强化 - 金融市场与产品+估值与风险模型 - lzy3 QQ2158933105

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Henry Liang
9KTOUX,83OTYZX[IZUX-URJKT,[Z[XK
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¾ Fixed-Income Products
z Bond Basics
z Bond Products – Treasury Bonds
z Bond Products – Corporate Bond
z Bond Products – MBS
z Valuation of Bonds
z Risk Metrics
z Rating Agencies
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¾ Derivatives
z Forward Market and Futures Market
z Forward and Futures Prices
z Interest Rate Futures
z Hedging Strategies using Futures
z Swap Market
z Properties of Stock Options
z Trading Strategies involving Options
z Exotic Options
z Option Valuation
z Risk Metrics – The Greek Letters
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¾ Central Counterparties
z Introduction
z Exchanges, OTC Derivatives, DPCs and SPVs
z Basic Principles of Central Clearing
z Risks Caused by CCPs: Risks Faced by CCPs
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¾ Risk Measurement and Management
z Measures of Financial Risk
z Putting VaR to Work
z Quantifying Volatility in VaR Models
z Expected and Unexpected Loss
z Country Risk
z Operational Risk
z Stress Test
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z Bond Basics
z Risk Metrics
z Rating Agencies
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¾ Risk-Free Rate
z Treasury Rates
9 The rates an investor earns on Treasury bills and Treasury bonds.
9 Treasury rates are risk-free rates in the sense that an investor who
buys a Treasury bill or Treasury bond is certain that interest and
principal payments will be made as promised.
z LIBOR
9 A LIBOR quote by a particular bank is the rate of interest at which
the bank is prepared to make a large wholesale deposit with other
banks.
z Repo Rates
9 In a repurchase agreement, the difference between selling price
(today) and the repurchased price (tomorrow or later) is called the
repo rate.
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¾ Compounding Frequencies
z Simple Interest
z Compounding Interest
9 Suppose we have an account where the simple interest is added in
each year and then that money also earns interest.
9 Assuming
Rc is the rate of interest with continuous compounding.
Rm is the rate of interest with discrete compounding (m per annum)
n is the number of years.
mn mn
§ R · R C un § R ·
FV PV ¨ 1 m ¸ FV PV u e PV u e Rc n
PV ¨ 1 m ¸
© m ¹ © m ¹
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¾ Bonds
z Characteristics of Bonds
9 Coupon Rate
9 Face Value
9 Maturity
9 Yield to Maturity (YTM)
¾ Bond Pricing
T
C1 C2 CT Ct
P
1 y (1 y)2

(1 y)T
¦ (1 y)
t 1
t
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¾ A bank uses a continuously-compounded annual interest rate of 5% in
one of its risk models. What is the equivalent interest rate the bank should
use if it converts to semi-annual compounding in the model?
A. 4.94%
B. 5%
C. 5.06%
D. 5.12%
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z Bond Basics
z Risk Metrics
z Rating Agencies
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¾ Treasury Market
z Treasury Bills: A short-term debt obligation backed by the U.S.
government with a maturity of less than one year.
§ n ·
cash price 100 ¨ 1 discount - rate u
© 360 ¸¹
Example: Suppose you have a 180-day T-bill with a discount rate, or

quoted price, of five (i.e., the annualized rate of interest earned is 5%
of face value). If face value is $100, the cash price is 97.5.
z Treasury Bonds: Fixed-interest U.S. government bonds with a
maturity of more than 10 years. Treasury bonds make interest
payments semi-annually. Quoted Price: Dollars and thirty-seconds of a
dollar for a bond with a face value of $100
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¾ Quotation of Treasury Bonds

z Accrued Interest and Day Count Conventions
9 Treasury bonds: actual/ actual
9 Corporate and municipal bonds: 30/360
9 Money market instruments (Treasury bills): actual/360
z Clean Price
9 The price of a coupon bond not including any accrued interest.
Immediately following each coupon payment, the clean price will
equal the dirty price.
z Dirty Price
9 A bond pricing quote referring to the price of a coupon bond that
includes the present value of all future cash flows, including interest
accruing on the next coupon payment.
dirty price = clean price + accrued interest
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z Example
Suppose a 1000 par value US corporate bond pays a semi-annual 10
percent coupon on January 1 and July 1. Assume that it is now April 1,
2005, and the bond matures on July 1, 2015. Compute the invoice
(full) price of this bond if the required annual yield is 8 percent.
Compute the flat (clean) price of the above bond.
Time Feb 1st Mar 1st Apr 1st May 1st June 1st July 1st
dirty price 1147.77 1155.30 1162.87 1170.50 1178.18 1185.90
clean price 1139.44 1138.63 1137.87 1137.17 1136.51 1135.90
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¾ Treasury Strips
z Separate Trading Registered Interest and Principal Securities
$5 $5 $5+$100
3-year bond
$5
C-STRIPS 1
$5
C-STRIPS 2
$5
C-STRIPS 2
$100
P-STRIPS
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z Bond Basics
z Risk Metrics
z Rating Agencies
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¾ Role of Corporate Trustee

z The corporate trustee is a third party to the contract. The trustee acts
in a fiduciary (legal) capacity on behalf of the investors. Acting on
behalf of the bondholders, the trustee must ensure that the bond
issuer is in compliance with the covenants of the indenture at all times.
¾ Different Coupon Payment
z Straight-coupon; Zero-coupon bonds; Floating-rate bonds
¾ Different Types of Corporate Bonds
z Mortgage Bonds
z Collateral Trust Bonds
z Equipment Trust Certificates
z Debenture Bonds
z Guaranteed Bonds
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¾ Zero-Coupon Corporate Bonds

z A zero-coupon bond eliminates reinvestment risk (shifting all of the risk
to interest rate risk;) because there is no coupon to reinvest.
z In bankruptcy, zero-coupon bond creditor claim original offering price
plus accrued and unpaid interest, but not the principal amount of
$1,000.
z A zero-coupon bond’s interest rate is determined by the original issue
discount (OID). The difference between the face amount and the
offering price when first issued is called the original-issue discount.
z Example:
9 Face value $1,000 N = 20; I/Y = 5;
9 20-year zero-coupon bond PMT = 0; FV = 1,000,
9 Yield 5% CPT PV = -377
9 Compounded annually ĺOID = 1,000 – 377 = 623
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¾ Corporate Bond Retirements

z Frequently, bonds are retired early, before maturity. There are several
mechanisms by which a corporation may go about retiring their debt.
Included below are some of the most important and commonly used
retirement mechanisms
9 Call provision
9 Sinking-fund provisions
9 Maintenance and replacement funds
9 Tender offers
¾ Corporate Bond Credit Risk
z Credit Default Risk
z Credit-Spread Risk
z Issuer Default Rate vs. Dollar Default Rate
z Recovery Rate
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¾ High-Yield Bond
z High-yield bonds are those rated below investment grade by the
ratings agencies, these issues are also known as junk bonds.
¾ Types of High-Yield Bond Issuers
z Original Issuers
z Fallen Angels
z Restructurings and Leverage Buyouts
¾ Payment Features
z Deferred-Interest Bonds
z Step-Up Bonds
z Payment-in-Kind (PIK) Bonds
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¾ The Spread of a Bond
z The market price of any security can be thought of as its value
computed using some term structure of interest rates plus a premium
or discount.
c c c F
P ಹ
1 f 1 s 1 f 1 s 1 f 2 s 2 s ಹ1 f T s
1 f 1 s 1 f
c c c F
P ಹ
1 f 1 s 1 1 f 1 s 1 1 f 2 s 2 s 2ಹ1 f T s T
1 f 1 s 1 1 f 2
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¾ Callable and Puttable Bond

z With callable bond, the upside price appreciation in response to
decreasing yield is limited (sometimes called price compression).
Consider the case of a bond that is currently callable at 102.
Price
Option-Free Bond
Call Option Value
102 Callable Bond
Negative Convexity Positive Convexity
y’ Yield
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z With puttable bond, the downside price appreciation in response to

increasing yield is limited. It gives the holder the right to sell the bond
back to the issuer at a set price.
Price
Puttable Bond
More Convexity
97
Option-Free Bond Put Option Value
y’ Yield
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¾ A portfolio manager has recently purchased a 10-year investment-grade

corporate bond. Which of the following tasks must typically be performed
by the corporate trustee listed in the bond’s indenture?
A. Act in a fiduciary capacity for the bond issuer.
B. Ensure that the bond issuer’s reported financial ratios meet the
requirements in the indenture.
C. Change the terms of the indenture to provide protection for the bond
purchaser.
D. Monitor the bond issuer’s balance sheet to ensure covenant
compliance.
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z Bond Basics
z Risk Metrics
z Rating Agencies
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¾ Mortgage Loans
z Almost exclusively on fixed rate residential mortgages.
z Agency or conforming loans are eligible to be securitized by such entities as
Federal National Mortgage Association (FNMA), Federal Home Loan
Mortgage Corporation (FHLMS), or Government National Mortgage
Association (GNMA). These Loans are relatively creditworthy.
z Non-agency or non-conforming loans have to be part of private-label
securitizations.
9 The relevant loan types include jumbos, which are larger in notional than
conforming loans but otherwise similar;
9 Alt-A, which deviate from conforming loans in one requirement.
9 Subprime, which deviate from conforming loans in several dimensions.
About 80% of subprime loans are adjustable-rate mortgages (ARMS)
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¾ Fixed Rate Mortgage Payments
z The mortgage loan is fair in the sense that the present value of the monthly
mortgage payments, discounted at the monthly compounded mortgage rate,
equals the original amount borrowed. In general, for a monthly payment X on a
T-year mortgage with a mortgage rate y and an original principal amount or
loan balance of B(0):
ª º
12T « »
1 12 « 1 »
X¦ B 0 ; X 1 B 0
n 1 § y ·
n
y « § y · »
12T
¨ 1 12 ¸ « ¨1 »
© ¹ «¬ © 12 ¸¹ »¼
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z The fixed monthly payment is often divided into its interest and
principal components, a division interesting in its own right as well as
for tax purposes; mortgage interest payments are deductible from
income tax while principal payments are not. Letting B(n) be the
principal amount outstanding after the mortgage payment due on date
n, the interest component on the payment on date n + 1 is:
y
B n u
12
z In words, the monthly interest payment over a particular period equals
the mortgage rate times the principal outstanding at the beginning of
that period. The principal component of the monthly payment is the
remainder, that is:
y
X B n u
12
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3(9
Example: A homeowner might borrow $100,000 from a bank at 4% and agree to

make payments of $477.42 every month for 30 years. The mortgage rate and the
monthly payment are related by the following equation:
360
1
$477.42¦ n
$100,000
n 1 § 0.04 ·
¨ 1 12 ¸
© ¹
In the example, the original balance is $100,000. At the end of the first month,
interest at 4% is due on this balance, which comes to $100,0000.04/12 or
$333.33. The rest of the monthly payment, $477.42 - $333.33 or $144.08, is
payment of principal. This $144.08 principal payment reduces the outstanding
balance from the original $100,000 to $100,000 - $144.08 or $99,855.92 at the
end of the first month.
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z Discounting using the mortgage rate at origination, the present value

of the remaining payments equals the principal outstanding. This is a
fair pricing condition under the assumptions that the term structure is
flat and that interest rates have not changed since the origination of
the mortgage.
Example: To illustrate this shortcut in this example, after 5 years or 60
monthly payments there remain 300 payments. The present value of
these payments at the mortgage rate of 4% is
ª º
300 « »
1 12 « 1 »
$477.42¦ $477.42 1 $90,448
n 1 § 0.04 ·
n
0.04 « § 0.04 · » 300
¨ 1 12 ¸ « ¨1 »
© ¹ ¬« © 12 ¹¸ ¼»
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¾ Prepayment Option
z Mortgage borrowers have a prepayment option, that is, the option to
pay the lender the outstanding principal at any time and be freed of the
obligation to make further payments.
z The prepayment option is valuable when mortgage rates have fallen.
In that case, the present value of the remaining monthly payments
exceeds the principal outstanding. Therefore, the borrower gains in
present value from paying the principal outstanding in exchange for
not having to make further payments.
z Example: In the example of the previous subsection, the mortgage
balance at the end of five years Is $ 90,448. At that time, therefore, the
borrower can pay the lender this balance and no longer have to make
monthly payments.
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z The single monthly mortality rate at month n, denoted SMMn, is the

percentage of principal outstanding at the beginning of month n that is
prepaid during month n. The SMM is often annualized to a constant
prepayment rate or conditional prepayment rate (CPR). A pool that
prepays at a constant rate equal to SMMn has 1 – SMMn of the
principal remaining at the end of one month, (1 – SMMn)12 remaining at
the end of 12 months, and therefore 1 – (1 – SMMn)12 principal
prepaying over those 12 months. Hence, the annualized CPR is
related to SMM as follows:
1 1 SMMn
12
CPRn
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¾ Mortgage-Backed Securities Market

z In the simplest structure, a mortgage pass-through, the cash flows
from the underlying mortgages, that is, interest, scheduled principal,
and prepayments, are passed from the borrowers to the investors with
some short processing delay.
z Mortgage servicers manage the flow of cash from borrowers to
investors in exchange for a fee taken from those cash flows.
z Mortgage guarantors guarantee investors the payment of interest
and principal against borrower defaults, also in exchange for a fee.
z The weighted-average coupon or WAC is the weighted average of
the mortgage rates of the loans.
z Weighted-average maturity (WAM)
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¾ Agency mortgage pools trade in two forms: specified pools and TBAs (To
Be Announced)
z In the specified pools market, buyer and sellers agree to trade a
particular pool of loans. Consequently, the price of a trade reflects the
characteristics of the particular pool.
z Much more liquid, however, is the TBA market, which is a forward
market with a delivery option. The TBA seller will pick the cheapest-to-
deliver pool, that is, the pool that is worth the least subject to the
issuer, maturity, and coupon requirements.
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¾ Dollar Rolls
z Consider an investor who has just purchased a mortgage pool but
wants to finance that purchase over the next month. One alternative is
an MBS repo. The investor could sell the repo, i.e., sell the pool today
while simultaneously agreeing to repurchase it after a month.
z An alternative for financing mortgages is the dollar roll. The buyer of
the roll sells a TBA for one settlement month and buys the same TBA
for the following settlement month. Two difference: 1) the buyer of the
roll may not get back in the later month the same pool delivered in the
earlier month. 2) the buyer of the roll does not receive any interest or
principal payments from the pool over the roll.
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¾ Prepayment Components
z Borrowers may prepay a mortgage due to the sale of the property or a desire
to refinance at lower prevailing rates. In addition, prepayments may occur
when the borrower has defaulted on the mortgage or when the borrower has
cash available to make partial prepayments (curtailment).
¾ Valuing MBS
z The Monte Carlo methodology is a simulation approach for valuing MBSs. The
binomial model is not appropriate for valuing MBSs because MBSs have
embedded prepayment options and the historical evolution of interest rates
over time impacts prepayments.
z A mortgage security is valued using the Monte Carlo methodology by:
9 Simulating the interest rate path and refinancing path.
9 Projecting cash flows for each interest rate path.
9 Calculating the present value of cash flows for each interest rate path, and
calculating the theoretical value of the mortgage security.
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¾ Zero-Volatility Spread (Z-Spread)

z The spread that an investor realizes over the entire Treasury spot rate
curve, assuming the mortgage security is held to maturity.
¾ Option-Adjusted Spread (OAS)

z The OAS is the spread that, when added to all the spot rates of all the
interest rate paths, will make the average present value of the paths
equal to the actual observed market price plus accrued interest.
z The option cost is the implied cost of the embedded prepayment
option and is calculated as the difference between the z-spread and
OAS.
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¾ A homeowner has a 30-year, 5% fixed rate mortgage with a current
balance of USD 250,000. Mortgage rates have been decreasing. Which of
the following is closest to the amount that the homeowner would save in
monthly mortgage payments if the existing mortgage was refinanced into
a new 30-year, 4% fixed rate mortgage?
A. USD 145
B. USD 150
C. USD 155
D. USD 160
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¾ A fixed-income portfolio manager purchases a seasoned 5.5% agency

