FRM PART I

SUMMARISE NOTES

Summarised by : Karan Aggarwal

Contact:
PIYUSH: 9674006544
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 INDEX
Page No.
VRM
A. Estimating volatilities & correlations 1
B. Valuation & risk model 2-4
C. Value at risk 5
D. Fixed income securities 6-9
E. Option valuation 10-11
F. Capital structure/credit risk 12
G. Operational risk 13-14
H. Arbitrage pricing theory 15
I. Ratings 16
FMP
A. Introduction to derivatives 17
B. Mechanics of futures 18
C. Interest rates 19
D. Forward & futures price determination 20
E. Hedging strategies using futures 21-22
F. Interest rate futures 23-24
G. Financial swaps 25-26
H. Derivative strategies 27-29
I. Option greeks 30-32
J. Exotic options 33-34
K. Commodity forwards & futures 35
L. Foreign exchange risk 36
M. Ccp 37
N. Banks 38
O. Insurance companies & pension funds 39
P. Mutual funds & hedge funds 40
Q. Corporate bonds 41
R. Mortgage backed securities 42
FOUNDATION
A. The standard capital asset pricing model 43-44
B. Financial disasters 45
C. Enterprise risk management 46
D. Risk management-a helicopter view 47
E. Corporate governance & risk management 48
F. Risk management failures 49
G. Getting up to speed on financial crisis 50
H. Risk management, governance, culture & risk taking in banks 51
I. Corporate risk management-a primer 52
QUANTS
A. Basic Statistics 53 - 59
B. Random Variable 60 - 64
C. Probability Distribution 65 - 68
D. Hypothesis Testing 69 - 72
E. Regression 73 - 78
F. Time Series 79 - 84
G. Measuring Returns Volatility & Correlation 85 - 88
 Contact : PIYUSH : 9674006544
Visit: www.ulurn.in Estimating Volatilities & Correlations Summarised by: Karan Aggarwal

Why volatility & correlation? In GARCH, PERFORMANCE OF GARCH MODEL

Current volatility is required for calculating VAR. (OMEGA)= VL
2 2 2
Suppose, there is a portfolio,whose returns are such that σ n= + u n-1 + σ n-1 Days ui
2 2
ui / σi
2
+ < 1,only then
normally distributed with a daily mean (µ=0) &
Gamma( ) + .
daily volatility (σ=1.5%).Portfolio is presently
 If + = , Gamma =0 i.e. =
worth $500million. & this becomes EWMA Model by
What is the daily VAR at 99% confidence level? treating λ.
 If + > 1, gamma< 0,so GARCH
model becomes unstable since
variance becomes mean fleeing
rather than mean reverting. High autocorrelation which Insignificant
shows presence of systematic correlation i.e.
1% 99%
DERIVATION OF EWMA APPROACH relationship. Autocorrelation
Step 1:You think about estimating daily The Ljung Box statistics test vanishes .So,
volatility of a stock for tomorrow i.e. un or σn is conducted to check for GARCH does a
Zσ µ=0 autocorrelation.
Step 2: You find that % change in stock today is good job.
x% i.e. un-1.But, we would take σn as avg of past
For an area of 1% in the tail,z=2.33 VOLATILITY TERM STRUCTURE & IMPACT OF
u’s.
So, Value At Risk =z*SD=2.33*1.5=3.5% Step 3:Decide upon a window size. VOLATILITY CHANGES
2
i.e. 3.5% of 500million=$17.5 million. σ n+T
Interpretation: 2
σ n=1/n Σ
n
i=1 u
2
n-i
Max loss that can take place in a day=$17.5 million Step 4: VL
with a 99% confidence level i.e. with just 1% chance Simple avg doesn’t make sense.Take weighted
of being exceeded. avg. T
2 T 2
In 1% of the worst cases,loss would be atleast $17.5 2 n 2 n σ n+T = VL+( + ) [ σ n- VL ]
σ n= Σ i=1 ai u n-i , where = Σ i=1 ai=1 2
milllion.So,we require estimate of cuurent volatility to σ n+T= Instantaneous variance T days from now.
Step 5: Recent obs should be given more 2
calculate VAR.Also,SD of portfolio depends on σ n+T is tending towards VL.
weightage.[EXPONENTIALLY DECLINIG 2
correlation. WEIGHTS] CASE 1: σ n > VL
For options valuation,we require an estimate of future 2 0 Volatility Term Structure is Downward
i.e. Weight of u n-1=(1- λ)* λ
volatility. 2 1 Sloping.
Weight of u n-2=(1- λ)* λ 2
2 0 2 1 2 CASE 2: σ n < VL
So, σ n=(1- λ)* λ u n-1+(1- λ)* λ u n-2+
Properties of Volatility 2 2 Volatility Term Structure is Upward Sloping.
(1- λ)* λ u n-3…upto infinity
 STOCHASTIC: It is changing in an 2 2 2
So,we get, σ n= λ σ n-1+(1-λ) u n-1
uncertain manner.Adapting wrt IMPACT OF VOLATILITY CHANGES
EWMA requires less storage.Just need to store 2
If current volatility changes, σ n+T will also
innovation. previous day’s estimate of volatility &
change.
Si-2 ui-1 Si-1 innovation.
 Volatility Term Structure predicted by
COMPARE EWMA WITH GARCH
Garch is not the same as Implied
n-2 n-1 n 1. EWMA approach is a special case of
GARCH when + = .
Volatility actual real life term
ui=(Si-Si-1)/Si-1 2. GARCH is better off than EWMA,since it structure.
2
σ n is variance for n which is estimated captures mean reverting tendency which  However,sensitivities of real life term
sitting on n-1 EWMA approach doesn’t. structure to changes in current
2 2 2
σ n is weighted avg of σ n-1 & u n-1 3. Still,practically EWMA is better,since it is volatility is the same as that of
parsimonious-requires just 1 parameter GARCH.So,trading houses use GARCH
estimation= λ,whereas GARCH requires 3 TERM STRUCTURE SENSITIVITY,to
parameters i.e. Omega,Alpha & understand how real life term
persistence innovation Beta.GARCH has greater noise.
structure is going to change.
This is EWMA approach[Exponentially PARAMETER ESTIMATION
 Trading Houses require 2 inf to carry
Weighted Moving Average Approach/Risk Two techniques:
out option trade:
Metrics Approach]  Unbiased Estimation
2 2 2 1 How much is volatilty going to
σ n= λ σ n-1+(1-λ) u n-1  Maximum Likelihood change? Short term volatilities will
Higher the λ,lower the adaptability wrt Estimation(MLE) change more & long-term volatilities
innovation-well behaved series. Parameter Estimation for volatility will change less.
Lower the λ,higher the adaptability wrt engines uses MLE.In this, we try to 2. Wrt change in volatility,how much
innovation-misbehaved series. maximize probability of obs will option price change?
 MEAN REVERSION:Volatility is mean- occurring.
reverting. Note: One way of implementing GARCH(1,1) 1 2 3
Let VL = LONG RUN VARIANCE RATE that increases stability + < 1 is by 1 1 r12 r13
2 2 2 r12 1 r23
If σ n< VL ,there is a tendency for σ to rise & variance targeting.This means,set
move towards VL. VL=sample variance. 3 r13 r23 1
2 2
If σ n> VL ,there is a tendency for σ to fall &
move towards VL. Correlation Matrix
EWMA Approach
2 Internal Consistency
So, σ n=f[VL , un-1 , σn-1] Covn(x,y)= λcovn-1(x,y)+(1- λ)un-1vn-1 If r12 is +ve & r13 is –ve, r23 must be -ve .
If , & refer to weights, (Here,u & v refer to % change in x & y). r122+ r132+ r232 - 2r12r13r23≤ 1
2 2 2
σ n= VL + u n-1 + σ n-1 Matrix which satisfies above property is
This is Generalized Autoregressive GARCH(1,1) internally consistent,known as Positive
Conditional heteroskedasticity i.e. Covn(x,y)= + un-1vn-1 + covn-1(x,y). Page 1
Semidefinite.General Condition is ∩ wT ≥ 0
GARCH(1,1 model). w
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Quantifying Volatility In VAR Models Use Normal Mixture VAR in such a situation MTHD 3:Mean reverting feature is captured
VAR-What is the max possible periodic loss under by GARCH(1,1)
2 2 2
normal circumstances at a certain confidence level? σ n= VL + r n-1 + σ n-1
If loss exceeds VAR(Value At Risk),what is the Drawbacks of Historical STD Approach
expected loss?-EXPECTED SHORTFALL or -Ghosting feature
CONDITIONAL VAR? E(L/L> ) -Gives equal weight to all observations
 95% daily VAR=$500 million means, -Doesn’t capture mean reversion.
Max possible loss that can occur in a single
day=500 million $ with a 5% chance of NON-PARAMETRIC APPROACH
being exceeded. It doesn’t assume any particular
In 5 % of worst circumstances,minimum distr.Common approach in this area is
possible loss is 500m$ HISTORICAL SIMULATION.
HISTORICAL PARAMETRIC METHOD UNConditional ND Step 1:Collect past returns as an asset
SIMULATION Conditional ND Step 2:Arrange them from worst to best.
Various Approaches for Estimating VAR Step 3: Now slice off X% from worst side.
SLICE Normal Distribution Suppose there are 200 observations
& you have to calculate 99% VAR.
n
5% 95% 5% Historical Based Implied Volatility Sol : 1% of 200=2
Two solutions allowed in FRM Part 1:
Approach Approach nd
1) 2 worst observation.
nd rd
$500m gains/losses
2) Avg. of 2 & 3 worst observation.
Hybrid - HISTORICAL SIMULATION APPROACH WITH
(worst to best) $500m =Z*SD
BOOT-STRAP involves random sampling from
Parametric
Non past observations with replacement.Then
Parametric data is arranged from worst to best.

PARAMETRIC APPROACH
HYBRID APPROACH
Based on assumption that asset returns follow
STOCHASTIC BEHAVIOUR OF RETURNS Combination of Historical Simulation &
normal distr/log normal distr.etc.Also called-
Whether empirical past data is satisfied by Normal Parametric Approach.
DELTA NORMAL METHOD,ANALYTICAL [x-1] k
Distribution? No,specially in the tails & risk lies in the (1-λ)λ / (1-λ )
APPROACH OR VARIANCE-COVARIANCE
tails.So,avoid using parametric & specially ND & Where, x=no. of days ago
APPROACH.(ADVANTAGE:LESS TIME PROCESS OF CALCULATING VAR:
supplement VAR with other risk measures such as CONSUMING & EFFICIENT UTILIZATION OF DATA)
stress testing & scenario analysis. 1)Assign weights to all past r
Eg:-Asset’s current value=$500m.Mean daily 2) Now order obs from worst to best.
return=0.1% & daily SD=0.25%.Calc 99% VAR 3) Cumulate the weights.
Asset Return Distribution tends to deviate from ND
VAR= 0.1-2.33*0.25=$2.41m 4) Check x% in the cumulative weight.
Because of As per Random Walk Theory, VAR=Z*SD
Fat tails i.e. leptokurtic Suppose:
DAYS r w CUM WEIGHTS
-Prob of extreme losses & gains is higher than ND. NOTE: If asset returns follow IID (Independent & AGO
-Prob of changes very close to mean is higher than
Identically Distributed),apply square root rule- 20 -9.1% 1.86% 3.97%
ND
So, Daily SD=Annual SD/√250
-Prob of intermediate range say ± 1 or 1.5 SD is lower
Weekly SD=Annual SD/√52 or Daily SD√5 15 -8.3% 2.54% 6.51%
as compared to ND.
NOTE: If µ=0 & square root rule is allowed i.e.(IID), For calculating 95% VAR=x
Negatively Skewed Then Daily VAR=Annual VAR/√250 Ans:-(x-9.1)/(9.1-8.3)=(5-3.97)/(3.97-6.51)
-Declines in asset price are more severe than MTHD 1: HISTORICAL SD So, x=8.78%
2
increase. σ =Simple moving average of past k squared
returns ANOTHER METHOD of calculating SD in
2 2 2 2
Changing Parameters =(r t-1+r t-2+r t-3+……r t-k)/ k Parametric Approach is
Parameters of ND are µ & σ Where k=window size. MULTI-VARIATE DENSITY
Logic 1: Should hve taken diff µ for diff periods-ND ESTIMATION(MDE)
would be satisfied & fat tail problem would Formula for sample variances Here weights are assigned based on relevancy
2 2
disappear. σ =Σ(r-µ) /(k-1) & not based on recency.
LOGIC NOT ENTERTAINED  If we take µ=0 & apply the MLE approach If distance is less, weight shd be high.
2 2
σ =Σr /k If distance is more,weight shd be less.
-Not possible to forecast conditional returns i.e. µ
CHOICE OF WINDOW SIZE (k)
Daily µ= Annual µ/ 250 days=too small to make a diff.
Higher K=Higher precision but lower adaptability Vector of Conditioning Variables =xt-i
Logic 2: Regime Switching Model Lower K=Lower precision but higher adaptability Suggested Conditioning Variables are-
Take diff σ for diff periods, high σ for high volatility PROPERTIES OF VOLATILITY  Level of int rate,if we are dealing
period & low σ for low volatility period.-We shd take Volatilty should keep on forecasting new with Int Rate Volatility.
conditional distribution ,then,ND will fit. volatility based on innovation i.e. recent  Implied volatility, if we are dealing
2
LOGIC NOT ENTERTAINED  r. with equity volatility.
2 2
-Not possible to forecast volatility accurately. σ n should be a fn of σ n-1  Int rate spread etc,if we are dealing
-Even on calculating standardized returns,z has It is mean reverting. with currency volatility.
problem of fat tails. MTHD 2:In EWMA,Recent obs are given more Now, KERNEL Fn converts vectors into
-NORMALITY CANNOT BE SALVAGED. weightage. weighing function w(x t-i) where sum of
2 2 2
Asset returns are random & unpredictable. σ n= λ σ n-1+(1-λ) r n-1 weights comes to 1.
Significant spike can happen in a low volatility 2 2
Page 2
regime. stickiness adaptability σ t= Σw(xt-i)r t-i
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REMEMBER: NOTE: However , under the square root rule,
For a high-confidence level, Z VAR is understated than One of the properties of a coherent risk since p=0, volatility is being overstated
what should have been actually. measure is sub-additivity i.e under Square Root Rule.
risk of portfolio<sum of risk of parts.
0043dddddddddddd.4eeeeeeeee  If current volatility i.e. σr01> long
COMPARISON BTW PARAMETRIC & VAR as a risk measure doesn’t necessarily
NON-PARAMETIC APPROACHES satisfy sub-additivity.
run mean reverting level, the
o Parametric Approaches are less time square root rule overstates true
consuming & use data more efficiently. DRAWBACKS OF ANALYTICAL APPROACH volatility.
o Parametric Approach assumes a certain Problem of fat tails.  If current volatility i.e. σr01<long
distribution & parameters of the distribution Curse of dimensionality run mean reverting level, the
which may be incorrect. Correlation’s spike during crisis such square root rule understates
o Parametric Approach suffers from the that the benefit of diversification is true volatility.
problem of fat tails & correlations spike not enjoyed when it’s most needed. According to Auto-Regressive Model,
during crisis. HISTORICAL SIMULATION
Xt= f(xt-1)
o GARCH is better than EWMA in sample. ADVANTAGE:
o EWMA is better than GARCH out of sample. Doesn’t suffer from problem of fat Xt=a+bxt-1+e
Testing of degree of accuracy of a volatility tails & curse of dimensionality. o If Xt > LRMRL
forecasting engine is done by computing Problem of correlation’s spiking during It has a tendency to fall
 MSE(Mean Squared Error). crisis is also not present. o If Xt < LRMRL
I
Σ(y-y )/N DISADVANTAGE: It has a tendency to rise
Y=Actual volatility Inefficient use of data & the fact that o If Xt = LRMRL
I
y =Estimate of volatility past may not be repeated in future. It has a tendency to remain
HS may be improved by weighing the historical same
Alternate approach, returns either under the Hybrid Method
i.e. Xt= Xt-1
 Y=a+bx (based on recency) or under the MDE approach.
i.e. Realized Volatility=a+b(Forecasted Volatility) Since, Xt=a+bxt
For a perfect engine, b =1 CENTAL LIMIT THEOREM We get, Xt=a/(1-b)
In this regard,MDE performs the best. If we have 500 delta P’s. We assume that these If b=1
delta P’s follow normal distribution. LRMRL is undefined
IMPLIED VOLATILITY (IV) BASED APPROACH We calculate Mean & SD of delta P’s. (Problem of Unit Route)
So, VAR=Mean-(Z*SD) Random Walk Time Series
Option Price=f(s,e,r,t,σ) However,this approach can only be applied If b>1
when the portfolio is extremely diversified. (Problem of Explosive Routes)
So, IV is the volatility implied by the current option So, b should be less than 1
price. Note: Continuously Compounded
Using, Xt+1=a+b Xt & y= Xt+1+ Xt
Returns/Geomteric Returns are additive. 2
ADVANTAGE:  r02=r01+r12 We get σy=σ√( +b )
2 2 2
IV is forward looking. So,σ r02= σ r01+ σ r12+2pσr01 σr12 If b<1; σy < σ√
New information gets incorporated into IV (where r02=2 day continuously So, square root rule overstates
instantly. compounded return; VAR under conditions of mean
IV > HV(Historical Volatility r01 & r12 are continuously reversion.
st nd
Justification-Stochastic Volatility Premium compounded 1 day & 2 day return;
VARIV>VARHV p is correlation coefficient)
DISADVANTAGE:  If returns are independent,p=0
2 2 2
IV is model dependent σ r02= σ r01+ σ r12
2 2
BSM assumes that stock prices are log- σr02=√σ r01+ σ r12
normally distributed with constant volatility.  If returns are identically distributed
This is unrealistic as volatility is time varying but not independent
2 2 2
& also diff at diff E. σ r02= σ + σ +2pσ σ
2 2
Difficult to backout implied correlation. σ r02=2 σ [1+p]
σr02=σ√2[1+p]
RETURN AGGREGATION & VAR  If returns are identically distributed
STEP 1: Map positions into limited no. of risk factors and independent
2 2 2
like equity positions can be mapped to market index. σ r02= σ + σ +0
2
STEP 2:Collect historical data on the no. of factors =2 σ
σr02= σ√2
Mthd 1
So, be cautious while using square
Historical
Mthd 2 Mthd 3 root rule.
Simulation
Based on Variance- RETURNS ARE MEAN REVERTING
Calc
Central Limit Covariance or Int Rate CORRELATION RULE
portfolio
Theorem, Analytical
return using
assume that Method
current Mean
return on Generate a
weights,arra Reverting
portfolio is Variance-
nge from Level
normally Covariance
worst to
distributed. Matrix & then
best & slice So,p<0
away req
VAR=(µ-Zσ) calculate VAR.
Time
Page 3
percentile.
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PUTTING VAR TO WORK
VAR Approaches

LOCAL FULL REVALUATION

DELTA NORMAL DELTA GAMMA FULL REVALUATION

VAR of a VAR= Delta Approach± Gamma Effect
derivative= As per Tailor’s approximation,
2
Delta* VAR of Risk ∆y=f ‘(x) ∆x +1/2f ‘’(x)( ∆x)
Factor
To be used in the Gamma Effect
rd
case of linear For well-behaved non-linear derivatives,the 3 &
derivatives like higher order terms are negligible.
fwd,futures & So,gamma effect=
2
swaps. 1/2*Gamma*(VAR of risk factor)
Delta-
Normal To be used in the case of non-linear derivatives
VAR of a which are well-behaved like options, non-option
long- embedded bonds.
position is For C+,Gamma effect is in our favour.So,
always VAR=VAR by Delta Approach-Gamma
overstated Effect.
. For C-, Gamma effect is against us.So,
VAR=VAR by Delta Approach+Gamma
Effect.
For P+,Gamma effect is in our favour.So,
VAR=VAR by Delta Approach-Gamma
Effect.
For P-,Gamma effect is against us.So,
VAR=VAR by Delta Approach+Gamma
Effect.
The answers provided by this approach are NOT
100% accurate.
But, since call & put are egs of well-behaved non-
linear derivatives,it gives a reasonable
approximation of the true ans that can be
manufactured by the full-revaluation approach.
CALCULATING VAR OF A BOND POSITION
Delta –Normal Method ( at 99% confidence level)
=z* yield volatility*Modified Duration* Price
(where Modified Duration= Duration/(1+r/m)
Suppose ytm is compounded semi-annually,Higher the frequency of
compounding,higher the volatility and higher the VAR.
Full Revaluation Method
At a 99% confidence level,yield can change by z*yield volatility.
So,new yield=old yield+( z*yield volatility)
Calculate old price(by using old yield) & new price(using new yield).
So, VAR=Old Price-New Price
Got to specify a pricing function (like Black Scholes Model) and
then use SMS( Structured Montecarlo Simulation) to regularly
revalue the position.
To be used in the case of Non-Linear misbehaved series like
option-embedded bonds i.e. callable bonds,puttable bonds &
mortgagebacked securities.Also to be used when we use
cross-partial effects.
Suppose,assume that stock-prices are log-normally distributed.
St+1=Steµ+zσ ( where µ=drift & σ is shock)
Where z=Random draw from the standard normal distribution
& time steps = daily for 100 days.
Now calculate stock price using the above equation for 1
run(i.e. 100 days)& the computer is made to carry out 10,000
runs.
S
22.75
20.19
18.22
Days
Now, out of 10,000 terminal stock prices,arrange them from worst to
best.Thus, the 99% VAR=Loss corresponding to the 100
th
th
observation.Suppose 100 obs=18.64
∴ = 20 − 18.64 = 1.36
NOTE: For a long straddle position i.e. P+ & C+ at the same E,the risk
of this strategy is Share Price not changing too much.So,we cannot
calculate VAR using Delta-Normal Approach.Instead use Full
Revaluation Approach using SMC i.e. assume S follows a certain
µ+zσ
distribution say Log Normal.So, St+1=Ste . Using random draws of
Z,we have various possible (St+1)’s.Value the straddle at each of the
possible Share Prices.Now, arrange straddle values from worst to best
& then slice away the required quartile to get VAR.
Price
Full
Revaluation
637.63 Delta Normal
Method

Delta-Normal gives a higher answer for a long position,since actual VAR

enjoys gamma effect(enjoys convexity which means lower risk/VAR).
Delta-Normal gives a lower answer for a short position,since actual VAR 5% 6.63% Yield
suffers gamma effect(negative convexity i.e. higher risk/VAR)
Page 4
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STRESS TESTING & SCENARIO ANALYSIS FOUR PROPERTIES OF A COHERENT RISK MEASURE
Structured Monte-Carlo Simulation is criticized since correlations spike during  MONOTONICITY- If E(y) > E(x)
crisis & diversification’s benefit is lodt. Then,p(x) > p(y)
So,use stressed correlation i.e. correlations of crisis periods. p is symbol for risk.

Worst Case Scenario(WCS)  POSITIVE HOMOGENITY(Leverage)

VAR doesn’t tell us “how bad things can be”. p(λx)= λp(x) Double the portfolio,double the risk.
If VAR is exceeded,what type of loss can we experience?
WCS is a technique designed to dig inside the tail  TRANSLATION IN VARIANCE
By adding risk free asset say cash to our portfolio,risk will be
reduced to that extent. p(x+c)=p(x)-c

When L>VAR, how much

 SUB-ADDITVITY
can be the loss? p(x+y) ≤ p(x) + p(y)

99% STEP 3:Expected Shortfall =E[ L/L>VAR]

Satisfies all the four properties & hence,it’s a coherent measure of risk.
STEP 4:VAR does not satisfy sub-additivity
So, its not a coherent measure of risk.VAR satisfies sub-additivity
LOSSES under normal distribution assumption,since diversification benefit
exists.
INTERPRETATION STEP 5:Implications of VAR not satisfying sub-additivity
For a 95% VAR,z=1.645  Traders & investors trading on exchanges have incentive of
If the horizon period (H)=500 days,how many days do we expect the loss to opening a no of trading A/Cs to reduce margin req.
exceed 1.645?=  Bank or financial conglomerate have incentive to break down &
5% *500=25 days. operate as separate units to bring down cap reqs.
 For a risk measure that satisfies sub-additivity,,risk managers
Conditional VAR/Expected Shortfall/Expected WCL add up individual risks,since they know that actual risk of entire
Expected loss given Loss> VAR aggregation would be less than sum total.
E(L/L>VAR)
STEP 6: How expected shortfall is a spectral risk measure?
Suppose, 1% WCL =2.95 E(S)=1/(1-∝) ∝ ∅pqpdp
This means that if VAR has been exceeded , we are 99% confident,that max loss
would be=2.95 ∅p=0 for p≤ ∝
∅p is equal for p>∝
MEASURES OF FINANCIAL RISK i.e. E(S) is based on risk neutrality

Coherent Measures How VAR is a spectral but not a coherent risk measure?
Mean Variance VAR Of Risk
VAR= ∅Pqpdp
Theory Several drawbacks
E(R) -Does not tell abt WCS ∅p=0 for p≠ ∝
-Most of the mthds suffer ∅p =1 for p=∝
From probs of fat tails & i.e. VAR gives 100% weightage to the particular quantile.Reflects risk-
skewness loving behavior so not coherent.
σ -It is not coherent
SD is not an REMEMEBER ONE ADDITIONAL POINT FOR VAR
appropriate  VAR is always one tailed
measure of risk in  There are 2 ways of representing Value At Risk:
case
of non-normal/
non-elliptical
distributions.
(T distr is an
elliptical distr)

COHERENT MEASURES OF RISK

STEP 1: SPECTRAL RISK MEASURE
M∅= ∅Pqpdp
10m 10m
Here,p represents percentile or confidence level.
Losses ---------------------Gains Gains--------------------------Losses
∅ is the weighing function
qp =quantile
5% VAR 95% VAR
( Simply, the weighted avg of various quantiles of loss/profit )
5 % chance 95% chance that loss will
STEP 2: Spectral measure is coherent when the weighing function reflects either that loss will be be ≤ 10 million $.
risk neutrality or risk aversion. > 10million$.
RISK NEUTRALITY-∅p should be equal irrespective of the level of qp
RISK AVERSION--∅p should be slowly rising as qp(amt of loss) is bigger
Page 5
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PRICING & YIELD DISCOUNT FACTORS REPLICATING PORTFOLIO

1.Bond pricing is a Discounting Cash Flow exercise. CASE 1:Suppose bond to be replicated is Bond B
Bond Price=PV of cash flows &bonds which can be used for replication are
Case 1:FLAT TERM STRUCTURE Bond A&C(MATURITY OF ALL BONDS MATCH)
NOTE: Tuckman assumes semi-annual coupon. ∴P0=C0.5d(0.5)+C1d1+C1.5d(1.5)+….Cndn
Coupon Rates
Decide whether bond is trading cheap or rich? A B C
Mthd 1: Using yield on similar bonds/opp. 2.00% 4.00% 7.00%
Cost/Required Return,calculate the model price & Discounting Factors
then compare it with actual price. Discount factors can be calculated by
If actual price < model price, bond is trading cheap & Boot Strapping Method.
Distance=2 Distance=3
investor should go long. REVERSE
Mthd 2: : Using yield on similar bonds/opp.  Calc d0.5
Cost/Required Return & actual price, calculate the d0.5=Price/FV
 Then using value of d0.5,calculate d1 3 : 2
yield on the bond & then compare the yields. So, Price of B =0.6PA +0.4 PC
If calculated yield > yield on similar bonds,bond is Price= Coupon*d0.5+(Coupon +SV)*d1
trading cheap & investor should go long. & so on
After all discount factors are calculated, CASE 2:MATURITIES DO NOT MATCH
Calculate Bond Equivalent Yield(BEY)/Spot Rates Suppose there is a 2 yr bond with 10%
P 1/2n coupon to be replicated & bonds to be
P2 Positive Convexity =r0, n=[{1/dn} -1]*2
Or used for replication are:
USING CALCULATOR: Bond Coupon FV n
P0
1 FV A 7% 100 6mths
dn ± PV
P1
2n N B 12% 100 1yr
r CPT i/y *2
r2 r0 r1
Ignoring convexity, slope of the tangent C 5% 100 1.5yr
PRICE QUOTATIONS
=Duration= (P2-P1)/ 2P0∆y
D 6% 100 2yr
Case 2:NON FLAT TERM STRUCTURE
Implies Interest Rates depend on maturity. So,we have,
Bond Price=Coupon*Σd+Principal*dL T-NOTES & CORPORATE & 103% of FD=105.So;FD=101.94
Suppose,maturity of bond is 3yrs,the bond should be T-BONDS MUNICIPAL BONDS & Coupon=3% of 101.94=3.06
looked upon as a portfolio of 6 C Strips & 1 P Strip.
To prevent arbitrage,actual price of bond should be Price quoted as Price quoted as 3.06+102.5%of FC=5; FC=1.8927
equal to sum of parts. “32nds” “8ths” Coupon amt from C=2.5%of 1.8927=0.0473
Eg:- 102-17 Eg:-102-03+
Sit 1: Actual Price< Calculated Bond Price =102+17/32 =102+3.5/8 3.06+0.0473+106%of FB=5; FB=1.7856
Bond is underpriced =102.53% of FV =102.4375% of FV Coupon amt from B=6% of 1.7856=0.1071
Buy the bond from market & submit it to treasury for
stripping.The treasury issues 6 C strips & 1 P strip LAW OF ONE PRICE & ARBITRAGE ARGUMENT 3.06+0.0473+0.1071+103.5%of FA=5,
which we sell for sum of parts(Calculated Bond o Consider a coupon-bearing bond as a FA=1.7252
Price).Arbitrage profit is their difference. portfolio of zero-coupon securities-
specifically C strips & P strip. Thus ,on adding up cash flows of Bond
Sit 2: Actual Price> Calculated Bond Price o Law of One Price states that investors got A,B,C & D, we get exactly same cash flows
Bond is overpriced to be indifferent btw same cash flow in all years as that of the bond to be
Buy the strips from market at sum of parts coming from different bonds if timing & replicated.
(Calculated Bond Price),submit it to treasury for re- risk of the cash flow is same.
constitution.Treasury issues the reconstituted bond So,Price of a coupon-bearing bond=Sum Cost of the Replicating Portfolio
which we sell in market at Actual Price. Of Parts = (PV of A)% of FA+(PV of B)% of FB+
Arbitrage profit is their difference. o Arbitarge opportunity exists if Law Of One (PV of C)% of FC+ (PV of D)% of FD
Price does not hold good,as discussed
INFERENCE FROM THE TERM- earlier.Arbitrage forces will cause Market  If price matches with that of the
“ BOND IS UNDERPRICED” Price to move close to the Model Price. portfolio to be replicated-
Style 1: P0< IV0 NO ARBITRAGE.
Style 2:Yield on the bond> Yield on Similar Bonds OBSERVATIONS REGARDING STRIPS  If price of portfolio to be
Style 3:Spread on the bond> Spread on Similar Strips are less liquid than treasury.So, replicated < cost of replicating
Bonds. investors demand liquidity premium,i.e. portfolio, buy it & short sell
Yield spread is calculated as spead over Benchmark strip price could be lower than normal replicating portfolio.
Yield treasury price. Arbitrage profit=Difference
i.e. 10 yr Treasury Yield=9% Strips are heavily used for Asset-Liability  If price of portfolio to be
10 yr Corporate Yield=11.2% Management(ALM) replicated >cost of replicating
So, Yield Spread=2.2% C-Strips can be put with any bond to portfolio, short sell it & buy
reconstitute but P strips are identified with replicating portfolio.
* * *
 r1 =r1 +z,r2 =r2+z,r3 =r3+z specific bonds. Arbitrage profit=Difference
(where r1,r2,r3 are benchmark spot rates; Short Term C Strips are high in demand – Treasury
z=z spread) Securities Actual/Actual
They trade rich.
Day Count
 In case of option-embedded bonds,we use a Long Term C Strips are low in demand- Convention Corporate &
binomial model or MCS Approach to find They trade cheap. Page
Municipal Bonds 6
30/360
out option-adjusted spread & not z-spread.
 Contact : PIYUSH : 9674006544
Visit: www.ulurn.in FIXED INCOME SECURITIES
Summarised by: Karan Aggarwal
Calculation Of Discount Factors From Swap Rates OBSERVATIONS: PULL TO PAR EFFECT
Interest Rate Swap is a portfolio of long-short bonds &  Discount factor curve is always downward PRICE
Swap Rate refers to fixed rate.(i.e. Coupon Rate of a sloping. PREMIUM BOND
Bond Trading At Par)  If the spot rate curve is upward sloping,forward
Suppose, d rate curve lies above it & par rate curve lies FV PAR
Maturity Swap Rates before it.
 When spot rate curve is downward DISCOUNT BOND
0.5 3% sloping,forward rate curve lies below it & par
1 3.4% rate curve will lie above it. MATURITY
For a disc bond,ytm> coupon rate &
1.5 3.8% PAR RATE ytm is higher for
Par Rate is that coupon rate which makes the bond trade short-term maturity bond.
2 4%
at par.
For a premium bond,ytm<coupon
2.5 4.5%
c/2=(1-dT)/AT {THIS IS PERIODIC} rate & ytm is higher for higher
Then multiply the above answer with 2. maturity bond.
101.5 * d0.5=100.So,d0.5=0.9852. NOTE:
1.7* 0.9852+101.7d1=100.So, d1=0.9668. IMPACT OF MATURITY ON PRICE  LOWER COUPON BONDS
d1.5=[100-1.9(0.9852+0.9668)]/101.9.So, d1.5=0.945 ARE MORE VOLATILE.
d2=[100-2(0.9852+0.9668+0.945)]/102.So, d2=0.9236.  In a ZCB,ytm=last year’s
d2.5=[100-2.25(3.8206)]/102.25=0.8939 spot rate.
PRICE RETURNS
Calculation Of Spot Rates From Discount Factors One period Gross realized yield
P(1.5)>P(1)  If our forecast of =(C+P1-P0)/P0
Consider discount factor as the price of a $1 FV Bond. Short Term rates is Focussing on numerator of price
1/2t
z(t)=[{1/dt} -1]*2 > f(1) & f(1.5),we appreciation.we have P1-P0=
Yes, if coupon
Or should invest at z0.5 P1-x + x-y + y-P0
rate > f(1.5)
USING CALCULATOR: & roll it over.
1 FV  If our forecast of Spread rate carry roll
No,if coupon rate Short Term rates is Change change down
df ± PV
2n N <f(1.5) < f(1) & f(1.5),we Old Expected Curren
CPT i/y *2 should invest long spread Term t term
term i.e. at z1.5. To new Structure structu
OBSERVATIONS spread to Actual re to
 When the spot rate curve is upward New Term Expect
sloping,swap rate curve(similar to par rates) term Structure ed
lies below it. structur Spread Term
 When the spot rate curve is downward RETURN,SPREAD & YIELDS e same same Structu
sloping,swap rate curve(similar to par rates) re,
lies above it. Gross Return=(EVt-BVt-1)/ BVt-1 spread
 When spot rate curve is flat,the par rate Where EVt=FV of reinvested coupon amt+Ending same
curve=spot rate. Price CARRY ROLL DOWN
Long term amortizing or callable bonds with high P0=Pt[Rt,St]
FORWARD RATE coupon rate have highest Reinvestment Risks. Y=Pt+1[ R’t+1,St]
Net Return=Gross Return-Financing Cost
For a positive spread, Expected Term Structure
f0.5 0 0.5
Actual market price<model price Choice 1:Realised Forward scenario
f1 0.5 1 For a negative spread, Realised fwd rate=Implied fwd
f1.5 1 1.5 Actual market price>model price st
rate,Gross yield =1 fwd rate i.e.
Tuckman has expressed SPREAD as a spread over f(0,0.5)
INTERPRETATIONS benchmark Forward rate i.e. what needs to be Fwd rates do not include risk prem.
 Fwd Rate is the rate fixed today for added to each of the forward rates to ensure If realized fwd rate>implied fwd
borrowing/investing a sum of money later. that model price=market price. rate-Buy ST bond & roll them over
 It represents the incremental return, if One would like to buy bond with the higher If realized fwd rate<implied fwd
maturity of our investment is extended. spread,given the features of 2 bonds are exactly rate-Buy LT bond.
 If our forecast of Short Term rates is > f(1) & same. Choice 2:Unchanged Term
f(1.5),we should invest at z0.5 & roll it over. YTM(Yield To Maturity) is IRR of a bond i.e. Structure scenario
 If our forecast of Short Term rates is < f(1) & single discount rate which makes model New f(0,0.5)=old(0,0.5) whereas in
f(1.5),we should invest long term i.e. at z1.5. price=market price. Choice 1: New f(0,0.5)=old(f0.5,1)
 Forward Rate is THE INDIFFERENT RATE i.e. Note-r1=f1, Gross realized return wl depend on
indifferent btw investing at z1 or at z0.5 & r2= Geometric mean of f1 & f2 & so on relation btw bond’s coupon rate &
rolling it over. YTM is a complex average of various spot rates. last fwd rate before bond matures.
It is slightly less than r3 if coupon rates are low. Fwd rates include risk premium.
FORWARD RATE But,if coupon rate is higher, r1 & r2 start getting Choice 3:Unchanged Yield Scenario
[(Bigger 6mth factor/Smaller 6mth factor)1/gap-1]*2 higher weights such that ytm would fall in an Calculate initial ytm.We assume this
upward term structure environment. ytm after one period remains same.
Realised yield =YTM if bond is held to maturity & Gross Return=ytm.Ytm criticized
all intermediate cash flows are reinvested at ytm.
Page 7
bcoz of reinvestment assumption.
 Contact : PIYUSH : 9674006544 Summarised by: Karan Aggarwal
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FIXED INCOME SECURITIES
ONE FACTOR RISK METRICS & HEDGES FORMULAS FOR CONVEXITY THEORIES OF TERM STRUCTURE
[Interest Rate Chaps Of Hull]
Bond Pricing is a DCF affair. If yield is EAY,  If 1 yr Spot Rate i.e. r0,1=8%
2
2
P0=C1/(1+r1) +C2/(1+r2) + C3/(1+r3)
3 Convexity of a ZCB=T(T+1)/(1+r) & Er(1,1)=10%
OR If yield is BEY, 2 Yr Spot Rate:-
2
P0= C1/(1+f0,1) +C2/[(1+f0,1)(1+f1,1)] + C3/[(1+f0,1)( 1+f1,1)(1+f2,1) Convexity of a ZCB=T(T+0.5)/(1+0.5) As per Pure Expectations
OR Convexity would be close to ,but lower than Theory (PET),=(8+10)/2=9%
2
2
P0=C1/(1+r) +C2/(1+r) + C3/(1+r)
3
PULLING VIA YTM T As per Liquidity Preference
Assume single risk factor & a change in that risk factor affects For all bonds, Theory (LPT), r2>9%
2
all other rates. Convexity=( P1+ P2-2P0)/ P0(∆y) As per Market Segmentation
Theory-DON’T KNOW.
2
DV0,1= $ VALUE OF A BASIS POINT Convexity adjustment=1/2*c*((∆y) Depends upon Demand or
MEANS BY WHAT $ AMOUNT WILL THE VALUE OF A BOND Supply in 2yr market.Does not
CHANGE WHEN YIELD CHANGES BY 1BASIS POINT i.e. by 0.1% PORTFOLIO DURATION & CONVEXITY depend upon r1 or
Also called PRICE VALUE OF A BASIS POINT. Dp = ΣwiDi expectation.
In some cases,calculate MD .Suppose it is =4.84% Cp= ΣwiCi  As per Pure Expectations
DV0,1= 4.84% of Price/100 [Assumes parallel shift in Yield curve] Here,weights are market value weights. Theory ;Er(1,1)=f(1,1)=10%
Criticized since it assumes,yield on all bonds As per Liquidity Preference
Face amount of bonds reqd to hedge an option position will change equally. Theory, Er(1,1)<f(1,1)
given DV0,1= Vp*[ DV0,1]p/ [ DV0,1]H As per Market Segmentation
where, Vp=Value of the position NEGATIVE CONVEXITY Theory-DON’T KNOW.
PNCB  Term structure is upward
[ DV0,1]p= DV0,1 of the position sloping bcoz:-
[ DV0,1]H= DV0,1 of the hedging tool As per PET,ONLY BCOZ INT
RATES ARE EXPECTED TO RISE,
[ DV0,1]p/ [ DV0,1]H= Hedge Ratio. PCB PCB=PNCB As per LPT
n -tr
Bond Price = Σ t=1= Ct e Might Might be
Might be
As per Taylor’s theorem, be interest
2 2 2 interest
∆p=dp/dr∆r + 1/2[d p/dr ](∆r) +…..higher order terms Negative Positive interest rates are
rates are
Convexity Convexity rates expected expected
Duration effect Convexity effect are to rise,but
to remain
For a callable bond,issuing ompany enjoys call expect same,but not to the
-rt -rt
Macaulay’s Duration= Σtcte /Σcte option i.e. right to buy back bond from ed to extent
on A/c of
Which means Average Waiting Time investors prior to maturity at Strike Price=X. fall,but implied by
liq prem,
(If yield changes by 1% in continuous terms,price would change Option is exercised when interest rate falls,in on A/c yield
r2>r1
by how much % in the opposite direction ignoring convexity?) order to refund old bonds via proceeds of liq curve,i.e.
collected in issuing new bonds at lower cost. prem, Er(1,1)-
When continuous compounding is not applied,we If yield falls,prob of bond being called rises. r2>r1. f(1,1)
get,Modified Duration=D/(1+r) [r=periodic ytm] So Bond Price rises at a lower rate=
i.e.( % change in Bond Price for a 1% change in Normal Yield) (negative convexity). PET:
Because of D & MD’s constant cash flow assumption,they are If yield rises,prob of bond being called Shape of yield curve depends only on
not suitable for OPTION EMBEDDED BONDS. falls.So Bond behaves like a non-callable expectations.
So, here we use Effective Duration. bond=(positive convexity). Fwd Rate is an unbiased estimate of
Expected Spot Rate.
Just like,MD =(P2-P1)/2P0∆y Similar behavior is observed in MBS,when Active strategy regarding ST vs LT bond
For a straight bond,Effective Duration(ED)=(P2-P1)/2P0∆y home owners prepay when int rate falls. is useless.
But in effective duration,P2 & P1 are calculated by a pricing On investing for 5 years,realised yield
model which considers the probability of option exercise. TYPES OF BOND PORTFOLIOS will always =r05.

