URS a4 Lea Risk and Return of Portfolios of Risky Assets For a portfolio of N securities, the expected portfolio rein N (Rp) =) )w;xEtR;) The variance of rer for oni of ro ‘sky secures isnt asimple weighted average ofthe vines ofthe wo eure. I depends ‘on how the eu o the euiies move topecher, which it mesure by the covaince of she recuns on he wo secu oh = whoh two +2w,wsCoR Rp) Con Ra) since corelation equ: 4XO5 variance can also be writen as 2 who? 40h OF = WAR + WROG +20 AMEPAROAME Diversifiable and Systematic Risk ‘The part ofthe volalty of single secuiys returns chat is uncoredated with the volaiy ofthe market portfolios that secur’ dlivesifiable isk. ‘The par of an individual security’ isk hat arises bemus of the postive covariance of hat security’ reruns with overall market returns is called is systematic ik. A srandardied measur of systematic isk s bet: be, = ORR) oh Capital Asset Pricing Model (CAPM) Tn equilibrium ll investors hold a pordolio oy assets that asthe sme weight the market pordolia. The CAPM is expres in the equition ofthe scuty male ine (SML). For any tingle sou or poroio of tects the ‘expected eur in eqiibrium is E(R;) = Rp +bet{/Rye)—Ry] CAPM Assumptions + Tnvesto sek main the expel wig of thei wet tthe ed ofthe pei, and al invest have he se invermen boon, «Investor ai see *+ Investors only consider the mean and standard deviation of rer (bic mpi aes he set eur ae nomaly dui). + Tavestor can borrow and lend athe se ci ie + Investor have te ame eperions oneing + There ar oeither tas nor tanto ear, and asset ar inky dvi This ofa refered to pees ale” Wessex a CriticaL CONCEPTS FOR THE 2010 FRM° Exam Price and Quantity of Risk ‘The risk premium of an asset is [E(R,,) ~ R, 18. heeayea “The pie ofthe mate prema (BIR) -R Firm Value Using CAPM fim cash ow “CAPM rear cutrent value of equity = fhe fm reduces sstematic isk through financial markets, the decrease in cash ows (the hedging cons) wil be js of by che lower the vale ofthe em “The thre level of efiiency az follows + Wa offen meant the infomation inp ice ater i inorposted in he ent price + Sieg fin ans tat al pale informatio, inclaig hatin pas pce panes, is icrprted in che carent pres + Sng ey res al inkration, incldig piv an pebliiincrporaed into the cue pice Measures of Performance The Teynor meat qual tothe ris prema divided by bet, or syemai ie EAR) Re] & “The Sharpe meatae is equal to he sk premium divided bythe standard deviation, or tora rie “Treynor measure enn 7 ‘The Jensen meat (aka. Jensen's alpha o just alpha), isthe asset’ exas eur over the return predicted by the CAPM: ~T Fensen measre = p= E(Rp)—IRp +BplERyq)—Rell ‘The information ratio is esetially the alpha of the managed porolio relative to is benchmark divided by the wackng exo. E(Rp) ER) TT acking ero ‘The Sotino ratio is similar othe Sharpe rato exept we replace the risk Fie rate with a sinimum acceptable rerum, denoted Ry nd ‘we replace the standard deviation with = ype of semi-sandad deviation, rio ratio= PRP) Rain _ i ‘emistandard deviation Arbitrage Pricing Theory (APT) ‘The APT assumes that rerurns can be modeled witha mulfcoerepesion model ofthe folowing fo: Ry = Ret Xgy Xby +--+ Nyy xy Ht, wher R, = returns for sock n Rp =rskfree ate Xqu = Hfactr exposure for tack 2 rerun for factor k ionymcratc return for stock n ‘The APT defines the structure of returns but does not define which factors shouldbe used in the model. The CAPM is a special cae of APT with only one factor exponute—the marker risk premium: Case Studies Mellgclichfe shorter furs contacts ued to hedge long-term exposure inthe pecleum markers stack and-roll edging sate; marking to market on furures caused huge ash Bow problems. Suita: trader atempred ro core the copper rake by buying age quantities of physical copper and lng futures postions; copper prices plunged, causing huge losses lesson isthe lck of operational and rk controls tha lowed this scheme to go undetected. Long-Term Capital Management: hedge fund that wed