FRM Juice Notes 2019 PDF Free

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JuiceNotes 2019
Financial Risk Manager (FRM) - Part I

https://www.fintreeindia.com/ © 2019 FinTree Education Pvt. Ltd.
INDEX
Book 1 -Foundations of Risk Management Concepts
Sr. No Name of Reading Page No.
1 Risk management : Helicopter View 1
2 Corporate Risk Management : A Primer 7
3 Corporate Governance and Risk Management 10
4 What is ERM 13
5 Risk Management, Governance, Culture, and Risk Taking 15
6 Financial Disasters 18
7 Deciphering the Liquidity and Credit Crunch 2007-08 21
8 Getting Up to Speed on the Financial Crisis 25
9
10
11
12
Risk Management Failures
ee
The Standard Capital Asset Pricing Model
Applying CAPM to Performance Measurement
Arbitrage Pricing Theory and Multifactor Models
30
31
38
39
13 Principles of Effective Data Aggregation and Risk Reporting 42
r
14 GARP Code of Conduct 47
nT
Book 2 - Quantitative analysis

15 Probabilities 51
16 Basic Statistics 57
17 Distribution 65
18 Bayesian Analysis 72
Fi
19 Hypothesis Testing and Confidence Intervals 76

20 Linear Regression with One Regressor 84
21 Regression with Single Regressor 88
22 Linear Regression with Multiple Regressors 92
23 Hypothesis Tests and Confidence Intervals in Multiple Regression 95
24 Modeling and Forecasting Trend 100
25 Modeling and Forecasting Seasonality 104

26 Characterizing Cycles 106
27 Modeling Cycles : MA, AR, and ARMA Models 109
28 Volatility 111
29 Correlations and Copulas 115
30 Simulation Methods 118
Book 3 - Financial markets and products

31 Banks 122
32 Insurance Companies and Pension Plans 125
33 Mutual Funds and Hedge Funds 131
34 Introduction ( Options, Futures and Other Derivatives) 133
35
36
37
38
Mechanics of Future Markets
Interest Rates
ee
Hedging Strategies Using Futures
Determination of Forward and Future Prices

135
138
140
147
39 Interest Rate Futures 156
r
40 Swaps 159
41 Mechanics of Options Markets 166
nT
42 Properties of Stock Options 169

43 Trading Strategies Involving Options 171
44 Exotic Options 174
45 Commodity Forwards and Futures 178
Fi
46 Exchanges, OTC Derivatives, DPCs and SPVs 181

47 Basic Principles of Central Clearing 183
48 Risks Caused by CCPs 185
49 Foreign Exchange Risk 187
50 Corporate Bonds 190
51 Mortgages and Mortgage-Backed Securities 192
Book 1 - Foundations
of Risk Management
Concepts
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Risk Management : A Helicopter View

LO 1.1 Concept of Risk
Risk arises from uncertainty regarding an entity’s future losses as well as future gains
Risk as Unexpected loss
Watch video with important
testable concepts here
Value-at-Risk Economic Capital
Ÿ Loss in terms of it’s chances of Financial cushion that a bank

occurrence i.e. the confidence employs to absorb unexpected
level of the analysis losses
Ÿ Useful in :
i. Liquid Position
ii. Normal market conclusion
iii. Short time period
ª Risk = Variability of unexpected adverse outcomes

ª Financial Risk = Volatility ( A special case of variability ) of unexpected losses
Risk
r Ÿ
Ÿ
Ÿ
Ÿ
What it is NOT
Size of a cost/loss.
Expected loss
Peril = Cause of loss
ee
Hazard = Condition that increases
probability
(frequency/severity) of loss
Ÿ
What it is
It is potential for unexpected

loss
Ÿ Variability of unexpected loss or
adverse outcome
LO 1.2 Risk management process

nT
Ÿ Identify the risk

Ÿ Quantify and estimate the risk exposures or determine appropriate methods to transfer
the risk
Ÿ Determine the collective effects of the risk exposures or perform cost benefit analysis
on risk transfer methods
Ÿ Develop a risk mitigation strategy
Ÿ Assess performance and amend risk mitigation strategy.
Two key problems - 1.Identifying the correct risk

Fi
2.Finding an efficient method of transforming the risk.
Challenges in the risk management process
Ineffective policies
Risk must be dispensed No overall risk due to derivatives
among willing and able Failure in preventing elimination rather trading leading to
participants market disruptions and transforming of risk overstating of the
(failed in 2008 financial accounting frauds from one party to financial position and
crisis) another understanding the
level of risk
1
LO 1.3 Measuring and Managing Risk
ª VaR is useful in: Ÿ Liquid positions
Ÿ Normal market conditions
Ÿ Short time period
Tools and procedures of Measuring and Managing Risk
Enterprise Risk
Quantitative Qualitative
Management
1.Scenario analysis: 1.Integrated approach to

1.VaR
Worst case scenario : Effects of risk management
2.Economic capital
macroeconomic scenario 2.Uses economic capital
2.Stress testing: and stress testing
Financial outcome based on 3.Consider entity wise risk
stressed inputs.
LO 1.4
Loss
è
of goods
Expected Loss
Ÿ Loss in the normal course of business
Ÿ Can be computed in advance with ease:
For financial institutions, it could be

recovered by charging commissions or
ee
è For retail business, it is priced into cost
Ÿ
business.
Unexpected Loss
Loss outside the normal course of
Ÿ Very difficult to predict

Ÿ Correlation risk drives up the potential
losses to the unexpected levels.
by implementing spreads.
r
LO 1.5 Risk and Reward
nT
Relationship between Risk and Rewards
Publicly traded securities Non-Public traded securities
Ÿ It is much easier to examine through It is very difficult because there is market price
credit risk that is accounted in yield spread validation.
Ÿ But liquidity risk, taxation impacts and risk
Fi
tolerances disguise the trees relation

between risks and returns.
Impact of conflicts of interest on management

1. Poor risk management leads to
a)overstating of potential returns
b)understating of potential risk
2. a)Due to no adjustment for risk
b)Due to ignoring correlation risk
3. Compensation based on ‘mark to market’ or ‘mark to market’
4. Profits are paid today that may turn out illusory, while the cost of any associated risk is
. pushed into the future.
2
Financial Risk
https://www.fintreeindia.com/
Fi
Credit Risk Market Risk
Gap risk
Ÿ Interest rate risk

Loan portfolio risk Transactional risk Ÿ Trading risk
nT
Foreign exchange risk
Ÿ Commodity price risk
Ÿ Equity price risk
Ÿ
Ÿ
Ÿ
Ÿ
Correlation risk
r
Concentration risk
Portfolio maturity risk

Liquidity risk
Ÿ
Ÿ
Ÿ
Ÿ
Default risk
Bankruptcy risk
Downgrade risk
Settlement risk
Ÿ
Ÿ General Market risk
Specific risk or idiosyncratic risk
Ÿ Systematic Risk:
Failure of one institution leading/triggering a chain reaction/domino effect on other institutions and
consequently collapse of entire financial market and even the global economy
ee
Ÿ ‘Margin Call’ triggered due to losses at an institution and leads to further increased ‘margin calls’.
3
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Market Risk
Investment losses due to change in market policies
Interest Rate Risk Foreign Exchange Risk Commodity Price Risk Equity Price Risk
Increase in market interest rate Losses due to open/ Price volatility of commodities
Fi Volatility of stock prices
leads to devaluation of fixed importantaly hedged positions due to concentration of
income security in particular foreign currency specific commodities with few
denominated assets and market players
liability
nT
1) Gap Risk Ÿ Imperfect correlations in the Ÿ Lack of liquidity 1) General Market Risk
movement of currency prices Ÿ Sudden price jumps
Ÿ Fluctuations in international
interest rates
Ÿ Losses due to sensitivity of that
r
Risk arising in the balance sheet
due to different sensitivity of
asset and liabilities to changes of
interest rates
portion of stock price to unique
factors of the entity (e.g: line of
business,strategic weakness)
Ÿ Can be diversified
2) Trading Risk 2) Specific Risk or

Idiosyncratic Risk
ee
Ÿ Curve risk:
No hedge against a change in Ÿ Losses due to sensitivity of periodic
the shape of yield curve value to changes in broad stock market
Ÿ Basis risk: indices
Unhedged / partially hedged Ÿ Cannot be eliminated through
portfolios due to imperfect diversification
correlation Ÿ Also known as systematic risk
4
Credit Risk
Loss from the failure of the counterparty to fulfill it’s contractual obligation or from the
increased risk of default during the term of the transaction

Fi
Transactional Risk
1. Default risk 2.Bankruptcy risk 3. Downgrade risk 4. Settlement risk

nT
Non payment of Liquidation collateral Decrease in credit In derivative
interest / principal value insufficient to worthiness of a transaction the losing
recover full loss on counterparty to a party refuses to pay
default transaction winning party
r
Loan portfolio risk
ee
1.Concentration risk 2.Correlation risk 3.Portfolio maturity risk 4.Liquidity risk
Lack of diversification Default at same time Loans maturing at same time Less cash inflow due to
maturity risk
5
LO 1.6: Risk Classes
Liquidity Risk
Funding Liquidity Risk: Ÿ Loss when an entity is unable to
a)Pay down/refinance its debt
b)Satisfy any cash obligations counter party
c)Fund any capital withdrawal.
Trading Liquidity Risk: Ÿ Loss when an entity is unable to buy/sell a security at

the market price due to absence (temporary) of a
counter party.
Operational Risk
Ÿ Are all the non financial problems

Ÿ Includes natural disasters, technology, risk, fraud, human error, inaccurate valuation of
complicated derivatives, incompetent management, etc.
Legal and Regulatory Risk
Ÿ Classified as operational risk in Basel II

Ÿ In derivative market, legal risk are only apparent when a counter party or an investor
losses money on transaction and decides to sue the provider firm to avoid meeting its
obligations
position. ee
Ÿ Regulatory Risk is a loss due to impact of change in tax laws on the market value of a
Business Risk
Financial loss due to decreased revenues and or the increased cost
Strategic Risk Reputation Risk

r
nT
Loss incurred due to Ÿ Belief that an enterprise can and fulfill its
promises to counter parties and creditors. Eg.
Ÿ Failure of a new business investment Lehman Bros. collapse
Ÿ Unsuccessful change in business strategy. Ÿ Belief that an entity is a fair dealer and
ethical practices.
Ÿ Social media risk
Fi
6
Corporate risk management :A Primer

LO 2.1 Hedging risk exposures Watch video with important
Modigliani & miller argued that value of firm will remain constant despite any attempt
Ÿ
to hedge risk exposures
Ÿ Due to unreasonable assumptions above argument is considered weak
Hedging Risk
Advantages Disadvantages
Ÿ Lowers the cost of capital

Ÿ More debt can be borrowed at cheaper
rate and with fewer conditions &
restrictions ,thus increasing the Ÿ Distracts management
investment opportunities Ÿ Un-monitored risk management
Ÿ Stability in earning strategy could be more fatal
Ÿ It controls the financial performance of Ÿ Compliance cost
Ÿ
Ÿ
Ÿ
Ÿ
board of directors.
Operational improvement
Cheaper than purchasing insurance
Allows tax saving
Practice it is not true
ee
the firm ,to meet the requirement of its Ÿ Due to difference between accounting
earnings and cashflows
LO 2.2&2.3 Hedging decisions

r
The role of Board Of Directors
Step 1: Determining and defining the ‘Risk Appetite’ in 3 ways

nT
a) Classifying risks as i.Tolerable (to be left unhedged)

ii.Intolerable (to be hedged)
OR
b) Quantity stating the value of tolerable risk ( using VaR)
OR
c) Using stress testing to articulate their Risk appetite
Ÿ Board faces a key dilemma when setting the Risk appetite due to potential conflict between
debtholders and shareholders
Fi
Ÿ Both accounting and economic profits can not be hedged simultaneously. Thus ,there is a trade off
between the two.
Step 2: ª Objectives / goals must be stated clearly and not in the form of slogans , such as
“maximum profit at minimum risk”.
Step 3: ª Gitorias for evaluating the achievement of objectives must be set in advance
Step 4: ª Clarify its objectives in terms of hedging accounting or economic profit
Step 5: ª Time horizon to achieve the goals must be definitive
Step 6: ª Define risk limits to allow management to operate within the zone of prices and rates
7
Defines risk appetite
Board of Drectors
Maps risk as A,B & C
Management Step 3
Cash flow
Currency risk
statement
Step 1 Timing of
inflows &
Balance sheet outflows of
foreign currency
Effect on asset
and liability in Step 2
foreign
currency. Income statement
Effect on sales & expenses in different

A - Insurable risk
currencies
B - Hedgable risk
C - Non - insecurable & non - hedgable risk
LO 2.4 ee
Hedging operational and financial risks
Foreign currency risks -

Hedge B.S, I.S and cash flow statement using a) Currency put option b) Forward
Hedging risk of a firm

r
Operational risk Financial risk
nT
Cost (production) and revenue (Sales) Effect on balance sheet hedge

hedging ‘Income statement’ ‘Balance sheet’
Pricing risk Interest rate risk
Use futures/forwards Use interest rate swaps

Fi
Static vs. Dynamic Hedging Strategies
Ÿ Static hedging strategy is a simple process in which the risky investment position is
initially determined and an appropriate hedging vehicle is used to match that position as
close as possible and for as long as required.
Ÿ In contrast, a dynamic hedging strategy is a more complex process that recognizes that
the attributes of the underlying risky position may change with time. Assuming it is
desired to maintain the initial risky position, there will be additional transaction costs
required to do so. 8
LO 2.5 Risk management instruments
Ÿ Exchange-traded instruments cover only certain underlying assets and are quite standardized
(e.g., maturities and strike prices) in order to promote liquidity in the marketplace.
Ÿ OTC instruments are privately traded between a bank and a firm and thus can be customized to
suit the firm’s risk management needs.
Ÿ In exchange for the customization, OTC instruments are less liquid and more difficult to price
than exchange-traded instruments.
Ÿ In addition, there is credit risk by either of the counterparties (e.g., default risk) that would
generally not exist with exchange-traded instruments.
r ee
nT
Fi
9
Corporate Governance and

Risk Management Watch video with important
LO 3.1 Best practices in corporate governance

Corporate governance Ÿ Board of directors should be comprised of majority of independent
member
Ÿ All members should posses a basic knowledge of the firm’s business
and industry, even if they are outside of the industry if someone who
lack knowledge should be provided some supplemental training prior
to joining board
1.The board should be watching out for the interests of the shareholders & other stakeholders.
2. The compensation committee within the board should design management compensation
plans so they are congruent with corporate goals in addition to minimizing or reducing agency
risk.
3.The board should maintain its independence from management.
4.The chief executive officer (CEO) would not also be the chairman of the
board because there is already an inherent conflict with the CEO being on both the
management team and the board of directors.
ee
5.The board should consider the introduction of a chief risk officer (CRO).
6.The CRO would technically be a member of management but would attend board meetings.
7.The CRO’s objective would be to link the corporate governance duties to the firm’s risk
management objectives.
8. CRO could report to the board and/or the management team, depending on the specific
nature of the CRO role within the firm.
Risk Management Economic performance is more important than accounting performance

r
Ethics committee is responsible for monitoring duties to ensure that those
standards are upheld.
Compensation should be determined based on performance on a risk-adjusted
nT
basis.
The board should be prepared to pose probing and relevant questions to

management and other staff in the context of professional skepticism.
Risk committee members need to understand the technical risk issues (e.g.,
risk appetite, relevant time period) in order to ask appropriate questions
and make informed decisions.
Risk committee should be separate from the audit committee given the
Fi
different knowledge base and skills required in each area.
LO 3.2 & 3.4 Risk governance

Risk advisory director
Ÿ A board member Ÿ Also meets senior management on regular

Ÿ Risk specialist basis
Ÿ However, it may be useful to have at least on Ÿ Act as liason between board and management
member on both committees to ensure that the Ÿ Educates members on best practices in both
committees are working toward same corporate corporate governance and risk management
objectives
10
Risk management committee
è Risk management committee (within the board) is responsible for identifying, measuring,
and monitoring financial risks (i.e., credit, market, liquidity).
è Responsible for approving credit facilities that are above certain limits or within limits but
above a specific threshold.
è Monitors the composition of the bank’s lending and investment portfolios in light of the
current economic environment in terms of credit, market, and liquidity risk to determine if
any changes in the portfolio composition are required.
è Risk management committee opens line of communication with the external audit,
internal audit, and management teams.
Compensation Committee
Ÿ Exists because of agency risk

Ÿ There could be the absence of any
Ÿ The compensation committee is independent
guaranteed bonuses or a cap could be
of management.
implemented on bonuses.
Ÿ Its role is to discuss and approve the
Ÿ Committee may consider introducing
remuneration of key management personnel.
elements of downside risk with management
Ÿ Committee should avoid designing
compensation.
compensation plans with bonuses based on
Ÿ It is not a perfect solution because there is
short-term profits or revenues given the
still potential for management to take
relative ease in which management may
excessive risks; their upside potential is
manipulate those amounts.
theoretically unlimited based on the stock
Ÿ Stock-based compensation is a potential
ª
solution to align management and
shareholder interests
LO 3.3
ee price increase but their downside potential is
limited if the stock becomes worthless
Risk appetite and Business strategy

A firm’s risk appetite reflects its tolerance to accept risk
ª There must be a logical relationship between firm’s risk appetite and business strategy
ª To make sure that a firm’s risk management plan aligns risk appetite with business decisions, the
r
firm should rely on its risk infrastructure while taking into account incentive compensation plans. An
appropriate infrastructure should be in place to allow the firm to identify, evaluate, and manage all
relevant risks. The results of incentive compensation plans should also be monitored to ensure that
the firm’s risk-adjusted return on capital meets the long-term expectations of stakeholders.
nT
LO 3.5 Interdependence of Functional units

ª The various functional units within a firm are dependent on one another when it comes to risk
management and reporting. All transactions must be recorded correctly and in the appropriate
period in order to ensure the accuracy of the periodic profit and loss (P&L) statements.
ª Using an investment bank, consider five separate units: (1) senior management, (2) risk
management, (3) trading room management, (4) operations, and (5) finance.
Fi
11
Senior Management Trading Room Management

• Approves business • Establishes and manages
plans and targets risk exposure
• Sets risk tolerance • Ensures timely, accurate,
• Establishes policy and complete deal capture
• Ensures performance • Signs off on official P&L
Interdependence Operations
Risk Management
• Develops risk policies • Books and settles trades
• Monitors compliance to • Reconciles front- and
limits back-office positions
• Manages risk committee • Prepares and decomposes
process daily P&L
• Vets models and • Provides independent
spreadsheets mark to market
• Provides independent • Supports business need
view on risk
• Supports business need
ee Finance
•Develops valuation and
finance policy
• Ensures integrity of P&L
• Manages business
planning process
r
• Supports business need
nT
LO 3.6 Audit committee
ª Audit committee responsible for accuracy of the firm’s financial statements and regulatory
reporting requirements.
ª It monitors the underlying systems in place regarding financial reporting, regulatory
compliance, internal controls, and risk management
ª Also largely meant to be independent of management but it should work with management
and communicate frequently to ensure that any issues arising are addressed and resolved
ª Audit committee in terms of meeting minimum (or higher) standards in areas such as legal,
Fi
compliance, and risk management
12
What is ERM?
LO 4.1 Enterprise risk management testable concepts here
One risk type can affect another, and risks (or their hedges) can be offsetting if viewed from
the perspective of the entire company
Treating each primary risk type in isolation ignores these interdependencies and can result in
inefficient and costly overhedging of risks at the firm level
various functional units responsible for evaluating and measuring risks may all use different
methodologies and formats in their risk measurements.
Define ERM: “Risk is the variable that can cause deviation from an expected
outcome. ERM is a comprehensive and integrated framework for
managing key risks in order to achieve business objective, minimize
unexpected earnings volatility, and maximize firm value.”
LO 4.2 ERM benefits and costs
1.Integration of Risk Organization:Increased 2.Integration of Risk Transfer: Better Risk

Organizational Effectiveness Reporting
Ÿ
Ÿ
An effective ERM strategy aggregates these
risks under a centralized risk management
process.
ee
(CRO) is often created, which reports to the
company’s chief executive officer (CEO)
and/or the board, while the various risk
management units report to the CRO
Ÿ ERM enables the company to take a holistic
view of all risks and risk hedges used in order
to hedge only those undesirable residual
risks that still remain after factoring in
diversification across risks
Ÿ Risks are categorized under a risk dashboard
of key risks, which includes an enterprise
level description of key exposures, total
losses, policy exceptions, and even early
r
warning indicators
nT
3.Integration of Business Processes: Improved

Business Performance
Ÿ ERM can optimize business performance through
business decisions, including capital allocation,
product development and pricing, and efficient
allocation of resources which results in reduced
risk and only takes on the most profitable risks
(i.e., maintains only those risks whose cost is less
than the benefit of the corresponding project)
Fi
Ÿ Cost of risk < benefit of corrosponding business
LO 4.3 The chief risk officer

Responsibilities: Ÿ The CRO is responsible for all risks facing a company, including market, credit,
operational, and liquidity risks,and specifically responsible for developing and
implementing an ERM strategy
Ÿ Reporting to the CRO typically are the heads of the various risk functions, including
the heads of credit, market, operational, and insurance risks
Ÿ Also measuring and quantifying risks and setting risk limits, developing the requisite
risk systems, and communicating a clear vision of the firm’s risk profile to the board
and to key stakeholders 13
Ÿ CRO typically reports to the CEO or the chief financial officer (CFO); however, the role is
placed somewhere between the CEO/CFO and the board
Ÿ An ideal CRO possesses five critical skills: (1) leadership, (2) power of persuasion, (3)
ability to protect the firm’s assets, (4) technical skills to understand all risks, and (5)
consulting skills to educate the board and business functions on risk management.
LO 4.4 ERM framework components
1. Corporate governance Ÿ Adequately control risks

Ÿ A successful corporate governance framework requires that senior
management and the board adequately define the firm’s risk appetite
and risk and loss tolerance levels
Ÿ Management should remain committed to risk initiatives and ensures
that the firm has the required risk management skills and
organizational structure to successfully implement the ERM program
2. Line management Ÿ Management of activities that relate directly to producing a firm’s
products and services.
Ÿ It integrates business strategy into corporate risk policy, assesses the
relevant risks, and incorporates them into pricing and profitability
decisions
Ÿ Managers should include the cost of risk capital and expected losses
in decisions about product pricing or investment returns.
ee
3. Portfolio management Ÿ Provides a holistic view of the firm’s risks if these risks are viewed as
individual components of the aggregate risks facing the firm
Ÿ Active portfolio management aggregates risk exposures and allows
for diversification of risks (partly through offsetting risk positions)
and prudent monitoring of risk concentrations against preset limits
4. Risk transfer Ÿ Risk transfer reduces or transfers out risks that are either undesirable
risks or are desirable but considered concentrated (i.e., excessive
risks)
Ÿ Natural hedges within the portfolio could also be incorporated into
r
the risk transfer process to reduce hedging and insurance costs, even
in the absence of third-party protection.
5. Risk analytics Ÿ Quantifies risk exposures for use in risk analysis, measurement, and
nT
reporting.
Ÿ Risk analytics can be used to calculate the cost-effective way of
reducing risk exposures, useful in evaluating the cost of managing
risks in-house or externally as long as the cost of managing them
externally is cheaper. The analysis and quantification of various risks
can ultimately increase shareholder value, boosting (NPV) and
economic value added (EVA).
6. Data technology
Fi
and resources Ÿ It improves the quality of data used in evaluating risks.
7. Stakeholder Ÿ It facilitates communicating a firm’s internal risk management

management process to external stakeholders, including shareholders, creditors,
regulators, and the public
14
Risk Management, Governance,

Culture, and Risk taking in Banks
LO 5.1 Optimal level of risk Watch video with important
Methods to determine O.L.R exposure Ÿ Targeting a certain i. Default probability

ii.Specific credit rating
Ÿ Sensitivity analysis or scenario analysis
Ÿ Targeting a certain default probability or targeting specific credit rating

Ÿ Bank should not always aim to earn highest credit rating possible
Ÿ Earning AAA rating likely involve large opportunity cost as bank would have to forego risky
projects that could otherwise earn high profits
LO 5.2 Risk - taking implications

Ÿ Optimal level of risk depends on specific focus of the bank’s activities, it differs among banks
For example, a bank that is focused on deposits, relationship lending customers or both
would usually set the level of risk lower and target a higher credit rating in order to satisfy
it’s customers desire for safety
Ÿ
Ÿ
counterparty to deal with
ee
The same would occur if the bank is a frequent counterparty in long term derivatives
transactions; the other counterparties would want to ensure bank is safe & reliable
A bank that is focused more on transactional activities would usually set the level of risk
higher and target a lower credit rating
Ÿ Overall, banks need to take on an optimal amount of risk in order to maximize shareholder
value while satisfying constrains imposed by bank regulators
r
Bank value as a function of bank risk measure by the banks’s credit rating
nT
Value of
Bank
(Self deposit banks)
Vsafe
(Transactional activities)
Vrisky
Fi
AA BBB
Credit rating
15
LO 5.3 How Risk management add or destroy value of bank
Ÿ If incremental changes in risk taken do not result in much change in the value
of a bank, then investing in risk management is destroying the bank’s value
due to the fixed cost of having a risk management department.
Ÿ However, if taking on incremental risk would otherwise result in excessive total

risk and a significant decrease in the bank’s value, then there is added value in
having risk management policies to prevent the bank from taking on excessive
risk.
LO 5.4 Risk management challenges and limitations
Limitations of Hedging
Risk measurement Risk taker

Hedging
technology incentive
limitation
limitation limitation
Ÿ Real - time risk measures

do not exist for entire
banks although they do
exist for certain banking
activities
ee
In theory, hedging would
reduce risk perfectly if a
bank was able to measure its
risk perfectly. However in
Some risk takers within bank
(e.g. Traders) are motivated
to maximize their
compensation by taking
practice, many risks are
excessive risks that may
Ÿ Additionally, risk nearly or entirely impossible
ultimately reduce the value
r
measures are far from to hedge e.g - correlation
of bank
perfect and can result in risk
inaccurate computations
nT
Role of risk management within Bank

ª Ideally, effective risk management would require that the risk management
function within a bank be independent of the activities of its business lines.
However, it is not possible for risk management merely to have a verification
function.
ª There must be a separation between the manager to whom the risk manager
Fi
reports and the manager of the business line that he is monitoring. However, if
the risk manager aspires to work in that business line in the future, then there
may be a problem with independence.
ª Another key point is that if the risk management process is viewed as a form of
internal policing, then the necessary dialogue between risk managers and
business unit managers will not exist. Specifically, it will be difficult for risk
managers to obtain information
16
Challenges & limitations of using VaR in setting limits
Firmwide VaR does not include / assess:

i.Non-interest income for banbks
ii.Operational risk
iii.Interest rate risk
iv.Unexpected changes in interest rate and credit spread (Credit VaR)
v.Funding liquidity risk
Other Challenges:
i.Adding up risks that follow a non-normal distribution
ii.Insufficient data to establish correlation between risks
LO 5.5 Impact of Bank governance on Risk profile and Bank’s performance

Risk Profile Bank’s performance
Governance No evidence No evidence
CRO’s higher status Lower risk No impact
Higher CRO centrality Lower voaltility Higher performance

r variable
Monitoring of loan
decisions eeLower default
risk
Centrality variable: CRO compensation as a % of CEO compensation
nT
Fi
17
Financial Disasters
LO 6.1 Misleading Reporting Cases testable concepts here
Chase Manhattan & Drysdale Securities
è In 1976, Drysdale obtained Ÿ Chase failed to detect the

$300 million in unsecured unauthorized positions: Chase
borrowing but only had $20 did not believe the firm’s capital
million in capital was a risk.
è Lost money on positions, Could Ÿ Inexperienced managers
not repay loans. Drysdale went Ÿ Did not correctly interpret
bankrupt. borrowing agreements that made
è Reputational damage to Chase Chase responsible for payments
(and stock price impact) due.
Ÿ More precise methods required to compute collateral value

Ÿ Need process control: new products should receive prior approval “risk function”
Kidder Peabody
Between 1992 and 1994, Joseph Jett exploited an accounting-type glitch in order to
book about $350 million in false profits (government bonds)
of artificial profits ee
Ÿ System did not account for present value (PV) forward transactions: allowed booking
Ÿ Management did not react to visible suspicions
Investigate a stream of large unexpected profits
Barings
r
Ÿ In 1994, Lesson lost $296 million through his trading activities , but reported a profit
of $46 million to management. His trading supposedly involved two main strategies -
selling straddles on the Nikkei 225 and arbitraging price differences on Nikkei 225
nT
futures contracts that were trading on different exchanges (Long short strategy)
Ÿ In an effort to recover those losses, he abondoned the hedged position in the long
short futures arbitrage strategy, and initiated a speculative long-long futures position
on both exchanges in hope of profiting from an increase in Nikkei 225
Sumitomo :
Ÿ Yasuo Hamanaka, lead copper trader at Sumitomo, attempted to corner the copper market
Fi
in a classic market manipulation strategy

Ÿ He essentially established a dominant long position in futures contract and simultaneously
purchased large quantities of physical copper
Ÿ His unusually low degree of supervision and broad powers allowed him to implement this
fraudulent trading strategy without detection, until the Commodity Trading Commission(CFTC)
began an investing of market manipulation in December 1995.
18
Ÿ Market risk – Leeson was short straddles on Ÿ Credit risk – Management of counterparty risk
Nikkei 225. Hoped index would trade in narrow & reporting of specific instrument exposures
range; planned to pocket premiums. However, to counterparties would have been an
after Kobe earthquake (1/1995): additional signal
1. Sent index into a tailspin.
Ÿ 2. Earthquake increased volatility (adds value
to both calls and puts) which “exploded” the
short put options
Allied Irish Bank :

John Rusnak, a currency option trader, entered into massive unauthorized trades
from 1997 to 2002, producing losses of $691 million.
– Was supposed to run small arbitrage
– But was disguising large naked positions
Ÿ Similar to Leeson (internal deception)

Ÿ Achieved by inventing imaginary trades
Ÿ However, Rusnak did not have advantage of Leeson of also
running the back - office
Long Term Capital Management (LTCM)

Ÿ From 1994 to 1998, renowned quants produced spectacular returns with relative value (“arbitrage”-
type) trades
Ÿ Model risk #1: Models assumed normal

distribution
ee
Ÿ In Summer 1998, series of unexpected and extreme events (e.g., Russian rouble devaluation led to
flight to quality) – New York Fed coordinated a private bailout ($3.65 billion equity investment)
Ÿ
Ÿ
Transparency and disclosure
Marking to market. “Conflict between
hedging strategies and cash
requirements”
Ÿ Model risk #2: Extrapolation of
r
historical returns. Did not anticipate Ÿ Transaction types: pairs trading, risk
once-in-a-lifetime event arbitrage, and bets on overall market
volatility
Ÿ Diversification: Risk models did not
nT
handle correlations that spiked during a Ÿ Liquidity squeeze: Asian crisis → Brazil
crisis event devalued its currency → Flight to quality
→ Spreads increase → Value of LTCM
Ÿ Funding liquidity risk: When firm lost ~ collateral drops → LTCM liquidates to
half its value in sudden plunge, lack of meet margin calls
equity capital created a cash flow crisis
Ÿ Insufficient risk management:
Ÿ Market risk: Extreme leverage combined “underestimated the likelihood that
with concentrated market risk—LTCM liquidity, credit and volatility spreads
Fi
had a balance sheet leverage of 28-to-1 would move in a similar fashion

simultaneously across markets”
Metallgesellschaft
ŸMGRM wrote (sold) long-term forward contracts to sell gas/oil – Hedged with long
positions in short-term futures (stack and-roll hedge)
Ÿ As spot oil prices dropped, oil futures curve shifted to contango – In 1993, creditors
rescued with a $1.9 billion package
19
Key Factors - 1. First factor was that the market shifted to contango (i.e., the futures price
is greater than the spot price).
– Greatly increased the cost of the stack-and-roll hedge.
– Led to cash flow (liquidity) problems
2. Second factor was German accounting methods required Metallgesellschaft

to show futures losses (i.e., from hedge) but could not recognize unrealized
gains from the forward.
– These reported losses triggered margin calls and a panic, which
led to credit rating downgrades.
Banker’s Trust (BT)
Ÿ To reducing their funding expenses, Proctor &