NOTE: LPT:
Price calculated using ED is not accurate,since it Investors love liquidity & like to invest
2yrs 5yrs 10yrs
assumes a linear relationship. for Short-Term.Borrowers like to borrow
Portf
Effective Duration underestimates rise in price ,but olio
long-term.To do away with this asset-
overestimates fall in price. Ladd 5m 5m 5m liability mismatch for Banks,LT rtaes wl
A
New price calculated using duration is always an er be raised.
underestimate of true price. Bullet 0 15m 0 So,Fwd Rate is a biased estimate of
B
Expected Spot Rate,i.e.
DV0,1= Effective Duration % of Price/100 f(1,1)>Er(1,1)
ED gives % change in price while DV01 gives $ change in price.
C Barbe 7.5m 0 7.5m
because of liquidity premium.
ll
ED is for 1% change in yield while DV01 is for a one basis Yield curves are mostly upward sloping
point change in yield. Barbell portfolio has same duration due to this.
ED is more useful while investing & while hedging, DV01 is as Bullet portfolio,but it’s convexity
more useful. is higher than Bullet portfolio. MST:
The portfolio that enjoys higher In each maturity segment,interest rates
CONVEXITY- Measures the rate of change of duration i.e. convexity wishes higher movement are determined by demand-supply in
2 2
d p/d r/p in yield.So,if yield changes a that segment.
lot,barbell portfolio wl provide There is no relation btw ST,MT & LT
higher returns. rates.
Page 8
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FIXED INCOME SECURITIES
Summarised by: Karan Aggarwal

MULTI- FACTOR RISK METRICS & HEDGES Suppose,our forecast of r01 will go up 40BP, Key Rate Duration
Interest Rate r05 wl go up by 80 BP & r09 wl go up by Most liquid ,”On the run treasury securities”are
120BP. chosen as Hedging Instrument to reduce High
r10 Hedging Cost.
80 BP If we have 1 yr,5 yr & 9yr treasury securities for
80/4=20 hedging, always choose r01,r05 & r09 as the key
r05
spot rates.
Suppose, r02, r05 & r09 changes by 120 BP for a 30
Maturity r1 2 3 4 5 6 7 8 9 yr Bond.
Acc to Single Factor Risk Measure,if yield curve 0 20 40 60 80 60 40 20 0 Change in spot rates wl be as follows:
shifts in parallel manner,then only the overall
portfolio loss will be=0
BIGGEST DRAWBACK-Assumption that all spot
120BP r02
rates are perfectly positively correlated that 40BP 40/4=10 80
will bring a parallel shift.
120 40
THIS IS NOT TRUE IN REAL LIFE.
BP
r01 2 3 4 5
REAL LIFE SHIFTS TAKE PLACE AS FOLLOWS:- 40 30 20 10 r02 r03 r04 r05
New in case of steepening

Old
New in case of flattening 120/4=30

r05 6 7 8 9 r05 120/4=30

Steep new
old [DOUBLE WHAMMY]
Butterfly shift
So, Use Multi factor Risk Measures like
1. Key Rate Duration
2. Partial 0,1
3. Forward Bucket 0,1
1.KEY RATE DURATION
STEP 1: Choose specific Key Rates
Key Rate Duration is % change in price due to
1% change in spot rate of a particular
maturity,keeping other spot rates constant.
Since its hard to find out treasury securities of
all maturities traded in market,we choose
SPECIFIC KEY RATES from the most liquid
ON-THE-RUN SECURITIES.
STEP 2: Forecasting change in Spot Rates
Eg: If economy is going on through
recession,so,in short run,RBI should decrease
interest rates to make borrowing cheaper for
companies,in order to increase their
production.
STEP 3: Assume a certain pattern of change in
neighbouring rates [LINEAR DECAY]
0 30 60 90 120 80 90
40 60
NOTE:Only neighbouring rates are affected 30
i.e. change in r01 will only affect r02, r03 & r04 &
not r06,r07 & r08. r02 r03 r04 r06 r07 r08 r09
STEP 4: Find out Key Rate Duration
Kr01 = ∆ in portfolio value for a 1 Basis Point
shock in spot rate of particular maturity.
Whereas, Key Rate Duration =A % change in r09 120BP
price due to 1% change in spot rate of a 90
particular maturity,keeping other spot rates 60
constant. 30
NOTE: For an increase in yield,if there is
positive Key Rate Duration(KRD) & positive r05 r06 r07 r08
KR01 which indicates there is decrease in Sum of Key Rate Durations=Effective Duration
value. If trades neutralize all Kr01s,then yield based
Taking the above supposition,we will DV01 is neutralized.But,if trades neutralize DV01,
calculate individual Kr01 will not be neutralized.So,a good
KRD & KR01 for only R01 change, for only R05 hedge neutralizes individual sensitivities too.
change & for only R09 change.
Had it been a case of Duration & DV01 ,we 2.PARTIAL 01
would have simply shifted all the spot rates Gives sensitivity of swap portfolio for one basis point shock in the
by say 40BP & found out the change in swap rates rather than the Key Spot Rates.
portfolio. In key rates, no. of interest rates are smaller as compared to
STEP 5: Hedging swap rates.
i.e. Partial01/Entire time period*more periods
Suppose, when only R01 changes ,KR01 as per
Partial01 curve is constructed based on swap curve & swap curve
calculations =0.0125 & we hve the foll inf:- is based on prices of money market & swap instruments.
BOND Kr01 of Kr01 Kr01 of r09 No of securities used in Partial01 > no. used in Key Rate
r01 r05 framework.-Calc of Partial01 is not independent of underling
swap curve.
A 0.0025 -
Swap market participants fit money market curves using-“DAILY
B 0.0030 0.0120 FIT INTO CURVE”.
3.FORWARD BUCKET01-Involves framing buckets from diff.
periods like (0 to 5)& (5 to 9).Then,forecast a parallel shift in 1yr
C 0.0010 0.0050 0.0130 fwd rate for each bucket.Reverse engineering these fwd
rates,new spot rates can be manufactured.
For hedging,  5*10 yr Swaption with E=5%,is an option to enter into
a swap after 5yrs for 10 yrs.Swap wl be entered if
Short these bonds;
actual swap rate in mkt after 5 yrs>5%.
0.0025/100*(FV of A)+0.0030/100*(FV of PORTFOLIO VOLATILITY
B)+0.0010/100*(FV of C)=0.0125 ∆ in portfolio value=KR01*∆r01+KR01*∆r05+ KR01*∆r09
Use similar equations for r05 & r09. Portfolio volatility=Sq root of (KR012σ2r012+
Solving ,we get FV of A,FV of B,FV of C. KR012σ2r052+2rKR01KR05*σr01*σr05) Page 9
 Contact : PIYUSH : 9674006544
Visit: www.ulurn.in OPTION VALUATION
Summarised by: Karan Aggarwal
For a call option,Future cash flows are payoffs i.e. y= b0+b1x FOR A PUT OPTION:
S-E. Stock Price 1.RISK NEUTRALITY APPROACH
Call Delta rt
This S is uncertain & needs to be modelled. [p*Pu + (1-p)*Pd]/e =Price of a put
Two processes of modelling: Price option.
Delta=∆= (Cu- Cd)/( Su-Sd)
 Binomial Process
Assume,Delta=0.3
 Black Scholes Process 2. DELTA HEDGING
Delta means:
BINOMIAL MODEL: P+ & ∆S+
1)For a 1 $ ∆change in stock price,call price
There are only two values that a stock price can take ∆ of put =-0.7 (0.7*550)-0=385
will change by 0.3$
after 1 year i.e. upside possibility & downside 2) One call=0.3 stock
possibility. 3) One stock=3.33 calls
σ t (0.7*450)+70=385
Upside factor (u)=e √
σ t STEP 1: Construct a Delta Hedged Portfolio i.e. (500*0.7)+P=363.20.Calculate P
Downside factor(d)=e - √ i.e. = 1/upside factor.
C- & ∆S+.
STEP 2: Calculate certain payoffs on both 3. BANKRUPTCY FREE PORTFOLIO
BLACK SCHOLES MODEL: upside & downside prices.Both wl be equal. S- & Invest PV of 550
Stock price can take infinite possibilities on a Eg : Exercise Price=520, ,r =5.8269% ctsly Amt to be invested =PV of max S,so that
continuous scale.Binomial is a discrete process & compounded we remain bankruptcy free.
Black Scholes is a continuous version of Binomial. 550 Payoff=0.3*550-30=135 500-550/R=18.86
Cu=30 100/70=1.4 put options are replicated.
S=500 So, P+=18.86/1.4=13.2
520 520 450 Payoff=0.3*450-0=135
Cd=0 4. REPLICATING PORTFOLIO
S0=500 500 STEP 3:Cost of constructing portfolio=PV of ∆S- & invest x/PV
payoff discounted at Rf x-(550*0.7)=0
So,(500*0.3)-C=135/1.06 x-(450*0.7)=70
So, C=22.64 x=385
350-385/1.06=13.20
BINOMIAL MODEL: TWO PERIOD BINOMIAL MODEL
Wthin Binomial process,option price can be found 3. BANKRUPTCY FREE PORTFOLIO
Replicating an option,such that payoff is Start with option valuation on
out using any of 4 mthds:- maturity & find out option
matched.
Call option is replicated by leveraged buying valuation at each prior
i.e. borrow & buy 1 stock. node(Backward Induction
REPLICATING
Risk Amt to be borrowed =PV of min S,so that we Process)
PORTFOLIO-Replicate the
Neutral option payoff by buying or remain bankruptcy free. Be careful about
valuation selling ∆s by borrowing x & Step 1: S+ & borrow 450/1.06=424.52.Own American/European Option.
DELTA Check in American option at
Approach payoff matched. money invested=500-424.52=75.48
HEDGING each prior node(incl initial
-Payoff PORTFOLIO Step 2: Calculate payoff
not node).Check whether or not
Kill BANKRUPTCY option wl be exercised if
changed. directional FREE 550 Payoff=550-450=100
Price of Cu=30 IV>Discounted value.
exposure by PORTFOLIO For American call without
option= buying or Buy or sell 1 stock S=500
PV of & borrow 450 Payoff=450-450=0 dividend,European call,European
selling ∆S & Put,directly pull the payoff from maturity
expected make the something to Cd=0
payoff. replicate the So,3.33 call options are replicated. to beginning.
payoff 2 2
= u *Cuu +(1- u) Cdd +2* u* d*Cud
option pay off Now, Price of 3.33C+ =Price of Bankruptcy free
certain. [Leveraged stock
portfolio.
buying payoff For American Put & American call with
method] 3.33 C+=75.48
So. C+=75.48/3.33=22.64. dividend,we build the entire tree.
Put option price can be found
I. RISK NEUTRAL APPROACH out from call option using
4. REPLICATING PORTFOLIO
formula P+S+=C+*PV of E
Call option is replicated by buying ∆S+ &
Price of an option =PV of payoff discounted at Rf borrowing x amt,such that payoff of
Two-Period Binomial Model is an
rt improvement over one-period
[p*Cu + (1-p)*Cd]/e =Price of a call option replicating portfolio is matched with payoff of
Binomial Model.
call option.
p means probability,found in such a way that value Once a delta hedged portfolio is
Step 1: Buy ∆ Stock & borrow x amt such that
created, we cannot sit idle,we
of stock yields Rf rate of return. payoff is certain.
rt have to do Dynamic Rebalancing
p=(e -D)/(u-D) Step 2:Calculate x
of the portfolio to ensure its
Ans for risk-averse & risk-neutral world would be 550 30=(550*0.3)-x
hedge.
same. Cu=30 x=135
S=500
450 0=(450*0.3)-x
2. DELTA HEDGING Cd=0 x=135
2 risky positions combined to construct a riskless
portfolio(DELTA-HEDGED PORTFOLIO) without any Step 3:Cost of call option=Cost of replicating
directional exposure,with constant payoff. portfolio
Cost of portfolio today=PV of payoff discounted at C+=150-(135/1.06)=22.64 Page 10
Rf.
 Contact : PIYUSH : 9674006544
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Summarised by: Karan Aggarwal

Special Cases For Binomial Model Stock prices follow a smooth process & do not exhibit jumps-False
1. Dividend Paying Stock: In reality,these jumps are to be modelled separately using poison
rt (r-y)t
u=(e -D)(U-D) = [e -D]/(U-D) process.
*
Payoff =S=E,instead of S -E. Volatility is known & constant.-False
Only historical volatility is known but option pricing models
2. Options On Currencies require future volatility,which needs to be estimated.
For a Rupee/Dollar quote, Also,σ is not constant during life of option.
If we are buying call option on Dollar,interest rate on Rf is known & constant.-False
Rupee will be thought of as r. Not sure as to take 90 yr T-Bill/1 yr T-Bond/30 yr T-Bond.Rf is
Interest rate on Dollar i.e. Rf Dollar will be thought of not constant.
*
as dividend. Stock has no cashflow.We can use S in BSM for stock paying
(r-y)t
u= [e -D]/(U-D) dividend.
(Rf rupee-Rf dollar)t
u= [e -D]/(U-D) General Assumptions:
Markets are frictionless
3. Options On Futures Options valued are European options.
Future contracts are zero growth instruments. BSM cannot be used for American options.However,we can use
u=(1-D)/(U-D) Black’s approximation for American options using BSM.

BLACK SCHOLES MODEL

Its an analytical model. -rt
P0=Ee N(-d2)-S0N(-d1)
-rt
C0= SN(d1)-Ee N(d2) N(-d2)=1-N(d2)
N(-d1)=1-N(d1)
S-PV of E (Min value of call option which is IV) Delta of Put= -N(-d1)
After incorporating volatility premium,
The formula becomes:  In American call option using Black’s approx,we find put the
-rt
C0= S0N(d1)-Ee N(d2) option value using 2 stages.
Since call option =leveraged delta stock buying. Stage 1: Stand just before the date of dividend & compare it with
But E is paid only in cases when option lands -rt
a loss of TV of money (i.e. X-Xe )
In The Money. If D> TV of money lost;
dC0/Ds=N(d1)=Delta of CA/OPTION Think of early exercise & vice versa.
N(d2)=Probability that call will land in the money. In case of a non-dividend paying stock,never exercise the option
prior to maturity.
d1= [ln(S0/E)+(rf+1/2σ2)t]σ√
Stage 2:Find out option value using BSM
d2=[ln(S0/E)+(rf-1/2σ2)t]/σ√ 1. Assuming no early exercise
or 2. Assuming early exercise
d2= d1-σ√ The maximum of these 2 values is the final American option value.

ASSUMPTIONS OF BSM

Stock prices follow a log normal distribution.

(GBM Process i..e continuous returns are normally
distributed)
E(St)=S0 eα+1/2σ^2 =eu
u=Expected Rate Of Return
α=Mean of continuous returns
α=u-1/2σ2

Continuous returns are normally distributed with a

mean of (µ-1/σ2)t & SD =σ√t
ln St – ln S0~N((µ-1/2σ2)t,σ√ )
ln St~N(lnS0+(µ-1/2σ2)t,σ√ )

Page 11
 Contact : PIYUSH : 9674006544
Visit: www.ulurn.in CAPITAL STRUCTURE/CREDIT RISK Summarised by: Karan Aggarwal
PROBABILITY OF DEFAULT/EXPECTED DEFAULT ECONOMIC CAPITAL
FREQUENCY
Model prob of default using Bernoulli Distribution.
Mean of Bernoulli Distribution=p(prob of default)
Variance of Bernoulli Distribution=p*q
SD of Bernoulli Distribution=√ ∗
UNEXPECTED
LOSS GIVEN DEFAULT LOSS
=1-Recovery Rate CM
Expected loss Capital
Charge
EXPOSURE AT DEFAULT
Capital= Unexpected Loss* CM
Some authors take it as Outstanding Loan Amount
Beta distribution is used to fit the portfolio loss distribution.
Some others take it as Outstanding Loan Amt+a certain %
STEP 1:On getting a loss distribution using MonteCarlo Simulation,fit the adequate
of unused commitment.
distribution ,generally BETA DISTRIBUTION.

STEP2:Find out parameters of both distributions i.e α & B using MLE( Maximum
Likelihood Estimate)
CAPITAL MULTIPLIER(CM)
UNEXPECTED STEP 3:Choose the confidence level at which Mgmt wants to find out ECONOMIC
LOSS CAPITAL.
INSURANCE
Expected loss Capital STEP 4:Find out loss amount x at given confidence level suing inverse function.
Charge INVERSE FUNCTIN: Beta Inv (99.9%,α,B)
EXPECTED LOSS=PD*LGD*EAD
UNEXPECTED LOSS= Standard Deviation Of Expected Loss STEP 5:Capital Multiplier =[X-ELp]/UELP
CAPITAL CHARGE=Unexpected Loss*Capital Multiplier
CAPITAL CHARGE AT 99.9% CONFIDENCE LEVEL means that we are 99.9% confident
Bank meets EXPECTED LOSS THROUGH PRICING (HIGHER that the loss amount ≤ capital charge.However, in 0.1% of cases,the loss amount
INTEREST RATE),UNEXPECTED LOSS THROUGH CAPITAL can exceed the economic capital,in which case,the company will be under stress.
CHARGE & EXTREME LOSSES THROUGH INSURANCE.
ADDITIONAL POINTS
VARIANCE OF Expected Loss=Variance(PD*LGD*EAD)  Amt of capital that a bank is required to hold depends on its desired safety
2
=EAD *VAR(PD*LGD) level(or target credit rating) of it’s senior debt.
2  Expected loss is calculated from the bottom-up approach(transaction by
PD LGD
2 2 transaction) & reimbursed through adequate loan pricing.
σ PD σ LGD
 The estimation horizon for probability of default is typically chosen at YR 1.
2 2 2 2  Loss given default includes all costs associated with a collection & sale of
VARIANCE= EAD (PD * σ LGD+ LGD *σ PD )
2 2 2 collateral.
UEL=EAD√PD * σ LGD+ LGD *σ PD )
 The tail of fitted Beta distribution depends upon ELp/ ULp .
For higher quality portfolios,ELp > ULP ,Capital Multiplier is bigger and a
EXPECTED & UNEXPECTED LOSS IN A PORTFOLIO fat tail.Here, Beta distribution overestimates economic capital.
(Assuming portfolio contains only 2 loans) For lower-quality portfolios, ELp < ULP ,Capital Multiplier is lower and too
thin a tail.Here, Beta distribution underestimates economic capital.
Exp loss(portfolio)=EL1+ EL2  PROBLEMS IN QUANTIFICATION OF CREDIT RISK:
2 2
Unexpected Loss(portfolio)=√UEL1 +UEL2 +2*r*UEL1UEL2 1. Credits are illiquid assets.
2. We use 1yr horizon period rather than multi-period horizon.
High correlation leads to concentration risk & modeling correlation 3. Each risk is treated in separate departments i.e. SLO Approach.
between credits is very difficult.

Diversification benefit=
Non diversified portfolio Unexpected Loss-Diversified Portfolio
Expected Loss

Risk Contribution

RC1=[UL1(1*UL1+r*UL2)]/ULP

RC2=[UL2(1*UL2+r*UL1)]/ULP
OR
RC2=UELP-RC1

Risk Contribution can be thought of as Incremental Risk i.e

extra amount of risk in the portfolio due to the addition of
exposure 1 or exposure 2.

Page 12
 Contact : PIYUSH : 9674006544 OPERATIONAL RISK
Visit: www.ulurn.in Summarised by: Karan Aggarwal
Risk on account of failure of people,processes & systems. STEP 4: Repeat same steps for all other BET cells to get
Anything that does not come in market risk & credit risk comes under operational operational distribution for each of them separately.
risk. Adding operational VAR of each BL-ET cell will overstate the
risk.Build dependencies at 3 levels:
THREE METHODS FOR OPERATIONAL RISK CAPITAL CHARGE
Dependence btw frequency & severity within a cell.
METHOD 1:
Dependence btw frequencies inter cells.
 STANDARDIZED METHOD % of Gross Income Dependence in severities inter cells.
 BASIC INDICATOR APPROACH Used by Small Banks Focus on only Level 2 frequency.
CELL 1 CELL2
 ADVANCED MANAGEMENT APPROACH (AMA) Used by banks with huge 1 u1 u2
infrastructure 2 z1 z2
* 2
In AMA approach,we develop an operational loss distribution & cut out certain quantile to 3 z1 z2 =r* z1+√1-r * z2
*
find out OPERATIONAL RISK CAPITAL CHARGE. 4 u1 u2
5 Poisson Inv Poisson Inv
*
STEPS : BL-ET(Business Lines Even Types) (u1,λ1) (u2 ,λ2)
BL - ET
FRAUD SYSTEM FAILURE

CB DATA STEP 5: GAUSSIAN COPULA

IB FREQUENCY SECURITY Aggregate VAR(Value At Risk) which are correlated using
Treasury Gamma
Copulas to get the organizational VAR for the entire
Distr organization.
Fat tail DATA BIASES:
distr  SCALE BIAS: Adjust it using turnover if reqd.
No of frauds internal+external  TRUNCATED DATA BIAS: Do the adjustment while
Internal data MLE parameter estimation.
 DATA CAPTURE BIAS:There is high probability of big
losses which can overstate capital charge.For
CONVOLUTION adjustment,reduce frequencies.
Commercial OPERATIONAL LOSS-DISTRIBUTION  DATA ADJUSTMENT:
Banking  Split losses:Split common losses btw
Fraud Repeat for all BL- ET cells different business lines.
 Old Losses: Frequency-Only upt last 5
yrs.Severity-Last 5 yrs data +older than
Then aggregate VAR which are correlated using Copulas
that with reducing weights.
to get the Organizational VAR.  Inflation adjustment:Adjust old losses as
STEP 1: Divide organization into several BL-ET cells.Model op loss distribution for each BL- ET per inflation index.
cell separately.  Insurance: MORAL HAZARD:
STEP 2:Let’s start with say,commercial banking fraud(one cell).Model 2 random numbers i.e. Behaviour changes thereby avoiding
frequency of losses ( no. of frauds in one year) & severity of losses( amt of loss in each precautionary measures.To avoid this,opt
fraud).Use discrete distribution for frequency of losses & continuous distribution for severity for:DEDUCTIBLES & LIMITS
of losses.Use empirical data for no. of frauds & amt of losses .For frequency,use internal Eg: Gross lmit 100m$
data.For severity,use data eg data from commercial vendors. Deductible 10m$
STEP 3:How to get operational loss distribution? Limit 80m$
1. Fit discrete & continuous distribution- Claim Minimum(Max(100-10,0),80)
Perform PARAMETER ESTIMATION,DISTRIBUTION FITTING & FINALIZING THE DISTRIBUTION 80m
80m
USING GOODNESS OF FITNESS TEST. Fix poisson distribution with parameter λ for freq of
losses & gamma distribution with parameter α & λ for severity of losses. 90m

2. Simulate frequency of losses & amt of loss in each fraud using inverse 10m gross loss
transformation method.
Eg: ADVERSE SELECTION: Arises due to information
Freq Poisson SEVERITY asymmetry.Insurance companies attract bad policy
Inv GAMMA INV (Rand (),α,λ) holders.This can be mitigated through proper
(Random()α,λ) information exchange btw insurance co & policy
4 Add first 4 losses holder.
2 Add first 2 losses
Total loss distribution needs to be adjusted for
3 Add first 3 classes
insurance claims while modelling the capital charge.
1 Add first 1 class
Process of adding up losses in such a manner is called CONVOLUTION.Then get
total loss distribution for 1 BET Call.Cut a certain quantile ,say 99% to get
99% operational VAR.

Page 13
 Contact : PIYUSH : 9674006544
Visit: www.ulurn.in OPERATIONAL RISK
Summarised by: Karan Aggarwal
CAPITAL ADJUSTMENT:
Look at Business Environment & Internal Control Factors.
Calculate Risks score for each bank on a scale of 0 to 10.
Low risk score-good BEICF-decrease in capital.
High risk score-poor BEICF-increase in capital.
Capital adjustments should be done in such a way that increase in capital is higher than discount given,using exponential function.
Risk Control,self assessment casuality analysis,KRI.
Use capital charge for unexpected losses & identify areas leading to high operational losses.
Egs of casualty analysis:-
Correlation btw edu of staff & no of mistakes to see whether poor edu of employees is causing large no of mistakes.Other KRIs are
poor customer satisfaction score,staff turnover etc.

ALLOCATION OF CAPITAL CHARGE

Use a score based approach on questionares
Score good-risk low-capital low

VALIDATION OF CAPITAL CHARGE

 If 99% operational VAR is say $ 500million,means only in 1% of cases,losses can exceed VAR.
If on checking past 2000 losses,u get more than or less than 2000 exceptions,means model is not correct.
 Stress Testing:Check if capital is sufficient to cover up extreme losses & incorporate stress parameters in the model.
 Sensitivity & Scenario Analysis:
If severity is highly sensitive,do extra analysis while deciding severity distribution & its parameters.Take out stressed scenarios & find
out sufficiency of capital charge.
Check from experts whether loss no & capital seems reasonable or not.

BUSINESS LINES & EVENT TYPES

Business lines
 Commercial Banking
 Retail Banking
 Investment Management/ Asset Management
 Retail Brokerage
 Trading & sales ( Market making & marketing securities)
 Corporate finance (M&A)
 Payment & Settlement
 Agency services (securities lending,depository receipts)

EVENT TYPES
 Internal Fraud
 External Fraud
 Employment practices & work safety (Workmen Compensation)
 Client products & business practices( Confidentiality issue,legal liabilities)
 Execution delivery & process mgmt
 Business disruption & systmen failure
 Damage to physical assets

Page 14
 Contact : PIYUSH : 9674006544
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ARBITRAGE PRICING THEORY
Summarised by: Karan Aggarwal

 Ri= Rf +(Rm-Rf)Be
Ri-Rf=Be(Rm-Rf)
0\1
Excess Market Risk Premium
Return PRICE
SENSITIVITY
ri= E(Ri) +B*F1+ei Surprise in unsystematic factor

Actual
return as Expected return as Value of factor
per your
per market surprise
belief
consensus of factor
value

 Multi-factor risk model

Ri=Rf +B1F1 +B2F2
ri=E(Ri)+B1F1+B2F2+e

 Rp =E(Rp) +BPF+ep
Var( Rp)=Var(BPF)+var(ep)
2 2
Where ;Var(ep)=σ ep=1/n*σ ei
When n is large,non-systematic variance approaches zero.

