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FINANCIAL RISK
ANALYTICS
Session 1 : Basic Risk Concepts
Topics & Learning Outcomes
Topics Learning Outcomes
1. Different type of financial risk 1. Understand the landscape of financial
2. Defining returns risk
3. Portfolio and diversification 2. Describe the market participants
3. Learn about Risk-Return trade off
Assumption
• All students must read the session topics listed in the course
document, prior to the session.
• Instead of getting deep into theory, I would like to provide anecdotal

information from my experience in the finance field.
• The course targets to impart knowledge analytical techniques from a

business perspective. Focus will be providing insights into application
of financial models and algorithms, as against their technicalities.
• The students are expected to be knowledgeable about technology

(Python, R, SAS)
Market Participants &
Financial Risks Landscape
Market Participants
Commercial Non Banking

Investment Banks Financial
Banks
Institutions
Mutual Funds Hedge Funds Pension Funds
Insurance
Sovereign Funds
Companies
Financial Mishaps 1970 - 2009
Types of Financial Risks
Types of Financial Risks
Reputationa
Market Systemic Model l
Risk Risk Risk Risk
Liquidity Credit Operational Legal

Risk Risk Risk Risk
Market
Risk
Occurs when changes in market prices, cause a loss.
Execution Mark-To-
Price Risk Risk Market
Risk
Market price of a security Trade execution risks The risk that the market
goes against expectation. which may lead to a value of a security
loss. declines.
Single security, Portfolio,
Derivatives, Options, E.g. Trade not booked The loss may not be
Fixed Income Securities, in time . realized through a sale.
Currency, Commodities
Credit
Risk
Occurs when Creditworthiness of the borrower deteriorates.
Clearing
Credit
Default Counterpar and
Mitigation
risk ty risk Settlement
risk
risk
The risk that the The risk of the The risk that a trading The operational side of
debtor becomes issuer of the counterparty will not credit risk, where one
insolvent and is security fulfil an obligation to party sends its value but
unable to pay timely. receiving a pay or deliver the counter party fails to
lower credit securities. send its value in time.
rating. Also call the Herstatt risk.
Liquidity
Risk
Occurs when transacting or funding is possible only on

adverse terms
Transactio Funding
Systemic
n liquidity liquidity
risk
risk risk
• Occurs when the market • Occurs when credit • Occurs as a general

is not deep enough for becomes unavailable, or impairment of the
transactions to be done is offered only on more financial system.
at competitive rates. stringent terms
• Buying or selling cannot • Financing for earlier

be done without positions cannot be
adversely affecting the continued.
price.
• Prices fall as market
participants sell, at
depressed prices.
Systemic
Risk
Occurs when there is a financial crises in the payments or credit intermediation

system as a whole causing serious macroeconomic consequences.
Financial crises commonly break out openly upon a severe decline in some asset prices, a major
default by a government or large financial intermediary, disruption of currency markets, or all
three. But crises are the manifestation of longer-standing and less-visible problems.
For e.g. : 2008 Subprime crisis, ILFS, Yes Bank
Characteristics of a Financial Crises:

• Market liquidity deteriorates - Liquidity Impasse.
• Volatility in Asset Prices & Returns
• Aggregate Credit shrinks; Credit rationing; Credit contraction can last a long time
• Payments systems integrity impaired
• Economic activity declines sharply
• Balance sheets shrink
• Dysfunction contagion to related and unrelated markets
Model
Risk
Occurs due to for loss arising from incorrect models
Modelling errors could be due to any of the following reasons :
1. Incorrect Data or Lack of Relevant Data (Subprime Crisis – AAA rating to some investors,
without historical data as subprime mortgages were not made prior to 2 decades)
2. Incorrect Parameterization
3. Omitted Variables
4. Incorrect Correlations (The risk of applying the “wrong” return correlation arises frequently
because correlation is hard to estimate. )
5. Other issues.
Reputational
Risk
Occurs due to bad publicity regarding an institution’s business practices, whether

true or not
• Also called headline risk, because of the dramatic way in which adverse news can surface.
• Loss could take the form of loss of revenue, loss of share value, exit of key employees, or
costly litigation
Operational
Risk
Occurs due to breakdown in Internal Policies/Controls Or due to External

Events
• Breakdowns in policies and controls that ensure the proper functioning of people, systems,
and facilities.
• Inadequate internal controls (“rogue trader” actions)
• Everything else that can go wrong!

Legal
Risk
Occurs when a firm is sued or a contract cannot be enforced.
Regulatory Complianc
Fraud Risk Risk e
Risk
The risk that a The risk that an The risk in which a

contract to which one activity will be found to firm experiences
is a party was entered be out of compliance losses from the
into fraudulently, or with regulations, or behaviour of its
that an asset’s value that a currently employees rather than
has been fraudulently sanctioned activity will corporate behaviour.
manipulated. be prohibited.
Defining Returns
Market
Risk
Financial Returns
A financial return is the money made or lost on an investment over a
period of time
Arithmetic Geometric Logarithmi

Returns Returns c Returns
Arithmetic Return = Geometric Returns = Logarithmic Return =

(Future Value / [ (1+Returns for Y1) Log (Future Value /
Present Value) - 1 x Present Value)
(1+Returns for Y2)
x
……
x
(1+Returns for Yn)]
^ 1/n
Market
Risk
Financial Returns
Quirk in Arithmetic Returns!
• Say you hold a stock as it increases from 100 to 105. Usually, this is reported as a return of 5%.
• Now consider if the stock appreciates 15% and then depreciates 15%, the total change is -2.25%,
which does not represent the reality!
• To avoid this quirk, practitioners sometimes use log returns, which are defined as follows:
Market
Risk
Financial Returns
Arithmetic Returns and Log Returns are not Interchangeable!
Market
Risk
Financial Returns
Relationship between Arithmetic Returns and Log Returns.
• There are no one‐to‐one

relationship between Log
returns and arithmetic
ones.
• The smaller the return, the

more arithmetic and log
returns tend to be similar.
Market
Risk
Financial Returns
Log Returns are not Impacted by the Compounding
Frequency
• Log returns are the constant proportional rate at which an asset price must change to grow or
decline from its initial to its terminal level, taking into account the growth in the “base” on
which returns are measured.
• Log returns tend to be considered as continuously compounded returns. This implies that the
compounding frequency does not matter and different assets can easily be compared.
Market
Risk
Financial Returns
Log Returns are Time-Additive. Arithmetic Returns are Not!
When considering a portfolio of multi--‐period assets, the n-‐period log return is equal to the sum
of the single consecutive log returns. As you can see below:
Portfolio And Diversification
Contents
1. Portfolio defined
2. Diversification
3. Risk Reward Trade Off
4. Risk Measures
a. Alpha
b. Beta
c. Volatility (Standard Deviation)
d. Variance
e. Covariance
f. Correlation
g. Sharpe Ratio
h. Treynor Ratio
5. Portfolio Optimization
a. Modern portfolio theory (MPT)
b. 2 Stock Portfolio
c. N Stock Portfolio
d. Efficient Portfolio
A portfolio is a collection of Financial Investments
• Investments could be in stocks, bonds, commodities, cash, and cash

equivalents, open and closed-end funds and exchange-traded
funds (ETFs), real estate, art, and private investments.
Diversification
Investors diversify for better returns for a given risk.
Returns
Year Asset A Asset B Asset Portfolio A & B
2001 50% 70% 60%
2002 60% 60% 60%
2003 70% 50% 60%
2004 80% 40% 60%
2005 90% 30% 60%
2006 90% 30% 60%
2007 90% 30% 60%
2008 80% 40% 60%
2009 70% 50% 60%
2010 60% 60% 60%
2011 50% 70% 60%
Risk Reward Trade Off
The risk-return trade-off is the trading principle that links high risk with high reward.
This may or may not be true. Generally speaking, a diversified portfolio reduces the
risks presented by individual investment positions. That said, the risk-return trade-
off also exists at the portfolio level. For example, a portfolio largely composed
of Shares presents both higher risk and higher potential returns.
Capital Allocation Possibilities

Government Bonds Shares ETFs Risk Expected Return
75% 0% 25% 19% 9%
50% 0% 50% 27% 12%
60% 20% 20% 27% 17%
40% 40% 20% 35% 25%
Covariance
Covariance measures how two variables move with respect to each other
and is an extension of the concept of variance (which tells about how a
single variable varies). It can take any value from -∞ to +∞.
• Higher the Covariance, more dependent is the relationship.

• A positive covariance denotes that there is a direct relationship If 2
stocks have a positive covariance, then these 2 stocks usually move
Xi – the values of the X-variable
together. Yj – the values of the Y-variable
• A negative covariance denotes an inverse relationship between the two X̄ – the mean (average) of the X-
variables.If 2 stocks have a negative covariance, then these 2 stocks variable
Ȳ – the mean (average) of the Y-
move in the opposite way, most of the times. variable
• If the covariance between 2 stocks is zero, then they are not related. n – the number of data points
• Though covariance is perfect for defining the type of relationship, it is
bad for interpreting its magnitude. If the Covariance between 2 stocks (A
and B) is greater than the Covariance between 2 stocks (A and C), it
cannot be inferred that A is strongly related, more with B than C or vice
versa.
Correlation
Correlation is used to measure how closely the price of two

stocks or portfolios changes with respect to each other.
• Correlation can range from -1 to +1. rxy – the correlation coefficient of the linear
relationship between the variables x and y
x i – the values of the x-variable in a
• +1 indicates that stocks/portfolios have a direct and sample
strong relationship. x̅ – the mean of the values of the x-
variable
yi – the values of the y-variable in a
• -1 indicates that there is a strong inverse relationship sample
ȳ – the mean of the values of the y-
between the stocks/portfolios. variable
• 0 indicates that the two stocks/portfolios are independent.

ρ(X,Y) – the correlation between the
variables X and Y
Cov(X,Y) – the covariance between the
variables X and Y
σX – the standard deviation of the X-
variable
σY – the standard deviation of the Y-
variable
Risk Measures
The following measures are normally used to measure risk for a portfolio:
1. Alpha
2. Beta
3. Variance
4. Volatility
5. Sharpe Ratio
6. Sortino Ratio
7. Treynor Ratio
8. Modigliani-Modigliani Ratio
Risk Measures
Alpha
Alpha measures risk relative to the market or a selected benchmark index.
For example, if the Sensex has been deemed the benchmark for a particular fund, the
activity of the fund would be compared to that experienced by the selected index.
If the fund outperforms the benchmark, it is said to have a positive alpha. If the fund
falls below the performance of the benchmark, it is considered to have a negative
alpha.
Risk Measures
Beta
Beta measures the volatility of a fund in comparison to the market or the selected
benchmark index.
A beta of one indicates the fund is expected to move in conjunction with the
benchmark. Betas below one are considered less volatile than the benchmark, while
those over one are considered more volatile than the benchmark.
Risk Measures
Portfolio Variance
Portfolio variance is a statistical value that assesses the degree of dispersion of the
returns of a portfolio.
Risk Measures
Volatility
A market witnessing sustained rises and falls over a significant period of time is a
volatile market. Higher volatility implies higher risk.
Volatility is normally calculated as the standard deviation of the returns.
An investment with a higher standard deviation has higher volatility and therefore,
greater risk of loss.
Risk Measures
Sharpe Ratio
The Sharpe ratio measures performance as adjusted by the associated risks.
This is done by removing the rate of return on a risk-free investment, such as a Government
Treasury Bond, from the experienced rate of return. This is then divided by the associated
investment’s standard deviation and serves as an indicator of whether an investment's return is
due to wise investing or due to the assumption of excess risk.
Return Volatility Sharpe Ratio Sharpe Ratio Grading Thresholds:

Portfolio A 20% 25.00% 1 Less than 1: Bad
Portfolio B 30% 56.00% 0.5 1 – 1.99: Adequate/good
Treasury Bills 2% 2 – 2.99: Very good
Greater than 3: Excellent
Risk Measures
Sortino Ratio
The Sortino ratio is a variation of the Sharpe ratio. It takes a portfolio’s return and divides it by the
“Downside Risk.”
Sortino Ratio Grading Thresholds:

Return LPSD Sortino Ratio
Less than 1: Bad
Portfolio A 16% 9.00% 1.44 1 – 1.99: Adequate/good
Portfolio B 30% 25.00% 1.08 2 – 2.99: Very good
Greater than 3: Excellent
Treasury Bills 3%
Risk Measures
Treynor Ratio
The Treynor ratio calculates the amount of excess return from the risk-free rate per unit of
systematic risk.
Return Beta
Equity 7% 1.25%
Fixed Income 5% 0.70%
Treasury Bills 2%
Risk Measures
Modigliani-Modigliani Ratio
The Modigliani-Modigliani ratio shows the return on an investment adjusted for risk in
comparison to a benchmark.
M2 = Return on adjusted portfolio - Return on market portfolio
Return MF Index Modigliani-Modigliani Ratio

Mutual Fund A 15% 10.00% 5%
Mutual Fund B 30% 40.00% -10%
Portfolio Optimization
The objective of portfolio theory is to allocate our assets optimally with
respect to risk and return.
Modern portfolio theory (MPT) – Devised by Harry Markowitz in 1952 for which he received a
Nobel Prize.
MPT helps construct portfolios either to :

a. Maximize expected return based on a given level of market risk.
b. Minimize risk for a given level of expected return.
MPT considers the first two moments of a security's return distribution: mean and variance.
Assumptions -
1. Stock markets are efficient
2. A typical investor is rational
3. An arbitrage opportunity would not last long
4. A rational investor would prefer stock with a higher expected return;
5. For a given return, a rational investor prefers stock with a lower risk level.
The objective of portfolio theory is to allocate our assets optimally with
respect to risk and return.
MPT considers the first two moments of a security's return distribution: mean and
variance.
Inputs
• A Return matrix
• A Variance Covariance matrix
Output
• An Efficient Portfolio.
• An Efficient Frontier is obtained by connecting numerous efficient portfolios.
Portfolio Returns for a 2 Stock Portfolio
Portfolio Returns Stock Investment Returns Weight

HDFC Bank Rs. 60,000 20% 60%
TCS Rs. 40,000 12% 40%
Total Rs. 1,00,000
Portfolio Returns (60%*20%) + (40%*12%) 16.8%
Expected Returns
Efficient Frontier
• The hyperbola is sometimes referred to as the "Markowitz bullet“

• The upward sloped portion of the hyperbola is the Efficient Frontier
• The Tangency Portfolio is the most efficient portfolio and has the highest Sharpe Ratio.
Appendix
Covariance vs Correlation
Basis Covariance Correlation
Covariance is an indicator of the extent to Correlation is an indicator of how strongly these 2

which 2 random variables are dependent variables are related provided other conditions are
Meaning
on each other. A higher number denotes constant. The maximum value is +1 denoting a
higher dependency. perfect dependent relationship.
Correlation provides a measure of covariance on a

Relationshi Correlation can be deduced from
standard scale. It is deduced by dividing the
p covariance
calculated covariance with standard deviation.
The value of covariance lies in the range of Correlation is limited to values between the range -
Values
-∞ and +∞. 1 and +1.
Correlation is not affected by a change in scales or
Scalability Affects covariance
multiplication by a constant.
Covariance has a definite unit as it is
Correlation is a unitless absolute number between
Units deduced by the multiplication of two
-1 and +1 including decimal values.
numbers and their units.
FINANCIAL RISK
ANALYTICS
Volatility Behavior and Forecasting
• Volatility Estimation • Analyze behavior of return volatility over
• Estimating volatility via GARCH time: volatility regimes and other typical
• Simple techniques for estimating
features
time-varying volatility • Time variation in return behavior across
assets
Volatility Estimation
What is Volatility?
1. Volatility is a measure of dispersion around the mean or average return of a security.
2. Volatility can be measured using the standard deviation, which signals how tightly the price of a stock is grouped
around the mean or moving average (MA).
• When prices are tightly bunched together, the volatility is small.
• When prices are widely spread apart, the standard deviation is large.
Characteristics of Volatility
• Not Directly Observable: Evolving over time in a continuous manner
• Volatility Clustering: This was first noted by Mandelbrot - "large

changes tend to be followed by large changes, of either sign, and
small changes tend to be followed by small changes."
• Investment Risk & Opportunity: Stock market volatility is generally

associated with investment risk; however, it may also be used to lock
in superior returns.
Volatility Clustering
Volatility Clustering refers to the observation that large
changes tend to be followed by large changes, of either
sign, and small changes tend to be followed by small
changes.
Financial time series, such as stock prices, exchange rates,

inflation rates, etc., often exhibit the phenomenon of
Volatility Clustering.
There are periods in which their prices show wide swings

for an extended time period followed by periods in which
there is relative calm.
Estimating volatility via GARCH
Homoskedasticity & Heteroskedasticity
• Heteroskedasticity happens when the standard errors of a variable,

monitored over a specific amount of time, are non-constant. In
Homoskedasticity, they are almost constant.
• With Heteroskedasticity, the tell-tale sign upon visual inspection of the

residual errors is that they will tend to fan out over time, as depicted in the
image above.
GARCH
• The Generalized Autoregressive Conditional Heteroskedasticity model (GARCH) was developed in
1982 by Robert F. Engle, an economist and 2003 winner of the Nobel Memorial Prize for
Economics.
• The GARCH process describes an approach to estimate volatility in financial markets and predict
the prices and rates of financial instruments.
GARCH is a recursive function as it calculates today’s variance using yesterdays variance. It is a

summation of 3 components assigned with weights -ω (Omega), α (Alpha), β (Beta).
𝝈𝟐𝒏 = 𝝎 + 𝜶𝒖𝟐𝒏−𝟏 + 𝜷𝝈𝟐𝒏−𝟏
The ω (Omega) weight is the product of the γ (Gamma) weight and

the σ2(LR) Long Run Variance (Unconditional Variance).
Weight α (Alpha) is assigned to U2n-1 (yesterdays squared return)
Weight β (Beta) is assigned to σ2n-1 (yesterday’s variance)

GARCH
GARCH(1,1)
𝝈𝟐𝒏 = 𝝎 + 𝜶𝒖𝟐𝒏−𝟏 + 𝜷𝝈𝟐𝒏−𝟏
Day Prices Relatives daily µi daily µ2i Weights
𝒖 𝒖𝟐 𝜶𝜷 −𝟏 𝜶𝜷 −𝟏 𝒖𝟐
−𝟏
0 20.00
1 19.80 1.01010 1.01% 0.000101 10.00% 0.0010%
2 20.13 1.01646 1.63% 0.000267 8.00% 0.0021%
3 20.15 1.00119 0.12% 0.000001 6.40% 0.0000% α 10%
4 20.18 1.00149 0.15% 0.000002 5.12% 0.0000% β 80%
… γ 10%
σ (LR) 0.00010
2
58 20.04 1.00002 0.00% 0.000000 0.00% 0.0000%
59 20.04 0.99983 -0.02% 0.000000 0.00% 0.0000% ω 0.000010
60 19.98 0.99743 -0.26% 0.000007 0.00% 0.0000%
50.0% Sum: 0.003210% σn-1 0.880348%
σ (MA) 0.0000083
2
σ σ
2 2
50.0% n 0.008210% n 0.008210%
σ(MA) 0.28730% 100.0% σn 0.906101% σn 0.906101%
Typical GARCH Plot
FINANCIAL RISK
ANALYTICS
Market Risk Measurement and Value-At-Risk
• Basic approaches to measuring • define and measure Value-at-Risk
market risk • describe standard asset distribution
• Capital Asset Pricing Model models
• Scenario analysis and stress testing • ability to estimate VaR over time
• different approaches to construct
scenarios
Value AT Risk (VaR) - Definition
• Value at risk (VaR) is a statistic that measures and quantifies the level
of financial risk within a firm, portfolio or position over a specific time
frame.
• Invented after the stock market crash of 1987
• This metric is most commonly used by investment and commercial

banks
• VaR is used to determine the extent and probability of potential losses

in their institutional portfolios.
Value AT Risk (VaR) - Application
• Firm-wide Risk Modelling : Investment banks commonly apply VaR
modelling to firm-wide risk due to the potential for independent trading
desks to unintentionally expose the firm to highly correlated assets.
Using a firm-wide VaR assessment allows for the determination of the
cumulative risks from aggregated positions held by different trading
desks and departments within the institution.
• Capital Reserves : Using the data provided by VaR modeling,

financial institutions can determine whether they have sufficient
capital reserves in place to cover losses or whether higher-than-
acceptable risks require them to reduce concentrated holdings.
Value AT Risk (VaR) - Measurement
• VaR Measurement : VaR is measured by assessing the amount of
potential loss, the probability of occurrence for the amount of loss,
and the timeframe.
For example, a financial firm may determine an asset has a 3% one-month VaR of
2%, representing a 3% chance of the asset declining in value by 2% during the one-
month time frame.
Value AT Risk (VaR) - Shortcomings
• There is no standard protocol for the statistics used to determine asset, portfolio or
firm-wide risk.
For example:
• Statistics pulled arbitrarily from a period of low volatility may understate the potential for risk events to occur and
the magnitude of those events.
• Risk may be further understated using normal distribution probabilities, which rarely account for extreme or
black-swan events.
• The assessment of potential loss represents the lowest amount of risk in a range of
outcomes. For example, a VaR determination of 95% with 20% asset risk represents an
expectation of losing at least 20% one of every 20 days on average. In this calculation,
a loss of 50% still validates the risk assessment.
For example:
• The financial crisis of 2008 that exposed these problems.
• Relatively benign VaR calculations understated the potential occurrence of risk events posed by portfolios of
subprime mortgages.
• Risk magnitude was also underestimated, which resulted in extreme leverage ratios within subprime portfolios.
• As a result, the underestimations of occurrence and risk magnitude left institutions unable to cover billions of
dollars in losses as subprime mortgage values collapsed.
Basic approaches to measuring market risk
VaR – Parametric Calculation
The Variance-Covariance Method
• This method assumes that stock returns are normally distributed and is based on the mean and standard deviation of an
investment portfolio.
• This method looks at the price movements of investments over a look-back period and uses probability theory to compute a
portfolio's maximum loss.
• This method calculates the standard deviation of price movements of an investment or security.
• Assuming stock price returns and volatility follow a normal distribution, the maximum loss within the specified confidence level
is calculated.
Example
Consider a portfolio that includes only one security, stock ABC. Suppose $500,000 is invested in stock ABC. The standard
deviation over 252 days, or one trading year, of stock ABC, is 7%. Following the normal distribution, the one-sided 95%
confidence level has a z-score of 1.645.
The value at risk in this portfolio is
$57,575 = ($500000*1.645*.07).
Therefore, with 95% confidence, the maximum loss will not exceed $57,575 in a given trading year.
Z-Score
• A Z-score can reveal to a trader if a value is typical for a specified data set or if it is atypical. In general, a Z-score below 1.8
suggests a company might be headed for bankruptcy, while a score closer to 3 suggests a company is in solid financial
positioning.
• A Z-score is a numerical measurement that describes a value's relationship to the mean of a group of values.
• Z-score is measured in terms of standard deviations from the mean.
• Z-score of 0 indicates that the data point's score is identical to the mean score.
• Z-score of +1.0 indicates a value that is one standard deviation above the mean.
• Z-score of -1.0 indicates a value that is one standard deviation below the mean.
VaR – Historical Calculation
The historical method re-organizes actual historical returns, putting them in order from worst to best. It
then assumes that history will repeat itself, from a risk perspective.
A historical simulation simply sorts the returns by size. If the sample include 100 returns, the value at
risk at a confidence of 95% is the fifth largest loss.
Shortcomings of this Approach

