FOUNDATIONS OF RISK • There are neither raxes nor transactions costs, and co hide crading losses; lessons include
and co hide crading losses; lessons include separacion
MANAGEMENT
Types of Risk
Key classes of risk include marker risk, credir
risk, liquidity risk, operarional risk, legal and
regulatory risk, business risk, srraregic risk, and
repuracion risk.
Market risk includes interest race risk, equity price
•
risk, foreign exchange risk, and commodity price risk.
• Credit risk inc ludes default risk, bankruptcy risk,
downgrade risk, and sctdcmcnt risk.
Liquidiy risk includes fundin g liquidiry risk and
•
crading liquidity risk.
Enterprise Risk Management (ERM)
Comprehensive and integraced framework for
managing irm risks in order co meec business
objeccives, minimize unexpecred earnings
volacility, and maximize irm value. Beneits
include (I) increased organizarional effecciveness,
(2) beccer risk reporting, and (3) improved
business perormance.
Determining Optimal Risk Exposure
Target certain deault probabiliy or specic cit
rating. high credit racing may have opporcunity
coses (e.g., forego risky/proicable projeccs).
i
Sensitiviy or scenario anays s: examine adverse
impaccs on value from specific shocks.
Diversifiable and Systematic Risk
The pare of the volacility of a single security's
recurns chac is uncorrelaced wich che volatility of
the markec porcolio is chat securicy's diversiiable
risk.
The pare of an individual securicy's risk char
arises because of the posirive covariance of thac
securicy's recuns with overall marker recurns is
called its systematic risk.
A standardized measure of systematic risk is beta:
Cov(R;.RM)
beta·=
I
2
OM
Capital Asset Pricing Model (CAPM)
In equilibrium, all investors hold a porcfolio
of risky assecs thac has the same weigh rs as rhe
market porcolio. The CAPM is expressed in che
equacion of the security market line (SML). For
any single security or portolio of securicies i, the
expected retun in equilibrium, is:
E(R;) = Ri= + b eca ; [E(RM )- RF)
CAPM Assumptions
•Investors seek to maximize the expected utility
of thei r wealth at the end of the period, and ll
investors have the same inv estment horizon.
•Investors are risk averse.
•Investors o nly consider the mean and standard
asset returns are normally distrib uted .)
deviation of returns (which impli cic ly assumes the
Inv estors can borrow and lend at the same risk-free
•
rate.
• Investors have the same expectations con c ernin g
ret urns .
sse tsare ininitely divisible. This is oten referred of ducies and managemenc oversighc.
to s "perfect markets." Alied Irish Bank: currency crader, John Rusnak,
Arbitrage Pricing heory (APT) hid $691 million in losses; Rusnak bullied back­
oice workers inco not following-up on crade
The APT describes expecced recurns as a linear
function of exposures to common risk factors: conirmations or ake trades.
E(R) R. + G;iRP, + G;iRP l + ... + 0,kRP k
=
UBS: equicy derivacives business lose millions due
co incorrecc modeling of long-daced opcions and
where:
0, = /' ac or beta or stock i ics srake in Long-Term Capical Managemenc.
i
RP = risk premium associated with risk factor j
Sociite Genemle: junior crader, Jerome Kerviel,
i parcicipaced in unauthorized crading accivicy and
The APT deines the scruccure of reruns but
hid accivicy with fake ofsT eccing cransaccions;
does noc deine which faccors should be used in
fraud resulred in losses of $7. I billion.
the model.
Metal!gesellschat: shorc-cerm futures concracts
The CAPM is a special case of APT with only one
used co hedge long-cerm exposure in che
factor exposure-che market risk premium.
pecroleum markecs; scack-and-roll hedging
The Fama-French three-actor model describes
scrategy; marking co markec on fucures caused
recurns as a linear funccion of che markec index
huge cash Row problems.
recurn, irm size, and book-co-markec faccors.
Long-Term Capital Management: hedge fund
Measures of Performance that used relative value stracegies with enormous
The ynor measure is equal co che risk amouncs of leverage; when Russia defaulced on
ics debt in 1998, the increase in yield spreads
measure -[ ]
premium divided by beta, or systemacic risk:
E(Rp) - RF caused huge losses and enormous cash Row
Treynor
problems from realizing marking co market
3p
losses; lessons include lack of diversiicacion,
The Sharpe measure is equal co che risk premium model risk, leverage, and funding and crading
Sharpe measure -
[E(Rp)-RF]
divided by che standard deviation, or coral risk:
Op
liquidity risks.
Bankers Trust: developed derivacive scruccures
that were incencionally complex; in caped phone
The Jensen measure (a.k.a. Jensen's alpha or jusc conversations, staf bragged abouc how badly
alpha), is the asset's excess retun over the return chey ooled clients.
JPMorgan and Citigroup: main councerparcies in
predicred by the CAPM:
Jensen measure -
Enron's derivatives transaccions; agreed to pay a
.p = E(Rp)-{Ri= + 3p[E(RM)- RF)} $286 million ine for assiscing wich fraud against
Enron investors.
The information ratio is essentially the alpha of
the managed porcolio relative co its benchmark Role of Risk Management
I. Assess all risks faced by che irm.
IR =
[
divided by che cracking error.
E(Rp)-E(Rs)
crackmg error
] 2. Communicace these risks co risk-caking
decision makers.
3. Monicor and manage these risks.
The Sortino ratio is similar co the Sharpe Objeccive of risk managemenc is co recognize
ratio excepc we replace the risk-free race wich a chat large losses are possible and co develop
minimum acceptable return, denoted Rm,.• and conti ngenc y plans that de al with such losses if
we replace the scandard deviarion wich a cype of they should occur.
semi-srandard deviation. Risk Data Aggregation
Sortino racio E_(_p_)_-_·R
R_ __'
m 1
ir _ -­
Deining, gathering, and processing risk daca for
- __
semi- standard deviation measuring performance againsc risk colerance.
Financial Disasters Beneics of effeccive risk daca aggregacion and
Drysdale Securities: borrowed $300 million in reporcing systems:
unsecured funds from Chase Manhaccan by • Incre ases abiliry to anticipate problems.
• Ide ntiies rouces to inancial he alth.
exploiting a Raw in che syscem or compucing che
• Impr oves resolvabilicy in event of bank stress.
value of collateral.
• I ncreases eiciency, reduces chance of loss, and
Kikr Peabody: Joseph Jett reporced subscancial
increases profitability.
arciicial proits; afcer the ake proics were
dececced, $350 million in previously reporced P Code of Conduct
Secs orth principles relaced co echical behavior
gains had co be reversed.
Barin(s: rogue crader, Nick Leeson, cook
speculative derivative posicions (Nikkei 225
wirhin che risk managemenc profession.
It scresses ethical behavior in che following areas:
Principles
fucures) in an actempc co cover crading losses;
• Professional integrity and cchical con duct
Leeson had dual responsibilicies of crading and
Con A ices of interest
•
supervising settlemet operacions, allowing him
• Conidentiality
Professional Sands
• Fundamental responsibilities
• Adherence to t practis
Violations of the Code of Conduct may result
in temporiry <n<pen<ion or permanent removal
from P membership. In addition, violations
could lead to a revocation of the right to use the
FRM designation.
Kurtosis is a measure of the degree to which distribution with mean µand variance equal to
a distribuion is more or lss "peaked" than a J2/n as the ample size becomes large.
oml disribuion. sss = urtosis-3.
Population and Sample Mn
• Lptonic describes a distribution at is more
mn
aked than a normal di<trihution.
The populaion sums all observed values
in the populaion and divides by the number of
• Plaic reers to a distribution chat is less
observations in the population, N.
peaked, or latter, than a normal distribution.
N
Exi
Desirable Properties of an Estimator
n unbased estimator is one or which the
µ= i=l
•

