Cea TES 4 a Risk and Return of Portfolios of Risky Assets Fora portfolio of securities, the expected portolioreeurn is N HR) = So ER) Fre eat aprel Le ae aa sa ae ogre ee eee ine ee eaiomaee ee eee eel aig acaeeer poeta ne of = who} + woh +20 amgCovR Rp) Conta) Since colton equa = pap = STRAT saiance ean also be writen as Er eect attr caieuiearee Diversifiable and Systematic Risk ‘The pat ofthe volatiliy of singe seeuiys seturns chat is uncorrelated with the volatlixy af the market portfolio that secuitys dlverifable risk “The par ofan individual secur sk thar arise because ofthe positive covaiance of chat secs earns with overall marker recurs is called its systematic rik. ‘Astandacized measure of systematic isi betas Cov(R.,Ry) Capital Asset Pricing Model (CAPM) In uli all investor hold «portfolio of isk assets that has the same weights a the ‘marker pordflio, The CAPM is expressed in the ation ofthe security market ine (SMI). For any single security o portfolio of scutes, the ‘expected return in equilibrium E(R,) = Rp + been lERy)— Rp] CAPM Assumptions + Tavestorsseck to maximize the expected utility oftheir wealth atthe end ofthe prio, and ll investors have the same investment hoon. + lavestr ar skewers + lnvestor only consider the mean and standard deviation of reeurns (hich impli assumes the st returns are normally distributed. + Tvesors can borrow an end at che same risk ice + Investors ave the same expectations concerning + There ae neither taxes nor transactions cost, and sects are infinitely divisible. This often referred toa “perfect markers.” gh ‘Measures of Performance ‘The Treynor measure is equal o he rise premium divided by beta o systematic risk: BIR, ‘Treynor messure = ‘The Sharpe measure is equal tothe rise premium divided by the standard deviation, total rise Sharpe measure: “The Jensen measure (aa. Jensen alpha or just alpha, isthe asset’ excess return over the recurn predicted by the CAPM: Jensen measute = op = EQRp)~ (Ry +BolERy)— Ry) “The information ratio is esscaally the alpha of the managed portfolio relative to its benchmark divided by the uacking ero 1p = [ER e)= BR) cwacking enor “The Sortino ratio is similar vo the Sharpe ratio except we replace the rsk-fre rate with a minimum acceptable retur, denoted Rand we replace che tandatd deviation with 2 ype of semi-standard deviation E(Ry) Rin ‘emistandard deviation ‘Morningstar Rating Sytem: compute risk- adjusted ranking (RAR) measure within 48 different equity and debt pect groups wo assign a star rating (110 5) tac fund. Va based risk-adjusted measures evaluate performance based on Sharpe-like rato Rp Rp VaRp /valuep Management related risk-adjusted meaures compare risk-adjusted return for a fund with the risk-adjusted rerun for the benchmark that captures the funds investment syle Arbitrage Pricing Theory (APT) ‘The APT assumes that recurs can be modeled a multifietor regression model ofthe following form: Ry =Re+XqyXby tot Xay xby tu, Sortino rt reaurns for stock » Fisketre rte Iefictor exposute for stock recurn for factor & tt, = idiosyncratic return for stock » ‘The APT defines the structure of rtusns but does not define which factors should be used in the model. The CAPM isa special case of APT with only one factor exposure—the market risk premium, Case Studies Metallgeellchaf: shorter fatutes contacts tse «0 edge long-term exposure inthe petroleum markets stack-and-rll hedging strategy; marking to market on futures caused huge eash low problems ‘Sumitomo: wader attempted to comer the copper market by buying large quantities of physical copper and long futures positions; copper prices lunged, causing huge loses: lesson i the lack ‘of operational and risk controls that allowed this scheme to go undetected, Long-Term Capital Mangement: bed fund chat used elative value strategies with enormous amounts of leverage: when Rusia defaulted on its debe in 1998, the increase in yield spreads ‘caused huge loses and enormous cash flow problems from realising marking to market losses: esons include ack of diversification, model ris, leverage, and funding and trading liquidity sks Barings: rogue wader, Nck Leeson, took speculative derivative positions (Nikkei 225 fucures) in an attemp to cover trading losses: Leeson had dual responsibilities of trading and supervising setlement operations, allowing him to hide trading losses; lessons include separation ‘of duties and management oversight. Doda Securities: borrowed $300 milion in ‘unsceured funds from Chase Manhattan by «exploiting faw in the sytem for computing