Gamble (P&G) and Gibson Greetings bought
complex derivative products offered by BT è Complex derivatives
Ÿ Due to losses (e.g., P&G lost >$100 million in è Evidence of some intent to deceive
1994), customers sued BT – Claimed they were (Discovery evidence)
exploited because they were not sophisticated
enough to understand their risks
Ÿ
Ÿ
Bankers trust scandal
ee
JP Morgan, Citi group, And Enron
Enron scandal : Questionable accounting practices

Disguise size of borrowings
One practice accounted for borrowed amounts as oil futures contracts
Ÿ Enron collected cash by selling oil futures for delivery and in return agreed to buy back
delivered oil at fixed prices
r
Ÿ Thus no oil was actually delivered, so the agreement was essentially a loan where
company paid cash at later date to receive cash at the beginning of agreement
Ÿ Advantage for company was that they did not have to account for these transactions as
loans on its financial statements
nT
Ÿ JP Morgan chase And Citi group were main counterparties in these transactions
Ÿ They declared that they shared no role in determining how the transactions were
accounted for on Enron’s financial statements
Ÿ According to JP Morgan And Citi group transactions were correctly reported
Ÿ Later it was revealed that, investment banks fully understood Enron’s intent when
entering into those loan-type transactions.
Fi
20
Deciphering the liquidity and credit crunch

2007-2008
The main causes for the Liquidity Crisis were : Watch video with important
A. Securitization and
B. The methods of asset and liability maturity management employed by the banks
LO 7.1 Key factors leading to Housing Bubble
Cheap credit Decline in lending standards

Ÿ Fed adopted low interest rate policy Ÿ Originate to distribute model transferred
default risk to investors
Ÿ High demand for US securities by
countries experiencing trade surpluses
LO 7.2 Banking industry trends & liquidity squeeze
Risk Transference through

ee
Liquidity Squeeze
Asset Liability maturity

asset securitization mismatch
r
When the underlying
mortgages or loans 1.Short-term Funding Instruments Long term
declined in value due to (Money Market Funds) defaulting Assets:
defaults, the structured
nT
Ÿ Commercial Paper and example MBSs and

products faced significant Ÿ Repo Market Funded other securitised
losses products
Trigger for
Banks sponsored SIVs
liquidity squeses
2.Banks (Structured Investment
Granting credit line Vehicles)
(Liquidity backdrop)
Fi
Spread of Credit Risk

Trigger for liquidity squeses Funding Liquidity Risk (FLR)
T1. Increase in sub-prime mortgage defaults

T2. Rating downgrades of sub-prime deals
Triggers for the Liquidity Crises
T3. Decline in prices of mortgages related securities
T4. Increases the systematic risk
21
LO 7.3 How CDO is created?
Collateralized debt obligation (CDO) is a “structured” product that banks can use
to unburden themselves of risk
CDO might be thought of as a three-step process
1. Form a diversified portfolio
2. Slice the portfolio into tranches - Most junior tranche offers a high interest rate but
receives cash flows only after all other tranches have been paid( sometimes referred to as
the “equity tranche” or “toxic waste. The highest-rated tranche, called the “super senior”
tranche (often rated AAA), is the safest tranche and the first tranche to be paid out;
however, it pays investors a relatively low interest rate
3. Sell tranches to investors - Most senior tranches are sold to institutions that desire or
require instruments with high credit ratings, such as pension funds. The lowest rated
(equity) tranches are (in theory, at least) retained by the CDO issuer to give that bank
incentive to monitor the loan. In practice, CDO issuers do not always hold onto this “toxic
waste.”
LO 7.4 Credit default swaps.
LO 7.5
è
è
ee
Holder of a bond or CDO tranche use a CDS to protect against a default.
Holding both credit instruments plus CDS protection on the same instrument
has a very low risk position.
Growth of Securitization and Structured Products
Rapid growth of Securitised Products

r
Ÿ Originating institutions were able to Offer lower interest rates on mortgages.
Ÿ Help overcome investment regulatory hurdles faced by institutional investors

nT
(e.g - Investing only in AAA rated bonds)
Ÿ Provides regulatory and weighting arbitrage opportunities to the originating

institutions.
Ÿ Were given high ratings based on faulty over optimism (Rating agencies
received higher fees)
Fi
ª Consequences of Easier credit availability due to decrease in lending standards

their increased use -
Banks only face “Pipeline Risk” leading to poor lending standards
Formation of credit bubble due to:

(a) Expansion of credit
(b) Poor lending standards.
Credit Risk remained within the banking system as banks themselves
were the buyers of the structured products
22
LO 7.6 Consequences of Financial Crisis
Increase in delinquency and foreclosures
Decrease in Housing Prices
Increase in Prices of CDS
Due to decrease in the ratings of securitised and structured products by

the three main rating agencies (June and July 2007)
Decrease in sale of commercial paper in the market
Commercial Paper was a major vehicle for SIVs to roll over their short term debt for
funding their investment in Long Term Instruments (ABS)
LO 7.7
Margin/Haircut Funding Risk

r ee
Funding liquidity and Market liquidity
Funding liquidity risk refers to the possibility that an institution will not be able
to settle its obligations when they are due.
Rollover Risk Redemption Risk
A risk that arises when a The risk that investors may not The risk that depositors will
decline in the collateral value of be able to roll over short-term withdraw funds from banks, or
an asset results in an increase debt to finance the purchase of that investors will redeem their
nT
in margin requirement, an asset. shares (e.g., from mutual

requiring additional equity funds).
capital
Market Liquidity
ease or difficulty of selling an asset to raise money.
Fi
Bid ask spread Market depth Market resiliency
The loss that would be The number of units of an asset The length of time it will take
sustained by a trader who sells a trader can buy or sell at the an asset to regain its price
an asset and then immediately current market quote (bid and after the price has fallen
buys it back. ask prices). temporarily.
Higher the spread lower Greater the market depth Stronger the market
the market liquidity. higher market liquidity. reselience highr the market
liquidity.
23
Funding Liquidity vs. Market Liquidity
Funding Liquidity Market Liquidity
Ÿ If Funding Liquidity increases, it is easier

to obtain against an asset Ÿ If it increases it’s easier to sell an asset
Ÿ FL= Issuing Debt, Equity, or any other Ÿ Refers to transfer of asset with its entire
Financial Contract against a cash flow cash flow.
generated by an asset.
Interaction of FL and ML can trigger sudden disappearance of liquidity, creating a financial disaster
Example :
Original value of asset = 100, original margin = 10% ($10), reduced value of asset = 95
Loss spiral Margin spiral
Loss in equity = 5 Loss in equity = 5

Balance equity = 5 (10 - 5) Balance equity = 5 (10 - 5)
Firm will sell asset worth $45 to maintain
margin ratio (95 -45 = 50)
(50 X 10% = 5)
ee Lets say margin ratio went upto 20%
Allowable asset in portfolio = 5/20% = 25
(50 X 10% = 5)
Firm will sell assets worth 70 (95-70) = 25
Conclusion : Marginal spiral results in lower overall position value and lower borrowing amount
r
Loss Spiral : Lower the market liquidity greater and stronger the loss spiral Loss
spiral refers to the forced sale of an asset by a leveraged investor to
nT
maintain margin or leverage ratio requirements.

Margin Spiral : Margin spiral refers to the forced sale of an asset as a result of an
increase in required margin, or a decline in the permitted leverage ratio.
LO 7.8 Network Risk

Increase in counter party Credit Web of contracting parties to
Leads to
Risk seek additional protection &
Fi
(particularly in an environment of liquidity

Market Stress)
Ÿ Centralised clearing house

Network risk can be mitigated with Ÿ Full Information
Ÿ Multilateral risk netting arrangements
24
Gettting up to Speed on the Financial Crisis

A One - Weekend - Reader’s Guide
Introduction
Reasons For Financial Crisis 07-09 Watch video with important
An interconnected
Relaxed lending Easy access to Inflated housing
banking & global
practices credit prices
financial system
LO 8.1& 8.2 Financial Crisis Overview

Key Terms Related to the Financial Crisis
Asset-backed commercial Nonfinancial firms with high credit ratings raise capital by issuing short-
paper (ABCP): term debt. ABCP is the bundling of longer-term debt from mortgages,
credit card receivables, and other loans. When ABCP reaches its maturity
date, it is rolled over and bundled into new ABCP.
Repurchase
ee
Bank run or “run”: When depositors withdraw cash from a bank thinking the bank is about to fail
Shadow bank: Is a financial institution other than a regulated depository institution e.g -
private equity funds, investment banks, hedge funds, mortgage lenders, and
insurance companies
Institutional investor making a short-term deposit of cash with a

agreements (repos): shadow bank that in turn pays the investor interest on the cash (called
the repo rate).
r
Haircut: Amount of collateral in a repo agreement in relation to a deposit.
nT
Financial Market Participants and Market Conditions
è The main financial market participants in the financial crisis were institutional investors
è Cash held by investors was larger than could be invested through a regular depository bank
è U.S. Treasuries were in short supply due to large holdings from foreign investors
è Shadow banks acted as financial intermediaries, providing institutional investors with a way to
turn their cash into an investment by issuing repos and ABCP as a substitute for U.S. Treasuries
è Major contributing factor in the financial crisis was the bundling of subprime mortgages into
mortgage-backed securities (MBSs) as well as asset-backed securities (ABSs) in the form of ABCP.
Fi
è When housing prices declined and homeowners defaulted on their mortgage loans, it reduced
the value and prices of ABCP (which held mortgages).
è When it came time for the shadow bank to reissue ABCP, institutional investors were not willing
to finance the reissue with continued deposits
è This issue resulted in a bank run on the shadow bank and the start of a liquidity crisis.
è During the same time period of 2007 and 2008, MMFs contained a high percentage of ABCP.
è Liquidity crisis continued to spread into repo agreements with average haircut going from near zero
at the beginning of 2007 to 25% by September of 2008 at the announcement of the bankruptcy
Lehman Brothers, each 1% increase in the haircut translating into a $ 10 billion withdrawal of
liquidity from the financial markets.
è The main trigger of financial crisis as described by Former Federal Reserve Chairman Ben Bernanke,
was the prospect of losses on subprime mortgages 25
LO 8.3 Lehman Brothers Failure
Fall in Repos
Haircut
Run on MMF
Financial disaster
Bank run on (Collapse of
shadow bank Lehman brothers)
September 2008
Default on
mortgages (due to Fall in prices
overvalued of ABCP
housing prices)
Start of Spread of
liquidity crisis liquidity crisis
LO 8.4 Previous Financial Crises

A banking crisis can be characterized by
(1) A run on banks that leads to a merger, takeover by the government, or closure
ee
of a financial institution
2) A merger, takeover, government assistance, or closure of a financial
institution that spreads to other financial institutions
ª Study by Schularick and Taylor showed that an increase in credit in the form of bank loans
is a strong predictor of a financial crisis
ª An acceleration in economy-wide leverage in the form of external debt (debt
borrowed from foreign lenders) and domestic government debt precedes a bank
crisis, and these bank crises lead to sovereign debt crises.
r
ª The increased borrowing by households was linked to reduced lending standards and
lenders willing to lend more as housing prices increased— using the house as collateral as
it became more valuable.
nT
ª A separate study done by Reinhart and Rogoff of five major bank crises in
developed countries from 1977 to 1992 showed significant increases in housing prices
just before the bank crises followed by significant declines in economic activity afterward
ª Another phenomenon that played a significant role in the recent financial crisis was the large
amount of institutional cash pools created in the decade before the crisis. These cash pools
created the demand in part for the ABSs, MBSs, CDOs, et cetera
ª The conclusion of these studies is that the financial crisis of 2007—2009 was not unique
and followed a pattern of increased public and private debt, increased credit supply, and
Fi
increased housing prices preceding and leading to the crisis.
LO 8.5 Panic Periods

Ÿ The two main panic periods of the financial crisis were August 2007 and September 2008
through October 2008
Ÿ Holders of ABCP, namely MMFs, experienced a decrease in value of their assets. At the time,
MMFs were thought to be a safe haven by investors
26
Ÿ By the end of 2007, approximately 40% of shadow banks issuing ABCP were experiencing
runs and having difficulty reissuing ABCP. This resulted in a reduction in the issuance of
ABCP by $350 billion, which negatively impacted the balance sheets of those shadow banks
Ÿ With the decrease in value of ABCP, the first runs on shadow banks occurred in August 2007
Ÿ By the end of 2007, approximately 40% of shadow banks issuing ABCP were experiencing runs and
having difficulty reissuing ABCP. This resulted in a reduction in the issuance of ABCP by $350 billion,
which negatively impacted the balance sheets of those shadow banks
Ÿ Since MMFs at the time included a large portion of ABCP in their portfolios, the run onthe
shadow banks spread to MMFs
Ÿ With the value of ABCP decreasing in the typical MMF portfolio, the MMFs were in turn bailed out
bytheir sponsors (banks or mutual fund families that managed MMFs). The bailouts were necessary to
maintain the net asset value of $1 per share in the MMFs.
Ÿ The second panic period started when Lehman Brothers filed for bankruptcy, which caused a major
shock to MMFs
Ÿ In addition, during the time from July 2007 to the eve of Lehman Brothers filing for bankruptcy,
haircuts on repo agreements rose from near zero to just over 25% along with downgrades of MBSs.
The rise in haircuts caused other nonmortgage-related short-term debt to fall in value
Ÿ Lehman’s failure caused a run on a particular MMF called Reserve Primary, which
contained commercial paper issued by Lehman
LO 8.6
r 1
Interest rate change

ee
Government Policy Responses
Central Bank—Monetary Policy and Liquidity Support
Liquidity support
Reduction of Reserve requirements, longer

interest rates funding terms,
more auctions, and/or
nT
higher credit lines
2 Government— Financial Sector Stabilization Measures
Recapitalization Asset purchases
Ÿ Capital injection (common Ÿ Asset purchases (individual assets,

stock/preferred equity) bank by bank)
Fi
Ÿ Capital injection (subordinated debt) Ÿ Asset purchases (individual “bad bank”)

Ÿ Provisions of liquidity in context of bad
asset purchases/removal
Ÿ On-balance-sheet “ring-fencing” with
toxic assets kept in the bank
Ÿ Off-balance-sheet “ring-fencing” with
toxic assets moved to a “bad bank”
Ÿ Asset guarantees
Liability guarantees
Ÿ Debt guarantee (new liabilities) Ÿ Enhancement of depositor protection

Ÿ Government lending to an individual institution Ÿ Debt guarantee (all liabilities) 27
To determine success of various actions taken, IMF used several indices and spread
measures
ª Economic Stress Index : Composite of confidence measures from businesses and
consumers, non financial firm stock prices and credit spreads
ª Financial Stress Index : Composite of stock prices, spreads and bank credit
IMF - indicators used to measure impact of,

A. Interest rate cuts : ESI & FSI
B. Liquidity Support : Interbank spreads & FSI
C. Recapitalization, liability guarantee & asset purchase : Interbank spreads & FSI
To determine the success of the actions taken, the IMF used several
different indices and spread measures.
To measure the impact of interest rate cuts, they used the economic
stress index (ESI) and the financial stress index (FSI)
Ÿ Interest Rate Cuts Impact of interest rate cuts with the result being no short-term impact on
the ESI and only a limited positive effect on the FSI, conclusion was that
the central bank actions were anticipated.
Ÿ
ee
Liquidity Support Effect of liquidity support was measured using the FSI and
interbank spreads. During the pre-Lehman period, a strong positive effect
was indicated by both measures
In the later measurement periods, the results were indeterminate, which
was thought to be due to liquidity support actions being anticipated
Recapitalization When the FSI was used to measure the effects of recapitalization,
the result was not as strong,due to the broader nature of the FSI and
the benefit of recapitalization going mostly to bondholders
Ÿ Liability Guarantees Both the FSI and CDS index were used to
r
and Asset Purchases measure the effectiveness of these measures
Most effective tool:
nT
1.Pre-Lehman period: Liquidity support to stabilize interbank markets

1.Later Period: Recapitalization
Fi
28
LO 8.7 Global Effects on Firms and the Economy
Ivashina and Scharfstein Rocholl, and Steffen Campello, Graham, and Harvey
Ÿ Syndicated loans Ÿ Focused on consumer loans, Ÿ Effects of the crisis in 2008

specifically how the U.S. on nonfinancial firms in North
Ÿ Lending to corporation crisis affected lending in America, Europe, and Asia
Germany
Ÿ The findings showed Ÿ Resources grouped into two
lending volume in fourth Ÿ The prevalence of loan categories - Constrained and
quarter of 2008 was 79% applications being rejected unconstrained
lower than at the peak of became more pronounced
lending boom in second with mortgage applications Ÿ Constrained firms reduced the
quarter of 2007 than consumer loans, once number of employees
again concluding a reduced
Ÿ A curious finding of study supply of bank loans Ÿ Constrained firms cited
was that as syndicated problems with their lines of
lending was down, credit
commercial and industrial
lending from regulated
banks was up because
borrowers were simply
accessing their credit
lines that had been
negotiated before crisis
r ee Ÿ Constrained firms bypassed
attractive investments
nT
Fi
29
Risk Management Failures :

What Are They and When Do They Happen?
LO 9.1 The Role of Risk Management Watch video with important

Risk management involves assessing, communicating, monitoring, and managing risks.
Ÿ Focuses on the output of a particular risk metric

Ÿ Usually evaluates several risk metrics (e.g., duration, beta)
Ÿ Risk management should recognize that large losses arepossible and develop
contingency plans.
LO 9.2 & Incorrectly Measuring and Managing Risk

9.3
Risk management can fail Ÿ Mismeasurement can Failing to take known and
if the firm does not - occur when management unknown risks into account
measure risks correctly, does not understand the can take three forms:
recognize some risk,
communicate risks to top
management, monitor and
manage risks, and use
appropriate metrics.
ee
distribution of returns of a
single position
Ÿ It also occur when
managers must use
subjective probabilities for
rare and extreme events.
Ÿ The subjective
probabilities can be biased
(1) ignore a risk that is
known
(2) failure to incorporate a
risk into risk models
(3) not finding all risks
from firm politics.

r
Senior managers must Risk managers must
understand the results of recognize how risk
nT
risk management in order characteristics change over

for it to be meaningful. time. Many securities have
Unless senior managers complex relationships with
have the correct market variables. Having an
information to make adequate incentive structure
decisions, risk management and firm-wide culture can
is pointless. help with the risk monitoring
and managing process.
Fi
LO 9.4 The role of Risk Metrics

Ÿ Risk metrics such as VaR are usually too narrow in scope. E.g - VaR usually assumes independent
losses across periods of time
Ÿ It generally fails to capture the effect of a firm’s actions on the overall market and behavior
patterns such as predatory trading
30
The Standard Capital Asset Pricing Model

LO 10.1 The Capital Asset Pricing Model (CAPM )
& 10.2 There are three major steps in deriving the CAPM Watch video with important
1. Recognize that since investors are only compensated for bearing systematic risk,
beta is appropriate measure of risk
2. Since arbitrage prevents mispricing of assets relative to systematic risk (beta), an

individual asset’s expected return is a linear function of its beta.
3. Equation for CAPM is:
E(Ri) = RF + [E(RM) - RF]βi
Average
Variance of Equally
1
+ n n- 1
2 covariance of
weighted portfolio =
2 n σ i cov all pairings of
(σ p) the assets in
the portfolio
Approaches Average
Ÿ
ee
zero as n ↑
Investors face no transaction costs.

variances of
all assets in
portfolio
Several assumptions underlying the CAPM
Ÿ Assets are infinitely divisible.

Ÿ No taxes.
r
Ÿ Investors buy and sell decisions have no effect on asset prices.
Ÿ Investors’ utility functions are based solely on expected portfolio return and risk.
Ÿ Unlimited short-selling
nT
Ÿ Single period is the same for all investors.

Ÿ All investors have the same forecasts of expected returns, variances, and covariances.
Ÿ All assets are marketable.
LO 10.3 The Capital Market Line (CML)

E(RP)
CML
Fi
(CML) expresses the

expected return of a
portfolio as a linear
function of its standard E(RM)
deviation, the market A
portfolio’s return and C Market Portfolio, M
standard deviation, and B
risk-free rate RF
σp
σM
31
Slope of CML Equation :
SR = E(RC) = RF + [ E(RM) - RF
σM
]σ C
Ÿ The CML is useful for computing the expected return for an efficient (diversified)
portfolio; however, it cannot compute the expected return for inefficient portfolios or
individual securities. The CAPM must be used to compute the expected return for any
inefficient portfolio or individual security.
LO 10.4 Calculating Expected Return Using the CAPM

The expected return for an asset calculated using the CAPM given the risk-free rate,
the market risk premium, and an asset’s systematic risk.
LO 10.5 Beta
Covi,m
Beta is calculated By: βi =
σ2m
Additional Resources -
r
Population variance
ee
Portfolio beta is the weighted average of the asset betas in a portfolio.
Sample variance
∑ (x-μ)2 ∑ (x-x)2
n n-1
nT
Covariance Correlation
µ It is a measure of how two assets move µ Standardized measure of covariance
together
µ Measures strength of linear relationship
µ Covariance of return with itself is its between two random variables
variance
µ Does not have a unit
Fi
µ Expressed in terms of square units

µ r = Cov(x,y)
µ Cov(x,y) = ∑(X-X) (Y-Y) σx x σy
n
µ Range = -1 to +1
µ Cov(x,y) = r x σx x σy
µ r = 1 means perfectly +ve relation
µ Range = -∞ to +∞ µ r = 0 means no relation
µ r = -1 means perfectly -ve relation
32
Risk aversion and its implications for portfolio selection
Risk-averse Risk-neutral Risk-seeking/loving

investor investor investor
An investor that simply Such investor has no An investor that prefers

dislikes risk preference regarding risk more risk to less
Given two He would be indifferent Given two

investments that have between two such investments that have
equal expected returns, investments equal expected returns,
a risk-averse investor a risk-loving investor
will choose the one will choose the one
with less risk with more risk
a risk averse investor will hold very risky assets if he feels that the extra
return he expects to earn is adequate compensation for the additional risk
Portfolio standard deviation
√(W1σ1)2 + (W2σ2)2 + 2W1σ1W2σ2 x r ee Or √(W1σ1)2 + (W2σ2)2 + 2W1W2 x Cov(x,y)
Portfolio risk when r = -1, 0, 1
When r = -1, When r = 0, When r = 1,

r
Sdp = (W1σ1) - (W2σ2) Sdp= √(W1σ1)2 + (W2σ2)2 Sdp = (W1σ1) + (W2σ2)
Sdp = Lowest Sdp = Highest
nT
Portfolio risk falls as the correlation between the assets’ returns decreases.
As long as r < 1, there is some benefit of diversification
Fi
33
E(R) E(R) E(R)
} Inefficient
portfolios
σ σ σ
Minimum Global minimum
Efficient frontier
variance frontier variance portfolio
Each point on MVF shows lowest Each point on EF shows lowest The portfolio on the efficient
risk (variance/standard risk (variance/standard frontier that has the least risk is
deviation) for given level of deviation) for given level of the global minimum-variance
returns returns portfolio
Each point on EF shows highest
returns for given level of risk
(variance/standard deviation)
E(R)
r
Id3 Id2 Id1
E(R)
ee
Optimal portfolio, given an investor’s utility and the capital allocation line
Capital
Allocation Line
E(R)
Id3 Id2 Id1
CAL
X
RFR
σ σ σ
nT
An investor will always choose the Possible combinations of risk-free X is the optimal portfolio i.e.
highest indifference curve (Id3) assets and risky assets is referred one that maximizes the
to as the capital allocation line investor’s expected utility
More risk-averse investor will have steeper indifference curves, reflecting

a higher risk aversion coefficient
Fi
Implications of combining a risk-free

asset with a portfolio of risky assets
For risk-free assets Standard deviation (σ) = 0

Correlation (r) with risky assets = 0
σp with risky asset σp = W1σ1
and risk-free asset
34
Capital allocation line and capital market line
E(R) E(R)
Capital Capital
CML is same as CAL except
Allocation Line Market Line
that CML assumes
homogeneous expectations Efficient
frontier
of investors (i.e. investors
X
have same estimates of risk,
return, and correlations with RFR RFR
other risky assets)
σ σ
X - Optimal risky portfolio or
Market portfolio
Lending portfolio
E(R) for CAL E(R) = RFR + Sharpe ratio of risky asset X σp Borrowing portfolio
E(R) for CML E(R) = RFR + Sharpe ratio of market X σp
Systematic risk Unsystematic risk

ª
ª
risk
ee
The risk that remains and cannot be
diversified away is called systematic
Arises due to changes in economy
Also called as nondiversifiable risk

or market risk
ª
ª
The risk that is eliminated by
diversification is called unsystematic
risk
Also called as unique, diversifiable or

firm specific risk
ª Unsystematic risk is not compensated

ª Firms that are highly correlated in equilibrium because it can be
with market returns have high eliminated for free through
r
systematic risk diversification
ª It is measured by beta (β)

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The required return on an individual security will depend only on its systematic risk
Total risk = Systematic risk + Unsystematic risk
Return generating models

Fi
A return generating model is an equation that estimates the

expected return of an investment, based on a security’s exposure to
one or more macroeconomic, fundamental, or statistical factors
Multifactor model - E(R) = RFR + E(Factor 1) β1 + E(Factor 2) β2 + .... + E(Factor k) βk
Single-factor model - E(R) = RFR + (Rm – RFR) x β
35
Covariance (x,y) r x σx x σy σ
Beta = = 2 = r σ
x
Variance (y) σ y y
In practice, asset betas are estimated by regressing returns on the asset on those of the market index
Excess
return on
stock
Regression
line
Regression line is referred to as
Security characteristic line
Slope = Cov (x,y)
σy2
RFR Excess
return on
market
Security Market Line (SML) and

Capital Asset Pricing Model (CAPM)
SML is same as CML except E(R) This relation between beta

that SML has beta (β) on x-axis
SML is used for security

selection
RFR
ee Security
Market Line
Market portfolio
(systematic risk) and expected
return is known as CAPM
E(R) for SML

(CAPM)
Kce = RFR + (Rm - RFR) x β
β
r
Assumptions Investors are Investor that dislikes risk.
of CAPM risk averse
Utility maximizing Investors choose the portfolio, based on their individual preferences,
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investors with the risk and return combination that maximizes their utility
Frictionless markets No taxes, transaction costs etc.
One-period horizon All investors have same time horizon
Homogeneous All investors have same expectations for assets’ expected
expectations returns, their standard deviation and correlations between them
Divisible assets All investments are infinitely divisible
Competitive markets Investors take the market price as given and no investor can influence
Fi
prices with their trades
36
Excess return
E(R) Impossible
on stock
Undervalued
portfolio
Possible Correctly valued

portfolios
RFR
Overvalued
RFR
Excess return
σ on market
Measures of risk adjusted returns
Sharpe ratio Treynor ratio Jensen’s Alpha M² ratio

Systematic risk Total risk
Total risk Systematic risk (Beta) (Standard deviation)
(Standard deviation) (Beta)
Actual return Sharpe ratio of
Rp - RFR Rp - RFR (Expected return) - portfolio x σm -
σ β Required return Market Risk
(CAPM) Premium
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Sharpe ratio & M2 ratio produce same rankings
If M2 ratio > 0, then Sharpe ratiop > Sharpe ratiom
If M2 ratio < 0, then Sharpe ratiop < Sharpe ratiom
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Fi
37
Applying the CAPM to Performance Measurement:

Single-Index Performance Measurement Indicators
LO 11.1 Measures of Performance
Three commonly used risk/return measures are: testable concepts here
E(RP) -RF
1 Treynor measure of a portfolio = [ βP ]
E(RP)-RF
2 Sharpe measure of a portfolio = [ σP ]
3 Jensen measure of a portfolio = αP = E(RP) - {RF + [E(RM)-RF]βP}
LO 11.2
Ÿ
Ÿ
ee
A portfolio with low diversification may have a higher Treynor measure, a higher alpha,
but a lower Sharpe measure than another portfolio.
Alpha can be modified by the use of other reference portfolios
Tracking error, the information ratio, and the Sortino ratio

Ÿ Tracking error is the standard deviation of alpha over time.
r
Ÿ Information ratio is the average alpha over time divided by the tracking error
Ÿ Sortino ratio should be used when there is more focus on the likelihood of loss:
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E(RP) - Rmin
Sortino ratio =
√ MSDmin
Ÿ MSDminis a semi-variance that only measures the variability of the portfolio’s return
observations below Rmin
Fi
38
Arbitrage Pricing Theory

LO 12.1 The Multifactor Model of Risk and Return testable concepts here
Active return: Return on portfolio (Rp) − Return on benchmark (RB)

Active risk: SD of active return
Aka tracking error or tracking risk
Active return
Information ratio:
Active risk
Types of multifactor models
Macroeconomic Fundamental Statistical

factor models factor models factor models
Factors are firm-specific and

Factors are surprises in stated as returns (not
macroeconomic variables surprises)
Factors:
Interest rates, credit spread,
inflation risk, and cyclical risk
Surprise:
Actual value − Estimated value
Intercept ‘E(Ra)’ is derived -

ee Factors:
P/E ratio, P/B ratio, market
cap, financial leverage
Betas are standardized
Standardized beta:
(Actual value − Mean value)/σ
Statistical methods are applied
to historical returns to
determine factors that explain
the observed returns
Types:
Analysis models: Factors are
portfolios that explain
covariance in returns
from APT model
Standardization allows us to
r
Principal component models:
Equation: use fundamental factors
Factors are portfolios that
Ra = E(Ra) + β1F1 + β2F2+ .... + measured in different units in
explain variance in returns
βnFn + ε the same factor model
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ε: Firm-specific surprise Intercept is not interpreted as

the expected return
LO 12.2 Expected return of an asset using a single-factor and

a multifactor model
Ÿ The equation for a K -factor model is:
Fi
R = E(R)+β1F1+β2F2+........+BkFk+ e
ª Return equals its expected value if none of the macro factors deviate from their expected
values and if the firm-specific return equals zero
ª If macro factor Fj deviates from its expected value, then Fj is nonzero
ª If the firm experiences a nonfactor related surprise, then the firm-specific component, e, will
be nonzero
ª Used to calculate the expected return after new macroeconomic and/or firm-specific
information is released.
39
LO 12.3 Well -Diversified Portfolios
Ÿ Risk reduction benefits achieved through diversification come from reducing
nonsystematic risk.
Ÿ Expected return on a well-diversified portfolio is determined by systematic risk as
measured by beta
The Single-Factor Security Market Line
E(RM)
RF
Ÿ
Ÿ
ee 1
SML is analogous to the capital asset pricing model (CAPM).