 CONSTRUCTING A PORTFOLIO TO HEDGE EXPOSURE TO MULTIPLE FACTORS

For a 2 factor portfolio named p with Bp1=0.5 and Bp2=0.75;suppose we wish to construct a portfolio q which replicates portfolio p,we
can buy 0.5 of p1,0.75 of p2 and (1-Bp1-Bp2) in Rf securities.
So,E(Rq)=Bp1E(r1)+Bp2E(r2)+(1-Bp1-Bp2)rf
=rf+Bp1[E(r1)-rf]+Bp2[E(r2)-rf]

So, E(ri)=rf+Bp1RP1+Bp2RP2+…….+BpkRPk

Suppose actual values turn out to be different from market expected values,calculate revised expectations for the rate of return on
stock.
Ri=E(ri)+Bi1F1+Bi2F2+…..+BikFk+ei

 FAMA – FRENCH THREE FACTOR MODEL

rit= αi + BIm RMt+BiSMBSMBt+BiHMLHMLt+eit

Market factor
Size factor Value (P/B)
factor

Where;
o SMB=Small Minus Big ; ie;return of a portfolio of small stocks in excess of return on a portfolio of large stocks
o HML=High Minus Low ; ie ; return of a portfolio of stocks with a high book-to market ratio in excess of the return on a
portfolio of stocks with a low book-to market ratio.

 Value stocks tend to outperform growth stocks.

For growth stocks, P high,MV high but low BV/MV
For value stocks, P low, high BV/MV

Small cap stocks tend to outperform large cap stocks.

Page 15
 Contact : PIYUSH : 9674006544
Visit: www.ulurn.in RATINGS
Summarised by: Karan Aggarwal

INTERNAL RATINGS EXTERNAL RATINGS IMPACTS ON INDUSTRIAL RATINGS:

1. Time horizon
In house models developed by Qualitative assessment. Long term ratings(through the cycle)-more
Banks to approve/disapprove Quantitative assessment. stable,less accurate;high ratings are revised less;
Loan for internal monitoring, Meeting with Co and Board ST rating transition matrix is highly unstable.
Economic capital calc etc Meeting of Rating 2. Economic Cycle
Should resemble rating Committee & decide a Downgrades & PDs –higher during recession.
Agencies’ model,back test int preliminary rating. 3. Recession
Rating systems,link PD to Communicate to co,then Less rating consensusfor financial farms.
Ratings. public 4. Geography
Can be point in time or Regular montitoring. Non US Ratings may be biased.
Through the cycle.
 Rating changes impact bond prices bcoz of
size & demand factor i.e. liquidation of
Rating Agencies
downgraded bonds;same capital req for
AAA & BBB Bond in Basel 1 thereby
SNP : Focusses only on PD & Industry risk. increasing demand of BBB;increase in price
volatility due to bond buying & shorting
Moody’s: Focusses on expected loss ie PD & LGD & business CDS;trigger of collateral demand.
fundamentals  Price impact of rating change is
determined by Modified Duration,full
revaluation,direct observation(EVENT
RATING SCALE
STUDY ANALYSIS) & spread
decomposition.
 Long term & ST
 Internal rating system is a template,to
 Issue or issuer specific
assess credit-worthiness,to find
 Opinions,not buy sell recommendations
eco/regulatory capital,pro-cyclical effects.
 Ranges from AAA to D
( Investment grade from BBB & above;
PRO-CYCLICAL EFFECT
Speculative grade from & and below)
 BASEL-II REQUIREMENTS
Higher capital req during recession,over lending in
RATING PROCESS good times ,underlending in bad times.
 Quantitative or qualitative  Expected loss rather than exposure
 Similar to equity analysis ,except that ,it focuses on bonbon Internal limits exhausted with current loans since
Holders perspective & its LT credit limits set in terms of expected loss ;PD
 Corporate issuers pay for the ratings. high,no space for new loans.
 At the point in time ratings (PIT)
TRANSITION MATRIX Underestimate risk during growth & overestimate
Checks the migration of ratings over time. risk during recessions.
 Diagonally,probs are highest.  Short-Term projects
 Relation is ordinal. PIT biased in favour of ST projects,sub-optimal
 Prob of default of suppose AAA ,for a matrix containing decisions.
AAA,AA,A,BBB is founded by
st
Prob of default in 1 yr as AAA + (prob of remaining AAA*prob of
default in next year as AAA)+(prob of becoming AA*prob of default
in next year as AA)+(prob of becoming A*prob of default in next year
as A)+(prob of becoming BBB*prob of default in next year as BBB)
 Rating matrix is time varying.
 Have homogenous default rates

Page 16
 Contact : PIYUSH : 9674006544
Visit: www.ulurn.in Summarised by: Karan Aggarwal

INTRODUCTION TO DERIVATIVES

Def:-A financial contract (y) that OPTION ORIENTATION Additional Points Leverage Payoff Ratio
derives its value from an underlying
variable (x).i.e y=f(x).  At the money options=
-One sided betting OTC-Likely to be
-If St>So
Eg:F/WContracts,Futures,options,s governed by
Lev Ratio= So/Co;
ISDA(International -If St<So
waps etc. Call Put Swap and Dealer’s Lev Ratio=0

 When S>E,call exercised

Association).
 Non ATM Options=
 When S>=E,put lapses
Standardized OTC Lev Ratio =
Used by entities -  When S<=E,call lapses
Derivatives.-Central
 When S<E,Put exercised [(St-K)*No of
Counter Party present
 Having exposure to x (Hedgers) & margins hve to be calls]/[St-So)*No of
 Having price belief( Two Types of options posted with them.Post Shares]
Speculators/betters) 1European Option-can be exercised only crisis,most of them
 Arbitragers( take offsetting on maturity required to be executed
positions for risk-less 2.American Option-can be exercised on Hedging can result in an
on Swap Execution
profit) or prior to maturity Facility(SEF) outcome,which is worse
Forward contract-To
buy/sell commodity at Positions in option- Non Standardized OTC
than what would hve been
a predetermined price  Long call( c+)-Right to buy the Derivatives-Bilaterally without hedging.
at some later date/both share at E/Right to enjoy the Traded
side-betting. upside/bullish/high
volatility/Highly risk averse- Avg trade size of OTC Payoff of Fwds and
Futures-Similar to (ltd loss &unltd profit) Market is bigger than options is not same.
F/W Contract except  Short call(c-)-Obligation to exchange-traded.
that it is exchange sell the share/obligation to
traded. suffer the upside/bearish/low
Futures Mkt suffers Theme- Tools For Hedging
volatility./less risk averse i.e.
from basis risk whereas
Financial Swaps- aggressive(ltd profit and
forward mkt has lower Option Option Forward
Portfolio of F/W unltd loss )
basis risk ,but suffers Buying Selling Cover
Contracts /Exchange  Long Put(p+)-Right to sell the
from lower liquidity &
of a stream of cash share/right to enjoy
higher counter-party
flows downside/bearish/highly risk Highly Less Risk Highly
averse.(ltd loss & ltd profit )
risk. risk Averse risk
 Short Put(p-) averse Firm averse
Obligation to buy the F- = P+ and C- firm expecting firm
share/oblg to suffer (payoff wise) expecting low having
2 Types of Derivatives downside/bullish/expects
high volatility no
low volatility/less risk averse
Over The Counter Exchange Traded i.e. risk aggressive.(ltd profit -Downside is ltd in volatility opinion
& ltd loss) about
both C+ and F+ while volatility
-Customised Standardized Options are only short at upside is unltd in
risk,not long at risk.
-No margin req Margin Req both C- and F- both
Moneyness of option have unltd max loss. Theme-Liquidity
-No mark to market Mark To Market
Risk
-Physically settled Squared off prior S>E S=E E>S P+ and S+ is Funding Trading or
on maturity to maturity else i.e. cash flow Asset or
cash settled Call In the At the Out of protective put -Credit Risk Product –
money money money strategy.P+ and S+ = Market Risk

-Unregulated Regulated C+ (profit wise)

Put At the In the
-Counter party Out of money money Theme-Market
Clearing house S+ and C-=P- ( profit
money Microstructure
-Suitable for Suitable for wise)
hedging speculation Quote/Dealer/Price Order
Driven mkt-Dealer earns Driven
Eg:-F/W contracts Eg:Futures Bid-ask spread+Rf Return Mkt.
&swaps on inventory Page 17
 Contact : PIYUSH : 9674006544
Visit: www.ulurn.in MECHANICS OF FUTURES Summarised by: Karan Aggarwal

Both Forwards & Futures belong to category of-“ FORWARD COMMITMENTS”-both sided betting.

Def-Contract to buy/sell a commodity at an agreed upon price at a later date.

Similar to F/W Contract except that it is exchange-traded. Diff btw the two same as btw OTC & Exchange Traded.

TERM STRUCTURE OF FUTURES PRICE

Margin Req:-
Trader---------Broker---------Member-------Clearing
House
(A)
Deposit Initial Margin.
Change in price reflects
in Margin.When margin
balance falls below
Maintenance
Margin,there is a
margin call & trader
brings back margin
balance back to Initial-
Margin brought back is
known as Variation
Margin.
COST OF CARRY MODEL
F = Se ^ ((r + u -y-c) x t)
Where
r=Risk free rate
u=Storage Cost
y=Monetary benefit
c=Convenience Yield
Consumption Asset-Does not have y except gold
Investment Asset-Does not have u & c
Changes made in OTC Mkt
post 2008 crisis- CASE I-F(3)>(F2)>F(1)>S -CONTANGO/NO
C/SHORT SHD DELIVER AT BEG. OF DELIVERY
Bilateral CCP
Settlement- Settlement PERIOD
ISDA,NETTING, Margin –(A)
(B) COLLATERALIZATION CASE I-F(3)<(F2)<F(1)<S-
Only Initial Margin With/without BACKWARDATION/VERY HIGH C/SHORT SHD
(CLEARING MARGIN) Threshold DELIVER AT END OF DELIVERY PERIOD
ON NET
LONG/SHORT RULE OF CONVERGENCE- F=S ON MATURITY
POSITION IN Standardization in Futures BASIS=S-F (+VE IN BACKWARDATION ,-VE IN
CONTRACT.
CONTANGO)(Shift can take place from contango to
 Asset Quality backwardation & vice versa)
 Contract Size
 Delivery Arrangement F+ Backwardation +ve Roll Yield
Contango -ve Roll Yield
 Delivery Period
 Price Limit & Position
F- Backwardation -ve Roll Yield
Limit
Contango +ve Roll Yield
(Choice always enjoyed
by short (F-),hence its F>E(S)=Normal Contango
futures price lower ) F<E(s)=Normal Backwardation
INTEREST ON MARGIN
INITIAL MARGIN VARIATION MARGIN
FUTURES CASH-INT RECD NO INTEREST
SECURITIES(MARGIN WITH
HAIRCUT)-NO INTEREST
F/W CASH-INT RECD CASH-INT RECD (because daily settlement
SECURITIES(MARGIN WITH does not take place as against Futures).
HAIRCUT)-NO INTEREST

Relationship btw Futures Price & Fwd Price(When F is +vely correlated to Int Rate,one would choose Long Futures over Long F/W)

DETERMINISTIC(PREDICTABLE) STOCHASTIC(UNPREDICTABLE)

FUTURES PRICE=F/W PRICE

Int Rate +vely correlated to Int Rate -vely correlated to F

F

Futures Price> FWD Price Futures Price< FWD Price (Eg

Eurodollar Futures)

Page 18
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Interest Rates Summarised by: Karan Aggarwal

Basics:
Derivative Valuation requires the use of Rf.
-Effective annual rate ieff = (1 +i/m)m -1 Rf

-Interest rate p.a. compounded m times a year=im = [ ( 1+ eff)1/m-1]*m Treasury Downward Biased (Rate on instrument issued by a
Rate Govt in its own currurency)

-John C Hull always uses Continuous Compounding . LIBOR Recommended by HULL

(Rate at which AA or AAA bank can borrow money
eic-1 on unsecured basis from another bank)
-Conversion Formula- ic ieff Fed Funds Unsecured interbank overnight rate of interest
Rate

Repo Rate= Sell sec at lower rate at T0 at say price X

ln(I + ieff)
(Diff btw X & BANK BANK
-Direct Multiplication/Division can take place in continuous Interest Rates
Y)

Treasury Bonds –Actual/Actual Repurchase sec at higher Rate at T1 at say priceY

-Day Count Convention BB
Theories of Term Structure
Corporate/Municipal Bonds- 30/360
Pure expectations F/W Rate =Unbiased Estimate of
E(S)
Money Market Instruments ( Eg. Commercial Paper)– Actual /360
Liquidity Prem F/W Rate =Overestimate of
E(S)
-Full Price= Clean Price + Accrued Interest
Segmentation Interest Rate-Demand& Supply
-Spot Rate(Zero Rate)=Yield on Zero-Coupon Bonds/Pure Rate Expectations-No role to play.

Term Structure Of Interest Rate- Derive Zero Rates? Forward Rate Agreement Additional Points-
n
Rel btw Spot Rates & -Boot Strap Approach
(FRA)
Maturity.It’s plot known as Since treasury ZCBs of different -Int rate risk of a bond-Single risk factor i.e.r
Treasury Spot Rate Curve. maturities are not available,use C which wl cause a change in the price of Bond
F/w contract on Interest p
strips and P strips,issued by Rate,primarily LIBOR.
Cash Price of Bond =PV of Future dealers.( Refer sums) FRA , always quoted in the
Cash Flows discounted at exam as compounded
appropriate SPOT RATE. quarterly,semi-annually etc.
FORWARD RATE- r
Future Zero Rate implied by
FRA
(When r rises , p falls at a decreasing rate (
Remember-Treasury always pays today’s term structure of interest Long Position Short Sharma ke),
coupon semi-annually. rates. Position When r falls, P rises at an increasing rate (jor se)
Upside Betting Upside
Bond Yield (YTM)=Disc Rate Fwd Rate for period btw Betting -Macaulay’s Duration=
-yt
which makes PV of Cash T1 & T2 ∑ti[cie i/B]
= ( R2 T2 - R1 T1)/( T2 - T1) Contract to pay Contract to
OR
Flows=MP of Bond FRA Rate & receive FRA
enjoy actual.(as Rate & pay
=∑wx (can be interpreted in yrs as well as %)
-Complex avg/proxy of diff. spot ( where x=1,2,3 & w= prop of bond price
per HULL) actual.( (as contributed by each cash flow)
rates-Use calculator to calculate Thus, bigger spot rate is per HULL)
effective yield & then convert also=weighted avg If yield is not ctsly compounded-
into continuous.( Feed arithmetic mean of Contract to Contract to D= Macualay’s Duration/(1+r)
PV,PMT,N,FV in calculator & i/y ) smaller spot rate & Fwd borrow notional invest (where r is periodic ytm)
Rate. amt after a notional amt Convexity=Rate of change of duration wrt
certain period at after a to yield/Slope of duration/
Remember- i/y gives always
FRA Rate certain 2nd derivative=∑wx2/∑w
effective rate in calculator. Instantaneous FwdRate,given
period at -Convexity Adjustment=1/2*c*∆y2*100
R= T-year rate -In case of discrete compounding,
FRA Rate
= R+ T*(Rate of change of R wrt T) modified convexity=Mac convexity/(1+r/m)2
Types Of Sums
Par Yield=Coupon rate on the 1.Valuation of FRA on -Higher maturity-higher dur-higher convexity
bond which makes the bond Maturity(IMP) -Higher coupon rate-lower dur-lower convexity
Upward sloping yield curve- -Higher yield-lower dur-lower convexity.
trade at par. 2. Valuation of FRA prior to
Fwd Rate>Zero Rate>Par Yield -BARBEL OUTPERFORMS BULLET PORTFOLIO FOR
Maturity(IMP) large ∆ in Int Rate.
Periodic Power Yield= -(Look through their sums.Don’t
Downward sloping yield curve- -Duration of ZCB=MATURITY
(1-dL)/(∑d) mug up formulas)
Fwd Rate<Zero Rate<Par Yield Page 19
-Duration of Perpetual Bond=(1+ytm)/ytm
-Convexity of ZCB= t2
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Forward & Futures Price Determination

Priced by the Prevention of Arbitrage Principle. ( Arbitrage means “Making Risk-less Profit” )
2 Types

Go long & short in 2 diff. derivatives Take a simultaneous long & short position
Today,such that there is +ve cash flow such that cash flow Today is nil & non- zero
Today & no risk of future loss. Prob. Of future profit.
PRICING OF A FWD CONTRACT VALUE OF A FWD CONTRACT OTHER LEARNING OUTCOMES

Price-The F/W Rate decided It refers to the amount that will be received or paid on A)
initially based on Prevention the cancellation or sale of the fwd contract. Investment Asset Consumption Asset
of Arbitrage. Value=ZERO ,to begin with.
Fwd Rate in the market
changes as time passes. Asset held for Asset held for
A)In case of Asset having no storage cost & no income investment. consumption eg.
copper,oil.
A)In case of Asset having no Value to the Long = S- Ke
-rt

storage cost & no income OR F/W /Futures price- F/W /Futures price-
CAN be determined by CANNOT be
rt
F=Se ( F-K )*e
-rt Arbitrage Arguments determined by
i.e. F=Spot Price + Funding where,F is the new F/W Rate Arbitrage Arguments
Cost & K is the old F/W Rate
rt
B) Short Selling-Borrow stock,sell it short
Case 1: If actual F > Se B)In case of Asset which provides known income Adv- Price fall,Short Int Rebate etc
-
Sell F/W, Buy spot & Borrow Disadv-Short squeeze, Price/Div Risk etc
funds at Rf
Value to the Long= S*-ke-rt C) Currency F/W Contracts
-CASH & CARRY ARBITRAGE
where, S =Ex coupon Spot Price=(S-I)
*
F= S e (rA-rB)t (if the quote is A/B)
Remember,
f= S*- ke-rAt
rt
Case 2: If actual F < Se
-Buy F/W,Shot sell spot & Value is denoted by f (Small f)
i.e.
Invest proceeds at Rf
f= S e-rBt-ke-rAt
-REVERSE CASH & CARRY Relationship btw F & E(S)
ARBITRAGE
F=E(S) {Pure Expectations Theory} D) Futures Price on commodities incorporating
F>E(S) {Normal Contango} income/storage cost and/or convenience yield.
Arbitrage Profit= Amt of
Mispricing
F<E(S) {{Normal Backwardation} F=(S+U)ert
Where U=PV of the storage cost
F ~ Sert FIRST EXPLANATION
KENES & HICKS
If storage cost is given as ctsly compounded rate,
Case 1:Hedgers are net short on the commodity
B)In case of Asset which (Eg. Bakery Firms)
To hedge, they wish to go long--- speculators wl go short F=Se(r+u)t
provides known income
,if, F>E(S) –NORMAL CONTANGO
(r+u)t
rt If F< Se , EVEN THEN,Reverse Cash & Carry
F=(S-I)e Case 2: Hedgers are net long on the commodity Arbitrage doesn’t occur-bcoz it’s a consumption
Where ;I = PV of div or coupon (Eg. Wheat farmers) asset.Convenience Yield is derived out of it.
within the maturity of the F/W To hedge, they wish to go short---speculators wl go long
Contract ,if, F<E(S) –NORMAL BACKWARDATION
So, F=Se(r+u-y)t
Case 3:Hedgers are neither net long nor net short
So, F= S*ert i.e. F=E(S) E) Delivery Options available in the Futures
*
where, S =Ex coupon Spot Market
Price SECOND EXPLANATION -which grade to deliver & when to deliver –
CAPM enjoyed by Short.
rt kt (r-k)t (r+u-y)t
F/e = E(ST)/e i.e. F=E(S)e ,where k= Rf+(Rm-Rf)Be In the eq:- F=Se i.e. F=Sect ,where
Remember, C=COST OF CARRY
Price is denoted by F (Capital Case 1: Beta=0 i.e. r=k i.e. F=E(S) Case 1: If c>0
F) Pure Expectations Theory r+u>y ( Assume delivery at the beginning of Month)
Case 2: +ve Beta i.e. k>r i.e. F<E(S) Case 2: If c<0
NORMAL BACKWARDATION y> r+u ( Assume delivery at the end of Month)
Case 3: -ve Beta i.e. k<r i.e. F>E(S) Page 20
NORMAL CONTANGO
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LONG vs SHORT HEDGE Practical & Theoretical Arguments Algebraic Understanding of Basis Tailing The Hedge
for & against Hedging Risk
Long hedge-Buying Futures Since futures are
to hedge an Central Theme- Non financial firms ---no Case 1 subject to daily
exposure/require a expertise to predict movements—they shd Imagine a wheat farmer who sells settlement,we
commodity/currency hedge all financial exposures. futures at F1 need to adjust the
later,afraid of At T=2, hedge i.e. tail the
commodity/currency price Issue 1 hedge.
Inflow =S2+ Profit from Futures i.e.
Can S/Hs of an airline co buy crude oil
rising Inflow=S2 +F1-F2 = F1+b2 Tailing the Hedge
futures?
Eg.Importer,Bakery means:-
Counter argument
Firm,Airline Co afraid of -Inf asymmetry & economies of scale No of Futures
*
crude price rising. Since S/Hs hold a diversified portfolio,no Case 2 contracts(N )=
need to hedge? Imagine a bakery firm who buys =
*
Calculate Cost i.e. Counter argument h *(QA*S)/(QF*F)
futures at F1
OUTFLOW on MATURITY Theoretically correct,practically no evidence
to prove that all S/Hs diversify.
At T=2,
DATE OR
Outflow =S2+ Loss on Futures i.e. *
[LOWER THE BETTER] = h *VA/VF
Issue 2 Outflow=S2 +F1-F2=F1+b2

Short hedge-Selling Futures Assuming Where,

Jewellery Industry-Price Elasticity-low So,Weakening of basis benefits long
to hedge an exposure/ have S=Spot Price
hedge,hurts short hedge
or expected to receive F=Futures Price
Dangers in Hedging when competitors do not Whereas,Strengthening of basis
commodity/currency QA=Exposure Size
hedge benefits short hedge,hurts long
later/afraid of QF=Lot Size of
Your margin unstable,competitor’s margin hedge.
commodity/currency price stable Futures
falling since they have to ∆Gold Effect on Effect on Effect on This makes the
SPECIAL CASE [CROSS HEDGE]
sell. Price price of profits of profits of hedge dynamic.
Asset underlying futures contract is
Eg.Exporter,Wheat Gold Take a safe &
different from asset to which we are
Farmer,Oil Refining Co jewellery chance co secure co
Rise Rise None Rise exposed
afraid of crude price falling.
Suppose ,airline co buys futures on
Fall Fall None Fall heating oil,whereas it requires jet
Calculate Inflow i.e. SALE
fuel at T2.
PROCEEDS ON MATURITY Let S1,S2 be spot price of jet fuel
DATE * *
Let S1 ,S2 be spot price of heating oil Hedge
[HIGHER THE BETTER] Issue 3 So,outflow= S2+loss on futures Effectiveness
Hedging can lead to worse outcome =S2+ F1-F2
2
PERFECT HEDGE Hedging via Futures protects from adverse =F1+S2-F2 =r
Uncertainity gets outcome,but does not allow to enjoy However S2-F2 is not basis. =Proportion of
completely eliminated- favourable outcome. * *
variance
when commodity So,basis = F1 +(S2 -F2)+(S2- S2 ) eliminated by
*
Here, ( S2 -F2)=basis risk hedging.
matches,maturity matches BASIS RISK *
& (S2- S2 )=Additional risk of diff
& quantity matches Termed as uncertainity that still remains even
btw spot price of our asset & spot price
(Doesn’t happen in real after hedging exposure via futures.
of asset underlying futures contract.
life/Ignore transaction Hedging is generally imperfect ( bcoz of
Asset/maturity/quantity mismatch)
MINIMUM VARIANCE HEDGE RATIO
costs,margin req. & daily In case of cross hedge,
 Choose underlying asset same as
mark to market features) *
No of Futures contracts= h *QA/QF
the asset to which firm is
Exposure maturity=Futures exposed/which is stongly correlated
maturity. to exposed asset.
*
Here, h =Minimum Variance Hedge
On Futures maturity,  Always choose futures maturity that Ratio,Optimum Hedge Ratio
Spot Price=Futures Price lies just after exposures maturity. -Slope of the best fit straight
and basis =0 ( Eg. for March futures,choose April line,when carrying out regression of
futures) ∆S on ∆F
In such a case, -Feb contract wl never be chosen
∆S
EFFECTIVE COST FOR LONG -March contract shd not be chosen
as option lies with Short-might not h*=rσ∆S/σ∆F
HEDGE/EFFECTIVE
suit Long.
REALISATION FOR SHORT Slope= h
*
The use of h
*
-May contract shd not be
HEDGE WILL BE = F1 chosen,as minimizes the
(i.e. Futures Price on Date of Greater distance btw exposures ∆F variance of our
Initiation Of Hedge) maturity & futures maturity-greater position.
is basis risk.
Page 21
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Hedging Strategies Using Futures continued.

STACK AND ROLL HEDGE

Hedging Systematic Risk Using Stock Index Futures

What is an Index? Index is a portfolio of securities

Eg. CNX Bank-Index of 12 large cap bank stocks
Eg. CNX Nifty- Overall Market Index of 50 stocks
 Index futures are always cash settled.
 Consider a FII,confident abt its portfolio but
afraid that market may collapse in short run
Obj-To protect against short term market
decline but enjoy long term appreciation of
portfolio
When a firm has long-dated exposure,( eg exposure
maturing in say 1,2 yrs etc.),hedging it via long dated
futures is not possible because long dated futures lack
liquidity.Hence one has to enter into short-dated futures
contract,say 1 mth,square it off at the end of 1 month &
enter into a fresh 1 mth contract.

Method1- Sell entire portfolio,invest in -Contango is beneficial in rolling a short hedge.

Treasury securities at Rf-sell them & buy back -Backwardation is beneficial in rolling a long hedge.
portfolio when market crashes.
Comment- Not advisable-involves transaction
Eg Metallgesellschaft Case (Imp)-It had entered into a 5 yr
cost & FII is worried only abt a temporary
Fwd contract to sell heating oil to customers.It ran the risk of
drop/not permanent.
price going up,due to which it entered into short dated
Method2-Sell Index Futures-If mkt futures & decided to roll them over-
crashes,gain on short futures wl offset loss on [This resulted into huge losses.]
portfolio.
Comment
This (S+,F-)results in hedged portfolio Reasons-
providing a Rf Return  Oil prices fell-Loss in futures position & gain in F/w
position.
Math Involved
 Market for oil changed from backwardation to
STEP 1
*
No of Futures Contracts (N ) =(BT-BP)VA/VF contango.
Where BT=TARGET BETA,  Futures loss resulted in cash outflow on futures
BP=BETA OF OUR PORTFOLIO, position but no cash inflow in fwd gain leading to
VA=VALUE OF OUR PORTFOLIO, liquidty problem.
VF=VALUE OF OUR FUTURES CONTRACT I.E.
FUTURES PRICE*LOT SIZE
ADDITIONAL POINTS(REMEMBER):-
STEP 2
Style of settlement on the day of lifting of  Variance of (S-F)
hedge.(Assume Futures are short & NIFTY
has fallen) =σ2S + σ2F-2cov (S,F)
- Calculate % fall in Nifty.Thereby,multiply it
by Be
of portfolio to calculate % fall in portfolio  Variance of (S-HF)
-Calculate profit on futures =σ S + H2σ2F-2Hcov (S,F)
2
-Calculate net gain as a % of portfolio value
where cov (S,F) =rσS σF
p.a.- Perhaps this is Rf.

 Be =r σy/ σx
where x=market;y=stock/portfolio

 Lot Size of SNP 500 Index=250

Page 22
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-Day Count Convention (Discussed earlier)

-Quoted Price of the bond/Clean Price/Ex-Interest + Accrued Interest = Full Price/Invoice Price/Dirty Price.

-The price of U.S. TNotes & T Bonds is quoted as 32nds of a dollar.

[ Eg 1:-if the price is 98-22,it means (98+22/32)% of F.V. =98.6875%of F.V.
Eg 2:-if the price is 98-1575,it means (98+15.75/32)% of F.V.=98.4922%of F.V.]

-T Bonds are long term coupon bearing bonds (HIGHLY VOLATILE) which pay coupon semi-annually.Their F.V. is taken to be 1 Lakh
 If somebody expects int rates to fall,buy T-bond(S+) or T-bond futures(F+).
 If somebody expects int rates to rise,sell T-bond(S+) or T-bond futures(F+).
 Profit/Loss on T-Bond Futures=∆Price= No.Of Ticks* $31.25*No of contracts
Why $31.25?
Since, 1 tick =1/32%
So,profit/loss due to ∆ in 1 Tick = 1/32% of 100000= $31.25

Conversion Factor(CF) Theoretical Futures Price Of T-Bond Futures EURODOLLAR FUTURES

Alternatives if you wish to hold bond on -Based on $1milion,3mth
Since T-Bond futures are physically settled,i.e. short has Maturity/Settlement Date: Euro Dollar Deposit.
to deliver & long has to pay & take delivery,if not 1. Buy Futures today(F+). (OR) -Euro Dollar Deposit refers
squared off prior to maturity,for this purpose,Exchange 2. Buy Spot today at full price. to $deposit outside U.S.
announces a basket of deliverable bonds. Today=Valuation date made by a MNC Bank or FI of
Eligibility: Bond with maturity >15 yrs(not callable Equating both alternatives,we get= atleast AA credit rating.
st
within 15 yrs from 1 day of Delivery Month) F*CFi+AIT =(S-I)e
rt  F=100-Annualized
The bond chosen by short to deliver=CTD(Cheapest To 3mL
Deliver Bond). Where;  Tick =0.01%
Exchange announces CF for each eligible bond,such that S=Clean Price on Valuation  Effect of 1
delivery price received by Short= F*CFI Date+Accrued Interest from last Tick=0.01% of
where,F is the last settlement price, coupon date to Valuation Date $10,00,000*3/12
CFi is the conversion factor of the particular bond(ith bond). =$25
I= PV of coupon pulled from next
CF ensures that short is not benefited by delivering worst
coupon date to Valuation Date
bond,so,diff bonds are made equivalent.
rt =Rate of borrowing for the Expectation:
Short buys the ith bond at Si & delivers it to get F*CFi period from Valuation Date to Case 1: Interest Rate wl rise,
So,Cost of delivering bond for Short= Si- F*CFi Maturity Date F will fall-Trader should take
F=Futures Price on Valuation Date a short position in Futures(F-
CTD Bond=Min[Si- F*CFi] for Maturity Date ).
CFi =Conversion Factor Case 2: Interest Rate wl fall,
Shortcut for CTD:- F will rise-Trader should take
AIT = Accrued Interest from next
Bond for which coupon date till Maturity Date a long position in Futures(F-)
Si/CFi is the least. Profit/Loss=Change in
Conclusion: ticks*$25*No of Contracts.
Calculation of Conversion Factor (Assume underlying
bond is a 6% U.S. T-Bond)
st F=[(S-I)ert- AIT]/ CFi
Step1-Stand on the 1 day of delivery month
Step2-What is the remaining maturity of the bond?
Step 3-Round it off downwards to the nearest 3 months WILD CARD PLAY(T-BOND FUTURES)
Step 4-Now calculate clean price with 6% disc rate.Divide it Suppose delivery month is Sept,when in Sept will
by 100 to get CF.Problem does not arise if Step 3 results in a the Short decide to deliver? Value Of A Contract
multiple of 6 months. Early Sept or Late Sept? =10,00,000[ 1-1/4*i]
This depends upon Wild Card Play.
Impact of level & shape of yield curve on CTD T-Bond Futures Market closes at 2pm.
T-Bond Cash Market closes at 4pm.
decision
Notice of intention to deliver can be delivered by
8 pm.
 If market yield>6% i.e. Si is low-GOOD Case 1: Bond Mkt starts falling after 2pm
Take lower coupon,long maturity bond. Short wl buy CTD from Mkt before
 If market yield<6%,Si is high-BAD 4pm(LOW),then serve notice to deliver at
Take higher coupon,short maturity bond. settlement price of F determined at 2pm(HIGH).
 Yc =upward sloping i.e. Si is low- GOOD Case 1: Bond Mkt doesn’t fall after 2pm
Take long maturity bond. Short wl wait for end of Sept to deliver.
 Yc =downward sloping i.e. Si is high- BAD Theme-Short doesn’t enjoy a distinctive adv,since
Take short maturity bond. there is lots of shorting making futures price
already less.
Page 23
 Contact : PIYUSH : 9674006544
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Interest Rate Futures continued.

Hedging Using Euro $ Futures Convexity Adjustment

Step 1:Calculate no. of Future contracts to be bought/sold.
For derivative pricing,we need Rf,which should be taken as
Step 2:Calculate actual interest income/expense. LIBOR.However neither LIBOR nor FRA are available beyond 1 yr .
So,use Suro Dollar Futures to backout Forward LIBOR.
Step 3:Calculate F using F=100-3mth LIBOR. Euro Dollar Futures are quoted at lower price.
Reason
Step 4:Calculate loss/profit = 1. F=100-L (People hate daily settlement)
(Change in ticks*$25*No of Future Contracts) 2. Settlement of futures takes place at T1
Instead of T2(This hurts)
Step 5:Calculate net Interest income/expense by using Step 2 & F=DOWNWARD BIASED means
Step 4. LIBOR implied by F=UPWARD BIASED
So,deduct convexity adjustment.
Step 6:Calculate Annual Interest earned/cost(in %)=
2
Step 5/(Amt to be invested or borrowed)*100*12/3 Convexity Adjustment=1/2*σ *T1*T2

Step 7:Adjust timing diff in no of contracts= Where, σ =SD of short term interest rate in 1yr.
1/[1+(( Int Rate)/100*1/4)] T1=Maturity of Futures Contract
No of contracts=Step 7*( Amt to be invested or borrowed) T2=T1+0.25

REMEMBER
Convert LIBOR implied by Futures Price into continuous & then
deduct convexity adjustment
Is Hedge via Futures perfect? Since convexity adjustment is in terms of continuous
compounding & LIBOR implied by Futures Price is based on a Day
No,its imperfect.Reasons: Count Convention.
 Problem of Standardization
 Daily MTM feature in Futures Using Euro Dollar Futures to extend LIBOR zero
 Timing difference –Suppose futures are settled curve
on T1,interest expense has to be incurred
3mths after T1.This can be tackled by adjusting Eg. I yr LIBOR= 8%
No of Future contracts as shown in Step 7. Fwd Rate for a 90 day period beginning in 1 yr =8.4%
Spot LIBOR for 1 yr 90 days
today=[(1*8)+(0.25*8.4)]/1.25
=8.08%

DURATION BASED HEDGING

Duration Based Hedge ratio/Price Sensitivity Based Hedge Ratio/No Of Contracts= (P* DP)/(VF* DF)

Where, P = Forward value of the portfolio being hedged at the ,maturity of hedge , else , current value of portfolio.
DP= Duration of portfolio at maturity of hedge.
VF= Value of 1 T-Bond Futures Contract (Remember F.V. =100000,not 1 million).

