Valuation and Risk Models

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0GARP
2020
EXAM PART I
Valuation and Risk Models
呡
Pearson
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2.4 Term Structures 20

Chapter 1 Measures of 1 2.5 Stressed Measures 20
Financial Risk
2.6 The Delta-Normal Model 21
2.7 Limitations of Delta-Normal
2 2 3 5 6 8 89
1.1 The Mean-Variance Framework Model 21

Combining Investments
The Efficient Frontier
2.8 Monte Carlo Simulation 23
1.2 The Normal Distribution 2.9 Estimating Parameter Values 24
1.3 VaR 2.10 Correlation Breakdown 24
1.4 Expected Shortfall 2.11 Worst Case Analysis 24
1.5 Coherent Risk Measures

Weighting and Spectral Risk Measures
Chapter 3 Measuring and
Monitoring
Chapter 2 Calculating and Volatility 27
Applying VaR 15
3.1 Deviations from Normality 28
2.1 Linear versus Nonlinear 3.2 Unconditional and Conditional
Portfolios 16 Normality 29
Slow Changes versus Regime Switching 29
2.2 Historical Simulation 17
3.3 How is Volatility Measured 30
2.3 Portfolio Valuation 19
Using the Absolute Value of Returns 30
·
·
i
1
1
6.7 Derivatives 80 8.2 Choosing Scenarios 101

6.8 Challenges 80 Historical Scenarios 101
Stress Key Variables 102
Ad Hoc Stress Tests 102
Using the Results 102
Chapter 7 Operational Risk 85 8.3 Model Building 102
Knock-On Effects 103
7.1 Large Risks 86 8.4 Reverse Stress Testing 103

Cyber Risks 86 8.5 Regulatory Stress Testing 104
Compliance Risks 87
8.6 Governance 104
Rogue Trader Risk 88
The Board and Senior
7.2 Basel II Regulations 88 Management 104
7.3 Revision to Basel II 89 Policies and Procedures 105
Validation and Independent
7.4 Determining the Loss Distribution 90 Review 105
Loss Frequency 90 Internal Audit 106
Loss Severity 90
8.7 Basel Stress-Testing
Monte Carlo Simulation 90
Principles 106
Estimation Procedures 91
Potential Biases 91
Scenario Analysis 92
Allocation of Economic Capital 92 Chapter 9 Pricing
Power Law 93 Conventions,
7 .5 Reducing Operational Risk 93 Discounting,
Causes of Losses 93 and Arbitrage 115
Risk Control and Self Assessment 94
Key Risk Indicators 94
Education 94 9.1 Treasury Bills 116
7 .6 Insurance 95 9.2 Treasury Bonds 117
Moral Hazard 95 9.3 Short Positions 119
Adverse Selection 95
9.4 The Law of One Price and
Arbitrage 119
Liquidity 120
Chapter 8 Stress Testing 99 9.5 Discount Factors from
Coupon-Bearing Bonds 121
Replicating Bond Cash Flows 122
8.1 Stress Testing versus
VaR and ES 100 9.6 ST RIPS 122
Stressed VaR and Stressed ES 100 9.7 Day-Count Conventions 123
Contents • v
15.5 Risk-Neutral Valuation 194

Chapter 14 Binomial Trees 177
15.6 Implied Volatility 195
15.7 Options on Stock Indices,
14.1 One-Step Trees 178 Currencies, and Futures 196
Generalization 179
15.8 Handling Discrete Dividends 197
14.2 Risk-Neutral Valuation 179 American Options 197
14.3 Multi-Step Trees 180 15.9 Warrants 198
A Two-Step Tree 181
A Put Example 181
American Options 181
Chapter 16 Option Sensitivity
Increasing the Number of Steps 182
Measures: The
14.4 Delta 183
"Greeks" 203
14.5 Other Assets 183
Stock Indices 183
Currency 184 16.1 Introduction 204
Futures 184 Stop-Loss Strategy 204
16.2 Delta Hedging 205
Delta Hedging 206
Chapter 15 The Black 16.3 Vega 207
Scholes-Merton 16.4 Gamma 209
Model 189
16.5 T heta 210
16.6 Rho 210
15.1 Stock Price Movements 190 16.7 Portfolios 211
The Lognormal Distribution 190
Return Calculations 191 16.8 Trading Limits 211
15.2 Volatility 192 16.9 Other European Options 211

