CrrticaL Conc MARKET RISK MEASUREMENT stile ‘Value at Risk (VaR) VAR fora given confidence level occursat the cutoff poine tha separates che eal lzer fram che remaining distribution. Hitorica seulaton spproash order return sbiervations and find the obtervation that corresponds tothe Valk Jos level. Paarericetamation approach: assumes eeribton forthe underlying chaervatora ‘Normal dgtribusion assum pin: VaR =, +0, 224) + Lognormal distribution assumption: Vat = (—ebr-emta) Expected Shortfall Provides am eximate of tai loss by averaging the ‘VaRs for increasing confidence level in the ail. Weighted Historical Simulation proaches + feeuighed adj dhe mont een (ian) abserations tobe mare (es) hewily weighed. + Velelin-weighted: replaces historic returns with volaliy-adjad returns actual prcedute of ccemating Vai unchanged + Coprlaermighind pans he orn covariance mati bran sti he pork, * Fike sora riralon ries 20 bootstrapping of standardind returns based 09 velo freer; able vo capture conivonal volo. volun cueing andlor data amet. Peaks-Over-Threshold (POT) Application of exreme value cheory (EVT) tothe dseivuion of exces los over high crcl ‘One ofthe goal of using the POT approschis {ocompuce VaR. From extimatesof VR, we can sderive the expected shortfall (E9. Backtesting VaR + Compares he numberof instances when loses exceed he VA lol (exceptions) with he number predicted by te model athe chosen level of ‘Confidence + Faia rae number of excepionlnuinbe of obserstions. + The Bisel Committee requires bicketing athe 996 conidence level ver one year establishes, sone fo the number of exceptions wh 0 Cox-ingesll Ros (CAR) model: mean-reveting model with constant volatility, 0, ad basi po wolaliy, ov, that increases a a decreasing rate: (@—2)de + ovedw Medel 4 flegrermal model yield vl, «scons, bur base poin volar, increases with the level ofthe short-term ate ‘There ae wo lognoemal model of importance: (0) lognormal with deteministe df and (2) lognormal with mean reversion. Overnight Indexed Swaps (O1S) Toners ate sap in which a fed interest cate is swapped for a Howing interest rte. The OIS tate isthe bes prony forthe neice rate inthe ‘aluaton of collateralized dervatives portfolios. Put-Call Parity e—peS-Xe" where: € = priceaf acl P ~ price of a puc 5. price of the underlying security = fifi ate TT = time lef o expiration expressed in years Volatility Smiles Garey option implied volatility ie ower for acthemoney options than ifr sway-from- ‘the money options fhe implied volatilities for aceal curency options ae greater For avay-from- the-money than at-the-money options. eurtency trades me think here ie a reter chance of cexceme price movements han predicted by 2 logroemal dtibation Equity opcione bighee implied vai for low sutke price options. The vlatity smirk ial smile exhibited by equity options tanslees into a lefskewed implied disuibucion of equiy price changes. Thisinicaes chat waders belive the probably of lage down movement in peice Js greater than lange up movernents in pice, compared with a lognormal ditibution. Re Sg aa Credit Risk * Gidit ri is ther the td of economic las rom default, or changes in cred events o° credit tings. Type of cri ky secures include: corporate sand sovereign deb, credit dviontivs, and srcuied ult procs Tiina eee eee Expected Loss (EL) Expected vale of credo EL= PD » (RR) x expomue + PD x LGD Probeiltyofdfeue (PD): likelihood thar a borrower will default within a specified time horizon. Lm given defeats (LGD): amoune of cxeditor loss in the event ofa defalt In percent terms, itis ‘equal to 1 minus the recovery rate (xe, 1 ~ BR). Exposure at defi: avout of money the lender can losein the event ofa borrowers defak. ‘The Merton Model * Avalucbed model where th vl ofthe B's ‘ouanding debe (D) ph equity (2 ivequal > the valve ofthe fam (V1, + Thevalucof the debs can serve aan indiator of Siem deft ck| + Since Fand Dare contingent claims, option pricing canbe sed to determine hee vals ay fellows payment wo shareholders: max(V~Dy payment wo debrholders: Dy —max(Dy,—Vy 0) * Equity asia to along cll option