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VisualizeFRM-Part I

Quantitative Analysis
Probability Distribution AB


Prob. & Prob. distribution


Hypothesis Testing

Correlation & Regression

Volatility Estimation

Monte Carlo Simulation

Discrete Continuous

Continuous uniform distribution

68% of Data

Normal Distribution (ND) Standardized RV is normalized mean = 0, = 1. Z-score: # of a given observation is from population mean. Z=(x- )/









Outcome only between [a, b] P(outside a & b) = 0

-4 -3 -2 -1

95% of Data 99.7% of Data

0 1 2 3 4

Mean: x i/n

Avg. of squared deviations from mean Sample variance s 2 =[ni=1 (Xi -Xmean ) 2]/(n-1) Population variance 2 =[Ni=1 (Xi - ) 2]/N

Mode:-Value that occurs most frequently

Positively : mean> median> mode Negatively : mean< median< mode Skewness of Normal = 0 Leptokurtic: More peaked than normal (fat tails); kurtosis>3 Platykurtic: Flatter than a normal; kurtosis<0 Kurtosis of Normal = 3 Excess Kurtosis = Kurtosis - 3


Counting principles

Sum rule and Bayes Theorem

Only 2 possible outcomes: failure or success. P(x)=nCx *p x(1-p) n-x

Fix the expectation =np. P(x)= x e-/x! if x>=0 P(x)=0 otherwise

Median:-Midpoint of data arranged in ascending order

Standard deviation = Variance Var(ax+by)=a2Var(x)+ b2Var(y)+2abCov(x,y)

No. of ways to select r out of n objects: nC = n!/[r!*(n-r)!] r

No. of ways to arrange r objects in n places: nP =n!/(n-r)! r

Cumulative density function (cdf) for Uniform distribution : F(x)=0 For x<=a F(x)=(x-a)/(b-a) For a<x<b F(x)=1 For x>=b

If Z is a standard normal R.V. An event X is defined to happen if either -1< Z < 1 or Z > 1.5. What is the prob. of event X happening if N (1) =0.8413, N (0.5) = 0.6915 and N (-1.5) = 0.0668, where N is the CDF of a standard normal variable

Binomial Random Variable E(X)=n*p Var(X)=n*p*(1-p)=n*p*q

P( B ) = P( A B ) + P ( Ac B)
P ( B ) = P ( B / A) * P ( A) + P ( B / Ac ) * P( Ac )
P(B/A) = P(A/B) * P(B) P(A/B) * P(B) + P(A/B c ) * P(B c )
Q. The subsidiary will default if the parent defaults, but the parent will not necessarily default if the subsidiary defaults. Calculate Prob. of a subsidiary & parent both defaulting. Parent has a PD = .5% subsidiary has PD of .9% Ans. P(PS) = P(S/P)*P(P) = 1*0.5 = 0.5%

Q. 2 of return of stock P= 100.0 2 of return of stock Q=225.0 Cov (P,Q) =53.2 Current Holding $1 mn in P. New Holding: shifting $ 1 million in Q and keeping USD 3 million in stock P. What %age of risk (), is reduced? Ans. P =[w2A 2 + (1-w)2 B 2 +2w(1-w)Cov(A,B)] w= 0.75 c 2 = 100*(0.75) 2 + 225*(0.25) 2 +2*0.25*0.75*53.2 P = 9.5 old = 100 = 10 Reduction = 5%

Q. If distributions of returns from financial instruments are leptokurtotic. How does it compare with a normal distribution of the same mean and variance? Ans. Leptokurtic refers to a distribution with fatter tails than the normal, which implies greater kurtosis.
Q. ABC was inc. on Jan 1, 2004. Its expected annual default rate of 10%. Assume a constant quarterly default rate. What is the probability that ABC will not have defaulted by April 1, 2004? Ans. P(No Default Year) = P(No default in all Quarters) = (1-PDQ1)*(1-PDQ2)*(1-PDQ3)*(1-PDQ4) PDQ1=PDQ2=PDQ3=PDQ4=PDQ P(No Def Year) = (1-PDQ)4 P(No Def Quarter) = (0.9)4 = 97.4%

Q. The number of false fire alarms in a suburb of Houston averages 2.1 per day. What is the (apprximate) probability that there would be 4 false alarms on 1 day? Ans. P(X=x) = ( x e-x )/x! X= 2.1, x = 4 P(2.1) = 0.1

Ques - The R.V. X with density function f(X) = 1 / (b - a) for a < x < b, and 0 otherwise, is said to have a uniform distribution over (a, b). Calculate its mean. a b

-1 +1 1.5 Ans The sum of areas shown in two figures Area 1 = 1-2*(1- N(1)) = 1-2*(0.1587) Area 2 = 0.0668 , Total Area = 0.7514

Q. At a particular time, the market value of assets of the firm is $100 Mn and the market value of debt is $80 Mn. The standard deviation of assets is $ 10 Mn. What is the distance to default? Ans. z = (A-K)/ A = (100-80)/10 = 2


Central limit theorem Ans. Since the distribution is uniform, the mean is the center of the distribution, which is the average of a and b = (a+b)/2

SE (x ) of the sample mean is of the dist. of sample means Known pop. Var. x = / (n) Unknown pop. var s x = s/ (n)

P(A) = # of fav. Events/ # Total Events 0 < P(A) <1, P(Ac )=1-P(A) P(AUB)=P(A)+P(B)-P(AB) =P(A)+P(B) If A,B Mutually exclusive P(AB)= P(AB)/P(B) P(AB)=P(AB)P(B) =P(A)P(B)If A,B Independent

Q. A portfolio consists of 17 uncorrelated bonds. The 1-year marginal default prob. of each bond is 5.93%. If spread of default prob. is even over the year, Calculate prob. of exactly 2 bonds defaulting in first month? Ans. 1-month default rate =1- (1-0.593)1/12 = 0.00508 Ways to select 2 bonds out of 17 = 17C2 = 17*16/2 P(Exactly 2 defaults) = (17*16/2)*(0.00508)2*(1-0.00508)15 = 0.325%

As Sample Size increases Sampling Distribution Becomes Almost Normal regardless of shape of population

Q. 25 observation are taken from a sample of known variance. Sample =70 and population = 60. You wish to conduct a two - tailed test of null hypothesis that the mean is equal to 50. What is most appropriate test statistic? Ans. Standard Error of mean ( x ) = /(n) = 60/25 = 12 Degrees of freedom = 24 Use t- statistic = (x - )/ x = (70 - 50)/12 = 1.67

Hypothesis Testing

Correlation & Regression

Alternative Hypothesis: Ha Con cluded if there is significant evidence to reject H0

Null hypothesis:H0

One tailed test

Two tailed test

Z & T test

P- value

2 Mean Test

Hypo thesis that the research er wan ts to reject

Actually tested Hypothesis

Test if the value is greater th an o r less than K H0; <=K vs. Ha: >K

Test if the value is different from K H0; =0 vs. Ha: 0


If n <30 an d un known , use t -Test Given H0 true, Pro b. of o btaining value of test statistic at least as extreme as the o ne that was actually observed. Hypothesis Tests for Variances

H0: Ha:

= 2 vs 1 2

Simple Linear Regression

Regression coefficient

Coefficient of Determination( R2)

Correlation Coefficient (CC)

Residual Diagnostic

Type 1 error: rejection of H0 when it is actually true Type 2 error :Fail to reject H0 when it is actually false




Critical value

= 0.025

= 0.025

-10 -5

Inference Based on Sample Data H0 is True

Real State of Affairs H0 is True Correct decision Confidence level = 1- H0 is False Type II error


Do not reject H0 Reject H0

LR model: Yi =b0+b1Xi +Ei Yi = Dep end ent variable, estimated value of Yi , given value of Xi Xi = independent variable b0 =intercept term; represents Y if X =0 b1 = slope coefficient; measures change in Y for 1 unit change in X

Appropriate Test structure: H0:b1=0; Ha:b10 Test: tb1=(b^1-b1)/sb^1 Decision Rule: reject H0 if t>+t critical or if t< tcritical

%age of to tal var. in Y explained by X R2 =( SSR / SST )=1-( SSE / SST) =explained variation/total variation

Only the linear correlation , -1 < CC < 1, if CC = 0, X & Y are uncorrelated rx,y = cov(x,y)/ xy=R2 The error variable must be normally distributed, The error variable must have a constant variance The errors must be ind ependent of each other.