Measuring Time 193 16.10 American Options 212
15.3 No-Arbitrage for Options 193 16.11 Portfolio Insurance 213
15.4 The Pricing Formulas 194 Index 219
Contents • vii
®
Chairman
Dr. Rene Stulz
Everett D. Reese Chair of Banking and Monetary Economics,
The Ohio State University
Members
Richard Apostolik Dr. Attilio Meucci, CfA
President and CEO, Global Association of Risk Professionals Founder, ARPM
Michelle McCarthy Beck, SMD Dr. Victor Ng, CFA, MD

Chief Risk Officer, TIAA Financial Solutions Chief Risk Architect, Market Risk Management and Analysis,
Goldman Sachs
Richard Brandt, MD
Operational Risk Management, Citigroup Dr. Matthew Pritsker
Senior Financial Economist and Policy Advisor/ Supervision,
Julian Chen, FRM, SVP
Regulation, and Credit, Federal Reserve Bank of Boston
FRM Program Manager, Global Association of Risk Professionals
Dr. Samantha Roberts, FRM, SVP
Dr. Christopher Donohue, MD
Balance Sheet Analytics & Modeling, PNC Bank
GARP Benchmarking Initiative, Global Association of Risk
Professionals Dr. Til Schuermann
Partner, Oliver Wyman
Donald Edgar, FRM, MD
Risk & Quantitative Analysis, BlackRock Nick Strange, FCA
Director, Supervisory Risk Specialists, Prudential Regulation
Herve Geny
Authority, Bank of England
Group Head of Internal Audit, London Stock Exchange Group
Dr. Sverrir S>orvaldsson, FRM
Keith Isaac, FRM, VP
Senior Quant, SEB
Capital Markets Risk Management, TD Bank Group
William May, SVP

Global Head of Certifications and Educational Programs, Global
Association of Risk Professionals
viii • FRM® Committee

Author
John C. Hull, PhD, University Professor, Maple Financial Group
Chair in Derivatives and Risk Management, University of Toronto
Reviewers
Paul Feehan, PhD, Professor of Mathematics and Director of the Tao Pang, PhD, FRM, CFA, Director of the Financial
Masters of Mathematical Finance Program, Rutgers University Mathematics Program, North Carolina State University
Erick W. Rengifo, PhD, Associate Professor of Economics, Donal McKillop, PhD, Professor of Financial Services, Queen's
Fordham University University in Belfast
Donald Edgar, FRM, MD, Risk & Quantitative Analysis, Carlos Martin, FRM, Risk Director, Royal Bank of Scotland
BlackRock
Dennis Wong, FRM, CFA, PMP, Product Consultant, Thomson
Jennifer Voitle, FRM, CFA, Senior Director of Model Risk Reuters
Management Group, Santander Bank
Olivier Vu Liem, FRM, Principal, Soci如Generale
Masao Matsuda, PhD, FRM, CAIA, President and CEO, Sandeep Guhargarkar, FRM, Senior Director, Capital One
Crossgates Investment and Risk Management
Attributions • ix
Financial risk is measured in several ways. In this chapter, we ITable 1.1 One-Year Returns and their Probabilities
start by discussing the mean and standard deviations of returns.
Probability Return
Specifically, we show how the mean and standard deviation
of a portfolio's return can be calculated using the means and 0.05 -20%
standard deviations of its components'returns. This leads to an 0.25 0%
important concept known as the efficient frontier, which shows
0.4 7%
the trade-offs between mean and standard deviation that are
available to the holder of a well-diversified portfolio. 0.25 15%
When portfolios are described by the mean and standard devia 0.05 40%
tion of their returns, it is natural to assume we are dealing with
normal distributions. However, most financial variables have where E denotes expected value and R is the return. We have
fatter tails than the normal distribution. In other words, extreme already calculated E(R) as 7.55% (or 0.0755). The term E(R勺 is
events are more likely to occur than the normal distribution calculated as follows:
would predict. This is relevant because risk managers are partic 0.05 X (-0.2)2 + 0.25 X 02 + 0.4 X 0.072 + 0.25 X 0.152
ularly interested in quantifying the probability of these adverse + 0.05 X 0.4 2 = 0.0176
extreme events.
The formula for the standard deviation gives
Value-at-risk (VaR) and expected shortfall are two risk measures
focusing on adverse events. Later in this chapter, we explain SD(R) = Y0.0176 - 0.0755 2 = 0.109
these measures and explore their properties. We find that or 10.9%.
expected shortfall, although less intuitive than VaR, has more
We have shown that the opportunity presented in Table 1.1
desirable theoretical properties and is an example of a coherent
has a return with a mean of 7.55% and a standard deviation
risk measure.
of 10.9%. We can then characterize the set of all investment
opportunities in a chart by plotting the various combinations of
means and standard deviations. Figure 1.1 shows the two assets
1.1 THE MEAN-VARIANCE we have mentioned so far:
FRAMEWORK
1. An asset having a return with a mean of 2.00% and a
Investors are faced with a trade-off between risk and return. The standard deviation of zero
greater the risks that are taken, the higher the expected return 2. An asset having a return with a mean of 7.55% and a
that can be achieved. It should be emphasized that the term standard deviation of 10.9%
expected return does not describe the return that we expect to
happen. Rather, the term is used by statisticians to describe the Combining Investments
average (or mean) return.
Now consider two available investments with expected returns
One measure of risk is the standard deviation µ.,1 and µ.,2. Suppose an investor puts a proportion w1 of available
．
of returns. Consider a risk-free asset, such
as a U.S. Treasury instrument. Suppose this Mean Return (%)
8
asset provides a one-year return equal to 2%.

