Market Risk Measurement and Management

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 Total Framework
Fixed-Income Estimation

Volatility Smile

Discount Rate
Market Risk
Measurement and VaR Estimation
Management

Coherent Risk Measures

Correlation and Copulas

Extreme Value
Fixed-Income Estimation
Interest Rate Tree (Binominal) Model ★★★ 性质、计算
① Using backward induction, the value of a bond at a given node in a
Application binomial tree is the average of the present values of the two possible
in values from the next period.
Bond ② The appropriate discount rate is the forward rate associated with the
Valuation node under analysis.

① Price the bond value at each node using the projected interest rates.
② Calculate the intrinsic value of the derivative at each node at maturity.
Application ③ Calculate the expected discounted value of the derivative at each node
in using the risk- neutral probabilities and work backward through the
Derivative tree.
Valuation
Interest Rate Term Structure ★★★ 性质、计算

① No drift
② Normally distributed

Model 1

dr  d, d   dt

① Positive drift term

② λ: interest rate drift

Model 2

dr  dt  d
Interest Rate Term Structure ★★★ 性质、计算

Time-dependent drift

Ho-Lee
Model dr   t  dt  d

① Mean-reverting
② k: reversion speed
③ θ: long-run value dr  k    r  dt  d
④ r: current level.
Vasicek
Model The half-life, τ, can be computed as the time to move halfway between the
current level and the mean-reverting level.

   r0  e  k  1 2    r0 
Interest Rate Term Structure ★★ 性质
① Time-dependent volatility

Model 3
② σ decreases exponentially to 0 for α > 0
dr   t  dt  e  t d

① Mean-reverting

dr  k    r  dt   r d
② Basis-point volatility increases at a
CIR Model
decreasing rate

① One solution to eliminate the negative rate problem is to use non-

negative distributions, such as the lognormal distribution.
Lognormal ② Alternative solution: negative interest rates are replaced with 0%
Model
Interest Rate Term Structure ★★ 性质
Lognormal with Deterministic Drift
Jensen's Inequality ★★★ 性质、计算
① The volatility of expected rates creates convexity,
 1  1 1
E  
which lowers future spot rates.
 1  r  E  1  r  1  E r 
② The convexity effect can be measured by using
Jensen's inequality.
Risk Metrics and Hedge ★★★ 性质、计算

① In a trade where the trader sells T-Bond and buy TIPS (Treasury Inflation Protected
Security), there is a dispersion of the change in the nominal yield for a given change in
the real yield.
② Denoting the face amounts of the real and nominal bonds by F R and FN and their DV01s
by DV01R and DV01N, the regression-based hedge, characterized earlier as the DV01
hedge adjusted for the average change of nominal yields relative to real yields, can be
written as follows: DV01N ˆ
F  F 
R N
R

DV01
Volatility Smile
Volatility Smile ★★★ 性质

For Foreign Exchange Options

① Currency traders believe there is a greater chance of extreme price movements than
predicted by a lognormal distribution.
② The volatility pattern used by traders to price currency options generates implied
volatilities that are higher for deep in-the-money and deep out-of-the-money options,
as compared to the implied volatility for at-the-money options.
Volatility Smile ★★★ 性质、计算

Why are exchange rate not lognormally distributed? Two of the

contidions for an asset price to have a lognormal distribution are:

① The volatility of the asset is constant.

Reasons for ② The price of the asset changes smoothly with no jumps.
Smile in Foreign
Currency In practice, neither of these conditions is satisfied for an exchange
Options
rate. The volatility of an exchange rate is far from constant, and

exchange rates frequently exhibit jumps (sometimes the jumps are

in response to the actions of central banks).

Volatility Smile ★★★ 性质

For Stock Options

① Equity traders believe the probability of large down movements in price is greater than
large up movements in price, as compared with a lognormal distribution.
② The volatility smile exhibited by equity options is more of a “smirk,” with implied
volatility higher for low strike price.
Volatility Smile ★★★ 性质、计算

① Leverage

As a company’s equity declines in value, the company’s leverage

increases. This means that the equity becomes more risky and its

Reasons for the volatility increases.