Reject H0

H0 is False

P (Type II error) = Correct decision Type I error Significance level Power = 1- = *

Q. A stock h as initial price o f $100. It p rice one year fro m now is given by S = 100 x exp(r), where the rate of return r is normally distributed with mean o f 0.1 and a stand ard deviation o f 0.2. Wh at is the range of S in an year with 95% confidence? Ans 100e(0.1-1.96*0.2) < S < 100e(0.1+1.96*0.2) 74.68 < S < 163.56 Q. If standard deviation o f a no rmal population is known to be 10 and th e mean is hypothesized to be 8. Suppose a samp le size of 100 is considered. What is the range of sample mean s in wh ich hyp othesis can be accepted at significance level o f 0.05? Ans s x = /n = 10/100 =1 z = (x- )/ x = (x-8)/1 At 95% -1.96<z<1.96 ; So 6.04<x<9.96

*Term represents the maximum probability of committing a Type I error

Tests fo r a Sin gle Population Variances Chi-Square test H0: 2 = c HA : 2 c

Tests for a two Population Variances F test H0: 12 22 = 0 HA : 12 22 0

2 =

(n 1)s 2 2
Upper tail test:


2 s1 s2 2

H0: 2 02 HA: 2 > 02

H0: 12 22 = 0 HA: 12 22 0

Do not reject H0

Reject H0

Do not reject H0


Reject H0


Pages 1 of 6

Financial markets

Volatility Estimation

Time value of money

Fixed Income Securities

Forward and Future



Foreign Currency Risk



Distribution of Possible Future Values

A Repo rate is the rate at which the ban ks can bo rrow money fro m the central bank of th e country in order to avoid scarcity of fun ds. LIBOR is a daily reference rate based o n th e in terest rates at which banks offer to len d unsecured funds to other banks in the London wholesale money market. The n-year zero coupon rate is the rate of in terest earned on an investment that starts to day and lasts for n years. The Yield Curve describes the yield differential among treasury issues of differing maturities. Future & Forward Prices Hedging using futures


Implied Volatility
Common Starting Point




Where, =Persistence factor/Decay Factor 1- = Reactive factor

2 2 n =21 +(1)un1 n

2 n2 = + u n 1 +


It involves option pricing, facto r affecting op tion pricing, American option, European op tion, p ut-call-parity, volatility smiles , Greeks, and Exotic option

2 n 1

=Weighted long run variance= VL VL=Long run avg. variance= / (1--) ++=1 +<1 for stability so that is not -ve

The implied volatility of an option contract is the volatility implied by the market price of the option based on an option pricing model.

A net long (short) currency position means a bank faces the risk that th e FX rate will fall(rise) versus the domestic currency. a) On-Balance Sheet hedging: matched maturity an d currency foreign assetliability book. b) Off-Balance Sheet hedging: enter into a p osition in a forward contract


Q.Using a daily RiskMetrics EWMA model with a decay factor = 0.95 to develop a forecast of the conditional variance, which weight will be applied to the return that is 4 days old? Ans. The EWMA RiskMetrics model is defined as ht = *ht-1 + (1- )*rt-1. For t=4, and processing r0 through the equation three times produces a factor of (1-0.95)*0.953 = 0.043 for r0 when t = 4.

Q. GARCH model is estimated as follows:

t2+1 = 0.000005 + 0.12t2 + 0.85 t2

Day count conventions

On a particular day t; actual return was -1% & the std. deviation estimate was 1.8%. Calculate the volatility estimate for next day (t+1) and long-term average volatility. Monte Carlo Simulation

Monte Carlo Simulation

Geometric Brownian Motion

Actual/actual: T-bond 30/360: US corporate & mun icipal bond. Actual/360: T-bills & other market instrument

Basis Risk: Arises out of two reasons a) The p roperties of th e underlying under the contract and the asset to be h edged are different b) The maturity date of the future contract is different than th e date at which asset is to be sold or bought Basis = Spot price to asset to be hedged Futures p rice of the contract Strengthening of Basis = Basis increase is good for short h edge and bad for long hedge Weakening of basis = Basis declines is good for long hedge and bad fo r sh ort hedge

Optimal hedge Ratio:

h* =

Cov ( S , F )
2 F

= *


Where S is the of spot price changes; F is the of futures price changes; is the co rrelation btw Spot & future prices Hedging with Futures: ( * P)/ A where P is the value of the portfolio , A is the value of the assets underlying one futures contract

Q. A bank has a USD50mn portfolio available fo r investing. Cost of fun ds for the USD50mn is 4.5%. The bank lends 50% of the assets to domestic customers at an loan rate of 6.25%. The rest of th e portfolio is lent to UK clients at 7%. The current exchange rate is USD1.642/GBP. At the same time, the ban k sells a forward contract equal to the expected receipts one year fro m n ow. The forward rate is USD1.58/GBP. What is the weighted average return to the bank . Ans. Th e return from domestic customers is 6.25%, The return from UK customers, $25,000,000/1.642 = GBP 15,225,335GBP*1.07 = GBP 16,291,108. The bank sells a forward contract: GBP 16,291,108*1.58 = USD 25,739,951 Earnin gs (USD 25,739,951 - 25,000,000)/ 25,000,000 = 2.96% Weighted average return = 6.25%*0.5 + 2.96%*0.5 = 4.61%

Ans. Long Term Volatility In the GARCH model, 12% is the weight given to latest squared return (reactive factor). 85% is the weight given to latest variance estimate (persistence factor). Therefore, 1-0.12-0.85 = 3% is weight given to long-term average Volatility. Therefore, 3%*VL = 0.000005 i.e. VL = 0.017%

Ans. Volatility estimate for next day VL = .017%, Also, variance estimate for t+1 = .000005 + 0.12*(-1%)^2 + 0.85*(1.88%)2 = 0.0317% Volatility (std. deviation) estimate for t+1 = sqrt(0.0317%) = 1.782%

Technique that converts uncertainties in input variables of a model into probability distributions Combining the distributions and randomly selecting values from them, it recalculates the simulated model many times and brings out the probability of the output.

dSt= tStdt + tStdz St=asset price dSt=infinitesimally small price changes t=constant instantaneous drift term t=constant instantaneous volatility dz=normally distributed random variable

Q. The price of a 91-day T-bill is 8%. Fin d the dollar amount of interest paid over the 91 day period and the corresponding rate of interest. Ans: Dollar in terest is $100*0.08*91/360 = $2 .0222 Rate o f interest = 2.022/(1002.0222) = 2.064 %


Q. Under which scenario is basis risk likely to exist? a) A hed ge (which was initially matched to the maturity of the underlying) is lifted before expiration. b) The co rrelation of the underlying and the h edge vehicle is less than one an d their volatilities are unequal. c) The un derlying instrument and the hedge vehicle are d issimilar. d) All of the above are correct. Ans. D

Q. Current S & P 500 future is 1,167 and the manager wants to reduce the Beta from 1.20 to .85. Value o f the p ortfo lio is $5 mn and the index multiplier is 250, the stock index futures position taken is : Ans. Short 6 con tracts Q. In August a fun d man ager has $10 million invested in a portfolio of government bonds with a duration o f 6.80 years and wan ts to h edge against interest rate mo ves between August and December. The manager decides to use Dec T-bond futures. The futures price is 93-02 or 93.0625 and th e duration of the cheapest to deliver bond is 9.2 years. The number of contracts that should be shorted is: Ans: 10 ,000 ,000 6 .80 = 79 93 ,062 .50 9 .20


Financial Markets and Products


PV of a CF is: CT/(1+y)T FV of the bond is: PV*(1+y)T If th e Rate is Semi-annual the PV is : CT/(1+y s /2) 2T. PV of an Ann uity: C/y where y = YTM

Continuously compounded interest rates Rc =m ln(1+ (Rm/m)) Rm=m(e Rc/m -1) wh ere Rc : continuously compounded rate; Rm: same rate with compounding m times per year. Equivalent annual yield = [1+r/n] n - 1 ; Or er - 1

Bond portfolio structure

Bond Price C = coupon p ayment T = Time to maturity r = in terest rate/required yield F = value at maturity,/par value

Principal Only strips : receives p rincipal payments; sold at d iscount; increase in value as p repayment increases; in verse relatio nship with interest rates Interest Only strips: receives interest payments; investor wan t p repayments to be slow; positive relatio nship with interest rates.

Q. Th e EAY of a loan with a quo ted rate o f 8%, comp ounded quarterly is equivalent to the EAY of a loan with a continuously compounded quoted rate of: Ans. Fo r q uarterly compounded rate , EAY = (1+ 0.08/4)^4 - 1 = 0.824 For continuously compounded loan, we want to find the value of Rc that solves = ln(1.0824 ) = 0.0792

Barbell : man ager uses bonds with short and long maturity Bullet : man ager buys bonds concentrated in the intermediate maturity range If a bullet and a barbell have the same duration, the barbell portfolio h ave greater convexity and is related to the square of maturity

P0 =
t =1

C F + (1 + r )t (1 + r) T

Bond Yields: Coupon yield: Coupon p ayment (C) divided by the face value = C / F Current yield: Coupon payment (C) divided by the bon d price = C / P0. Yield to maturity: (YTM) is the discount rate which returns the market price of the bo nd, is also called IRR.





