2018

TIME
SAVING
TIPS!

HOW TO PASS THE

2018 FRM EXAM
®

THE ULTIMATE PART I CHEAT SHEET


INTRODUCTION
• Success will take a lot of hard work, around 200 hours of study
time, and intuition and understanding of the topics rather than
rote learning.
• Wiley’s FRM Exam Review lectures have as much information as
the Study Guides. Don’t neglect them. Use the tips in the lectures
to guide your learning as you read through the study notes. Make
sure that you are really comfortable with the “calculate” learning
objectives and focus on what lead author Christian Cooper tells
you is important.
• The FRM Exam Review program has been created in a way that
connects as many of the dots as possible to improve study
retention, increase understanding, and give you the confidence
to rely on your best guess. We’ve all taken tests where two of the
answer options are obviously incorrect but the remaining two
could be 50/50. This is where you will pass the test, using intuition
to increase your odds beyond a random guess.
THE SYSTEM
• The class/lectures notes provide the basis for the lectures.
Students should underline, highlight, circle, as well as annotate
in the margins any examples, insights, tips and so forth given by
Christian.
• This active learning will greatly enhance retention, so it is an
integral part of the approach.
• The importance of question practice to retain the material until
exam day cannot be overstated. We are going to focus on topics
that can be connected, the calculate learning objectives, and the
“must know” 80% to get you to a passing score on exam day.
THE WINNING STRATEGY
• Set up a study plan, follow it, and reach out to Christian for
anything you are stuck on. No question is too basic and if you are
having a problem, you can be certain that many other candidates
are, too, and that is something Christian can focus on to explain
better. Christian is your partner in passing and wants to help in
anyway he can. Sometimes the dreaded duo of personal and
professional responsibilities will conspire to disrupt your study
plans. At some point, intelligent compromises may have to be
made to stay on track with your study plan. Start with at least
two evenings during the working week and half a day during the
weekend, then gradually ramp up the hours as you get closer
to exam day. And put your phone in a different room so that it
doesn’t distract every other minute!
FRM PART I TOPIC WEIGHTS
• The FRM Part I exam is a four-hour paper that takes place in
the morning session of the FRM exam day and consists of 100
multiple-choice questions. That’s just a little under two and a
half minutes per question, so pace and stamina are important.
Get into a habit of timing yourself when you are working through
the practice exams and make sure that you do not spend too
much time on any one question (all questions have the same
weighting).
• The following table outlines the weights of the four topic areas
that make up the FRM Part I exam:
efficientlearning.com/frm
Topic Exam Weight 
Foundations of Risk Management  20% 
Quantitative Analysis 20% 
Financial Markets and Products 30% 
Valuation and Risk Models 30% 
• Your study plan should allocate time to cover all four topic areas
in line with their exam weighting. Use the lecture tips to help you
to cover the syllabus effectively and in a time efficient manner.
• GARP does not disclose the passing score, only the pass
percentage of the test taking population. Instead of trying to
game the exam, we are going to focus on the core areas of the
syllabus you must know to give you the best chance of passing,
but also stop short of making you a complete expert in every topic
area. Remember that no one gets a perfect score in the exam!
TIPS
FOUNDATIONS OF RISK MANAGEMENT
(EXAM WEIGHT 20%, 14 TOTAL READINGS)
RISK MANAGEMENT SECTION WITHIN FOUNDATIONS
OF RISK MANAGEMENT
This section begins with a top-down approach to risk
management and how risk management creates firm value.
The readings are generally qualitative and light on formulae.
The key concepts that you should focus on are listed below.
• Basic risk types, measurement and management tools
• Market risk (including interest rate risk, equity price risk,
foreign exchange risk, commodity price risk).
• Credit risk (including default risk, bankruptcy risk, downgrade
risk, settlement risk).
• Liquidity risk (including funding liquidity risk and trading
liquidity risk).
• Operational risk (including human factor risk and
technology risk).
• Other risks include legal/regulatory risk, business risk,
strategic risk, reputation risk and systemic risk.
• Companies typically want to hedge “non-core” risks to their
business.
• Absolute vs relative risk.
• Impact from risk management can have a positive or negative
P/L even when correctly applied.
• Role of risk management in corporate governance
• The board of directors is responsible for defining a risk
appetite in line with a company’s capacity and willingness
to take risk and ensuring that an effective risk management
program is in place to ensure compliance with risk limits.
• Risk limits are usually set top down at the risk committee level
and then distributed among the different business lines, e.g.
VaR limit or capital allocation.
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• Enterprise risk management (ERM)
• Used to identify and manage risks across the entire firm.
• Four components of an ERM program: (1) define a risk policy
for the firm; (2) estimate the risks faced by the company; (3)
decide if risks should be avoided/transferred/hedged/left
unhedged; and (4) monitor the risk profile and performance.
• Creating value with risk management
• The way to determine the optimal level of risk is to start with
the firm’s risk appetite.
• The credit rating that maximizes a bank’s value will depend on
the nature of the bank’s business lines.
• Risk managers can destroy value by not making sure that the
bank has the right amount of risk for the type of business and
capital structure the bank has.
• Banks need to use compensation incentives and promote
a culture in which risk management is a partner in creating
value.
