σP= w 21 σ 21 + w 22 σ 22 +2 ρw 1 w 2 σ 1 σ 2

√
[E(S T )−K ]. Risk neutral valuation: e−rT [ E( S T )−K ]=e−rT [S 0 erT −K ]=S 0−Ke−rT . Value of binary option= X e−rT N (d 2 ).
−µT
Real world value of a contract: e
S0
ln ( )+(µ−σ 2 /2)T σ2
d 2=
V
σ √T
. V =S 0 exp ⁡[ μ−
2 ( )
T −N −1 ( q ) σ √T ]. Prob that loss exceeds = V – K.

2 2 2 2 2 2
EWMA: σ n=λ σ n−1 +(1−λ) un−1. GARCH (1,1): σ n=ω+ α un−1 + β σ n−1

ω
Long run variance: V L= . GARCH variance forecasts: E [σ 2n+t ]=V L +(α + β )t (σ 2n−V L ). GARCH volatility forecasts for options:
1−α− β
1−e−aT 1
√
∆ σ (T )=s 252(V L +
aT
[ V ( 0 )−V L ] ) where a ≡ ln α + β
cov n
Correlation between x and y on day n: ρn =
√ var x ,n var y ,n
Covariance models- EWMA: cov n =λ cov n−1 +(1−λ)x n−1 y n−1. GARCH (1,1): cov n =ω+ α xn −1 y n−1+ β cov n−1
2
Copula model- One-factor: U i=ai F + √ (1−a ) Z i i

N−1 ( PD )− √ ρ N −1 ( X )
Prob (Ti<T ∨F )=N ( )
√ 1−ρ
N −1 ( PD )+ √ ρ N −1 ( X ) 1+ ( m−2.5 )∗b
Worst Case Default Rate- WCDR (T , X )=N ( ). ρ=0.12(1+e−50∗PD ). b=[0.11852−0.05478∗ln ( PD ) ] 2. MA= .
√ 1−ρ 1−1.5∗b
RWA=12.5∗EAD∗LGD∗( WCDR−PD )∗MA
−1

VaR=µ+ σ N −1 (X ). ES=µ+ σ e−N ¿¿¿

¿
n−m
Kupiec’s two tail: K=−2 ln [(1− p) pm ]+2 ln [( 1−m/n)n−m (m/n)m ]∼ χ 21
( x−μ ) 2
−( )
1 ( 1−q ) q
√
2
2σ
Estimated standard error of quantile estimate: . f ( x )= e
f (x) n
√2 π σ 2
RWA = Total credit equivalent amount x risk weight. Capital required = RWA x 0.08.
2

Future stock price: S =S (e μ − σ2 )∗T +σ √ T ¿ N −1

( X)
T 0

−r f ∗i
Default free value of forward contract: V = X∗( P −P )∗e T
1 0
CAPM assumes investors hold same portfolio of risky assets. Under CAPM only need to manage β. Under multi-factor manage exposure to each factor. FI’s worry about
financial institutions. Banks have high leverage, so small hit to income can create distress, regulators ensure they maintain adequate levels. Moral hazard is risk than
insurance policy causes holders to take more risk, overcome by deductibles and policy limits. Adverse selection is tendency of company to attract bad risk, high risk people
more likely to insure. Conflicts of interest, bank recommends securities it tries to sell, bank passes info to investment bank.

Risk-neutral world, investors do not care about risk, E(R) = Risk free rate. Risk-neutral valuation: derivatives priced as if investors are risk-neutral, all risk info embedded in
price of underlying. Limitations of duration and convexity: Expected payoffs and discount rates higher in real world. Duration measures effects of small, parallel yield changes,
adding convexity captures effects of larger changes, neither measure effect of non-parallel shifts

VIX provides 30 day estimate from S&P 500. Correlation is inadequate in measuring independence. Zero correlation does not imply independence except for case of
multivariate normal.

VaR: summary risk measure, easy to understand, directs attention to bad outcomes, practical way of allocating risk budgets, useful for regulation. ES: more informative than
VaR, better theoretical properties, called conditional VaR or expected tail loss. Bank regulation moving towards ES: avoid sub-additivity problem, more conservative. Coherent
risk measures- monotonicity: if A is worse than B, risk measure should be greater. translation invariance: adding K to a portfolio should reduce its risk by K. homogeneity:
changing portfolio size by λ should scale risk measure by λ. Sub-additivity: portfolio risk measure not exceed sum of risk measures of constituent securities.

Importance of covariance and time variation: correlation and volatility increase during a crisis, EWMA and GARCH style weights more useful than equal weights. Linear model
and options: useful for portfolio of stocks, bonds and linear derivatives. Fails to capture skewness. Implications: linear approximation ignores gamma. Monte Carlo-
Improvements: non-normal distributions, copulas. Limitations: computational complexity with many variables, not goods for portfolios with derivatives and positions with
small deltas.

Reasons for regulating banks: ensure banks have enough capital for risks, failures from large banks lead to failures by other large banks and collapse of financial system.
Regulatory capital is minimum amount required by FIs. Adequate capital matters to: individual FIs, depositors, lenders, shareholders, regulators, taxpayers. Regulatory
capital: seek to keep default probability at a low level, maintain stability and manage systemic risk. FIs own capital targets may exceed regulatory minimums: assess risk
differently, protect against violating regulatory minimum, capacity to exploit future growth opportunities, signal quality to market, target credit ratings by agencies.

Cash is not part of the ASF, is part of the RSF