the value of collateral. Kidder Peabody: Joseph Jot eported substantial anificial profits after the fake profits were dexected, $350 milion in previously reported sins had to be reversed Aled Irish Bank acutreneyeadet, John Rusnak; hid $691 milion in losses; Rusnak bullied back-ofice workers into not following- ‘up on trade confirmations for fake trades. Barker’ Trust developed derivative structures thac were intenconally complex: in taped phone conversations, sta bragged about how badly they Fooled clients. Enterprise Risk Management + Integrated rk management as opposed 10 managing individual risks partly. + Big-picture approach that positively impacts ‘decision making throughout the organization, + ERM framework covers four types of tke (0) hazard risks, 2) financial ri, (3) operational sks, and (4) strategie risks Role of Risk Management 1. Asses al sks fed by the fm. 2. Communicate these risks to risk-taking decision makers. 13. Monitor and manage these risks. (Objective of tsk management sro recognize that large losses are posible and to develop contingency plans that deal with such losses if they should occur.GARP Code of Conduct The Code of Conduct sts forth principles related 0 ethical behavior within the risk ‘management profession. Ie stresses ethical behavior inthe following areas: Principles 1, Profesional integrity and ethical conduct, 2 Confit of interest 3. Confidentiality. Professional Standards 1. Pundamental responsibilities. 2. Adherence wo best practices Violations of the Code of Conduct may result in temporary suspension of permanent removal from GARP membership. In addition, violations could lead to a revocation ofthe right to use the FRM designation, CU aah Expected Value ‘The expected value isthe weighted average of the posible outcomes of a random variable, ‘where the weights ae the probabilities thatthe ‘outcomes wil occu EX) = Pte = Ped + Pande tnt Plea a Variance “The yatlance provides a mesure of the extent ofthe dispersion inthe values ofthe random ‘arable aroun the mean. The square rot ofthe ‘atiance called the standard deviation varianee(X) = EI(X ~)?] Covariance CCovatanc isthe expected value ofthe product ofthe deviation of two random variable from their respective expected values Cov(Ri Rj) = EIR, -B(R,))<1R —BAR})} Sums of Random Variables IfXand Vare any random variables: (K+ ¥) = £09 + £0) IfXand Yare independent random variables: VanfX 6 ¥) = VattX) + VartY) IfXand Vare NOT independent: VariX + ¥) = VarlX) + Vart¥) +2 « CovoX.y) Simple Random Sampling * Selecting a sample so that exch fem inthe population haste same ikeihood of being Included in the ample + The individual cms drawn forthe sample are known as independently and identically distibuted (i...) random variables. Sumpling eto is the ference berween a sample statistic and is coresponding population parameter Desirable Properties of an Estimator + An unbiased eximator is one for which the expected vale ofthe estimator is qa to the ameter jou are yng to eximat, + An unbiased eximatoris aso offen if the ‘atiance of is simpling dsibution is smaller than all he other unbiased extimacors ofthe parameter you ae tying wo estimate + Aeomisteneximator sone for which the ‘accuragy ofthe parameter estimate increases a the sample ze increases Population and Sample Variance ‘The population variance is defined asthe average ofthe squared deviations from the mean ‘The population standard deviation isthe square root ofthe population variance. S06 -H? isthe memure of clspetson that applies when we are evaluating ‘asamp of » observations from a population, Using a1 instead of in the denominator improves the satiscal properties of? a an estimator of eee Sample Covariance covariance = ea Skewness and Kurtosis Shewnes, oF skew, refers othe ant 0 which 2 diarbuvon ino ymmectic. The skewnest Of normal dissbucon eal tz 1A piel heard dsb i chai by ty utr the pp gino sight + rept sewed Ubtion has lptoporitonsel lange amour f oul th fll within i over al Sank? skewness Kurtosis is a measite of the degree to which a distribution is more ot less “peaked” than a normal distribution. Excess kurtosis = kurvsis 3. * Leptokutic describes a distribution that is more peaked than a normal distribution, + Playkurtic refers toa disibucion tha is ess peaked, or far than a normal distribution. Yu -x kurosis = Normal Distribution ‘Normal distribution is completely described by its mean and variance, + 689 of abservaions fl within + 1s, + 90% of observations fl within 1.658 + 950) of observations fal within + 1.968 + 9906 