1.

Basic Intro

2. What are derivatives and why are they used?

Derivatives can be defined as a financial instrument whose value depends on (or derives from) the values of
other, more basic, underlying variables.

There are two types of derivatives:

 Privately traded over-the-counter derivatives that do not go through an exchange or other intermediary.
This is the type of derivative you can buy from financial service providers such as banks.
 Exchange traded derivatives bought and sold through specialised derivatives exchanges or other
exchanges. These are standard contracts that you can buy and sell on an exchange without the need to
interact with an intermediary like a bank.

The four most common types of derivatives are futures, forwards, options and swaps.

Use of Derivatives:

Derivatives help companies manage risk and are increasingly used by firms seeking to protect themselves from
the volatility of financial markets.

3. Difference between Forward and Futures.

Fundamentally, forward and futures contracts have the same function: both types of contracts allow people to
buy or sell a specific type of asset at a specific time at a given price.

However, it is in the specific details that these contracts differ:

First of all, futures contracts are exchange-traded and, therefore, are standardized contracts. Forward contracts,
on the other hand, are private agreements between two parties and are not as rigid in their stated terms and
conditions. Because forward contracts are private agreements, there is always a chance that a party may default
on its side of the agreement. Futures contracts have clearing houses that guarantee the transactions, which
drastically lowers the probability of default to almost never.

Secondly, the specific details concerning settlement and delivery are quite distinct. For forward contracts,
settlement of the contract occurs at the end of the contract. Futures contracts are marked-to-market daily, which
means that daily changes are settled day by day until the end of the contract. Furthermore, settlement for futures
contracts can occur over a range of dates. Forward contracts, on the other hand, only possess one settlement
date.

4. Elucidate payoff profile of short put and differentiate it from long call.
5. Define Delta, Gamma, Vega and Theta

Delta is the rate of change between the option's price and a $1 change in the underlying asset's price – in other
words, price sensitivity.

Gamma is the rate of change between an option portfolio's delta and the underlying asset's price - in other
words, second-order time price sensitivity.

Vega is the rate of change between an option portfolio's value and the underlying asset's volatility - in other
words, sensitivity to volatility.

Theta is the rate of change between an option portfolio and time, or time sensitivity.

6. Diagrammatically comment on the above mentioned sensitivities for a long call/put.

7. What are the parameters for Black and Scholes?

Underlying Price
Time to Expiration
Volatility
Interest Rates
Strike Price
Dividend Yield if considered

To be exact, underlying price and time to expiration are variables and rest are parameters. But we can take all of
the above as input parameters.

8. Differentiate Realized and Implied Vols.

Realized volatility is also known as historic volatility and is the actual variance in the price of an option over
time. Realized volatility is measured in terms of the standard deviation of the price from an average.
The implied volatility is the volatility of the underlying which when substituted into the Black–Scholes formula
gives a theoretical price equal to the market price. In a sense it is the market’s view of volatility over the life of
the option.

9. Diagrammatically represent volatility surface (skew, forward skew, and reverse skew)

10. Expand on the Risk Reversal strategy.

Risk Reversal Investment Strategy:

A risk-reversal is an option position that consists of being short (selling) an out of the money put and being long
(i.e. buying) an out of the money call, both with the same maturity. A risk reversal is a position which simulates
profit and loss behaviour of owning an underlying security; therefore it is sometimes called a synthetic long.
This is an investment strategy that amounts to both buying and selling out-of-money options simultaneously.

Risk Reversal (measure of Vol-skew)

Risk reversal can refer to the manner in which similar out-of-the-money call and put options, usually foreign
exchange options, are quoted by finance dealers. Instead of quoting these options' prices, dealers quote their
volatility.

For a given maturity, the 25 risk reversal is the Vol of the 25 delta call less the Vol of the 25 delta put. The 25
delta put is the put whose strike has been chosen such that the delta is -25%.

FX Questions:

11. What is a base currency and counter currency.

In the FX market, currency units are quoted as currency pairs. The base currency – also called the transaction
currency - is the first currency appearing in a currency pair quotation, followed by the second part of the
quotation, called the quote currency or the counter currency.

12. Assuming USDINR is at 60 with forecast of USD appreciation, which option would you purchase?

Call option on USDINR.

13. If Vols are going to increase then which position would you prefer? Long Call or Short Put?

Long Call

14. CNY vs CNH

Onshore – CNY and Offshore - CNH

Bloomberg describes the CNY as a reference rate and not a rate at which a US company can exchange USD for
Chinese currency. CNH on the other hand they define as a rate at which entities can exchange USD for Chinese
currency albeit through Hong Kong. The two rates are rarely more than a few pips apart.

15. Define CCY arbitrage.

Triangular arbitrage (also referred to as cross currency arbitrage or three-point arbitrage) is the act of exploiting
an arbitrage opportunity resulting from a pricing discrepancy among three different currencies in the foreign
exchange market. A triangular arbitrage strategy involves three trades, exchanging the initial currency for a
second, the second currency for a third, and the third currency for the initial. During the second trade, the
arbitrageur locks in a zero-risk profit from the discrepancy that exists when the market cross exchange rate is
not aligned with the implicit cross exchange rate. A profitable trade is only possible if there exist market
imperfections. Profitable triangular arbitrage is very rarely possible because when such opportunities arise,
traders execute trades that take advantage of the imperfections and prices adjust up or down until the
opportunity disappears.

Currency arbitrage is a FX strategy in which a currency trader takes advantage of different spreads offered by
brokers for a particular currency pair by making trades. Different spreads for a currency pair imply disparities
between the bid and ask prices. Currency arbitrage involves buying and selling currency pairs from different
brokers to take advantage of this disparity.

