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Risk and Return of Portfolios of Risky Assets

For a portfolio of N securities, the expected portfolio return is:


E(RpJ= LW; xE(Rj)


The variance of returns for a portfolio of fWO risky securities is not a simple weighted average of rhe variances Ilf the two securities. It depends ,

, on how the returns on the securities move together, which is measured by the covariance of the returns on the two securities.

aF = wicr~ +w~(Ji +2wAWSCov(RA,RB)

" Cov(RA,Rs)

SInce correlation equals = P A,S = ,

(JA xcrB

Diversmable and Systematic Risk The part of the volatility of a single security's returns that is uncorrelated with the volatility of the market portfolio is that security's diversifiahle risk

The pan of an individual security's risk that arises beeause of the positive covariance of that security's returns with overall market returns is called its systematic risk

A standardized measure of systematic risk is beta:

beta. = Cov(Ri,RM)

1 2


Capital Asset Pricing Model (CAPM) In equilibrium all investors hold a portfolio

of risky assets that has the same weights as the market portfolio. The CAPM is expressed in the equation of the security market line (SML). For any single security or portfolio of securities i, the expected return in equilibrium is:

E{Rj) = RF +betaj(E(RM)-RF]

CAPM Assumptions

o Investors seek to maximize the expected utility of their wealth ar the end of the period, and all investors have the same investment horizon.

o Investors are risk averse.

o Investors only consider the mean and standard deviation of returns (which implicitly assumes the asset returns are normally distributed).

o Investors can borrow and lend at the same risk-free rate.

o Investors have the same expectations concerning returns.

o There are neither taus nor transactions com, and assets are infinitely divisible. This is often referred to as ·perfect tnarkm."

Pric~ and Quantity of Risk

The risk premium of an asset is [E(~) - f\.l~. The quantity of risk is ~.

The price of risk is rhe market risk premium:


Firm Value Using CAPM

firm cash flow current value of equity = ----- 1'+ CAPM return

If the firm reduces its systematic risk through financial markets, the decrease in cash flows (the hedging costs) will be just offset by the lower required rate of return, and the value of the firm is }lnchanged.

Market Efficiency

The three levels of efficiency are as follows:

• ~ak efficiency means that the information in past price patterns is incorporated into the current prices.

• Semntro1ng efficiency means that all public information, including that in past price patterns; is incorporared into the current prices.

• Strong efficiency means that all information, including private and public, is incorporated into the current prices.

Measures ofPerfonnance

The Treynor measure is equal to the risk premium divided by bera, or systematic risk:


Treynor measure = _;_~-..:..

. ~p

The Sharpe measure is equal to the risk premium divided by the standard deviation, or total risk:


Sharpe measure = (Jp

The Jensen measure (a.k.a. Jensen's alpha or just alpha), is the asset's excess return over the return predicted by the CAPM:

- Jensen measure =

Olp = E(Rp)-{RF Hp[E(RM)-RFll

The infonnation ratio is essentially the alpha of the managed portfolio relative to its benchmark divided by the tracking error.

IR = [E{Rp~ - E(RB)j

tracking error

The Sortino ratio is similar to the Sharpe ratio except we replace the risk-free rate with a


minimum acceptable return, denoted Roo,' and

we replace the standard deviation with a type cif semi-standard d~ation.


Sortino ratio

semi-standard deviation

Arbitrage Pricing Theory (APT)

The APT assumes that returns can be modeled with a multifacror regression model of the following form:

Rn = RF + Xn,! X b] + ... + Xn,k x bk + lin


R, = returns for stock n RF = risk-free rate

Xn,k = k factor exposure for stock n bk = return for factor k

Un = idiosyncratic return for stock n

The APT defines the structure of returns but does not define which factors should be used in the model. The CAPM is a special case of APT with only one factor exposure-the market risk premium:

Case Studies

Metallgestilschaft: short-term futures conrracts used to hedge long-term exposure in the petroleum markets; stack-and-roll hedging strategy; marking to market on futures caused huge cash flow problems.

Sumitomo: rrader attempted to corner the copper market by buying large quantities of physical copper and long futures positions; copper prices plunged, causing huge losses; lesson is the lack of operational and risk controls that allowed this scheme to go undetected.

Long- Term capital Management: hedge fund that used relative value strategies with enormous amounts ofleverage; when Russia defaulted on its debt in 1998, the increase in yield spreads caused huge losses and enormous cash flow problems from realizing marking to market losses; lessons include lack of diversification, model risk, leverage, and funding and trading liquidity risks.

Barings: rogue trader, Nick Leeson, took speculative derivative positions (Nikkei 225 futures) in an attempt to cover trading losses; Leeson had dual responsibilities' of trading and supervising settlement operations, allowing him to hide trading losses; lessons include separation, of duties and management oversight.

Drysdale Securities: borrowed $300 million in unsecured funds froni Chase Manhattan by exploiting a Haw in the system for computing the value of collateral.