Net Exposurei = (FX Assetsi FX Liabilitiesi) + (FX Bought i FX Sold i) = Net Foreign Assetsi + Net FX Bought i Where, i is the ith currency.

MP =
t =1

(1 + YTM )t

F (1 + YTM) T

Ways to Terminate a Commodity Swap 1) Physical Delivery 2) Square off position by entering into a contract of equal size but an opposite position 3) Enter into an Exchange for Physical (EFP) agreement 4) Alternative Delivery Procedure

Law of One Price: Two assets (with the same liquidity, tax rates etc) that have the same cash flows, should have the same price. C-STRIPS: Zero Coupon STRIPs derived from the coupon cash flows in a bond P-STRIPS: Zero Coupon STRIPs derived from the principal cash flow in a bond

Clean and dirty price

Duration & convexity

When Bond sells at a discount: YTM > coupo n yield. When Bond sells at a premium: co upon yield > YTM. When bond sells at par: YTM = coupon yield. YTM: Bond prices go down wh en the YTM goes up and vice-versa. Term to maturity lon g maturity bond s have greater price volatility than short maturity bonds Size of coupon low coupon bonds have greater price volatility than high coupon bonds

Clean price : Bon d price without accrued interest Dirty price : Includ es accrued interest; Flat p rice (Clean price) = Full price ( Dirty price)- Accrued In terest


Forex Volatility Dollar Loss/Gain in a currency = [Net exposure of foreign currency in dollars] * volatility of the $/foreign currency exchange rate

Open Interest Open interest is the number of long or short future contracts outstanding that have not been squared off.

Bonds lying above the yield curve are cheap. Bond lying below the yield curve are rich. You should buy cheap securities and sell rich securities.

Retiring of Corporate Bonds before Maturity 1) Call and refunding provision 1) Fixed Cost Call Provision 2) Make-Whole Call Provision 2) Sinking Funds Bonds are retired periodically Accelerated Sinking Funds grant the issuer to retire more bonds 3) Maintenance and Replacement Funds 4) Redemption through sale of assets 5) Tender Offers not mentioned in the bonds indenture

Lease Rate The effect of the premium or discount of the bond prices decreases as the maturity date approaches. This is called Pull to Par

Value of a Bond with an Embedded Option = Option Free Bond Cost + Value of embedded Option

Types of Bonds: Call feature/bond allows the issuer to redeem /pay-off the bond prior to maturity, usually at a premium Retractable bonds allows the holder to sell the bonds back to the issuer before maturity Extendible bonds allows the holder to extend the maturity of the bond Sinking funds funds set aside by the issuer to ensure that the firm is able to redeem the bond at maturity Convertible bonds can be converted into common stock at a pre-determined conversion price Zero coupon Bond does not pay any coupon during the tenure of the bond High Yield Bond low rating high risk bond with relatively high yield Inflation Linked Bonds allows the holder to mitigate risk against inflation

Interest Rate Paritiy 1 + rdom = F * [1+rfor]/S Rates are expressed as the domestic/foreign exchange rate

Q. Which of the following is TRUE? i. A barbell portfolio will have a smaller convexity than a bullet portfolio with the same duration ii. The duration of a zero-coupon bond will be greater than the duration of a coupon bond of the same maturity. iii. Duration and co nvexity are based, respectively, on the first and second derivatives of price with respect to yield. iv. Convexity increases with the square of a bond's duration. a) I an d II. b) II and Ill. c)III only. d) I, III, and IV Ans. B

Where r is the effective annual interest rate

A poison put is an option given in a bonds indenture to redeem the bond at par in case of a corporate restructuring.

Q. A US corporate bo nd (30/360 days convention with 10% coupon pays semiannually on Jan 1 and July 1. Assume that today is April, 1, 2005 an d the bond matures on July, 1, 2015. Compute the Dirty price and Clean Price of the bond, if the required annual yield is 8%. Ans. Use Calculator , N=21, PMT = 50, 1/Y= 4, FV=1000,CPT = PV = 1,140.29; Then 90 days later , on April, 1, 2005, the DP = 1,140.29 *(1.04)^.5 = $1,162.87 CP = DP - AI (1000*.1*.25) = $1,162.87- $25 = 1,137.87

Q.A Fixed income instrument offers annual payment of $90 fo r 10 years. The current Value of the instrument is $ 950. Calculate YTM on this security. Ans. Use Financial calculator , N=10, PMT = 90, PV = -950; CPT = 1/Y = 9.81%

Nominal Interest Rate Decomposition Ri = rri +iei Nominal Interest Rate = Real Interest Rate + Inflation Rate

Contango: A market where the future prices are trading above spot prices. The forward curve is upward sloping. The lease rate is less than the risk free rate. Backwardation A market where future prices trade below spot prices. The forward curve is downward sloping The lease rate is more than the risk-free rate

Recovery Rate = Market price at the time of default Par value

Issuer Default Rate = Number of Issuers that Default Total Number of Issuers at the Beginning of the year Dollar Default Rate = Cumulative $ value of all defaulted Bonds (Cumulative $ value of all issuance) X (weighted avg. no of years outstanding) Cumulative annual Default Rate = Cumulative $ value of all defaulted Bonds Cumulative $ value of all issuance

Purchasing Power Parity

When a company has a series of dates that face price risk, it can use: 1) Strip Hedge Use many futures contacts each with a maturity that matches those dates 2) Stack Hedge (Stack and Roll) Use the near-by most liquid futures contract and roll over at that contacts maturity.


Pages 2 of 6

CA T Bill: The cash Price is: (100 - Y)* 360/n where Y is the Quoted Price(QP)in the market. T-Bill Futures quoted price Z = 100 - (360/n)* (100 - Y) The T-Bill futures cash invoice price =10,000[100 - (n/360)*(100 - Z)] T Bond Cash price = QP +AI T Bond Futures price = (quoted futures p rice) (conversion factor) +AI Eurodollar Future: is a future based on Eurodollar deposits. Contract Price = 10000*[100 - 0.25*( 100 - Q)] Cheapest-to-deliver ( CTD) The party with the short position will have an option to deliver the CTD bo nd, a CTD bond is for which the following is the least: Quoted spot price - (Quoted futures p rice x Conversion factor) Q. Supp ose the of short rate changes is 1.2%. Find the forward rate when the 8-year eurodollar futures price q uote is 94. The time to maturity is 8 yrs, whereas the maturity of th e rate underlying the futures is 8.25 years. Find the convexity adjustment and hence the forward rate. Ans:Forward rate = [6% pa/360 (qtrly)]/ [365/90*log(1+.06/4)] - *0.0122 *8 *8.25 = 5.563 % Comparative advantage

D Interest rate swap


Currency Swap


Duration hedging

Characteristics of Duration


Co. Fixed Rate Flo ating Rate A 4% L + 20 B 5% L + 60 In this example, Company A has absolute advantage in fixed and floating rate. Assume B & A wants to raise money in a fixed and floating rate respectively, However, comparatively B has to pay 1% higher than A on fixed rate but only 0.4% higher than A on floating rate. Therefore B has comp arative advantage in raising loan on floating rate interest and A in fixed rate.

-One party pays fixed and other p ays depending on th e floating reference rate (LIBOR is the reference rate) -At incep tion, the value o f a swap is 0. -After inception, the value for the swap is the difference b/w the PV of the remaining fixed & floating rate payments. V swap to pay fixed =Bfloat-Bfiixed V swap to receive fixed =Bfixed- Bfloat

Exchange payments in 2 different curren cies; payment can be fixed or floating ; If a swap h as a positive value to on e counterparty th at party is exposed to credit risk.

Duration : First derivative of the price/yield relationship; the longer (shorter) the duration, more (less) sensitive the bonds price to change in interest rates; can be used for linear estimates of bond price changes.