IR Questions:

16. How is a yield curve generated?

Yield curve is constructed using the most liquid instruments available in the market. For e.g. USD Derivatives
curve is created by using deposit rates in the short tenor (Till 6M), Euro-Dollar futures in the middle tenor (Till
18M) and USD swaps for the long tenor (more than 18M).

The constructed curve is then bootstrapped using the respective conventions (Day count, compounding
frequency etc.) to obtain the zero curve that is used for discounting and forward cash flow generation.

17. How is the Price of bond calculated? What are the Bond sensitivities (Duration, Convexity)? Can
Convexity be negative?

18. What is a swap, which Swaption would you prefer in a selloff scenario with high volatility?

A swap is an instrument where you exchange cash flows with a counterparty. They can be:

a. Interest rate swap - Pay Fixed/Receive Float (or vice versa); Generally No Principal exchange
 b. Cross Currency Swap - Pay Fixed in CCY1 and Receive Floating in CCY2 (or vice versa); In this case
the principal is exchanged at the maturity of the swap

A swap has following parameters

a. A fixed leg and a floating leg (In a cross currency swap both legs can be fixed also)
b. Payment frequencies (Fixed and Float legs) / Payment dates
c. Floating leg index on which the Floating leg cash flows will be based
d. Floating Leg spread (over the Floating arte Index)
e. Day count conventions for both legs
f. Business day conventions
g. Payment currency
h. Discount curve (s)

A swaption (swap option) is the option to enter into an interest rate swap or some other type of swap. In
exchange for an option premium, the buyer gains the right but not the obligation to enter into a specified swap
agreement with the issuer on a specified future date.
Long swaption on Receive Fixed and Pay Float swap

19. What is the FED rate that was increased by a quarter % and how is it calculated?

In the United States, the federal funds rate is the interest rate at which depository institutions (banks and credit
unions) lend reserve balances to other depository institutions overnight, on an uncollateralized basis.

20. Explain the Interest Rate Parity using carry unwind principle.

Simple Interest rate parity

Given foreign exchange market equilibrium, the interest rate parity condition implies that the expected return on
domestic assets will equal the exchange rate-adjusted expected return on foreign currency assets. Investors then
cannot earn arbitrage profits by borrowing in a country with a lower interest rate, exchanging for foreign
currency, and investing in a foreign country with a higher interest rate, due to gains or losses from exchanging
back to their domestic currency at maturity.

Link: https://en.wikipedia.org/wiki/Interest_rate_parity

21. Do negative rates exist?

Yes. The Bank of Japan, the European Central Bank and several smaller European authorities have ventured
into the once-uncharted territory of negative interest rates.

22. What is VaR? What are the different types of methods for calculation of VaR? What are their
advantages and disadvantages?

Var Computation
 VaR-Covar
 Historical simulation
 Monte Carlo

VaR parameters
i. Confidence level - For Economic capital its decided based on the rating of the Bank
ii. Liquidity horizon - This can be based on the liquidity of the asset class i.e. how much time it will take
to liquidate/hedge the asset without adversely impacting the price of the asset
a. One way to do it is to take input from the respective traders on what is their view on the
liquidity horizon of the asset and then backtest the same on the data during the stress period
 b. Another method is to compute Bank’s market share with respect to the overall market and
based on this percentage determine the time it will take to liquidate the entire portfolio of the
Bank
iii. Weight - How to calibrate (Compare forecasted data with actual data and minimize SSE to compute
weight)
iv. Lookback period (For HS VaR)
a. If exponentially weighted VaR is being computed, then as per regulatory guidelines the
effective look back period should be at least 6 months. Hence, depending on the value of
Lambda (97%, 99% etc.), the actual look back period can be determined (can be 500 days or
more)
b. Also, in HS VaR computation we would want the PL distribution to be Independent and
Identical in nature (i.e. without any auto-correlation and stationary). Hence the lookback
period can correspond to the period where the distribution is IID

Full revaluation approach

Sensitivity based approach - Taylor series
Partial Reavaluation

23. What is marginal vaR, Incremental VaR and Conditional VaR?

Marginal VaR - Existing asset

Incremental vaR - New asset
Conditional VaR - Losses in the tail (Weighted average loaaes in the tail)

24. How is VaR of 5Y fixed rate sovereign bond with semi-annual coupons calculated using sensitivity
based HistSim method?

i. Strip the bond into 10 ZC bonds

ii. Calculate PV01 for each of the stripped bonds
iii. Calculate historical shocks for each of the 10 tenor points using historical data of the zero curve
iv. Multiply the historical shocks of each tenor with respective tenor PV01s to obtain the 10 PnL vectors
v. Add the 10 PnL vectors to obtain the final PnL vector and calculate the VaR at desired quantile

25. What is expected shortfall and its advantages?

i. Captures tail risk

ii. Sub-additivity

26. What is backtesting? What are the various backtesting tests?

i. Traffic light approach

ii. Kupiec Test
iii. Christoffersen’s Test

27. How to handle missing market data?

i. Use proxies
ii. Use interpolation logic
iii. Use Brownian Bridge - How to implement in excel (Use randbetween function along with any
distribution based on the underlying distribution assumption; Ran() function in excel is uniformly
distributed)

28. Stress Testing Questions

i. Identification of major risk factor using correlation analysis or PCA

ii. Scenario generation
iii. Scenario expansion
iv. Stress PL computation using full revaluation or sensitivity based approach