Smile in Equity
Options ② Crashophobia

1987 stock market crash: higher premiums for put prices when the

strike prices lower.

Discount Rate
Discount Rate Selection ★★★ 性质
Treasury rates are generally considered to be artificially low:
① Treasury bills and Treasury bonds must be purchased by
financial institutions to fulfill a variety of regulatory
requirements. This increases demand for these Treasury
instruments driving the price up and the yield down.
Why not ② The amount of capital a bank is required to hold to support an
Treasury Rates? investment in Treasury bills and bonds is substantially smaller
than the capital required to support a similar investment in
other instruments with very low risk.
③ In the United States, Treasury instruments are given a favorable
tax treatment because they are not taxed at the state level.
Discount Rate Selection ★★★ 性质

① During the credit crisis, LIBOR rates soared because banks were

reluctant to lend to each other.

② The TED spread (3-month Eurodollar deposit rate - 3-month US

Treasury bill rate) is less than 50 basis points in normal market

Why not LIBOR? conditions.

③ Between October 2007 and May 2009, it was rarely lower than 100

basis points and peaked at over 450 basis points in October 2008.

④ Banks did not regard loans to other banks as close to risk-free during

this period!
Discount Rate Selection ★★★ 性质

An overnight indexed swap is a swap where a fixed rate for a period

OIS (e.g., 1 month or 3months) is exchanged for the geometric average of
the overnight rates during the period.

Prior to Market participants usually used LIBOR/swap rates as proxies for risk-
Credit Crisis free rates.

① For collateralized transactions, most financial institutions have

moved away from LIBOR rates to OIS rates because OIS rates are
more closely tied to funding costs.
Following the ② For non-collateralized transactions they continue to use LIBOR, or
Credit Crisis an even higher discount rate.
③ This reflects a belief that the discount rate used by a bank for a
derivative should represent its average funding costs, not a true
risk-free rate.
VaR Estimation
Basic VaR Estimation ★★★ 性质、计算

Square Root Rule VaR T days  VaR 1day  T

Portfolio VaR VaR 2P  VaR 12  VaR 22  2  VaR 1  VaR 2

Parametric Estimation of VaR ★★★ 性质、计算

Properties Requires a specific distribution of returns.

Normal VaR VaR  %       z      Value

Lognormal VaR  
VaR  %   1  e  z    Value
VaR  dP   D*P  VaR  dy 
VaR  dP     VaR  dS
Delta-Normal

VaR  dP    D*P  VaR  dy   1 2  C  P   VaR 2  dy 

Delta-Gamma
VaR  df     VaR  dS  1 2   VaR 2  dS
Non-Parametric Estimation of VaR ★★ 性质

Non-parametric estimation does not make restrictive assumptions

Properties
about the underlying distribution like parametric methods.

① Data can be skewed or have fat tails;

② Conceptually straightforward;
Advantages
③ There is readily available data;
④ They can accommodate more complex analysis.

① They are slow to respond to changing market conditions;

② They are affected by volatile (quiet) data periods;
Disadvantages
③ They cannot accommodate plausible large losses if not in the data
set.
Historical Simulation ★★ 性质

① Historical simulation does not assume a particular distribution of asset

returns.

Definition ② Historical simulation applies equal weight to all returns of the whole
period. This can be improved by using age-weighted simulation,
volatility-weighted simulation, correlation-weighted simulation, and
filtered historical simulation.

① The bootstrap technique draws a sample from the original data set,
records the VaR from that particular sample and “returns” the data. This
procedure is repeated over and over and records multiple sample VaRs.
Bootstrap Since the data is always “returned” to the data set, this procedure is
Historical akin to sampling with replacement. The best VaR estimate from the full
simulation data set is the average of all sample VaRs.