xpected value of the estimator is equal to the

N
QUANTITATIVE ANALYSIS parameter you are g o estimate.
The sample mn is the sum of all vlues n
• n unbiased stimator is also ficient f the
variance of is sampling distribution is smaller than a ample of a populaion, X, divided by e
Probabilities all the ocher unbiased ators of the parameter number of observaions in the ample, n. It is used
Unconditional pobabiliy (marginal probability) is you are trying to estimate. to make inmces about the population mean.
the probability of an event occurring. A cosstnt estimator is one or which the accuracy
io/ proabiiy, P( A J B), is the probability of
•
Population and Sample Variance
of the parameter estimate increases as the sample
an evnt A crgivn that t B s cr.d
The population variance is deined as the average
size increases.
of the squared deviations from the mean. The
Bayes' heorem • A point estimate should be a inear estimator when
population standad diation is the square root
it can be used as a linear function of sample a.
Updates the prior probability for an event in of the poplation variance.
rsponse to the arrival of new inormation. Continuous Uom Distribution N
P(O I) Distribution where the probability of X occurring
E(xi -µ) 2
P(IIO)= J xP(I)
P(O)
in a possible range is the length of the range
c? = --
relative to the total of all possible values. Letting N
Expected Value a and b be the lower and upper limits of the
The sample variance, r, is the measure of
Weighted average of the possible outcomes of uniform distribution, respectively, then for
dispersion that applies when we are evaluating a
a random variable, where the weights are the a� x1 <s� b:
sample of n observations from a population. Using
probabilities that the outcomes will occur. (x2
- xi)
E(X)= P (x1 -
<X<x
- 2) = �-� n - 1 instad of n n the denominator improves the
(b-a) saisial pros of 2 as an esimator of J2•
EP(xi)Xi = P(x1)x1 +P(x2 )x2 + .. . + P(x0)x0 n
-
Binomial Distribuion � i -X)2
--(X
Variance Evaluates a random variable with two possible s2 = i=� l
� ____

