After Mid Course FRM

OPTIONS MARKET AND VALUATION
An option is a contract which gives the buyer (the owner) the right, but not the obligation, to
buy or sell an underlying asset or instrument at a specified strike price on or before a
specified date. The seller has the corresponding obligation to fulfill the transaction – that is to
sell or buy – if the buyer (owner) "exercises" the option. The buyer pays a premium to the
seller for this right.
Some basic concepts:

Exercise price / Strike price:
The price at which the underlying security can be purchased (call option) or sold (put option).
The exercise price is determined at the time the option contract is formed. It is also known as
strike price.
Spread:
A spread position is entered by buying and selling equal number of options of the same class
on the same underlying security but with different strike prices or expiration dates.
At the Money: ATM (current market price = strike price)

An option is said to be at the money if the current stock price is equal to the strike price.
It doesn't matter if we are talking about calls or puts. Any call or put whose underlying
stock price equals the strike price is said to be at the money. Sometimes you will see "At
The Money" abbreviated as "ATM." You may also see "OTM" which mean "Out of the
Money" and ITM which means "In the Money".
In the Money: ITM (current market price > strike price)

A call option is said to be in the money when the current market price of the stock is above the
strike price of the call. It is "in the money" because the holder of the call has the right to buy
the stock below its current market price. When you have the right to buy anything below the
current market price, then that right has value. That value is also referred to as the option's
"intrinsic value."
Out of the money: OTM (current market price < strike price)
A call option is said to out of the money if the current price of the underlying stock is
below the strike price of the option.
Exercise price and premium relation:
Both have opposite direction. When exercise price is high premium will be low and
vice versa, because the chance of exercise is associated with the price of stock.
Decision to exercise the option: The decision to exercise the option is always made by the
Long because he has the right to exercise and the short is obligated to obey the transaction.
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Waseem A. Qureshi MM141063

Party position, expectations, premiums and profits.
Party Requirements Position Expectation Premium profit
Long He wants to Right to buy Asset Price Cost/expense. The
Call buy some will rise in difference
an asset at a He will pay
particular the future. between
future time at the premium
asset on a market
specific rate. to
Bullish future date. price and
counterparty
(Buy a strike price
that is a short
contract) minus
call.
premium
paid
Long He wants to Right to sell Asset Price Cost/expense. The
Sell particular will decrease difference
Put an asset at a He will pay
asset on a in the future. between
future time at the premium
future date. market
specific rate. to
price and
Bearish counterparty
(Buy a strike price
that is a short
contract) minus
put.
premium
paid
Short He wants to Obligated to Asset Price Profit/gain. The only
Call earn the profit will decrease profit is
sell He will
when contract in the future. premium
receive the
expires an asset at a received if
premium from
Bearish worthless. future time at contract
the
specific rate. expires
counterparty
worthless.
that is a long
call.
Short He wants to Obligated to Asset Price Profit/gain. The only
Put earn the profit will rise in profit is
buy He will
when contract the future. premium
receive the
expires an asset at a received if
premium from
Bullish worthless. future time at contract
the
specific rate. expires
counterparty
worthless.
that is a long
put.
Party position and payment of premium:
Main Party Counterparty premium paid by premium received by
(cost for) (gain for)
Long call short call long call short put
Long put short put long put short call
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HINT: premium is always paid by long to short, whether the position of long is call or put. It
is an expense for long and gain for short. And the decision always lies with long because he
buys the right.
Strategies for long and short positions:
1. Long call option strategy
The long call option strategy is the most basic option trading strategy whereby the options
trader buys call options with the belief that the price of the underlying security will rise
significantly beyond the strike price before the option expiration date.
However, call options have a limited lifespan. If the underlying stock price does not move
above the strike price before the option expiration date, the call option will expire worthless.
2. Long put option strategy
The long put option strategy is a basic strategy in options trading where the investor buy put
options with the belief that the price of the underlying security will go significantly below the
striking price before the expiration date.
 Profit = Strike Price of Long Put - Premium Paid
Long Put Payoff Diagram
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3. Short call strategy
The index short call strategy is a bearish strategy designed to earn from the premiums for
selling the index call options with the hope that they expire worthless. The options trader
employing the index short call strategy expects the underlying index level to be below the call
strike price on option expiration date.
Maximum profit is limited to the premiums received for selling the index calls.
 Max Profit = Premium Received - Commissions Paid
Short Call Payoff Diagram
4. Short put strategy
The index short put strategy is a bullish strategy designed to earn from the premiums for
selling the index put options with the hope that they expire worthless. The options trader
employing the index short put strategy expects the underlying index level to be above the put
strike price on option expiration date.
Maximum profit is limited to the premiums received for selling the index puts.
 Max Profit = Premium Received - Commissions Paid
Index Short Put Payoff Diagram

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STRATEGIES:
 Long calls (right to buy) = when you believe the underlying stock will go up.
 Long puts (right to sell) =when you believe the underlying stock will go down.
 Short on calls (obligated to sell) = when you believe the underlying stock go down.
 Short on puts (obligated to buy) = when you believe the underlying stock go up.
Uses of options:
There are two main uses op options.
1. Hedging 2. Speculation
Following may be some different situations that may occur on the basis of situation a
speculator or hedger expects in the future.
1. Buy 1 call option at low price and sell one call option at high price. (Bull Spread)
2. Buy 1 call option at low, 1 call at high and sell 2 call options at middle. (Butterfly)
3. Buy 1 call option and 1 put option at same exercise price. (V-Shape)
4. Buy 1 call option and 1 put option when these are out of money. (Strangle)
5. Buy 2 call option and 1 put option at same exercise price. (Strip)
6. Buy 1 call option and 2 put option at same exercise price. (Strap)
7. Buy 1 call option at high price and sell 1 call option at low price. (Bear Spread)
8. Buy 1 put option at low price and sell 1 put option at high price. (Spread)
9. Buy 1 put option at high and sell 1 put option at high price. (Bear Spread)
Now we will explain diagrammatically one by one all above situations.
1. Buy 1 call option at low price and sell one call option at high price. (Bull Spread)
Bull spread, the investor who expects a rise of prices in the future.
Exercise price call option
90 6 Long
100 4.5
110 4 short
What decision will be taken with different market prices?

Buy 1 Call option at low price = 90 at a premium of 6
Sell 1 call option at high price = 100 at a premium of 4
MPS Long Call Short Call Net position
70 (6) 4 (2)
80 (6) 4 (2)
90 (6) 4 (2)
100 4 4 8
110 14 4 18
120 24 (6) 18
130 34 (16) 18
140 44 (26) 18
83

20
18 ---------
16
12
0
70 80 90 100 110 120 130 140
-2
-4
-8 This is called ―BULL SPREAD‖.
HINT: when ever Market price is lower to exercise price, the option will not be exercised and
the contract will be closed. The only expense or cost is premium which is paid in start or at the
time of contract.
For situation 1, where MPS is 70, exercise price is 90 and premium is 6 for long call, the
option will not be exercised and the buyer will pay 6 to leave the contract. At the same price
the decision for short call will be made by long. Here contract price is 110 and market price is
70, it is unfavorable for long as he can buy at lower price from market and will not exercise
the option. He will leave the contract and only $4 will be loss to him which is a gain for short
position. Result is, 6 loss for long call and 4 gain for short call.
For situation 6, where MPS is 120, exercise price is 90 and premium is 6 for long call, the
option will be exercised and the buyer will receive $30 by selling at 120 which is bought for
90. The cost is $6 for premium, so net gain is 30-6 = 24. At the same price the decision for
short call will be made by long. Here contract price is 110 and market price is 120, it is
favorable for long and he will not exercise the option. He will earn a profit of $10 by selling at
120 and his cost is 4. So net for long is 10-4 = 6, a gain for long is loss for short. Here our
position is short, so 6 is a loss for short.
Net position:
Minimum loss is $2 and maximum gain is $18 for the combination. This combination is called
―Bull Spread‖.
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2. Buy 1 call option at low, 1 call option at high and sell 2 call options at middle.
(Butterfly spread)
Exercise price Call option

90 6 Long
100 4.5 Short
110 4 Long
Buy 1 Call option at low price = 90 at a premium of 6

Buy 1 Call option at high price = 110 at a premium of 4
Sell 2 call option at middle price = 100 at a premium of 4.5 (4.5 x 2= 9)
MPS Long Call-I Long Call-II Short Call Net position

70 (6) (4) 9 (1)
80 (6) (4) 9 (1)
90 (6) (4) 9 (1)
100 4 (4) 9 9
110 14 (4) (11) (1)
120 24 6 (31) (1)
130 34 16 (51) (1)
140 44 26 (71) (1)
9
7
5
3 =Counter party
1
0 70 80 90 100 110 120 130 140
-1 = Main party
-3
-5
-7
-9 This is called ―BUTTERFLY SPREAD‖.
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3. Buy 1 call option and 1 put option at same exercise price. (V-shape)
Exercise price call option put option

90 6 3 One exercise price
100 4.5 3.5
110 4 5
Buy 1 Call option and 1 put option at 90 on a premium of 6
MPS Long Call Long Put Net position
70 (6) 17 11
80 (6) 7 1
90 (6) (3) (9)
100 4 (3) 1
110 14 (3) 11
120 24 (3) 21
130 34 (3) 31
140 44 (3) 41
Here the investor expects an abnormal movement in future.
25
20
15
10
0
70 80 90 100 110 120 130 140
-5
-10
-15 This is called ― V - SAHPE‖.
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4. Buy 1 call option and 1 put option when these are out of money. (Strangle)
Exercise price call option Put option

90 6 3 out of money (Long Put)
100 4.5 3.5
110 4 5 out of money (Long Call)
Buy 1 Call option and 1 put option at 90 at a premium of 6

70 (4) 17 13
80 (4) 7 3
90 (4) (3) (7)
100 (4) (3) (7)
110 (4) (3) (7)
120 6 (3) 3
130 16 (3) 13
140 26 (3) 23
Here the investor expects an abnormal movement in future.
25
20
15
10
5
0
70 80 90 100 110 120 130 140
-5
-10
-15 This is called ―STRANGLE‖.
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5. Buy 2 call option and 1 put option at same exercise price. (Strip)

90 6 3 one exercise price
100 4.5 3.5
110 4 5
Buy 2 Call options and 1 put option at 90 on a premium of 6 (same exercise price).
70 (12) 17 5
80 (12) 7 (5)
90 (12) (3) (15)
100 8 (3) 5
110 28 (3) 25
120 48 (3) 45
130 68 (3) 65
140 88 (3) 85
Here the investor expects an abnormal movement in future, but probability of increase is
double to probability of decrease. Chance of movement on either sides are not equal.
28
20
15
10
0
-2 70 80 90 100 110 120 130 140
-5
-10
-15
This is called ―STRIP‖.
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6. Buy 1 call option and 2 put option at same exercise price. (Strap)

90 6 3 one exercise price
100 4.5 3.5
110 4 5
Buy 2 Call options and 1 put option at 90 on a premium of 6 (same exercise price).
70 (6) 34 28
80 (6) 14 8
90 (6) (6) (12)
100 4 (6) (2)
110 14 (6) 8
120 24 (6) 18
130 34 (6) 28
140 44 (6) 38
Here the investor expects an abnormal movement in future, but probability of increase is
double to probability of decrease. Chance of movement on either sides are not equal.
28
24
20
15
10
5
0
-2 70 80 90 100 110 120 130 140
-6
-10
-16 This is called ―STRAP‖.
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7. Buy 1 call option at high price and sell 1 call option at low price. (Bear Spread)

50 8 6 Sell one call at low.
60 5.5 4
70 4 3 Buy one call at high.
Buy 1 Call option at 70 on a premium of 4, and sell 1 put option at 50 on a premium of 8.

30 (4) 8 4
40 (4) 8 4
50 (4) 8 4
60 (4) (2) (6)
70 (4) (12) (16)
80 6 (22) (16)
90 16 (32) (16)
Here the investor expects to decrease the prices in future.

24
20
16
12
8
4
0
-4 70 80 90 100 110 120 130 140
-8
-12
-16
90

8. Buy 1 put option at low price and sell 1 put option at high price. (Spread)

50 8 6 Buy 1 long put
60 5.5 4
70 4 3 Sell 1 Short put
Buy 1 put option at 50 on a premium of 6, and sell 1 put option at 70 on a premium of 3.

MPS Long Put Short Put Net position
30 14 3 17
40 4 3 7
50 (6) 3 (3)
60 (6) 3 (3)
70 (6) 3 (3)
80 (6) (7) (13)
90 (6) (17) (23)

24
20
16
12
8
4
0
-4 30 40 50 60 70 80 90 100
-8
-12
-16
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9. Buy 1 put option at high and sell 1 put option at low price. (Bear Spread)

50 8 6 sell 1 short put
60 5.5 4
70 4 3 buy 1 long put
Buy 1 Call option and 1 put option at 70 on a premium of 3, and sell 1 put option at 70 on a
premium of 3, both at high rates.
MPS Long Put Short Put Net position
30 37 6 43
40 27 6 33
50 17 6 23
60 7 (4) 3
70 (3) (14) (17)
80 (3) (24) (27)
90 (3) (34) (37)
48
40
32
24
16
8
0
-8 30 40 50 60 70 80 90 100
-16
-24
-32
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Duration:
Duration is the average life of Bond. The life of bond is inversely related with bond
value. Longer the life, lower will be the value of bond and vice versa.
EXAMPLE 22:
An 8% bond is traded in the market. The maturity period is 5 years. Interest is payable on
annual basis. Market yield rate is 10%. What is fair value of bond? What is duration of bond?
What is convexity of bond if interest rate increases to 11%.
YEAR CASH FLOWS PVF = 1/ (1+i)n PV of CF PV of CF * t

1 80 .909 72.72 72.72
2 80 .826 66.08 132.16
3 80 .751 60.08 180.24
4 80 .683 54.64 218.40
5 1080 .621 670.68 3353.40
∑= 924.20 ∑= 3956.92
a. Present value of Bond.

PV Factor = 1/ (1+i)n
PV of bond = 924.20 (it is net present value of cash flows from bond in 5 years)
b. Duration of Bond
CF ∗T/(1+i)n ∑(PV of CF ∗t)
𝐷= or 𝐷= whereas: t stands for time (year)
CF /(1+i)n ∑(PV of CF )
3956.92
𝐷 = = 4.32 years
924.20
b. Convexity of Bond
Change in Bond value due to change in interest rate.