β
Systematic risk is measured as the exposure of the asset to a well-diversified market index
portfolio.
Ÿ Index portfolio can be any well-diversified portfolio thought to be highly correlated with the
systematic factor that affects the returns of assets.
Ÿ Equation for the single-factor SML :
r
E(Rp) = RF + βp[E(RM) — RF]
where
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RF - risk-free rate,
M - observable welldiversified market index
βp- beta of any portfolio,
P- relative to the market index.
LO 12.4 Hedging Exposures to Multiple Factors
è A multifactor model can be used to hedge away multiple factor risks

Fi
è Investor can create factor portfolios, with beta equal to one for a single risk
factor, and betas equal to zero on the remaining risk factors
è Factor portfolios can be used to hedge multiple risk factors by combining the
original portfolio with offsetting positions in the factor portfolios
40
LO 12.5 Arbitrage Pricing Theory
Arbitrage pricing theory describes expected returns as a linear function of exposures to
common (i.e., macroeconomic) risk factors
E(Ri) = RF + βi1RP1 + β i2RP2 +...+ βikRPK
where
Rpj is the risk premium associated with risk factor j.
The CAPM is a special case of the APT where there is only one priced risk factor (market risk).
The Fama-French Three-Factor Model
Ÿ It describes returns as a linear function of the market index return, firm size, and
book-to-market factors
Ÿ The firm size factor, SMB, equals the difference in returns between portfolios of
small and big firms
Ÿ The book-to-market factor, HML, equals the difference in returns between
portfolios of high and low book-to-market firms
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41
Principles for Effective Risk Data Aggregation

and Risk Reporting
LO 13.1 Benefits of Risk Data Aggregation Watch video with important

Ÿ An increased ability to anticipate problems. Aggregated data allows risk managers to

understand risks holistically. It is easier to see problems on the horizon when risks are
viewed as a whole rather than in isolation.
Ÿ In times of financial stress, effective risk data aggregation enhances a bank’s ability to
identify routes to return to financial health. For example, a bank may be better able to
identify a suitable merger partner in order to restore the bank’s financial viability.
Ÿ Improved resolvability in the event of bank stress or failure. Regulatory authorities should
have access to aggregated risk data to resolve issues related to the health and viability of
banks. This is especially important for global systemically important banks (G-SIBs).
Ÿ By strengthening a bank’s risk function, the bank is better able to make strategic
decisions, increase efficiency, reduce the chance of loss, and ultimately increase
profitability.
ee
Principles of Effective Risk Data Aggregation
Governance Data & IT infrastructure Data aggregation Reporting

r
P 1.Governance P 2.Data architecture P 3.Accuracy & integrity P 7.Accuracy
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& infrastructure P 4.Completeness P 8.Comprehensiveness

P 5.Timeliness P 9.Clarity & usefullness
P 6.Adoptibility P 10.Frequency
P 11.Distribution
LO 13.2 Governance
Principle 1- Governance :
Fi
A bank’s risk data aggregation capabilities and risk reporting

practices should be subject to strong governance arrangements consistent with the other
principles and guidance established by the Basel Committee
42
Data aggregation and risk reporting practices
Ÿ Fully documented.
Ÿ Independently reviewed and validated by individuals with expertise in information
technology (IT) and data and risk reporting functions.
Ÿ Considered when the firm undergoes new initiatives, including new product
development, acquisitions, and/or divestitures. As part of an acquisition, the bank
should assess the risk data aggregation and reporting capabilities of the target firm
and explicitly evaluate those capabilities when deciding whether to make the
acquisition. In addition, a time frame should be established to integrate the risk
data aggregation and reporting processes of the two firms.
Ÿ Unaffected by the bank’s structure. Specifically, decisions regarding data
aggregation and reporting should be independent of the bank’s physical location or
geographical presence and/or legal organization.
Ÿ A priority of senior management, who should support risk data aggregation and
reporting processes with financial and human resources. Senior management
should include risk data aggregation and reporting in strategic IT planning and
ensure that the implementation of these processes is not impeded.
Ÿ Supported by the board of directors, which should remain aware of the bank’s
implementation of and compliance with the key governance principles set out by
the Basel Committee.
LO 13.3 ee
Data Architecture and IT Infrastructure
Principle 2 — Data Architecture and Infrastructure:

A bank should design, build and maintain data architecture and IT infrastructure which fully
supports its risk data aggregation capabilities and risk reporting practices not only in
normal times but also during times of stress or crisis, while still meeting the other Principles
r
Ÿ Risk data aggregation and reporting practices should be a part of the bank’s planning
processes and subject to business impact analysis.
Ÿ Banks establish integrated data classifications and architecture across the banking
group. Multiple data models may be used as long as there are robust automated
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reconciliation measures in place. Data architecture should include information on data

characteristics (metadata) and naming conventions for legal entities, counterparties,
customers, and account data.
Ÿ Accountability, roles, responsibilities, and ownership should be defined relative to the
data.
LO 13.4 Risk Data Aggregation Capabilities

Fi
Principle 3— Accuracy and Integrity:

Data should be aggregated on a largely automated basis so as to minimize the probability of errors.
(Limited workarounds are okay)
43
• Data aggregation and reporting should be accurate and reliable.

• Controls applied to risk data should be as robust as those surrounding accounting data.
• To ensure the quality of the data, effective controls should be in place when the bank relies
on manual processes and desktop applications such as spreadsheets and databases.
• Data should be reconciled with other bank data, including accounting data, to ensure its
accuracy.
• A bank should endeavor to have a single authoritative source for risk data for each specific
type of risk.
• Risk personnel should have access to risk data to effectively aggregate, validate, reconcile,
and report the data in risk reports.
• Data should be defined consistently across the bank.
• While data should be aggregated on a largely automated basis to reduce the risk of errors,
human intervention is appropriate when professional judgments are required. There should be
balance between manual and automated risk management systems. (Manual workaround)
• Bank supervisors expect banks to document manual and automated risk data aggregation
systems and explain when there are manual workarounds, why the workarounds are critical
to data accuracy, and propose actions to minimize the impact of manual workarounds.
Principle 4— Completeness
Ÿ Both on- and off-balance sheet risks should be aggregated.
Ÿ Risk measures and aggregation methods should be clear and specific enough that senior
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managers and the board of directors can properly assess risk exposures. However, not all
risks need to be expressed in the same metric.
Ÿ Bank risk data should be complete. If risk data is not complete, the bank should identify
and explain areas of incompleteness to bank supervisors.
Ÿ Data should be available by business line, legal entity, asset type, region etc.
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Fi
44
Principle 5 — Timeliness Principle 6— Adaptability
ª Data aggregation capabilities should be

adaptable and flexible. Adaptable data
makes it easier for managers and the
board of directors to conduct stress tests
and scenario analysis. Data should be
available for ad hoc data requests to
Ÿ Bank supervisors will review the timeliness assess emerging risks. Adaptability
and specific frequency requirements of includes:
bank risk data in normal and stress/crisis è Aggregation processes should be flexible
periods. and should allow bank managers to
Ÿ Systems should be in place to produce assess risks quickly for decision-making
aggregated risk data quickly in purposes.
stress/crisis situations for all critical risks. è Data should be customizable (e.g.,
Critical risks include, but are not limited to: anomalies, dashboards, and key
è Aggregated credit exposures to large takeaways) and should allow the user to
corporate borrowers. investigate specific risks in greater detail.
è Counterparty credit risk exposures, è It should be possible to include new
including derivatives. aspects of the business or outside factors
è Trading exposures, positions, and that influence overall bank risk in the risk
operating limits.
è
è
è
Market concentrations by region and
sector.
Liquidity risk indicators.
ee
Time-critical operational risk indicators.
è
ª
data aggregation process.
Regulatory changes should be
incorporated in risk data aggregation.
A bank should be able to pull out specifics
from aggregated risk data. For example, a
bank should be able to aggregate risks of
a certain country or region. Credit risk
exposures (e.g., corporate, bank,
sovereign and retail exposures) for a
specific country should be readily
r
accessible. Data regarding risks across
geographic areas or business lines should
be available
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Ÿ The principles of integrity, completeness, timeliness, and adaptability. A bank may choose to
put one principle ahead of another
LO 13.5 Effective risk reporting practices

Principle 7 — Accuracy
Ÿ Risk reports should be accurate and precise. Senior managers and board members shoul be able
to use the reports to make critical decisions about bank risks.
Fi
Ÿ To ensure the accuracy of risk reports the bank should:

ª Define the processes used to create risk reports.
ª Create reasonableness checks of the data.
ª Include descriptions of mathematical and logical relationships in the data that should be verified.
ª Create error reports that identify, report, and explain weaknesses or errors in the data.
Ÿ The bank should ensure the reliability, accuracy, and timeliness of risk approximation (e.g.,
scenario analysis, sensitivity analysis, stress testing, and other risk modeling approaches).
Ÿ The board of directors and senior managers should establish precision and accurate requirements
for regular and stress/crisis risk reports. The reports should include information on positions and
exposures in the market. The criticality of decisions made using the data should be clearly stated.
Ÿ Bank supervisors expect banks to impose accuracy requirements on risk data (both regular and
stress/crisis) commensurate with and analogous to accounting materiality. For example, if an
omission influences risk decision-making, then it is deemed material
45
Principle 8— Comprehensive
Ÿ Reports should contain position and risk exposure information for all relevant risks,
such as credit risk, liquidity risk, market risk, and operational risk. The report should
also include detailed information for specific risks. For example, credit risk reports
should include information on the country, region, sector, industry, and/or single name
exposures. Risk related measures such as the bank’s regulatory capital should also be
included in risk reports.
Ÿ Risk reports should be forward-looking and should include forecasts and stress tests.
The bank’s risk appetite/tolerance should be discussed in the context of emerging risks.
Recommendations for reducing risk should be included where appropriate. Senior
managers and the board of the directors should gain a sense of the bank’s future capital
and risk profiles from reports.
Ÿ Bank supervisors should be satisfied that the bank’s risk reporting is sufficient in terms
of coverage, analysis, and comparability across institutions. A risk report should include,
but not be limited to, information regarding:
è Credit risk. è Regulatory capital.
è Market risk. è Liquidity projections.
è Liquidity risk. è Capital projections.
è Operational risk. è Risk concentrations.
è Results of stress tests. è Funding plans
è Capital adequacy.
Principle 9— Clarity and usefulness Principle 10— Frequency
• Reports be tailored to the end user (e.g.,

the board, senior managers, and risk
committee members) and should assist them
with sound risk management and decision-
making.
ee • The frequency of reports will vary
depending on the recipient (e.g., the board,
senior managers, and risk committee
members), the type of risk, and the purpose
of the report. The bank should periodically
• Reports will include: test whether reports can be accurately
è Risk data. produced in the established time frame both
r
è Risk analysis. in normal and stress/crisis periods.
è Interpretation of risks. • In stress/crisis periods, liquidity, credit,
è Qualitative explanations of risks and market risk reports may be required
•Aggregation increases as the report moves immediately in order to react to the
nT
up in the organizational hierarchy i.e. senior mounting risks.

mangers and to the board. There is a greater
need of qualitative interpretation and
explanation as aggregation increases
Principle 11— Distribution

Fi
Reports should be disseminated in a timely

fashion while maintaining confidentiality
where required. Supervisors expect banks to
confirm that recipients receive reports in a
timely manner.
46
GARP Code of Conduct

LO 14.1 The Code of Conduct testable concepts here
1. Professional Integrity and Ethical Conduct
1.1. shall act professionally, ethically and with integrity in all dealings with employers, existing
or potential clients, the public, and other practitioners in the financial services industry.
1.2. shall exercise reasonable judgment in the provision of risk services while maintaining
independence of thought and direction. GARP Members must not offer, solicit, or accept any
gift, benefit, compensation, or consideration that could be reasonably expected to compromise
their own or another’s independence and objectivity.
1.3. must take reasonable precautions to ensure that the Member’s services are not used for
improper, fraudulent or illegal purposes.
1.4. shall not knowingly misrepresent details relating to analysis, recommendations, actions,
or other professional activities.
1.3. shall not engage in any professional conduct involving dishonesty or deception or engage
in any act that reflects negatively on their integrity, character, trustworthiness, or professional
ability or on the risk management profession.
1.6. shall not engage in any conduct or commit any act that compromises the integrity of
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GARP, the FRM® designation, or the integrity or validity of the examinations leading to the
award of the right to use the FRM designation or any other credentials that may be offered by
GARP.
1.7. shall be mindful of cultural differences regarding ethical behavior and customs, and avoid
any actions that are, or may have the appearance of being unethical according to local
customs. If there appears to be a conflict or overlap of standards, the GARP Member should
always seek to apply the highest standard.
2. Conflict of Interest 3. Confidentiality
2.1. act fairly in all situations and must fully

3.1. shall not make use of confidential
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disclose any actual or potential conflict to all

information for inappropriate purposes and
affected parties.
unless having received prior consent shall
2.2. make full and fair disclosure of all
maintain the confidentiality of their work,
matters that could reasonably be expected to
their employer or client.
impair independence and objectivity or
3.2. must not use confidential information for
interfere with respective duties to their
personal benefit
employer, clients, and prospective clients.
4. Fundamental Responsibilities :
Fi
4.1. comply with all applicable laws, rules, and regulations (including this Code) governing the
GARP Members’ professional activities and shall not knowingly participate or assist in any violation
of such laws, rules, or regulations.
4.2. have ethical responsibilities and cannot outsource or delegate those responsibilities to others.
4.3. understand the needs and complexity of their employer or client, and should provide
appropriate and suitable risk management services and advice.
4.4. be diligent about not overstating the accuracy or certainty of results or conclusions.
4.5. clearly disclose the relevant limits of their specific knowledge and expertise concerning risk
assessment, industry practices, and applicable laws and regulations. 47
5. Best Practices
5.1. execute all services with diligence and perform all work in a manner that is independent
from interested parties. GARP Members should collect, analyze and distribute risk information
with the highest level of professional objectivity.
5.2. be familiar with current generally accepted risk management practices and shall clearly
indicate any departure from their use.
5.3. ensure that communications include factual data and do not contain false information.
5.4. make a distinction between fact and opinion in the presentation of analysis and
recommendations.
LO 14.2 Violations of the Code of Conduct

Ÿ All GARP Members are expected to act in accordance with the GARP Code of Conduct as
well as any local laws and regulations that pertain to the risk management profession. If the
Code and certain laws conflict, then laws and regulations will take priority.
Ÿ Violations of the Code of Conduct may result in temporary suspension or permanent

removal from GARP membership. In addition, violations could lead to a revocation of the
right to use the FRM designation. Sanctions would be issued after a formal investigation is
conducted by GARP.
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Fi
48
Book 2 - Quantitative
Analysis
permitted by law.
The unauthorized duplication of these notes is a violation of global copyright laws. Your assistance
49
Financial Modelling
What is Financial Modelling?

l Financial Modelling involves modelling Financial Data for Decision Making
l Financial Modelling Skills are applied to variety of scenarios like Equity
Research, Mergers and Acquisition, Project Finance etc.
l Financial Modelling Certification at FinTree equips candidates to develop a
model from scratch without using ready-made templates
What is the Course

Content?
We have dividend Financial Modelling Course
into Four Parts:
Part I: A d v a n c e E x c e l Tr a i n i n g
Part II: Building Financial Model
Infrastructure
Part III: Forecasting
Part IV: Valuation
What is duration of the Course?

l The duration of one batch is roughly three months. The Certification is
provided by FinTree after the completion of the batch.
l For classroom, we operate on a club Membership model, wherein, in the
same fees, candidate are allowed to (and encourages to) attend three more
(1+3) subsequent batches. Every batch we pick up models from different
sectors and that provides deeper understanding to the participants.
l Online course validity: 1 year
To know more, visit www.fintreeindia.com
FinTree 50
Probability
LO 15.1, 15.2, 15.3, 15.4, 15.5 & 15.6 testable concepts here
e
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Fi
51
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Fi
52
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Fi
53
e
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54
e
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Probability Matrix
Calculating joint probabilities using a probability matrix:
Given the following incomplete probability matrix, calculate the joint probability of a
normal economy and an increase in rates, and the unconditional probability of a good economy
Interest Rates
Fi
Increase No Increase
Good 10% X2 X3
Economy Normal X1 25% X4
Poor 10% 20% 30%
50% 50% 100%
X1 = 50% -10% - 10% = 30% X3 = 10% + 5% = 15%
X2 = 50% -25% - 20% = 5% X4 = 100% - 30% - 15% = 55%

55
Ÿ Joint probability of normal economy & increase in rate = 30% (X1)
Ÿ Unconditional probability of a good economy = 15% (X3)
Ÿ Conditional probability that economy is good given interest rates

have increased
10%
P (G/I) =
50%
Ÿ Conditional probability that interest rate have decreased given

that it's a good economy
5%
P (Ic/G) =
15%
= 33.33%
e
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Fi
56
Basic Statistics
LO 16.1 testable concepts here
Measures of central tendency
& 16.2
FRM Part 1
e FRM Part 1
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Fi
57
e
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Fi
58
Eg. #1
X (X - X) (X - X)2
10 -5 25
20 5 25
5 -10 100
25 10 100
60 250
X = 15 Sample SD = Population SD =
√ 250
3
√ 250
4
e
= =
√83.33 √62.50
= 9.128 = 7.90
re
Calculator shortcut:
2nd 7 X 01=10 X 02=20 X 03=5 X 04=25
2nd 8 LIN ↓ ↓ ↓ Sx = 9.12 σx = 7.910
Eg. #2
nT
Probability X (X - X) (X - X)2 P(X - X)2
10% 10 -8 64 6.4
50% 10 -8 64 32
20% 20 2 4 0.8
20% 40 22 484 96.8

Fi
136
X = (10%×10) + (50%×10) + (20%×20) + (20%×40)
= 18
σx = √136 = 11.66
59
Calculator shortcut:
2nd 7 X 01=10 Y 01=10 (not 0.10)
X 02=10 Y 02=50
X 03=20 Y 03=20
X 04=40 Y 04=20
(Tip: total of Y should be 100)
2nd 8, 2nd set and reach on 1-V
↓↓↓ σx = 11.66 (Not Sx)
LO 16.4 Covariance and correlation
Sample Sample
covariance correlation
Measures how two variables move

together
e
Measures strength of linear relationship
between two variables
Captures the linear relationship between
two variables
Standardized measure of covariance
∑ (X − X) (Y − Y)
re
Cov(x,y) = Cov(x,y)
n−1 r=
Sx × Sy
Cov(x,y) = r × Sx × Sy Unit = No unit
2
Unit = % Range = −1 to +1
Range = −∞ to +∞ r = 1 means perfectly +ve correlation

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+ve covariance = Variables tend to r = 0 means no linear relationship

move together
r = −1 means perfectly −ve correlation
−ve covariance = Variables tend to
move in opposite directions
−ve covariance −ve correlation −ve slope
+ve covariance +ve correlation +ve slope

Fi
Scatter plot: Graph that shows the relationship between values of two variables
Limitations to correlation analysis
Nonlinear relationship Outliers Spurious correlation
Measures only linear Extremely large or small Appearance of causal linear

relationships, not non linear values may influence the relationship but no economic
ones estimate of correlation relationship exists
60
Eg. #1
X Y → enter data (2nd 7)
10 5 → enter stat function (2nd 8)
→ ↓ ↓ σx (STO 1)
15 5
→ ↓ ↓ σy (STO 2)
20 10
→ ↓ ↓ r (STO 3)
20 10
LIN mode:
COV (X,Y) = σx × σy × r (X,Y) = 9.375 or COV (X,Y) = Sx × Sy × r (X,Y) = 12.5

(Population) (Sample)
Eg. #2
Calculate covariance.
Y = 10 Y = 12 Y = 25
X = 10 0.20 - -
X = 15 - 0.60 -
e
X = 20 - - 0.20
COV (X,Y) = ∑ PXY - ∑ PX × ∑ PY

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= 228 - 14.2 ×15 = 15
Y = 10 Y = 12 Y = 25 Y = 10 Y = 12 Y = 25 Y = 10 Y = 12 Y = 25
X = 10 0.20 - - X = 10 0.20 - - X = 10 0.20 - -

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X = 15 - 0.60 - X = 15 - 0.60 - X = 15 - 0.60 -
X = 20 - - 0.20 X = 20 - - 0.20 X = 20 - - 0.20
= 10×20% (+) 12×60% ×15 (+) 25×20% ×20 = 10×20% (+) 12×60% (+) 25×20% = 10×20% (+) 60% ×15 (+) 20% ×20
Fi
= 228 = 14.2 = 15
61
Interpretation of scatter plot
Perfect positive Less than perfect Zero correlation

correlation positive correlation
Ƿ = +1 Ƿ = +0.7 Ƿ=0
Y Y Y
x x x
Perfect negative Less than perfect

correlation negative correlation
Y Ƿ = -1 Y Ƿ = -0.7
x x
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LO 16.6 Skewness and kurtosis
& 16.7
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Fi
62
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Eg. #1 Calculate mean, var, skew and kurtosis
X f(x)
(20) 10%
(8) 15%
5 45%
10 25%
20 5%
63
Solution:
X f(x) X.f(x) (x-μ)2 f(x) (x-μ)3. f(x) (x-μ)4. f(x)
(20) 10% (2) 50.9 (1147) 25857
(8) 15% (1.2) 16.7 (176) 1858
5 45% 2.25 2.7 6.6 16
10 25% 2.5 13.9 103 770
20 5% 1 15.2 266 4636
99.3 (947) 33182
Mean = 2.55 Var = 99.3 σ = 9.96
947 99182
Skewness = = -0.95 Kurtosis = = 3.37
9.963 9.964
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LO 16.8 Best linear unbiased estimator
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Point estimates are used to estimate Population parameters
Sample mean Population mean
a.k.a Estimator
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Desirable properties for estimator:
Œ Unbiased → Expected value X = μ

Efficient → Lowest covarience
Ž Unbiased → as n → Accuracy
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Linear (for regressions)
64
Distribution
Difference between parametric and non-parametric distribution
Parametric Non - Parametric
Ÿ Such as normal distribution Ÿ Such as historical distribution
Ÿ Makes restrictive assumption Ÿ Fit the data perfectly
Ÿ Easier to draw conclusions about data Ÿ Without generalizing data, difficult to

derive conclusion
Ÿ Can be described by using
mathematical function Ÿ Can not be described by using
predetermined mathematical function
LO 17.1 The Uniform distribution
A Continuous uniform Range that span between same lower limit (a) and upper limit (b)
e
distribution - which serve as the parameter of distribution.
Properties - Ÿ For all a<x1<x2<b
Ÿ P(X<a or X>b)=0
Ÿ P(x<X1<x2)=(x2-x1)/(b-a)
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Eg. #1
Mean and Variance of uniform distribution are
X is uniformly distributed between 3 & 11. Calculate
the probability that X will be between 5 & 7. 2
a+b (b - a )
Solution: E ( x) = Va r ( x ) =
7-5
= 0.25 2 12
11-3
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Fi
65
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B Bernoulli Distribution Binomial distribution
ª A binomial random variable is defined as

ª Only has two possible outcomes
no of successes in a given trials, where the
ª Outcomes can be defined as Success or
outcome can be either Success or Failure
Failure
ª Probability of success (p) is constant for
ª The probability of success (p) denoted with
each trial and trials are independent
1 and probability of failure (1-p) ,denoted
ª A binomial random variable for which no of
with 0.
trials is 1 is called Bernoulli distribution
66
Eg. #2
Compute the probability of drawing 2 black beans from a bowl of black and white beans if the
probability of selecting a black bean in any given attempt is 0.4. You will draw 6 beans from the
bowl.
2 4
Solution: 6C * ( 0 .4 ) * ( 0 .6 )
2
= 3 1 .1 0 4 %
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C Expected value and variance of a Binomial variable
Formula of expected value
Expected value of x = E(x) = np

which means we perform n trials and the probability of
successes on each trial is p.
Fi
Formula of variance
Variance of x = np (1 - p) = npv
V = 1-p is the probability of failure
67
Poisson distribution
Introduction - It has real world applications
e.g- No of defects in production process or no of calls per hour arriving at 911 emergency
Formula :
where : x refers to the no of successes per unit
x γ
P( X = x) = ëe
x!
refers to the average or expected no of successes per unit
Both, mean 2 variance of poisson one equal to the parameter.
Normal Distribution Properties

Eg. #3
On average, 911 emergency switchboards receive 2
5 incoming calls per min. What is the probability Ÿ X is normally distributed with mean ì and ó
that in 2 minutes exactly 20 phone calls will be variance.
received, assuming the arrival of calls follows a Ÿ Skewness=0
Poisson distribution. Ÿ Mean=Mode=Median
Ÿ Kurtosis=3
Solution: 20 10 Ÿ A linear combination of normally
P(X=20)= 10 e = 0 .18668 = 18 .668 % distributed independent random variable is
20! also normally distributed.
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Confidence Interval - Range of value around expected outcome within which the actual
outcome is to be some specified % of time.
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Example - A 95% confidence interval is a range that we expect random
variation to be in 95% of time
Standard normal distribution

Eg. #4
The average return of mutual fund is 12% per A normal distribution that has been standardized has a
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year and the standard deviation of annual is mean of zero and standard deviation of 1 (i.e. N ~ 0,1)
20%. If returns are approximately normal,
what is the 99% confidence interval for the Standardization in the process of converting
mutual fund return next year. observation value for random variable to it’s Z value
Solution: Formula :
12±2.58*(20)= -39.6% to 63.6% z = Observation-Population mean
Standard deviation =
x - μì
Expressed as P(-39.6% ≤ R ≤ 63.6)=99%
óσ
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Calculate probability using Z - Value
Ÿ The values in the Z- Table are probability of observing the Z-Value in less that the given
value Z [ i.e. P(Z< z) ]
Ÿ Numbers in the first column are Z value
Ÿ Columns to the right gives probability for Z values with 2 decimal places
Ÿ To find probability that standard normal distribution variance will be less than 1.66 ( for
example)
Ÿ Table value is 95.15%
Ÿ Probability that random variable will be zero that - 1.66 is 1-0.9515 = 0.0485 = 4.85%
Ÿ Is also the probability that variance will be greater than +1.66
68
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D Lognormal distribution - Ÿ Generated by the function ex where x is normally distributed.

Ÿ Logarithms of lognormally distributed random variable are normally distributed
Fi
69
LO 17.2 & 17.3 Central limit theoram
è States that for random samples of size n from a population with a mean μ and finite
variable σ , the sample distribution of sample mean x approaches a normal
probability distribution with mean as sample size becomes large
è Possible because when sample size is large ,the sums of independent and identically
distributed random variable will be normally distributed
è Useful because normal distribution is easy to apply to hypothesis testing and to the
construction of confidence interval.
è Specific inferences about the population mean can be made from sample mean as
long as sample size is sufficiently large (which usually means n ≥ 30)
Properties - Ÿ If Sample size n is sufficiently large(n>30),sampling

- distribution of the sample means
will be approximately normal.
Ÿ Mean of the population and mean of the distribution of all possible sample means are
equal. 2
Ÿ Variance of the distribution of the sample mean is . óσ

n
Student’s T - Distribution
Introduction - Ÿ A bell shaped probability distribution that is symmetrical about
e
it’s mean.
Ÿ Useful when constructing CI based on small samples (n<30)
from population with unknown variance and normal distribution.
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ª Symmetrical
Properties of Student’s ª Defined by single parameter, degrees of freedom.
T distribution ª More probability in the tails than the normal distribution.
ª As degrees of freedom gets larger, shape of t-distribution
approaches a standard normal distribution
CHI - Squared Distribution

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Ÿ Asymmetrical
Bounded below by zero
Ÿ
Ÿ Approaches normal distribution as D.O.F increase.
F - Distribution - Ÿ Used when the hypothesis is concerned with the equality of variances of two
populations.
Ÿ Assumes that the population from which samples are drawn are normally
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distributed and that samples are independent.

Ÿ F-Distribution is right-skewed and truncated at zero on the left hand-side.
2
Ÿ Formula:
s 1
2
s 2
Properties - Ÿ Approaches normal distribution as no. of observations increases.