• Volatility Clustering not considered: Historical simulation assumes that returns are independent
and identically distributed. This is not necessarily the case; real-world data often displays volatility
clustering.
• Equal Weightage: Returns in the recent-past and far-past are given equal weighting. However,
recent returns have greater bearing on future behaviour than older returns.
• Historical data may not be available: This method requires a large set of historical data for
accuracy; this, however, is not always available.
• Subjective Information cannot be considered: Because the method is entirely reliant on historical
data, the result cannot be influenced by subjective information (as with Monte-Carlo simulation).
This may be significant if a fund manager predicts large changes in the business environment.
VaR - Monte Carlo Calculation
A Monte Carlo simulation is a model used to predict the probability of different
outcomes using random variables. Monte Carlo simulations assume perfectly
efficient markets.
• Reduces Uncertainty: The basis of a Monte Carlo simulation involves

assigning multiple values to an uncertain variable to achieve multiple results
and then to average the results to obtain an estimate. A Monte Carlo
simulation considers a wide range of possibilities and helps us reduce
uncertainty.
• Flexible: A Monte Carlo simulation is very flexible; it allows us to vary risk

assumptions under all parameters and thus model a range of possible
outcomes. One can compare multiple future outcomes and customize the
model to various assets and portfolios under review.
Monte Carlo
The Monte Carlo Simulation method involves developing a model for future stock price
returns and running multiple hypothetical trials through the model.
A Monte Carlo simulation normally is a "black box" generator of random, probabilistic

outcomes.
Example:
• Assume we ran a Monte Carlo simulation with 100 monthly trials for a particular stock
based on its historical trading pattern.
• Among them, two outcomes were between -15% and -20%; and three were between -
20% and 25%.
• That means the worst five outcomes (that is, the worst 5%) were less than -15%.
• The Monte Carlo simulation, therefore, leads to the following VAR-type conclusion: with
95% confidence, we do not expect to lose more than 15% during any given month.
Capital Asset Pricing Model
Capital Asset Pricing Model - Definition
The Capital Asset Pricing Model (CAPM) describes the relationship
between systematic risk and expected return for assets, particularly
stocks.
CAPM is widely used throughout finance for pricing risky securities and
generating expected returns for assets given the risk of those assets
and cost of capital.
The formula for calculating the expected return of an asset given its risk
is as follows:
ERi = Rf + βi (ERm − Rf)
where:
• ERi = expected return of investment
• Rf = risk-free rate
• βi = beta of the investment
• (ERm − Rf) = market risk premium
The goal of the CAPM formula is to evaluate whether a stock is fairly valued when its risk
and the time value of money are compared to its expected return.
Investors expect to be compensated for risk and the time value of money.
1. The risk-free rate in the CAPM formula accounts for the time value of money.
2. The other components of the CAPM formula account for the investor taking on
additional risk.
• The beta of a potential investment is a measure of how much risk the investment will
add to a portfolio that looks like the market. If a stock is riskier than the market, it will
have a beta greater than one. If a stock has a beta of less than one, the formula
assumes it will reduce the risk of a portfolio.
• A stock’s beta is then multiplied by the market risk premium, which is the return
expected from the market above the risk-free rate.
• The risk-free rate is then added to the product of the stock’s beta and the market risk
premium.
• The result should give an investor the required return or discount rate they can use to
find the value of an asset.
Capital Asset Pricing Model - Calculation
For example:
• Stock price - $100 per share
• Dividend - 3% annual dividend.
• Beta - 1.3 (riskier than a market portfolio)
• Risk-free rate - 3%
• Market expectation - +8% per year
The expected return of the stock based on the CAPM formula is 9.5%.
9.5% = 3% + 1.3×(8%−3%)
The expected return of the CAPM formula is used to discount the expected dividends and
capital appreciation of the stock over the expected holding period.
If the discounted value of those future cash flows is equal to $100 then the CAPM
formula indicates the stock is fairly valued relative to risk.
Capital Asset Pricing Model - Shortcomings
Several CAPM assumptions do not always hold in reality:
1. Securities markets are very competitive and efficient
2. These markets are dominated by rational, risk-averse investors, who seek to
maximize satisfaction from returns on their investments.
3. The risk-free rate may not remain constant over the discounting period.
4. The assumption that future cash flows can be estimated for the discounting process.
If an investor could estimate the future return of a stock with a high level of
accuracy, the CAPM would not be necessary.
5. The market portfolio used to find the market risk premium is only a theoretical value
and is not an asset that can be purchased or invested in as an alternative to the
stock. Most of the time, investors will use a major stock index, like the S&P 500, to
substitute for the market, which is an imperfect comparison.
6. Including beta in the formula assumes that risk can be measured by a stock’s
price volatility. However, price movements in both directions are not equally risky.
Despite these issues, the CAPM formula is still widely used because it is simple and
allows for easy comparisons of investment alternatives.
Capital Asset Pricing Model & Efficient
Frontier
An investor may use CAPM to optimize a portfolio’s return relative to risk. This could be plotted on a curve
called the efficient frontier. In the following chart, you can see two portfolios that have been constructed to fit
along the efficient frontier.
Portfolio A is expected to return 8% per year and has a 10% standard deviation or risk level. Portfolio B is
expected to return 10% per year but has a 16% standard deviation. The risk of portfolio B rose faster than its
expected returns.
Modern Portfolio Theory

• Starting with the risk-free rate, the expected return of a portfolio increases as the risk increases
• Any portfolio that fits on the Capital Market Line (CML) is better than any possible portfolio to the right of
that line
Note - It is impossible to know whether a portfolio exists on the efficient frontier or not because future returns
cannot be predicted deterministically.
Capital Asset Pricing Model – Practical
Value
The CAPM relies on assumptions about investor behaviours, risk and return distributions, and market
fundamentals that don’t match reality. However, the underlying concepts of CAPM and the associated
efficient frontier can help investors understand the relationship between expected risk and reward as
they make better decisions about adding securities to a portfolio.
Scenario 1
Stock A’ share price - $100
Discount Rate – 13%
Peer group’s performance over the last 5 years - 10%
Stock A’ performance over the last 5 years – 9%
Should we invest in Stock A?
Scenario 2
Portfolio Return – 10% per year for the past 3 years
Portfolio Risk (SD) – 10%
Market Return – 10% per year for the past 3 years
Market Risk (SD) – 8%
The holdings that are either dragging on returns or have increased the portfolio’s risk
disproportionately can be identified, the investor can make changes to improve returns.
Scenario analysis and stress testing
What is Scenario Analysis ?
• Scenario analysis is the process of estimating the expected value of a portfolio after a
given change in the values of its key factors (for e.g. Interest Rates) take place.
• Both likely scenarios and unlikely worst-case events can be tested in this fashion
However scenario analysis is commonly used to estimate changes to a portfolio's value
in response to an unfavourable event and may be used to examine a theoretical worst-
case scenario.
• Scenario analysis can apply to investment strategy as well as corporate finance.
• Scenario analysis is only as good as the inputs and assumptions made.

Scenario Analysis - Working
• What If Analysis: Scenario analysis provides a process to estimate shifts in the value
of a portfolio, based on the occurrence of different situations (scenarios) following the
principles of "what if" analysis.
• Risk Assessment : These assessments can be used to examine the amount of risk
present within a given investment as related to a variety of potential events, ranging
from highly probable to highly improbable. Depending on the results of the analysis, an
investor can determine if the level of risk present falls within his comfort zone.
Scenario Analysis - Usage
• Simulating Extremes :
• Determine the standard deviation of daily or monthly security returns
• Compute what value is expected for the portfolio if each security generates returns that are two or
three standard deviations above and below the average return.
• This gives a reasonable amount of certainty regarding the change in the value of a portfolio during a
given time period, by simulating these extremes.
• Single or Multiple Variables :

Scenarios being considered can relate to
• a single variable, such as the relative success or failure of a new product launch, OR
• a combination of factors, such as the results of the product launch combined with possible changes
in the activities of competitor businesses..
• Business Decisions:
Selecting one of two facilities or storefronts from which the business could operate. This could include
considerations such as the difference in rent, utility charges, and insurance, or any benefit that may
exist in one location but not the other.
• Consumer Decisions:
A person can use scenario analysis to examine the different financial outcomes of purchasing an item
on credit, as opposed to saving the funds for a cash purchase.
What is Stress Testing?
• Stress testing is a computer-simulated technique to analyze how banks and investment
portfolios would fare in drastic economic scenarios.
• Stress testing helps gauge investment risk and the adequacy of assets, as well as to
help evaluate internal processes and controls.
• Regulations require banks to carry out various stress-test scenarios and report on their
internal procedures for managing capital and risk.
• This became popular after the financial crisis of 2007-08

Stress Testing for Risk Management
• Portfolio Management Companies
• Use internal proprietary stress-testing programs to evaluate how well the assets
they manage might weather certain market occurrences and external events AND
• Then set up any hedging strategies necessary to mitigate against possible losses.
• Corporate Finance
• Asset and liability matching stress tests are widely used, too, by companies that
want to ensure they have the proper internal controls and procedures in place.
• Retirement and Insurance Portfolios

• Retirement and Insurance Portfolios are also frequently stress-tested to ensure that
cash flow, pay-out levels, and other measures are well aligned.
Regulatory Stress Testing
• 2010 Dodd-Frank Act : Following the 2008 financial crisis, regulatory reporting for the
US financial industry—specifically for banks—was significantly expanded with a
broader focus on stress testing and capital adequacy.
• Comprehensive Capital Analysis and Review (CCAR) : Beginning in 2011, new

regulations in the United States required the submission of CCAR documentation by
the banking industry. These regulations require banks to report on their internal
procedures for managing capital and carry out various stress-test scenarios.
• “Too Big To Fail” Banks : Banks in the United States deemed too big to fail by the
Financial Stability Board—typically those with more than $50 billion in assets—must
provide stress-test reporting on planning for a bankruptcy scenario. In 2018, 22
international banks and eight based in the United States were designated as too -big-to-
fail.
• BASEL III : This international regulation requires documentation of banks’ capital

levels and the administration of stress tests for various crisis scenarios .
Stress Testing - Types
• Historical Scenario: In this type, the business—or asset class, portfolio, or individual
investment—is run through a simulation based on a previous crisis. Examples of
historical crises include the stock market crash of October 1987, the Asian crisis of
1997, and the tech bubble that burst in 1999-2000.
• Hypothetical Stress Test: is generally more specific, often focusing on how a

particular company might weather a particular crisis. For example, a firm in California
might stress-test against a hypothetical earthquake or an oil company might do so
against the outbreak of war in the Middle East.
• Stylized scenarios are a little more scientific in the sense that only one or a few test
variables are adjusted at once. For example, the stress test might involve the Dow
Jones index losing 10% of its value in a week.
How is Stress Testing done?
• Monte Carlo Simulation: This type of stress testing can be used for modelling
probabilities of various outcomes given specific variables. Factors considered in the
Monte Carlo simulation, for example, often include various economic variables.
• Risk Management and Software Providers: Moody’s Analytics is one example of an

outsourced stress-testing program that can be used to evaluate risk in asset portfolios
and investment portfolios against possible future financial situations.
Appendix
Python Sample Code
• IBM Stock Example - Page 396
• Walmart Example – Page 398
• VaR based on sorted historical returns – Page 405
FINANCIAL RISK
ANALYTICS
Risk Management
• VaR Framework • Implementing quantitative risk
• Change management management
• Understand technique of back testing
VaR Framework
What is Backtesting?
• Risk managers use a technique known as backtesting to determine the accuracy
of a VaR model.
• Backtesting involves the comparison of the calculated VaR measure to the actual
losses (or gains) achieved on the portfolio.
• A backtest relies on the level of confidence that is assumed in the calculation.
• The backtest must be performed over a sufficiently long period to ensure that
there are enough actual return observations to create an actual return distribution.
For a one-day VaR measure, risk managers typically use a minimum period of
one year for backtesting.
Example:
• An investor who calculated a one-day VaR of $3 on a $100 investment with 95%
confidence will expect the one-day loss on his portfolio to exceed $3 only 5% of
the time.
• If the investor recorded the actual losses over 100 days, the loss would exceed $3
on exactly five of those days if the VaR model is accurate.
Validating the Backtesting..
• What is the rationale for accepting a 95% confidence VaR
model that produces, say, 46 or 57 exceptions over 1,000
days, instead of exactly 50?
• And how can one determine an exact cutoff for the

number of exceptions such that one should reject a VaR
model?
Kupiec’s Proportion of Failure Test
• The Kupiec POF method, provides an approximate
formula to directly calculate the boundaries of the
acceptable range.
• This method based on advanced statistics
• The method involves forming a “test statistic” called a

“likelihood ratio.”
• This ratio is based on the binomial distribution of the

number of errors over a single backtest.
Jasper’s Spreadsheet
• The Kupiec likelihood formula is used in column L.
• The likelihood ratio as a number ranges between zero and infinity.
• The smaller the value, the more likely the model is correct.
• The ratio is zero when the number of exceptions is the expected 5%*N,
where N is the number of days in the backtest.
• As the number of exceptions found in a particular backtest (column H)

increases or decreases away from 5%*N, the likelihood ratio increases.
• Values anywhere between 0 and 3.84 correspond to 95% of the possible

occurrences of this ratio for a perfect VaR model.
• Any specific observation of the ratio greater than 3.84 in a single backtest
indicates that one should reject the VaR model.
Percentage of exceptions
Total backtest fails
Months in lookback 2 3 6 9 12
period
S&P 6.1%, 2 6.1%, 2 5.6%, 6 5.6%, 7 5.4%, 7
Shanghai 5.9%, 2 5.6%, 1 5.0%, 1 4.9%, 4 4.8%, 6

Basel Rules of Backtesting
Change management
What is Change Management?
The coordination of a structured period of transition from situation A to situation B in order
to achieve lasting change within an organization.
BNET Business Dictionary
Change management is the process, tools and techniques to manage the people-side of
business change to achieve the required business outcome, and to realize that business
change effectively within the social infrastructure of the workplace.
Change Management Learning Center
The systematic approach and application of knowledge, tools and resources to deal with
change. Change management means defining and adopting corporate strategies,
structures, procedures and technologies to deal with changes in external conditions and
the business environment.
SHRM Glossary of Human Resources Terms, www.shrm.org
Why is Change Management Important?
• Studies still show a 60-70% failure rate for organizational change projects — a statistic
that has stayed constant from the 1970’s to the present.
• One important reason is while the content and approach of change management is
reasonably correct, but the managerial capacity to implement it has been woefully
underdeveloped.
Change Management – Best Practices
Change Management – Best Practices
1. Establish a Vision – Effective visions are: Clear, Unambiguous, Personally relevant, Simple, Vivid.
2. Involve Senior Leadership - Senior leaders need to be sponsors of the change, as stakeholders tend to
respond more positively to messaging from this group.
3. Develop a Change Management Plan - Key components of a Change management plan are: Vision
and goals, Stakeholders, Resources, Time-specific milestones, Communications tools and strategy,
including key messages, Metrics, Roles and responsibilities, Results from change readiness or risk
analyses (if applicable)
4. Engage Stakeholders – Stakeholders could either be Change champions (individuals who are
supportive of change and eager to see it implemented) or Change resistors (individuals who oppose
change and may try to prevent its implementation).
5. Communicate at all Levels - Communication should occur repeatedly and through multiple channels,
Include opportunity for questions and feedback and Be tailored to specific recipients
6. Create Infrastructure to Support Adoption - Reinforce change through organizational structures:

Policies, Procedures, Systems
7. Measure Progress - Organizations need metrics to measure progress and change. Pertinent questions
are - Who will collect and analyse the data? How and when are data collected? What will organization
do with the results?
Kotter’s
Eight Step Change Management Process
FINANCIAL RISK
ANALYTICS
Implementation of VaR
• Nonlinearity and VaR: option gamma • build methods of computing VaR using
and fixed income convexity simulation and historical data
• Value-at-Risk for portfolios • identifying and measuring risk factors for
fixed income, foreign exchange and
equity
Nonlinearity and VaR: option gamma and
fixed income convexity
Options
• Options are trading products that provide investors with
the chance to make money and hedge current
investments.
• An options contract gives an investor the right, but not the

obligation, to buy (or sell) securities/assets at a specific
price at any time, as long as the contract is in effect.
American vs European Options

• American style options may be exercised at any time
before the option expires.
• European style options may be exercised only at
expiration.
Put and Call Options
• Put options give holders of the option the right, but not the
obligation, to sell a specified amount of an underlying
security at a specified price (Strike Price) either on or
before the expiration date of the options contract.
• A Call option, which gives the holder the right to buy the
underlying security at a specified price (Strike Price),
either on or before the expiration date of the options
contract.
Options - Profit Or Loss
• In The Money (ITM) refers to an option that will produce a profit if it is exercised.
Call option Strike Price < Market price for the underlying asset.
Put option Strike Price > Market price for the underlying asset.
• Out Of The Money (OTM) which would mean that the holder of the option would incur a
loss if the option is exercised.
Call option Strike Price > Market price for the underlying asset.
Put option Strike Price < Market price for the underlying asset.
• At the money (ATM) is a situation wherein if the option holder exercises the option, it
will result in neither loss nor gain because the exercise price or strike price is equal to
the current spot price of the underlying security.
Call option Strike Price = Market price for the underlying asset.
Put option Strike Price = Market price for the underlying asset.
Call Option - Example
Alex, a trader is bullish on the S&P 500 index, which is currently trading at 2973.01 levels on
2nd July 2019.
He believes that the S&P 500 index will surpass the levels of 3000 by the end of July 2019 and
decided to purchase a call option with a strike price of 3000. Details of the same are mentioned
below:
S&P 500 Index closed at 3020 levels on the date of expiry. In such a case, the profit made by
Alex is equivalent to $8 (after adjusting for the $12 paid by him)
On the contrary, if the S&P Index expired below 3000 levels on the expiry date, the call option
will be worthless, and loss to Alex will be equivalent to the premium paid by him for acquiring
the call option.
Put Option - Example
Ryan is a trader and highly bearish on the S&P 500 index, which is presently trading at 3000 levels.
He believes that the global economic environment is pessimistic, and the recession in us is not far away and
expects the market to fall badly. He believes that the S&P 500 index will easily fall to the levels of 2500 within
two months and decided to purchase a huge quantity of put options with a strike price of 2700.
Details of the same are mentioned below:
The above numbers signify that Ryan will be in profit if S&P 500 index closes below 2680 on the expiry day
(after adjusting for the premium cost)
S&P 500 index closed at 2600 levels on the date of expiry. And Ryan made a jackpot return on the expiry date
equivalent to $80 (after adjusting for the $20 paid by him)
However, if suppose S&P closed above 2700 levels on expiry, the maximum loss suffered by Ryan will be
equivalent to the premium paid by him on the put options as the option will be worthless.
Delta
• Delta expresses the amount of price change a derivative will see based on the price of
the underlying security.
• Delta for a Call option is always positive and between 0 and 1.
• Delta for a Put option is always negative, between -1 to 0.
Example
HDFC Shares Price Price Change HDFC Shares Delta

Share Price 20 21 Call Option 0.35
Call Option 2 2.35 Put Option -0.65
Put Option 2 1.35
Gamma
• Gamma is the rate of change in an option's delta per 1-point move in the underlying
asset's price.
• As an analogy to physics, the delta of an option is its "speed," while the gamma of an
option is its "acceleration.“
• When the option is deep in or out-of-the-money, gamma is small.
• When the option is near or at the money, gamma is at its largest.
• Since an option's delta measure is only valid for short period of time, gamma gives
traders a more precise picture of how the option's delta will change over time as the
underlying price changes.
Example of Gamma
Suppose a stock is trading at $10 and its option has a delta of 0.5 and a gamma of 0.1.
Then, for every 10 percent move in the stock’s price, the delta will be adjusted by a
corresponding 10 percent. This means that a $1 increase will mean that the option’s delta
will increase to 0.6. Likewise, a 10 percent decrease will result in corresponding decline
in delta to 0.4.
Linearity & Nonlinearity
• Linearity describes a situation where the relationship between an
independent variable and a dependent variable is direct and
predictable.
• Nonlinearity describes a situation where the relationship between an

independent variable and a dependent variable is indirect and
unpredictable.
• While a linear relationship creates a straight line when plotted on a

graph, a nonlinear relationship creates a curve.
Nonlinear Risk
• Nonlinear derivatives come with nonlinear risk exposure
• Returns of a nonlinear derivative are not normally distributed and are

skewed.
• Options are nonlinear derivatives because the input variables

associated with options do not create proportional changes in output.
• Option prices in general aren't linear with strike prices due to the
nonlinear distribution of option premium.
• Option payoffs change with time and the location of the strike price to
the spot price.
• A standard VaR model (parametric, historical) would not work and

instead, another model, such as a Monte Carlo VaR, would need to
be used.
Fixed Income Securities
• A Fixed Income security provides investors with a stream of fixed
periodic interest payments (in the form of coupon payments) and the
eventual return of principal upon its maturity.
• Bonds are the most common type of fixed-income security, but others
include Certificate of Deposits, money markets, and preference
shares.
• Different bonds have different terms as well as credit ratings assigned

to them based on the financial viability of the issuer.
• Government fixed-income securities, are guaranteed by the

Government, making these very low risk, but also relatively low-return
investments.
Bond Prices and Interest Rate
The price of the bond depends on several characteristics including the market interest
rate and can change regularly. The bond yield is the earnings or returns an investor can
expect to make by buying a bond.
Relation between Bond Prices and Interest Rates: Bond prices and yields move in the
opposite or inverse direction. As interest rates fall, bond prices rise. Conversely, rising
market interest rates lead to falling bond prices. This is because, as rates rise, the bond
may fall behind in the earnings in comparison to other securities.
Example:
• If an investor owns a fixed-rate bond that pays 2% and interest rates begin to rise
above 2%, he may want to sell this lower paying security. Investors don't want to hold a
bond that pays 2% if they can invest the same principle into one that pays a higher rate
in the future.
• Because there is a glut of bonds at the lower rate on the market, the prices for these
debt holdings will drop.
• As bonds sell off and the price falls, the investor may wait for rates to stop rising before
getting back in the bond market.
Bond Duration
• Duration of a bond is the length of the time it takes for the bond’s cash flow to repay the
investor.
Duration and Interest Rate