Q. A bank entered into a 5-year $150 million annual-pay LIBOR-based interest rate swap three years ago as the fixed rate payer at 5.5%. The relevant discount rates (continuously compounded) for 1 year and 2-year obligations are currently 5.75% an d 6.25%, respectively. A paymen t was just mad e. The value of the swap is closest to: Ans. Fixed rate Coupon = $150* 0.055 = $8.25 million; Bfixed = 8.25e-0.0575 + 158.25e-0.0625*2 = $147.44 Bfloating = $150 million; Value of Swap = $150 millio n - $147.44;

Q. Which o f the following regarding th e payoff of a 1-period risky swap to a risk-free counterparty paying a fixed amount and receiving a variable is (are) TRUE? i. The payoff profile is th e same as a short position on a put o ption and a long position on a call. ii. The payoff profile is th e same as a long position on a put o ption and a short position on a call. iii. If the correlation between the risky counterparty an d the variable payment declines, the potential payoff is unaffected. iv. If the correlation between the risky counterparty an d the variable payment declines, the potential payoff is affected. a) I on ly. b) II only. c) II and III. d) I and IV. Ans. D

Q. Which o f the following swap positions can be used to transform a floating-rate asset into a fixed-rate asset? a) Receive the floating-rate leg and receive the fixed-rate leg of a plain vanilla interest-rate swap. b) Pay the fixed-rate leg and receive the floating-rate leg of a plain vanilla interest-rate swap. c) Pay the floating-rate leg and pay the fixed-rate leg of a plain vanilla interest-rate swap. d) Pay the floating-rate leg and receive the fixed-rate leg of a plain vanilla interest-rate swap. Ans. D

Macaulay duration : Weighted average term to maturity of a bonds cash flows. Modified duration (D*) : In case of n times compounded yield, the Macaulay Duration is not valid anymore & Modified duration is used

Maturity increases, duration increases; Coupon increases, duration decreases ; Yield decreases, duration increases. Zero coupon bond :The duration is equal to the bonds term to maturity. Therefore, the longest durations are found in stripped bonds or zero coupon bonds. These bonds have the greatest interest rate elasticity. Q. Ceteris paribus, the duration of a bond is positively correlated with the bond's A. time to maturity. B. coupon rate. C. yield to maturity. D. all of the above. Ans. A Q. Given the time to maturity, the duration of a zero coupon bond is higher when the discount rate is A. higher. B. lower. C. equal to the risk free rate. D. independent of the discount rate. Ans. Duration of the Zero Coupon Bond is its term to maturity.

Convexity : Second derivative of the price/yield relationship. Price change for larger interest rates estimated by duration and convexity are more precise since convexity can capture the curvature

Convexity Approximat ion =

D* =

where r is the yield to maturity of the bond, and n is the number of cash flows per year.

Macaulay Duration 1+ r n

P ( y) 2 * Convexity = D m * y + P 2
The convexity relationships imply that a larger price increase occurs with a yield decrease than a price decrease associated with an identical yield increase

P+ + P 2P 0 2 * P0 * ( y) 2

Effective Duration =

(BV y BV + y ) 2 * BV * y

0 DV01: Dollar value of basis point is the absolute change in the bond price from one basis change in yield DV01 = price at YTM0 - price at YTM1|

Q. Using a semiannual compounding, compute DV01 for 10 yrs, 5% bond that is yielding 4.5%. Ans. Price at 4.49%: N=10*2, PMT = 5/2, 1/Y= 4.49/2, FV=100, CPT = PV Price at 4.5%: N=10*2, PMT = 5/2, 1/Y= 4.5/2, FV=100, CPT = PV . Please note: The PV is always negative value.

Q. Royal Bank has a $25 million par position in a 5-year, zero-coupon bond that has a market value of $19,059,948. The modified duration of the bond is closest to: Ans. YTM of the bond is , PV = 19,059,948, N= 10, PMT = 0, 5.5.%. Macaulay duration is equal to maturity for a zero-coupon bond, so modified duration = 5/(1+0.055/2) = 4.866 years. Please note: while inserting PV type it as a negative value.

Q. Holding other factors constant, which one of the following bonds has the smallest price volatility? a. 5-year, 20% coupon bond ; b. 5-year, 12% coupon bond c. 5 year, 14% coupon bond d. 5-year, 0% coupon bond Ans. A. Higher the sensitivity of the bond to its interest rate, higher the volatility.

Q. Evaluate, at the same yield , the investment that is expected to have the greatest convexity is a. 10 year zero- coupon bond b. Portfolio with a duration of 10 yrs that contains a 5 year and a 15 year zero- coupon bond c. 6% coupon bond of 10 year duration d. Callable 6% coupon bond of 10 year duration Ans. B Q. A bond has effective duration of 7.5 and a convexity of 104, if the yield rise by 82 bps, the price of the bond will: Ans. % price change = [-duration *y*100] + [(1/2)*convexity*y^2 *100] =Decrease by 5.8%

Q .A fund manager has $10 mn invested in a portfolio of government bonds with a duration of 6.80 years and wan ts to hedge against interest rate mo ves between Aug and Dec. How man y Dec T-bond futures should manager use. Ans: The futures price is 93-02 or 93.0625 and the duration of the CTD bo nd is 9.2 years = (10,000,000*6.8) / (93,062.5*9.2) = 79. Q. If the quoted price for th e June 2006 Eurodollar futures contract is 96.89, the value of one co ntract is closest to Ans. $992,225

Q. Bank One enters into a 5-year swap contract with Mervin Co. to p ay LIBOR in return fo r a fixed 8% rate on a nominal principal o f $100 million. Two years from now, the market rate o n 3-year swaps at LIBOR is 7%; at this time Mervin Co. d eclares bankruptcy and defaults on its swap obligation. Assume th at the net payment is made o nly at the end of each year for the swap contract period. What is the market value of the lo ss incurred by Bank One as result o f the default? a. $1.927 million b.$2.245 million c.$2.624 million d.$3.011 millio n Ans. C; At the new swap rate, the replacement cost o n the swap is $1 million a year discounted at 7% fo r each of the 3 years, which is $2.624 million.

Duration Hedging: 1. Hedge ratio: [DV01 (per $100 of initial position)* beta]/ DV01 of hedging instrument). 2. Hedge ratio: P*DP /(F C*DF); where P = portfolio value; DP = Duration of Portfolio; F C = Future position with a contract; DF = Duration of future contract.


Forward Pricing

Forward Valuation

Interest Rate Futures

Factors affecting an option price

Rules for exercising American Option

Put Call Parity

Binomial Option pricing

Black ScholesMerton Model

Option trading strategies


Volatility smiles

Futures Contracts: Agreement to buy or sell an asset for a certain price at a certain time. Its is traded on an exchange. Forward Contracts : Forward contracts are similar to futures except that they are traded Over the Counter (OTC) Spot rate: A t-period spot rate is the Yield to Maturity of on a Zero Coupon Bond that matures in t-years.
Forward Rates: Forward rates are interest rate between two dates in future as implied by the spot rates F 21 = (S2T 2 - S1T1) / (T2 - T 1) , where F 21 = Forward rate b/w time T 2 and T 1 S1 and S2 = Spot rate for maturity T1 and T2 respectively Backwardation : Spot price is higher than the future price (high convenience yield compared to the cost i.e. rate of interest) 2nd Graph. Contago vice versa 1st Graph. The cost of carry is the storage cost plus the interest costs less the income earned

Investment Asset F 0 = S0 ert, for non yielding asset F 0 = S0 e(r-d)t , continuous dividend paying stock F 0 = (S0 - I) ert , discrete dividend paying stock, Foreign Exchange F 0 = S0 e(r-rf)t , Currency Forward Commodity F 0 = S0 e(r-)t , for commodity with lease rentals F 0 = (S0 + M) ert, commodity with storage costs F 0 = S0 e(r+-c)t , commodity with convenience yields
Consumption Commodities F 0 <= (S0 + M) ert Where r = annual interest rate, t = Time period d= % of annual dividend I = the PV of dividend received. rf = foreign currency domestic risk free rate M is the PV of storage costs = lease rate (cost of borrowing the commodity) c= % annual convenience yield (CY is the benefit of owing the consumable asset) = % annual storage cost Short selling involves selling securities that is not owned.

For non yielding asset : f = (F0 - K) ert For continuous yielding underlying : f = S0e-dt - Kert For discrete dividend paying stock : f = S0 - I - Kert K is delivery price in a forward contract F 0 is forward price that would apply to the contract today



Option price bounds



c = S 0 N(d 1 ) Xe rT N(d 2 )

p = Xe rT [1 N(d 2 )] S 0 [1 N(d 1 )] ln d1 = S0 + r + 2 * T K 2 * T

EE ED Currency option: implied volatility is lower for ATM option than it is for away from the money option. Equity option: have volatility skew, the volatility decreases as the strike price increases, i.e. volatility used to price a low-strikeprice option is higher than that used to price a high-strike-price option

Upper bound European/American call: c <= S0 ; C<=S0 Upper bound European/American put: p<= Xe-rT ; P<=X Lower bound European call on a non dividend paying stock c >= max(S0-Xe-rT,0) Lower bound European put on a non dividend paying stock p >= max(Xe-rT-S0,0) Forward Rate Agreements Q. If the current USD/AUD rate is 0.6650 (1 AUD=0.6650 USD) and the risk-free rates for the USD and AUD are 1.0% and 4.5% respectively, what is the lower bound of a 5-month European put option on the AUD with a strike price of 0.6880? Ans. Lower bound = 0.6880 x [exp-(0.01x 5/12)] -0.6650 x [exp-(0.045x 5/12]] = 0.6880 x (0.9958) -0.6650 x (0.9814)=0.04 Q. According to Put Call parity for European options, purchasing a put option on ABC stock will be equivalent to a) Buying a call, buying ABC stock and buying a Zero Coupon bond. b) Buying a call, selling ABC stock and buying a Zero Coupon bond. c) Selling a call, selling ABC stock and buying a Zero Coupon bond. d) Buying a call, selling ABC stock and selling a Zero Coupon bond Ans B