② The bootstrapping technique consistently provides more precise

estimates than historical simulation on raw data alone.
Age-Weighted Simulation Method ★★★ 性质、计算
The age-weighted simulation method adjusts the most  i1  1   
recent (distant) observations to be more (less) heavily w  i 
weighted. 1  n
Volatility-Weighted Simulation Method ★★★ 性质
Replaces historic returns with volatility-adjusted  T,i 
r 
*
r
returns. However, the actual procedure of estimating    t,i
t,i
VaR is unchanged.  t,i 
Correlation-Weighted Simulation Method ★★ 性质
The historical correlation matrix needs to be adjusted to the new information environment.
This is accomplished, loosely speaking, by “multiplying” the historic returns by the revised
correlation matrix to yield updated correlation-adjusted returns.

Filtered Historical Simulation Method ★★ 性质

Combines the traditional historical simulation model with GARCH model.
Quantile-Quantile Plot ★★★ 性质

① A visual inspection of an empirical quantile relative to a hypothesized

theoretical distribution.
Properties
② If the empirical distribution closely matches the theoretical distribution,
the QQ plot would be linear.

Plot
Backtesting VaR ★★★ 性质、计算

Comparing the number of instances when the actual profit/loss exceeds

Definition the VaR level (called exceptions) with the number predicted by the model.
Using failure rates in model verification.

Hypothesis H0: accurate model; Ha: inaccurate model

① Binomial → z-statistics
② LR. If LR > 3.84, we would reject the hypothesis that the model is
correct.

 
Test Statistic
LRuc  2ln  1  p  p   2ln 1   N / T   N / T 
T N N T N N

③ where P is the   N is the number of exceptions

probability of exception, 
and T is the number of samples

Green 0 to 4 3.00
Basel Penalty
(99%, 250) Yellow 5~9 3.40~3.85
Red 10 or more 4.00
VaR Mapping ★★★ 性质、计算

The Mapping
Process
VaR Mapping ★★★ 性质、计算
Portfolio exposures are broken down into general risk factors and
Definition
mapped onto those factors.

① Principle Mapping: Includes only the risk of repayment of the

principal amounts. This method considers the average maturity of the
portfolio.
② Duration Mapping: Risk of the bond is mapped to zero-coupon bond
Fixed Income of the same duration. Duration mapping uses the duration of the
Risk Mapping portfolio to calculate the VaR.
③ Cash Flow Mapping: Risk of the bond is decomposed into risk of each
of the bonds' cash flows. This is the most precise method because we
map the present value of the cash flows onto the risk factors for zeros
of the same maturities and include the inter-maturity correlations.

Derivatives Delta-normal VaR can be applied to many types of instruments when the
Mapping risk factors are linearly related.
Coherent Risk Measures
Coherent Risk Measure ★★ 性质

① A more general risk measure than either VaR or ES is known as a

coherent risk measure.
Definition ② A coherent risk measure is a weighted average of the quantiles of the
loss distribution where the weights are user-specific based on individual
risk aversion.

Monotonicity Homogeneity
Properties
Translation Invariance Subadditivity
Expected Shortfall ★★★ 性质、计算

① VaR does not estimate the expected tail loss.

② Expected shortfall overcomes this deficiency by dividing the tail region
into equal probability mass slices and averaging their corresponding
Properties VaRs.
③ The expected value of the loss when it exceeds VaR.
④ One can show that it qualifies as a subadditive risk measure.
⑤ ES is coherent risk measure while VaR is not.
Correlation and Copulas
Correlation in Trading ★★ 性质
A correlation swap is used to trade a fixed correlation between two assets
with the realized correlation. The payoff for the investor buying the
Correlation
correlation swap is:
Swap
notional amount   realized  fixed 

In May of 2005, several large hedge funds had losses on both sides of a
CDO hedge position (short the CDO equity tranche and long the CDO
Trading mezzanine tranche). The decrease in default correlations in the
mezzanine tranche led to losses in the mezzanine tranche.

AIG and Lehman Brothers were highly leveraged in CDSs during the recent
CDSs financial crisis. Their financial troubles revealed the impact of increasing
default correlations combined with tremendous leverage
Mean Reversion and Autocorrelation ★★ 性质
Implies that over time, variables ore returns regress back to the
mean or average return.