mortgage-backed security with a weighted average loan age of 60
months. The current balance on the loans is USD 20 million, and the
conditional prepayment rate is assumed to be constant at 0.4% per year.
Which of the following is closest to the expected principal prepayment this
month?
A. USD 1,000
B. USD 7,000
C. USD 10,000
D. USD 70,000
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z Bond Basics
z Risk Metrics
z Rating Agencies
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¾ Spot, Forward and Yields

z Spot Rate: A t-period spot rate, or zero rate, denoted as z(t), is the
yield to maturity on a zero-coupon bond that matures in t-years.
z Forward rates: interest rates corresponding to a future period implied
by the spot curve.
T2 T1
1 Z1 1 F1,2 1 Z2
T1 T2
Z2 T2 Z1T1
e Z1T1 u e 1,2
T2 T1
e Z2 T2 F1,2
F
T2 T 1
z Discount Factor: d(t), for a term of (t) years, gives the present value
of one unit of currency ($1) to be received at the end of that term.
1
dt
zt ·
2t
§
¨¨ 1 ¸
© 2 ¸¹
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4.00% 3.62%
STRIPS Prices and Discount Factors
Spot Rate
3.31%
3.50%
Strips Discount Spot 2.94%
Maturity 3.00% 2.53%
Price Factor Rate 2.50% 2.15%
0.5 99.2556 0.992556 1.50% 2.00% 1.50%
1.0 97.8842 0.978842 2.15% 1.50%
1.5 96.2990 0.962990 2.53% 1.00%
0.50%
2.0 94.3299 0.943299 2.94%
0.00%
2.5 92.1205 0.921205 3.31% 0.5 1.0 1.5 2.0 2.5 3.0
3.0 89.7961 0.897961 3.62% Maturity(Years)
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6.00%
Forward Rate
Spot Rates and Forward Rates 4.80%
5.18%
5.00%
Maturity Spot 6-Month 4.17%
(Years) Rate Forward Rate 4.00% 3.29%
2.80%
0.5 1.50% 1.50% 3.00%
1.0 2.15% 2.80% 2.00% 1.50%
1.5 2.53% 3.29% 1.00%
2.0 2.94% 4.17%
0.00%
2.5 3.31% 4.80% 0.5 1.0 1.5 2.0 2.5 3.0
3.0 3.62% 5.18% Maturity (Years)
¾ Par Rate
z The T-year, semiannual par rate is the rate, C(T), such that a fixed-rate
asset with par value of $100 that makes regular semi-annual coupon
payments of C(T)/2$100 discounts to a present value equal to the par
value of $100
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¾ Bond Replication
z Absent confounding factors (e.g., liquidity, financing, taxes, credit risk),
identical sets of cash flows should sell for the same price.
z Example: three bond yields and prices are shown below.
Price (% of
Maturity YTM Coupon
par)
1 1 year 4% 0% 96.154
2 2 years 8% 0% 85.734
3 2 years 8% 8% 100
z The 2-year spot rate is 8.167%. Is there an arbitrage opportunity using

these three bonds? If so, describe the trades necessary to exploit the
arbitrage opportunity?
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Time = 0 1 year 2 years

(cost of 2-year,
-1,000,000.000 8% coupon +80,000 (coupon) +1,080,000 (coupon)
bonds)
(proceeds 1-year,
+76,923.20 -80,000 (maturity)
0% bonds)
(proceed 2-year,
+925,927.20 -1,080,000
0% bonds)
+2,850.40 Net 0 0 (maturity)
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¾ Pricing Bond using Discount Factors, Spot Rates, or Forward Rates

z Assume a 1-year treasury bond that pays a 6% semi-annual coupon.
Maturity Spot Rate (%) Discount Factor 6 Month Forward Rate (%)
0.50 1.50 0.992556 1.50
1.00 2.00 0.980296 2.50
1.50 2.25 0.966995 2.75
2.00 2.50 0.951524 3.25
2.50 2.75 0.933997 3.75
z Price = ($30.992556) + ($1030.980296) = $103.95

$3 $103 $3 $103
Pr ice Pr ice
§ 0.015 · § 0.02 ·2 § 0.015 · § 0.015 · § 0.025 ·
¨1 2 ¸ ¨1 ¨1 2 ¸ ¨1 2 ¸ u ¨1 2 ¸
© ¹ © 2 ¸¹ © ¹ © ¹ © ¹
$103.95 $103.95
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¾ Price of an Annuity and a Perpetuity

z Annuity: An annuity with semiannual payments is a security that
makes a payment c/2 every six months for T years but never makes a
final “principal” payment (i.e., FV=0). The price of an annuity, A(T), is
given by: ª § · º
2T
c « ¨ 1 ¸ »
A «1 ¨ ¸ »
y« ¨ y¸ »
« ¨© 1 2 ¸¹ »
¬ ¼
z Perpetuity: A perpetuity bond is a bond that pays coupons forever.
The price of a perpetuity is simply the coupon divided by the yield.
c
Pr ice of a perpetuity F
y
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¾ Yield to Maturity: internal rate of return found by equating the present

value of the cash flows to the current price of the security.
CF1 CF2 CFn CF1 CF2 CFn
P } }
(1 yn ) (1 yn )2 (1 yn )n (1 z1 ) (1 z2 )2 (1 zn )n
Interest Rate Interest Rate
9 9
8 8
Forward Curve
7 7
Spot Curve Yield Curve
6 6
Yield Curve
5 5 Spot Curve
Forward Curve
4 4
3 3
0 1 2 3 4 5 6 7 8 9 10 0 1 2 3 4 5 6 7 8 9 10
Maturity(Year) Maturity(Year)
Upward-Sloping Term Structure Downward-Sloping Term Structure
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¾ Reinvestment Risk and Interest Rate Risk
z The yield to maturity can be viewed as the realized return on the
bond assuming all cash flows are reinvested at the YTM and the bond
is held to maturity.
z Future interest rates can be less than the yield to maturity at the time
bond is purchased, known as reinvestment risk.
z If the bond is not held to maturity, the investor faces the risk that he
may have to sell for less than the purchase price, resulting a return
that is less than the yield to maturity, known as interest rate risk.
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z Example
Compute the price of a $100 face value, 2-year, 4% semiannual
coupon bond using annualized spot rate in Figure below:
Maturity (Years) Spot Rates(%)

0.5 2.5
1.0 2.6
1.5 2.7
2.0 2.9
2 2 2 102
B $102.14
1 0.025 2 1 0.026 2 2 1 0.027 2 3 1 0.029 2 4
Yield :
N 4;PV 102.14;PMT 2;FV 100,CPT o I Y 1.4455
Yield 2.89%
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¾ Decomposition of P&L
Start period 2010-1-1 2011-1-1 2012-1-1 price P&L

Pricing date: 2010-1-1; annual coupon=1
Initial Term structure 2% 3% 4%
93.0229
forwards spreads 0.5% 0.5% 0.5%
Pricing date: 2011-1-1; annual coupon=1
Carry-roll- Term structure 3% 4%
94.3485 +1.3256
down spreads 0.5% 0.5%
Rate Term structure 2% 3%
96.1800 +1.8315
change spreads 0.5% 0.5%
Spread Term structure 2% 3%
95.2577 -0.9223
change spreads 1% 1%
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¾ Below is a table of term structure of swap rates:
Maturity In Years Swap Rate

1 2.5%
2 3%
3 3.5%
4 4%
5 4.5%
The 2-year forward swap rate starting in three years is closest to:
A. 3.5%
B. 4.5%
C. 5.5%
D. 6.0%
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¾ Given the following bonds and forward rates:

Maturity YTM Coupon Price
1 year 4.5% 0% 95.694
2 years 7% 0% 87.344
3 years 9% 0% 77.218
z 1-year forward rate one year from today = 9.56%
z 1-year forward rate two years from today = 10.77%
z 2-year forward rate one year from today = 11.32%
Which of the following statements about the forward rates, based on the bond
prices, is true?
A. The 1-year forward rate one year from today is too low.
B. The 2-year forward rate one year from today is too high.
C. The 1-year forward rate two years from today is too low.
D. The forward rates and bond prices provide no opportunities for arbitrage.
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¾ An annuity pays $10 every year for 100 years and currently costs $100.
The YTM is closest to:
A. 5%
B. 7%
C. 9%
D. 10%
¾ A $1,000 par bond carries a coupon rate of 10%, pays coupons

semiannually, and has 13 years remaining to maturity. Market rates are
currently 9.25%. The price of the bond is closest to:
A. $586.60
B. $1,036.03
C. $1,055.41
D. $1,056.05
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z Bond Basics
z Risk Metrics
z Rating Agencies
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¾ One-Factor Risk Metrics

z Macaulay Duration T
ª Ct º T
9For a zero coupon bond, the Macaulay

¦ « (1 y) t
u t» ¦ >PV(C ) u t @
t
D
t 1 ¬ ¼ t 1
T
duration equals to its maturity. Ct P
9For a plain bond, the Macaulay duration is
¦ (1 y)
t 1
t
less than or equal to its maturity. T

ª PV(Ct ) º T
9For consol, the Macaulay duration is 1+1/y. ¦ «¬

t 1 P
u t»
¼
¦ (Ȧ u t)
t 1
t
z Modified Duration and Dollar Duration

ǻP 1 ǻP
MD u DD
ǻy P ǻy
DMacaulay
MD u P
1 y
z All else being equal, duration and convexity both increase for longer
maturities, lower coupons, and lower the yields.
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z DV01
DV01 = Modified Duration Bond Value 0.0001

DV01 per $100 of initial position
HR
DV01 per $100 of hedging instrument
Example: Suppose the yield on a zero-coupon bond declines from 3%

to 2.99%, and the price of the zero increases from $17.62 to $17.71.
Compute the DV01.
'BV
DV01
10,000 u 'y
$17.71 $17.62 $0.09
$0.09
10,000 u 0.0001 1
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z Convexity
9 A measure of the non-linear relationship between price and yield
duration of a bond to changes in interest rates, the second
derivative of the price of the bond with respect to interest rates
(duration is the first derivative).
1
P P0 D*P0 ǻy CP0 (ǻy)2
2
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z Example
Estimate the effect of a 100 basis point increase and decrease on a
10-year, 5%, option-free bond currently trading at par, using the
duration/convexity approach. The bond has a duration of 7 and a
convexity of 90.
Using the duration / convexity approach :

percentage bond price change | duartion effect convexity effect
'B'y | > 7 u 100 u 0.01@ ª¬1 2 u 90 u 100 u 0.012 º¼ 6.55
'B'y | ª¬ 7 u 100 u 0.01 º¼ ª1 2 u 90 u 100 u 0.01 º

2
7.45
¬ ¼
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z Effective Duration and Effective Convexity
P P P(y 0 ǻy) P(y 0 ǻy)

DE
2P0 ǻy 2P0 ǻy
D D ª P(y 0 ǻy) P0 P0 P(y 0 ǻy) º

CE « » / ǻy
ǻy ¬ P0 ǻy P0 ǻy ¼
Example: Suppose there is a 15-year option-free noncallable bond
with an annual coupon of 7% trading at par. If interest rates rise by 50
basis points (0.5%), the estimated price of the bond is 95.586%. If
interest rates fall by 50 basis points, the estimated price of the bond is
104.701%. Calculate the convexity of this bond.
104.701 95.586 2 u 100
Convexity 114.8
100 u 0.005
2
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z Portfolio Duration and Convexity: In regard to both modified (effective)

duration and convexity, portfolio duration and convexity equal the weighted
sum of individual, respectively, durations and convexities where each
component’s weight is its value as a percentage of portfolio value.
Example: Using the portfolio as outlined in the following figure, calculate the
portfolio duration (semiannual coupon payment)
Coupon Maturity YTM Price (% or par) Par Weights D C
(millions)
5.00% 5 4.00% 104.4912925 3 22.97% 4.41 22.92
6.00% 15 5.00% 110.4651463 4 32.37% 10.11 132.54
7.00% 30 5.50% 121.9169965 5 44.66% 14.00 299.36
z Answer:
9 D = (0.22974.41)+(0.323710.11)+(0.446614) = 10.54
9 C = (0.229722.92)+(0.3237132.54)+(0.4466299.36) = 181.86
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¾ Multi-Factor Risk Metrics

z Key Rate Shifts
9 The key rate shift technique is an approach to nonparallel shifts in
the yield curve, which is allows for changes in all rates to be
determined by changes from selected key rates. A few rates along
the term-structure are picked which are representative of the curve.
9 Shifts in the key-rates are decline linearly.
9 The rate of a given maturity is affected solely by its closest key-
rate.
9 Key Rate 01s: which is the key rate equivalent of DV01.
9 Key Rate Duration: which is the key rate equivalent of durations.
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¾ Calculate the impact of a 10 basis point increase in yield on the following bond
portfolio: Bond Value (USD) Modified Duration
A. USD -41,000 1 4,000,000 7.5
B. USD -52,500 2 2,000,000 1.6
3 3,000,000 6.0
C. USD -410,000
4 1,000,000 1.3
D. USD -525,000
¾ An increase in which of the following factors will increase the duration of a fixed-
rate coupon bond?
A. Yield-to-maturity
B. Maturity
C. Coupon value
D. Coupon frequency
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¾ MTGE4. MTGE7. MTGE10 are mortgage-backed securities (MBS) that pay 4%.
7%. and 10% coupons, respectively prevailing mortgage rates are 10% Assuming
these securities have the same maturity and coupon frequency, which of the
following is correct?
A. In most cases, convexity is sufficient to approximate MBS price changes
resulting from yield changes for the purpose of estimating VaR.
B. In most cases, duration is sufficient to approximate MBS price changes
resulting from yield changes for the purpose of estimating VaR.
C. The Optionality embedded in a MBS makes the implementation of the
duration-convexity method less appropriate for the purpose of estimating
VaR.
D. As rates fall, MTGE10 price change approximations using the duration-
convexity method are likely to be better than MTGE4 price change
approximations.
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¾ The following table provides the initial price of a C-Strip and its present value after
application of a one basis point shift in four key rates.
Value
Initial Value 25.11584
2-year shift 25.11681
¾ What is the key rate ’01 for a 30-year shift?
A. -0.058 C. 0.103
B. 0.024 D. 0.158
¾ What is the key-rate duration for a 30-year shift?
A. -4.57 C. 38.60
B. 15.80 D. 41.13
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z Bond Basics
z Risk Metrics
z Rating Agencies
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Note: Moody’s adds numerical modifiers (1, 2, and 3) to each generic rating
classification from Aa through Caa, where ‘1’ indicates an obligation that ranks at the
higher end of category and ‘3’ indicates the lower end of the category.
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¾ The rating process will differ according to the type of instrument being
rated. The rating process for industrial bonds (following the example of
S&P) focuses on the following areas:
z Business Risk
z Industry Characteristics
z Competitive Positioning
z Management
z Financial Risk
z Financial Characteristics
z Financial Policies
z Profitability
z Capitalization
z Cash flow protection
z Financial Flexibility
¾ Internationally, the sovereign rating will be the ceiling for the rating of an
issuer within that country. For sovereigns, there are additional factors to
consider such as:
z Political stability
z Social and economic coherence.
z Integration into global economic system.
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¾ Ratings communicate an opinion about the creditworthiness of an issuer

or an issuer’s obligation. They should indicate the likelihood and severity
of default. Characteristics of ratings performance for corporate bonds are
as follows:
z Ratings and corporate default rates are inversely related. This inverse
relationship holds for all time periods following the ratings, such as one
year, five years, ten years, etc.
z Yield spreads over treasury bonds correlate highly with ratings (i.e.,
the greater the spread, the lower the credit rating).
z Default rates for investment grade issues (Baa or better) are
substantially lower than default rates for speculative grade issues (Ba
or worse).
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¾ Link between Ratings and Default
z Agencies publish cumulative default rates categorized by rating (i.e.,
the cumulative default rate per rating category) and transition matrices.
Transition matrices plot the frequency of rating migrations over time;
Rating Rating To Time 0 Time 1 Time 2

From A B C D A A
A 97% 3% 0% 0% B B
B
B 2% 93% 2% 3%
C C
C 1% 12% 64% 23%
D D
D 0% 0% 0% 100%
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¾ Through-the-Cycle and At-the-Point Approach

z At-the-Point-in-Time: assesses credit quality over the near term; i.e.,
a few months or one year.
z Through-the-Cycle: rating agencies try to incorporate business

cycles. Ratings are therefore typically considered “through-the-cycle”.
Through-the-cycle ratings try to “filter out” cycle fluctuations. Because
they incorporate an average, when economic conditions vary from the
average, through-the-cycle may over- and under-estimate credit
quality.
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¾ Ratings Change Impact Bond Prices

z Downgrades have a negative impact on bond prices; upgrades have a
positive impact
z But the relationship is statistically stronger for upgrades than
downgrades
¾ External and Internal Ratings Approaches
z External rating agency scales have become commonplace.
z Internal Rating System: A bank can try to mimic the external agencies.
Typically, a template assigns weights to credit risk factors (a
scorecard) in order to produce a weighted score.
z Pro-cyclicality: tendency of internal ratings models to reinforce credit
and business cycles.
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¾ A bank uses a 4-grade scale for its Rating Form Rating To

internal credit model. The 1-year
rating transition probabilities for this A B C D
model are given. If a newly issued A 90% 10% 0% 0%
bond is rated “A” by this model, B 10% 81% 8% 1%
what is the probability that it will be
rated “B” or lower two years from C 0% 5% 80% 15%
now? D 0% 0% 0% 100%
A. 9% C. 18%
B. 10% D. 19%
¾ The following statement is made by S&P about the creditworthiness of

company XYZ: “Strong capacity to meet financial commitments, but
somewhat susceptible to adverse economic conditions and changes in
circumstances.” What is the rating assigned by S&P to company XYZ?
A. AAA C. B
B. A D. C
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¾ Derivatives
z Swap Market
z Exotic Options
z Option Valuation
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¾ Forward
z Agreement to buy/sell asset at future time for certain price.
z Traded in the over-the-counter (OTC) market.
¾ Futures
z Like forward, agreement to buy/sell asset at certain price & time.
z Standardized, trades on an exchange.
z Require a daily settlement of gains and losses.
Exchange-Traded Over-the-Counter
Standardized Customized
Backed by a clearing house Trade with counterparty (Default Risk)
Trade in a physical exchange Not trade in a central location
Regulated Unregulated
Trading volume: small Trading volume: large
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¾ Market Participants
z Hedgers
9 Use derivatives markets to offset the risk of prices moving
unfavorably for their ongoing business activities.
z Speculators
9 Use derivatives to seek profits by betting on the future direction of
market prices of the underlying asset.
z Arbitrageurs
9 Use derivatives to take offsetting positions in two or more
instruments to lock in a profit.
z Marker maker
9 Maintains bid and offer prices in a given security and stands ready
to buy or sell lots of said security, at publicly quoted prices.
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¾ Commodity Forward Contract

z Underlying commodities mainly include: base metals - copper,
aluminum, lead; precious metals - gold, silver, platinum; energy - WTI
crude oil, Brent crude oil and so on.
z Commodity Terminology
9 Storage Costs
9 Lease Rate
9 Convenience Yields
z Commodity Spread
9 If we can take a long position in one commodity that is an input
(e.g., oil) into another commodity that is an output (e.g., gas or
heating oil), then we can take a short position in the output
commodity and the difference is the commodity spread.
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¾ Financial Forward Contract

z Similar to commodity forward contract, but the underlying asset is
financial asset. For example, a foreign exchange contract.
z Forward Rate Agreement
9 A forward rate agreement (FRA) is an agreement that a certain rate
will apply to a certain principal during a certain future time period.
9 The buyer of an FRA locks in a borrowing rate, and the seller locks
in a lending rate. The long benefits from an increase in rates, and
the short benefits from a fall in rates.
9 An FRA settles in one month on three-month LIBOR is called 14.
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z Example: Suppose that a company enters into a FRA that specifies it
will receive a fixed rate of 4% on a principal of $1 million for a 3-month
period starting in 3 years. If 3-month LIBOR proves to be 4.5% for the
3-month period, then compute the payoff.

3 years 3 years+3months
now settlement 1 million u (0.04 - 0.045) u 0.25

$1,250
$1,250
$1,236.09
1 0.045 u 0.25
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¾ Assume that the 3-month and 6-month LIBOR spot rates are 4% and 5%
respectively (continuously compounded). An investor enters into an FRA
in which she will receive 8% (quarterly compounding) on a principal of
$5,000,000 between months 3 and 6. Calculate the value of an FRA.
A. $23,773
B. $24,773
C. $25,773
D. $26,773
¾ Consider the following 69 FRA, Assume the buyer of the FRA agrees to
a contract rate of 6.35% on a notional amount of 10 million USD, calculate
the settlement amount of the seller if the settlement rate is 6.85%.
Assume a 30/360 day count basis.
A. –12,500
B. –12,290
C. +12,500
D. +12,290
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¾ Trading Manner of a Futures Contract

z Close Out: Most Futures contracts do not lead to delivery, because
most trades “close out” their positions before delivery. Closing out a
position means entering into the opposite type of trade from the
original.
z Physical Delivery: When there are alternatives about what is
delivered, where it is delivered, and when it is delivered, the party with
the short position chooses.
z Cash Settlement
z Exchange for Physicals
¾ Crush spread and Crack spread

z Soybean vs. Soybean meal and soybean oil
z Crude oil vs. gasoline or heating oil
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z Example: Suppose we plan on buying crude oil in one month to

produce gasoline and kerosene for sale in two months. The 1-month
futures price for crude oil is currently $30/barrel. The 2-month future
prices for gasoline and heating oil are $41/barrel and $31.5/barrel,
respectively. Calculate the 5-3-2 crack (commodity) spread
The 5-3-2 spread tells us the amount of profit that can be locked in by
buying five barrels of oil and producing three barrels of gasoline and
two barrels of heating oil.
profit for a 5 - 3 - 2 spread

3 u $41 2 u $31.50 5 u $30
$36 for five barrels, or $7.2 / barrel
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¾ Specifications of Futures Contract

z The specifications of a Futures contract include, but are not limited to:
9 Asset͵When the asset is a commodity (e.g., cotton, orange juice),
the exchange specifies a grade (quality).
9 Contract Size
Treasury bond Futures has a face value of $100,000;

S&P 500 Futures contract is index$250 (multiplier of 250)
Eurodollar futures contract has a face value of $1 million
9 Delivery Arrangement; Delivery Month; Price Quotes; Price limits

and position limits
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¾ Margin Requirement
z Initial Margin
9 Must be deposited when contract is initiated.
z Maintenance Margin
9 Investor can withdraw funds in the margin account in excess of the
initial margin. When the balance in the margin account falls below
the maintenance margin, broker executes a margin call. The next
day, the investor needs to “top up” the margin account back to the
initial margin level.
z Variation Margin
9 Extra funds deposited by the investor after receiving a margin call.
9 Variation margin = initial margin – margin account balance
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¾ Example
z A investor long a gold futures contract at $993.60. Each contract
controls 100 troy ounces for a current market value of $99,360.
Assume that the initial margin is $2,500, the maintenance margin is
$2,000, and the futures price drops to $991 at the end of the first day
and $985 on the end of the second day. Compute the amount in the
margin account at the end of each day for the long position and any
variation margin needed.
9 At the end of the first day, the loss is computed as -$260. The
buyer’s margin account balance is now $2,240.
9 At the end of the second day, the daily loss is -$600, and the
buyer’s margin account balance is reduced to $1,640. At $1,640 the
investor will get a margin call since the margin account balance is
less than the maintenance margin. The variation margin is $860.
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¾ Trading Order
z Market Order
9 A request that a trade be carried out immediately at the best price available
in the market.
z Limit Order
9 This order specifies a particular price, The order can be executed only at
this price or at one more favorable to the investor.
z Stop Order/Stop-Loss Order
9 Also specifies a particular price. The order is executed at the best available
price once a bid or offer is made at that particular price or a less-favorable
price. In effect, a stop order becomes a market order as soon as the
specified price has been hit.
z Stop-Limit Order
9 A combination of a stop order and a limit order. The order becomes a limit
order as soon as a bid or offer is made at a price equal to or less favorable
than the stop price.
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¾ Clearing House
z Clearing is the process by which trades in futures and options are
processed, guaranteed, and settled by an entity known as a clearing
house.
z A complete clearing house acts as the central counterparty to and
guarantor of all trades that it has accepted for clearing from its clearing
members.
z Each exchange has a clearinghouse.
z The clearinghouse guarantees that traders in the futures market will
honor their obligations.
z The clearinghouse manage the margin account.
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¾ Jack Johnson is going to receive a physical commodity from a settling

long futures trade. Which of the following statements best describe the
role of Johnson and the clearing house in this process?
A. The clearinghouse will coordinate Johnson’s settlement with any
eligible settling shorts.
B. Johnson will have to contact the clearinghouse to coordinate with any
eligible settling short.
C. Johnson will have to close his position with the original counterparty.
D. The clearinghouse will coordinate Johnson’s settlement with the
original counterparty only.
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¾ A trader buys one wheat contract (underlying = 5,000 bushels) at a price

of $3.05 per bushel. The initial margin on the contract is $4,500 and the
maintenance margin is $3,750. At what price will the trader receive a
maintenance margin call?
A. $2.30 C. $3.20
B. $2.90 D. $3.80
¾ To utilize the cash position of assets under management, a portfolio
manager enters into a long futures position on the S&P 500 index with a
multiplier of 250. The cash position is $15 million which at the current
futures value of 1,000, requires the manager to be long 60 contracts. If
the current initial margin is $12,500 per contract, and the current
maintenance margin is $10,000 per contract, what variation margin does
the portfolio manager have to advance if the futures contract value falls to
995 at the end of the first day of the position being placed?
A. $30,000 C. $300,000
B. $0 D. $75,000
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¾ On September 10, a trader opens a long position in 100 December S&P 500
futures contracts. The initial margin requirement is USD 2 million, and CME
requires a maintenance margin of USD 1.5 million. Assume that the position is
kept open until September 14 and no withdrawals take place. The following table
summarizes the daily change in value of the position for that period:
Date December S&P 500 Futures price Daily Gain/Loss (USD)

September 10 1,734 -
September 11 1,756 550,000
September 12 1,712 -1,100,000
September 13 1,698 -350,000
On what dates will additional margin be required?

A. September 12, but not September 13
B. September 13, but not September 12
C. September 12 and September 13
D. Neither September 12 nor September 13
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¾ An investor with a long position in a futures contract wants to issue instructions to
close out the position. A market-if-touched order would be used if the investor
wants to:
A. Execute at the best available price once a trade occurs at the specified or
better price.
B. Execute at the best available price once a bid/offer occurs at the specified or
worse price.
C. Allow a broker to delay execution of the order to get a better price.
D. Execute the order immediately or not at all.
¾ A natural gas producer wants to hedge the risk of a decline in the price of natural
gas over the next three months. The trader representing the producer wants a
short position in the 3-month natural gas futures contract to mitigate this risk and
puts in an order to short the contract at a price of USD 5 per MMBTU or above.
Which of the following describes this type of order?
A. Market-not-held order
B. Stop-loss order
C. Discretionary order
D. Limit order
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¾ Derivatives
z Swap Market
z Exotic Options
z Option Valuation
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¾ Cost of Carry Model

z The cost-of-carry model sets a futures price as a function of the spot
price: the futures price equals the spot price compounded at the
interest rate plus the storage cost of the asset less any income earned
on the asset.
z For a non-dividend-paying investment asset (i.e., an asset which has
no storage cost) the cost of carry model says the futures price is given
by:
F0 S0 erT
S0 e
r u q y T
F0 F0 S0 U I e r y T
F0 S0 e
r q T
F0 S 0 I er T
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¾ Example
z Suppose we have an asset currently worth $1,000. The current
continuously compounded rate is 4% for all maturities. Compute the
price of a 6-month forward contract on this asset.
z Compute the price of a 6-month forward contract for which the
underlying asset is a stock index with a value of $1,000 and a
continuously dividend yield of 1%. Assume the risk-free rate is 4%.
z A stock’s price today is $50. The stock will pay a $1 (2%) dividend in
six months. The risk-free rate is 5% for all maturities. What is the price
of a long forward contract to purchase the stock in one year?
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¾ Interest Rate Parity

z Interest rate parity is a no-arbitrage condition representing an
equilibrium state under which investors will be indifferent to interest
rates available on bank deposits in two countries.
T
§ 1 rDC ·
Forward Spot ¨ ¸ Forward Spot u e(rDC -rFC )T
© 1 rFC ¹
z Example
The 2-year interest rates in Australia and the US are 5% and 7%
respectively (continuously compounding). The spot rate is 0.6200 USD
per AUD. Calculate 2-year forward rate. If it is 0.6300, how to arbitrage?
0.6200e(0.07 0.05)u2 0.6453 ! 0.6300
Arbitrage͹ buy spot USD and sell USD forward
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z Foreign Exchange Risk: The risk that an investor will have to close
out a long or short position in a foreign currency at a loss due to an
adverse movement in exchange rates. Also known as "currency risk"
or "exchange-rate risk".
z A positive net exposure position means that we are net long in a
currency; A negative net exposure position means that we are net
short in a currency.
z On-Balance-Sheet Hedging is achieved when a financial institution
has a matched maturity and currency foreign asset-liability book.
Rather than matching foreign assets with foreign liabilities, we may
choose to remain un-hedged on the balance sheet, and hedge off-
balance-sheet by taking a position in the forward market.
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¾ Normal and Inverted Futures Market

Futures Price Spot Price
Spot Price Time Futures Price Time
z If the forward price is higher than the spot price (or the distant forward
price is higher than the near forward price) the Futures curve is said to
be normal, or in Contango.
z If the forward price is less than the spot price (or the distant forward
price is less than the near forward price), the Futures curve is said to
be inverted, or in Backwardation.
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¾ Valuing the Forward Contract

z If today appears to be the day when the contract is first negotiated, the
delivery price K is set equal to the forward price F0 and the value of the
contract f is 0.
z As time passes, K stays the same while F0 changes and f becomes
either positive or negative.
S0 Ke rT
°
f F0 K erT f ® S0 I Ke
rT
°S e qT Ke rT
¯ 0
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¾ A risk analyst observes that an emerging market stock index has hit a new
all-time high with a value of 10,000, measured in the emerging market’s
currency. The analyst suggests buying futures on the index as a hedge on
the firm’s short exposure to this market. If the interest rate is 4% annually
in this market and the average annualized dividend yield on the index for
the next six months is 1%, what is the approximate price of a 6-month
futures contract on the index in the emerging market’s currency?
A. 9,700
B. 9,850
C. 10,150
D. 10,300
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¾ The current price of Commodity X in the spot market is $42.47. Forward contracts
for delivery of Commodity X in one year are trading at a price of $43.11. If the
current continuously compounded annual risk-free interest rate is 7.0%, calculate
the implicit lease rate for Commodity X. Holding the calculated implicit lease rate
constant, would the forward market for Commodity X be in backwardation or
contango if the continuously compounded annual risk-free rate immediately fell to
5.0%?
A. The implicit lease rate is 1.49%. Holding this rate constant, the forward
market would be in contango if the continuously compounded annual risk-
free rate immediately fell to 5.0%.
B. The implicit lease rate is 5.50%. Holding this rate constant, the forward
market would be in backwardation if the continuously compounded annual
risk-free rate immediately fell to 5.0%.
C. The implicit lease rate is 1.49%. Holding this rate constant, the forward
market would be in backwardation if the continuously compounded annual
risk-free rate immediately fell to 5.0%.
D. The implicit lease rate is 5.50%. Holding this rate constant, the forward
market would be in contango if the continuously compounded annual risk-
free rate immediately fell to 5.0%.
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¾ A stock index is valued at USD 750 and pays a continuous dividend at the
rate of 2% per annum. The 6-month futures contract on that index is
trading at USD 757. The risk-free rate is 3.5% continuously compounded.
There are no transaction costs or taxes. Is the futures contract priced so
that there is an arbitrage opportunity? If yes, which of the following
numbers comes closest to the arbitrage profit you could realize by taking
a position in one futures contract?
A. 4.18
B. 1.35
C. 12.60
D. There is no arbitrage opportunity.
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¾ Given the following:

z Current spot CHF/USD rate: 1.3680 (1.3680CHF = 1USD)
z 3-month USD interest rates: 1.05%
z 3-month Swiss interest rates: 0.35%
(Assume continuous compounding)
A currency trader notices that the 3-month future price is USD 0.7350.
In order to arbitrage, the trader should investment
A. Borrow CHF, buy USD spot, go long CHF futures
B. Borrow CHF, sell CHF spot, go short CHF futures
C. Borrow USD, buy CHF spot, go short CHF futures
D. Borrow USD, sell USD spot, go long CHF futures
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¾ Three months ago a company entered in a one-year forward contract to

buy 100 ounces of gold. At the time, the one-year forward price was USD
1,000 per ounce. The nine-month forward price of gold is now USD 1,050
per ounce. The continuously-compounded risk-free rate is 4% per year for
all maturities, and there are no storage costs. Which of the following is
closest to the value of the contract?
A. USD 5,000
B. USD 4,852
C. USD 7,955
D. USD 1,897
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¾ You are asked to evaluate the price relationship between the cash and
futures markets on the S&P 500 index, based on the following
information.
Futures Expiry Futures Price

03/2015 1,845
06/2015 1,867
09/2015 1,897
How would you describe the structure of this market?
A. The market is normal
B. The market shows backwardation
C. The market is mixed
D. The market is inverted
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¾ Derivatives
z Swap Market
z Exotic Options
z Option Valuation
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¾ T-Bond Futures
z In Treasury bonds futures contract, any government bond that has
more than 15 years to maturity on the first day of the delivery month
and is not callable within 15 years from that day can be delivered.
z Since the deliverable bonds have very different market values, the
Chicago Board of Trade (CBOT) has created conversion factors.
z Specially, the cash received by the short position is:
Cash received = (QFPCF) + AI
z Cheapest-to-Deliver Bond
Cost = quoted bond price – (QFPhCF)
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¾ Assume an investor with a short position is about to deliver a bond and
has four bonds to choose from which are listed in the following table. The
last settlement price is $95.75 (this is the quoted futures price). Determine
which bond is the cheapest-to-deliver.
Bond Quoted Bond Price Conversion Factor Cost

1 99 1.01 2.29
2 125 1.24 6.27
3 103 1.06 1.51
4 115 1.14 5.85
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¾ Eurodollar Futures
z The most popular interest rate futures contract in the United States is
the three-month Eurodollar futures contract traded by the CME Group.
z Eurodollar is a dollar deposited in a US or foreign bank outside US.
z A three-month Eurodollar futures contract is a futures contract on the
interest that will be paid (by someone who borrows at the Eurodollar
interest rate) on $1 million for a future three-month period.
z The value of one Eurodollar Futures contract
Pt 10,000 u ª¬100 0.25 100 FQ t º¼ 10,000 u >100 0.25Ft @
z 1 basis point up move in the futures quote corresponds to a gain of
$25 per contract for long position.
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¾ Difference between Forward and Futures Price

z With the same underlying and the same maturity, They should be the
same if interest rates are perfectly predictable.
9 ȡ6 r) > 0, Futures are more attractive by two reasons: daily
settlement and reinvest profit. Futures price is higher than forward
price.
9 ȡ6 r) < 0, Futures price is lower than forward price.
9 For short maturities, the differences are small enough to be
ignored.
¾ Eurodollar Futures vs. FRA – Convexity Adjustment
1 2
Forward Rate Futures rate - ı T1T2
2
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¾ A company plans to borrow $3.0 million for three months starting in one
year. The Eurodollar futures contract that matures in one year has a
quoted price of 98.00 and the company wants to (net) effectively lock-in
this 2.0% LIBOR interest rate. At the end of one year, LIBOR increases to
3.0%. The company's borrowing (at the higher 3.0% LIBOR) will increase
but will be hedged by the gain on the Eurodollar futures contract. What is
the futures trade and what is the gain on the futures contract only?
A. Long one contract for a gain of $2,500
B. Long three contracts for a gain of $7,500
C. Short one contract for a gain of $2,500
D. Short three contracts for a gain of $7,500
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¾ A Eurodollar futures price changes from 98.00 to 97.20. What is the gain/loss to
an investor who is LONG one contract?
A. LIBOR decreased by 80 basis point for a loss (to the long position) of $2,000
B. LIBOR increased by 80 basis point for a loss (to the long position) of $2,000
C. LIBOR decreased by 80 basis point for a gain (to the long position) of $2,000
D. LIBOR increased by 80 basis point for a gain (to the long position) of $2,000
¾ If the volatility of the short interest rate (LIBOR) is 4.0%, what is the convexity
adjustment for a five (5)-year Eurodollar futures contract?
A. 0.75%
B. 1.1%
C. 2.1%
D. 4.2%
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¾ Derivatives
z Swap Market
z Exotic Options
z Option Valuation
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¾ Short Hedge and Long Hedge

z A short hedge occurs when the hedger shorts (sells) a futures
contract to hedge against a price decrease in the existing long
position.
z A long hedge occurs when the hedger buys a futures contract to
hedge against an increase in the value of the asset that underlies a
short position.
¾ Strip Hedge and Stack Hedge

z Hedge a stream of obligations by offsetting each individual obligation
with a futures contract matching the maturity and quantity of the
obligation.
z Hedge using futures with single maturity to offset changes in the
present value of the future obligations.
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¾ Minimum Variance Hedge Ratio

z A hedge ratio is the ratio of the size of the futures position relative to
the spot position. The optimal hedge ratio, which minimizes the
variance of the combined hedge position, is defined as follows:
ıS
HR ȡS,F
ıF
z The effectiveness of the hedge measures the variance that is
reduced by implementing the optimal hedge. This effectiveness can be
evaluated with a coefficient of determination (R2) term where the
independent variable is the change in futures prices and the
dependent variable is the change in spot prices.
z As the HR is also the beta of spot prices with respect to future contract
prices, the R2 measure for this simple linear regression is the square
of the correlation coefficient (ȡ2) between spot and futures prices.
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¾ Using Stock Index Futures Contracts to Change a Stock Portfolio’s

Beta
portfolio value
number of contracts ȕportfolio u
value of futures contract
portfolio value
ȕportfolio u
futures price u contract multiplier
number of contracts ȕ *

ȕ u
portfolio value
value of futures contract
¾ Tailing the Hedge

z To correct for the possibility of over-hedging, a hedger can implement
a tailing the hedge strategy. It is to multiply the hedge ratio by the daily
spot price to futures price ratio.
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Example
1. Suppose a currency trader computed the correlation between the spot
and futures to be 0.925, the annual standard deviation of the spot price
to be $0.10, and the annual standard deviation of the futures price to
be $0.125. Compute the hedge ratio.
0.100
HR 0.925 u 0.74
0.125
2. You are a portfolio manager with a $20 million growth portfolio that has
a beta of 1.4, relative to the S&P 500. The S&P 500 futures are trading
at 1,150, and the multiplier is 250. You would like to hedge your
exposure to market risk over the next few months. Identify whether a
long or short hedge is appropriate, and determine the number of S&P
500 contracts you need to implement the hedge.
$20,000,000
Short 1.4 u | 97 contracts
1,150 u 250
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3. Suppose that you would like to make a tailing the hedge adjustment to
the number of contracts needed in the previous example. Assume that
when evaluating the next daily settlement period you find that the S&P
500 spot price is 1,095 and the futures price is now 1,160. Determine
the number of S&P 500 contracts needed after making a tailing the
hedge adjustment.
1.4 u ª¬ $20,000,000 (1,150 u 250)º¼ u 1,095 1,160 92 contracts
4. Suppose we have a well-diversified $100 million equity portfolio. The
portfolio beta relative to the S&P 500 is 1.2. The current value of the 3-
month S&P 500 Index is 1,080. The portfolio manager wants to
completely hedge the systematic risk of the portfolio over the next
three months using S&P 500 Index futures. Demonstrate how to adjust
the portfolio’s beta
100,000,000
number of contracts 0 1.2 444.44
1,080 u 250
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S1 Spot price
S2
F1 Futures price F
2 Basis : b1 S1 F1
b2 S2 F2
t1 t2
¾ The hedging risk is the uncertainty associated with b2 and is known as

basis risk.
z Different asset
z Different maturity
¾ Cross hedging occurs when the assets underlying the futures contract
and the asset whose price is being hedged are different.
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z Long the basis refers to a set of positions that consists of a short

futures position and a long cash position. Position that are long the
basis benefit when the basis is strengthening. This occurs when the
cash price increases at a faster rate than the futures price or when the
cash price decreases at a rate slower than the futures price.
z Short the basis refers to a set of positions that consists of a long
futures position and a short cash position. Positions that are short the
basis benefit when the basis is weakening. This occurs when the
futures price increases at a faster rate than the cash price or when the
futures price decreases at a rate slower than the cash price.
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¾ It's June 2nd and a fund manager with USD 10 million invested in
government bonds is concerned that interest rates will be highly volatile
over the next three months. The manager decides to use the September
treasury bond futures contract to hedge the value of the portfolio. The
current futures price is USD 95.0625, each contract is for the delivery of
USD 100,000 face value of the bonds. The duration of the manager's
bond portfolio in three months will be 7.8 years, the cheapest to deliver
bonds in the treasury bond futures contract is expected to have a duration
of 8.4 years at maturity of the contract. At the maturity of the treasury
bond futures contract, the duration of the underlying benchmark treasury
bond is 9 years. What position should fund manager undertake to mitigate
his interest rate risk exposure?
A. short 94 contracts
B. short 98 contracts
C. short 105 contracts
D. short 113 contracts
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¾ The current value of the S&P 500 index is 1,457, and each S&P futures contract is
for delivery of 250 times the index. A long-only equity portfolio with market value of
USD 300,000,000 has beta of 1.1. To reduce the portfolio beta to 0.75, how many
S&P futures contract should you sell?
A. 288 contracts C. 906 contracts
B. 618 contracts D. 574 contracts
¾ On Nov. 1, Jimmy Walton, a fund manager of a USD 60 million U.S. medium-to-
large cap equity portfolio, considers locking up the profit from the recent rally. The
S&P 500 index and its futures with the multiplier of 250 are trading at 900 and
910, respectively. Instead of selling off his holdings, he would rather hedge two-
thirds of his market exposure over the remaining two months. Given that the
correlation between Jimmy’s portfolio and the S&P 500 index futures is 0.89 and
the volatilities of the equity fund and the futures are 0.51 and 0.48 per year
respectively, what position should he take to achieve his objective?
A. Sell 250 futures contracts C. Sell 167 futures contracts
B. Sell 169 futures contracts D. Sell 148 futures contracts
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¾ A European firms needs to hedge the Mexican pesos in six months, but
peso futures are not liquid. So the firm decided to hedge its exposure by
buying futures contract on USD. The standard deviation of pesos against
the Euros over a six-month period is 18%, while the standard deviation of
USD/EUR futures price over a six-month period is 10%. If the correlation
coefficient between pesos and dollars is 0.65, calculate the optimal hedge
ratio.
A. 0.15
B. 0.36
C. 1.17
D. 2.77
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¾ An oil producer has an obligation under an agreement to supply one
million barrels of oil at a fixed price. The producer wishes to hedge this
liability using futures in order to address the possibility of an upward
movement in oil prices. In comparing a strip hedge to a stack and roll
hedge, which of the following statements is correct?
A. A stack and roll hedge tends to involve fewer transactions.
B. A strip hedge tends to have smaller bid-ask spreads.
C. A stack and roll hedge tends to have greater liquidity.
D. A strip hedge tends to realize gains and losses more frequently.
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¾ Derivatives
z Swap Market
z Exotic Options
z Option Valuation
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¾ Swaps
z Interest Rate Swap
z Currency Swap
¾ Comparative Advantage Argument
z Interest Rate Swap Example: Fixed Floating
Consider two companies: ABC has ABC 4% Libor + 1%
a better credit rating than XYZ. XYZ 6% Libor + 2%
z Now assume that these two corporations enter into an interest rate
swap. ABC will pay LIBOR + 0.5% to XYZ and XYZ will pay 4% fixed
to ABC (we are ignoring transaction costs):
4% Fixed 4% Fixed
ABC XYZ
Libor + 0.5% Libor + 2%
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z Comparative Advantage Argument: Company A needs GBP, and
Company B needs USD. Company A has an absolute advantage in
both markets but a comparative advantage in the USD market.
Company B has a comparative advantage in the GBP market.
USD Borrowing GBP Borrowing

A 5% 7%
B 6% 7.5%
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¾ Principles
z If two companies enter into an interest rate swap arrangement, then
one of the companies has a swap position that is equivalent to a long
position in floating-rate bond and a short position in a fixed-rate bond.
VSwap = BFloat – BFixed
z The counterparty to the same swap has the equivalent of a long

position in a fixed-rate bond and a short position in a floating-rate
bond:
Vswap = BFixed – Bfloat
z Notes: The value of a floating rate bond will be equal to the notional
amount at any of its periodic settlement dates when the next payment
is set to the market rate (floating).
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z Example: Consider a $1 million notional swap that pays a floating rate based
on 6-month LIBOR and receives a 6% fixed rate semiannually. The swap has
a remaining life of 15 months with pay dates at 3, 9 and 15 months. Spot
LIBOR rates are as following: 3 months at 5.4%; 9 months at 5.6%; and 15
months at 5.8%. The LIBOR at the last payment date was 5.0%. Calculate the
value of the swap to the fixed-rate receiver using the bond methodology.
Answer :
B fixed (PMTfixed,3 months u e-(r ut ) ) (PMTfixed,9 months u e-(r ut ) ) [(notional PMTfixed,15 months ) u e-(r ut ) )]
($30,000 u e-(0.054u0.25) ) ($30,000 u e -(0.056u0.75) ) [($1,000,000 $30,000) u e-(0.058u1.25) )]
$29,598 $28,766 $957,968 $1,016,332
rfloating
Bfloating [notional notional u ] u e-(r ut )
2
0.05
[$1,000,000 $1,000,000 u ] u e-(0.054u0.25) $1,011,255
2
Vswap Bfixed - Bfloating $1,016,332 $1,011,255 $5,077
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¾ Principles
VSwap = BD – S0BF
z The valuation of currency swap is given by:
Vswap = S0BF – BD
¾ Example
z At the outset of the swap, company A pays a principal amount to B of
USD 175 million, and B pays GBP 100 million to A.
z Both parties pay the interest rate of the borrowed currency.
z At the end of the swap, the principal amounts are re-exchanged.
z Suppose the yield curves in the United States and Great Britain are flat
at 2% and 4%, respectively, and the current spot exchange rate is
USD1.50=GBP1. Value the currency swap just discussed assuming
the swap will last for three more years.
-(6
' (
;9*
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¾ Firm X wants to borrow GBP at a floating interest rate, and Firm Y wants
to borrow GBP at a fixed annual interest rate. The interest rates that they
face are shown in the table below. What is the maximum spread a
financial intermediary could get if it designs a swap making firms X and Y
each better off by 20 basis points?
Firm Fixed Floating

X 4.50% 6-month LIBOR + 1.5%
Y 5.50% 6-month LIBOR + 2.0%
A. 5 basis points
B. 10 basis points
C. 15 basis points
D. 20 basis mints
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¾ XYZ Corporation plans to issue a 10-year bond 6 months from now. XYZ
would like to hedge the risk that interest rates might rise significantly over
the next 6 months. In order to effect this, the treasurer is contemplating
entering into a swap transaction. Under the swap, she should:
A. Pay fixed and receive LIBOR
B. Pay LIBOR and receive fixed
C. Either swap (a or b above) will work
D. Neither swap (a or b above) will work
¾ A trader executes a $420 million 5-year pay fixed swapͧduration 4.433ͨ
with one client and a $385 million 10-year receive fixed swapͧduration
7.581ͨ with another client shortly afterwards. Assuming that the 5-year
rate is 4.15 % and 10-year rate is 5.38 % and that all contracts are
transacted at par, how can the trader hedge his net delta position?
A. Buy 4,227 Eurodollar contracts
B. Sell 4,227 Eurodollar contracts
C. Buy 7,185 Eurodollar contracts
D. Sell 7,185 Eurodollar contracts
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¾ Consider the following 3-year currency swap, which involves exchanging

annual interest of 2.75% on 10 million US dollars for 3.75% on 15 million
Canadian dollars. The CAD/USD spot rate is 1.52. The term structure is
flat in both countries. Calculate the value of the swap in USD if interest
rates in Canada are 5% and in the United States are 4%. Assume
continuous compounding. Round to the nearest dollar.
A. $152,000
B. $145,693
C. $131,967
D. $127,818
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¾ Derivatives
z Swap Market
z Exotic Options
z Option Valuation
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¾ Basics
z Call and Put Options
z European and American Option
¾ Moneyness
z In the money: Immediate exercise would generate a positive payoff
z At the money: Immediate exercise would generate no payoff
z Out of the money: Immediate exercise would result in a loss
Moneyness Call option Put Option
In-the-money S˚X S˘X
At-the-money S=X S=X
Out-the-money S˘X S˚X
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¾ Intrinsic Value and Time Value

z Intrinsic Value ͵ The amount that it is in the money, and zero
otherwise
9 Intrinsic value of call option: C=max [S – X, 0]
9 Intrinsic value of put option: P=max [X – S, 0]
z Time Value: The difference between the price of an option (called its
premium) and its intrinsic value is due to its time value
¾ Early Exercise Features of American Call and Put Options
z All other things being equal, the value of an American style option
must be at least as great as a European option with the same features.
z From a mathematical standpoint, it is never optimal to execute an early
exercise on an American call option on a non-dividend paying stock.
However, it can be optimal to execute an early exercise on an
American put.
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¾ Six Factors that Affect on Option’s Price
Factor European call European put American call American put
S + ˉ ˉ ˉ
X ˉ + ˉ +
T ? ? + +
ı + + + +
r + ˉ + ˉ
D ˉ + ˉ +
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¾ Upper and Lower Bonds for Option Prices

Option Proxy Min Value Max Value
European call c max (0, S0ˉ Xe-rT) S0
American call C max (0, S0ˉ Xe-rT) S0
European put p max (0, Xe-rT ˉS 0) Xe-rT
American put P max (0 , XˉS0) X
¾ Put-Call Parity
C KerT p S0 p S0 c D Xe rT
S X d C P d S XerT S0 X D d C P d S0 Xe rT
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¾ A risk manager is analyzing the option prices for a non-dividend-paying

stock. How would the risk manager create a synthetic long European call
option position on this stock using an appropriate zero-coupon risk-free
bond and options having the same exercise price and exercise date?
A. Buy a European put on the stock, buy the stock, and sell a zero-
coupon risk-free bond.
B. Buy a European put on the stock, sell the stock, and buy a zero-
C. Sell a European put on the stock, buy the stock, and sell a zero-
D. Sell a European put on the stock, sell the stock, and buy a zero-
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¾ The current stock price of a share is USD 100, and the continuously
compounding risk-free rate is 12% per year. The maximum possible
prices for a 3-month European call option, American call option, European
put option, and American put option, all with strike price of USD 90, are:
A. 100, 100, 87.34, 90
B. 100, 100, 90, 90
C. 97.04, 100, 90, 90
D. 97.04, 97.04, 87.34, 87.34
¾ Stock UGT is trading at USD 100. A 1-year European call option on UGT
with a strike price of USD 80 is trading at USD 30. No dividends are being
paid in the following year. What should be the lower bound of an American
put option on UGT with a strike price of USD 80 in order to not have
arbitrage opportunities? Assume a continuously-compounded risk-free
rate of 4% per year.
A. 6.1 C. 5.7
B. 7.7 D. 6.9
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¾ Derivatives
z Swap Market
z Exotic Options
z Option Valuation
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¾ Simple Strategies
z Covered Call = -C + S z Protective Put = S + P
Stock
Profit Stock Profit Profit
Covered Call Protective Put
ST
0 ST Put Option
0
Written Call
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¾ Spread Strategies
z Bull Call Spread z Bull Put Spread
Profit Profit
X1
0 X1 X2 ST 0 ST
X2
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z Bear Call Spread z Bear Put Spread
Profit Profit
X2 X2
0 X1 ST 0 X1 ST
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z Butterfly Spread z Butterfly Spread
Profit Profit
X1 X3
0 0
X1 X3 X2
ST ST
X2
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z Calendar Spread
Profit Profit
0 0
ST ST
z Diagonal Strategies: Different strike price, different maturity, different
positions in both calls or puts.
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¾ Combination Strategies
z Collar: Created by purchasing a put and writing a call with different
strike prices.
Profit
0
X1 X2 ST
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z Straddle z Strangle
Profit Profit
X1 X2
0 0
ST ST
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z Strip: betting on volatility but is z Strap: betting on volatility but is

more bearish since it pays off more bullish since it pays off
more on the downside. more on the upside.
Profit Profit
0 0
ST ST
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¾ An investor sells a June 2008 call of ABC Limited with a strike price of USD 45 for
USD 3 and buys a June 2008 call of ABC Limited with a strike price of USD 40 for
USD 5. What is the name of this strategy and the maximum profit and loss the
investor could incur?
A. Bear spread, maximum loss USD 2, maximum profit USD 3
B. Bull spread, maximum loss Unlimited, maximum profit USD 3
C. Bear spread, maximum loss USD 2, maximum profit unlimited
D. Bull spread, maximum loss USD 2, maximum profit USD 3
¾ Which of the following will create a bear spread?
A. Buy a call with a strike price of 45 and sell a call with a strike price of 50.
B. Buy a call with a strike price of 50 and buy a put with a strike price of 55.
C. Buy a put with a strike price of 45 and sell a put with a strike price of 50.
D. Buy a call with a strike price of 50 and sell a call with a strike price of 45.
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¾ An investor constructs a long straddle by buying an April $30 call for $4 and
buying an April $30 put for $3. If the price of the underlying shares is $27 at
expiration, what is the profit on the position?
A. -$4
B. -$2
C. $2
D. $3
¾ Consider an option strategy where an investor buys one call option with an
exercise price of $55 for $7, sells two call options with an exercise price of $60 for
$4, and buys one call option with an exercise price of $65 for $2. If the stock price
declines to $25, what will be the profit or loss on the strategy?
A. -$3
B. -$1
C. $1
D. $2
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¾ Derivatives
z Swap Market
z Exotic Options
z Option Valuation
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¾ Standard and Nonstandard American Options

z In a standard American option, exercise can take place at any time
during the life of the option and the exercise price is always the same.
z The American options that are traded in the over-the-counter market
sometimes have nonstandard features.
9 Early exercise may be restricted to certain dates – Bermudan
Option.
9 Early exercise may be allowed during only part of the life of the
option.
9 The strike price may change during the life of the option.
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¾ Compound Options
z Compound options are options on options. There are four main types
of compound options: a call on a call, a put on a call, a call on a put,
and a put on a put.
z The advantages of compound options are that they allow for large
leverage and they are cheaper than straight options. However, if both
options are exercised, the total premium will be more than the
premium on a single option.
z The payoff structure of the four main types is as follow:
max ª¬C T1 X1,0 º¼ max ª¬P T1 X1,0 º¼
max ª¬ X1 C T1 ,0 º¼ max ª¬ X1 P T1 ,0 º¼
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+ÛZOI5VZOUTY
¾ Forward Start Options

z A forward start option is an advance purchase of a put or call option
that will become active at some specified future time. It is essentially a
forward on an option.
z Note that when the underlying asset is a no dividend 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.
¾ Chooser Option
z A chooser option has the feature that after a specified period of time,
the holder can choose whether the option is a call or a put.
z Suppose that the time when the choice is made is T1. The value of the
chooser option at this time is:
max c,p
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¾ Barrier Options
z Barrier options are options whose payoffs and existence depend on whether
the underlying’s asset price reaches a certain barrier level over the life of the
option.
z Barrier options are usually less expensive than standard options, and
essentially come in either knock-out or knock-in flavors. A knock-out option
ceases to exist when the underlying asset price reaches a certain barrier while
a knock-in option comes into existence only when the underlying asset price
reaches a barrier.
z In-out parity is the barrier option’s answer to put-call parity. If we combine one
“in” option and one “out” barrier option with the same strikes and expirations,
we get the price of a vanilla option. Note that this argument only works for
European options.
z Moreover, unlike other simpler options, barrier options are path-dependent.
That is, the value of the option at any time depends not just on the underlying
at that point, but also on the path taken by the underlying.
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¾ Binary Options
z Binary option is a type of option where the payoff is either some fixed amount
of some asset or nothing at all. Two main types of binary option are cash-or-
nothing options and asset-or-nothing option.
z The cash-or-nothing binary option pays some fixed amount of cash if the
option expires in-the-money while the asset-or-nothing pays the value of the
underlying security.
Qe rTN(d2 ) S0 e qTN(d1 )
z A regular European call option is equivalent to a long position in an asset-or-
nothing call and a short position in a cash-or-nothing call where the cash
payoff in the cash-or-nothing call equals the strike price.
z Similarly, a regular European put option is equivalent to a long position in a
cash-or-nothing put and a short position in an asset-or-nothing put where the
cash payoff on the cash-or-nothing put equals the strike price.
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¾ Lookback Options
z Lookback Options are options whose payoffs depend on the maximum or
minimum price of the underlying asset during the life of the option. There exist
two kinds of lookback options: with floating strike and with fixed strike.
z A floating lookback call pays the difference between the expiration price and
the minimum price of the stock over the horizon of the option. A floating
lookback put pays the difference between the expiration and maximum price of
the stock over the time period of the option.
z A fixed lookback call has a payoff function that is identical to a regular
European call option except that the final asset price is replaced by the
maximum asset price achieved during the life of the option.
z 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.
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¾ Shout Options
z A shout option is a European option where the holder can “shout” to
the writer at one time during its life. At the end of the life of the option,
the option holder receives either the usual payoff from a European
option or the intrinsic value at the time of the shout, whichever is
greater.
¾ Asian Options
z Options where the payoff depends on the arithmetic average of the
price of the underlying asset during the life of the option. There are two
types of Asian Options: average price option and average strike option.
z The payoff from an average price call is Max(Save – K, 0) and that from
an average price put is Max(K – Save, 0)
z An average strike call pays off Max(ST – Save, 0) and an average strike
put pays off Max(Save – ST, 0)
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¾ Volatility and Variance Swaps

z 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.
z Much like a volatility swap, a variance swap involves exchanging a
pre-specified fixed variance rate for a realized variance rate.
z However, unlike volatility swaps, variance swaps are easier to price
and hedge since they can be replicated using a collection of call and
put options.
¾ Static Options Replication

z This technique involves searching for a portfolio of actively traded
options (regular options) that approximately replicates the exotic
option. Shorting this position provides the hedge.
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¾ A 1-year forward contract on a stock with a forward price of USD 100 is

available for USD 1.50. The table below lists the prices of some barrier
option on the same stock with a maturity of 1 year and strike of USD 100.
Assuming a continuously compounded risk-free rate of 5% per year what
is the price of a European put option on the stock with a strike of USD
100.
Option Price
Up-and-in barrier call, barrier USD 95 USD 5.21
Up-and-out barrier call, barrier USD 95 USD 1.40
Down-and-in barrier put, barrier USD 80 USD 3.5
A. USD 2.00
B. USD 4.90
C. USD 5.11
D. USD 6.61
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¾ Vega is the sensitivity of an option’s price to changes in volatility.

Increases in an underlying instrument’s volatility will usual increase the
value of options since increases in volatility produce a greater probability
that an option will find its way into the money. Of the four options listed
below, which investment has the potential to produce a negative vega
measure?
A. Shout option. C. Put option.
B. Call option. D. Barrier option.
¾ A cash-or-nothing call (also known as a digital call) pays a fixed amount to
the buyer if the asset finishes above the strike price. Assume that at the
end of a 1-year investment horizon, the stock is equal to $50, the fixed
payment amount is equal to $45, and N(d1) and N(d2) from the Black-
Scholes-Merton model are equal to 0.9767 and 0.9732, respectively. The
value of this cash-or-nothing call when the risk-free rate equals 3% is
closest to:
A. $5. C. $44.
B. $42. D. $47
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¾ Derivatives
z Swap Market
z Exotic Options
z Option Valuation
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¾ Risk-Neutral Valuation
z In a Risk-Neutral World all individuals are indifferent to risk.
z In such a world, investors require no compensation for risk, and the
expected return on all securities is the risk free interest rate.
z All cash flows should be discounted to present using the risk-free
interest rate.
¾ Assumption:
z The stock price follows geometric Brownian motion
z Risk neutral;
z u=1/d;
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¾ One-Step Binomial Model

S0u
p fu = max(S0u – K, 0)
Stock Price = S0
Option Price f
1–p S0d
fd = max(S0d – K, 0)
e
r q 't
er't d d
S0 ª¬S0 u u u p S0 u d u 1 p º¼ e r't p or p
ud ud
f ª¬pfu 1 p fd º¼ e r't u eı 't

;d eı 't
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¾ Two-Step Binomial Model

S0uu
S0u fuu
S0 fu S0ud
S0d fud
f
fd S0dd
fdd
er't d
p
ud
f e 2r't ª¬p2 fuu 2p(1 p)fud (1 p)2 fdd º¼
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¾ Example: Two-step European Call Option, with Up and Down Informed

by Volatility
Asset Strike Time Volatility Riskless Div. Yield

$810 $800 0.5 20% 5% 2%
u d p
1.1052 0.9048 0.5126
$989.34
$895.19
$810 $810 Option Value = 53.40
$732.92
$663.17
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¾ American Options
Ӯ‫ީލ‬ի‫ݕ‬
ӹ‫ۼ‬੧
‫ۼ‬੧
S0uu
S0 u
fuu
Make sure that the
S0 fu S0ud option value at each
f S0 d fud node is no less than
S0dd the intrinsic value.
fd
fdd
Ӯ‫ީލ‬ի‫ݕ‬
ӹ‫ۼ‬੧
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¾ Example: American Put Option with price jump of +/- 20%
Asset Strike Time Riskless Div. Yield

$50 $52 2 5% 0%
u d p
1.2 0.8 0.6282
$72
$60
$50 $48 Option Value = 5.09
$40
$32
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¾ Assumptions
z The price of the underlying asset follows a lognormal distribution.
z The price of the underlying asset is continuous, jump is not considered.
z The (continuous) risk-free rate is known and constant.
z The volatility of the underlying asset is known and constant.
z The markets are frictionless.
z There are no cash flows on the underlying asset.
z The options valued are European options.
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¾ The price of European call option
c SN d1 Ke rTN d2 c Se qTN d1 KerTN d2

The price of European put option
p KerTN d2 SN d1 p KerTN d2 Se qTN d1
Where

ln S Ke rt r 1ı d1,2

ln Se qT KerT rı T
d1,2 T
ı T 2 ı T 2
¾ The early exercise of American options

z For American call
Dn ! X 1 e
r T tn

X 1 e
r T tn
z For American put Dn
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¾ A stock is currently trading at USD 45, and its annual price volatility is
30%. The risk-tree rate is 1.5% per year. A risk manager is developing a
1-step binomial tree for a 2-year horizon. What is the risk-neutral
probability that the stock will move down?
A. 30%
B. 43%
C. 57%
D. 70%
¾ Which of the following is an assumption of the Black-Scholes-Merton
model?
A. Securities are traded in a frictionless market.
B. Short selling of securities is not possible
C. Only American style options are used
D. The underlying security's price follows a normal distribution.
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¾ JTE Corporation is a non-dividend-paying stock that is currently priced at $49. An
analyst has determined that the annual standard deviation of returns on JTE stock
is 8% and that the annual risk-free interest rate on a continuously compounded
basis is 5.5%. Calculate the value of a 6-month American call option on JTE stock
with a strike price of $50 using a two-period binomial model.
A. $0.32
B. $0.65
C. $1.31
D. $2.97
¾ Stock ABC trades for $60 and has 1-year call and put options written on it with an
exercise price of $60. The annual standard deviation estimate is 10%, and the
continuously compounded risk-free rate is 5%. The value of both the call and put
using the BSM option pricing model are closest to:
Call Put
A. $6.21 $1.16 z 0.04 0.05 0.06
B. $4.09 $3.28 0.4 0.6700 0.6736 0.6772
C. $4.09 $1.16 0.5 0.7054 0.7088 0.7123
D. $6.21 $3.28
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¾ An investor holds an American call option on a dividend paying stock with the
following characteristics
z Current stock price ,S=USD 50
z Strike price, K=USD 50
z Time to expiration ,T=2 mouths
A divided, D, of USD 1 per share has just been announced ,with an ex-dividend
date, t, of one month from now, Assuming the risk-free rate, r, is 1.5% and the
option stays at-the-money, is it optimal to exercise the option right before the ex-
dividend date?
A. Yes, because S < K*e (-r(T-t)) + D
B. Yes, because D > K*(1-e(-r(T-t)))
C. No, because the call option is at-the-money ,and early exercise is only
optimal when it is deep in-the-money
D. No, because unlike an American put option, it is never optimal to exercise an
American call option early.
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¾ Derivatives
z Swap Market
z Exotic Options
z Option Valuation
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¾ Implication of Delta
z The delta of an option, ǻ is the ratio of the change in price of the
call/put option to the change in the price of the underlying assets.
z Delta is the slope of the option pricing function at the current stock
price.
&DOORSWLRQǻUDQJHIURPWR
Delta
1
3XWRSWLRQǻUDQJHIURP-1 to 0.
0.5
Call Options Long Call ǻ!
0 K
Short Call ǻ<0
-0.5
Put Options Long Put ǻ
-1
Short Put ǻ!
Call and Put Option Delta
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Delta
1.0
0.9
0.8
0.7
0.6
0.5
0.4
0.3
0.2 90-day
60- 30-
0.1 10-day
0.0
90 100 110
Spot Price
z When tĺT, delta is unstable
z For a call option at the money, ǻ =0.5
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¾ According to the BSM Model

wc wc
ǻ N(d1 ) ǻ e qTN(d1 )
wS wS
or
wp wp
ǻ N(d1 ) 1 ǻ e qT >N(d1 ) 1@
wS wS
Where:
F = change in the call option priceͺ
S = change in the put option priceͺ
6 = change in the stock price
¾ Forward Delta 1 or e-qT
¾ Futures Delta erT or e(r – q)T
¾ Portfolio Delta: summation of the product of each option position and its
delta.
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¾ Delta Hedge
z A position with a delta of zero is called a delta neutral position.
z Example:
9 A call delta equals to 0.6 means that the price of a call option on a
stock will change by approximately $0.60 for a $1.00 change in the
value of the stock. If an investor is short 1,000 call options, he will
need to be long 600(0.61,000)shares of the underlying.
z Because delta changes, a position is delta neutral only instantaneously
(for a very short period of time).To maintain a delta neutral position, the
trader must re-balance the portfolio.
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¾ Dynamic Aspects of Delta Hedge

z Because delta changes, a position is delta neutral only instantaneously
(for a very short period of time).To maintain a delta neutral position, the
trader must re-balance the portfolio.
z Continuously maintaining a delta-neutral position can be very costly in
terms of transaction costs.
z If gamma is higher (such as the case when the options are at-the-
money), rebalancing more frequently is required. On the other hand,
when gamma is lower (such is the case when options are deeply in the
money or deeply out of the money), rebalancing is required less
frequently.
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¾ Implication of Gamma
z The Gamma of options on an underlying asset is the rate of change of the
option’s delta with respect to the price of the underlying asset. That is to
measure the stability of delta.
z Gamma is used to correct the hedging error associated with delta-neutral
positions by providing added protection against large movements in the
underlying asset's price.
Current Value of Option
10
5
Delta + Gamma Actual
Delta
0
90 100 110
Current Price of Underlying Asset
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z When gamma is large, delta will

be changing rapidly.
z Gamma is largest when an
option is at-the-money.
z Gamma is the same for call and
put options.
z Delta Neutral Positions
Hedge against small changes in
stock price.
z Gamma Neutral Positions
Long Short Long Short Hedge against larger changes in
Call Call Put Put
stock price.
Ȗ! Ȗ Ȗ! Ȗ
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¾ Example: Creating a Gamma Neutral Position
z Suppose an existing short option position is delta-neutral but has a
gamma of -6,000. Here, gamma is negative because we are short the
options. Also, assume that there exists a traded option with a delta of
0.6 and a gamma of 1.25. Create a gamma-neutral position.
9 Buy 6,000/1.25 = 4,800 options
9 Sold 4,8000.6 = 2,880 shares of the underlying position.
z You can also create a gamma needed position, e.g., gamma of -1,000
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¾ Implication of Vega
z Vega is the rate of change of the value of the option with respect to the
volatility of the underlying asset.
z Most sensitive to changes in volatility when they are at the money.
z Vega of a call is equal to the Vega of a put.
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¾ Implication of Theta
z Theta is the rate of change of the value of the option with respect to
the passage of time with all else remaining the same.
z Theta is sometimes referred to as the time decay. As time to maturity
decreases with all else remaining the same, the option tends to
become less valuable, so theta is usually negative for an option.
z For long position, theta<0,

means option lose value as
time goes by.
z Short-term at the money
option has a greatest
negative theta.
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¾ Implication of Rho
z Rho is the sensitivity to the interest rates.
z The equity options are not as sensitive to changes in the risk-free rate
as they are to changes in the other variables.
z In the money calls and puts are more sensitive to changes in rates
than out-of-the-money options.
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¾ Which of the following is true regarding options’ Greeks?

A. Theta tends to be large and positive when buying at-the-money
options.
B. Gamma is greatest for in-the-money options with long maturities.
C. Vega is greatest for at-the-money options with long maturities.
D. Delta of deep in-the-money put options tends towards +1
¾ How can a trader produce a short vega, long gamma position?
A. Buy short-maturity options, sell long-maturity options.
B. Buy long-maturity options, sell short-maturity options.
C. Buy and sell options of long maturity.
D. Buy and sell options of short maturity.
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¾ A delta-neutral position exhibits a gamma of -3,200. An existing option
with a delta equal to 0.5 exhibits a gamma of 1.5. Which of the following
will generate a gamma-neutral position for the existing portfolio?
A. Buy 4,800 of the available option.
B. Sell 4,800 of the available options.
C. Buy 2,133 of the available options.
D. Sell 2,133 of the available options.
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z Introduction
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/TZXUJ[IZOUTUL))6
¾ OTC derivatives are private bilateral contracts that give rise to

counterparty risk during a counterparty default scenario and can create
significant market volatility.
¾ Counterparty risk has historically been mitigated bilaterally through
clearing.
¾ During the global financial crisis, several large institutional market players
defaulted on their obligations and ultimately declared bankruptcy or had to
be bailed out by their national government.
¾ The failure of these large players creates systemic risk and instability in
the market, including increased illiquidity and price volatility.
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¾ Following the global financial crisis, regulatory initiatives (e.g., Dodd-

Frank Act, EMIR) were introduced to mandate central clearing of all
standardized OTC derivatives.
¾ The initiatives aimed at reducing counterparty risk, improving market
transparency, and reducing market interconnectedness.
¾ Regulations were later amended to require posting of initial margin for all
non-cleared OTC derivatives.
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¾ In central clearing, the CCP assumes the rights and obligations of the
counterparties thereby limiting counterparty risk.
¾ Advantages of central clearing through CCPs:
z Setting standards for clearing members;
z Multilateral netting;
z Collecting and maintaining margin;
z Mutualization of losses among clearing members;
z Enhanced trade liquidity and reduced overall market disruptions.
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¾ Drawbacks:
z The potential failure of a CCP (this would create systemic risk in the
market);
z Moral hazard problem (CCPs designated as systemically important
would accept higher risk knowing that a government bailout in a
default scenario is likely);
z Increased costs arising from tying up funds as initial margin;
z Adverse selection (a large counterparty that has better insight into
risks than the CCP is likely to over-trade products for which the CCP
underestimates risk, and vice versa).
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z Introduction
194-279
+ÎNGTMKY5:)*KXO\GZO\KY*6)YGTJ96<Y
¾ Trading derivatives can be done bilaterally or through exchanges. An

exchange is a central market where standardized contracts can be traded.
¾ Exchanges perform three primary functions:
z Product standardization
z Trading venue
z Reporting services
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¾ Clearing, margining, and netting are important counterparty risk mitigants.

z Clearing is the process of reconciling and matching contracts between
counterparties.
z Margining represents both upfront funds posted to mitigate against
counterparty default (initial margin), and daily transfer of funds to cover
position gains and losses (variation margin).
z Netting refers to consolidating multiple offsetting positions between
counterparties into a single payment.
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¾ The three forms of clearing include direct clearing, clearing rings, and
complete clearing (i.e., central clearing).
z Direct clearing is a mechanism for bilaterally reconciling commitments
between two counterparties.
z A clearing ring is a mechanism to reduce counterparty exposure
between members by allowing for counterparty substitution.
z Complete clearing is clearing through a CCP, where the CCP assumes
the obligations of clearing exchange members.
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¾ The main benefits of OTC derivatives include customization of terms,

settlement, and documentation, which are negotiated bilaterally between
two parties.
z Customization can be beneficial since it reduces basis risk (i.e., risk of
term mismatches).
¾ Disadvantages of OTC derivatives include counterparty risk, difficulty in
unwinding trades, and novation of contracts.
¾ Clearing is more challenging for OTC derivatives compared to exchange-
traded derivatives given the generally longer maturities.
z OTC derivatives trades could be cleared by CCPs.
¾ OTC derivatives comprise of five broad classes of derivatives: interest
rate, foreign exchange, equity, commodity, and credit derivatives. Interest
rate derivatives comprise the largest class, followed by foreign exchange
derivatives and credit derivatives
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¾ Mechanisms for controlling counterparty risk include: special purpose

vehicles (SPVs), derivatives product companies (DPCs), monolines, and
credit derivative product companies (CDPCs).
z SPVs are bankruptcy remote legal entities set up by a parent firm to
shield the SPV from any financial distress of the firm.
z SPVs essentially alter bankruptcy rules and transform counterparty
risk into legal risk.
z The legal risk is consolidation, or the risk that the courts view the SPV
and the originating firm as the same legal entity.
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¾ DPCs are bankruptcy remote subsidiaries of firms set up to originate

derivatives products sold to investors.
¾ DPCs are separately capitalized and have restrictions on their activities
and margin.
¾ They are generally AAA rated where the rating depends on three criteria:
(1) market risk minimization (2) parent support, and (3) credit risk and
operational risk management.
¾ Monolines are highly-rated insurance companies that provide financial
guarantees, or “credit wraps" to investors.
¾ CDPCs are akin to DPCs, but with a business model that is closer to that
of a monoline.
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z Introduction
201-279
(GYOI6XOTIOVRKYUL)KTZXGR)RKGXOTM
¾ CCPs play important roles in the clearing and settlement of transactions.

Clearing refers to the processes between the period from trade execution
until settlement.
¾ Settlement refers to the satisfaction of legal obligations and trade
completion.
¾ Functions of a CCP include novation, netting, margining, managing the
auction process, and loss mutualization.
z Auctioning refers to selling off the defaulted member‘s trades to the
surviving members through an auctioning process.
z Loss mutualization refers to members’ contributions to a default fund to
cover future losses from member defaults.
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¾ Other aspects and mechanics of CCPs include:

z Categories of OTC derivatives products: (1) long history of central
clearing (e.g., interest rate swaps), (2) short history of central clearing
(e.g., index credit default swaps), (3) soon to be centrally cleared (e.g.,
interest rate swaptions, credit default swaps), and (4) not suitable for
central clearing (e.g., exotic derivatives).
z Conditions needed for central clearing: product standardization, lower
complexity, and high liquidity.
z Participants: Transacting with CCPs is restricted to clearing members
only. Member criteria include admission criteria, financial commitment,
and operational criteria.
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z Number of CCPs: It is generally not feasible to have a single CCP due

to regional differences in trades and requirements, differences in
product types, and regulatory reasons.
z Types of CCPs: CCPs could be utility-driven CCP (i.e., focused on
long-term stability) or profit-driven CCP (i.e., focused on bottom line).
Arguments generally support profit-driven CCPs.
z Failure of a CCP: The potential failure of a large CCP could create a
catastrophic event. CCPs must therefore ensure sufficient loss
absorption capacity.
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¾ Advantages of CCPs include: transparency, offsetting, loss mutualization,

legal and operational efficiency, liquidity, and default management.
¾ Disadvantages of CCPs include: moral hazard, adverse selection,
separation of cleared and non-cleared products, and procyclicality of
margin requirements.
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¾ Margining includes posting both initial margin and variation margin.

Margining tends to be more stringent in central clearing than in OTC
markets.
¾ CCPs set margin requirements based only on the risks of the members‘
transactions, and the credit quality of the member is typically not a
consideration for initial margin.
¾ Novation refers to replacing a bilateral OTC contract with another contract
(or contracts) with the CCP, where the CCP is the insurer of counterparty
risk. The CCP maintains a "matched book" of trades with no net market
risk.
¾ Multilateral offset, or netting, refers to creating a single net obligation
between each participant and the CCP from the various bilateral OTC
trades (which typically include redundant trades). Netting reduces total
risk and minimizes contagion from a member default.
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¾ By including a CCP in the clearing process, systemic risk can be both

reduced and increased.
z Systemic risk is reduced because counterparty risk is reduced, and
transparency and liquidity improve.
z Systemic risk is increased because higher initial margin during times of
stress would heighten market risk, and the failure of a CCP may lead
to a catastrophic event.
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z Introduction
208-279
8OYQY)G[YKJH_))6Y
¾ CCPs face five major risks: default risk, model risk, liquidity risk,
operational risk, and legal risk.
¾ Other risks they may face include investment risk, settlement and
payment risk, foreign exchange risk, custody risk, concentration risk,
sovereign risk, and wrong-way risk.
¾ The default of a clearing member and its flow through effects is the most
significant risk for a CCP.
¾ Because of a default, there may be the default or distress of other clearing
members given that default correlation is likely to be high among OTC
derivatives market participants.
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8OYQY)G[YKJH_))6Y
¾ Non-members face exposure from CCPs, clearing members, and other

non-members.
z If a CCP fails, a non-member may be able to avoid losses so long as
its counterparty is solvent.
z Non-members are not required to contribute to default funds so they
are not exposed to losses that result from CCP failures.
z The extent of non-members‘ losses lies with the initial margins and
whether they are segregated, guaranteed, or both.
z Non-members face the risk of not being able to port their trades should
the counterparty member default.
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8OYQY)G[YKJH_))6Y
¾ Lessons learned from prior CCP failures include:

z Operational risk must be controlled to the maximum extent possible.
z Variation margins should be recalculated often and collected quickly.
z CCPs should have an information system that allows for automated
payments.
z There should be cross-margining linkage arrangements between
CCPs.
z Initial margins and default funds should be sufficiently large.
z CCPs must actively monitor positions.
z CCPs must have one or more external sources of liquidity.
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z Country Risk
z Operational Risk
z Stress Test
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¾ Coherent Risk Measure

z Monotonicity
9 A random cash flow or future value R1 that is always greater than
R2 should have a lower risk.
z Subadditivity
9 The portfolio’s risk should not be greater than the sum of its parts.
z Positive Homogeneity
9 The risk of a position is proportional to its scale or size.
z Translation Invariance
9 Like adding cash
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¾ Mean-Variance Framework
¾ Value at Risk
z VaR is the maximum loss over a target horizon and for a given
confidence level.
z Disadvantages of VaR
9 Did not contain worst conditions, did not describe tail loss.
9 Not sub-additive.
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z If an expected return other than zero:
VaR X% | E R z X% u ı |
z Example: calculating VaR given an expected return for a

$100,000,000 portfolio, the expected 1-week portfolio return and
standard deviation are 0.00188 and 0.0125, respectively. Calculate the
1-week VaR at 5% significance level.
VaR | E R z X% u ı | uportfolio value

| 0.00188 1.65 u 0.0125 | u100,000,000
$1,874,500
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z Square Root Rule: If fluctuations in a stochastic process from one
period to the next are independent (i.e., there are no serial correlations
or other dependencies), volatility increases with the square root of the
unit of time.
VaR X% J days VaR X% 1 days u J
9 With trendsĺpositive correlationĺVaR increase
9 With mean reversionĺnegative correlationĺVaR decrease
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¾ Conditional VaR
z Also called expected shortfall, tail conditional expectation, conditional
loss, expected tail loss. It is the average of the worst 100(1-Į)% of
losses.
5% 5%
VaR VaR
zExample: Given the following 30 ordered percentage returns of an
asset, calculate the VaR and expected shortfall at a 90% confidence
level: -16, -14, -10, -7, -7, -5, -4, -4, -3, -1, -1, 0, 0, 0, 1, 2, 2, 4, 6, 7, 8,
9, 11, 12, 12, 14, 18, 21, 23.
¾ Spectral Risk Measures
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¾ Your colleague reports a 95.0% one-day value-at-risk (VaR) of $1.4 million

for a equities portfolio. If we assume 250 trading days in a year, each of
the following is a valid conclusion except which of the following is false
(cannot be concluded from the statement)?
A. If the VaR is accurate, we expect a daily loss in excess of $1.4 million
to occur on about 12 or 13 days (12.5) during year
B. If the return distribution is normal, then we can assume the VaR is
sub-additive
C. This is a parametric VaR and therefore cannot characterize a heavy-
tailed distribution
D. If the returns are i.i.d. normal, we can scale to a 10-day VaR with
$1.4*SQRT(10) = $4.3 million 95% 10-day VaR
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¾ A bond with a face value of $10.0 million has a one-year probability of
default (PD) of 1.0% and an expected recovery rate of 35.0%. What is the
bond's one-year 99.0% expected shortfall (ES; aka, CVaR)?
A. $3.25 million
B. $6.5 million
C. $9.1 million
D. Not enough information: need the tail distribution
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z Country Risk
z Operational Risk
z Stress Test
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¾ VaR of Linear Derivatives – Delta-Normal Approximation
VaRLinear Derivative ǻ u VaRUnderlying Risk Factor
z Delta-Normal Approach: the linear approximation is assumed and

the underlying factor is assumed to follow a normal distribution.
Although the delta-normal method analytically tractable, it is only an
approximation. It is not good for derivatives with extreme nonlinearities
(MBS, Fixed-income securities with embedded option).
VaR dP | D*P | u VaR dy

VaR df | ǻ | u VaR dS
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z Example: The Big Pharma Inc’s stock is trading at USD 23 and the
stock has a daily volatility of 1.5%. Using the delta-normal method,
what is the VaR at the 95% confidence level of a long position in an at-
the-money put on this stock with a delta of -0.5 over a 1-day holding
period?
VaR | delta | u1.645 u ı u S0 0.5 u 1.645 u 0.015 u 23 0.28
¾ VaR of Nonlinear Derivatives – Delta-Gamma Approximation
1
VaR dP D*P u VaR dy C u P u VaR dy
2
2
1
VaR df ǻ u VaR dS ī u VaR dS
2
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¾ VaR of Nonlinear Derivatives - Full Revaluation Method

z Full re-pricing of the portfolio under the assumption that the underlying
risk factor(s) are shocked to experience a loss. i.e., what is the worst
expected change in the risk factor, given some confidence and time
horizon. Then, full revaluation prices the portfolio under changed risk
factors.
z Full revaluation is accurate but computationally burdensome.
9 Historical Simulation
9 Bootstrap Simulation
9 Monte Carlo Simulation
9 Scenario Analysis
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¾ An investor has a short position in put option (i.e., has written a put) on an
underlying asset with value of $100,000. The delta of the put option is -
0.40. The 95.0% value at risk (VaR) of the underlying asset is 12.0%.
Which of the following statements is correct when second-order terms
(quadratic VaR) are considered?
A. VaR of the short option position is slightly less than $4,800
B. VaR of the short option position is slightly more than $4,800
C. VaR of the short option position is slightly less than $12,000
D. VaR of the short option position is slightly more than $12,000
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¾ A stock with a current price of $200.00 has an annual volatility of 30.0%.

An at-the-money (ATM) call option has a delta, N(d1), of 0.6180 and
gamma of 0.00950. If we assume 250 trading days, what is the one-day
95.0% confident delta-gamma value at risk (VaR) of a long position in the
call option?
A. $1.99
B. $3.67
C. $3.85
D. $14.72
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z Country Risk
z Operational Risk
z Stress Test
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¾ Potential Reasons for the Existence of Fat Tails

z The phenomenon of “fat tails” is most likely the result of the volatility
and/or the mean of the distribution changing over time.
9 If the mean and standard deviation are the same for asset returns
for any given day, the distribution of returns is referred to as an
unconditional distribution of asset returns.
9 However, different market or economic conditions may cause the
mean and variance of the return distribution to change over time. In
such cases, the return distribution is referred to as a conditional
distribution.
z The second possible explanation for “fat tails” is that the volatility is
time-varying.
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z A regime-switching volatility model assumes different market

regimes exist with high or low volatility. The conditional distributions of
returns are always normal with a constant mean but either have a high
or low volatility.
z The regime-switching model captures conditional normality and may
resolve the fat-tail problem and other deviations from normality.
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¾ Historical-Based Approach and Implied Volatility-Based Approach

z Historical-based approach typically fall into three sub-categories
9 Parametric model typically assumes asset returns are normally or
lognormally distributed with time-varying volatility.
9 Nonparametric approach is less restrictive in that there are no
underlying assumptions of the asset returns distribution. The most
common nonparametric approach models volatility using the
historical simulation method.
9 Hybrid approach combines techniques of both parametric and
nonparametric methods to estimate volatility using historical data.
An example of a popular hybrid approach is Filtered Historical
Simulation (FHS). Filtered historical simulation “updates” the
volatility by fitting a model such as GARCH to the time-series.
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z The implied volatility-based approach uses derivative pricing

models such as the Black-Scholes-Merton option pricing model to
estimate an implied volatility based on current market data rather than
historical data.
9 The advantage of implied volatility is the forward-looking predictive
nature of the model. The implied volatility model reacts immediately
to changing market conditions.
9 The disadvantages of implied volatility is that implied volatility is
model dependent. (1) Options on the same underlying asset may
trade different implied volatilities. (2) The model assumes constant
volatility, but volatility tends to change over time. (3) Limited
availability because it requires traded price.
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¾ Multivariate Density Estimation

z Multivariate density estimation (MDE) allows for weights to vary based
on how relevant the data is to the current market environment,
regardless of the timing of the most relevant data.
z MDE is very flexible in introducing dependence on economic variables
(called state variables or conditioning variables.)
¾ Historical Simulation
z No parameter estimates are required, the only thing we need to
determine up front is the lookback window. Once the window length is
determined, we order returns in descending order, and go directly to
the tail of this ordered vector.
z The model is not subject to estimation error related to correlations and
the problem of higher correlations in downward markets.
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¾ Hybrid Approach
z The hybrid approach uses historical simulation to estimate the
percentiles of the return and weights that decline exponentially (similar
to EWMA). The following three steps are required to implement the
hybrid approach.
9 Step 1: Assign weights for historical realized returns to the most
recent K returns using an exponential smoothing process as
follows:
1 Ȝ 1 Ȝ 1 Ȝ k 1
, Ȝ,..., Ȝ
1 Ȝk 1 Ȝk 1 Ȝk
9 Step 2: Order the returns.

9 Step 3: Determine the VaR for the portfolio by starting with the
lowest return and accumulating the weights until x percentage is
reached.
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z Example: calculating 5% VaR using hybrid approach. The most recent

observations is K=100, and Ȝ 0.96.
hybrid
six lowest # of past hybrid
rank cumulative
returns periods weight
weight
1 -4.70% 2 0.0391 0.0391
2 -4.10% 5 0.0346 0.0736
3 -3.70% 55 0.0045 0.0781
4 -3.60% 25 0.0153 0.0934
5 -3.40% 14 0.0239 0.1173
6 -3.20% 7 0.0318 0.1492
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¾ Estimating Volatility
z The historical standard deviation approach assumes all m returns
in the window are equally weighted.
Si Si1 1 m 1 m 2
ui
Si1
u ¦ uni
mi1
ı n2 ¦u
m i 1 ni
z Each day, the forecast is updated by adding the most recent day and
dropping the furthest day. In a simple moving average, all weights on
past returns are equal and set to (1/M). Note raw returns are used
instead of returns around the mean (i.e., the expected mean is
assumed zero). This is common in short time intervals, where it makes
little difference on the volatility estimate.
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z The exponential smoothing methods place a higher weight on more

recent data, and the weights decline exponentially to zero as returns
become older.
EWMA GARCH
ı 2
n Ȝı 2
n 1 1 Ȝ u
2
n 1 ı n2 ȖVL Įun21 ȕı n21
z Persistence: In GARCH (1,1), the sum of the alpha Į and beta (ȕ)
parameters. High persistence implies slow decay toward to the long-
run average variance.
z GARCH (1, 1) is unstable if the persistence > 1. A persistence of 1.0
implies no mean reversion. A persistence of less than 1.0 implies
“reversion to the mean,” where a lower persistence implies greater
reversion to the mean.
z EWMA is a special case of GARCH.
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¾ Which of the following best summarizes the key difference(s) between
these two approaches to VaR estimation: exponentially weighted moving
average (EWMA; aka, RiskMetrics) versus the hybrid approach?
A. Hybrid approach does not utilize exponentially declining weights
B. Hybrid is parametric and EWMA is non-parametric
C. Hybrid estimates the VaR as a quantile (percentile) of ordered (but
weighted) historical returns, but EWMA does not sort returns
D. There is no difference: EWMA is the hybrid approach
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¾ A risk manager is considering switching from using historical volatility to

using implied volatility in VaR calculations. Which of the following
statements about implied volatility are correct?
A. Implied volatility estimates are model dependent and a mis-specified
model can result in erroneous forecasts.
B. Implied volatility estimates require that historical returns are
indicative of future returns.
C. Implied volatility estimates tend to underestimate future volatility as a
result of mean reversion
D. Implied volatility estimates are generally accurate even if there is only
one trade in the option used to calculate an estimate.
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z Country Risk
z Operational Risk
z Stress Test
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¾ Credit Risk
z Credit risk is the risk that arises from any nonpayment or rescheduling
of any promised payments (i.e., default-related events) or from
(unexpected) credit migrations (i.e., events that are related to changes
in the credit quality of a borrower) of a loan and that gives rise to an
economic loss to the bank.
¾ Three Drivers
z Probability of Default: Probability that a borrower will default before
the end of a predetermined period of time or at any time before the
maturity of the loan.
z The exposure amount of the loan at the time of default.
z The loss rate, that is, the fraction of the exposure amount that is lost
in the event of default, meaning the amount that is not recovered after
the sale of the collateral.
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¾ Expected Losses
z A bank can expect to lose, on average, a certain amount of money
over a predetermined period of time when extending credits to its
customers.
z A prudent bank should set aside a certain amount of money (often
called loan loss reserves) to cover these losses that occur during the
normal course of their credit business.
adjusted exposure OS Į u COMU
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¾ Unexpected Loss
z By definition, EL does not itself constitute risk. If losses always
equaled their expected levels, there would be no uncertainty, and there
would be no economic rationale to hold capital against credit risk. Risk
arises from the variation in loss levels—which for credit risk is due to
unexpected losses (UL).
z Unexpected loss is the standard deviation of credit losses.
z ULs cannot be anticipated and hence cannot be adequately priced for
in a loan’s interest rate. They require a cushion of economic capital.
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¾ Portfolio Credit Risk

z The expected loss of a portfolio of credits is straightforward to
calculate because EL is linear and additive.
z When measuring unexpected loss at the portfolio level, we need to

consider the effects of diversification because – as always in portfolio
theory – only the contribution of an asset to the overall portfolio risk
matters in a portfolio context.
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z Unexpected Loss Contribution
z Total contribution to the portfolio’s UL
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¾ Big Bank has contractually agreed to a $20,000,000 credit facility with Upstart
Corp., of which $18,000,000 is currently outstanding. Upstart has very little
collateral, so Big Bank estimates a one-year probability of default of 2%. The
collateral is unique to its industry with limited resale opportunities, so Big Bank
assigns an 80% loss rate. The expected loss (EL) for Big Bank is closest to:
A. $68,000 C. $272,000
B. $72,000 D. $288,000
¾ Bigger Bank has two assets outstanding. The features of the loans are
summarized in the following table. Assuming a correlation of 0.2 between the
assets, what is the value of the unexpected loss of the portfolio (ULP)?
A. Less than $100,000 Asset A Asset B
Exposure $5,100,000 $3,600,000
B. Between $100,000 and $200,000
PD 2% 1%
C. Between $200,000 and $300,000 LR 50% 40%
D. Greater than $300,000 ıPD 2% 5%
ıLR 25% 20%
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z Country Risk
z Operational Risk
z Stress Test
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¾ As companies and investors globalize, they are exposed to the political
and economic turmoil that often characterize these markets.
¾ As firms shift from local markets to foreign ones, we face three questions:
z Whether investments in different countries are exposed to different
amounts of risk?
z Whether this risk is diversifiable in global portfolios?
z Whether we should be demanding higher returns in some countries?
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1. Economic growth life cycle
z A country that is still in the early stages of economic growth will
generally have more risk exposure than a mature country.
z A global recession generally takes a far greater toll of small, emerging
markets than it does in mature markets.
z In an emerging market, a recession or recovery can easily translate
into double-digit growth, in positive or negative terms.
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2. Political Risk
z Investors and companies that value government stability (and fixed
policies) sometimes choose authoritarian countries, because a strong
government can essentially lock in policies for the long term and push
through changes that a democracy may never be able to do.
z The chaos of democracy does create more continuous risk (policies
that change as governments shift), dictatorships create more
discontinuous risk.
z The more stable policies an authoritarian system offers can be
accompanied by other costs (political corruption and ineffective legal
systems) that overwhelm the benefits of policy stability.
z It is difficult to draw a strong conclusion about which system is more
conducive to higher economic growth.
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z If those who enforce the rules are capricious, inefficient or corrupt in

their judgments, there is a cost imposed on all who operate under the
system.
z Countries that are in the midst of physical conflicts will expose
investors/businesses to the risks of these conflicts.
z If your profits can be expropriated by the business (with arbitrary and
specific taxes imposed just upon you) or your business can be
nationalized (with you receiving well below the fair value as
compensation), you will be less likely to invest.
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3. Legal Risk
z Investors and businesses are dependent upon legal systems that
respect their property rights and enforce those rights in a timely
manner.
4. Economic Structure
z Some countries are dependent upon a specific commodity, product or
service for their economic success.
z That dependence can create additional risk for investors and
businesses, since a drop in the commodity’s price or demand for the
product/service can create severe economic pain.
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Risk services’ limitations:
z Many of the entities that develop the methodology and convert them
into scores are not business entities and consider risks that may have
little relevance for businesses.
z The scores are not standardized and each service uses it own
protocol.
z The country risk scores are more useful for ranking the countries than
for measuring relative risk.
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Sovereign Default Risk

¾ A large proportion of sovereign defaults have occurred with foreign
currency defaults, as the borrowing country finds its short of the foreign
currency to meet its obligations.
¾ Facts about sovereign default risk:
z Countries have been more likely to default on bank debt owed than on
sovereign bonds issued.
z Latin American countries have accounted for much of sovereign
defaulted debt in the last 50 years.
1. Lacking significant domestic savings and possessing the allure of
natural resources
2. Borrowed heavily
3. Military conflicts
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Local Currency Defaults

¾ Reasons for default in the local currency
z Gold Standard: In the decades prior to 1971, when some countries
followed the gold standard, currency had to be backed up with gold
reserves. As a consequence, the extent of these reserves put a limit on
how much currency could be printed.
z Shared Currency: The crisis in Greece has brought home one of the
costs of a shared currency.
z Countries feel reluctant to print more currency to pay debt obligations
as this will devalue the currency and cause inflation to increase.
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Consequences of Default
z Reputation loss: A default government will make it more difficult to
raise financing in future rounds.
z Capital Market turmoil: Investors withdraw from equity and bond
markets, making it more difficult for private enterprises in the defaulting
country to raise funds for projects.
z Real Output: sovereign defaults are followed by economic recessions,
as consumers hold back on spending and firms are reluctant to commit
resources to long-term investments.
z Political Instability: Default can also strike a blow to the national
psyche, which in turn can put the leadership class at risk.
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Factors determining sovereign default risk

z Degree of indebtedness
z Pensions/Social Service Commitments: countries that have larger
commitments on these counts should have higher default risk
z Revenues/Inflows to government: access to a larger tax base should
increase potential tax revenues, which, in turn, can be used to meet
debt obligations.
z Stability of revenues: countries with more stable revenue streams /
diversified economies should therefore face less default risk. Income
tax based systems generate more volatile revenues than sales tax.
z Autocracies are more likely to default than democracies.
z Implicit backing from other entities: the danger is that the backing is
implicit and not explicit.
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)U[TZX_8OYQ9U\KXKOMT8GZOTMY
¾ Biggest advantages:
z They have been assessing default risk in corporations for a hundred
years and presumably can transfer some of their skills to assessing
sovereign risk.
z Bond investors who are familiar with the ratings measures, from
investing in corporate bonds, find it easy to extend their use to
assessing sovereign bonds.
¾ Critiques:
z They do not change quickly enough to alert investors to imminent
danger.
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Rating Process:
z A sovereign rating is focused on the credit worthiness of the sovereign
to private creditors and not to official creditors
z Notch-up approach: the foreign currency rating is viewed as the
primary measure of sovereign credit risk and the local currency rating
is notched up, based upon domestic debt market factors.
z Notch-down approach: it is the local currency rating that is the anchor,
with the foreign currency rating notched down.
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¾ Sovereign bonds with investment grade ratings have defaulted far less
frequently than sovereign bonds with speculative ratings. But ratings
agencies have been criticized for:
z Ratings are upward biased
z Herd behavior
z Rating agencies take too long to change ratings, and that these
changes happen too late to protect investors from a crisis.
z Vicious Cycle: Once a market is in crisis, there is the perception that
ratings agencies sometimes over react and lower ratings too much
z When a ratings agency changes the rating for a sovereign multiple
times in a short time period, it is admitting to failure in its initial rating
assessment.
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Why do ratings agencies sometimes fail?
z Information problems: The data that the agencies use to rate
sovereigns generally come from the governments
z The agencies cannot afford to hire too many analysts.
z Revenue Bias
z Some of the analysts who work for S&P and Moody’s may seek work
with the governments that they rate, it is uncommon and thus should
not pose a problem with conflict of interest.
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¾ The interest rate on the bond can be compared to a rate on a riskless

investment in that currency to get a market measure of the default spread
for that country.
¾ Advantages to using the default spreads:
z The market differentiation for risk is more granular than the ratings
agencies;
z The market-based spreads are more dynamic than ratings, with
changes occurring in real time.
¾ Weaknesses:
z More volatile than ratings
z Can be affected by variables that have nothing to do with default.
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¾ Physical settlement: The buyer of the CDS can deliver the “defaulted”
bond to the seller and get par value for the bond.
¾ Cash settlement: The seller of the CDS can pay the buyer the difference
between par value of the defaulted bond and the market price, which will
reflects the expected recovery from the issuer.
¾ The first is that the protection against failure is triggered by a credit event
¾ If the seller defaults, the insurance guarantee will fail.
¾ Corporate CDS represent the bulk of the market, followed by bank CDS
and then sovereign CDS.
¾ The narrowness of the market does make it vulnerable, since the failure of
one or more of the big players can throw the market into tumult.
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¾ The prices that investors set for credit default swaps should provide us
with updated measures of default risk in the reference entity.
¾ CDS spreads are more timely and dynamic than sovereign ratings and
that they reflect fundamental changes.
¾ It is not clear that the CDS market is quicker or better at assessing default
risks than the government bond market.
¾ Limitations with using CDS prices as predictors of country default risk
z The exposure to counterparty and liquidity risk can cause changes in
CDS prices
z The narrowness of the CDS market can make individual CDS
susceptible to illiquidity problems.
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z Country Risk
z Operational Risk
z Stress Test
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¾ Operational Risk
z The risk of direct and indirect loss resulting from inadequate or failed
internal processes, people, and systems or from external events
¾ Seven Categories of Operational Risk
z Internal Fraud
z External Fraud
z Employment Practices and Workplace Safety
z Clients, Products, and Business Practices
z Damage to Physical Assets
z Business Disruption and System Failures
z Execution, Delivery, and Process Management
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¾ Approaches to Measuring Operational Risk

z Top-down approach
z Bottom-up approach
Top-Down Approaches Bottom-I[ Approaches
Sophistication Simple Complex
Data Requirement Non-intensive Intensive
HFLS vs. LFHS Undifferentiated Differentiated
Diagnostic Ability No Yes
Perspective Backward-looking Forward-Looking
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¾ Get a Loss Distribution from the Loss Frequency distribution and the Loss
Severity Distribution
z The loss frequency distribution is the distribution of the number of losses
observed during the time horizon (typically one year). For loss frequency, a
common probability distribution is the Poisson Distribution.
z The loss severity distribution is the distribution of the size of a loss, given
that a loss occurs. It is typically assumed that loss severity and loss frequency
are independent. For the loss severity distribution, a lognormal probability
distribution is often uses.
z The frequency and severity distributions must be combined; Monte Carlo
simulation can be used for this purpose.
9 We sample from the frequency distribution in order to determine the
number of loss events (=n)
9 We sample n times from the loss severity distribution to determine the loss
experienced for each loss events (L1, L2, … Ln)
9 We determine the total loss experienced (= L1 + L2 + … Ln)
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z Data Issues
9 Loss frequency distribution: bank’s own data as far as possible.
9 In regard to the loss severity data, regulators encourage banks to
use their own data in conjunction with external data. There are two
sources of external data: data obtained through sharing
arrangements between banks; and publicly available data collected
by third-party vendors.
9 Relevant historical data is difficult to obtain, so regulators
encourage banks to use scenario analysis, in addition to internal
and external loss data. This involves managerial judgment to
generate scenarios where large losses occur.
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¾ Operational Risk Regulatory Capital
z Basic Indicator Approach: In the Basic Indicator Approach (BIA),
banks must hold capital for operational risk equal to a fixed percentage
(currently 15%) of positive annual gross income over the previous
three years:
¦
i last three years
GIi u Į
K operational,BIA
3
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z Standardized Approach: activities divided into eight business lines:

9 Corporate Finance 9 Payment and Settlement
9 Trading and Sales 9 Agency Services
9 Retail Banking 9 Asset Management
9 Commercial Banking 9 Retail Brokerage
Within each business line, gross income is a proxy for scale. Capital
charge is gross income of business multiplied by a factor (called
beta). The total capital charge is calculated as the three-year average
of the simple summation of the regulatory capital charges across each
of the business lines in each year.
½
® ¦ max ª¬ ¦ GIline18 u ȕline18 ,0 º¼ ¾
K operational,SA ¯i last three years ¿
3
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z The Basel Committee has listed conditions that a bank must satisfy in
order to use the standardized approach or the AMA approach. It
expects large internationally active banks to move toward adopting the
AMA approach through time. The capital charge for AMA is calculated
as the bank’s operational value at risk with a one-year horizon and a
99.9% confidence level.
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5VKXGZOUTGR8OYQ
¾ Operational Risk Management

z Risk control and self-assessment (RCSA) involves asking business
unit managers to identify their operational risks. Sometimes
questionnaires designed by senior managers are used.
z Risk indicators are key tools in the management of operational risk.
The most important indicators are prospective. They provide an early-
warning system to track the level of operational risk in the
organization. Examples of key risk indicators are staff turnover and
number of failed transactions.
272-279
+^KXIOYKY
¾ In constructing the operational risk capital requirement for a bank, risks are
aggregated for:
A. Commercial and retail banking
B. Investment banking and asset management
C. Each of the seven risk types and eight business lines that are relevant.
D. Only those business lines that generate at least 20% of the gross revenue of
the bank.
¾ In the Basel II Standardized Approach for operational risk, the beta factor serves
as a proxy for the industry-wide relationship between the operational risk loss
experience for a given business line and the aggregate level of gross income for
that business line. Which of the following lines has the highest beta factor?
A. Corporate finance
B. Retail banking
C. Commercial banking
D. Asset management.
273-279
,XGSK]UXQ
z Country Risk
z Operational Risk
z Stress Test
274-279
9ZXKYY:KYZOTM
¾ Stress Testing
z Generically, simple stress testing consists of three steps:
9 Create a set of extreme market scenarios (i.e., stressed scenarios)
— often based on actual past events;
9 For each scenario, determine the price changes to individual
instruments in the portfolio; sum the changes in order to determine
change in portfolio value
9 Summarize the results: show estimated level of mark-to-market
gains/losses for each stressed scenario; show where losses would
be concentrated.
9 The goal of stress testing is to identify unusual scenarios that would
not be covered by standard VaR models.
275-279
9ZXKYY:KYZOTM
¾ Benefits and Drawbacks of Stress Testing
¾ Unidimensional and Multidimensional Scenario Analysis

z Unidimensional scenarios focus ”stressing” on key one variable at
time. The key weakness of a unidimensional analysis is that scenarios
cannot, by definition, account for correlation.
z Multidimensional is more realistic and attempts to stress multiple
variables and their relationships.
276-279
9ZXKYY:KYZOTM
¾ Prospective Scenarios and Historical Scenarios

z Prospective scenarios try to analyze the implications of hypothetical
one-off surprises; e.g., a major bank failure, a geopolitical crisis.
z Historical scenarios look to actual past events to identify scenarios
that fall outside the VaR window.
¾ Event-Driven Scenarios and Portfolio-Driven Scenarios

z Event-Driven: Scenario formulated from plausible events that
generate movements in risk factors.
z Portflio-Driven Scenarios: First, risk vulnerabilities in the current
portfolio are identified. Second, translated into adverse movements in
risk factors.
277-279
9ZXKYY:KYZOTM
¾ Standard Portfolio Analysis of Risk System

z SPAN is a scenario-based method for measuring portfolio risk.
z Calculates worst possible loss portfolio might incur over a specified
time period (one trading day).
¾ How the results of a stress test can be used to improve our risk
analysis and risk management systems.
z Set aside economic capital to absorb worst-case losses
z Purchase protection or insurance
z Modify the portfolio
z Restructure the business or product mix to enhance diversification
z Develop a corrective or contingency plan should a scenario occur
z Prepare alternative funding sources in anticipation of liquidity
crunches.
278-279
/ZȍYTUZGTKTJH[ZP[YZZNKHKMOTTOTM
Your life can be enhanced, and your happiness enriched, when you choose
to change your perspective. Don't leave your future to chance, or wait for
things to get better mysteriously on their own. You must go in the direction of
your hopes and aspirations. Begin to build your confidence, and work
through problems rather than avoid them. Remember that power is not
necessarily control over situations, but the ability to deal with whatever
comes your way.
▲‫ޚ‬Պ݅र୼ொङઅ‫ͫچ‬҂ङࣿࡴѫ崼ࣀ‫ٸͫ߇ڐ‬क़‫ڽ‬Щѫ‫ݎ‬廼৲ߛ澞Ӱс
ӟ‫ݗ݋‬ո଍ङПԈߓͫЭӰܶ߈‫ق‬வѫЉՕ‫ۃ‬ઑङ‫૴ױ‬澞҂‫ீڷ‬Њӄ‫ڶ‬٥߈
Њࢽ‫࠵ە‬લ▲ਚ澞‫ॹڏ‬ਘҒͫ‫ހ‬йЊ֟஡िҾब‫ͫݎ‬৲ள৉ଳ৲੧澞ઓѻͫ
ԃ୏Љީ௟橆‫ق‬Ԏङࡣ‫ֳޗͫؗ‬Љ‫ݥ‬ङਈԃ۵ީ߂୍੽ङ澞
279-279

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【梦轩考资www.mxkaozi.

com】 QQ106454842 专业提供CFA FRM全程高清视频+讲义

z Bond Products – Treasury Bonds

z Bond Products – Corporate Bond

z Bond Products – MBS

z Exchanges, OTC Derivatives, DPCs and SPVs

z Basic Principles of Central Clearing

z Risks Caused by CCPs: Risks Faced by CCPs

¾ Risk Measurement and Management

z Measures of Financial Risk

z Putting VaR to Work

z Quantifying Volatility in VaR Models

z Expected and Unexpected Loss

z Bond Products – Treasury Bonds

z Bond Products – Corporate Bond

z Bond Products – MBS

9 Yield to Maturity (YTM)

¾ A bank uses a continuously-compounded annual interest rate of 5% in

use if it converts to semi-annual compounding in the model?

z Bond Products – Treasury Bonds

z Bond Products – Corporate Bond

z Bond Products – MBS

Example: Suppose you have a 180-day T-bill with a discount rate, or

¾ Quotation of Treasury Bonds

dirty price 1147.77 1155.30 1162.87 1170.50 1178.18 1185.90

clean price 1139.44 1138.63 1137.87 1137.17 1136.51 1135.90

z Bond Products – Treasury Bonds

z Bond Products – Corporate Bond

z Bond Products – MBS

¾ Role of Corporate Trustee

¾ Zero-Coupon Corporate Bonds

¾ Corporate Bond Retirements

¾ The Spread of a Bond

z The market price of any security can be thought of as its value

computed using some term structure of interest rates plus a premium

¾ Callable and Puttable Bond

Negative Convexity Positive Convexity

z With puttable bond, the downside price appreciation in response to

¾ A portfolio manager has recently purchased a 10-year investment-grade

z Bond Products – Treasury Bonds

z Bond Products – Corporate Bond

z Bond Products – MBS

¾ Fixed Rate Mortgage Payments

mortgage payments, discounted at the monthly compounded mortgage rate,

equals the original amount borrowed. In general, for a monthly payment X on a

T-year mortgage with a mortgage rate y and an original principal amount or

loan balance of B(0):

Example: A homeowner might borrow $100,000 from a bank at 4% and agree to

z Discounting using the mortgage rate at origination, the present value

z The single monthly mortality rate at month n, denoted SMMn, is the

¾ Mortgage-Backed Securities Market

¾ Zero-Volatility Spread (Z-Spread)

¾ Option-Adjusted Spread (OAS)

¾ A homeowner has a 30-year, 5% fixed rate mortgage with a current

balance of USD 250,000. Mortgage rates have been decreasing. Which of

monthly mortgage payments if the existing mortgage was refinanced into

a new 30-year, 4% fixed rate mortgage?

¾ A fixed-income portfolio manager purchases a seasoned 5.5% agency

z Price = ($30.992556) + ($1030.980296) = $103.95

DV01 = Modified Duration Bond Value 0.0001

'B'y | ª¬ 7 u 100 u 0.01 º¼ ª1 2 u 90 u 100 u 0.01 º

P P P(y 0 ǻy) P(y 0 ǻy)

D D ª P(y 0 ǻy) P0 P0 P(y 0 ǻy) º