2
Ÿ A random variable’s t-value squared ( t ) with n-1 d.o.f is F- distributed.
Ÿ Relationship between the F- and Chi-Squared distributions such that:
X2
Ÿ F= as the # of observations in denominator is ∞
# of observations in numerator
70
Mixture Distribution
Ÿ Contain element of both parametric and non-parametric distribution

Ÿ Distribution used as inputs are parametric while weights are non-parametric
Ÿ More use of inputs ,more closely the mixture distribution will follow actual data
Ÿ By this it’s easy to see how skewness and kurtosis can be altered
Ÿ Skewness can be changed by combining distribution with different means and kurtosis is
changed by combining distribution with different variances.
Ÿ By combining distribution with different means mixture distribution with multiple modes
can be created
Ÿ Risk models can be improved by incorporating the potential for low frequency, high-severity
events.
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71
Bayesian Analysis
LO 18.1 Introduction
Baye’s Theorem: Update a given set of prior probability for a given event in response to the arrival of
new information.
Formula: P(B/A) × P(A)

Ÿ Another way of expressing Baye’s Theorem: P(A/B)=
P(B)
Ÿ Joint Probability of both events A & B is determined by:
(I) P(AB)= P(B/A)×P(B)
(ii) P(AB)=P(A/B)×P(A) respectively.
Conditional Probability: Probability of one random event occurring given that

another event has already occurred.
Unconditional Probability: Random event not contingent on any additional

Information or events occurring.
e
Bond A
No default Default
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No default 80% 7% 87%
Bond B
Default 8% 5% 13%
88% 12% 100%
Ÿ Unconditional probability default A = 12%

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Ÿ Unconditional probability default B = 13%
Ÿ Joint probability of both bonds defaulting = 5%
Ÿ Joint probability of no default = 80%

Ÿ Two event for each bonds must sum to 100%
A B
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Probability of No default = 88% 87%

Probability of default = 12% 13%
100% 100%
Ÿ If the probability of defaults were independent, then probability of both the bonds
defaulting would be = 12% × 13%
= 1.56%
Ÿ Notice, actual probability (based on matrix) for both bond defaulting (5%) is quite
higher than 1.56%
72
Ÿ This is due to the high default correlation
Ÿ An independent probability matrix would have assumed r =0
Ÿ Conditional probability of default of A when B has already defaulted
Joint probability (A
=
Unconditional probability (B)
7%
= = 53.86%
13%
Note: If two events are highly correlated, conditional probability > unconditional Probability.
BAYESIAN FREQUENTIST
Ÿ Draw conclusion from sample data

Ÿ Used with larger sample size
Ÿ Based on prior belief regarding Ÿ Easy to implement and understand
probability of an event occurring
e
Ÿ It involves drawing conclusions
Ÿ Used when the sample size is small from sample data based on the
Ÿ Cumbersome frequency of that data
Ÿ Frequentist approach is simply
based on the observed frequency
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of positive events occuring
Baye’s theorem examples
Eg. #1
Suppose you are an equity analyst for ABC Insurance Company. You manage an equity fund of funds
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and use historical data to categorize the managers as excellent or average. Excellent managers are
expected to outperform the market 80% of the time. Average managers are expected to outperform
the market only 60% of the time.
Assume that the probabilities of managers outperforming the markets for any given year is
independent of their performance in prior years ABC Insurance Company has found that only 30% of
all fund managers are excellent managers and the remaining 70% are average managers.
A) A new fund manager to the portfolio started three years ago and outperformed the market all three
years. What is the probability that the new managers was an excellent managers when she first
Fi
started managing portfolio three years ago?
B) What are the probabilities that the new manager is an excellent or average manager today?(Given
that she Out Performed the markets for 3 years.)
C) What is the probability that the new manager will beat the market next year, given that the new
manager outperformed the market the last three years.?
73
Solution: 12.2%
%
80
=
O
O = 20%
c
15.3%
%
80
=
O
19.2% O = 20%
c
%
80
=
O
O = 20%
c
24%
%
80
=
O
= 30%
ent O = 20%
c
ell
Exc
Fund Manager
Ave
rag
e=
70% O = 60
%
e
42%
O
O=6
c
0%
=
40
O
c
25.2%
%
O=6
40
0%
re %
15.1%
O
Beginning
c
O=6
=
0%
40
%
O
c
Year 1 9.07%
=
40
%
Year 2
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Year 3
(Today)
Year 4
A) A new fund manager to the portfolio started three years ago and outperformed the market all
three years. What is the probability that the new managers was an excellent managers when she first
started managing portfolio three years ago?
è 30%
Fi
B) What are the probabilities that the new manager is an excellent or average manager today? (Given
that she Out Performed the markets for 3 years.)
è Manager is outperforming in two scenarios, being excellent and average.
Total probability of outperforming = 15.3% + 15.1% = 30.4%
C) What is the probability that the new manager will beat the market next year, given that the new
manager outperformed the market the last three years?
è We will use the updated probabilities
= 50.32% × 80% + (1- 50.32%)× 60%
≈ 70% 74
Eg#2:
Suppose now that we add another possible outcome where a manager is below average. The prior
belief regarding the probabilities of a manager outperforming the market are 70% for an excellent
manager, 40% for an average manager, and 10% for a below average manager. Furthermore, there
is a 10% probability that a manager is excellent, a 60% probability that a manager is average, and a
30% probability that a manager is below average. Solve using Bayes’ Theorem.
Solution: 2.4%
%
70
=
O
O = 30%
c
3.4%
%
70
=
O
O = 30%
c
4.9%
%
70
=
O
O = 30%
c
7%
%
e
70
=
O
%
10 O = 30%
c
n t=
lle
e O = 40%
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E xc O = 40% 3.8%
1.5%
O = 40%
Fund O = 40% 24% 9.6%
Oc
Manager Oc Oc =
Oc =6 = 60
= 60 %
60 0% %
%
O=
90%
nT O
c
=
3%
10
O=
%
90%
O
c
=
10
0.3%
%
O=
90
%
O
c
=
Fi
Year 1
10
0.03%
%
O=
90
%
O
=c
10
Year 2 0.003%
%
Year 3
(Today)
Year 4 75
Hypothesis Testing And

Confidence Intervals Watch video with important
Introduction:
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76
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LO 19.1 Sample mean and sample variance
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Fi
77
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LO 19.2 Confidence Interval
Point estimate ± (reliability factor ×standard error)

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78
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Fi
79
LO 19.3 Hypothesis Testing
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LO 19.4 One-tailed and two-tailed tests of hypothesis

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80
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Fi
81
LO 19.5 Hypothesis tests with specific level of confidence
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Fi
Interpretation: at least 75% observations lie within ± 2 SD of mean
82
LO 19.6 Backtesting
Ÿ It involves comparing expected outcomes against actual data
Ÿ If we apply 95% confidence interval, we expect event to exceed the confidence interval
with a 5% probability
Ÿ Risk managers to backtest their value at risk (VaR) model
Ÿ When VaR measure is exceeded during a given testing period it is known as exception
or an exceedance
Ÿ After backtesting, if number of exceptions if greater than expected, the risk manager
may be underestimating actual risk
Ÿ There is high probability that an exception will occur after the previous period had an
exception
Ÿ VaR exceptions tend to be higher (lower) when market volatility is high (low)
Ÿ This may be result of a VaR model failing to quickly react to changes in risk levels
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83
Linear Regression with One

Regressor Watch video with important
LO 20.1 Regression Analysis
Linear Process
Representation of relationship with linear equation where one dependent variable explained
by one or more independent variable.
Regression Analysis: Measure changes in one variable, i.e. dependent or explained variable
explained by changes in independent or explanatory variable.
Scatter Plot : Ÿ Visual representation of relation between dependent and a given
independent variable.
Ÿ Indicate positive relationship.
Dependent variable Independent variable

Aka response variable Aka the regressor
e
Variable you are seeking to Variable you are using to explain
explain changes in the dependent variable
Also referred to as explained Also referred to as explanatory

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variable/endogenous variable/exogenous
variable/predicted variable variable/predicting variable
y
Regression
Rp = RFR + β (Rm − RFR) line
Dependent
variable
Dependent Slope
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variable
Intercept Independent
x
Independent
variable variable
LO 20.2 Population regression function
Population Regression Error Term

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Function
ª Denoted as ei
ª Consists of parameter called ªDifference between Y and its corresponding
Regression coefficient. conditional expectation.
ª Simple two variance function: ª A. K. A Noise component.
E(Return/Lockup ª Provides another way of expressing population
Period)=B0+B1+(Lockup period) regression function: Yi=b0+b1*Xi+eihg
ª E(Yi/Xi)=B0+B1*(Xi) ª Represents effects from independent variable
not included in the model.
84
Independent variable
y = a + bx + ε
Dependent Slope
variable
Intercept Error term
Ÿ Intercept coefficient - is the expected value of y if X = 0

Ÿ Slope coefficient, which is the expected change in y for a unit change in X
Ÿ There is a dispersion of X-values around each conditional expected value. The difference
between each y and its corresponding conditional expectations (i.e, the line that fits the
data) is the error term or noise component denoted £i
LO 20.3 Sample regression function
Sample Regression Function
e
Ÿ Represents the relation based on sample of population
Ÿ slope and coefficient is different from population regression function
Ÿ Represented as Yi=b0+b1+Xi+ei
ei≠Ei
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Ÿ
ª The sample regression function is an equation that represents a relationship between the y and
X variable(s) that is based only on the information in a sample of the population
Ÿ Properties of Regression:
ª Relates to Independent variable
ª Independent variable enters into equation without transform such as square root or logarithm.
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ª Dependent variable is a linear function of parameters, but doesn't require linearity in variables.
Note: Linear Regression model assumes that the equation is linear

in parameter, it may or may not be linear in variations.
LO 20.4 Properties of regression

Ÿ Under certain, basic assumptions, we can use a linear regression to estimate the
Fi
population regression function. The term “linear” has implications for both the
independent variable and the coefficients
Ÿ If it is the case that the relationship between the dependent variable and an
independent variable is non-linear, then an analyst would do that transformation first
and then enter the transformed value into the linear equation
Ÿ Therefore, when we refer to a linear regression model we generally assume that the
equation is linear in the parameters; it may or may not be linear in the variables
85
LO 20.5 Ordinary least squares regression
Ÿ Ordinary least squares (OLS) estimation is a process that estimates the population
parameters Bi with corresponding values for bi that minimize the squared residuals
(i.e., error terms). Recall the expression ei - Yi - (b0 + b1 x Xi); the OLS sample
coefficients are those that:
minimize ∑ei2 = ∑ [Yi - (b0 + b1 × Xi)]2
Ÿ The estimated slope coefficient (b1) for the regression line describes the change in
Y for a one unit change in X. It can be positive, negative, or zero, depending on the
relationship between the regression variables. The slope term is calculated as:
_ _
∑( Xi _ X)( Yi _ Y ) Cov( X, Y )
n
b1 = i =1
_ =
∑ ( Xi _ X)
n 2
Var ( X)
i =1
Ÿ The intercept term (b0) is the line’s intersection with the Y-axis at X = 0. It can be
positive, negative, or zero. A property of the least squares method is that the intercept
term may be expressed as:
_ _
b0 = Y -b1X
_
e
where:
_ = mean of Y
Y
X = mean of X
The intercept equation highlights the fact that the regression line passes through a
re
__
point with coordinates equal to the mean of the independent and dependent variables
(i.e., the point, X,Y).
LO 20.6 Assumptions Underlying Linear Regression
Ÿ Expected value of the error term is zero

Ÿ All (X, Y) observations are independent and identically distributed (i.i.d.)
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Ÿ A linear relationship exists between the dependent and independent variable

Ÿ The independent variable is uncorrelated with the error terms
Ÿ Variance of error term is constant
Ÿ No serial correlation of the error terms exists
Ÿ The error term is normally distributed.
LO 20.7,20.8 Properties of OLS estimator

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Ÿ OLS estimated coefficients are unbiased, consistent, and (under special conditions)
efficient.
Ÿ Since OLS estimators are derived from random samples, these estimators are also
random variables because they vary from one sample to the next.
Ÿ Therefore, OLS estimators will have their own probability distributions (i.e., sampling
distributions).
Ÿ These sampling distributions allow us to estimate population parameters, such as the

population mean, the population regression intercept term, and the population
regression slope coefficient.
86
LO 20.7 OLS regression results
& 20.8
Ÿ The sum of squared residuals (SSR), sometimes denoted SSE, for sum of squared errors
Ÿ The coefficient of determination, represented by R2, is a measure of the “goodness of
fit” of the regression. It is interpreted as a percentage of variation in the dependent
variable explained by the independent variable
Total Sum of squares = Explained sum of + Sum of squared

squares residuals
_ _ _
Ó _
∑ (Y i Y ) = ^
∑ (Y
Ó Y ) + ∑Ó(Y i
_Y )^ 2
TSS = ESS + SSR
Ÿ Components of total variation

Unexplained error
Y
} Ó∑(Y _ Y )
}
^ 2
Yî = b0 + b1 Xi i _
e _
(SSR)
Ó _
∑ (Y i Y )
_
_ } Ó∑ ( Y Y ) ^
(ESS)
(TSS)
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Y
Explained error
b0
X
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Ÿ Coefficient of determination can be calculated as,
_
_ ^
∑ (Yi Y )
Ó
2
∑ (Yi _ Y )
^ 2
ESS _ 2 SSR Ó
R2 = =
_ 2
R =1- =1- _
TSS ∑ (Yi Y )
Ó TSS ^
Ó _
∑ (Yi Y )
2
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In a simple two-variable regression, the square root of R2 is the correlation

coefficient (r) between Xi and Yi. If the relationship is positive, then:
r = √R2
Ÿ The standard error of the regression (SER) measures the degree of

variability of the actual Y-values relative to the estimated Y-values from a
regression equation. The SER gauges the “fit” of the regression line. The
smaller the standard error, the better the fit.
Ÿ SER will be low (relative to total variability) if the relationship is very

strong and high if the relationship is weak. 87
Regression with A Single Regressor

LO 21.1 Calculate the confidence interval for the regression coefficient

^
b1 ± (tc × SE)
Slope Standard error of

regression coefficient
Critical value (t-value)

DoF = n − 2
^
Eg.1 b1 = 0.48 SE = 0.35 n = 42 Calculate 90% confidence interval
Confidence interval: 0.48 ± (1.684 × 0.35) −0.109 to 1.069
Eg.2 Estimated slope coefficient is 0.82 and Standard Error is 0.30.Sample had 38 observations.
Calculate 95% confidence Interval.
e
Confidence interval: 0.82 ± (2.03 × 0.30) 0.211 to 1.429
LO 21.3
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Hypothesis test for significance of regression coefficients
^
Eg. b1 = 0.48 SE = 0.35 n = 42 Confidence interval = 90% Perform a test of significance
^ ^
Step 1: Define hypothesis H0: b1 = 0, Ha: b1 ≠ 0
Sample stat. − HV 0.48 − 0

Step 2: Calculate test statistic 1.371
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Std. error 0.35
Step 3: Calculate critical values t-distribution, DoF = 40

−1.684 1.684
Since calculated test statistic lies inside the range, conclusion is ‘Failed to reject the null hypothesis’
Slope is not significantly different from zero
Solution:
Fi
Estimated slope coefficient is 0.82 and Standard Error

0.82 - 0
is 0.30.Sample had 38 observations. Determine if the t= = 2.73
estimated slope coefficient is significantly different 0.30
than zero at 5% level of significance. Critical two tailed T-value is 2.03
Reject the Null hypothesis (because 2.46>2.03)
88
LO 21.2 P Values
Reject
Reject Candidate to be
FTR FTR
FTR rejected only if
Think of some they are taller or
person who does equal to P-Value
not like tall people
5 ft. 3.8 ft. 4 ft. 6 ft. 4.5 ft. 5 ft.

P-value
Significance level
P-value is the lowest level of significance at which null hypothesis is rejected
Predicting dependent variable

^ ^ ^ ^ ^ ^ ^ ^
Y = b0 + b1 X1 + b2 X2 + …. + bk Xk
Intercept Forecasted
value (x)
e
Predicted Slope
value (y)
Eg. Forecasted return (x) = 12% Intercept = −4% Slope = 0.75 Standard error = 2.68
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n = 32 Calculate predicted value (y) and 95% confidence interval
Predicted value Confidence interval

^
^ ^ ^ Y ± (tc × SE)
Y = b0 + b1 × Xp
5 ± (2.042 × 2.68)
Y = −4 + 0.75 × 12 = 5%
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−0.472 to 10.472
Dummy variables
Y = b0 + b1 X1 + b2 X2 + …. + bk Xk + ε
Intercept Independent
Fi
variable
Dependent Slope Error

variable term
Dummy variables: Independent variables that are binary in nature (i.e. in the form of yes/no)
They are qualitative variables
Values: If true = 1, if false = 0
Use n – 1 dummy variables in the model
89
Smallest level of significance for which null hypothesis is rejected.
Predicted Values Ÿ Values of the dependent variable based on estimated regression coefficients
and prediction about the value of the independent variable.
Ÿ Simple regression Predicted Value is
Ÿ Example: yˆ = b 0 + b1 Xp
Predicting the dependent variable
WPO =-2.1+(0.72)(S&P500)
a)Calculate the predicted value ^
WPO excess returns if forecasted S&P 500 excess returns are 20%
Answer: a) ^
WPO= 2.1%±(0.72)(20%)
=12.3%
b) D.O.F = 36
tc= 2.03
^
WPO+(tc*sf)= 12.3%±(2.03*3.25)=5.0725% to 18.9%
Dummy Variables ª There are occasions when the independent variable is binary nature i.e.
e
“on” or “off”.Variables in this category are called dummy variables.
ª Quantify the impact of qualitative events.
LO 21.4 What is Heteroskedascticity?

re
Homoskedastic Heteroskedastic
Residuals are constant Residuals are not constant
Heteroskedastic
nT
Conditional Unconditional
Fi
ü Related to the level of ü Not related to the level of

Independent variable. Independent variable
ü Increases or Decreases as value ü doesn’t change with changes in
of independent variable the value of Independent
changes. variable.
ü Create significant problem for ü causes no major problem with
statistical inference regression.
90
Effect of Heteroskedasticity on Regression Analysis
è Standard errors are usually unreliable estimates.
è Coefficient estimates aren’t affected
è If standard errors are too small, but coefficient estimates aren’t affected, t-
statistics is too large and null hypothesis of no statistical significance is rejected
too often.
è Vice Versa if the standard errors are too large.
Detecting Heteroskedasticity
With Residual Plot
Residual
Independent
Variable
INTERPRETATION:
e
There is presence of heteroskedasticity as the variation in regression residual increases
as the independent variable increases.
Correcting Heteroskedasticity
re
Calculate Robust Standard Errors
Ÿ That calculate t-statistics using original regression coefficients.
LO 21.5
Gauss - Markov theorem
& 21.6
States that if Linear Regression Model assumptions are true and regression errors
display homoskedasticity then OLS estimators have following properties:
nT
è Minimum Variance
è Based on Linear Functions
è Unbiased
è OLS estimate of the variance of errors is Unbiased
Limitations of è Not hold when error term are heteroskedastic .

the Theorem : è Alternative Estimators which aren’t Linear or Unbiased, sometimes
more efficient than OLS estimators.
Fi
LO 21.7 Conditions to hold T-statistic when Sample Size is small :

ª Error terms must be Homoskedastic.
ª Must be Normally distributed.
Note: With Large Sample size, differences between the t-distribution and the Standard Normal
Distribution can be ignored.
91
Linear Regression with multiple regressor

LO 22.1 Omitted variable bias Watch video with important
Conditions Ÿ Omitted Variable is correlated with the movement of the Independent

Variable.
Ÿ Omitted Variable is a determinant of the Dependent Variable.
Addressing Bias Ÿ Divide data into groups and examine one factor at a time keeping
others constant.
Ÿ Multiple Regression can achieve that.
LO 22.2
Simple Regression Multiple Regression
Ÿ Analysis with one Independent Ÿ Analysis with more than one

Variable. Independent variable.
Ÿ Quantify the influence of one Ÿ Quantify the influence of two or
e
Independent Variable on more Independent Variable on
Dependent Variable. Dependent Variable
LO 22.3
re
OLS estimators in Multiple Regression Methodology
Ÿ Estimate Intercept and slope coefficient such that sum of squared error term is minimized.
Ÿ Estimators of these coefficients are OLS estimators.
Slope Coefficient in Multiple Regression: Change in Dependent Variable for one

unit change in the Independent Variable keeping other Independent variables constant.
Hence the reason for slope coefficient being called Partial Coefficients.
nT
LO 22.4 Describe Homoskedasticity and Heteroskedacticity

Heteroskedasticity Homoskedasticity
Means the dispersion of Condition that the variance of
error term varies over the error term is constant for
sample. all independent variables.
Fi
LO 22.6 Standard error of regression
ª Measure the uncertainty about accuracy of predicted value of Dependent

Variable.
ª Is the Standard Deviation of error terms in regression.
ª Specified as,
n n n 2
2 SSR ∑ [Yi - (b 0 + biXi )] ∑( Yi- Yi ) ∑ ei
SER= se
=
n- k-1
= i =1
n-k-1
= i =1
n-k-1
= i =1
n- k- 1
ª Gauges the “fit” of Regression Line.
ª Smaller the standard error better the fit.
92
Coefficient of Determination
Ÿ Test the effectiveness of all the Independent Variable in explaining Dependent variables.
total variation - unexplained variation TSS - SSR Explained variation ESS
Ÿ Calculated as = = =
total variation TSS total variation TSS
Adjusted R2
Ÿ R2 is not a reliable measure of explanatory power as it increases when Independent

Variables are added more.
Ÿ Referred to as problem of overestimating Regression.
2
Ÿ To overcome, Adjusted R is used
Ÿ Calculated as : 2
R a =1 - ( n n- K- 1- 1) ×(1 - R ) 2
Ÿ Note: (I) R2a < R2

(ii) Adding Independent variable increases R2 but can either increase or
decrease the R2a
(iii) R2a is < 0 if R2 is low enough.
LO22.7
è
e
Assumptions of multiple regression
Linear relationship between Dependent and Independent variable.
re
è Independent variables aren’t random and no exact linear relation between two or more
independent variables
è Expected value of error term is zero.
è Variance of error term is constant for all observations
è Error term of for one observation isn’t correlated with another observation
è Error term is normally distributed.
LO22.8 Multicollinearity
nT
Ÿ Two or more Independent variable are highly correlated with each other.
Ÿ Distorts standard error & coefficient error of regression
Ÿ Create problems when conducting t-tests.
Ÿ Am important consideration when performing multiple regression with dummy variables

is the choice of the number of dummy variables to include in the model.
Fi
Ÿ Whenever we want to distinguish between n classes, we must use n - 1 dummy variables.
Ÿ In general, if every observation is linked to only one class, all dummy variables are
included as regressors, and an intercept term exists, then the regression will exhibit
perfect multicollinearity.
Ÿ This problem is known as the dummy variable trap.
Ÿ This issue can be avoided by excluding one of the dummy variables from the regression
equation (i.e., n - 1 dummy variables). With this approach, the intercept term will
represent the omitted class.
93
Multicollinearity
Perfect Multicollinearity Imperfect Multicollinearity
Arises when two or more

One Independent variable is Independent variable are highly
perfect Linear combination of other correlated, but less than perfectly
Independent variable. correlated.
Effects of Multicollinearity
Committing type II error i.e. incorrectly conclude that a variable is not statistically significant
Detecting Correcting
Ÿ Present where T test indicate that
e
no individual coefficient is
significantly different than zero,
while R2 is high To omit one or more of the
Ÿ High correlation among independent variable through standard
independent variable suggest sign procedures like stepwise regression
re
of multicollinearity but low
correlation doesn’t indicate that
multicollinearity is not present.
nT
Fi
94
Hypothesis Tests and Confidence

Intervals in Multiple Regression
LO 23.1 Statistical significance of a regression coeffiicient Watch video with important
Example:
The future 10-year real earnings growth in the S&P 500(EG10) can be explained by the
trailing dividend payout ratio of the stocks in the index (PR) and the yield curve
slope(YCS). Test the statistical significance of the independent variable PR in the real
earnings growth at 10% significance level. Assume that the number of observation 43.
Coefficient Standard Error
Intercept -12% 1.285%
PR 0.30 0.023
YCS 0.12 0.290
Solution:
e
Step 1 : Hypothesis Step 2 : Test statistics Step 3 : Critical value
Outside the range ⸫ reject

H0 : bPR = 0 0.30 - 0
re
0.023
-1.684 +1.684
Ha : bPR ≠ 0 = 13.04
10%, two tailed

Dof = 43-2-1
= 40
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Student’s T- Distribution
Fi
95
P-value
Reject
Reject
FTR FTR
FTR
5 ft. 3.8 ft. 4 ft. 6 ft. 4.5 ft. 5 ft.

P-value
Significance level
P-value is the lowest level of significance at which null hypothesis is rejected
Interpreting P values : Ÿ P values < Significance Level, Null hypothesis rejected.

Ÿ P values > Significance Level, Null hypothesis can’t be rejected.
Two Tail test
e
Test the null hypothesis that PR is equal to 0.15 versus the alternative that it is not equal to
0.15.Using 1% significance level.
Solution:
re
Step 1: Ho: PRB1 = 0.15
Ha:PRB1 ≠ 0.15
0.30-0.15
Step 2: T-statistics =
0.023
= 6.5217
Step 3: Since T-statistics is very large therefore, Reject the null hypothesis.
nT
One Tail test
Test the null hypothesis that the intercept term is less than or equal to -15.0% versus the
alternative that it is greater than -15.0% using a 5% significance level.
Solution:
Fi
Step 1: Ho Bo≤-15%
Ha Bo≥-15%
Step 2: t-statistics
-12-(-15)
=
1.285
= 2.33%
96
Step 3:
The sign of alternate hypothesis can be used to understand direction of rejection area
Ha : B0 > -15
→ right direction
→ reject on right hand side of critical value
→ right tailed test
2.33 (test stat) ⸫ Reject null
+1.684
Rejection area
Student’s T- Distribution
e
re
nT
Confidence Interval for Regression coefficient
Calculate the 95% confidence interval for the estimated coefficient for the independent variable PR in
the real earnings growth example.
Solution: B1± (tcv*S.E) = 0.30±2.02*0.023)

= 0.253 to 0.346
Fi
Predicted Value for Dependent Variable
Calculate the predicted 10-year real earnings growth for the S&P 500, assuming the payout ratio of the
index is 60%.The slope of yield curve is currently 2%.
Solution:
٨ ٨ ٨
(Eg10) = B0+B1(PR)+B2(YCS)
= -12%+0.3(60%)+0.12(2%)
= 6.24%
97
LO 23.2, 23.3 Joint hypothesis testing
& 23.5
Joint Hypothesis ª Joint hypothesis tests two or more coefficients at the same time
ª A Robust method for applying joint hypothesis testing, especially when
independent variables are correlated, is known as F- Statistic
F-Statistic ü Test that at least one Independent Variable explains variation of Dependent
Variable.
ü Always one-tailed test when testing hypothesis that all regression coefficients
are simultaneously zero.(Rejection in tail)
Example:
A regression is run of monthly value stock returns on six Independent variables over 60 months.
The total sum of squares is 480 and the sum of squared residuals is 150.Test the null hypothesis
at the 2.5% significance level that all the six independent variables are equal to zero.
F test
Step 1 : Hypothesis Step 2 : Test statistics Step 3 : Critical value
e
Ÿ Mean explained error Ÿ Numerator Dof
H0 : B 1 = B 2 = B 3 = B 4 =K=6
= B5 = B6 = 0 150
=
6 Ÿ Denominator Dof
Ha : at least one = 25 = n – k - 1= 53
re
(Closet is 60)
Bj ≠ 0 Ÿ Mean unexplained error
⸫ Reject
480-150
=
53
= 6.22
2.63
150
Ÿ F= = 4.015
6 Rejection area
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F-Table at 2.5%
Fi
Ÿ Therefore, we can reject the null hypothesis and conclude that at least one of the six
independent variables is significantly different than zero.
98
Specification Refers how slope coefficient and other statistics for Independent Variable
Bias are different in simple regression compared to the same variables included
in multiple regression.
LO 23.4 Hypothesis test of single Restriction involving Multiple coefficients

Approaches:
ü Test restriction stated in null.
ü Transforms regression and uses null hypothesis as an assumption to simplify
regression model.
LO 23.6 Model misspecification

Omitted Variable Bias result if,
Ÿ It is a determinant of Dependent variable.

Ÿ It is correlated with at least one Independent variable.
2 2
LO 23.7 R and adjusted R
e
When computing both the R2 and the adjusted R2, there are a few pitfalls to
acknowledge, which could lead to invalid conclusions
1. If adding an additional independent variable to the regression improves the R2, this
re
variable is not necessary statistically significant.
2 . The R2 measure may be spurious, meaning that the independent variables may show
a high R2; however, they are not the exact cause of the movement in the dependent
variable.
3. If the R2 is high, we cannot assume that we have found all relevant independent
variables. Omitted variables may still exist, which would improve the regression results
nT
further.
4. The R2 measure does not provide evidence that the most or least appropriate
independent variables have been selected. Many factors go into finding the most robust
regression model, including omitted variable analysis, economic theory, and the quality
of data being used to generate the model
Restricted vs. Unrestricted Least Square Models

Fi
Restricted - è Imposes value on one or more coefficients to analyze if

restriction is significant
2 2 2
è R is called restricted R or R r
Unrestricted - è Includes both Independent variables.
2 2
è Unrestricted R or R r
F-Stat to test restriction is significant or not,
Ÿ Known as Homoskedasticity - only F-Stat

(SSRur - SSRr)/m
Ÿ Alternative Formula is F =
SSRur/(n - Kur - 1)
Ÿ If error terms aren’t homoskedastic, Heteroskedastic-robust F-Stat is applied.
99
Modeling And Forecasting Trend

LO 24.1 Time series Watch video with important
Time series: Ÿ Set of observations on a variable’s outcomes in different time periods

Ÿ Used to explain the past and make predictions about the future
1 Linear Trend Model 2 Non-Linear Trend Model
= Yt = B0 + B1 (t)
Y Y
x x
20t - 0.2 (t)2 Y = 200 - 5(t) + 0.1(t)2
Second term negative First term negative
3 Exponential Trend
e
4 Log-Linear Trend Model
re
LN (Yt) = LN (B0)+ B1 t
Positive Negative
Y Y
x x
nT
0.04 × t
Y=S×e Y = - S × e- 0.4 × t
Linear trend models Log-linear trend models
Dependent variable changes at a constant Dependent variable changes at an

rate with time exponential rate with time
Fi
Has a straight line Has a curve
Upward-sloping line: Convex curve:

+ve trend +ve trend
Downward-sloping line: Concave curve:

−ve trend −ve trend
Equation: Equation:
yt = b0 + b1t + εt ln yt = b0 + b1t + εt
Used for financial time series

100
LO 24.2 Ordinary Least Square Regression
Ÿ Estimate the coefficients in a trend line.
Ÿ β + βâ̂ 1(t )
Calculated as = ŷ = â̂
Ÿ Period 2 = ŷ 2 = â̂
β0 + â̂β1 (2)
Ÿ Similarly, in period 3 = ŷ 3 = βâ̂ 0 + βâ̂ 1 (3)
Ÿ This means ŷ increases by the value of β
â̂ 1 each period
Selecting the Correct Trend Model

Linear trend model: Ÿ Appropriate when the data points are equally distributed above and
below the regression line.
Ÿ Variable grows by constant amount
Log-linear trend model: Ÿ Appropriate when the residuals from linear trend model are serially
correlated (Autocorrelated).
Ÿ Variable grows at constant rate
Linear Trend Model
e Log-Linear Trend Model

re
y y
x x
nT
Ÿ Exhibits exponential growth along with Ÿ Plot of the natural logs of original data and
linear trend model. representative log-linear line.
Ÿ Doesn’t fit the transformed data better. Ÿ Fits the transformed data better ,thus
Ÿ When variance increases overtime by yields more accurate forecasts..
constant amount, this model is more Ÿ Appropriate when variable grows at a
appropriate constant rate.
Fi
Limitation of trend models is that they are not useful if the error terms are serially correlated
101
LO 24.3 Model selection criteria
Mean Squared Error Model Selection
Ÿ Statistical Measure computed as Ÿ Most important criteria in forecasting data.

Ÿ Based on in-sample data Ÿ Selecting best model based on highest R2 or
Ÿ Model with small MSE will also have smallest smallest MSE is not effective in producing good
sum of squared residuals and largest R2. out-of-sample models.
2
Ÿ Closely related with R Ÿ Hence, better methodology is to find model with
T smallest out-of-sample, one-step ahead MSE.
2
∑ et
t =1
Ÿ MSE =
T
S2 Measure - Unbiased estimator of MSE because it corrects for degrees of freedom.
Data mining
Ÿ Risk of over-fitting the in-sample data.
Ÿ Problem with data mining is regression model explains in sample data well but poor job
of forecasting out-of-sample data.
Ÿ Thus, important to adjust number of variables or parameters.
e
2
Ÿ Best model is selected based on smallest unbiased MSE or S that ranks model the same
2
way as Adjusted R
2 2
Ÿ Model with highest R will have smallest S
re
S2 Akaike Information Criterion Schwartz Information Criterion
T T T
∑e 2
t 2K ∑e 2
t K ∑e 2
t
2 T t =1 ( )
T t =1
( ) t =1
T
S =[ ] AIC = e SIC = T
T-K T T T
nT
2
Penalty factors for S , AIC, and SIC
SIC > AIC > S2

SIC
3
Fi
2.5
Penalty Factor
2
1.5 AIC
S2
1
0.5
0
0.00
0.01
0.03
0.04
0.05
0.07
0.08
0.09
0.11
0.12
0.13
0.15
0.16
0.17
0.19
0.20
K
T 102
è S2 penalty factor is the flattest line with slow increase as k/T increases
è AIC penalty factor increases at a slightly higher rate than the S2 penalty factor
è SIC penalty factor increases exponentially at an increasing rate and has the highest penalty factor
Penalty Factors
S2 AIC SIC
2K K
T ( ) ( )
K
e T T T
Consistency Asymptotic Efficiency
Used to compare different selection Ÿ Property that chooses regression model

Consistency
criteria with one-step-ahead forecast error
variance closest to the variance of true
e
Two conditions required, model
Ÿ When the true model or data generating Ÿ AIC is asymptotically efficient but SIC is
process (DGP) is one of the defined not
regression models, the probability of
re
selecting true model approaches one as Ÿ SIC is best selection criteria because it is
sample size increases. consistent and has the highest penalty
factor
Ÿ When DGP is not one of the defined
regression models being considered, Ÿ S2 adjusts for DOF, but adjustment is too
probability of selecting the best small for consistency
approximation model approaches one
as sample size increases. Ÿ With large sample sizes AIC tends to
nT
select models that have too many

variables or parameters
Ÿ Consistency - SIC
Efficiency - AIC
Fi
103
Modeling and Forecasting Seasonality

LO 25.1 Sources of Seasonality
Pattern that tends to repeat from year to year. Watch video with important
Stochastic Seasonality Deterministic Seasonality

Annual changes are approximate. Annual changes are exact.
Ÿ Approaches for modeling and forecasting Time Series impacted by seasonality
1 Seasonally Adjusted Time Series Ÿ Remove seasonal variation from the data.
Ÿ Used in macroeconomic forecasting.
Ÿ Measure the Non-seasonal Fluctuations of a variable.
Ÿ Inappropriate in business forecasting.
2 Regression Analysis Ÿ ”Pure” seasonal dummy model
represents seasonal factors

s
e
yt = ∑ γ iDi , t + εt
i =1
represents dummy variable
Ÿ If all are equal, time series shows absence of seasonality and seasonal
dummy variables can be dropped.
re
Ÿ Alternative to including dummy variable is to include an intercept and
then s-1 dummy variable
s -1
yt = β 0 + ∑βiDi , t + εt
i =1
Ÿ S-1 Dummy variables are used to avoid the problem of multicollinearity.

nT
LO 25.2 Modeling seasonality with regression analysis

& 25.3
Calendar Effect - 1.Holiday Variations (HDV)
2.Trading-Day-Variations (TDV)
Ÿ Pure seasonal dummy model:

Fi
yt = ∑ γ iDi , t + εt
i =1
Ÿ Adding a trend, the model is:

s
yt = β 1(t ) + ∑ γ i( Di , t ) + εt
i =1
104
Ÿ Allowing for HDV and TDV expands:
s v1 HDV v2 TDV
∑ γ i( Di , t ) + Ó
yt + h = β 1( T ) + Ó ∑δ ( HDVi , t ) + Ó
∑δ (TDVi , t ) + εt
i i
i =1 i =1 i =1
Ÿ h-step-ahead point forecast:

s v1 HDV v2 TDV
∑ δi
∑ γ i( Di , T + h ) + Ó
yt + h = β 1(T + h ) + Ó ∑δ
( HDVi , T + h ) + Ó (TDVi , T + h ) + εT + h
i
i =1 i =1 i =1
e
re
nT
Fi
105
Characterizing Cycles
Introduction
Covariance Stationary Covariance Structure
Relationship among past and present Covariance among the values of a time series at
values remain stable over time its various lags or displacements ( ) τ
Autocovariance Function
Ÿ Covariance between current Autoregression
value of time series and its value Linear regression of a time series against its
periods in the past is covariance own past values
Ÿ τ
Autocovariances for all makes
autocovariance function.
Ÿ If time series is covariance τ Partial Autocorrelation Function
stationary, this function is stable Ÿ Regression coefficients that results from
over time. autoregression is partial autocorrelation.
Ÿ To convert autocovariance Ÿ It makes up partial autocorrelation function
function to Autocorrelation for all lags
Function
Ÿ Which gives autocorrelation for
each scaled between +1 and -1 Note
Autocovariance of each τ Ÿ Autocorrelation approaches zero as gets large
Always the case for covariance stationary.
e
Ÿ
Variance of Time Series
LO 26.1 Properties for Time Series to be covariance stationary

re
Mean must be Variance must be finite covariance structure
stable over time. and stable overtime. must be stable over time
LO 26.3
nT
Models that aren’t Covariance stationary
Ÿ If time series is not Covariance Stationary then identify and isolate an

underlying, covariance stationary aspect of time series.
Ÿ However, a nonstationary series can be transformed to appear

covariance stationary by using transformed data, such as growth rates
Fi
Modeled in two ways
Dealing separately with

properties like trend and Apply transformation to the
seasonality and modeling series in ways like first
time series after filtering differences, logarithmic
out these properties. scaling, etc.
106
LO 26.4 & 26.5 White noise
Ÿ Broadly speaking, white noise indicates random data with no pattern (and autocorrrelation)
⸫ White noise data can’t be modeled (with time series)
White noise process
Zero mean white Independent white Normal white noise

noise noise
(Weak white noise) (Strong white noise)
Zero mean ✔ ✔ ✔
Constant var ✔ ✔ ✔
No serial correl ✔ ✔ ✔
Serial independence - ✔ ✔
Normally distributed - - ✔
e
NOTE:
ª Not all Independent White Noise processes are normally distributed, but all Normal
White Noise processes are Independent White Noise.
ª Gaussian means Normally Distributed.
ª Autocorrelation or Partial Autocorrelation Function for perfectly serially uncorrelated
re
process show zeroes for all its displacement (beyond zero)
Unconditional Mean & Variance Conditional Mean & Variance

Zero and constant variance. Not Constant.
nT
LO 26.6 Lag operator
yt= value of time series at time t

yt-1 = value one period earlier
yt-1=Lyt Similarly,
yt-2=L(Lyt)=L2yt
Fi
yt-2=Lyt-1 Lmyt=yt-m
107
LO 26.7,
26.8 & 26.9 Wold’s theoram
Holds that a covariance stationary

Ÿ Applied to any covariance stationary series.
process is modeled as an infinite
Ÿ Known as General Linear Process.
distributed lag of white noise process.
ε terms are referred to

as innovation
Ÿ Wold’s Theorem is not effective if it requires

an infinite series of past innovations.
Ÿ Result from a good forecast of Ÿ However, can be approximated with ratio of
covariance stationary process. rational distributed lags which have finite
Ÿ Not necessarily be independent. number of terms.
Ÿ Have conditional relation with past Ÿ Using this, an approximation will have as
innovation many as two rational distributed lags in the
Ÿ Conditional mean changes over time ratio.
e
LO 26.10
Estimating Correlations
& 26.11
Sample Autocorrelation Function: ü Set of sample autocorrelations for a time series
re
ü a.k.a correlogram
Sample Partial Autocorrelation: Results when the linear regression of time series is
performed
Determining whether Time Series is a White Noise

nT
ü By displaying its autocorrelation

and partial autocorrelation Test stat for this
function with bands ± 2 T hypothesis is
Box-Pierce
Q-Stat
ü By testing the hypothesis where
autorcorrelation are jointly equal
Follow
to zero
chi-Square
Distribution
Fi
Ljung-Box
Test stat useful with small samples is
Q-Stat
108
Modeling Cycles: MA, AR AND ARMA

LO 27.1 Moving average
A moving average process is a linear regression of the current values of a time series against
both the current and previous unobserved white noise terms, which are random rocks
First Order Moving Average

Ÿ The first moving average [MA(1)] process has a mean of zero and constant
variance and can be defined as:
Ÿ Considered first order because it only has one lagged error term.
Ÿ Short-term memory.
Ÿ One key feature is autocorrelation (Ƿ) cutoff.
θ1
ρ1 =
2
1+ θ
1
Ÿ Autocorrelation will be zero beyond first lagged error term.
Ÿ Moving Average has both current random shock and lagged unobservable shock.
Ÿ To incorporate observable shocks in MA, autoregressive representation is used.
LO 27.2 MA (q) process
Ÿ yt = ε t + θ 1 ε t 1 + ..... + θ q ε t q
e
Ÿ Captures complex patterns in detail, that provides for more robust
forecasting.
re
Ÿ Lengthens the memory from one period to the qth period.
Ÿ Experiences autocorrelation cutoff after the qth lagged error term.
LO 27.3 First - order autoregressive process [AR(1)]
Ÿ When a moving average is inverted it becomes an autoregressive representation.

nT
Ÿ [AR(1)] process have a mean of zero and constant variance.

Ÿ Specified as variable regressed against itself in lagged error form.
yt = φ yt 1 + ε t
Ÿ For [AR(1)] process to be covariance stationary, the absolute value of coefficient on

lagged operator must be less than one.
Ÿ To estimate autoregressive parameters accurate estimation of autocovariance of data
series is required.
Ÿ The significance is that for Autoregressive process, Autocorrelation decays very gradually.
Fi
LO 27.4 AR(p) process
Ÿ It expands the AR(1) process to the pth observation.

yt = φ1yt - 1 + φ2 yt - 2 + .... + φpyt - p + ε t
Ÿ Covariance stationary if, φ < 1
109
AR(p) & AR (1)
Similarity Differences
Ÿ AR(1) only evidences oscillations in

its autocorrelations when the
Both exhibits the same decay in coefficient is negative
autocorrelations. Ÿ AR(p) naturally oscillate as it has
multiple coefficients interacting
with each other.
LO 27.5 Autoregressive moving average process (ARMA)
Ÿ More complex
yt = φ yt - 1 + ε t + θ ε t - 1
Ÿ Merges the concepts of AR and MA process.
e
Ÿ φ < 1 must be observed for ARMA to be covariance stationary.
Ÿ Decays gradually.
re
LO 27.6 Application of AR and ARMA process
ª If autocorrelation decay gradually then either AR or ARMA process should be considered.

ª Should be considered especially if periodic spikes are noticed in autocorrelation.
ª Test various models using regression results.
nT
Fi
110
Volatility
LO 28.1 Volatility, Variance, And Implied Volatility testable concepts here
Volatility Variance Implied Volatility
Ÿ Represented as standard Ÿ Is a square root of volatility Ÿ Computed from an option

deviation of variable’s Ÿ Increase in linear fashion pricing model.
continuously. compounded over time. Ÿ Reverse calculation
return. Ÿ Computed using Historical
Ÿ Increase with square of Data.
time.
Ÿ Computed using Historical
Data.
LO 28.2 Power law
Ÿ The Power Law states that when X large, the value of a variable V has the following
e
property: P(V > X) = K × X -α
Ÿ It’s an alternative approach to assuming Normal Distribution.
Ÿ Taking logarithm of both sides of the equation, Regression analysis is performed to
determine the Power Law, K and α
Ÿ ln [P(V > X] = ln (K) - α ln(X)
re
α
Ÿ The law suggest that extreme movements have a very low probability of occurring,
but this probability is higher than the one indicated by the normal distribution.
Eg. #1
K=15 and α =7.
Calculate probability that this variable is greater than value of 2 and 4.
Solution:
nT
P(V>2)=15*2-7=
P(V>4)=15*4-7=
LO 28.3 Weighing schemes in estimating volatility
If we assume the mean return is zero, which would be true when the mean is small
compared to variability, we obtain the maximum likelihood estimator of variance
Fi
Assume zero
n 2
σ2n = ∑ (μ n-μ)
i =1
i
σ2n = 1n ∑ μ
2
i
i =1
1
è Weight of each observation = n = equal
è i.e this approach assumes that past observations & current observations have equal
influence of estimated volatility
111
è This approach will clearly not work when volatility regime has changed For example:
Returns
Current regime
Past regime
Time
è Alternate approach could be to weight recent observations more (ARCH, GARCH, EWMA
models)
è Autoregressive conditional Heteroskedasticity (ARCH)
(Fancy name, simple concept !)
σ2n = r v +∑ α μ
2
L
i =1
e
σ2n = w + ∑ α μ
2
VL = Long run variance

re
= r + ∑α = 1
è Therefore the volatility estimate is a function of a long-run variation level and a series
of squared return observations, whose influence declines the older the observation is in
the tome series of the data.
nT
2 m
2
Ÿ Weighting schemes represented as: α = ∑ α i un i
n
i =1
Ÿ Frequently used model is an Autoregressive Conditional heteroskedasticity model, ARCH(m)
Ÿ Equtions:
m m
2 2 2 2
óσn = γ vL + ∑ α i u
n -1 With γ + ∑α i so that óσn = ω + Ó
∑ α i un
i =1
i
i =1
Fi
LO 28.4 & 28.8 Exponentially weighted moving average (EWMA)

Ÿ Specific case of the general weighting model.
Ÿ Main difference is, weights are assumed to decline exponentially back through time.
2
2
σ = λ σ n-1 + (1 - λ) un2 -1
n
Ÿ Where λ Ranges between zero and one
112
Ÿ Example:
Decay Factor 0.82, Daily Volatility 2% and stock market return is 1%. New estimate of
volatility using EWMA model?
Solution: σ2n = 0.82(0.02)2+(1-0.82) × (0.01) 2
= √0.00036
= 1.86%
Ÿ Benefit is, it requires few data points.
LO 28.5 & 28.6 GARCH(1,1) Model
ª Incorporates the most recent estimates of variance and squared return.
ª σ n2 = ω+ α un2 -1 + β σ n2 -1
where,
α = weighting on previous period’s return
β = weighting on previous volatility estimate
ω = weighted long-run variance = ϒVL
VL= long-run average variance = ω

1- α - β
α + β +ϒ = 1
α + β < 1 for stability so that ϒ is not negative
ª EWMA is a special case of GARCH(1,1).

ª Implicit assumption that variance tends to revert to a long-term average level
Example :
The parameters of a generalized autoregressive conditional heteroskedastic (GARCH)

(1,1) model are ω = 0.000005, α = 0.04, β= 0.92
If daily volatility is estimated to be 2% and today’s stock market return is 1%.
What is the new estimate of volatility using the GARCH(1,1) model, and what is the
implied long-run volatility level?
Solution:
2
σ = ω + α un2 -1 + β σn2 -1
n 2 2
= 0.000005+0.05(0.01) +0.92*(0.02)
= 0.000378
= 1.994%
ω 0.000005
= = = 0.0001
(1 - α - β ) (1 - 0.05 - 0.90)
= 0.0001 = 1% = Long-run volatility
113
LO 28.7 Mean Reversion
Rate at which volatility persistence of one means

Higher the persistence there is no reversion and
revert to its long-term longer time to revert to
value following large with each change in
mean following a shock. volatility, new level is
shockfit margin
attained
Ÿ Sum of α+β is called persistence.
Maximum Likelihood Ÿ Maximize the likelihood that the observed data will occur in a sample.
Estimator : Ÿ GARCH models are estimated using this technique.
-
LOS 28.9 GARCH Models perform in volatility forecasting
&28.10
Very good at modeling volatility clustering when periods of high volatility
tends to be followed by other periods of high volatility and periods of low
e
volatility tends to be followed by subsequent periods of low volatility.
re
nT
Fi
114
Correlation and Copulas

LO 29.1 Correlation and covariance testable concepts here
Ÿ Co-movements of assets over time and measure strength between linear

relationships of two variables.
Ÿ Measures the same relationship. cov( X, Y )
Ÿ Correlation is mathematically determined by: ρ X , Y =
σ XσY
Ÿ Correlation of zero doesn’t imply the non-dependency between two variables.
Ÿ Covariance is calculated by: cov(X, Y) = ρ X, Y × σ X σ Y
LO 29.2 EWMA and GARCH Models

Ÿ Designed to vary the weight given to more recent observations:
Eg.
An EWMA model with λ=0.95 to update correlation and covariance rates. The correlation estimate
for two variables X and Y on day n-1 is 0.8. In addition, the estimated standard deviations on day
n-1 for variables X and Y are 1.3% and 1.8% respectively. Also the percentage change on day n-1
for variables X and Y are 1% and 2%. What is the updated estimate of covariance rate and
correlation between X and Y on day n?
Solution:
Given λ=0.95 rn-1=0.8 xn-1=1%
e
yn-1=2% σx(n-1)=1.3% σy(n-1)=1.8%
re
Cov(n-1)= 0.8*1.3%*1.8%=0.0001872
a) Using EWMA
Covn= λCovn-1 +(1-λ)Xn-1*Yn-1
=0.95*(0.0001872)+(0.05)(0.01)(0.02)
= 0.00018784
b)Correlation (rn)= Covn

nT
σxn-σxn
Using EWMA for σxn& σxn
σ xn=λ(σ x(n-1))+(1-λ)x n-1
2 2 2
=0.95*(1.3%)2+(0.05)(0.01)2
=0.01286623
Similarly,
σyn=0.0181052
Therefore, rn=0.80634j
Fi
GARCH (1,1) Model
GARCH(1,1) model
Covn= 0.000002+0.14xn-1yn-1+0.76covn-1 Solution:
This implies α=0.14,ẞ=0.76 and ω=0.000002.
The analyst also determines that the estimate of Covn = 0.000002+(0.14*0.022)+(0.76*0.000324)
covariance on day n-1 is 0.000324 and the most = 0.000002+0.000056+0.000246
recent returns on X and Y are both 0.02. = 0.000304
What is the updated estimate of covariance?
115
LO 29.3 Consistency conditions to covariance
Ÿ Necessary condition for Variance-Covariance Matrix to be internally
consistent (A. K. A positive-semidefinite):
ùω T ÙΩùω ≥ 0
Ÿ Another method for testing consistency is to evaluate:
ρ 2 +ñ
ñ ρ2 + ñ
ρ2 2ñρ12ñρ13ñρ23≤1
12 13 23
LO 29.4 Procedure of generating samples
Independent samples are Samples are then generated.

obtained from univariate First sample of X variable is Conditional Sample of Y
standardized normal same as random sample from a variables is determined as
distribution. univariate standardized normal
distribution
LO 29.5
e
One factor model
re
Properties Advantages
Ÿ Every Ui has standard normal

distribution
Ÿ Constant is between -1 and +1
Ÿ Covariance matrix is semi
nT
Ÿ F and Zi have standard normal

distributions and are positive-semidefinite.
uncorrelated with each other. Ÿ No. of correlations between
Ÿ Every Zi is uncorrelated with variables is greatly reduced.
each other.
Ÿ All correlations between Ui and
Uj result from their dependence
common factor, F.
Fi
CAPM: Well-known one factor model
Systematic Non-Systematic
Component Component
Ÿ Measured by Ÿ A. K. A Idiosyncratic Component

Ÿ correlated with market Ÿ Independent of the return on
portfolio return. other stocks and market.
116
LO 29.6 Marginal distributions of two variables
If Normal : Then Joint distribution of variable is bivariate normal.
If Not Normal : Then Copula is necessary to define correlation between two variables.
Copula : Ÿ Creates a joint probability distribution between two or more variables while
maintaining their individual marginal distributions.
Ÿ Accomplished by mapping marginal distribution to a new known distribution
Ÿ Done based on percentiles.
Key Property of Preservation of the original marginal distributions while defining a correlation
Copula Correlation : between them.
LO 29.8 Types of Copula
Student’s
One-Factor Copula
T Distribution
Similar to the Gaussian copula but variables

Where F and Zi standard normal are mapped to distributions that have
e
distribution. bivariate Student’s t-distibution rather than
a normal distribution.
re
Multivariate Copula Gaussian Copula
Define a correlation structure for Maps the marginal distribution of each

more than two variables. variable to the standard normal
distribution.
nT
LO 29.7 Tail dependance
Ÿ Greater Tail dependence in a bivariate Student’s T-distribution than in a bivariate normal

distribution i.e., more common for two variables to have the same tail values at the same
time using bivariate Student’s t-distribution.
Ÿ Student’s t-copula is better than Gaussian copula in describing correlation structure of
Fi
assets that historically have extreme outliers in the distribution tails at the same time.
117
Simulation Methods
LO 30.1 Monte carlo simulation testable concepts here
Specify the data Generate random inputs that are assumed

generating process (DGP) to follow a specific probability.
Estimate an unknown Generate scenarios or trials based

variable or parameter. on randomly generated samples.
Save the estimate

from step 2
Allow for data analysis related to properties of the

probability distribution of the output variables
e
Go back to step 1 and
repeat this process N times
re
LO 30.3 Techniques to reduce Monte carlo standard error
&30.4
Antithetic Variates Control Variates
Reduce the error by rerunning the

nT
ª
simulation using a complement set of the
original set of random variables.
ª Results in negative covariance between
original random draws and their Involves replacing a variable having
complements. unknown properties with variable having
ª Thus its use causes the error terms to be known properties.
independent for two sets, resulting in
negative covariance term in the variance
equation.
Fi
ª Monte Carlo sampling error must always

be smaller using this approach
LO 30.5 Benefits of reusing sets of random numbers

Benefits : Reduces the estimate variability across experiment.
Examples of Reusing sets : Ÿ Dickey-Fuller Test: Determine whether a time series is covariance stationary.
Ÿ Different experiments with options using time series data.
118
LO 30.6 Bootstrapping Method
Draws random return data from a sample of historical data
Advantages
Ÿ No assumptions are made regarding the true distribution of the parameters estimate.
Ÿ Inclusion of outliers will produce a distribution with fatter tails than the normal
distribution allowing for a realistic view of actual return data.
LO 30.8 Situations where Bootstrapping method is ineffective

è Outlier
è Non-Independent Data.
Note:
è Major Advantage of bootstrapping approach over traditional approaches is that it
doesn’t require any assumptions of the probability distribution of the sampled data
è To overcome the problem of autocorrelation, Moving Block Boostrap technique is used
e
LO 30.9 Disadvantage of simulation approaches
ª High computation costs.

ª Results are imprecise.
re
ª Results are difficult to replicate.
ª Results are experiment-specific.
nT
Fi
119
Book 3 - Financial
Markets and Products
permitted by law.
The unauthorized duplication of these notes is a violation of global copyright laws. Your assistance
120
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121
Banks
LO 31.1 Risks faced by banks Watch video with important
The major risks faced by a bank include the following
• Credit risk from defaults on loans or by counterparties.

• Market risk from declines in the value of trading book assets.
• Operational risk from external events or failure of internal controls
Types
Commercial Banks Investment Banks
(Take deposits & (Assist in capital

make loans) raising &
corporate finance)
Retail
Banks
Serve individual &

small business
ee
Wholsale
Banks
Serve corporate &

institutional
investors
LO 31.2 Regulatory Vs Economic Capital

r
Regulatory capital - Ÿ Amount of capital that regulators require a bank to hold
Ÿ Includes equity, or Tier 1 capital, and long-term subordinated
debt, or Tier 2 capital
nT
Economic capital- Ÿ Amount of capital a bank believes it needs to hold based on

its own models
Ÿ Regulatory capital is typically greater than economic capital
LO 31.3 How deposit insurance gives rise to Moral hazard
Ÿ To increase public confidence in the banking system and prevent runs on banks, most
Fi
countries have established systems of deposit insurance. These systems are funded by
insurance premiums paid by banks.
Ÿ Moral hazard - Observed phenomenon that insured parties take greater risks than they
would normally take if they were not insured. In the banking context, with deposit
insurance in place, the moral hazard arises when depositors pay less attention to banks’
financial health than they otherwise would. This allows banks to offer higher interest
rates on deposits and make higher-risk loans with the funds they attract. Losses on such
loans contributed to increased bank failures in the United States in the 1980s and 2000s.
Ÿ One way of mitigating moral hazard is by making insurance premiums risk-based. For
example, in recent years, poorly-capitalized banks have been required to pay higher
deposit insurance premiums than well-capitalized banks.
122
LO 31.4 Investment banking financing arrangements
Ÿ Private placement - Securities are sold directly to qualified investors
Ÿ Public offering - Securities are sold to the investing public
Investment banking arrangements
Private Placements Public Offering
Ÿ Securities are sold directly

to qualified investors
Firm Best effort

Commitment Basis
Ÿ
ee
Purchase entire
issue from company
Sells to public at a
higher price (earns
spread)
Ÿ Agrees to distribute
without commitments
ª An IPO price can be discovered using dutch auction process.

r
LO 31.5 Potential conflict of Interest
nT
ª Bank’s task of selling newly issued stocks and bonds may conflict with a securities
unit’s duties to act in the best interests of its clients and recommend actions
independently.
ª Bank regulators generally require these activities to be kept separate, by
preventing firms from engaging in more than one of these activities or by requiring
Chinese walls between these units of a bank.
ª Another clear conflict of interest among banking departments involves material non
public information. A commercial banking or investment banking division may
acquire non public information about company when negotiating a loan or
Fi
arranging a securities issuance
LO 31.6 Banking book Vs Trading book
Ÿ Banking book - loans made by a bank
Ÿ Balance sheet value of a loan includes the principal amount to be repaid and accrued interest,
unless the loan becomes nonperforming, in which case the value does not include accrued interest
Ÿ Trading book - Assets and liabilities related to a bank’s trading activities, they are marked to
market daily based on actual market prices when they exist or on estimated prices when necessary
123
LO 31.7 Originate-to-distribute model
Ÿ Originate-to-distribute model involves banks making loans and selling them to other parties,
many of which pool the loans and issue securities backed by their cash flows.
Ÿ This model frees up capital for the originating banks and may increase liquidity in sectors of
the loan market. However, it led to decreased lending standards and lower credit quality
r ee
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Fi
124
Insurance Companies And Pension Plans

LO 32.1 Categories of Insurance Companies
Risks facing insurance companies, Watch video with important

1) insufficient funds to satisfy policyholders’ claims

2) poor return on investments
3) liquidity risk of investments
4) credit risk
5) operational risk.
Insurance Companies
Life Property &

Health insurance
Insurance casualty insurance
Term
Coverage for fixed

r
time period
ee
Whole life
Coverage for life
Property Casualty
nT
Coverage property Ÿ Covers third party

loss such as fire liability for injuries
sustained while on
policyholder premises
Ÿ Subject to long tail risk
Ÿ Risk of a legitimate
claim being submitted
years after insurance
coverage has ended
Fi
e.g. existence of cancer

causing substance
LO 32.2 Mortality Tables
Mortality tables : Used to compute life insurance premiums. It includes information related to
the probability of an individual dying within the next year, the probability of an individual
surviving to a specific age, and the remaining life expectancy of an individual of a specific age
125
Partial hypothetical probability table
MALE
Prob. of death Survival Life

Age within one year probability expectency
30 - 97% 48
31 2.06% 95% 39
95% = 97% × (1 - 2.06%)
Probability of Probability of Probability of

surviving till surviving till 30 not dying in
31st year years 31st year
Example: Ÿ Interest rate = 3% p.a SA

Ÿ Premiums paid annually at the beginning of the year
Ÿ
Age
(Years)
ee
1000000 term contract for 60 year old male
Assume, payouts occur halfway throughout the year
Calculate breakeven premium for a two year term plan
Prob. of death
within one year
Survival
probability
Life
expectency
60 0.011197 0.86112 21.48

r
61 0.012009 0.85147 20.72
62 0.012867 0.84125 19.97

nT
Step 1: Expected payout first year
Payout is in middle of the

year
0.5
0
Fi
1000000
× 0.011197 Prob. of dying in year 60
11197
11031.5
@ 1.5% for 1 period
126
Step 2: Expected payout second year
1.5
0 1
Prob. of not dying last year
1000000
× (1-0.011197)
× 0.012009 Prob. of dying this year
11874.53
11355.81
@ 1.5% for 3 periods
Step 3: Total PV of payout
= 11031.5 + 11355.81
r
Step 4:
ee
= 22386.8
Calculate the breakeven premium to mater PV inflow = PV of outflow
Lets assume premium received is X. Premium is paid at the beginning of the year
Time Premium Prob. of Prob. of PV

received receiving premium adjusted value
0 x 1005 x x
nT
1 x (1-0.011197) 0.9888x 0.9888x
2 (1.015)2
22386.8
⸫ X + 0.9888X
Fi
2 = 22386.8
(1.015) Should be same as
PV inflows
= 1.030225X + 0.9888X = 23063.44
⸫ X = 11423.05
127
LO 32.3 P&C Insurance Ratios
Ÿ The loss ratio for a given year is percentage of previous versus

premiums generated, usually between 60 - 80% and increasing over
time
Ÿ The expense ratio for a given year is the percentage of expenses versus
premiums generated, usually between 23 -30% and decreasing over
time
Ÿ Loss ratio + expense ratio = combined ratio
Ÿ Combined ratio + dividends = combined ratio after dividends
Ÿ Combined ratio after dividends — investment income = operating ratio
LO 32.4 Moral hazard and Adverse selection
Moral hazard - Risk to the insurance company Adverse selection - Unable to differentiate
that having insurance will lead the policyholder between a good risk and a bad risk
to act more recklessly than if the policyholder
did not have insurance Methods to mitigate adverse selection - Greater
initial due diligence and ongoing due diligence
Methods to mitigate moral hazard - Deductibles,
coinsurance, and policy limits
LO 32.5
Ÿ
ee
Mortality risk Vs Longevity risk
Mortality risk = Risk of policyholders dying earlier than expected. For the
insurance company, the risk of losses increases due to early insurance payout
Ÿ Longevity risk = Risk of policyholders living longer than expected, risk of losses
r
for insurance company increases due to the longer-than expected annuity
payout period
nT
Ÿ Longevity risk is bad for the annuity business but good for the life insurance
business, and mortality risk is bad for the life insurance business but good for
the annuity business
Ÿ There is a natural hedge (or offset) for insurance companies that deal with both
life insurance products and annuity product
LO 32.6 Capital requirements for insurance companies

Fi
Life insurance
Equity &
Assets
liability
Equity capital 10% Investments 80%
Policy reserves 85%
Subordinated 5% Other assets 20%

long term debt
128
P & C insurance
Equity &
Assets
liability
Equity capital 35% Investments 80%
Policy reserves 50%
Uncovered 10% Other assets 20%

premium
Subordinated 5%
long term debt
Corporate bonds Highly liquid bonds
Ÿ Under an asset-liability management Ÿ Shorter maturities than those used by life
Ÿ
approach, the life insurance company
attempts to equate asset duration with
liability duration. ee
Comprise the bulk of the investments, so
there is credit risk assumed
Ÿ
insurance companies
On the liability side, the unearned

premiums represent prepaid insurance
contracts whereby amounts are received
but the coverage applies to future time
periods; unearned premiums do not
Ÿ Policy reserves represent the present generally exist for life insurance
value of the future payouts as determined companies
by actuaries
r
Ÿ More equity capital for a P&C insurance
Ÿ Risk is that the policy reserves are set too company than for a life insurance
low if life insurance policyholders die too company, due to the highly unpredictable
nT
soon or annuity holders live too long nature of claims (both timing and
amount) for P&C insurance contracts.
LO 32.7 Guaranty system
For insurance companies in US, every insurer must be a member of the guaranty
Fi
association in the state(s) in which it operates
If insurance company becomes insolvent in a state, then each of the other insurance
companies must contribute an amount to the state guaranty fund based on the amount of
premium income it earns
Guaranty system for banks in the US is a permanent fund to protect depositors that consists
of amounts remitted by banks to the Federal Deposit Insurance Corporation (FDIC)
Insurance companies regulated at state level only (and banks are regulated at federal level
only)
129
LO 32.8 Pension Funds
è In Defined contribution plan both

è Defined benefit plans explicitly state the
employer and employee contributions
amount of the pension an employee will
being invested in one or more investment
receive upon retirement.
options selected by the employee
è Calculated as a fixed percentage times the
è Virtually no risk borne by the employer
number of years of employment times the
annual salary for a specific period of time
è Risk of underperformance of the plan’s
investments is borne solely by the
è Significant risk borne by the employer
employee
r ee
nT
Fi
130
Mutual Funds And Hedge Funds

