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FRM Formulas PDF
FRM Formulas PDF
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Future
Price
Spot Price
Time
Choice of contracts
Optimal Hedge Ratio:
S
F
Where
S is the standard deviation of S, the change in the spot price during the hedging period
F is the standard deviation of F, the change in the futures price during the hedging period
is the coefficient of correlation between S and F
h * NA
Qf
In order to change the beta () of the portfolio to (*), we need to long or short the (N*) number
of contracts depending on the sign of (N*)
N*
P
A
N * ( * - )
P
A
= (F0 K )erT
f = S0e-qt Ke-rt
f = S0 I Ke-rt
Index futures: A stock index can be considered as an asset that pays dividends and the dividends paid are the
dividends from the underlying stocks in the index
If q is the dividend yield rate then the futures price is given as:
F0= S0e(r-q)t
Index Arbitrage
When F0 > S0e(r-q)T an arbitrageur buys the stocks underlying the index and sells futures
When F0 < S0e(r-q)T an arbitrageur buys futures and shorts or sells the stocks underlying the index
F0 S 0 e
( rbc r fc ) T
Formula to remember:
If Spot rate is given in USD/INR terms then take American Risk-free rate as the first rate
In other words, individual who is interested in USD/INR rates would be an American (Indian will
always think in Rupees not dollars!!!!!), which implies foreign currency (rf) in his case would be rINR
( rUSD rINR )T
USD
USD
INR
INR
A terminal amount
P principal amount
r annual rate of interest
t number of years for which the principal is invested
Bond pricing
The price of a bond is the present value of all the coupon payment and the final principal payment received at the end
of its life
T
B Ce rt Pe rT
t 1
C coupon payment
P bond principal
T time to maturity
(1 YTM) n
B I
YTM
1
F
(1 YTM) n
The yield of a bond is the discount rate (applied to all future cash flows) at which the present value of the bond is
equal to its market price
The par yield is the coupon rate at which the present value of the cash flows equal to the par value (principal value) of
the bond
If we are looking at a semi-annual 5 year coupon bond with a par value of $100 then the coupon payment would be
solved using the following equation:
5
Ft1, t2
R 2 T2 R 1T1
T2 T1
Payment to the long at settlement = Notional Principal X (Rate at settlement FRA Rate) (days/360)
---------------------------------------------------------1 + (Rate at settlement) (days / 360)
10
Duration
Macaulays duration: is the weighted average of the times when the payments are made. And the
weights are a ratio of the coupon paid at time t to the present bond price
t *C
n*M
t
(1 y ) n
t 1 (1 y )
Macaluay Duration
Current bond price
n
Where:
t = Respective time period
C = Periodic coupon payment
y = Periodic yield
n = Total no of periods
M = Maturity value
11
Duration contd
A bonds interest rate risk is affected by:
Yield to maturity
Term to maturity
Size of coupon
From Macaulays equation we get a key relationship:
B
DY
B
In the case of a continuously compounded yield the duration used is modified duration given as:
D*
Macaulay Duration
r
1
n
12
Convexity
Convexity is a measure of the curvature of the price / yield relationship
1 d 2B
C
B dy 2
Note that this is the second partial derivative of the bond valuation equation w.r.t. the yield
Hence, convexity is the rate of change of duration with respect to the change in yield
P*
Yield
13
Convexity
The convexity of the price / YTM graph reveals two important insights:
The price rise due to a fall in YTM is greater than the price decline due to a rise in YTM, given an
identical change in the YTM
For a given change in YTM, bond prices will change more when interest rates are low than when they
are high
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V B D M o d i V B 0 .5 C V B i
15
(1 ilt ) n (1 ist
year 1
)(1 ist
year 2
)...(1 ist
yearn
yearn
Expectations theory
The long rate is the geometric mean of
expected future short interest rates
Liquidity preference theory
Investors must be paid a liquidity
premium to hold less liquid, long-term
debt
Market segmentation theory
year 1
)(1 ist
year 2
)...(1 ist
16
17
18
HR
19
N*
PDP
FC DF
FC
DF
DP
20
Key rate duration provides the approximate percentage change in the value of the bond
Key Rate Duration = (-1/BV) * (Change in Bond Value/Change in Key rate)
21
Put-call parity relationship, assumes that the options are not exercised before expiration day, i.e. it
follows European options
22
Minimum Value
Maximum Value
ct Max(0,St-(X/(1+RFR)t)
St
Ct Max(0, St-(X/(1+RFR)t)
St
pt Max(0,(X/(1+RFR)t)-St)
X/(1+RFR)t
Pt Max(0, (X-St))
23
Binomial Method
Assuming the price of the underlying asset can take only two values in any given interval of time
Risk Neutral Method
Su
p
IV1 = Max[(Su2-X), 0]
1-p
S0
1-p
Su 2
p
Su
1-p
Sud
Sd 2
IV2
IV3
24
[ N ( d 1) P ] [ N ( d 2) X e
R f T
Where,
P
ln[ ] [Rf (0.5 2 )]T
d1 X
T
d 2 d1 T
Value of Put = [ X e
R f T
25
Delta (cont.)
