INTF 6010 Lecture 2

Introduction to Market Risk

Measurement

Market Risk

Market Risk is the risk of loss due to

movements in market factors such as interest
rates, exchange rates, equity and commodity

Notes

prices

Market risk can affect instruments and

portfolios that contain bonds or other fixed
income instruments, equities, foreign
exchange positions or instruments,
derivatives, commodity positions, structured
products.

Fixed Income

Fixed income instruments or bonds are a

form of debt.

The price of a bond is the present value of all

its future cash-flows

Ct represents cashflows (Principal or

interest)
in period t
t represents the
number of periods
(e.g. half years) to
each payment
T is the number of
periods to final

The formula below shows that price (P) is a

function of yield (y)
T

Ct
P
t
t 1 (1 y )

Price Yield Relationship

The chart below shows the relationship between Price and Yield for a fixed
income instrument and one with an option.

Market Risk Fixed Income

Fixed income risk arises from potential

movements in the level of volatility of the risk
factors, usually taken as bond yields.

Movements in yields reflect economic

fundamentals.

Notes

The primary factor in determining the level of

interest rates is inflationary expectations.

For corporate and agency bonds or foreign

currency sovereign bonds Credit Spread risk
is another factor that affects bond yields.

Bond Sensitivity Measures

Two common derivatives of the price-yield

function are Duration and Convexity

Duration and Convexity are the first and

second derivatives of the price yield function

Notes

From a mathematical perspective:

Duration represents a tangent to the price yield

function

Convexity represents the curvature of the price

yield function

Duration

Duration represents an average of the time to

wait for all cash-flows

Duration is a measure of the interest rate

sensitivity of a bond.

Ct represents cashflows (Principal or

interest)
in period t
t represents the
number of periods
(e.g. half years) to
each payment
T is the number of
periods to final

Duration and modified duration are calculated

using the formulas:
T

D
t 1

tCt

(1 y)

D
D*
(1 y )

/P

Convexity

Convexity can be used together with duration

to give the full impact of interest rate changes
on the price of a bond

Ct represents cashflows (Principal or

interest)
in period t
t represents the
number of periods
(e.g. half years) to
each payment
T is the number of
periods to final

Convexity is calculated as follows:

C
t 1

t (1 t )Ct

(1 y)

t 2

/P

The Duration and Convexity Effect

The duration effect can be summarized as

follows:

Convexity actually
reduces the duration
impact.

P P0 D * P0 y

Duration represents the percentage change in

value of a bond from a 100 basis point (1%)
change in yield.

The combined duration and convexity effects

are as follows:

P P0 D * P0 y 1 2 CP0 y 2

Duration and Convexity

Duration of a Zero Coupon instrument is the

same as its time to maturity.

The duration of a floating rate instrument is

the time to the next coupon reset.

Notes

The duration of a callable bond is calculated

using the call date as the maturity date.

Convexity is always positive for regular

coupon paying instruments.

All else equal duration and convexity both

increase for longer maturities, lower coupons
and lower yields .

Market Risk - Equities

Equity holders make returns from the

appreciation in price and payment of
dividends.

Notes

Both price movement and dividend payments

are dependent on the performance of the
company.

There are also preferred stocks (preference

shares) where the dividend payments are
fixed i.e. specific rate and dates

Market Risk - Equities

Equity Risk arises from potential movements

in the value of stock prices

Equity Risk can be decomposed into:

Market wide Risk

Stock specific Risk

Volatility can be used as a measure of the risk

of a stock or stock index

Value at risk (VaR) can also be calculated for

a stock or portfolio of equities.

Market Risk - Currencies

Foreign Exchange (FX) or currency market is

the most actively traded in the world.

FX trading consists of Spot Transactions,

Forward Contract and Currency Swaps.

Notes

Currency conversion rates are typically

quoted in European Terms i.e. units of the
currency per US dollar.

The exceptions to this convention are the

British Pound and the Euro which are quoted
in American Terms i.e. units of US dollar per
unit of foreign currency.

Market Risk - Currencies

Currency risk arises from potential

movements in the value of foreign exchange

rates.
See example 11.3
on pg 263

This can occur in the following situations:

Pure Currency Float where market demand and

supply determine FX rate movements

Fixed Currency System where rates are subject

to one off adjustments (devaluations or
revaluations).