LO 33.1 Type of Mutual Funds Watch video with important
Open-end mutual Close-end mutual Exchange traded

funds funds funds (ETFs)
Ÿ Transact at the Ÿ Transact Ÿ Transact

next available net throughout trading throughout trading
asset value (NAV) day day
Ÿ Shares redeemed Ÿ Shares can not be Ÿ Shares trade at NAV

directly redeemed
Ÿ Usually have lowest
internal fees
Ÿ Closed-end funds tend to invest in niche areas like specific emerging markets, while open-end
mutual funds tend to invest in broader areas
Ÿ Open-end fund investors have poor price visibility. Since shares are transacted at an unknown price,
investors cannot use stop orders or limit orders.
Ÿ Purchase of shares in an open-end mutual fund will increase the number of shares outstanding
e
because new shares are created, but a closed -end fund’s number of shares remain static
Ÿ Closed-end fund investors cannot simply redeem their shares from the fund company. They must
find another investor to buy shares
Ÿ It is very common for a closed-end fund to trade at either a discount or a premium to its actual NAV.
re
LO 33.2 Net Asset Value
Total assets - Liabilities

NAV =
Total shares outstanding
Ÿ Recall that the NAV for an open-end mutual fund is only calculated after the close of
trading on any given day, while the NAV for an closed-end mutual fund and exchange
nT
traded funds is calculated continuously throughout the day.
LO 33.3 Hedge Funds

Ÿ Hedge funds are only marketed to wealthy and sophisticated investors
Ÿ They escape certain regulatory oversight, which avoid allowing investors to redeem
shares at any time
Fi
Ÿ Permitted to use leverage and short selling
Ÿ Uses lock-up periods to prevent investor withdrawals at the wrong time for the fund
LO 33.4 Hedge fund expected return and Fees structure
Hedge funds use 2% and 20% incentive fee structure
They earn management fees for investment results relative to a given hurdle rate
Investors are partially protected with the use of high-water marks and clawback clauses
131
LO 33.5 Hedge Fund Strategies
Long/short equity funds : Take both long and short positions
Diversifying or hedging across sectors or market capitalizations
and have directional exposure
Dedicated Short : Take net short positions in equities

Returns are negatively correlated with equities
Distressed hedge funds : Invest across the capital structure of firms that are under financial
or operational distress or are in the middle of bankruptcy
Merger arbitrage funds: Bet on spreads related to proposed merger and acquisitions
Convertible arbitrage funds: Profit from the purchase of convertible securities and shorting of
corresponding stock
Fixed income arbitrage funds: Obtain profits by exploiting inefficiencies and price anomalies
between related fixed income securities
Emerging market funds: Invest in currencies, debt, equities, and other instruments in
countries with emerging markets
Global macro managers: Large bets on directional movements in interest rates, commodities,
e
exchange rates, and stock indices
Managed futures funds: Attempt to predict future movements in commodity prices based
on - technical analysis or fundamental analysis
re
LO 33.6 Hedge fund performance and measurement bias
Backfill bias - arises when the database is backfilled with the fund’s previous returns
Measurement bias - indicates that not all hedge fund report their performance to
index providers. Participation in hedge fund indices is voluntary.
If the fund had good performance, then they will report their results to the index
nT
vendor. If they did not have good results, then they simply do not report their
results to the index.
Fi
132
Introduction (Options, Futures And other Derivatives)
LO 34.1 Derivative Markets
ª Over-the-counter (OTC) market is used for large trades Watch video with important
ª Typical OTC trade is conducted over the phone
ª The OTC market has more credit risk
ª Exchanges are organized to eliminate credit risk
LO 34.2 Basics of Derivative Securities
Call option - Right to Put option - Right to sell

buy a specified a fixed number of shares
number of shares
ee
A forward contract -
Agreement to buy or sell
an asset at a pre
selected future time for
a certain price
Futures contract - More
formalized, legally
binding agreement to
buy or sell a commodity
or financial asset
LO 34.3 Option and Forward Payoff

r
Payoff on a call option Payoff on a put option Payoff to a long position
nT
in a forward contract
CallT = max (0, ST — X) PutT = max (0, X — ST)
Payoff = ST — K
where:
ST = spot price at maturity , X = strike price of option , K = delivery price
LO 34.4 Hedging Strategies

Fi
Ÿ Hedgers use derivatives to control or eliminate a financial exposure.
Ÿ Futures lock in the price of the underlying and do not allow for any upside potential
Ÿ Options hedge negative price movements and allow for upside potential
LO 34.5 Speculative Strategies
è Speculators use derivatives to make bets

è Futures require initial margin requirement
è Futures contracts can result in large gains or large losses
133
LO 34.6 Arbitrage Opppurtunities
Ÿ Arbitrageurs seek to earn a riskless profit through manipulation of mispriced securities
Ÿ It is earned by entering into equivalent offsetting positions in one or more markets
Ÿ It do not last long as the act of arbitrage brings prices back into equilibrium quickly
r ee
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Fi
134
Mechanics of Futures Markets

LO 35.1 Features of Future contract testable concepts here
Ÿ A long (short) futures position obligates the owner to buy (sell)

Ÿ Most futures positions are reversed (or closed out) as opposed to satisfying the contract
by making (or taking) delivery
Ÿ Open interest is the total number of long positions in a given futures contract. It also
equals the total number of short positions in a futures contract. An open interest of 200
would imply that there are 200 short positions in existence and 200 long positions in
existence
Ÿ Daily price limits - The exchange sets the maximum price movement for a contract during
a day. For example, wheat cannot move more than $0.20 from its close the preceding
day, for a daily price limit of $1,000.
Ÿ When a contract moves down by its daily price limit, it is said to be limit down. When the
contract moves up by its price limit, it is said to be limit up
Ÿ Position limits - The exchange sets a maximum number of contracts that a speculator
may hold in order to prevent speculators from having an undue influence on the market.
Such limits do not apply to hedgers.
LO 35.2
Ÿ
Ÿ
ee
Futures/Spot convergence
Spot price of a commodity is the price for immediate delivery
Futures price is the price today for delivery at some future point in time
Basis is the difference between the spot price and the futures price, as the
maturity date nears, the basis converges toward zero.
r
Ÿ Arbitrage will force the spot and futures prices to be the same at expiration
LO 35.3
nT
Operation of Margins
Ÿ Initial margin is the necessary collateral to trade the futures

Ÿ Maintenance margin is the minimum collateral amount required
to retain trading privileges
Ÿ Variation margin is the collateral amount that must be deposited
to replenish the margin account back to the initial margin
Ÿ Gains and losses due to changes in futures prices are computed
at the end of each trading day known as marking to market
Fi
LO 35.4 Clearinghouse
Ÿ It maintains an orderly and liquid market by acting as the counterparty
Ÿ In (OTC) markets, clearinghouse also becomes the counterparty to both parties in an OTC transaction
135
LO 35.5 Central counterparties in Over-the-counter transactions
& 35.6
Ÿ Over-the-counter (OTC) market - good deal of credit risk
Ÿ Clearinghouse for standard OTC transactions are referred as central counterparties
(CCPs). They operate in similar fashion to clearinghouse on futures exchanges.
Ÿ After two parties (X and Y) negotiate an OTC agreement, it is submitted to the
clearinghouse for acceptance. Assuming the transaction is accepted, the
clearinghouse will become the counterparty to both parties X and Y. Thus, the
clearinghouse assumes the credit risk of both parties in an OTC transaction
Ÿ This risk is managed by requiring the parties to post initial margin and any variation
margins on a daily basis
Ÿ Arguments for the use of clearinghouses in OTC markets include: (1) collateralized
positions with reserve and margins (2) reduction of financial system credit risk, and
(3) increased transparency of OTC trades
Ÿ Historically, OTC markets have functioned as a series of bilateral agreements
between parties, this process known as bilateral clearing.
Ÿ If CCP was instead used for every OTC transaction, each market participant would
only deal with a central clearing party. However, because only some OTC
transactions are currently required to use CCPs, in practice the current OTC market
is a mix of both bilateral agreements and transactions that use centralized clearing
r Ÿ
No Netting
ee
This collateralization is basically marked to market feature for the OTC market
where any loss is settled in cash at the end of trading day.
Counterparty Risk Exposures
Bilateral Netting Multilateral Netting
X X X
nT
0
2 3 3 3
5 6 CCP
0 0
Y 4 Z Y Z Y Z
3
1
Fi
Ÿ Clearly both the bilateral and multilateral netting frameworks significantly reduce risk exposures
compared to the netting framework. However, the biggest advantage of a CCP is the ability to
mitigate systematic risk through multilateral netting.
Ÿ Figure 1 implies that systematic risk exposures are reduces more under multilateral netting than
bilateral netting.
Ÿ However, the reduction in risk exposures for the multilateral netting framework as opposed to the
bilateral framework are only possible if a relatively small number of CCPs clear a relatively large
number of transaction.
136
LO 35.7 &
Normal and Inverted Futures Market
35.8
Ÿ Closing period: Futures settlement price is an average of the prices of the trades
during the last period of trading
Ÿ It is used to make margin calculations at the end of each trading day
Ÿ Increasing settlement prices indicate normal market, while decreasing indicate an

inverted market
Ÿ A position may also be settled through an exchange for physicals. Here you find a
trader with an opposite position to your own and deliver the goods and settle up
between yourselves, off the floor of the exchange (i.e. an ex-pit transaction)
LO 35.9 Delivery Process

ª Short can terminate the futures contract by delivering the goods
ª Long pays price to short to accepts this delivery known as the delivery process
LO 35.10
ee
ª In a cash-settlement contract, delivery is not an option
Types of Orders
Market order: Buy or sell at the best price available
Limit order: Buy or sell away from the current market price
Stop-loss order: Prevent losses or to protect profits
Stop-limit order: Combination of a stop and limit order
r
Market-if-touched order: Become market orders once a specified price is reached
nT
LO 35.11 Comparison of Forward and Future Contract

Ÿ Both allow for a transaction to take place at a future date at a price agreed upon today
Ÿ Difference between the two is that forward contracts are private, customized
contracts, while futures trade on an organized exchange and are highly standardized
Fi
137
Hedging strategies using futures

LO36.1 Define and differentiate between short hedge and long hedge
Short Hedge Long Hedge
It is appropriate when It is appropriate when

1) A long position on the underlying. 1)A short position on the underlying
2) Expect prices to decline. 2)Expect prices to rise.
Ÿ Short future realises the profit Ÿ Long future realizes the profit
Ÿ user locks in a future selling price Ÿ User locks in future purchasing price.
LO36.2 Arguments for and against hedging
FOR:
Hedging leads to less uncertainty regarding future profitability.
LO36.3
AGAINST:
ee
Leads to less profitability if the asset being hedged ends up increasing in value.
Questionable benefit that accrues to shareholder
Define the basis and explain the various sources of basis risk, and
explain how basis risk arise when hedging futures
FORMULA : Basis = Spot - Future

r
CAUSES OF BASIS RISK:
ª Difference in underlying
nT
ª Difference in maturity
Strengthening of Basis Weakening of Basis
ª Spot increases faster rate than ª Spot decreases at faster rate than
future future.
ª Future decreases at faster rate ª Future increases at faster rate
Fi
than spot than spot
Sources:
ª Interruption in the convergence of futures and spot prices
ª changes in the cost and carry
ª Imperfect matching between the cash asset and the hedge asset.
138
Hedge Ratio
Optimal Hedge Ratio Hedge Effectiveness Calculated as
Minimum variance Higher R2 is better ª Perfect Hedge is = 1.

Hedge ratio ª Optimal Hedge not
CovS,F necessarily = 1
h*=
σF2
LO36.5 & Optimal number of future contracts and tailing the hedge adjustment
36.6
Optimal Number of Futures
Size of the position Dollar Value

Quantity of Asset Value of Asset
N*= HR × N*=HR ×
Quantity of Future Value of Future
Tailing the Hedge

ee β Adjustment
Allows for the impact of Use of stock Index Futures to

r
Ÿ
daily settlement. change stock portfolio’s beta
Ÿ Multiply the N* optimal Ÿ N*= β× Va/Vf
Hedge ratio by (S/F) Ÿ N*=(β*-β)×Va/Vf
nT
LO36.7 Rolling a Hedge Forward
ª As maturity date approaches, hedger must close out

the existing position and replace it with another
contract at later maturity. This is known as rolling
the hedge forward.
Fi
ª Rolling a hedge forward, hedgers are not only

exposed to basis risk of original hedge but also to the
basis risk of new position. This is rollover risk.
139
Interest Rates
LO 37.1 Types of Rates Watch video with important
Treasury Rates LIBOR Repo Rates
Ÿ Credit risk exists here Ÿ Implied rate on

Ÿ Considered RFR Ÿ Better reflects trader’s repurchase agreement
Ÿ No credit Risk opportunity cost of Ÿ Existence of credit
capital. risk.
LO 37.2 &37.3 Compounding

Example: Convert 10% annual compounding to semiannual, monthly, weekly (52 Weeks)
& continuous compounding
9.531 9.76%
e
Continuous Semi annual
re
10%
Annual
nT
9.539 9.56
Weekly Monthly
Calculator keys on TI BA II:

C/Y Nominal
Fi
2nd - 2 ( to enter I conv)

2nd CLR WRK (to clear memory)
2 9.76
- enter 10 at nominal ↓
- keep C/Y as 1 ↓ 12 9.56
- press CPT at effective, you would get 10! 52 9.539
- now don't change eff tab, change C/Y & CPT nominal 9999999.. 9.531
(Approx. for continuous)
140
M)
e
re
nT
Fi
141
Dollar
LO 37.4
e
Spot Rates and Bond Pricing
re
ª Spot Rates or Zero Rates are computed from coupon
bonds using bootstrapping.
ª Forward Rates computed from spot or Zero rates.
ª Construction of spot curves and Forward Rate curves.
nT
Spot Rates and Bond Pricing
Spot Rates or Zero Rate Bond Pricing YTM = IRR = Bond Yield
Ÿ ZCB yields Ÿ PV of its cash flows Ÿ Single Discount rate

when each is discounted that equates the P.V. of
Ÿ Appropriate discount at the appropriate Spot a bond to its mkt. price.
rate for a single cash rate for its maturity
Fi
flow at a particular
time or maturity
Par Rates ª Rate of which the price of a bond equal to its par value
ª In this case when Bond is trading at par Coupon Rate= Bond’s yiels/YTM
142
e
re
LO 37.5
nT
Fi
143
Derive forwards interest rates from set of spot rates
Ÿ CASE I: Upward sloping Spot Curve CASE II: Downward sloping Spot Curve
Ÿ Corresponding Forward Rate curve is Ÿ Corresponding Forward Rate curve is

upward sloping downward sloping
Ÿ Lies above the spot curve. Ÿ Lies below the spot curve
LO 37.6 Effect of inflation on capital budgeting analysis

Characteristics of US LIBOR:
ª It is a rate at which one bank lends another bank
ª For short term
ª Currency is USD
ª Issued out of US
ª It is an add-on rate
ª Different LIBOR exist for different maturities
ª 360 day convention is used
30 60
1 × 3 FRA:
e
60 90
2 × 5 FRA:
90 90
3 × 6 FRA:
re
60 120
2 × 6 FRA:
3 Price and value of forward rate agreement (FRA)
Eg. FRA: 4 × 5 Nominal amount: $ 10,000,000 Position: Short

nT
LIBOR (today) LIBOR (after 90 days)

30 day 300 bps 30 day 370 bps
120 day 390 bps 120 day 520 bps
150 day 400 bps 150 day 580 bps
Fi
144
Price of the FRA
Formula Logic Magic

(approx.)
) 1 + (0.04 × 150/360)
1 + (0.039 × 120/360)
−1
) × 360/30
4 × 150/360
150 days
1.67
3.9 × 120/360 = 1.3% 0.37%

1.67
120 days
4 × 150/360 = 1.67%
150 days
$100 $101.67
3.9 × 120/360 = 1.3%
120 days
$100 $101.3
Rate for 30 days:

PV = −101.3 FV = 101.67 N = 1
CPT I/Y = 0.362%
4.34%
e
0.362 ð 30 days 0.37 ð 30 days
re
4.34% ð 360 days 4.44% ð 360 days
Price of new FRA (after 90 days)

30 days
120 days 30 days
Day 90
) 1 + (0.038 × 60/360)
)
nT
−1 × 360/30 = 3.89%
1 + (0.037 × 30/360)
Value of the FRA

10,000,000 × (4.34% − 3.89%) × (30/360)
= $3,726.4
1 + (0.038) × 60/360)
Fi
145
LO 37.8 Convexity
e
re
LO 37.9 Calculate the change in a bond’s price given its duration, its convexity
and a change in interest rates
Ÿ Percentage change in price due to convexity.

Ÿ Amount of price change not explained by Duration.
nT
Ÿ For option Free bond, convexity is always positive.

Ÿ Convexity effect = 0.5 × convexity × y2
Ÿ It decreases the drop in price (due to increase in yields) & adds to the rise
in price (due to fall in yields).
LO 37.10 Compare and contrast the major theories of the term structure of interest
rates
Fi
EXPECTATION THEORY:
ª Forward Rates are good predictors of Expected future spot raetes.
ª Fails to explain all future spot rates expectations.
MARKET SEGMENTATION THEORY:

ª Bond market is segmented based on maturity.
ª Demand in each maturity range define the rates in that maturity.
LIQUIDITY REFERENCE THEORY:

ª Most depositor prefer short term liquid deposit.
ª Long term rates are increased by adding premium.
146
Determination of Forward And Future Prices

LO 38.1 Differentiate between investment nd consumption asset
Investment asset is held Consumption asset is testable concepts here
for the purpose of held for the purpose of

investing. consumption.
Eg: Stocks and Bonds Eg: Oil and Natural gas
LO 38.2 Short Selling and Short Squeeze
Ÿ Short Sales are orders to sell securities that the seller does not own. Also known as
shorting and is possible with investment assets.
Ÿ For a short sale: seller (1) simultaneously borrows and sells securities through broker,
(2) must return the securities at the request of lender or when short sale is closed out,
and (3) must keep portion of the proceeds of short sale on deposit with broker
Ÿ Short seller may be forced to close his position if the broker runs out of his securities to
borrow. This is known as short squeeze.
Ÿ
Ÿ
Ÿ
LO 38.3, 38.4
Rules for short selling: Short seller
ee
(1)must pay all dividends due to the lender of security
(2)Must deposit collateral to guarantee eventual repurchase of agreement
Forward and futures contracts

& 38.9
r
FUTURE CONTRACTS FORWARD CONTRACTS
nT
Ÿ Trade on organized
exchanges. Ÿ Do not trade on an
Ÿ Highly standardized.
exchange.
Ÿ Customized contracts.
Ÿ Clearinghouse is the
Ÿ Contracts with the
counterparty to all future
contracts. originating counterparty.
Ÿ Not regulated.
Ÿ Government regulates
future markets.
Fi
Introduction
Forward commitments
Forwards Futures Swaps
è No arbitrage forward/futures price = Spot × (1 + RFR)n

è Value of forward/futures at initiation is zero
è Two fundamental rules for arbitrage:
Investmment = 0
Exposure to market risk = 0 147
Eg. Spot price: $100 RFR: 10% Maturity: 1 year
S = 100 S = 130 Long = 110
0 0.6 1
Price of the contract (0.6): 130 × (1+10%)0.4 = $135.05
Value of the contract at expiration (1): 135 − 110 = $25.05

25
Value of the contract today (0.6): = $24.11
(1+10%)0.4
Pricing and valuation of forward and fututres

1 Price and value of forward and futures (with dividend)
Eg. Spot price: $625 RFR: 8% CC Maturity: 6 months Spot rate in month 2 = $630
Expected dividends: $10 (Month 1), $20 (Month 3)
S = 625 D = 10 D = 20
0 1
ee 3 6
(20.4)
(10.34)
650.5
Price of the contract (Long): 619.76

r
S = 630 D = 20
0 2 3 6
nT
(20.4)
647.03
Price of the new contract (Short): 626.62
Value in month 6 (626.67 − 619.76) : 6.86

−0.08 × 4/12
Value in month 2 (6.91 × e ): 6.67
Fi
2 Price and value of forward and futures (continuous dividend yield)
Eg. #1 Spot index: $2,700 RFR: 10% Dividend yield: 2% CC Maturity: 6 months
Continuously compounded rate: LN (1.1) = 9.53%
Price of the contract: 2700 × e(9.53% − 2%) × 6/12 = 2803.59
148
Eg. #2 Spot index: ₹8,780 RFR: 6.9% CC Dividend yield: 1.8% CC Maturity: 40 days
Spot index on day 10: ₹8,900
S = ₹8,780 S = ₹8,900
0 10 40
Price of the contract (Short): 8780 × e(6.9% − 1.8%) × 40/365 = 8829.2

Price of the new contract (Long): 8900 × e(6.9% − 1.8%) × 30/365 = 8937.4
Value of the contract (Day 40): 8829.2 − 8937.8= (108.18)
Value of the contract (Day 10): 8900 × e(6.9%) × 30/365 = (107.56)
Characteristics of US LIBOR:
ª It is a rate at which one bank lends another bank
ª For short term
ª Currency is USD
ª Issued out of US
ª It is an add-on rate
ª Different LIBOR exist for different maturities
ª 360 day convention is used
1 × 3 FRA:
2 × 5 FRA:
3 × 6 FRA:
30
60
90
ee 60
90
90
60 120
2 × 6 FRA:
r
3 Price and value of forward rate agreement (FRA)
nT
Eg. FRA: 4 × 5 Nominal amount: $ 10,000,000 Position: Short

120 day 390 bps 120 day 520 bps
Fi
150 day 400 bps 150 day 580 bps
149
Price of the FRA
Formula Logic Magic

(approx.)
) 1 + (0.04 × 150/360)
1 + (0.039 × 120/360)
−1
) × 360/30
4 × 150/360
150 days
1.67
3.9 × 120/360 = 1.3% 0.37%

1.67
120 days
4 × 150/360 = 1.67%
150 days
$100 $101.67
3.9 × 120/360 = 1.3%
120 days
$100 $101.3
Rate for 30 days:

PV = −101.3 FV = 101.67 N = 1
CPT I/Y = 0.362%
4.34%
ee
0.362 ð 30 days
4.34% ð 360 days
Price of new FRA (after 90 days)

0.37 ð 30 days
4.44% ð 360 days
30 days
r
120 days 30 days
Day 90
) 1 + (0.038 × 60/360)
)
nT
−1 × 360/30 = 3.89%
1 + (0.037 × 30/360)
Value of the FRA

10,000,000 × (4.34% − 3.89%) × (30/360)
= $3,726.4
1 + (0.038) × 60/360)
Fi
4 Price and value of currency forward contracts
Eg. Spot price: ₹66.505/$ Interest rates: India = 7% USA = 2%

Position: Long Investment: $1,000,000 Maturity: 6 months
After 2 months: Spot price: ₹68.15/$ Interest rates: India = 6.9% USA = 1.5%
150
0.5
Price of the contract: 66.505 ×

) )
1.07
1.02
= ₹68.1155
4/12
Price of the new contract: 68.15 ×

) )
1.069
1.015
= ₹69.3377
1,000,000 × 1.2223
Value of the contract: = ₹1,195,342.94
5 Price of cheapest-to-deliver bond futures
Eg. Full price: $1,020 Maturity: 1.4 years Coupon: 12% semi-annual RFR: 10% semi-annual
Conversion factor: 1.17
S = 1,020 C = 60 C = 60
0 0.5 1 1.4
1.4/0.5
1,020 × 1.05 60 × 1.050.9/0.5 60 × 1.05 0.4/0.5
ee
Accrued interest (60 × 0.4/0.5):
(62.38)
(65.5)
1,169
1,041.12
(48)
Future price: 993.1
Conversion factor: 1.17
r
Quoted future price (993.1/1.17): 848
nT
LO 38.6 Currency Basics

Introduction
Exchange rate Price of one unit of currency in terms of another
Spot exchange rate Exchange rate for immediate delivery
Forward exchange rate Exchange rate for a transaction to be done in future

Fi
$3 Price currency
€ Base currency
€ - Depreciated $2 $3 $4 € - Appreciated
$ - Appreciated € € € $ - Depreciated
151
Eg. ZAR 52 ZAR 57
$ $
Closing value Opening value
% Appreciation: − 1 % Depreciation: − 1
Opening value Closing value
57
$ - Appreciated: −1 = 9.62%
52
52
ZAR - Depreciated: −1 = 8.77%
57
Forward premium/discount for a given currency

Eg. #1 Bid/Ask: Spot $/€ = 1.1820/1.1824 Forward points (3 months) = −15.2/−14.6
15.2
3 month forward bid rate = 1.1820 − = 1.1804
10,000
14.6
3 month forward ask rate = 1.1824 − = 1.1809
10,000
Eg. #2 Spot rate MXN/USD = 19.26 Forward rate MXN/USD = 18.35
ee
Calculate forward premium/discount
USD discount:
MXN premium:
18.35
19.26
19.26
18.35
-1 = -4.72%
-1 = 4.95%
Forward contract: Any exchange rate transaction that has a settlement date longer than T + 2
r
Forward premium/discount = Forward rate – Spot rate
Mark-to-market value of a forward contract

nT
Mark-to-market: Profit/loss that is realizable from closing out a position
Eg. Forward contract: 1 mln GBP Rate: 1.3000 USD/GBP Term: 6 months
Spot rate after 90 days: 1.3100/1.3105 90-day forward points : +120/+125 90-day LIBOR: 4%
All-in three-month forward rate: 1.3100 + (120/10,000) = 1.3220
CF at the settlement date: (1.3220 − 1.300) × 1,000,000 = USD 22,000

Fi
USD 220,000
Mark-to-market value: = USD 21,785.34
1 + 0.04 × (90/360)
152
International parity conditions

International Fischer relationship (precise)
1 + Nominal interest rate = (1 + Real interest rate) × (1 + Expected inflation)
Determining forward rate

USA India
2% ₹50 10%
$
$1mln ₹50mln
$1mln 10%
+ 2% int.
₹55mln 55 ₹55mln
$1.02mln 53.92
53.92 1.02
(1 + Int. rate)n
Forward rate = S ×
(1 + Int. rate)n
ee
Forward rate = 50 ×
= 53.92
(1 + 10%)1
(1 + 2%)1
Interest rate parity
Int. rate (India) = 20%

Int. rate (USA) = 10%
r
(1 + Int. rate)n
F = S × = ₹54.54
nT
₹50 (1 + Int. rate)n

$
Expected
(1.1538)
spot rate = 50 ×
(1.0576)
= ₹54.54
Real int.
Inflation rate
rate = 4%
(1 + 20%)
India = = 15.38%
(1 + 4%)
Fi
(1 + 10%)
USA = = 5.76%
(1 + 4%)
Covered interest
Forced by arbitrage. It is always true
rate parity
Uncovered interest
Not forced by arbitrage. It may not be true
rate parity
153
Eg. Spot rate: $1.2/€ 1-year forward rate: $1.3/€

USD interest rate: 9% Euro interest rate: 7% Determine if an arbitrage opportunity exists
Forward rate 1 + USD int. rate

=
Spot rate 1 + Euro int. rate
Forward rate
× 1 + Euro int. rate Vs 1 + USD int. rate
Spot rate
1.3
× 1 + 7% Vs 1 + 9%
1.2
1.1591 Vs 1.09
Invest Borrow
Cash And Carry & Reverse Cash and Carry Arbitrage
F0=S0rt
r Ÿ
Ÿ
Cash & Carry Arbitrage
F0>S0
Sell the forward.
rt
Buy the asset with the

borrowed funds.
Ÿ Forward overvalued
ee Ÿ
Ÿ
Ÿ
Ÿ
Reverse Cash & Carry
Arbitrage
F0<S0rt
Short sell the asset.
Lend out the proceeds.
Buy the forwards.
Forward undervalued
LO 38. 7 &
38.8
ª F0= (S0-I)ert : I Cash flow from Underlying Asset
ª F0= S0e(r-q)T : q= Dividend continuous compounding
nT
ª Value of forward at inception is Zero

Ÿ Pricing of future or forward uses cost of carry model.
Ÿ Currency Future uses IRP = F0=S0e(rdc-rfc)
LO 38. 10 Delivery options in the Future Market

Fi
When convenience yield> Cost of carry

Ÿ Short will delay the delivery.
When Cost of carry > convenience yield

Ÿ Short will deliver early.
154
LO 38. 11 Futures and Expected Futures Market & Contango and
& 38.12 Backwardation
Expectation Model
NORMAL BACKWARDATION NORMAL CONTANGO

ª F0< E(ST) ª F0> E(ST)
ª Exhibits positive ª Exhibits negative
systematic Risk. Systematic Risk.
Cost of carry model
BACKWARDATION CONTANGO
Ÿ Future prices are below Ÿ Future Prices are above
current spot prices current spot prices.
Ÿ Convenience yield must Ÿ Cost of carry must be more
be more than cost of carry than convenience yield.
e
re
nT
Fi
155
Interest Rate Futures

LO 39.1 Day Convention
Ÿ US T- Bonds= ACT/ACT
Ÿ US Corporate & Municipal Bonds = 30/360
Ÿ US T- Bills = ACT/360
Ÿ Accrued Interest = Coupon × # of days since last coupon payment
# of days in coupon period
LO 39.2 Quotations for T-Bonds

ª T-Bonds are percentage of par ª Cash Price = Quoted Price +Accrued Interest
ª Full Price a.k.a Transaction cost, Invoice,
ª T-Bond prices are quoted relative to $100 par
Dirty Price, Cash Price
amount in dollars and 32nds
ª Quoted Price a.k.a Clean Price and Flat Price
ª Example: 95-05
95+05/32
95.15625% of par
LO 39.3
Ÿ
Ÿ
ee
Quotations for T-Bills and other Money Market Instruments
Uses Discount rate basis and an actual/360 day count

Given: I)Cash price ‘Y’
ii)Days to maturity = n
iii)Future Value = 100
Ÿ T-Bill quoted as
360
r
T-Bill Discount Rate= n × (100-Y)
nT
LO 39.4, 39.5 & Treasury Bond Futures

39.6
ª Conversion Factor determines the price received by short on contract.
ª C.F= (Discount Price Face

of Bond - Accrued Interest
Value
)
Fi
ª Cash received= (QFP*CF)+A.I.

where QFP is Quoted Future Price (most recent settlement price) and CF is a bond
to be delivered
156
Cheapest to Deliver T-Bond for short on T-Bond Futures
Ÿ Buy the Underlying Asset(T-Bond) at Cash Price= QBP+AI

Ÿ To deliver T-Bond:
à Maturity>15 years
à Non-callable within 15 Years
Ÿ Short on Future Underlying Asset= T-Bond
à Min QBP-(QFP*CF) OR Max (QFP*CF)-QBP
Ÿ $$ Received (QFP*CF)+AI
Decision on CTD T-Bond
LEVEL OF YIELD CURVE SHAPE OF YIELD CURVE
Case I: Yield>6% Case I: Yield upward sloping

è CTD will be low coupon & long maturity. è CTD will be long maturity.
Case II: Yield<6% Case II: Yield downward sloping