• Bond duration measures the change in a bond's price when interest rates fluctuate.
• The higher the duration the greater the interest rate risk i.e. the more a bond's price will
drop as interest rates rise.
• The lower the duration the lower the interest rate risk i.e. the less a bond's price will
• The general rule is for every 1% change in interest rates (increase or decrease), a
bond’s price will change approximately 1% in the opposite direction, for every year of
duration.
Example:
If a bond has a duration of five years and interest rates increase 1%, the bond’s price
will drop by approximately 5% (1% X 5 years). Likewise, if interest rates fall by 1%, the
same bond’s price will increase by about 5% (1% X 5 years).
Bond Duration (Cont’d)
• Duration is used to quantify the potential impact a bond’s risk factors will have on a
bond's price. The two risk factors of a bond are :
1. Credit Risk
2. Interest Rate Risk
• Both the Credit & Interest Rate risks affect a bond's expected Yield.
Example
If a company begins to struggle and its credit quality declines, investors will require a
greater reward or Yield to own the bonds. In order to raise the Yield of an existing
bond, its price must fall.
The same factors apply if interest rates are rising and competitive bonds are issued
with a higher Yield.
Duration Strategies
• Long-duration strategy
• An investor purchases bonds a high duration i.e. with a long time before maturity
and greater exposure to interest rate risks.
• A long-duration strategy works well when interest rates are falling, which usually
happens during recessions.
• Short-duration strategy
• An investor purchases bonds with a small duration i.e. a small amount of time to
maturity.
• A short-duration strategy when investors think interest rates will rise or when they
are very uncertain about interest rates and want to reduce their risk.
Convexity
• Convexity is used, as a risk-management tool, to measure and manage a portfolio's
exposure to interest rate risk. As convexity increases, the systemic risk to which the
portfolio is exposed increases.
• The relationship between bond prices and yields is typically convex, which is why the
term “Convexity”. Convexity is the measure of the curve between a bond’s price and it’s
yield.
• A bond’s price and yield are inversely related but the rate at which this happens slows
over time
• As the price decreases, its yield increases
• As the price increases, its yield decreases
However it is generally seen:

• Price decreases and yield increases slower in comparison
• Price increases and yield decreases faster i.e. it accelerates.
Convexity
• Convexity is a measure of the curvature,
or the degree of the curve, in the
relationship between bond prices and
bond yields.
• Duration is a good measure of how bond

prices may be affected due to small and
sudden fluctuations in interest rates.
• Convexity is a better measure for

assessing the impact on bond prices
when there are large fluctuations in
interest rates.
Fixed Income Securities - Risks
1. Low Returns: Investing in fixed-income securities usually results in low returns and
slow capital appreciation or price increases.
2. Low Liquidity: The principal amount invested can be tied up for a long time, particularly in
the case of long-term bonds with maturities greater than 10 years. As a result, investors
don't have access to the cash and may take a loss if they need the money and cash in
their bonds early.
3. Loss of Potential Income: Fixed Income products might cause loss of potential income as
they often pay a lower return than equities.
4. Interest Rate Risk: The rate paid by the security could be lower than interest rates in the
overall market. For example, an investor that purchased a bond paying 2% per year might
lose out if interest rates rise over the years to 4%.
5. Risk of Default: Bonds issued by a high-risk company or an unstable government may not
be repaid, resulting in loss of principal and interest.
6. Inflation Risk: Since the interest rate paid on most bonds is fixed for the life of the bond,
inflation risk can be an issue if prices rise by a faster rate than the interest rate on the
bond. If a bond pays 2% and inflation is rising by 4%, the bondholder is losing money
when factoring in the rise in prices of goods in the economy.
Foreign Exchange
• Foreign Exchange (forex or FX) is the trading of one currency for another. For example, one
can swap the U.S. dollar for the euro.
• There will also be a price associated with each pair, such as 1.2569. If this price was
associated with the USD/CAD pair it means that it costs 1.2569 CAD to buy one USD. If the
price increases to 1.3336, then it now costs 1.3336 CAD to buy one USD. The USD has
increased in value (CAD decrease) because it now costs more CAD to buy one USD.
• Foreign exchange transactions can take place on the foreign exchange market, also known
as the Forex Market.
Example of Foreign Exchange

A trader thinks that the European Central Bank (ECB) will be easing its monetary policy in the
coming months as the Eurozone’s economy slows. As a result, the trader bets that the euro will
fall against the U.S. dollar and sells short €100,000 at an exchange rate of 1.15. Over the next
several weeks the ECB signals that it may indeed ease its monetary policy. That causes the
exchange rate for the euro to fall to 1.10 versus the dollar. It creates a profit for the trader of
$5,000.
By shorting €100,000, the trader took in $115,000 for the short-sale. When the euro fell, and
the trader covered their short, it cost the trader only $110,000 to repurchase the currency. The
difference between the money received on the short-sale and the buy to cover is the profit. Had
the euro strengthened versus the dollar, it would have resulted in a loss.
Foreign Exchange - Risks
1. Leverage Risks - In forex trading, leverage requires a small initial investment, called a margin, to gain access to
substantial trades in foreign currencies. Small price fluctuations can result in margin calls where the investor is
required to pay an additional margin. During volatile market conditions, aggressive use of leverage will result in
substantial losses in excess of initial investments.
2. Interest Rate Risks - Interest rates have an effect on countries' exchange rates. If a country’s interest rates rise, its
currency will strengthen due to an influx of investments. Conversely, if interest rates fall, its currency will weaken as
investors begin to withdraw their investments. Forex prices can dramatically change due to the changes in interest
rates across countries.
3. Transaction Risks - Transaction risks are an exchange rate risk associated with time differences between the
beginning of a contract and when it settles. Forex trading occurs on a 24 hour basis which can result in exchange
rates changing before trades have settled. The greater the time differential between entering and settling a contract
increases the transaction risk.
4. Counterparty Risk - Counterparty risk refers to the risk of default from the dealer or broker in a particular
transaction. During volatile market conditions, the counterparty may be unable or refuse to adhere to contracts. In
forex trades, spot and forward contracts on currencies are not guaranteed by an exchange or clearing house. In
spot currency trading, the counterparty risk comes from the solvency of the market maker.
5. Country Risk - When weighing the options to invest in currencies, one must assess the structure and stability of
their issuing country. In many developing and third world countries, exchange rates are fixed to a world leader such
as the US dollar. In this circumstance, central banks must sustain adequate reserves to maintain a fixed exchange
rate. A currency crisis can occur due to frequent balance of payment deficits and result in devaluation of the
currency. This can have substantial effects on forex trading and prices.
Equity
• Equity represents the value that would be returned to a
company’s shareholders if all of the assets were
liquidated and all of the company's debts were paid off.
• The calculation of equity is a company's total assets

minus its total liabilities.
• Equity represents the shareholders’ stake in the company,

identified on a company's balance sheet.
Equity - Risks
1. Their dependence on the economy: No matter how good a company, its growth will depend on
the growth of the economy.
2. Industry Risk:
A company’s growth will be in sync with the industry’s robustness to an extent. There are a few
exceptional cases where a company may perform irrespective of that industry going through a bad
phase.
3. Management Risk:
A management team will hold the whip hand to formulate strategies that will make or break the
company. Hence, quality of management is one thing that an investor must assess before banking on
it.
4. Company level risks: There are two broad categories of Company Level Risks including: Internal
and external. Internal risks refer to the company’s operation and external risks cater to operating
conditions that is beyond the control of the company.
5. Financial risks: The way a company handles its finances i.e. activities like borrowing, creating fixed
payment obligations in the form of interest, will all play a pivotal role in deciding the company’s
financial risks.
6. Interest rate: The increase in interest rate will increase the cost of borrowing which will trigger an
increase in the prices of products that will detrimentally affect its sales. A mounting interest rate will
affect the company’s earning with its effect felt on the share price.
7. Inflation risk: Inflation can have a negative effect on a company in numerous ways be it with
respect to wage hikes, magnified corporate profits owing to an overvaluation of closed inventory that
makes the company bear the brunt of high taxes.
Value-at-Risk for portfolios
Value-at-Risk for Portfolios
This topic would be covered via project implementation in Python. The
following project topics need to be implemented:
Projects Topics Page No.

Project 3 VaR based on sorted historical returns 405 405
Project 3 Simulation and VaR 408 408
Project 3 VaR for portfolios 409 409
Project 3 Backtesting and stress testing 411 411
FINANCIAL RISK
ANALYTICS
Implementation of VaR
• Nonlinearity and VaR: option gamma • build methods of computing VaR using
and fixed income convexity simulation and historical data
• Value-at-Risk for portfolios • identifying and measuring risk factors for
fixed income, foreign exchange and
equity
Nonlinearity and VaR: option gamma and
fixed income convexity
Options
• Options are trading products that provide investors with
the chance to make money and hedge current
investments.
• An options contract gives an investor the right, but not the

obligation, to buy (or sell) securities/assets at a specific
price at any time, as long as the contract is in effect.
American vs European Options

• American style options may be exercised at any time
before the option expires.
• European style options may be exercised only at
expiration.
Put and Call Options
• Put options give holders of the option the right, but not the
obligation, to sell a specified amount of an underlying
security at a specified price (Strike Price) either on or
before the expiration date of the options contract.
• A Call option, which gives the holder the right to buy the
underlying security at a specified price (Strike Price),
either on or before the expiration date of the options
contract.
Options - Profit Or Loss
• In The Money (ITM) refers to an option that will produce a profit if it is exercised.
Call option Strike Price < Market price for the underlying asset.
Put option Strike Price > Market price for the underlying asset.
• Out Of The Money (OTM) which would mean that the holder of the option would incur a
loss if the option is exercised.
Call option Strike Price > Market price for the underlying asset.
Put option Strike Price < Market price for the underlying asset.
• At the money (ATM) is a situation wherein if the option holder exercises the option, it
will result in neither loss nor gain because the exercise price or strike price is equal to
the current spot price of the underlying security.
Call option Strike Price = Market price for the underlying asset.
Put option Strike Price = Market price for the underlying asset.
Call Option - Example
Alex, a trader is bullish on the S&P 500 index, which is currently trading at 2973.01 levels on
2nd July 2019.
He believes that the S&P 500 index will surpass the levels of 3000 by the end of July 2019 and
decided to purchase a call option with a strike price of 3000. Details of the same are mentioned
below:
S&P 500 Index closed at 3020 levels on the date of expiry. In such a case, the profit made by
Alex is equivalent to $8 (after adjusting for the $12 paid by him)
On the contrary, if the S&P Index expired below 3000 levels on the expiry date, the call option
will be worthless, and loss to Alex will be equivalent to the premium paid by him for acquiring
the call option.
Put Option - Example
Ryan is a trader and highly bearish on the S&P 500 index, which is presently trading at 3000 levels.
He believes that the global economic environment is pessimistic, and the recession in us is not far away and
expects the market to fall badly. He believes that the S&P 500 index will easily fall to the levels of 2500 within
two months and decided to purchase a huge quantity of put options with a strike price of 2700.
Details of the same are mentioned below:
The above numbers signify that Ryan will be in profit if S&P 500 index closes below 2680 on the expiry day
(after adjusting for the premium cost)
S&P 500 index closed at 2600 levels on the date of expiry. And Ryan made a jackpot return on the expiry date
equivalent to $80 (after adjusting for the $20 paid by him)
However, if suppose S&P closed above 2700 levels on expiry, the maximum loss suffered by Ryan will be
equivalent to the premium paid by him on the put options as the option will be worthless.
Delta
• Delta expresses the amount of price change a derivative will see based on the price of
the underlying security.
• Delta for a Call option is always positive and between 0 and 1.
• Delta for a Put option is always negative, between -1 to 0.
Example
HDFC Shares Price Price Change HDFC Shares Delta

Share Price 20 21 Call Option 0.35
Call Option 2 2.35 Put Option -0.65
Put Option 2 1.35
Gamma
• Gamma is the rate of change in an option's delta per 1-point move in the underlying
asset's price.
• As an analogy to physics, the delta of an option is its "speed," while the gamma of an
option is its "acceleration.“
• When the option is deep in or out-of-the-money, gamma is small.
• When the option is near or at the money, gamma is at its largest.
• Since an option's delta measure is only valid for short period of time, gamma gives
traders a more precise picture of how the option's delta will change over time as the
underlying price changes.
Example of Gamma
Suppose a stock is trading at $10 and its option has a delta of 0.5 and a gamma of 0.1.
Then, for every 10 percent move in the stock’s price, the delta will be adjusted by a
corresponding 10 percent. This means that a $1 increase will mean that the option’s delta
will increase to 0.6. Likewise, a 10 percent decrease will result in corresponding decline
in delta to 0.4.
Linearity & Nonlinearity
• Linearity describes a situation where the relationship between an
independent variable and a dependent variable is direct and
predictable.
• Nonlinearity describes a situation where the relationship between an

independent variable and a dependent variable is indirect and
unpredictable.
• While a linear relationship creates a straight line when plotted on a

graph, a nonlinear relationship creates a curve.
Nonlinear Risk
• Nonlinear derivatives come with nonlinear risk exposure
• Returns of a nonlinear derivative are not normally distributed and are

skewed.
• Options are nonlinear derivatives because the input variables

associated with options do not create proportional changes in output.
• Option prices in general aren't linear with strike prices due to the
nonlinear distribution of option premium.
• Option payoffs change with time and the location of the strike price to
the spot price.
• A standard VaR model (parametric, historical) would not work and

instead, another model, such as a Monte Carlo VaR, would need to
be used.
Fixed Income Securities
• A Fixed Income security provides investors with a stream of fixed
periodic interest payments (in the form of coupon payments) and the
eventual return of principal upon its maturity.
• Bonds are the most common type of fixed-income security, but others
include Certificate of Deposits, money markets, and preference
shares.
• Different bonds have different terms as well as credit ratings assigned

to them based on the financial viability of the issuer.
• Government fixed-income securities, are guaranteed by the

Government, making these very low risk, but also relatively low-return
investments.
Bond Prices and Interest Rate
The price of the bond depends on several characteristics including the market interest
rate and can change regularly. The bond yield is the earnings or returns an investor can
expect to make by buying a bond.
Relation between Bond Prices and Interest Rates: Bond prices and yields move in the
opposite or inverse direction. As interest rates fall, bond prices rise. Conversely, rising
market interest rates lead to falling bond prices. This is because, as rates rise, the bond
may fall behind in the earnings in comparison to other securities.
Example:
• If an investor owns a fixed-rate bond that pays 2% and interest rates begin to rise
above 2%, he may want to sell this lower paying security. Investors don't want to hold a
bond that pays 2% if they can invest the same principle into one that pays a higher rate
in the future.
• Because there is a glut of bonds at the lower rate on the market, the prices for these
debt holdings will drop.
• As bonds sell off and the price falls, the investor may wait for rates to stop rising before
getting back in the bond market.
Bond Duration
• Duration of a bond is the length of the time it takes for the bond’s cash flow to repay the
investor.
Duration and Interest Rate

• Bond duration measures the change in a bond's price when interest rates fluctuate.
• The higher the duration the greater the interest rate risk i.e. the more a bond's price will
• The lower the duration the lower the interest rate risk i.e. the less a bond's price will
• The general rule is for every 1% change in interest rates (increase or decrease), a
bond’s price will change approximately 1% in the opposite direction, for every year of
duration.
Example:
If a bond has a duration of five years and interest rates increase 1%, the bond’s price
will drop by approximately 5% (1% X 5 years). Likewise, if interest rates fall by 1%, the
same bond’s price will increase by about 5% (1% X 5 years).
• Duration is used to quantify the potential impact a bond’s risk factors will have on a
bond's price. The two risk factors of a bond are :
1. Credit Risk
2. Interest Rate Risk
• Both the Credit & Interest Rate risks affect a bond's expected Yield.
Example
If a company begins to struggle and its credit quality declines, investors will require a
greater reward or Yield to own the bonds. In order to raise the Yield of an existing
bond, its price must fall.
The same factors apply if interest rates are rising and competitive bonds are issued
with a higher Yield.
Duration Strategies
• Long-duration strategy
• An investor purchases bonds a high duration i.e. with a long time before maturity
and greater exposure to interest rate risks.
• A long-duration strategy works well when interest rates are falling, which usually
happens during recessions.
• Short-duration strategy
• An investor purchases bonds with a small duration i.e. a small amount of time to
maturity.
• A short-duration strategy when investors think interest rates will rise or when they
are very uncertain about interest rates and want to reduce their risk.
Convexity
• Convexity is used, as a risk-management tool, to measure and manage a portfolio's
exposure to interest rate risk. As convexity increases, the systemic risk to which the
portfolio is exposed increases.
• The relationship between bond prices and yields is typically convex, which is why the
term “Convexity”. Convexity is the measure of the curve between a bond’s price and it’s
yield.
• A bond’s price and yield are inversely related but the rate at which this happens slows
over time
• As the price decreases, its yield increases
• As the price increases, its yield decreases
However it is generally seen:

• Price decreases and yield increases slower in comparison
• Price increases and yield decreases faster i.e. it accelerates.
Convexity
• Convexity is a measure of the curvature,
or the degree of the curve, in the
relationship between bond prices and
bond yields.
• Duration is a good measure of how bond

prices may be affected due to small and
sudden fluctuations in interest rates.
• Convexity is a better measure for

assessing the impact on bond prices
when there are large fluctuations in
interest rates.
Fixed Income Securities - Risks
1. Low Returns: Investing in fixed-income securities usually results in low returns and
slow capital appreciation or price increases.
2. Low Liquidity: The principal amount invested can be tied up for a long time, particularly in
the case of long-term bonds with maturities greater than 10 years. As a result, investors
don't have access to the cash and may take a loss if they need the money and cash in
their bonds early.
3. Loss of Potential Income: Fixed Income products might cause loss of potential income as
they often pay a lower return than equities.
4. Interest Rate Risk: The rate paid by the security could be lower than interest rates in the
overall market. For example, an investor that purchased a bond paying 2% per year might
lose out if interest rates rise over the years to 4%.
5. Risk of Default: Bonds issued by a high-risk company or an unstable government may not
be repaid, resulting in loss of principal and interest.
6. Inflation Risk: Since the interest rate paid on most bonds is fixed for the life of the bond,
inflation risk can be an issue if prices rise by a faster rate than the interest rate on the
bond. If a bond pays 2% and inflation is rising by 4%, the bondholder is losing money
when factoring in the rise in prices of goods in the economy.
Foreign Exchange
• Foreign Exchange (forex or FX) is the trading of one currency for another. For example, one
can swap the U.S. dollar for the euro.
• There will also be a price associated with each pair, such as 1.2569. If this price was
associated with the USD/CAD pair it means that it costs 1.2569 CAD to buy one USD. If the
price increases to 1.3336, then it now costs 1.3336 CAD to buy one USD. The USD has
increased in value (CAD decrease) because it now costs more CAD to buy one USD.
• Foreign exchange transactions can take place on the foreign exchange market, also known
as the Forex Market.
Example of Foreign Exchange

A trader thinks that the European Central Bank (ECB) will be easing its monetary policy in the
coming months as the Eurozone’s economy slows. As a result, the trader bets that the euro will
fall against the U.S. dollar and sells short €100,000 at an exchange rate of 1.15. Over the next
several weeks the ECB signals that it may indeed ease its monetary policy. That causes the
exchange rate for the euro to fall to 1.10 versus the dollar. It creates a profit for the trader of
$5,000.
By shorting €100,000, the trader took in $115,000 for the short-sale. When the euro fell, and
the trader covered their short, it cost the trader only $110,000 to repurchase the currency. The
difference between the money received on the short-sale and the buy to cover is the profit. Had
the euro strengthened versus the dollar, it would have resulted in a loss.
Foreign Exchange - Risks
1. Leverage Risks - In forex trading, leverage requires a small initial investment, called a margin, to gain access to
substantial trades in foreign currencies. Small price fluctuations can result in margin calls where the investor is
required to pay an additional margin. During volatile market conditions, aggressive use of leverage will result in
substantial losses in excess of initial investments.
2. Interest Rate Risks - Interest rates have an effect on countries' exchange rates. If a country’s interest rates rise, its
currency will strengthen due to an influx of investments. Conversely, if interest rates fall, its currency will weaken as
investors begin to withdraw their investments. Forex prices can dramatically change due to the changes in interest
rates across countries.
3. Transaction Risks - Transaction risks are an exchange rate risk associated with time differences between the
beginning of a contract and when it settles. Forex trading occurs on a 24 hour basis which can result in exchange
rates changing before trades have settled. The greater the time differential between entering and settling a contract
increases the transaction risk.
4. Counterparty Risk - Counterparty risk refers to the risk of default from the dealer or broker in a particular
transaction. During volatile market conditions, the counterparty may be unable or refuse to adhere to contracts. In
forex trades, spot and forward contracts on currencies are not guaranteed by an exchange or clearing house. In
spot currency trading, the counterparty risk comes from the solvency of the market maker.
5. Country Risk - When weighing the options to invest in currencies, one must assess the structure and stability of
their issuing country. In many developing and third world countries, exchange rates are fixed to a world leader such
as the US dollar. In this circumstance, central banks must sustain adequate reserves to maintain a fixed exchange
rate. A currency crisis can occur due to frequent balance of payment deficits and result in devaluation of the
currency. This can have substantial effects on forex trading and prices.
Equity
• Equity represents the value that would be returned to a
company’s shareholders if all of the assets were
liquidated and all of the company's debts were paid off.
• The calculation of equity is a company's total assets

minus its total liabilities.
• Equity represents the shareholders’ stake in the company,

identified on a company's balance sheet.
Equity - Risks
1. Their dependence on the economy: No matter how good a company, its growth will depend on
the growth of the economy.
2. Industry Risk:
A company’s growth will be in sync with the industry’s robustness to an extent. There are a few
exceptional cases where a company may perform irrespective of that industry going through a bad
phase.
3. Management Risk:
A management team will hold the whip hand to formulate strategies that will make or break the
company. Hence, quality of management is one thing that an investor must assess before banking on
it.
4. Company level risks: There are two broad categories of Company Level Risks including: Internal
and external. Internal risks refer to the company’s operation and external risks cater to operating
conditions that is beyond the control of the company.
5. Financial risks: The way a company handles its finances i.e. activities like borrowing, creating fixed
payment obligations in the form of interest, will all play a pivotal role in deciding the company’s
financial risks.
6. Interest rate: The increase in interest rate will increase the cost of borrowing which will trigger an
increase in the prices of products that will detrimentally affect its sales. A mounting interest rate will
affect the company’s earning with its effect felt on the share price.
7. Inflation risk: Inflation can have a negative effect on a company in numerous ways be it with
respect to wage hikes, magnified corporate profits owing to an overvaluation of closed inventory that
makes the company bear the brunt of high taxes.
Value-at-Risk for portfolios
Value-at-Risk for Portfolios
This topic would be covered via project implementation in Python. The
following project topics need to be implemented:
Projects Topics Page No.