edlative vale strategies with enormous amounts of leverage; when Rusia dfwulted on iu deb in 1998, che increase in yield spreads ‘caused huge loses and enormous cash low problen from reining marking to market Tose lesons ncde lack of diverifation, modal is, leverage, and funding and trading liu sik Barings ogue trader, Nick Leeson, took speculative derivative postions (Niki 225 forum) in an aempt to cover wading losses Lezion had dual esponsibiles of trading and ‘supervising serdement operations, allowing him to hide trading losses lesons ince separation of duties and management oversight. Dayle Secritcz borowed $300 milion in unsecured fund rom Chase Manbatan by exploiting 2 faw in the sytem for computing the ae of collateral Kidder Peabody: Joseph Jet epoted substantial arial profs afer the fake profs were detected, $350 milion in previously reported sins had tobe reversed Allied Tih Bank currency trade, Job Rasnak, hid $691 milion in loses; Rusnak bullied backofce workers into not fllowing- upon tide confirmations for fke trades. UBS: equity derivatives business lost hundreds of milios of dollar the loses were mostly de to inconrect modeling of long-dated options and the Gm’ large stake in Long-Term Capital ‘Management.Dive: Tesury bond trader, Toshihide Iguchi, covered up SI. billion in loses; his misieading reporting weat undeeced due to his dul role as the head of both trading and the back-office suppor function Banker: Tra: developed derivative suctues that were intentionally complex: in aped phone conversations, staf raged about how badly they fooled cles GARP Code of Conduct ‘The Code of Conduct sets forth principles selted to ethic behavior within the sk ‘management professon. It sess eiicl behavior in the following areas Principles (0) Professional integrity and ethical conduct (2) Conflicts of interest (8) Confidenilry Profesional Standards (0) Fundamental responsibilities (2) Adherence to best practices ‘Violations ofthe Code of Conduct may result in temporary suspension or permanent removal fiom GARP membership. In aditon, violations could ead ro a revocation ofthe right ro use the FRM designation TETAS Bayes’ Formula Baye focmula wed wo opda iven sf -ttoe probabil foragiren event in respond 19 the aval of new information. For eaple, io rant find he probably chit he cd pow gies a tok wp, you wold te the following eqution: RUIG) xPIG (PG) «PU ]G)+PR)xRUR)) ay ‘= probability the economy glows: = PIR) sbability of a feces = PU) = pobaby : hdipesonin eet ass s arable around he mean Tht squat yoo ofthe vafiaice fi ced the sandr deviation, Chebyshev’ Inequality Foc any ec of biewain:, the pecenage ofthe erations hate within sandard deviations of che mean is a least 1 ~ 1/4? forall k > 1. Population and Saruple Mean Population mean: all che observed values in the ‘population are summed (5X) and divided by the ‘number of observations in the population, N x ds = N ‘The sample mean is the sum ofl the values in 4 sample of population, DX, divided by the ‘umber of observations inthe ample, Geometric Mean The geomet mean is ofen used when ‘lean invesment recurs ver muliple petods or when measuring coimpound growth LRG = ACER DRO TRIKE) were c= the return fo period ¢ Population and Sample Variance ‘The population variance is defined asthe average ofthe squared devon from he mean ‘The population andar deviation ithe sqere ror of ie poplin vac. 0% -F N ‘The spl vafianc, isthe masa of dispetion tha applics when we a clitng 4 sample of mobsciaios fom spopdaion, Using a ined of nin the denominator ipo hc nil propel i a Skee, kei hi ene wich 4 distbton ino pmmeicl: The sewnes ‘ofa notmaldistibuionisequal tae, inl Are dsibuin charac by ‘any outer inthe uppet eon, or right al SA neatly sewed dbo aia ~ propionate rg amount of cui that a iin i owe) Kanai nei ft ee: wich 2 dsb gore ot les “peaked” haa nota distribution Exes rts = rts —3 * Leptaaicdsctbs ibn that is more pend chat otal dincbution, + Pfayinic fers dieubuton hati es paled or