New interest rate is 11%, old is 10%, it is denoted by ∆ R
∆R .11−.10
Convexity = - 𝐷 ∗ = -4.32 * = -.39 , -3.9%
1+𝑅 1+.10
It means every 1% increase in interest rate will decrease a value of bond by 3.9%.
Valuation of Options
Until now, we have looked only at some basic principles of option pricing. Other than put-call
parity, all we examined were rules and conditions, often suggesting limitations, on option
prices. With put-call parity, we found that we could price a put or a call based on the prices of
the combinations of instruments that make up the synthetic version of the instrument. If we
wanted to determine a call price, we had to have a put; if we wanted to determine a put price,
we had to have a call. What we need to be able to do is price a put or a call without the other
instrument. In this section, we introduce a simple means of pricing an option. It may appear
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that we oversimplify the situation, but we shall remove the simplifying assumptions gradually,
and eventually reach a more realistic scenario.
Binomial Model
The word "binomial" refers to the fact that there are only two outcomes. In other words, we let
the underlying price move to only one of two possible new prices. As noted, this framework
oversimplifies things, but the model can eventually be extended to encompass all possible
prices. In addition, we refer to the structure of this model as discrete time, which means that
time moves in distinct increments. This is much like looking at a calendar and observing only
the months, weeks, or days. Even at its smallest interval, we know that time moves forward at
a rate faster than one day at a time. It moves in hours, minutes, seconds, and even fractions of
seconds, and fractions of fractions of seconds. When we talk about time moving in the tiniest
increments, we are talking about continuous time. We will see that the discrete time model
can be extended to become a continuous time model.
Two models:
1. Discrete model
Discrete model can be a. single period binomial model
b. Two period binomial model
2. Continuous model.
Continuous model can be a. Black-Schole Model
b. Merton Model
Some basic calculations, signs & formulas and model:
We start with a call option. If the underlying goes up to S+, the call option will be worth c+.
If the underlying goes down to S¯, the option will be worth C¯. We know that if the option
is expiring, its value will be the intrinsic value.
S0 = Spot price S+ = price goes up. S¯ = price goes down X= exercise price
S+ = Su = S0(1+u) where u is upward movement in price
S¯ = Sd = S0(1-d) where d is downward movement in price
C+ = Max(0, S+ - X) Maximum of 0 or S+ - X
C¯ = Max(0, S¯ - X) Maximum of 0 or S¯ - X
𝜋 𝐶 + + 1−π 𝐶 −
Value of call option = 𝐶=
1+r
1+𝑟−𝑑
Where as:- π = probability and is calculated by: 𝜋=
u−d
Calculate no. of underlying to be purchased or sold against one unit of option.
𝐶 +− 𝐶 −
It is, 𝑛=
𝑆 +− 𝑆 −
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Hedge Ratio: (net amount required to be invested)
H = nS – C (initial outlay)
H+ = nS+ – C+ (outlay one period later if price goes up)
H¯= nS¯ – C¯ (outlay one period later if price goes down)
Following diagram illustrates this scenario, commonly known as a binomial tree.
S+ = S0(1+u)
π C+ = Max(0, S+ - X)
S0
C=? S¯ = S0(1-d)
1-π C¯ = Max(0, S¯ - X)
The call price today is C, which is weighted average of the next two possible call prices, C+
and C+. The weights are π and 1-π. This weighted average is then discounted one period at the
risk free rate.
Example 23: (One period binomial)
Suppose the underlying is a non-dividend-paying stock currently valued at $50. It can either
go up by 25 percent or go down by 20 percent. Thus, u = 1.25 and d = 0.80.
S+ = Su = 50(1.25) = 62.50
S¯ = Sd = 50(0.80) = 40
Assume that the call option has an exercise price of 50 and the risk-free rate is 7 percent.
Thus, the option values one period later will be:
Option values at expiration:

C+ = Max(0, S+ - X) = Max(0, 62.50 - 50) = 12.50
C¯ = Max(0, S¯ - X) = Max(0, 4O - 50) = 0
S+ = 50(1.25) = 62.50
π C+ = Max(0, 62.50 - 50) = 12.50
S0 = 50
C=? S¯ = 50(0.80) = 40
1-π C¯ = Max(0, 4O - 50) = 0
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a. What is the value of call option?
𝜋 𝐶 + + 1−π 𝐶 −
1+r
1+𝑟−𝑑 1+.07−.80
First we calculate π 𝜋= = = 0.60
u−d 1.25−.80
.60 12.5 +.40(0)

𝐶= = 7.01 (Fair price of call option premium)
1+.07
ARBITRAGE OPPORTUNITY:
Suppose the option is selling for $8. If the option should be selling for $7.01 and it is selling
for $8, it is overpriced-a clear case of price not equaling value. Investors would exploit this
opportunity by selling the option and buying the underlying. The number of units of the
underlying purchased for each option sold would be the value n:
𝐶 +− 𝐶 − 12.5−0
𝑛= = = 0.556
𝑆 +− 𝑆 − 62.5−40
Thus, for every option sold, we would buy 0.556 units of the underlying. Suppose we sell
1,000 calls and buy 556 units of the underlying. Doing so would require an initial outlay of :-
H = nS – C = 556(50) - 1,000(8) = $19,800.

One period later, the portfolio value will be either
H+ = nS+ – C+ = 556(62.5) - 1,000(12.5) = $22,250. OR
H¯= nS¯ – C = 556(40) - 1,000(0) = $22,240.
These two values are not exactly the same, but the difference is due only to rounding the
hedge ratio, n. We shall use the $22,250 value. If we invest $19,800 and end up with $22,250,
the return is:-
22,250
g= − 1 = 0.1237 = 12.37%
19,800
The arbitrage will give 12.37% risk free which is better to risk free of 7%.
Example 24: (One period binomial)
Consider a one-period binomial model in which the underlying is at 65 and can go up 30

percent or down 22 percent. The risk-free rate is 8 percent.
A. Determine the price of a European call option with exercise prices of 70.
B. Assume that the call is selling for 9 in the market. Demonstrate how to execute an arbitrage
transaction and calculate the rate of return. Use 10,000 call options.
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Solution:
First find underlying prices in the binomial tree. We have u = 1.30 and d = 1 - 0.22 =0.78.
S+ = Su = 65(1.30) = 84.50
S¯ = Sd = 65(0.78) = 50.70
Option values at expiration:

C+ = Max(0, S+ - X) = Max(0, 84.50 - 70) = 14.50
C¯ = Max(0, S¯ - X) = Max(0, 50.70 - 70) = 0
The risk-neutral probability is π

1+𝑟−𝑑 1+.08−.78
𝜋= = = 0.5769
u−d 1.30−.78
𝜋 𝐶 + + 1−π 𝐶 −
1+r
.5769 14.5 +.4231(0)

𝐶= = 7.75 (Fair price of call option premium)
1+.08
ARBITRAGE OPPORTUNITY:
Suppose the option is selling for $9. If the option should be selling for $7.75 and it is selling
for $9, it is overpriced-a clear case of price not equaling value. The number of units of the
underlying purchased for each option sold would be the value n:
𝐶 +− 𝐶 − 14.5−0
𝑛= = = 0.4290
𝑆 +− 𝑆 − 84.5−50.70
Thus, for every option sold, we would buy 0.4290 units of the underlying. Suppose we sell
10,000 calls and buy 4290 units of the underlying. Doing so would require an initial outlay of:
n= 10,000 x .4290 = 4290 options
H = nS – C = 4290(65) - 10,000(9) = $188,850.

One period later, the portfolio value will be either
H+ = nS+ – C+ = 4290(84.5) - 10,000(14.5) = $217,505. OR
H¯= nS¯ – C = 4290(50.70) - 10,000(0) = $217,503.
These two values are not exactly the same, but the difference is due only to rounding the
hedge ratio, n. We shall use the $217,505 value. If we invest $188,850 and end up with
$217,505, the return is:-
217,505
g= − 1 = 0.1517 = 15.17%
188,850
The arbitrage will give 15.17% risk free which is better to risk free of 8%.
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Valuation of options: (Two period binomial model)
S+ +
C+ +
S+
π C+ S+ ¯
C+ ¯
S0 S¯ +
C=? C¯+
1-π S¯
C¯ S¯ ¯
C¯ ¯
S0 = spot price current price of the underlying

S+ = Su = S0(1+u) where u is upward movement in price
S¯ = Sd = S0(1-d) where d is downward movement in price
C+ = Max(0, S+ - X) Maximum of 0 or S+ - X
C¯ = Max(0, S¯ - X) Maximum of 0 or S¯ - X
S+ + = S+u = Suu = Su2 = S0(1+u)2
S+ ¯ = S+d = Sud = S0(1+u) (1-d)
S¯ + = S¯u = Sdu = S0(1+u) (1-d)
S¯ ¯ = S¯d = sdd = Sd2 = S0(1-d)2
C+ + = Max(0, S+ + - X)
C+ ¯ = Max(0, S+ ¯ - X)
C¯ ¯ = Max(0, S¯ ¯ - X)
1+𝑟−𝑑
𝜋=
u−d
(value of call option)
𝜋 𝐶 ++ + 1−π 𝐶 +−
𝐶+ =
1+r
𝜋 𝐶 −+ + 1−π 𝐶 −−
𝐶− =
1+r
𝜋 𝐶 + + 1−π 𝐶 −
𝐶=
1+r
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Number of units of underlying for each unit of option.
𝐶 +− 𝐶 −
𝑛=
𝑆 +− 𝑆 −
𝐶 ++ − 𝐶 +−
𝑛+ =
𝑆 ++ − 𝑆 +−
𝐶−+ − 𝐶 −−
𝑛− =
𝑆 −+ − 𝑆 −−
Example 25: (Two period binomial)

Consider a two-period binomial model in which the underlying is at 30 and can go up 14
percent or down 11 percent each period. The risk-free rate is 3 percent per period.
A. Find the value of a European call option expiring in two periods with an exercise price of
30.
B. Find the number of units of the underlying that would be required at each point in the
binomial tree to construct a risk-free hedge using 10,000 calls.
SOLUTION:
First find underlying prices in the binomial tree: We have u = 1.14 and d =1- 0.1 1 = 0.89.
S+ = Su = S0(1+u) = 30(1.14) = 34.20
S¯ = Sd = S0(1-d) = 30(0.89) = 26.70
S+ + = Su2 = S0(1+u)2 = 30(1.14)2= 38.99
S¯ ¯ = Sd2 = S0(1-d)2 = 30(0.89) 2= 23.76
S+¯ = Sud = 30(1.14)(0.89) = 30.44
Option prices at expiration:

C+ + = Max(0, S+ + - X) = Max(0, 38.99- 30) = 8.99
C+ ¯ = Max(0, S+ ¯ - X) = Max(0, 30.44 - 30) = 0.44
C¯ ¯ = Max(0, S¯ ¯ - X) = Max(0, 23.76 - 30) = 0
We will need the value of 𝝅:

1+𝑟−𝑑 1+.03−0.89
𝜋= 𝜋= = 0.56
u−d 1.14−0.89
1-π = 1 - 0.56 = 0.44
Value of call option:
𝜋 𝐶 ++ + 1−π 𝐶 +− 0.56(8.99)+ 0.44 0.44

𝐶+ = 𝐶+ = = 5.08 (value if price goes up)
1+r 1.03
𝜋 𝐶 −+ + 1−π 𝐶 −− 0.56(0.44)+ 0.44 0

𝐶− = 𝐶− = = 0.24 (value if price goes down)
1+r 1.03
99

𝜋 𝐶 + + 1−π 𝐶 − 0.56(5.08)+ 0.44 0.24
𝐶= 𝐶= = 2.86 ( value of option today)
1+r 1.03
HINT: value of 𝐶 + and 𝐶 − used for calculation of C are taken from above formula calculation
Where 𝐶 + = 5.08 and 𝐶 − = 0.24
Number of units of underlying for each unit of option.
𝐶 +− 𝐶 − 5.08−0.24
𝑛= 𝑛= = 0.6453 (no. of units at spot price)
𝑆 +− 𝑆 − 34.20−26.70
𝐶 ++ − 𝐶 +− 8.99−0.44
𝑛+ = 𝑛+ = = 1.00 (when price goes up)
𝑆 ++ − 𝑆 +− 38.99−30.44
𝐶−+ − 𝐶 −− 0.44−0
𝑛− = 𝑛− = = 0.0659 (when price goes down)
𝑆 −+ − 𝑆 −− 30.44−23.76
The number of units of the underlying required for 10,000 calls would thus be 6,453 today,
10,000 at time 1 if the underlying is at 34.20, and 659 at time 1 if the underlying is at 26.70.
Putting the values in the tree:
S+ + = 39.98
C+ + = 8.99
S+ = 34.20
π = 0.56 C+ = 5.08 S+ ¯ = 30.44 or S¯ +
C+ ¯ = 0.44 or C¯+
S0 = 30 S¯ + = 30.44
C = 2.86 C¯+ = 0.44
1-π =0.44 S¯ = 26.70
C¯ = 0.24 S¯ ¯ = 23.76
C¯ ¯ = 0
THE BLACK-SCHOLES-MERTON MODEL

BLACK-SCHOLES-MERTON MODEL or Continuous model can be divided in two
categories.
a. Black-Schole Model b. Merton Model
When we move to a continuous-time world, we price options using the famous Black-Scholes-
Merton model. Named after its founders Fischer Black, Myron Schole: and Robert Merton.
The model can be derived either as the continuous limit of the binomial model, or through
taking expectations, or through a variety of highly complex mathematical procedures.
100

Black-Schole Model gives a closed-form solution for the price of a European option on a non-
dividend stock while Merton model provides a solution for the price of a European option on a
stock paying a continuous dividend.
ASSUMPTIONS OF THE MODEL:

1. The underlying price follows a log normal diffusion process.
This assumption is probably the most difficult to understand, but in simple terms, the
underlying price follows a lognormal probability distribution as it evolves through time
Log returns are often called continuously compounded returns. If the log or continuously
compounded return follows the familiar normal or bell-shaped distribution, the return is said to
be log normally distributed.
2. The risk free rate is known and constant.

The Black-Scholes-Merton model does not allow interest rates to be random. Generally, we
assume that the risk-free rate is constant. This assumption becomes a problem for pricing
options on bonds and interest rates, and we will have to make some adjustments then.
3. The volatility of the underlying is known and constant.

The volatility of the underlying asset, specified in the form of the standard deviation of the log
return, is assumed to be known at all times and does not change over the life of the option.
This assumption is the most critical. In reality, the volatility is definitely not known and must
be estimated or obtained from some other source. In addition, volatility is generally not
constant. Obviously, the stock market is more volatile at some times than at others.
Nonetheless, the assumption is critical for this model.
4. There are no taxes and transaction cost.