on the velue ha fis ase where fae valve of deb iethe scribe price the opcion, * Debris similar to ack free bond and shore put ‘option on the value of frm’ ass where face sale of dex i the eee price of ce option. ‘The KMV Model Builcon the Merton model and ties to adjust for same ofits shortcomings. Asumes there are only two debr issues. The defaul cheshold isa linear combination of chese values and i equal tothe par value ofthe firm’ abilities. A rae for determining the default threshold et Sshorcterm abilities + 0,5 x long-term liabiliies “The dranc w dea (OD) leas he Peeters eh capil eitononay on ofthe nur dton sod theta el at ~ sandard deviation af oo? Once DD is compued, the probably of default ca be Found by evaluating the DD of her fim that have defsled. (Credit Scoring Models = Fider lnc dicriminant anhyis segreggtes 2 ine grep om horegencan aibgn + Rouneri dioimination ues se Faction te dermie the member of the sabgrap, The Sie devine which hyn e cheraton eed oup). + mmc nigh toga new cont how clad it rere rember ey in roup. + ‘Ssppet sector machines vides bgt gro > sebypoops ng hyperplane. Credit Spread Diference berwee the yield on asdky bond (eg, corporate bond) and he yield on ike fee bond (eg. T-bond) given thatthe two insumenishave the same mati, pp. where: D ~cuttent value of debe F face vue of debe Credit Risk Portfolio Models Thee model arempt wo eximace a porflic rede value a isk. Credit VAR dirs fom matict ER in that c measures losses chat ae doe specclly © default rik and cred deterioration isk Creithch: determines default probably coneations and defaule probabilities by using a set of common risk actors foreach obligor. Crees: ses bstorical daca o estimate the probably of a bond being upgraded or dowograded using historical easton matte. OMY Portfio Manager: fal probability is a Function of firm ase growth and the level of debe The higher the growth snd lower the debe level, the lower che default probabily GreditPoefoo View: multifactor model for simulating joi conditional disuibutions of credit migration and default probable that incorporates macroeconomic Fctor. Credit Derivatives ‘A crit derivative isa contract wth payots ‘contingent ona specified credit event. Cnt events include: Fail to make required payments * Restcrsing chat hers the cede. + Tnvocaton of crossdefaul clause. Cre defile sap (CDI): like insurance: patty seling the protection receives a fe, pays based on swap’ notional amount in the case of defsule. Fis-o deft put CDS variation where a party paysan insurance premium in exchange for being ‘made wile fo the ist defale fom a asker of sets, More com effective option than CDS if sex have uncortlated defauke risks. Tal reture swaps el recutn on an ase: (bord) is exchanged for a ic (or viable) payment, vocal eum receiver gets any appreciation (capital ‘sine and cash flows, pays any depreciation: payments tke plce whether o aot a credit event occurs Buyer exchanges credit rk of issuer defaulting forthe combined risk ofthe issuer and the derivative counterparty, Valacrable eption: option with default risk holder receives promised payment only if seller of the ‘option is able to make the paymens. Asser backed credit kinked nate: embeds a deft iwo a deb iasuance. It i debe instrament with ts coupon and principal ak ted to an cundedying debe instrument (eg, bond or loa). Conventions Yeeld spread: TM sky bond - YTM benchmark goverament bond ‘spread: YTM sky bond —lineatyincexpolaed ‘YTM on benchmatk goverament bond _espread: bass poins added o each spot rae on a benchmark curve DS spread macket premium of CDS of isuer bond Hazard Rates “The hazard ate (fault items) i represented by he (conse) parameter and the probabilityof default over the next, small ime incerval, irae, ‘Cumulative PD If the time ofthe defsul even is denoted ¢*, the cumulative defuul time distribution FG) represents the probabilcy of defsuls over (0,9) Pier et)=RQ=1-e* ‘The curvval dietribution is P(e > )=1-F) =e™ Probability of Default ‘The probability of default (PD) of a debt security can be calculated by using the following