è CTD will be high coupon & short maturity. è CTD will be short maturity.
LO 39.7
THEORETICAL
FUTURE PRICE
ee
Treasury Bond Futures Prices
EURODOLLAR
FUTURE PRICE
CONVEXITY ADJUSTMENTS
FOR EURODOLLAR FUTURES
Ÿ F0=(S0-I)ert=(QFP*CF)+AI Ÿ Underlying Asset is Eurodollar Ÿ Actual Forward Rate:
Ÿ S0=Y=QBP+AI Deposit Forward Rate Implied by
r
Ÿ I= Discount dividend/coupon Ÿ Future Value = 1million Futures - 0.5×σ2×T1× T2
to be received in future = Ÿ Interest Rate= 90 Day LIBOR
Coupon*e-rt Ÿ QP for Eurodollar Futures=Z
Ÿ Eurodollar Future
nT
Price=10000(100-((0.25)(100-Z))
Ÿ This contract settles in cash and
minimum price change is “one
tick”, which is a price change of
one basis point, or $25 per $1
million contract.
Fi
LO 39.10 Explain how Eurodollar futures used to extend the LIBOR zero curve
LIBOR ZERO Forward Rates Implied by Convexity-Adjusted eurodollar Futures
CURVE/SPOT CURVE : Produces LIBOR Spot Curve.
157
LO 39.11 Duration-Based Hedging
P×Dp
N=
F×Df
where
à N is No. of Contracts
à P is portfolio values at Hedging Horizon
à Dp is Duration of portfolio at Hedging Horizon
à F is Future position of contract
à Duration of the Futures at Hedging Horizon
LO 39.12 Limitation of Duration
The price/yield relationship of a bond is convex, meaning it is nonlinear in shape. Duration

measures are linear approximations of this relationship.
Therefore, as the change in yield increases, the duration measures become progressively
less accurate.
Moreover, duration implies that all yields are perfectly correlated. Both of these
r ee
assumptions place limitations on the use of duration as a single risk measurement tool
nT
Fi
158
Swaps
LO 40.1 Mechanics of Interest Rate Swaps testable concepts here
Swaps Agreements to exchange a series of payments on periodic settlement dates
At each settlement date, the two payments are netted so that only one
payment is made
The length of the swap is termed as tenor
Simplest type of swap is plain vanilla interest rate swap
Plain vanilla interest rate swap
Eg. Fixed rate - 8% Floating rate - LIBOR + 2% Notional principal = 100,000
Fixed rate Fixed rate

payer receiver
A
Floating rate
receiver
Floating rate
Net rate
Year 1
0%
ee Year 2
11%
3%
Year 3
LIBOR = 6% LIBOR = 9% LIBOR = 4%

8% 6%
2%
B
Floating rate
payer
Net amount 0 3000 2000
r
Will be paid by Will be paid by
B to A A to B
nT
Some important points of Swaps
ª Swaps do not require payment at initiation by either party

ª They are custom instruments
ª They are not traded in any organized secondary market
ª They are largely unregulated.
ª There is default risk associated with swaps
Fi
ª Participants in the swaps market are generally large institutions. Individuals are rarely
participants of swap market
LO 40.2
A swap could be used to convert,
ª Fixed rate asset ↔ Floating rate asset
ª Fixed rate liability ↔ Floating rate liability
159
LO 40.3 Financial Intermediaries
& 40.4
Ÿ Fee is charged to compensate the intermediary for the risk involved
Ÿ If one of the parties defaults on its swap payments, the intermediary is

responsible for making the other party whole
Ÿ Confirmations: A representative of each party signs the confirmation, ensuring

that they agree with all swap details and the steps taken in the event of default
LO 40.5 Comparative Advantage

Example : Borrowing rates for X and Y
Company Fixed borrowing Floating borrowing

Y 5.0% LIBOR + 10 bps
X 6.5% LIBOR + 100 bps
Difference: 1.5% 0.9%
Ÿ Difference of difference: 1.5% - 0.9% = 0.6% which is combined benefit of
Ÿ
Company X’s cost is higher by Y by:
1.5% when it borrows at fixed rate ✗
0.9% when it borrows at floating rate ✔
ee Ÿ
Ÿ
entering into swap
Company Y’s cost is higher by X by:

1.5% when it borrows at fixed rate ✔
0.9% when it borrows at floating rate ✗
It has comparative advantage in floating rate It has comparative advantage in fixed rate
r
LO 40.6 Discount Rate
nT
Ÿ Forward rates implied by either forward rate agreements (FRAs) or the

convexity-adjusted Eurodollar futures are used to produce a LIBOR spot curve
Ÿ Swap cash flows are discounted using the corresponding spot rate from this curve
Ÿ Connection between forward rates and spot rates:
T1
RFORWARD =R2 +(R2 - R1)
T2 - T 1
Where,
Fi
R1 =spot rate corresponding with T1 years

RFORWARD = forward rate between T1 and T2
160
LO 40.7 Valuing an Interest Rate Swap with Bonds
Method 1 :
Step 1: Determine cash flows using (LIBOR / Forward rates)
Step 2: Discount the cash flows using discount rate from LIBOR spot/Zero curve
Method 2:
Bond Method
Vswap = Bfloating - Bfixed
Pricing and valuation of swaps

1 Price and value of swaps (spot rates)
Eg. Spot rates (today) Spot rates (after 6 months)

1 6% 0.5 8%
2 8% 1.5 8.5%
3 9% 2.5 9.7%
4 10% 3.5 11%
Maturity: 4 years Notional amount: $10 mln

rPrice of the swap:
1 − Z4
Z1 + Z2 + Z3 + Z4
Z1 = 1/(1.06)1
ee
Z2 = 1/(1.08)2
1 − 0.683
0.9433 + 0.8573 + 0.7721 + 0.683
Z3 = 1/(1.09)3
Value of fixed coupon bond:

Z4 = 1/(1.1)4
= 9.74%
{[Coupon × (Z1 + Z2 + Z3 + Z4)] + (FV × Z4)}

nT
[0.974 × (0.962 + 0.8848 + 0.7933 + 0.694)] + (10 × 0.694)
$10.18 mln
0.5
Z1 = 1/(1.08) Z2 = 1/(1.085)1.5 Z3 = 1/(1.097)2.5 Z4 = 1/(1.11)3.5
MV + Coupon 10 + 0.6
Value of floating coupon bond: = $10.1998 mln
Fi
n/12
(1 + Spot raten) (1 + 0.08)0.5
Value of the swap (fixed rate payer): Value of floating coupon bond − Value of fixed coupon bond
Value of the swap (fixed rate payer): 10.1998mln − 10.18mln = $0.0198 mln
161
2 Price and value of swaps (LIBOR)
Eg. LIBOR (today) LIBOR (after 30 days)

90 day 1.5% 60 day 3%
180 day 1.8% 150 day 3.3%
270 day 1.9% 240 day 4%
360 day 2.15% 330 day 4.1%
Maturity: 1 year (quarterly pay) Notional amount: $100 mln
1 − Z4 1 − 0.9789
Price of the swap: = 0.0053 × 4 = 2.13%
Z1 + Z2 + Z3 + Z4 0.9962 + 0.991 + 0.9859 + 0.9789
Z1 = 1/{1 + [0.015 × (90/360)]} Z2 = 1/{1 + [0.018 × (180/360)]}

Z3 = 1/{1 + [0.019 × (270/360)]} Z4 = 1/1.0215
Value of fixed coupon bond:
{[Coupon × (Z1 + Z2 + Z3 + Z4)] + (FV × Z4)}
ee
{[100 × 2.13% × 90/360 × (0.995 + 0.9864 + 0.974 + 0.9606)] + (100 × 0.9606)}
$98.46 mln
Z1 = 1/{1 + [0.03 × (60/360)]} Z2 = 1/{1 + [0.033 × (150/360)]}

r
Z3 = 1/{1 + [0.04 × (240/360)]} Z4 = 1/{1 + [0.041 × (330/360)]}
MV + Coupon 100 + (1.5 × 90/360)

Value of floating coupon bond: = $99.87 mln
nT
(1 + Spot rate) (1 + 0.03) × 60/360
Value of the swap (fixed rate receiver): Value of fixed coupon bond − Value of floating coupon bond
Value of the swap (fixed rate receiver): 98.46mln − 99.87mln = ($1.14 mln)
LO 40.8 Interest rate swap is equivalent to forward rate agreement when

forward contract rate equal to the swap fixed rate
Fi
Payer swap : Can be replicated by using a series of LONG off market FRAs

Receiver swap: Can be replicated by using a series of SHORT off market FRAs
Off market FRAs - FRAs that do not have value of zero at iniatiation
162
LO 40.9, Currency Swaps
10, 11, 12.
Valuation of currency swap
Case - I Case - II
Pay F.C & receive Pay D.C & receive

D.C (Cash flows) F.C (Cash flows)
Vswap = BD - S0 BF Vswap = S0 BF - BD
S0 - Exchange rate given at the end of contract
BD - Domestic bond (C.F - in contact , Disc rate - Interest rate)
BF - Foreign bond (C.F - in contact , Disc rate - Interest rate)
UK LIBOR (today) US LIBOR (today)

180 day 130 bps 180 day 200 bps
270 day
360 day
UK LIBOR (after 30 days)

60 day 90 bps
ee
150 bps
170 bps
270 day
360 day
60 day
220 bps
250 bps
US LIBOR (after 30 days)

190 bps
150 day 100 bps 150 day 250 bps
r
240 day 110 bps 240 day 300 bps
330 day 120 bps 330 day 320 bps
nT
Maturity: 1 year (quarterly pay) Notional amount: £1 mln

Spot rate: $1.5/£ Spot rate after 30 days: $1.75/£
1 − Z4
Price of the swap (UK): = 0.42 × 4 = 1.68%
Z1 + Z2 + Z3 + Z4
1 − Z4
Price of the swap (US): = 0.6175 × 4 = 2.47%
Z1 + Z2 + Z3 + Z4
Fi
Value of USD bond:
{[Coupon × (Z1 + Z2 + Z3 + Z4)] + (FV × Z4)}
{[1.5mln × 2.47% × 1/4 × (0.9968 + 0.9896 + 0.9803 + 0.9715)] + (1.5mln × 0.9715)}
$1,493,733 163
Using a currency swap
For a party paying interest in foreign

currency : The foreign principal is
Exchange of both principal and received and domestic principal is
interest in one currency for P & I in paid at the beginning of swap’s life
another currency
At the end the foreign principal is
paid and domestic principal received
LO 40.13 Swap credit risk

Ÿ Whenever one side of a swap has a positive value, the other side must be negative
Ÿ This results in increased credit risk to a party with positive value since the
likelihood of default increases as the counterpart has larger and larger payments to
make to the part with positive value
Ÿ However, the potential losses in swaps are generally much smaller than the
potential losses from defaults on debt with the same principal. This is because the
value of swaps is generally much smaller than the value of the debt
LO 40.14
Ÿ ee
Other type of Swap
In an equity swap, the return on a stock, a portfolio, or a stock index is paid each period by
one party in return for a fixed-rate or floating-rate payment. The return can be the capital
appreciation or the total return including dividends on the stock, portfolio, or index.
Value of GBP bond:
{[Coupon × (Z1 + Z2 + Z3 + Z4)] + (FV × Z4)}

r
{[1 mln × 1.68% × 90/360 × (0.9985 + 0.9958 + 0.9927 + 0.9891)] + (1 mln × 0.9891)}
nT
£1,005,819 = $1,760,184 (1,005,819 × 1.75)
Value of the swap (USD receiver): Value of USD bond − Value of GBP bond
Value of the swap (USD receiver): 1,493,733 − 1,760,184 = ($266,450)
Price and value of equity swaps

Fi

180 day 200 bps 150 day 250 bps
270 day 220 bps 240 day 300 bps
360 day 250 bps 330 day 320 bps
Maturity: 1 year (quarterly pay) Notional amount: ₹1.5 mln

Equity index today: ₹27,600 Equity index after 30 days: ₹29,300
164
1 − Z4
Price of the swap: = 0.6175 × 4 = 2.47%
Z1 + Z2 + Z3 + Z4
Value of the bond:
{[Coupon × (Z1 + Z2 + Z3 + Z4)] + (FV × Z4)}
{[1.5mln × 2.47% × 4 × (0.9968 + 0.9896 + 0.9803 + 0.9715)] + (1.5mln × 0.9715)}
₹1,493,733
29,300
Value of the equity index: 1.5 mln × = ₹1,592,391
27,600
Value of the swap (fixed rate payer): Value of equity index − Value of bond
Value of the swap (fixed rate payer): 1,592,391 − 1,493,733 = ₹98,658
Ÿ ee
Swaption is an option which gives the holder the right to enter into an interest rate swap.
Swaptions can be American- or European-style options
Firms may enter into commodity swap agreements where they agree to pay a fixed rate
for the multi-period delivery of a commodity and receive a corresponding floating rate
based on the average commodity spot rates at the time of delivery. Although many
commodity swaps exist, the most common use is to manage the costs of purchasing
energy resources such as oil and electricity
Ÿ A volatility swap involves the exchanging of volatility based on a notional principal. One
side of the swap pays based on a pre-specified volatility while the other side pays based
r
on historical volatility
nT
Fi
165
Mechanics Of Options Markets

LO 41.1 & 41.2 Types of Options testable concepts here
Ÿ Option contracts have asymmetric payoffs. The buyer of an option has the right to exercise
Ÿ Call option gives the owner the right, but not the obligation, to buy the stock from the
seller of the option
Ÿ Put option gives the owner the right to sell a stock to the seller o f the put at a specific
price
FLEX options: Ÿ Exchange-traded options on equity indices and equities that allow some
alteration of the options contract specifications.
Ÿ The nonstandard terms include alteration of the strike price, different
expiration dates, or European-style (rather than the standard American-
style).
Ÿ FLEX options were developed in order for the exchanges to better compete
with the nonstandard options that trade over the counter. The minimum
size for FLEX trades is typically 100 contracts.
ETF options: Ÿ While similar to index options, ETF options are typically American-style
options and utilize delivery of shares rather than cash at settlement
Credit event
ee
Weekly options: Ÿ Short-term options that are created on a Thursday and have an expiration
date on the Friday of the next week.
Binary options: Ÿ Generate discontinuous payoff profiles because they pay only one price
($100) at expiration if the asset value is above the strike price
Ÿ CEBO is a specific form of credit default swap.

binary options: Ÿ The payoff in a CEBO is triggered if the reference entity suffers a qualifying
credit event (e.g., bankruptcy, missed debt payment, or debt restructuring)
prior to the option’s expiration date
r
Doom options: Ÿ These put options are structured to only be in the money in the event of a
large downward price movement in the underlying asset
nT
Effect of Dividends and Stock Splits

Ÿ Options are not adjusted for cash dividends. This will have option pricing consequences
that will need to be incorporated into a valuation model. Options are adjusted for stock
splits. For example, if a stock has a 2-for-l stock split, then the strike price will be
reduced by one-half and the number of shares underlying the option will double
Ÿ Stock dividends are dealt with in the same manner. For example, if a stock pays a 25%
stock dividend, this is treated in the same manner as a 5-for-4 stock split
Fi
Underlying assets for Options
Individual Foreign Stock

Futures
Stocks Currency Indices
Ÿ American Style Ÿ European Style Ÿ European Style

Ÿ 100 shares of stock Ÿ 10000 units for Ÿ Cash settled Ÿ Black model for
in one contract other Ÿ Both OTC and valuation
exchange traded
166
X = Strike price
2 Options
P = Premium
Call Put
Long Short Long Short
Right to buy Obligation to sell Right to sell Obligation to buy
Pays premium Receives premium Pays premium Receives premium

Maximum
profit Infinite Premium X-P Premium
Maximum
Premium Infinite Premium X-P
loss
Breakeven Breakeven
Point for call - X + P Point for put - X - P
ee
ª Seller of the option is also called as writer
ª Premium is also referred to as price of the option
ª American options - Can be exercised at any time between purchase date and expiration date
ª European options - Can be exercised only on expiration date
ª Bermudan options - Can be exercised only on certain days. Eg. Once a month
r
ª At expiration, an American option and a European option on same asset with same strike
price are identical
nT
Eg. X = 100, P = 10 Calculate Profit/Loss for long and short if,

Spot price (S) = 0, 60, 110, 150, 200 (Call) Spot price (S) = 0, 60, 90, 120, 170 (Put)
Call S = 0 60 110 150 200 Put S = 0 60 110 150 200
Profit/ Long = 10 10 0 40 90 Profit/ Long = 90 30 0 10 10

Loss Short = 10 10 0 40 90 Loss Short = 90 30 0 10 10
Fi
Maximum Loss BEP Maximum Profit BEP

Maximum Profit Maximum Loss
167
Moneyness - It refers to whether an option is in the money or out of the money
In the money - If immediate exercise of the option generates positive

payoff, it is said the option is in the money.
Out the money - If immediate exercise of the option generates negative

payoff, it is said the option is out of the money.
At the money - If immediate exercise of the option generates neither

positive payoff nor negative payoff, it is said the option is at the money.
Call option Put option

In the money In the money
S-X>0 S-X<0
Out of the money Out of the money

S-X<0 S-X>0
At the money At the money

S=X S=X
Eg. S = 9000
X = 8800
P = 225
Expiry - 21 days
= S - X = 200
ee
Intrinsic value and time value
Intrinsic value(exercise value)
Time value(speculative value)

Option Premium = Time Value + Intrinsic Value
Intrinsic value is never negative
Time value can be negative if the option is deep
= P - Intrinsic Value = 25 in the market for European put options
r
nT
Fi
168
Properties Of Stock Options

LO 42.1 Factors that determine the value of an option Watch video with important
Value of call Value of put

Factor
option option
Spot Ç Ç È
Strike Ç È Ç
Volatility Ç Ç Ç
Maturity Ç Ç Ç
RFR Ç Ç È
Dividend yield Ç È Ç
LO 42.2 & 42.4

ee
Upper & lower pricing bounds
Lowerbound Upperbound
EC Max [0, S - PVX] S

r
AC Max [0, S - PVX] S
nT
EP Max [0, PVX - S] PVX
AT Max [0, X - S] X
Ÿ All else equal, the payment of dividend will reduce the lower pricing bound for a call option
Ÿ All else equal, the payment of dividend will increase the lower pricing bound for a put option
Fi
Relationship between American call & put options

Ÿ Put-call parity only holds for European options. For American options, we have an
inequality. This inequality places upper and lower bounds on the difference between the
American call and put options.
S0 - X ≤ C - P ≤ S 0 - Xe - rT
169
LO 42.3 Put - call Parity
Put-call parity Synthetic equivalence for

(Works only for European option) each individual security
Sip Pepsi Be Cool S=B+C−P
P=B+C−S
S+P = B+C
C=S+P−B
Stock + Put Bond + Call
B=S+P−C
+ve sign - take long position

Protective Put Fiduciary Call −ve sign - take short position
Put-call forward parity for European options
F = S0 X (1 + RFR)n
F
S=
(1 + RFR)n
Put-call parity - S + P = B + C
F X
Put-call forward parity -
ee (1 + RFR)n
F-X
(1 + RFR)n
+P =
+P = C
(1 + RFR)n
Impact of Dividends on Early Exercise for American Calls and

+C
Put -Call Parity

Put-call parity is adjusted for dividends in the following manner:
r
p + S0 = c + D + Xe-rT
nT
Relationship between American call and put options is modified as follows:
S0 - X - D ≤ C - P ≤ S 0 - Xe - rT
Fi
170
Trading Strategies Involving Options
LO 43.1 Covered Calls And Protective Puts
ª Covered call = Long stock + Short Call testable concepts here
ª Maximum profit = X − S0 + P
ª Maximum loss = S0 − P
ª BEP = S0 − P
ª Investment objectives:
Œ Income generation: Writing the option to earn the premium, drawback: giving up on the upside
Improving on the market: Investor with a long stock position can potentially earn more by using
covered call strategy
Ž Target price realization: Investor with a long stock position can potentially earn more when the
stock price reaches its target
Protective put
ª Protective put = Long stock + Long put
ª Maximum profit = Unlimited

ª Maximum loss = S0 − X + P
ª BEP = S0 + P
e
ª Investment objective:
To protect against losses when the stock price falls (similar to buying insurance)
ª Drawback: Consistent use of this strategy would reduce portfolio returns significantly
re
Equivalence to long stock/short forward
Delta of call option: +ve
Delta of put option: −ve
For a non-dividendpaying stock:
Delta of call option: Between 0 and 1
Delta of put option: Between 0 and −1
Delta of long stock/short forward: 1
nT
Covered call delta = Delta of stock – Delta of call option

Protective put delta = Delta of stock + Delta of put option
Cash-secured put = Short put + Long bond
Option strategies
Bull spread Bear spread
Fi
Call options Put options Call options Put options
Net outflow Net inflow Net inflow Net outflow
Buy (long) expensive Buy (long) cheap Buy (long) cheap Buy (long) expensive
option and sell (short) option and sell (short) option and sell (short) option and sell (short)
cheap option expensive option expensive option cheap option
171
LO 43.2 Spread Strategies
Bull call spread profit/loss
When stock price is 500: 80 − 140 = (60)
(Both long and short options are out-of-the-money)
When stock price is 750: (750 − 700) + 80 − 140 = (10)

(Long option is in-the-money but short option is out-of-the-money)
When stock price is 850: (800 − 700) + 80 − 140 = 40

(Both long and short options are in-the-money)
Straddle
ª Long straddle: Long call + Long put

ª Short straddle: Short call + Short put
ª Options must have same stike price, underlying asset and maturity
ª Long straddle: Used if investor expects higher future volatility

ª Short straddle: Used if investor expects the markets to be neutral
ª Long straddle:
Ÿ Maximum profit: Unlimited
e
Ÿ Maximum loss: Premiums of call and put
Ÿ BEPs: S0 + PremiumC and S0 − PremiumP
es
ts
re
ofi
ss
Lo
Pr
S0 + PremiumC S0 + PremiumC
Losses Profits
S0 − PremiumP S0 − PremiumP
Lo
Pr
ofi
ss
es
ts
nT
Long straddle Short straddle
Collar
ª It is a combination of covered call and protective put
ª Objective: Decrease the volatility of returns
ª Zero-cost collar: Long put premium = Short call premium

Fi
ª Drawback: Giving up on the upside
ª Maximum profit: XC − S0 − PP + Pc
ª Maximum loss: S0 − XP − PP + Pc− PP
ª BEP: S0 + PP − Pc
172
Calendar spreads
Used when two options have same strike price and underlying but different maturities
Long calender spread (net outflow): Long longer expiry + Short shorter expiry
Short calender spread (net inflow): Long shorter expiry + Short longer expiry
Objective: To take advantage of time decay
Interest rate caps and floors

Interest rate cap: A series of interest rate call options
Used by a floating rate borrower to hedge the risk of increase in
interest rates
Interest rate floor: A series of interest rate put options

Used by a floating rate lender to hedge the risk of decrease in
interest rates
Payer swap: Long interest rate cap + Short interest rate floor
Receiver swap: Short interest rate cap + Long interest rate floor
If rates increase and bond If rates decrease and bond
e
Option
prices decrease prices increase
Value of call on LIBOR

re
Value of call on bond price
Value of put on LIBOR
Value of put on bond price

nT
Fi
173
Exotic Options
LO 44.1, Evaluating Exotic options Watch video with important
44.2 & 44.3 testable concepts here
Ÿ Exotic derivatives are customized to fit a specific firm need for hedging that cannot be
met by plain vanilla derivatives
Ÿ A package is defined as some combination of standard European options, forwards,
cash and underlying asset
Ÿ Bull, bear, and calendar spreads, as well as straddles and strangles are examples of
packages because packages often consist of a long position and a short position, they
can be constructed so that the initial cost to the investor is zero.
LO 44.4 Transformation of standard American option

into non-standard American option
Restrict early exercise

By introducing lock out Changes in strike price
to certain data results
period over the life of options
in a Bermudan option
LO 44.5
e
Exotic option payoff structure
re
Gap Options
Ÿ A gap option has two strike prices, X1 and X2. (X2 is sometimes referred to as the
trigger price.)
Ÿ For a gap call option, if X2 is greater than X1 and the stock price at maturity, ST, is
greater than the trigger price, X2, then the payoff for the call option will be equal to
ST— X1
Ÿ If the stock price is less than or equal to X2 , the payoff will be zero. Note that a
nT
negative payoff can occur if the stock price is greater than X2 and X2 is less than X1
In this case, the payoff will be reduced by X2 — X1
Example -
Scenario 1 Scenario 2
Fi
X2 = 70 , X1 = 50 X2 = 40 , X1 = 50
SR = 95, Payoff = 45 SR = 95, Payoff = 45
ST = 70 or 60 or 40, Payoff is zero ST = 46, Payoff is - 4
Payoff = ST -X1 Payoff = ST -X1
Conclusion : Call option is exercised (mandatory) above X2
174
Forward start option: Ÿ Forward start options are options that begin their existence at some
time in the future.
Ÿ Employee incentive plans commonly incorporate forward start options
Ÿ Note that when the underlying asset is a nondividend paying stock,
the value of a forward start option will be identical to the value of a
European at-the-money option with the same time to expiration as
the forward start option
Compound option: Ÿ Are options on option
Chooser option: Ÿ This interesting option allows the owner, after a certain period of time
has elapsed, to choose whether the option is call or put.
Barrier Option
1. Value of standard call = Down & out call + Down & in call
2. Value of standard put = Up & out put + Up & in put
3. Increase in volatility (Vega) does not leads to increase in the value of up & out
option i.e. Vega is -ve of knock-out option
Ÿ Up - barrier limit is above the current market value
e
Ÿ Down - barrier limit is below the current market value
Ÿ In - comes in existence
Ÿ Out - Cease to exist
re
Binary Option - payoff only one value
Cash or nothing call Asset or nothing call
Ÿ A fixed amount Q is paid if the asset Ÿ Pays the value of asset S0 , if at

ends up above the strike price expiration asset is above risk
-qT
Ÿ Value = S0e N(d1)
Ÿ Value = Qe-rT N(d2)
nT
Ÿ q = Continuous dividend yield
Ÿ Binary options generate discontinuous payoff profiles because they pay only one price at
expiration if the asset value is above the strike price
Ÿ In the case of a cash-or-nothing call, a fixed amount, Q, is paid if the asset ends up above
the strike price. Since the Black-Scholes-Merton formula denotes N(d2) as the probability
of the asset price being above the strike price, the value of a cash-or-nothing call is equal
to Qe-rT N(d2)
Fi
Ÿ An asset-or-nothing call pays the value of the stock when the contract is initiated if the
stock price ends up above the strike price at expiration. The corresponding value for this
option is S0e-qT N(d1), where q is the continuous dividend yield.
175
Lookback options: Ÿ Lookback options are options whose payoffs depend on the maximum
or minimum price of the underlying asset during the life of the option.
Ÿ A floating lookback call pays the difference between the expiration
price and the minimum price of the stock over the horizon of the
option.
Ÿ This essentially allows the owner to purchase the security at its
lowest price over the option’s life. On the other hand, a floating
lookback put pays the difference between the expiration and
maximum price of the stock over the time period of the option.
Ÿ This translates into allowing the owner of the option to sell the
security at its highest price over the life of the option.
Ÿ Lookback options can also be fixed when an exercise price is
specified. A fixed lookback call has a payoff function that is identical
to a European call option. However, for this exotic option, the final
stock price (or expiration price) in the European call option payoff is
replaced by the maximum price during the option’s life.
Ÿ Similarly, a fixed lookback put has a payoff like a European put option
but replaces the final stock price with the minimum price during the
option’s life.
Shout options: Ÿ A shout option allows the owner to pick a date when he “shouts” to
the option seller, which then translates into an intrinsic value
e
Asian options: Ÿ Asian options have payoff profiles based on the average price of the
security over the life of the option. Average price calls and puts pay
off the difference between the average stock price and the strike
price.
re
Ÿ Note that the average price will be much less volatile than the actual
price. This means that the price for an Asian average price option will
be lower than the price of a comparable standard option.
Ÿ Average strike calls and average strike puts pay off the difference
between the stock expiration price and average price, which
essentially represents the strike price in a typical intrinsic value
calculation
nT
Exchange options: Ÿ A common use of an option to exchange one asset for another, often
called an exchange option, is to exchange one currency with another
Basket options: Ÿ Basket options are simply options to purchase or sell baskets of
securities.
LO 44.6 Volatility and Variance swaps

Fi
Ÿ A volatility swap involves the exchange of volatility based on a notional

principal. One side of the swap pays based on a pre-specified fixed volatility
while the other side pays based on realized volatility.
Ÿ Unlike the exotic options we have discussed thus far, volatility swaps are a bet
on volatility alone as opposed to a bet on volatility and the price of the
underlying asset.
176
LO 44.7 Issues in Hedging exotic options
Ÿ Hedging is simpler with some exotic options than it is with plain vanilla options. Asian
options, for instance, depend on the average price of the underlying. Through time, the
uncertainty of the average value gets smaller. Hence, the option begins to become less
sensitive to changes in the value of the security because the payoff can be estimated
more accurately.
Ÿ Hedging positions in barrier and other exotic options are not so straightforward
Ÿ Dynamic options replication requires frequent trading, which makes it costly to
implement
Ÿ As an alternative, a static options replication approach may be used to hedge positions
in exotic options
e
re
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Fi
177
Commodity Forwards And Futures Watch video with important

LO 45.1 Storage costs, carry markets, lease rate, and convenience yield.
ª Forward price must be greater than the spot price to compensate for the physical and
financial storage costs.
ª Market in which a commodity is stored is a carry market.
ª Lease rate - Amount of interest a lender of a commodity requires
ª Convenience yield - Holding an excess amount of a commodity for a non-monetary

return
ª Since commodity forward prices are based on expected spot prices and expected spot
prices are, in turn, dependent on expected supply and demand forces, forward prices
for commodities need not to be constant from period to period
LO 45.2 Pricing commodity forward

Commodity forward price today :
e
(risk-free rate)T
F0,T = E(ST)e
LO 45.3 Commodity Arbitrage

re
Steps in a cash-and-carry arbitrage
Ÿ At the initiation:
Step 1: Borrow money at market interest rates
Step 2 : Buy underlying commodity at the spot price
Step 3 : Sell a futures contract at the current futures price
nT
Ÿ At expiration:
Step 1: Deliver the commodity and receive the futures contract price
Step 2 : Repay the loan with interest
LO 45.4 Lease Rates

Ÿ Lease rate - Amount of return investor requires to buy and lend a commodity
Fi
Ÿ If an active lease market exists, a commodity lender can earn lease rate by
buying a commodity and immediately selling it forward.
Ÿ Market is in contango with an upward-sloping forward curve when the lease rate
is less RFR
Ÿ Market is in backwardation with a downward sloping forward curve when the

lease rate is greater than RFR
Ÿ The commodity forward price for time T an active lease market expressed as,
(r - δ)T
F0,T = S0e
Where, S0 = current spot price, r - δ = risk free rate less the lease rate 178
LO 45.5 & Storage Costs
45.6
Range of arbitrage free valuation
S0e (r+⅄ -c)T ≤ F0,T ≥ S0e (r+ ⅄)T
r = rfr
⅄= storage cost (cc)
c = convenience yield
Ÿ If the owners of the commodity need the commodity for their business,
holding physical inventory of commodity creates value
Ÿ The non-monitory benefit of holding excess inventory is referred to as the
convenience yield
LO 45.7 Comparing lease rate with convenience yield

Ÿ Lease rate is equal to the convenience yield minus storage cost
Ÿ Hence, lease rate are negatively related to storage cost. This explains why
sometimes when storage costs are high, lease rates can be negative
e
LO 45.8 Commodity Characteristics
Gold Forward Ÿ Gold forward prices indicate presence of positive lease rates; holders of
Prices: gold (e.g. central banks) do lend it out for a free. It would make sense,
re
therefore, for an investor to obtain exposure to gold via long forward
contracts (synthetic gold) rather than physically buying and holding gold
(and not earning a lease payment).
Ÿ Sometimes, when the storage costs are very high, lease rates may turn
negative (holders of gold are willing to pay someone to store rather than
pay high storage costs themselves)
Corn Forward Ÿ Corn production is seasonal while its demand is relatively throughout
nT
Prices: the year.