Provides a measure of the xtent of the dispersion outcomes over a series of n trials. The probability n-1
in the values of the random variable around the of"success" on each trial equals:
mean. The square root of the variance is called p(x) = (number of s to choose x from n ) Sample Covariance
n (X·1
the standard deviation. p'(l- p)n-• . X)(Y1 -Y)
covariance = E
- ·

variance(X) = EHX -µ)2 ] For a binomial ranom varabe:

i=l n-1
xpected value = np
iance variance= np(l- p)
Expected value of the product of the deviaions
Standard Error
Poisson Distribution The standard error of the sample mn is the
of two random variables from their respective
Poisson random variable X refers to the number standard deviation of the distribution of the
xpected values.
of successes per unit. The parameter lambda (X) sample means. When the standard deviation of
Cov(Ri,Rj) = E{[R i -E(Ri)] x [R j - E(R j )])
refers to the average number of successes per unit. the population, J, is known, the standard error of
For the distribution, both its mean and variance the sample mean is calculated s:
Correlation
X. J
Jx =
are equal to the parameter,
Measures the strength of the linear relationship
Axe-
.
_
betwen two random variables. It ranges rom-1 P(X=x)=-­
x!
to +l. Coidence nel
Cov (Ri,R j) Normal Distribution If the opulation s a normal distribution h
Corr (Ri,Rj)-
Normal distrihurion i< complere ly de.crihed hy
-
o(Ri)o Rj)
a known variance, a coidence interval for the
( its mean and variance. population mean is:
68% of observations ll within ± ls. J
Sums of andom Variables •
-± Z./2
X _
90% of observations ll within ± l.65s.
If X and Y are any random variables:
•

• 95% of observations llwithin ± l.96s.

z
+
99% of observations llwihin ± 2.58s.
E(X + ) = E() E) ll
= 1.65 for 90% coidene intervals
l)
•

(signiiance level 10%, 5% in each

If X and Y are independent random variables:
Var(X + ) = Var() + Var(Y)
If X and Y are NT independent:
Var(X + ) = Var() + Var(Y) + 2 x ovX,)
Swness and Kurtosis
Swness, or skew, refers to the xtent to which a
distribution is not symmetricl. The skwness of
a normal distribution is equal to zero.
• A positivey skeed distribution is cherized by
many outliers n the upper reion, or right l.
• A ngativey d distribution has a
disproportionately large amount of outliers that
ll within its lower let) tail.
Stand Random Variables
A sanardi:ud om varabe is normd
so that it has a man of o and a stand
deviation of 1.
-scort: represens number of standard deviations
a given observation is rom a population mean.
x -µ
= --
observation -population mean
z=
standard deviation
Centrl Limit heorem
When selecting simple random samples of size
n rom a population with mean µ and inite
variance J2, the sampling distribution of sample
means approaches the normal probability
z = 1.96 for 95% conidence intervals
2
(signiiance level 5%, 2.5% in ach l)
zll= 2.58 for 99% conidence intervals
(signiicance level 1%, 0.5% in each l)
Hypothesis Testing
Nul ypothesis (HJ: hypothesis
the researcher
wants to reject; hypothesis that is actually tested;
J
the basis for selection of the test statistics.
tati: ypothesis (H A): what is concluded
if there is siant evidence to reject the null
hypothesis.
One-taied es: tests whether value is greater n
or less than another value. For xample:
H0: µ� 0 versus HA: 11>0
Two-taied test: tess whether value is diferent • The arince of the error term is constant or ll assumption results in a speciic relationship or
rom another value. For xample: independent variables. variance in the model:
H0: µ= 0 versus HA: µ � 0 No serial corelaion of the error terms.
� =(1- .);_, + ..r�-1
•