equation: Da ie (CS seprsene he crediespead, which i the dlference between the yield on risky deb andthe tiakefiee rate. Lom given defale (LGD) sequal ro ‘one minus the recovery rate. Single-Factor Model Examines the impact of varying defsule correlations based on a credit potions beta. Each individual fem or credit, i, has a beta correlation, 2B, withthe matket,m. Firm #+ individual asset return is defined a amit Vi-BPes where [iB « fers sandard deviation of iiosynerati isk «= fis idiosyncratic shock Originate-to-Distribute Model Enables lenders to originate a loan based on ril/teward pricing and then outsource the tsk though varios channel. This provides bewer access to capital for less eeditwocthy borrowers and more diversification options for investors. Collateralized Debt Obligations + Genea em for an asevhacked secuity tha ‘urs secuntis hat py peincpal and ince rom, 2 collatal poo of debe isramenes + In order ro create a CDO, che nur packages a sete of deb instrament and sls the picage fev several clases of sete called eanches + The let partoFa CDO is pically the senior ceanche, which wally caries an AA ot ANA crit rating, qa of he qualiy of the undying, ss inthe poo Sputbetic COO: xiginacor retains referoce assess con balance shee but transfers credit risk to an SPV, which then erates the tadabe synhetic CDO. This product bets onthe default fa pool of asus, nor on the assets themselves. Securitization “Transforms the illiquid asew of fnancial institution into a package ofeserbacked securities (ABS) or mortgage-backed securities (MBS6).A third party uss credit enhancements, liquidcy enhancements, and sructaing wise securities backed by the pooled cash Bows (oF che same underlying ase). * Cedi enhancements include overcllateraiation, subordinating note cases, arpa tep-p, and + The fos piece (equity pice) abc ini lomo hl by eigen ABS/MBS Performance Tools ‘Ato loans: oss curves, absolute prepayment speed. Cri card deb: delinquency ratio, default ratio, monthly payment cate Mertgagas debt service coverage eato, weighted average coupon, weighted average maturity, weighted average lif, single monthly morelicy, constant prepayment rate, Public Securities ‘Assocation, ime Mortgage Market paces arcane ‘or arong indicators of pomble irre desl. + Indicator offre defule par dlinguenccn, jndgments,foredoeurs, eposesions, chage off, seal tank gow FICO sre igh eb +The wre major of subprime lane ae aduable xe mong. Counterparty Risk ‘These shac a countesparty is unable or ‘availing t ive up to m contractual abligxtions. Crit exposure oe that is "conditional" on the sounerparty defaulking. acer measuted by the recovery rate, which Js the portion ofthe oustanding chim accually recovered afer deful, Wrong ny exprure exposes that ae negatively conelated with the eounterpary’ redic qual. ‘They increase expected credit ses. ‘Mark-tomarkes (Mi): accra accounting, ‘measure hac is equal tothe sum ofthe MM voles of al contac with 2 gen counterparty. Credit Exposure Metrics Expected Mit: forward expected value of transaction at given poinin the Fru. Expected expnure (EE): amoune cha i expected to be lost (positive MeM only) ifthe counterparty defuks Potential fave exposure (PFE): worst exponste hat could occurat. give time inthe frute a3 sven confidence level ‘Expecued poviive expovue (EPE): average EE through ime. ftve EE: equal 10 von-decreasing EE. ‘fictive BPE. average of eecive EE. ‘Maximum PFE: highest PFE vale over a ated time Fame. Credit Mitigasion Techniques _Naing a legly binding agreerenc chat enables couoterpris with multiple derivative contract to nether obligations (eg, Pay Aomes Parry B $50 million: Paty B mes Pary A $40 milion 0 Pany A pays a net $10 million to Party B). Coleteeizaton: the value of derivative contracsis above a smted threshold, collateral ‘must equal the dilfeence between the vale of the contscs andthe thethod level, Collateral agreements have two major benefits: (1) expand ‘he lise of potenalcoucterparies because rei rating sales important concern and (2) reduce ‘economic capital requirement Modeling Collateral Cerin