Q. Consider a 1 year European call option with a Strike price of $27.50 that is currently valued at $4.1 on a $25 stock. The 1 year risk free rate is 6%. Which of the following is the closest to the value of the corresponding put option Ans: p=c + D-S0 + Xe

d 2 = d1 T

Q. The stock price is $25. A put option with a $20 strike price that expires in 6 months is available. N(-d1) = 0.0263 and N(-d 2) = 0.0349. If the underlying stock exhibits an annual of 25%, & the continuously compounded risk-free rate is 4.5%, the BSM value of the put is: Ans. p = Ke-rt N(-d 2) - SoN(-d 1) = $0.03

Forward Rate Agreement (FRA) is an agreement to pay or receive a certain rate between two future dates : FRA = N(F0 - F t) (T2 - T1) e -r(T2 - t) FRA = Value of the FRA to receive fixed rate at time t N = Notional Amount ; Ft = Forward rate between time T2 and T 1 quoted at time t F0 = Rate between time T 2 and T 1 quoted at time 0 r = Risk free rate


Variable S0

c + ? + + -

p + ? + +

C + + + + -

P + + + +

K T r D

Q. Current 1-year forward exchange rate is 1.200 USD /EUR. An American bank pays 2.4% annual interest rate on a 1-year deposit and a 4.0% annual interest rate on a 3-year USD deposit. A European bank pays a 1.5% annual interest rate for a 1-year deposit and a 2.0% annual interest rate for a 3-year EUR deposit. The forward exchange rate in USD per EUR for exchange 3 years from today is closest to: Ans. The 2 year forward rate in US = [(1.04) ^3 / 1.024] - 1 = 4.81% The 2 year forward rate in Europe = [(1.02)^3 / 1.015] - 1 = 2.25% The forward exchange rate in USD per EUR for exchange three years: 1.2 *(1.0481^2) / (1.0225^2) = 1.261

Q. FRA that settles in 30 days, $1 million notional, based on 90-day LIBOR, Forward rate of 5%, Actual 90-day LIBOR at settlement is 6% Ans. I = (6% - 5%) * (90/360)* $1m = $2,500 PV= 2,500 / (1 + (90/360)*6%) = $2,46

Q. If 1 & 1.5 years spot rates are 1.8% and 2.2%, the 6-month forward rate on an investment that matures in 1.5 years is : Ans. (2.2%*1.5 - 1.8%*1)/0.5 = 3%

Arbitrage 1. If F 0>S0erT,borrow loan, buy spot, sell forward today, deliver asset, repay loan at the end 2. If F 0<S0erT,Short sell the asset, invest the proceeds at risk-free rate, buy forward today, collect loan buy asset under forward contract, deliver to cover short sale.

N(d 1) is the delta of the option and therefore S0N(d1) represents the current price of delta. N(d 2) is the probability that a call option will be exercised, 1- N(d2) is the probability that a put option will be exercised,

Pages 3 of 6

EB Early Exercise: It is never optimal to exercise an American call on a non-dividend paying stock before its expiration date American Put can be optimally exercised early if 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 Q. Early exercise of an option is more likely for: i. European calls options on stocks paying large dividends. ii. American call options on stocks paying small dividends. iii. American call options close to maturity. iv. American put options on stocks paying large dividends a) I and IV. Ans. C b) II and IV. c) III only. d) III and IV. ED

EC Binomial Pricing: At each step, it is assumed that the underlying instrument will move up or down by a specific factor (u or d) per step of the tree. So, if S is the current price, then in the next period the price will either be : Sup = S*u and Sdown = S *d; where U=e and D=1/U. At each final node of the tree i.e. at expiration of the option the option value is simply its intrinsic, or exercise value. The following formula is applied at each node: European Option Payoff = [ p x Option up + (1-p) x Option down] x exp - r t Q: Assume that a binomial interest-rate tree indicates a 6-month period spot rate of 2.5%, and the price of the bond if rates decline is 98.45, and if rates increase is 96. The risk-neutral probabilities respectively associated with a decline and increase in rates if the market price of the bond is 97 correspond to: Ans. [p*98.45 + (1-p)*96] / [1+ (0.025/2)] = 97







Covered call

Protective Put

Bull spread

Bear spread

Butterfly spread

Calendar spread

Long straddle


Strips & Straps

Delta: estimates the change in value of an option for a unit change in stock price. A delta of 0.5 means that price of a call option will change by $.5 for $1 change in value of the stock. Call options delta : 0 for deep out of money; 0.5 for at the money; 1 for deep in the money, Put option delta : - 1 deep in the money, - 0.5 for at the money and - 0 for deep out of money. Delta of a option = c / s Delta of a forward position is equal to 1 Delta of Future= ert

Theta: Time decay, most negative when option is at the money & close to expiration Theta is negative because as time passes the value of both calls and puts decreases..

Long stock plus short call Long stock plus long put, also called portfolio insurance

Purchases call option with low Strike price, & subsidized the purchase with sale of a call option with a higher Strike price

3 different options. Buy 1 call with low exercise price, another with high exercise price, & short 2 calls with an exercise price in b/w. Butterfly buyer is betting the stock will stay near the price of the written calls

Bet on volatility, buy a call & a put of same exercise price & expiration date. Profit is earned if stock price has a large change in either direction

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

Delta Neutral Hedging: To completely hedge a short call position , purchase no. of shares of stock=delta*no. of options sold. Only appropriate for small changes in the value of underlying asset Gamma can correct hedging error by protecting against large movement in asset price Gamma neutral positions are created by matching portfolio gamma with an offsetting option position.

Gamma: rate of change in delta as underlying stock price change ( also Convexity); largest when option is ATM, which indicates that option price changes very fast as Stock price changes. ITM options and OTM options have low gammas. As the maturity nears, the option gamma increases. Fixed coupon bonds, have positive convexity. Positive gamma is beneficial, it implies that value of the asset drops more slowly and increases more quickly. Long positions in options, ( calls or puts) , create positive gamma

Vega: sensitivity of the option price to changes in the volatility of the underlying stock, highest for longterm ATM options. close to 0 when option is deep ITM or OTM; Vega decreases with maturity.

Rho: sensitivity of the option price to changes in the Risk free rate. Largest for ITM option ITM calls and Puts are most sensitive to changes in the rates than OTM

Q. An investor is looking to create an options portfolio on XYZ stock that will have virtually zero Vega exposure while maximizing the ability to profit from increases in interest rates. If the current price of XYZ is $50, which of the following would accomplish his goals? I. Sell a call with Strike price (SP) 50 II. Buy a call with a SP of 25. III. Sell a put with a SP of $75. IV. Buy a put with a SP of $25. a) I only. b) II and III. c) II and IV. d) III and IV. Ans B

Q. Long on a Call and short on a put on the same stock with higher strike price and same maturity is called a. Calendar Spread b. Butterfly Spread c. Bear Spread d. Bull Spread Ans. D

Purchase call with high strike price, short call with low strike price. Bear spread with puts involves buying put with high exercise price and selling put with exercise price . Both the option has same expiry date in bull and bear Spreads Q. In a butterfly spread Both the upside & downside are unlimited Both the upside and downside are limited The upside is unlimited, but downside is limited The upside is limited, but downside is limited Ans. B

2 options with different expiration. Sell a short dated option & buy a long dated option. Investor profits if stock price stays in a narrow range.

Strip : when downside move is expected to be more likely, buy two puts and one call of same strike and expiry. Strap : when upside move is expected to be more likely , buy two calls and one put of same strike and expiry. Q. An investor constructs a strap and buys 2 calls with Strike price of $40 at $3 each and One put with Strike price of $40 at $2. If the price of the underlying asset is $46, what is the Profit/Loss on the position? Ans. 6

Q. An existing option short position is delta neutral, but has a -5,000 gamma exposure. An option is available that has a gamma of 2 and a delta of 0.7. What actions should be taken to create a gamma neutral position that will remain delta neutral? a.Go long 2,500 options and sell 1,750 shares of the underlying stock. b.Go short 2,500 options and buy 1,750 shares of the underlying stock. c.Go long 10,000 options and sell 1,750 shares of the underlying stock. d.Go long 10,000 options and buy 1,750 shares of the underlying stock Ans: A, - Gamma means we are short on options, to create a gamma-neutral portfolio (5000/2) = 2,500 long option. However this will change the position from delta-neutral portfolio to 2,500*.7 = 1,750 long delta. So sell 1,750 shares to be gamma and delta neutrality.