DF=Duration of CTD at the maturity of Futures Contract.

LIMITATIONS OF DURATION BASED HEDGING

It assumes parallel shift i.e. all interest rates would change by the same amount in the same direction.
In real life,parallel shifts are infrequent.
Spot Rate F
Initial
[Short Term Rate has fallen ,while long term rate has gone up.]
Time So, DA=DL used by FIs’ is just 1 step out of many other tools to manage interest rate
exposure.
Page 24
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Suppose a firm(X) expects LIBOR to rise in next 5 yrs-To speculate on the same,it can enter into a “receive floating,pay fixed bond”.
8%

X ‘’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’
Counterparty [Here,the fixed rate is known as the swap rate.And principal ’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’
amt here is notional].
’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’’ So, a financial swap=exchange of a stream of cash flows.
Calculation of cash flows depends upon some reference Interest Rate(Int rate
6mL
‘’’’’’’’’’’’’’’’’’’’’’’ Swap),Exchange Rate( Currency Swap),equity price( Equity Swap),commodity
Market Makers quote bid & ask rates,i.e. price(Commodity Swap),default by a reference entity(Credit Default Swap) etc.
fixed rates of the swap against floating Relationship btw Swap & F/W Contract
rate i.e. LIBOR. Swap is a portfolio of forward contracts.
F/W involves single betting while Swap involves multiple betting.
So, Swap Rate refers to Avg of Bid & Ask
Rate.( Spread =Ask Rate-Bid Rate). Swap is often routed through a Financial Intermediary(FI).Thus, a FI enters into 2 offsetting
Confirmation=Legal Agreement detailing swaps,thereby locking in a spread.However,it is exposed to counter-party credit risk wrt
the Swap,signed by both parties(Mentions default by both parties.Also, the parties face counter-party risk wrt to FI.
Notional Amt,Term,Swap Fixed Rate
etc).Based on Master Agreement provided
by ISDA.
Motive 2:Transformation of Asset

Why Interest Rate Swap? 5%p.a. Let’s assume swap is routed through Intermediary.
5.015% 4.985%

Microsoft Intel
Microsoft FI INTEL
L L

6mLIBOR
Motive 1:Transformation of Liability 4.7% L-0.2%
Microsoft: Already has a floating rate liab at L+0.1,expecting Microsoft already has a fixed rate asset at 4.7%,expecting interest rate to rise.Intel already has
Interest Rate to rise. So wishes to convert floating rate into floating rate asset at L-0.2%.
fixed rate liab. Microsoft’s Effective Return= L-0.315%
Intel’s Effective Return =4.785%
5%p.a. Motive 3:Comparative Advantage Theory(Most Imp Motive)
Fixed Floating Preference
Microsoft Intel
A Ltd 4% 6mL-0.1% Floating

B Ltd 5.2% 6mL+0.6% Fixed

6mLIBOR
Spread 1.2% 0.7%
L +0.1
Effective Cost =5.1%
Intel : Already has a fixed rate liab at 5.2,expecting Interest Quality Spread Differential = 1.2-0.7=0.5%( Overall Gain/ Cost Reduction)
Rate to fall.So,wishes to convert fixed rate into floating rate A enjoys an absolute adv over B in both markets,but a comparative adv in Fixed Market.
liab. B –comparative adv in Floating Market.
So, A&B should borrow as per their comparative adv & then enter into a swap to achieve their
5%p.a. desire at a cheaper cost.

Microsoft Intel DIRECT SWAP SWAP THROUGH A FI( FI earns a spread of 40 BP,say)
L L L
A B A FI B
4.35% 4.33% 4.37%
6mLIBOR
5.2%
Effective Cost =L+0.2% 4% L+0.6% 4% L+0.6%
EC of A=L+4-4.35=L-0.35 vs L-0.1% EC of A= L-0.33% vs L-0.1%
Criticism of Comparative Adv Theory So, cost reduction for A =0.25% So, cost reduction for A =0.23%
-Fixed Rate Borrowing by A is valid for 5 yrs,but floating
rate borrowing by B is valid for 6m.If,after 6 m,credit quality EC of B= L+0.6 +4.35-L=4.95% vs 5.2% EC of B=4.97% vs 5.2%
of B deproves,effective cost of B will rise.So,agreement of
So, cost reduction for B =0.25% So, cost reduction for B =0.23%
Comparative Adv is not complete.
-Effective cost of A is subject to counter party risk of FI. Here ,net gain of 0.5% (as stated above) Here, out of Net gain 0.5%(as stated above) ,4 BP
-Owing to inferior credit quality of B,fixed rate investors are Is equally divided btw A&B i.e. 0.04 is attributed to FI. Leftovergain=0.46,equally
charging 120BP additional rate from B,while floating rate divided btw A&B.
investors are charging 70BP higher only,reason being,Fixed Page 25
Rate is applicable for 5 yrs while floating rate for 6 mths.
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CURRENCY SWAP
 Currency Swap-Exchange of a stream of cash flows in 2 different currencies.
4 Types- Fixed to fixed,Fixed to floating,Floating to fixed, Floating to floating. (Focus on Fixed to fixed)
 Principal amounts are decided based on Initial Spot Rates.Here,principal amounts are not notional.There is an exchange of principal at the beginning
& a re-exchange at the end of the swap.
[Eg for a 5yr swap, at T=0 There is an initial exchange of prinicipal.
T= 1 to 5 Annual Interest t/fs without netting.
T= 5 Final re-exchange of Principal.
(Note- Swap is not in favour of anybody.As per Interest Rate Parity,the currency with a lower Interest Rate will be at a Fwd premium)
 Why currency swap?
1) Used to transform assets & liabilities.( Eg : U.S firm wishing to borrow £ may borrow $ & then convert it into £ liab
( Apna ghar mein hero)
2) Comparative Advantage Theory(Covered in Int Rate Swap)-If routed through FI,the FI is exposed to some currency risk.

Valuation Of Interest Rate Swap Valuation Of Currency Swap

The avg of Bid & Ask Rate is known as Price of the Swap
i.e. Swap Rate,determined in such a manner,such that
Value of a Swap=0 to begin with.
Value of Swap = Value of Floating- Value of Fixed.
(If floating rate is received & fixed is paid)
OR
Value of Swap = Value of Fixed- Value of Floating.
(If fixed rate is received & floating is paid).
-Value of a floating bond trades at par on every reset
date.
-Periodic Swap Price= (1-dL)/∑d
-Swap Rate is less than the general borrowing rate in the
market,since,Swap Rate is against LIBOR which can be
rolled over every 6mths & so risk is less.
Valuation of Swap
Assume,we are paying floating & receiving fixed,&
swap has a remaining life =1.25 yrs.
Method 1: As a portfolio of Long-Short Bonds
Value of Fixed= PV of Coupon +PV of Principal.
Value of Floating= [Value at Reset Date(i.e. Par
Value)+Floating coupon for 6mths
as per 6mth LIBOR Rate at the
last Payment Date] pulled today.
Value of Swap = Value of Fixed- Value of Floating
Method 2: As a portfolio of FRAs
Since, we are paying floating & receiving fixed,it is
similar to selling FRA.
1)Calculate first payment 3mths from now
=[Fixed Interest Rate(semi-annually compounded)-
6mLIBOR at last payment date]*Notional Principal*1/2
2)Calculate 3*9 FRA continuous Interest Rate.Convert it
into semi-annually compounded LIBOR.
Payoff=[Fixed Int Rate-Semi Annually compounded
LIBOR]*Notional Principal*1/2
3)Calculate 9*15 FRA continuous Interest Rate.Convert
it into semi-annually compounded LIBOR
Payoff=[Fixed Int Rate-Semi Annually compounded
LIBOR]*Notional Principal*1/2
Value of Swap=PV of all payoffs from FRA
Note: A swap is a portfolio of OFF-MARKET
FRAs.,where each of the F/W contracts have a non-zero
value but the sum total of value of all F/W contracts to
begin with is 0.
Suppose,there is a U.S. based FI that receives Int Rate coupon on ¥ 1200m& pays Int Rate on $10m
& Cuurent Exhange Rate is 1$=¥110.
Method 1: As a portfolio of Long-Short Bonds
Step 1-For ¥ Bond,Calculate PV of coupon & PV of Principal using prevailing Japanese Yen Interest
Rate.Convert this value into $ using Current Exchange Rate.
Step 2-Similarly, For $ Bond,Calculate PV of coupon & PV of Principal using prevailing US Dollar
Interest Rate.
So,Value of Swap= Step1- Step 2
Method 2: As a portfolio of Forward Currency Contracts
(r¥-r$)t
F1=S e
(r¥-r$)t
F2=F1 e
(r¥-r$)t
F3=F2 e
As per Pure Expectations Theory,consider these Forward Rates to be Expected Spot Rates.
Use them to convert (coupon),(coupon),(coupon+ principal) amt for all 3 yrs denoted in £ into $
cash inflow every year.
Thereby,calculate Net $ inflow ( $ inflow- $ outflow) every year & pull them by prevailing US
Dollar Interest Rate.
CREDIT RISK IN SWAP
Faced by the party having a +ve Market value.Credit exposure=Max[MV,0].Credit exposure is
always either zero or +ve.
Eg. If M.V. of the swap to A is +ve $40 million,M.V. of the swap to B will be –ve $40 million.
Credit Exposure for A =40 million &
Credit Exposure for B=0
-If an FI enters into an interest rate swap,wherein it’s the fixed rate receiver & term structure is
upward sloping,the swap value wl be +ve in initial periods & negative in later periods.Implies,lower
credit exposure for the FI,as default generally takes place later.
-If an FI has entered into a currency swap,where it is paying lower fixed rate-same as above.Credit
exposure in currency swap is higher than interest rate swap as principal amt is also exchanged.
Different Types of Swaps
1) Basis Swap- (Floating-Floating) swap based on 2 different reference rates.
2) Amortizing Swap-Principal Amt would be decreasing.
3) Step up or Accreting Swap- Principal Amt would be increasing.
4) Constant Maturity Swap-After every 6 mths, 6mLIBOR as well as 10 yr Swap Rate wl
change. 6mL
A B
10 yr Swap rate
5) Constant Maturity Treasury Swap
6mL
A B
10yr Treasury Yield
6) Equity Swap-One leg is equity return while the other leg can be anything.
7) Forward Swap-A Forward contract to enter into a swap later.
8) Swaption- An option to enter into a swap later.
9) Extendable Swap-One party enjoys the right to extend the maturity of the swap.
10) Puttable Swap- One party enjoys the right to terminate the swap prior to maturity.
11) Commodity Swap-One leg is commodity price/return,the other leg can be anything.
12) Volatility Swap- σ =14%
Page 26
A B σ =Realized
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Option Trading Strategies

Spread Strategies Combination Strategies Synthetic Strategies

Simultaneous Buying & Selling Combining call & put Combining stock& options
similar options (either calls or puts)

Price Spread-same stock,same maturity,but

diff stock price.
Calendar or Time Spread-same stock,same
Strike price,but diff maturity.
Diagonal Spread-same stock,diff maturity &
diff strike price.

PRICE SPREAD (LTD. PROFIT & LTD. LOSS) CALENDAR SPREAD BUTTERFLY SPREAD
It invoves simultaneously buying/selling Consider 3 strike prices XL & XM & XH
π BULLISH CALL/ PUT SPREAD either calls/puts on the same stock at the XM =Body of butterfly
same strike but different maturity. XL & XH= Wings
TV is highest for near at the money
options. Buying A Butterfly Spread
It involves selling short-term option & (NON-VOLATILE BUTTERFLY SPREAD)
buying long-term option at the same K,& Buy the wings & sell the body
K1 K2 ST since long-term option is more =Initial Outflow.If strike prices are
costly,there is an initial outflow. equidistant,follow the initial poetry.
Expectation: ST ≅ K π
+ -
Short-term option expires & Long-term
option is sold in the market,whose TV is
π
high.There can be a loss,if option becomes
deep in/out of the money on maturity date.
BEARISH CALL/ PUT SPREAD
ST
REVERSE CALENDAR SPREAD XL XM XH
It involves buying-short term option &
selling long-term option i.e. Initial Inflow + 2- +
K1 K2 ST Expectation- Option lands deep in the Selling A Butterfly Spread
money/out of the money on maturity. (VOLATILE BUTTERFLY SPREAD)
- +
Sell the wings & buy the body
Eg: A person enters into a bearish call spread BOX SPREAD(ONLY ARBITRAGE STRATEGY) =Initial Inflow.If strike prices are
Reason- The person,being bearish, undertakes Involves same stock,same maturity,different equidistant,follow the initial poetry .
C- at K1 ,but,afraid of the unlimited loss that could occur stock price.
To prevent arbitrage,
if the stock price goes up steeply.So,to protect on the π
right side ,he undertakes C+ at K2. Sum total of call & put premium difference=PV
Thus, Spread Strategies are designed for moderate bullish of Strike difference.
& moderate bearish price belief.Designed for a highly risk Case 1: CD + PD< PV of XD
averse trader,who doesn’t want to suffer unltd loss & is Buy a box spread i.e. Bullish call spread &
content with ltd profit. bearish put spread.
i.e. C+ & P- AT Lower Strike Price. ST
REMEMBER: & C- & P+ AT Higher Strike Price. XL XM XH
For Call Option: Think about K1 Initial Outflow= CD + PD( assume borrowed at Rf).
T
For Put Option: Think about K2 Outflow at T=(CD + PD)(1+Rf) & Payoff=XD
Profit= XD- Outflow. - 2+ -
Consider Bullish Call & Bearish Put as Natural Strategies,
Bearish Call & Bullish Put as Abnormal Strategies. Case 1: CD + PD> PV of XD
Sell a box spread i.e. Bearish call spread &
POETRY: bullish put spread.
In case of Initial Outflow i.e. C- & P+ AT Lower Strike Price.
Max Loss= Initial Outflow & C+ & P- AT Higher Strike Price.
Max Profit=Diff. Of Strike Price-Max Loss Initial Inflow= CD + PD( assume invested at Rf).
T
In case of Initial Inflow Infow at T=(CD + PD)(1+Rf) & Payoff=-XD
Max Profit= Initial Inflow Profit= Inflow -XD
Max Loss=Diff. Of Strike Price-Max Profit
Page 27
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COMBINATION STRATEGIES

This involves combining call & put in order to exploit a

volatile or non-volatile price-belief.

LONG STRADDLE/BOTTOM STRADDLE STRIP

This involves P+ & C+ at the same strike 2P+,C+ at the same E. More bearish than PAYOFF OF A COLLAR
price.(Volatile Price Belief). bullish. Payoff
π π

k-x

P0+C0 { k-x k k+x ST

P+ C-
=x ST
2P0+C0 This is a payoff diagram of a zero cost collar.
P+,C+
2P+,C+ (Range Forward Contract).
SHORT STRADDLE/TOP STRADDLE STRAP
P+,2C+ at the same E. More bullish than SYNTHETIC STRATEGIES
This involves P- & C- at the same strike
price. (Non-Volatile Price Belief). bearish. Combining two or more techniques to achieve a
π particular risk-return profile.Many a times, they
π may be cheaper than rhe direct techniques.
P0+C0=x Backbone : Put-Call Parity
i.e. To prevent Arbitrage,
If two portfolios have identical payoff,the cost
of the 2 portfolios should be same.
Thus,cost of protective put=Cost of fiduciary
k-x k k+x ST
ST call.
P-,C-
P0+2C0 P0+S0=C0+PV of X
k-x
P+,2C+ If question asks to create synthetic strategies
STRANGLE profit wise & not payoff wise-
COLLAR Use the equation
Long Strangle:P+ at a lower K & C+ at a
Consider an investor who holds a P+,S+=C+
higher K. share.To protect himself from a Similarly, the synthetic position for long put &
substantial fall in Share Price,he buys a short call = Short stock
π
put option.Also, to avoid suffering the & the synthetic position of S+ & C- =P-
pain of put premium,he simultaneously Covered Call Writing
decides to sell a call,at same amt of You own a stock & you write a call option on a stock.
premium. Why?
ST This results in hedging the downside & 1 To improve upon the market-Being overweight on
foregoing the upside distribution. the stock,you wish to sell a certain portion of
P0+C0 P+ C+ it.However, you write an In The Money Call to improve
Maximum amt of loss is lower in strangle upon S0.However,you run the risk of stock price
as compared to straddle.However,the area crashing down.
within which loss can occur is wider. 2 To generate income-You expect the stock to be
Hedged Hedged flat.You’ll keep on holding the stock unless stock price
Straddle has a faster breakeven.
significantly rises.You decide to write a call at a higher
E ,since you, wish to generate some income on a
regular basis.However,you run the risk of stock price
P+ S+ C- rising.You are foregoing Right-Side of the return
Investor is range bound between distribution.
P+ and C- 3 To offload the stock at the target price-
Since, your firm’s research analyst has set a target for
a higher Share price than S0,sell Out Of The Money Call
at that targeted Higher Share Price.
Risk same as point no.2. Page 28
Covered Call Writing continued. DERIVATIVE STRATEGIES CONTD Summarised by: Karan Aggarwal
Valuation of Contingent Claims
Speedy Profit Calculation -It’s a derivative where the owner of the
Initial Outflow =S0-C0 claim enjoys a right to a pay off without
So, Break Even Point = S0-C0 Equivalence of Long Stock/Short Forward any obligation to do so.Eg: Option
Maximum Loss if ST =0 = S0-C0 Position -All derivatives including options are
Maximum Profit= [XH-S0]+C0 Background-Two types of derivatives: priced according to Prevention of
1.Linear Derivatives: Value of a Forward Arbitarge Principle.
PROFIT DIAGRAM Contract is a linear function of Share Price. Arbitrage involves:
π So,rate of change i.e. slope known as Delta is No invt of own funds.
constant.Delta of Fwd Contract on a non- No risk.
[X-S0]+C0 dividend paying stock=1 Non-zero probability of +ve return.
2.Non-Linear Derivatives: i.e. contingent -We use replicating portfolios & law of
S0-C0 ST claims like options,credit derivatives do not one price i.e. if two portfolios have
XH have a linear relationship to the underlying identical payoff,price of both portfolios
S0-C0 S+,C- Share Price. should be same-Eg:-PCP
-
Synthetically equal to P at XH,with a -We focus on market risk,ignoring credit
premium of [XH-S0]+C0. & liquidity risk.
Min value of call Assumptions:
1) All assets required for
Cash Backed Pull Writing Flat Tangent Steep Tangent
-- replication are investible &
Normal stuff i.e. P ,which is obligation to
marketable.
pay.To fulfill this obligation, we must have X
2) Frictionless Market
on maturity.So, we deposit the PV of X in an
Deep out Near At Deep In Money 3) Unltd. Rf lending & borrowing
ESCROW A/C.
Of money Money ∆≅1 opportunity at Rf.
+ + ∆≅0 ∆=0.5 4) No restrictions on short-selling.
Protective Put (P ,S )
5) The underlying asset has a
-You own a stock & buy a put
∆ of call lies btw 0 to 1; known statistical distribution.
option,generally OTM Put at XL. ∆ of put is –ve=∆ of call-1
-But, there is no proctection for fall in stock
from S0 to XL.So, S0 -XL is a deductible. Imagine:
Risk. Protective At The Money Put OPTION PRICING MODELS
-Continuous Proctective Put is not 100 S+ & 100 P+
recommended,since,it is very expensive & ∆ of portfolio= 100*1+100*(-0.5)=50
exposes the client to the risk of not being
able to achieve the investment Covered At The Money Call Writing
objective.So,temporary protective put is 100S+ & 100C-
recommended. ∆ of portfolio= 100*1+100*(-0.5)=50
-Initial Outflow= S0+P0 Binomial Model Black Scholes Model
-BEP = S0+P0 Long Stock & Short Forward for Half The Amt
-Max Loss if ST< XL= deductible amt plus put 100 S+ & 50F- BINOMIAL MODEL assumes that the
premium. ∆ of portfolio= 100*1+50*(-1)=50 stock price follows a discrete process
-Max Profit=uncapped. wherein the stock can go up & down
π HENCE,THE EQUIVALENCE. each period.

BLACK SCHOLES MODEL(BSM) assumes

that the stock price follows a Geometric
Brownian Motion (GBM) which if simply
uncapped stated,evolves out of Log Normal
Distribution.
ST Thus, ln[ST/ST-1] i.e. the continuously
XL compounded return on the asset follows
P+,S+ Normal Distribution.
Deductible+ P0 BSM is based on stochastic calculation.
So, this is equivalent to synthetic long call
i.e. C+ at XL.,with a premium of Deductible+ Under Binomial Model,we can price
P0. option using:-
Mthd 1- Replicating Portfolio Approach
Mthd 2- Delta Hedging Approach.
Mthd 3-Risk Neutralization Approach.

Page 29
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Mind MAP

1. Sensitivity Analysis: y=f(x1,x2,………..xk)

dy/dx1,dy/dx2,……dy/dxk-Partial Derivatives
-sensitivities-slope

2. Option Price= f ( S, σ, t, r)
Delta
Vega
Theta
Rho

C Actual Call
Delta+Gamma Price
Effect
Delta:Rate of change of option price wrt stock price cet par. Gamma effect=
Gama: Rate of change of Delta wrt stock price cet par. ½*G*(New Share Price-Old Delta Effect
Vega:Rate of change of option price wrt volatility cet par. Share Price)
2

Theta: Rate of change of option price wrt passage of time cet par.
Rho : Rate of change of option price wrt interest rate cet par.
On A/C of cet par,Greeks are known as static risk measures. S
Old New
3.Delta: S C ,∆ of C > 0 SP SP
S P ,∆ of P <0
Black Scholes Model -For a small change in share price,delta alone does a good
CASE 1: NON DIV PAYING STOCK job,but for a large change,it does a poor job.
∆ of Call= N(d1) -As S rises,∆ of call increases at -For a large change in share price,Delta+Gamma does a
∆ of Put= -N(-d1) an increasing rate. good job,but not perfect.
- As S rises,∆ of put falls ( - For a large change in share price,New option price
∆ of call lies btw 0 to 1; intuition wise,ignoring minus estimated using Delta only will always underestimate the
∆ of put is –ve=∆ of call-1 i.e. btw -1 to 0. sign). actual option price.
But,mathematically,it rises. -The Delta+Gamma approach will overestimate the call
CASE 1: DIV PAYING STOCK price for a rise in share price,but underestimate the call
Delta Hedged/Neutral Portolio(∆=0) price for a fall in share price.
∆ of Call= N(d1)e-st (Assume,∆ of call=0.6,∆ of put =-0.4)
∆ of Put= -N(-d1)e-st Egs: 1000C-,600S+ HINT: Multiply by the delta of the position & divide by the
1000S+,1667C- delta of the hedging instrument.
∆ of call lies btw 0 & e -st 1000S+,2500P+ Delta Neutral Portfolio is hedged i.e. insensitive to
1000P+,400S+ infinitesimally small changes in share price.For a large
∆ of put lies btw - e-st & 0
600P+, 400C+ change in Share Price,there is Gamma Risk(Non Linearity
1000P+,667 C+ Risk).

Remember:
4. Gamma: Rate of change of Delta wrt stock price cet par. -Gamma of Call & Put is always same.
Whenever a delta –hedged portfolio is constructed by buying options,Gamma is +ve & Theta is –ve. -If someone has long option position,it
Gamma is +ve -Any movement in stock up or down will be beneficial means +ve gamma.He will enjoy.
Theta is –ve -It means we will suffer time decay. LIMITATIONS OF BSM
-BSM assumes cts compounding,cts
For immunizing yourself against Share Price,construct a Gamma Delta Neutral Portfolio as follows:- rebalancing a delta-hedged portfolio.But
1. Identify an option which is overpriced & option which is underpriced using whatever Model. market reopens next day with a gap up
2. Go long in the underpriced option & short in the overpriced option in the inverse ratio of Gamma. or down-High Gamma Risk.
3. Now,calculate delta of the Gamma Neutral Portfolio set up. -BSM assumes that stock price follows
4. Accordingly,take long short in equivalent no of shares to achieve Gamma Delta Hedge. Geometric Brownian Motion.However
stock price eg illiquid counters,currencies
of emerging mkt exhibit jumps-High
IMPORTANT PROPERTIES OF DELTA & GAMMA Gamma Risk.
With Respect to Moneyness With Respect to Time
Behaviour of ITM options have higher delta magnitude wise. ITM options –As we approach maturity,delta tends towards modulus
Delta OTM options have lower delta. |1|.OTM options-As we approach maturity, delta tends towards zero.
ATM options- As we approach maturity,delta changes i.e. swings
wildly from 0 to 1.
Behaviour of So,Gamma is higher when S is close to As we approach maturity,Gamma rises i.e. near term options have
Gamma X i.e. ATM options. higher gamma than far options.

OTM ATM ITM

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5.Theta: Rate of change of option wrt passage of time cet par.Both call & put ( long positon) have –ve Theta i.e. will suffer time decay.
However call will suffer more & put will suffer less (Stress on BSM Equation).
Infact,in extreme cases, i.e. deep in the money put,Theta may be +ve. (Theta of Put is ambiguous in sign).
Behaviour of Theta wrt moneyness & wrt time is exactly the same as Gamma.

6.Vega: Rate of change of option premium wrt volatility of the underlying asset cet par.
Long option positions ( both call & put) have +ve vega while short options have –ve vega.
Vega of call=Vega of put.
2 uniqueness in Vega:
 Exposure to risk factor i.e. volatility which is not visible.(Difficult to explain if portfolio loses on A/C of Vega risk).
 Vega is highest of all option Greeks i.e. option values are highly sensitive to volatility captured by Vega.
With Respect to Moneyness With Respect to Time
Behaviour of Vega Same as Gamma & Theta ,i.e. high Vega for Opposite behavior as compared to Gamma &
ATM options. Theta i.e. Long Term Options have higher Vega
than Short Term Options.Short dated options
have a higher Vega.

7.Rho : Rate of change of option wrt continuously compounded Rf Interest Rate cet par.
C+ is a substitute of S+ & saves financing cost while P+ is a substitute of S- & results in losing Interest Income.
So, Rho of call is +ve while that of put is –ve.
Rho of short-term equity options is negligible & hence,not focussed.

8. Implied Volatility : Implied Volatility is the volatility implied by the current option price.Thus, we use BSM or any other pricing model to
backout Sigma.It is difficult to to speak out,which call option should have a higher price.For this,we compare options with
their respective IV’S. The call option with lower IV will be relatively underpriced.
What does IV speak out?
 It means that market consensus estimate of the annualized volatility is IV,which translates to IV/√250 (%) DAILY.
 It shows the price that the investors in the market place are ready to pay for risk mitigants.
NOTE :FII’s ,having diversified equity portfolio are exposed to systematic risk of market collapse.They usually buy OTM put,when they are
more afraid ,happens when market goes down-CRASHOPHOBIA.On A/C of crashophobia,there is greater demand for OTM putd i.e.
ITM calls,which causes IV to be higher at lower Strike Price.
IV A plot of IV across Strike Price in the equity
markets is a HALF SMILE OR SMIRK
(VOLATILITY SMIRK).
In currency markets, this shapes up as a
smile because of the possibility of extreme
X
movements in currency on either side.
7500 7600 8100 8200

NYSE computes a weighted avg of the IV of SNP 500 Index options at various Strike Prices for the nearest maturities.
This is published as VIX (Volatility index).Volatility Index is known as the fear index.It shoots up when the market crashes.

NOTE: Certain financial institutions like interest rate,inflation & volatility are mean reverting( not trading like Stock Prices).
This means , if a particular stock has IV ranging from 15% to 50%,we may divide the region into percentiles.Now,if current IV of the
stock is say,46%,it may imply 87% percentile.
SHORT VEGA TRADE
VOLATILITY TERM STRUCTURE
50

MEAN REVERTING LEVEL

15 LONG VEGA TRADE

9.|∆call| +|∆put| is always =1 (False)[ Since, this is true only for a non div paying stock.Doesn’t happen for a div paying stock].
10.Magnitude wise(ignoring the sign),
 ITM options have higher delta & OTM options have lower delta.
 If S rises, ∆call rises & ∆ put falls.
 If S falls, ∆call falls & ∆ put rises.
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Summarised by: Karan Aggarwal

ADDITIONAL POINTS:
1)On rebalancing the delta-hedged portfolio,it hurts since:
 When Share Price falls,∆ call falls ,we are made to sell share a lower S.
 When Share Price rises,∆ call rises ,we are made to buy share a higher S.
SOURCE OF ALL THIS GAIN is GAMMA .
If out of frustration,you decide not to rebalance,Share price may move significantly in adverse direction resulting in substantial loss.
Too frequent rebalancing:
Adv- Reasonably Hedged Portfolio
Disadv-High Transaction Cost
So, Delta Hedging turns out to be Dynamic Delta Hedging.
Not possible to enjoy both.So what to do?
2) Two Deterministic Option Greeks : Theta & Gamma
Ll Enjoy Scenario 1: Expecting sudden change in price,buy option & make portfolio
T e e
both ? delta-neutral.Let’s hope that the sudden change in S takes place quickly,so
o n n that negative theta doesn’t hurt us.
j j
Scenario 2: Expecting no movement in share price,or a slight movement,sell
e o o
options & make portfolio delta-neutral.This way, we will enjoy theta i.e. time
n y y decay.Let’s hope that the share price doesn’t change & we are safe from loss
j due to –ve gamma.
Sell call or Buy call or
o
put & then put & then
hedgey it via hedge it via
S+ or S-. S- or S+.

3) Remember that Vega,Theta & Gamma have a Normal Distribution Like relationship wrt share price.

Vega ATM-High
Gamma
ITM & OTM -Low

S=E S=E S

Theta

4)In aDelta-Neutral Portfolio,Gamma & Theta are almost equal in magnitude,opposite in sign.

5)
VEGA
Greater maturity left, ATM ITM OTM
Greater Vega?
  
THETA & GAMMA
Lower maturity left, ATM ITM OTM
Greater Theta & Gamma?
  
-qt rt (r-q)t
6) ∆ of stock=1; ∆ of forward =1 or e ; ∆ of futures=e or e [ Use q when dividend yield].
7) Relationship btw Delta,Theta & Gamma
2 2
r π=Theta + r S∆ +1/2 σ S Gamma
2 2
For a delta neutral portfolio; r π=Theta +1/2 σ S Gamma ( where, π is the value of the portfolio).

8)For portfolio insurance,it put options turn out to be illiquid, we may sell futures=Value of Spot position*∆ of put/∆ of futures.(Dynamic Hedging).

9)Option trading desks enjoy economies of scale-Means that it may get expensive to maintain delta neutrality for an individual position,but its realistic for a
large portfolio of options.Traders carry out scenario/what if analysis selected by mgmt or model generated.

10) Naked & covered option position generates a stop loss,trading strategy,but is too expensive.
11)Rho of call is +ve while that of put is –ve.

12) Theta of put > Theta of call.(with sign-mathematically).

13)For an ATM,as an option approaches maturity,Theta tends away from 0 & becomes increasingly negative.
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 Contact : PIYUSH : 9674006544
Visit: www.ulurn.in EXOTIC OPTIONS Summarised by: Karan Aggarwal

-Non standard derivative products created to suit the unique hedging requirements of our clients-often created to take adv of A/C,taxation or
legal/regulatory instructions.Also created to reflect a particular view on a market variable.
Eg:-If I have an opinion that stock price will go below 400 & then finally land up above 500 after 6mths-Very Strong Opinion-
Buy a down & in call option.This wl therefore be cheap.