parimecers impact the efciveness of collateral io lessening ced exposure. These parameter area follows: Remargin prod the time between the call for collateral and ites Threshold: an exponut level below which collateral i noe called. ie epresents an amount of Acollatertzed exporue. Minirwem tafe enount: the miniomsm quantity crblockin which colstera may be tranufred. ‘Quancits below this amount sepriene ncollstraliaed expoeure. Independent amen: an smount por independently of ary subsequent colaealization. ‘Thiele refered toa che intl margin Bounding he process by which a collateral al amount wll be adjasted (rounded) toa cxrain Increment Central Counterparties ‘The main woe of central councerpary (CCD) js to manage and concol systemic rite The CCP performs the following functions: valuation and ‘erdement in OTC marke, tide compresion and ncng,collacral management, increase transparency, lot mutilation, and avction proces for defulked members. Credit Value Adjustment (CVA) Expected vale of price of counterparty erat fk. A psiive wale representa costo the counterparty that beara greater propensity to deasle The CVA should secount for the counterparty defal probably, the transaction 1a question, netuingcllaterl, and hedging ova tape 2 als)xt(s)=0(4_1 ll were (9) = discount Fctons Incremental and Marginal CVA + brcrmonal Ch clasts the con of new trade serwr an exiting one to datermine he ect that dhe new ede ha on CVA. The oc identical to wand alone CVA, exep forthe eof ineremenl expeced exponire + Marginal CVA i sed for tide level asbution. “The formal idence to sandalone CVA, cep forthe us of marginal expected expec Risk-Neutral Default Probability Represents etimates of default probably based on observed matker pices of securities (¢, bonds, cred defal sap) ‘sk-neutaldefiul probability «real-world defsle pobabiicy + liguidicy premium + defsule ik prema Weong-Way Risk vs. Right-Way Risk Wrong-ay ite ncceen counterparty rk increases edit value sdjusmens (CVA) and decreases deb vale adjustment (DVA)). Rigi avay rick. decteaves counterparty tsk (decreases CVA and increases DVA) ga sa) Ges Risk-Adjusted Return on Capital ‘The RAROC measure isesential wo success inweprated risk management. fx main function isto relate the rerum on capital a he riskiness of firm investments. The RAROC i ik adjumed return divided by riseadj usted capital Ge, economic capita).‘An adjusted RAROC (ARAROC) measur was developed w beter alia thers ofthe busines with the fee Gis equ ‘Adjused RAR@C- RAROC-B.(R,,-R.) Model Riske Rick anociated with wing Gaancial modes we simulate complexsclaconships, Sowers of model tiskinclude mode ees, erorsin sumptions ander in implemearxion. Common mode cre ince mederestimatng sk fxs. miapplyng « model, sad suming conseat ‘elalsy normal disibodans, pnfct marke, and adequace liquid. Liquidiey Risk The lack ofa mack for asa 1 prveatit from being bought ot sold quickly enough ve Prevent of minimize 3 ose could ele mn set allocation, funding ates, collated Pobcies or mismanagement of tals. “Tramsaccions liguidiny ride risk chat the act of buying or ling an atc wll een a0 adver laced peeing real eae Veen xed peition i exherdeeicrating oF is perceived by marker paricipanns to be decorating. Liquidity-Adjusted VaR The coment rad aprech ecules bg idry- adjueed Vat (LYAR) suming the bideetk spread isrnaot ran) (Q5RV Dans (aes er amas 2 TR ends permet ended deta ere (ask price bid price) Gk ice Hd pee INR can aia be calculate given che Gixributooal characte ofthe spread. Tit jsnowa a he angranes red appre. Ifyou are piven the mean and standard deviation of the spe py te lovig forma VAR = VaR + 05 x(us +26 x09) x¥ spreads 9, = spread standard deviation = spread eonfdence paramere Liquidity at Risk (LaR) + Masimatn Lic ash oun oer du horzos tid spect conidene: xd, + Alo knows cach Sonat rie (CFARD + Aposive inet) valu for LaR mens che srercouenme wil be asecned ih an eto (nfow of ash + LaRiesinilar co Va, burned a change in sale & dss wi mh Bowe Entesprise Risk Management (ERM) In developing an ERM cyt, management shuld flow alli vo 1 