[Cu:it.Jn Peabody: Joseph jett, reported substantial artificial profits; after the fake profits were detected, $350 million in previously reponed gains had to be reversed.

AJ1jed Irish Bank: a currency trader, John Rusnak, hid $691 million in losses; Rusnak bullied back~ffice workers into bot followingup on trade confirmations for fake trades.

UBS: equity derivatives business lost hundreds of millions of dollars; the losses were mostlydpe to incorrect modeling of long -dated options and the firm's large stake in Long-Term Capital Management.

Daaua: a Treasury bond trader. Toshihide Iguchi. covered up $1.1 billion in losses; his misleading reponing went undetected due to his dual role

as the head of both trading and the back-office support function.

Banker': Trust: developed derivative structures that were intentionally complex; in taped phone conversations. staff bragged about how badly they fooled clients.

GARP Code of Conduct

The Code of Conduct sets forth principles related to ethical behavior within the risk management profession. It stresses ethical behavior in the following areas:


(1) Professional integrity and ethical conduct (2) Conflicts of interest

(3) Confidentiality

Professional Standards

(1) Fundamental responsibilities (2) Adherence to best practices

Violations of the Code of Conduct may result

in temporary suspension or permanent removal from GARP membership. In addition, violations could lead to a revocation of the right to use the FRM designation.


. ,

B~y~' Jl()riD.~ ". ~',_- .

~~y'elf6rmulaisuse~ t~ update:~giVen.,se(of;

· prl~r probabilitleii tor a giveli event inresp0rist . to t!1e.aihvai :6fnew info~nla~oll: For ei<aiilple!,. if:y'o.ll'~t.to6~~ the.probability thatthe.·.:.·· .'.

· e~Q~ygi9W~ ~i~ 'a:stQcldsup; yo~':~o~ld' :

uSe.i:he.f<iUo~Dg equation: . ... . ... ... ..


.:. 'where: ,,'

· P(G), = pr~~1>iU!Y the eC~o~y grow~' ", _

. P_(~) = p~oQa~i!itr, of.i recess,ion .. .''''; ','.


:wliet(tIi~ ~eigh~~i~itkp_!ij~,~~t!e.S'that the -: '


The ~ianf.e plYMd¢S :I: m~ure ,9f the exrerll:'-offAe dis~~o~jn the, ~of.tIie Iando~ . ~m~bl~ aio~ihlie; iiieiii;~~&qu~:~~ot' ~f.ilie ~aiianCe is cilled 'thc'$ta!liWd devi~tion,' .

,. . .. , '--'-"'_"--' _,

;"vuianee(X, ;;;: F.HX"~~~] "~j:"", ..

Chebyshev's Inequality

For any set of observations. the peicentage of the observations that lie within R standard deviations of the mean is at least 1 - ! Ik? for all k > 1.

Population and Sample Mean Population mean: all the observed values in the population are summed (EX) and divided by the number of observations in the population. N.



!.l.= ;=1


The sample mean is the sum of all the values in a sample of a population, EX. divided by the number of observations in the sample. n.

Geometric Mean

The geometric mean is often used when calculating investment returns over multiple periods or when measuring compound growth


. where:

R, . = the return for period t

'. PopwaQoJi and S~pleVariance

The. p.Dpulation. variance is defined as the' average of the squated' d~iarions from the mean.

· The population standard deviation is the square

· root of'the population variance.

N .....


ri= i-:-I " N

· T~e~aihpi~Vaiiiili~;r ;.is the measure of ,·dispeisI9n·~tipp~~when W,e'ar~~Viil~atiJig .. ,··a:sa.ntple .~£ it olisefyatio.Ii~Jtoma:PQPulatioil.. . ,

:'~~~i!:'~~~~~:~~~;~~p~~~t7::a~r~ ~::

.: es'tU1i!!rQ~9fa2." .v .', :.c:,.". .

'li:~(;l;,~)j~~;.t .. · ..



;, 'Aji' ~#~f~lskiUitddlStri6tiijQriJiu,a " ,,:.

... ' .et:" .. ''' ... , .. '.. ..... '.

.. ..• .. ~sp~opoitioiuiti:Iy:Jarge iIrtloUn!of ou~i~lhat

, • 'filhyiihiii jtili>.w_~i ,(Jeft)~]; "," ..

; ~· ..•. ~~-yx~~;:

:~ kurt~~~:~trir~~~~r~~:d~~\?"which:

a distfjDutiQn~Ii)Qte:.Qdess~p~aked·th~ a • normal distributioit:EXCesskurtosiS = kurtosiS -3. •• Li:ptokUrtit deiciibes a distributiQn thads more .

' -. ~~ thari .·nofuiaiillifriblition " ..

.' Pla~(rJe~'~o: a di$trib~tl~n that is less

pemd,.or Ha,tt~ ~inormal distribudon.


[(Xi _X)4

kurtosis ~ ..1;i-::!Ic__-,- __ X.!..

s4 n

Relative Frequencies

A frequency distribution is a tabular presentation of statistical data that aids the analysis of large data sets. The relative frequency is calculated by dividing the absolure frequency of each return interval by the total number of observations.