of observations fll within # 2.58 Standardized Random Variables A mandardized random variables normalized so thac it has a mean of zero and a standard deviation of 1. Zescore: represents # of standard deviations 3 tgiven observation is from a population mean. cbse ypulation mes seandard devation Central Limit Theorem Central limissheorena when selecting simple random samples of size from population with ‘mean and finite variance 0, che sampling dlistibution of sample mean approaches normal probability distebution with mean tad variance ‘equal co on asthe sample size becomes lage Standard Error ‘The standard error of the sample mean isthe standard deviation ofthe distribution of the sample means. When the standard deviation of the population, «snow, the standard error of the sample mean is calculated as: os ‘TDistribution ‘The rditribution i bell-shaped probsbilty 1.65 for 90% confidence intervals (Cigificance level 10%, 5% in each tail) 2, = 1.96 for 95% confidence incervals (Gigificance evel 5%, 2.5% in each tail) 1,,= 2.58 for 99% confidence intervals (Ggnificance level 19%, 0.5% in each ail) Hypothesis Testing ‘Ned hypothesis (H,): hypothesis the researcher ‘wants to eects hypothesis thai actually tested the basis for sletion ofthe test statistics. Akernative hypothesis (He what is concluded ifthe is significant evidence to reject che null hypothesis, One tiled tes: ets whether value is grater than cores than another valu. For example Hy: us Overus He w> 0Totaled tees whether vale ie different from another value. For example Hy p= 0 verus Hy ya 0 ‘Type | and Type Il Errors ‘Type I ertor: Rejection ofthe mull hypothesis when itis actully tue The significance eels the probably of making a‘Type lero. “Type eror: Failure wo tejec he ml Iypothesis when tis actualy fase. The power of «tes one minus the probability of making “ype tt error. ‘The Binomial Distribution Evaluates a random variable with ewo posible outcomes oer a series of m wal. The probability oF succes” on ech rial equals: pt = (umber of ways to choose x from n)p'(1~p) Fora binomial random variable ‘The Poisson Distribution Poison random variable X refers tothe number ‘of succeses per unit, The parameter lamba CX) refers to che average number of success et unit For the dsttbution, both its mean and ‘variance are equal othe parameter, Ned ‘Simple Linear Regression Y eB, B «X42 where Y= dependent or explained variable X independent or explanatory variable B= imerept cooicient slope eoeficient ‘Total Sum of Squares For the dependent variable in a regression model, there ia tora sum of squats (TSS) azound the sample mean tora sum of squares = explained sum of squares + sun of squared resid PIX =x) Tas 8S SSR Loi = Dee w «Don iF Coefficient of Determination Represeated by Rts measure ofthe “goodnes of ft" ofthe regression, ae, SE TSS | TSS Ina simpie two-variable regression, the squate root (oF R’ isthe correlation coeficient (1) berween X and V. Ifthe telaionship is positive, then reve Linear Regression Assumptions + Alinear ebtonship exists ewe the depend nd the independent vaca. + Theindependen variables uncorelaed withthe The expect vale of the eo trm to + The variance of the ero tem is constant fr all independent variables. + No serial cotltion of the err terms. + "The modal is cocmtly specified (doesnot omit sate) Regression Assumption Violations Hecrokedasicty ours when the variance ofthe residual snot the same across all observations in the simple Mueiclinenriy refers the condition when two lor more ofthe independent variables, or linear combinations ofthe independent variables, in 4 multiple eresion are highly correlated with ‘ach other Serial craton eles wo the scaton in which the residual term ate conlted with one another: Standard Error of the Regression (SER) Measuces the degree of variably of the actual values relative to the etimated Fvalucs For a regression equation. The SER gauges the “Bt? ofthe regression line. The amaler he sande stron the better the ‘Multiple Linear Regression ‘Asimpleregroson isthe two-variable egesion with one dependent variable, Y, and one independent variable, X, A mutveriae mresion sus more than one independent variable, 0 +B, xXy +B, XX, +5 ‘The F-statisti “The Fate allows for the testing ofthe joint Inypothesis thar multiple slope cooicients equal 2¢t0,Ircan be calculated as ESS; Fe qpit SR Adjusted R-Squared Adjusted R° is use 0 analyz the importance of ‘an added independent variable toa regression, (=k?) x a-1 adjusted R? = EWMA Model Theexponcntaly weighted ving serge {EWMA) model snes weights ddine ‘ponent bck through nme. This assumption resuks in a specif elaonship for variance in the mode Ng MOR = 3S eight on previous volt enimate aoe High vais of wil ite the fc of ally peteniage tru, whereas low aes of wl fal erie taticcot dy pesinige fearon ie cuter vlliy eo GARCH Model AGARCHIL LI iat ipa dase tesenc temas f arin ed spire rear but ab a vale thar ccounrs ara long-ran average level of variance. ehautod , +02 where: = weighting on previous period's return ‘weighting on previous volatility estimate ‘weighted longerun variance long-run average variance $5 < for stability ‘The EWMA is nothing other than a special case ofa GARCH(,1) voatily proces, with «0, @=1-dand d=, “The sum c+ Bis called che persistence, and ifthe ‘mogel is to be stationary overtime (with reversion to the mean), the sum must be les than one. Monte Carlo Simulation ‘Step 1: Choose a stochastic process and its parameters (e.g, an approximation 0 Brownian motion. Step 2: Generate preusosequence of random variables (using a random number generator or bootstrapping), and use these as inputs o the model to simulate a price path Siep 3+ Calculate the asset value for this pice path atthe end ofthe inveament horizon. ‘Siep 4: Run a large number of iterations of eps 2and 3, FINANCIAL MARKETS AND PRODUCTS Futures Market Participants Hedger lock-in a ied price in advance Specnlaror accept the pic Fisk that hedgers ae Unurling vo bea. Arbioragenr:ntetested in matket inefFciencies 0 ‘obvainrskless pro Option and Forward Contract Payoff ‘The payoff on a ell option tothe option buyer is calculated as follows C, = max(0,5,-0 “The price paid forthe call option, Cis refereed to asthe al pemium. Thus, the prof tothe option buyer i ealeulated as follows prof - C, ~C, ‘The payoff ona put option is calculated as follows P, = max(0, X-S,) The payoft w long postion i forward contrat is alculated as follows: payolt=$, -K where 5, K Basis “The basis ina hedge is defined as the difference Ibewcen the spot price on a hedged aset and the faites price ofthe hedging instrument (gs futures conxact). When the hedged ast and thease underying the hedging inseument ae the same, the basis wll be zero at maturity ‘Minimum Variance Hedge Ratio “The hedge nario nimies the variance ofthe combined hedge position. This i abo the bea of spor prices with respect to futures contrat prices ot price at mauricy livery price HR = psp Hedge Effectiveness “Measites the vatiance tht is reduced by implemeneing the oprimal hedge. This effectiveness can be evaluated with 3 cofcient of dltcrmination (0) term where the independent ‘atiale isthe change in futures prices, andthe dependent variable is the change it spo pricesHedging With Stock Index Futures ot eonrc = fy | Bento ra aereeciee Adjusting Portfolio Beta A ebeseefte pial ener pcteg mel elie cee e ie ete aia eeeetrree aes We cont (target beta ~ portfolio ea Forward Interest Rates Forward rates ate interest rates implied by the spot curve for a specified future period. The forward rate berween T, and T, can be caeulated Forward Rate Agreement (FRA) Cash Flows An FRA is forward contact oblgating wo paris to agree that a certain interest rate will apply toa principal amount during a speciied furure time. The T, eash flow of an FRA that promises the receipt or payment of Ris cashflow (i receiving Ryg) = x(x -R)x()~T) cashflow (i paying Ry)= Lx(R=Ry)x (Th) imei expressed in years Cost-of-Carry Model Forward price when underlying aset does not have ash flows: Raea Foeward pie eben ceding moot hs cash flows Fy=(y—Ne™ Forward pric wth coninsous dividend yield) Besa Forward price with norage cons: ee ee eer end paced eee ere Rese Fltyand ci esha ge ag incest te pay (RP) Fy=Sye7 Arbre Remember to by low sl high © IF Fy >Spe, borrow, buy spor, sell forward. ted dle se, opay loan ated © TF Ry py) <€" Currency Swaps Exchanges payments in two different currencies; payments can be fixed or floating. Ifa swap has 4 positive value to one counterparty, tha pay is ‘exposed to credit risk, Vewap(DC)= Bc ~ (Sp *Brc) where: Sp = spot rate in DC per FC Option Pricing Bounds Upper bound European/American call ESS5CSS) Upper bound European/American put: psxesPsx Lower bound European call on non-dividend-paying stock: > max(Sp—Xe™0) Lower bound European put on non-diviend-paying stock max(Xe-*™ — 55,0) Rules for Exercising American Options + Ieisnever optimal to exercize an American cll ona nonaividend-paying stock before is expiration date + American puts canbe optimally exercised ety if they ate