Package-Portfolio consisting of standard Case 1: GAP PUT Chooser Option[As you like it option]
European Call/Put,fwd contracts,cash & Sit 1: Trigger Price> Strike Buy an option today & later decide whether
the underlying asset itself.Eg:-Protective payoff it’s a call or put.
Put,covered call writing,Bull & Bear Call or put decide?
500
Spread,Straddle,Butterfly Spread etc.
Easy to create package with initial cost=0 T0 T1 T2
Lapse Buy chooser
Best eg:-Range Forward. S  Similar to straddle i.e P+ & C+ at the
X=500 T=550
Q) How to create/transform a std same strike. But as against straddle,
American option into a non-standard -50 choice is only upto T1,therefore it’s
American option? cheaper.
Sit 2: Trigger Price< Strike  Chooser can be synthesized with a
 By converting strike price from payoff
fixed to package of-
variable. 1) A call option with a strike K &
 By converting exercise option at maturity T2
50 -q(T2-T1)
any time prior to maturity to 2) e Put options with strike
Lapse -(r-q)(T2-T1)
exercisable at discrete price Ke & maturity T1.
S
times/non-exercisable for some T=500 X=550
lock-out period. Barrier Option[PATH DEPENDENT]

If T=X,it’s a regular option.
Gap Option-Trigger price which 
In a gap call,where T<X,payoff can be –ve. Out variety In variety
determines whether payoff will occur i.e. 
In a gap put where T>X,payoff can be –ve.
whether exercised or lapsed though there 
So,gap options are cheaper than regular
is a normal exercise price i.e. (X) that options for the same strike.The payoff
determines the amt of payoff. diag is discontinuous. If B is breached, Only if B is breached, does
Case 1: GAP CALL option dies. the option come to life.
Sit 1: Trigger Price> Strike Forward Start Options
payoff 6m UP= B>S
DOWN=B<S
1m 5m  Higher the frequency of check,higher the
50 value of IN option & lower the value of
Lapse OUT option.
T0 T1 T2
 Barrier options of the OUT variety cloase
F+ C+
X=500 T=550 S to the barrier have a –ve vega.
Step 1:First,calculate price of the 5m call option
 Regular Call= Combination of down &
Price of this gap option should be greater than today i.e. say “c”
out with down & in call.Whenever
call option wih a strike price of 550. Step 2: If Annualized dividend yield on the stock
there’s a combination of out & in,the
i.e. q=0,Price of Fwd Start Option today=c
barrier becomes irrelevant.
If Annualized dividend yield on the stock
Sit 1: Trigger Price<Strike BINARY OPTION
i.e. q=4% continuous,So,Price of Fwd Start Option
q(T1-T0) 0.04*1/12 Options with discontinuous payoff.
today=c/( e =C/e .
payoff Type 1: Cash or nothing
Case 1: If S<X on maturity,call lapses & payoff =0.
Compound Option
Case 2: If S>X on maturity,call exercised & payoff
(-) payoff Option on Option
=fixed amt.
Put on Put
Lapse Type 2: Asset or nothing
S Case 1: If S<X on maturity,call lapses & payoff =0.
Call on Call Put on Call
T=500 X=550 Case 2: If S>X on maturity,call exercised & payoff
Call on Put
=fixed amt.(Payment=Price of the asset underlying
-50 Suppose, there is a 3mth call on 9mth call at X=130.
the option).
Priced at 19.That is pay 19 today for C+ on another
PRICE OF CASH OR NOTHING
C+ i.e. to get a right to buy a 6mth call option after
3mths. rt rt
QN(d2)/e QN(-d2)/e
After 3 mths,
where Q=cash payoff
Sit -1: 6m call option priced at 62,which is less
than 130-Call lapses .Pay off=0.Loss =19
PRICE OF ASSET OR NOTHING
Sit -2: 6m call option priced at 162,which is more
than 130-Call exercised i.e. we buy 6m call at 130 qt qt
S0N(d1)/e S0 N(-d1)/e
instead of 162
Page 33
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Look Back Option[Path Dependent]
Payoff depends upon the max or min price
reached during the price of the option.
700
450 440
400
350 280
0 Maturity
TWO VARIETIES OF LOOK BACK OPTIONS:
Type 1: Fixed Look Back
Fixed Strike Price( say E=400).
So, we have to choose S to get pay off.
For call option,S =max share price=700
Payoff from call=700-400=300
For put option,S=min share price=280
So,payoff =E-S=400-280=120
Type 2: Floating Look Back
Strike Price is not fixed. It is to be taken as
max/min SP i.e.
E=min share price in case of call=280
E=max share price in case of put=700
Say, SP on maturity i.e. 440
Payoff from call=440-280=160
Payoff from put=700-440=260
 Look Back Call Option is the way,holder
can buy underlying asset at the lowest
price achieved in the life of
option.Similarly,interpret Look Back Put
Option.
 Value of lookback option will depend
upon observation frequency.
 As obs frequency increases,Knock in
variety barrier option increases & Look
Back option increases.
 IV of a fixed look back option can be
negative,cannot be negative for
Floating look back option.
Shout Option [Designed to reduce regret] [Path
Dependent]
European Option where the holder can shout to
the writer at one time during its life.
S1
S0 S2
Payoff (S1-E, S2-E,0) whichever is higher.
Exotic Options contd. Summarised by: Karan Aggarwal
Asian Option Volatility & Variance Option
Payoff depends upon average price of the Bet on volatility or variance rather
underlying asset. than underlying asset price.
Type 1: Avg price option Payoff=Diff btw realized volatility or
S=Savg variance compared to pre-specified
E=given volatility or variance.
Payoff from call= Savg-E
Payoff from put=E-Savg Observation:
Type 1: Avg strike option
E is not fixed. Variance options are easy to value
So, take E as Savg because replication is possible using a
S= Smaturity portfolio of calls & puts.
Payoff from call= Smaturity-Savg
Payoff from put=Savg-Smaturity
Static Options for Replication
Observations:
If a firm requires raw material Delta Hedging is dynamic,causes
evenly throughout period/has a problems especially if delta changes
foreign currency wildly.So, we advice static options
receivable/payable spread evenly replication.
throughout period-they would
like to use Asian options. Imagine, we have purchased an
As volatility of avg options is exotic option.Identify a portfolio of
always smaller,Asian options regular & actively traded options that
would be cheaper than standard approx replicate the exotic options.
options. Now short this portfolio.
The delta of barrier options
Approx, The payoff from replicating
changes dramatically making
portfolio & exotic option should be
delta hedging difficult.The delta same at the boundary i.e Time
of Asian options changes Interval/Price Range.
smoothly.As time passes, avg S
becomes more predictive,making
payoff from Asian option more
certain
So,delta hedging is easier with
Asian Option.
Exchange Option
Barter System i.e. right to exchange one asset
for another.
Rainbow Option
Option involving 2 or more risky assets.
Page 34
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ct
 F=Se n
Alt 2 SPECIAL TYPES OF COMMODITY FUTURES
Where; c= rf+SC-mb-CY STACK & ROLL
If it does not hold good,there is an
Gold-Low storage cost,low lease rate,low
arbitrage opportunity.
Buying short-term futures for the entire convenience yield on A/C of Rf. It exhibits
Monetary benefit like dividend in FA
exposure & then rolling it over for the next GENTLE CONTANGO.
is=lease rate in physical commodities.
(r-Ş)t maturity.
Hence, F=Se
Recommended because Short Term Futures Corn-Seasonal production, constant demand
Where Ş=k-g
have high liquidity i.e. low bid-ask throughout the year-Harvested in Sept-
Lease Rate= -Storage Cost
spread,backwardation,abnormally steep Nov.Then consumed from Nov to Sept.
COC doesn’t hold good in real life since
forward curve expected to flatten. So,high storage cost Nov
it’s based on unrealistic assumptions & it
OFCOURSE, IT HAS HIGHER BASIS RISK. onwards.Hence,Contango, nov onwards.
doesn’t incorporate technical factors that
influence E(S).
Electricity-Cannot be stored,max supply
(r-ά)t  Whether derivatives can be used by fixed,wild swings in Fwd Price,Fwd price
 F=E(S)e
business houses who are exposed to reflects price discovery,seasonal
Since investors are risk averse,
the risk of adverse weather demand,demand peaks in winter in U.S.,while
ά≠ r
fluctuation? demand peaks in June in Southern
So, F≠ E(S)
HDD=Max[ S-65°F,0] hemisphere.So, segmented or geographical
So, Fwd is a biased estimator of E(S)
CDD=Max[65-S,0] curve with swings.
S stands for avg temperature.
 Lease Rate is not observable but
Where, HDD=Heating Degree Days Natural Gas-Huge storage cost &
can be derived,since it can be
CDD=Cooling Degree Days transportation cost.
earned only if commodity is
loaned ,unlike,dividend.
Oil- Compared to Natural Gas,less storage cost
& transportation costs.So, less price
 Buying crude oil futures & selling
fluctuations & flatter forward curve.
heating oil & gasoline futures-
CRACK SPREAD
REMEMBER:
 Going long in soyabean futures &
 1 gallon=42 barrels
short in soyabean meal &
soyabean oil futures-
 For a consumption commodity,there
CRUSH SPREAD
will always be a region in which
Forward Price should lie
CROSS HEDGE
Hedging an exposure with different r+SC-CY r+SC
Se ≤ F≤ Se
underlying asset.
Has significant basis risk
i.e. Variance of (S-F)+variance of
S+variance of F-2rσsσF

Strip vs Strap Hedging

Suppose, you have a contract to deliver

100000 barrels of oil at the end of every
month for 1 yr at a fixed price.
Since, you are afraid of oil price rising,
To hedge the same, buy oil futures.
n
Alt 1
STRIP HEDGING
Buying the same futures contract
corresponding to exposure maturity.
LOW BASIS RISK.

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WARM UP:
Exchange Rate: Price of one currency in terms of
another.
A/B ,where B is the base currency while A is the
price currency.So, it means no of units of A per unit
of B.
HC/FC-Direct Quote
FC/HC-Indirect Quote
Conversion Process without Bid-Ask Rate
Conversion Process,given A/B=x
Convert 50,000 units of B into A
=50,000 * x
Convert 50,000 units of A into B
=50,000/x
Conversion Process with Bid-Ask Rate
Suppose Bank quotes : GBP/USD -0.7380/0.7420
Bid Ask
Rate Rate
This means that market maker i.e. City Bank has
announced that it is ready to buy 1USD at GBP
0.7380 & ready to
sell 1 USD at GBP 0.7420.So,if it is equally struck on
both sides of the quote,it will lock in a spread of
0.7420-0.7380
=GBP 0.0040/USD
= Shellings 0.40/USD
From customer’s point of view, to buy one
USD,customer will have to pay GBP 0.7420.To sell
one USD, customer will get GBP 0.7380.
So, Bid Ask Spread is a transaction cost for
customer.
Conversion Process,given A/B=x/y
Step 1: Choose the rate by focussing on base
currency.
For buying B i.e. y or
For selling B, i.e. x
Step 2: You have a certain amt say 80,000 & a rate
x/y.MULTIPLY OR DIVIDE
 If you have to buy 80,000 units of
B?How much A required?
=80000*y
 If you have to buy 80,000 units of
A?How much B required?
=80000/x
 If you have to sell 80,000 units of
B?How much A will you get?
=80000*x
 If you have to sell 80,000 units of
A?How much B will you get?
=80000*y
Interest Rate Parity states that interest rates
across the world on a covered basis must be equal-
 If interest rate in Country A is less than in
country B,the currency of Country A
should be at a forward premium.
 If int rate in Country B is greater than
Country A,country’s B currency should be
at forward discount.
IRP equation
F/S=factor/factor
Foreign Exchange Risk
Foreign exchange trading Activities of A Bank
 Enabling customer participation in
Export & Import
 Enabling customer participation in
international real & financial
transactions.
 Hedging Transactions
 Speculative Transactions
Net Exposure in a Currency
= ( Asset-Liability)+(Buy –Sell)
Suppose,quote is $/£=1.4620/1.4650
Case 1: Positive Net Exposure
i.e. Long position
City bank is afraid of £ falling.
Case 2: Negative Net Exposure
City bank is afraid of £ rising.
Remember: Always calculate the net
exposure.Don’t judge the instituition’s
exposure to a currency via a single
transaction.
Gains & loss tend to set off each other.
This is known as the benefit of
diversification.
Given,Real interest rate=4%
Inflation=3%
Nominal Interest Rate≅ 7%
To be precise ,Nominal Interest Rate=
[(1.04)(1.03)]-1=7.12%.
If real interest rate in a country
rises,the currency (spot rate)
appreciates.
Higher inflation in an economy
makes its goods costlier.So Export
rises & Import falls.So,the currency
of that country depreciates.
Risk Taking By A Bank & Calculation Of
Spread
Step 1: US bank Borrows $ 100 m loan at 6%
for 1 yr & makes a loan of $100 m at 9% for 1
yr.
Spread=9-6=3%
Step 2: US bank Borrows $ 100 m loan at 6%
for 1 yr & makes a loan of $50m at 9% for 1 yr
& $50m CHF equivalent @ 15% for 1 yr.
Suppose,spot rate = CHF 2.20/USD
Loan Amt=50*2.2=CHF 110m
Scenario 1: CHF appreciates to CHF 2.10/USD
Inflow after 1 yr=110*1.15/2.10= $60.2381m
So, yield on CHF loan in $ terms=
(60.2381-50)/50*100=20.47%
So, weighted avg return on loan
portfolio=14.74%
Spread=14.74-6=8.74%
Scenario 2:CHF falls to 3 CHF/USD
Calculate spread as above to get=-9.34%
BANK’S SPREAD IS TOTALLY UNCERTAIN &
DEPENDS UPON S1.
Summarised by: Karan Aggarwal
Methods of Hedging By Bank
Mthd 1:ON B/S Hedging:
Bank should hve borrowed 50m USD equivalent CHF
@ 12% to make the CHF Loan.
Assuming Scenario 2,
Calculate Spread of bank.
Step 1: Cost of funds in $ terms for CHF
Loan=110*1.12/3=$41.073.
So,cost=(41.07-50)/50*100=-17.87%
Weighted avg cost of funds=-5.93%
Step 2: Weighted avg return=-3.34%
So, Spread=-3.34-(-5.93)=+2.59%
So, by hedging via on B/S,you are not significantly
affected by S1.
Shortcut On B/S Hedging:
Just calculate avg return & avg cost using stated
rates.Calc the difference.
Case 1:If exchange rate has fallen,ans would be less
than the diff.
Case 2: If exchange rate has gone up,ans would be
more than the diff.
Mthd 2:OFF B/S Hedging
Take 100m $ loan @ 6% as usual & give 2 loans.
Loan 1: 50m $ loan @ 9%
Loan 2: 50 m$ equivalent i.e. 50*2.2=CHF 110m
loan @ 15%
Now hedge the CHF receivable by selling forward.
Calculate F.
F/S=factor CHF/factor USD
So, F=2.20*1.15/1.09=CHF 2.3211/$
Inflow after 1 yr on CHF loan in $ terms
=110*1.15/2.3211=$ 54.50m
So,return=(54.50-50)/50*100=9%
So,avg return on both loans=9% & spread=3%
SUM SOVING IN EXAM
TYPE 1: Calc gain/loss on currency position.
Step 1: Net exposure= (A-L) +(B-S)
Step 2: Convert the net exposure of Step 1 into
home currency using S0.
(Be cautious abt divide and multiply) & then apply
% appreciation/depreciation.
TYPE 2: Calculation of Net Interest Margin.
General Style: Calc avg return on asset & avg cost of
fund.
-So,net interest margin is the diff.
-If it’s a US Bank having USD liab,cost is the stated
cost.For a US Bank having USD asset,return is the
stated return.
-If it’s a US Bank having GBP asset-
Step 1: Convert $ amt at S0 into GBP.
Step 2: Amt of GBP receivable =Step 1*(1+r)
Step 3: Convert Step 2 back to $ at S1 or F
Step 4:Compare Step 3 with initial amt of USD
converted in Step 1-Accordingly calc return in $
terms.
Same steps are true for calc of cost.
-If you have asset A1 or A2 whose returns in
domestic currency terms are R1 & R2
Avg Return = [(A1* R1) +( A2* R2)]/( A1 + A2)
Similar averaging is required for liability.
Finally,Net Interest Margin=
Avg Return on Asset –Avg Return on Liab.
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CCP
Visit: www.ulurn.in Summarised by: Karan Aggarwal

B 120 A 100 C ADVANTAGES OF CCP DISADVANTAGES OF CCP

If counterparty B defaults,A wl still have to fulfill its obligation towards
C-Counter party default risk. Reduces impact of insolvency Catastrophic event;disincenticizes
This is quantified by Credit Value Adjustment due diligence,high risky contracts
Increases transparency Pro-cyclicality-Financial burden inc
Price of a risky derivative=Risk neutral price(using Rf)-CVA when economy goes down
CVA=PD*LGD*Adjusted Exposure Multi-lateral netting Liquidity disruptions
Adjusted Exposure=Max of(MTM,0)

FEATURES OF OTC TRADING Loss waterfall provision Can itself increase systemic risk
 Customised contracts
 ISDA Agreement(Collateral reqs & netting provs) Margining,netting increase Not beneficial everywhere
operational efficiency
IMPACT OF COUNTER-PARTY RISK Legal risk reduced by
 Systemic risk(Initial spark+chain reaction+explosion) centralization
 One sided collaterization(Smaller counter party cant ask Big Improves market liquidity
Market player to post collateral) Through auction
 Replacement illiquidity
MARGIN REQUIREMENTS
REDUCTION OF COUNTER-PARTY RISK  Variation margin covers net change in market
 High capital req (Basel III) values,t/fered daily/intra-day basis,posted in cash
 CCP Clearing  Initial margin covers worst case close cuts,changes
 Trade Repositories frequently with change in market conds,usually
cash/liquid securities/assets
CCP(Central Clearing Counter Parties)  Margin is based on risk of transaction & is much
NOVATION-CCP positioned btw buyers & sellers just stricter in centrally-cleared mkts than bilateral mkts
like an exchange to act as an insurer. RISKS FACED BY CCP
Exposure in case of CCP Netting< Billateral Netting -Default risk;non default risk like fraud,operational
CCP has no market risk,but has a counter party risk. risk,legal,investment risk;model risk; liquidity risk;wrong-way risk etc
& terminates all contracts In event of default.
CCP guarantees performance of their trades by REASONS OF CCP FAILURE LESSONS LEARNT
replacement of defaulted counter-party &
auctioning defaulted members’ position. Large market Control operational risk,prompt
Default losses are reallocated –Waterfall structure volatility,insufficient collection of variation
margins,liquidity risk,initial margins,automated payment
Initial margin margin not updated,high systems,initial margin calculated after
defaults. proper stress testing,penalize
Default fund concentrations.

CCP Equity MECHANISMS OF CCP-Execution,clearing & settlement

Default fund ADVANTAGES OF EXCHANGE TRADED DERIVATIVES-Product
of non- standardization,trading venue,reporting services,inc transparency.
defaulting DEVELOPMENTS IN CLEARING
members Bilateral clearing

Other loss Variation margin gains Clearing rings

allocation haircut & selective tier CCP Clearing
methods up of positions Clearing Rings- Group of exchange members that agree to accept
each other’s contracts & allow counter-parties to be
Remaining interchanged.Simplify dependencies of a member open position &
CCP Capital allow them to close contracts more easily.CCP/clearing house
becomes counter-party to all transactions,assumes all rights &
Liqudity obligations.
support

Before CCP-We had special purpose vehicles(SPVs),derivative product

companies(more separate than SPVs) that uses structured notes to
manage risk,monolines eg AIG(finance guarantee co with no margin
requirements)
Page 37
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BANKS
Summarised by: Karan Aggarwal

BASIC ACTIVITIES OF A BANK SOLUTIONS TO CONFLICT OF INTEREST

 Traditional Banking:Giving loans out of deposits 1933-Separate commercial banking from invt banking
with a higher spread to cover adm costs,NPA etc. 1987-Holding co can have 2 subsidiaries-commercial and small invt banking
 Today’s Banking: 1997-Commercial banks allowed to aquire IBS
1999-Financial services modernization act eliminated all restrictions
COMMERCIAL BANKING INVESTMENT BANKING 2008-Caused sufferings,making GS & MS enter into commercial banking as well.
Req. of Chinese Walls-to prevent sharing information btw commercial
& invt banking.
 RETAIL  Assist co to raise
MAJOR RISKS FACED BY BANKS
COMMERCIAL capital.
Market Risk-From bank’s trading operations
BANKING:  Advice on
Credit Risk- From lending & derivatives’ transactions.
Small loans from mergers,acquisiti
Operational Risk-From internal system failures or external events.
small ons & facilitating
To cover these risks:
deposits.Higher it. Regulatory Capital-As per basel norms;VAR
Spread  Assist in calculated based on a certain confidence
corporate level & certain horizon.In the form of tier 1 &
 WHOLESALE restructuring tier 2 capital.
COMMERCIAL  Brokerage
BANKING: services. Economic Capital-Capital backup based
Big on management’s own estimate of
loans/services to risk,using internal models.
medium/large
corporate
DEPOSIT INSURANCE
clients.Lower
 A guarantee programme provided by FDIC,wherein they provide
Spread,Money
insurance to depositors against losses upto a certain level of
Centre Banks
deposits;ins prem is paid by banks;causes loss of cautious approach by
both banks & depositors;money is put by investor without due
INVESTMENT BANKS help companies to raise capital. diligence ;REMEDY-RISK BASED DEPOSIT INSURANCE PREMIUM.
Stage 1: Originating the securities- ACCOUNTING OF BANKS
Preparing legal documents,prospectus,finding out  REGULATORY ARBITRAGE SECURITIZATION
contingent liabs,agree upon price of secs.
Stage 2:Placing securities with investors- Trading Book Banking Book
Through private placement or public offering via IPO/FPO Assets & liabs held with Contains loans to corporations & inds.
Can be done in two modes: intention to trade. Not Mto Mkt,but principal amt due+ acc
 Best efforts public offering(no responsibility if Mto Mkt else Mto model. interest.
securities are not sold fully) Record gains & losses
 Firm Commitment public offering-Buy all securities
If loan not paid from last 90 days,NPA.
immediately,when
initially at x and sell them to investors at x+Delta. MtoMkt.
Provision for loans losses
Responsibilty to hold it,if not sold fully. Source of market risk. Source of credit risk.

SPINNING
Investment Banking offering Initial Public Offer,to fund Securitization is a process whrein illiquid loans are packaged into liquid
managers & to senior executivesof large companies,to get tranches.
Senior Tranche
business from them.
Remedy:-DUTCH AUCTIONS Loans SPV
Mezannine tranche
Prospectus issues,cos bid no of shares & price at which they
want to buy,shares are issued to highest bidder,next highest
bidder,but all pay at same price. Junior tranche

CONFLICT OF INTEREST
 IB lends money to co in return of
confidential info,passes it to M&A div of
IB,which wl further give this info to
another co in return of M&A business.
 Arrange bond issue for poor loans of the
bank,by becoming an SPV.
 Research wing recommending securities
on CNBC to obtain some business.
 Brokerage div of Ib recommending
investor to buy bad securities.
Benefit for banks-B/S free,lower capital req.,bank can also become SPV & earn
fee for originating & servicing loans.
SPV is sometime govt sponsored-Fannie Mae,Freddie Mac,Ginnie Mae
This being advantageous for investors ,causes problem of moral hazard:
Investors take prepayment & default risk.
Due to subprime lending,entire securitization market got out of contro in
2000-2006,& securitizing it caused bigeest financial crisis of 2008
Page 38
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Visit: www.ulurn.in
PENSION FUNDS Summarised by: Karan Aggarwal

CATEGORIES OF INSURANCE COMPANIES Calculation of premium using Mortality Tables

Life Insurance:Long Term,provides payment to policy holder’s
beneficiaries when policy holder dies.
Non Life Insurance:Shorter term,provides compensation for losses
from accidents,fire etc.Pension plans:Sort of retirement plan where
employer & employee contributes certain % of salary to pension
plan.
Life Insurance
Term life:If policy holder does not die during term of policy,no
payment is made.
Whole life:Policy holder makes regular payments until his/her death
Can be redeemed before maturity,linked with investment plans.
Level premium consists of :
Risk cover & surplus premium( part of premium not reqd to cover
risk of payout,invested to cover deficit later on).
Variable Life: Allows policy holder to choose fund for investing
surplus premiums.
Universal Life:Surplus premium is invested by ins co in fixed income
products,guaranteeing a fixed min return.
Variable Universal:Invt decisions by policy holders & premiums can
be reduced.
Group life:For all employees(can be contributory/non contributory)
Annuities: Eg pension plans,can be immediate/deferred.Policy
holder makes a lump sum payment to insurance co & ins co
provides policy holder with an annuity.
Endowment plans:
Pure endowment:Policy holder is paid only if he survives a certain
term.
Property Casualty insurance:Provides protection against damage to
property,fire,theft,water etc
Casualty insurance:Provides protection against legal liability
exposures.
Catastrophic Insurance:Provides cover against natural disasters.
Liability Insurance:Possibility of claims being made several yrs after
insured period is over.Eg:Log Tail Risk.
Pension Plans:
DEFINED BENEFIT PLANS DEFINED CONTRIBUTION
PLANS
Equate PV of premium to PV of claims,taking “x” as premium amt and
find x.
RISKS FACED BY INSURANCE COS:
 Deficit risk,market risk,liquidity risk,credit risk,operational risk.
Moral Hazard-Risk of change in behaviour of policy holder due
to presence of insurance.Moral hazard can be dealt
with:Deductibles,limits & co-insurance.
Adverse selection-Attracting bad risk,because of same price for
everyone . Moral hazard can be dealt with:Detailed medical
examination,yearly changes in premium.
 Longevity Risk:due to advances in medical sciences;not
beneficial for annuity contracts )
 Mortality Risk:due to epidemics eg AIDS;adverse for life ins )
Actuaries assess insurance company’s net exposure.
Hedging instruments-Longevity bonds(Survivor bonds).
Capital Requirements
Policy reserves is higher in life insurance,due to certainity of payouts.
Unearned premium finds it way in Non-Life Insurance.
Long term invts are in LT corp bonds;short term invts are in ST bonds.
Regulatory System
Insurance cos are regulated at state level.
Diff btw insurance companies & banks
Regulations for bank require that bank doesn’t pose systemic risk in
economy,while regs for insurance co require it to remain solvent.
For banks,there is a permanent fund created from premium paid by
banks to FDIC.
RATIOS FOR PROPERTY & CASUALTY COMPANIES
 Loss Ratio =Claims/Insurance
 Expense Ratio= (Loss adjustment expenses+selling
expenses)/Premiums
 Combined Ratio= (Claims+expenses+dividends)/Premiums.
 Operating Ratio: Combined ratio after adjustment for
investment income.

Benefit to be paid to employees Amt of contribution by

Is defined.
If employee dies during employ
ment,a lump sum is of the
payable to dependents & a
monthly income may be payable
to spouse/dependent’s
children.
employer & employee is
defined,but not benefit payable
on retirement.
Employee’s choice to choose
btw
a no of investment alternatives.
Defines Benefit Plan imposes
significant risks on
employers,since they are
responsible for paying
promised benefits.

Page 39
 Contact : PIYUSH : 9674006544
Visit: www.ulurn.in MUTUAL FUNDS & HEDGE FUNDS
Summarised by: Karan Aggarwal

DIFFERENCE BTW MUTUAL FUNDS & HEDGE FUNDS HEDGE FUND STRATEGIES
1.Long short equity- Buy underpriced stocks and sell overvalued
MUTUAL FUNDS HEDGE FUNDS stocks(fundamental analysis).
2. Equity Market Neutral: Long & short are matched in some way:-
Meant for small investors. Meant for big players. Beta Neutral( Be =0)
More regulated. Less regulated. Dollar Neutral ( Long & short equal amounts)
No lock-in period. Min lock-in period. Sector Neutral (Long & short positions matched within a
Less leverage,less Derivatives used sector)
derivatives,no short-selling heavily,short-selling allowed. Factor Neutral (Beta wrt oil price,inflation,int rate etc is
Eg:Money market MF,Bond Eg: Hedge Fund zero)
funds,equity & hybrid Strategies,equity long Distressed securities( Buying non invt grade/junk bonds
funds. short,fixed income arbitrage. 1) Passive- Buy distressed debt when price is low,wait.
2) Active-Buy distressed debt in large quantity.
Types of Mutual Funds:
Open Ended Mutual Fund: 3. Dedicated Short Strategy: Short sell overvalued co .
Buying/selling of shares through MF window. 4. Merger Arbitrage Strategy:Buying shares of prospective
Total no of units goes up/down. acquired co & selling shares of prospective acquiring co
Closed Ended Mutual Fund: 5.Convertible strategy: Buying underpriced convertible
Fixed no of units outstanding. bonds.Hedge equity risk by delta S-,credit risk by buying CDS,int rate risk bu
Buying or selling takes place on exchange . buying Int Rate Futures.
Exchange Traded fund: 6.Fixed Income Arbitrage: Relative value strategy,market neutral
Designed to mirror any index.Features of strategy,directional strategy.
both closed ended (exchange traded)& open 7.Emerging Market Strategy:Specializing in invts associated with
ended(no diff btw traded prices & FMV). developing countries.
Net Asset Value 8.Global Macro:Investing on exchange rates on studying global
Open ENDED Fund economic trends.
NAV= MV of each asset in portfolio/ Total No of units O/S 9.Managed Futures:Betting on coomodity prices on back testing.
Closed ENDED Fund
NAV1= Mkt price of units.
NAV2=MV of assets in portfolio/No of units O/S
NAV1 < NAV2 RISK FACED BY HEDGE FUND
Liquidity risk(Collateral needs to posted in short-term)
COSTS WHILE INVESTMENT

MUTUAL FUND HEDGE FUND RETURNS

a) FRONT END LOAD-Fees charged when investor first Bias in evaluating performance of hedge fund
buys shares in MF. Self reporting bias: Non reporting by small hedge funds with poor returns
b) BACK END LOAD-Fees charged when investor sells Only survivor hedge-funds which have performed well are reporting.
shares in MF.
c) Management fees & incentive fees. Back feel Bias: Giving all past positive data i..e positive returns,causing
overall returns to be biased upwards.
HEDGE FUND
a) Management fees –Generally 1-3% of total assets
b) Incentive fees-Generally 15-30% of total Net Profits.
Hedge fund manager has a call option on assets of
fund which promotes unnecessary risk taking .

HURDLE RATE
Minimum return necessary for incentive fee to be applicable.
HIGH WATERMARK
Any previous losses must be recouped by new profits before an
incentive fees applies.Calculated individually for different
investors after proportionality adjustment.
CLAWBACK PROVISION
A recovery A/C,where a part of incentive fees is deposited
every year to compensate future losses.

Page 40
 Contact : PIYUSH : 9674006544
Visit: www.ulurn.in CORPORATE BONDS
Summarised by: Karan Aggarwal

For every bond issue,supporting bond indenture containing issuer’s RISKS IN CASE OF BOND ISSUE
promises,investor’s rights,covenants,definition of default exists.
Corporate trustee has following responsibilities:  CREDIT DEFAULT RISK
sssscddd
Duty to see,investors’ rights are protected.
 CREDIT SPREAD RISK
Everything is fulfilled & bond issuer is incompliant
with covenants.
Spread widening(spread duration)-Bond value fall.
TYPES OF BONDS: Coupon:
Spread may change due to issue-specific or macro-economic factors.
 EVENT RISK
STRAIGHT COUPON BONDS(Re-invt risk high):
Restructuring,merger,acquisition,leveraged buy-outs causing Bond
Fixed Rate bonds:
value to fall due to changed capital structure or higher leverage.
 Participatory in profits
 Income Bonds(cumulative & non-cumulative)
Floating Rate Bonds
 Coupon rate=MIBOR+Spread(variable coupons)
Zero Coupon Bonds(Int risk is high) TYPES OF DEFAULT RATES
 Deferred Interest Rate  Issuer default rate= No of issuers that defaulted/Total no of
 Pay In kind issuers at beginning of issue
 Dollar default rate=Par value of all defaulted bonds/Total
par value outstanding at beginning
HIGH YIELD  Avg annual default rate=Cumulative default rate/Weighted
 Original Issuers(Story Bonds) no of years outstanding
-
Speculative grade;rating lower than BBB  Cumulative default rate=Cumulative $ value of default rate
Young growing concerns tell story projecting future bond/Cumulative $ value of all issues
 Fallen Angels
Someone with good financial histories now fallen in junk
categoty.
 Restructuring & Leverage Buyout
Issuing debt (high yield) to buy out companies in bad financial
status EMPIRICAL EVIDENCE FOR PROB OF DEFAULT & LOSS
Deferred In rate,payment in kind,step-up bond. GIVEN DEFAULT FOR CORPORATE BONDS
1. Recovery rate: calculated based on trading price of bond at
time of default/par value.
COLLATERAL 2. Distribution of recovery rates is bimodal
 Debenture Bonds-Unsecured debt 3. Higher the PD, higher the LGD(Loss Given default)
 Mortgage Bonds-Collateral are properties.(Blanket 4. Recovery rates-low in case of economic downturn.
mortgage;after-acquired clause) 5. High recovery rates for tangible asset intensive industry.
 Collateral Trust Bonds 6. PD same regardless of level of seniority of bonds,recovery
 Equipment Trust Certificates rate higher for senior bonds.

REPAYMENT PROVISIONS
 Call & Refunding provisions
Can be called by issuer for redemption before maturity.
Reinvestment risks for investors.
Callable bond price=Price of non-callable bond-Call Option
Call price can be fixed price or fixed spread (Make whole
price).
Non-refundable provisions can exist.
 Sinking fund provision(Money applied periodically to
redemption off bonds before maturity;lower default risk for
investor)
 Maintenance & Replacement funds
For maintaining value of asset collateral backing th debt.
 Tender Offer
Desire of company to buy-back specific debt-issue.

Page 41
 Contact : PIYUSH : 9674006544
Visit: www.ulurn.in MORTGAGE BACKED SECURITIES Summarised by: Karan Aggarwal
1/12
1-SMM=(1-CPR)
MBS1 Credit risk, Here, SMM =Single monthly mortality rate
Market risk CPR=Conditional Prepayment Rate
Pool
LOANS MBS2
(SPV)
Prepayment PSA Benchmark is a unit prepayment speed.
MBS3 risk 100 PSA Benchmark –CPR grows at 0.2% every month & after 30
months, it stabilizes at 6%.
Net coupon on MBS=Weighted Avg Coupon-Servicing fees 200 PSA Benchmark – CPR grows at 0.4% every month & after 30
months,it stabilizes at 12%.

Prepayment Risk MODELLING CHAIN

Pre-payment Risk.Pre-payment is a function of current interest PSA---------------CPR---------------SMM--------------Monthly prepayment
rates,path which interest rate follows to come at current level.
CPR fn(Turnover,refinancing,curtailment,default)
6% Heavy re-financing Turnover-Lock in effect when interest rises.
Refinancing-Toreduce cost & cash out;I=[(WAC-R)*WALS*A]-k
Low-refinancing Where;I=Incentive i.e. gain from re-financing
5% 5% WALS =Weighted Avg Loan Size
4% High re-financing K=Servicing cost & prepayment penalty
A=Annuity factor
Prepayment Risk also occurs due to non-interest related factors like
divorce,relocations.
It is the risk that the speed at which prepayment will occur is PAC Tranches: PAC Tranch(Do not like contraction;nor extension risk)
uncertain. Companion/Support tranch:Ready to take all
E(CFi)=Ii +SPi +PRi contraction & extension risks for a higher Risk Premium.
SPi+ PRi = Only Principal as W ;X =Time of receiving
Caution=Here,W =Principal amt without PV Loans are of two types: Agency & Confirming Loans
Non Confirming Loans are btw subprime & prime.
PREPAYMENT RISK Players involved in the process of securitization:
1.Original Bank
CONTRACTION RISK EXTENSION RISK 2.MBS Issuer(Pooling Agency)
Int Rate falls. If in rate rises ,prepayment 3.Services(Collection Agents)
Prepayment speed wl increase slows down & avg life increases. 4.Guarantors
Avg life shortened Problem:opportunity cost
Problem:Reinvestment risk

Note: MBS+=Non MBS+ C- Dollar Role-(Reverse Repurchase Agreement)

So,prepayment risk is like an American call option for borrower on
known prepayable mortgage with E=principal amt o/s
 The investors sell MBS for settlement on one date & buy it
back for settlement at later date.
 Investor gives principal & interest payments during roll
period but could invest the proceeds.
 But back security at a lower price than SP.Diff in price=drop
Value of drop+int earned on proceeds-int & principal
foregone on mortgage=Roll specialness or financing
advantage.