Project 3 VaR based on sorted historical returns 405 405
Project 3 Simulation and VaR 408 408
Project 3 VaR for portfolios 409 409
Project 3 Backtesting and stress testing 411 411
FINANCIAL RISK
ANALYTICS
Credit and Counterparty Risk
• Financial distress: default, ratings • understand quantitative measures of
migration, insolvency and default risk
bankruptcy • implementing quantitative methods for
• The special treatment of insolvency PGD/LGD
for financial firms • assessing credit worthiness of single
• Credit Risk Models borrower
Credit
Risk
Clearing
Credit
Default Counterparty and
Mitigation
risk risk Settlement
risk
risk
Financial distress: default, ratings
migration, insolvency and bankruptcy
Credit Default
• Default is failure to pay on a financial obligation.
• Default occurs when the value of the assets is smaller than that of the debt, that is, the equity is
reduced to zero or a negative quantity.
Default events include :
1. Distressed Exchanges : The creditor receives securities with lower value or an amount of cash
less than par in exchange for the original debt.
2. Impairment : A credit can be impaired without default, in which case it is permissible to write down
its value and reduce reported earnings by that amount.
3. Bankruptcy is a legal procedure in which a person or firm “seeks relief” from its creditors to either
reorganize and restructure its balance sheet and operations, or liquidate and go out of business in
an orderly way.
During bankruptcy, the creditors are prevented from suing the bankrupt debtor to collect what is
owed them, and the obligor is allowed to continue business. At the end of the bankruptcy process,
the debt is extinguished or discharged.
Quantitative Measures of Default Risk
Three quantitative factors which are considered to have the strongest relationship with Default Risk:
1. Probability of Default : Probability Of Default (POD, PD) measures the likelihood that a borrower will be unable to
make payments in a timely manner. Ratings assigned by the various rating agencies can interpreted as a direct
measure of the probability of default. However, credit stability and priority of payment are also factored into the
rating.
2. Loss given Default : Loss Given Default (LGD) is the share of an asset that is lost if a borrower defaults. LGD
looks at the size of the loans, any collateral used for the loan, and the legal ability to pursue the defaulted funds if
the borrower goes bankrupt.
There is actually no universally accepted method of calculating LGD. Most lenders do not calculate LGD for
each separate loan; instead, they review an entire portfolio of loans and estimate total exposure to loss.
3. Exposure at default : Exposure at default (EAD) is the total value a lender is exposed to when a loan
defaults. EAD is a dynamic number that changes as a borrower repays a lender. Banks calculate an EAD value
for each loan and then use these figures to determine their overall default risk.
Exposure at Default = Recovery + LGD

Expected Loss = EAD x PD x LGD
Exposure at Default and Credit Risk Capital
• Credit Risk Capital: EAD, LGD, and POD are used to calculate the Credit Risk Capital
of financial institutions.
• Basel and EAD: EAD is an important variable to be monitored under BASEL. In

response to the credit crisis of 2007-2008, the banking sector adopted international
regulations to lessen its EAD.
The aim of these regulations are to improve the banking sector's ability to deal with
financial stress. Through improving risk management and bank transparency, the
international accord hopes to avoid a domino effect of failing financial institutions .
Ratings
• A rating is an assessment tool assigned by an analyst or rating agency to a stock or bond.
• The three major rating agencies are Standard & Poor’s, Moody’s, and Fitch.
• Analyst Ratings may include a buy, hold, or sell rating and an explanation of why they recommend
this action for the stock.
• Agency Ratings are based primarily upon the insurer's or issuer's creditworthiness.
Types of Ratings
1. Analyst Ratings
• Analysts on the buy-side will write opinions for their teams for the purposes of informing portfolio management decisions. Analy sts on
the sell-side will write opinions to educate others on their research and in an attempt to sell particular stocks.
• For a stock, an analyst may assign a buy, hold, or sell rating and an explanation of why they recommend this action for the stock .
When it comes to major Wall Street banks and institutions, they all have different terminology and classifications. To label stock s
• Goldman Sachs - market outperformer, market performer, and market underperformer. Timeline for their ratings is six to 18 months.
• Morgan Stanley - overweight, equal-weight, and underweight. Timeline for their ratings is 12 to 18 months.
• Credit Suisse - outperform, neutral, and underperform. Timeline for their ratings is 12 months.
2. Rating Agency Ratings

• A rating agency will assess the bond's ratings based on :
1. It’s relative safety based upon the issuing entity's fundamental financial picture
2. A scrutiny of the issuer's ability to repay the principal and make interest payments
• Rating Agencies:
1. S&P - leading data source and index provider of independent credit ratings.
2. Moody’s - provider of international financial research on government and commercial issued bonds.
3. Fitch -. This agency bases its ratings on factors such as how sensitive a company is to internal changes and the kind of debt the comp any
holds.
4. CRISIL
Assessing Creditworthiness
Lenders use quantitative methods to assess the creditworthiness of firms relying on balance sheet and other business
data of the firm as well as data on the state of the economy or the firm’s industry.
• Credit Rating: A credit rating is an alphanumeric grade that summarizes the creditworthiness of a security or a
corporate entity. Credit ratings are generally assigned by credit rating agencies that specialize in credit assessment.
The most prominent in the United States are Standard and Poor’s (S&P), Moody’s, Fitch Ratings, and Duff and
Phelps. These rating agencies have been granted special recognition by the Securities and Exchange Commission
(SEC). Their ratings are used as part of the bank and securities markets’ regulatory system, though the 2010 Dodd-
Frank Act mandates a reduction of the regulatory role of ratings in the United States
• Probability of Default: Rating agencies also assess the probability of default for companies based on their letter
ratings
• Rating Migration: Rating migration, or change in letter rating, occurs when one or more of the rating revises the
rating of a firm (or a government) or its debt securities. These probability estimates are summarized in transition
matrices, which show the estimated likelihood of a company with any starting rating ending a period, say, one year,
with a different rating or in default.
Typically, the diagonal elements in a transition matrix, which show the probability of finishing the year with an
unchanged rating, are the largest elements. Also typically, the probability of ending in default rises monotonically as
the letter rating quality falls. Finally, note that there is no transition from default to another rating; default is a
terminal state.
• Conflict of Interest: The ratings business provides a good example of conflicts of interest in credit markets. Ratings
agencies have generally been compensated for ratings by bond issuers rather than by sale of ratings data to
investors. In this so-called issuer-pays model, a potential conflict arises between investors in rated bonds, who
expect ratings to be based on objective methodologies, and issuers of bonds. This conflict has been identified by
some observers as having played a material role in causing the subprime crisis.
Counterparty Risk
• The risk that a trading counterparty will not fulfil an obligation to pay or deliver
securities.
• Counterparty risk can exist in credit, investment, and trading transactions.
OTC vs Exchange Traded derivatives - An over the counter (OTC) derivative is a financial
contract that does not trade on an asset exchange, and which can be tailored to each
party's needs. Exchange-traded derivatives (e.g. options) are traded on an asset
exchange.
• Counterparty risk is higher in OTC derivatives, since these are purely bilateral contracts
between two private counterparties. Exchange-traded derivatives have far less
counterparty risk, since the exchanges interpose a clearinghouse as a counterparty to
every trade.
• The clearinghouses historically have been well capitalized, since each clearing member
is obliged to put up clearing margin, and clearinghouse failure is quite rare. No
individual customer is exposed to another individual counterparty. Rather, each is
matched up against the clearinghouse.
Counterparty Risk
• Brokerage relationships. Clients often assume significant counterparty risk to their
brokers, if their brokers finance their positions. This makes the broker a Counterparty to
their client. Prior to the subprime crisis, the presumption had been that the broker, but
not the client, had credit exposure. The crisis experience, in which clients experienced
losses on exposures to failed brokerages such as Lehman, but broker losses on client
exposures remained comparatively rare, changed this presumption.
• Netting : Two dealers might find they have traded with one another at various prices,
obliging each one to deliver a large amount of the commodity to the other in exchange
for a large amount of money. Netting their contracts is an obvious efficiency gain for
both dealers. Multilateral netting, or netting among many counterparties, is far more
complicated, but brings the same efficiencies.
Counterparty Risk
Double Default Risk : Double default risk arises from the possibility that the counterparty of a credit derivative such as
a credit default swap that protects you against the default of a third party will default at the same time as that third party.
Prior to the Sub Prime crisis, AIG was a well-capitalized firm with an AAA rating, and was therefore an attractive
counterparty for firms, especially banks and broker-dealers, looking to buy protection on a wide range of credit
exposures via CDS. It had also invested in CDO tranches backed by mortgage collateral. If AIGFP proved unable to
meet its obligations under the CDS contracts at the same time that the bonds they owned suffered a material
impairment, they would lose their hedges. This scenario became far likelier during the subprime crisis, which is why
they were bailed out by the US Govt.
Credit Default Swap

A credit default swap (CDS) is like an insurance policy, a financial derivative or contract that allows an investor to
"swap" or offset his or her credit risk with that of another investor. For example, if a lender is worried that a borrower is
going to default on a loan, the lender could use a CDS to offset or swap that risk. To swap the risk of default, the lender
buys a CDS from another investor who agrees to reimburse the lender in the case the borrower defaults.
Credit Debt Obligation

A collateralized debt obligation (CDO) is a complex structured finance product that is backed by a pool of loans and
other assets and sold to institutional investors. These assets become the collateral if the loan defaults. To create a
CDO, investment banks gather cash flow-generating assets—such as mortgages, bonds, and other types of debt—and
repackage them into discrete classes, or tranches based on the level of credit risk assumed by the investor.
Counterparty Risk - Mitigation
Approaches to mitigating counterparty risk :
1. Accurately measure exposures,
2. maintain assessments of the credit condition of counterparty,
3. maintain a diverse set of counterparties
4. limit exposure to weaker counterparties.
Financial distress: insolvency and
bankruptcy
Insolvency
Insolvency involves the following:
• Financial Distress: Insolvency is a state of financial distress in which a person or business is
unable to pay their debts – loans, bills.
• Poor Cash Flow: Insolvency in a company can arise from various situations that lead to poor
cash flow.
• Restructuring of Debt: Business owners may contact creditors directly and restructure debts into
more manageable instalments. Creditors are typically amenable to this approach because they
desire repayment, even if the repayment is on a delayed schedule.
If a business owner plans on restructuring the company’s debt, they assemble a
realistic proposal showing :
1. Cost Reductions - How they can reduce company overhead
2. Other plans for support
3. Continue carrying out business operations.
4. how the business may produce enough cash flow for profitable operations while paying its
debts.
• Legal Action: Legal action might be initiated for insolvency proceedings against the insolvent
person or entity, and assets may be liquidated to pay off outstanding debts.
Bankruptcy
Bankruptcy is a legal proceeding involving a person or business that is unable to repay
their outstanding debts. Bankruptcy offers an individual or business a chance to start
fresh by forgiving debts that simply cannot be paid while giving creditors a chance to
obtain some measure of repayment based on the individual's or business's assets
available for liquidation.
The bankruptcy process begins with a petition filed by the debtor (more likely), or on
behalf of creditors (less likely).
All of the debtor's assets are measured and evaluated, and the assets may be used to
repay a portion of outstanding debt.
Bankruptcy is a legal proceeding carried out to allow individuals or businesses freedom

from their debts, while simultaneously providing creditors an opportunity for repayment.
Bankruptcy can allow you a fresh start, but it will stay on your credit reports for a number
of years and make it difficult to borrow in the future.
Types of Bankruptcy
1. Chapter 7 Bankruptcy –
• Traditional bankruptcy is called ‘Chapter 7’ of the Bankruptcy Code.
• Important requirement is that you do not have any real income to allow you to pay off any portion of your debts.
• Either pay for or give up your properties for secured debts.
• Surrender any non-exempt property to pay off as much of your other debt as possible.
• Keep all of your other exempt property and are released from any obligation to repay the remaining dis-chargeable debt.
• If you have any kind of possible income that can be termed ‘enough’, you need to file under Chapter 13.
• Do not need to get rid of all of your debt entirely, but try and do a combination as below:
1. Consider your income and restructure your payments OR
2. Get rid of a part of your total debt so that you can manage payments.
• Monthly/weekly payment amounts can be reduced and can be stretched for upto five years by:
1. Spreading your payments over a longer period of time OR
2. By paying only a part of the loan.
• Finances will be under constant supervision of the trustee during this entire time.
• Negotiating with creditors is part of the process as they try to get you to change your plan so they get more money or get it
faster.
• If creditors object, Chapter 13 can still be approved as long as the judge deems it fair and if each creditor gets as much as
if you had filed under Chapter 7.
• A person or company become a debtor-in-possession if they file for Chapter 11 Bankruptcy.
• They continue to have most of their responsibilities for operating the business
• Additional responsibility to work with the trustee for a plan to reorganize their debts.
• If both the judge and the creditors approve, the plan to do so can be put into action.
Insolvency vs. Bankruptcy
• Insolvency is the financial state in which a person or entity is no longer able to pay the
bills or other obligations.
• A bankruptcy is an actual court order that depicts how an insolvent person or business
will pay off their creditors, or how they will sell their assets in order to make the
payments.
• A person or corporation can be insolvent without being bankrupt, even if it's only a
temporary situation. If that situation extends longer than anticipated, it can lead to
bankruptcy.
The special treatment of insolvency for
financial firms
financial firms
• Banking Regulations: Banking regulation has specific mandates in place to reduce the risk of bank failures and catch problems at banks
early.
• Insolvency does happen: Banks and Non Banking Financial firms can and do become insolvent (ILFS, PMC Bank, Yes Bank, Global Trust
Bank Ltd., Nedungadi Bank Ltd., United Western Bank Ltd., Bank of Rajasthan Ltd. and Sangli Bank Ltd).
• Special Rules: To ensure the proper functioning of financial markets require application of special rules. The aim of the special rules is to
ensure that these firms wind down, or are rescued, in ways that promote the soundness of the financial markets . Regulatory agencies may
be involved in the process.
• Bank Insolvencies are different: Banks can become insolvent for a variety of reasons, ranging from failing to meet reserve requirements to
having a high default rate on the debt they issue. Bank insolvencies are somewhat different from regular business insolvency because the
collapse of the bank could cause significant financial problems for bank customers. Banks are typically insured and funds wil l be returned, up
to a certain amount, to people who had money on deposit with the bank.
• Bank Insolvency Resolutions: Regulatory agencies usually want to encourage banks to stay open by any means possible. A Regulator can
take either of the following steps:
1. Take over of the bank by an administrator who will attempt to help the bank recover
2. Restructuring can allow a bank to reopen, and the bank will be monitored to confirm it is adhering to the terms of the restructuring.
3. Sale of the bank to another firm can be negotiated, with the firm taking on the debt obligations of the bank. Regulators usually offer
a sweetener to the bank insolvency deal to encourage companies to buy failing banks and turn them around.
4. Close the bank.
• Strike Teams To Prevent Domino Effect: Economic uncertainty tends to be accompanied with a rise in bank insolvencies. Under normal
financial conditions, a handful of banks may fail in a given year. Once multiple large banks start to fail, a domino effect c an occur, with
smaller banks being dragged down as consumers start to panic and people fail to pay on their debts. In an economic climate wh ere bank
insolvency is a common problem, strike teams of regulators and government representatives may be developed in order to respond quickly
to failing banks.
Credit Risk Models
The Merton Model
• The Merton model is used to assess the credit risk of a company's debt.
• The Merton model provides a structural relationship between the default risk and the assets
of a company.
• Loan officers, stock analysts and investors utilize the Merton model to analyse a
corporation's risk of credit default.
This model helps :

1. In easier valuation of the company
2. To understand how capable a company is at meeting financial obligations and servicing its
debt.
3. To determine if the company will be able to retain solvency by analysing maturity dates and
debt totals.
• In 1974, economist Robert C. Merton proposed this model for assessing the structural credit
risk of a company by modelling the company's equity as a call option on its assets.
• This model was later extended by Fischer Black and Myron Scholes to develop the Nobel-
prize winning Black-Scholes pricing model for options.
The Merton Model - Calculation
The Formula for the Merton Model Is
E = Theoretical value of a company’s equity

Vt =Value of the company’s assets in period t
K = Value of the company’s debt
t = Current time period
T = Future time period
r = Risk-free interest rate
N = Cumulative standard normal distribution
e = Exponential term(i.e. 2.7183...)
σ = Standard deviation of stock returns
Understanding the Merton Model
The Merton Model helps to find out the Probability of Default (PD).
Assumptions
1. The company has issued capital in the form of
a. Equity (Et – Equity Value at time t) and
b. Debt (K – Debt Value at time t).
2. Equity and Debt together will form the Value of the Firm (Vt).
So, Vt = Et + K
Note - The Value of the firm keeps changing because of the various actions the company keeps
taking.
3. The debt issued by the company is in the form of Zero Coupon bonds. A zero coupon bond does
not pay interest but instead trades at a deep discount, rendering a profit at maturity, when the
bond is redeemed for its full face value.
4. The company will not pay any dividend on its equity.
5. At the end of a future time period (T), the company will :
a. Pay off its Debt (DT – Debt Value at time T).
b. Pay off the Equity holders, with the remaining amount after paying of the Debt (VT – DT)
c. Wind Up (Close Down).
1. If VT < DT, then there will be a default, because the company cannot pay its debt
obligation. The Debt Investor is going to get only VT and the remaining (DT – VT) will not
be paid to him. The Equity investor will be not be paid anything.
2. If VT >= DT, then the Debt Investor will be completely paid off i.e. DT. The balance (VT –
DT) is paid to the Equity investor.
3. Note that the debit obligation (DT) is a constant, known in advance.
4. The above conditions can be shown in the table below:

Condition Payout to the Debt Investor Payout to the Equity Investor
If VT < DT VT 0
If VT >= DT DT DT - VT
5. The above relationship can be stated as a Call Option as follows:
The Value of Equity Holders is a European Call Option on the Value of the firm (VT) with a
maturity period (T) and the Strike Price equal to the value of the total debt (DT).
Excel Example
Appendix
Credit Risk Terminology
• Spread - The difference between credit-risky and risk-free interest rates.
• Collateralised Debt Obligations (CDOs) - A collateralized debt obligation (CDO) is a

complex structured finance product that is backed by a pool of loans and other assets
and sold to institutional investors. These assets become the collateral if the loan
defaults.
FINANCIAL RISK
ANALYTICS
Credit and Counterparty Risk
• Financial distress: default, ratings • understand quantitative measures of
migration, insolvency and default risk
bankruptcy • implementing quantitative methods for
• The special treatment of insolvency PGD/LGD
for financial firms • assessing credit worthiness of single
• Credit Risk Models borrower
Credit
Risk
Clearing
Credit
Default Counterparty and
Mitigation
risk risk Settlement
risk
risk
Financial distress: default, ratings
migration, insolvency and bankruptcy
Credit Default
• Default is failure to pay on a financial obligation.
• Default occurs when the value of the assets is smaller than that of the debt, that is, the equity is
reduced to zero or a negative quantity.
Default events include :
1. Distressed Exchanges : The creditor receives securities with lower value or an amount of cash
less than par in exchange for the original debt.
2. Impairment : A credit can be impaired without default, in which case it is permissible to write down
its value and reduce reported earnings by that amount.
3. Bankruptcy is a legal procedure in which a person or firm “seeks relief” from its creditors to either
reorganize and restructure its balance sheet and operations, or liquidate and go out of business in
an orderly way.
During bankruptcy, the creditors are prevented from suing the bankrupt debtor to collect what is
owed them, and the obligor is allowed to continue business. At the end of the bankruptcy process,
the debt is extinguished or discharged.
Quantitative Measures of Default Risk
Three quantitative factors which are considered to have the strongest relationship with Default Risk:
1. Probability of Default : Probability Of Default (POD, PD) measures the likelihood that a borrower will be unable to
make payments in a timely manner. Ratings assigned by the various rating agencies can interpreted as a direct
measure of the probability of default. However, credit stability and priority of payment are also factored into the
rating.
2. Loss given Default : Loss Given Default (LGD) is the share of an asset that is lost if a borrower defaults. LGD
looks at the size of the loans, any collateral used for the loan, and the legal ability to pursue the defaulted funds if
the borrower goes bankrupt.
There is actually no universally accepted method of calculating LGD. Most lenders do not calculate LGD for
each separate loan; instead, they review an entire portfolio of loans and estimate total exposure to loss.
3. Exposure at default : Exposure at default (EAD) is the total value a lender is exposed to when a loan
defaults. EAD is a dynamic number that changes as a borrower repays a lender. Banks calculate an EAD value
for each loan and then use these figures to determine their overall default risk.
Exposure at Default = Recovery + LGD

Expected Loss = EAD x PD x LGD
Exposure at Default and Credit Risk Capital
• Credit Risk Capital: EAD, LGD, and POD are used to calculate the Credit Risk Capital
of financial institutions.
• Basel and EAD: EAD is an important variable to be monitored under BASEL. In

response to the credit crisis of 2007-2008, the banking sector adopted international
regulations to lessen its EAD.
The aim of these regulations are to improve the banking sector's ability to deal with
financial stress. Through improving risk management and bank transparency, the
international accord hopes to avoid a domino effect of failing financial institutions .
Ratings
• A rating is an assessment tool assigned by an analyst or rating agency to a stock or bond.
• The three major rating agencies are Standard & Poor’s, Moody’s, and Fitch.
• Analyst Ratings may include a buy, hold, or sell rating and an explanation of why they recommend
this action for the stock.
• Agency Ratings are based primarily upon the insurer's or issuer's creditworthiness.
Types of Ratings
1. Analyst Ratings
• Analysts on the buy-side will write opinions for their teams for the purposes of informing portfolio management decisions. Analy sts on
the sell-side will write opinions to educate others on their research and in an attempt to sell particular stocks.
• For a stock, an analyst may assign a buy, hold, or sell rating and an explanation of why they recommend this action for the stock .
When it comes to major Wall Street banks and institutions, they all have different terminology and classifications. To label stock s
• Goldman Sachs - market outperformer, market performer, and market underperformer. Timeline for their ratings is six to 18 months.
• Morgan Stanley - overweight, equal-weight, and underweight. Timeline for their ratings is 12 to 18 months.
• Credit Suisse - outperform, neutral, and underperform. Timeline for their ratings is 12 months.
2. Rating Agency Ratings