Q. True or False a.Theta affects the value of a call and a put in similar way. True b.Theta is more pronounced when the option is in the money. False c.Theta usually decreases in absolute terms as expiration approaches. False d.It is possible for a European put option that is in the money to have a positive theta value. True e.Rho for fixed income is small. false f.Call option delta range from 0 to 1. True g.A Vega of .1 suggests that for 1% increase in volatility, the option price will increase by $.10. True h.Theta is the most negative for OTM options. false i.Options are most sensitive to changes to volatility, when they are At the money. True

Q. At the money options close to the maturity tend to have a high a.Rho b. Gamma c. NPV Ans B d. Vega

Q.Which of the following have Delta a.Strangle b. Straddle c.Bear Spread d. Bull Spread Ans C

Foundation of Risk Management

Foundation of Risk Management

Sources of Risk

Tools for Risk Management

Risk Management & value creation

Performance Measurement

Risk & return Portfolio

Markowitz efficient frontier

Capital Market Line (CML)


Security market line (SML) & CAPM

Business risk: Sp ecific fo r the busin ess house. Ex: Increase in the prices of cement fo r a construction company Financial Risk: result of a firms financial market activities; volatility in various market related in struments Ex: The recent market crash. Types of Financial Risk

Derivatives is the mo st popular tool used by Risk Managers for RM. Other tools include: Stop-loss limit: Limit on th e amount of losses in a p osition. Notional Limit: Maximum amount to be invested in a asset. Exp osure limit: Exposure to risk factors like d uration for debt instruments & Beta fo r Equity Investments. VaR: maximum lo ss at given confidence level. Q.PV (Before edging) . .Probability $200 0.10 $300 0.20 $400 0.30 $500 0.40 Debt $300 Bankruptcy Cost $75 PV (after h edging) Prob $200 0.00 $300 0.25 $400 0.30 $500 0.45

By handling bankruptcy costs : (Expected Value of firm) = (Present Value of firm) + (PV of bankruptcy costs) Risk management cost. Firms can use risk management to move their income across time horizon and reduce tax burden . Reducing WACC: Also we can reduce th e tax outgo by in creasing interest outgo, but expected financial distress / bankruptcy costs because of leverage hamper th e firm value beyon d a level. By Reducing The Probability Of Debt Overhang: Debt Overhang refers to situation where the amt of d ebt the firm is carrying p revents the shareholders fro m investing in +ive NPV p ro jects By Reducing The Pro blem Of Information Asymmetry: In formation Asymmetry results in two problems: Investors have to rely on mgmt estimates fo r profitability of new projects Exten t to which the performance is due to man agement decisions o r external factors

Treynor Ratio: Is th e excess return divided by per un it of market risk( Beta) in an investment asset [E(RP )-RF]/p Sharpe Ratio: Is th e excess return d ivided by per unit of to tal risk in an investment asset: [E(RP )-RF]/p, where Rp = p ortfolio return, Rf = risk free return Sortino Ratio (SR): Excess return divided by Semi standard deviation(SSD) which considers only d ata points that represent a loss. More relevant when the distribution is more skewed to th e left. (Rp MAR) / SSD, MAR is min imum accepted return, Higher the SR, lower is the risk of large losses Alpha: measure of assessing an active man ager's p erformance as it is the return in excess o f a benchmark index. i < rf: the manager h as destroyed value i = rf: the manager h as neither created nor destroyed value i > rf: the manager h as created value The d ifference i r f is called Jensen's alpha Jensens excess return o f a stock, over its required rate o f return as determined by CAPM: = Rp Rc ; where Rp = portfolio return, Rc = return predicted by CAPM Tracking error(TE) : TE = Ep (Std . d ev. of portfolios excess return over Benchmark index) ; Where Ep = Rp Rb ;Rp = portfolio return, Rb = benchmark return Lower the tracking error lesser the risk d ifferential between portfolio and the benchmark index TE Volatility(TEV) = = A2 - 2* AB* A* B+ B2 Relative Risk W= *P Information ratio: is d efined as excess return divided by TE. E(RP)-E(Rb)/TE Q. Last 4 years, th e returns on a po rtfolio were 6%, 9%, 4%, & 12%. The return s of the benchmark were 7%, 10%, 4%, & 10%. The minimum acceptable return is 7%. What is the portfolio's SR? 0.4743

- Expected return : E(RP)=ni=1W iE(R i) - Variance for 2 asset portfolio 2=w 1212+w2222+2w1w2 1,212 - Correlation: (X,Y) = cov(X,Y)/(X *Y) - Lower the correlation greater the benefits from diversification

- Combinations along the EF (Efficient Frontier) represent portfolios (explicitly excluding the risk-free alternative) for which risk for a given level of return is lowest - Risk-free asset has 0 variance in returns ,it is also uncorrelated with any other asset

-Systematic risk (non-diversifiable risk or beta) : individual securitys risk that arises because of the positive covariance of the securitys return with overall market returns. Beta (a ) = Cov (ra, rp)/Var(rp) -Unsystematic risk (diversifiable risk): part of the volatility of a single securitys return that is uncorrelated with the volatility of the market portfolio.

Market Risk: risk of value decrease due to change in prices of assets in th e market. Liquidity Risk: risk of n ot being able to quickly liquidate a p osition at a fair p rice. Asset Liquidity: Large positions affecting asset prices. Funding liquidity: Inability to honor margin calls, capital withdrawals. Ex: Lehman. Credit risk: risk o f loss due to coun terparty default. Sovereign Risk: Willingness an d ability to repay. Settlemen t Risk: Failure of counterparty to deliver its obligation Expo sure & recovery rate: Calculated on th e hap pening of a cred it event. Operation risk: risk due to inadequate mon itoring, systems failure, man agement failure, human error. Model risk, p eople risk, leg al an d compliance risk

Efficient frontier: The optimal portfolios plotted along the curve have the highest expected return possible for a given amount of risk. Efficient Frontier

CML: When a risky portfolio is combined with some allocation to a risk free asset, the resulting riskreturn combinations will lie on a straight CML. All points along the CML have superior risk-return profiles to any portfolio on the Efficient Frontier

Efficient-market hypothesis: it is impossible to consistently outperform the market by using any information that the market already knows The three forms of market efficiency weak-form efficiency : future prices cannot be predicted by analyzing price from the past semi-strong-form efficiency : prices adjust to publicly available new information very rapidly and in an unbiased fashion strong-form efficiency : prices reflect all information, public and private, and no one can earn excess returns CML Efficient Frontier

- Investors will only be compensated systematic risk since Unsystematic risk can be diversified. - SML: indicates a return an investor should earn in the market for any level of Beta risk. -The equation of the SML is CAPM (return & systematic risk equilibrium relationship -CAPM: E(Ri )=RF+ i[E(Rmkt)-RF] - [E(Rmkt)-RF] is the risk premium


Risk free return

Rf The Arbitrage Pricing Theory (APT) : APT model points towards the relationship between factors and expected returns. CAPM is a special case of APT with only one factor exposure: market risk premium. R n = Xn.k * bk + un ; R n = Excess return for stock n Xn = Exposure of Stock n to factor k ; bk = Factor return for factor k ;un = Stock ns specific return`

Ans Debt value=probability*expected payment to debt i.e. 10% * 125+ 90% *300 = 282.5 Eq uity value = probability * expected payment to equity i.e. 30% * 100+ 40%*200=110, Thus EV=392.5 2. If Hed gin g cost is 10 & after h edging PV are also sh own as abo ve Debt value =probability * expected p ayment to d ebt i.e. 100% *300=300 Eq uity value= probability *expected payment to equity i.e. 0.30%*100+ 45%* 200 =120, Thus EV=42010=410 3. Incremental benefit=410-392.5=17.5

Q. Value o f portfolio =100, Portfolio return p = 25% Portfolio benchmark B = 20% Correlation , PB =0.961 Calculate TEV Ans: = 0.25^2 + 0.20^22*0.961* 0.25* 0.20 = 8% Relative risk = 8%*100 =8

Q. E(RA ) = 10%, A = 20%, E(R B) = 10%, B = 20%. Assume the weights to be 50 % for A & B. Calculate portfolio returns when :Case 1 : AB = 1 ; Case 2 : AB = 0,Case 3 : AB = -1 Case 1. (0.5^2)*(0.2^2)+ (0.5^2)* (0.2^2)+2*0.5*0.5*0.2*0.2*1 =0.04 Case 2 : (0.5^2)*(0.2^2)+ (0.5^2)* (0.2^2)+2*0.5*0.5*0.2*0.2*0 =0.02 Case 3 : (0.5^2)*(0.2^2)+ (0.5^2)* (0.2^2)+2*0.5*0.5*0.2*0.2*-1 =0.00

Fama And French Three Factor Model: A factor model that expands on the capital asset pricing model (CAPM) by adding size & value factors in addition to the market risk factor in CAPM. This model considers the fact that value and small cap stocks outperform markets on a regular basis. r = Rf + beta3 x ( Km - Rf ) + bs x SMB + bv x HML + alpha

Pages 4 of 6

Value at Risk

Case Studies

Value at risk

EWMA Model

Factors affecting portfolio risk

GARCH Estimation Model

Linear vs Nonlinear derivatives

Types of VaR

Methods of VAR calculation

Project & CF VAR

Risk budgeting D

Types of Risk Management Failure


Metallgesellschaft (MRM)



Assets concentration Assets volatility Assets correlation Systematic risk

n2=+r 2n-1+ 2n-1 Implicitly assumes variance reverts to a long run average level Sum of (+) <= 1 for the model to be stationary

Relationship b/w an underlying factor and the derivatives value are linear in nature B

Cash Flow at Risk: It is a measure of the expected cash flow at loss beyond a confidence level. If beta () of an asset is X with the portfolio then the cash flow at risk (CFAR) = X * CFAR of portfolio. Project VAR: when considering a new project, you can explicitly calculate the dollar cost of the increase in CFAR and include it as an additional cost of the project.