Here; MPT=Mortgage Pass Through Securities

CMO=Collateralized mortgage operations

CMO

Sequential pay Accrual Tranch

A A
B B
C C
D Z – Z tranch has highest extension
Contraction risk is falling & risk & lowest contraction risk.
extension risk is rising as we Page 42
move from A to D.
 Contact : PIYUSH : 9674006544 THE STANDARD CAPITAL ASSET PRICING MODEL
Visit: www.ulurn.in Summarised by: Karan Aggarwal

MODERN PORTFOLIO THEORY  For an equally weighted portfolio of risky assets,

2
 Optimum portfolio for investor is portfolio with maximum σ p = (variance-covariance)/N +covariance
expected utility  Investors should invest in the most diversified
+ -
f[Exp Return ,Risk ] portfolio i.e. market portfolio ,since it has the
 Indifference curve(IC)=Locus of all combinations of risk & return highest Sharpe Ratio.
providing same utility.
E(Rp) IC1 IC2 IC3 IC4 STANDARD CAPM(CAPITAL ASSET PRICING MODEL)
ASSUMPTIONS OF CAPM
Investors are rational,like to choose a portfolio on efficient
Investor likes to achieve highest frontier,uniform single period investment
possible Indifference Curve horizon,homogenous expectations.
Asset returns are multi-variate normal,freely
σ traded,perfectly competitive market,no frictions,markets
 Expected Return of portfolio i.e. ER(p)=weighted average are in equilibrium: E(R )=Re
=WA E(RA) + WB E(RB) Unlimited borrowing/lending at Rf.
2 2 2 2
 Risk (σp)=√ σ A + W σ B + 2 WA WB cov(A,B) INVESTORS’ BEHAVIOUR
Where, W=Weight & cov(A,B)=rσA σB All investors have the same efficient frontier.On A/C of
E(Rp) presence of Rf ,Efficient Frontier changes from a curve to a
P3 B straight line starting from Rf and tangential to old Efficient
P2 Frontier.
PX New Efficient Frontier(staright line)
Py
E(Rp)=Rf+[(E(Rt)-Rf)/σT] *σp
Min
Variance A E(Rp) New EF(CAL)
Portfolio σ E(RT) T
Inefficient
A to Py = ineffiecient
Py to B= efficient Rf
A to B = feasible Σp
Rational investor will now choose an optimum portfolio as
If we combine stocks A&B in different proportions, the point of tangency btw this new EF and highest possible
Case 1: A & B are perfectly positively correlated IC (Indifference Curve).The tangency portfolio is the
σp =WAσA +WBσB market portfolio i.e. portfolio combining of all risky assets
Case 2: A & B are perfectly negatively correlated with weights proportional to their market capitalization.
σp =WAσA - WBσB This CAL is called Capital market Line-SEPARATION
For a risk free portfolio, σp=0 THEORY.
So, WA σA = WB σB Re= Rf +risk premium
So, WA/WB=σB/σA TWO TYPES OF RISK:
Case 3: r lies between -1 & +1 SYSTEMATIC RISK- Risk related to economy/market
Benefit of diversification exists i.e. σp < weighted average related factors-Market Risk/non-diversifiable risk.
But σp cannot be =0 UNSYSTEMATIC RISK-Relates to firm-specific factors-
Efficient Firm Risk/Diversificable Risk/Idio-syncratic Risk.
E(Rp) Re= Rf + Systematic Risk Premium
Re= Rf + extra return req as a compensation for Be
Inefficient Idiosyncratic risk gets cancelled off.
Re=Rf +(Rm-Rf)Be OR E(R) =Rf +(Rm-Rf)Be
(since CAPM is an equilibrium model)
Re
σp SML Slope=Rm-Rf

Rm M
E(Rp) IC
Rf
EF
0 Be
OPTIMUM PORTFOLIO

σp Defensive Aggressive
Stocks Stocks

Page 43
For temporary periods of disequilibrium in CAPM,  On combining 2 assets ,σA =10%, σB= 14%
E(R) ≠ Re Is it possible to construct a portfolio combining A &B with
Alpha(α)= E(R) –Re σp< σA ?
 If α >0, E(R) > Re,stock is underpriced. o If short selling is allowed-always yes
 If α<0, E(R) < Re,stock is overpriced. o If short selling is not allowed;
Ri
If r< σ lower/σ higher
Best fit line/Characteristic line
(Derived by Least Squares Mthd)
If r < σ lower/σ higher No
Slope=Be Yes
 For a Minimum Variance Portfolio
wA= (Doosre ka variance –covariance)/(Dono ka variance-2
Rm covariance)
Purpose=calculation of Be
2
Be= slope of Characteristic Line=cov(x,y)/σx HARDCORE ASSUMPTIONS OF AUTHOR
Author assumes no inflation.Presence of inflation
PARTICU will cause inflation risk & make Rf volatile.
LARS CML SML CL
Predicted variance > Historical variance because of
uncertainity surrounding the mean.
Def It is efficient It is equation It is the best Debate btw long term frame > short term frmae
Risk of CAPM fit line btw i.e. statistical accuracy vs adaptibility.
Frontier Stock and Square root rule is based on iid assumption.
Market.
 Jensen Alpha = Actual Return of portfolio - Re
Purpose Investors Asset pricing i.e. To compute
Combine Rm given the Beta Be
& Rf of stock,what
Is its Re?

Slope Sharpe ratio Rm-Rf Be

of mkt portf
i.e.(Rm-Rf)/σm

Rel btw E(Rp) & σp E(R)/Re Ri & Rm

only for & Be for ind for ind stocks.
efficient stocks,
portfolios . inefficient
portfolios &
Efficient
Portfolios.

Page 44
 Contact : PIYUSH : 9674006544
Visit: www.ulurn.in
FRAUD
DISASTER DUE TO MISLEADING REPORTING
VALUATION ISSUES
JDNKJN
1. Chase Manhattan vs
Drysdale Securities
INCIDENT-
-Drysdale borrowed T-
securities from sec dealer
through Chase Manhattan,
indulged in arbitrage by short
selling US Treasuries for Mkt
Price+ Acc Int in Govt sec Mkt
& borrowing US treasuries at
MkT Price In Repo Mkt.
Collateral valuation
- resulting in huge
was made without Acc
interest. Mkt rallied,brought
huge losses & Chase had to
bear coupon payments on
behalf of Drysdale.
LESSONS LEARNT-
Rules for collateral valuation
& Risk Control Functions.
2. Kidder Peabody
INCIDENT-
rt
-Value of Fwd Contract=Se -S
IGNORED
PRICING OF
WRONG
FORWARDS.
INSTANT PROFIT RECORDED
-S/Holders lost confidence in
company; no cash loss.
LESSONS LEARNT-
Investigate unexpected profits
& review models.
3.UNION BANK OF
SWITZERLAND (UBS)
INCIDENT-
-Concentration Risk ( LARGE
STAKE IN LCM).
-Unusual Independence to
Derivatives Division.
-Low realization while selling
Basket of Equity
Long Dated
options,but not apparent due
to usage of Marked to Model
feature.
-Inappropriate hedging of
Bank Warrants
-British Tax Law Changes
LESSONS LEARNT-
Separate risk mgmt
department
& correct model for
valuations.
FINANCIAL DISASTERS
Summarised by: Karan Aggarwal
NO FRAUD DISASTER DUE TO
CUSTOMER BUSINESS
DISASTER DUE TO LARGE
MARKET MOVES
IMAGINARY TRADES Trust
HOARDING
Bankers
1.Barings Bank Sumitomo 1.LTCM
INCIDENT- INCIDENT- INCIDENT-
INCIDENT-
- For Interexchange S+,F+ -On being approached by
-Hedge Fund developed by Scholes &
arbitrage using Nikkei -Bought all P&G & Gibson for a
Merton
Futures,used Short physical derivative trade that would
-Indulged in relative value trades-sold
Straddle i.e.(P-,C-) & commodities reduce their funding cost,
D the run & bought off the run
on
Long Futures on both along with their Bankers Trust presented
securities due to contrarian view.
the Index( 2F+). futures. their strategy in such a
-Due to Kobe -Heavy losses due C
- onvergence strategies- complex manner that
earthquake, Nikke to liquidity Went long on Russian sovereign P&G & Gibson could not
futures fell & risk.Impact loss securities,had a view that their risk understand.
high.
volatility increased has been overestimated,which on -No competitive quote –A
correction will result in lower feeling of tailor-made
losses. yield.But Ruble crisis resulted in flight strategy.
-Changed software to to quality,widening the spread . -Tapped phone
not report trades,since Sold options expecting mean conversations showed how
head of front & back reversion of volatility,BUT it shot up. Bankers Trust STAFF
office same. FOOLED THEIR CLIENTS.
-Warning signals like M
- odel Risk-Based on historical -Lost customers’
data & lot of assumptions
Trust.Reputational Loss.
unexpected profits in
imaginary
trades(changed
T
- ail Risk not captured .
software) & margin
call outflow bcoz of
-Liquidity –Did not have liquidity LESSONS LEARNT-
when margin calls trigerred. -Complex strategies are
exchange trade possible but should be
feature. communicated
LESSONS LEARNT- understanding the
LESSONS LEARNT-
Independent trading Better use of stress tests in assessing sophistication level of
office & inquire credit risks,need for initial margin if client.
unexpected profits & counterparty’s principal business is -Customers should be able
sources of cash. trading,need to incorporate to obtain price quotes
endogenous & exogenous liquidity from an area independent
I
2.Allied rish Bank
risks. of front office.
-Firms should be cautious
INCIDENT- 2 Metallgesellschaft of communications .
-For arbitrage using FX
options,indulged in
speculation.
INCIDENT-
SDFSDF
Entered into a 5 yr Fwd contract to
-VAR under-reported. sell heating oil to customers.Ran the
-Bullied back office risk of price going up,due to which it
employees. entered into short dated futures &
-Sold options to show decided to roll them over-[This
high cash flows in the resulted into huge losses.]
OTC Market & only Reasons-
modest gains  Oil prices fell-Loss in futures
reported.
position & gain in F/w
position.
 Market for oil changed from
backwardation to contango.
 Futures loss resulted in cash
outflow on futures position
but no cash inflow in fwd
gain leading to liquidty
problem.
Page 45
 Contact : PIYUSH : 9674006544
Visit: www.ulurn.in
DEFINITION & MEANING
Definition:
Minimizing deviations from organizational
goals- It’s a process(comprehensive &
integrated approach) that comes from Top
Mgmt,manages risk to be within
appetite,coordinates activities to handle
uncertainity that gives rise to risk, in order
to achieve business objectives ,minimize
unexpected earnings’s volatility &
maximize firm’s value.
Meaning:
Develop process for each
significant risk.
Use an integrated/portfolio
approach.Don’t take Risk
Management in Silos.
SILOS.[Eg:-If risk can be
naturally hedged in 2 positions
due to correlation,use ERM,
don’t’ hedge both positions
separately,thus avoiding hedging
cost].
Consistency in standards of
representation.
Top Mgmt should get complete
picture by ensuring
implementation of firm wide
policies & standards for Risk
Mgmt & effective communication
btw Risk Managers.
ROLE OF CRO: SKILLS OF CRO:

Achieving
Business
objectives &
goals (increasing
S/Hs’ value)

Communicating
Risk objectives &
goals(Eg:
Earnings
Volatility < 10%)
 Identifying Key
Risk Indicators
(eg. non-suitable
work
environment
that harms risk
appetite)
 Allocating
Economic
Capital(Eg
RAROC)
ENTERPRISE RISK MANAGEMENT
Summarised by: Karan Aggarwal
BENEFITS OF ERM (MEMORIZE : ERP) COMPONENTS OF ERM
E
 Organisational ffectiveness
 CORPORATE GOVERNANCE-
Processes,controls established by Board plus
Individual & interdependencies amongst risk is regulatory initiatives Eg. SARBANES OXELEY
well-addressed.
ACT.
R
 Timely & Relevant isk Reporting  LINE MANAGEMENT-Include expected losses
Developing Risk dashboards that increases Risk & cost of risk capital of organization to
transparency. conclude viability.
P
 Improved Business erformance
Transparent review process by taking
corporate approvals.
Proper capital allocation,product
 PORTFOLIO MANAGEMENT-
development,pricing,mergers.
Capture diversification benefits from natural
Reduced losses, lower earnings’s volatility &
improved shareholders’ value & taking more of hedges & by setting portfolio targets & risk
profitable risks. limits for optimal returns.
 RISK TRANSFER-
ERM INTEGRATIONS REQ. (MEMORIZE:OTP) Lower the cost of transferring undesirable
risks,avoid risk concentration,evaluate hybrid
 Integrated Risk Organisation
products consistently.
Organisational Central Risk  RISK ANALYTICS-
Management Unit .(CRMU) Model credit,operational,market risk with
better tools like Risk Adjusted NPV,VAR etc.
 Integration Of Risk Transfer  DATA & TECHNOLOGICAL RESOURCES-
Strategies Improve quality of data fed into Models after
Manage only residual risk after properly capturing prices,volatilities etc.
considering diversification.
 STAKEHOLDER MANAGEMENT
 Integration Of Risk Management into
Improve Risk Tranparency in firm’s
P
Business rocesses relationship with key Stakeholders.
Optimization of business performance
rather than control.
 Multiyear Inititaive
ROLE OF SENIOR MANAGEMENT
Continued sponsorship & investment
(MEMORIZE : ABCDE)
in human & technological resources by

Top Mgmt.
Required for both Leading & Lagging
Appetite –Risk Mgmt & Audit
organizations.
Risk Benchmark
ROLE OF CRO Risk Culture & CRO’S Role
CRO-An Elevation To Development & Training
 Leadership skills Profession
Hire & train talented o Attractive ERM Framework
Risk Professionals career path.
 Evangelical Skills o Increasing
Convert skeptics to Salaries.
believers. o Strategic Roles
i.e. CRO(Credit HURDLES IN ACHIEVING SUCCESSFUL ERM
 Technical Skills
Risk Officer)
Knowledge of like CEO.
credit,market &
operational risks.  Reactive approach rather
 Stewardship than proactive approach.
Safeguard company’s
 Followed by pressures from
assets
Auditors,regulators,shareholders,rating
 Consulting Skills agencies,analysts etc.
Educating
Board,Senior & Line  Different Risk Instruments-Adequate Use of
Managers Each Is Required.
Page 46
 Contact : PIYUSH : 9674006544
RISK MANAGEMENT-A HELICOPTER VIEW
Visit: www.ulurn.in Summarised by: Karan Aggarwal

RISK? Any thing which is difficult to predict,involving uncertainity. RISK VS RETURN

RISK MANAGEMENT?-Actively managing type & level of risk.  Higher risk,higher return.
NOT DEFENSIVE(ASKS FOR PROPER  Invest in asset class giving higher return per unit of risk.
PLANNING)  Risk appetite varies with risk.
Risk mgmt & Risk taking are two sides of same POOR RISK MANAGEMENT PRACTICES
coin.(COMPLEMENTARY) Exaggerated potential returns while diminishing perceived potential risks.
Inconsistencies in handling disasters due to Potential for large losses arise from activities that generate,attractive stream of
 herd behavior of risk managers ; profits in short-run.
 financial engineering covering up real economic conds of Lack in adjusting present performance measures in line with future risk.
poorly performing firms in boom period(Eg ABS,MBS) Regulator’s collusion-
 Risk Mgmt technologies are a double edged sword(can When economy is in boom,regulators all around world have colluded with local
be used for risk-reduction , as well as,for taking more
banking industry to allow firms to misreport risky assets on B/S.
risk)
Risk Mgmt(too imp to be left to only rocket scientists)- need of
everyone in organization. JOBS OF A RISK MANAGER
Identify sources and make them visible tokey decision makers & stakeholders.
Giving a distribution estimate rather than a point estimate.
RISK is losses beyond the expectations;unexpected loss.
Implement appropriate policies,methods & infrastructure.
Use statistics to define extent & potential loss via probability
Developing tools for measuring potential returns & losses.
distributions rather than point estimates.
Balancing risk & reward.
Identify risk factors driving volatility.
Clear definition of roles & reporting lines.
Organizations need to have a risk appetite.
POSITIVES IN RISK MGMT NEGATIVES IN RISK MGMT
KEY TASKS ABOUT RISK MGMT  Better future prospects  Challenge to balance fiduciary
Confidence in skills & infrastructure prevalent to  Career path to C level positions responsibilities against the cost
measure Unexpected Loss.  Adoption of sophisticated Risk of offending business heads.
Capital sufficiency to protect against Unexpected Loss. Mgmt processes  Not revenue generator.
Computation of Risk Adjusted NPV(after adjusting for  Addition of new financial  Unified measurements of diff
Cost of Risk Capital)instead of only NPV.Cost of Capital products for Risk Mgmt kinds of risk is diff.
i.e. appropriate returns from risky activities.  Widening of Risk Measurement  Quantifying organisation wide
Communication of target risk profile to everyone. scope to all types of risks. risk exposure is complicated.
 Increase in Global risk mgmt  Risk Mgmt impacts
RISK MANAGEMENT PROCESS industry organization iif perception goes
associations(GARP,PRMIA) to be too risk averse.
Identify risk exposures
i.e. credit,operational
& market risk TYPES OF RISK

BUSINESS RISK NON-BUSINESS RISK

Measure and Find instruments &
estimate risk facilities to shift risk.
exposures. Non-
Decisions Environment
Financial Risk
1.Strategic 1.Macro env Financial
1.Market Risk
(Eg TATA (Eg Trade Risk
Eg Equity price risk (like
Chorus) War) 1.Reputatio
general risk & specific risk);
Assess effects of Assess cost & benefit 2.Product 2.Competitio n
Interest rate risk(Basis
exposures. of instruments (Eg NANO) n (Eg Cyrus
Risk); Commodity Price
(Eg Jio vs Mistry,
Risk;Foreign Exchange Risk.
Bharti vs PWC,Satyam
2.Credit Risk
Vodafone) Scam,PNB)
(Downgrade Risk,Default
3.Technology
Rsik,Settlement Risk)
(Eg Nokia; 2.Regulation
3.Operational Risk
Electric BSIV
RISK MITIGATION STRATEGY Failure in
Cars,Artificial
People,Processes &
Intelligence,
AVOID Systems;Eg;PNB
Data
TRANSFER Fraud.Maggie,ransomware
Analytics
MITIGATE 4.Liquidity Risk(Funding &
Is the need
KEEP Trading Liquidity Risk)
of the hour.)
5.Investment Risk
(Eg: All invtss concentrated
in a single asset class)
Page 47
 Contact : PIYUSH : 9674006544
Visit: www.ulurn.in CORPORATE GOVERNANCE & RISK MANAGEMENT Summarised by: Karan Aggarwal

Corporate Governance means BOD of Company should look after best interest of stakeholders.So, Risk Management should be a part of
Corporate Governance to maximize Shareholders’ wealth.

Corporate Governance & Risk Mgmt

CONSEQUENCES OF FINANCIAL SCANDALS
Pressure on Board & Mgmt to implement
Risk Mgmt practices effectively:
1.Corporate Governance & Risk Mgmt
2.Risk Mgmt Committee
3.Risk Advisory Directors
Pressure on Regulatory Agencies to
upgrade their capabilities.
Inattention & incompetence punished as a
deliberate act.
Evolvement of Risk Analytics Discipline
(Eg:-Limits based on VAR)
Key drivers of financial scandals:
1)Misleading info to Board 2)Financial Engineering,allows non disclosure of economic risks.
 Integration of RM with Corp Governance required
1.Agency costs(conflict of interest)
2.Bus strategies(Analyze reward & risk)
3.CRO
4.Development of overall strategic plan
(set risk limits based on risk appetite)
5.Economic rather than A/cing performance
(A/cing perf may be manipulated)
 CRO should report to BOD,Risk Mgmt Committee & CEO/CFO
 CRO=Risk strategists + Risk Managers (Member of Risk Mgmt Committee)
 CRO-Should be independent of line mgmt,should communicate overall risk limits,should direct
bus lines to reduce their position,delegate responsibilities to heads of business lines,should
independently monitor limits.

Also, foll 2 things need to be kept in mind for Risk Mgmt Committee
assessing RISK MANAGEMENT:
Independently review Report & communicate with Establish Risk policies,risk limits &
 Factors showing seriousness of Risk controlling of risks. Chief Inspector,Auditors, delegate limits to CRO
Management Approve individual Mgmt Committee
 Standards for managing risk. credits of higher amts.

RISK ADVISORY DIRECTOR DELEGATION PROCESS:

Works to improve overall efficiency & effectiveness Risk Committee of Board
of senior risk committees & Audit Committee plus
independence & quality of Risk oversight by main Delegation to Senior Risk Committee
Board.
Delegation to CRO

Reasons for This Role: Delegation to Heads Of Business( Eg Head Of Treasury Dept)
 Lack of risk mgmt skills across Board
 To provide independent support. Delegation to Business Unit Manager( Eg: Head of equity Dept within Treasury Dept)
 To examine interface btw corporate
governance & risk mgmt INDEPENDENCE BTW DIFFERENT UNITS TRADING ROOM MGMT
 To participate in Audit Committees,Key SENOR MANAGEMENT -Approves bus Deal Capture, sign off P&L
Risk Committee MEETINGS & provide plans,set risk tolerance & ensure performance.
independent commentary on Risk
Reporting.
RISK POLICIES FINANCE OPERATIONS
Develop policies,monitor Integrated P&L Settle trades,reconciliation btw bank & front
Skiils required By Risk Advisory Director compliance with offices,decomposes P&L,independent MARKED
& valuations
o Internal controls limits,manage risk TO MARKET VALUE.
o Business strategies committee process.
o Financial statements,accounting
CHECKING SERIOUSNESS OF RISK MGMT
principles,disclosures.
Authorized risk based transactions,Accuracy of inf,Boosting fin results,Compensation in form of Risk
o Internal & External Audit Reports
Adjusted performance linked,Checks & Balances,Career path,Culture,Proper Delegation of
o Relation with Affiliates
responsibilities.
o External competitiors

STANDARDS FOR MANAGING RISK AUDIT FUNCTION

LIMITS( RM translates risk appetite into app risk limits)
 Variance btw actual &  PERIODIC INVESTIGATION & INDEPENDENT
PORTFOLIO TIER 1-SINGLE predicted volatility. ASSESSMENT
Level OVERALL LIMIT  Escalation procedure for limit  CHECKING INTEGRITY OF MGMT INF
FOR EACH ASSET exception. SYSTEM
LIMITS Type A-Reserve/refer to senior risk  CHECK FOR SIGNIFICANT CHANGES IN RISK
RISK committee. MANAGEMENT PROCESS
TIER 2- Type B-Direct approval by CRO or  CHECKING DERIVATIVE PRICING MODELS
Level GENERAL clearance orders.  CHECKING SOUNDNESS OF RISK MEASURES
BUSINESS  Timeliness of Reports & P&L  BACK TESTING
Function of bank activities
LEVEL Statements
size,sophistication,comparability
CONCENTRATI  Data used in limit monitoring
& exposures (In normal
ON LIMITS shd be independent,reconcilied Page 48
course,40-60% of limit is subject
to exposures) & consolidated.
 Contact : PIYUSH : 9674006544
Visit: www.ulurn.in RISK MANAGEMENT FAILURES
Summarised by: Karan Aggarwal

THEMES:
A)Sources of Risk Management failures are:-
 Measurement of Risks
1. Mismeasurement of known risks
Risk mismeasurement arises on A/C of 2 reasons:-
Lack of historical data
Subjective forecasts
-Before the subprime crisis,there was a lack of stressed data of Real Estate prices.
-A risk manager need to be statistically sure that data fits right distribution.But he is not required to know why losses behave as per
that distribution.
2. Failure to take risks in into A/C (eg LTCM)(i.e. unknown risks like liquidity risk).
 Communication of Risk
Failure in communicating risk to the Top Management.
 Management of Risk
1.Failure in monitoring risks.
“Increasing certainity for one variable introduces uncertainity for another” is TRUE for Mark To Market Accounting .
2.Failure in managing risks.
3.Failure to use appropriate risk metrics
Stulz offers various criticisms of One Day VAR( It is least helpful to Top Management).

B)Heavy losses cannot be said to be Risk Management failures.Calculated risks are ought to be taken which can trigger huge losses.This is not
Risk Management failure but not having proper backup(economic cpital) and contingency plans to minimize impact of those losses amounts to
failure.

C)Having high leverage doesn’t necessarily account for Risk Mgmt failure.Amt of leverage by a company varies in different situations.
D)The articulation of firm’s risk appetite is the Board’s decision.
E) RISK

FINANCIAL RISK Correlated NON-FINANCIAL RISK

1)Credit Risk Business Risk Non-Business Risk

2)Operational risk Eg:-Strategy & & Reputational &
3)Market risk technological Political Risk
innovations

F)Too much monitoring can obstruct the innovation of Trading department

G)Link compensation with Risk Management (Eg: VAR/zero days exceeding VAR but overall losses may be possible)
Also incorrect time horizon for VAR can lead to problems.Complement VAR with scenario analysis.

PERFORMANCE MEASUREMENT(Can be ex-ante or post-facto)

Metrics for appraising performance of fund manager

Sharpe RATIO Treynor Ratio Information Ratio Sortino Ratio

=(Rp-Rf)/σp =(Rp-Rf)/Bp =Expected Alpha/SD of Alpha  (Rp-Rf)/Downside SD
Excess return Excess return 2 variants of calculating expected Aplha  (Rp-Minimum Acceptable
per unit of total per unit of 1) Active Alpha Rp=10% ,RB=8% Return)/Downside SD
risk. systematic Active Alpha= Rp- RB
Used for non- risk,used for Alpha reflects selection & allocation skills.
diversified well-diversified We check consistency by calculating SD of active alpha.
portfolios. portfolio. (i.e. ACTIVE RISK)
2) Residual Aplha/Jensen Alpha
Take CAPM as benchmark.
Re=Rf+(Rm-Rf)Be
Residual Alpha=Rp-Expected Return as per CAPM

Page 49
 Contact : PIYUSH : 9674006544
Visit: www.ulurn.in GETTING UP TO SPEED ON FINANCIAL CRISIS Summarised by: Karan Aggarwal

VULNERABILITIES INDICATIONS TO CRISIS DETECTION OF CRISIS

Exposure to sub prime loans Before crisis-
Exposure to short term deposits to External debt AUG 2007 SEPT,OCT 2008
fund long term assets. & domestic RUN ON ABCP LEMON CRISIS
govt debt is 1)Main investors-Money Market 1)Run on money market mutual fund
very Mutual Funds 2)No supply of funds to corporations
Repurchase agreement Commercial high.Accelerati
Collaterized deposits in Paper Main issuers-Financial & Financial intermediaries
on of system Institutions 3)Flight towards govt funds
banks by Large Trouble wide leverage
Institutional Investors rolling them 2)No rollover 4)Money Market Mutual funds
just before 3)Money Mkt Mutual Funds sold collapsed & bailed out.
where bank promises to over. crisis.
pay overnight repo rate their underlying assets in
Post crisis- distressed sale.
on deposited Decrease in
money,but haircuts on credit supply
repo collateral rise & due to lack of Action:GOVT’S POLICY RESPONSES TO FINANCIAL CRISIS
trouble rolling liquidity. 1)REDUCTION OF INTEREST RATES
repurchase agreements. Economic stress index-No much positive effect
Shadow banking CONSEQUENCES OF Financial stress index-Little positive effect.
Run on shadow banking led to run on LEMON CRISIS 2)Reserve Requirements,longer funding,higher credit lines(Liquidity support)
banks. 1)Full-fledged global crisis. Pre Lemon Crisis-Positive impact on inter bank spreas
2)Risk of default from After Lemon Crisis-No improvement
Reaction:Global effects of financial crisis counterparties to FI. 3)Stabililty measures
1)Loss of customer confidence 3)ABCP decline because of Recapitalization-Capital injection,debt guarantees,deposit insurance,govt
2)Hoarding & stop of lending high YTMs. lending-positive effect
3)High rejection rates for mortgage loans. 4)Loss of confidence in Asset purchase,ring fencing,liability guarantees-no effect.
financial system
5)Bank Hoarding
liquidity.(i.e. no lending)

DECIPHERING LIQUIDITY CRISIS

TWO Types of Liquidity : Funding liquidity & market liquidity.

Evaporation of liquidity i.e. liquidity crisis causing financial crisis & systematic risk.

Causes of Liquidity Crisis LOSS SPIRAL Reduced positions

Subprime loans –Banks facing delinquency of mortgages causing fire
sale of assets. Initial losses Funding problems Prices away from fundamentals
Subprime loans-SPV-CDOs rating downgraded,collateral calls. (eg credit) (Predatory Trading)
Subprime loans-ABCP-Roll over Money Market Mutual Funds

Higher Margin(i.e. Higher haircuts)

HOUSING BUBBLE Losses in existing position
REASONS OF SUBPRIME LOAN-Relaxed interest rate policy bcoz of Dot
Com Bubble & Financial Innovation (Originate & Distribute Model)
TED SPREAD increased,higher severity of liquidity crisis.
FUNDING LIQUIDITY MARKET LIQUIDITY
FACTORS LEADING TO HOUSING BUBBLE Margin lending/haircut Bid-Ask spread high
o Lending standards tightened risk Market depth low
o Fire sale of asset because of run on FI. High haircut Risk Market resiliency
o Lending process dryup. Roll Over Risk
o Increase in mortgage delinquencies. Inability to roll over Commercial
o Chain reaction Paper
Redemption Risk
POPULARITY OF CDOs/CDS Withdrawal of deemed
CDOs-1)Senior tranche deposits(Run On) .
2)Mezzanine tranche
3) Junior tranche
FI’s were hedging themselves by buying Senior Tranches & buying CDS
Reasons for popularity of CDO
-Catering different investors
-Risk transfer to those who r ready to bear
-Allows FIs to indirectly assess these assets.
-Regulatory arbitrage
-CRA were giving favourable ratings.
-Cheap credits were available
-Bank faced only pipeline risk(no credit risk)
-Teaser rates,no documentation,piggy back mortgages,Ninja Loans.
Page 50
 RISK MANAGEMENT,GOVERNANCE,CULTURE & RISK TAKING IN BANKS Summarised by: Karan Aggarwal
INTROUDUCTION
 Role of Risk Mgmt in Banks-shareholders’ wealth maximization:
1. By producing low risk liquid liabilities.
2. Optimum level of risk exposure.
S
Level of leverage,Risk has different implications for different banks and types of operations.
3. Too much/too little risk
Value Optimum level

Risk
Too little risk-NPV projects are lost.Too much risk-Might suffer heavy losses.So,operate at optimum level-subjective
& depends on activities of Bank.
 Structural challenges & limitations to Effective Risk Management(Identifying,measuring,aggregating & monitoring risks)
1.Incentive to take bad risk.
2.Limited resources in observing & measuring risks.
3.Difficulty to identify optimum level of risk.
4.Issues with limits:
More limits, more granular limits thus decreasing positive NPV projects.
Can’t control risk that is not observed & measured.
No limits on strategic risk.

Impact of Risk Management on Bank’s risk profile & STRESS TESTING & OTHER RISK MANAGEMENT TOOLS
performance
Importance Of Stress Testing:
Bank’s Incentive structure RISK CULTURE  Translates scenarios into loss estimates which are used to decide risk capital.
governance Performance Values,attributes &  Stress testing is an enterprise wide view of risk.
Independent appraisals on basis behavior of VAR Stress Testing
RM team & of Risk Adjusted employees towards
CRO reporting Returns,but can fail Risk. Market view Accounting view
,tradeoff btw if risk is
too high & too mismeasured.
low
independence. Focusses on losses at point in time Focusses on long period of time

Unconditional scenarios Adhoc & conditional scenarios

GOVERNANCE OVER STRESS TESTING
o Stress testing shoud be rigorous.
Probability is imp Probability not imp
o Elements of Effective Governance in Stress Testing:-
S-GOVERNANCE STRUCTURE,
D-POLICIES,PROCEDURES & DOCUMENTATIONS
R-VALIDATION & INDEPENDENT REVIEW
A-INDEPENDENT AUDIT LINKING VAR MODELS

GOVERNANCE STRUCTURE
1.BOD should be knowledgable,who understand
assumptions,limitations,challenge them & supplement with
quantitative & qualitative info.
2.SENIOR MGMT-Accountable to Board for reporting,making
policies,allocating resources,proper coordination,stress-tests & taking
internal summary of test results ,remaining updated for new risks.
200M 500M 800M
DOCUMENTATION-Document stress testing purpose,process for
VAR
choosing scenarios,review,validation,stress tests used.
Provides transparency to third parties,tracks  Suppose probability =0.01%,even then stress testing is very imp for
results,responses,helps stress test developers. organisation
VALIDATION & INDEPENDENT REVIEW-  Basel Norms require to calculate Stressed VAR,which is calculated using
Unbiased,review of quantitative aspects of stress-testing,helps Historical Data. ADVANTAGES & DISADV OF
acknowledge limitations,checking accuracy of
TYPES OF STRESS TESTING STRESSED RISK METRICS
models,application of appropriate development standards.
INTERNAL AUDIT  Challenging scenarios o Helps to keep adequate
Questioning stress testing team,independent  Firm specific & systemic stress events capital.
valuation,review,handling stress test deficiencies.  Enterprise wide stress testing o Risk taking is conservative.
ASPECTS OF STRESS TESTING  Reverse Stress Tests o Disadv-Current market
Appropriate risk coverage,individual & enterprise wide  Incremental & Cumulative effects conditions are not
level,consider correlation among diff exposure activities,  Capital & Liquidity Stress Testing considered,instead only
relevant time horizon-LT & ST  Use copulas & correlation based Page 51
hypothetical scenarios are
models. considered.
 Contact : PIYUSH : 9674006544
Visit: www.ulurn.in CORPORATE RISK MANAGEMENT-A PRIMER
Summarised by: Karan Aggarwal

Financial Risk mgmt-CRITICAL CORPORATE ACTIVITY

 Disclosure of exposure of a co to financial risk necessary.
 CEO &CFO personally liable for losses in organization due to Internal Control weaknesses.

ARGUMENTS AGAINST MANAGING RISK

1)M&M Proposition: Cap Mkts work under absolute perfection,investors can themselves diversify their specify risks.So,enagaging in risk
reduction activity by org involves Hedging cost.
2)Hedging-ZERO SUM GAME
3)Distracts mgmt from core business
4) Risk mgmt requires resources,skills,time,DOUBLE-EDGED SWORD.
5) Stringent disclosure & acing reqs for derivatives.