scien in-the-money. + An American call on a diviend-paying tock may be exercised cal ifthe dividend exceeds the amount of forgone interest Pat-Call Parity ptSy=etXe™ Covered Call and Protective Put Covered cll Long stock pls shor cal. Protective put: Long stock pls long put Also called porflio insurance. Option Spread Strategies Bull spread: Purchase cll option wit low exercise price and subsidize the purchase with sale ofa call option with a higher exercise price. ‘Bear spread: Short bull spread. Purchases call with high strike price, and shors call with low strike price. Investor keeps diferene in price of the options if tock price falls. Bear spread wich puss involves buying put with high exercise price and selling put with low exercise price. Busey spread Thre different options: buy one call with low exercise price, buy another witha high exercise price, nd short to calls with an exercise price in berween. Buxerfly buyer is betting thestock price will say near the price ofthe written call Calendar spreac Two options with different cxpirations. Sella short-dated option and buy a long-dated option. Investor profits if stock price stays in narrow Diagonal pres Similar to a calendar spread except thatthe options can have different strike prices in addition to different expirations Box spread: Bull cal spread and a bear put spread fon the same asset. The payofT is always the same (the risk-free rat). Option Combination Strategies Long sradte Beton volatility. Buy acl and a put with the same exercise price and expiration dat. Profit is earned if tock price has large change in either direction. Short straddle Sell put and a call with the same exercise price and expiration date. If stock price remains unchanged, seller keeps option premiums. Unlimited potential lose. Sagi Similar to srl except purchased option isoutof-the-money, so iis cheaper to implement. Stock price has to move more to be profitable Sips and srs: Add an addtional put (tip) or cal rap) ta straddle sate: Foreign Currency Risk Ane ong (shor? curtency position means a bank faces the risk thatthe FX rae will ill (se) versus the domestic currency net currency exposure = (asets— liabilities) + (bought — sold) On-balance sheet hedging. matched maturity and currency foreign aselabilty book OfFbalance sheet hedging: enter into a position in 2 forward contact. SEATS en his Bond Valuation ‘There are thee steps inthe bond valuation proces 1. Bximate theca flows. Fora bond there ae ‘wo pes of ash lows (1) dhe anaual or semiannual coupon payments and (2) che recovery of principal at maturity, oF when the bond is ried 2. Devermine se appropiate dicount rte. The approximate discount rates either the bonds Yield to maturity (YTM) ora series of spot 3. Calle che PV ofthe eximated cash lus. The PV is determined by dacounting the bonds cash Bow seam by the appropriate discount ral). Compounding Discrete compounding raraftes] where: F annual ate ‘m= compounding periods per year n=years Continuous compounding: FV, = PV ye" Holding petiod rerurn: onl Be PVs Spot Rates ‘A rperiod spot rate, denoted 2s 2() isthe yield to maturity on a zero-coupon bond that macures in ryears. I can be calculated using financial calculator or by using the following formula (assuming periods are semiannual} ts"-| Forward Rates Forward rates ate inceest rates that span furure periods. a) =2) oj x= + Pio yield"? (1+ periodic yield) Yield to Maturity (YIM) ‘The YIM of fixed-income scutty x caver to its internal eae of return. The ‘YIM is che discount rate tha equates the present value of all cash flows associated with the instrument to is price. The yield to maturity assumes cash lows wll be reinvested a the YTM and assumes that the bond willbe held uns matuty Relationship Among Coupon, YIM, and Price coupon rate > YTM, bond price will be greater than pa value: premio bond. coupon rate < YIM, bond price will be less than pa value: dicount bond. coupon rate - YTM, bond price willbe equal to par value: par bond Dollar Value of a Basis Point ‘The pice value of basis point (PVBP) or the dollar value ofa bass poine (DVO) isthe absolute change in bond price from a one basis poine change in yield DVO1 =| price at YIMy ~ price at YM | (1+ forward where YIM = inal YM YTMy =YTM one basis point above or below YTMy DVO1 Hedge with Options {option value)x DVO option position) = ‘DVOU(bond position) x (bond value) Effective Duration and Convexity Diuavon: fst derivative ofthe priceyield relationship: most widely used measure of bond price wolatliy the longer (shorter) the