It is the percentage of total 'Observations falling within each interval.

Normal Distributions

Normal distribution is completely described by its mean and variance.

• 68% of observations fall within ± Is.

• 90% of observations fall within ± 1.65s.

• 95% of observations falJ within ± 1.965.

• 99% of observations fall within ± 2.58s.

Standardized Random Variables

A standardized random varitlbk is normalized so that it has-a mean of zero and a standard deviation of 1.

Z-score: represents # of standard deviations a given observation is from a population mean.

observation - population ·mean x - f.L

z= .'. ..... =--

standard devarion (J

Central Limit Th~rem

Central limIt theorem: when selecting simple random samples of size n from population with mean II and finite variance cr1; the sampling distribution of sample mean approaches normal probabilirrdistribution with mean fJ. and variance equal to crYn as the sample size becomes-large.

,Standard Error' ' ':,' .

· Tlie'staiidafd'error of the n.inpl~,h~ is the staridarddeviation of the-distributien of the- . s~ple mearu..When,thest~d~d d~i~U~n'.'6·f thep~pU1~~iQn,:d; ~ knd~~,th~ stafidu<!,eir9! of

· the sample mean is calcukted as: "::. .

... 0"., .

.. (Ji~c~. ~.:, .

f~f)istiibiid~n'" , ,

Tkl~Jisirib~#o~:~·~·:~~I)-Sh~peaprobab~itr.· .• dlstributjori:lli~~ .is SYIiinie.tricil.~6iin~ .iDem ..

~~tjf~~J.:~~t~~~j~~~t~·~~:~ft.· .

· ~mall saitipliifiom populations ~th.:wiloi~~n 'vananieaii(inorJIla:l;.oi.ap'pmxirri~i~y norinal,

distributiqn .. : ' , .

':. .' .. X-:·fJ.

'. t-test:.t = .. 'r:

.. ,.s/"n

Chi~SquareDiStrib~tiott .

Thechi-squate' tesr is we~ fin hypothesis tests co.ncerningthe variance ofa normallydistributed

population. .'

· • .... .c, :'C 2 . (~~ 1)82

chi-square test: X = -.--

. . cr~

. F-DistribUrlon'

The F-test is used for hypotheSe'S tes~conCerning the equality of the variances of two populations.

. s2 ' . . ,

F-test: F = -1


Adjusting Portfolio Beta

• If the beta of me capital asset pricing model is used as me systematic risk measure, then hedging boils down to a reduction of the portfolio beta.

# of contracts =.

( b . . portfolio value

target eta - portfolio beta)-'-----underlying asset

Forward Interest Rates

Forward rates are interest rates implied by the spot curve for a specified future period. The forward rate between TI and T2 can be calculated


Forwar_d Rate Agreement (FRA) Cash FlowS

An FRA is a forward contract obligating two parties to agree that a certain .interesr rate will apply to a principal amount during a specified future time. The T, cash flow of an FRA that promises the receipt or payment of RK is:

cash flow(if receiving R K) = ~X(RK -R)x(T2 - TI)

cash flow(if paying RK) = Lx (R-RK)x{Tz - TI)


L = principal

R K =: annualized rate on L

R = annualized actual rate Ti = timei expressed in years

Cost-of-9lriY Model

Fo~d p~ when underlying asset does not hav~ cash Haws: .

Po =SoerT

Forward price when underlying asset has cash Rows:

Po = (So - I)erT

Forward price with continuous dividend yield (q):

Po = Soe(r-q)T

Forward price with storage costs:

Po = (So + U)erT or Po = Soe(r+u)T

Forward price with convenence yield: lb = Soe(r-c)T

Forward foreign exchange rate using interest rate parity (IRP):

Po = Soe(rd -rr )T

Arbitrage: Remember to buy low, sell high.

• If Po > SoerT, borrow, buy spot, sell forward today; deliver asset, repay loan at end.

• If Po < SoerT, short spot, invest, buy forward today; collect loan, buy asset under futures contract, deliver to cover short sale.

Backwardation and Contango

• BackwaJdation refers to a situation where me futures price is bdow me spot price. For this to occur there must be a significant benefit to holding the asset.

• Contango refers to a situation where me futures price is above the spot price. If there are no

benefits to holding the asset (e.g., dividends, coupons, or convenience yield), contango will occur because the futures price will be greater than the Spot price.

Clean and Dirty Prices

When a bond is purchased, the buyer must pay any accrued interest (AI) earned through the settlement date.

# of days from last coupon I

AI to the serclement date

= coupon x

# of days in cou:,on period


Clean pnc« (a.k.a. quoted price): bond price without accrued interest.

Dirty price (a.k.a, cash price): includes accrued interest; price the seller of the bond must. be paid to give up ownership.