We have made this assumption all along in pricing all types of derivatives. Taxes and
transaction costs greatly complicate our models and keep us from seeing the essential financial
principles involved in the models. It is possible to relax this assumption, but we shall not do so
here.
5. There no cash flows on the underlying.

There are no any cash flows like dividend on the securities during the period.
6. The options are European.
With only a few very advanced variations, the Black-Scholes-Merton model does not price
American options. Users of the model must keep this in mind, or they may badly misprice
these options.
Black-Scholes-Merton formula:
The input variables are some of those we have already used: So is the price of the underlying,
X is the exercise price, rC is the continuously compounded risk-free rate, (that is ln of r) and T
is the time to expiration. The one other variable we need is the standard deviation of the log
return on the asset. We denote this as σ and refer to it as the volatility.
HINT: r is always used after calculating natural log of r. that is , rc = ln(1+r)

101

Black-Scholes-Merton formulas for the prices of call and put options are:-
-rT
Call option value, C= S0 N(d1) – Xe N(d2)
rT
Put option value, P = Xe- 1 − N(d2) S0 1 − N(d1)
After simplifying formula for put option is:
rT
P = Xe- − S0 + C
So σ2
𝑙𝑛 + r+ T
x 2
𝑑1 =
σ √T
d2 = d1 – σ √T
N(d1) = Value of d1 from normal distribution table.

N(d2) = Value of d2 from normal distribution table.
Put-Call Parity.
In financial mathematics, put–call parity defines a relationship between the price of
a European call option and European put option, both with the identical strike price and
expiry, namely that a portfolio of a long call option and a short put option is equivalent to (and
hence has the same value as) a single forward contract at this strike price and expiry.
In simple when we calculate the price of put option through price of call option, it is called
put-call parity.
NORMAL DISTRIBUTION:
102

103

Example 26: (Black-Scholes-Merton Model)
Use the Black-Scholes-Merton model to calculate the prices of European call and put options
on an asset priced at 52.75. The exercise price is 50, the continuously compounded risk-free
rate is 4.88 percent, the options expire in 9 months, and the volatility is 0.35. There are no cash
flows on the underlying.
Solution:
S0 = 52.75 σ = 0.35 σ2 = 0.1225 T = 9/12 = 0.75 √T = 0.87 rc =0.0488
-rT
rT
First calculate d1 and d2.

So σ2 52.75 .1225
𝑙𝑛 + r+ T 𝑙𝑛 + 0.0488+ .75
x 2 50 2
𝑑1 = 𝑑1 = = 0.4489 = 0.45
σ √T .35 (0.87)
d2 = d1 – σ √T d2 = 0.45 – 0.35 (0.87) = 0.1455 = 0.15
N(d1) = Value of d1, 0.45 from normal distribution table. = 0.6736

N(d2) = Value of d2, 0.15from normal distribution table. = 0.5596
-(.0488)(.75)
Call option value, C= 52.75(.6736) -50 e .5596
C = 35.50 – 48.20 (.5596) = 8.53
rT
Put option value, P = Xe- 1 − N(d2) S0 + C
-(.0488)(.75)
P = 50 e 1 − 0.5596) 52.75+8.53
P = 48.2 – 52.75 + 8.53 = 3.98
Merton Model:
Merton added the concept of interim cash flows. He said that we can calculate the value
of option even if there are some cash flows involved. E.g. dividends. The only difference
between Black-Schole and Merton is the calculation of So. For Merton model So is denoted as
So/ and is calculated by:-
-rT
So/ = So e = whereas r is the rate of dividend on stock.
Example 27:
So = 100 T = 180/365 Dividend rate = 8%
-rT
So/ = So e = 100 e-(.08)(180/365) = 103.98
The formula will be same as Black-Schole model. Only change is, we use value
of So/ instead of So.
104

OPTION SENSITIVITIES
Determinants of option price / factors influencing option price.
Following are the five factors or inputs of Black-Schole-Merton Model, that influence the
price of options to change.
1. The underlying price. (Delta & Gamma)

2. The exercise price.
3. The risk free ratio. (RHO)
4. Time to expiration. (Theta)
5. Volatility. (Vega).
Now, we explore, what is the response of option price to these factors that determine the price.
This is called ―sensitivity of option prices to these factors‖.
The option price sensitivities all derive from calculus. For example, the sensitivity of
the option price with respect to the stock price is simply the first derivative of the option
pricing formula with respect to the stock price. The first derivative of the call price with
respect to the stock price is just the change in the call price for a change in the stock price.
∆C / ∆S
These sensitivities are calculated through Greeks.
GREEKS
In mathematical finance, the Greeks are the quantities representing the sensitivity of the price
of derivatives such as options to a change in underlying parameters on which the value of an
instrument or portfolio of financial instruments is dependent. The name is used because the
most common of these sensitivities are denoted by Greek letters (as are some other finance
measures). Collectively these have also been called the risk sensitivities, risk measures
or hedge parameters.
USE OF THE GREEKS

The Greeks are vital tools in risk management. Each Greek measures the sensitivity of the
value of a portfolio to a small change in a given underlying parameter, so that component risks
may be treated in isolation, and the portfolio rebalanced accordingly to achieve a desired
exposure; see for example delta hedging.
The Greeks in the Black–Scholes model are relatively easy to calculate, a desirable property
of financial models, and are very useful for derivatives traders, especially those who seek to
hedge their portfolios from adverse changes in market conditions. For this reason, those
Greeks which are particularly useful for hedging--such as delta, theta, and vega--are well-
defined for measuring changes in Price, Time and Volatility. Although rho is a primary input
into the Black–Scholes model, the overall impact on the value of an option corresponding to
changes in the risk-free interest rate is generally insignificant and therefore higher-order
derivatives involving the risk-free interest rate are not common.
105

1. Delta ∆
Change in option premium due to change in spot price is called ―Delta‖ ∆.

HINT: ∂ is used for partial change. It is a sign of partial derivative.
Change in Call option ∂C

Delta = ∆= = N (d1)
change in Spot price ∂ So
2. Theta θ
Change in option premium due to change in time to expiration is called ―Theta‖ θ
Change in Call option ∂C −S0 Nˊ(d1)σ

Theta = θ = = - r x e-rT N(d2)
change in time to maturity ∂T 2√ T
3. Vega ɣ
Change in option premium due to change in risk or volatility is called ―Vega‖ ɣ

Vega = ɣ = = S0√T Nˊ(d1)
change in risk ∂σ
4. Rho δ
Change in option premium due to change in risk free rate is called ―Rho‖ δ

Rho = δ = = x T e-rT N(d2)
change in risk free rate ∂r
5. Gamma γ
Change in option premium due to change in Delta is called ―Gamma‖ γ
Change in Delta ∂∆ Nˊ(d1)

Gamma = γ = =
change in spot price ∂ So So σ √ T
Whereas:-
1 2
Nˊ(d1) = e-0.5 (d1)
√2π
and the value of π is 22/7 or 3.142
Effect of sensitivities on call and put option premiums
DIRECTOIN CALL OPTOIN PUT OPTION

Increase in spot price Increase Decrease
Increase in exercise price Decrease Increase
Increase in risk free rate Increase Decrease
Decrease / passing time to expiry Decrease Increase
Increase in volatility Increase decrease
106

Example 28:
Suppose spot price for an underlying is 100, exercise price is 100, compounded risk free is
8%, volatility is 30% and time is 180 days. Calculate all the sensitivities.
Solution:
S0 = 100 σ = 0.30 σ2 = 0.09 T = 180/365 = 0.493 √T = 0.70 rc =0.08
-(.08)(.5) rT
e = 0.9608 Xe- = 100e-(.08)(.5) = 96.08
-rT
rT

So σ2 100 .09
𝑙𝑛 + r+ T 𝑙𝑛 + 0.08+ .493
x 2 100 2
𝑑1 = 𝑑1 = = 0.29
σ √T .30 (0.70)
d2 = d1 – σ √T d2 = 0.29 – 0.30 (0.70) = 0.08

Call option value, C= 100(.6141) – 96.08 (.5319) =

C = 61.41 – 51.10 = 10.31
rT
Put option value, P = Xe- − S0 + C
P = 96.08 – 100 + 10.31 = 6.39
HINT: Sometimes the value of d1 may be negative. In this case the calculation will be done
using this formula. Suppose in above case delta is -.29
N(-d) or 1 –N(d) where N(d) = .6141 and 1 – .6141 = .3859 now d1 = 0.39
Sensitivity measures:
1. Delta ∆
∂C
∆= = N (d1) = .6141
∂ So
2. Theta θ
∂C −S0 Nˊ(d1)σ
θ = = - r x e-rT N(d2)
∂T 2√ T
Whereas:-
107

1 -0.5 (0.29)2 1
Nˊ(d1) = e = (.9588) = 0.40(0.9588) = 0.3835
√2(3.142) 2.50
−100 .3836 (.30)

= - .08(96.08)(.5319) = -8.14 – 4.08 = -12.22
2 √0.5
3. Vega ɣ
∂C
ɣ = = S0√T Nˊ(d1) = 100(.70)(.3835) = 26.85
∂σ
4. Rho δ
∂C
δ = = x T e-rT N(d2) = 100(.50)(.96)(.5319) = 25.53
∂r
5. Gamma γ
∂∆ Nˊ(d1) .3836
γ = = = = .018
∂ So So σ √ T 100 .30 (.70)
Changes in values.
Call option is 10.31 and the spot price is 100. Calculate the changes.
1. Change in delta due to change in spot price. (Delta through Gamma) = .6141
New price is 101, old was 100.
New ∆ = .6141 + .018 = .6321
New C = 10.31 + . 6141 = 10.92

2. Change in call option premium due to change in expiry. (Theta) = -12.22
It is 37 days from start of period, t=180 = 37/365 = 0.1014
New C = 10.31 + .1014(-12.22) = 9.07
3. Change in call option premium due to change in risk / volatility. (Vega) = 26.85
σ increase by 1%, from 0.3 to 0.4 ,
New C = 10.31 + .1(26.85) = 12.98
(call premium increases due to increase in risk)
4. Change in call option premium due to change in risk free rate (Rho). = 25.50
Risk free increases by 1%.
New C = 10.31 + .01(25.50) = 10.55
108

EXAMPLE 29: Assignment No. 3
Schlumberger Limited (SLB)

Monthly data for the period of 2014-2015
MONTH PRICE
April-15 99.74 R
May-15 102.2 0.024
June-15 116.3 0.129 S.D. 0.0786
July-15 106.9 -0.085 Annualized S.D. 0.2722
August-15 108.5 0.015 σ2 0.741
September-15 100.6 -0.075 r 0.08
October-15 97.63 -0.03 ln(1+r) 0.077
November-15 85.05 -0.138 So 94.61
December-15 84.91 -0.002 X 104.07
January-15 81.91 -0.036 T 180/365
February-15 84.16 0.027 T 0.5
March-15 83.44 -0.009 √T 0.71
April-15 94.61 0.126
Solution:
S0 = 94.61 σ = 0.27 σ2 = 0.741 T = 180/360 = 0.5 √T = 0.71 rc =0.077
-(.077)(.50) rT
X = So + 10% = 104.07 e = .9622 Xe- = 104.07e-(.077)(.50) = 100.14
-rT
rT
rT
OR P = Xe- − S0 + C
94.61 .741
𝑙𝑛
So
+ r+
σ2
T 𝑙𝑛 104 .07 + 0.077+ 2 .50
𝒅𝟏 = x 2
𝑑1 = =
σ √T .27 (0.71)
−0.095+ .4475 (.50) 0.1288

𝑑1 = = 𝑑1 = = 0.67
.27 (0.71) 0.1917
d2 = d1 – σ √T d2 = 0.67 – 0.27 (0.71) = 0.48

109

Call option value,
-rT
C= S0 N(d1) – Xe N(d2)
C= 94.61(.7486) – 100.14 (.6844) =
C = 70.82 – 68.53 = 2.28
rT
Put option value, P = Xe- − S0 + C
P = 100.14 – 94.61 + 2.28 = 7.81
Sensitivity measures:
1. Delta ∆
∂C
∆= = N (d1) = 0.7486
∂ So
2. Theta θ
∂C −S0 Nˊ(d1)σ
θ = = - r xe-rT N(d2)
∂T 2√ T
Whereas:-
1 2
Nˊ(d1) = e-0.5 (d1)
√2π
1 -0.5 (0.67)2 1
Nˊ(d1) = e = (.7153)
√2(3.142) 2.50
Nˊ(d1) = 0.40(0.7153) = 0.2861
−94.61 .2861 (.27)

θ= - .077(100.14)(.6844)
2√0.50
−7.30
θ= - .077(100.14)(.6844) = - 5.14 – 5.27 = -10.42
1.42
3. Vega ɣ
∂C
ɣ = = S0√T Nˊ(d1) = 94.61(.71)(.2861) = 19.22
∂σ
4. Rho δ
∂C
δ = = x T e-rT N(d2) = 100.14(.50)(.96)(.6844) = 32.90
∂r
5. Gamma γ
∂∆ Nˊ(d1) .2861
γ = = = = .016
∂ So So σ √ T 94.61 .27 (.71)
110

Changes in values
Call option is 2.28 and the spot price is 94.61. Calculate the changes.
1. Change in delta when spot price increase by Re.1.
Delta = .7486 New price is 95.61, old was 94.61.
New ∆ = ∆+γ
New ∆ = .7486 + .016 = 0.7646
New C = 2.28 + 0.7486 = 3.03
2. Change in call option premium after 60 days.

(Theta) = -10.42
It is 60th day from start of period, t=180 = 60/360 = 0.1667
New C = 2.28 + .1667(-10.42) = 0.543
3. Change in call option premium when risk increase by 10%

(Vega) = 19.22
σ increase by 10%, from 0.27 to 0.30 ,
New C = 2.28 + .10(19.22) = 4.20
(call premium increases due to increase in risk)
4. Change in call option premium when risk free rate increases by 2%.
(Rho). = 32.90
Risk free increases by 2%.
New C = 2.28 + .02(32.90) = 2.94
Value At Risk – VaR

A statistical technique used to measure and quantify the level of financial risk within a firm or
investment portfolio over a specific time frame. Value at risk is used by risk managers in order
to measure and control the level of risk which the firm undertakes. The risk manager's job is to
ensure that risks are not taken beyond the level at which the firm can absorb the losses of a
probable worst outcome. The VaR is measured either at 95% confidence level or at 99%
confidence level.
Value at Risk is measured in three variables:

The amount of potential loss, the probability of that amount of loss, and the time frame.
For example, a financial firm may determine that it has a 5% one month value at risk of $100
million. This means that;
111

a. There is a 5% chance that the firm could lose more than $1000 million in any given
month.
b. There is a 95% chance that in any given month the firm will not suffer a loss of $1000.
Suppose $1000 represents 12% chance of a loss, we say that;
a. There is a 5% chance that the loss will exceed 12%.
b. There is a 95% chance the loss will not exceed 12%.
Methods for computing the VaR.