duration, the mote (less) sensitive the bond's price to changes in interest rates can be used for linear «estimate of bond price change. BY_ay —BVi.ay 2xBY, Ay Convers messute ofthe degre of carve Gecond derivative) ofthe pricelyield relationship; accounts for errr in pice change fective duration = cextimates from duration. Convexty always has 3 favorable impact on bond price. BV_ay +BVy.a) -2xBVo BVp x dy? Bond Price Changes With Duration and Convexity percentage bond price change = duration effect + convexity effect converity = ‘AB L x Sp = duration Ay + xconvesty Ay? Bonds With Embedded Options Callable bond: issuct has the right to buy back the bond in the future at 2st pric; 3s yields fll, bond is likely tobe calle prices wil rise a a decreasing rate—negasive convexity Puzable bonds bondholder has the right to sell bond back to he issuer at set price. Binomial Option Pricing Model ‘A onestep binomial models best described within a two-state world where the price ofa stock will either go up once or down once, and the change will occur one step ahead a the end ofthe holding period. In the nueperid binomial model and tmuli- petiod models, che tree is expanded to provide for a greater numberof potential outcomes. ‘Step I: Caleulate option payofis a end in all ares Step 2: Calelate option values using risk-neutral probabilitics. size of up move = U size of down move =D = 1. U-D Siep 3: Discount to today using risk-free rate. 7,, cam be altered so that the binomial model can price options on: stocks with dividends, stock indices, currencies, and futures Stocks with dividends and sock indices: replace ©" with "0, where qs the dividend yield of stock o stock index Gurrenccs: replace €” with €7, where 1 the foreign risk-free rate of interest. Facures: replace €? with 1 since fucures ate considered zero growth instruments. Black-Scholes-Merton Model 8p XIN(dy) — Xe"*™N(€3) fe TNCd;)—SpN-A) $ Sewn =1~y ep ° where io 50} fr 0502} Smead 4, =4,-(oxyT) T time to mautiy Sp =e pce Teck price ' ie cock return volatility cumulative normal probability Black’s Approximation + Popular approximation for pricing American call ‘options on dividend paying stocks.+ Blick suggests using the procedure for European ‘options on Tand sand then aking the larger of the two 25 che price ofthe American call option. Greeks Dela estimates the change in value for an option fora one-unie change in stock price. + Call delta between 0 and +1; increses a srk. price increases. + Gall dle dose ro 0 for fr out-of the money cll: dose oI fr deep in-the money call + Pucdelta berween 1 and 0; increats from -1 0.0 as stock price increase. + Pudala cower 0 fr far out-of he-money pats closer =1 for deep inthe-money puts The dla ofa forwatd contracts equal. The dla ofa fares contact is equal oe", ‘When the underlying asset pays a dividend, q, the dela must be adjusted. Ia dividend yield exis, eta of call equals *" x NU), dele of put equals eT [N(d) =] dle of forward equal ead eles of atures equal "9 Theta ime decay; change in value ofan option fora one-unit change in time; most negative ‘when option is at-the-money and close to expiration, Gemma rate of change in delta as underlying stock price changes largest when option is a-the- money. Vege change in valuc of an option for a onc-unit change in volatility; largest when option i at- the-money; close t 0 when option is deep in- or ‘out-of the-money. ho: sensitivity of options price o changes in the rik fee rate; largest for in-the-money options. Delta-Neutral * To comple hedge along stoc/shor call postion, purchase shares of stock equal wo dlea x ‘numberof opeons sold + Only appropiate for smal changes inthe value of the underlying se, + Gamma can corect hedging eror by protecting guns lage movements in set pice + Gamma-neuttal postions are created by matching portfolio gamma with an offering option positon, ‘Value at Risk (VaR) “Minimum amount one could expect to lose with aagiven probability overa specific period of ime. VaR (X88) = 264% Use the square root of ime to change daily to sony or annual VaR, VAR) dp = VaRCK99) yl ‘VaR Methods ‘The dels-normal methad (ka. the vaiance- covariance method) for estimating VaR requires the assumption of a normal distribution. The smethod utilizes the expected return and standard deviation of returns “The historical :inulation method for estimating VaR uses historical data. For example, co calculate the 5% daly VaR, you accumulate a number of. past daily rerurns, rank the reruns from highest tolowest, and then identify the lowest 5% of "The Monte Carla simulation method fers to computer software that generates any possible outcomes from the distributions of Inputs specified by the user. ll f the examined portfolio eeurns will form a distibution, which will approximate dhe normal distribution. VaR is then calculated in the same way as with the deli sormal method. Stress Testing VaR cells che probability of execding 2 given loss but fils to inconporate che posible amount of loss chat results from an extreme amount. Sees testing complements VaR by providing information about the magnitude of loses that ‘may occur in extreme market conditions Expected Shortfall (ES) + Average or expected vale ofl loses greater than the VaR: Elly [1 > VaR + Popular measure to repo along with VaR. + S's alo now as conditional VaR or expected tales. + Unlike VaR, ES has the ability to satisfy the propery of badd Linear vs. Nonlinear Derivatives + Adervative is described as fnear when the ‘elaonship beqween an undeving facto and the derivatives vale ar nea in nature, NR, = AVER.. + Anonliner derivatives ali funtion of the change in the valu ofthe underlying asc and is {ependent onthe sate ofthe underlying ast Operational Risk (Operational risk is defined as: “The risk of direct cane indivec ls renting rom inadequate or failed jnernal proces, people, and stems or from external events Operational Risk Capital Requirements + Bwic indicator approach: capital cage measured con a Rrmwide basis a8 perentage of annual gross + Standardized approach: bak divide cvs among busines ins capital charge ~ sum for «ach busines line, Capital for cach busines line determined with bee factors and annual gross + Aavenced measurement approach: banks wse their ‘own methodologies for asessing operational Fisk. Capital allocation is based on the banks ‘operational VaR. Loss Frequency and Loss Severity (Operational rik loses are clasfed along two independent dimensions: Los fequency: the number of losis over a specific time petiod (ypically one yar). Often modeled with the Poison disriburion (a distribution that models random even) Loss severity. value of financial loss suffered. ‘Ofien modeled with the lognormal disributon (Gisuibution is asymmetrical and has ft cil). PN: 32002121 ISAN-13: 9781427738943, IseN10; 1427738947 814271738943 US,$4840 ©2012 Kaplan, nc A ight Reserved (Classifications of Operational Risk High funy lowseverty (AFL) tsk occur frequently but eel in small loses. Low-frequency, igh-seveiy (FHS) risks are the grees area of concern for operational isle managers. Because they are race, there is ide available data to analyze such rks, and their cost 10 the fim could be catastrophic ‘Top-Down and Bottom-Up Models Top-down mode examines aggregate impact of operational failures, macro view: relies on Iiscrial daa “Advantages: imple ro we, nr data-ntensive + Duadvantages: docs ao dingush beeen HLS ‘vents and LFHS evens cannot dignose speci treat of weakness baka looking. Bortem-ap model: analyzes ski individual I pdrantages: itinguses eowen HFLS ret and LFTIS evens can dingnote weakness in Procedures and saggest correcions: forward Tooking + Disadvantages complex and daa intensive ‘Methods for Hedging Operational Risk * Insurance. + Sclfinsurance + Derivative ec Catastrophe Options and Bonds Cat options publily traded; payof linked ro index Ge. underwriting losses in the insurance industry); spread option that has limited upeide Cat bonds bond contracts with embedded options that can be triggered by internal evens, ternal events, or the vale ofan index. Internal Credit “Aesth point approach goa so predic the credit ‘quality over relatively shore horizon of ew ‘months or, more generally a yea Tirough-tbecee approach: fuses on 2 longer time horizon and includes the effects of Forecasted ces ed Loss ‘The expected la (EL) represents the decrese in ‘value ofan. asc (portfolio) with a given exposure subject to a positive probabil of default expected loss = exposure x os given default probability of defale expected loss = adjusted expose loss given defsulex EDF Outstandings and Commitments Ouastandingr (OS) denote the ced extended 0 the borrower through bonds, loans, or receivables di. “The commitment (COM) represents the total amount the bank is prepated to lend wo the borrower (commitment = oustandings + unused portion of commitmens). ‘ajated expnure(AE) = OS + usage given defile COM, Unexpected Loss Unexpected los reptesents the variability of potential losses ad can be modeled using the definition of standard deviation UL=AEx {EDF xofgp +LGD*xofoe