price, and shon two calls with an exercise
price in between. Butterfly buyer is hecring the scock
price will stay near the price of the written calls.

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.

( notional

p :$ Xe-rT; p :$ x

Bull sprrad: Purchase call option wich low exercise

Upper bound European/American put:

OptionSpread Strategies

QFP =quoted futures price

CF = conversion factor
QB P =quoted bond price
AI
accrued interest

Bfloating = notional +

OptionPricing Bounds
Upper bound European/American call:
c :$ S0; C :$ S0

c max(S0 -Xe-rT ,0)

cash flow (if paying RK ) =

T. x (R - RK)x (Tz - Ti)

Bows,/:

Forward price wich convenience yield,

F. o - Soe (r -c)T

Calendar sprrad: Two options with different

expirations. Sell a shore-dated option and buy a

long-dated option. Investor profits if stock price

stays in a n arrow range.
co a calendar spread
except chat the options can have different strike
prices in addition to different expirations.

Diagonal sprrad: Similar

Box spread: Combination of bull call spread and

bear put spre ad on che same assec. This strategy

chat is equal to che
high exercise price minus che low exercise price.

will produce a constant payoff

Option Combination Strategies

Bee on volarilicy. Buy a call and a
put wich the same exercise price and expiration
date. Profit is earned if scock price has a large
change in either direction.
Short straddlr. Sell a put and a call with the
same exercise price and ex.pirarion date. If stock
price remains unchanged, seller keeps option
premiums. Unlimited potential losses.
Stranglr. Similar to straddle except purchased option
is out-of-the-money; so it is cheaper to implement.
Stock price has to move more to be profitable.
Long straddle.

Add an additional put (strip) or

call (strap) to a straddle strategy.

Strips and straps:

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) +
(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)

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

Annual

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
.

Step 3:

Discount to today using risk-free rate.

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

-rr"P

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

c =So N(d1 )- Xe-rTN(d2)

p = Xe-rT N(-d2)-S0N(-d1)

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

where:
In

Use the square root of time to change daily to

monthly or annual VaR

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

e'1- D
; 'ITdown = 1- 'rrup
'ITup =
U D
_

+ r +0.5 xcr xT

axJf

-(ox.ff)

= d1
= rime to maturity
= asset price
= exercise price
= risk-free rate
cr
= stock return volatility
N() =cumulative normal probability
d2

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
lowest, and then identify the lowest 5% of returns.
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.

()

T
So
X
r

Gree ks
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
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:

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.

BondValuation
There are three steps in the bond valuation process:
Step 1: Estimate the cash flows. For a bond, there

are two types of cash flows: (1) the annual

cash flows associated with the instrument to its

the recovery of principal at maturity, or

will be reinvested at the YfM and assumes that

or semiannual coupon payments and (2)

when the bond is retired.

iscount rate. The

Step 2: Determine the appropriate d
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

discount rate(s).

Sources ofcountry risk-. (1) where the country is in

the bond will be held until maturity.

(3)

Relationship Among Coupon, YfM,

and Price
If coupon rate

>

YTM, bond price will be greater

than par value: prmzium bond.

If coupon rate < YTM, bond price will be less

iscount bond.
than par value: d

If coupon rate

YTM, bond price will be equal

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.

Dollar Value of a Basis Point

The DVO 1 is the change in a fixed income

security's value for every one basis point change in

interest rates.

DVOl =

Effective Duration and Convexity

the seller of the bond must be paid to give up

relationship; most widely used measure of bond

Duration: firsc derivative of the price-yield

price volatility; the longer (shoner) the duration,

the more (less) sensitive the bond's price is to

Compounding

changes in interest rates; can be used for linear

Discrete compounding:

( )mxn

estimates of bond price changes.