• The model is coly sied (does not omit

T-Distribution variabls). where:
The t-distribution s a bell-shaped probability RssionAssumptionV iolations ..= weight on previous volatility estimate
(between zero and one)
distribution that is symmetrical about its mean. Heeroskeasticiy occurs when the variance of the
t is the appropriate distribution to use when residuals is not the same across all observations in High values of>. will minimize the efect of daily
constructing conidence intervals based on the sample. percenage returns, wheeas low values of.. will
small samples from populations with unknown MulticoOineariy reers to the condition when two tend to increase the efect of daily percentage
ariance and a normal, or approximately normal, or more of the independent variables, or linear returns on the current volatility estimate.
distribution. combinations of the independent variables, in ARCHModd
a multiple rrssion are highly orrelatd with A GRCH(l,1) model incorporats the most
t-test: t= x - .
st n each other. recent estimates of variance and squared retun,
Serial conation refers to the situation in which the and also includes a variable that accounts or a
Chi-Squae Distribution residual terms are correlated with one another. long-run average level of variance.
The chi-square test is used for hypothesis tests
concerning the variance of a normally distributed Multiple Linear Regression r� =w+r;_, +0r�-l
population. A simpe ssion is the two-variable egression
with one dependent variable, Yi, and one where:
. 2 (n -l)s 2 t =eighting on prvious period's ren
chi-square test: X = � independent variable, .· A multivariate ression 0 = weighting on prvious volatility ate
s more than one independent variable. w = weighted long-run variance
Yi=Bo +B 1 xX1i +B 2 xX2i +ei w
F-Distribution VL = long-run e variance =
l-t-0
The F-est is used for hypotheses tess concening t+ 0 < 1 or stability
Adjuste. R-Squared
the equality of the variances of two populations.
Ajusted R 2 is used to analyze the imporance of The EA is nothing other than a special case
s2
F-test: F= - an added independent variable to a regression. of a GRCH(l,1) volatility process, with w = 0,
s2 n-1 . = 1 ->., and 0 = ..
adjusted R2 = 1- (1 - R2 ) x --
n - k-l The sum t + 0 is alled the persistence, and f the
SimpleLinear ssion
model is o e saionary over ime (with reversion
Yi= B0 + B1 x X i + Ei TheF-Statisic
to the man), the m must be less n one.
where: The F-sat is used to tst whether at last one of
Y i = dependent or xplained variable the independent variables xplains a signicant SimulationMethods
portion of the variation of the dependent variable. Monte aro simuations n model complx
� independent or xplanatory variable
=

The homoskeastiiy-ony F-stat can only be problems or estimate variables when there are
B0 intercept coeicient
small sample sizes. Basic steps are: (1) speciy
=

B1 =slope cocicicnc lerivel from R2 when the error rerms clisplay

Ei = error term
TotalSum of Sqs
For the deendent variable in a reression model,
there is a total sum of squars (TSS) around the
sample mean.
total sum of squares = xplained sum of squares +
homoskedasticity. data generating process, (2) estimate unknown
variable, (3) save estimate from step 2, d (4) go
ForeastingModelSelection
back to step 1 and repat process N s.
Model selection criteria s the form of penay
Boostrapping simuations reply draw data
facor times mean squa"d error (MSE).
from historial data sets and replace data so it
MSE is computed as:
n be re-drawn. Requires no assumptions with
T

sum of squared residuals E e;/T respect to the true distribution of parameter

t=l
estimates. However, it is inefective when there are
TSS = ESS + SSR outliers or when data is non-independent.
Penalty factors for unbiased MSE (s2), Akaike
information criterion (AIC), and Schwan

Coeicient of Detenination
Represented by R 2, it is a masure of the
"godness of it" of the regression.
R2 =
ESS
= l SSR _
TSS TSS
n a simple two-variable regression, the squae root
of R 2 is the coaion ficient (r) between X'
and Y, If the relationship s positive, then:
r= 2 autoreressive ) models. Models that lack
Sandard Error of thession (SER)
Measures the degre of variability of the actual
Y-values relative to the estimated -values from
a regression equation. The SER gauges the "it"
of the regression line. The smaller the standard
error, the better the it.
Linear RssionAssumptions
• A linear relationship sts between the dependent
and the independent variable.
• The independent varible is uncorrelated ith the
error terms.
• The xpected value of the error term is zero.
information criterion (SIC) are: (T IT - k),
e<2 11, and T(UI), respectively.
SIC has the largest penalty actor and is the most
consistent selection criteria.
CovarianceStationary
A time series is covariance stationary if its
mean, variance, and covariances with lagged
and leading values do not change over time.
Covariance stationarity is a requirement for using
covariance sationarity are unstable and do not
lend themselvs to mulforcasting.
Autossive (R) Prss
The first-order autoregressive process [R(l)] is
speciied as a variable regressed against itself in
laged orm. It has a mean of zero and a constant
variance.
Yt =�1-1 +et
EWMAModel
The exponentially weightd moving average
(EA) model assumes weights decline
xponentially back through time. This
FINANCIAL MARKETS AND
PRODUCTS
Option andForwardContract Payos
The payof on a lloption to the option buyer is
calculated as ollows: T=max(O, ST- X)
The price paid for the all option, C0, is reerred
to as the llpremium. Thus, the proit to the
opion buyer is td as follows:
proit= T- C0
The payof on a put opion is alculatd as follows:
PT= max(O, X- ST )
The payof o a long position in a forward
contract is calculated as ollows:
payof= ST - K
whee:
ST = spot price at maturity
K = devey pice
Fus Market Participants
Hegers: lock-in a xed price in advance.
Specuators: accept the price risk that hedgers are
unwilling to bear.
Arbitrageurs: in te ested in marker ineiciencies co
obtain riskless profic.
Basis
The basis in a hedge is deined as che diference
between che spoc price on a hedged assec and
che utures price of che heding inscrument
{e.g., urures concracc). When che hedged asset
and che asset underlying che hedging inscrument
are che same, che basis wlle zero ac maruricy
mm Variance Hedge Raio
The hege ratio minimizes che variance of che
combined hedge position. This is also che beca of
spoc prices wich respecc co urures concracc prices.
HR = Ps,F�
rp
Forward price wich convenience yield, : OptionPricing Bounds
. -
o - Soe (r -c)T Upper bound European/American ll:
c $ S0; C $ S0
Forward foreign exchange rate using interest ae
paricy OP): Upper bound European/American put:
;� -S e <i-r )T
•o - o
p $ Xe-rT; p $ x
Arbitrage. Remember to buy low, sell high. Lower bound European ll on non-dividend­
• If o > S0erT ,orrow, buy spot, sell orward paying stock:
. today; deliver asset, repay loan at d. c � max(S0 -e-rT ,0)
• If b < S0e rT , shon spot, invest, buy od
today; collecc loan, buy asset under ucures Lower bound European put on non-dividend­
concracc, deliver to cover shon sale. paying stock:
Baation and Contango T
p � max(Xe-r -S o ,O)
• Baon reCrs to a situation he the uus
price is below the spot price. For this to ocur, here xercising AmericanOptions
must be a signiicant beneit to holding the st. • t s nver optil to xercise an mericn llon a