fares an panna dncbuton. Relative Frequencies A feequeny distibution is tabular presentation of statist das that ads the analysis of large aa sets. Thereaive fequency is caesated by dividing the absolureFequency ofeach return iter by the tol numberof observations. Ieis the percentage of torl observations fling within each interval ‘Normal Distributions Noxmal distribution is completly descibed by its mean and variance + 68% of cbservans ill within + 1s + 90% of obseraions ill within # 1.65 + 95% of cheracins il within + 1 96. + 99% of oberon: ill within + 258s, Standardized Random Variables A sandediedrendom varisbeis normalized so that ichasa mean of ero and 2 standard deviation of Zor represents # of standard deviations 3 ‘ven observation is fom a population mean, = sheetion~popultion mean _x—p standard devation @ Central Limit Theotem Cena iit horn: when selecting simple random simple of sie» rom population with ‘mean p an finite variance 0; the sampling isbn of ample mean approaches noemal probably dtribution wih mean and variance equ to oa the sample sie becomes large Standard Error “The standatdeor ofthe eample mein ithe standard deviation of the dsbiton ofthe sample meant. Whe the standard deviation oF the popilation,¢, is known, the standaid error of ‘the sample mean calculated as & ‘EDistribution ‘The disibatons abel shaped probably. ebuton tit symmetrical about ean Teisthe appropri dstibuion oie when “conttucng cabdence itera based 6a Small sample from populations with uaksiown serine and nial, ot pproinatty normal, Chi-Squire Distribution “The chi quae ti ued fo hyporbei vests ciceraing the vance of oma distributed Population i? aque en? 0" EDistribution ‘The Fests sed for hypotheses tess concefning, the equality ofthe varices of two populations.Adjusting Portfolio Beta IE the be ofthe capital ase pricing models ed asthe stemati rik mesure chen hedging boils down to a reduction ofthe porta bet. # of contnas= folio value (arget bets ~ poli era) PO eos, (expe tea pon ing Forward Interest Rates Forward rae arinters rts implied by the spot cure fora specied tue peiod The forward rte becwen, andT, can be clelted Rie ERK TT i Reh Rl | Forward Rate Agreement (FRA) Cash Flows ‘An FRA isa ford contact obliging wo parties 0 agee that erin interes rae wil apply to2 principal amount during speci future ime. The T cach fow ofan FRA that promises the recip or payment of Rie cash fw recrving Ry) = Ex -RxT=Ty shou pig y= Dae RRC Cost-of-Carry Model Forward price when underlying aset does not shave cash flows: Fy = Spe Ferwatd pice when undedyng ae ha ash flows: Fy =(y-De™ Forward rc wih continsous dvdend yd (Q): msgl-a Forward pice with storage costs: Fy = Got UT oc = Sy Forward pice with convenience yield: Baye Forward frcgn exchange ate using interest rate psi ORE): erage: Remeber toby low high Tee boro, buy sot sel forward contac, deliver to cover shor sal. ‘Backwardation and Contango + Backwardaton refers toa situation where the Facures price i below the spr prc. Fortis to occur there mu bea significant bene to holding he ase. + Coontango refers oa sitation where che fares ice is aboe the spor price. If there are no benefit olin the act (eg dividends, coupons coneniene ye), contigo wil ecu bese the furures rice wil be reer than the spo pie. Clean and Dirty Prices ‘When bond is purchased, the buyer mas pay any accrued intrest (Al) earned through the settlement date. 1 ain ge | tothe senlement date AI C000 ays in coon pee | | ie prie (aka. quoted pie: bod pice without accrued ices, Ding price (aks. cash pie: includes acrucd ines pice the seller ofthe bond mus be paid ‘0 giveup owner. Treasury Bond Futures Jn a bond furures contact, a government bond with more than 15 years wo matuiy on theft ofthe dlvery month (and noc clble within 15 yeas) dlverble on the const ‘The procedure ro determine which bondi the cheapest-ever (CTD) as fellows: cath recived bythe shor = (QFP CF) + Al costo purchase bond = QBP + Al one quoted fu QE? = quae ures