Calculating VaR is a simple matter but requires assuming that asset returns conform to
a standard normal distribution. Recall that a standard normal distribution is defined by two
parameters, its mean (μ=0) and standard deviation (σ=1), and is perfectly symmetric with 50%
of the distribution lying to the right of the mean and 50% lying to the left of the mean. The z-
score may be measured at any one of two confidence levels. i.e. 95% or 99%. The z-score at
these two levels are:-
z-score at 95% confidence level is 1.65
z-score at 99% confidence level is 2.31
There are three methods to measure the VaR.

1. Historical method
2. Monte Carlo Method.
3. Variance, covariance method / parametric method.
1. Historical method
The fundamental assumption of the Historical Simulations methodology is that you base your
results on the past performance of your portfolio and make the assumption that the past is a
good indicator of the near-future. The data should be for last 200 to 500 days.
For example, we take the data for last 240 days. Our confidence level is 95%. We compute it
is as under:
Steps:
a. Pick the data for last 240 days.
b. Arrange the data in descending order.
c. Take 5% of 240, 240 x 5% = 12
d. Now see the 12th value from bottom. (in the return column)
Suppose the 12th value from bottom is -.17. It means that there is a 5% chance that the loss will
be more than 17% in a day.
2. Monte Carlo Method.

Monte Carlo Simulations correspond to an algorithm that generates random numbers that are
used to compute a formula that does not have a closed (analytical) form – this means that we
need to proceed to some trial and error in picking up random numbers/events and assess what
the formula yields to approximate the solution. Drawing random numbers over a large number
of times (a few hundred to a few million depending on the problem at stake) will give a good
indication of what the output of the formula should be.
The only difference from historical simulation is to use the random numbers instead of
continuous series of returns.
112

3. Variance, covariance method / parametric method.
Calculating VaR on percentage basis and VaR on dollar basis:
VaR on percentage basis.
In order to calculate VaR on %age basis, we would use a critical z-value of -1.65 and multiply
by the standard deviation of percent returns. The resulting VaR estimate would be the
percentage loss in asset value that would only be exceeded 5% of the time.
Formula: VaR(%) = - zσ (where value of z at 5% is 1.65 and at 1% is 2.31)
VaR on dollar basis.

VaR can also be estimated on a dollar rather than a percentage basis. To calculate we simply
multiply the percent VaR by the asset value. It is interpreted as; the dollar loss in asset value
that will only be exceeded 5% of the time.
Formula: VaR($) = - zσ (p) (where p is the value of asset / portfolio)
Example 30:
Calculating percentage and dollar VaR.
A risk management officer at a bank is interested in calculating the VaR of an asset that
he is considering adding to the bank‘s portfolio. If the asset has a daily standard deviation of
returns equal to 1.4% and the asset has a current value of $5.3 million . calculate the VaR (5%)
on both a percentage and dollar basis.
Solution:
σ = 1.4% p= 5.3 million
VaR(%) = - zσ = -1.65(.014) = -.0231 = -2.31%
VaR($) = - zσ (p) = -1.65(.014)(5.3) = -.0122430
Thus, there is a 5% chance that, on a given day, the loss in the value of asset will exceed from
2.31% or $122,430.
Time Conversion of VaR
VaR, as calculated above measures the risk of a loss over a period of one day. We can
calculate it for longer periods such as a week, month, quarter or year. It can be converted
simply by multiplying the daily VaR to the required period.
HINT: (always consider 5 days in a week, 20 days in a month and 240 days in a year)
To calculate multiply the daily value with √n
Example 31:
VaR(5%)daily = - zσ = -1.65(.014) = -.0231
VaR(5%)weekly = VaR(5%)daily √n = -.0231 x √5 = -.052
VaR(5%)month = VaR(5%)daily √n = -.0231 x √20 = -.10
VaR(5%)quarter = VaR(5%)daily √n = -.0231 x √60 = -.18

113

VaR(5%)year = VaR(5%)daily √n = -.0231 x √240 = -.358
Or we can calculate it from monthly or quarterly values of VaR.
VaR(5%)quarter = VaR(5%)monthly √n = -.10 x √3 = -.18
VaR(5%)year = VaR(5%)monthly √n = -.10 x √3 = -.358
HINT: in the same way VaR($) can be calculated by simply multiplying the value of VaR%
to asset value.
Assumptions of VaR
1. Stationarity
Stationary assumes that the probability of experiencing a fluctuation is the same in all
periods. It also assumes that mean and variance do not change over the time.
Stationarity can be defined in precise mathematical terms, but here, we mean a flat
looking series, without trend, constant variance over time, a constant autocorrelation
structure over time and no periodic fluctuation.
2. Random walk
It means, a deviation in one period I independent form a deviation in another period.
Price follow a random behavior.
3. Non-negativity
Limited liability asset values are never negative. This assumption is violated by
derivatives such as futures, forwards and swaps, which can have negative value.
4. Time consistency
All assumptions that apply in one period also apply in a multiple-period scenario. The
assumptions for a 1-day period and a 1-week period are same.
5. Normal distribution
One period fluctuation in return is assumed to be normally distributed with a mean of
zero and standard deviation of one.
Continuously Compounded Rates of Returns

Normally, we calculate VaR on daily basis. A risk manager may be interested in
calculating VaR on a multi-period basis by extending the daily VaR using the square root rule.
In doing so, however, it is important that the distributional assumptions of the single-period
VaR are preserved after transforming the measure into a multiple-period VaR. using
continuously compounded rates of return allows the preservation of the single-period
assumptions. We calculate compounded returns by natural log of returns.
Rt = ln(Pt / Pt-1)
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Thus, it preserves the assumption that VaR is normally distributed no matter what time period
is used. In addition, continuously compounded returns also preserve the assumptions of
Stationarity and time consistency.
Exception: although it is generally preferable to use continuously compounded rates
of return to calculate VaR, there is one exception. For interest rate related variables (i.e. yield
to maturity, credit spread etc), compounded rates are inappropriate since the focus is on the
absolute yield change in basis points. In this situation, VaR must be adjusted to account for
duration and convexity.
Portfolio VaR
Portfolio risk, as measured by standard deviation, decreases as the correlation among assets
within the portfolio decreases. In a similar manner, VaR is affected by the diversification
effect that assets with low correlation bring to the portfolio. For a two-asset portfolio, VaR(%)
is calculated as follows:
VaR(%)portfolio = - z σp =
VaR($)portfolio = - z σp(a,b) = (a,b, is the value of portfolio assets)
Whereas:-
𝜎𝑝 = ω1²σ1² + ω2²σ2² + 2ω1 ω2 σ1σ2 r1,2
or σp2 = ω1²σ1² + ω2²σ2² + 2ω1 ω2 σ1σ2 r1,2
Example 32:
A fund manager manages a portfolio of two investments: A and B. Of the portfolio‘s current
value of $6 million, A make up 4 million and B, 2 million. The standard deviation for A is .06
and for B 0.14. Correlation (r1,2) is -0.5. Calculate the VaR for this portfolio.
Solution:
A = 4 m B= 2 m σ1 = 0.06 σ2 = 0.14 ω1 = 4/6 = 0.67 ω2 = 2/6 = 0.33 r1,2 = -.5
VaR(%)portfolio = - z σp and VaR($)portfolio = - z σp(a,b)
𝜎𝑝 = ω1²σ1² + ω2²σ2² + 2ω1 ω2 σ1σ2 r1,2
𝜎𝑝 = . 67 2 . 06 2 + . 33 2 (.14)² + 2(.67)(.33)(.06)(.14)(−.5) = .044
VaR(%)portfolio = - z σp = -1.65(.044) = .0726
VaR($)portfolio = - z σp(a,b) = -1.659.044(6) = 0.43 million
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Factors affecting the portfolio VaR
There are four primary factors that affect the risk of a portfolio. These factors
Include asset concentration, asset volatility, asset correlation and systematic risk.
1. Asset concentration: Asset concentration means weight of a particular asset in portfolio.
As the portfolio becomes heavily weighted towards one asset, portfolio risk increases.
2. Asset volatility: As the variance of assets within the portfolio increases, portfolio risk
increases.
3. Asset correlation: As the asset correlation between assets increases towards +1,
portfolio risk increases.
4. Systematic risk: As the number of assets within the portfolio becomes large,
systematic becomes the more relevant factor for assessing additional assets.
Individual VaR
Individual VaR is the VaR of an individual position in isolation. Let the position weight be ωi,
the portfolio vale be P, the position volatility be σi, then the individual VaR is;
VaR = -zσi ǀωiǀ p
We use the absolute value of the weight because both long and short positions pose risk.
Example:
VaR1 = 2.4, VaR2 = 1.6, what is VaR when r1,2 is 0 ?
Solution:
𝑉𝑎𝑅𝑝 = Var² + VaR2² = 2.4 2 + (1.6)² = 8.32
VaR, when assets are uncorrelated, positively correlated or negatively correlated.

1. No correlation r1,2 = 0
𝑉𝑎𝑅𝑝 = Var² + VaR2² or
(𝑉𝑎𝑅𝑝)² = W1²(Var1)² + W2²(Var2)²
2. Positively correlated r1,2 = + 1
𝑉𝑎𝑅𝑝 = W1(Var1) + W2(Var2)
3. Negatively correlated r1,2 = - 1
𝑉𝑎𝑅𝑝 = W1 Var1 + W2 Var2
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VaR for portfolio with more than two assets (n, number of assets)
a. Equally weighted;
1 1
𝑉𝑎𝑅𝑝 = 𝜎 + 1− r
N N
Whereas N= no. of assets in portfolio.

It has three assumptions.
1. Equal investment in all assets.
2. Same risk for each asset class.
3. Same correlation.
b. Unequal weights;
𝜎11 𝜎12 𝜎13 𝜔1
𝜔1 𝜔2 𝜔3 𝜎21 𝜎22 𝜎23 𝜔2
𝜎31 𝜎32 𝜎33 𝜔3
This should be done through Excel.
Marginal VaR
Marginal VaR is the change in a portfolio VaR that occurs from an additional one dollar
investment in a give position.
∂VaR −z Cov (Ri ,Rp )
𝑀𝑉𝑎𝑅𝑝 = or
∂P σP
Incremental VaR
Incremental VaR is the change in VaR from the addition of a new position in a portfolio. It can
be calculated precisely from a total revaluation of the portfolio.
Component VaR
Component VaR for position I, denoted CVaRi is the amount a portfolio VaR would change
from deleting that position in a portfolio. In a large portfolio with many positions, the
approximation is simply the marginal VaR multiplied by the dollar weight in position.
CVaRi = MVaRi (ωi x p)
Credit risk
Credit risk refers to the risk that a borrower will default on any type of debt by failing to
make required payments.[1] The risk is primarily that of the lender and includes
lost principal and interest, disruption to cash flows, and increased collection costs. The loss
may be complete or partial and can arise in a number of circumstances. For example:
 Bond. A business or government bond issuer does not make a payment on a coupon or
principal payment when due
 Loan. A consumer may fail to make a payment due on a mortgage loan, credit
card, line of credit, or other loan
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 Firm. A company is unable to repay asset-secured fixed or floating charge debt
 Individual. A consumer does not pay mortgage loan, credit card, line of credit, or
other loan
Assessing Default Probabilities

There may be two aspects of assessing the probability of default. Qualitative and Quantitative
A. Qualitative Model
Following are some factors that must be evaluated under qualitative model before making
decision about issuance of loan.
1. Collateral. Since collateral backed loan give the debt holder a first claim against
specific assets of the borrower, collateral decreases the probability of default.
2. Leverage. Above certain debt-to-equity levels, the probability of default increase
dramatically. A large debt burden imposes a drain on cash flows that are used to make
interest and principal payments.
3. Volatility of earnings. As earning‘s volatility increases, the probability that a borrower
will not be able to make debt payments also increases.
4. Reputation. The borrower‘s past credit performance is assumed to continue into the
future. A borrower who has consistently made payments on time is more likely to
receive favorable terms from the lender.
5. Business performance. The phase of business cycle has a significant effect on
default probabilities. The phases under which, the business is currently running will
show its ability to pay or default.
6. Other debts. The other debts a company is currently paying or requiring to pay
off also decide the credit paying worth of the borrower.
B. Quantitative Model
Quantitative models such as, linear probability model, logit and linear
discriminant models, often use financial and economic variables to estimate default risk
and probabilities. Under this type, we will see how to calculate the Marginal Probability
of default and Cumulative probability of default.
BOND: Firs we see probability of default on Bonds.
Marginal Probability of default
i = T. Bill rate k = Corporate Bond rate

When interest rate increases, risk will also increase. Default risk on T. Bills is normally
very low as they are Government guaranteed.
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We calculate the probability to pay or default using these formulas.
1+𝑖
Probability to pay = 𝑃=
1+k
1+𝑖
Probability to default = 1 – P or 𝑑 =1−
1+k
Where P is probability to pay and d is probability to default.
Example 33:
Compute the Marginal Probability of default for the following data (one period)
T. Bill rate = i = 8%
Coupon rate (Company A) = k = 11%
Coupon rate (Company B) = k = 13%
Company A
1+𝑖 1+.08
Probability to default 𝑑 =1− 1− = 0.027
1+k 1+.11
There is a 2.7% chance that the company A will default.
Probability to pay = 1–d = 1 - .027 = 0.973
There is 97.3% probability that company A will pay the loan.
Company B.
1+𝑖 1+.08
1+k 1+.13
There is a 4.4% chance that the company B will default.
There is 95.6% probability that company B will pay the loan.
Example 34: Compute the Probabilities of default for the following data (Two periods)
T. Bill rate (1 year) = i = 10%
T. Bill rate (2 years) = i2 = 11%
Coupon rate (1 year) = k = 14%
Coupon rate (2 years) = k2 = 16%
Required: 1. Marginal probability of default (year 1)
2. Marginal probability of default (year 2)
3. Cumulative probability of default (2 years)
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Solution:
Year 1.
1+𝑖 1+.10
1+k 1+.14
There is a 3.5% probability that the Bond will default in year 1.