Hedgingih Stock Indx Futures • Congo reers to a situation where the ucures non-dividend-paying stck ore is xpiration date.
price is above the spot price. If there are no benefits • merican puts n be optimally xercised early if

porolio value to holding the asset (e.g., dividends, coupons, or the y e suiciently in-the-money.
# of ont ras =3r x convenience yield), cont ano ll occur because the • n merican ll on a dividend-paying stock
fucures price x uus price ll be greater than the spot price. may be exercised early if the dividend esthe
concracc multiplier
amount of orgone inteest.
Treasury BondFutures
AdjustingPorolio Beta In a T-bond utures concracc, any government Put-CallPariy
f che beta of che capial sst pricing model s bond with more n 15 s o icy on p = c - S +e-rT
used as che systematic risk masure, chen hg che fuse of che delivery monch {and noc allable
os down co a rduion of che porolio beta. wichin 15 yars) s d elieable on e concracc. c= p+S-Xe-rT
# of os= The prcedu re to determine which bond is che
cheapest-to-deliver (D) is as follows: Covered Call andProtective Put
(t beta-poioIio a) on
olio value
underlying asset Cored cll: Long scock plus short ll.
cash received by che s hore = {QFP x CF)+AI
rotective pur. Long stock plus long put. Also
cost to purchase bo nd=QB P+AI
ForardInterest Rates alled portfolio insurance.
Forward rates are interest rates implied by che spot where: OptionSpread Strateies
curve for a speci ie d urure period. The forward QFP =quoted futures price
Bull sprrad: Purchase call option wich low exercise
rate between T1 and T2 can be calculated as: CF = conversion actor
price and subsidize the purchase with sale of a all
QB P =quoted bond price
R
R owd - 1T2-R1T1 I =accued interest option with a higher exercise pri ce.
T2 - TI
=R 1 + (R 2 - R 1 ) x (_)
T1 -T1
T he CTD is che bond that minimizes che
foll owing: Q B P- (QFP x CF). This formula
calculates the cost of delivering che bond.
Bear sprrad: Purchase call with high strike price
and shon llwich low strike price.
Investor keeps diference in price of che options
f stock price alls. B e ar spread wich pus involves
Forard Ratereement (FRA) Duration-Based Hedge Ratio
buying puc wich high exercise price and seling
shls T he obje ccive of a duraion-based hege is to ae
a combined position char does not change in i
put wich low exercise pr ce.
n FRA s a forward onct obing two Bty: eedierent opions: buy one
paris to ee chat a certain interst rate ll value when yields change by a small amounc.
llwih low ce prie, buy another with a hih
apply to a principal amount during a sped ponolio value x durarionp
#of contracts= e price, and hon o lswith an e
fucure ime. The T2 cash Bow of an FRA chat ures value x durationp price n en. Buely buyer is g the scock
promises che receipt or payment of RK is: price ll say nr the price of the itn ls.
h low (if receiving R<) =
Interest RateSwaps
Lx(RK-R)x(T2 - T1J Plain vanilla interest at e swap: nges xed for ar sprrad: Two options with diferent
loat ing -race payments over che life of the p .
expirations. Sell a shore-dated option and buy a
cash low (if paying RK ) = At inception, the value of che p is zero. Ater long-dated option. Investor proits if stock price
T. x (R - RK)x (Tz - Ti) inception, the value of the swap is the diference stays in a n rrow range.

where : between che present value of che remaining xed­ Diagonal sprrad: Similar o a alendar spread