Dasemiae dhe rai amp abled f 1 Bedon thems wre bt tng ei he piel Ges tale) roped op or te eae {eel of fin the seperti + Dezcrming the idea in fp nd idk he will achieve tie ppropine dbs rag. + Gane indiidss managers he infomationend he incre they seed w make deco speope: te msinain te ribepicl eae of. “The implementation sep of ERM are x follow: = Adcoeify che wicks of the firm. + Dendop + eostent method eo eta the por teen ds Firm: Wide VaR ms at aie alk (ABD eo ac poten Jos amuse wil ve mulepke VaR meets + Mikes rise rt i and operons. iw och produce ove VRinezn, + Doe o denim cl Gm-wide VR wl be les an the nw of ta aks Se a ek ay Ratio ‘Ams veage favo i equal ws ase divided by equity eeDE ETE Leverage Effect Renure on equity (ROE) isbigheras lorerage incre, along 25 the is eum on as (ROA) cured the ens: of borrowing funds. The leverage effect can be expresed a: ROE « (leverage rato x ROA) — ( everage ratio = 1) x cost of debe) ‘Transaction Cost The 99% conficlence interval on ecansaction eost is: ah Py Kb +2330) where: Pwesimase of he next diy ance midpice a= bid piead 1G + 2.534) =99% spread sk ator Operational Risk Data Elements ‘The four data cements thar a bank must use in ‘ratios combinations wo cies the operational {ik cpiol charge heel on the AMA framework sre (1) cera od, (2) exter dia, G) scemasio anadysic, and (4) business envirooment sd inte: nal coat czars BEICED. Basel If Operational Risk Event Types acer Frud 2 Exe Ped * Employment Pacts ad Woikglce Sey + Czoee Prods and Busan Prctien + Damage w Phys Aves. + Doi Darupion and Sy Fares + Eascaton, Oclvery, and Pome Mantes. Exvemal Loss Dame {1044 Ake F1RST.cabcripiondacbue:iaddes desriptions and analytes of operoal isk teres derived fam legal and regulary sources sad neva ales (OpeainalReshdate Xchange Aneciason (ORY: conser breed sk event eric sgsthers anonymous operon ik events 6m senbe, Toss Distribution Approach ‘The oe ditibution approach (LDA) is used to meet the Basel operabooal eis zandards for segplsory peal The LIA bas evel sepx +" Cganize and poup low dient a bse ine ‘ene pe mati Weight ever data point in the matic Medal Ton dizbacon i ach cl ofthe mati + Doermine the opensioel idk opin. euemens fer cach bust Bre. F Distributions ‘ode most ofen we the Pion Aimnbuson, the maguire tacomial dombuton, 2 the binomial dinnibion. + Prcsonen wgges only wing sta dea Imus its most leant end itdificut ‘conte the exmplarness of xem: daa. + Medsing the fancy ditab tion seguir lo {hea when compe we dling ety Severity Distributions + The wvetiy of ech even floras paramccic Asibuin, such = «Iogear dnibuion oa Webull dssbuson. + Sve dinibdome ae roca omar mone limporant than fequeny dsbucces + One problem with nding merit is hat scent inven loss daca may nox be wficent fer salibraag te el of de distin + Ging external dace wally cures sing the dam sed sorbining dom fom sera our rurchase ts (Repos) Pian aoa ate 124 speed prac wich s somites to buy bac the mary at foe dice igh pre. + From the pepectve ofthe beer pon ofr reaively cheap ote of shor tem finds, em te penpetie ofthe lender eves Pon sed fe he invting or Bcaneing Pope. Capital Plan Rule + Mandates that bank bing compaie devel + ‘apical plan and evan copia adequacy + Copia seq prow iodades k caanagencent Foundadon, ramus oat ‘Ssntion thd, pac on epi aoqy ‘opie planing od inurl eos pile and (precranae neigh Operational Risk Governance “The Basel Commies ceeppizes cree common lunes of defense used uw cael e eration is: (1) busines line eanagement, (2) independent prational ck mansgemensfubzin, and ) independent reviews of wperstonal ska and tisk anagrrent. Risk, te Framework (RAF) + Semi pace dest, fturotientod perpecine of ‘the fem target ri profile & number of diferent scenatics and mape out rtenegy forachieving dae sik profile. scare wit a sk appoie sxe dat iscucndaly 2 mision some fm ask gape. + Bente include ating fms in paring foe che napeaed and gray improving 3 in cape Ploning and tactical deciion-makng Basel I: Three Pillars Filler 1° Minimum capital reguiremens. Backs should maintain s minimum level of capital