There is 96.5% probability that Bond will pay in year 1.
Year 2
We first calculate new rate of interest for year 2. We need an average rate of return for
two years. We denote the T. Bill average interest rate (f1) and corporate Bond rate (c1).
Calculations for 2 years average rates are.:-
a. Marginal Probability of default.
(1+𝑖2)2 (1+.11)2
T. Bills = 1 + 𝑓1 = = 1 + 𝑓1 = = 1.12
(1+i) (1+.10)
f1 = 0.12 12% (rate for two years)
(1+𝑘2)2 (1+.16)2
Corporate Bond = 1 + 𝐶1 = = 1 + 𝐶1 = = 1.18
(1+k) (1+.14)
c1 = 0.18 18% (rate for two years)
(now calculate probabilities with these rates for year 2)

1+𝑓1 1+.12
1+c1 1+.18
b. cumulative Probability of default.

Cumulative probability is the probability that a borrower will default over a
multiyear period. It is calculated by:
Cp = 1 – ( P1 x P2 x P3 x ……..Pn)
Cp = Cumulative probability of default
Pn = marginal probability to pay in year n
Cumulative Probability of default = 1 – P1 X P2 = 1- .965 X .949 = .084

There is 8.4% probability that Bond will default in next two years.
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Example 35:
Compute the Probabilities of default for the following data (Three periods)
T. Bill rate (1 year) = i = 8%
Coupon rate (1 year) = k = 11%
Required: 1. Marginal probability of default (year 1)

4. Cumulative probability of default (3 years)
Solution:
Year 1.
1+𝑖 1+.08
1+k 1+.11

Year 2
two years. We denote the T. Bill average interest rate (f1) and corporate Bond rate (c1).
a. Marginal Probability of default.(year 2)
(1+𝑖2)2 (1+.07)2
T. Bills = 1 + 𝑓1 = = 1 + 𝑓1 = = 1.06
(1+i) (1+.08)
f1 = 0.06 6% (rate for two years)

(1+𝑘2)2 (1+.10)2
(1+k) (1+.11)
c1 = 0.09 9% ( rate for two years)

1+𝑓1 1+.06
1+c1 1+.09

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Year 3
three years. We denote the T. Bill average interest rate (f2) and corporate Bond rate
(c2).
b. Marginal Probability of default (year 3)
(1+𝑖3)3 (1+.09)3
T. Bills = 1 + 𝑓2 = = 1 + 𝑓2 = = 1.13
(1+𝑖2)2 (1+.07)2
F2 = 0.13 13% (rate for year three)
(1+𝑘3)3 (1+.12)3
(1+𝑘2)2 (1+.10)2
C2 = 0.16 16% (rate for year three)

1+𝑓2 1+13
1+c2 1+.16
c. cumulative Probability of default.

Cumulative Probability of default = 1 – P1 X P2 x p3 = 1- .973 X .972 x .975 = .078
There is 7.8% probability that Bond will default in next three years.
Firms default / Credit risk.
1. Linear probability model

2. Z-Score model
3. Advance credit risk model
Linear probability model
A linear probability model uses linear regression with financial ratios to explain historic
repayment patterns. It is a special case of a binomial regression model. Here the dependent
variable for each observation takes values which are either 0 or 1. The probability of observing
a 0 or 1 in any one case is treated as depending on one or more explanatory variables. For
the "linear probability model", this relationship is a particularly simple one, and allows the
model to be fitted by simple linear regression.
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Example 36:
Suppose that there are two observed characteristics of the borrower. Fixed cost is 35%
and leverage is 25%. Further suppose that the linear probability model for the probability of
default of borrower A is represented by the equation Z = 0.45(FC) + 0.2(LEV),
The probability of default is Z = 0.45(0.35) + 0.2(0.25) = 20.75%
Z_Score model
The Z-score formula for predicting bankruptcy was published in 1968 by Edward I.
Altman, who was, at the time, an Assistant Professor of Finance at New York University.
The formula may be used to predict the probability that a firm will go
into bankruptcy within two years. Z-scores are used to predict corporate defaults and an
easy-to-calculate control measure for the financial distress status of companies in academic
studies. The Z-score uses multiple corporate income and balance sheet values to measure
the financial health of a company.
Z – Score = 1.2X1 + 1.4 X2 + 3.3 X3 + 0.6 X4 + X5

Whereas:-
X1 = WC / TA = liquidity
X2 = EBIT / TA = Profitability
X3 = retained earnings / TA = Growth
X4 = MV of equity / BV of debt = leverage
X5 = sales / TA = efficiency
When the value is :-
0 ≤ Z < 1.81 (company is in ―Danger zone‖)
1.81 ≤ Z < 2.96 (company is in ―Gray zone‖)
2.96 ≤ Z < 4.06 (company is in ―Safe zone‖)
Hint: Z in this context is a measure of ability to pay, but in other applications Z refers to
default probability.
Example 37:
Income statement of A Balance Sheet of A
Sales 50,000 cash 20,000 Creditors 30,000
CGS 30,000 A/R 25,000 Accruals 20,000
G.P. 20,000 investmnts 35,000 L.T. Debt 80,000
Op. exp. 10,000 F.A. 120,000 Ret. Earning 20,000
EBIT 10,000 Capital 50,000
Int. exp 2,000 Assets total 200,000 Net liabs. 200,000
Net Profit 8,000
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Solution:
X1 = WC / TA = 30,000 / 200,000 = 0.15
X2 = EBIT / TA = 20,000 / 200,000 = 0.10
X3 = retained earnings / TA = 10,000 / 200,000 = 0.05
X4 = MV of equity / BV of debt = 55,000 / 80,000 = 0.68
X5 = sales / TA = 50,000 / 200,000 = 0.25
Z – Score = 1.2(.15) + 1.4(.10) + 3.3(.05) + 0.6(.68) + 0.25 = 2.63
The company is in gray zone. To make decision about credit, when a company lies in
the gray zone, the lender should be very much careful about the lending decision because
the company can go either ways, to safe zone or danger zone in the coming period. To
clarify, it is advised to use 3 years z-score to make the decision.
CREDIT RISK / Estimation Techniques

Measurement of credit risk is an important exercise for financial institutions, more so because
of regulatory requirements. Credit risk can be classified under two categories – issuer risk and
counterparty risk.
Issuer risk is the risk that the issuer/obligor defaults and is unable to fulfill payment
obligations.
counterparty risk includes default risk, replacement risk and settlement risk.
default risk -risk that counterparty defaults without any payment / incomplete payment on the
transaction.
replacement risk – risk that, after default occurs, replacing the deal under the same conditions
is not possible.
settlement risk, risk that parties involved in the settlement fails before the transaction is settled.
Basel I, II and III.
Basel I is the round of deliberations by central bankers from around the world, in 1988,
the Basel Committee on Banking Supervision (BCBS) in Basel, Switzerland, published a set
of minimum capital requirements for banks. This is also known as the 1988 Basel Accord, and
was enforced by law in the Group of Ten (G-10) countries in 1992. A new set of rules known
as Basel II was later developed with the intent to supersede the Basel I accords. However they
were criticized by some for allowing banks to take on additional types of risk, which was
considered part of the cause of the US subprime financial crisis that started in 2008. In fact,
bank regulators in the United States took the position of requiring a bank to follow the set of
rules (Basel I or Basel II) giving the more conservative approach for the bank. Because of this
it was anticipated that only the few very largest US Banks would operate under the Basel II
rules, the others being regulated under the Basel I framework. Basel III was developed in
response to the financial crisis; it does not supersede either Basel I or II, but focuses on
different issues primarily related to the risk of a bank run.
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Under Basel I, the risk weights depend on the categorization of obligors. They do not consider
the actual obligor risk rating or the tenor of the facility and do not recognize any form of
collateral. Therefore, the credit risk capital required as a percentage of exposure will be a
constant 8% across all facility ratings.
Under Basel II, banks are expected to employ the standardized approach to estimate their
economic capital for credit risk. In Basel II, banks are allowed to use their own credit risk
models, which enable them to better segregate risk and include diversification effects of the
bank's portfolio.
Focus of the study
This document focuses on issuer risk and the associated parameter estimation techniques
applicable to retail and wholesale banks. Therefore, the term credit risk used is meant to imply
issuer risk. Issuer risk is applicable to loans, exchange-traded products, and OTC-traded
products.
Credit Capital Calculation Approaches

Regulatory framework prescribed by the BIS is used as the foundation for exploring the
calculation structure of credit regulatory capital and the various parameter estimation
techniques.
The three credit capital calculation approaches suggested by the BIS are discussed –
 Standardized,
 Internal Ratings Based-Foundation
 Internal Ratings Based-Advanced.
Components of Credit Risk
The integral components of credit risk, as recognized by the Bank of International Settlements
(BIS), are:
 Probability of Default (PD): Probability that the obligor will default within a given time
horizon
 Exposure at Default (EAD): Amount outstanding with the obligor at the time of default
 Loss given Default (LGD): Percentage loss incurred relative to the EAD
 Maturity (M)1: Effective maturity of the exposure
Regulatory Framework
Under Basel II, the credit risk measurement techniques proposed under capital adequacy rules
can be classified under:
 Standardized Approach: This approach uses a simplistic categorization of obligors,

without considering their actual credit risks; external credit ratings are used
 Internal Ratings-Based (IRB) Approach: In this approach, banks that meet certain
criteria are permitted to use their own estimated risk parameters to calculate
regulatory capital required for credit risk
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The IRB approach can be further classified into:
Foundation-IRB: Banks are allowed to calculate the probability of default (PD) for each asset;
while the regulator will determine Loss Given Default (LGD) and Exposure at Default (EAD).
Maturity (M) can be assigned by either
Advanced-IRB: Banks are allowed to use their internal models to calculate PD, LGD, EAD,
and M
The primary objective of employing these models is to arrive at the total risk weighted assets
(RWA), which is used to calculate the regulatory capital. The RWA calculation is based on
either ―Standardized‖ or ―IRB‖ approach
To determine the minimum capital required for credit risk, banks are required to categorize
their claims into groups mentioned in regulatory guidelines.
These categories are used to calculate/determine their respective risk weights.
The risk weights required for the calculation of credit capital can either be „regulator
determined‟ or calculated using credit risk parameters, estimated using „internal models‟.
APPROACH PD LGC M EAD

Standardized Regulator Regulator Regulator Regulator
determined determined determined determined
Foundation-IRB Internal model Regulator Regulator Regulator
determined determined determined
Advanced-IRB Internal model Internal model Formula Internal model
provided
o According to the standardized approach, the categorizations are used to determine

regulator-prescribed risk weights. To determine the EAD for on-balance sheet items, the
balance sheet values of the items are used as exposures. For off-balance sheet items, the
undrawn commitment is multiplied by a regulator-prescribed CCF.
o For the IRB approaches, the risk parameters are inputs to the respective risk weight
formulas. To determine the EAD, on-balance sheet items use the balance-sheet values
and the off-balance sheet items use CCFs suggested by the regulators.
o For the foundation approach, the CCFs are the same as those for the standardized
approach, but with a few exceptions.
o For the advanced approach, the CCFs can be the bank's own internal estimates.
As the Basel II guidelines suggest, banks are allowed to use a variety of ―internal models‖
using advanced credit risk estimation techniques, thereby raising concerns of potential
estimation differences across banks. Therefore, those banks that wish to implement the IRB
approach must first apply to the regulators for accreditation. To get a go-ahead from the
regulators, bank‘s internal estimation techniques should meet some stringent quantitative and
qualitative requirements as follows:
o Internal models are expected to be risk-sensitive to the portfolio of the bank.
126

o The internal model should be able to capture obligor characteristics and should have
sufficient information to estimate the key risk parameters within statistical confidence
levels
o There should be proper corporate governance and internal controls
o The modeling and capital estimation framework should be linked to the day-to-day
operations of the bank
o There should be an appropriate validation and testing process, ensuring the estimation of
the precise PD, LGD, EAD, and capital estimates for credit risk.
The following sections discuss the standardized approach, the IRB approach, and the various
internal models that can be employed to estimate credit risk capital.
1. Standardized Approach
In the standardized approach (Basel II), the risk weights for different exposures are specified
by the Basel committee. To determine the risk weights for the standardized approach, the bank
can take the help of external credit rating agencies that are recognized as eligible by national
supervisors in accordance to the criteria specified by the Basel committee.
Types of claims and their risk-weights

Following are the different types of claims and the risk-weights specified by Basel committee.
• Sovereign loan, public sector entities, multilateral development banks, banks, securities
firms, and corporate: These categories have different risk weights, specified according to
their ratings e.g. (A+ rated sovereign claim has a risk weight of 20%). Each of the six
categories has tables mentioning the risk weights to be used for different ratings and other
points that should be taken into consideration while deciding on the risk weights.
• Regulatory retail portfolio: Claims falling under this category are given risk weight of 75%.
• Residential property: Minimum risk weight of 35% is advised by the Basel committee
• Commercial real estate: Risk weight of 100% is advised by the Basel committee
• Past due loans: Only the unsecured portion of the loan, which is more than 90 days are
considered and different risk weights are assigned depending on the outstanding amount
• Higher risk categories: These claims are given risk weight of 150%
• Other assets: These claims are given risk weight of 100%
• Off balance sheet items: These are converted into credit exposure equivalents by using
credit conversion factors (CCF).
• Securitized transactions: Risk weights are assigned according to their ratings and maturity
OTC transactions: Specified guidelines (mathematical formula) are provided to calculate the
exposure
Classifying the securities into different categories and then determining the risk weights
of the instrument is a critical task. This requires an in-depth understanding of all the products
of the bank, and also the Basel norms specifying guidelines for the classification. Furthermore,
while dealing with OTC derivatives, it is essential to go through the terms and conditions of
these products. Sound knowledge of the business as well as legal aspects of the products is
essential.
Once the risk weights are determined, the capital required could be calculated as:
Capital Requirement = Asset Value x Risk-Weight x 8%
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Calculation of credit capital requirement under Standardized Approach for Sovereign Loan is
shown below:
Category AAA to AA- A+ to A- BBB+ to BB+ to Below unrated
BBB- B- B-
Risk Weight 0% 20% 50% 100% 150% 100%
Asset Value $100m $100m $100m $100m $100m $100m
RW * AV $0m $20m $50m $100m $150m $100m
Capital $0m $1.6m $4m $8m $12m $8m
Reqrd
Credit Risk Mitigation

Banks are allowed to use credit risk mitigation (CRM) techniques to reduce their capital
requirement. Below are the CRM techniques that banks can use:
 Collateralized transactions
 On-balance sheet netting
 Guarantees and credit derivatives
 Maturity mismatch
2. Internal Ratings-Based Approach