1. 2. 3. 4. 5. 6.

Risk metrics failure. Ex: MRM & LTCM Incorrect measurement of known risks. Ex: MRM & LTCM. Ineffective risk monitoring. Ex: Barrings & Sumitomo Ineffective risk communication Ignorance of significant known risks. Ex: MRM & LTCM. Unknown risk.

LTCM was a hedge fund using highly leveraged arbitrage trading activities in fixed income in addition to pairs trading. Before failing in 1998, it had given spectacular returns in 1995-97 periods (upto 40% post-fees). Post Russian default on its ruble denominated debt, LTCM lost more than 4bn USD in 4 months. LTCM used proprietary mathematical models to engage in arbitrage trading in U.S., Danish, Russian, European and Japanese Govt. bonds. In 1998, LTCMs positions were highly leveraged (1:28) with ~ USD 5: 130 billion of equity and assets. LTCMs model assumed maximum volatility of 20% annually. Based on its models, it was expected to losses more than ~500 million USD in once in 20 months. It had its bet on convergence of Russian & American G-sec yield, which however diverged after Russian default.. Its failure led to a huge bailout by large commercial & merchant banks under the guidance of Federal Reserve It had various risk exposures .such as Model Risk, Funding liquidity risk, Sovereign Risk, Market Risk.

It used Stack and roll hedging strategy In 1991, it offered fixed price contract for supplying gasoline for 5 to 10 years. In order to hedge MG took long positions in near month futures and rolled the stack into next near month contract every time by decreasing the trade size gradually so as to match the stack with pending short position (in long term supply contracts). MG bought futures on NYMEX to offset its forward commitments exposure with hedge ratio of one (every barrel was hedged). As these derivatives were short-term thus MRM had to roll them forward every month-end or term-end till 5-10 years or the contracts end. Company was exposed on rising spot prices. It eventually lost more than USD 1.5bn in 1993. It had various risk exposures .such as Basis Risk, Market Risk, Funding Liquidity Risk.

Yasuo Hamanaka - copper trader at Sumitomo manipulated copper prices on London Metal Exchange. Fall in copper prices in June 1996 after revelation of Hamanakas unfair dealings led to ~2.6bn USD loss for Sumitomo Positions were so large that company could not liquidate them completely Hamanaka used his independence to trade in the market on behalf of the company and manipulated the copper prices by buying physical copper in large quantities and storing in the warehouse thereby creating lack of copper in the market He sold put options to collect the premiums as he thought he can push the prices up & thus writing put options was not risky for him Though, he never imagined that he could be susceptible to steep decline of copper prices It had various risk exposures .such as Operational Risk, Employee/ People Risk, Liquidity Funding Risk, Market Risk

n2= *2n-1+(1-)r2n-1 Where = weight on previous volatility and (1- ) weight on squared return

Q. The current estimate of daily volatility is 1.5 %. The closing price of an asset yesterday & today are $30 and $30.5 respectively. Using the EWMA model with = 0.94, the updated estimate of volatility is? Ans. 1.5096

Q. Let h t be the variance at t and r 2(t-1) the squared return at t - 1. Which of the following GARCH models will take the shortest time to revert to its mean? a. h t = 0.02 + 0.06r 2(t-1) + 0.93h t-1 b. h t = 0.03 + 0.04r 2(t-1) + 0.94h t-1 c. h t = 0.04 + 0.05r 2(t-1) + 0.95h t-1 d. h t = 0.05 + 0.01r 2(t-1) + 0.96h t-1 Ans. (D) The speed of mean reversion is defined by 1 + , which is lowest for d, it is .97

Q.A firm with existing projects have expected cash flow of $100 mn and cash flow volatility of $60 mn. New project with a cost of $30 mn and cash flow volatility of $20 mn. The correlation between two cash flows is 0.3. Calculate the volatility of the firms projects with new projects at 95% confidence level and the additional project cost due to the increased cash flow volatility, if the cost of cash flow volatility is $0.12. Ans. projects = sqrt (602 + 302 + 2*(.3)* 60*20) = $68.7 mn CFAR (at 5%) existing = 1.65*60 = $99 mn CFAR (at 5%) with new project = 1.65*68.7 = $113.4 mn The additional project cost due to increased cash flow volatility is: ($113.4 mn - $68.7 mn)*.12=$1.73 mn

Q. Which of the following reasons does not help explain the problems of LTCM in August and September 1998? 1. A spike in correlations 2. An increase in stock index volatilities 3. A drop in liquidity 4. An increase in interest rates on on-the-run Treasuries Ans: D, An increase in interest rates on on-therun Trasuries

Nick Lesson, trader at Baring PLC, took concentrated positions Nikkei 225 derivatives for bank in Singapore International Monetary Exchange (SIMEX). He took arbitrage positions on Nikkei derivatives on different exchanges viz. Osaka, Tokyo & SIMEX. Lesson was solely responsible for back & front office operations of Singapore. He used an error account hide his losses by fraudulently transferring funds to & from his error accounts He kept on selling straddles on Nikkei futures with an assumption that Nikkei is under-priced. He took double long exposure on the same index from different exchanges. He kept on building his positions even after Nikkei kept on falling, however after Jan95 earthquake, he could not sustain his positions & failed to honor the margin calls It eventually led to the collapse of Barings bank, when it was sold to ING for mere $1.60 only It had various risk exposures such as Operational Risk, Market risk, Employee/People risk

Q: Which of the following is false? a. EWMA approach of Risk Metrics is a particular case of a GARCH process. b. GARCH allows for time-varying volatility. c. GARCH can produce fat tails in the return distribution. d. GARCH imposes a positive conditional mean return. Ans. D


VaR for Linear and Non Linear Derivatives Linear Assets: When the value of the delta is constant for all changes in the underlying. Example: Forwards, futures. Delta (1st derivative or duration in bonds) can be used to estimate the VAR for linear derivatives. The deltanormal approach (generally) does not work for portfolios of nonlinear securities. VAR Linear Derivative = Delta * VAR Underlying risk factor


Non Linear Assets: When the value of the delta keeps on changing with the change in the underlying asset. Examples: Options, Credit Derivatives, Swaps. Taylor Approximation: large changes can be explained by the 2nd derivative i.e. gamma expected change in the delta of an option( or convexity in bonds).Taylor approximation is ineffective for callable bonds & mortgage backed securities.

Q. A trader has an allocation equal to 8% of the firms capital; the beta of traders return with the return of the firm is .90. The contribution of the trader to the Firms VAR of $120 million is: a. $7.8 mn b) $8.6mn c) $9.6 mn d) $10.8mn Ans:.08*.9*120 million = 8.64 million,

Q. A bond of $10 mn, with modified duration of 3.6 yrs and annualized yield of 2%. calculate the 10 day holding period VaR of the position with 99% confidence interval, assuming there are 252 days in a year. Ans. VAR = $10,000,000* 0.02*3.6* [10/ (252)]* 2.33 = $334,186

Q. A 6 month call option with a strike price of $10 is currently trading for $1.41, the market price of the underlying stock is $11. A 1% decrease in the stock to $10.89 results in a 6.35% decrease in the call option with a value of $1.32. If the annual volatility of the stock is s = 0.1975 and the risk free rate of return is 5%, calculate the 1 -day 5% VAR for this call option. Ans. The daily volatility is = 1.25% (0.1975 /250); VARstock (5%) = 1.65 *1.25%= 2.06%; Delta of the call = 0.0635/.01 = 6.35 ; VARcall = VARstock = 6.35*2.06% = 13.1%,


Value At Risk
Types of VAR

How to measure VAR VaR (daily VaR) (in %) = ZX% * - ZX% : the normal distribution value fo r the given probability (x%) (normal distribution has mean as 0 and standard deviation as 1) - : standard deviation (volatility) of the asset (or portfolio) VAR (X %) dollar basis = VAR (X %) * asset value VAR for n days using 1day VAR : VAR(X%)n-day s = (VAR(X%)1-day s )*n

Value at Risk (VaR) has become the standard measure that financial analysts use to quantify this risk.VAR represents maximum potential loss in value of a portfolio of financial instruments with a given probability over a certain horizon. Example: The daily 5% VAR is $10,000, it indicates that there is only 5% chance that on any given day, th e portfolio will experience a loss of $10,000 or more. VAR Benefits: Aggregates all the risks in a portfolio into a sin gle number Provides an approach to arrive at economical capital. Relates capital with th e exp ected losses Scaled to time


Diversified VAR: accounts for diversification effects. DVARP = z* std dev* portfolio value =(VAR12+VAR22)

Undiversified VAR: sum of the individual VARs for each risk factor. It assumes that all prices will move in the worst direction simultaneously, which is unrealistic. VARP =(VAR12+VAR22+2VAR1VAR2) =VAR1+VAR2

Marginal VAR is the change in VaR of the portfolio with one unit change in the components = DVAR * A /portfolio value

Incremental VAR : The change in VAR from the addition of a new position in a portfolio.