7
The return, therefore, has a mean of 2% and

6
a standard deviation of zero (when using a

one-year horizon).
5 4 3 2 1 0
Consider next the asset presented in Table 1.1.

The expected return is calculated by weighting
the returns by their probabilities:
0.05 X (-20%) + 0.25 X 0% + 0.4 X 7%

+ 0.25 X 15% + 0.05 X 40% = 7.55%
。
S.D. Return (%)

The return standard deviation is ，，，
8
2
I I
10 12
SD(R) = VE(R2) - [E(R)]2 I Figure 1.1 Two alternative risk-return possibilities.
2 • Financial Risk Manager Exam Part I: Valuation and Risk Models

缸 Risk-Return Combinations from Two and

Investments n n
<rp =
L LPijWiWj吓坏 (1.4)
W1 W2 µp Up i= 1 j= 1
0.0 1.0 8.0% 16.0% where Pij is the correlation between the returns from invest
0.2 0.8 7.4% 13.6% ments i and j.
0.4 0.6 6.8% 11.8% Investors want high expected returns and low risks. If we mea
10.8% sure risk by the standard deviation of the return, we can argue
0.6 0.4 6.2%
that some portfolios in Table 1.2 and Figure 1.2 dominate oth-
0.8 0.2 5.6% 10.9% ers for these investors. For example, given a choice between
1.0 0.0 5.0% 12.0% the w1 = 1.0 (whereµ,P = 5.0% and aP = 12.0%) and w1 = 0.6
(whereµ,P = 6.2% and aP = 10.8%), investors would seem to
prefer the latter because its return has a higher mean (6.2% versus
funds into investment 1 and w2 = 1 - w1 into investment 2. The 5.0%) and a lower standard deviation (10.8% versus 12.0%).
portfolio expected return (肛p) is therefore a weighted average of
Of the six investments in Figure 1.2, the upper four (correspond
the expected return from the two investments:
ing to w 1 = 0.0, 0.2, 0.4, and 0.6) form what is referred to as
J.Lp = w化1 + w犯2 (1.1) an efficient frontier. For each of these four investments, there
The standard deviation of the portfolio's return (ap) is more com is no other investment (or combination of investments) that has
plicated and involves the coefficient of correlation between the both a higher expected return and a lower standard deviation of
returns from the two investments (p): return.
ap = Yw 阳 +w回+ 2p w议沪仅2 (1.2)

Suppose that µ.,1 5% and µ.,2 8%; a1
= 12% and a2 16%; = = =
The Efficient Frontier
and p = 0.25. Table 1.2 shows several possible outcomes for As mentioned, most investors want to maximize their expected
various weightings for investment 1 and investment 2. These are returns and minimize their risk. If we measure risk by the return
plotted in Figure 1.2. standard deviation, we can surmise that these investors want to
We can extend the previous result to the situation in which there move as far into the upper-left region in Figure 1.2 as possible.
are n investments and JJ.,; and a; are respectively the return mean Using Equations (1.3) and (1.4), we find that an investor can
and standard deviation for the ith investment. When the weight move further in the desired direction by incorporating additional
given to the ith investment is w;, the mean and standard devia investments. For example, a third investment can be combined
tion of the portfolio return are with any combination of the first two investments to obtain new
n risk-return trade-offs. A fourth investment can be combined with
µ., p
=
�W;JJ.,; (1.3) any combination of the first three investments to obtain even
i= 1
more risk-return trade-offs, and so on.
．
Mean Return (%) Of course, there are limits as to how favor
able the risk-return combinations can
．
become. When all possible combinations
of all risky investments are considered, we
obtain the efficient frontier of all risky invest
ments. This is shown in Figure 1.3. All risk
return combinations in the shaded area below
o,867 45 2301 and to the right of the efficient frontier can
be created. Those to the upper-left cannot be
created.
So far, we have only considered risky invest
。
S.D. Return (%)
，，，，，，，， ments in constructing the efficient frontier.
0.02 0.04 0.06 0.08 0.1 0.12 0.14 0.16 0.18 We now consider what happens when a
Figure 1.21 Risk-return combinations in Table 1.2. risk-free investment earning a return of RF is
Chapter 1 Measures of Financial Risk• 3