The Internal Ratings-Based (IRB) Approach of Basel II allows banks to use their internal
estimates of risk parameters to calculate the required capital related to the exposure.
The IRB approach estimates risk parameters under:
o Foundation approach: Banks estimate PD using internal models, while the other
parameters take supervisory estimates
o Advanced approach: Banks provide their own estimate of PD, LGD, and EAD and their
calculation for M is subject to the supervisory requirements
Under the IRB approach, banks are required to categorize their banking book exposures into
the following asset classes:
Corporate , Sovereign , Bank , Retail and Equity.
Basel provides risk weight formulas for the IRB approach; the PD, LGD, and M are inputs to
these formulas. The formula varies depending on the exposure category. Under the IRB–
Foundation, the formula assumes a value for LGD and M, while under the IRB–Advanced, all
parameters are estimated using internal models.
Probability of Default – IRB

Probability of default (PD) is an estimate of the likelihood that the obligor will be unable to
meet its debt obligation over a certain time horizon. PD is integral to estimating credit risk and
its associated economic capital/regulatory capital.
According to Basel II, a default event on an obligation would occur if either or both of the
following conditions meet:
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a. The obligor is unlikely to be able to repay its debt without giving up any pledged
collateral
b. The obligor has passed more than 90 days without paying a material credit obligation.
Estimation of PD depends on two broad categories of information:
 Macroeconomic – unemployment, GDP growth rate, interest rate

 Obligor specific – financial ratios/growth (corporate), demographic information (retail)
PD categories and modeling techniques
a. Unstressed/stressed PD. If the PD is estimated considering the current macroeconomic

and obligor-specific information, it is known as unstressed PD. Stressed PD is estimated
using current obligor-specific information and “stressed” macroeconomic factors
(independent of the current state of the economy).
b. Through-the-cycle/point-in-time PD. Point-in-time PD estimates incorporate
macroeconomic and the obligor’s own credit quality, whereas through-the-cycle PD
estimates are mainly determined by factors affecting the obligor’s long-run credit quality
trends.
Any of the following four modeling techniques can be used to estimate PD:
 Pooling– estimated empirically using historical default data of a large universe of

obligors
 Statistical– estimated using statistical techniques through macro and obligor-specific
data
 Reduced-form– estimated from the observable prices of CDSs, bonds, and equity
options
 Structural– estimated using company level information
i. Pooling Approach
a. Corporate Exposures
Empirical survey takes into consideration all the historical defaults that have occurred in the
past.
Historical PD is calculated by taking the ratio of the bonds that have defaulted to the total
bonds issued in the past, provided the bonds taken into consideration are identical in nature.
Calculation for this method is divided into two categories:
 Cohort method
 Duration (intensity)-based method
Under the cohort method, the ratio of default bonds to the total bonds are taken without
considering the time taken to default; only the status at the end of period is taken into
consideration.
𝑑𝑒𝑓𝑎𝑢𝑙𝑡𝑒𝑑 𝑏𝑜𝑛𝑑𝑠
𝑃𝐷 =
𝑇𝑜𝑡𝑎𝑙 𝑏𝑜𝑛𝑑𝑠
For example: Total number of bonds is 5,000,000 and bond defaulted during period are
600,000
129

𝑑𝑒𝑓𝑎𝑢𝑙𝑡𝑒𝑑 𝑏𝑜𝑛𝑑𝑠 600,000
𝑃𝐷 = 𝑃𝐷 = = .12 = 12%
𝑇𝑜𝑡𝑎𝑙 𝑏𝑜𝑛𝑑𝑠 5,000,000
However, under the duration-based method, the time taken by the bond to default is also
included in the calculation. Therefore, in the duration-based method, the numerator is the
proportion of bond years defaulted and the denominator is the total number of bond years.
𝐵𝑜𝑛𝑑 𝑑𝑒𝑓𝑎𝑢𝑙𝑡𝑒𝑑 𝑖𝑛 𝑦𝑒𝑎𝑟 1

𝑃𝐷 =
𝑇𝑜𝑡𝑎𝑙 𝑏𝑜𝑛𝑑𝑠 𝑖𝑛 𝑦𝑒𝑎𝑟 1
For example: Total number of bonds is 1,000,000 and bond defaulted during year 1 are 20,000
𝐵𝑜𝑛𝑑 𝑑𝑒𝑓𝑎𝑢𝑙𝑡𝑒𝑑 𝑖𝑛 𝑦𝑒𝑎𝑟 1 20,000

𝑃𝐷 = 𝑃𝐷 = = .02 = 2%
𝑇𝑜𝑡𝑎𝑙 𝑏𝑜𝑛𝑑𝑠 𝑖𝑛 𝑦𝑒𝑎𝑟 1 1,000,000
In the same way calculations can be done for n years.

Calculation of PD would also require the list of all the bonds that have defaulted in the past
and their characteristics. The market price of bond trading in the market after the default gives
its default price. The other data required would be the characteristics of the defaulted bond,
such as its rating, maturity, issuance date, seniority, issuer's rating, covenants, and country.
b. Retail Exposures
For retail exposures, the facilities that have defaulted in the past are considered. Historical PD
is calculated by taking the ratio of the facilities that have defaulted to the total facilities that
existed in the concerned time frame.
In this method, the facilities are divided into different categories/pools based on their risk
drivers.
The primary risk drivers are facility types, delinquency in payment, customer score,
geographical location, etc. The PD for each category is calculated by taking the average PD of
all the loans in that category. The PD calculated for that category is assigned to the exposure
whose PD is to be determined.
ii. Statistical Approach

Historical data on characteristics of retail obligors and corporate obligors can be used to
estimate their respective probability of defaults.
Many statistical techniques can be used to estimate and classify PD of an obligory. Regression
(linear/logit/ probit), discriminant analysis, neural networks, hazard model, decision trees are
some of them. .
To analyze a new loan or an existing loan, we use the output from the model and
compare it with two threshold levels (predetermined), which are used to determine whether the
loan is good, bad, or needs brief evaluation.
The two threshold levels (0<T1<T2<1) are chosen such that it minimizes the cost of
evaluation.
130

 If the output of the regression is PD< T1 then loan is considered to be of good quality
 If the output is PD> T2 then the loan is most likely to default
 If the output of the regression Yi is between T1 and T2, then there are less chances of
default and needs more evaluation
Some of the common variable sources used to estimate the PD of a corporate are financial
statements, owner‘s data, type of loan, size of loan, and industry of the company.
Similarly, for retail obligors, variable sources could be customer demographics, income
statistics, age of loan, and the number of late payments.
Calculations:
First calculate Z value and then PD.
Z = β1X1 + β2X2 + β3X3 + ………… βnXn
e𝑧
𝑃𝐷 =
1+ e 𝑧
Example: z value is 1.5, what is PD.

e𝑧 e 1.5 4.48
𝑃𝐷 = 𝑃𝐷 = = 𝑃𝐷 = = 0.83
1+ e 𝑧 1+ e 1.5 5.48
When z value is 1.5, there is 83% probability of default.
iii. Structural Approach

Structural models are used to calculate the probability of default for a corporate based on the
value of its assets and liabilities. The central concept of structural model is that a company
(with limited liability) defaults if the value of its assets is less than the debt of the company.
This is because the value of equity becomes negative (asset value = equity value + liability
value), which can be given away at zero cost.
Structural model was first suggested by Merton and after that many models with variations
have been designed. The most widely used versions are:
 Merton Model
 KMV Model (a variant of the Merton’s model) (KMV = Kealhofer, McQuown and Vasicek)
Merton's Model – the basic set-up of Merton's model considers that the firm‘s liabilities
consist of one zero-coupon bond with notional value L and maturing at T. So, there will be no
payments until T, at which point the default decision is taken. Therefore, the PD is the
probability that the value of the assets is below the value of liabilities, at time T.
Merton model uses an option theoretical framework (Black-Scholes) to model the default
behavior.
In the Black-Scholes framework, the probability of default is the probability that this option
expires out of the money, which is given by the following equation:
At σ2
ln + (μV – )(T − t)
PD = 𝑁 − L 2
σ√(T − t)
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where,
N = Cumulative standard normal distribution (Value in table)
At = Value of the firm/assets at time t
L = loan / debt of the firm
μV = mean value of assets
σV= standard deviation of log of assets return
Example 38:
At = 100m Loan = 60m μV = .10 σV = 0.30
a. what is PD?
At σ2 100 .09
ln +(μ V – )(T−t) ln +(.10− )(0.5)
L 2 60 2
PD = 𝑁 − = PD = 𝑁 −
σ√(T−t) .30(√.50)
.5102+ .0225
PD = 𝑁 − = N (-2.56) = 1- N(2.56) (see value of 2.54 in table, .9948)
.21
PD = 1-0.9948 = .0052 = .52% Probability of default.
b. Payment to bond holder.

= L – Max(L – A, 0) = 60-Max(60-100,0) = 60
It means the business has the capacity to repay the bond holder.
c. Payment to equity holder.
= Max(A – L, 0) = Max(100-60,0) = 40
40m is the amount to be paid to equity holder.
KMV Model (a variant of the Merton’s model) (KMV = Kealhofer, McQuown and Vasicek)
Probability of default is PD = 1 –DD

σ2
𝑙𝑛 𝑉−𝑙𝑛 𝑑𝑒𝑓𝑎𝑙𝑢𝑙𝑡 𝑡𝑕𝑟𝑒𝑠 𝑕𝑜𝑙𝑑 + 𝐸 𝑅𝑜𝐴 − 𝑀
2
Whereas:- 𝐷𝐷 =
𝜎 √𝑀
Or it can also be written as:

V σ2
ln + 𝐸 𝑅𝑜𝐴 − 𝑀
Defalut Threshold 2
𝐷𝐷 =
𝜎√𝑀
Whereas:
DD = Distance to default
Ln V = log for value of assets
Default threshold = weighted average loan
E(RoA) = expected rate of return
132

Example 39:
Loan Time CF * T
A 2,000 2 years 4,000
B 3,000 5 years 15,000
Total 5,000 19,00
𝐶𝐹∗𝑇 19,000
𝑚= = 𝑚= = 3.8 Maturity period.
𝐶𝐹 5,000
Threshold value =w1*CF + w2*CF = .5 * 2000 + .5 * 3000 =2500 (assume equal weights)
Asset value = 6,000 m = 3.8 Th = 2500 σ = .30 ROA = .04
V σ2 6000 .09
ln + 𝐸 𝑅𝑜𝐴 − 𝑀 ln + .04 − 3.8
Defalut Threshold 2 2500 2
𝐷𝐷 = 𝐷𝐷 = = 1.46 Distance to default
𝜎√𝑀 .30√3.8
Now see this value in table 1.46 = .9279
PD = 1 –DD = 1. .9279 = .0711 OR 7.11%
vi. Reduced Form Approach

Reduced form PD is calculated using the credit spreads of non-defaulted risky bonds currently
trading in the market. The spread above treasury bonds is the indicator of the risk premium
demanded by the investors. However, this spread reflects the expected loss – which includes
both PD and LGD – and liquidity premiums.
Therefore, the modeling requires separating PD from the remaining parameters.

In case of p1, as mentioned above, suppose the face value of the bond is 1$ and the one-year
risk-free rate is equal to R1 and the recovery rate is δ. The value of the one-period corporate
bond is shown as:
𝑒 −𝑅𝑅 = 1 ∗ 1 − P + δP 𝑒 −𝑅
Whereas:
P = Probability of default
1 = 1 in the formula is par value of asset.
δ = Recovery rate
R = Risk free rate
RR = Rate of return / yield rate
Example 40:
δ = 0.70 R = .08 RR = .12 What is probability of default.
𝑒 −𝑅𝑅 = 1 ∗ 1 − P + δP 𝑒 −𝑅 = 𝑒 −.12 = 1 ∗ 1 − P + .7P 𝑒 −.08

0.887= (1-.3P) (.923) = 1 - .3P = 0.887/0.923
1 - .3P = .962 = .3P = 1 - .962 = .3P = .038
P = .038 / .3 = .13 or 13% (probability of default)
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Loss Given Default – IRB
Loss Given Default (LGD) is defined as the percentage loss rate on EAD, given the obligor
defaults. It provides the loss that a bank is bound to incur when a default occurs. The actual
loss incurred will be the product of LGD and EAD.
The components of the loss that will be incurred, given the obligor defaults are:
 Loss of principal
 Carrying costs
 Workout expenses
The estimation of LGD is crucial to the calculation of the required economic capital because
the value of risk-weighted assets is more sensitive to changes in LGD than in PD.
Value of LGD varies with the economic cycle, so the following variations in LGD are defined:
 Cyclical LGD (Point-in-Time LGD)

 Long-run LGD (Through-the-Cycle LGD)
 Downturn LGD
Cyclical LGD is calculated based on the recent data and its value depends on the economic
cycle.
Long-run LGD represents the average long-term LGD, corresponding to a non-cyclical
scenario that is not dependent on the time the LGD is calculated.
Downturn LGD represents the LGD at the worst time of the economic cycle.
Basel II requires that the LGD must reflect the downturn conditions wherever it is necessary to
capture the relevant risks.
Under the IRB-Foundation approach, senior claims on sovereigns, corporate, and banks
not secured by accepted collateral are given an LGD value of 45% and the subordinated claims
are given LGD value of 75%.
Under the IRB- Advanced approach, LGD needs to be estimated using internal models.
Techniques for LGD

Four broad modeling techniques can be employed for estimating LGD under this approach, as
mentioned below:
 Market LGD: estimated using market prices of defaulted bonds/loans

 Workout LGD: estimated using cash-flows from workout process
 Implied Market LGD: estimated from market prices of non-defaulted bonds/loans
 Statistical LGD: estimated using regression on historical LGDs and facility
characteristics
1. Market LGD
Market LGD is a historical-data-based method. In this technique, the observable default price
of the bonds and loans that trade in the market after the firm has defaulted are used as the
proxy for LGD.
134

The actual prices of the bonds are based on par and thus can be easily converted into LGD as:
{100% of par value - default price}.
This technique reflects the investor‘s expectations about the recovery (i.e. 100% - LGD)
through market prices of defaulted bonds and marketable loans.
2. Workout LGD
Workout LGD calculates the LGD based on the actual cash flows that can be recovered from
the firm by the workout process, once the firm has defaulted.
The Workout LGD methodology involves prediction of the future cash flows that can be
recovered from the company, after the company has defaulted on its payments.
The forecasted cash flows are discounted using an appropriate discount rate for the defaulted
firm. These discounted cash flows are added to provide the expected recovery amount. The
total exposure of the firm at the time of default minus the expected recovery amount gives the
loss given default in absolute terms. The ratio of loss given default in absolute value to
exposure at default gives the LGD in percentage terms.
Computation of workout LGD can be shown as below:
𝑇 𝑇
𝐸𝐴𝐷𝑡 − 𝑃𝑉( R ) + 𝑃𝑉(
𝑡=𝑚 t 𝑡=𝑚
Ct )
𝑊𝑜𝑟𝑘𝑜𝑢𝑡 𝐿𝐺𝐷 =
𝐸𝐴𝐷𝑡
Whereas:
𝐸𝐴𝐷𝑡 = Exposure at default at time t
∑𝑇𝑡=𝑚 = T is end time of recovery and t=m is start time of recovery