price CE ‘The CTD isthe bond that minimies the following: QBP - (QFP x CP, This formule calles the cos of delivering the bond. Eurodollar Futures Contract, ‘This contract sees in cash and the minimum price change is one ick,” which sa price change of one bass point, o $25 per $1 milion contact. The interest rate undeying this contacts exenialy the 3-month (0-day) Sorward LIBOR. If Zs the quoted price fora urodollar furs cont, the contact price is ucla futures price = $10,0001100 ~(025)000~2)) Coney adjusoment The diy matking to smatker asec ofthe fuurs contrac can result in dferences beoveen actual forward rates and shined yee cones forward rte = Cree ersnen) hay oe we conc ‘Ty = matury ofthe ate underlying the a = anda deviation of change inte Duration-Based Hedge Ratio ‘The objective of a dunation-based hedge is to ‘create a combined poston that does not change ‘inva when yes change by small amount _ortolio alex duraony rues value x durations Interest Rate Swaps lin vail interes rate swap exchanges fixed for floating-rate payments over the i of the swap. A inception, the vale ofthe swap 4 of contac = is tea Afr inception, cheval ofthe swap is the dference berween the presen ae of he scainng faed- and Bouing-ate payments: Voy pit = Btn ~ Bt Von efit = Bie — Bind = PMTs, + (PMTyaeds, 6) + + [ooiona + PMTgads, Prong pein ain te Currency Swaps Exchanges payment in wo diferent currencies, payment can be fixed o oxtng IF swap has, 2 poste vale ro onecounterpary chat ary exposed to cred ik. Voay(DC)= Boe ~ (S84) wher: Sy =spot exe in DC per EC Option Pricing Bounds Upper bound Euopean/Ameican cal: ESSjiCSS Upper bound uropean/American pu: psxeTPsx Lower bound European call on ‘non dividend. paying stock: 2 maxlSp— Xe" 0) Lower bound European pt on ‘non-dividend: paying stock: p2max(XeT — 55,0), Rules for Exercising American Options + Hisar pina exe a Amen clon 4 none ping stock bere expiraion de + Aci pus can be optinay eid elif thy alien inheenoncy + AnAmetica cl on died pying wack ray be ern ely ifthe iden eed the oun of gone ere Put-Call Parity ptSaetxe™ Covered Call and Protective Put Covered eal: Long stock pls shor call Proeive put: Long stock pls long pat. Also cid prot insurance Option Spread Strategies Ball prea: Purchase cll option wih low exeise price ad subside the purchase with le ofall option witha higher exercise price. ‘Bear grsd Shor bul spread Puschass call with high ste price and shores call with low srike pric. Investor keep diference in price of the options if ssock price fll. Bear spread with pus involves buying put with igh exercise price and selng put wit low exercise price. Buttery spread: Thee diferent options: buy one call with ow execs price, buy another wi thigh excise price and hore wo calls with an care pric in berween.Buterfy buyer is being the tock price wil tay near the price of the wrt clCalendar spread Two options with different expiration. Sella shor-dated option and buy 2 long.dated option. Investor profs if tock pice stays ina narrow range. Diagonal spread: Simla oa calendar spread ‘except thatthe options can have differen strike prices in adaition ro diferent exprations. Option Combination Strategies Lorg saddle Beton voli. Buy a call and 2 pc withthe same exercise price and expiration dae, Profit is earned if tock rice has a ‘ge change in cthe direction, Shortsraddle: Sela pt anda call withthe same exercise price and expiration dae stock price remains unchanged, ser keps option premiums, Unlimited potential loses Srangle Similar to saddle ecep purchased option is out-of the money, siti cheaper to implement. Stock price Has to move more tobe profile Ships and svar: Add an adiinal put (sip) ot call (rap) saddle strategy. Foreign Currency Risk ‘net lang (shor) cutency postion means a bank fics the risk hat he FX rat wll fal ie) versus che domestic currency. net cutency exposure» ases-libits) + © (bought —sold) On-balence sheet beeing ached maturity and curreney foreign sc iaby book Offbalance sheet