Change in currency regime where a fixed

currency system is changed to floating or vice
versa.

Market Risk - Currencies

The risk associated with spot transactions

can be measured using volatilities and value
at risk (VaR).

Exercise analyze
the currency swap on
pgs 264 266.

Market Risk - Commodities

Commodities typically involve the trading of

contracts on:

Notes

Agricultural Products e.g. wheat, corn

Livestock and meats e.g pork bellies

Base Metals e.g. copper, aluminum

Precious Metals e.g. gold, silver, platinum

Energy Products e.g. crude oil, natural gas

Commodity contracts include Spot, Futures

and Options on Futures.

Market Risk - Commodities

Important concepts:

Convenience Yield benefit of holding an

inventory of a commodity that is used in

If the lease rate on a

commodity is y and
the risk free market
interest rate is r
then:
Contango occurs
when y<r
Backwardation
occurs when y>r

production.

Lease Rate When a commodity can be lent

out for profit.

Contango When the futures price of a

commodity is higher than the spot price.

Backwardation when the spot price is

higher than the futures price.

Market Risk - Commodities

Commodity Risk arises from potential

movements in the value of commodity prices.

See Example 11.8

on pg 273

Volatility, correlations and value at risk can

be calculated for commodity contracts.

Energy commodities are more volatile than

other commodities since they are less
storable than metals and as a result are more
affected by variations in demand and supply.

Portfolio Sensitivity Measures

All of the concepts covered above can be

applied a portfolio level

Wi represents the
weight of each
security in the
portfolio
See examples 6.15
and 6.16 on pg 150

Portfolio Duration and Convexity can be found

by calculating the weighted average.

DP*

Di* wi

t 1
N

Cp

C w
i

i 1

Portfolio Sensitivity Measures

Portfolio volatility can be calculated using the

following:

2
p

w' w

w represents the
matrix of weights
Sigma represents
the covariance
matrix.

Correlations among the assets in the

portfolio is also very important. A portfolio of
assets that is highly correlated will tend to
move up and down together. Correlation
matrices can be used to determine the
correlation among securities.

Derivatives

A Derivative instrument is a private contract

that derives its value from some underlying
asset price, rate or index such as a stock,

Notes

bond, currency or commodity.

Derivatives can be traded in private over the

counter (OTC) markets or on organized
exchanges

The most common derivatives include

Forward Contracts, Futures Contracts, Swaps
and Options

Forward Contracts

Forward contracts are contracts to buy or sell

an asset, currency or commodity at a
specified time in the future.

Example: A corn farmer can enter into a

forward contract today to sell corn at a
specified price for delivery in the future.

Forward contracts are contracts between

parties and typically do not involve a
clearinghouse. This gives rise to counterparty
risk.

Forward Contracts
t Current Time
T Time of Delivery
T-t
St Current Spot Price
Ft Current Forward Price
Vt Current Value of Contract
K Underlying asset price
r current risk free rate
r * dividend yield or foreign
risk free rate
n quantity or number of
units in contract

The valuation of a forward contracts can be

calculated using the following:

Ft e r St
Ft e r St PV ( D)
Ft e r St e r *
Vt St e r * Ke r Ft e r Ke r ( Ft K )e r

Futures Contracts
Futures are very similar to Forward contracts

in that they both allow the ability to buy or

sell something using a price determined
Valuation of Futures
are done with the
same formulas as
Forward Contracts.

today but executed at a date in the future.

The key differences with Futures include:

Trades on organized exchanges

Standardization i.e. fixed contact sizes and

limited expiration dates

A Clearinghouse assumes the counterparty risk

Marked to Market Daily

Margins are required

Swaps
Swaps are OTC agreements to exchange a

series of cash-flows according to prespecified terms.

Review:
Interest Rate Swap
pg 239
Currency Swap Pg
264
To be discussed in
class

Swaps are typically longer in tenor than

Forwards or Futures.
Common Swaps include:

Interest Rate

Currency

Credit Default Swaps (CDS)

Commodity

Total Return etc.