The delta of a portfolio of derivatives (such as options) with the same underlying asset, can
be found out if the deltas of each of these derivatives are known
portfolio
i1
W i
26
Theta (cont.)
We have theta of call given by:
S 0 N ' ( d 1 )
rKe
2 T
( Call )
Where:
rT
N (d 2 )
K = Strike price
T = Time of maturity of the option measured in
years, so that 6 months will be 0.5 years
Where:
rT
e (x^2)/2
N '(x)
2
S 0 N ' ( d 1 )
( Put )
rKe
2 T
N ( d 2 )
27
Gamma (cont.)
Calculation of Gamma
Gamma for European options can be calculated using the following formula:
N ' ( d 1)
S 0 T
0.2
0.4
0.6
0.8
1.0
1.2
1 4 7 10 13 16 19 22 25 28 31 34 37 40 43 46 49
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Vega
The Vega of a derivative portfolio is the rate of change of the value of the portfolio with the change in
the volatility of the underlying assets. It can be expressed as:
V=
, where is the value of the portfolio, and is the volatility in the price of the underlying.
For European options on a stock that does not pay dividends, Vega can be found by:
V=S0
by:
e (d 1^ 2 ) / 2
N ' ( d 1)
2
The Vega of a long position is always positive
A position in the underlying asset has a zero Vega
Thus its behavior is similar to gamma
Vega is maximum for options that are at the money
16
14
12
10
8
6
4
2
0
Vega
1 4 7 1013161922252831343740434649
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Rho
Rho of a portfolio of options is the rate of change of its value with respect to changes in the
interest rate
Rho =
30
20
10
Rho (Call)
Rho (Put)
-10
-20
-30
1 4 7 10 13 16 19 22 25 28 31 34 37 40 43 46 49
30
Valuation of swaps
Hence the value of the swap can be given as:
V = Bfix Bfl
Where:
Bfix = PV of payments
Bfl = (P+AI)e-rt
Value of a floating bond is equal to the par value at coupon reset dates and equals to the Present
Value of Par values (P) and Accrued Interest (AI)
31
Commodity Forwards
Commodity forward prices can be described using the same formula as used for financial
forward prices
0 , T
( r
) T
32
(r )T
F0,T S0e
Since r is always positive, assets with =0 display upward sloping (contango) futures term structure
With >0, term structures could be upward or downward sloping
33
Commodity loan
With the addition of the lease payment, NPV of loaning the commodity is 0
The lease payment is like the dividend payment that has to be paid by the person who
borrowed
a stock
Therefore:
F0 ,T S 0 e ( r )T
Where is lease rate
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1
l r In (F0 ,T / S )
T
(1 r )
l
1
1/T
(F0 ,T / S )
35
F0 ,T S 0 e rT (0,T )
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=c
37
F0 ,T S 0 e ( r )T
And if, = c
Then, F0,T = S0e(r+ -c)T
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S0 e
( r c )T
F0 ,T S 0 e
( r )T
39
1 rDC
Forward Spot
1 rFC
40
Default rates
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k 1 to N
R p Wk R k
W WW P
2
k k
i k i ki
k 1toN;i 1toN;k i
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So there is a risk reduction from holding a portfolio of assets if assets do not move in
perfect unison
44
Zero Correlation
Correlation between two assets is zero
45
s
p
Efficient Frontier
Rf
Volatility
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R s R f R m R f
Rm- Rf: Risk Premium
: Quantity of Risk
covR i , R m
i
VarR m
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E(R
) R F ( E ( R M ) R F ) ( M R F ) ( i R F )
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Beta
Sensitivity of the return of the asset to the market return is known as Beta
Beta is calculated as follows:-
cov R i , R m
i
Var R m
Portfolio Beta
Beta can also be calculated for portfolio
Portfolio Beta is the weighted average of the betas of individual assets in the portfolio
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Beta
Sharpe ratio:
Sharpe ratio
R R
p
p
Rp = portfolio return, Rf = risk free return
The higher the Sharpe measure, the better the portfolio
Treynor ratio:
Treynor ratio
Rf
Beta
Rp = portfolio return, Rf = risk free return
Jensons alpha:
Jensons alpha R p R c
Rp = portfolio return, Rc = return predicted by CAPM
Positive alpha (portfolio with positive excess return) is always preferred over negative alpha
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Measures of performance
Tracking Error (TE): TE E P
(Std. dev. of portfolios excess return over Benchmark index)
Where Ep = RP RB
RP = portfolio return, RB = benchmark return
Lower the tracking error lesser the risk differential between portfolio and the benchmark index
IR
Rb
TE
Higher IR indicates higher active return of portfolio at a given risk level
SSD
MAR
SSD
1/t R p MAR 2 ,
MAR is Minimum Accepted Return. SSD is standard deviation of returns below MAR. (Or) SSD is the Semi Standard Deviation
from MAR where Rp<MAR
Higher the Sortino Ratio, lower is the risk of large losses
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Quantitative Analysis
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Counting Principle
Number of ways of selecting r objects out of n objects
nCr
n!/(r!)*(n-r)!
Number of ways of giving r objects to n people, such that repetition is allowed
Nr
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P( A) [0,1]
If the probability of happening of event A is P(A), then the probability of A not happening is
(1-P(A))
For example, if the probability of a company going bankrupt within one year period is 20%, then
the probability of company surviving within next one year period is 80%
P( A) 1 P( A)
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P( B) P( A B) P( Ac B) P( B / A) P( A) P( B / Ac ) P( Ac )
We know that P(AB) = P(B/A) * P(A)
Also P(BA)= P(A/B) * P(B)
Now equating both P(AB) and P(BA) we get:
P( B / A) * P( A)
P( A / B)
P( B)
P(B) can be further broken down using sum rule defined above:
P( A / B)
P( B / A) P( A)
P( B / A) P( A) P( B / Ac ) P( Ac )
55
Mean
The expected value(Mean) measures the central tendency, or the center of gravity of the
n
population
It is given by:
E(X )
x
i 1
-4
-2
56
Geometric Mean
Geometric Mean: is calculated as:
G n X 1 X 2 X 3 ... X n
Where there are n observations and each observation is Xi
Compound Annual Growth Rate(CAGR): Its the geometric mean of the returns
57
Properties of Expectation
E(cX) = E(X) x c
E(X+Y) = E(X) + E(Y)
E(X2) [E(X)]2
E(XY) = E(X) x E(Y) [if X and Y are independent]
58
VAR
i1
(xi )2
N
The standard deviation, which is the square root of the Variance, is more convenient to use,
as it has the same units as the original variable X
n
SD(X) =
VAR ( x )
i1
(xi )2
N
59
60
Var ( aX b ) a 2Var ( X )
n
Variance of a constant = 0
i 1 j 1
i 1
i 1
Var ( X i ) Var ( X i )
61
Skewness
Skewness describes departures from symmetry
n
Sk
3
(
x
)
i
i 1
Symmetric Distribution
62
Kurtosis
Kurtosis describes the degree of flatness of a distribution, or width of its tails
n
(x
i 1
)4
Because of the fourth power, large observations in the tail will have a large weight and hence
create large kurtosis. Such a distribution is called leptokurtic, or fat tailed
A kurtosis of 3 is considered average
Platykurtic
K<3
0.45
0.4
0.35
Leptokurtic
K>3
0.3
0.25
0.2
Mesokurtic
K=3
0.15
0.1
0.05
0
-4
-3
-2
-1
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Errors in estimation
Type I and Type II Errors
Type I error occurs if the null hypothesis is rejected
when it is true
Type II error occurs if the null hypothesis is not rejected
when it is false
Significance Level
-> Significance level
the upper-bound probability of a Type I error
1 - ->confidence level
the complement of significance level
Actual
Inference
H0 is True
H0 is False
H0 is True
Correct Decision
Confidence
Level = 1-
Type-II Error
P(Type-II Error)
=
H0 is False
Type-I Error
Significance
Level =
Power=1-
Test for
Single Population Variance
Example Hypothesis
H0: 2 = 02
HA: 2 02
Test for
Two Population Variances
Chi-Square Test
Statistic
,( n 1)
2
(n 1) s
02
Example Hypothesis
2
H0: 1 2 = 0
HA: 12 22 0
2
F-test Statistic
F ,ndf ,ddf
s12
2
s2
/2
/2
H0: 2 = 02
HA: 2 02
Lower Tail test:
H0: 2 02
HA: 2 < 02
H0: 2 02
HA: 2 > 02
1)s
2
2
Where
H0: 2 02
HA: 2 > 02
2
Do not reject H0
Reject H0
2
H0: 2 02
HA: 2 < 02
H0: 2 = 02
HA: 2 02
/2
/2
2
Reject
Do not reject H0
21-
2
Reject
21-/2
Do not
reject H0
Reject
2/2
/2
/2
H0: 12 22 = 0
HA: 12 22 0
Lower Tail test:
H0: 12 22 0
HA: 12 22 < 0
H0: 12 22 0
HA: 12 22 > 0
s12
F 2
s2
s 12
= Variance of Sample 1
(n1 1) = numerator degrees of freedom
s 22
= Variance of Sample 2
(n2 1) = denominator degrees of freedom
Chebyshevs inequality
Chebyshev's inequality says that at least 1 - 1/k2 of the distribution's values are within k
standard deviations of the mean.
Where k is any positive real number greater than 1
Y 0 1 X u
Observed Value of
Y for Xi
Slope = 1
Predicted Value of
Y for Xi
Intercept = 0
x
Mean marks for hours of study
Individual persons marks
73
Dependent
Variable
Population
y intercept
Population
Slope
Coefficient
Independent
Variable
Random
Error
term, or
residual
Y 0 1X u
Linear component
Random Error
component
74
y b 0 b1x e
Observed Value of
Y for Xi
ei
Predicted Value of
Y for Xi
Slope = 1
Intercept = 0
xi
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Estimated
(or predicted)
y value
Estimate of the
regression
slope
Independent
variable
Error term
b 1x e
76
(y
y
)
2
(y
(b
b
x))
0
1
77
( y y ) 0
The sum of the squared residuals is a minimum
Minimize ( ( y y ) 2 )
The simple regression line always passes through the mean of the y variable and the mean
of the x variable
The least squares coefficients are unbiased estimates of 0 and 1
78
b1
( x x )( y y )
(x x)
2
Algebraic equivalent:
b1
x y
xy
n
2
(
x
)
x2
n
And
b 0 y b1 x
79
b0
x
80
y
yi
RSS = (yi - yi )2
_2
ESS = (yi - y)
_
y
Xi
_
y
81
TSS
Total sum of Squares
TSS
2
(
y
y
)
RSS
Sum of Squares Error /
Residual Sum of Squares
RSS
(
y
y
)
ESS
Sum of Squares Regression /
Explained Sum of Squares
ESS
(
y
y
)
Where:
y = Average value of the dependent variable
y = Observed values of the dependent variable
y
= Estimated value of y for the given x value
82
Coefficient of determination, R2
The coefficient of determination is the portion of the total variation in the dependent
variable that is explained by variation in the independent variable
The coefficient of determination is also called R-squared and is denoted as R2
SSR
R
SST
2
where
0 R 1
83
Coefficient of determination, R2
Coefficient of determination
SSR
sum of squares explained by regression
R
SST
total sum of squares
2
R2 r2
Where:
R2 = Coefficient of determination
r = Simple correlation coefficient
84
( x x )( y y )
[ ( x x ) ][ ( y y )
2
n xy x y
[n( x 2 ) ( x ) 2 ][ n( y 2 ) ( y ) 2 ]
Where:
r = Sample correlation coefficient
n = Sample size
x = Value of the independent variable
y = Value of the dependent variable
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su
RSS
n k 1
Where:
RSS = Residual Sum of Squares (summation of e2)
n = Sample size
k = number of independent variables in the model
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Xi su
2
s bo
s b1
n (x x ) 2
su
(x x )
su
2
x
( x) 2
n
Where:
s b = Estimate of the standard error of the least squares slope
su
RSS
n2
87
Multiple Regression
Using more than one explanatory variable in a regression model
Y = b0 + b1X1 + b2X2 + b3X3 + uI
88
Yi b0 b1 X 1i b2 X 2 i ......... bk X ki i
Where:
Yi = ith observation of dependent variable Y
Xki = ith observation of kth independent variable X
b0 = intercept term
bk = slope coefficient of kth independent variable
i = error term of ith observation
n = number of observations
k = total number of independent variables
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Yi b0 b1 X 1i b 2 X 2 i ......... b k X ki
Now the error in the ith observation can be written as:
i Yi Yi Yi b0 b1 X 1i b2 X 2 i ......... bk X ki
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Estimation of Volatility
Let xi be the continuously compounded return during day i (between the end of day
i-1 and end of day I)
Let n be the volatility of the return on day n as estimated at the end of day n-1
Variance estimate for next day is usually calculated as:
variance = average squared deviation from average return over last n days
x
n
Variance
i 1
n 1
Mean of returns (x-bar) is usually zero, especially if returns are over short-time period
(say, daily returns). In that case, variance estimate for next day is nothing but simple average (equally
weighted average) of previous n days squared returns
n
Variance
x
i 1
n 1
What if the volatility is dependent on the values of volatility observed in the recent past?