• Financial disasters and risk management failures
• System error/erroneous reporting (Chase Manhattan/
Drysdale, Kidder Peabody).
• Rogue trader (Barings, Allied Irish Bank, SocGen).
• Poor oversight (UBS).
• Large market moves/liquidity risk (LTCM).
• Basis risk (Metallgesellschaft).
• Unclear explanation of risks faced by the customer (Bankers
Trust).
• Counterparties to fraudulent Enron trades (JPMorgan,
Citibank).
• Banking industry trends leading up to the liquidity squeeze
included the originate-to-distribute model (securitization)
and financing with short-term commercial paper.
• “Loss spiral” worsens because (1) the absence of liquidity
is often an indicator of increased future volatility, and (2)
asymmetry of information between asset buyers and sellers.
• Central bank liquidity support was helpful both to the real
economy and to Wall Street throughout the financial crisis
(pre-Lehman collapse to June 2009) but over the later stages
of the crisis, direct capital injections were the most effective in
their short-term impact.
• Risk management failures may be linked to the (1)
measurement of known risks; (2) identification of risk
exposures; (3) communication of risk; and (4) monitoring of
risk.
PORTFOLIO MANAGEMENT SECTION WITHIN
FOUNDATIONS OF RISK MANAGEMENT
In this section, we move into a more quantitative treatment of
risk management by looking at the return of an asset relative
to risk (expressed as standard deviation) and the theoretical
bounds we place around the pricing of risky assets. The key
areas for your exam are listed below.
• Capital Asset Pricing Model (CAPM)
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• Uses a single factor to define risk and scales that risk
according to an asset’s beta (relative systematic risk).
• Calculating CAPM required return and beta (learn formulae).
• Assumes that investors only need to know the expected
returns, variances and covariances of returns to determine
optimal portfolios.
• Investor can use leverage to increase their exposure to the
market portfolio.
• Security Market Line (SML): expected return vs beta.
• Capital Market Line (CML): expected return vs standard
deviation.
• Risk-adjusted performance measurement
• Calculating all the risk-adjusted performance measures
below (learn formulae).
• Sharpe ratio measures excess return per unit of total risk (for
undiversified portfolios).
• Treynor ratio measures excess return per unit of beta
(systematic risk).
• Jensen’s alpha measures the difference between the
portfolio’s actual return and its required return using the
CAPM.
• Treynor ratio and Jensen’s alpha should be used to evaluate
diversified portfolios.
• Information ratio measures active return per unit of tracking
risk.
• Sortino ratio measures excess return (over a minimum
accepted return) per unit of downside risk.
• Multi-factor models
• APT extends the CAPM to multiple risk factors and relaxes
some of the strict assumptions of the CAPM.
• Fama-French model utilizes the following risk factors: (1)
equity risk premium (RMRF); (2) small-cap return premium
(SMB); and (3) value return premium (HML). The smaller the
company and/or the higher the ratio of book-to-market, the
greater the required return.
• Calculating required return using the Fama-French model
(learn formula).
• Information risk and data quality management
• Consistent risk data aggregation, especially in periods of
crisis, is extremely important at the trading desk level and at
the enterprise level.
• Key principles related to a strong risk data aggregation
capability: (1) accuracy and integrity; (2) completeness; (3)
timeliness; and (4) adaptability.
• Key principles related to effective risk reporting practices: (1)
accuracy; (2) comprehensiveness; (3) clarity; (4) frequency
of reports should reflect the needs of recipients; and (5)
distribution to relevant parties.
• Ethics and the GARP Code of Conduct
• Make sure that you cover this reading thoroughly as ethical
conduct is a hot topic in financial markets.
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• Rules of conduct can be summarized as follows: (1) exercise
reasonable judgment in the provision of risk services and act
with honesty and integrity at all times; (2) disclose actual or
potential conflicts of interest; (3) avoid using confidentiality
information inappropriately; (4) comply with all applicable
laws and avoid misrepresentation; and (5) apply generally
accepted risk management practices.
• Local law takes precedence over the Code.
• GARP can choose to temporarily suspend or permanently
remove the right to use the FRM designation if a violation of
the Code has occurred.
QUANTITATIVE ANALYSIS
(EXAM WEIGHT 20%, 16 TOTAL READINGS)
Quantitative Analysis may seem intimidating but question
practice will help you to master this topic! FRM candidates
should be prepared to use calculations in otherwise what might
be an “explain” or “apply” learning objective. Understand the
relationships between the concepts because sometimes you can
easily eliminate clearly incorrect answer options, e.g. hypothesis
testing pops up in multiple regression. The key concepts and
formulae to master for your exam are listed below.
• Population and sample statistics
• Conditional vs unconditional probabilities.
• Calculating the mean, standard deviation and variance of a
discrete random variable (learn formulae).
• Calculating covariance and correlation between two random
variables (learn formulae).
• Calculating the expected return and variance of a two-asset
portfolio (learn formulae).
• Skewness vs kurtosis.
• Negative values of skewness and coskewness tend to indicate
greater risk.
• Discrete and continuous probability distributions and estimating
the parameters of distributions
• Calculating the probability of observing a specified number
of successes for a specified number of Bernoulli trials using
the binomial distribution (learn formula).
• Using Normal distribution tables to calculate cumulative
probabilities (needed for Black-Scholes-Merton option
pricing).
• One-tailed and two-tailed z values for the Normal distribution
(memorize the 90%, 95% and 99% values).
• Familiarity with the lognormal distribution, chi-squared
distribution, student’s t distribution (used in hypothesis
testing), central limit theorem and F-distribution.
• Bayesian analysis
• Calculating a posterior probability using Bayes’ theorem
(learn the formula or construct a probability tree).
• Bayesian analysis is preferred when there is very little data
(although subjective assumptions about prior probabilities
may be required) whereas the frequentist approach is easier
to use with lots of data.
efficientlearning.com/frm
• Statistical inference and hypothesis testing
• Calculating the confidence interval for a population mean
(learn the formula and remember that this is always a two-
tailed scenario).
• Procedure for performing a hypothesis test: (1) state the
null and alternative hypothesis (one-tailed or two-tailed);
(2) calculate the test statistic; (3) identify the critical value
based on the significance level and number of observations;
and (4) make the statistical decision. This procedure can be
used for all hypothesis tests in your exam and enables you to
determine whether the null hypothesis should be rejected or
not.
• When backtesting VaR, the distribution of exceedances follows
a binomial distribution. The probability of seeing a specified
number of exceedances over a specified number of days is
calculated using the standard binomial distribution formula.
• Linear regression with one regressor
• Assumptions about the regression error: (1) expected value of
zero; (2) homoskedastic; (3) uncorrelated across observations;
and (4) normally distributed.
• Calculating the standard error of the regression (SER) and
coefficient of determination (R2) – learn the formulae.
• Calculating the confidence intervals for regression
coefficients (same approach as when calculating a confidence
interval for a population mean).
• When performing a hypothesis test on a regression coefficient,
reject the null hypothesis that the regression coefficient is
equal to 0 when the p-value is less than the significance level.
• If regression error is heteroskedastic, then confidence
intervals and hypothesis tests need to be based on
heteroskedasticity-robust standard errors, otherwise the
t-statistic calculated will be incorrect.
• If the three least squares assumptions hold, the OLS
estimators of slope and intercept: (1) are unbiased and
consistent; (2) have a sampling distribution with a variance
that is inversely proportional to the sample size; and (3) have
sampling distributions that are normal in large samples.
• If the three least squares assumptions hold and the regression
error is homoskedastic, then the OLS estimator is the Best
Linear conditionally Unbiased Estimator (BLUE). This is the
conclusion of the Gauss-Markov Theorem.
• Alternatives to the OLS estimator are: (1) weighted least
squares estimator (when the error is heteroskedastic) and (2)
least absolute deviations estimator (when large outliers are
significant).
• Linear regression with multiple regressors
• Standard error of the regression (SER) is dependent on
number of regressors.
• Formula for coefficient of determination (R2) is the same as
that for regression with one regressor.
• Adjusted R2 can increase or decrease as the number of
regressors increases but is always less than R2.
• Multiple regression requires four least squares assumptions:
the same three as regression with one regressor, plus the
assumption that the regressors do not exhibit perfect
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multicollinearity (it is not possible to compute the OLS
estimator with perfect collinearity).
• If the regressors exhibit imperfect collinearity, then the
coefficients of one or more of the individual regressors will be
estimated incorrectly.
• Calculating confidence intervals and performing hypothesis
tests for a single regression coefficient (same approach as
used in regression with one regressor).
• Null hypothesis for F-test is that the slope coefficients are
jointly (simultaneously) equal to 0.
• If regression error is heteroskedastic, the F-test needs to be
based on the heteroskedasticity-robust F-statistic.
• R2 and adjusted R2 indicate whether the regressors have
explanatory power. They do not tell you whether the
regressors are a true cause of the movements in the
dependent variable or whether you have chosen the most
appropriate set of regressors.
• Time series modelling and forecasting
• Model selection criteria: SIC penalizes degrees of freedom
most heavily and is consistent; MSE, s2 and AIC are not. Select
model with lowest SIC.
• When modelling seasonality, we only need (s – 1) seasonal
dummies, where s is the number of seasons that we want to
differentiate between.
• To forecast a series, we need the series to be covariance
stationary (such a series will have autocorrelation and partial
autocorrelation functions that approach 0).
• A time series process that is independently and identically
distributed as normal, with zero-mean and constant
variance is called Gaussian (or normal) white noise, and all
the autocorrelations and partial autocorrelations beyond
displacement 0 are equal to 0.
• Any covariance stationary series can be modelled with
using some infinite distributed lag of white noise (Wold
representation). The Wold representation (which is an infinite
order moving average process) can be approximated using a
rational distributed lag, producing a model of cycles that are
parsimonious, e.g. ARMA forecasting model.
• The Ljung-Box Q test jointly tests if any of a group of
autocorrelations of a time series are different from 0. The
Box-Pierce Q-statistic is a simplified version of the Ljung-Box
Q-statistic.
• A MA(1) process is covariance stationary and expresses the
current value of the observed series as a function of current
and lagged unobservable shocks. All autocorrelations beyond
displacement 1 are 0. Partial autocorrelations will decay
gradually to 0.
• An AR(1) process is only covariance stationary if the absolute
value of lag coefficient is less than 1. The autocorrelations will
decay gradually to 0 while the partial autocorrelations beyond
displacement 1 will be 0.
• An ARMA process is a combination of AR and MA models to
better approximate the Wold representation while being
parsimonious. The autocorrelation and partial autocorrelation
functions both decay gradually to 0.
efficientlearning.com/frm
• Estimating correlation and volatility using EWMA and GARCH
models
• Estimating probability using the power law as an alternative
to the Normal distribution (learn formula).
• Calculating volatility using the EWMA model (learn formula to
be on the safe side).
• Calculating volatility using the GARCH(1,1) model (learn
both versions of the formula). Note that the EWMA model is a
specific case of GARCH(1,1).
• A GARCH(1,1) model exhibits mean reversion to a long-run
average variance rate whereas the EWMA model does not
(expected future variance rate equals the current variance
rate).
• A GARCH model should remove autocorrelation in a series
(look for Ljung-Box Q-statistic in the low double digits).
• When current volatility is above/(below) long-term volatility,
GARCH(1,1) estimates a downward/(upward) sloping volatility
term structure.
• Correlations and copulas
• Calculating covariance using the EWMA model (learn
formula).
• Calculating covariance using the GARCH(1,1) model (learn
formula).
• A copula allows us to define a correlation structure between
two marginal distributions which do not have well-defined
characteristics (e.g. not normally distributed). Examples of
copulas are Gaussian and student-t copulas.
• Simulation methods
• Methods of reducing Monte Carlo sampling error include
antithetic variate technique, stratified sampling, low-
discrepancy sequencing and control variates.
• Bootstrapping uses the distribution of actual data when
identifying simulation data but will not work well when (1)
there are outliers, and (2) data is non-independent.
• Disadvantages of simulation to financial problem solving
include (1) being computationally expensive; (2) imprecise
results; (3) results that are difficult to replicate; and (4) results
are experiment specific.
FINANCIAL MARKETS AND PRODUCTS
(EXAM WEIGHT 30%, 21 TOTAL READINGS)
The bulk of this topic area covers the mechanics and valuation
of forwards/futures, swaps and options and the application of
these financial derivatives in hedging and risk management.
This is where your question practice should be concentrated.
Other areas covered include the regulation and risks of financial
institutions, foreign exchange risk, corporate bonds and
mortgage-backed securities. The key concepts and formulae for
your exam are listed below.
• Banks
• Banks are required to hold regulatory capital for credit risk,
market and operational risk.
• Economic capital is the capital that a bank thinks it needs
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based on internal modelling.
• The existence of deposit insurance allowed banks to pursue
riskier strategies than they would have otherwise (moral
hazard problem).
• Insurance companies
• Interpreting mortality tables to calculate the premium
payment for a term life insurance for a one-year and two-year
term.
• Calculating the operating ratio for a property-casualty
insurance company (learn proforma).
• Ways of alleviating the moral hazard problem in property-
casualty and health insurance include deductibles, co-
insurance provision and policy limit.
• Adverse selection is the problem that an insurance company
faces when it cannot differentiate between insuring ‘good’
and ‘bad’ customers.
• Longevity risk has an adverse effect on annuity contracts but
a positive effect on life insurance contracts. Mortality risk has
the opposite effect on these contracts.
• Due to difference in risks taken by life insurance and property-
casualty insurance companies, a property-casualty insurance
company is more likely to have higher equity and investments
with shorter maturities.
• Mutual funds and hedge funds
• Mutual funds are heavily regulated whereas hedge funds face
very little regulation.
• Many hedge fund strategies take both long and short
positions.
• Hedge fund performance may be affected by measurement
biases such as voluntary reporting and backfill bias.
• Futures: mechanics and hedging
• Futures contracts are standardized, which provides less
flexibility but more liquidity compared to forwards.
• They are exchange traded with a clearinghouse acting as an
intermediary between longs and shorts.
• Futures are marked to market daily and futures price
converges to the spot price of the underlying as futures
contract delivery approaches.
• Normal vs inverted futures markets.
• A company using a short/(long) hedge wants basis to
strengthen/(weaken).
• Basis risk tends to increase as the time difference between the
hedge expiration and the delivery month increases.
• Calculating the minimum variance hedge ratio and the
optimal number of futures contracts for a cross hedge,
including tailing the hedge (learn formula).
• Calculating the number of stock index futures contracts
required to hedge an equity portfolio and change the beta
of an equity portfolio (learn the formula). Remember that
you would need to take a long/(short) position to increase/
(decrease) the beta.
• A stack and roll hedging strategy may lead to liquidity
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problems, e.g. Metallgesellschaft.
• Interest rates and measures of interest rate sensitivity
• Calculating the price of a bond using continuously-
compounded treasury zero (spot) rates.
• Calculating forward rates from spot (zero) rates with
continuous compounding (learn formula).
• Valuing a FRA before maturity (learn formula with continuous
compounding).
• Calculating modified duration from Macaulay duration (learn
formula).
• Calculating the change in a bond’s price for a small change in
yield given modified duration and convexity (learn formula).
• A portfolio with zero duration and zero convexity is
immunized against parallel shifts of the yield curve but is still
exposed to nonparallel shifts.
• Theories of the term structure of interest rates: expectations,
market segmentation and liquidity preference. The
expectations theory predicts that forward interest rates are
equal to expected future spot rates whereas the liquidity
preference theory predicts that forward interest rates higher
than expected future spot rates.
• Pricing of forwards and futures
• Calculating the forward price for an investment asset
(stock, bond, stock index) with known income or yield (learn
formulae with continuous compounding).
• Calculating the value of a forward contract before maturity
(learn formula with continuous compounding).
• When the price of the underlying is positively correlated with
interest rates, futures price > forward price. When the price
of the underlying is negatively correlated with interest rates,
futures price < forward price. Generally, we assume that
futures and forward prices are the same.
• Calculating the price for a forward currency contract (learn
interest rate parity formula with continuous compounding).
• Futures prices vs expected future spot prices: (1) Keynes
predicted that futures price < expected future spot price
if hedgers are net sellers of futures contracts; (2) If the
underlying asset has positive/(negative) systematic risk, the
futures price is lower/(higher) than the expected spot price.
• When the futures price is lower/(higher) than the expected
future spot price, this is known as normal backwardation/
(contango).
• Calculating the forward price for a commodity that is an
investment asset with lease rate or storage costs (learn
formulae with continuous compounding).
• Calculating the forward price for a commodity that is a
consumption asset with storage costs and convenience yield
(learn formula with continuous compounding).
• Shape of commodity forward curves: (1) Gold forward curve
shows that the forward price increases with time to contract
maturity; (2) Corn forward price typically rises due to storage
costs between harvests, then falls at harvest; (3) Electricity
price is set by demand and supply at a specific time; (4) Gas
forward curve tends to rise during the fall (autumn) months
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due to storage just before peak demand; and (5) Oil forward
curve is typically non-seasonal.
• Analyzing a commodity spread. 5-3-2 crack spread is the
profit from taking 5 gallons of oil as input and refining it to
produce 3 gallons of gasoline and 2 gallons of heating oil. You
would need to buy oil futures, sell gasoline futures and sell
heating oil futures in these proportions. Remember that there
42 gallons in 1 oil barrel.
• Basis risk is a major consideration for commodities due to:
(1) storage and transportation costs; (2) differences in asset
quality; and (3) hedging distant obligations with short-term
futures, e.g. using a stack and roll strategy (rolling is profitable
if futures prices are in backwardation).
• Interest rate futures
• Calculating the duration-based hedge ratio when hedging a
bond portfolio with Treasury bond futures (learn formula).
• To hedge a long position in bonds, sell Treasury bond futures
and/or sell Eurodollar futures.
• Duration matching (portfolio immunization) immunizes a
portfolio against small parallel shifts of the yield curve but not
against nonparallel shifts.
• Structure, mechanics, and valuation of swaps
• An interest rate swap can be viewed as the exchange of a
fixed-rate bond for a floating-rate bond.
• Calculating the value of an interest rate swap as the
difference between two bond prices (the value of the swap
to the counterparty paying fixed is value of the floating rate
bond less the value of the fixed rate bond). Remember that a
floating rate bond is valued at par at swap inception and at
each payment date.
• Calculating the value of a fixed-for-fixed currency swap as the
difference between the values of two fixed rate bonds (make
sure that you can value an interest rate swap accurately first
as the same principles can be applied to valuing a currency
swap).
• Credit risk on a currency swap is greater than on an interest
rate swap due to the exchange of principal at the end of a
currency swap’s life.
• Structure, mechanics, and valuation of options
• Factors affecting the price of European and American
options (looking at the impact of an increase in each factor
individually):
Factor Call Put
Underlying asset price ↑ ↑ ↓
Interest rate ↑ ↑ ↓
Strike price ↑ ↓ ↑
Dividends ↑ ↓ ↑
Volatility ↑ ↑ ↑
Time to expiration ↑ ? (European) ? (European)
↑ (American) ↑ (American)
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• Using put-call parity for European options (learn formula).
This formula should also be used in conjunction with the
Black-Scholes-Merton formula for the value of a European call
option to calculate the value of a European put option.
• It is never optimal to exercise an American call option on a
non-dividend-paying stock early, but it can be optimal to
exercise an American put option on a non-dividend-paying
stock early.
• Covered call strategy (buying stock, writing call option on
stock) is used when there is a flat outlook for the stock’s price.
• Protective put strategy (buying stock, buying put option on
stock) provides downside protection and unlimited upside
potential.
• Bull spread (buying one European call with a LOW strike,
selling one European call with a HIGHER strike) is a bullish
strategy with limited profit potential. Maximum loss is the net
premium paid. Maximum profit is the difference in the strike
prices minus the net premium paid. You should sketch out
the P/L diagram starting from the maximum loss rather than
learning the formulae. Can also be constructed with European
puts in the same way.
• Bear spread (buying one European put with a HIGH strike,
selling one European put with a LOWER strike) is a bearish
strategy with limited profit potential. Maximum loss is the net
premium paid. Maximum profit is the difference in the strike
prices minus the net premium paid. You should sketch out
the P/L diagram starting from the maximum loss rather than
learning the formulae. Can also be constructed with European
calls in the same way.
• Box spread = Bull call spread + bear put spread with the same
strikes. Payoff is the difference between the strike prices and
the value today is the present value of the payoff.
• Butterfly spread (buying one European call with a LOW
strike, buying one European call with a HIGH strike, and
selling two European calls with a strike that is halfway
between the LOW and HIGH strikes) is used when there is
a flat outlook for the stock’s price. Maximum loss is the net
premium paid. Maximum profit is the difference in the LOW
and INTERMEDIATE strike prices minus the net premium
paid. You should sketch out the P/L diagram starting from the
maximum loss rather than learning the formulae. Can also be
constructed with European puts in the same way.
• Straddle (buying one European call and buying one European
put with the SAME strike) is a volatility strategy. Maximum loss
is the total premium paid. Potential gains are unlimited.
• Strip (buying one European call and buying two European
puts with the SAME strike) is a volatility strategy where the
investor believes that the likelihood of a stock price decrease
is greater.
• Strap (buying two European calls and buying one European
put with the SAME strike) is a volatility strategy where the
investor believes that the likelihood of a stock price increase
is greater.
• Strangle (buying one European call with a HIGH strike and
buying one European put with a LOW strike) is a volatility
strategy. Maximum loss is the total premium paid. Potential
gains are unlimited but a strangle requires more extreme
stock price movements compared to a straddle before profits
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are made.
• Hedging exotic options using static options replication is
superior to delta hedging because static options replication:
(1) does not require frequent rebalancing; (2) can be used for
a wide range of options; and (3) user flexibility in choosing the
boundary values to be matched.
• Exchanges, OTC markets and central counterparties
• All exchange-traded derivatives contracts are subject to
complete clearing with a central counterparty (CCP).
• Wrong way risk is a significant consideration for credit default
swaps.
• OTC derivatives markets have historically managed
counterparty risk by using methods such as netting,
margining, periodic cash resettlement, SPVs, DPCs, monolines
and CDPCs to minimize counterparty risk and systemic risk.
• OTC derivatives are increasingly being centrally cleared,
dependent on degree of standardization, complexity and
liquidity.
• Central clearing is based on the following principles: novation,
multilateral offset, margining, auctioning of a defaulted
member’s position and loss mutualization (the last two
principles play a key role in reducing systemic risk).
• Disadvantages of CCPs include moral hazard, adverse
selection, bifurcations between centrally cleared trades and
non-cleared trades and procyclicality.
• Risks faced by CCPs include: (1) default risk (including failed
auctions, resignations and reputational risk); (2) non-default
loss events (including fraud and operational losses); (3)
model risk related to margin calculations; (4) settlement and
payment risk; (5) FX risk; (6) concentration risk; and (7) wrong-
way risk.
• Foreign exchange risk
• Calculating a bank’s overall FX exposure in a specified
currency (learn formula).
• FX risk exposure relates to open currency positions taken by
the bank for speculative purposes.
• Calculating the potential gain/loss from a foreign currency
denominated investment.
• Methods to reduce FX risk exposure include: (1) direct hedging
through matched foreign asset-liability books; (2) hedging
through forward contracts; and (3) hedging through foreign
asset and liability portfolio diversification.
• Corporate bonds
• Credit default risk vs credit spread risk.
• Spread duration is a common measure of credit spread risk.
• Event risk has led to some bond indentures including a poison
put and a maintenance of net worth clause.
• Issuer default rate vs dollar default rate.
• The higher the bondholder’s seniority, the greater the
recovery rate.
• Mortgage-backed securities
• Agency loans vs non-agency loans (jumbo, Alt-A and
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subprime) for residential MBS.
• Calculating a fixed rate mortgage payment (refer to the
FRM Exam Calculator Guide to set up your Texas BAII Plus
calculator correctly and learn how to use it to calculate
mortgage payments, including the principal and interest
components).
• Mortgage prepayment option increases in importance when
mortgage rates fall. Prepayment modelling typically utilizes
four factors: refinancing (including burnout), turnover,
defaults and curtailments.
• Calculating the conditional prepayment rate for a mortgage
pool given the single monthly mortality rate (learn formula).
• Option-adjusted spread (OAS) with a Monte Carlo framework
is the most popular relative value measure for MBS. OAS
should be uncorrelated with interest rate for the purposes of
relative value trading and hedging.
VALUATION AND RISK MODELS
(EXAM WEIGHT 30%, 18 TOTAL READINGS)
This topic area is a deep dive into risk management building on
concepts that have been introduced in the earlier topic areas,
notably VaR, options, bonds, credit risk, operational risk and
stress testing. A thorough understanding of these areas in FRM
Part I is essential as these concepts will be analyzed further in
FRM Part II. Focus on the key concepts and formulae listed below
for your exam.
• VaR
• Asset returns tend to be fat-tailed, skewed and unstable
(e.g. regime switching).
• Conditional vs unconditional distributions.
• Historical-based approaches to VaR estimation: (1) parametric
(imposing a specific assumption on the distribution of
conditional asset returns); (2) non-parametric (uses historical
data directly without imposing a specific distributional
assumption); and (3) hybrid (uses historical simulation and
RiskMetrics exponential smoothing).
• Parametric approaches to estimating conditional volatility:
(1) historical standard deviation; (2) RiskMetrics exponential
smoothing; and (3) GARCH (less restrictive than RiskMetrics).
• Non-parametric approaches to estimating conditional
volatility (only for large samples): (1) historic simulation (uses
data inefficiently); and (2) multivariate density estimation
(weights depend on the similarity of the current state of the
world to past states and are no longer a constant function of
time, unlike RiskMetrics).
• Implied volatility based approach to VaR estimation uses
implied volatility from current derivatives prices and
derivatives pricing models to predict future volatility.
• With mean reversion in returns, the square root rule
overstates true long horizon volatility.
• With mean reversion in return volatility, the square root rule
overstates/(understates) true long horizon volatility if current
volatility is above/(below) true long horizon volatility.
• Calculating conditional volatility with and without mean
reversion using the square root rule (learn formulae).
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• Calculating VaR for linear derivatives (learn formula).
• VaR for non-linear derivatives can be calculated using: (1)
delta-normal approach (usually linear/delta approximation
but computationally inexpensive); and (2) full revaluation
approach (more accurate but computational intensive).
• Structured Monte Carlo (SMC) facilitates (1) generation
of a large number of possible values for the underlying
when calculating the VaR for non-linear derivatives; and
(2) generation of a large number of economically realistic
scenarios for stress testing that reflect the variance-
covariance matrix of underlying risk factors of the portfolio.
• Correlation breakdown in periods of extreme market stress
may reduce the usefulness of SMC and motivate the use of a
historical simulation-based approach to stress testing.
• Worst case scenario analysis focuses on the loss distribution
during the worst trading period (far greater than the
corresponding VaR).
• Expected shortfall (ES)
• A coherent risk measure exhibits monotonicity, subadditivity,
positive homogeneity and translational invariance.
• VaR is not a coherent risk measure because it is not
subadditive.
• ES is a coherent risk measure and is superior to VaR because:
(1) ES tells us how bad a bad loss might be; and (2) it is
subadditive.
• While ES is a coherent and spectral risk measure, it may not be
the ‘best’ risk measure as it assigns tail losses an equal weight
(does not reflect risk aversion).
• Spectral risk measures can be constructed such that they
attach higher weights to higher losses, directly reflecting the
user’s risk aversion. These spectral risk measures increase in
magnitude as the user becomes more risk-averse.
• Option valuation
• Calculating the value of European and American stock
options using the two-step binomial tree (learn formulae for
the risk-neutral probability, u and d).
• Calculating the delta of a stock option when it is valued using
a binomial model.
• For American options, work backwards through the tree to
check if early exercise is optimal (if so, use the payoff from
early exercise).
• As the number of time steps increases, the value of a
European option calculated using a binomial tree converges
to that calculated by the Black-Scholes-Merton (BSM) model.
• Key assumptions of the BSM model: (1) stock price follows
a lognormal distribution; (2) no dividends paid during the
option’s life; (3) risk-free rate is constant; and (4) options are
European.
• Calculating the BSM price of a European call option (learn
formula, including d1 and d2).
• Use put-call parity to derive the price of a European put
option if required.
• Calculating the value of a warrant, based on adjusting the
price of a call option and assuming that there are no benefits
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to the company from the warrant issue (learn formula).
• Calculating the BSM price of a European call option when
there are dividends (learn formula).
• When using the BSM model, delta of a European call = N(d1);
delta of a European put = N(d1) – 1
• Delta of long call/(put) is positive/(negative).
• A delta hedge requires rebalancing to maintain the delta
neutral position. This provides protection against small stock
price movements between hedge rebalancing.
• Gamma of a long option position is positive. Gamma
neutrality provides protection against larger stock price
movements between hedge rebalancing.
• Hedges using at the money options will have large gammas
so frequent rebalancing will be required to maintain the delta
hedge. Conversely, hedges using deep in or out of the money
options will have small gammas and rebalancing will not be
required as frequently.
• Theta is usually negative for an option.
• Vega of a long option position is positive.
• Rho is positive/(negative) for a European call/(put) option on
a non-dividend paying stock.
• Fixed income valuation
• STRIPS prices are discount factors.
• Clean vs dirty pricing of bonds.
• Calculating forward rates from spot rates using semiannual
compounding.
• When the spot rate curve is upward-sloping, the par rate curve
is below the spot rate curve and the forward curve is above
the spot rate curve.
• Calculating a bond’s yield to maturity with semiannual
compounding (refer to the FRM Exam Calculator Guide for
keystrokes).
• A bond’s yield to maturity is a complex average of the spot
rates used to discount the bond’s cash flows. The coupon
effect means that a zero-coupon bond will have a higher/
(lower) yield to maturity than a bond that pays a coupon
when the spot rate curve is upward/(downward) sloping.
• Calculating DV01 and effective duration of a bond (learn
formulae). Note that the formula for effective duration is not
the same as that for modified duration (seen in the Financial
Markets and Products topic area).
• Calculating the face amount of bonds required to hedge an
option position using DV01 (learn formula).
• Duration of a portfolio is the weighted average of the
individual durations.
• Constructing a barbell portfolio to match the value and
duration of a bullet investment (learn formula).
• If the duration of two portfolios are the same, the portfolios
whose cash flows are more dispersed will have higher
convexity.
• Duration hedging is based on the assumption that yields
move in a parallel manner. When there is curve risk, multi-
factor approaches such as key rate exposures should be used.
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• Key rates and partial ‘01s express the exposures of a position
in terms of hedging securities. Forward bucket ‘01s are
calculated by shifting the forward rate over each of the
regions/buckets of the term structure, one at a time.
• Country and sovereign risk models and management
• Sources of country risk: life cycle, political risk (including
continuous vs discontinuous risk, corruption, physical
violence and nationalization/expropriation), legal risk and
economic structure.
• Countries are increasingly defaulting on local and foreign
currency debt simultaneously.
• Consequences of sovereign default include reputation loss,
capital market/banking system turmoil, decline real output,
political instability and currency devaluation.
• Market spreads can be superior to ratings as a predictor of
default because they adjust more rapidly to information
and therefore provide earlier signals of default compared to
ratings, but they are much more volatile and may be affected
by variables (e.g. liquidity) that are unrelated to default risk.
• External and internal credit ratings
• External rating agencies use “through-the-cycle” (average
cycle) ratings to make the ratings less volatile.
• A bond downgrade is associated with lower bond returns
(statistically significant). A bond upgrade is associated with
bond outperformance (less statistically significant).
• A bond downgrade significantly affects stock prices but an
upgrade does not.
• Internal rating approaches: at-the-point-in-time score
volatility is much higher than through-the-cycle score
volatility.
• Risks when using the at-the-point-in-time approach: (1)
procyclicality when sticking to probabilities of default without
any internal rating scale; and (2) unstable transition matrices
associated with an internal rating scale.
• Biases that may affect an internal rating system include
time-horizon bias, homogeneity, distribution bias (related to
quantitative scoring systems), backtesting bias and scale bias
(related to the stability of the internal transition matrices).
• Expected and unexpected losses
• Economic capital for credit is dependent on the riskiness of
the bank’s assets and the confidence level. The higher the
riskiness of the bank’s credit assets, the greater the economic
capital needed.
• Calculating expected loss (EL) on a standalone basis, based
on PD, EA and LR (learn formula).
• Calculating unexpected loss (UL) on a standalone basis (learn
formulae, including the formula for calculating the standard
deviation of PD).
• EL of a portfolio of credits is the sum of the individual
expected losses.
• Calculating the UL and ULC of a portfolio of n loans where
the loans have the same size and characteristics and pairwise
correlations are the same (learn formula)
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• Calculating economic capital based on the portfolio UL and
capital multiplier (learn formula).
• Operational risk
• Three approaches for calculating regulatory capital for
operational risk: (1) basic indicator approach (15% of average
annual gross income); (2) standardized approach (average
annual gross income for each business line multiplied by
a “beta factor” and then summed up); and (3) advanced
measurement approach (internal approach based on a one-
year 99.9%VaR).
• Loss frequency can be modelled using the Poisson
distribution while loss severity is often modelled using the
lognormal distribution.
• AMA implementation considerations: (1) small sample sizes
and lack of information sharing amongst banks can introduce
biases in the estimation of the loss frequency and loss severity
distributions; (2) loss frequency must be specific to the
bank and based on internal data and scenario analysis; (3)
Data from vendors is most useful for estimating relative loss
severity; and (4) business environment and internal control
factors should be considered when estimating loss frequency
and loss severity.
• Calculating the probability of large losses using the power
law (same formula as in the Quantitative Analysis topic area).
• Stress testing and scenario analysis
• Effective governance over stress testing covers: (1) governance
structure; (2) policies, procedures and documentation; (3)
validation and independent review; and (4) internal audit.
• Stress testing vs economic capital (EC)/VaR measures: (1)
stress testing uses a few scenarios whereas VaR measures use
a very large number of scenarios; (2) Stress testing focuses
on an accounting view of losses whereas EC methods focuses
on a “market view; (3) Stress testing does not focus on the
probability of scenarios whereas VaR models are probabilistic
in nature; and (4) Stress testing uses ad hoc scenarios whereas
VaR metrics typically use unconditional scenarios, e.g. Monte
Carlo simulation.
• Using a stressed risk metric (e.g. stressed VaR measure) is
more conservative but is dependent on portfolio composition,
not current market conditions.
• Weaknesses in stress testing practices prior to financial
crisis: (1) risk assessment was often done in vacuum without
integration with front office; (2) stress testing was often done
in silos and there was limited aggregation of exposures across
a bank; (3) Use of historical statistical relationships were
inappropriate once the financial crisis unfolded; (4) stress
scenarios were not extreme enough, used shorter durations
and ignored correlation breakdown; (5) certain risks were not
adequately analyzed, e.g. risks related to complex structured
products, pipeline risk, basis risk, counterparty credit risk,
contingent risk and funding liquidity risk.
Remember that the more thorough your coverage of the
Part I curriculum, the fewer surprises there will be on exam day.
Good luck!
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