Rt = Recovery amount during workout process
Ct = Cost of recovery during workout process
Example 41:
A recovery for loan starts on June 8, 2013. Amount is 100m. recovery during year 1 is
30m and in year 2 is 40m, cost for respective years is 2m and 3m. opportunity cost of capital is
10%. Calculate workout LGD.
𝑇 𝑇
𝐸𝐴𝐷𝑡 − 𝑃𝑉( R ) + 𝑃𝑉(
𝑡=𝑚 t 𝑡=𝑚
Ct )
𝑊𝑜𝑟𝑘𝑜𝑢𝑡 𝐿𝐺𝐷 =
𝐸𝐴𝐷𝑡
First calculate PV of Rt and Ct
30 40
𝑃𝑉 𝑜𝑓 𝑅 = + = 27.25 + 33.05 = 60.30
1.10 (1.10)2
2 3
𝑃𝑉 𝑜𝑓 𝐶 = + = 1.8 + 2.48 = 4.28
1.10 (1.10)2
100− 60.3+4.28
𝑊𝑜𝑟𝑘𝑜𝑢𝑡 𝐿𝐺𝐷 = = .439 or 43.90%
100
135

3. Implied LGD
Implied market LGD calculated LGD from market-observable information i.e. market prices.
The assumption in these models is that the market prices incorporate all the risk parameters.
So, by using these prices, the risk parameters such as PD and LGD can be extracted. The
advantage of implied market LGD is that it is forward looking, as the prices incorporate the
future expectation.
Implied LGD can be calculated by the following two methods:
 Structural-form model
 Reduced-form model
structural model is based on the framework developed by Merton. It uses the option pricing
theory developed by Black and Scholes. Here the term structural is used as these models use
the structural characteristics of the company, such as assets and their volatility, and leverage of
the company.
The basic idea behind these models is that the company will default if the company's assets
value fall below its debt at maturity.
So the company's default risk is driven by the asset‟s value and its volatility, which need to be
estimated.
The value of LGD is calculated as 1 – Recover rate (RR). Recovery rate is the estimated value
of assets in case of default i.e. the value of assets if it is less than the value of debt at maturity.
Using the Black Scholes option pricing theory, recovery rate is given by:
Implied LGD = 1 – RR
where,
A0 −μ 𝑇 N(−d1)
𝑅𝑅 = 𝑒 V ( )
D N(−d2)
A σ2
ln +(μ V + )T
D 2
d1 =
σ√T
d2 = d1 - σT
RR = Recovery Rate
N = Cumulative standard normal distribution
A0 = Value of the firm at time t
D = Strike of the option which is the debt of the firm
μV = expected growth rate of assets
σ = standard deviation of log of assets return
136

Example 42:
A0 = 100m D = 70m μV= 0.05 σ = 0.30 T = 6 months what is RR?
A0 −μ 𝑇 N(−d1)
𝑅𝑅 = 𝑒 V ( )
D N(−d2)
A σ2 100 .09
ln +(μ V + )T ln + .05+ .50
D 2 70 2
d1 = d1 = d1 = 1.90 (in table it is .9713)
σ√T .30√.5
d2 = d1- σT = 1.90 - .3(.5) = 1.75 (in table it is .9599)

N (-d1) = N(-1.90) = 1 – N(1.90) = 1 - .9713 N(-d1) = .0287
N (-d2) = N(-1.75) = 1 – N(1.75) = 1 - .9599 N(-d2) = .0401
100 .0287
𝑅𝑅 = 𝑒 −.05∗.5 ( ) = 0.99 Recovery rate RR is 99%
70 .0401
So implied LGD is 1 –RR = 1 - .99 = .01 1%

4. Statistical LGD
Loss given default can be estimated with the help of statistical techniques using historical data.
The LGD will be the dependent variable and other factors that can change the value of LGD
form the independent variables. LGD of the past facilities for the retail exposure or the default
price for corporate exposure is used as a proxy for LGD.
The independent variables consist of factors such as issuer's rating, rating of the facility,
seniority of the facility, maturity, interest rates, labour market data, and business indicators
such as gross domestic product, consumer price index, and inflation data
Here, is a linear equation formed by the linear combination of independent variables and is
given by the following equation:
Xt= b0+b1Y1+……..+bnYn
Xt=ln(LGD/1-LGD)
or it can be written as
Z = β1X1 + β2X2 + β3X3 + ………… βnXn

e𝑧
𝑃𝐷 =
1+ e 𝑧
Following are the points to be kept in mind while implementing this model:
 Only the statistically significant variables should be considered in the final model
 Variables should have economic meaning in explaining the variation of LGD
 Independent variables should be able to explain the LGD significantly
 Data should be properly processed. For instance, removal of outliers to get the correct
relationship
137

Exposure at Default (EAD)
A key risk parameter to address the bank‘s exposure at the time of default is called exposure at
default (EAD). The amount which the bank is expected to lose in the event of an obligor
defaulting represents the EAD.
Calculation of EAD according to the product type can be divided into two sections:
1. Lines of credit: This is a credit source provided to an entity (obligor) by a bank.
Some types of „lines of credit‟ are demand loan, term loan, revolving credit, and overdraft
protection.
Banks are required to estimate EAD for each facility type, which should reflect the chance of
additional drawings by the obligor. The methods used to estimate the EAD for lines of credit
and off-balance sheet items are:
 Credit Conversion Factor (CCF) Method

2. Derivatives: These are vanilla and over-the-counter (OTC) instruments, the pay-outs of
which depend on the movements of some asset class (underlying).
The risk of default or counterparty credit risk is prevalent for OTC derivatives.
The EADs of a few derivative products, such as interest rate swap, caps, floors, swaptions,
cross currency swaps, equity swaps, and commodity swaps, are calculated in a different
manner.
EAD estimation methods for derivative products can be done by the below methods:
 Current Exposure Method (CEM)

 Standardized Method (SM)
 Internal Model Method (IMM)
Under the internal ratings-based approach, calculation of EAD is further divided into the
following two sections:
Foundation Approach (F-IRB): In this approach, EAD associated with ―lines of credit‖ and
―off-balance sheet transactions‖ are to be calculated using the CCF method, where the CCFs
are provided in the Basel guidelines; collaterals, guarantees or security are not taken into
consideration while estimating EAD. To estimate EAD of derivatives, any of the
abovementioned methods under the derivatives section can be chosen.
Advanced Approach (A-IRB): For this approach, banks are allowed to use their own models,
and they have the flexibility in choosing their models. For the CCF method, the CCFs are not
provided by the regulatory guidelines and have to be calculated.
1. CCF Method
The amount which the borrower will owe to the bank at the time of default is the EAD. The
following are the two types of credit exposures:
 Fixed exposure: Exposures for which the bank has not made any future commitments to
provide credit in the future and the on-balance sheet value gives the value of exposure.
The value of the exposure is given by the following formula:
EAD = Drawn Credit Line
138

EAD for the fixed exposures will equal to the current amount outstanding on the balance sheet
and as a result no modeling is required for Basel ll requirements.
 Variable exposure: Exposures in which the bank provides future commitments, in

addition to the current credit. Therefore, the exposure will contain both on- and off-
balance sheet values. The value of exposure is given by the following formula:
EAD = Drawn Credit Line + Credit Conversion Factor * Undrawn Credit Line
where,
Drawn Credit Line = Current outstanding amount
Credit Conversion Factor = Expected future drawdown as a proportion of undrawn amount
Undrawn Credit Line = Difference between the total amount which the bank has committed
and the drawn credit line
As the future draw downs are not known, to estimate EAD we need to model for the CCF
factor of each exposure.
Credit Conversion Factor (CCF) Modeling

The CCF is the ratio of the estimated extra drawn amount during 12 months before default
over the undrawn amount at the time of estimation. It can be defined as the percentage of
undrawn credit lines (UCL) which has not been paid out, but can be utilized by the borrower
until the point of default. The CCF should lie between 0 and 1.
𝐼𝑛𝑐𝑟𝑒𝑎𝑠𝑒 𝑖𝑛 𝑒𝑥𝑝𝑜𝑠𝑢𝑟𝑒 𝑢𝑛𝑡𝑖𝑙 𝑑𝑒𝑓𝑎𝑙𝑢𝑙𝑡 𝑑𝑎𝑦

𝑐𝑐𝑓 =
𝑀𝑎𝑥𝑖𝑚𝑢𝑚 𝑝𝑜𝑠𝑠𝑖𝑏𝑙𝑒 𝑖𝑛𝑐𝑟𝑒𝑎𝑠𝑒 𝑒𝑥𝑝𝑜𝑠𝑢𝑟𝑒 𝑢𝑛𝑡𝑖𝑙 𝑑𝑒𝑓𝑎𝑢𝑙𝑡 𝑑𝑎𝑦
The CCF is calculated for the default exposures which are used to estimate the CCF for the
non-default exposures.
The following steps are employed to estimate the CCF of non-default exposures:
 Exposures which had defaulted in the past are divided into pool on the basis of Exposure at
default risk drivers(EADRD) – attributes of the exposure viz. factors affecting borrower‟s
demand for funding/facilities, nature of particular facility
 Each individual default-exposure‘s CCF is estimated within the pools
 The average CCF for each pool is calculated – the CCF of the pool is defined as the
weighted average of the CCF which were estimated for the defaulted individual exposures
 If the volatility of CCFs is low and lies around the average, it is advisable to use the
average CCF; if the CCF values are volatile then it should represent the economic
downturn conditions appropriately
 The average CCFs of default-exposure pools is used to estimate the CCFs for the non-
default exposures using lookup tables
 The CCF obtained is checked whether it is appropriate for the current macroeconomic
scenario and then used to calculate the EAD
CCF Estimation for Defaulted Exposures

Estimation of the CCF for defaulted exposures is primarily done by two methods:
 Fixed-horizon method
 Cohort method
139

In both the methods, the observation time period is fixed (as fixed by the regulators) and is
usually one year.
Fixed horizon method

This methodology assumes that all the exposures that are in non-default state will default at
the same time over the time horizon chosen for the estimation. The CCF is calculated with
respect to the time horizon that is always fixed.
The CCF is the ratio of the increase in the exposure until the default day to the maximum
possible increase in exposure. These values are calculated with respect to the fixed time
horizon. Therefore, the numerator indicates how much the exposure of the bank increased
from the exposure at the fixed interval prior to default and the denominator indicates the
maximum increase in the exposure that could have happened during the fixed interval.
Here the amount that will be drawn at the maturity is related to the drawn/undrawn amount at
a fixed time prior to default. The CCF is given by the formula:
𝐸𝐴𝐷 − 𝑜𝑛_𝑏𝑎𝑙𝑎𝑛𝑐𝑒𝑓𝑖𝑥𝑒𝑑 𝑕𝑜𝑟𝑖𝑧𝑜𝑛

𝑐𝑐𝑓𝑓𝑖𝑥𝑒𝑑 𝑕𝑜𝑟𝑖𝑧𝑜𝑛
𝐿𝑖𝑚𝑖𝑡𝑓𝑖𝑥𝑒𝑑 𝑕𝑜𝑟𝑖𝑧𝑜𝑛 − 𝑜𝑛_𝑏𝑎𝑙𝑎𝑛𝑐𝑒𝑓𝑖𝑥𝑒𝑑 𝑕𝑜𝑟𝑖𝑧𝑜𝑛
Where,
-EAD: Exposure at the time default occurred
-On_balance (fixed horizon): Exposure of the bank at fixed time horizon (one year) prior to
default
-Limit (fixed horizon): Maximum exposure that the bank can have with the counterparty at
the
fixed horizon
Cohort method
The observed time horizon is divided into different short time windows (default can occur at
any time in the time window). Therefore, the time horizon with respect to which the CCF is
calculated is not fixed.
The CCF is the ratio of the increase in the exposure until the default day to the maximum
possible exposure. These values are calculated with respect to the start of the time window.
The numerator indicates how much the exposure of the bank increased from the exposure at
the start of time window prior to default. The denominator indicates the maximum increase in
the exposure that could have happened during the time window. As the default can occur at
any time within the time window, the time interval between the start of window and the
default is not fixed.
Here the amount that will be drawn at maturity is related to the drawn/undrawn amount at the
beginning of the different time horizons. The CCF is given by the formula:
𝐸𝐴𝐷 − 𝑜𝑛_𝑏𝑎𝑙𝑎𝑛𝑐𝑒𝑠𝑡𝑎𝑟𝑡 𝑜𝑓 𝑤𝑖𝑛𝑑𝑜𝑤

𝑐𝑐𝑓𝐶𝑜𝑕𝑜𝑟𝑡
𝐿𝑖𝑚𝑖𝑡𝑠𝑡𝑎𝑟𝑡 𝑜𝑓 𝑤𝑖𝑛𝑑 𝑜𝑤 − 𝑜𝑛_𝑏𝑎𝑙𝑎𝑛𝑐𝑒𝑠𝑡𝑎𝑟𝑡 𝑜𝑓 𝑤𝑖𝑛𝑑𝑜𝑤
where,
-EAD: Exposure at the time default occurred
-On_balance (start of window): Exposure of the bank at the start window period prior to
default
140

-Limit (start of window): Maximum exposure that the bank can have with the counterparty at
the
start of the time window
In the event of the CCF being negative or greater than 1, appropriate adjustment is made to
make it applicable for calculation of EAD.
CCF Estimation for Non-Defaulted Exposures

The CCF for non-default exposure is calculated using the CCFs from the defaulted exposures.
The current non-default EADRD pools are compared with the EADRD pools of the defaulted
exposure – whose CCFs have been calculated. The lookup table method is employed to
achieve this. Apart from the approach discussed above, regression analysis can be used to
estimate the non-default exposure CCFs. Once the CCFs for default exposures are calculated,
the EADRDs can be grouped as independent variables and the CCFs calculated as dependent
variable. A regression model for the universe of exposure data can be developed or regression
models for each pool can also be calibrated. On entering the non-default exposure EADRD
data, the corresponding CCF is estimated.
2. Current Exposure Method