hedging: eet io a position in 1 forward contrac. Coneessionality Concesionlicy isthe et com ofa mulieat rexrucaring agreement. concesonality = (PV of eriginal loss) ~ (PV of restructured loan) ‘The lower the PV ofthe restructured loan in selacon tothe orginal loan, the more the bank ‘as given up, andthe reser the cost of oan resrucrring, OU INL¢ ‘Compounding Discete compounding + = annual rae ‘m= compounding periods n=yen Continsous compounding FY, =0Vq Holding period sere: PV, ‘Spot Rates ‘epetod spc rae, denoted ase) he yield to maturity of a zo:coupon bond that matures in years. can be calelaed using a Grancal calealatoro by using the following forma {assuming periods re eriannu): Foard eae ites tes thar span fue pei 0+ pec yield) “ME ie wield (forward ate! =: (option ae) BVO opin poson DVOl(band postion) (bond value) :Eifective Duration and Convexity Duns: Bet ecvaive ofthe pricelyield tationships mst widely sed mena of bond "Sip: Cael option pay at ead al © Dek esinatés the chang? in value for an option. “ota dein chang a mock price price way the longer (shore) the duration, the more (les) sensitive he bond’ price ro changin intrest aes canbe wsed fr linear estimates of bond price changes. BV ay BV yay 2KBYp xy CConsexin. measure ofthe degree of curvature (cond dervacve) ofthe priceild relationship; counts for ertor in pice change estimates from duration. Convex always has favorable impact on bond price BV. ay +BVsay ~2*BVo BV xy? Bond Price Changts With Duration and Convexity percentage bond pric change» duration eft © conventy effect AB 1 = ~duration x Ay + — x convexity Ay? 7 rt iyx dy" cffectve duration = convey = Bonds With Embedded Options Calc bon sue bas he ight to buy back the bond in che fare ata se price 3 il fl, bond is they ro be alle pies wl ise a4 deren rate—negatve covering Puacbe bond: bondboler ha te ight tl bond Bick tothe ue at er ree = Binomial Option Pricing Model. ‘Aone binomial models best descibed within. 2 ewostae world where th prick of tod wll ther go up once or don onc, andthe change well ocut one sep ahead atthe end ofthe hong prod. - In che ne pevodSinomitnedl and my petod mls, he ue a Sepia: a greater numberof potent ‘Sip 2 Calealate option vale using ) ETN 2 pexe NC) SNA) * Cal dla between O and #1 increase a ck prc incase.Cosnfidence Interval “elf the population has 3 nermal dismibution with «noun variance, a confidence inter for the population mean Thane 249" 1.65 for 9096 confidence interval (Gicance lee 108%, 596 in exch ail) 14 1.96 for 95% confidence ites (Snifcance ee 5%, 2.59 in exc ai) 58 for 99% confidence inerals (Giiicance level 1%, 0.59% in echt) Hypothesis Testing ‘Nal ypthess (Hypothesis the esearch wants to eject; hypothe chat i aculy rested the basis for selection ofthe test tiie Aerie hp (H,): whats concluded if hee is signa evidence to eject he nll hypothesis One sald ts whether value is restr than or les than anther value. For example: Hz s0 vem Hy p>0 Toile tes wheter vale i diferent fiom another vale or example: Hyp =O ves Hy: 140 ‘Type and Type Il Errors ‘Typel exor: Rejection af the ull hypothesis when cis aculy re. The sneene leis the probability of making 2 Type ero. ‘Type Ue: Fae a eject he nl Iypotheis when ici actualy false. The pour of «tts one minus the probability of mck a Tipell exon ‘The Binomial Distribution ralutes random vale with two posible utomes over sie of mri The probably oF cen ich tal gue pt) = (ourber of way chon omni —pr* Fora binomial mando arial expected value= np vatince = np=p)"! ‘The Poisson Distribution. Poisiod random vatbleX fei wo the umber of esses pet ut, The parameter lambda 0) ‘eft the atige fuer of ces per ani For the bth is mean and. variance are equ the parameter). pee pXS yee a ‘Simple Linear Regression Y,oB, +B, xX,+6, whee: Y, = dependent ot explained variable X, # independent or explanatory variable 3, = intercept coeficient B= slope cient & sertoctem ‘Total Sum of Squares For the dependent able ins regression mode, there is