Treasury Bond Futures

In a T-bond futures contract, anY government

. bond with more than 15 years to marurity on the first of the delivery month (and not callable within 15 years) is deliverable on the contract. The procedure to determine which bond is the cheapest-to-deliver (CfD) is as follows:

cash received by [he shore = (QFP x CF) + A1 cost to purchase bond = QBP + AI


QFP = quoted futures price CF = conversion factor QBP = quoted bond price

The CfD is the bond that minimizes the following: QBP - (QFP )( CF). This formula calculates the cost of delivering the bond.

Eurodollar Futures Contract

This contract settles in cash and the minimum price change is one "tick," which is a price change of one basis point, or $25 per $1 million contract. The interest rate underlying this contract is essentially me 3-month (90-day) . forward UBOR. If Z is the quoted price for a eurodollar futures contract, the contract price is: . eurodollar futures price =

$10,000[100 - (0.25)(100 - Z)]

Convexity adjustment: The daily marking to market aspect of the futures contract can result in differences between actual forward rates and those implied by futures contracts.

actual forward rate =

(imPtdb;d fur:es } - (X X 02 X T1 X T2 )


T 1 = maturity on the futures contract T2 = maturity of the rate underlying the


o = standard devivation of change in rat~

Duration.Based Hedge Ratio

The objective of a duration-based hedge is to create a combined position that does Dot change in value when yidds change by a small amount.

# f Portfolio value X diuationp

o contracts = .

futures value X durationj,

Interest Rate Swaps

Plain vanilla interest rate swap: exchanges fixed for Roating-rate payments over me life of the swap. At inception, the value of the swap

is zero. After inception, the value of the swap is the difference between the present value of the remaining fixed- and floating-rate payments;

V,wap 10 pay fix«i = BHoal - Bfix V,wap to receive fixed = BflX - B lIoal BflXed = (PMTflXed,tl X e -ro, )

+ (PMTflX«i,12 X e -rr2 ) + ...

+ [(notional + PMT fix«i r ) X e -rr. 1

Bllooting = I notional + [ notional ~. lfI;.r )1 x e -rr,

Currency Swaps

Exchanges payments in two different currencies; payments can be fixed or floating. If a swap has

a positive value to one counterparty, that party is exposed to credit risk.

V!w'p (DC) = BDC - (So X BFcl


So = spot rate in DC per FC

Option Pricing Bounds

Upper bound European/American call: c~So;C~So

Upper bound European/American put: p~ Xc-rT; P~ X

Lower bound European call on non-dividend-paying stock: .

c ~ max(So - Xe -rT ,0)

Lower bound European put on non-dividend-paying stock: .

p~max(Xe-rT -50,0):

Rules for Exercising American Options

o It is never optimal to exercise an American call on a non-dividend-paying stock before its expiration date.

o American puts can be optimally exercised early jf they are sufficiently in-the-money.

• An American call on a dividend-paying stock may be exercised early if the dividend exceeds the amount of forgone interest.

Put-Call Parity

p+So =C+Xe-IT

Covered Call and Protective Put Covmd raU: Long stock plus short call. ProtertiJx put: Long srock plus long put. Also called pqrtfolio insurance.

Option Spread Strategies

Bull spread: Purchase call option with low exercise price and subsidize the purchase with sale of a call option with a higher exercise price.

Bear spread: Short bull spread. Purchases call with high strike price and shorts call with low strike price. Investor keeps difference in price of the options if srock price falls. Bear spread with purs involves buying put with high exercise price and selling put wim low exercise price.

Buttnf/y spread: Three different options: buy one call with low exercise price, buy another with

a high exercise price, and short two calls with

an exercise price in between. Butterfly buyer is betting the stock price will stay near the price of the written calls.

Cakndar spread: Two options with different expirations. Sell a shan-dated option and buy a long-dated option. Investor profits if stock price stays in a narrow range.

Diagonal spread: Similar to a calendar spread except that the options can have different strike prices in addition to different expirations.

Option Combination Strategies

Long JtradJk: Bet on volatility. Buy a call and a put with the same exercise price and expiration date. Profit is earned if stock price has a >rge change in either direction.

Short straddle: Sell a put and a call with the same exercise price and expiration date. If stock price remains unchanged, seller keeps option premiums. Unlimited porential losses.

Strangle: Similar to straddle except purchased option is out-of-the money, so it is cheaper to implement. Stock price lias to move more to be profitable.

Strips and straps: Add an additional put [srrip) or call (strap) to a straddle strategy.

Foreign Currency Risk

A net long (short) currency position means a ' bank faces the risk that the FX rate will fall (rise) versus the domestic currency.

net currency exposure = (assets -liabilities) +

• (bought - sold)

On-balance Iheet hedging: matched maturity and currency foreign asset-liability book.

Off-balance sheet hedgil1[- enter into a position in a forward contract.


Concessionaliry is the net cOS! of a multiyear

restrucru ring agreement ..

concessionality = (PV of original loan) - (PVof

restructured loan)

The lower the PV of the restructured loan in relation to the original Joan, the more the bank has given up, and the greater the cost of loan



. -_" ....