Interest Rate Swap Structure

The diagram below shows the a typical interest rate swap structure where

Credit Default Swap

The diagram below shows the a typical credit default swap structure

Options

Options are instruments that gives a holder

the right (but not the obligation) to buy or sell
an asset at a specific price (strike price)

Common notations:

usually on a specific date.

Option Premium
Strike price or
exercise price
Long or short (i.e.
buy or sell)

Options to buy are called Call Options while

options to sell are called Put Options.

European Options can only be exercised at

maturity while American Options can be
exercised at anytime before or at maturity.

Call and Put Options

The two most common options are call and

put options

Call option gives the buyer the right to buy

and asset while a Put option gives the buyer

Notes

the ability to sell an asset.

Holding a short position (i.e. you sold

options) then you become obligated to buy or
sell the asset if the buyer exercises the
option.

Payoff on Options

The payoff profile of a long position in a call

option is:

Ct = Value of the Call

option

Ct Max( St K ,0)

option is:

Pt = Value of the Put

option
St = Current price of
the asset
K= strike price of the
option

The payoff profile of a long position in a put

Pt Max( K St ,0)

From the payoff profiles when is it best to use

call and put options?

Payoff for a Long Call

Combining Options

Combinations of call and put options to

create various kinds of payoff profiles.

A long position in a call option plus a short

position in a put option in the same asset

See pages 183 to

185 for more option
combinations

with the same strike price and maturity dates

is equivalent to a long position in the
underlying asset.

Other payoff structures include Straddles,

Bull Spread, Bear Spread, Butterfly Spread
etc.

Combining Options

The link in the relationship between the value

of a call and put option is known as Put-Call
Parity. The relationship can be expressed as:

Put-Call Parity is
demonstrated on
table 8.1 on pg 181

c p Se

r *

Ke r ( F K )e r

This works well for European options but

does not hold exactly fro American Options
as there is the possibility of early exercise.

General Relationships
The value of an option consists of two

components:

Notes

The Intrinsic Value which is the value if

exercised today.

The Time Value which is the portion of the

option premium that is attributable to the
amount of time remaining until the expiration of
the option contract.

General Relationships
Some other general option terminology:

At-the-money when the current spot price is

close to the strike price

Notes

In-the-money when the intrinsic value is

large

Out of the money when the spot price is

much lower than the strike price

Upper and Lower Bounds

The following are some general bounds for

European options:

ct Ct S t
ct St Ke r
pt Pt K

A American Call
Option on a nondividend paying
stock should never
be exercised early
An American Put
Option on a non
dividend paying
stock may be
exercised early

pt Ke r St

If these do not hold then there will be

arbitrage opportunities.

Caps and Floors

A cap is a call option on interest rates with

value:

CT Max[iT K ,0]
Notes

A floor is a put option on interest rates with

value:

PT Max[ K iT ,0]

A Collar is a combination of buying a cap and

selling a floor.

Introduction to VaR

Value at Risk or VaR was developed to

measure how much an investor could lose on
an investment over a specified horizon with a
specific probability.

It addresses the shortcomings in other

sensitivity measure such as Duration.

While sensitivity measures such as Duration

are useful they do not give a probability of
occurrence and cannot be combined for
different types of assets.

Value at Risk

VaR provides one number that that

aggregates the risks across the whole
portfolio, taking into account leverage,

VaR is usually
expressed as a
dollar loss.

diversification and providing a risk measure

with an associated probability.

VaR is defined as the worst expected loss

over a target horizon under normal market
conditions at a given confidence level.

Visual Representation of VaR

Steps in Calculating VaR

1.

Mark to market of the security or portfolio

2.

Measure the variability of the risk factors (e.g.

standard deviation of returns)

Notes

3.

Set the time horizon or holding period.

4.

Set the confidence level.

5.

Calculate and report the worst case loss

using the information above (e.g. $7 million
VaR)

Steps in Calculating VaR

The general VaR formula is as follows:

VaR MarketValu e t
There are three
dominant VaR
Methods:
Parametric
Historical
Monte Carlo

For bonds the VaR formula is as follows:

VaR MarketValu e MDuration WorstYield Increase

Basel 2 recommends a 10 day VaR at 99%

confidence level as the Market Risk Charge.

Questions
Comments
Discussion