a total sum of squares (TSS) around the cxplined sum of squares + residual sum of squares TSS = ESS + RSS Doi - Lai- Dy Coefficient of Determination Represented by Rc isa measut ofthe goodness of fit” of the regression, 5s Ts Ina simple wo-varble regression, the square rootof Ris the comlation coefcient 7) between X and Y, Ifthe relationship is poste, then we Jarque Bera Test “The Jrgue Ber tate a method for eig if the socal sumption i resonable ; sp B ‘Multiple Linear Regression ‘A simple recon the wo-raible epresion with one dependeat vasisble,Y, and one independent varsble,X, A maria epeion has mote han one independent aisle =By +B xXy +B) xXq46; ‘The F-statistic ‘The Fsaiiéallows fo the esting ofthe joint ‘hypothesis that mulipleslope coefficients equal sero: Ieeanbé eaeulated tt BY ‘Adjued R Squared ‘Adjuied RPs wsed wo aoa the imporiance of “an added independent variable regrsion.- sil 1 OR EWMA Model Theagoeaaly wih moving ee (EWMA) model assumes weighs deline exponential back through time, This assumption sui specific elatonship for ‘arance inthe model: Gh O-N tod ety siliy hain ily sna Cbevee oand on) High vals of X wil minimize the effect of daily pétocnage eras whereas low Yale of X wil tend to increase the eet of daly percentage ‘teturns on the current volatilicy estimate. GARCH Model. AGARCH(I,1) model incorporates the most. -Tecent estimates of variance and squared retur,. ‘bur also a variable that accounts for a long-run nip ality +a, +03 Weighting on previous period’ return weighting on previous volatiy estimate i-a=8 +B <1 forseaility ‘The EWMA is noting ater than a special cae of GARCH(1 voatliy proces, with w= 0, ael-Rand ed ‘Thesum +i called he pesitnce and if the ml ist besaionary over ime (with reversion «othe mean), the sum must be es than one. Wee Option and Forward Contract Payoff ‘The payofon al option cosh opion buyer is calealteds flows: C,=mai0,5,-X) ‘The rice pad forthe cll option, C, is efered «os thecal premium. Ths, the proto the option buyer clalted a flows: profs C,=C, ‘The payoff on put option is leased as foliows: P= max(0,X-S,) Tye pyofTeo long position in forwacd contacts caelated as fellows payoff 5, -K where S,= spor pie at matty K = delivery price Basis “The bss ina hedge ie dfined athe diference Ieeween the pot price ona hedged ster and the furs prc ofthe hedging instrument (eg fatres cna). When the hedged aset and theaset underlying the hedging instrument are the sume, the basi willbe aero at maturity. Minimum Variance Hedge Ratio “The hedge atone the variance ofthe combined hedge position. Tiss aso the bet of Spot pies with spectro furs contact prices R= pop % Hedge Effectiveness Measures the aiance tha is reduced by implementing the optimal hedge. Tit effecivenes can be evaluated with a oeicient of ecrmination (R) term where the independent variable isthe change in furs prices and the dependent ales the change in sot pics Hedging With Stock Index Futures lio value Fares price x contact multiplier of contacs =f x* Call delta close to 0 for far out-of che-money calls; close for deep inthe mney cl. + Puc dela berween-1 and 0; increses rom -1r0 0 as tok pice increases, + Pur dela os 100 fo frou the money pus, close ro order in-the-money ps * The delta of formard conc isequal + The dela oft futures contac isequal oe, + When the undying ase pays dividend, the ela must be adjted, Ifa dividend yield exis, det ofall equals "x N(), dela of pu equals Fe (NG) = Th dela of forward egal and dela of ures equals e°" ‘Thee: time decay change in value ofan option fora one-unit change in ime; most negative ‘when option is ae-the-money and dos 0 cepiraton Gam: ae of change in deta 8 undesying stock price changes largest when aption is at-che- ‘money. Nga: change in value ofan option for a oneanit change in volt, lage when option isai- themoney; dos to Owhen option it dep in cut-ofthe-mone. he: sesiivty of options price vo changes in the ‘kee rae largest for in-the-money options. Delt-Neatral Hedging Tocomple