Ÿ This timing mismatch between production and consumption means that
corn must be stored.
Ÿ Thus storage (and interest)costs are highly relevant in corn forward
prices. Corn forward prices tend to fall around harvest and subsequently
rise (until next harvest) to reflect cost of storage
Ÿ Thus, corn forward curve increases until harvest time, drops sharply, and
then slopes upward again after harvest time is over.
Electricity Forward Ÿ Electricity is not a storable commodity. Once it is produced, it must be

Fi
Prices: used or it will likely go to waste.

Ÿ The demand for electricity is not constant and will vary with time of day,
day of the week, and season.
Ÿ Given the non-storability characteristic of electricity, its price is set by
demand and supply at a given point in time. Since arbitrage opportunities
do not exist with electricity (i.e., the inability to buy electricity during
one season and sell it during another season) futures prices on electricity
will vary much more during the trading day than financial futures.
Ÿ Futures prices primarily driven by expected spot prices in future.
179
Natural Gas Ÿ Natural gas is an example of a commodity with constant production but
Forward Prices: seasonal demand.
Ÿ Natural gas is expensive to store, and demand in the United States peaks
during high periods of use in the winter months.
Ÿ In addition, the price of natural gas is different for various regions due to
high international transportation costs.
Ÿ Storage is at its peak in the fall just prior to the peak demand. Therefore,
the forward curve rises steadily in the fall.
Oil Forward Ÿ The physical characteristics of oil make it is easier to transport than
Prices: natural gas. Therefore, the price of oil is comparable worldwide.
Ÿ In addition, demand is high in one hemisphere when it is low in the
other.
Ÿ Lower transportation costs and more constant worldwide demand causes
the long-run forward price to be more stable.
LO 45.9 Commodity Spread
Ÿ A commodity spread results from a commodity that is an input in the production process
of other commodities. For example, soybeans are used in the production of soybean
meal and soybean oil. A trader creates a crush spread by holding a long (short) position
in soybeans and a short (long) position in soybean meal and soybean oil.
e
Ÿ Similarly, oil can be refined to produce different types of petroleum products such as
heating oil, kerosene, or gasoline. This process is known as “cracking,” and thus the
difference in prices of crude oil, heating oil, and gasoline is known as a crack spread. For
example, seven gallons of crude oil may be used to produce four gallons of gasoline and
re
three gallons of heating oil.
Ÿ Commodity traders refer to the crack spread as 7-4-3, reflecting the seven gallons of
crude oil, four gallons of gasoline, and three gallons of heating oil. Thus, an oil refiner
could lock in the price of the crude oil input and the finished good outputs by an
appropriate crack spread reflecting the refining process. However, this is not a perfect
hedge because there are other outputs that can be produced e.g. jet fuel.
nT
LO 45.10 Basis Risk

Ÿ Basis is the difference between the spot price (or rate) and the futures prices
(or rate)
Ÿ For commodities, as opposed to financial contracts, these specifications
introduce storage and transportation cost complexities for hedgers.
Fi
LO 45.11 Strip hedge and Stack hedge

Ÿ Strip hedge is created by buying futures contracts that match the maturity
and quantity for every month of the obligation
Ÿ Stack hedge is created by buying a futures contract with a single maturity

based on the present value of the future obligations
Ÿ Advantages of the stack hedge are the availability and liquidity of near-term
contracts and narrower bidask spreads for near-term contracts
180
Exchanges, OTC derivatives, DPCs And SPVs

LO 46.1 Exchange Functions Watch video with important
Ÿ Trading derivatives can be done bilaterally or through exchanges

Ÿ Exchange is a central market where contracts can be traded
Ÿ Three primary functions: product standardization, trading venue, and reporting services
LO 46.2 Forms of Clearing

Ÿ Clearing - Reconciling and matching contracts between counterparties, forms of clearing
include 1.Direct clearing 2.Clearing rings 3.Complete clearing
Ÿ Direct clearing is a mechanism for bilaterally reconciling commitments between two
counterparties.
Ÿ This type of direct clearing for OTC derivatives is typically called netting, or payment
of difference.
Ÿ Clearing ring - a mechanism to reduce counterparty exposure between three or
more exchange members. A clearing ring is voluntary for exchange members. Once
members join, however, they must accept the rules of the exchange and must
accept each other’s contracts and allow for counterparties to be substituted
Ÿ Not all exchange members would benefit from joining a clearing ring. Members that
e
have a single position with another counterparty would not benefit from the ring
Ÿ Complete clearing - clearing through a central counterparty (CCP). Assumes the
contractual obligations of clearing exchange members and acts as a buyer to sellers
and a seller to buyers
Ÿ Complete clearing - can be seen as an improvement to a clearing ring since it
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reduces the risk of member failure and any resulting contagion effect
Ÿ Margining - Both upfront funds posted to mitigate against counterparty default (initial
margin), and daily transfer of funds to cover position gains and losses (variation margin)
Ÿ Netting - Consolidating multiple offsetting positions between counterparties into a single
payment
Ÿ Clearing, margining, and netting are important counterparty risk mitigants
LO 46.3 Exchange traded Vs. OTC derivatives

nT
Ÿ Benefits of OTC derivatives include customization , settlement, and documentation

Ÿ Beneficial since it reduces basis risk
Ÿ Disadvantages of OTC derivatives include counterparty risk, difficulty in unwinding
trades, and novation of contracts
Ÿ Clearing is more challenging for OTC derivatives compared to exchange-traded
Ÿ OTC derivatives trades could be cleared by CCPs
Fi
LO 46.4 Classes of OTC derivatives

Ÿ OTC derivatives comprise of five broad classes: Interest rate, foreign exchange, equity,
commodity, and credit derivative
Ÿ Interest rate derivative dominate the five classes
Ÿ Counterparty risk is particularly a concern foreign exchange derivative (including cross-currency
swap) which typically have long-dated maturities and require the exchange of notional principal
Ÿ Wrong - way risk (when the credit quality of the counterparty is inversely related to the level of
exposure to the counterparty)
Ÿ Measuring OTC derivatives exposure through gross notional value can be misleading
Ÿ As a result gross market value is often seen as more useful measure for OTC derivatives ,
including ratio of gross market value to gross notional value. The ratio is typically relatively small
ans was close to 3% (at June 2013) for interest rate, foreign exchange, and credit default swaps.181
LO 46.5 Mitigating risk of OTC derivatives
It includes: special purpose vehicles (SPVs), derivatives product companies (DPCs), monolines,
and credit derivative product companies (CDPCs)
Ÿ DPCs - set up to originate derivatives

products sold to investors
Ÿ SPVs are set up by a parent firm to shield
the SPV from any financial distress Ÿ DPCs are separately capitalized and have
restrictions on their activities and margin
Ÿ It alters bankruptcy rules and transform
counterparty risk into legal risk Ÿ DPCs rating depends on:
(1) market risk minimization
(2) parent support
(3) credit risk and operational management
Ÿ Monolines provide financial guarantees, or “credit wraps” to investors
e
re
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Fi
182
Basic Principles Of Central Clearing

LO 47.1 Role of a Central Counterparty
Trade Execution Clearing Settlement
Ÿ Margining Ÿ Trade completed

Ÿ Payments made
Ÿ Netting Ÿ Legal obligations
satisfied
Ÿ Loss mutualization is a form of insurance and refers to members contribution to a default fund
to cover future losses from member defaults
Ÿ Clearing refers to process (including margining and netting) between the period from trade
execution untill settlement
Ÿ Settlement of trade occurs when the trade completed and all payments have been made and
legal obligations satisfied
Ÿ When a central clearing member defaults, rather than closing out the trades at market value, the
CCP typically auctions off the trades to the surviving members through an auctioning process
e
Ÿ These criteria can be onerous, and as a result, only large banks or global financial institutions
typically become clearing members.
Ÿ Smaller entities including small banks and financial institutions and some non-financial end users
would likely not participate as direct clearing members, but would participate in the clearing
process through transacting with a member on a principal-to-principal basis, or on an agency
re
basis.
Ÿ These players would therefore have a bilateral relationship with clearing member but not the CCP.
Ÿ This clearing process may be similar to the clearing between the member and the CCP, with some
differences, including no default fund commitment by the non-member players.
Products : 1. Products with long history - interest rate swap

2. Products with short history - index credit default swap
nT
3. Products that may soon centrally cleared - interest rate swaptions, CDS
4. Products that not suitable for central clearing - exotic derivatives
Type of CCPs
1. Utility Driven CCPs 2.Profit Driven CCPs
LO 47.2 Cental Clearing

Fi
Advantages Disadvantages
1. Moral hazard
1. Transparency 2. Adverse selection
2. Offsetting 3. Bifurcation
3. Loss mutualization 4. Procyclicality - essentially reflects downside of
4. Legal & operational efficiency margining. It reflects a scenario where a CCP
5. Liquidity increases margin requirements (initial) in volatile
6. Default management markets or during crisis, which may aggravate
systematic risk.
183
LO 47.3 Margining
Ÿ CCPs set margin requirements based only on the risks of the members’ transactions
Ÿ For initial margin, credit quality of the member is typically not a consideration
Ÿ Members with different credit risk may be posting the same amount of initial margin
LO 47.4 Novation and Netting

Ÿ CCP is the insurer of counterparty risk
Ÿ CCP maintains a “matched book” of trades with no net market risk because all trades
are centralized
Ÿ It does have conditional credit risk from a member’s potential default
Ÿ Multilateral offsetting/ Netting - When trades are novated to a CCP, these redundant
trades become a single net obligation between each participant and the CCP
Ÿ Netting reduces total risk
Bilateral OTC Market
e
Novation to CCP CCP Netting
A A A
re
50 125 75
50 125
A A A
50 125 25 50
75 75
A A A A A A
nT
75
LO 47.5 Impact of Central Clearing
è Systemic risk in the financial markets is reduced, but can be increased at

the same time
è Risk is reduced because CCPs reduce counterparty risk by offsetting

Fi
positions - it provide transparency for the market and improve liquidity
è Members post higher initial margin during times of increased market

volatility could increase systemic risk
184
Risk caused by CCPs

LO 48.1 Risks faced by central counterparties Watch video with important
Default risk: Ÿ The default of a clearing member and its flow through effects is
the most significant risk for a CCP.
Ÿ In the event of a failed auction or an insufficient number of
bids, the CCP will be required to pass on the defaulting
member’s losses through rights of assessment, loss allocation
methods, or both
Ÿ The loss allocation methods may be considered unfair because
some of them, such as variation margin gains haircutting
(VMGH) and tear-ups, impose losses on “winning positions”
Ÿ With VMGH, members whose positions increased in value (i.e.,
they are owed variation margin) will likely not receive the full
amount for their gains (i.e., haircutting). Members who instead
owe money to the CCP will still be required to pay the full
margin amount to the CCP.
Ÿ Risk that exposure to a counterparty is negatively correlated
with the credit quality of the counterparty
Model risk: Ÿ Many models are linear in nature, which means that an initial
e
margin will be adjusted in proportion to the increase in the size
of the position.
Ÿ However, for large or concentrated positions, the margin may be
too low. The use of a supplement to the computation, such as a
margin multiplier, may assist in sufficient coverage of the risk
re
Liquidity risk: Ÿ The CCP attempts to earn the greatest return possible on the
funds it holds without incurring too much credit or liquidity risk,
thereby most commonly investing in short-term deposits, repos,
and reverse repos. Should there be a default by one or more
members, the CCP is still required to meet the obligations of the
other members.
nT
Operational risk: Ÿ CCPs face operational risks that are common to all entities such
as business interruption due to information systems failures and
internal or external fraud.
LO 48.2 Risk to clearing members & non - members
ª Non-members face exposure from CCPs, clearing members, and other non-members
ª If CCP fails, a non-member may be able to avoid losses as its counterparty is solvent
Fi
ª Non-members losses due to defaults of CCPs and clearing members lies with the
initial margins and whether they are segregated, guaranteed, or both
ª Non-members face the risk of not being able to port their trades should the
counterparty member default
ª It is possible that clearing members are able to pass on losses to non-members

through VMGH or tear-up, which reduce the gains
ª Clearing members are unable to pass on losses resulting from default fund
utilization, rights of assessment, and forced allocation
185
LO 48.3 Lessons from CCP failures
è Operational risk must be controlled to the maximum extent possible

è Variation margins should be recalculated often and collected quickly
è CCPs should have an information system that allows for automated payments
è Cross-margining linkage arrangements between CCPs
è Initial margins and default funds should be sufficiently large
è Actively monitor positions
è Must have one or more external sources of liquidity
e
re
nT
Fi
186
Foreign Exchange Risk

LO 49.1 Overall foreign exchange exposure Watch video with important
Net currency exposure = (currency assets — currency liabilities) + (currency bought —

currency sold)
LO 49.2 Net position exposure
Net long (short) position - Bank faces the risk that the FX rate will fall (rise) in value versus the
domestic currency
LO 49.3 Potential dollar gain or loss
ª If a financial institution fails to maintain a balanced position, the institution will

exposed to variations in the FX rate
ª More volatile the FX rate, the more potential impact a net exposure (either long or
short) will have on the value of a portfolio
LO 49.4
e
Foreign trading activities
Financial institution’s key trading activities

Ÿ Enabling customers to participate in international commercial business transactions
Enabling customers to take positions in real and financial foreign investments
re
Ÿ
Ÿ Offsetting exposure to gain currency for hedging purposes
Ÿ Speculating on future FX rate movements
LO 49.5 Sources of profits and losses on foreign exchange trading
Ÿ Most returns on FX trading arises from speculation in currency

nT
Ÿ Revenues are earned from market - making activities, acting as agents for
retail or wholesale customers, or a combination of both.
LO 49.6 Potential gain or loss from a foreign currency dominated investments
FC - Gain
Fi
Ÿ Net foreign currency (FC) asset

FC - Loss
FC - Loss
Ÿ Net foreign currency liability
FC - Gain
187
LO 49.7 Principle methods of controlling the impact of FX exposure
On-balance-sheet hedging is achieved Off-balance-sheet hedging occurs

when a financial institution has a matched through the purchase of forwards for
maturity and foreign currency balance institutions that choose to remain
sheet unhedged on the balance sheet
Balance Sheet Hedging
On-Balance-Sheet Hedging Off-Balance-Sheet Hedging
On-balance-sheet hedging is hedge Off-balance-sheet by

achieved when and currency taking position in the forward
foreign asset-liability book market
LO 49.8 Interest rate parity
International parity conditions
e
International Fischer relationship (precise)
re
1 + Nominal interest rate = (1 + Real interest rate) × (1 + Expected inflation)
Determining forward rate

USA India
2% ₹50 10%
$
$1mln ₹50mln
nT
$1mln 10%
+ 2% int.
₹55mln 55 ₹55mln
$1.02mln 53.92
53.92 1.02
(1 + Int. rate)n
Forward rate = S ×
Fi
(1 + Int. rate)n
(1 + 10%)1
Forward rate = 50 ×
(1 + 2%)1
= 53.92
188
Interest rate parity
Int. rate (India) = 20%

Int. rate (USA) = 10%
(1 + Int. rate)n
F = S ×
(1 + Int. rate)n
= ₹54.54
₹50
$
Expected
(1.1538)
spot rate = 50 ×
(1.0576)
= ₹54.54
Real int.
Inflation rate
rate = 4%
(1 + 20%)
India = = 15.38%
(1 + 4%)
(1 + 10%)
USA = = 5.76%
(1 + 4%)
Covered interest
Forced by arbitrage. It is always true
rate parity
Uncovered interest
Not forced by arbitrage. It may not be true
e
rate parity
Eg. Spot rate: $1.2/€ 1-year forward rate: $1.3/€

USD interest rate: 9% Euro interest rate: 7% Determine if an arbitrage opportunity exists
re
Forward rate 1 + USD int. rate
=
Spot rate 1 + Euro int. rate
Forward rate
× 1 + Euro int. rate Vs 1 + USD int. rate
Spot rate
1.3
nT
× 1 + 7% Vs 1 + 9%
1.2
1.1591 Vs 1.09
Invest Borrow
Fi
LO 49.9 Diversification in multicurrency asset-liability positions

& 49.10
Since interest rates and stock returns do not usually move in perfect
correlation, opportunities for potential gains can offset currency risk
Ÿ Real interest rate - Given currency’s real demand and supply for its funds
Ÿ Nominal interest rate - Compounded sum of the real interest rate and the expected
rate of inflation over an estimation horizon
189
Corporate Bonds
LO 50.1 Bond Indenture Watch video with important
Ÿ A bond indenture sets obligations of the issuer
Ÿ Trustee interprets the legal language of the indenture and works

to make sure the issuer fulfills obligations to bondholders
Ÿ The trustee would monitor the corporation’s activities to make
sure the issuer abides by the indentures covenants
Ÿ Basic goal of trustee is to protect the rights of bondholder
LO 50.2 Maturity Date

ª Bond issuer’s obligations are fulfilled on the maturity date or before
ª Bonds can be retired before that date
LO 50.3 Interest Payment Classifications
Straight-coupon bonds Zero-coupon bonds Floating-rate bonds
Pay a fixed cash coupon

periodically
e
Increase in value over
the life of the issue
Pay a cash amount that
varies with market rates
re
Ÿ Some bonds have principal in one currency and coupons in another currency
LO 50.4 Zero Coupon Bonds
Ÿ Zero-coupon bonds have low reinvestment risk

nT
Ÿ Interest is based on the time-to maturity at issuance and the original-issue

discount - difference between the face value and the offering price
Ÿ In case of bankruptcy, bondholder has a claim only equal to the issue price
plus accrued interest to that date - not the full face value
LO 50.5 Bond Types

Fi
è Holder of a mortgage bond has the first lien on real property owned by the issuer
è Collateral trust bonds are backed by stocks and bonds
è Collateral is also called personal property
è Equipment trust certificates - mortgage bond where the trustee actually owns the
property, and property is often in the form of standardized equipment i.e. easily sold
è Debentures are unsecured debt and Owners have a claim on the company’s assets
190
LO 50.6 Methods For Retiring Bonds
Ÿ Call provisions allow the firm to retire debt early at a given price
Ÿ Sinking-fund provisions require the firm to buy back portions of debt
Ÿ Call provisions are generally considered detrimental to bondholders, but sinking-
fund provisions may be beneficial
Ÿ A maintenance and replacement fund helps maintain the financial health of the firm
Ÿ Cash in the fund can be used to retire debt
Ÿ Bond issuers can retire debt through a tender offer
Ÿ Offer price may either be a fixed price or variable price with a market rate such as
that on comparable treasury securities
LO 50.7 Credit Risk

Credit default risk Credit spread risk
Ÿ The difference between corporate

Indicator - credit rating bond’s yield & yield on a comparable -
maturity benchmark treasury security
Ÿ It should be noted that other factors
such as embedded options and
liquidity factors can affect this
spread; therefore, it is not only a
e
function of credit risk.
LO 50.8 Event Risk

re
Event risk - Possibility of a merger, restructuring, acquisition, can increase the risk
of the bond by changing the ability of the firm to pay off the bonds
Indenture can try to address some of these events, but some can be omitted
LO 50.9 High - Yield Bonds

nT
High-yield bonds may be fallen angels (i.e., one-time investment grade bonds)
High-yield bonds may have coupon structures which allows to conserve cash in early years
(1) deferred-interest bonds
(2) step-up bonds
(3) payment-in-kind bonds
LO 50.10 Default Rate

Fi
Ÿ Issuer default rate - Proportion based on the number of issues that default as a
proportion of all issues
Ÿ Dollar default rate estimates the dollar amount of defaulted bonds compared to the
dollar amount of the corresponding population of bonds outstanding
LO 50.11 Recovery Rate
ª In event of default, the recovery rate refers to the amount a bondholder receives as a
proportion of the amount owed
ª Bonds with higher seniority usually have higher recovery rates 191
Mortgages And Mortgage - Backed Securities

LO 51.1 Types Of Residential Mortgage Products Watch video with important
Ÿ Key attributes of mortgages are lien status, original loan term, credit classification,
interest rate type, prepayments/prepayment penalties, and credit guarantees
Ÿ Agency MBSs are guaranteed by government-sponsored enterprises (GSEs)
Ÿ Most of the MBSs are issued by GSEs
Ÿ GSEs have restrictions on which mortgages, which opened up the private label market
for those participants willing to take on the risks inherent in non conventional
loans—jumbo loans or loans with high loan to-value ratios
Interest Rate Type
Ÿ Fixed-rate mortgages have a set rate of interest for the term of the mortgage. Payments are
constant for the term and consist of blended amounts of interest and principal
Ÿ Adjustable-rate mortgages (ARMs) have rate changes throughout the term of the mortgage.
The rate is usually based on a base rate (e.g., prime rate, LIBOR) plus a spread.
Ÿ
ee
Ÿ The risk of default is high, especially if there are large rate increases after the first year,
thereby significantly increasing the total payment amount (due to the increase in interest)
Prepayments and Prepayment Penalties
To counteract the negative effects of prepayments, many loans contain prepayment penalties
Ÿ Soft penalties are those that may be waived on the sale of the home; hard penalties may not
be waived
r
LO 51.2 Fixed Rate Mortgage Payments
nT
ª Mortgage - Loan that is collateralized with a specific piece of real property, either
residential or commercial
ª A level-payment, fixed-rate conventional mortgage has a fixed term, interest rate,

and fixed monthly payment
ª Though the term, rate, and payment are fixed, the cash flows are not known with
certainty because borrower has the right to repay all or any part of the mortgage
balance at any time
Fi
LO 51.3 Prepayment
Forms of Mortgage prepayments
(1) Increasing the frequency or amount of payments
(2) Repaying/refinancing the entire outstanding balance
Other factors that influence prepayments include seasonality, age of

mortgage pool, personal, housing prices, and refinancing burnout
192
Seasonality: Ÿ The summertime is a popular time for individuals to move (and mortgages
must be paid out prior to the sale of a home)
Age of mortgage
pool: Ÿ Lower the age of the mortgage pool, the less likely the risk of prepayment
Housing prices: Ÿ Property value increases may spur an increase in prepayments caused by
borrowers wanting to take out some of the increased equity for personal
use. Property value decreases reduce the value of collateral, reduce the
ability to refinance, and, therefore, decrease the risk of prepayment
Refinancing burnout Ÿ To the extent that there has been a significant amount of prepayment or
refinancing activity in the mortgage pool in the past, the risk of
prepayment in the future decreases
Ÿ That is because presumably the only borrowers remaining in the pool are
those who were unable to refinance earlier (e.g., due to poor credit
history or insufficient property value), and those who did refinance have
been removed from the pool already
LO 51.4 Securitization Of MBS
ª Special purpose vehicle (SPV) sell the loans to a separate entity, in exchange for cash
ee
ª An issuer purchases those mortgage assets in the SPV and issue mortgage-backed
securities to investors; the securities are backed by the mortgage loans as collateral
ª Fixed-rate pass-through securities trade in following ways:

Ÿ Specified pools market.
Ÿ To Be Announced (TBA) market
Ÿ The specified pools market identifies the number and balances of the pools prior to a trade. As
a result, the characteristics of a given pool will influence the price of a trade.
r
Ÿ For example, high loan-balance pools, which make better use of prepayment options, trade for
relatively lower prices.
Ÿ The TBA market, which is more liquid than specified pools, involves identifying the security and
establishing the price in a forward market. However, there is a pool allocation process whereby
nT
the actual pools are not revealed to the seller until immediately before settlement.
Ÿ The characteristics of the pools that can be used for TBA trades are regulated to ensure
reasonable consistency.
LO 51.5 WAM, WAC, And CPR

Value of an MBS is a function of - Ÿ Weighted average maturity (WAM)
Ÿ Weighted average coupon (WAC)
Fi
Ÿ Speed of prepayments
We can convert the CPR into a monthly prepayment rate called the single monthly
mortality rate (SMM) (also referred to as constant maturity mortality) using the following
formula:
1/12
SMM = 1 - (1 - CPR)
If given the SMM rate, you can annualize the rate to solve for the CPR using the following
formula:
CPR = 1 - (1 - SMM )12
193
Ÿ An SMM of 10% implies that 10% of a pool’s beginning-of-month outstanding balance,

less scheduled payments, will be prepaid during the month.
Ÿ It is important for you recognize that the nonlinear relationship between CPR and
SMM implies that the SMM for 150% PSA does not equal 1.5 times the SMM for 100%
PSA
LO 51.6 Dollar Roll Transactions

Ÿ When an MBS market maker is bu ying positions for one settlement month and selling
those positions for another
Ÿ We can think of dollar roll transaction similar (vaguely) to repo transaction
Factors Causing a Dollar Roll to Trade Special:
When the price difference/drop is large enough to result in financing at less than the implied
cost of funds, then the dollar roll is trading special. It could be caused by:
Ÿ A decrease in the back month price (due to an increased number of sale/settlement

transactions on the back month date by originators)
Ÿ An increase in the front month price (due to an increased demand in the front month for
deal collateral)
Ÿ Shortages of certain securities in the market that require the dealer to suddenly purchase
Ÿ
month”
ee
the security for delivery in the front month, thereby increasing the front month price.
The earlier settlement is referenced as the “front month” and later considered “back
Think of “front month” as month as month in which asset is fronted (given) & back month
is when it is bought back.
Collateralized Mortgage Obligations

Ÿ The ability to partition and distribute the cash flows generated by a mortgage pool into
r
different risk packages has led to the creation of collateralized mortgage obligations
(CMOs)
Ÿ Each CM O tranche represents a different mixture of contraction and extension risk
nT
Planned Amortization Class Tranches

Ÿ The most common type of CM O today is the planned amortization class (PAC). A PAC
is a tranche that is amortized based on a sinking fund schedule that is established
within a range of prepayment speeds called the initial PAC collar or initial PAC bond
Ÿ It should be pointed out that the extent of prepayment risk protection provided by a
support tranche increases as its par value increases relative to its associated PAC
tranche
Fi
194
Strips
Principal-only strips (PO strips) Interest-only strips (PO strips)
Ÿ Receive only the principal Ÿ Receive only the interest

payment portion of each component of each payment
mortgage payment Ÿ IO investors want prepayments
Ÿ PO strips are sold at a to be slow.
considerable discount to par Ÿ IO is that its price has a
Ÿ Higher prepayment rates result tendency to move in the same
in a faster-than-expected return direction as market rates
of principal and, thus, a higher
yield
Ÿ Since prepayment rates increase
as mortgage rates decline, PO
prices increase when interest
rates fall
Investment Characteristics of IOs and Pos
Price $ ee
Pass-through security
r
Interest-only strip
nT
Principal-only strip
Mortgage Rates (%)
LO 51.7 Prepayment Modeling

Fi
Ÿ Borrowers may prepay a mortgage due to the sale of the property or a desire to refinance
at lower prevailing rates
Ÿ Prepayments may occur when the borrower has defaulted on the mortgage or when the
borrower has cash available to make partial prepayments (curtailment)
Ÿ Given a substantial increase in property value, a borrower may take out a new mortgage
with a higher balance that not only pays off the existing mortgage but also has extra cash
for other purposes. Extracting home equity is also known as cash-out refinancing.
195
LO 51.8 Dynamic Valuation
Monte Carlo methodology is a simulation approach for valuing MBSs
Binomial model is not appropriate for valuing MBSs because - embedded prepayment options
and historical evolution of interest rates impacts prepayments
The following steps are required to value a mortgage security using the Monte Carlo
methodology:
ª Step 1: Simulate the interest rate path and refinancing path.
ª Step 2 : Project cash flows for each interest rate path.
ª Step 3 : Calculate the present value of cash flows for each interest rate path.
ª Step 4: Calculate the theoretical value of the mortgage security.
ª Step 1: Simulate the interest rate path and refinancing path
Ÿ The dispersion of future interest rates in the simulation is determined by the volatility
assumption
Ÿ Short yield volatility is typically assumed to be greater than long yield volatility
LO 51.9 Option - Adjusted Spread
Option-adjusted spread (OAS) - Zero-volatility spread (Z - spread) -

When added to all the spot rates of all the
interest rate paths, will make the average
ee
present value of the paths equal to the actual
observed market price plus accrued interest
spread that an investor realizes over the entire
Treasury spot rate curve, assuming the
mortgage security is held to maturity
Limitations of OAS: (1) Modeling risk associated with Monte Carlo simulations
(2) Required adjustments to interest rate paths
(3) Model assumption of a constant OAS over time
(4) Dependency on the underlying prepayment model
r
Ÿ OAS is determined with an iterative process. If the average theoretical value determined by the
model is higher (lower) than the MBS market value, the spread is increased (decreased)
nT
Ÿ Option cost = zero-volatility spread — OAS

Ÿ As volatility declines, the option cost decreases, and the previously described relationship suggests
that OAS increases as volatility declines, all other things equal.
Fi
196
FinTree
TM
FRM® Part I JuiceNotes 2019
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Financial Risk Manager (FRM) - Part I

Book 2 - Quantitative analysis

19 Hypothesis Testing and Conﬁdence Intervals 76

25 Modeling and Forecasting Seasonality 104

Book 3 - Financial markets and products

Determination of Forward and Future Prices

42 Properties of Stock Options 169

46 Exchanges, OTC Derivatives, DPCs and SPVs 181

FinTree Placement Services

Our Placement Team purely leverages these contacts to

Risk Management : A Helicopter View

Ÿ Loss in terms of it’s chances of Financial cushion that a bank

ª Risk = Variability of unexpected adverse outcomes

It is potential for unexpected

LO 1.2 Risk management process

Ÿ Identify the risk

Two key problems - 1.Identifying the correct risk

2.Finding an eﬃcient method of transforming the risk.

Challenges in the risk management process

Tools and procedures of Measuring and Managing Risk

1.Scenario analysis: 1.Integrated approach to

For ﬁnancial institutions, it could be

Loss outside the normal course of

Ÿ Very diﬃcult to predict

Relationship between Risk and Rewards

Publicly traded securities Non-Public traded securities

tolerances disguise the trees relation

Impact of conﬂicts of interest on management

Ÿ Interest rate risk

Portfolio maturity risk

2) Trading Risk 2) Speciﬁc Risk or

increased risk of default during the term of the transaction

1. Default risk 2.Bankruptcy risk 3. Downgrade risk 4. Settlement risk

Trading Liquidity Risk: Ÿ Loss when an entity is unable to buy/sell a security at

Ÿ Are all the non ﬁnancial problems

Legal and Regulatory Risk

Ÿ Classiﬁed as operational risk in Basel II

Strategic Risk Reputation Risk

Corporate risk management :A Primer

Ÿ Lowers the cost of capital

LO 2.2&2.3 Hedging decisions

Step 1: Determining and deﬁning the ‘Risk Appetite’ in 3 ways

a) Classifying risks as i.Tolerable (to be left unhedged)

Maps risk as A,B & C

Eﬀect on sales & expenses in diﬀerent

Foreign currency risks -

Hedging risk of a ﬁrm

Cost (production) and revenue (Sales) Eﬀect on balance sheet hedge

Pricing risk Interest rate risk

Use futures/forwards Use interest rate swaps

Static vs. Dynamic Hedging Strategies

Corporate Governance and

LO 3.1 Best practices in corporate governance

Risk Management Economic performance is more important than accounting performance

The board should be prepared to pose probing and relevant questions to

diﬀerent knowledge base and skills required in each area.

LO 3.2 & 3.4 Risk governance

Ÿ A board member Ÿ Also meets senior management on regular

Ÿ Exists because of agency risk

Risk appetite and Business strategy

LO 3.5 Interdependence of Functional units

Senior Management Trading Room Management