to ‘cover credit, mathe, and operaiona sks. Piller 2-Supervicry review proce Banks shoul see the adequacy of eat saive wo sk andsupervisor shauld view snd eke caresve setian if problems wcue Pilar 3: Marks divine, Risks Sou be adequately disclosed ard t llew mater perecipate to ates « bani it peal andthe deeuacy oF cap Basel Tl: Forms of Capital ‘er Ls harder equity reained coeningss noniedeemuble,nancumult ve prefered ack “ier 2; wndisclsed reterves,reveluat oa rere, general prouisionvgenera ean-lare sexes, Eybni debe espinal instument, and vubardicated tenn debe Credit Risk Capital Requirements ‘The nanderdzad approach incorpontes ‘ik weigher bused ob eneroal cede ting sracaiments. The amaunt of capil hae a bank rt had is specie tothe el fee ky ass, the ype of inst cut an che aim i writen dn, ad the strc of thon anes. ‘Phe ical ang bed (8) epproacher (Goundacian and advanced) uses bonis awn inva ex maes of eediwerthiness to dex:mine the ise weight agin eh epi elelasion. 1 nada ppt: an exit probably of dct (PD) + Adowacd approach bank ctictcs at oaly ED, tele lon pen cule (LGD) xpos a etl (EAD), and cbse macy Market Risk Capital Requirements Standarizad meted. dowresines capital charges asrocaned with various market rk expsures (equity nl intrest aes, foreign exchange "tk, commodity tt, and opt en se). The snare ak capital charge for each marker ik x computed a 8% of ts mother raky ses Teeral made approach (MLA): love a bale te use ns own sk management stern determine market ik opin charge. ‘The rarer charge i the higher of (1) che previous days aR or (2) the average VaR ovr the [nie 60 business dayeadjutted by « muleipiatve factor (object = Roar of 3) Backtesting VaR An except on occurs if the day’ change in velue snceodel the VAR etirace of the previous dy ‘hen bacaestng VAR, the numberof exceptions is determined for 250-day wing perad. Bosed on the number ofexcepians, che hank’ exposure is eategored into one of thie snes nd Va is sled up by tie appropiate mulkpir(subjec ra 2 aor of 3) * Green sone: exceptions incnate in exponte alii 0. + Yellow mone 5-9 exepions expose mul pli iecaees beeen 0.4 snd 088 + Redaene: Crewe than or equalto 18 ceepions, sruhipic ices by 1 Operational Risk Capital Requirements Basi indice approach meats the capil sharge on afimvide bai. Banks will had cpt fbr opersiensl ak qua. 10s Raed pecencge ache bales average anil goa income aver the prior thee ye. The Basel Cammitee has ropes 2 Fae perceanage equal 15%. Stendartned approach: lows baks vo divide seve long reandundized busines lines. ‘Within each busines line, Bess incame wil be mukiplied by fixed bew facoe. Yhe apitel change for operational isk s the sum of each business lines charges. The bem fecas for the cit busines lines re as follow: + Trading and sac 18% CConpora: Gna: 1856 Payment sclemant 189% Commercial banking: 159% Arpney sis 1386 emi banking 1256 emi brokerage: 12% ‘Asser ranagement 195 Aducaced Measurement Approach (AMA): Ifa bank, ‘on meet more rigorest supervisory standards, itmay use the AMA far eperatianal ri apical ‘aleulaions. The capital charge for AMCA is ‘alculited a he banks operstiona value at rik (@pVER) with 1-yearhorion and 199.9% confidence lev. Having insurance con edce this capitsl charge by as much 2s 204 Basel IIT 4 Mise apie seman bos qualry and quancy). + Suengthen 1k coverage of sail farsework + Regu leverage ati tsupplement epi cequnement. + Promos: evuneiycliat buffers daring franca shocks + ite plicis co addres sytemic sk and inecrmanestcines + Tawi loba liquidity sada (gui, funding, and monitoring meu. Liquidity Coverage Ratio Geal ensure bankshave adequate. high-quality liguid esses wo survive shor term sess senati. UCR = (stock af high-quatey lquid ase cml ee cash euflons overncat 34 elendar dap} > 100 Net Stable Funding Ratio Gach promer bunks ov longtime horizon shan LCR. [NSFR = (evalable amount of ble fonding/ ‘equine smounc of sls fonding) > 100 Stressed Value at Risk 'SVAR is calcula by cambining curtene portfolio. perfarmance daw with the fem’ hiserial daca ‘rom sipifcanly Gnancial steteed periad