ble ener al patton, pchae share of sock ul wo deka x uber of ptons sol * Ont appropri for small change in he valu of che nderying ase. + Gunma can correct hedging error by poteing puns large mover in ase pe + Garuma-new poston ze rested by matching ponfoio gama witha ofering option ‘puiton ‘Value at Risk (VAR) Minimarn amount one could expect se with Use the gue infin tag aly ‘nontly oF anal VAR. VAR ties hora dit Forzample i calli che 5% daly VAR you acrarulie a ‘nurber of pst daly return rnk the serum ‘roa highest lowes, ad dhe deny the lonest 5% of eum. ‘The Monte Carl simsdtion method eles = te compute sowie chat generated manj posible outcomes fron the dibition of inpucs specified bythe wer Al ofe examined = portolio rerun wil form a debuts, which will approximate che nortaldsibuon. VAR is the aise in th ae way a withthe eles ‘normal method: = Stress Testing -VAR tls the probably of excbding given low but ilécoincport the posible amount of {os that resuls fom an extreme amount Ses teving complements VAR by providing information about the magnitude of loses that may eceur in exten matket condions. Expected Shortfall (ES) * Average o expected value of all loses greaer than she VAR Ef | 1,» VARL + Popul maser repr along wih VAR. + Sisal nown 3 coniconal VAR or expeced alos + Unlike VAR, ES hash abil to satis he property of subadditiviy. Linear vs. Nonlinear Derivatives 1 Adee is decibed e car hen the telaintip beeen an undeting ioe and the deriva ee nein ate VAR, = AV + Kam deacon he change in the vale ofthe undetying et andi dependence ato the andrying at Opérational Risk Operations skis defined as: "Theis ofirer “and indie ls resubing from inadequate or filed inurl process, peopl and sero fom ‘external eens” Loss Frequency and Loss Severity ‘Operational rs loses ae clasifed along two independent dimensions Loss quency the nuraber of losses over a specific ‘time period (ypicily one year). Often modeled with the Paiuon dbus dsbucion which models random events). Low evriy vale of financial loss suffered, Often riodeled with the lognormal distribution, (distribution is azymmetrical and has fat tails). Classifications of Operational Risk High jane, lw eet HELS) fists oat frequently but result in small losses. _Bessgunc higheeiy (LPS) ek est ares of concer for operation re ‘nanager. Because they ae tare, there is ide avalabledit ona such fk andthe cot the ie cold be cathe ‘Top-Down and Bottom-Up Models. Tadeo mode xine aggregate impact “of tional failures, macro view; telies rece ea zdvanags dc nce dink beeen = HHELS event and LFHS ees cannot diagnose. = speci area of wens ckward looking. in it in z Sng dsingshes between HLS event {ed LEHS sean gore wee in -procedutes and suggest correeions; forward loking > Dindrningescmpler ind din ini PPN:AA761FRM SBN 1427789553 shreiazr' ll US 39.40 2010 fan ne, Ag Reseed, Methods for Hedging Operational Risk * Tsurane + Sinuace + Dera ects Catastrophe Options and Bonds Gat epion: Publi tadeds pays inked to inder(e, underwriting less in che insurance indy); spread option tha has inited upside. Cer bode: Bond contrac with embedded options cha an be triggered by internal evens, ‘external evens, or the Valu oft index Internal Credit Ratings Ave pin approach: gato pede he eet qui vera elativly shor hotiaon ofa few ‘mont of mere genera yea. Thrngh-te ele approach Focuses on a longer tin hriaon and ncudes heeft of be opt ign risk wate forcigngoreroment may defal ‘on alan or fil to honor business cominiments dduetoa change in atonal policy: When exposed to sovetgn rk th ender legal reeds are very limited ‘Cedi should + Beanie the sovereign i quai the county inhi cher ese + Aesth red qualy ofthe i Debt Repudiation Deberepudiion the uinuinoial ful of county to honor forégn deb and equi obligations of sborower are canceled Deke Reschediling Debs tichedlng aca when. county. ot expected Loss epee sepa the vanity of potent loses and canbe indeed the Aefniion of andar devition. “UL = Ab fEDFehan + LGD cog