L = princi pal and floating-rate paymnts: except chat the options can have diferent strike
RK = annulized rate on L Vap to pay rXd = Bloat - Brx prices in addition to diferent xpirations.
R = annualized actual rate Vap to ccve xd = B rx - Bloat Box spread: Combination of bull call spread and
Ti = time i xpressed in years
B rxd = (PMTd,t, x e-re, )
r put spre ad on che same assec. This stratey
ll produce a constant payof chat is equal to che
Cost-o- CryModel + (PMT xd,t2 x e -c2 ) + ...
Forward price when underlying asset does not high exercise price minus che low xercise price.
+ [{notional + PMTxd t ) xe-n" J
have cash flows: Option Combination Sis
o = SoerT [
Bloating = notional + ( notional x ��)J x e -n, Long d. Bee on volailicy. Buy a lland a
put wich the same xercie prie and xpiration
Forward price when underlying asset s cash Currency Swaps date. Proit is arned if sock price has a large
Bows,/: Exchanges paymens in two diferent rncies;
change in either direction.
b = (S0 - I)er
T payments an be xd or Boating. f a swap has
Short sd. Sell a put and a llwith the
a positive value to one oountey, chat parry is
ame exercise price and .pirarion date. If stock
Forward price wih continuous dividend yield, : xposed to credit risk.
price remains unchanged, seller keeps option
Fo = Soe (r-q )T Vwap(DC) =Boe -(S0 x Bpc ) premiums. Unlimited potential losses.
Forard price wich storage co ss , u: rang. Similar o sdle ept purd option
where:
u)T s out-of-the-money; so it is cheaper to implement.
b =(So + U )er or b = Soe(r+
T So = spot rate in DC per FC
Stock price s to move more to be proitable.
 Add an additional put (strip) or
Strips and straps:
ll(strap) to a straddle stratey.
xotic Options
Gap optWn: payof is increased or decrased by the
diference between two strike prices.
ompound opton: option on another option.
Chooer option: owner chooses whether opion s a
all or a put ater initiation.
air option: payof and existence depend on
price raching a cerain barrier level.
Binay option: pay either nothing or a fxed amount.
Lookback optron: payof depends on the maximum
(all) or minimum (put) value of the underlying
asset over the lie of the option. This an be fxed
or loating depending on the speciication of a
strike price.
Shout option: owner receives intrinsic value of option
at shout date or xpiration, whichever is greater.
Asian option: payof depends on average of the
underlying asset price over the life of the option;
less volatile than standard option.
asket options: options to purchase or sell baskets
of securitis. These baskets may be deined
speciically or the individual investor and y
be composed of speciic stocks, indices, or
currencies. Any xotic options that involve several
fent assets e more generally reerred to as
rainbow optWns.
Forein Currency Risk
A net long (short) currency position means a
bank aces the risk that the FX rate will fall (rise)
versus the domestic currency.
net currency xposure (assets - liabilities) +
= lowest, and then identify the lowest 5% of returns.
(bought - sold)
On-baance shut heging. matched maturity and
currency foreign asset-liability book.
f-baance sheet heging. enter into a position in
a forward contract.
Central Counterparties (CCPs)
When trades e cenlycld, a CCP becoms
the seller to a buyer and the buyer to a seller.
Advanages ofCCs: transparency, osetting, loss
mutualizacion, legal and oerational eicienc,
liquidity, and deault management.
Disadvanags ofCCs: moral d, adverse
selection, separation of cleared and non-cleared
products, and margin procyclicality.
sks fced by CCs: deault risk, model risk,
liquidity risk, operational risk, and legal risk.
Default of a clearing member and its low through
eects is the most signiicant risk or a CC.
MBSPrepay ment Risk
Factors that afect prepayments:
• Prevailing mortage rates, including (l) spread
of current versus o riinal mortgage rates, (2)
mortgage ae path (reinancing burnout), and (3)
level of mortage rates.
• Undeying moe characteristics.
• Ssonl ictors.
• Geneal economic activity.
Conditional Prepay ment Rate (CPR)
nnl rate at which a mortgage pool balance
is assumed to be prepaid during the life of the
pool. The single monthly mortality (SMM) rate is
derived from CPR and used to estimate monthly
prepayments for a moe pool:
SMM l -(l -CPR) 1112
= _
Option-Adjusted Spe ad (OAS)
•Spread ater the "optionality" of the cash flows is
taken into account.
•Expresses the diference between price nd
heoicl lue.
• When comparing two MBSs of sr credit
qulity, buy the bond with the biggest OAS.
• OAS zero-volatility sprad-option cost.
=
'4'l:ii''':''';11i1i:1r''',jf1
. .
Value at Risk (VaR)
Minimum amount one ould expect to lose with
a given probability over a speciic period of time.
V aR(Xo) =zx% x r
Use the square root of time to change daily to
monthly or annual VaR
V aR(Xo)J-das = VaR(X%)1day�
VaRMethods
The ea-normal methd (a.e.a. the variance­
covariance method) for stimating VaR requires
the assumption of a normal distribution. The
method utilizes the expected retun and standard
deviation of returns.
The hisorical simuation method for estimating