in the sine partflio, Calculates af SVaR a definad as fallow sax (SV3R,_., mubipinave Fite SVR) Solvency II Enmblishes capital tquirement forthe operatiansl investment, and underwriting rks of insurence companies * Specifies minimum spite requirement (MCRD andsaivcrcy pl rouicmenes SCR). + SCR may bewlcu sed using cther sanded approech ar incr! models aprosch + Stoned prac Ince fo kas septal insane ms; mp he tke prof ofthe netgeinsurancs fer. + Tinea! meds approach: Siac tn the 1B approech under Bac! AAR i lca wih {ayer tincbodean sa 99.54 wren: Dodd-Frank Act Trended ee protect consumers fem abuses and prevent ficurebailows and/or callapss of banks and other nancial firms. + Essblihed Financial Sbilisy Oversight Caunel seo) + Eneblithed Offceaf Financia Research (OF). + Boablihad Valecs Pale incnded w csr preprctarycrading by books. 1+ Banks considered oo big to fl must be dented aed could be broken up i their livng wil ae jiclged unacecpmble, + [eared regulation and improved transparency for srerthe-counres (@TC) detivatins, aD Ta Portfolio Construction Techniques 1 Screen simply choo ace by ranting apa ee eee includes anew fom al asc chee, + Tee tmp to contre & pots dar dently scab te beedirad, + Quai prograing explicitly conic aphe, (ik and canmesons om Portfolio Risk Diverifed aR. fel + whol + Vay = 2.20 Rn 2 Px we Ondiverifed VaR: VeRp = VaR? VaR] +2VAR, Vill, 2 VaR, + VaR Vek for Uncoelted Pavia Vat = (VAP + VoRE Martina! VaR per dollar change in porelie VaR. ‘hic occurs from an ddiional investmencin 2 pesiion Mar,- “xp, ceca Pte Mite pith Secale ele eeae ae teal MV rex alleen * Oban he oct gai acuta the VARs ofall perl postions Incremental Vale change in VaR from the addition ‘of new postian in portale Component VaR: smu of risk particular find ‘ontibuve: toa pordilio of funds, CVaR, = MVAR, x7, xP = Risk Manage eatabliahes risk budget forthe ene te perfolioand chen allecares isk w individsel petitions based ona predetermined fund risk level. ‘The risk budgeting pracess difers from marker vale allociion since i valves the allecatian af risk. Budgeing rte acon ae claw: selecting set. whose cambined VaRe ae es than che eatal allewed, Budgering rite acon active manager: the optimal allcotien i schieved with de follwing fermuls repprtelgampdby aoe ei pontlis'swacang coe TR} x maniger'e ching rorsquidicy Durst Apprsimatioa ofthe number of days ccsemacy te dipoe ofa pocdoli baldings without = ‘guicant marker inpact. umber of has of ouity tetera Dolkr-veighted rate ofrturn: the internal rte of ‘eum (IRR) on 2 porialio king ins accouat exh inflowszad ousdlews Timesveighed raw of rau measures compound powth, lis te rate at which S1 compounds weer & speified time horizon, ‘Measures of Performance “The Sharpe rai calcul the smount of excess requ (over the tok Bice rte) eaned per unit of tol sk, Keune standard deviation a1 the relevant measure of ak. erage scone turn += rvecagerskfe rerun 0, _= sundae deviation of account returns “The Tgp mean is very similar wo the Sharpe ‘io arp tat ic wes ex (ymematic i) asthe ‘mens of ick Ie hows exces exam (ve the riche fve cate) earned prune of sytematic Fisk. Fy = average secouae seta i= serge kieran BL = werage bea esis alphas the ditierence beeen sen srsurn and icc roquired wo compensa fot ‘yremszi tk To cleat the measure, subuee: the recro clcdated by the cape nee pricing sodel (CAPM) fren the aecoune return. m4 =R,-ER,) where os alphe Ry atheatum on dhesoount Ef) = »8,ER,) —R,) “The informacion ratios the co of spl cena (ina parcculapeniod) to sandard deviation Ie nae he amount of risk undermken (denominato) to achieve asertin Level of return shove the bench (aumento). Ry = BAR oe where: Ry 7 Beer scoune crim Re avetge rel fe rerum standard deviation of exces rts measured a8 the difference between account and benchmark returns “The Meagaared (34) mee compares reuca camed on the managed portato against the ‘sre rum, afer adjusting or differences ia seanderd deviations berwern the (wo portolio, Tecan be illuxrated by comparing the CML fer the matket index aod the CAL forthe managed