-. -':,:"::-:-': ,,:.;,:":;"

.. _-_

. e,

Compounding Discrete compounding:

f . ]rn)(n

FVn =PVoe+; .

.. where:

r = annual rate

m = compounding periods . n := years

Continuous compounding:

FVn = PVoetXn

Holding period return: 1

r = m ( :~: txn -I

:Spo,tRates . ' .

:.¥t.petiod spot rate, denoted ~ z(t},is the yield . to maturity on a sere-coupon bond ,din rnatures-: inr-years. Itcarihe~cUJaled ,~lng. a ,financi;!l cilculat.ororbYllSing ~t;:r6IJo~qg formuja

(::~~:jP(;~~:"~'"i. .

, ' d(t)} ". ' '

. ..

._ ..

,:--the:&ond ,e· e 'Ufi o;matul'lty .. · ... --"".". . "". -;"

price volatility; the longer (shorter) the duration, the more (less) sensitive the bond's price to changes in interest rates; can be used for linear estimates of bond price changes.

o • BV_l!.y -BV+l!.y

effective duration = ----''----.:..

2xBVo x6y'

Convexity. measure of the degree of curvature . . (second derivative) of the price/yield relationship: accounts for error in price cllange estimates

from duration. 'COnvexity always has a favorable impact on bond price,

o BV_l!.y+BV+l!.y-2xBVo

convexity = 2

BVo xt1y


Bond Price Chang~ With Duration and Con:vexity

percentage bond price change e duration effect + convexity effect

t1B 0 I . 2

- = -duration X Ay + - xconvexrtyx l:1y ...

B 2" .

Bonds With.Embedd~ QptiQDS Callabk.'bond:issu~i h~ the righnolJuy b;tc~. .

. the bond ill the future at a sei:price;'as yields f.ill,' bond is likely to becall~d;pIj~:'Yill !i.ieat~, tk~asing rate-::-negatille ~o,!i;e~;ty.. , . '.' . .,.. , Putable bond:' boridhil.Jdec:haS'che .right .io:self ':,' bono b~i:k to the issue{af ~ s~Fprl~": ..::, '

,Bin~mial (jp.tion,PtiChig:i(to~~:~ :,~:: , .' .. -'.

. A one-step binomial.moeM is bestdescribed wjthj~ . . a two-stare world where the price'ofa stCJ.ikY'.At· 'eithergo up once or down onc(a!)dj:he:di,ai1ge .

will occur one step ahia~ at ihe.endo~~~~::,'.:/:···:


:::S~::r::;~&T~~o~;~~t:::J~~~0!:~:P~::j:'Z:.¥i~;;;jS~:·~~ ,':':,w~~~e~.:' ,c s) ,'~ ~:,:~.: ~::,> ·cci~~,:'o;_~~.~:L;~i~:~:;

.' " :, -..In(:.:...Q.)+[i+'05X0"2-JX1''~. :' .... : ·~;~;,;i;

" ,',d1 ">,.: K,:,' -'~~'it:~- .~~<,:_(.~:~:~j,~r:'-~':

,'" ',d"·'" •.

'. '" . ~::.:~.:.:-:: ~::;':. ~~ ' .... "- "'- .

C(lnfidence Interval

... If the population has a normal distribution with a known variance, a confidence interval for the population mean is:

-.,L (J

x -,-Zo./2 Fn

Znl1 = 1.65 for 90% confidence intervals (significance level 10%, 5% in each tail) z"n = 1.96 for 950/0 confidence intervals (significance level 5%, 2.5% in each tail) l"a = 2.5 8 for 9~% confidence intervals (significance level I %, 0.5% in each rail)

Hypothesis Testing

Nu/J hypothesis (Ho): hypothesis the researcher, wants to reject; hypothesis that is actually tested; the basis for selection of the test statistics. Alternative hypothesis (HJ what is concluded

if there is significant evidence to reject the null hypothesis,

One-tailed test: tests whether value is greater than , or less than another value. For example:

Ho: f1 S 0 versus H ... : ~ > 0

Two-tailed test: tests whether value is differenr from another value. For example:

Ho:'f1 = 0 versus,HA:J1 't- 0

Type Land TyPe UErro t s

Type I erronRejection'of the null hypothesis when it is actually, rrue:Thesignificance level is the probability of making a Type I error, ' Type Il.erron Failureto.rejectrhe null hypothesis when iris acmany false:'The pOWfr. of a test is one minus the probabilitVof making a' Type Ilerror,

The Biitonrl,a( Pis~ibllti~n, ' "

Evalaates a'iaD4oii;.:varlablewlth: 1\\;[; possible ',' " outcom~ove~.~ sUies:oIiI~tri~:'The,proba~ilit}r ,

o~~i~~~~n:,)~mt~FBuals:'" ".