VaR uss historial data. For xample, to calculate
the 5% y , you accumulate a number of
past daily retuns, rank the returns rom highest to
The Monte Carlo simuation method refers
to computer sore that generates many
possible outcomes from the distributions of
inpus speciied by the user. ll of the examined
portfolio returns will form a distribution, which
will approximate the normal distribution. VaR is
then calculated in the same way as with the dela­
normal method.
d Sholl S)
• Average or xpectd value of ll losses rar tan
the VaR: E[4 I I. > VR].
• Popular masure to report along with VaR.
• S is also known as conditional VR or expectd
ail loss.
• Unlike , ES has the ability to satisy the
coherent risk measure property of subadditivity.
Binomial Option PricingModel
A one-step binomial moel is best described within
a two-sate world where the price of a stock ll
either go up once or down once, and the change
will occur one step ahead at the end of the
holding period.
In the two-period binomial moel and multi­
period models, the tre is xpanded to provide for
a greater number of potential outcomes.
Sp 1: Calculate option payos at the end of ll
states.
Stp 2: Calculate option values using risk-neutral
probabilities.
f
size of up move= U = er J
size of down move = D= _
u BondValuation
e'1- D
Tup = ; Twn = 1- rrup
U D
Step 3: Discount to today using risk-ree rate.
rr"Pcan be altered so that the binomial model
n price options on stocks with dividends, stock
indices, currencies, and utures.
Socks with diviens d stock indies: replace 'T
with .T, where q is the dividend yield of a stock
or stock indx.
Curnes: replace 'T with .-r�T, where rr s the
forein risk-free rate of interest.
uturts: replace 'T with 1 since futures e
considered zero rowth instruments.
Black-Schols-MertonModel
x
c =So N(d1 )- Xe-rTN(d2)
p = e-rT N(-d2)-S0N(-d1)
where:
(�)
2
In [ ]
+ r +0.5 xr xT
axf
= d1 -(oxff)
d2
T = rime to maturity
So = asset price
X = xercise price
r = risk-re rate
r = stock ren volaility
N(•) =cumulative normal probability
Gees
Delta: estimates the change in value for an option
for a one-unit change in stock price.
• Clldelta between 0 and + 1; increases as stock
price increases.
• Clldelta close to 0 for ar out-of-the-money alls;
close to 1 or deep in-the-money calls.
• P ut delta between -1 and O; increases from -1 to 0
as stock price increases.
• P ut delta close to 0 or ar out-of-the-money puts;
close to -1 or deep in-the-money puts.
• The delta of a orard contract i s equal to 1.
The delta of a utures contract is equal to /T.
• When the underlying asset pays a dividend, q, the
x
delta must be adjusted. If a di vidend yield xiss,
delta of ll equals iT N(d1), dela of put equals
iT x N(d,)-1], delta of fod equals iT, and
delta of s quals -�T.
Thea: rime deay; change in value of an option
for a one-unit change in rime; more ngative when
option s at-the-money and close to xpiration.
Gamma: rate of change in delta as underlying stock
price changes; largest when option is at-the -money.
Vega: change in value of an option for a one-unit
change in volatility; largest when option is at-the­
money; close to 0 when option is deep in- or out­
of-the-money.
ho: sensitivity of option's price to changes in the
risk-ree rate; largest for in-the-money options.
Delta-Neutral Heding
• To completely hedge a long stoc/short cll
position, purchase hs of stock equal to delta x
number of options sold.
• Only appropriate or mll changs in the lu e of
the underlying asset.
• Gmaan correct hdging error by protecting
st large movements in asset price.
• Gamma-neutral positions are creatd by mag
porolio mawith an osetting option osiion.
There e thre steps in the bond valuation pss:
Step 1: Estimate the cash ows. For a bond, there
 are two types of cash lows: (1) the annual
or semiannual coupon payments and (2)
the recovery of principal at maturity, or
when the bond is retid.
Stp 2: Determine the appropiate discount ate. The
approximate discount rate an be either the
bond's yield to maturity rM) or a seris
of spot rates.
Stp 3: cuate the PVofthe stimad cash ws.
The PY is determined by discounting the
bond's cash .ow stream by the appropriate
cash lows associated with the instrument to is
price. The yield to maturity assumes cash lows
will be reinvested at the fM and assumes that
the bond will be held until maturity.
Relationship Among Coupon, M,
and Prie
f coupon rate > TM, ond price llbe ar
an par value: prmzium bon.
If coupon rate < TM, bond price llbe less
an par value: discount bon.
If coupon rate TM, bond price will be equal
=
Country Risk
Sous ofcounty ris. (1) where the country s in
the economic growth life cycle, (2) political risks,
(3) the legal systems of a country, including both
the structure and the eiciency of legal systems,
and (4) the disproporionate reliance of a country
on one commodity or service.
Fos inluencing sign aut ris. (1) a
country's level of indebtedness, (2) obligations
such as pension and social service commitments,
(3) a country's level of and stability of x receipts,
(4) political risks, and (5) backing from other