Component VAR is the Amount a portfolio VAR would change by deleting either of the assets from a portfolio = DVAR * A * weight of asset A.

Mean =0 Approximately Normal Curve Representing VAR

Q.Weight of asset A & B are 0.6 & 0.4 in a portfolio. The value of the total portfolio is USD1 million and its is 0.060606; if the betas of asset A and asset B are 1.3 and 0.8 respectively, the respectively. What is the MVAR of Asset B and CVAR of Asset B at a 95%. Ans: DVAR = 1.95*0.060606*1,000,000 = 99,999.90 MVAR = 99,999.90*.8/1,000,000 = $0.08 CVAR = 99,999.90*.8 *0.4 = $32,000. Q. A portfolio has an equal amount invested in X and Y. The expected excess return of X is 9% and that of Y is 12%. The MVAR are 0.06 and 0.075 respectively. What should manager do to move towards the optimal portfolio? Ans. The Expected excess Return ratio for X and Y are 1.5 and 1.6 respectively. Therefore portfolio weight in Y should increase to move the portfolio towards the optimal portfolio.

port = wa2 a2 + wb2 b2+2wawb* a* b* correlation (a,b) VaRport (daily VaR) (in %): = (wa2 (%VaRa)2 + wb2 (%VaRb )2+2wawb *(VaRa)*(%VaRb)* ab) $ VAR portfolio = ($ VARa 2 + $ VARb 2 +2$ VARa *$ VARb* a,b ) VAR of uncorrelated positions: VAR portfolio = (VAR12 + VAR22 )

Q. If the assets has a daily of returns equal to 1.4% and asset has a current value of $5.3 mn, calculate the VAR ( 5%) on both percentage & dollar basis. Ans. Z5%* = 1.65* 1.4% = 2.31%, and 0.0231* $5,300,000 = $122,430

The area under the normal curve for confidence value is:

D Risk Budgeting involves choosing and managing exposure to risk, 1st step is to determine the total amount of risk, as measured by VAR, Next is the optimal allocation of assets for that risk exposure.

Funding Risk: is the risk that the value of the assets will not be sufficient to cover the liabilities of the fund

Q. A portfolio is composed of 2 securities. Calculate VAR at 95% confidence level. Investment in security A & B are USD 1.5mn and 3 mn respectively.Volatility of security A & B are 7% & 3% respectively. Correlation A & B is 10% Ans. portfolio = (1/3)2 (7%) 2 + (2/3) 2 (3%) 2 + 2*(1/3)*(2/3)*10%* 7%*3% = 0.0316 VAR = 1.65 * 0.0316 * 4,500,000 = 234,630

Q.If the value of stock is 100 and the value of the put option at 110 is 20. 10 units change in the underlying brings in change of 4 units change in the option premium. If the ann ual volatility is 0.25. Calculate d aily VaR at 97.5% assuming 250 days? Delta = 0.4 STDEV(an nual) =0.25 Days = 50 daily STDEV= 0.015811 Z at 97.5% =1.96 Optio ns Value = 20 units VAR fo r option = 0.247923 units

Risk Budgeting

Q. A Fund has $200 mn in assets and $180mn in liabilities. Expected return on the surplus, scales by assets is 4%, i.e. surplus is expected to grow by $8 mn over 1st year. The volatility of surplus is 10%. Use Z =1.65, what is the deficit with the loss associated with the VAR. Ans: Surplus = (200 - 180 ) = $20 mn, expected to grow by $8 mn to a value of $28 mn; VaR = 1.65* 20* .1 = $33 mn The deficit is: ( 33 - 28) = 5 mn

Risk Budgeting with Active Mangers: is done using Tracking error ( Active Returns - benchmark return) & Information ratio (TE / volatility of managers TE) Weight of portfolio managed by manager i = IRi *(portfolios tracking error volatility)/ IRi*(managers tracking error volatility)

Q. Determine the optimal weight ratio TE vol Ratio IR Manager A 5% .70 Manager B 5% .50 Benchmark 0% 0 Portfolio 3% .82 Ans. A=51%, B=37% and remaining 12% in benchmark

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Full valuation: to take into account nonlinear relationships

Local valuation: for Linear derivatives

Historical Simulation: simply reorganizes actual historical returns, putting them in order from worst to best. Assumes history repeats itself. Pitfalls: Time variation in risk, unusual events

MC Simulation: The price returns are subjected to simulation using certain Simulation Models to generate a set of random numbers which are mapped to particular statistical distributions and hence the tail events are calculated to arrive at the VaR; Pitfalls: Model risk

Delta-Normal or Variance-Covariance Method: assumes that the portfolio exposures are linear and that the risk factors are jointly normally distributed (ND); VAR(X%)=zx%* Pitfall: non linearity , fat tails underestimate the occurrence of large observations because of its reliance on a ND

RiskMetrics approach is similar to the delta-normal approach. The only difference is that the risk factor returns are measured as logarithms of the price ratios, instead of rates of returns.

Q. Calculate VAR for an S&P 500 futures contract using the HS approach. The current price is 935 and the multiplier is 250. The historical price data for the previous 300 days, What is the VAR of the position at 99%. Returns: -6.1%,-6%,-5.9%,-5.7%, -5.5%, 5.1%..........4.9%, 5%, 5.3%, 5.6%, 5.9% Ans: The 99% return among 300 observations would be the 3rd worst observation i.e. 5.9%; Therefore (935)*250* (0.059) = $13,791.

Q. Delta-normal, historical simulation, & MCS are methods available to compute VAR. If underlying returns are normally distributed (ND), then a. Delta-normal method VAR will be identical to the HS VAR. b. Delta-normal method VAR will be identical to the MCVAR. c. MCVAR will approach the delta-normal VAR as the number of replications increases. d. MCVAR will be identical to the HS VAR. Ans: C, In finite samples, the HS VAR will be in different from the delta-normal method, as the sample size increases, they converge when the returns are ND.

Q: Under usually accepted rules of market behaviour, the relationship bw parametric delta-normal VAR and historical VAR will tend to be a. Parametric VaR will be higher. b. Parametric VaR will be lower. c. It depends on the correlations. d. None of the above are correct. Ans: B, parametric VAR at high confidence levels will generally underestimate VAR

Q: If you use delta-VAR for a portfolio of options, which of the following is always correct? a. It necessarily understates the VaR because it uses a linear approximation. b. It can sometimes overstate the VaR. c. It performs most poorly for a portfolio of deep ITM options. d. It performs most poorly for a portfolio of deepOTM options. Ans: B, The delta-VAR could understate or overstate the true VAR, depending if the position is net long or short options, it is generally better for ITM options, because these have low gamma and for OTM options, delta is close to zero, so the deltaVAR would predict zero risk.

Worst Case Scenario (EVT): focuses on distribution of worst possible outcomes given in an unfavourable event, expected loss is then determined from distribution. EVT stresses on the extreme value. EVT is calculation of the tail events & captures expected value of the fat-tail. The expected shortfall is mean of the observations exceeding VaR value. Back Testing: process of testing a trading strategy on prior time periods.

Stress testing: VAR tells the probability of exceeding a given loss but fails to incorporate the possible amount of a loss that results from an extreme event. Stress testing complements VAR by providing information about the magnitude of losses that may occur in extreme market conditions

Q. Which of the following is NOT a drawback to stress testing? a. Calculated losses may be extremely high relative to the 99% VAR significance level. b. Historical correlations mix normal and hectic periods. c. It identifies important factors not observed in historical data. d. The number of scenarios increases greatly with additional risk factors. Ans: C

Q: Which of the following methods would be most appropriate for stress testing your portfolio? a. Delta-gamma valuation b. Full revaluation c. Marked to market d. Delta-normal VAR Ans: B

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