Mean Reversion St  S t 1  a    S t 1 
St  S t 1  Y;a  , aS t 1  X  Y     X
where a is the mean reversion rate, μ is the long-run mean value, β
is equal to the negative of a.
Measures the degree that a current variable value is correlated to
Autocorrelation
past values.

Best-Fit Distributions for Correlation ★★★ 性质

① Equity correlation distributions and default probability correlation distributions are best
fit with the Johnson SB distribution.
② Bond correlation distributions are best fit with the generalized extreme value
distribution, but the normal distribution is also a good fit.
Statistical Correlation Measures ★★★ 性质、计算
Pearson COVXY
Linear relationship  XY 
Correlation X Y

① Creates a joint probability distribution between two or more

variable while maintaining their individual marginal distribution.
② A Gaussian copula maps the marginal distribution of each variable to
the standard normal distribution which has a mean of zero and a
Copula standard deviation of one. In finance, the Gaussian copula is a
common approach for measuring default risk.
③ Copula correlation models failed during the 2007-2009 financial
crisis due to assumptions of a negative correlation between the
equity and senior tranches in a CDO structure.
Statistical Correlation Measures ★★★ 性质、计算

CGD  Qi (t),...,Qn (t)  Mn N1(Q1(t)),...,N1(Q n (t)); M 

① CGD: Gaussian default time copula.

② Qi(t): cumulative default probability of asset i at time t.

David Li’s Copula ③ Mn : the joint, n-variate cumulative standard normal

distribution.

④ ρM: the n*n symmetric, positive-definite correlation matrix of

the n-variate normal distribution Mn.

⑤ N−1: the inverse of a univariate standard normal distribution.

Statistical Correlation Measures ★★★ 性质、计算

① Linear dependencies: do not appear often in finance.

② Zero correlation does not necessarily mean independence. E.g.

Y=X2 (correlation=0).
Limitations of ③ Linear correlation measures are natural dependence measures only
the Pearson
Correlation if the joint distribution of the variables is elliptical: Normal or t.
Approach
④ The variances of the sets X and Y have to be finite.

⑤ Not invariant to transformations: For example, the Pearson

correlation between pairs X and Y is in general different from the

Pearson correlation between the pairs ln(X) and ln(Y).

Statistical Correlation Measures ★★★ 性质、计算

n Where n is the number of

Spearman Rank 6 d 2
i observations for each variable and di
Correlation Coefficient S  1  i 1
is the difference between the ranking

n n 1 2
 for period i.

Where the number of concordant pairs is represented as n c

Kendall’s τ
Correlation Coefficient and the number of discordant pairs is represented as n d.
A concordant pair of observations is when the rankings of
two pairs are in agreement:
nc  nd Xt  Yt and X t*  Yt* ,or X t  Yt and X t*  Yt* ,and t  t *
 A discordant pair of observations is when the rankings of
n  n  1 2 two pairs are not in agreement:

Xt  Yt and X t*  Yt* ,or X t  Yt and X t*  Yt* ,and t  t *

Spearman’s and Kendall’s τ, as ordinal measures, underestimate risk by ignoring the impact
of outliers.
Extreme Value
Extreme Value Theory ★★★ 性质

EVT can be used to model extreme events in financial markets and to

Definition
compute VaR, as well as expected shortfall.

Generalized ① Block Maxima Method

Extreme Value ② Location parameter μ, scale parameter σ, and tail index ξ.
Distribution ③ ξ > 0, Frechet, heavy tail.

① Peaks over Threshold: it models the values that occur over a given
threshold. There is a tradeoff because the threshold must be high
Generalized enough so that the GPD applies, but it must be low enough so that
Pareto there are sufficient observations above the threshold to estimate
Distribution the parameters.
② The parameters of a GPD are the scale parameter β and the shape
parameter ξ.
Extreme Value Theory ★★★ 性质

Generalized Extreme Value Distribution (Block Maxima Method)

Generalized Pareto Distribution (Peaks over Threshold)

GEV vs POT

Block Maxima Method Peaks over Threshold