FVn = PV0 1 +

effective duration =

where:
r = annual rate
m = compounding periods per year
11 = y ears

Continuous compounding:

(second derivative) of the price/yield relationship;

accounts for error in price change estimates from

duration. Positive convexity always has a favorable

convexity

Spot Rates

to maturity on a zero-coupon bond that matures

in t-years. It can be calculated using a financial

calculator or by using the following formula

(assuming periods are semiannual), where d(t) is a

discount factor:

(-)
1

121

d(t)

-1

percentage bond price change ::::: duration effect +

convexity effect

Callable bond: issuer has the right to buy back

the bond in the future at a set price; as yields fall,

Forward rates are interest rates that span future

)1

= -duration x y + .!. x convexity x y2

Bonds With Embedded Options

Forward Rates

rorward rate
(1 + ,.

BV_y + BV+y - 2 x BV0

BV0 x y2

Bond Price Changes With Duration

and Convexity

periods.

2 x BV0 xy

Convexity: measure of the degree of curvature

A t-period spot rate, denoted as z(t), is the yield

z(t) =

BV_Y - BV+Y

impact on bond price.

rx n

FVn = PVoe

ic yield)'+!
+ period
(I __:.
_
____:. _;.__

= _

_
_

bond is likely to be called; prices will rise at a

decreasing rate-negative convexity.

Putable bond: bondholder has the right to sell

at a set price.
i
bond back to the ssuer

(1 + periodic yield)1

Rc-1,c

BV, + C, - BV,_1

Factors influencing sovereign default risk-. (1) a

country's level of indebtedness,

(2) obligations

such as pension and social service commitments,

(3) a country's level of and stability of tax receipts,

(4) political risks, and (5) backing from other

countries or entities.

Internal Credit Ratings

At-the-point approach: goal is to predict the credit

quality over a relatively short horizon ofa few

time horizon and includes the effects of forecasted

cycles.

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.
expected loss

exposure amount (EA)

x

loss rate (LR)

probability ofdefault (PD)

Unexpected Loss

Unexpected loss represents the variability of

potential losses and can be modeled using the

definition of standard deviation.

UL = EA x PDxcr[R + LR2 x cr0

Operational Risk

Operational risk is defined as: The risk ofdirr:ct

and indirect loss mu/ting.from inadequate or failed

internal processes, people, and systems or from

external events.

Operational Risk Capital Requirements

Basic indicator approach: capical charge measured

on a 6rmwide basis as a percentage of annual gross
income.
Standardized approach: banks divide activities
among business lines; capical charge = sum for

each business ine.

Capical for each business line
l

determined with beta factors and annual gross

income.

Advanced measurement approach: banks use their

own methodologies for assessing operational risk.
Capital allocation is based on the bank's
operational VaR.

Loss Frequency and Loss Severity

Operational risk losses

are

independent dimensions:

classified along two

models random events).

PPN: 32007227
ISBN-13: 9781475438192

Loss severity. value of financial loss suffered.

Often modeled with the lognormal distribution

(distribution is asymmetrical and has fat

tails).

Stress Testing

The net realized return for a bond is its gross

VaR tells the probability of exceeding a given loss

realized return minus per period financing costs.

but fails to incorporate the possible amount of a

loss that results from an extreme amount.

Yield to Maturity (YTM)

Stress testing complements VaR by providing

The YfM of a fixed-income security is equivalent

discount rate that equates the present value of all

the disproportionate reliance of a country

time period (typically one year). Often modeled

BV1-l

to its internal rate of return. The YTM is the

(4)

on one commodity or service.

with the Poisson distribution (a distribution that

The gross realized return for a bond is its end-of

value divided by its beginning-of-period value.

the structure and the efficiency of legal systems,

and

Lossfrequency. the number of losses over a specific

Realized Return

period total value minus its beginning-of-period

(2) political risks,

the legal systems of a country, including both

Through-the-cycle approach: focuses on a longer

10,000xy

Clean price. bond price without accrued interest.

ownership.

the economic growth life cycle,

months or, more generally, a year.

BV

DVOl = duration x 0.0001 x bond value

Dirty price. includes accrued interest; price

Country Risk

price. The yield to maturity assumes cash flows

9 7 8 1 4 7 5 438 1 9 2
U.S. $29.00 <Cl 2015 Kaplan, Inc. All Rights Reserved.

information about the magnitude of losses that

may occur in extreme market conditions.