discount rate(s). to par value: par bon.

Clan and Dirty Bond Prices
When a bond is purchased, the buyer must pay
any accrued inteest (AI) earned through the
settlement date.
countries or entities.
Dollar Value of a Basis Point
The DVO 1 is the change in a ixed income
Intenal Crdit Ratings
At-thpoint approach: goal is to predict the credit
security's value for every one basis point change in
quality over a relatively short horizon ofa few
interest rates.
months or, more generally, a year.
�BV
DVOl = Through-he-yce approach: ocuses on a longer
10,000x�y
tme horion and includes the fects of orested
DVOl = duration x 0.0001 x bond value cycles.

Cean price. bond price without accrued interest.
Diry price. includes accrud interest; price
the seller of the bond must be paid to ive up
ownership.
fie Duration and Conxity
Duration: ic derivative of the price-yield
relationship; most widely used masure of bond
xpected Loss
The pected ss(EL) represens the dcrase in
value of an asset (pofolio) with a given xposure
subject to a positive probability of dt.

Compounding
price volatility; the longer (shoner) the duration,
the more (less) sensitive the bond's price is to
ted loss = xposure amount )
x
x
probability ofdault D)
loss rate )

changes in interest rates; an e used for linear

FVn = PV0 1 +
( �)mxn
Discrete compounding:
estimates of bond price changes.
BV_�Y - BV+�Y
Unxpected Loss
Unpected oss represents the variability of
efective duration = potential losses and can be modeled using the
2 x BV0 x�y
deinition of standard deviation.
where: Convxiy: measure of the degree of curvature
r = annual rate
(second derivative) of the price/yield relationship;
�
UL = A x PDxr[R + LR2 x r�0
m = compounding periods per year
accounts for error in price change estimates from Operaional Risk
11 = y ears
duration. Positive convxity always has a avorable Operational risk is deined as: The risk ofdi:ct
Continuous compounding: impact on bond price. and indirect oss mu/ting.rom inaequate or aied
rx n
FVn = PVoe . BV_�y + BV+�y - 2 x BV0 inal processes, ppe, and ystems or from
convxity
tl evens.
=

BV0 x �y2
Spot Rates
A -period spot rate, denotd as z(t), is the yield
ional k pil qemns
Bond Price Changes ih Duration • Basic indicator appach: capial charge measured
to maturity on a zero-coupon bond that matures
and Conxity on a 6rmwide basis as a percentage of annual ros
in t-yars. t an be alculated using a financial
inome.
percentage bond price change :::duration ft+
calculator or by using the following formula • Sanared apph: s divide activities
(assuming periods are semiannual), where d(t) s a convexity efect
among business lines; apial charge = sum for
discount actor:
�B
= -duration x �y + . x convxity x �y2 each business ine.
l Capial or each business line

z(t) = 2
(-)
1 121
-1
B
Bonds ih Embedded Options
2 determind with beta actors and annual ross
income.
d(t) • Advanced measunt approach: banks use their
alabe bond: issuer has the right to buy back
own methodologies or assessing operational risk.
the bond in the uture at a set price; as yields all,
Capital allocation is based on the bank's
Forwd Rates bond is likely to be alled; prices will rise at a operational VaR.
Forward rates are interest rates that span future ecreasing rate-negative convxiy.
periods. Putabe bond: bondholder has the right to sell
Loss Frequency and Loss Sverity
Operational risk losses e classiied along two
)1 ic yield)'+!
+ period
(I . i
bond back to the ssuer at a set price.
(1 + ,.
rorward rate = _ __ _. __
_ _ independent dimensions:
(1 + periodic yield)1
ossequeny. the number of losses over a speciic
time period (typically one year). Oten modeled
dn
with the Poisson distribution (a distribution that
The gross realized return for a bond is its end-of­
models random events).
period total value minus its beginning-of-period
PPN: 32007227 Loss seiy. value of inancial loss sufered.
value divided by its beinning-of-period value.
ISBN-13: 9781475438192 Oten modeled with the gnormal ution
BV, + C, - BV,_1
(distribution is asymmetrial and s at s).
_

Rc-1,c -
BV1-l
The net ed return for a bond is its gross
red retun minus per period inancing costs.
Yield o Maturity M)
The fM of a xed-income security is equivalent
to its internal rate of retun. The TM is the
discount rate that equates the present value of ll
U.S. $29.0 l 2015 Kaplan, Inc. All Rights Resed.
9 7 8 1 4 7 5 438 1 9 2
Stress Testing
VaR tells the probability of xceeding a given loss
but ails to incorporate the possible amount of a
loss that resuls from an xtreme amount.
Stress testing complements VR by providing
information about the manitude of losses that
may occur in extreme market conditions.