portfolio. The differeace in eum between the ‘wo ponfolios equals che M? measur. Peformance Attribution ‘Ass alecation atvibtion equals the diffe fn retaas atrbueabl 1 score eset allocation decisions of the portfolio manager. Selation anribtion uals the difference i tenunsatsibumblewsuperior individual security selection (ant section of mispriaed secuntct) and sonar soca (correct ove a0 Underweghting of seeor wihin asct ase). Hedge Fund Serategjes Equity lengihors soap 0 lag and shoe Similar secuhies © exploit mizpicings— decreases ate dik snd generates alpha Globe macro args rakes leveraged bem 00 ancipated pine movemensin broad uty and Sxed-income mares incren rae, Forga change, and eoamodiic. “Managed fe te. Foose on ivesmcats in bond, equcy, eammodiy fara, and curency smackew around the wold. Employs ahh dee oflevenge because Frares contacts are sed ‘eed income brag matey longthoet sstegy that lok for pricing inetences bores vatiousRxcd-aeeme secure. Comerible wbioage mary avec purchases ‘convertible bond sad sell short he undedyig, Merger abitrge srangyinvelves purchasing ‘shares in x megs fem ad sling shor shes in the purchasing frm. Dinresed imering ray: purchase bord of dineesed company and sl shor the sock. anicipacng that he shares wil eventually be worl. Enoging marken money ives in developing counsied secures or soveregs debe. and of bade ferde prfoussrcesing and due dligence of other Funds Fens can be extensive, and thedve dligenae dacs no alway denify faud. Alezyadvencage is dive cation benee without large epic commitment liquid Asset Return Biases Biases chat espace reported iiquid asee reruns Sees ‘xporing rule ay fa or never begin ‘rporing ecnure bona porta i weak. + Secon bas: At vies ers ved w be __ fone when ay a high rading Bem, volte tod fone aco ow whe ey ae compu ‘ung the meported ett oF infequeny ded pen 3 007 8 (5BN-13: 9781475436208 oMerarsi4. WS.S2960 O20 6a, me Aight Resend. ce eur LLL lal |e uu Fy Best Practices in Risk Management + Use long time pariads to pot zy tends + Ue mote ate eng cin tab as scaoune rogue onges Do cot view isk miigewgacionsiniolion. + sablsh provisions fr love Lome + Cleat dematives though & CCP. Funding Mechanisms ‘Alow iasttios co obtain shor ces financing for finding requiemens. Meanizas indude See ys eels money masker mutual Svads,ceparchare oe oot mens ol le funding of nuo-U.S. banks. Lender of Last Resort (LOLR) Leading. Can help seo liquid ers befae ie worsens. Liquidity regulations should complessent LOLR solutions ‘Adveriage: I) liquid cesion for scien good ‘nd (2) promoves optimal Ia ofiquidicyand manus transformation, Challenges (1) potential mord bazar cose, (0) takes ue 0 determine if problem is marke tide lig even tnd Gtk ng coo md collateral for protean, Dimensions of Liquidity ‘tronodiac: Tame 10 compece a wansaction, ‘Begth ani rence: Frequency of large Wades and level of wilingess and imveres to wana Brahe Consixenoy in diserbring iquidiy ‘pti sue tnd cos acs ‘Tighimes: Cos oFcompleing ¢ transact ax Medeioad: Calta dor chs pice bux meanses snd mathe impact ets Reforming Benchmark Rates eco ea ieee LABOR, les suecpuible to manipulation, i sermenmended w (1) base benchmark exes 08 ‘manmosons (cathe: chan submissions) and @) we 1 second benchmark cate (e.g, Trasury bil ees, ratesactby canta banks, goer eolaked repo ‘he O1 axe) Central Counterparty Failures Mesuces to decease the probabil timp of CCP fire include increas! regulation and sandards for OCP, seoveryplanaing, iii wail through te earl bank bank capil requiceneass to emer OCP exposes, 20d planing, ‘solucion Swess Testing Evolution Je November 201, the Federal Reserve implemen ye of al cpl pln compl ene kon ache Com ipl Repo ted Review (CCAR) proce: pplesto bark haldng compacies (BCH) with Sibe blion in consol daed ase This anu renew proces erahles the Fel to have more ciely ‘information and to papery asst bank heath ty Framework +e cote ions: (1 det) pratt 9) dacs, (4) rapend, and 6) ewes + Ridconcismen: ines chasing Infermeton, ing vex wd vlncabiie mesuing {ik and eomumrvoing Tae + Proton mente ndode eutonee