• A rating agency will assess the bond's ratings based on :
1. It’s relative safety based upon the issuing entity's fundamental financial picture
2. A scrutiny of the issuer's ability to repay the principal and make interest payments
• Rating Agencies:
1. S&P - leading data source and index provider of independent credit ratings.
2. Moody’s - provider of international financial research on government and commercial issued bonds.
3. Fitch -. This agency bases its ratings on factors such as how sensitive a company is to internal changes and the kind of debt the comp any
holds.
4. CRISIL
Lenders use quantitative methods to assess the creditworthiness of firms relying on balance sheet and other business
data of the firm as well as data on the state of the economy or the firm’s industry.
• Credit Rating: A credit rating is an alphanumeric grade that summarizes the creditworthiness of a security or a
corporate entity. Credit ratings are generally assigned by credit rating agencies that specialize in credit assessment.
The most prominent in the United States are Standard and Poor’s (S&P), Moody’s, Fitch Ratings, and Duff and
Phelps. These rating agencies have been granted special recognition by the Securities and Exchange Commission
(SEC). Their ratings are used as part of the bank and securities markets’ regulatory system, though the 2010 Dodd-
Frank Act mandates a reduction of the regulatory role of ratings in the United States
• Probability of Default: Rating agencies also assess the probability of default for companies based on their letter
ratings
• Rating Migration: Rating migration, or change in letter rating, occurs when one or more of the rating revises the
rating of a firm (or a government) or its debt securities. These probability estimates are summarized in transition
matrices, which show the estimated likelihood of a company with any starting rating ending a period, say, one year,
with a different rating or in default.
Typically, the diagonal elements in a transition matrix, which show the probability of finishing the year with an
unchanged rating, are the largest elements. Also typically, the probability of ending in default rises monotonically as
the letter rating quality falls. Finally, note that there is no transition from default to another rating; default is a
terminal state.
• Conflict of Interest: The ratings business provides a good example of conflicts of interest in credit markets. Ratings
agencies have generally been compensated for ratings by bond issuers rather than by sale of ratings data to
investors. In this so-called issuer-pays model, a potential conflict arises between investors in rated bonds, who
expect ratings to be based on objective methodologies, and issuers of bonds. This conflict has been identified by
some observers as having played a material role in causing the subprime crisis.
Counterparty Risk
• The risk that a trading counterparty will not fulfil an obligation to pay or deliver
securities.
• Counterparty risk can exist in credit, investment, and trading transactions.
OTC vs Exchange Traded derivatives - An over the counter (OTC) derivative is a financial
contract that does not trade on an asset exchange, and which can be tailored to each
party's needs. Exchange-traded derivatives (e.g. options) are traded on an asset
exchange.
• Counterparty risk is higher in OTC derivatives, since these are purely bilateral contracts
between two private counterparties. Exchange-traded derivatives have far less
counterparty risk, since the exchanges interpose a clearinghouse as a counterparty to
every trade.
• The clearinghouses historically have been well capitalized, since each clearing member
is obliged to put up clearing margin, and clearinghouse failure is quite rare. No
individual customer is exposed to another individual counterparty. Rather, each is
matched up against the clearinghouse.
Counterparty Risk
• Brokerage relationships. Clients often assume significant counterparty risk to their
brokers, if their brokers finance their positions. This makes the broker a Counterparty to
their client. Prior to the subprime crisis, the presumption had been that the broker, but
not the client, had credit exposure. The crisis experience, in which clients experienced
losses on exposures to failed brokerages such as Lehman, but broker losses on client
exposures remained comparatively rare, changed this presumption.
• Netting : Two dealers might find they have traded with one another at various prices,
obliging each one to deliver a large amount of the commodity to the other in exchange
for a large amount of money. Netting their contracts is an obvious efficiency gain for
both dealers. Multilateral netting, or netting among many counterparties, is far more
complicated, but brings the same efficiencies.
Counterparty Risk
Double Default Risk : Double default risk arises from the possibility that the counterparty of a credit derivative such as
a credit default swap that protects you against the default of a third party will default at the same time as that third party.
Prior to the Sub Prime crisis, AIG was a well-capitalized firm with an AAA rating, and was therefore an attractive
counterparty for firms, especially banks and broker-dealers, looking to buy protection on a wide range of credit
exposures via CDS. It had also invested in CDO tranches backed by mortgage collateral. If AIGFP proved unable to
meet its obligations under the CDS contracts at the same time that the bonds they owned suffered a material
impairment, they would lose their hedges. This scenario became far likelier during the subprime crisis, which is why
they were bailed out by the US Govt.
Credit Default Swap

A credit default swap (CDS) is like an insurance policy, a financial derivative or contract that allows an investor to
"swap" or offset his or her credit risk with that of another investor. For example, if a lender is worried that a borrower is
going to default on a loan, the lender could use a CDS to offset or swap that risk. To swap the risk of default, the lender
buys a CDS from another investor who agrees to reimburse the lender in the case the borrower defaults.
Credit Debt Obligation

A collateralized debt obligation (CDO) is a complex structured finance product that is backed by a pool of loans and
other assets and sold to institutional investors. These assets become the collateral if the loan defaults. To create a
CDO, investment banks gather cash flow-generating assets—such as mortgages, bonds, and other types of debt—and
repackage them into discrete classes, or tranches based on the level of credit risk assumed by the investor.
Counterparty Risk - Mitigation
Approaches to mitigating counterparty risk :
1. Accurately measure exposures,
2. maintain assessments of the credit condition of counterparty,
3. maintain a diverse set of counterparties
4. limit exposure to weaker counterparties.
Financial distress: insolvency and
bankruptcy
Insolvency
Insolvency involves the following:
• Financial Distress: Insolvency is a state of financial distress in which a person or business is
unable to pay their debts – loans, bills.
• Poor Cash Flow: Insolvency in a company can arise from various situations that lead to poor
cash flow.
• Restructuring of Debt: Business owners may contact creditors directly and restructure debts into
more manageable instalments. Creditors are typically amenable to this approach because they
desire repayment, even if the repayment is on a delayed schedule.
If a business owner plans on restructuring the company’s debt, they assemble a
realistic proposal showing :
1. Cost Reductions - How they can reduce company overhead
2. Other plans for support
3. Continue carrying out business operations.
4. how the business may produce enough cash flow for profitable operations while paying its
debts.
• Legal Action: Legal action might be initiated for insolvency proceedings against the insolvent
person or entity, and assets may be liquidated to pay off outstanding debts.
Bankruptcy
Bankruptcy is a legal proceeding involving a person or business that is unable to repay
their outstanding debts. Bankruptcy offers an individual or business a chance to start
fresh by forgiving debts that simply cannot be paid while giving creditors a chance to
obtain some measure of repayment based on the individual's or business's assets
available for liquidation.
The bankruptcy process begins with a petition filed by the debtor (more likely), or on
behalf of creditors (less likely).
All of the debtor's assets are measured and evaluated, and the assets may be used to
repay a portion of outstanding debt.
Bankruptcy is a legal proceeding carried out to allow individuals or businesses freedom

from their debts, while simultaneously providing creditors an opportunity for repayment.
Bankruptcy can allow you a fresh start, but it will stay on your credit reports for a number
of years and make it difficult to borrow in the future.
Types of Bankruptcy
• Traditional bankruptcy is called ‘Chapter 7’ of the Bankruptcy Code.
• Important requirement is that you do not have any real income to allow you to pay off any portion of your debts.
• Either pay for or give up your properties for secured debts.
• Surrender any non-exempt property to pay off as much of your other debt as possible.
• Keep all of your other exempt property and are released from any obligation to repay the remaining dis-chargeable debt.
• If you have any kind of possible income that can be termed ‘enough’, you need to file under Chapter 13.
• Do not need to get rid of all of your debt entirely, but try and do a combination as below:
1. Consider your income and restructure your payments OR
2. Get rid of a part of your total debt so that you can manage payments.
• Monthly/weekly payment amounts can be reduced and can be stretched for upto five years by:
1. Spreading your payments over a longer period of time OR
2. By paying only a part of the loan.
• Finances will be under constant supervision of the trustee during this entire time.
• Negotiating with creditors is part of the process as they try to get you to change your plan so they get more money or get it
faster.
• If creditors object, Chapter 13 can still be approved as long as the judge deems it fair and if each creditor gets as much as
if you had filed under Chapter 7.
• A person or company become a debtor-in-possession if they file for Chapter 11 Bankruptcy.
• They continue to have most of their responsibilities for operating the business
• Additional responsibility to work with the trustee for a plan to reorganize their debts.
• If both the judge and the creditors approve, the plan to do so can be put into action.
Insolvency vs. Bankruptcy
• Insolvency is the financial state in which a person or entity is no longer able to pay the
bills or other obligations.
• A bankruptcy is an actual court order that depicts how an insolvent person or business
will pay off their creditors, or how they will sell their assets in order to make the
payments.
• A person or corporation can be insolvent without being bankrupt, even if it's only a
temporary situation. If that situation extends longer than anticipated, it can lead to
bankruptcy.
financial firms
financial firms
• Banking Regulations: Banking regulation has specific mandates in place to reduce the risk of bank failures and catch problems at banks
early.
• Insolvency does happen: Banks and Non Banking Financial firms can and do become insolvent (ILFS, PMC Bank, Yes Bank, Global Trust
Bank Ltd., Nedungadi Bank Ltd., United Western Bank Ltd., Bank of Rajasthan Ltd. and Sangli Bank Ltd).
• Special Rules: To ensure the proper functioning of financial markets require application of special rules. The aim of the special rules is to
ensure that these firms wind down, or are rescued, in ways that promote the soundness of the financial markets . Regulatory agencies may
be involved in the process.
• Bank Insolvencies are different: Banks can become insolvent for a variety of reasons, ranging from failing to meet reserve requirements to
having a high default rate on the debt they issue. Bank insolvencies are somewhat different from regular business insolvency because the
collapse of the bank could cause significant financial problems for bank customers. Banks are typically insured and funds wil l be returned, up
to a certain amount, to people who had money on deposit with the bank.
• Bank Insolvency Resolutions: Regulatory agencies usually want to encourage banks to stay open by any means possible. A Regulator can
take either of the following steps:
1. Take over of the bank by an administrator who will attempt to help the bank recover
2. Restructuring can allow a bank to reopen, and the bank will be monitored to confirm it is adhering to the terms of the restructuring.
3. Sale of the bank to another firm can be negotiated, with the firm taking on the debt obligations of the bank. Regulators usually offer
a sweetener to the bank insolvency deal to encourage companies to buy failing banks and turn them around.
4. Close the bank.
• Strike Teams To Prevent Domino Effect: Economic uncertainty tends to be accompanied with a rise in bank insolvencies. Under normal
financial conditions, a handful of banks may fail in a given year. Once multiple large banks start to fail, a domino effect c an occur, with
smaller banks being dragged down as consumers start to panic and people fail to pay on their debts. In an economic climate wh ere bank
insolvency is a common problem, strike teams of regulators and government representatives may be developed in order to respond quickly
to failing banks.
Credit Risk Models
The Merton Model
• The Merton model is used to assess the credit risk of a company's debt.
• The Merton model provides a structural relationship between the default risk and the assets
of a company.
• Loan officers, stock analysts and investors utilize the Merton model to analyse a
corporation's risk of credit default.
This model helps :

1. In easier valuation of the company
2. To understand how capable a company is at meeting financial obligations and servicing its
debt.
3. To determine if the company will be able to retain solvency by analysing maturity dates and
debt totals.
• In 1974, economist Robert C. Merton proposed this model for assessing the structural credit
risk of a company by modelling the company's equity as a call option on its assets.
• This model was later extended by Fischer Black and Myron Scholes to develop the Nobel-
prize winning Black-Scholes pricing model for options.
The Merton Model - Calculation
The Formula for the Merton Model Is
E = Theoretical value of a company’s equity

Vt =Value of the company’s assets in period t
K = Value of the company’s debt
t = Current time period
T = Future time period
r = Risk-free interest rate
N = Cumulative standard normal distribution
e = Exponential term(i.e. 2.7183...)
σ = Standard deviation of stock returns
The Merton Model helps to find out the Probability of Default (PD).
Assumptions
1. The company has issued capital in the form of
a. Equity (Et – Equity Value at time t) and
b. Debt (K – Debt Value at time t).
2. Equity and Debt together will form the Value of the Firm (Vt).
So, Vt = Et + K
Note - The Value of the firm keeps changing because of the various actions the company keeps
taking.
3. The debt issued by the company is in the form of Zero Coupon bonds. A zero coupon bond does
not pay interest but instead trades at a deep discount, rendering a profit at maturity, when the
bond is redeemed for its full face value.
4. The company will not pay any dividend on its equity.
5. At the end of a future time period (T), the company will :
a. Pay off its Debt (DT – Debt Value at time T).
b. Pay off the Equity holders, with the remaining amount after paying of the Debt (VT – DT)
c. Wind Up (Close Down).
1. If VT < DT, then there will be a default, because the company cannot pay its debt
obligation. The Debt Investor is going to get only VT and the remaining (DT – VT) will not
be paid to him. The Equity investor will be not be paid anything.
2. If VT >= DT, then the Debt Investor will be completely paid off i.e. DT. The balance (VT –
DT) is paid to the Equity investor.
3. Note that the debit obligation (DT) is a constant, known in advance.
4. The above conditions can be shown in the table below:

Condition Payout to the Debt Investor Payout to the Equity Investor
If VT < DT VT 0
If VT >= DT DT DT - VT
5. The above relationship can be stated as a Call Option as follows:
The Value of Equity Holders is a European Call Option on the Value of the firm (VT) with a
maturity period (T) and the Strike Price equal to the value of the total debt (DT).
Excel Example
Appendix
Credit Risk Terminology
• Spread - The difference between credit-risky and risk-free interest rates.
• Collateralised Debt Obligations (CDOs) - A collateralized debt obligation (CDO) is a

complex structured finance product that is backed by a pool of loans and other assets
and sold to institutional investors. These assets become the collateral if the loan
defaults.
FINANCIAL RISK
ANALYTICS
Portfolio Credit Risk
• Default Correlation • Understand and use single-factor model
• Risk Measurements • Using simulation and copula for credit risk
• Estimate Portfolio Risk models and Value-at-Risk at Portfolio
level
Portfolio Credit Risk
A portfolio of credit-risky securities may contain bonds, commercial paper, off-balance-sheet
exposures such as guarantees, as well as positions in credit derivatives such as credit default swaps
(CDS).
Financial institutions are increasingly measuring and managing the risk from credit exposures at the
portfolio level, in addition to the transaction level. This change in perspective has occurred for a
number of reasons:
1. The recognition that the traditional binary classification of credits into “good” credits and “bad”
credits is not sufficient—a precondition for managing credit risk at the portfolio level is the
recognition that all credits can potentially become “bad” over time given a particular economic
scenario.
2. The second reason is the declining profitability of traditional credit products, implying little room
for error in terms of the selection and pricing of individual transactions, or for portfolio decisions,
where diversification and timing effects increasingly mean the difference between profit and loss.
3. The management has more opportunities to manage exposure proactively after it has been
originated, with the increased liquidity in the secondary loan market, the increased importance of
syndicated lending, the availability of credit derivatives and third-party guarantees, and so on.
Default Correlation
Default Correlation
• Default Correlation is the likelihood of having multiple defaults in a portfolio of debt issued by
several obligors.
• The credit default correlation between two companies or countries is a measure of their tendency to
default at the same time.
• Default correlation is important in risk management when analyzing the benefits of credit risk
diversification.
Default Correlation
• When modelling a credit-risky position, there are a number of elements that we take into
consideration. These include:
1. The probability of default
2. The LGD and recovery rate
3. Rating migration probabilities
4. Spread risk
5. Possible eventual proceedings for a company in distress, such as the restructuring of debt
• A portfolio of credit instruments is exposed to a myriad of risks just like any other portfolio. Although
the probability of default of two firms may be uncorrelated, default events do show some correlation.
Spread risk refers to the risk that the credit spread for a particular investment turns out not to be high enough to justify
investing in that particular loan or bond versus other, lower default risk investments, causing the investment to be less
worthwhile. For example, if an investor buys a corporate bond with a 3 percentage point credit spread above the
comparable Treasury bond, and that premium later drops to 1 percentage point, the value of the bond will drop since
investors will be less inclined to take on the added default risk for that smaller spread.
Default Correlation
To understand the concept of default correlation, let’s assume the following:
• We have positions in two firms
• The probability of default (or restructuring) is π1 and π2
• The time horizon is τ
• The joint probability of default is π12
Default Correlation
When modelling the credit risk of our two-firm position, we can interpret the portfolio as the distribution
of the product of two Bernoulli-distributed random variables, xi , with four possible outcomes, as
illustrated in the table below:
Note -
• All probabilities must add up to 1
• The probability that at least one firm defaults can be found in two ways: First, we can simply subtract
the probability of the first outcome from 1.Alternatively, we can sum up the probabilities of the last
three outcomes.
P [Firm 1 or Firm 2 or both default] = π1 + π2 − π12
Default Correlation - Moments
• The means of the two Bernoulli-distributed default processes are
E [xi ] = πi , i = 1, 2
• The expected value of the product—representing joint default—is

E [x1x2] = π12.
• The variances are

E [xi]2 − (E [xi])2 = πi(1 − πi), i = 1, 2
• The covariance is
E [x1x2] − E [x1] E [x2] = π12 − π1π2
• The default correlation, is
• The joint default probability, is

Default Correlation – Example 1
An investment firm holds a position in two credits.
• The first credit is rated AAA with a probability of default of 0.001 over the next time
horizon t.
• The second credit is rated BBB with a probability of default of 0.004 over a similar
horizon.
• The joint probability of default over time horizon t is 0.00018.
The default correlation for this portfolio is calculated as given below:
= 8.82%
Default Correlation – Example 2
An investment firm holds a position in two credits.
1. The first credit has a rating of BBB+ with probability of default π1 = 0.0025
2. The second credit has a rating of BBB- with probability of default π2 = 0.0125
If the defaults are uncorrelated, then the joint probability of default π12 = 0.000031, less
than a third of a basis point.
If, however, the default correlation is +5 percent, then the joint probability of default π12 =
0.000309, nearly 10 times as great, and at 3 basis points, no longer negligible.
In other words, the higher the positive correlation, the greater the joint probability
of default.
Drawbacks in the Correlation-Based
Credit Portfolio Framework
1. Dimensionality - In a situation where there are N credits in the portfolio, we must
define N default probabilities and N recovery rates. What’s more, we require N(N−1)
pairwise correlations.
2. Rare Event - For most companies that issue debt, most of the time, default is a
relatively rare event. This means :
a. Default correlation is hard to measure or estimate using historical default data.
Moreover these correlations have been observed to vary widely for different
time periods, industrial sectors, and regions.
b. Default correlations are small in magnitude
3. Contingent Credit Positions - Some credit positions exhibit features that do not
blend in well within the default correlation credit model. For instance, guarantees
and revolving credit agreements are contingent in nature and behave more or less
like options and therefore possess some technical factors that are not
accommodated within the default correlation framework.
Risk Measurements
Risk Measurements
1. Portfolio Credit Value-at-Risk
2. Portfolio Credit Value-at-Risk with The Single Factor

Model
3. Using Simulation and Copulas to estimate Portfolio

Credit Risk
Portfolio credit VaR
• Portfolio Credit VaR is defined as a quantile of the credit loss, minus the expected loss
of the portfolio.
• Default correlation affects the volatility and extreme quantiles of loss rather than the
expected loss. Thus default correlation has an impact on Portfolio Credit VaR
• If default correlation in a portfolio of credits is equal to 1, then

• The portfolio behaves as if it consisted of just one credit
• There are no diversification benefits.
• If default correlation is equal to 0, then

• The number of defaults in the portfolio is a binomially distributed random variable
• There is no correlation with other firms in the portfolio.
• Significant credit diversification may be achieved.
Portfolio Credit VaR – Computation
Example 1
Default Correlation = 1
Number of Credits = 1
Portfolio Value = $100,000,000
Default probability for each credit π = 2%
Recovery Rate for each credit = 0 (In the event of default, the position is wiped out and there’s a total loss.)
Calculate the Portfolio Credit VaR at 95% Confidence level.
Solution
• Since the default correlation equals 1, the entire portfolio will act as if it is a single credit.
• Expected loss = π× total value of the portfolio = 2%× $100,000,000 = $2,000,000
• The credit VaR is the quantile of the credit loss minus the expected loss.
At 95%, the credit VaR = 0 – $2,000,000 = -$2000,000
Important point:
• If π is greater than the confidence level of the credit VaR, the VaR is equal to the entire $100,000,000 less than the
expected loss. If π is less than the confidence level, then the VaR is less than zero, since we always subtract the
expected from the extreme loss. In the example above, the default probability is 2% and the confidence level is 98%
(2%<98%), thus the credit VaR is negative (i.e. a gain) because there is a 98% probability that the credit loss in the
portfolio will be zero.
• When the Default Correlation = 1. regardless of the value of n, say, 5, 10, 50 etc., the portfolio will behave as if n = 1.
Example 2
Default probability for each credit π = 0.02
The 95th percentile of the number of defaults = 3.
Solution
• For n = 50, each position has a future value, if it doesn’t default, of $2,000,000
• If there are three defaults, the credit loss is 3 × $2000,000 = $6,000,000
• The expected loss is total portfolio value times the probability of default = 0.02 × 100,000,000 = $2,000,000
• The credit VaR at the 95% confidence level is credit loss of $6,000,000 less the expected loss of $2,000,000 =
$4,000,000
Example 3
Default probability for each credit π = 0.02
The 95th percentile of the number of defaults = 28
Solution
• As the portfolio value is $100,000,000 and is made up of 1,000 credits, it implies each credit has a future value of
$100,000 if it doesn’t default.
• The expected loss is total portfolio value times the probability of default = 0.02 × 100,000,000 = $2,000,000
• If there are 28 defaults, the credit loss is 28 × $100,000 = $2,800,000
• The credit VaR at the 95% confidence level is credit loss of $2,800,000 less the expected loss of $2,000,000 =
$800,000
• As the portfolio becomes more and more
granular(by increasing the number of
# of Credits Credit VaR credits), the credit value at risk decreases,
for a given default probability.
1 -$2,000,000
50 $4,000,000 • However, it is harder to reduce VaR by
making the portfolio more granular, if the
1000 $800,000 default probability is low.
Till now, we have only looked at credit portfolio risk by restraining ourselves to
default correlations of 0 or 1. In reality, default correlations often lie in between 0
and 1.
Estimate Portfolio Risk
Credit VaR - Single-Factor Model
• Till now, we have only looked at credit portfolio risk by restraining ourselves to default correlations of
0 or 1. In reality, default correlations often lie in between 0 and 1.
• The single-factor model for measuring Credit VaR allows us to vary default correlation through :
1. The credit’s beta to the market factor
2. The role played by idiosyncratic risk. (for e.g. a company’s internal event)
• To use the single-factor model to measure portfolio credit risk, we start with a number of firms i = 1,
2, . . . N,
Each firm has :

• A beta correlation βi with the Market, m. A beta correlation is between 0 and 1.
• Its own standard deviation of idiosyncratic risk
An idiosyncratic shock ϵi (for e.g. death of CEO).
In these circumstances, the firm’s individual asset return is given by:

Credit VaR - Single-Factor Model [Cont’d]
Credit VaR - Single-Factor Model [Cont’d]
Conditional Independence in the Single-Factor Model
• Once a particular value of the market factor is realized, the asset

returns—and hence default risks—are independent of one another i.e.
the firms’ returns are correlated only via their relationship to the
market factor.
• It follows that the Single Factor Model can be used to measure default
probabilities that are conditional on market movement.
Copulas
• The copula is a probability model that represents a
multivariate uniform distribution, which examines the association or
dependence between many variables.
• Correlation coefficient work best with normal distributions
• The copula is applied to areas of finance such as option pricing and

portfolio value-at-risk to deal with non-normal distributions - skewed
or asymmetric distributions.
• Copulas are a multivariate mathematical tool to help

identify economic capital adequacy, market risk, credit risk, and
operational risk, where there is a need to hedge against a number of
risks simultaneously.
Credit VaR-Simulation of Joint Defaults
• Joint defaults present a big problem for portfolio credit risk managers.
• There’s a nonzero probability of joint default because the default is driven not just by a company’s
unique situation but also by the state of the economy and perhaps an industry sector. This is why
the Factor models make sense.
Copulas can help us model joint defaults and provide us

with a useful tool that can help determine how defaults are
correlated with one another using simulation.
1. To calculate the credit VaR, we start with a set of

univariate default time distributions for each credit in
the portfolio.
2. Then, we simulate joint defaults devising a
multivariate default time distribution.
Appendix
Gaussian Copula
https://www.youtube.com/watch?v=z43_pf5Y6A8
FINANCIAL RISK
ANALYTICS
Structured Credit Risk
• Basics of structured credit • Perform risk analysis of securitization
• Tranching and waterfall tranches
• Models and approaches to • Measure and model the impact of default
structured credit risk measurements rates and default correlation
Basics Of Structured Credit
Basics Of Structured Credit
• Structured finance is a financial instrument available to companies with complex financing needs,
which cannot be ordinarily solved with conventional financing.
• These are vehicles that create bonds or credit derivatives backed by a pool of loans, bonds or other
claims.
• Traditional lenders do not generally offer structured financing.
• The major types of securitizations and structured credit products are collectively called portfolio
credit products.
• Structured financial products, such as collateralized debt obligations, are non-transferable.
• Structured finance is being used to manage risk and develop financial markets for complex
requirements of emerging markets.
• There are several dimensions for classifying the great variety of structured credit products:
1. Underlying Assets
2. Type of structure
Structured Credit Types based on
Underlying Assets
• Every structured product is based on a set of underlying loans, receivables, or other claims that constitute the
collateral or loan pool.
• The collateral is typically composed of residential or commercial real estate loans, consumer debt such as credit
cards balances and auto and student loans, and corporate bonds. Non-debt assets such as recurring fee income,
can also be packaged into securitizations.
• The credit quality and prepayment behaviour of the underlying risks is critical in assessing the risks of the structured
products built upon them.
Securitizations could be at 3 levels of aggregation:

• Level 1 : Securitizations that are based on a pool of cash-debt securities
• Asset backed securities (ABS)
• Mortgage-backed securities (MBS)
• Collateralized loan obligations (CLOs).
• Level 2 : Securitizations that repackage other securitizations could be :
• Collateralized debt obligations (CDOs), issuing bonds against a collateral pool consisting of ABS, MBS, or
CLOs),
• Collateralized mortgage obligations (CMOs)
• Collateralized bond obligations (CBOs).
• Level 3 : CDO-squareds
• CDO-squareds are third-level securitizations, in which the collateral pool consists of CDO liabilities, which
themselves consist of bonds backed by a collateral pool.
Underlying Assets – Cont’d
Covered bonds
• Secured by a cover pool consisting of aggregated mortgage loans
• The cover pool stays on the balance sheet of the bank and therefore not considered full-fledged
securitizations. They are segregated from other assets of the bank in the event the bank defaults.
• The pool assets would be used to pay off the covered bond owners before they could be applied to
repay general creditors of the bank. Apart from the security of the cover pool, the covered bonds are
backed by the issuer’s obligation to pay.
• The principal and interest on the secured bond issue are paid out of the general cash flows of the
issuer, rather than out of the cash flows generated by the cover pool.
• They are issued mainly by European banks, mainly in Germany and Denmark.
Mortgage pass-through securities

• Backed by a pool of mortgage loans
• Removed from the mortgage originators’ balance sheets
• True securitizations and structured products
• Administered by a servicer, who collects principal and interest from the underlying loans and
distributes (“passed through”) them to the bondholders.
• Credit risks dependent on the pool of underlying loans.
• Cash flows depend not only on amortization, but also voluntary prepayments by the mortgagor.
Bondholders are therefore exposed to prepayment risk.
Underlying Assets – Cont’d
Collateralized Mortgage Obligations
• Amortize over time, creating cash flow streams that diminish over time.
• CMOs are “sliced,” into tranches that are paid down on a specified schedule.
• The simplest structure is sequential pay, in which the tranches are ordered, with “Class A” receiving
all principal repayments from the loan until it is retired, then “Class B,” and so on.
• The higher tranches in the sequence have less prepayment risk than a pass-through, while the
lower ones bear more.
Synthetic Securitization
• The assets of these structured products are not cash debt instruments, but rather credit derivatives,
most frequently CDS.
• These are called synthetic securitizations, in contrast to cash or cash-flow securitizations.
• The set of underlying cash debt instruments on which a synthetic securitization is based generally
consists of securitization liabilities rather than loans, and is called the reference portfolio.
Structured Credit Products based on
Types of Structure
• Structured products are usually set up as special purpose entities (SPE) or vehicles (SPV), also
known as a trust to make bankruptcy remote.
• A structured product can be thought of as a “robot” corporate entity with a balance sheet, but no
other business. The underlying debt instruments in the SPV are the robot entity’s assets, and the
structured credit products built on it are its liabilities.
• This arrangement is intended to legally separate the assets and liabilities of the structured product
from those of the original creditors and of the company that manages the payments. This permits
investors to focus on the credit quality of the loans themselves rather than that of the original
lenders in assessing the credit quality of the securitization.
• Structured products are tools for splitting and redirecting the cash flows and credit losses, generated
by the underlying debt instruments, to the structured products in specified ways.
Managing Risks using Asset Pools
There are three different approaches to manage risks for structured credit products tending to
coincide with asset class:
• Static pools are amortizing pools in which a fixed set of loans is placed in the trust. As the loans
amortize, are repaid, or default, the deal, and the bonds it issues, gradually wind down. Static pools
are common for such asset types as auto loans and residential mortgages, which generally
themselves have a fixed and relatively long term at origination but pay down over time.
• Revolving pools specify an overall level of assets that is to be maintained during a revolving
period. As underlying loans are repaid, the size of the pool is maintained by introducing additional
loans from the balance sheet of the originator. Revolving pools are common for bonds backed by
credit card debt, which is not issued in a fixed amount, but can within limits be drawn upon and
repaid by the borrower at his own discretion and without notification. Once the revolving period
ends, the loan pool becomes fixed, and the deal winds down gradually as debts are repaid or
become delinquent and are charged off.
• Managed pools are pools in which the manager of the structured product has discretion to remove
individual loans from the pool, sell them, and replace them with others. Managed pools have
typically been seen in CLOs. Managers of CLOs are hired in part for skill in identifying loans with
higher spreads than warranted by their credit quality. They can, in theory, also see credit problems
arising at an early stage, and trade out of loans through the secondary market they believe are more
likely to default.
Tranching And Waterfall
Structured Credit Products - Tranche
• Most structured products have a sequential capital structure with different tranches (slice, section,
portion). The tranching refers to the number and size of the bonds carved out of the liability side of
the securitization:
• Tranches are portions of a pooled collection of securities (usually debt instruments) that are split up
by risk or other characteristics in order to be marketable to different investors.
• Tranches carry different maturities, yields, and degrees of risk—and privileges in repayment in case
of default.
• Tranches are common in securitized products like Collateralized Debt Obligations (CDOs) and
Collateralized Mortgage Obligations (CMOs).
• If losses occur, Junior tranches are written down first. Senior tranches begin to bear credit losses
once the junior tranches have been written down to zero.
• The safest tranche is also known as the senior tranche. It offers the lowest interest rate, but it’s
the first to receive cash flows from the underlying asset portfolio.
• The middle (mezzanine) tranche offers a slightly higher interest rate and ranks just below the
senior tranche. It takes the second spot during cash flow distribution. It will absorb losses only after
the equity tranche is completely written down.
• The most junior tranche, also called the equity tranche, offers the highest interest rate (or high
spread if the claim is floating) but ranks last during cash flow distribution. It’s also the first tranche to
absorb any loss that may be incurred. The amount available for distribution to the equity (junior)
tranche is whatever is left from the two other tranches less management fees. These fees can range
from 0.5% to 1.5% annually.
• The boundary between the senior tranche and the mezzanine tranche, expressed as a percentage
of the total of the liabilities, is called the attachment point of the more senior tranche
and detachment point of the junior (mezzanine) tranche. The equity tranche only has a detachment
point, and the most senior only has an attachment point.
• The part of the capital structure below a given tranche is called its subordination or credit
enhancement. We can interpret it as the fraction of the collateral pool that must be lost before the
tranche takes any loss. Credit enhancement is greater for more senior bonds in the structure.
Credit enhancement (CE) can take two forms - Internal CE or External CE.
Internal CE
• Over-collateralization (OC) is the provision of collateral that is worth more than enough to cover the claims from
investors. In other words, the assets underlying the product have a value that’s in excess of the face value of
securities issued to investors.
• Excess spread is the difference between the cash flows collected and the payments made to all bondholders. For
instance, let the interest rate received on the underlying collateral be 11%, and the coupon on the issued structured
security be 10% (including fees). In this case, the excess spread is 1%. The excess spread is a built-in margin of
safety that protects the pool (and originator) from losses. Its presence can actually improve the ratings on the
structured product being assembled and make the resulting security more attractive to investors.
External CE
• Investors in these tranches can protect themselves from default by purchasing credit default swaps. This CDS
guarantees a pre-specified compensation in the event that a given tranche defaults. In turn, the investors must make
regular payments to the credit protection seller (writer of the CDS).
• Performance guarantees are typically provided by monoline insurance companies. The insurer guarantees
timely repayment of bond principal and interest in exchange for insurance premiums.
Each tranche is assigned its own credit rating, except the equity tranche. For instance, the senior tranche is
constructed to receive an AAA rating. Highly rated tranches are sold to investors, but the junior ranking ones may end
up being held by the issuing bank. That way, the bank has an incentive to monitor the underlying loans.
Structured Credit Products - Waterfall
The Waterfall structure involves the rules about how the cash flows from the collateral are distributed
to the various securities in the capital structure.
The Waterfall could take various forms:
1. Waterfall payment structures could allow higher-tiered creditors to be paid principal and interest
ahead of lower-tiered creditors.
2. Lower-tiered creditors could be paid interest-only payments until the higher-tiered creditors are
paid in full.
3. Waterfall payments can be structured to pay off one loan at a time or pay all loans in a systematic
fashion.
Example 1
Assume a company has taken loans from three creditors, Creditor A, Creditor B, and Creditor C. The scheme is
structured so that Creditor A is the highest-tiered creditor while Creditor C is the lowest-tiered creditor. The arrangement
for what the company owes each of the creditors is as follows:
a. Creditor A is owed a total of $5 million in interest and $10 million in principal.
b. Creditor B is owed a total of $3 million in interest and $8 million in principal.
c. Creditor C is owed a total of $1 million in interest and $5 million in principal.
Assume in year one the company earns $17 million. It then pays off the entire $15 million owed to Creditor A, leaving it
with $2 million to pay off further debts. Since the priority structure is still in place, this $2 million must be applied to
Creditor B. Assume the company pays $1 million to Creditor B for interest and $1 million to Creditor B for the principal.
The result after year one is as follows:
a. Creditor A is fully paid.
b. Creditor B is owed a total of $2 million in interest and $7 million in principal.
c. Creditor C is owed a total of $1 million in interest and $5 million in principal.
If in year two, the company earns $13 million, it could then pay off the remaining obligation to Creditor B and begin
paying off Creditor C. The result after year two is as follows:
a. Creditor A is fully paid.
b. Creditor B is fully paid.
c. Creditor C is owed $2 million in principal.
This example was simplified to show the mechanics of a waterfall payment scheme. In reality, some waterfall schemes
are structured so minimum interest payments are made to all tiers during each payment cycle.
Example 2
A collateralized loan obligation is comprised of 100 identical leveraged loans with a par value of $1,000,000 each,
priced at par. The loans pay a fixed spread of 4% over one –month Libor. The capital structure consists of equity, and a
junior and a senior bond. Determine the excess spread, assuming that there are no defaults in the collateral pool
Assumptions:
1. The swap curve (“Libor”) is flat at 5%
2. There are no upfront, management, or trustee fees
3. The loans in the collateral pool and the liabilities are assumed to have a maturity of five years.
4. All coupons and loan interest payments are annual, and occur at year-end
5. There are no defaults in the collateral pool
Loan and Tranche Information

Example 2
Solution
• From the data, we can be able to see that the junior bond has a much wider spread than that of the senior, and much
less credit enhancement; the mezzanine/ junior tranche attachment point is 5 percent, and the senior attachment
point is 15 percent.
• The annual cash flows will be as follows:
• Ideally, therefore, holders of the equity tranche would receive $3,325,000.

• However, the actual amount received is likely to be much less because of several reasons:
1. Cash flows to the equity tranche may be subject to an overcollateralization trigger where the maximum amount the
tranche can receive is specified with any excess cash flows channelled to a trust account.
2. Cash flows will also be lower if defaults occur.
Example 2
Solution
• To illustrate default, let’s go back to our example and assume that the default rate is 5% per year. That implies that
on average, about 5 loans will default over the year.
• In this case, the total cash inflow from collateral will be $8,550,000 [= $100,000,000 * 0.09 *(1 – 0.05)].
• There will still be sufficient cash to pay senior and junior bondholders in full.
• However, the cash flows into the equity tranche will be reduced.
• Tranche Interest Information Assuming 5% Annual Default Rate

Structured Credit Products – Default
Definition of a default event for a tranche is somewhat different from that pertaining to individual, corporate, and
sovereign debt.
• For a corporate or sovereign bond, default is a binary event; if interest and/or principal cannot be paid, bankruptcy or
restructuring ensues.
• Losses to the bonds in securitizations are determined by losses in the collateral pool together with the waterfall.
Losses may be severe enough to cause some credit loss to a bond, but only a small one to the overall collateral
pool.
Example
If a senior ABS bond is 80 percent of the balance sheet of a trust, and the collateral pool has credit losses of 21
percent, the credit loss or write down to the bond will be approximately 1/100−20 or 1.25 percent.
• Material Impairment:
A material impairment is either missed interest payments that go uncured for more than a few months, or a
deterioration of collateral pool performance so severe that interest or principal payments are likely to stop in the
future.
Corporate debt typically has a “hard” maturity date, while securitizations have a distant maturity date that is rarely the
occasion for a default. For these reasons, default events in securitizations are often referred to as material
impairment to distinguish them from defaults.
Key Participants in the Securitization
Process
Loan Originator
• The loan originator is the original lender who creates the debt obligations in the collateral pool.
• This is often a bank, for example, when the underlying collateral consists of bank loans or credit card receivables.
But it can also be a specialty finance company or mortgage lender.
• If most of the loans have been originated by a single intermediary, the originator may be called the sponsor or seller.
Underwriter
• The underwriter is the financial engineer behind the securitization structure and is at times called the arranger.
• The underwriter is often, but not always, a large financial intermediary.
• Typically, the underwriter aggregates the underlying loans, designs the securitization structure, including things like
the coupon rates, tranche sizes, and triggers. In this capacity, the underwriter is also the issuer of the securities.
• The underwriter bears warehousing risk, the risk that the deal will not be completed and the value of the
accumulated collateral still on its balance sheet falls.
Process
Rating Agencies
• Rating agencies help investors to assess the riskiness of the investment by assigning credit ratings to the various
tranches engineered.
• Attachment points and the subordination structure are key cogs in the rating process.
• Rating agencies are usually more engaged in the structuring process and do more than just opining on
creditworthiness, when issuing securitizations. They have little influence over creditworthiness and are not involved
in the structuring process, when issuing a non-securitized bond.
• A potential conflict of interest arises from the fact that rating agencies are compensated by the originators.
• The agencies may be faced with a situation where they feel obliged to provide a favourable rating even when
there are serious issues regarding the creditworthiness of the structure.
• The fact that the agencies are actively involved in designing the securitization structure only serves to
exacerbate the potential conflict of interest.
• The agencies may dictate the amount of enhancement required to guarantee an investment-grade rating.
• Investors can cope with the potential conflict of interest by carrying out their own credit review of the deal or even
demanding a wider spread.
• Although the ratings under a securitization structure may be based entirely on the credit quality of the pool and the
liability structure, they may also reflect any performance guarantees typically provided by monoline insurance
companies. The insurer guarantees timely repayment of bond principal and interest in exchange
for insurance premiums.
Process
Servicers and Managers
• The Servicer
1. Collects principal and interest from the loans in the collateral pool
2. Disburses principal and interest to the liability holders,
3. Disburses fees to the underwriter and itself.
4. May also be actively involved in the monitoring of the collateral pool. If a loan in the pool is in distress, for
example, the servicer may have the authority to evaluate possible options, including extending the term of the
loan or foreclosing.
5. When the collateral pool is actively managed, the manager may not be so keen to monitor the financial health of
the pool if there’s no incentive to do so.
• Conflict of interest between servicer and bondholders, or, between different classes of bondholders.
1. Equity holders are often keen to have all the loans performing to maturity because they are first in line to absorb
any eventual loss. Therefore, they will be open to any arrangement that can help the borrower to see out the
contract, including extending maturity.
2. Senior bondholders, on the other hand, are less concerned with the possibility of default especially if the
historical default rate is low such that there’s a very small chance that the senior tranche will make a loss.
3. Nonetheless, any loan extension may avoid immediate loss but increase the potential future loss, thereby
increasing the riskiness of the bond as a whole and eroding the credit enhancement.
4. At any one time, the servicer takes action that is better aligned with the interests of some bondholders than of
others.
• To mitigate conflict of interest, the structure may be designed in such a way that the originator or manager bears the
first loss in the capital structure.
Models And Approaches To Structured
Credit Risk Measurements
Credit Scenario Analysis of a
Securitization
Let’s revisit Example 2 where the excess spread (after paying senior and mezzanine tranche bondholders) was
$3,325,000.
• Originators often divert part of the Excess Spread to a trust/overcollateralization account (OA), instead of channelling
the entire amount to the equity holders.
• The funds in the overcollateralization account will be used to pay interest on the bonds if there is not enough interest
flowing from the loans in the collateral pool
• The funds in the overcollateralization account earn interest at the money market rate.
• Any funds in the overcollateralization account at maturity will be released to equity holders.
• The overcollateralization account creates a reliable buffer especially when the default rate is low. Unless the default
rate is very high, there will be some cash inflow into the OA every year.
Securitization
Assumptions:
1. Loans in the collateral pay no interest if they have defaulted any time during the prior year. That means there is no
partial interest; interest is paid at the end of the year by surviving loans only.
2. In the event of default, the recovery rate is 40%, and all recovered monies are channelled into the
overcollateralization account where accumulation occurs at the money market rate.
Notation
• N = number of loans in initial collateral pool (in our case, N = 100)
• dt = number of defaults in the course of year t
• Lt = aggregate loan interest received by the trust at the end of year t
• B = Total coupon (interest) due to both the junior and senior bonds (in Example 2 , B = $5,675,000 for all t)
• K = maximum amount diverted from excess spread into the overcollateralization account at the end of year t
• OCt = amount actually diverted from excess spread into the overcollateralization account at the end of year t
• Rt= recovery amount deposited into the overcollateralization account at the end of year t
• r = money market rate, assumed to be constant (We will assume r = 5%)
Notation
N = number of loans in initial collateral pool (in our case, N = 100)
dt = number of defaults in the course of year t
Lt = aggregate loan interest received by the trust at the end of year t
B = Total coupon (interest) due to both the junior and senior bonds
K = maximum amount diverted from excess spread into the OA at the end of year t
OCt = amount actually diverted from excess spread into the OA at the end of year t
Rt= recovery amount deposited into the OA at the end of year t
Cash Flow to Equity r = money market rate, assumed to be constant (We will assume r = 5%)
To determine the cash flow to equity, we will ask ourselves the following question:
Q: Is the excess spread positive?

In notations, we are simply asking: is Lt − B ≥ 0?
If yes:
A further test must be performed to determine how much flows into the OA:
Is Lt−B≥K?
If yes, then K is channelled into the OA, and Lt−B−K, flows to equity holders: OCt=K.
If no, then the entire amount Lt−B is channelled into the OA, and equity holders receive nothing: OCt=Lt−B
If No:
• If the excess spread is not positive, then the interest is not sufficient to pay bondholders and all Lt goes to
bondholders. The shortfall, therefore, is B−Lt.
• In this scenario, the next step is to check if the OA has accumulated an amount that can cover the shortfall. If the OA
has enough funds, bondholders are paid in full. If the OA does not have enough, the bondholders suffer a write-
down.
Securitization
Notation
Impact of positive default rate on cash flows. B = Total coupon (interest) due to both the junior and senior bonds
Assumptions: OCt = amount actually diverted from excess spread into the OA at the end of year t
1. The number of defaults, dt is constant in any given year Rt= recovery amount deposited into the OA at the end of year t
r = money market rate, assumed to be constant (We will assume r = 5%)
2. The recovery rate in year t is 40%.
• If the test is true, then the bondholders are paid in full. If not,
• The recovery amount deposited into the overcollateralization account at the
end of year t, Rt is calculated as follows: then the OA is literally swept clean and all of its holdings
channelled to bondholders. In this case, they receive
Rt = 0.4dt × loan amount
• Thus, the total amount deposited into the trust account in year t is:
Rt+OCt t= 1,....T−1
• The amount to be diverted in any year t is given by:
• The value of the overcollateralization account at the end of year t, including

the cash flows from recovery and interest paid on the value of the account
at the end of the prior year, is:
• Once we have established how much excess spread, if any,

• If the excess spread is negative, i.e.Lt−B < 0, the custodian must check if flows into the OA at the end of year t, we can determine how
the OA has an amount enough to cover the shortfall. Formally, the test is much cash flows to equity holders at the end of year t. The
as follows: equity cash flow is
max(Lt−B−OCt,0) t=1,…T−1
• Note that we do not have OCt to add to Rt in the equation above because
there is no excess spread in the current period.
Securitization
Terminal Year Cash Flows
In the terminal year, cash flows are examined separately for several reasons:
• All of the surviving loans up to that point reach maturity and principal is returned
• There is no diversion to the OA because the structure ends. All proceeds have to be shared
• Since there is no diversion to the OA, there’s no need to test overcollateralization triggers.
The equations below summarize terminal cash flows:

• Loan interest=
• Proceeds from redemption of all surviving loans= Notation

• Recovery B = Total coupon (interest) due to both the junior and senior bonds
OCt = amount actually diverted from excess spread into the OA at the end of year t
Rt= recovery amount deposited into the OA at the end of year t
• Residual in OA account = r = money market rate, assumed to be constant (We w ill assume r = 5%)
In the terminal year the waterfall mechanism takes full effect:

• If the sum of all terminal cash flows is large enough, the senior tranche is paid off.
• The remainder, if any, is used to pay off the junior tranche
• Any further remainder flows to equity.
Sometimes there may be no cash flows left for equity holders after paying off the junior tranche, especially if the default rate has
been high.
Equity IRR given different default rates
Example
• With a constant default rate of 2%, the equity tranche generates an IRR of approx. 29.79%.
• However, increasing the default rate to 8% generates a negative IRR of – 87.80% for equity.
• The excess spread declines over time as defaults pile up.
The Simulation Procedure and the
Role of Correlation
• In our calculations up to this point, we have made several assumptions, notably that the default rate
is constant, and there’s no correlation between loans. In reality, the default rate is a random variable,
and loans show some correlation.
• We can estimate credit losses for the various tranches in a securitization structure by way of
simulation, which allows us to change our initial assumptions.
Step 1: Estimate parameters

The first step is to determine the parameters for the valuation, particularly the probability of default for
each security. We also need to determine the correlation that ties the securities together.
Step 2: Generate default time simulations

Next, we need to simulate the default times of each security included in the collateral pool, using the
estimated parameters and the copula approach. We simulate the default times of each security in the
collateral pool.
Step 3: Compute the credit losses

Using the simulations results, (i.e., default probabilities and associated timings), we can simulate cash
flows from the security pool in every period.
Tranche Risk
1. Systematic Risk:
• Even when the collateral pool is well-diversified, structured products tend to have a high
systematic risk.
• The degree of systematic risk is highly dependent on the securities making up the collateral
pool and the level of credit enhancement.
• High systematic risk can be expressed through the presence of a high default correlation. As
long as the correlation is high, all the tranches have a high degree of systematic risk.
• There’s a likelihood of a large loss in the senior bond if the correlation is high.
2. Tranche Thinness:
• In most securitization structures, the equity and junior tranches are relatively thin. In the
examples we have used so far, the two tranches constituted just 15% of the collateral pool.
• This thinness manifests itself in VaR calculations. The 95% and 99% credit VaRs are quite close.
• This implies that if the two have been breached, there’s a high likelihood that the loss is very
large.
3. Granularity:
• The granularity of the collateral pool is a major indicator of the level of diversification.
• A collateral pool made up of a few large loans is more risky than another pool with many loans of
smaller amounts.
Implied Correlation
• The implied default correlation is the value of the correlation built into the observable market prices
of the various securitized tranches.
• Structured credit products are claims on cash flows of credit portfolios. Their prices, therefore,
reflect an implied default correlation of those portfolios.
• The implied default correlation is a risk-neutral parameter estimated based on observable prices of
the portfolio credit products.
• The implied default correlation is similar to the implied volatility of an option contract which refers to
the value of the volatility of the underlying instrument which, when input in an option pricing model,
will return a theoretical value equal to the current market price of said option.
• It is possible to reverse engineer the valuation process and use the market-observed prices of
structured credit products and come up with a value of the default correlation.
Issuer and Investor Motivations for
Structured Credit
Incentives of the issuers
1. Lower Cost of funding: Securitization provides a cheaper funding method for the issuer. The
interest rate payable to investors in securitized assets is much lower than that which the originator
would have to pay if they issued a coupon bond of the same maturity as the securitized portfolio.
2. Exit Avenue : Without securitization, the originator would have to either have to retain the
underlying assets on the balance sheet or sell them in the secondary market. As such,
securitization offers a good “exit” route especially when the securitization costs much less than the
next best alternative.
3. Arbitrage CDOs : Sometimes, securitization may be designed to specifically capture the spread
between the underlying loan interest and the coupon rates payable to investors.
4. Balance sheet Relief : Having a significant amount of loans off the balance sheet can come with
benefits for the originator. Banks, for example, may be subject to lower regulatory capital
requirements.
5. Fees: A sponsor may make more money from originating and possibly servicing loans than
retaining them on the balance sheet.
Issuer and Investor Motivations for
Structured Credit
Incentives of Investors
1. A unique Investment Opportunity : Securitization allows investors to have more direct legal
claims on loans and portfolios of receivables. Capital market investors are able to participate in
diversified loan pools in sectors that would otherwise be the preserve of banks alone. These include
mortgages, credit card receivables, and automobile loans.
2. Risk and Maturity Matching : Investors can easily access securities matching their risk, return,
and maturity needs. For example, a pension fund with a long-term horizon can have access to long-
term real-estate loans.
3. Liquidity : Securitization allows for the creation of tradable securities with better liquidity
Appendix
Effect of Default Probabilities and Default
Correlations on the Credit Risk in a Securitization
The interaction between default probability and default correlation has important implications on the
credit risk under a securitization framework.
• An increase in the default rate hurts all the tranches in a securitization structure. It increases bond
losses and also decreases the equity IRR.
• An increase in correlation, on the other hand, can bring about mixed results, depending on the level
of default.
Equity Tranche
• The equity value tends to exhibit positive convexity: as the default rate increases from a very low
level, the effect on equity value is extremely huge. But as the default rate increases further and
further from its low values, the responsiveness of the equity value drops off
• Once you have lost most of your investment due to an increase in the default rate, you will be left
with much less to lose following even more defaults in the future.
Mezzanine Tranche
• When the default rate is low, an increase in correlation increases the likelihood of losses to the
mezzanine tranche (similar to the senior tranche). But when the default rate is high, an increase in
correlation actually decreases the expected losses to the mezzanine tranche because of the
increased likelihood of fewer defaults. In other words, the mezzanine bonds behave more like the
senior bonds at low default rates and more like the equity tranche when the default rates are high.
We can also look at this differently: at low default rates, there’s a very small chance that the
attachment point for mezzanine bonds will be broken. But at high default rates, a breach of the
attachment point is highly likely.
• Convexity presents yet another interesting perspective when it comes to default rates. Maybe to
take you back to bond convexity a little bit, a bond that has positive convexity would typically
experience larger price increases as yields fall but relatively smaller price decreases when yields
increase.
Senior Tranche
• At low correlations, senior bonds exhibit negative convexity: as defaults pile up, the decline in bond
value increases. The mezzanine tranche is ambiguous: it exhibits negative convexity for low default
rates and positive convexity for high default rates.
• At high correlations, all bonds tend to shake off the convexity effect. They respond more linearly to
an increase in default rates.
FINANCIAL RISK
ANALYTICS
Leverage Risk
• Forms of leverage: carry trades and • Defining and measuring leverage in
embedded leverage finance
• Collateralized securities markets • Assessing leverage risk and the attraction
• Leverage risk and financial fragility of leverage
Forms of leverage:
Carry Trades & Embedded Leverage
What is Leverage?
• Leverage refers to the amount of debt a firm uses to finance assets.
• Leverage is an investment strategy of using borrowed money—

specifically, the use of various financial instruments or borrowed capital—
to increase the potential return of an investment.
• Leverage results from using borrowed capital, as a funding source, when

investing to expand the firm's asset base to generate returns on risk
capital.
• Leverage refers to the use of borrowed funds to amplify returns from an

investment or project.
• Investors use leverage to multiply their buying power in the market.
• Companies use leverage to finance their assets—instead of issuing stock

to raise capital, companies can use debt to invest in business operations
in an attempt to increase shareholder value.
Leverage Ratio
• The leverage ratio or debt-to-equity ratio of the firm’s is the ratio of its assets to its
liabilities.
• The lowest possible value of leverage is 1. A leverage value of 1 implies that there is no
debt.
• Leverage ratio increases with an increase in debt.

Leverage Effect
• Leverage is a double-edged sword because it amplifies gains but also magnifies losses. Although the increase in
leverage increases profits in good times, it can also magnify losses should the return on assets prove to be lower
than the cost of debt.
• The leverage effect is the increase in the Return On Equity (ROE) that results from increasing leverage.
• The Leverage effect is equivalent to the difference between the Return On Assets (ROA) and the Cost Of Funding.
• The Leverage Effect can be expressed as:
ROE = (ROA X Leverage Ratio) − [ ( Leverage Ratio−1) X Cost Of Debt ]
• The return on equity (ROE) increases with the increase in leverage as long as return on assets (ROA) is greater than
the cost of debt.
• Although the increase in leverage increases profits in good times, it can also magnify losses should the ROA prove
to be lower than the cost of debt.
• For example, if the leverage ratio is 4, 75% of the balance sheet is financed with debt, and only 25% financed with
equity. Thus, for every $4 of assets, $3 is borrowed funds (debt), and $1 in equity. In the formula expression, we
multiply the cost of debt by 3.
• The higher the leverage factor, the larger the multiplier but also the higher the debt costs.
Leverage and Leverage Effect
Example
• Increasing the leverage, by borrowing an extra unit of
• A firm has an ROA =0.20, while its cost of debt =0.10. funds and investing it in an extra unit of assets, deviates
The firm’s balance sheet is as given below: the balance sheet to:
• Find the firm’s leverage and return on equity (ROE). • Find the Firm’s ROE
Solution Solution
Increasing the amount of debt increases the return on equity for shareholders in this instance.
Hurdle Rate
• The ROE hurdle rate (the minimum rate of return on equity), allows companies to make important
decisions on whether or not to pursue a specific project.
• The firm’s hurdle rate influences the leverage.
Example
Assumptions:
• A firm’s ROE hurdle rate is 12%,
• ROA equals 8%,
• Cost of debt equals 4%.
The firm chooses a leverage ratio of 2.0, as calculated below:
ROE=(2×8%)–(1×4%)=12%
Carry Trade
• A carry trade is a trading strategy that involves borrowing at a low-interest rate and investing in
an asset that provides a higher rate of return.
• A carry trade is typically based on borrowing in a low-interest rate currency and converting the
borrowed amount into another currency.
• Generally, the proceeds would be deposited in the second currency if it offers a higher interest rate.
The proceeds also could be deployed into assets such as stocks, commodities, bonds, or real estate
that are denominated in the second currency.
• The carry trade strategy is best suited for sophisticated individual or institutional investors with deep
pockets and a high tolerance for risk.
Embedded Leverage
• Embedded leverage is the amount of market exposure per unit of committed capital.
• Many financial instruments are designed precisely to provide embedded leverage such as options,
leveraged exchange traded funds (ETFs) and other securities that embed leverage.
• An investor can gain substantial market exposure without using outright leverage (i.e., without
borrowing) by buying such instruments.
• Investors are unable (or unwilling) to use enough outright leverage to get the market exposures they
would like. For instance, individual investors and pension funds may not be able to use any
leverage, banks face regulatory capital constraints, and hedge funds must satisfy their margin
requirements.
• Investors are therefore willing to pay a premium for securities with embedded leverage and
intermediaries who meet this demand are compensated for their risk.
Collateralized securities markets
Collateralized securities markets
• Collateral is of essence in credit transactions as it provides security for lenders, hence ensures the availability of
credit to borrowers. Besides, the use of collaterals makes it easy to establish short positions in securities.
• The borrowers might permit the banks and brokers to lend their collateral assets to a third party and in turn may be
compensated either through a lower cost of borrowing or a rebate on fees. This practice is called
rehypothecation or repledging of collateral.
• Markets for such collateral securities are created when securities are used as collateral to obtain secured loans of
cash or other securities.
• The role of collateral has expanded in modern finance, following the progression of securitization. Securitization
generates securities that can be pledged as collateral for credit. Securitized assets generate cash flows, may
appreciate and can be used as collateral for other transactions.
• Collateral markets prop up the growth of non-bank intermediaries.

1. Life insurance companies own portfolios of high-quality securities. This enables them to borrow cash at a low rate,
which they can then invest in earning higher rates of return.
2. Hedge funds have inventories of securities which they use as collateral to get financing of the portfolio at a
reduced rate than unsecured borrowing.
3. Firms with excess cash are more willing to lend at a low rate of interest if the loan is secured by collateral.
Haircut and Variation Margin
• A haircut is the percentage difference between the amount of a loan given and the market value of the asset to be
used as collateral for the loan.
For example, when a banks lends money it asks for collateral. However, it will apply a haircut – a reduction in the
value of the collateral. Let’s say, an asset worth $1 million at market price, given a haircut of 30%, would only be
sufficient to collateralize a loan for $700,000. By devaluing the assets provided as collateral, the lender gets a
cushion, a measure of risk protection to defend against market value drops.
• The lender may insist on a variation margin - a periodic additional fund deposit to maintain the difference between
the lent amount and the collateral. The variation margin protects the lender against fluctuations in the value of the
collateral.
For example, if the haircut of $300,000 reduces to $200,000 at any particular period, the borrower must top up the
amount by an additional $100,000 to maintain the haircut at $300,000.
Types of Collateral Markets
Margin loans:
• A margin loan or a margin account is a short term loan made by a brokerage house to a client that allows the
customer to buy stocks on credit. The term margin itself refers to the difference between the market value of
the shares purchased and the amount borrowed from the brokerage.
• The brokerage holds the securities as collateral for the loan and retains their custody. in a street account, (i.e.,
registered in the name of the broker rather than that of the owner).
• Registering using a street name account allows the broker to use the securities for other purposes. These may be
borrowing money in the secured money market to obtain the funds he/she lends to margin customers.
Repurchase Agreements (Repos):

• Repurchase agreements are a form of short-term collateralized loans sold to buy back at a later date at a higher
price (the forward price). Both the spot and forward prices are agreed upon today, and the difference is the interest
rate.
• Repos encompass high-yield bonds and whole loans, and more recently, structured credit products.
• For instance - A dealer sells government securities to investors, usually on an overnight basis, and buys them back
the following day at a slightly higher price. That small difference in price is the implicit overnight interest rate.
Securities Lending:
• Securities lending is the act of loaning a stock, derivative or other financial instrument to a broker for trading in
exchange for collateral to a counterparty at a fee, called a rebate.
• The lender continues to receive interest cash flows and dividends from the security.
• Securities lending is generally carried out by large institutional equity investors and is important in several trading
activities, such as short selling, hedging, arbitrage.
• The investor holds the equities through a broker in “street name,” thus making them available for lending.
• They can then be rehypothecated to a trader who wishes to sell the securities short. The investor receives a rebate
in exchange.
• A short sale involves the sale and buyback of borrowed securities. The goal is to sell the securities at a higher price,
and then buy them back at a lower price. These transactions occur when the securities borrower believes the price of
the securities is about to fall, allowing him to generate a profit based on the difference in the selling and buying
prices. Regardless of the amount of profit, if any, the borrower earns from the short sale, the agreed -upon fees to the
lending brokerage are due once the agreement period has ended.
• Fixed-income securities’ lending transaction aims to earn a spread between less and more risky bonds. For example,
lending treasury securities and using the cash to invest in high-risk bonds.
Total Return Swaps:
• In a total return swap, one party makes payments according to a set rate, while another party makes payments based on the
rate of an underlying or reference asset. The two parties involved in a total return swap are known as the total return payer and
the total return receiver.
• The payer earns the total return (both income and capital gains) on a reference asset without owning it.
• The total return receiver collects any income generated by the asset and benefits if the price of the asset appreciates over the
life of the swap. The total return receiver must pay the asset owner the set rate over the life of the swap. If the asset's price falls
over the swap's life, the total return receiver will be required to pay the asset owner the amount by which the asset has fallen.
The receiver therefore assumes systematic, or market, risk and credit risk.
• The payer forfeits the risk associated with the performance of the referenced security but takes on the credit exposure to which
the receiver may be subject.
Example
Assume that two parties enter into a one-year total return swap in which one party receives the London Interbank Offered Rate,
or LIBOR, in addition to a fixed margin of 2%. The other party receives the total return of the Standard & Poor's 500 Index (S&P
500) on a principal amount of $1 million.
After one year, if LIBOR is 3.5% and the S&P 500 appreciates by 15%, the first party pays the second party 15% and receives
5.5%. The payment is netted at the end of the swap with the second party receiving a payment of $95,000, or [$1 million x (15% -
5.5%)].
Conversely, consider that rather than appreciating, the S&P 500 falls by 15%. The first party would receive 15% in addition to the
LIBOR rate plus the fixed margin, and the payment netted to the first party would be $205,000, or [$1 million x (15% + 5.5%)].
Leverage Risk and Financial Fragility
Leverage Risk and Financial Fragility
• Financial fragility is the vulnerability of a financial system to a financial crisis.[1]
• Financial fragility refers to a financial system's susceptibility to large-scale financial

crises caused by small, routine economic shocks.
• Financial fragility can be described as the degree to which small shocks have
disproportionately large effects.
Sources of financial fragility

There are two views of financial fragility which correspond to two views on the origins
of financial crises:
1. According to the fundamental equilibrium or business cycle view, financial crises arise
from the poor fundamentals of the economy, which make it vulnerable during a time
of duress such as a recession.
2. According to the self-fulfilling or sunspot equilibrium view, the economy may always
be vulnerable to a financial crisis whose onset may be triggered by some random
external event, or simply be the result of herd mentality.
Reducing financial fragility
The natural financial fragility of banking systems is seen by many economists as an important justification for financial
regulation designed to reduce financial fragility.
1. Circuit breakers
Some economists including Joseph Stiglitz have argued for the use of capital controls to act as circuit breakers to
prevent crises from spreading from one country to another, a process called financial contagion. Under one proposed
system, countries would be divided into groups that would have free capital flows among the group's members, but not
between the groups. A system would be put in place such that in the event of a crisis, capital flows out of the affected
countries could be cut off automatically in order to isolate the crisis. This system is partly modelled on electrical
networks such as power grids, which are typically well-integrated in order to prevent shortages due to unusually high
demand for electricity in one part of the network, but that have circuit breakers in place to prevent damage to the
network in one part of the grid from causing a blackout throughout all houses connected through the network.
2. Taxing liabilities
As described above, many economists believe that financial fragility arises when financial agents such as banks take
on too many or too illiquid liabilities relative to the liquidity of their assets. Note that asset liquidity is also a functi on of
the degree of stable funding available to market participants. As a result, the reliance on cheap short term funding
creates a negative risk externality. Some economists propose that the government tax or limit such liabilities to reduce
such excessive risk-taking. Prudential Pigouvian charges have been proposed on unstable short term funding and
unstable foreign flows.
3. Capital requirements
Another form of financial regulation designed to reduce financial fragility is to regulate bank's balance sheets directly
via capital requirements. This is usually expressed as a capital adequacy ratio of equity as a percentage of risk-
weighted assets. These requirements are put into place to ensure that these institutions do not take on excess leverage
and risk becoming insolvent.
FINANCIAL RISK
ANALYTICS
Liquidity Risk
• Commercial banking and liquidity risk • Describe source of liquidity risk
• Market Liquidity Risk • Understand the funding of liquidity risk
Liquidity and It’s Categories
What is Liquidity?
• In financial markets, an asset is liquid if it is a good substitute for cash. In other words, the asset can
be converted into cash quickly at a reasonable price without fluctuating the price significantly.
• A market is liquid if market participants unwind positions rapidly, at reasonable transaction costs,
and without excessive price deterioration.
Liquidity has two major categories

1. Transaction liquidity
• Transactions liquidity refers to the ability to buy or sell an asset without moving its price.
• Money is a liquid asset. Non-Money Assets have to be liquidated before they can be exchanged for other assets.
Liquidating non-money assets takes some time and the sale proceeds are uncertain to some extent.
• When an order to buy an asset is large, it causes a substantial short-term imbalance between the demand and
supply of the asset leading to price changes. This causes a lack of market liquidity implying that a market
participant may be locked into a losing position.
2. Funding liquidity
• Funding liquidity is the ability to finance assets continuously at an acceptable borrowing rate.
• It relates to an individual’s or an organization’s creditworthiness.
Sources of Liquidity Risk
There are different risks related to liquidity which include:
1. Transaction liquidity risk: This is the risk that results in the adverse price movement of an asset during buy and
sell transactions. Transaction liquidity risk is low if assets can be liquidated quickly and cheaply, without moving the
price “too much to exchange an asset for other assets easily.”
2. Balance sheet risk (funding liquidity risk): Funding liquidity risk occurs when lenders withdraw or change the
terms of borrowing due to the deteriorating credit position of the borrower. Typically, in the banking sector, funding
liquidity risk is high due to maturity mismatch, i.e., funding long term assets (bank loans) with short term liabilities
(bank deposits).
3. Systemic risk: This is the risk of failure of the entire financial system due to heavy financial stress. In situations of
severe financial stress, the ability of the financial system to allocate credit, support markets in financial assets,and
even administer payments and settle financial transactions may be impaired.
4. Correlation between different types of liquidity risks accelerate problems : For example, if the counterparty
increases collateral requirements, the investor may have to unwind it before the full realization of the expected
return. Reducing the trade horizon causes deterioration of funding liquidity, which increases the transaction liquidity
risk.
Transaction Liquidity Risk
Transaction Liquidity Risk
Causes of Transactions Liquidity Risk
Transaction liquidity risk is due to costs, including the cost of searching for a counterparty, market institutions that assi st
in the search, and inducing someone else to hold a position. These market microstructure fundamentals can be
classified as follows:
1. Trade processing costs: These are costs associated with finding a counterparty on time. Although these costs
may form a significant part of the transaction costs, it is unlikely to increase the liquidity risk unless the trading
system gets affected either by human-made circumstances.
2. Inventory management of the dealers: Dealers provide trade immediacy to other market participants. Therefore,
dealers must hold inventories of assets. Holding inventories exposes dealers to price volatility risk and thus requires
compensation.
3. Adverse selection: A dealer is compensated by bid-ask spread for the risk of dealing with uninformed vs. well-
informed traders.
4. Differences of opinion: When market participants (investors) disagree on the correct price or about how to
interpret new information about specific assets, it becomes more difficult to find a counterparty.
Different market organizations have different microstructure fundamentals: For example, in a quote-driven
system, typically found in OTC markets, certain intermediaries are obliged to post two-way prices publicly and to buy or
sell the asset at those prices within known transaction size limits. These intermediaries must hold inventories of the
asset and trade heavily to redistribute inventories of securities and thus ultimately reduce them. On the contrary, order -
driven systems, typically found on regulated exchanges, are more similar to a perfectly competitive auction model.
Usually, the best bids and offers are matched, where possible, throughout the trading session.
Commercial banking and liquidity risk
Asset-Liability Management Process at a Fractional Reserve Bank and Liquidity Transformation
Commercial Banking
• Commercial Banks carry out liquidity, credit, and maturity transformation. Maturity transformation is when banks take
short-term sources of finance, such as deposits from savers, and turn them into long-term borrowings, such as
mortgages.
• A commercial bank’s core function is to take deposits and to provide loans to non-financial institutions.
• It transforms long-term illiquid assets (loans) into short-term liquid ones (deposits).
• Bank deposits are “sticky.” Depositors remain in the bank unless impelled to change banks’ circumstances such as
moving houses.
• Banks also raise funds by issuing bonds, commercial paper, and other forms of debt and use it for lending purposes.
This is called wholesale funding, and it involves longer-term deposits, which can be redeemed at short notice.
Fractional Reserve Banking

• Bank assets (Loans) are typically long term and less liquid. On the other hand, bank deposits that contribute to
roughly 60-70% of the bank’s liabilities are short term, sticky, and more liquid.
• Banks use deposits for lending purposes. In other words, banks match short-term liabilities with long term assets.
This is referred to the as fractional reserve banking system.
• A bank that lends deposits is known as a fractional-reserve bank.
Asset-Liability Management
• The traditional Asset-Liability Management (ALM) function of the bank is to ensure that it remains liquid by reducing
funding liquidity risk. In other words, ALM is the process of using deposits to finance loans.
• ALM is a crucial process which includes measures such as:
1. Tracking and forecasting available cash and cash needs; and
2. Keeping specific ratios of cash and marketable securities to meet unusual demands by depositors.
Bank Runs
• Asset-Liability Management system can adequately protect a fractional-reserve bank against a loss of confidence in
its ability to pay out depositors.
• However no degree of liquidity can secure a bank entirely against a run as long as it executes a liquidity and maturity
transformation, and has liabilities on-demand.
• The following figure demonstrates the impact on a bank when its customers withdraw more than the bank’s reserves.
Withdrawals exceed the

Bank’s reserves
Increased Bank Fragility Suspension of Convertibility

A run on the bank increases Bank not able to convert deposits
liquidity risk further resulting to a immediately into cash
rollover risk. The bank cannot
raise new capital at this point.
Run on the Bank
Depositors concerned about the

bank’s liquidity attempt to pull
their money out of the bank before
other depositors and lenders
Mitigation against a Bank Run
A high fragility can be mitigated through higher capital and higher reserves:
1. High capital reduces depositors’ concern about solvency, the typical trigger of a run.
2. Higher reserves, which reduces concern about liquidity.
The fragility of bank funding was illustrated following the Lehman Brothers bankruptcy.
• Following the crisis, commercial paper borrowing abruptly declined as it could no longer be placed.
• Banks faced difficulty in rolling over the long-term commercial paper, and in obtaining funding with
maturities of more than a few weeks.
• The share of very short-term issuance significantly increased to almost 90% due to fewer
alternatives.
Mitigation: The Federal Reserve intervened and created the following:

1. Commercial Paper Funding Facility (CPFF) to purchase Commercial paper from issuers unable to
roll the paper over.
2. Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility (AMLF), which lent
to financial institutions purchasing ABCP from MMMFs.
BIS Principles for Sound Liquidity Risk
Management
Bank regulators issued revised principles on how banks should manage liquidity following the 2007
subprime crisis. These are as follows:
1. A bank takes the responsibility of sound management of liquidity risk in that it should establish a
robust liquidity management framework for enough liquidity.
2. A bank should explicitly articulate a liquidity risk tolerance that is convenient for its business
strategy as well as its role in the financial system.
3. Senior management should develop strategies, policies, and practices to manage liquidity risk in
line with the risk tolerance and to certify that the bank maintains sufficient liquidity.
4. A bank should consider liquidity costs, risks in the internal pricing, benefits, performance
measurement, and new product approval process for all substantial business activities. This aids
the bank in aligning the risk-taking interests of individual businesses with the potential liquidity
risks their activities generate for the bank as a whole.
5. A bank should employ an effective procedure for identifying, measuring, tracking, and controlling
liquidity risk. The procedure should encompass a robust framework for a large projection of cash
flows arising from assets, liabilities, and off-balance-sheet items over a suitable time frame.
6. A bank should manage the intraday liquidity positions and risks to cover payment and settlement
liabilities under both normal and stressed market conditions promptly. This creates a smooth
functioning of payment and settlement systems.
7. A bank should manage its collateral positions, establishing a difference between encumbered and
unencumbered assets.
Management – Cont’d
8. A bank should create a funding strategy that offers adequate diversification in the sources and
tenor of funding. It should further monitor the legal entity and the place where the collateral is held
and how to mobilize it on time.
9. A bank must have a strict contingency funding plan (CFP) that sets out the strategies for
addressing liquidity shortfalls in emergencies.
10. A bank should track and control liquidity risk exposures and funding needs within and across legal
entities, business lines, and currencies, considering the legal, regulatory, and operational
limitations to the transferability of liquidity.
11. A bank should regularly reveal public information that helps market participants to make an
informed decision about the effectiveness of its liquidity risk management framework and liquidity
position.
12. A bank should keep a cushion of unencumbered, high-quality liquid assets to be held as insurance
for a range of liquidity stress scenarios, including those that involve the loss or impairment of
unsecured and typically available secured funding sources
13. A bank should employ stress tests regularly for a diversity of short-term and protracted institution-
specific and market-wide stress scenarios to establish the sources of potential liquidity strain and
to ensure that current exposures remain following a bank’s established liquidity risk tolerance.
14. Supervisors should frequently perform a comprehensive assessment of a bank’s overall liquidity
risk management framework and liquidity position to establish whether they deliver an adequate
level of resilience to liquidity stress given the bank’s role in the financial system.
Management – Cont’d
14. Supervisors should communicate among themselves and between public authorities, such as
central banks, both within and across national borders, to facilitate practical cooperation regarding
the supervision and oversight of liquidity risk management.
15. Supervisors should intervene to require useful and timely corrective action by a bank in
addressing deficiencies in its liquidity risk management or liquidity position.
16. Supervisors should supplement their standard assessments of a bank’s liquidity risk management
framework and liquidity position by monitoring a mix of internal reports, prudential reports, and
market information.
Market Liquidity Risk
Characteristics of Market Liquidity
Since the 2007-2009 financial crisis, more attention is being paid to measuring Market liquidity risks in a firm. To better
understand the causes of illiquidity, we look at the primary characteristics of asset liquidity used to measure market
liquidity.
1. Tightness: This refers to the cost of a round-trip transaction, measured by the bid-ask or bid-offer spread and
brokers’ commissions. The smaller the spread, the tighter it is, and thus the higher the liquidity.
2. Depth: Depth describes how large a transaction it takes to move the market significantly. If a large institution sells,
it is most likely to impact the price adversely.
3. Resiliency: It refers to the length of time it takes a lumpy order to move the market away from the equilibrium
price. In other words, it refers to the ability of the market to bounce back from temporary incorrect prices.
Both depth and resiliency affect the immediacy of a market participant to execute a transaction.
Market Illiquidity manifests itself in observable hard-to-measure ways such as the bid-ask spread, which introduces
liquidity risk when it fluctuates. Moreover, adverse price impact is the impact on the equilibrium price of the trader’s
activity.
Slippage is the deterioration in the market price triggered by the amount of time it takes to get a trade done. If the
market is trending, it can go against the trader, even if the order is not large enough to influence the market.
Liquidity risk is complicated to measure. We need to focus on :

1. The fluctuation of the bid-ask spread
2. The trader’s actions impact the price of the asset
3. The deterioration of the asset price by the time trade happens.
Bid-Offer Spread
Four factors influence the price at which an asset can be sold. These are:
1. The amount of the asset is to be sold;
2. The mid-market price of the security (asset), or an estimate of its value;
3. The urgency with which it is sold; and
4. The prevailing economic environment.
The bid price decreases while the offer price tends to increase with the size of a trade.
Measuring Market Liquidity
The Bid-Offer Spread Measure
The bid-offer spread measure is one of the ways of measuring market liquidity. It can be measured as
a dollar amount or a proportion of the asset price. The dollar bid-offer spread is calculated as follows;
p=Offer price–Bid price
On the other hand, the proportional bid-offer spread for an asset is equivalent to:
The mid-market price is halfway between the offer price and the bid price commonly regarded as the
fair price.
A bank experiences a cost equal to , whenever it liquidates an asset position, where α is the mid-
market value of the position.
The cost implies that trades are not done at the mid-market price. Therefore, a buy trade is made
at the offer price while a sell trade is made at the bid price.
Cost of Liquidation
One way of measuring the liquidity of a book is finding how much it would cost to liquidate the book in
normal market conditions within a stipulated time.
Supposing that is an estimate of the proportional bid-offer spread in normal market conditions for
the financial security held by a financial institution, and is the dollar value of the security’s
position, then:
It is worth noting that diversification does not necessarily reduce liquidity trading risk.
However, increases with the size of position j.
This implies that holding small positions instead of a few large ones entails less liquidity risk. Setting
limits to the size of any position can thus, be one way of reducing liquidity trading risk.
Cost of Liquidation
Example: Cost of Liquidation (Normal Market)
Suppose that HBC bank has bought 15 million shares of one company and 45 million ounces of a
commodity. Assume that the shares are bid $90.4, offer $91.6. The commodity is bid $20, offer $ 20.2.
The mid-market value of the position of the shares is equivalent to:

15×91=$1,365 million
The mid-market of the position in the commodity is:

45×20.1=$904.5 million
The proportional bid-offer spread is equivalent to:
Shares Commodity
The cost of liquidation in a normal market is:
1,365×0.01318×0.5+904.5×0.00995×0.5=$13.495
Cost of Liquidation (Stressed Market)
The cost of liquidation in a stressed market within a specified period is another liquidity cost measure .
Where:
is the mean, while is the standard deviation of the proportional bid-offer spread for
the instrument held.
λ is the parameter that gives the required confidence level for the spread. Suppose that we are
considering the “worst-case” spreads that are exceeded only 1% of the time, if the spreads are
assumed to be normally distributed, then λ=2.326.
Cost of Liquidation (Stressed Market)
Example: Cost of Liquidation (Stressed Market)
Suppose that HBC bank has bought 15 million shares of one company and 45 million ounces of a
commodity. Assume that the shares are bid $90.4, offer $91.6. The commodity is bid $20, offer $20.2.
The bid-offer spread for the shares has a mean and standard deviation of $1.5 and $1.8, respectively.
Further, the mean and standard deviation for the bid-offer spread for the commodity are both $0.14.
The proportional bid-offer spread for the position of shares has a mean of 0.01158 and a standard
deviation of 0.02678. On the other hand, the proportional bid-offer spread for the position of the
commodity has a mean of 0.004898 and the same standard deviation of 0.004898.
Assuming the spreads follow a normal distribution, calculate the cost of liquidation at the 99%
confidence limit.
0.5×1,365×(0.01158+2.326×0.02678)+0.5×904.5×(0.004898+2.326×0.004898)
=$57.79
This is more than four times the cost of liquidation in normal market conditions.
Systemic Risk and Interaction Between
Different Liquidity Risks
Systemic Risk
• Systemic risk can be defined as a risk that occurs in one firm or market and can be amplified to the
other firms or broader markets. As a result, the entire markets or economies can be exposed to the
risk.
• Systemic risk is the possibility that an event at the company level could trigger severe instability or
collapse an entire industry or economy.
• Systemic risk was a major contributor to the financial crisis of 2008.
• Companies considered to be a systemic risk are called "too big to fail.“ These institutions are large
relative to their respective industries or make up a significant part of the overall economy.
• A company highly interconnected with others is also a source of systemic risk.

Interaction Between Different Liquidity
Risks
Different types of liquidity risks are interrelated, and this accelerates problems.
1. A key mechanism that links funding and transaction liquidity is leverage.
Example
An investor with a long position may be forced to sell an asset if it can no longer fetch funding. This, in turn, decreases the
number of potential asset holders, leading to a reduction in asset valuation. This depresses the asset price, regardless of its
expected future cash flows. This decline can be temporary; however, if the length of the depressed asset price is long, it can
adversely impact the solvency of the investor who initially purchased the asset
2. A rapid deleveraging of assets causes a “debt-deflation crisis.” Transactions liquidity could also constrain funding liquidity.
Example
If a hedge fund is facing redemptions, it is forced to raise cash by selling assets and, therefore, must decide which assets to
sell first. The fundamental trade-off is that by selling the most liquid assets first, the investor incurs the smallest adverse
impact.
However, he/she is left with a more illiquid portfolio with which to face any continuing funding liquidity pressure. If instead, he
sells illiquid assets first, the realized losses increase the real or perceived risk of insolvency, and may, therefore, worsen the
funding liquidity pressure.
3. The level of economy-wide liquidity directly impacts the level of systemic risk.
• When market conditions deteriorate, liquidity tends to become constrained when investors need it the most.
• Problems in payments, clearing, and settlement systems are some of the channels through which liquidity risk events can
become systemic risk events.
• Severe stress to the financial system would affect investors simultaneously, suggesting that the illiquidity of one
counterparty may have an economic domino effect on other investors throughout the system.
FINANCIAL RISK
ANALYTICS
Extreme events and market risk measurement
• Real World Asset pricing behaviour • Understand behaviour of asset prices in
• Alternative Modelling approaches stress period
• Evaluate alternative to VaR
• Learn about extreme value theory
Real World Asset Pricing Behaviour
Real World Asset Pricing Behaviour
In our discussions, so far, we have used standard models using lognormal distributions. However
asset prices or risk factors in the real world are very often not lognormally distributed.
To study real world asset pricing behaviour, we start by comparing the standard model, in which asset
prices or risk factors are lognormally distributed, to actual market price behaviour, as evidenced by the
time-series behaviour of their returns.
We then provide a few statistical measures of deviations from the normal and a visual tool that
summarizes how far asset prices are from normal.
Deviations from the normal model can be summarized under three headings:
1. Kurtosis
2. Skewness
3. Time Variation
Real World Asset Pricing –
S&P 500 Daily Returns
99.998
Real World Asset Pricing –
VIX Returns
VIX - Created by the Cboe Global Markets (originally known as the Chicago Board Options Exchange (CBOE)), the Cboe Volatility Index, or VIX,
is a real-time market index that represents the market's expectation of 30-day forward-looking volatility. Derived from the price inputs of the S&P
500 index options, it provides a measure of market risk and investors' sentiments. It is also known by other names like "Fear Gauge" or "Fear
Index." Investors, research analysts and portfolio managers look to VIX values as a way to measure market risk, fear and stress before they take
investment decisions.
Kernel Estimator - The k ernel estimator is a technique for estimating the probability density function from a sample of the data it generates. It
can be thought of as a method of constructing a histogram of the data, but with useful properties such as smoothness and continuity that a
histogram lacks.
Alternative Modelling Approaches
Alternative Modelling Approaches
A great variety of alternatives to the standard model have been put forward to better account for and
forecast asset return behaviour.
The common alternative modelling approaches focusing on forecasts of extreme returns are:
1. Jump Diffusion Models

2. Extreme Value Theory (EVT)
Jump Diffusion Models
Jump diffusion is a stochastic process that
involves jumps and diffusion.
A jump process is a type of stochastic process that has

discrete movements, called jumps, with random arrival
times, rather than continuous movement, typically modelled
as a simple or compound Poisson process.
A diffusion process is a continuous-time Markov

chain/process with almost surely continuous sample paths.
It is a solution to a stochastic differential equation.
A Markov chain/process is a stochastic model describing

a sequence of possible events in which the probability of
each event depends only on the state attained in the
previous event.
A countably infinite sequence, in which the chain moves

state in a continuous-time process is called a continuous-
time Markov chain/process.
Extreme Value Theory
What are Extreme Values?
Extreme value is either a very small or a very large value in a probability distribution.
An extreme value is one that has a low probability of occurrence but potentially disastrous (catastrophic) effects if it
does happen.
In other words, the occurrence of extreme events is very rare but can prove very costly in financial terms .
Some of the events that can result in extreme values include:

• A large market decline (as happened after the September 2001 attacks in the U.S.)
• The failure of major institutions (e.g., failure of Lehman Brothers, Bear Sterns in 2007)
• The outbreak of politically motivated clashes
• A major natural phenomenon (e.g., the Kobe earthquake in Japan, 1995)
• The 2020 Global Pandemic
The main challenge posed by modelling extreme values is that there are only a few observations from which a credible,
reliable analytical model can be built.
In fact, there are some extreme values that have never occurred, but that does not necessarily imply there’s no chance
of occurrence in the future.
Researchers tackle the challenge by assuming a certain distribution. However, choosing a distribution arbitrarily is ill-
suited to handle extremes because the distribution will tend to accommodate the more central observations because
there are so many of them, rather than the extreme observations, which are much sparser.
• Extreme value theory (EVT) is a branch of applied statistics developed to address study and predict the
probabilities of extreme outcomes.
• It differs from “central tendency” statistics where we seek to dissect probabilities of relatively more common events,
making use of the central limit theorem.
• Extreme value theory is not governed by the central limit theorem because it deals with the tail region of the relevant
distribution.
• Studies on extreme value make use of what theory has to offer. There are several extreme value theorems that seek
to estimate the parameters used to describe extreme movements:
1. The Fisher–Tippett–Gnedenko theorem

2. The Peaks-Over-Threshold (POT) Approach
The Fisher–Tippett–Gnedenko theorem
According to this theorem, as the sample size gets large, the

distribution of extremes converges to the generalized
extreme value (GEV) distribution. The generalized
extreme value distribution is used to model the smallest or
largest value among a large set of independent, identically
distributed random values that represent observations.
We segregate losses recorded over equal time intervals,

say, 10 day periods, and record the largest loss in each
interval to give us block maxima.
We then use the GEV distribution to estimate probabilities of

extreme losses based on the block maxima.
The probability density function for the generalized extreme

value distribution is given alongside, where :
• μ is the location parameter
• σ is the scale parameter
• ξ is the shape parameter
The following restriction holds for the above formulae:
The Peaks-Over-Threshold (POT) Approach
Whereas the generalized extreme value theory provides the natural

way to model the maxima or minima of a large sample, the peaks-
over-threshold approach provides the natural way to
model exceedances over a high threshold.
The figure alongside compares the generalized extreme value

approach and the peaks-over-threshold approach.
On the left, we can see that the GEV concerns itself with selected
observations that are maxima of groups of three.
In the right, we can see that the POT approach concerns itself with
all observations greater than u. Notably, some of the observations
ignored in the GEV (block maxima) approach make the cut in the
POT approach.
The distribution of excess losses over our threshold u is given by

the formula :
Where
• X is as a random iid loss variable with distribution function F(x)
• u as the threshold value for positive values of X
Estimating VaR with EVT
The table shown alongside contains S&P 500 return data (83 years i.e. 20921
days from Jan. 3, 1928 to Apr. 14, 2011) for 22 days on which returns were
below the threshold of -7.5 percent. The last column y(i,t) shows the order
statistics of the corresponding exceedances.
The exceedance column of data is entered into the log-likelihood function and
our estimated parameters that maximize the likelihood function are α = 4.514
and β = 0.0177.
Number of Observations NOBS = 20,921.

Number of Occurrences k = 22
Probability of a return less than –7.5 percent is

22 × 20,921−1 = 0.001052
VaR at a confidence level of 99.99 percent is the value of r that satisfies

following formula
On solving the above formula we get r = 12.96 percent.
In other words, using our estimated extreme value distribution, we would

expect to see a one-day decline of about 13 percent or worse roughly once in
83 years.

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FINANCIAL RISK

• Instead of getting deep into theory, I would like to provide anecdotal

• The course targets to impart knowledge analytical techniques from a

• The students are expected to be knowledgeable about technology

Commercial Non Banking

Mutual Funds Hedge Funds Pension Funds

Liquidity Credit Operational Legal

Occurs when changes in market prices, cause a loss.

Occurs when Creditworthiness of the borrower deteriorates.

Occurs when transacting or funding is possible only on

• Occurs when the market • Occurs when credit • Occurs as a general

• Buying or selling cannot • Financing for earlier

Occurs when there is a financial crises in the payments or credit intermediation

For e.g. : 2008 Subprime crisis, ILFS, Yes Bank

Characteristics of a Financial Crises:

Occurs due to for loss arising from incorrect models

Modelling errors could be due to any of the following reasons :

Occurs due to bad publicity regarding an institution’s business practices, whether

Occurs due to breakdown in Internal Policies/Controls Or due to External

• Inadequate internal controls (“rogue trader” actions)

• Everything else that can go wrong!

Occurs when a firm is sued or a contract cannot be enforced.

The risk that a The risk that an The risk in which a

Arithmetic Geometric Logarithmi

Arithmetic Return = Geometric Returns = Logarithmic Return =

• There are no one‐to‐one

• The smaller the return, the

• Investments could be in stocks, bonds, commodities, cash, and cash

Capital Allocation Possibilities

• Higher the Covariance, more dependent is the relationship.

Correlation is used to measure how closely the price of two

• 0 indicates that the two stocks/portfolios are independent.

Volatility is normally calculated as the standard deviation of the returns.

Return Volatility Sharpe Ratio Sharpe Ratio Grading Thresholds:

Sortino Ratio Grading Thresholds:

M2 = Return on adjusted portfolio - Return on market portfolio

Return MF Index Modigliani-Modigliani Ratio

MPT helps construct portfolios either to :

Portfolio Returns Stock Investment Returns Weight

Portfolio Returns (60%*20%) + (40%*12%) 16.8%

• The hyperbola is sometimes referred to as the "Markowitz bullet“

Covariance is an indicator of the extent to Correlation is an indicator of how strongly these 2

Correlation provides a measure of covariance on a

• Volatility Clustering: This was first noted by Mandelbrot - "large

• Investment Risk & Opportunity: Stock market volatility is generally

Financial time series, such as stock prices, exchange rates,

There are periods in which their prices show wide swings

• Heteroskedasticity happens when the standard errors of a variable,

• With Heteroskedasticity, the tell-tale sign upon visual inspection of the

GARCH is a recursive function as it calculates today’s variance using yesterdays variance. It is a

𝝈𝟐𝒏 = 𝝎 + 𝜶𝒖𝟐𝒏−𝟏 + 𝜷𝝈𝟐𝒏−𝟏

The ω (Omega) weight is the product of the γ (Gamma) weight and

Weight α (Alpha) is assigned to U2n-1 (yesterdays squared return)

Weight β (Beta) is assigned to σ2n-1 (yesterday’s variance)

• Invented after the stock market crash of 1987

• This metric is most commonly used by investment and commercial

• VaR is used to determine the extent and probability of potential losses

• Capital Reserves : Using the data provided by VaR modeling,

Shortcomings of this Approach

• Reduces Uncertainty: The basis of a Monte Carlo simulation involves

• Flexible: A Monte Carlo simulation is very flexible; it allows us to vary risk

A Monte Carlo simulation normally is a "black box" generator of random, probabilistic

ERi​ = Rf​ + βi ​(ERm​ − Rf​)

Portfolio Returns (60%20%) + (40%12%) 16.8%

ERi = Rf + βi (ERm − Rf)