The Current Exposure Method comprises of two components: Current Exposure (CE) and
Potential Future Exposure (PFE). The formula for EAD under this method is given by the
formula:
Equation 1: EAD = CE + PFE
where,
Current Exposure is the current market value of the contract or the replacement costs
for a party if counterparty defaults today. It equals the market value if it is positive and zero if
the market value is negative. Therefore, CE = max {market value; 0}
Potential Future Exposure is the maximum amount of exposure expected to occur on a
future date with a high degree of statistical confidence.
The PFE is calculated by multiplying the notional values of the contracts with a fixed
percentage which is the Credit Conversion Factor (CCF) as shown below:
Remaining Interest rates FX & gold Equities Precious Other comdty

metal
< 1year 0.0% 1.05 6.0% 7.0% 10.0%
1-5 years 0.5% 5.0% 8.0% 7.0% 12.0%
>5 years 1.5% 7.5% 10.0% 8.0% 15.0%
3. Standardized Method
This method is employed by banks which are not capable of computing their OTC derivative
exposures using the internal model method (discussed in the following section). However, this
method is more risk sensitive than the Current Exposure Method. The Standardized method is
used only for OTC derivatives.
Exposure at Default using the standardized method is calculated according to the following
formula:
EAD = β * max [Current Exposure; k(NPRk * CCFk)]
141

where,
Current Exposure is the mark-to-market value after netting and collateral reduction
NRPs are the absolute value of the net risk positions in the hedging sets
CCFs are the credit conversion factors applied for the k hedging sets
k is the index that designates hedging sets
β represents extra reserve for potential downturns in the economy and also captures
model risk; its value is fixed by regulators at 1.4
The CCF values for the standardized method are provided in the following table:
Asset Class CCF Asset Class CCF

Interest rate 0.2% Gold 5%
derivatives
Credit derivatives 0.3% Equity 7%
Debt instruments 0.6% Precious metal w/o 8.5%
gold
Exchange rate 2.5% Other commodities 10%
Electricity 4% Other derivatives 10%
4. Internal Model Method

The Internal Model Method (IMM) is the most risk-sensitive approach for EAD calculation
available under the Basel II framework. A bank requires approval from local market regulators
to use the IMM to calculate EAD. The IMM calculates the counterparty exposure of the bank
at a future dates. These exposures are calculated for each netting set6. The exposure at default
in IMM is given by the following formula:
EAD = α * effective EPE
where,
α: multiplier set by regulators to 1.4
Effective EPE: Effective Expected Positive Exposure.
Alpha (α)7 accounts for correlations between market and credit risk, credit portfolio
assumptions, concentration risk and model risk. Banks can use their own estimates for α which
is subject to floor value of 1.2. Effective EPE is the average of Expected Exposure (EE) for
certain time interval at a future date.
Model Validation
Once complete implementation of the risk framework – data integration, capital models, stress
models, stress scenarios – takes place, a thorough validation and independent review of the
relevant models is carried out. Also, all the methodologies, processes, system information, key
assumptions, and suggested actions require proper documentation.
Regulatory Perspective
Model risk management is a key component. The regulatory guidelines such as those issued by
the Office of the Comptroller of the Currency (OCC) in the US and Financial Services
Authority (FSA) in the UK need to be strictly adhered to.
Banks are expected to have a robust system to validate the accuracy and consistency of various
models used for capital and risk estimations. They should establish internal validation
processes to assess the performance of such models. The suggested process cycle for models
validation includes the following:
142

 Regular monitoring of model performance, which includes evaluation and rigorous
statistical testing of stability of the model and its key coefficients
 Identifying and documenting individual fixed relationships in the model that are no longer
appropriate
 Periodic testing of model outputs versus outcomes, at least on an annual basis
 Demanding change control process, which specifies procedures to be followed before
making changes in the model, as a response to validation outcomes
Model Understanding
The models can be categorized as valuation models (of financial instruments), risk models (to
model risk parameters and estimate risk), and econometric models (on modeling variable
relationships). Typical models used in a retail or commercial banking setup include loan
valuation models, default estimation models, LGD estimation models, EAD models,
prepayment models and lending scorecards.
Proper checking of the models needs to be carried out to ensure that the models are
appropriate, flexible and accurate. Limitations of the models need to be properly understood.
Also, a proper documentation of all assumptions made during the process of modeling is
required.
Operational Risk
Operational risk refers to as ―the risk of losses resulting from inadequate or failed
internal processes, people and systems or from external events‖.
Although designed for financial institutions, this definition should be applicable for any
industry, institution or individual. The banking and insurance industries are addressing
operational risk under Basel II and solvency II accords.
The Basel and solvency approach to operational risk breaks it into seven major
categories, 18 secondary categories and 64 subcategories. The great majority is not unique
to financial services and can provide a good framework for addressing operational risk in
any industry.
1. Internal frauds
a. Unauthorized activities
i. Transactions not reported (informational)
ii. Transaction type unauthorized (with monetary loss)
iii. Mismarking of position (international)
b. Theft and Fraud
i. Fraud / credit fraud / worthless deposits
ii. Theft / extortion / embezzlement / robbery
iii. Misappropriation of assets
iv. Forgery
v. Check kiting
vi. Smuggling
vii. Account takeover / impersonation etc.
143

viii. Tax noncompliance / evasion (willful)
ix. Bribes / kickbacks
x. Insider trading
2. External Fraud
a. Theft and Fraud
i. Theft / robbery
ii. Forgery
iii. Check kiting
b. System Security
i. Hacking damage
ii. Theft of information
3. Employment Practices
a. Employee relations
i. Compensation, benefit, termination issues
ii. Organized labor activities
b. Safe Environment
i. General facility
ii. Employee health and safety rules, events
iii. Worker‘s compensation
c. Diversity and discrimination
i. All type discrimination
4. Clients, Products and Business Processes

a. Suitability, Disclosure and Fiduciary
i. Fiduciary breaches / guideline violations
ii. Suitability / disclosure issues
iii. Retail consumer disclosure violations
iv. Breach of privacy
v. Aggressive sales
vi. Account churning
vii. Misuse of confidential information
viii. Lender ability
b. Improper Business or Market Practices
i. Antitrust
ii. Improper trade / market practices
iii. Market manipulation
iv. Insider trading (on firm‘s account)
v. Unlicensed activity
144

c. Product Flaws
i. Product defects
ii. Model errors (poor design)
d. Selection, sponsorship and exposure
i. Failure to investigate client per guidelines
ii. Exceeding client exposure limits
e. Advisory activities
i. Disputes over performance of advisory activities.
5. Damage to physical assets

a. Disaster and other events
i. Natural disaster losses
ii. Human losses from external sources
6. Business Disruptions and Systems Failure

a. Systems
i. Hardware
ii. Software and middleware
iii. Telecommunications
iv. Utility outage / disruptions
7. Execution Delivery and process management

a. Transaction capture, Execution and Maintenance
i. Miscommunication
ii. Data entry, maintenance or loading error
iii. Missed deadline or responsibility
iv. Model / system disoperation
v. Accounting error / entity attribution error
b. Monitoring and Reporting
i. Failed mandatory reporting obligation
ii. Inaccurate external report
c. Customer instate and documentation
i. Client permission / disclaimer missing
d. Customer / client Account Management
i. Unapproved access given to accounts
ii. Incorrect client record (loss incurred)
iii. Negligent loss or damage of client assets
e. Trade counterparties
i. Non client counterparty performance
ii. Miscellaneous non client counterparty disputes
145

f. Vendors and suppliers
i. Outsourcing
ii. Vendor disputes
Sovereign Risk
The risk that a government could default on its debt (sovereign debt) or other obligations.
Also, the risk generally associated with investing in a particular country, or providing funds to
its government. It is also called country risk.
Economic factors
1. Debt servicing ratio = interest + principal / exports

2. Import ration = imports / foreign reserves
3. Variance of exports = σ2 exports
4. Investment ratio = real investment / GNP
5. Money supply growth rate = MSt – MSt-1 / MSt-1
Debt rescheduling
Following choice are available for rescheduling.
1. Multiyear restructuring
It involves revisiting the terms and conditions of loan. Revisiting may involve increase
in rates or some debt concessions.
Example 43:
Consider a loan of 300 million for a period of 3 years. The borrower agrees to pay 8%
interest on loan. Cost of fund for lender is 7%. It is agreed to repay 100 million principal every
year plus interest.
The borrower is unable to pay back the loan and lender agrees to restructure the loan.
He agrees to increase the maturity period up to 5 years and allowing a grace period of 1 year.
New loan interest rate will be 8% and borrower will pay 1% upfront restricting fee. Loan is
payable in equal installments and will cost 10% to the lender. Calculate the cash flows in both
conditions.
Solution:
Existing conditions:
Maturity period: 3 years
Interest rate: 8%
Loan payable: 100 million per year + interest
Cost to lender: 7%
146

0 1 2 3
Principal 0 100 100 100
Interest 8% 0 24 16 8
Cash flows - 124 116 108
P V F 1/(1.07)n 1 .935 .873 .826
PV of CF - 116 101 89
Net cash flows = 116 + 101 + 89 = 306 million
The borrower had to pay 306 million under existing conditions.
Restructuring:
Maturity period: 5 years
Grace period: 1 year
Interest rate: 8%
Upfront fee: 3 million
Loan payable: equal installments
Cost to lender: 10%
0 1 2 3 4 5
Principal - - 75 75 75 75
Interest 8% - 24 24 18 12 6
Upfront fee 3 - - - - -
Cash flows 3 24 99 93 87 81
P V F 1/(1.10)n 1 .909 .826 .751 .683 .621
PV of CF 3 22 82 70 59 50
Net cash flows = 3 + 22 + 82 + 70 + 59 + 50 = 286 million
Borrower will pay 286 million under new restructured conditions, which is less than 306
million. It means borrower is granted a concession.
2. Debt for development SWAP

Financing part of a development project through the exchange of a foreign-currency-
denominated debt for local currency, typically at a substantial discount. The process
normally involves a foreign nongovernmental organization (NGO) that purchases the
debt from the original creditor at a substantial discount using its own foreign currency
resources, and then resells it to the debtor country government for the local currency
equivalent (resulting in a further discount). The NGO in turn spends the money on a
development project, previously agreed upon with the debtor country government.
3. Debt for debt SWAP

Replacement of new loan for an old loan is called debt for debt swap. The country may
take some new loans to repay the old loan and hence no actual cash transactions take
place. Brady bonds are a good example of debt for debt swaps. Under this the state
issues the bonds to repay the loan.
147

4. Debt for equity SWAP
A debt/equity swap is a refinancing deal in which a debt holder gets an equity
position in exchange for cancellation of the debt.
Country Ratings:
International Country Risk Guide Methodology
The International Country Risk Guide (ICRG) rating comprises 22 variables in three
subcategories of risk: political, financial and economic. A separate index is created for each of
the subcategories. The political risk index is based on 100 points, financial risk on 50 points
and economic risk on 50 points. The total points from three indices are divided by two to
produce the weights for inclusion in the composite country risk score. The composite scores,
ranging from zero to 100, are then broken into categories from very low risk (80 to 100) to
very high risk (0 to 49.90) points.
1. Political risk components: (100 points)

1. Government stability 12
2. Socioeconomic conditions 12
3. Investment profile 12
4. Internal conflict 12
5. External conflict 12
6. Corruption 6
7. Military in politics 6
8. Religious tensions 6
9. Law and order 6
10. Ethnic tensions 6
11. Democratic accountability 6
12. Bureaucracy quality 4
Total 100
2. Economic Risk Components (50 points)

1. GDP per head 5
2. Real GDP growth rate 10
3. Inflation 10
4. Budget balance as % of GDP 10
5. Current account as % of GDP 15
Total 50
148

3. Financial Risk Components (50 points)
1. Foreign debt as a % of GDP 10
2. Foreign debt as a % of export 10
3. Current account as a % of exports
Of goods and services 15
4. Net international liquidity as
Months of import cover 5
5. Exchange rate stability 10
Total 50
* BEST OF LUCK *
149

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OPTIONS MARKET AND VALUATION

Some basic concepts:

At the Money: ATM (current market price = strike price)

In the Money: ITM (current market price > strike price)

Waseem A. Qureshi MM141063

Waseem A. Qureshi MM141063

2. Long put option strategy

 Profit = Strike Price of Long Put - Premium Paid

Long Put Payoff Diagram

Waseem A. Qureshi MM141063

Short Call Payoff Diagram

4. Short put strategy

 Max Profit = Premium Received - Commissions Paid

Index Short Put Payoff Diagram

Waseem A. Qureshi MM141063

Now we will explain diagrammatically one by one all above situations.

What decision will be taken with different market prices?

Waseem A. Qureshi MM141063

-8 This is called ―BULL SPREAD‖.

Waseem A. Qureshi MM141063

Exercise price Call option

Buy 1 Call option at low price = 90 at a premium of 6

MPS Long Call-I Long Call-II Short Call Net position

Waseem A. Qureshi MM141063

Exercise price call option put option

-15 This is called ― V - SAHPE‖.

Waseem A. Qureshi MM141063

Exercise price call option Put option

Buy 1 Call option and 1 put option at 90 at a premium of 6

Waseem A. Qureshi MM141063

Exercise price call option Put option

This is called ―STRIP‖.

Waseem A. Qureshi MM141063

Exercise price call option Put option

Waseem A. Qureshi MM141063

Exercise price call option Put option

Buy 1 Call option at 70 on a premium of 4, and sell 1 put option at 50 on a premium of 8.

Here the investor expects to decrease the prices in future.

Waseem A. Qureshi MM141063

Exercise price call option Put option

Buy 1 put option at 50 on a premium of 6, and sell 1 put option at 70 on a premium of 3.

Here the investor expects to decrease the prices in future.

Waseem A. Qureshi MM141063

Exercise price call option Put option

Waseem A. Qureshi MM141063

YEAR CASH FLOWS PVF = 1/ (1+i)n PV of CF PV of CF * t

a. Present value of Bond.

Change in Bond value due to change in interest rate.

Waseem A. Qureshi MM141063

Some basic calculations, signs & formulas and model:

Calculate no. of underlying to be purchased or sold against one unit of option.

Waseem A. Qureshi MM141063

Following diagram illustrates this scenario, commonly known as a binomial tree.

Example 23: (One period binomial)

Option values at expiration:

Waseem A. Qureshi MM141063

.60 12.5 +.40(0)

Calculate no. of underlying to be purchased or sold against one unit of option.

H = nS – C = 556(50) - 1,000(8) = $19,800.

Example 24: (One period binomial)

Consider a one-period binomial model in which the underlying is at 65 and can go up 30

Waseem A. Qureshi MM141063

Option values at expiration: