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FRM-Formulas (104p EduPristine - Com) PDF
FRM-Formulas (104p EduPristine - Com) PDF
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Hedging in a practical world (Basis Risk)
Basis = spot price of asset – futures price contract
• Basis = 0 when spot price = futures price
Future
Price
Spot Price
Time
Where
• σS is the standard deviation of δS, the change in the spot price during the hedging period
• σF is the standard deviation of δF, the change in the futures price during the hedging period
• ρ is the coefficient of correlation between δS and δF
In order to change the beta (β) of the portfolio to (β*), we need to long or short the (N*) number
of contracts depending on the sign of (N*)
P
N* β
A
P
N * ( * - )
A
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
FUSD S
USD e
INR INR
The cost of carry, c, is the storage cost plus the interest costs less the income earned
5
100 (C / 2)e rt 100e 5 r
t 1
Payment to the long at settlement = Notional Principal X (Rate at settlement – FRA Rate) (days/360)
----------------------------------------------------------
1 + (Rate at settlement) (days / 360)
Macaulay’s 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
n*M
t 1 (1 y )
t
(1 y ) n
Macaluay Duration
Current bond price
Where:
• t = Respective time period
• C = Periodic coupon payment
• y = Periodic yield
• n = Total no of periods
• M = Maturity value
In the case of a continuously compounded yield the duration used is modified duration given as:
Macaulay Duration
D*
r
1
n
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
Tangent
Y* Yield
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
We can approximate the change in a bond’s price for a given change in yield by using
duration and convexity:
V B D M o d i V B 0 .5 C V B i
2
Day count defines the way in which interest is accrued over time. Day count conventions normally
used in US are:
• Actual / actual treasury bonds
• 30 / 360 corporate bonds
• Actual/360 money market instruments
The interest earned between two dates
The party with the short position can chose to deliver the cheapest bond when it comes to
delivery, hence he would chose the cheapest to deliver bond
Net pay out for delivery ( he has to buy a bond and deliver it):
• Quoted bond price – (settlement price * conversion factor)
Hedge ratio is calculated using DV01 with the help of following relation
PDP
N*
FC DF
Key Rate ‘01 measures the dollar change in the value of the bond for every basis point shift
in the key rate
• Key Rate ‘01 = (-1/10,000) * (Change in Bond Value/0.01%)
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)
Expressed as:
• Value of call + Present value of strike price = value of put + share price
Put-call parity relationship, assumes that the options are not exercised before expiration day, i.e. it
follows European options
• Assuming the price of the underlying asset can take only two values in any given interval of time
– Risk Neutral Method
Su 2 IV1 = Max[(Su2-X), 0]
p
Su
p 1-p
S0 Sud IV2
p
1-p
Su
1-p IV3
Sd 2
n
portfolio
i1
W i i
Calculation of Gamma
• Gamma for European options can be calculated using the following formula:
N ' ( d 1)
S 0 T
• Where symbols have their usual meaning
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 Π is the value of the portfolio, and σ 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) Vega
2 16
The Vega of a long position is always positive 14
12
A position in the underlying asset has a zero Vega
10
Thus its behavior is similar to gamma 8
Vega is maximum for options that are at the money 6
4
2
0
1 4 7 1013161922252831343740434649
Rho of a portfolio of options is the rate of change of its value with respect to changes in the
interest rate
Rho = r
, where Π is the value of the portfolio, and r is the rate of interest
For European options on non dividend paying stocks, we have;
• Rho (call) = KTe-rTN(d2), where the symbols carry their usual meanings
• Also, Rho (put) = -KTe-rTN(-d2), the symbols carrying their usual meanings
Commodity forward prices can be described using the same formula as used for financial
forward prices
( r ) T
F 0 , T S 0 e
For financial assets, is the dividend yield
• For commodities, is the commodity lease rate
• The lease rate is the return that makes an investor willing to buy and lend a commodity
• Some commodities (metals) have an active leasing market
• Lease rates can typically only be estimated by observing forward prices
The set of prices for different expiration dates for a given commodity is called the forward
curve (or the forward strip) for that date
If on a given date the forward curve is upward-sloping, then the market is in contango
If the forward curve is downward sloping, the market is in backwardation
Note that forward curves can have portions in backwardation and portions in contango
(r )T
F0,T S0e
• Since r is always positive, assets with =0 display upward sloping (contango) futures term structure
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 δ is lease rate
1
l r In (F0 ,T / S )
T
(1 r )
l 1/T
1
(F0 ,T / S )
One will only store a commodity if the PV of selling it at time T is at least as great as that of
selling it today
Whether a commodity is stored is peculiar to each commodity
If storage is to occur, the forward price is at least
Where (0,T) is the future value of storage costs for one unit of the commodity from time 0
to T
F0 ,T S 0 e rT (0,T )
Convenience Yield
• Some holders of a commodity receive benefits from physical ownership (e.g., a commercial user)
• This benefit is called the commodity’s convenience yield
• The convenience yield creates different returns to ownership for different investors, and may or may
not be reflected in the forward price
Convenience and leasing
• If someone lends the commodity they save storage costs, but lose the ‘convenience’
– Stated as ( –c)
• Therefore, commodity borrower pays a lease rate that covers the lost convenience less the storage
costs:
– =c–
F0 ,T S 0 e ( r )T
And if, = c –
From the perspective of an arbitrageur, the price range within which there is no arbitrage is:
( r c )T ( r )T
S0 e F0 ,T S 0 e
Where c is the continuously compounded convenience yield
The convenience yield produces a no-arbitrage range rather than a no-arbitrage price. Why?
There may be no way for an average investor to earn the convenience yield when engaging
in arbitrage
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Expected Return and Standard Deviation of Portfolio
Return of Portfolio
R p Wk R k k 1 to N
p Wσ WWσ σ P
k k
2
k i k i ki k 1toN;i 1toN;k i
So there is a risk reduction from holding a portfolio of assets if assets do not move in
perfect unison
Zero Correlation
• Correlation between two assets is zero
Capital Market Line: A line used in the capital asset pricing model to illustrate the rates of return
for efficient portfolios depending on the risk-free rate of return and the level of risk
(standard deviation) for a particular portfolio
Represents all possible combinations of the market portfolio (P) and risk free asset
σs
E(R s ) R f E(R p ) R f
σp
Efficient Frontier
Pe
Rf
Volatility
As per CAPM, stock’s required rate of return = risk-free rate of return + market risk premium
R s R f βR m R f
covR i , R m
βi
VarR m
E(R p ) R F ( E ( R M ) R F ) ( M R F ) ( i R F )
M dividend yield of market portfolio
i dividend yield for stock i
T tax factor
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
βi
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
Sharpe ratio:
R R
p f
Sharpe ratio σp
• Rp = portfolio return, Rf = risk free return
• The higher the Sharpe measure, the better the portfolio
Treynor ratio:
R p Rf
Treynor ratio Beta
• Rp = portfolio return, Rf = risk free return
• The higher the Treynor measure, the better the portfolio
• However, this measure should be used only for well-diversified portfolio
Jenson’s alpha:
Jenson’s alpha α 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
• 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
R p Rb
TE
• Higher IR indicates higher active return of portfolio at a given risk level
• 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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Counting Principle
Number of ways of selecting r objects out of n objects
nCr
n!/(r!)*(n-r)!
P( A) 1 P( A)
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( B / A) P( A)
P( A / B)
P( B / A) P( A) P( B / Ac ) P( Ac )
The expected value(Mean) measures the central tendency, or the center of gravity of the
population n
It is given by: x i
E(X ) i 1
N
The graph shows the mean of normal distributions
0.45
0.40
0.35
0.30 Standard Normal Distribution
0.25 = 0, = 2
0.20
0.15 = 1, = 1
0.10
0.05
0
-4 -2 0 2 4
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): It’s the geometric mean of the returns
E(X2) ≠ [E(X)]2
(xi )2
VAR i1
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
• SD(X) =
(xi )2
VAR ( x ) i1
N
A correlation of 1 means that the two variables always move in the same direction
A correlation of -1 means that the two variables always move in opposite direction
If the variables are independent, covariance and correlation are zero, but vice versa
is not true
n n n
Var ( X i ) Cov ( X i , X j ) Covariance between same variables is also their variance
i 1 i 1 j 1
n n
Var ( X i ) Var ( X i ) For independent or uncorrelated variables,
i 1 i 1 • covariance or correlation = 0
i
( x ) 3
Sk i 1
3
Skewness can be negative or positive. Symmetric Distribution
(x i )4
K 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
0.2
Mesokurtic
0.15 K=3
0.1
0.05
0
-4 -3 -2 -1 0 1 2 3 4
Actual
Type I and Type II Errors H0 is True H0 is False
• Type I error occurs if the null hypothesis is rejected Inference
when it is true Correct Decision Type-II Error
• Type II error occurs if the null hypothesis is not rejected H0 is True Confidence P(Type-II Error)
when it is false Level = 1-α =β
Type-I Error
H0 is False Significance Power=1-β
Significance Level Level = α
• -> Significance level
– the upper-bound probability of a Type I error
• 1 - ->confidence level
– the complement of significance level
• Lower Tail test:
H0: σ2 σ02
HA: σ2 < σ02
Where
2 = standardized chi-square variable
n = sample size
s2 = sample variance
σ2 = hypothesized variance
2
Lower tail test: H0: σ2 σ02 Two tail test: H0: σ2 = σ02
HA: σ2 < σ02 HA: σ2 ≠ σ02
/2
/2
2 2
• Lower Tail test:
H0: σ12 – σ22 0
HA: σ12 – σ22 < 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
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
Y 0 1 X u
Observed Value of
Y for Xi
Slope = β1
Predicted Value of Random Error for
Y for Xi this x value
ui
Intercept = β0
xi x
Population Random
Dependent Population Slope Independent Error
Variable y intercept Coefficient Variable term, or
residual
Y β 0 β1X u
Linear component Random Error
component
Y
y b 0 b1x e
Observed Value of
Y for Xi
ei
Slope = β1
Predicted Value of Random Error for
Y for Xi this x value
Intercept = β0
xi x
y i b 0 b 1x e
e 2
(y ŷ ) 2
(y (b 0 b 1 x)) 2
The sum of the residuals from the least squares regression line is 0
( y yˆ ) 0
The sum of the squared residuals is a minimum
Minimize ( ( y yˆ ) 2 )
The simple regression line always passes through the mean of the y variable and the mean
of the x variable
b1
( x x )( y y )
(x x) 2
xy x y b 0 y b1 x
b1 n
x2
2
( x )
n
b0 is the estimated average value of y when the value of x is zero. More often than not it
does not have a physical interpretation
b1 is the estimated change in the average value of y as a result of a one-unit change in x
y
Y b 0 b 1 X
slope of the line(b1)
b0
x
y
yi •RSS = Residual sum of squares
y
TSS = Total sum RSS = (yi - yi )2
of squares
_
TSS = (yi - y)2
y _2
_ ESS = (yi - y)
_
y y
•ESS = Explained Sum of squares
x
Xi
TSS ( y y ) 2
RSS ( y ˆ
y ) 2
ESS ( ˆ
y y ) 2
Where:
• y = Average value of the dependent variable
• y = Observed values of the dependent variable
ŷ
• = Estimated value of y for the given x value
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
2
R where 0 R 1 2
SST
Coefficient of determination
SSR
2 sum of squares explained by regression
R
SST total sum of squares
R2 r2
Where:
• R2 = Coefficient of determination
• r = Simple correlation coefficient
r
( x x )( y y )
[ ( x x ) ][ ( y y )
2 2
]
n xy x y
r
[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
The standard deviation of the variation of observations around the regression line is
estimated by:
RSS
su
n k 1
Where:
• RSS = Residual Sum of Squares (summation of e2)
• n = Sample size
• k = number of independent variables in the model
Xi su
2
s bo
n (x x ) 2
su su
s b1
(x x ) 2
( x) 2
x 2
Where:
• s b = Estimate of the standard error of the least squares slope
1
RSS
su
• n2 = Sample standard error of the estimate
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
• εi = error term of ith observation
• n = number of observations
• k = total number of independent variables
As we calculated the intercept and the slope coefficient in case of simple linear regression
by minimizing the sum of squared errors, similarly we estimate the intercept and slope
coefficient in multiple linear regression
n
i Yi Yi Yi b0 b1 X 1i b2 X 2 i ......... bk X ki
Let xi be the continuously compounded return during day i (between the end of day
“i-1” and end of day “I”)
Let σn 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
2
i x
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
x
2
i
Variance 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?
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
Hence we have
m i 1 2
2
n (1 ) u n i m 2
nm
i 1
• Variance estimate for next day (n) is given by (1-λ) weight to recent squared return and λ weight to the previous
variance estimate
• Risk-metrics (by JP Morgan) assumes a Lambda of 0.94
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:
2
t1 V L t
2
t
2
2
t 1 t
2
t
2
VL
1
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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Measuring Value-at-Risk (VAR)
0.45
0.4
0.35
0.3
VAR X % (in %) Z X % *
0.25
0.2
0.15
0.1
0.05
0
-4 -2 0 2 4
Mean = 0
ZX% : the normal distribution value for the given probability (x%) (normal distribution has mean as 0 and
standard deviation as 1)
σ : standard deviation (volatility) of the asset (or portfolio)
VAR in absolute terms is given as the product of VAR in % and Asset Value:
VAR VARX % (in %) * Asset Value
This can also be written as:
VAR Z X % * * Asset Value
This comes from the known fact that the n-period volatility equals 1-period volatility multiplied by
the square root of number of periods(n).
As the volatility of the portfolio can be calculated from the following expression:
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: