FRM PART I

FORMULA SHEET

BOOK CHAPTER FORMULA VARIABLES

𝜎𝑖 𝐶𝑜𝑣(𝑖, 𝑚) 𝜎𝑖𝑚
𝛽𝑖 = 𝜌(𝑖𝑚) = 2 = 2
𝜎𝑚 𝑖 𝜎𝑚 𝜎𝑚
𝑅𝑚 = expected market rate of return
CAPM formula
(expected return on 𝐸(𝑅𝑖 ) = 𝑅𝑓 + 𝛽𝑖 (𝑅𝑚 − 𝑅𝑓 ) 𝑅𝑓 = risk-free rate
asset i)
𝐸(𝑅𝑖 ) = expected return on asset i
𝐶𝑜𝑣(𝑖, 𝑚) 𝜎𝑖𝑚
𝜌𝑖𝑚 = =
𝜎𝑖 𝜎𝑚 𝜎𝑖 𝜎𝑚

𝑅𝑚 = expected market rate of return

Modern
Book 1 Portfolio 𝑅𝑓 = risk-free rate
Foundation of Theory (MPT) 𝜎𝑝
Capital market line 𝐸(𝑅𝑝 ) = 𝑅𝑓 + (𝑅 − 𝑅𝑓 ) 𝐸(𝑅𝑝 ) = portfolio expected return
Risk and the Capital 𝜎𝑚 𝑚
Management Asset Pricing
𝜎𝑝 = portfolio standard deviation
Model (CAPM)
𝜎𝑚 = market standard deviation

𝑅𝑖 = expected rate of return on asset i

𝑅𝑓 = risk-free rate

𝜎𝑝 𝐸(𝑅𝑝 ) = portfolio expected return

Capital allocation line 𝐸(𝑅𝑝 ) = 𝑅𝑓 + (𝑅 − 𝑅𝑓 )
𝜎𝑖 𝑖 𝜎𝑝 = portfolio standard deviation
𝜎𝑖 = standard deviation of asset

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𝜎(𝑅𝑃 ) = portfolio standard deviation

𝐸(𝑅𝑝 ) − 𝑅𝑓
Sharpe ratio Sharpe ratio = 𝐸(𝑅𝑝 ) = portfolio expected return
𝜎(𝑅𝑃 )
𝑅𝑓 = risk-free rate

𝛽𝑃 = portfolio beta
𝐸(𝑅𝑝 ) − 𝑅𝑓
Treynor ratio Treynor ratio = 𝐸(𝑅𝑝 ) = portfolio expected return
𝛽𝑃
𝑅𝑓 = risk-free rate

𝑅𝑃 = return on the portfolio

The tracking error (TE) 𝑇𝐸 = (𝑅𝑃 − 𝑅𝐵𝑒𝑛𝑐ℎ𝑚𝑎𝑟𝑘 )
𝑅𝐵𝑒𝑛𝑐ℎ𝑚𝑎𝑟𝑘 = return on the benchmark portfolio

𝑇 = target or required rate of return

𝑅𝑝 − 𝑇 1 𝑁 2
𝑆𝑅 = ∑ min(0, 𝑅𝑝𝑡 − 𝑇) = downside deviation,
Sortino ratio (SR) 1 𝑁 2 𝑁 𝑡=1
∑
𝑁 𝑡=1 min(0, 𝑅𝑝𝑡 − 𝑇) as measured by the standard deviation of negative
returns

𝐸(𝑅𝑃 − 𝑅𝐵 ) 𝑅𝑃 = return on the portfolio

Information ratio (IR) 𝐼𝑅 =
√𝑉𝑎𝑟(𝑅𝑃 − 𝑅𝐵 ) 𝑅𝐵𝑒𝑛𝑐ℎ𝑚𝑎𝑟𝑘 = return on the benchmark portfolio

𝑅𝑖 = rate of return on security 𝑖

𝐼1 − 𝐸(𝐼1 ) = difference between observed and
The Arbitrage expected values in factor k
Pricing Theory 𝑅𝑖 = 𝐸(𝑅𝑖 ) + 𝛽𝑖1 [𝐼1 − 𝐸(𝐼1 )] + ⋯ + 𝛽𝑖𝐾 [𝐼𝑘 − 𝐸(𝐼𝑘 )]
and Multifactor Return on a security + 𝑒𝑖 𝛽𝑖𝑘 = coefficient measuring the effect of changes
Models of Risk in a factor 𝐼𝑘
and Return
on the rate of return of security 𝑖
𝑒𝑖 =noise factor (i.e., the idiosyncratic factor).

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Variance/Covariance
𝑀2 − 𝑀
for a factor model with 𝑀+ 𝑀 = number of factors in the model
𝑀
M factors

Number of covariances 𝑛2 − 𝑛
𝑛 = number of variances
required 2

𝐸(𝑅𝑖 ) = expected return on stock 𝑖

𝑅𝑓 = risk-free interest rate
𝑆𝑀𝐵 = size factor

The Fama-French 𝐸(𝑅𝑖 ) = 𝑅𝑓 + 𝛽𝑖,𝑀𝐾𝑇 𝐸(𝑅𝑚 − 𝑅𝑓 ) + 𝛽𝑖,𝑆𝑀𝐵 𝐸(𝑆𝑀𝐵) 𝛽𝑖,𝑆𝑀𝐵 = factor-beta for the size factor
Model (FFM) + 𝛽𝑖,𝐻𝑀𝐿 𝐸(𝐻𝑀𝐿)
𝐻𝑀𝐿 = value factor
𝛽𝑖,𝐻𝑀𝐿 = factor-beta for the value factor
𝐸(𝑅𝑚 − 𝑅𝑓 ) = CAPM market factor
𝛽𝑖,𝑀𝐾𝑇 = factor-beta for the market-factor

Mutually exclusive 𝑃(𝐴 ∩ 𝐵) = 𝑃(𝐴 𝑎𝑛𝑑 𝐵) = 0 𝑃(𝐴 ∩ 𝐵) = probability A intersection B

events 𝑃(𝐴 ∪ 𝐵) = 𝑃(𝐴 𝑜𝑟 𝐵) = 𝑃(𝐴) + 𝑃(𝐵) 𝑃(𝐴 ∪ 𝐵) = probability A union B

Book 2 Fundamentals 𝑃(𝐴 ∩ 𝐵) 𝑃(𝐴│𝐵) = probability of A given B

of Probability Conditional probability 𝑃(𝐴│𝐵) =
Quantitative 𝑃(𝐵) 𝑃(𝐴 ∩ 𝐵) = P(A|B)P(B)
Analysis
𝑃(𝐴 ∪ 𝐵) = 𝑃(𝐴 𝑜𝑟 𝐵) = 𝑃(𝐴) + 𝑃(𝐵) − 𝑃(𝐴 ∩ 𝐵)
Independent events
𝑃(𝐴 ∩ 𝐵) = 𝑃(𝐴 𝑎𝑛𝑑 𝐵) = 𝑃(𝐴) × 𝑃(𝐵)

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Conditional 𝑃(𝐴)𝑃(𝐵)
𝑃(𝐴|𝐵) = = 𝑃(𝐴)
Probability 𝑃(𝐵)

𝑃(𝐵|𝐴)𝑃(𝐴)
Bayes’ Theorem 𝑃(𝐴|𝐵) =
𝑃(𝐵)

𝑛!
𝑃(𝑋 = 𝑥) = 𝑝 𝑥 (1 − 𝑝)𝑛−𝑥 , 𝑥 = 0,1,2, … , 𝑛 𝑃(𝑋 = 𝑥) = probability mass function of X
𝑥! (𝑛 − 𝑥)!

Binomial distribution |𝑥|

𝑛
𝐹𝑋 (𝑥) = ∑ ( ) 𝑝𝑖 (1 − 𝑝)𝑛−𝑖 𝐹𝑋 (𝑥) = cumulative distribution function of X
𝑖
𝑖=1

𝐸(𝑋) = 𝑛𝑝 𝐸(𝑋) = expectation of X

Univariate
Random 𝑉(𝑋) = 𝑛𝑝(1 − 𝑝) 𝑉(𝑋) = variance of X
Variables

𝑃(𝑋 = 𝑥) = 𝑝 𝑥 (1 − 𝑝)1−𝑥 , 𝑥 = 0,1 ; 0 < 𝑝 < 1 𝑃(𝑋 = 𝑥) = probability mass function

0, 𝑦<0
Bernoulli distribution 𝐹𝑋 (𝑥) = {1 − 𝑝, 0 ≤ 𝑦 < 1 𝐹𝑋 (𝑥) = cumulative distribution function
1, 𝑦≥1

𝐸(𝑋) = 𝑝 𝐸(𝑋) = expectation of X

𝑉(𝑋) = 𝑝(1 − 𝑝) 𝑉(𝑋) = variance of X

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1
𝑃(𝑋 = 𝑥) = , 𝑥 = 1,2, … , 𝑛 𝑃(𝑋 = 𝑥) = probability mass function
𝑛

𝑛+1
Uniform distribution 𝐸(𝑋) = 𝐸(𝑋) = expectation of X
2

𝑛2 − 1
𝑉(𝑋) = 𝑉(𝑋) = variance of X
12

𝜆𝑥 𝑒 −𝜆
𝑃(𝑋 = 𝑥) = , 𝑥 = 0,1,2, … ; 𝜆 > 0 𝑃(𝑋 = 𝑥) = probability mass function
𝑥!

|𝑥|
Poisson distribution 𝜆𝑖
𝐹𝑋 (𝑥) = 𝑒 −𝜆
∑ 𝐹𝑋 (𝑥) = cumulative distribution function of X
𝑖!
𝑖=1

𝐸(𝑋) = 𝑉(𝑋) = 𝜆 𝐸(𝑋) = expectation of X

1
𝑓𝑋 (𝑥) = ,𝑎 ≤ 𝑋 ≤ 𝑏 𝑓(𝑥) = probability density function of X
𝑏−𝑎
0, 𝑥<𝑎
𝑥−𝑎
𝐹𝑋 (𝑥) = { ,𝑎 ≤ 𝑥 ≤ 𝑏 𝐹𝑋 (𝑥) = cumulative distribution function
𝑏−𝑎
Continuous uniform 1, 𝑥≥𝑏
distribution
𝑎+𝑏
𝐸[𝑋] = 𝐸(𝑋) = Expectation of X
2

(𝑏 − 𝑎)2
𝑉[𝑋] = 𝑉(𝑋) = Variance of X
12

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1 1 𝑥−𝜇 2
− ( )
𝑓(𝑥) = 𝑒 2 𝜎 , −∞ <𝑋<∞ 𝑓(𝑥) = probability density function of x
𝜎√2𝜋

Normal distribution 𝐸(𝑋) = 𝜇 𝐸(𝑋) = expectation of X

𝑉(𝑋) = 𝜎 2 𝑉(𝑋) = variance of X

1 1 𝑙𝑛𝑥−𝜇 2
− ( )
𝑓(𝑥) = 𝑒 2 𝜎 𝑓(𝑥) = probability density function of x
𝑥𝜎√2𝜋

2 2
𝑉(𝑋) = (𝑒 𝜎 − 1)𝑒 2𝜇+𝜎
Log-normal distribution 1
𝐸[𝑋] = 𝑒 𝜇+2𝜎2

𝑙𝑛𝑋 − 𝜇
𝐹𝑋 (𝑥) = Φ ( )
𝜎
∞
1 𝑘 𝑥
𝑓(𝑥) = 𝑥 2 −1 𝑒 −2 , 𝑥>0 𝛤(𝑛) = ∫ 𝑥 𝑛−1 𝑒 −𝑥 𝑑𝑥
𝑘
𝑘 0
22 𝛤 ( )
2
Chi-square distribution 𝑘
𝐸(𝑆) = 𝑘
𝑆 = ∑ 𝑍𝑖2
1=1
𝑉(𝑆) = 2𝑘

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𝑍
𝑋=
1 √𝑈
𝑘+1
−
𝛤 (𝑘 + 2) 𝑥2 2 𝑘
𝑓(𝑥) = (1 + )
𝑘 𝑘 𝑍 = standard normal variable,
√𝑘𝜋 𝛤 (2)
Student’s t-distribution 𝑈 = a chi-square variable with k degrees of
freedom
𝐸(𝑋) = 0
𝑘
𝑉(𝑋) =
𝑘−2
𝑈1
(𝑘1 𝑋)𝑘1 𝑘2𝑘2 ⁄𝑘
√ 𝑋= 1
∼ 𝐹(𝑘1 , 𝑘2 )
(𝑘1 𝑋 + 𝑘2 )𝑘1 +𝑘2 𝑈2
F-distribution 𝑓(𝑥) = ⁄𝑘
2
𝑘 𝑘
𝑥𝐵( 21 , 22 ) 𝑈𝑖 = chi-squared distributions that are
independent with 𝑘𝑖 degrees of freedom.
1
𝑓(𝑥) = 𝑥 𝑎−1 (1 − 𝑥)𝑏−1 , 0≤𝑥≤1
𝐵(𝑎, 𝑏)

𝑎 Γ(𝑎)Γ(𝑏)
Beta distribution 𝐸(𝑋) = 𝐵(𝑎, 𝑏) =
𝑎+𝑏 Γ(𝑎 + 𝑏)
𝑎𝑏
𝑉(𝑋) =
(𝑎 + 𝑏)2(𝑎 + 𝑏 + 1)

1 −𝛽𝑥
𝑓𝑋 (𝑥) = 𝑒 ,𝑥 ≥ 0
𝛽
Exponential distribution 𝑥
−
𝐹𝑋 (𝑥) = 1 − 𝑒 𝛽

𝐸(𝑋) = 𝛽
𝑉(𝑋) = 𝛽 2
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𝑛! 𝑥 𝑥
PMF of a trinomial 𝑓𝑋 1 ,𝑋2 (𝑥1 , 𝑥2 ) = 𝑃 1 𝑃 2 (1 − 𝑃1
𝑥1 ! 𝑥2 ! (𝑛 − 𝑥1 − 𝑥2 )! 1 2
random variable
− 𝑃2 )𝑛−𝑥1 −𝑥2

𝐹𝑋 1 ,𝑋2 (𝑥1 , 𝑥2 ) = ∑ ∑ 𝑓(𝑋 ,𝑋2 ) (𝑡1 , 𝑡2 )

1
CDF of a bivariate 𝑡1 𝜖𝑅(𝑋1 ) 𝑡2 𝜖𝑅(𝑋2 )
random variable t1 ≤x1 t2 ≤x2

𝑓𝑋1 (𝑥1 ) = ∑ 𝑓𝑋 1 ,𝑋2 (𝑥1 , 𝑥2 ) 𝑓𝑋1 (𝑥1 ) = marginal distribution of 𝑋1

𝑥2 𝜖𝑅(𝑥2 )

Marginal distribution
𝑓𝑋2 (𝑥2 ) = ∑ 𝑓𝑋 1 ,𝑋2 (𝑥1 , 𝑥2 ) 𝑓𝑋2 (𝑥2 ) = marginal distribution of 𝑋2
𝑥1 𝜖𝑅(𝑋1 )
Multivariate
Random
Variables
𝑓𝑋 1 (𝑥1 )𝑓𝑋2 (𝑥2 ) 𝑋1 and 𝑋2 are independent
Conditional distribution 𝑓𝑋 1 │𝑋2 (𝑥1 │𝑋2 = 𝑥2 ) =
𝑓𝑋2 (𝑥2 ) 𝑓𝑋 1 ,𝑋2 (𝑥1 , 𝑥2 ) = 𝑓𝑋 1 (𝑥1 )𝑓𝑋2 (𝑥2 )

Expectation of 𝐸(𝑔(𝑋1 , 𝑋2 ) = ∑ ∑ 𝑔(𝑥1 , 𝑥2 ) 𝑓𝑋 1 ,𝑋2 (𝑥1 , 𝑥2 )

𝑥1 𝜖𝑅(𝑋1 ) 𝑥2 𝜖𝑅(𝑋2 )
(𝑔(𝑋1 , 𝑋2 )

1st moment: 𝐸(𝑋) = [𝐸(𝑋1 ), 𝐸(𝑋2 )] = [𝜇1 , 𝜇2 ]

Moments 2nd moment: 𝑉𝑎𝑟(𝑋1 + 𝑋2 ) = 𝑉𝑎𝑟(𝑋1 ) + 𝑉𝑎𝑟(𝑋2 ) + 𝐶𝑂𝑉(𝑋1 , 𝑋2 ) = 𝐸[𝑋1 𝑋2 ] − 𝐸[𝑋1 ]𝐸[𝑋2 ]
2𝐶0𝑣(𝑋1 , 𝑋2 )

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𝐶𝑜𝑟𝑟(𝑋1 , 𝑋2 ) = correlation coefficient between
𝑋1 and 𝑋2
𝐶𝑜𝑣(𝑋1 , 𝑋2 ) 𝜎12
Correlation 𝐶𝑜𝑟𝑟(𝑋1 , 𝑋2 ) = 𝜌𝑋1 𝑋2 = = 𝑉𝑎𝑟(𝑋1 ) = 𝜎12
√𝜎12 √𝜎22 𝜎1 𝜎2
𝑉𝑎𝑟(𝑋2 ) = 𝜎22
𝐶𝑜𝑣(𝑋1 , 𝑋2 ) = 𝜎12

𝑉𝑎𝑟(𝑋1 + 𝑋2 ) = 𝑉𝑎𝑟(𝑋1 ) + 𝑉𝑎𝑟(𝑋2 ) + 2𝐶𝑜𝑣(𝑋1 , 𝑋2 )

The variance of a sum
of two random variables 𝑉𝑎𝑟(𝑎𝑋1 + 𝑏𝑋2 )
= 𝑎2 𝑉𝑎𝑟(𝑋1 ) + 𝑏 2 𝑉𝑎𝑟(𝑋2 ) 𝑎 and 𝑏 are constants
+ 2𝑎𝑏𝐶𝑜𝑣(𝑋1 , 𝑋2 )

The variance of a sum

of two random variables
𝑉𝑎𝑟(𝑋1 + 𝑋2 ) = 𝑉𝑎𝑟(𝑋1 ) + 𝑉𝑎𝑟(𝑋2 )
if 𝑋1 and 𝑋2 are
independent

Conditional 𝐸(𝑋1 |𝑋2 = 𝑥2 )= ∑ 𝑥1𝑖 𝑓(𝑋1 │𝑋2 = 𝑥2 ) 𝐸(𝑋1 |𝑋2 = 𝑥2 ) = conditional expectation of 𝑋1
expectations 𝑖
given 𝑋2 = 𝑥2

𝑉𝑎𝑟(𝑋1 |𝑋2 = 𝑥2 ) = 𝐸(𝑋12 |𝑋2 = 𝑥2 ) − [𝐸(𝑋1 |𝑋2 = 𝑥2 )]2 𝑉𝑎𝑟(𝑋1 |𝑋2 = 𝑥2 ) = conditional variance of 𝑋1
Conditional variance
given 𝑋2 = 𝑥2

𝑃(𝑎 < 𝑋1 < 𝑏, 𝑐 < 𝑋2 < 𝑑)

𝑏 𝑑
The joint pdf = ∫ ∫ 𝑓𝑋 1 ,𝑋2 (𝑥1 , 𝑥2 )𝑑𝑥1 𝑑𝑥2
𝑎 𝑐

𝑓𝑜𝑟 𝑓𝑋 1 ,𝑋2 (𝑥1 , 𝑥2 ) ≥ 0

𝑛 𝑛 𝑛
Mean of (iid) random
𝐸 (∑ 𝑋𝑖 ) = ∑ 𝐸(𝑋𝑖 ) = ∑ 𝜇 = 𝑛𝜇 𝐸(𝑋𝑖 ) = 𝜇
variable
𝑖 𝑖 𝑖

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𝑛 𝑛 𝑛 𝑛 𝑛
Variance of (iid)
𝑉𝑎𝑟 (∑ 𝑋𝑖 ) = ∑ 𝜎 2 + 2 ∑ ∑ 0 = ∑ 𝜎 2 = 𝑛𝜎 2 𝑋𝑖𝑖𝑖𝑑 ∼ N(μ, σ2)
random variable
𝑖 𝑖 𝑗=1 𝑘=𝑗+1 𝑖
𝑛
1 𝑋̅ = sample mean
Population mean 𝜇 = 𝑋̅ = ∑ 𝑋𝑖
𝑛 𝜇 = the population mean
𝑖=1
𝑛 𝑛
1 1
𝐸(𝜇̂ ) = 𝐸(𝑋̅ ) = 𝐸 [ ∑ 𝑋𝑖 ] = ∑ 𝐸(𝑋𝑖 )
𝑛 𝑛 𝜇 = population mean.
Expectation of the mean 𝑖=1 𝑖=1
𝑛
estimator, 𝜇̂ 1 1 𝑛 = sample size
= ∑ 𝜇 = × 𝑛𝜇 = 𝜇
𝑛 𝑛
𝑖=1
𝑛 𝑛
1 1
𝑉𝑎𝑟(𝜇̂ ) = 𝑉𝑎𝑟 ( ∑ 𝑋𝑖 ) = 2 [∑ 𝑉𝑎𝑟(𝑋𝑖 )]
Variance of the mean 𝑛 𝑛
𝑖=1 𝑖=1
𝑛
estimator, 𝜇̂ 1 1 𝜎2
2 2
= [∑ 𝜎 ] = × 𝑛𝜎 =
Sample 𝑛2 𝑛2 𝑛
𝑖=1
Moments
𝑛
Sample estimator of 1
𝜎̂ = ∑(𝑋𝑖 − 𝜇̂ )2
2
variance, 𝜎̂ 2 𝑛
𝑖=1
𝑛
2
𝑛 𝑛 1
𝑠 = 𝜎2 = × ∑(𝑋𝑖 − 𝜇̂ )2 𝜎 2 = sample variance
𝑛−1 𝑛−1 𝑛
The unbiased estimator 𝑖=1
𝑛 𝑠 2 = unbiased estimator of variance
of variance 1
= ∑(𝑋𝑖 − 𝜇̂ )2 𝑛 = sample size
𝑛−1
𝑖=1

𝜇̂ − 𝜇 𝜇 = population mean.
𝜎 → 𝑁(0,1)
The central limit
𝜇̂ = population mean estimator
theorem (CLT)
√𝑛 𝜎 = the population standard deviation

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Test statistic
The test statistic (Sample statistic − Hypothesized value)
=
Standard error of the sample statistic

𝐶𝛼 = critical value at α test size.

Confidence Interval 𝜎̂ 𝜎̂
with two-sided test [𝜇̂ − 𝐶𝛼 × , 𝜇̂ + 𝐶𝛼 × ] 𝑛 = sample size
alternatives √𝑛 √𝑛
Hypothesis 𝜇̂ = sample mean
Testing
𝐶𝛼 = critical value at α test size.
𝜎̂
Lower alternative: (−∞, 𝜇̂ − 𝐶𝛼 × ) 𝑛 = sample size
√𝑛
The confidence interval 𝜇̂ = sample mean
for one-sided alternative
𝜎̂
Upper alternative: (𝜇̂ + 𝐶𝛼 × , ∞)
√𝑛

𝛽0 = the constant intercept

The linear regression 𝛽 = the slope

𝑌 = 𝛽0 + 𝛽𝑋 +ϵ
model ϵ = an error
Linear
Regression
The residual sum of squares is: 𝛽̂0 = 𝑌̅ − 𝛽̂ 𝑋̅
The ordinary least 𝑛 𝑛
∑𝑛𝑖=1(𝑥𝑖 − 𝑋̅)2 (𝑦𝑖 − 𝑌̅)2
squares (OLS) ̂0 − 𝛽̂ 𝑥𝑖 )2 = ∑ 𝜖̂𝑖2
∑(𝑦𝑖 − 𝛽 𝛽̂ =
∑𝑛𝑖=1(𝑥𝑖 − 𝑋̅)2
𝑖=1 𝑖=1

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1 𝑛
∑𝑖=1(𝑥𝑖 − 𝑋̅)2 (𝑦𝑖 − 𝑌̅)2 𝐶𝑜𝑣(𝑋, 𝑌)
̂
𝛽= 𝑛 =
1 𝑛 𝑉𝑎𝑟(𝑋)
∑𝑖=1(𝑥𝑖 − 𝑋̅)2
𝑛
𝜎̂𝑋𝑌 𝜌̂𝑋𝑌 𝜎̂𝑋 𝜎̂𝑌 ρ̂XY σ
̂Y
= 2 = 2 =
𝜎̂𝑋 𝜎̂𝑋 ̂X
σ

Multiple regression 𝑌𝑖 = 𝛽0 + 𝛽1 𝑋1𝑖 + 𝛽2 𝑋2𝑖 + ⋯ + 𝛽𝑘 𝑋𝑘𝑖 +ϵi , ∀ i

= 1,2, … , n 𝛽𝑖 ′𝑠 = coefficients of the the regression model
model

𝑅 2 = coefficient of variation
Measures of goodness 𝑟 = correlation coefficient between X and Y
𝑅2 = 𝑟2
of fit 𝐶𝑜𝑣(𝑋, 𝑌)
𝑟=
𝜎𝑋 𝜎𝑌

Regression with
Multiple Method for regression 𝑛 𝑛 𝑛 ∑𝑛𝑖=1(𝑌𝑖 − 𝑌̂) =2 explained sum of squares (ESS)
Explanatory with one or more than 2 2 2
∑(𝑌𝑖 − 𝑌̅)2 = ∑(𝑌̂𝑖 − 𝑌̅) + ∑(𝑌𝑖 − 𝑌̂) ∑𝑛𝑖=1(𝑌̂𝑖 − 𝑌̅) = residual sum of squares (RSS)
Variables one independent
𝑖=1 𝑖=1 𝑖=1
variables ∑𝑛𝑖=1(𝑌𝑖 − 𝑌̅)2 = total sum of squares (TSS)

𝑅𝑆𝑆 = residual sum of squares

Coefficient of 𝐸𝑥𝑝𝑙𝑎𝑖𝑛𝑒𝑑 𝑣𝑎𝑟𝑖𝑎𝑡𝑖𝑜𝑛 𝐸𝑆𝑆 𝑅𝑆𝑆
determination 𝑅2 = = =1− 𝐸𝑆𝑆 = explained sum of squares
𝑇𝑜𝑡𝑎𝑙 𝑣𝑎𝑟𝑖𝑎𝑡𝑖𝑜𝑛 𝑇𝑆𝑆 𝑇𝑆𝑆
𝑇𝑆𝑆 = total sum of squares

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𝑅𝑆𝑆 = residual sum of squares

𝑅𝑆𝑆 𝐸𝑆𝑆 = explained sum of squares

( )
Adjusted 𝑅 2 𝑅̅ 2 = 1 − 𝑛 − 𝑘 − 1 = 1 − ( 𝑛 − 1 ) (1 − 𝑅 2 ) 𝑇𝑆𝑆 = total sum of squares
𝑇𝑆𝑆 𝑛−𝑘−1
(
𝑛 − 1) 𝑛 = the number of observations
𝑘 = the number of independent variables.

𝐸𝑆𝑆
( ) 𝑛 = number of observations
𝐹= 𝑘
F-statistics 𝑆𝑆𝑅
( ) 𝑘 = number of independent variables.
𝑛 − (𝑘 + 1)

Regression
Diagnostics Cariance inflation factor 1 𝑅𝑗2 comes from a regression of Xj on the other
𝑉𝐼𝐹𝑗 =
for the variable 𝑋𝑗 1 − 𝑅𝑗2 variables in the model

−𝑗
𝑌̅𝑖 = fitted value of 𝑌̅𝑖 when the observed value
−𝑗 2
∑𝑛𝑖=1 (𝑌̅𝑖 − 𝑌̂𝑖 ) j is excluded
Cook's distance 𝐷𝑗 = 𝑘 = number of coefficients in the regression
𝑘𝑠 2
model
𝑠 2 = estimated error variance

𝑡 =time
𝛾𝑡,𝜏 = 𝐸[(𝑌𝑡 − 𝐸(𝑌𝑡 ))(𝑌𝑡−𝜏 − 𝐸(𝑌𝑡−𝜏 ))]
Autocovariance function 𝑟 = lag
Stationary 𝛾𝑡,𝜏 = autocovariance
Time Series
Autocorrelation 𝐶𝑜𝑣(𝑌𝑡 , 𝑌𝑡−𝜏 ) 𝛾𝜏 𝛾𝜏
𝜌(𝑡) = = =
Function (ACF) √𝑉(𝑌𝑡 ) √𝑉(𝑌𝑡−𝜏 ) √𝛾0 𝛾0 𝛾0

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𝛽 = AR parameter
𝛼 = the intercept
𝑌𝑡 = 𝛼 + 𝛽𝑌𝑡−1 + 𝜖𝑡 𝜖𝑡 = the shock.

𝛼
The 1st order 𝐸(𝑌𝑡 ) = 𝜇 = 𝐸(𝑌𝑡 ) = expectation of 𝑌𝑡
Autoregressive 1−𝛽

(AR 1) Model 𝜎2
𝑉(𝑌𝑡 ) = 𝛾0 = 𝑉(𝑌𝑡 ) = variance of 𝑌𝑡
1 − 𝛽2

𝛾𝜏 = autocovariance function under the AR1

𝛾𝜏 = 𝛽 |𝜏| 𝛾0
model

𝛽 𝜏 𝛾0 𝜌(𝜏) = autocorrelation function under the AR1

𝜌(𝜏) = = 𝛽 |𝜏|
𝛾0 model
𝐿 = lag operator
The Lag Operator 𝐿𝑌𝑡 = 𝑌𝑡−1 𝑌𝑡 = time index at time 𝑡
𝑌𝑡−1 = time index at time 𝑡 − 1
The pth order 𝑌𝑡 = time index at time 𝑡
autoregressive model 𝑌𝑡 = 𝛼 + 𝛽1 𝑌𝑡−1 + 𝛽2 𝑌𝑡−1 + ⋯ + 𝛽𝑝 𝑌𝑡−𝑝 + 𝜖𝑡
(AR(p)) 𝑌𝑡−𝑖 = time index at time 𝑡 − 𝑖, i=1, 2,.,p

Measuring 𝑅𝑡 = return at time t

return, The Simple Returns 𝑃𝑡 − 𝑃𝑡−1
𝑅𝑡 = 𝑃𝑡 = price of an asset at time t
volatility, and Method 𝑃𝑡−1
correlation 𝑃𝑡−1 = price of an asset at time 𝑡 − 1

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𝑇
Return over multiple 𝑅𝑇 = return over multiple periods
𝑅𝑇 = (∏(1 + 𝑅𝑡 )) − 1
periods 𝑅𝑡 = return at time t
𝑡=𝑖

𝑟𝑡 = continuously compounded return at time t

Continuously
compounded returns 𝑟𝑡 = ln 𝑃𝑡 − ln 𝑃𝑡−1 𝑃𝑡 = price of an asset at time t
method
𝑃𝑡−1 = price of an asset at time 𝑡 − 1

𝐽𝐵~𝜒22
2
𝑆̂ 2 (𝑘̂ − 3) 𝑇 = sample size
Jarque-Bera test 𝐽𝐵 = (𝑇 − 1) ( + )
6 24 𝑆 = skewness
𝑘 = kurtosis

𝑀 = market value of assets at the close of the day

Fund 𝑀−𝐿
Net asset value, NAV 𝑁𝐴𝑉 = 𝐿 = liabilities
Management 𝑁
Book 3 𝑁 = number of outstanding shares
Financial
Markets and 𝜌𝑆𝐹 = correlation between spot prices and the
Products futures prices
The optimal hedge 𝜎𝑆
Using Futures 𝐻𝑅 = 𝜌𝑆𝐹 ×
ratio/minimum variance
for Hedging 𝜎𝐹 𝜎𝑆 = standard deviation of the spot price
ratio
𝜎𝐹 = tandard deviation of the futures price

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𝑝𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜 𝑣𝑎𝑙𝑢𝑒
The optimal number of 𝑁 = 𝛽𝑝𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜 × [ ]
𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑓𝑢𝑡𝑢𝑟𝑒𝑠 𝑐𝑜𝑛𝑡𝑟𝑎𝑐𝑡
futures contracts needed
to hedge an exposure 𝑝𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜 𝑣𝑎𝑙𝑢𝑒
= 𝛽𝑝𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜 × [ ]
𝑓𝑢𝑡𝑢𝑟𝑒𝑠 𝑝𝑟𝑖𝑐𝑒 × 𝑐𝑜𝑛𝑡𝑟𝑎𝑐𝑡 𝑚𝑢𝑙𝑡𝑖𝑝𝑙𝑖𝑒𝑟

𝛽 = portfolio beta
Adjusting a stock 𝑃
𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑐𝑜𝑛𝑡𝑟𝑎𝑐𝑡𝑠 𝑟𝑒𝑞𝑢𝑖𝑟𝑒𝑑 = (𝛽 ∗ − 𝛽)( ) 𝛽 ∗ = target beta after hedging
portfolio’s beta using 𝐴
stock index futures P = portfolio value
𝐴 = value of the underlying

𝐹 = 𝑆(1 + 𝑅)𝑇 𝑆 = spot price

𝐹 = forward price
The known income case 𝐹 = (𝑆 − 𝐼)(1 + 𝑅)𝑇 𝑅 = risk-free interest rate per year compounded
Pricing annually
Financial 𝑄 = Yield
Forward price
Forwards and
Futures 𝑇 = time to maturity
1+𝑅 𝑇
The known yield case 𝐹 = 𝑆{ } I = income
1+𝑄
{𝐹(1 + 𝑄)𝑇 }
𝑆=
(1 + 𝑅)𝑇

Value of a long forward 𝐹−𝐾

Value of a long forward contract = (1+𝑅)𝑇
contract
Valuing
Forward 𝐹 = 𝑆(1 + 𝑅)𝑇
Contracts Value of a long forward
𝐾
contract; known income Value of a long forward contract = 𝑆 − 𝐼 − {(1+𝑅)𝑇 }
case

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Value of a short forward 𝐾−𝐹

Value of a short forward contract = (1+𝑅)𝑇
contract

Value of a short forward

𝑆 𝐾
contract; known yield Value of a short forward contract= {(1+𝑄)𝑇 } − {(1+𝑅)𝑇 }
case

𝑌 = convenience yield,
𝑇 = time to maturity

1 𝐹 = forward price
Convenience yield, Y 𝑆+𝑈 𝑇
𝑌=( ) (1 + 𝑅) − 1 𝑅 = interest rate
𝐹
1+𝑅 𝑇
𝐹 = (𝑆 + 𝑈) × ( )
1+𝑌
𝑈 = present value of storage cost

𝐹 = forward price
Commodity 1+𝑅
Cost of carry, 𝐶 = 1+𝑄 − 1 ≈ 𝑅 − 𝑄 𝑅 = risk-free interest rate per year compounded
Cost of carry, C
Forwards and annually
Futures
Q = yield

𝑆 = present value of an asset

𝐹 = future value of an asset
𝐹 = 𝑆𝑒 (𝑅−𝑄)𝑇
Future value of an asset 𝑅 = risk-free interest rate per year compounded
annually
𝑄 = yield

Future value of an asset, C = cost of carry

in case of storage costs 𝐹 = 𝑆𝑒 (𝐶−𝑌)𝑇
Y = convenience yield

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non-dividend paying
stocks 𝑐 ≥ max(S0 − Ke−rT , 0) 𝐾 = strike price
Lower pricing bound for
European calls on: 𝑆0 = value of the stock today.
dividend-paying stocks 𝑆𝑇 = Price of the stock at time T
𝑐 ≥ S0 − Ke−rT − 𝐷𝑒 −𝑟𝑇 𝑐 = value of a European call option
𝐶 = value of an American call option
Lower pricing bound for 𝑝 = value of a European put option
European puts on non- 𝑝 ≥ max(Ke−rT − 𝑆0 , 0) 𝑃 = value of an American put option
dividend paying stocks
Properties of
Options

Put-call parity 𝑐 + 𝐾𝑒 −𝑟𝑇 = 𝑝 + 𝑆0

Option Minimum value Maximum value

𝐶
American ≥ max(0, S0
Lower bounds for S0
call − Ke−rT )
American options
𝑃
American put ≥ max(0, K − 𝑆0 ) K

𝑛 = time in years
𝑚×𝑛
𝑅
Future value 𝐹𝑉 = 𝐴 (1 + ) 𝑚 = compounding frequency per year
𝑚
Properties of 𝑅 = interest rate compounded m times per year
Interest Rates
Future value for 𝐹𝑉 = future value
continuous 𝐹𝑉 = 𝐴𝑒 𝑅×𝑛
compounding, 𝑅 = continuously compounded rate of interest

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Relationship between 𝑓𝑡,𝑟 = forward rate between time t and t + r

(1 + 𝑦𝑡+𝑟 )𝑡+𝑟
forward rates and spot 1 + 𝑓𝑡,𝑟 = 𝑦𝑡+𝑟 = spot rate at time t+r
rates (1 + 𝑦𝑡 )𝑡
𝑦𝑡 =spot rate at time t

Macaulay Duration for a 𝑛 𝑐𝑖 𝑒 −𝑦𝑡𝑖 𝑡𝑖 = time in years until cash flow 𝑐𝑖 is received
𝐷𝑢𝑟𝑎𝑡𝑖𝑜𝑛 = ∑ 𝑡𝑖 [ ]
zero-coupon bond 𝑖=1 𝑃 𝑦 = continuously compounded yield on a bond 𝑃

𝑀𝑎𝑐𝑎𝑢𝑙𝑎𝑦 𝑑𝑢𝑟𝑎𝑡𝑖𝑜𝑛
Modified duration 𝑀𝑜𝑑𝑖𝑓𝑖𝑒𝑑 𝑑𝑢𝑟𝑎𝑡𝑖𝑜𝑛 = 𝐷 ∗ = 𝑦
(1 + 𝑛)

𝑃0 = bond’s market price

Dollar duration 𝐷𝐷 = 𝐷 ∗ × 𝑃0
DD = dollar duration
DV01 𝐷𝑉01 = 𝐷𝐷 × Δ𝑦 = (𝐷 ∗ × 𝑝0 ) × 0.0001
𝐵𝑉−𝛥𝑦 = price estimate if yield decreases by a
given amount, Δy
𝐵𝑉−Δ𝑦 − 𝐵𝑉+Δ𝑦 𝐵𝑉+𝛥𝑦 = price estimate if yield increases by a
Effective duration 𝐸𝑓𝑓𝑒𝑐𝑡𝑖𝑣𝑒 𝑑𝑢𝑟𝑎𝑡𝑖𝑜𝑛 =
2 × 𝐵𝑉0 × Δ𝑦 given amount, Δy
𝐵𝑉0= initially observed bond price
Δy = change in yield expressed in decimal form
Change in price = Duration effect + Convexity effect
Change in price = [−Duration × 𝑝𝑟𝑖𝑐𝑒 ×𝛥𝑦] + [1/2 × Convexity
× price × (𝛥𝑦)^2 ]

Corporate Original issue discount(OID)

Zero-coupon bonds = Face value − Offering price
Bonds

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Bond expected return
The expected return = risk free rate + credit spread
from a bond − expected loss rate

𝑃𝑟𝑖𝑛𝑐𝑖𝑝𝑎𝑙 PMT = amount of each payment

Amount of each 𝑃𝑀𝑇 =
1 − (1 + 𝑟)−𝑛 𝑟 = monthly interest rate
payment ( )
𝑟 𝑛 = total number of months
Mortgages and Weighted average 𝑊𝐴𝐶 = ∑(Percentage value of each mortgage
Mortgage- coupon (WAC) × Respective interest rates)
backed
Securities
Percentage value of each mortgage
The percentage value of Value of each mortgage
each mortgage =
Total value of the portfolio

𝑇1 𝑅𝑖 = spot rate corresponding with the year 𝑇𝑖

Forward rate 𝑅𝑓𝑜𝑤𝑎𝑟𝑑 = 𝑅2 + (𝑅2 − 𝑅1 )
𝑇2 − 𝑇1 𝑅𝑓𝑜𝑤𝑎𝑟𝑑 = forward rate between 𝑇1 and 𝑇2

Swaps To the pay fixed, 𝑉𝑠𝑤𝑎𝑝 = value of the swap 𝑃𝑓𝑖𝑥 = PV of fixed-leg
receive floating 𝑉𝑠𝑤𝑎𝑝 = 𝑃𝑓𝑙𝑡 − 𝑃𝑓𝑖𝑥 payment
𝑃𝑓𝑙𝑡 =PV of the floating leg payment.
To the pay floating,
𝑉𝑠𝑤𝑎𝑝 = 𝑃𝑓𝑖𝑥 − 𝑃𝑓𝑙𝑡
receive fixed

Book 4 Measures of
Valuation and Financial Risk Volatility of the return,
𝜎𝑅 = √𝐸(𝑅 2 ) − [𝐸(𝑅)]2 𝜎𝑅 = Volatility of the return, R
Risk Models R

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𝜎1 = standard deviation of the first investment

The variance of the
portfolio expected
return
𝜎2 = standard deviation of the second investment
𝜎𝑃2 = 𝑤12 𝜎12 + 𝑤22 𝜎22 + 2𝜌𝑤1 𝑤2 𝜎1 𝜎2
𝜌 = correlation between investment the first and
the second investment

𝑈 = point in the standard normal distribution that

has a probability of 𝑋% of being exceeded
VaR for normally μP = portfolio mean
VaR = μP + 𝜎𝑃 𝑈
distributed loss
σP = portfolio standard deviation

𝑋 = confidence level

Expected Shortfall (ES) 𝑈2 𝑈 = point in the standard normal distribution that

𝑒− 2 has a probability of 𝑋% of being exceeded
for normally distributed 𝐸𝑆 = 𝜇𝑃 + 𝜎𝑃 ( )
loss (1 − 𝑋)√2𝜋
μP = portfolio mean
σP = portfolio standard deviation

VaR for linear 𝑝𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑐𝑎𝑙𝑙 𝑣𝑎𝑙𝑢𝑒

𝑉𝑎𝑅linear derivative = Δ × 𝑉𝑎𝑅𝑢𝑛𝑑𝑒𝑟𝑙𝑦𝑖𝑛𝑔 𝑓𝑎𝑐𝑡𝑜𝑟 Δ=
derivatives 𝑝𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑠𝑡𝑜𝑐𝑘 𝑝𝑟𝑖𝑐𝑒

Calculating and
Applying VaR

VaR using Historical 𝑉𝑎𝑅(𝑇, 𝑋) = value at risk for a time horizon of T

Simulation 𝑉𝑎𝑅(𝑇, 𝑋) = √𝑇 × 𝑉𝑎𝑅(1, 𝑋) days and confidence level X

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Expected Shortfall using 𝐸𝑆(𝑇, 𝑋) = expected shortfall for a time horizon

Historical Simulation 𝐸𝑆(𝑇, 𝑋) = √𝑇 × 𝐸𝑆(1, 𝑋) of T days and confidence level X

𝑟𝑖 = return on a day i
𝑆𝑖 −𝑆𝑖−1
𝑟𝑖 = 𝑆𝑖−1

𝑆𝑖 = value of an asset on a close of trading day, i

𝑚
Volatility of assets 1 𝑆𝑖−1 = value of an asset on a close of trading day,
returns in a day, n 𝜎𝑛 = √ ∑(𝑟𝑛−𝑖 − 𝑟̅ )2
𝑚−1 𝑖−1
𝑖=1
𝑟̅ = average return from the previous m
days defined as:
1
Measuring and 𝑟̅ = 𝑚 ∑𝑚
𝑖=1 𝑟𝑛−𝑖
Monitoring
Volatility

𝑚
Simplified formula for 1 𝜎𝑛 = current volatility
2
current volatility 𝜎𝑛 = √ ∑ 𝑟𝑛−𝑖
𝑚 2
𝑟𝑛−1 = squared return on day n-1
𝑖=1

𝜎𝑛2 = variance rate on day n

Estimating volatility by 𝜆 = a positive constant that is less than one
Exponentially Weighted 2 2
𝜎𝑛2 = 𝑤0 𝑟𝑛−1 + 𝜆𝜎𝑛−1 assets return 𝑤0 = weight applied to the most recent return
Moving Average
(EWMA model) (i.e., the return on day n-1)
𝑤0 = 1 − 𝜆

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The updated correlation
coefficient under
EWMA
GARCH 1,1 model
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FORMULA SHEET
2
𝑟𝑛−1 = squared return on day n-1
𝐶𝑜𝑟𝑟(𝑋𝑛 , 𝑌𝑛 ) = updated correlation coefficient
𝐶𝑜𝑣𝑛 = covariance for day n
𝐶𝑜𝑣𝑛 = 𝜆𝐶𝑜𝑣𝑛−1 + (1 − 𝜆)𝑋𝑛−1 𝑌𝑛−1
𝐶𝑜𝑣𝑛
𝐶𝑜𝑟𝑟(𝑋𝑛 , 𝑌𝑛 ) = 𝑋𝑛−1 = value of X at day n
𝜎𝑋𝑛 𝜎𝑌𝑛
𝑌𝑛−1 = value of Y at day n
𝜎𝑋𝑛 = standard deviation of X at day n
𝜎𝑌𝑛 = standard deviation of Y at day n
𝜎𝑛2 = variance rate on day n
𝛼 = weight given to the most recent squared
return.
𝛽 = weight given to the previous variance rate
estimate
2 2
𝜎𝑛2 = 𝑤 + 𝛼𝑟𝑛−1 + 𝛽𝜎𝑛−1 𝛾 = weight given to long-run average variance
rate
𝑤 = 𝛾𝑉𝐿
𝑉𝐿 = long-run variance rate
𝑤 𝑤
𝑉𝐿 = =
𝛾 1−𝛼−𝛽
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𝛼+𝛽+𝛾 =1

2
𝜎𝑛+𝑡 = expected variance rate on day, t
The expected variance 2
𝜎𝑛+𝑡 = 𝑉𝐿 + (𝛼 + 𝛽)𝑡 (𝜎𝑛2 − 𝑉𝐿 ) 𝜎𝑛2 = variance rate on day n
rate on day t
𝑉𝐿 = long-run variance

𝐿𝐺𝐷 = loss given default

(1-Recovery rate)
Expected loss 𝐸𝐿 = 𝑃𝐷 × 𝐿𝐺𝐷 × 𝐸𝐴𝐷
𝑃𝐷 = Probability of default
𝐸𝐴𝐷 = exposure at default

Portfolio expected loss 𝐸𝐿𝑃 = ∑𝐸𝐴𝑖 × 𝑃𝐷𝑖 × 𝐿𝐺𝐷𝑖 𝐸𝐿𝑃 = expected portfolio loss

𝑈𝐿 = unexpected loss
Measuring
Credit Risk Unexpected loss 2
𝑈𝐿 = 𝐸𝐴 × √𝑃𝐷 × 𝜎𝐿𝑅 2
+ 𝐿𝑅 2 × 𝜎𝑃𝐷 𝐿𝑅 = loss rate
2
𝜎𝑃𝐷 = 𝑃𝐷 × (1 − 𝑃𝐷)

Portfolio unexpected 2
𝑈𝐿𝑃 = 𝐸𝐴 × √𝑈𝐿2𝑖 × 𝑈𝐿2𝑖 + 2𝜌𝑈𝐿𝑖 𝑈𝐿𝑗 𝑈𝐿𝑖 = 𝐸𝐴 × √𝑃𝐷𝑖 × 𝜎𝐿𝑅 + 𝐿𝑅𝑖2 × 𝜎𝑃𝐷
2
loss 𝑖 𝑖

𝐿𝑖 = amount borrowed in the ith loan

The mean of credit
𝑝𝑖 × 𝐿𝑖 (1 − 𝑅𝑖 ) 𝑝𝑖 = probability of the default for the ith loan
losses
𝑅𝑖 = recovery rate in the event of the default by
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 FRM PART I
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the ith loan

𝜎𝑖 = standard deviation of loss on the ith and jth

The standard deviation loan
of credit losses 𝜎𝑖 = √(𝑝𝑖 − 𝑝𝑖2 )[𝐿𝑖 (1 − 𝑅𝑖 )]2
𝐿𝑖 (1 − 𝑅𝑖 ) = loss if the ith loan defaults

Credit risk portfolio

𝜎𝑃 = √𝑛𝜎 2 + 𝑛(𝑛 − 1)𝜌𝜎 2 𝜎𝑃 = portfolio standard deviation
standard deviation

𝑛 = number of loans
Standard deviation
expressed as the 𝜎𝑃 𝜎√1 + (𝑛 − 1)𝜌 𝐿𝑖 = amount borrowed in the ith loan
percentage of the size of 𝛼= =
𝑛𝐿 𝐿√𝑛 𝜌 = correlation between losses on the ith and jth
the portfolio
loan

𝐹 = common factor for all 𝑈𝑖 and 𝑍𝑖

𝑎𝑖 = parameter values that lie between -1 and +1
𝑈𝑖 = 𝑎𝑖 𝐹 + √1 − 𝑎𝑖2 𝑍𝑖 𝐹 ∼ 𝑁(0,1)

The Gaussian Copula 𝑍𝑖 ∼ 𝑁(0,1)

Model-One factor
model
𝐸(𝑈𝑖 ) = 𝐸(𝑈𝑗 ) = 0
𝐸(𝑈𝑖 𝑈𝑗 ) − 𝐸(𝑈𝑖 )𝐸(𝑈𝑗 )
𝜌𝑈𝑖 𝑈𝑗 = = 𝐸(𝑈𝑖 𝑈𝑗 ) = 𝑎𝑖 𝑎𝑗 𝜎𝑈𝑖 = 𝜎𝑈𝑗 = 1
𝜎𝑈𝑖 𝜎𝑈𝑗
𝑎𝑖 = parameter values that lie between -1 and +1

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A bank defaults if: 𝑁 −1 = inverse of the cumulative normal

𝑈𝑖 ≤ 𝑁 −1 (𝑃𝐷) distribution
𝑃𝐷 = probability of default

𝜌𝑈𝑖𝑈𝑗 = 𝑎𝑖 𝑎𝑗 = 𝑎. 𝑎 = 𝑎2 𝑎𝑖 = 𝑎

The Vasicek Model 𝐷𝑒𝑓𝑎𝑢𝑙𝑡 𝑅𝑎𝑡𝑒 𝑎𝑠 𝑎 𝐹𝑢𝑛𝑐𝑡𝑖𝑜𝑛 𝑜𝑓 𝐹

𝑁(𝑁 −1 (𝑃𝐷) − 𝑎𝐹)
=
√1 − 𝑎2

𝑊𝐶𝐷𝑅 = worst-case default rate

Capital requirement for banks under the IRB:
𝐿𝐺𝐷 = loss given the default
(𝑊𝐶𝐷𝑅 − 𝑃𝐷) × 𝐿𝐺𝐷 × 𝐸𝐴𝐷
𝐸𝐴𝐷 = total exposure at default

𝑎𝑠 Δ𝑋𝑖 → 0 Δ𝐹𝑖
𝑛 𝑄𝑖 = 𝑋𝑖
Δ𝑋𝑖
Euler’s Theorem 𝐹 = ∑ 𝑄𝑖
Δ𝑋𝑖 = small change in 𝑋𝑖
𝑖=1
Δ𝐹𝑖 = small change 𝐹𝑖

Basic indicator Gross income = Interest earned − Interest paid

approach + Noninterest income

Operational
Risk 𝑋 = all losses
Standardized
Measurement Approach = 𝑌 = losses greater than EUR 10 million
(SMA) 𝐿𝑜𝑠𝑠 𝑐𝑜𝑚𝑝𝑜𝑛𝑒𝑛𝑡 = 7𝑋 + 7𝑌 + 5𝑍
𝑍 𝑍 = losses greater than EUR 100 million

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The probability of n 𝑒 −𝜆 𝜆𝑛 𝜆 = average losses

losses Pr(𝑛) =
𝑛! 𝑛 = number of losses

𝜎 = standard deviation of the loss

𝜇𝜎 𝜇 = mean of the loss size
Logarithm of Mean = ln( )
√1 + 𝑤 𝜎 2
Logarithm of Mean and
𝑤=( )
Variance Loss Severity 𝜇

𝜎 2
𝑉𝑎𝑟𝑖𝑎𝑛𝑐𝑒 = ln(1 + 𝑤) 𝑤=( )
𝜇

𝐸𝑠𝑡𝑖𝑚𝑎𝑡𝑒𝑑 𝑙𝑜𝑠𝑠 𝑓𝑜𝑟 𝑏𝑎𝑛𝑘 𝐴

= 𝑂𝑏𝑠𝑒𝑟𝑣𝑒𝑑 𝑙𝑜𝑠𝑠 𝑓𝑜𝑟 𝑏𝑎𝑛𝑘 𝐵
Bank’s estimated loss 𝐵𝑎𝑛𝑘 𝐴 𝑟𝑒𝑣𝑒𝑛𝑢𝑒 0.23
×( )
𝐵𝑎𝑛𝑘 𝐵 𝑟𝑒𝑣𝑒𝑛𝑢𝑒

𝑣 = random variable
𝑥 = random variable greater than 𝑣
Power law Pr(𝑣 > 𝑥) = 𝑘𝑥 −𝛼
𝑘 = scale factor
𝛼 = a power

𝑃 =price of the bond

Bond Yields 𝐶1 𝐶2 𝐶3 𝐶𝑁 𝐶𝑡 =annual cash flow in year t
The formula for
and Return 𝑃= 1
+ 2
+ 3
+⋯+
Calculations
calculating YTM (1 + 𝑦) (1 + 𝑦) (1 + 𝑦) (1 + 𝑦)𝑁 N=time to maturity in years
y=annual yield (YTM to maturity)

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1
𝑓𝑎𝑐𝑒 𝑣𝑎𝑙𝑢𝑒 𝑦𝑒𝑎𝑟 𝑡𝑜 𝑚𝑎𝑡𝑢𝑟𝑖𝑡𝑦
YTM of a zero-coupon 𝑌𝑇𝑀 = ( )
bond 𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑝𝑟𝑖𝑐𝑒 𝑜𝑓 𝑡ℎ𝑒 𝑏𝑜𝑛𝑑
−1

Δ𝑟 = the size of a parallel shift in the interest rate

term structure measured in basis points
Δ𝑃
DV01 𝐷𝑉01 = − 𝛥𝑃 = resultant change in the value of the position
Δ𝑟 being considered

Applying 𝛥𝑟 = size of a parallel shift in the interest rate

Δ𝑃⁄ term structure measured in basis points
Duration, Effective Duration (D) 𝐷=− 𝑃 = − Δ𝑃
Convexity, and Δ𝑟 𝑃Δ𝑟 𝛥𝑃 = resultant change in the value of the position
DV01 being considered
𝑃+ = value of the position when all rates increase
by Δ𝑟
1 𝑃+ + 𝑃− − 2𝑃
Effective Convexity 𝐶= [ ] 𝑃− = value of the position corresponding to the
𝑃 (Δ𝑟)2
decrease of all rates by Δ𝑟

𝑓 = value of the option

𝑆 = current stock price
𝑓𝑢 = value of the stock when the stock price
moves up by u
Binomial Trees One-step binomial 𝑓 = (𝑓𝑢 𝑝 + 𝑓𝑑 (1 − 𝑝))𝑒 −𝑟𝑡 𝑓𝑑 = value of the stock when the stock price
moves down by d
𝑟 = risk-free rate of interest
𝑡 = time to maturity
𝑝 = risk neutral probability

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𝑒 𝑟𝑡 − 𝑑
𝑝=
𝑢−𝑑
𝑢 = 𝑒 𝜎√𝑡
1
𝑑=
𝑢

𝑓𝑢 = (𝑓𝑢𝑢 𝑝 + 𝑓𝑢𝑑 (1 − 𝑝))𝑒 −𝑟𝑡

𝑓𝑑 = (𝑓𝑢𝑑 𝑝 + 𝑓𝑑𝑑 (1 − 𝑝))𝑒 −𝑟𝑡
𝑓 = value of the option
𝑆 = current stock price
𝑟 = risk-free rate of interest
Two-step binomial 𝑓 = (𝑓𝑢 𝑝 + 𝑓𝑑 (1 − 𝑝))𝑒 −𝑟𝑡 𝑡 = time to maturity
𝑝 = risk neutral probability
𝑒 𝑟𝑡 − 𝑑
𝑝=
𝑢−𝑑
𝑢 = 𝑒 𝜎√𝑡
1
𝑑=
𝑢

𝑃0 = value of a put option

𝐶0 = value of a call option
−𝑟𝑇 −𝑟𝑇
Black Schole’s Non-dividend paying 𝐶0 = 𝑆0 𝑒 × 𝑁(𝑑1 )– 𝐾𝑒 × 𝑁(𝑑2 ) 𝐾 = strike price
Merton Model stock −𝑟𝑇 −𝑟𝑇
𝑃0 = 𝐾𝑒 × 𝑁(−𝑑2 )– 𝑆0 𝑒 × 𝑁(−𝑑1 ) 𝑆0 = current stock price
𝑟 = risk-free rate of interest
𝑇 = time to maturity

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𝑃0 = value of a put option

𝐶0 = value of a call option
Dividend-paying stocks 𝐶0 = 𝑆0 𝑒 −𝑞𝑇 × 𝑁(𝑑1 )– 𝐾𝑒 −𝑟𝑇 × 𝑁(𝑑2 )
𝑞 = dividend yield
at a dividend-yield, q 𝑃0 = 𝐾𝑒 −𝑟𝑇 × 𝑁(−𝑑2 )– 𝑆0 𝑒 −𝑞𝑇 × 𝑁(−𝑑1 )
𝑆 𝜎^2
ln ( 𝐾0 ) + [𝑟 − 𝑞 + (
𝑑1 = 2 )] ^ 𝑇
𝜎√𝑇

𝑆 𝜎2
ln ( 0 ) + [𝑟 − 𝑟𝑓 + ( 2 )] 𝑇
𝐾
𝑑1 =
𝜎√𝑇
Options on foreign 𝐶0 = 𝑆0 𝑒 −𝑟𝑓𝑇 × 𝑁(𝑑1 )– 𝐾𝑒 −𝑟𝑇 × 𝑁(𝑑2 )
currency 𝑑2 = 𝑑1 − 𝜎√𝑇
𝑃0 = 𝐾𝑒 −𝑟𝑇 × 𝑁(−𝑑2 )– 𝑆0 𝑒 −𝑟𝑓𝑇 × 𝑁(−𝑑1 )
𝑟𝑓 = foreign risk-free rate
r= domestic risk-free rate

𝐹0 = price of the option.

𝑃0 = value of a put option

𝐶0 = 𝐹0 𝑒 −𝑟𝑇 × 𝑁(𝑑1 )– 𝐾𝑒 −𝑟𝑇 × 𝑁(𝑑2 ) 𝐶0 = value of a call option

Options on futures
𝑃0 = 𝐾𝑒 −𝑟𝑇 × 𝑁(−𝑑2 )– 𝐹0 𝑒 −𝑟𝑇 × 𝑁(−𝑑1 ) 𝐹 𝜎2𝑇
ln ( 𝐾0 ) + 2
𝑑1 =
𝜎√𝑇
𝑑2 = 𝑑1 − 𝜎√𝑇

𝑃 = price of each employee stock option

Warrants: The price of 𝑁
each employee stock 𝑃= ( ) ∗ Value of the option 𝑁 = total number of shares outstanding
option 𝑁+𝑀
𝑀 = number of new shares (options)
contemplated

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Greek letters for European options: non-dividend paying

stocks 𝑆 𝜎2
ln ( 𝐾0 ) + [𝑟 + ( 2 )] 𝑇
Greek letter Call option Put option 𝑑1 =
𝜎√𝑇
Delta 𝑁(𝑑1 ) 𝑁(𝑑1 ) − 1 𝑑2 = 𝑑1 − (𝜎√𝑇)
Vega 𝑆0 √𝑇 𝑁 ′ (𝑑1 ) 𝑆0 √𝑇 𝑁 ′ (𝑑1 ) 𝑇 = time to maturity
𝑆0 = asset price
𝑁 ′ (𝑑1 ) 𝑁 ′ (𝑑1 ) 𝐾 = strike price
Gamma
𝑆0 𝜎√𝑇 𝑆0 𝜎√𝑇 𝑟 = continuously compounded risk-free rate
𝑆0 𝑁 ′ (𝑑1 )𝜎𝑒 −𝑞𝑇 𝑆0 𝑁 ′ (𝑑1 )𝜎𝑒 −𝑞𝑇 𝜎 = stock volatility
− − 𝑁(𝑑𝑖 ) = cumulative distribution function for a
Theta 2√𝑇 2√𝑇
− 𝑟𝐾𝑁(𝑑2 )𝑒 −𝑟𝑇 + 𝑟𝐾𝑁(−𝑑2 )𝑒 −𝑟𝑇 standardized normal distribution variable

Rho 𝐾𝑇𝑒 −𝑟𝑇 𝑁(𝑑2 ) −𝐾𝑇𝑒 −𝑟𝑇 𝑁(−𝑑2 )

Option
sensitivity Greek letters for European options: dividend-paying 𝑆 𝜎2
Measures ln ( 𝐾0 ) + [𝑟 + ( 2 )] 𝑇
stocks 𝑑1 =
𝜎√𝑇
Greek letter Call option Put option 𝑑2 = 𝑑1 − (𝜎√𝑇)
Delta 𝑒 −𝑞𝑇 𝑁(𝑑1 ) 𝑒 −𝑞𝑇 [𝑁(𝑑1 ) − 1] 𝑇 = time to maturity
Vega 𝑆0 √𝑇 𝑁 ′ (𝑑1 )𝑒 −𝑞𝑇 𝑆0 √𝑇 𝑁 ′ (𝑑1 )𝑒 −𝑞𝑇 𝑆0 = asset price
𝑁 ′ (𝑑1 )𝑒 −𝑞𝑇 𝑁 ′ (𝑑1 )𝑒 −𝑞𝑇 𝐾 = strike price
Gamma 𝑟 = continuously compounded risk-free rate
𝑆0 𝜎√𝑇 𝑆0 𝜎√𝑇 𝜎 = stock volatility
𝑆0 𝑁 ′ (𝑑1 )𝜎𝑒 −𝑞𝑇 𝑆0 𝑁 ′ (𝑑1 )𝜎𝑒 −𝑞𝑇 𝑁(𝑑𝑖 ) = cumulative distribution function for a
− −
Theta 2√𝑇 2√𝑇 standardized normal distribution variable
+ 𝑞𝑆0 𝑁(𝑑1 )𝑒 −𝑞𝑇 − 𝑞𝑆0 𝑁(−𝑑1 )𝑒 −𝑞𝑇 1 −𝑥 2
𝑁 ′ (𝑥) = 𝑒 2
− 𝑟𝐾𝑁(𝑑2 )𝑒 −𝑟𝑇 + 𝑟𝐾𝑁(−𝑑2 )𝑒 −𝑟𝑇 √2𝜋
Rho 𝐾𝑇𝑒 −𝑟𝑇 𝑁(𝑑2 ) −𝐾𝑇𝑒 −𝑟𝑇 𝑁(−𝑑2 ) 𝑞 = dividend yield

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