What if they also depend on the latest returns?
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EWMA Model
In an exponentially weighted moving average model, the weights assigned to the u 2 decline
exponentially as we move back through time
This leads to: 2n 2n 1 (1 ) u n2 1
Apply the recursive relationship:
n2 n2 2 (1 ) u n2 2 (1 ) u n21
n2 (1 ) u n21 u n2 2 2 n2 2
Hence we have
2
n
m i 1 2
(1 ) u n i m
i 1
2
nm
Variance estimate for next day (n) is given by (1-) weight to recent squared return and weight to the previous
variance estimate
Risk-metrics (by JP Morgan) assumes a Lambda of 0.94
92
EWMA Model
Since returns are squared, their direction is not considered. Only the magnitude is considered
In EWMA, we simply need to store 2 data points: latest return & latest volatility estimate
Consider the equation: t21 (1 0.94) t2 0.94 t2
In this equation, variance for time t was also an estimate. So we can substitute for it as follows:
93
GARCH (1,1)
GARCH stands for Generalized Autoregressive Conditional Heteroscedasticity
Heteroscedasticity means variance is changing with time.
Conditional means variance is changing conditional on latest volatility.
Autoregressive refers to positive correlation between volatility today and volatility yesterday.
(1,1) means that only the latest values of the variables.
GARCH model recognizes that variance tends to show mean reversion i.e. it gets pulled to
a long-term Volatility rate over time.
2
t1
2
t
2
t
94
GARCH (1,1)
2
t 1
2
t
2
t
VL
95
S
t
S
Drift
Shock
The first step in simulating a price path is to choose a random process to model changes in
financial assets
Stock prices and exchange rates are modeled by geometric Brownian motion (GBM) shown
in the above equation
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VAR X % (in %) Z X % *
Mean = 0
ZX% : the normal distribution value for the given probability (x%) (normal distribution has mean as 0 and
standard deviation as 1)
: standard deviation (volatility) of the asset (or portfolio)
VAR in absolute terms is given as the product of VAR in % and Asset Value:
98
portfolio wa2 a2 w 2b b2 2w a w b * a * b * ab
The above written expression can also be extended to the calculation of VAR:
99
100
Adjusted Exposure
Let the value of bank asset at time T be V
Let the already drawn amount be OS (outstanding)
Let COM be the commitment
Let d be the fraction of the commitment which would be drawn before the default
Portion which is not drawn and risk free = COM*(1-d)
Risky portion = OS + d*COM
This Risky Portion is known as Adjusted Exposure also known as Exposure At Default
EL = Adjusted Exposure*LGD*PD
d is also known as Usage Given Default (UGD)
101
102
Unexpected Loss
UL is the estimated volatility of the potential loss in value of the asset around its EL
UL is the standard deviation of the unconditional value of the asset at the time horizon
UL = s.d. of expected asset value
UL = AE*[EDF* 2LGD +LGD2* 2EDF ]
Underlying assumption that EDF is independent of LGD. In case it is not so then correlation between LGD
and EDF terms will come into picture. Though it has been found that they will affect the result only slightly
103