(nwnbei ,0£ ~ ':t;;~oo~e it from'n) 'i(l~' )n-. :

"...,ys , ,,' ,,' p, ,p "

For a binijiiid[ f¥do'm: ii4nabie,," "',' ..,

expected, value:" ~p .:. '

variance = np(t~ p.).-} : " "

lhePQi§on:biSttji;ution:,,; " "

PoisSon :f~dom'v;Uiibj~x refetsC~o theti:uhbct, .: of sU#~,~P:~:~t;j!~;p'~~~tei,i~~~~'-p..)",:

teferstotheav", 'e.rium~eiof$uCceSSes er':"

unit~F.~t:~:~li~ti~~~~Cjth{ts~~ap !id;, '.


Simple.llii"~:~sio,n Yi='l\+~;~*i~i>:

where';" ,.

y; = i;l~p~d~XQr~p1~ed variable

~ =ind~pe",~en!o~ ~'~atorykriable

Bo :Uit~rcCPt ~efficient '

B = slcilpeoodnderif ~~" '

I, ':",.'"

e:j =errertemr:

Total Sum. of Squares

For the dependent variable, in a regression model, there is a total sum of squares (TSS) around the sample mean.

total sum of squares = explained sum of squares + residual sum ot squares TSS = ESS + RSS

" -z"'-Z,, 'Z ~(Yi - Y) = ~(Y - Y) + ~(Yi - Y)

Coefficient of Determination Represented by R', it is a measure of the "goodness of fit" of the regression.

R 2 = ESS = 1 _ RSS


In a simple two-variable regression, the square root of Rl is the correlation coefficient (r) between X and Yi• If the relationship is positive, then:


jarque-Bera Test

The Jarque-Bera test is a method for testing if the normality assumption is reasonable.

JB=~+Z + (K~3)21

Multiple Linear Regression, "

A simple rwessiim is the two-variable regression with one dependent variable, Yi, and one independent variable, X;~A'inulti~ariate regression has morethan one independent variable. "

Yj =Bo tBI x_ XutBz x X;j +Ej , '

The F-statistic'

Adj~~l~-Sq~ed ':" ,", '

A,djus#d Rl,iSrisedto analyze me imporiiu1C(iCif

:':'an~dckd iDaq,e!ldeiit vaiiaJ,le to:~Te~i~n}:,'

, :' ~'~dj~~ed:f'lyl ~ (~- it 2) X, n~~~~-r':: " ~ •. '

. .... -

,:EWM!:ModeJ', ,

':rii~,dp~~~ti@y,~e~gh~~'~QVi~g: ~ve~e , :(EWM.A)~~ ~iilne$:\veights :d~line ',' ,

,', eJ(pQiientia»yback,tiIrougn tim<rhis', : " , :,~llnlption~tsin a:spe~~c relatio~p-for ' '~a,riance inilie'iilooe.l: "'"

':~~ == (I ~~~)r;~l + ~cr~~1

, where

).. = weight 011 previous yolatility'estim~te

, ' (be~n 'ierQ and on~) ," : ",' ,

Higbvalues,~fXwill,_tn.iIi.4nize the -effect of c!aiiy , perCeiitage remms, wher~~ Iow'v~i1es ofXwili " tend to increase the e.ffect of dailypetcentage

r~t\lfIlS on ~current vo~ati1io/ ~ii.matc. '. ' GARCilModd.,

AGARCH(J,i) modd 'incoip~rares the, most,

, reCent estima~ of varianCe 8hdsq\lared return, ' butalso a accounts for a long-run average level ()f variance.


Ct = weighting on previous period's return

~ = weighting on previous volatility estimate w = weighted long-run variance ,

• U) ,

VL = long-run average variance = " l-o:-~

ex + ~ < 1 for stability

The EWMA is nothing other than a special case of a GARCH(l,l) volatility process, with w = 0, n = 1 - A, and ~ = A.

The sum Ct + ~ is called the persistence, and if the model is to be stationary over time (with reversion to the mean), the sum must be less than one.'



Option and Forward Contract ,Payoffs The payoff on a call option to the option buyer is calculated as follows:

C; = max(O, ST- X)

The price paid for the call option, Co' is referred to as the call premium, Thus, the profit to the option buyer is calculated as follows:

profit = C; - Co

The p.lyoff on a put option is calculated as follows:

PT= max(O,X-ST)

The payoff to a long position in a forward contract is calculated as follows:

payoff = ST - K


ST = spot price at maturity K = delivery price


The basis in a hedge is defined as the difference between the spot price on a hedged asset and

the futures price of the hedging instrument

(e.g., futures contract). When the hedged asset and the asset underlying the hedging instrument are the same, the basis will be zero at maturity.

Minimum Variance Hedge Ratio

The hedge ratio minimizes the variance of the combined hedge position. This is also the beta of SpOt prices with respect to futures contract prices.


Hedge Effectiveness

Measures the variance that is reduced by implementing the optimal hedge. This effectiveness can be evaluated with a coefficient of determination (R2) term where the independent variable is the change in futures prices and the dependent variable is the change in spot prices.