this case, demand for investment X would exceed supply, and its to it) occurring. Values close to the center of the distribution are
price would increase until the over -representation disappeared. most likely to occur, whereas values at the tails of the distribu
tion are less likely to occur.
We have tacitly assumed that all investors make the same
assumptions about the mean and standard deviations of, and As with all probability density functions, the probability of a
coefficients of correlation between, the returns from different value between a and b occurring is equal to the area under the
investments. We have also assumed that they care only about probability density function between a and b. The cumulative
the mean and standard deviation of the returns from their port density function provides the area under a distribution up to
folios, and that they can all borrow at the risk-free rate of inter a certain point. The probability of a value between a and b is
est. These assumptions are, at best, only approximately true. equal to the cumulative distribution up to b minus the cumula
Efficient frontiers are closely related to the capital asset pricing tive density function up to a.
model (CAPM). This is discussed further in the Foundations of A standard normal distribution is one where the mean is zero
Risk Management readings. and the standard deviation is 1 so that the density function is
1 x2
f(x) = e-— ( 1.6 )
1.2 THE NORMAL DISTRIBUTION 声 2
The normal (or Gaussian) distribution is one of the most well Tables are often used to provide the cumulative distribution
known and widely used probability distributions. It has two for the standard normal distribution. For example, the area
parameters: the mean and standard deviation. A normally dis between minus infinity and 1.0 is 0.8413. For a distribution with
tributed variable x, with meanµ., and standard deviation a, has a meanµ., and standard deviation a, we can use z -scores. The
density function: cumulative probability up to a value x is the cumulative probabil
ity for a standard normal up to
1 (x-µ,)2
f(x) = e (1.5) X - JJ.,
27Ta-
v2
2
2cr
z=
。畛
Figure 1.5 shows the density function forµ., = 2 and u = 5. The

For example, whenµ, = 2 and a- = 5, the probability that the
center of the distribution isµ.,, and u is a measure of dispersion
value is less than 1 is the probability that a standard normal vari
about the mean.
able is less than
The height of the normal distribution for a value of x can be
1 - 2
thought of as the probability of that value of x (or a value close = -0.2
5
0.1
0.08
0.04
0.02
。。
5
-20 -15 - 10 -5 10 15 20 25
I Figure 1.51 A normal distribution with mean 2 and standard deviation 5.
Chapter 1 Measures of Financial Risk• 5

ITable 1.31 Percentage of Days when the Change normal probability distribution predicts that a variable will
in the S&P 500 is Greater than a Number of Standard exceed three standard deviations only 0.27% of the time.2 A
Deviations and the Predictions Made by the Normal three standard deviation move is therefore over six times more
Model likely than the normal distribution would predict. Looking at
other rows in Table 1.3, we see that the normal distribution pre
Predicted by
diets that four, five, and six standard deviation moves should
Movement Actual Results Normal Distribution
hardly ever happen. In practice, we observe them on 0.60%,
>1 SD 21.79 31.73 0.32%, and 0.12% of the days, respectively.
>25D 5.01 4.55 Most financial variables are like the S&P 500 in that they have
>35D 1.65 0.27 fatter tails than the normal distribution. Most portfolio returns
>45D 0.60 0.01 that can be created also have fatter tails than the normal dis
tribution. The situation is illustrated in Figure 1.6. The actual
>SSD 0.32 0.00 distribution and the normal distribution have the same standard
>65D 0.12 0.00 deviation. However, the actual distribution is more peaked
than the normal distribution and has fatter tails. This means
that both small changes and large changes happen more often
From tables, this is 0.4207.
than the normal distribution would suggest, while intermedi
Since 2007, Excel has provided a convenient function for the nor ate changes happen less often. This is consistent with our S&P
mal distribution. For example, NORM.DIST(1, 2, 5, TRUE) gives the 500 data. The probability of a percentage change less than one
probability that a normal variable with mean 2 and standard devia standard deviation is 100% - 21.79% = 78.21%, whereas the
tion 5 is less than 1. As we have just mentioned, that probability is normal distribution would predict it to be 100% - 31.73% or
0.4207 Similarly, NORM.DIST(4, 2, 5, TRUE) gives the probability 68.27%. The probability of a percentage change greater than
of a value less than 4. This is 0.6554. The probability of a value three standard deviations is 1.65% compared with 0.27% for
between 1 and 4 is 0.2347 (=0.6554 - 0.4207). the normal distribution. The probability of an actual percent
age change between one and three standard deviations is
The normal distribution is often assumed for the returns on
21.79% - 1.65% = 20.14%, whereas the probability of this for
financial variables. It is a convenient choice because all we need
the normal distribution is 31.73% - 0.27% = 31.46%.
is the mean and standard deviation of the returns, and these can
be calculated for a portfolio from Equations (1.3) and (1.4).
In practice, financial variables tend to have much fatter tails than 1.3 VAR
normal distributions. We will illustrate this using data on the S&P
500 Index. Over a 20-year period ending on December 14, Risk managers are concerned with the possibility of adverse
2017, the standard deviation of the daily change in the index events. We have shown that describing a probability distribution
was 1.214%.1 Table 1.3 shows by its mean and standard deviation and then assuming a normal
• The percentage of days in which the actual daily return distribution is likely to underestimate the probability of extreme
events. The standard deviation of a distribution, although a use
exceeded one, two, three, four, five, and six standard
ful measure in many situations, does not describe the tails of a
deviations; and
probability distribution. VaR is an important risk measure that
• The percentage of days we would expect this to happen if
focuses on adverse events and their probability.
the probability of daily returns had been normally distributed.
The VaR for an investment opportunity is a function of two
Consider, for example, the row in Table 1.3 corresponding to parameters:
">3 SD". Out of the sample of 5,034 days, the daily change in
the S&P 500 was greater than three standard deviations (or • The time horizon, and
3 x 1.214% = 3.641%) on 83 days, or 1.65% of the time. A • The confidence level.
1 For the purposes of this examp le, we assume that the mean daily 2 The Excel function NORM.DIST(-3) gives 0.00135 indicating that
return on the S&P 500 was zero. Over short time perio ds, such as one a decline of three standard deviations or more has a probability of
day, the standard deviation of the return is much more important than 0.135%. Similarly, the probabi lity of an increase of three stan dard
the mean return. For our data, the mean daily return was only 0.028%, deviations or more is 0.135%. The probability of a movement exceeding
so that the daily standard deviation was over 40 times the mean. three standard deviations is therefore 2 X 0.135% or 0.27%.
6 • Financial Risk Manager Exam Part I: Valuation and Risk Models


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无论谁给您发资料，一律加微信：xuebajun100s/,课程后期一律加密处理，否则后期不更新，影响考试概不负责！

2.4 Term Structures 20

1.1 The Mean-Variance Framework Model 21

1.2 The Normal Distribution 2.9 Estimating Parameter Values 24

1.3 VaR 2.10 Correlation Breakdown 24

1.4 Expected Shortfall 2.11 Worst Case Analysis 24

1.5 Coherent Risk Measures

6.7 Derivatives 80 8.2 Choosing Scenarios 101

7.1 Large Risks 86 8.4 Reverse Stress Testing 103

15.5 Risk-Neutral Valuation 194

15.2 Volatility 192 16.9 Other European Options 211

Michelle McCarthy Beck, SMD Dr. Victor Ng, CFA, MD

William May, SVP

viii • FRM® Committee

asset provides a one-year return equal to 2%.

The return, therefore, has a mean of 2% and

a standard deviation of zero (when using a

Consider next the asset presented in Table 1.1.

0.05 X (-20%) + 0.25 X 0% + 0.4 X 7%

S.D. Return (%)

2 • Financial Risk Manager Exam Part I: Valuation and Risk Models

缸 Risk-Return Combinations from Two and

ap = Yw 阳 +w回+ 2p w议沪仅2 (1.2)

Chapter 1 Measures of Financial Risk• 3

Figure 1.5 shows the density function forµ., = 2 and u = 5. The

Chapter 1 Measures of Financial Risk• 5

6 • Financial Risk Manager Exam Part I: Valuation and Risk Models

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