Hedging With Stock Index Futures

# of contracts = ~p x

ponfoli~ value futures price X contract multiplier

• Call delta close to 0 for far our -of-the-money calls; dose to 1 for deep in-the-money calls.

o Put del ra between -1 and 0; increases &om -1 to 0 as stock price increases.

o Put deltaclose to 0 fat far our-of-the-money putS;

close to -1 for deep in-the-money puts.

• The delta of a forward contract is equal to I.

• The delta ora futures contract is equal to erT.

o When the underlying asset pays a dividend, q, the delta must be adjusted. If a dividend yield exists, delta of call equals e-<lT )( N(d,),ddta of put equals e-qT x [N(d,l- 11, delta of forward equals e-qT, and delta of futures equals e,,-qIT.

Theta: time decay; change in value of an option for a one-unit change in time; most negative when option is at-the-money and close to

expiration. .

GaJnma: rate of change in delta as underlying stock price changes; l~gest when option is at-the. money.

·\4>git: change in value option f.or a one-unit change in volatility; largesrwheneption is.ii- '. the-money; close to 0 wben option i~ deep in- or

out-of-the-money. .

Rho: sensitivity of option's price to cJl~g~ iri the risk-free rate; largest for in-the-money options ..

. DeJta~NefitralH~dgiQg... .

. ; To complerelyhedge.a :Iohg stoek/shon eii.ll ' •• ,. position, piltclWe'sh~~sofst~~keq~ to.·delta x '

number ofoptions sold, .... . .

• Only appropriate. Jot small.changesin the value of

the underlying asset. '.~ . . .

• Gamma can correct hedging t;rror by protecting: . against large mevemenn in-asset price; -". : .

• Gamma-neurralposirions are cr.elIte4bY"in~t:Ching:,

portfolio gamma omi:.ttiii~· 0Ru!)n .


V~ueat Rislc(VAR) . .,

Miriiin~: ~owit ~1l~~~6u1~~eip~C~)~:t~~~t,Ji:.\ .a given ptob~iliry ovei :a:specificpeiiqa·:,(;)fiiniei:~:·

'y AR(~'%)::;;·~i%xf +..:> .. ))::'\j \;~::(ni~t.~;',

• ' ~t:i;1rt~l;;7eJQ:~~~~'~~i'~~::~;~~!.;'

. vrr~l~~(X\l~!;":~-~,


· .. :::e!~;t~~~tf~~~~r:'~:iY&~[;:)

.'.d~tlbh ·6f~flihij},,:s::;::,,:,:<::,::":::.::~: ",<:::',.;,;:

': Th~:~;;~1i~~~~ij/~H~~}~~~h~t fo~~es#~_a~ing ',,-

'YARuses liliIDiICiifdati.~·Forexam 'Ie,:to'.:

... _..... . ....... . .. '"" ...... 1> .......

"caIi:tAaie the5%_q~uy.yARY~u !l¢CIiID\iliite a.'" '.

·-n~~~i::pfp~d.3.i.lj,T~!~r.ns;::r~n~: 4~:.~~: ',' ' ...

. ~~:t~~~~;~;;~~-f~~]&n~ ~e'.,

Th·e-Mimt.eCarIoiimUfafi~ii iniihoa{efers .

: to ..9mp:~teiso~ m!lt gen~r:\tesmwy ::posSiblf:o~~c6~frotri.·(lie di~i1btiti9n~. of. . .

. t!tit:~!~::ibt~~~~~~:~~~l~~~/'

'~~pp'~Ximate thdl~~iiiai di$trjbuti~n.VARis. ~ :~~;ca1ctlja:ted i~,this~~ ~y'~.Wi~ diedC1u.~··

,normalIlleth9~. ... .. ...

S~'restiQgi:.:~: \ , . , .

:YAJ.t~u.s.:~eprot;ablli.ty:()fexceedil).g ~ given loss . : hUt faili t()~iticOiPo~tet1ie possible amount ofa

~OS$ihlit .resulrs from lin extreme amount,

Stress wring complements YAR by providing information about the magnitude oflosses that may occur in market condnions.

Expected SbortfaU (ES)

• Average or expected value of all losses greater than . .. the VAR: E[Lp I Lp > VARJ.

• Popular measure to report along with V AR.

• ES is also known as conditional VAR or expected tail loss,

• Unlike VAR, ES has the ability ro satisfy the property of subadditiviry,

Linear vs, Nonlinear Derivatives

• A derivative is described as linear when the relationship between an underlying factor and the derivative's value are linear in nature. VARp = !1VAR.,

• A nonlinear derivative's value is a function of the change in the value of the underlying asset and is

. dependent on the state of the underlying asset.

Operational Risk

Operational risk is defined as: 'The risk of direct and indirect loss resultingfrom imuLequateor foiled internal processes, people, and systems or fiwn, external events. "

Loss Frequency and Loss Severity Operational risk losses are classified along two

, independent dimensions: .

: .. Loss frequmcy: the number of losses over a specific 'time period (rypically one year).Ofr~n mod~led with the·foissondistribution (a distribution which models random events),

. L~!sjeverity: value of financial loss suffered. Often modeled with the lognorinal distribution. . (distribution is asymmetrical ana has fat tails).

. ClaSsifications ofOpe.i'ational Risk'

. . Highjr,;qmry, IOW-Sf(!erity(Hfl:.S) risks occur' .' .ti~qg~~rJY~ut'resUlti~snialilcisseS,· .

.. jj~w.';foqu'en"" .. high~stvmiy (Lr..ti$) risks are ',: .'


; '~~~bJe::aata:[~~ai~ such riskS; Md"iliiir'cost . ::t(j:tli~ fifm'~oUld becatasu()phi~ . .' ..... ..

':TOp~D6~' and Bottoln"Up Mooels . ·.:~nj.JOW;z1ia~de(_~~ij;irii;S~igg;~ega;tdmpa!=~ ~::' .

;··~tt~~L~t~~:.~,·~~~or~~·r~es.·~n:.~ ..


«Ji:~LS ~entS"al)!I L.fHS ~eii~i611ll!of clj~os~:" :,;.~~t#Var.~ looking::;: ::~:~ .. J)b.ttoff!:'up .. :I!1_~d~/i iii.~ r.iSk ~indivi~uaL::·:::

;,; iu'pce§ies; >. . .' ,. , " .

, . '~.Advri~ci~diStiilgilishes berween-HFl.$-everitil··

···::~:~~~!tr:{=t~~:~o:tZ:}q :,:, ' .:

"loi>king-' .. . ..

. ·~.Disad~~ge~; c~~plex and datil intensive: , .

PPN:44761FRM ISBN 1427789533

9 7 u.s. $49.00 ~ 2010 Kaplan,lnc. All Rights Reserved.

Methods tor Hedging Operational

Risk ~

• Insurance.

• Self-insurance.

• Derivative securities.

Catastrophe Options and Bonds

Cat options: Publicly traded; payoffs linked to index (i.e., underwriting losses in the insurance industry); spread option that has limited. upside. Cat bonds: Bond contracts with embedded options that can be triggered by internal events, external events, or the value of an index.

Internal Credit Ratings

At-the-point approach: to predict the credit quality over a relatively short horizon of a few months or, more generally, a year. Through-the.cycle approach: focuses on a

longer time horizonandincludes the effects of

forecasted cycles. .

The risk that a foreign government may.default on a 10;!j\ or fail to hono.rbu~iness commitments due toa change innatiOllaJpolicy::Whenexposed' to sovereign risk; the lender's legal remedies are

· very limited.' . .

Creditors shoUld:

o Examine thesovei'eig~,d~kqli~ity: ~fthe country

in which the fuin residii: . .' .

•• Assessihetieditq~l~~f:the nrn;:.· .••..

DebfRepudiation······ '" ,'" .

. Debt. repudiation is die .Uri~quivoCa!r.~:ilof a .' country to honoragreements ii;iwhii:haH.future·:

· foreign.debt'and~ujtY"ob(l~ticim-9{!l:pcirrQwer ...

arecancelled, '. . •... ." •. ' .. ,

· ~e~,~~:U::i;~ei~t~~~1:6t.~>~· .

: ~ grCll~p:()t ~~dll6i:SJ!i;tfi~t.:~~,ttY,i¥~i~teia'~' ..... · •. suspei1Sjoi(6.f.i"6t~~el~y.~~;i~~~~ii~~~t~~,fU!lIre::~ . •. deDt064ga~c511~·a:ti.d:~~:~~§:#iirtli:e~~~t's-'H·': •••..

contractual tei:ms '. suc1l:as'iritereiitntes·iriaaebi.· :

" ., ... : ,- _-_.~' .. - r : -" .: '.~:.: .•. _'. " ••.•. ', :.".,'!.'.: '.'~:: ;.:,~;~;i.' .. :~~~_',~.';'.~'-,:".,:~ .. "'~" .. ~~:::.~~::;: ',:.: .: .~:

..l1laiiiri11i.-":·· . . ,_ : .


;::~~ii~'t~:~P~!td.#;pk!lli~I,[W~f~~I#'@:i::;;~:',:~·~ • ,:::·~Ii~~~:~#.~'S:~~W~~3~~~~~~·~::h'~i


',.' •. ~~~~.i~o\Vci _cluo;~~~~~~~;,J~~~~,~~2ili~~~ .•. ·• •.

.• T!:~:7~~~:\?-~~~~~~:,:1t:~::~:·. .

: .. borrower .(corillnitriwQi.·~~~~~.~~~.+':l1n~d:

.: P:;~~;=~~!~b~l:·:~~;~el'~~~wi


.potentiaIloss~ andCan'b~iitooeled~iIig' .:Jie. .: . .

· definicion cifStmdar_Q deviation. ". . ... ..

ill ~AE' .'~ IEDFxui . ~+I.GD2:~~EDi· .. .' . . . . . 'J . , .. ~D. _ .. " ... p .