ADVANTAGES OF RISK MGMT

 Reduces chances of default.
 Self interest of stabililty in earnings (brand value creation)
 Stable earnings bring lower taxation than volatile earnings
 Stabilization of cost & pricing policy of co.
 Reduces cost of capital.
 Should be taken as seriously as insurance
 Investors may not be rational(imperfect capital market)

Operations Risk-Outside scope of CAPM.

Focus on business areas having comparative advantage & reducing risk in production & selling activities.

B/S Position- Eg $ receivables for Infosys-

Should not hedge Should hedge if capital

If capital markets are markets are not perfect /7 co
perfect has better inf abt markets than
investors.

PUTTING RISK MGMT INTO PRACTICE:

Objectives:DETERMING RISK & RETURN;
 Identify general and specific issues,time horizon for Risk mgmt objectives ,liquidity,accounting & tax implications.
 Identify key risk to hedge & key risk to assume as a part of business strategy.
 Identify criteria for measurement of objectives.
 Approve certain risk limits & prevent exposure beyond limits.

RISK MAPPING:
Estimate current & future magnitude of loss by appropriate classification of risk into business,market,credit & operational risk.
MARKET RISK: Int rate changing,economy slowdown
CREDIT RISK:High default rates
OPERATIONAL RISK:Lack of controls in processing loan
(corruption)

Deciding Instruments
Choose between hedging via financial markets or internal(natural) hedging after doing cost-benefit analysis.
STRATEGY BUILDING & IMPLEMENTATION
 May set up hedging models
 Dynamic or static hedging strategies
 Understanding potential accounting & tax implications for each strategy.
 Performance evaluation
 Evaluated periodically
 Checking extent to which overall goals were achieved
 Actual vs Budgeted analysis of Risk Manager Page 52
 Summarised by : Karan Aggarwal

BASIC STATISTICS

1. Branches of Statistics -

Descriptive Stat. Inferential Stat.

 Describing the Characteristics of the data  inferencing about the population data
based on the study of sample data.

2. Numerical Measures of Descriptive Statistics -

Measures of Measures of Measures of Measures of Measures of

central dispersion Dependence symmetricity peakedness
tendency
- Range - skewness - Kurtosis
- Mean - Variance or SD
- Median
- Mode
- Quartiles

Correlation covariance

Karl Spearsman Kendall

Pearson Rank Tau

3. Measures of Central tendency -

i. Mean

Arithmetic Mean Geometric Mean

1  Used to calculate investment
AM   Xi
N i 2 return over multiple periods.
5  10  12  7  1  Ex: RG=
Ex : AM 
1  R1  1  R2  .....(1  Rn )
1/2
5 1
AM  7

 Mean is the First Moment

Page 53
 Summarised by : Karan Aggarwal

Simple Mean

Population Mean Sample Mean

 Denoted as   Denoted as X or ̂
1 n
 X  Xi
n i 1
 Sample mean is a Best Linear Unbiased estimator of
population Mean [BLUE] ie
E ( X or ˆ )   ie. Bias =0
 Sample mean is best among linear unbiased
estimator ie. It has the LOWEST VARIANCE
1 n 
 Variance of Mean Estimator V   Xi 
 n i 1 
1  n  1 n
1 2
 v  Xi 
n2  i 1  n
V  Xi  
i 1 n2
n  2

n
Note: covariance = 0, since xi’s are 11D Random
Variable.
 Variance of Mean Estimator decreases as n
increases. Therefore, larger samples produce
estimates of mean closer to population mean.

ii. Median =
it is the midpoint of a data set or 50% quantile of the distribution.
 n  1  * 50% 
th

 Ex : find out the median of 3, 5, 7, 9, 11, 13, 15
Median = ((7  1)*50%)  9th
=9

iii. Mode –
 Value that occurs most frequently in the dada set.
 For a symmetric distribution, Median is in the center of the distribution.
 For a symmetric distribution – median > mean (Left - skewed)
Median < Mean (right – skewed)

4. Measures of Dispersion -
I. Range = Maximum value – Minimum value
II. Variance = “ Average squared Deviations round the mean.’’
 Var (x) = E (x2) – [E(x)]2 Variance is the second Moment.

Population Variance Sample Variance

 It is denoted as 2  It is estimator of Population Variance denoted as

Page 54
 Summarised by : Karan Aggarwal

 Population SD  ̂ 2 or s2
 Sample Variance
 X   
2


n

SAMPLE VARIANCE

BIASED ESTIMATOR UNBIASED ESTIMATOR

2
1 n
ˆ 2    Xi  ˆ 
n i 1 1 n 2

 S2    Xi  ˆ 
Bias  E ˆ 2    2 n 1 i 1

n 1 2  BIAS  E (S 2 )   2
   2   2  2
n
 2 0

n
 ̂ underestimate true variance
2
 S (sample SD) calculate using n-1 is not
& thus there is downward Bias an unbiased estimator of  (population SD)

 Sample SD = s 
 (x  x )
2

n 1
 An estimator is said to be consistent when bias decreases as n increases and the variance of the estimator
V (ˆn) approaches to zero as n gross larger.

5. Measures of symmetricity –

Skewness measures the asymmetricity in the data.

 
 Normal distribution is a bel 
shaped curve, totally symmetrical
therefore skewness=0
 Mean=Median=Mode
Positive skewness or Right skewed
distribution has Low probability
items on Right Side.
 Ex: Lottery
 Mean > Median > Mode

 Negative skewness or Left
distribution has Low probability
items on left side.
 Ex: Age at retirement, Asset
Returns
 Mean < Median < Mode
 Change of observing high negative
value in higher than chance of
observing Large positive value.

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 Summarised by : Karan Aggarwal

 the third central moment  E ( X 3 )  [E ( X )]3

Or
n

 (x   )
i
3

 i 1

 ( Xi   ) 3

Third Central Moment N

Skewness = or
3 3
1 n
 estimator of skewness = ˆ3 / ˆ 3 where ˆ s   (xi  ˆ)3
n i 1

6. Measure of peakedness –
 kurtosis measure the peakedness and Fatness in tails.

 For a Normal
Kurtosis = 3
 excess kurtosis = 0
 Platykurtic
Distribution  Leptokurtic  Lawer peaks, thin tails
 Higher peaks, higher/ Fat Tails.  Kurtosis < 3
 Kurtosis > 3  Excess Kurtosis < 0
 Excess kurtosis > 0

Note: Excess Kurtosis = Kurtosis -3

N

 (X I  )
 4 central moment E ( X )  E  X  or
4 4
th i 1

N
n

 (x   )
i 1
i
4

4th Central Moment n

 Kurtosis or
4 4
1 n
 Estimator of kurtosis = ˆ 4 / ˆ 4 or ˆ4  
n i 1
(xi  ˆ )4

Concept of co-skewness and co-kurtosis –

E (X   )3
Skewness=
x
3

E ( X   2 ) (Y   ) E ( X   ) (Y   )2
Co- skewness = Sxxy  or Sxyy 
 y
2
x  x  y2
 Co - skewness will be 0 if there is no sensitivity.
 Co - skewness of Bivariate Normal is always 0, even when correlation  0

Interpretation: If x produces large value away from its mean, where would y lie?

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E ( X   )4
Kurtosis  K 
4
Co - kurtosis 

E ( X   )2 (y   )2 E ( X   )3 (y   )
 K( xxyy )  K( x x x y ) 
 x2  y2  x3  y

E ( X   ) (y   )3
K( x y x y ) 
 x  3y

Plot of Co - Kurtosis –

Measures of Dependence –

Covariance Correlation
 measures how 2 variables, say X & y move together.  Measures the linear dependence between two
Does not capture the strength of the relationship variables.
 population covariance  correlation is the standardized version of covariance.

 xy  
( X  X ) (Y  Y ) Cov( X , y)
 Population correlation e. 
n x y

Sample covariance (ˆ XY ) 

 (X  X ) (Y  Y ) Sample correlation ie. r 
Cov( X ,Y )
n 1 S x Sy
 Covariance ranges from -  to + 
 unit of covariance = %2  Correlational ranges from -1 to +1
 Properties: -
I. Cov( X ,Y )  E( XY )  E (X ) E (Y )
II. Cov( X , P  Q)  Cov (X , P)  cov( X , Q)
III. Cov(a x , by)  ab Cov(x , y)

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IV. Cov(bx , c  dy)  bd cov(x , y)

 Sample Covariance Estimator –
1 n
ˆ xy   ( X i  ˆ x ) (Yi  ˆy )
n i 1
Note: - ˆ x and X can be used interchangeably

 correlation is unitless
 Limitations:
 It only captures the linear Relationship. Zero
correlation does not imply independence
 Correlation influenced by outliers.
 Spurious correlation exists i.e correlation may
come out to be significant even if no economic
relationship exists.
 correlation will be biased because SD is always Biased.
 correlation estimator =
ˆ xy ˆ xy
pˆ xy  
ˆ x ˆ Y ˆ x ˆ y
2 2

8. Methods of Correlation –

Karl Pearson Spearman Rank Kendall's Tau

Cov (x , y) Step 1: convert original data to ranks Ex: Situation 1 –

 p
 x Y of Data (Ascending or descending)  8.8% 0.8%
 Drawbacks X Y
Step 2: Find out KP’s correlation
 It captures only linear  5.1%  1.5%
between Ranks.
relationship. These are Discordant pairs
 Correlation changes even if
Alternate Formula:
variables are monotonically n Situation 2 –
transformed. 6 di2 1%  3.3%
1 2 i 1
X Y
n(n  1)
Where di = Difference f Ranks 4.7% 6.2%
There are concordant pairs

Situation 3 –
9.6% 4%
X Y
9.6% 4%

No change in pairs
n n
Kendall’s Tau (j)= c D
nc 2
nc = No of concordant Pairs

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n0 = No. of Discordant Pairs

nc2  nc  nb  nN

No change

Behavior of all 3 methods of correlation –

Linear dependence Non - Linear Dependence

KP correlation Y = aX + e Y = ex+ e
Spearman’s Rank value close to each other Low
Kendall Tall Lower High
High but lower as compared to
Spearman’s rank.

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RANDOM VARIABLE

Univariate RV (One RV) Bivariate RV (Two or more RV)

Discrete RV Continuous RV
 It assigns probability to a  Can take infinite values.
set of distinct values.  Probability at a single
 Ex: Throwing a dice with point does not exist
probability of face  Ex: Assume pdf of a ZCB
proportional to face. with N.V of $10 is given
x
by: f x   0.75 on
X PMF CDF 8
[P(X = x)] [P(X x)] domain [6, 10] where x =
1 1/21 1/21 price of bond CDF:
x
2 2/21 3/21
3 3/21 6/21
 f  x  dx
6

4 4/21 10/21 x
x 
5 5/21 15/21   8  0.75  dx
6

6 6/21 21/21 x2
  0.75x  2.25
16
PMF: Probability at a point
CDF: probability upto a point Mean:
Mean: E  X    x  p  x  E  X    x f  x  dx
1 2 3 10
x 
 1  2   3   x   0.75  dx
21 21 21 6 
8 
4 5 6  8.667
4   5   6 
21 21 21
= 4.33
VaR: E  X 2   E  X  
2

10

VaR: E  X   E  X   E  X 2    x 2 f  x  dx
2 2

6
1 2 3 4 6  76
 1   22   32   42 
2

21 21 21 21
V X 1
5 6
5   62   4.332 = 2.25
2

21 21

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Bivariate RV (Two or more RV)

Discrete RV Continuous RV

Ex: 2x  y 10  x  20;
Ex: f  x , y  
3000 5  y  5
X
Y 1 2 3  Marginal distribution function of x: fX  x 
1 0.1 0.1 0.05 0.25 5
2x  y x
2 0.15 0.1 0.05 0.3  f  x , y  dy  
Y 5
3000
dy 
150
3 0.2 0.05 0 0.25
4 0.15 0.05 0 0.2  Marginal distribution function of y: fY  y 
0.6 0.3 0.1 1 20
2x  y y  30
  f  x , y  dx   dx 
X 10
3000 300
 Joint Probability is denoted by f(x, y)
 fx (x): Marginal Probability Distribution of X  Unconditional Mean –
20 20
4
x
  f  x, y  E  X    x  fX  x  dx   x  dx  15.55
y 1 10 10
150
5
X P (X) 30  y
E Y    y  fY  y  dy   y  dy  0.277
1 0.6 Y 5
300
2 0.3
3 0.1  Unconditional Variance –
V  X   E  X 2   E  X  
2
 fy(y): Marginal Probability Distribution of Y
3 20
  f  x, y  x
E  X 2    x 2 fx  x  dx   x 2  dx  250
x 1
x 10
150
X P (Y) V  X   250  15.552  8.011
1 0.25
V Y   E Y 2   E Y  
2

2 0.3
5
3 0.25 30  y
E Y 2    y 2 dy  8.33
4 0.2 5
300
 Unconditional Mean = E  X    X P  x  V Y   8.33  0.2772  8.252
 1  0.6  2  0.3  3  0.1  1.5
E Y   Y P Y   1  0.25  2  0.3  3  0.25  4  0.2  2.4 f  x, y  2x  y
 f  x |y   
fy  y  300  10y
Unconditional Variance = V  x   E  x 2   E  x  
2
 f  x, y  2x  y
f  y|x   
 1  0.6  2  0.3  3  0.1  1.5  0.45
2 2 2 2
fx  x  20 x
v  y   E  y 2   E  y    1.14
2

 E  XY     xy f  x , y  dx dy
  X  Y  P  x, y 
 E  XY   X Y

X Y 5 20
2x  y
   xy dx dy  4.1667
 Cov  x , y   E  xy   E  x  E  y  5 10
3000
(Note: We can integrate is any order)

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Cov  x , y   Covariance (X, Y)  E  XY   E  X  E Y 

 Corr  x , y  
SDx SDy  4.1667  15.55  0.277
  0.1547
 Conditional Probability of X given Y is denoted as
f  x, y 
fx  X |Y  . Ex: Find fx  X |Y  1   Conditional Mean of X given Y –
f y
X|Y = 1 Probability E  X |Y    x f  x |y  dx
X
1 0.1/0.25 = 0.4 20
2x  y
2 0.1/0.25 = 0.4   x  300  10y dx
10
3 0.05/0.25 = 0.2 1  14000 300 y 
   
300  10y  3 2 
 Conditional probability of Y given X is denoted by
fy  y | x 
E Y | X    y f  y | x  dy
Ex: Find fy  y | x  2  y
5
Y|X = 2 Probability 2x  y 250
y dy 
1 0.1/0.3 = 0.33 5
20 x 60 x
2 0.1/0.3 = 0.33
3 0.05/0.3 = 0.167
4 0.05/0.3 = 0.167

 Conditional Mean:
E  x |y  1    X  P  x |y 
 1  0.4  2  0.4  3  0.2  1.8
E  y |x  2  Y  P  y |x 
 1  0.33  2  0.33  3  0.167  4  0.167
 2.159

 How to check if X and Y are independent ?

If X & Y are independent, then –
 f  x |y   f  x 
Or,
 f  x, y   f  x   f y 

Bivariate Normal Distribution –

We have 2 random independent Normal Variables

X1  N  1 ,  12 
X 2  N  2 ,  22 

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These can be two cases –

RV are not correlated RV are correlated. (Not in Syllabus)

Joint Probability = f  x1 , x2 
2 2
1 x   1 x  
1   1 1
2 1  1   2 2
2 2 
 e  e
 1 2  2 2
  x     x2  2  
1 2 2
1 2 
Where is constant and Joint density is dependent on e   
1 1
  
    1    2  
2
1 2 2

Trinomial Distribution –

Trinomial distribution has 3 parameters –

i. n i.e. no. of experiments
ii. P1 i.e. probability of outcome 1
iii. P2 i.e. probability of outcome 2 ex. Probability of stock going up is 0.45. probability of stock going down
is 0.45 and probability of stock being flatish is 0.1. A short call option holder will benefit if stock
remains flatish for 5 days out of 20 days and stock falls for 7 days. Find probability of winning:
20!
  0.1    0.45    0.45  0.006268
5 7 8

7! 8! 5!

EFFECTS OF LINEAR TRANSFORMATION ON MOMENTS –

Y = a + b X (X is linearly transformed)
a = Location Shift b = Scaling
We are given E  X  , VaR  X  ,  x , K x & now after linear transformation let’s check its effect only.
Mean Variance Deviation Skewness
E Y   E  a  bX  var Y   var  a  bX  Y  E Y  E Y  E Y  
3

y 
E Y   E  a   E  bX  var Y   var  a   var  bX   a  bX  E Y   3y
E Y   a  b E  X  var Y   b2 var  X   a  bX  a  b E  X   E  b  X  E  X   
3

SD :  y  |b|   x  bX  bE  X  y 
 3y
 b  X  E  X   b3
y  x
|b|3

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Kurtosis Covariance Correlation

E  y  E  y 
4
Cov  X , a  bX  Case 1: Corr (X, Y) Case 2: Correlation between 2
Ky  Cov  X , Y  transformed variables
 4y  b Cov  X , X  
 X Y b  d  cov  X1 , X2 
E b  x  E  x   
4
 b var  X  Corr  a  bX1 ,  dX2  
Ky  b var  x  |b|  x 1 |d |  x 2
 4y 
 x |b| x
b 4
b d
Ky  4 Kx b    12
| b|  |b| |d |
|b|
Ky  K x  Sign  b   Sign  d   12

Jensen’s Inequality  E g  x    g E  x  

It provides insight into the expectation of a Non – Linear function.
Ex: g  x   x 2
x 0 1 2
E g  x    02  0.25  12  0.5  22  0.25  1.5
P  X  x  0.25 0.5 0.25
E  x   0  0.25  1  0.5  2  0.25  1
gx 02 12 22

g E  x    E  x    12  1
2

E g  x    g E  x   i.e. 1.5  1

Jensen’s inequality applies when Non – linear function is either concave or convex.

 
E g  x    g E  x   E g  x    g E  x  
Ex : g  x   x 2 Ex : g  x   x

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PROBABILITY DISTRIBUTIONS

1. Random Variable – A variable which can take any value randomly.

Discrete value RV. Continuous RV.

 Countable  Continuous RV is measured
 Finite  EX- claims Amount
 Ex- no of claims in next 1 month.

2. Distribution Function -

Probability Mass Function (PMF) Cumulative Distribution Function (CDF)

 Probability at a point  Probability at a point
 Ex:  Ex:
f (x)  ncx p x q n  x F ( x)  P ( X  x )
0
p(x  0)  f (0)  nc0 p.15 0.85 20
F (2)  P( X  2)  P( X  0)
 0.039 P( X  1)  P(x  2)

1. Discrete Random Variable –

Bernoulli Binomial Poisson

Def: Trials with only 2 outcomes ie. Def: ‘x’ number of successes ‘n’ no. Def: x number of events in a
Success or failure. of trials. particular time period.
Parameter: p = prob of success. Parameter = n = number of trials or Parameters:  = Hazard rate
PMF: P x (1  P)1 x experiments. e  x
P = prob of success. PMF:
Mean: p x!
Var: P(1-P) PMF: ncx (P)x (1  P)n  x Mean: 
Mean: np Variable: 
Var: npq Note: Poisson RV are always No-
negative & Integer valued.

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2. Continuous Random Variable –

Uniform Normal Lognormal

Def: Any value within the range [a,b]  Also known as Gaussian distribution  If x is lognormally distributed, In x
is equally likely to occur. Parameter:   mean will be normally distributed.
Parameter  a= Lower Lt  2  variance  RV can take only positive values.
b = upper Lt 2 Ex- stock prices.
  x 
1
1
1 PDF: e 2  Parameter:  &  2 from normal
PDF: 2 2   
ba distribution.
ab Where x ranges - to too
Mean: Mean: not required
Mean: 
2 Var: not required
Var: 2
(b  a)2
Var: Skewness: 0 (symmetrical)
12
Kurtosis: 3 (benchmark)
 Has a Bell-Shaped Curve.

PDF of Normal Distribution

 CDF of ND is not integrable & thus

Student’s t
 Closely related to Normal but has
heavier trails.
Parameters:  = degree of freedom
 student’s t converges to standard
normal as   
does not have a closed form solution.
 Since we do not have values for
different , and x, we resort to
“standardization”
This is the special case where =0 and
2 =1.
It is called the Standard Normal
Distribution.
 it is denoted by random variable, z
x
z

F Exponential
 F Distribution is Right skewed Def: Prob of waiting time between
 Parameters: 1 = Numerator degree events.
of freedom Parameters: 
2 = Denominator degree of freedom PDF:  e   x
 Used in hypothesis Testing for CDF: 1  e
x

Equality of Variables. Mean: 1 / 

Var: 1 /  2

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Note:   1 /  .,
Exponential dist. Is Memoryless.

Beta
 Def: Model Random Variables that fall into a range with
minimum & maximum limit.
 Parameters:  ,

 Mean:


var:
(   ) (    1)
2

Central limit Theorem

 CLT states that irrespective of population distribution for a vary large n sum or average of n no of independent and

identically distributed random no’s approaches Normal Distribution with Mean =  and SD 
n
 For CLT, n should be sufficiently large & technically greater than 30

Bivariate Central limit Theorem

 Irrespective of population distribution, for very large sample, the sampling distribution of combination of two
 x 
sample mean will be bivariate Normally distributed with mean =  
 y 
 2 x  xy 
 n n 
Variance: 
  xy  2y 
 n n 

 As per bivariate CLT, correlation in data produces a correlation between sample Mean.

 Corr (x , y)  Corr ( x , y )  p

Original series sample means

 In case of bivariate CLT, we get confidence region instead of an interval.

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Bivariate CLT

30
25
20
15
10
5
0
1 2 3 4 5 6 7 8 9 10 11

Distribution Descriptions Parameter PDF CDF Mean Variance

Bernoulli Trails with 2 outcomes p p (1  p)
x x P pq
success or Failures
Binominal x no of success “n” n, p ncx p x q n x np npq
trails
Poisson X success in a  e  x  
particular time x!
Exponential Prob of ‘x’ time for   e x 1  ex 1 1
next 1 month  2
Gamma Prob of ‘x’ time for  ,  -  
events  2
Weibull Prob of ‘x’ waiting time ,  - - -
given a failure rate
Beta Model RV with min and ,  -  
  (    1)
2
max limit   
 
Normal Avg RV will Bell Shaped ,  2 2
1  x    2
1  
2  

Curve e
2 2
Log - normal RV which can take only , 2 - e   1/2
2
-
positive values (from ND)
Uniform Any value within the a, b 1 ab (b  a)2
range [a,b] is equally ba 2 12
likely to occur.

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HYPOTHESIS TESTING

1. DIKKI – FULLER TEST –

1) Testing of Mean –
Ex: A researcher has a data on daily returns of a portfolio of call option over a period of 250 days. The
mean daily return has been 0.1% and standard deviation has been 0.25%. Researcher believes that
Mean daily return is not equal to zero. Construct a hypothesis test at 5% significance level.

Acceptance Rejection Confidence Interval Statistic Critical P – value Method

Method Method Method
Step 1: Define Step 1: Define Step 1: Define Step 1: Define
Hypothesis – Hypothesis – Hypothesis – Hypothesis –
H0 :   0 H0 :   0 H0 :   0 H0 :   0
Ha :   0 Ha :   0 Ha :   0 Ha :   0
Step 2:  = 5% Step 2:  = 5% Step 2:  = 5% Step 2:  = 5%
Two – sided test Two – sided test Two – sided test Two – sided test
distribution: t – distribution: t – distribution: t – distribution: t –
distribution ( distribution ( unknown) distribution ( distribution (
unknown) unknown) unknown)
Step 3: Construct Step 3: Construct Step 3: Test statistic = Step 3: Probability
Acceptance Region – Confidence interval X  corresponding to test –
  t  st error t at X  t  st error s.e statistic. In this
2.5% dof = 250 – 1 =  0.001  1.96  0.000158 0.000310  0 example, p – value is
UL = 0.0006901  very low near zero.
249 0.000138
s LL = 0.0013098  6.38
 0  1.96 
n
UL = 0.000309
LL = - 0.000309
Step 4: Decision Rule – Step 4: Decision Rule – Step 4: If test statistic > Step 4: p value < 
check if X lies within check if  lies between test critical, we reject reject
accept, region. confidence interval. the Null Hypothesis.
Conclusion: The value Conclusion:  = 0 does Conclusion: Statistic Conclusion: P – value <
of 0.001 lies outside not lie within the C.I. Value of 6.32 as , so we reject the Null
the acceptance region.  We reject the Null greater than critical Hypothesis.
We reject the Null Hypothesis value of 1.96 so we
Hypothesis reject the Null

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2. Whether to use Z – distribution or t – distribution ?

Check whether the population is

NORMALLY DISTRIBUTED

Yes No

 known  not known n > 30 n < 30


Z

n > 30 n < 30  known  not known Not -

    available
Z or t t Z t

3. Remember these Z – values at various confidence level –

One – tailed –
95% - 1.645 (5% tail)
97.5% - 1.96 (2.5% tail)
99% - 2.326 (1% tail)
99.5% - 2.576 (0.5% tail)
99.9% - 3.090 (0.1% tail)

4. Looking at t – critical values –

Significance Level
DOF Two tailed 10% 5% 2% 0.2% 0.1%
One tailed 5% 2.5% 1% 1% 0.05%
1 6.314 12.706 31.821 318.309 636.619
2 2.920 4.303 6.965 22.327 31.599
3 2.353 3.182 4.541 10.215 8.610

Ex –
Check the value at 95% confidence level at n = 4. Assume it’s a two tailed test.
 slope = n – 1 = 4 – 1 = 3
So, t value at 95% confidence as 5% significance level (two – tailed) = 3.182

5. Testing of Variance –
Sampling distribution of variance follows chi – square distribution with degree of freedom = n – 1 i.e.
 2 n  1. Chi – sq. is a Right – tailed distribution.
Ex:- HREF has advertised its monthly return has SD of 4%. They want to verify whether this claim still
adequately describes SD of these funds. HREF collected returns for 24 months period (98 – 20) & measured

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a SD of monthly return of 3.8%. Determine if most recent SD is differed from advertised SD at 95%
confidence level.
Step 1: Define Hypothesis –
H0 :  2  0.0016
Ha :  2  0.0016
Step 2: Significance level () = 5%
Two – tailed test
 2 distribution

Step 3: Test Statistic =

 n  1 S 2
2


 24  1  0.0382
 0.075
0.042
 critical at 24 – 1 = 23 dof:
2

At 97.5%,  2  11.689
2.5%  2  38.076
Step 4: Decision rule – If chi sq. statistic lies between the critical value we “fail to reject” the Null
Hypothesis.
Step 5: Conclusion – We fail to reject the null hypothesis.

6. Looking up value at Chi – Square Table – [GIVES PROBABILITY IN RIGHT TAIL]

DOF 0.99 0.975 0.95 0.1 0.05 0.025

1
2
3
4 0.297 0.484 0.711 1.064 7.79 9.488
5

Ex:- You want to check the value at 95% confidence level, [one – sided] for n = 5.
 = 5%.
Chi – square gives prob in right tail
 2 0.95, 4  7.79

7. Testing of Equality of Mean & Testing of Equality of Variance

Equality of Mean Equality of Variance

Ex: Consider two distributions that measure the Ex: Anni belives that earnings of textile industry are
average rainfall in city X & city Y. more divergent than those paper industry. Anni
i. They are correlated with correlation = 0.30 took sample of 15 textile manufactures and a
ii. City X and Y are independent. sample of 21 paper companies. SD of earnings of
X  10 cm Y  14 cm textile industry is $4.320 & that of paper industry is
 2 x  4  2Y  6, nx  ny  12 (when or else $3.80. Determine if earnings of textile ind have
greater SD than those of paper industry at 95%
nx  16, ny  12 corr) check that the average confidence level.

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rainfall in city X and Y are significantly Step 1: State the Hypothesis –

different from 0 at 95% confidence level. H0 :  T2   2P
Step 1: Define Hypothesis –
Ha :  T2   2P
H0 :  x   y  0
Step 2: One – tailed test  = 5% F – Distribution
Ha :  x   y  0
S 2T
Step 2: Two – tailed test  = 5% Step 3: F – Statistic = [Bigger variance in the
S 2P
Step 3: Test – Statistic numerates] F – distribution has 2 parameters i.e.
Numerator DOF & Denominator DOF.

F – Table at 5%
X & Y Correlated X & Y Uncorrelated Numerator ……………………… 14
  = Denominator
T
  Y    x  Y 
X
T
 X  Y    x  Y 
 2 x   2 y  2 xy  2x  2y

n nx ny
20 2.20
= -5.21 = -4.618
Step 4: Decision Rule: If Statistic Value > Critical
Step 4: Decision Rule: Test Statistic > Test Critical – Value, we reject the Null
Reject Step 5: Conclusion –
Step 5: At 95% confidence, level test critical = 1.96, 4.302
so we reject the Null Hypothesis. F – Statistic =  1.280
3.802
F statistic < F critical so we fail to Reject the Null.

8. Concept of Error in Hypothesis Testing –

Actual
H0 TRUE H0 FALSE
Accept - Type II Error
Model =1-
Reject Type I Error =  Power of Test
=1-

Type I Error – Rejecting a True Hypothesis

Type II Error – Accepting a False Hypothesis
Ex:
H0 : A Person is Innocent
Ha : A Person is not innocent
Type I Error – Innocent Person is failed
Type II Error – Releasing a Guilty Person.

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REGRESSION
STEPS INVOLVED IN FITTING REGRESSION MODEL MTHD 3:FORMULA BASED CALCULATIONS
Regression line passes through Mean of X & Y.
Ȳ=b0+b1X
b1=cov(X,Y)/σx2 = r*σyσx/σx2
If correlation exists If correlation does not exist
B0= Ȳ- b1X = rσy/σx
Stop MTHD 4: ANOVA TABLES
Correlation spurious Regression output can come in form of ANOVA Tables i.e. showing how
Logical much Variance in Y(say,Lottery exp) is being explained by Variance in
STOP X(say,Disposable income)
 If explained variance is high,this model is good for forecasting
SIGNIFICANT NON-SIGNIFICANT expenditures.
(HYPOTHESIS TESTING) STOP  Not 100% of variance in Y is explained by just disposable
Fit regression line income.All variables not captured under Regression model go
under error terms.
E= y- ŷ
Actual y Forecasted y
Model fitting. Checking accuracy of the model.
Interpretation of b0 & b1 [y=0.081x+7.6181]
Find out intercept & slope Innova-Hypothesis Testing of regression coeff
b1 (slope coefficient) of 0.081 means if income rises by Rs 1,lottery exp wl
Using ordinary least square Checking assumptions made.
rise by 0.08145
Method.
b0(Intercept) of 7.6181 means when Disposable Income is 0,even then
people are buying lottery & expending 7.618 from their past savings.
Y is dependent variable & X is independent variable.
b0 & b1 is found out by minimizing sum of squared errors in solver.
So, we are regressing Y on X.
Fit a linear regression model btw lottery & personal disposable income.
3 PARTS OF REGRESSION OUTPUT:
Step 1: Find out correlation btw X & Y.
Part 1-Regression Statistics
Step 2:Check whether correlation has economic rationale.People with higher
Part 2-ANOVA TABLE
income wl spend more on lottery
Part 3-Hypothesis Testing
Step 3:If we find that correlation is significant i.e. we reject null hypothesis
that population correlation=0
Part 2: ANOVA (Analysis of Variance)
Step 4:Fitting regression model either simple/multiple.
Anova table shows how much of the variance in Y (Lottery exp)
Also,sample regression function(SRF) or population regression function(PRF)
Is being explained by the model & how much is not explained by model.
PRF SRF
Y=B0+B1x +E y=b0+b1x+e
Total sum of square = Σ( Y-Ȳ)2=Σ(Ŷ-Ȳ)2+Σ(Y- Ŷ)2
Ŷ= B0+B1x ŷ=b0+b1x
/df
n-1= k + n-k-1
E(b0)=B0, b0 is an estimator of B0
Mean Square Total≠ Mean Square Explained+Mean Square Residual
E(b1)=B1,b1 is an estimator of B1
Variance of error terms=σ2 =Mean squared Residual
E(e)=E,e is an estimator of E
Standard error of estimate/std error of regression=σ=√𝑴𝑺𝑹
Expectation of b0 =B0
=√𝜮𝒆 2/n-k-1
METHODS FOR FIITING REGRESSION MODEL: We want higher ESS,lower RSS,lower standard error of estimate.
MTHD 1:TRENDLINE
Draw a scatter plot of x&y & pass a linear trend line through it.Equation of EXAMPLE OF ANOVA TABLE
Y(Lottery Ŷ=b0+b1X TSS RSS ESS
that line is regression model.
Exp) (Y-Ȳ)2 (Y-Ŷ)2 (Ŷ-Ȳ)2
Eq: y=0.081x+7.6181 18 19.8364 121 3.87 83.97
24 21.8727 25 4.52 50.79
26 23.9091 9 4.37 25.92
23 25.94 36 8.67 9.33
30 27.98 1 4.07 1.037
27 30.018 4 9.11 1.037

MTHD 2:ORDINARY LEAST SQUARE METHOD 34 32.05 25 3.78 9.33

Fit all possible lines in a scatter plot & find out errors corresponding to each 35 34.09 36 0.83 25.9174
possible line.
33 36.13 16 9.78 50.798
Choose the line having minimum sum of squared errors.
40 38.16 121 3.37 83.972
Avg =29 394 51.89 342.109
ANOVA TABLE
df SS MS=SS/df
Explained k=1 342.109 342.109
Residual (n-k-1)=8 51.89 6.48636
Ordinary Least Square means ,change the value of b0 & b1 in such a manner Total (n-1)=9 394 43.7711
that sum of squared errors is minimized & resulting equation is Best Fit Line.

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REGRESSION

Part 3: Hypothesis Testing ADDITIONAL ASSUMPTIONS

(B0,B1) & (b0,b1) are estimators of population parameters.We can get many 1. A linear relation exists btw dependent &
(b0,b1) based on different sample datas. independent variables.
E(b0)=B0 To run linear regression,linearity in parameters is
Std error = Sb0 required.
E(b1)=B1 i.e.ŷ =b0+b1x2 i.e. b0 & b1 should have power 1.
Std error = Sb1 If non-linear relation exists btw X&Y,transform
Generally on taking sample size >30,therefore CLT (Central Limit Theorem) variables to perform linear regression.
Comes into picture & we can say that sampling distribution follows normal 2.All imp. Independent variables are taken in the
distribution. model(to avoid omitted variable bias).
Here, we use σ2 ,T-distribution with df=n-k-1. 3.Error terms are normally distributed.
Step 1: Define the hypothesis As per CLT,error terms are normally distributed with a
H0 =B1=0 mean of 0 & variance of σ2.
Hn=B1≠0 4.The variance of error term is constant for all Xis.
For accepting model for forecasting purposes ,we need to reject Null 5.There should be no correlation btw error terms.
Hypothesis. 6.There should not be any correlation btw X & error
Step 2: Say, α=5% terms.
Two tailed test t distribution df=n-k-1=8 7.In multiple regression,there should not be any
Step 3: Method 1: Correlation btw each independent variable.
t stat=(b-B1)/Sb1 ,say =7.2624 GAUSS –MARKOV THEOREM [GMT]
Say, t critical =2.306 If our regression holds 3 main assumptions plus
homoskedastic error terms,then as per GMT,OLS estimators
are BLUE plus consistent.

ESTIMATORS

-2.306 +2.306 7.26 LINEAR NON-LINEAR

Since t statitistic> t critical ,we reject the null hypothesis. OLS MLE,LEAST ABSOLUTE,DEVIATIONS
So, model is fit for prediction.
Biased Unbiased
Method 2:
Best Not Best
1. E(b0)=B0
E(b1)=B1
α ß E(σ2)= σ2
2.Linear means linearity in parameters.
3.Best among the linear unbiased estimators i.e. our
-2.306 +2.30 7.26 estimator has the lowest standard error among all other linear
ß value i.e. area in both the tails corresponding to t statistic=0.0087% biased estimators.
Since, ß< α;we reject the null hypothesis. Alternative estimators which are not linear,more biased may be
more efficient than OLS estimators.
Method 3: Consistent: If we increase the sample size,standard error of
CONFIDENCE INTERVAL METHOD estimator reduces-this is called consistency.
Lower Limit= b1-t*Sb1 Part 1: Regression Statistics
Upper Limit= b1+t*Sb1 Multiple R –This gives correlation btw x & y
Since, B1=0 does not lie within the confidence interval,we reject R Square =Say, 0.868.Means the above model has 86 % of
null- hypothesis. explanatory power. i.e. coefficient of determination.Suppose our
model contains only one independent variable which is Personal
ASSUMPTIONS OF ORDINARY LEAST SQUARE REGRESSION Disposable Income.So,our model which contains only Personal
Avg of error terms= Disposable Income explains 86.8% of the variance in lottery
E(ei /xi)=0 expenditure. R2 > 80% is a good model. IF R2< 60%,we need to
intoduce more variables which can explain the variance in Y.
R2= r2 applies only for simple regression. ESS/TSS
Limitation of R2
Avg =0 R2 only captures accuracy & does not penalize
Avg =0 complexity.So,variables are added
Adjusted R2= 1-(RSS/TSS)*(n-1)/(n-k-1)
Accuracy factor. Penalty for complexity>1.
All X & Y observations are independent & identically Lower it is,higher the Higher the no of k,higher the penalty,
distributed. Adjusted R2 lower the Adjusted R2
There should be no presence of outliers in the data. On adding independent variables,we should compare Adjusted R2 without
extra variable & Adjusted R2 with extra variable.If adjusted R2 increases,it
means rise in accuracy > rise in complexity,so adding extra variable is
justified.

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REGRESSION
VIOLATION OF REGRESSION ASSUMPTIONS 2. Multi-Collinearity
1. Heteroskedasticity Step 1: Run the regression with Y=sales,
Problem when variance of error terms is not constant. X1=population,X2=mortgage rate
Step 2:Find correlation matrix btw independent variables.
Step 3:Run the regression again with
Conditional Unconditional Y=sales,X1=population,X2=mortgage rate,X3=year.
Heteroskedasticity Heteroskedasticity Effect: Std error of coefficients increased, t statistic down.We
Variance of error term Variance of error term changes may end up accepting a false hypothesis; causing a Type-2 error.
changes systematically with X but not in line with X. DETECTION-
This is more problematic,since F Test explains whether the set of independent variables as a
it violates regression assumption group explain a dependent variable,
that there should not be any correlation H0 B=B1=B2=B3=0
btw X & error terms. Ha Null hypothesis wl be atleast one of the coefficients is non-
Effect: Sb0 or Sb1 may be underestimated/ zero.
overestimated causing T-statistic to be higher/ High value of F statistic is preferable ,since we want to reject
lower leading to type-1 or type-2 error. null hypothesis.
Also estimators are no longer efficient. F STATISTIC=Mean squared explained/Mean squared residual
Coefficient estimates are not impacted. = SSE/R
 Standard error biased & unreliable SSR/(n-k-1)
 Coefficients remain unbiased. F CRITICAL requires degree of freedom of numerator k ,degree
Detection:Plot of residuals of freedom of denominator n-k-1.
Breusch research Pagan Test: A lower F significance means F statistic is very high ,we reject
the null,so model has good explanatory power.
 Regression between e2 and x – NOTE:In case of only one Independent variable,F statistic=(T
ê2  b0  b1 x1  b2 x2  b3 x12  b4 x22  e Statistic)2

 H0 : b1  b2  b3  b4  0 TYPES OF MULTI-COLLINEARITY
 Test statistic: nr  
2 2
k ( k  3) , k = no of regressors
2

This is a right - tailed test, R2 can never be negative

 If R2 is significant, this means there is Heteroskedasticity PERFECT MULTI- IMPERFECT MULTI-
COLLINEARITY COLLINEARITY
 We reject the null when nR   2 2
k ( k  3)/2 If there is perfect If correlation btw independent
Correction:Calculate Robust standard errors. correlation btw variables<perfect
Method 1 - Ignore heteroskedasticity when estimating parameter independent variables,we  It’s possible to run
wl not see the regression regression
& sue heteroskedasticity Robust covariance estimator. output.  It’s case of multi-
Method 2 - transform the data. Generally, Heteroskedasticity is This is called problem of collinearity
multi-collinearity. PROBLEM OF PERFECT MULTI-
found when data is positive. So, take log of data. OR, Divide
COLLINEARITY CANNOT BE
Dependent variable by strictly positive variable. Ex- Dividing Another classic eg: SOLVED BUT PROBLEM OF
Dummy Variable Trap.
Dividend by share price. IMPERFECT MULTI-
Method 3 - Use weighted Least Squares (WLS) COLLINEARITY CAN BE
SOLVED.
 Applying weights before estimating parameters
CORRECTION-
Var (ei )  wi 2  2 [non-constant variable]
For detection as well as for the correction of the problem of
Transforming data by dividing wi - multicollinearity we use Variance Inflation Factor (VIF)
yi     xi  ei
X ji  b0  b1 X ii  b2 X2i  b3 X3i
yi 1 x e
   i  i 1
wi wi wi wi Calculate R 2 ,VIFJ 
 1  R 2j
yˆ      e
i i

e  1 High R2 leads to a low denominator & high VIF value. High

Var (ei )  Var  i   2  wi    
2 2 2

 wi  wi R2 shows that all other independent variables explain jth

 How to determine weights (wi)?
OLS  estimate weights using residuals  Re - estimate
transformed model. This approach is known as Feasible
WLS or feasible Generalized Least squares.
independent variable with good accuracy.
Those independent variables which have VIF greater than
10 causes the problem of multicollinearity & should be
removed.

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REGRESSION
3.OMITTED VARIABLE BIAS 2 methods to select the important variable are –
Some of the variables not taken in our regression model: Method 1 Method 2
1.Are important variables as they explain y.  Stepwise regression or  K-fold cross validation -
2.Correlated with current independent variables
general to specific Model:
These imp independent variables correlated with both X & Y causes
omitted variable bias.  Begins by specifying a  Used in out of sample
Problem since these variables not captured in the model sits in the error large model including all prediction.
term & thus error terms and X becomes correlated which is a direct relevant variables.  Consider all possible
violation of regression assumption.  Remove variables with combinations of
Detection: highest p-value of b is explanatory variables.
Find out correlation btw X and error terms.
insignificant, or smallest  Choose the model which
Effect:
Coefficients drastically changes when omitted variables are added.OLS absolute t-statistic. has lowest sum of squad
estimates become inconsistent & biased.  Re-estimate using Residual in validation Data
Correction: remaining explanatory set.
Perform research to identify variable correlated with X &Y & then adding variables.  K-1 block is referred as
it into model.  Repeat step 1 & step 2 till Training set. And omitted
all insignificant ’s are block is Validation set.
Suppose the model is - yi    1 X1  2 X2  ei
removed.
If x2 is excluded from estimated model, then the model is –
yi    1 X1  ei 5. COOK’S DISTANCE –
In large sample,̂1 converges to 1  2 where,  Outliers if removed produce large changes in estimated
coefficient.
cov( X1 , X2 )
  Cook’s distance measures the sensitivity of fitted values in
v ( X1 ) a regression to dropping a single observation j.
 n
Slope coefficient.  (yˆ i
( j)
 yˆi )2
The bias depends on the strength of relationship between X1 & X2 . Dj  i 1

When X1 & X2 are highly correlated, there is upward bias (bias is large) ks2
If X1 & X2 are uncorrelated, ̂1 is consistent estimator of 1. (yˆi ( j ) = Fitted value of yi when j is dropped.
K= number of coefficients.
4. DILEMMA OF MULTICOLLINEARITY & OMITTED VARIABLE BIAS S2 = error variance of model with all observation
Case 1: Adding a correlated variable decreases standard error of Dj should be small when observation is inlier.
individual coefficients as well as overall standard error.Avoiding this Dj > 1 indicates that observation j has large impact on
variable causes omitted variable bias while adding this variable does not
model parameter.
cause problem of multi-collinearity.
Case 2:Adding the independent variable which is correlated with current
variable increases the standard error of model,standard error of 6. MULTIVARIATE CONFIDENCE REGION -
individual coefficients & model becomes insignificant.This is the type of When we preform regression resultant beta coefficients are
multi-collinearity we want to avoid.So,live with the consequence of random variable & have a probability distribution. In case of
Omitted Variable Bias. multiple regression, the structure of regression equation is –
Case 3:Adding the correlated variables changes value of coefficient
drastically,increases standard error of current coefficient but overall yi    1 X1  2 X2  ......   k X k  e
model still remains significant.So,it is advisable to correct Omitted Suppose we have a model with two explanatory variables, this
Variable Bias by adding correlated variable & then live with consequence
of multi-collinearity.
case 1 and p2 together follow a joint/bivariate Normal or t-
distribution.
Larger Models have Lower Bias but leads to the problem of High To explain variance in y, either x has to do the talking or p.
Variance or high estimation error. If ,  x 1 x 2  0 then  ˆ1 ˆ2  0
Models with few explanatory variables have less estimation error but
have highly parameter estimates.  x 1 x 2  0 , then  ˆ1 ˆ2
0
 x 1 x 2  0 , then  ˆ1 ˆ2  0

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REGRESSION

In case of bivariate regression, we have a bivariate confidence Region. These regions are multidimensional ellipse that account for
variance of each parameter & correlation between them.

TESTING OF RESTRICTIONS
In case of tradeoff btw cost (complexity) & benefit(accuracy),how to decide?
 Check if adding one more variable in regression model increases Adjusted R2? If yes,include it ,otherwise not.
 Use concept of restricted vs unrestricted least square models.
 Restricted Regression Model
Sales=b0+b1*price
Unrestricted Regression Model
Sales= b0+b1*price+b2*Advertisement

CASE 1: WHEN ERROR TERMS ARE HETEROSKEDASTIC

F STAT= (R2unrestricted –R2restricted)/m
(1-R2unrestricted)(n-KUR-1)
Where KUR means no of independent variables in unrestricted model.
M =no of restrictions
If value of F statistic is high,the variable should be added.

CASE 2: WHEN ERROR TERMS ARE HOMOSKEDASTIC

F STAT= (SSRUR –SSRr)/m
SSRUR/(n-KUR-1)
Low value of F statistic indicates that the variable should be added.

CONFIDENCE INTERVAL OF PREDICTED VALUES

Forecasted Y i.e predicted value of dependent variable itself is a random variable & not constant. Confidence interval around Ŷ is given by
Ŷ±t.SE of Ŷ
S2f (Variance of forecast)=σ2 (1+1/n+( X-X2)/ (n-1)S2X

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REGRESSION

Problem Detection Impact Correction

1 Multicollinearity T Test & F Standard Errors grow large Stepwise Regression Bias
Test Coefficients remain unbiased VIF>10 Variance
2 OVB No Test Coefficient biased and Include omitted Trade off -
inconsistent variable K fold
3 Heteroskedasticity Breusch Standard Error, biased & Feasible GLS cross
Pagan unreliable White Corrected Validation
Test Coefficients remain unbiased
4 Serial Correlation DW test Standard Error, biased & Build Auto Regressive
unreliable
5 Serial Correlation Standard Error, biased & Model specification
Lagged dependent unreliable
Variable Coefficients also Biased &
inconsistent
6 Outliers Cooks Wrong estimate Remove outliers if not
distance genuine

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TIME SERIES ANALYSIS

A random/stochastic process is a collection of random PRECONDITIONS FOR FITTING ARMA MODELS

variables at different possible points of time. TIME SERIES SHD BE COVARIANCE STATIONERY
4 steps of stochastic processes are:- 1. STRICT STATIONARITY-Joint PDF function across the time should
CASE 1 DISCRETE DISCRETE Eg:No of frauds be constant.Not achievable
SPACE TIME recorded yearly/Rating 2. WEAK STATIONARITY-It only asks for 3 things i.e. mean,variance
Matrix & co-variance to be same.
CASE 2 DISCRETE CONTINUOUS INSURANCE ARMA models are used to model cyclicalities,the reason of a
SPACE TIME (Transition from series being non-covariance stationery is either trend or
Healthy to sick to seasonality which needs to be removed so as to model the cyclical
dead) portion alone.
CASE 3 CONTINUOUS DISCRETE TIME SERIES ANALYSIS
If series is non-covariance stationery,it’s made stationery using 2
SPACE TIME
approaches:-
CASE 4 CONTINUOUS CONTINUOUS GBM/RW a) D-Trending & D –seasonalizing
SPACE TIME TREND MODEL yt=b0+b1t+et
For any stochastic process,we need to study the following Et=yt-(b0+b1t) De-Trended
properties: New yt for seasonality
1 .Stationarity Yt=b0+b1*J+b2*F+…..et
2.Increments Et-New yt for cyclicality
3.Markovian Et=yt-(b0+b1*J+…..)
4.Filteration Detrended & Deseasonalized series
WHAT IS TIME SERIES DATA? b) Using differencing i.e. order differencing & seasonal
Collection of data at different points of time. differencing
Analyzing time series data & fitting time-series regression model to ARMA model or ARIMA models (I portion means integrated or
forecast bookings in future is known as MODELLING TIME SERIES differenced)
Which includes four components: Fitting ARMA model means-
 Trend means increasing/decreasing values over a period of 1. Checking if auto –regression & moving average
time. patterns are found in data.
 Seasonality means short term patterns that repeat 2. Deciding the order of ARM model using ACF(Auto
themselves correlation function )or PCF(Partial Auto-Correlation
 Cyclicality means long term patterns that repeat themselves
function) at various lags.
 Error term: Even on modeling 3 components perfectly ,the
Methods of checking covariance-stationarity
forecasted value cannot match with actual value and the
Mthd 1: We can achieve weak stationarity i.e.
difference is called ERROR TERM.
o Mean across the time should be constant.
ERROR TERM SHOULD BE PURELY RANDOM( WHITE NOISE)
o Variance across the time should be constant.Covariance is log dependent
& IS NON-MODELLABLE.
but not time-dependent.
Mthd 2: Auto-correlation function (ACF)
Trend can be modelled using linear regression.
It is the plot of correlation btw original time series data & its various lags.For time
Yt=b0+b1*time+et
series to be stationery, the ACF plot should exhibit a fast decay.
While modeling the components,model is fitted on in-sample data &
Partial Auto-Correlation Function
accuracy is checked on out-of sample data to ensure there is not
Suppose correlation btw sale of lemonade & sale of icecream is 0.943.This might be
overfitting bias.
due to effect of temperature i.e. their linkage to temperature respectively.
Seasonality can be modelled using dummy variable
True correlation btw lemonade & ice-cream controlling effect of temperature is
regression.
called partial auto-correlation. Partial correlation controlling effect of temp is
yt=b0+b1*jan+b2*feb+………………………………b11*Nov
actually 0.On running regression btw lag 0 & lag 1 to lag 12 ,slope coeeficients can
Dummy codes are used i.e. 0 or 1
be considered to be partial auto-correlation.
1 in Jan & 0 in all other months means we are forecasting for the
Mthd 3: Fit an auto-regression model of order 1
month of Jan & sales will be higher by b1.
Be<1 Time Series is covariance-stationery.
Cyclicality can be modelled using Auto Regression Moving
Be=1 Unit route problem & series is not covariance stationery.
Average (AR MA Model)
Be>1 Explosive route problem ,series is not covariance stationery.
AR yt=b1yt-1+et

Lemonade sale today Lemonade yesterday

Moving Average: Regressing a variable with previous error term

Yt=b1 et-1 + et
AUTO REGRESSION MODEL OF ORDER 1
AR(1)
yt=b1 yt-1 +et

LAG 1

AR(2)
Yt=b1yt-1 + b2 yt-2 +et

LAG 1 LAG 2

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TIME SERIES ANALYSIS

Dikki – Fuller Test – Series can be made covariance-stationery by removing trend & seasonality
Suppose we fit AR(1) model – Mthd 1: Detrending & de-seasonalizing
Fit a regression model for trend and find out error term.That error term
ˆ  b0  b1 yt
yt ˆ 1 becomes new yt for seasonality.Run a dummy variable regression btw new
Covariance stationary time series means revert, and at mean reverting yt & mths,thus find out error term for second time.This error term is de-
level, trended &
We have: de-seasonalized & should be co-variance-stationery.If series is not yet
covariance stationery,resort to method 2
ˆ  b0  b1yt
yt ˆ Method 2:Differencing
Step 1: Take log of series to ensure variance of data is made constant.
b
ˆ  0
yt Step 2:Plot ACF in log series.For a seasonal differencing of 12,data becomes
1  b1 yt-yt-12.Presence of trend needs to be removed by first differencing ,ie
Series would be stationary if |b1|<1 take seasonal differenced series as new yt.First differencing then becomes
If, new yt-yt-1.
b1=1, : unit root problem
b1 >1, : problem of explosive root
so it’s a case of Random Walk & AR model can’t be used.

We perform Dikki Fuller Test:

H0 : b1  1
Ha : b1  1
For series to be covariance stationary, we want to reject H0
We regress:
dyt  b0  (b1  1) yt  1  et *
(Regress change with lagged variable)
H0 : g  0
 Dikki Fuller Test
Ha : g  0
This test has its own set of critical values.
In case of higher order processes, we use Augmented Dikki
Fuller Test-
dyt  b0  b1 xt  b2 yt 1  b3 Yt 1  b4 yt 2 ....

Deterministic Lagged Lagged Difference

Term Level
Concerns:
 How many terms to consider for previous change in y is unknown.
 Critical values increased with trend.

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TIME SERIES ANALYSIS

Stationarity Investibiility Correlation STATIONARITY

What is a characteristic equation?
AR Characteristic Always Yule Walker eq Eg:- yt=0.6yt-1+et
Eq: |b|<1 1-bz=0
MA Always Characteristic Full calculation z=1/b
eq |z|>1 for series to be stationery
|1/b|>1, |b|<1
For MA model, ACF shows a cut off point but PACF will never
MA series is always stationery while for AR series,we have to check
become 0,it will always tend to 0.For AR model,PACF will show a
stationarity.
cut off while ACF wl never become 0.It wl always tend to 0
(decaying pattern)
INVERTIBILITY
For MA, we see autocorrelation function & the lag at which auto-
A series is invertible if we can express it in terms of yt only.
correlation function cuts off,order wl be one lag less to that.
AR series is always invertible.
For auto-regression,we plot PACF & see the cut off point.If PACF
For MA series,check invertibility using characteristic equation.
cuts off say at lag 4,we fit AR(3) model in that case.
1+bz=0
z=-1/b
COVARIANCE
|z|>1 for series to be invertible
Gammak =cov(yt,yt-k),where k=lags
|-1/b| or |1/b|>1,|b|<1
Gamma 1= cov(yt,yt-1)
Gamma 0= cov(yt,yt)
MEAN & VARIANCE OF AUTO-REGRESSION USING MOVING AVG
=var(yt)
MODEL
1. Lag operator/Backshift operator
AR(1)
LYT =Yt-1;L2YT=Yt-2; L3YT=Yt-3
Gamma1=bGamma0
2. AR(1) model can be expressed as MA (∞) model.
Gamma2=bGamma1+0
MA(1) model can be expressed as AR(∞)model.
Gamma2=bGamma1+σ2
AR(1)
Yt= Byt-1 +et;Yt=BLYT+et.So,Yt=et/(1-BL)[Infinite GP Series]
Yule Walker Equation
MA(1)
1)Slope coefficient X
Yt=-Bet-1+et;Yt= -BLet + et; et=yt/(1-BL)
2) AR(1) –gamma1 [ORDER-LAG]
AR(1) –gamma2
UNCONDITIONAL MEAN,UNCONDITIONAL VARIANCE,CONDITIONAL
AR(1) –gamma3
MEAN & CONDITIONAL VARIANCE OF AR(1) MODEL
AR(1) –gamma0
Suppose time series data belongs tol sales of a particular good.Think of
a factor-Loyalty of Customers as AR(1) model.
CORRELATION
AR(1) model is yt=0.5yt-1[0.5 can be thought of as rate of loyalty]
For Auto correlation function,
Case1:No inf of previous sales.So,mean forecast is called unconditional
corr=cov(X,Y)/σX σy
mean=0
corryt,yt-k=cov(Yt,yt-k)/σyt σyt-k
Case 2:Suppose we know last sale.Given this,forecast mean sales-
=Gamma k/ 𝒈𝒂𝒎𝒎𝒂𝟎 𝒈𝒂𝒎𝒎𝒂 𝟎 Conditional Mean
E(yt/yt-1)=EB(yt-1/yt-1) +E(et/yt-1)=B(yt-1)+0
R=gamma k/gamma 0 Next conditional forecasted mean wl be 0.5*1000=5000kgs

At lag 1,r=b CONDITIONAL VARIANCE & UNCONDITIONAL VARIANCE

At lag 2,r=b2 [Decay pattern in auto-correlation Var(yt)= σ2/ 1-B2
At lag 3,r=b3 function for AR model] Conditional Variance
At lag 4,r=b4 Yt=Byt-1+et,given Ὠ =yt-1
For AR(1) model,auto correlation always decays while partial Var(Yt/yt-1)=var(Byt-1/yt-1)+var (et/yt-1)
auto-correlation cuts off at lag 2. =B2*0+σ2= σ2
Incident of giving coupons is modellable error term for which we can fit MA(1)
model.Disc coupons at t-1 reduce sales.
MOVING AVERAGE MODEL (MA MODEL)
So, MA model=-0.6et-1
Gamma1=cov(yt,yt-1) Regular AR(1) model continues
=cov(bet-1+et,bet-2+et-1) For MA(1) model,ACF cuts Ὠ = (𝑒𝑡 − 1, 𝑒𝑡 − 2, 𝑒𝑡 − 3 … . … . … . . . 𝛼)
=be2 off at lag 2 while PACF
Gamma0=cov(yt,yt) shows a decaying pattern. UNCONDITIONAL MEAN
=cov(bet-1+et,bet-1+et) Yt=Bet-1 +et
=b2 σ2+σ2 E(yt) =0+0 +ve impact
Gamma2=cov(yt,yt-2) E(yt|Ὠ)=E(Bet-1|Ὠ)+ E(et|Ὠ)=Bet-1+0 =Bet-1 et of adv
=cov(bet-1+et,bet-3+et-2) MA(1) AR(1) ctd
=0 =0.5et-1
r1=b σ2/ b2 σ2 +σ2=b/(b2+1)
r2=gamma2/gamma0=0

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TIME SERIES ANALYSIS

AR is declining bcox loyalty rate wl always be less than 100% To check correlation btw error terms,we conduct 2 hypothesis testing i.e.
Yt=Bet-1+et Box Pierce & Ljung Q Statistic.
Var(yt)=var(Bet-1)+var(et)=B2 σ2+ σ2= σ2( 1+B2)
NULL HYPOTHESIS
CONDITIONAL VARIANCE Correlation=0 i.e. error terms are not correlated.
Var(yt|Ὠ)=var(Bet -1|Ὠ) +var(et|Ὠ) Alternate hypothesis
Correlation≠0 i.e. error terms are serially correlated & modellable.
CONDITONAL CONDITIONAL For a perfect modelaccept NULL HYPOTHESIS.
MEAN VARIANCE
BOX PIERCE Q STATISTIC
AR(1) Byt-1
2
σ
=T*Normal sum of squares upto that lag.

MA(1) Bet-1
2
σ LJUNG BOX Q STATISTIC
=T(T+2)*Weighted sum of squares upto that lag where the weights are
1/(T-LAG)
UNCONDITIONAL UNCONDITIONAL
Both these statistics follow a 𝝌 2 distribution with df=lags
MEAN VARIANCE
T=sample size
AR(1) 0 σ2/(1-ß2)
CHECKING ACCURACY OF MODEL
MA(1) 0 σ2/(1+ß2)
3 TESTS

Scale dependent errors Goodness Fit Information Criteria

WOLD THEOREM & GENERAL LINEAR PROCESS 1.Sum of squared errors 1. R2 1.S2
2.Root mean square error 2.Adjusted R2 Akaike inf criteria
WOLD’S REPRESENTATIONAL THEOREM Sehwarz inf criteria
Points out the appropriate model fittable on covariance
stationery series. If we are doubtful btw choosing MA(1) vs AR7 & MA(1)
Take out of ample data ( to avoid overfitting and fit both models)
Yt=Σ∞i=0 Biet-1
Correct model for covariance stationery series is some infinite Root Mean Squared Error=√Σet2/n
distributed lag of white noise called Wold Representation. Lower for model with higher parameters (AR 7,MA 1)
Conditions: Since,something out of error term is taken out ,so explanatory power
1)Error terms are purely random increases.
Et follows white noise.Mean=0 ,variance=σ2,Bi2< ∞ R2=Sum of sq explained/Sum of square Total =SSE/SST
This wl also increase since explanatory power increases.
General Linear Process
Yt=ΣBiet-1 A good metric should contain reward for increases in accuracy
Only covariance stationery series can be written that way & Penalize for the increase in accuracy.
linear becauseWOLD reperesentation expresses the series as a RMSE & R2 includes first feature,lacks the second.
linear function of its innovation. For checking forecasting accuracy,
Use following 4 metrics:
Rational Distributed Lags 1. ADJUSTED R2
They economize on parameters.They are parsimonious which MA(1) AR(7) MA(1)
nevertheless provide accurate approx to the WOLD R2 0.76 0.88 0.12
representations Adjusted R2 0.76 Case 1: Benefit of taking extra variables
0.12;cost associated with
0.70 0.18 complexity 0.18.Loss 0.06.So,don’t
ARMA MODELS Case 2: choose AR(7) & MA(1)
 Correlation is normally distributed with mean 0 & 0.80 0.12
variance 1/n.For a 95% confidence interval, 0.08 Increase in accuracy
Lower Limit=𝜇-2SD=0-1.96*1/√𝑛 Benefit=0.12
Upper Limit=0+1.96*1/√𝑛 Cost =0.08 So,net benefit =0.04
So,we accept AR(7) & MA(1)
If correlation lies btw these limits, it’s considered zero. 2.S2,AIC & SIC
SIC PENALTY
ACF & PCF is used at 3 places: FACTOR
To check if series is covariance stationery,ACF AIC
AIC e 2k/t Σet2/T* e 2k/t
& PACF should exhibit a fast decay pattern. PENALTY
To decide the order of AR & MA S2 SIC Tk/T Σet2/T*Tk/T
To check if error terms are serially
uncorrelated or not.
S2 1/T-K Σet2/(T-K)
PARAMETERS

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Out of these 3,
 S2 penalizes for df(no of parameters).So,inconsistent.
 AIC penalizes more when compared with S2 yet not substantial enough to be considered a consistent metric.
 SIC which penalizes most for increase in complexity is the most consistent .Inconsistent means selecting model with
larger no of parameters which may be far from being a best approximation of the model..

ASYMPTOTIC EFFICIENCY
Ie selecting a model that forecasts error variance at same rate as done by a true model when N is large.
AIC is found to be most efficient inspite of being inconsistent.

ERROR TERMS:
 Error term has a mean of 0 & constant variance of σ2
 If 2 variables are serially uncorrelated,they may or may not be independent.
But if 2 variables are independent ,then they definitely have a correlation of 0
If 2 variables are bivariate normal,correlation 0 means independence (x+y)
So,error terms are independent & identically distributed & they follow a normal distribution with meam of 0 &
variance of σ2 or so called Gorsian White Noise

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Time Series

Box Jenkins
Single Time Mul ple Time
Series Series
We can use regression model
1. Mean, variance & check if me series but we check for co - integra on
co - variance data is co - variance
2. Plot ACF & PACF sta onary Dickey Fueller - Engle Granger test.
3. Dickey Fueller Test
& Augmented DF
Test.
Yes No

Detrend &
Differencing
Deseasonalize

1. linear & log linear 1. First order differencing

regression for trend. for trend.
2. Dummy variable 2. Seasonal differencing
regression for seasonality for seasonality.

Cov. sta onary

ARMA Model Selec on

1. Plot ACF & PACF

2. Use A/C, B/C
1. Plot ACF & PACF
Based on Model parameters 2. Ljung Box & Box Pierce Q Sta s c
find fi ed Yt & ct

Check

Error term is White Noise Error term is not White Noise

- independent
i.e., no serial correla on btw error terms
- iden cally distributed
i.e., constant Mean & Variance Not Independent Not Iden cally distributed
i.e. serial correla on i.e. variance is not
btw error terms. constant

Check Model specifica on improve your model by

again. using GARCH & ARCH

Use Model for

Forecas ng

n - period ahead forecasts. Page 84

 Summarised by : Karan Aggarwal

MONTE CARLO SIMULATION & GAUSSIAN COPULA

 Simulation means generating artificial values,monte-carlo PERFORM FOLLOWING 2 STPES TO PERFORM MONTECARLO SIMULATION
simulation means a specific type of simulation in which we STEP 1: Generate random nos using RAND()
generate artificial values from some probability distribution. STEP 2:Get value of X using NORMINV(RAND(),𝜇, 𝜎)
 Higher the no of runs,the better the accuracy. Finding probabililty given x
 Monte-carlo simulation is used for generating values for STEP 1:z=(x-𝜇)/𝜎
random variables.
STEP 2: Z looking table
 Given that Monte-Carlo is subject to assumptions,
It is subject to model risk.
STEPS INVOLVED IN MODELLING: Finding x given probability
1. COLLECTING DATA: Step 1: Z using tables
Data can be of two types: Step 2: x=𝜇+z𝜎
Either historical data or cross-sectional data. Z AREA in one tail
Before working with data,we need to work on
outliers & missing treatments. 2.58 0.5%
2. MODEL FITTING 2.33 1%
Deciding which distribution the data follows.
Fit data to all possible distributions & decide best 1.96 2.5%
distribution using CHI SQUARE GOODNESS OF FIT 1.65 5%
TEST.
3. PARAMETER CALLIBERATION
5. INCORPORATING CORRELATION & COPULA
That is finding parameters of the distribution.2
methods for parameter caliberation :
1) MOMENT MATCHING ESTIMATION
Eg:we equate mean of data & mean of 1. 𝝁1 𝝁2 Ran()
distribution to find put the parameter. 2. z1 z2 NORMSINV
2) MAXIMUM LIKELIHOOD ESTIMATION (MLE) 3. z1 z2 *
z2 *=r*z1+√𝟏 − 𝒓2 z2
4. RUNNING MONTECARLO SIMULATION 4. 𝝁1 𝝁2 *
NORMSDIST
STEP 1: Rand()=Rand function 5. DIST FIT
We interpret these random nos to be cumulative probabilities.
Fit to any distribution that the random variable follows
STEP 2: NORMSDIST()
Gives cumulative probability for a given value of Z ( Distribution with GAMMAINV(u1,alpha,λ)
mean 0 and SD 1) Beta Inv (𝝁 2*,alpha,ß)
STEP 3:NORMDIST()
Gives cumulative probabilities given value of X,mean,SD NOTE:NORMAL BECAUSE GORSEAN COPULA & GORSEAN MEANS
STEP 4:NORMSINV() NORMAL
Gives values of Z given a cumulative probability. COPULA SEPARATES DEPENDENCE FROM DISTRIBUTION.
STEP 5:NORMINV()
Gives the value of X given a cumulative probability,Mean & SD

To get precise results in Monte Carlo Simulation, either: 1. The Mean of a Normal –
 Generate a large no of random nos Random variable X follows Normal Distribution i.e.
 Use some VARIANCE REDUCTION TECHNIQUES
This reduces the standard error.Stock prices follow a X  N,  2 
Geometric Brownian Motion ie stock prices can be modelled
using 2 components:- Drift & Shock  
St= S0*exp [ (𝜇 − 𝜎 2)t + σ*z*√𝑡] Mean Variance
2 
Anti Thetic Variable Technique  
We know, E X   and var  X  
n
and S.E. =
Take anti(opposite) random nos for each random no earlier
n
generated. To approximate Mean, we generate n number of simulations. Standard
1. For each z ,take opposite no as z* error decrease as n increases. Ex: If n increase by a factor of 25, the
2. Using GBM EQUALTION;we will get St & St* which is
standard error decreases by a factor of 5.
negatively correlated.
3. C= Max( ST-E,0)*e-rt
C*=Max(ST*-E,0)*e-rt X Mean of X SD of X
4. Take avg of C & C*
50 1.017 0.428
NOTE:Reduced standard error for same monte carlo runs.
1250 1.005 0.087  1 
Control Variate Technique  0.428  
 25 
1.C= max(ST-E,0)*e-rt
2. Introduce a controlling variable whose properties are
already known & which brings –ve correlation with the current call price. 1
C= S0+Max(ST-E,0)*e-rt-S0* Note: Standard error of a simulated expectation is proportional to
St*e-rt n
NOTE: S0 brings –ve correlation which reduces standard error .
*

ADVICE: Find standard error using each method & whichever method
has the lowest standard error will give final avg call price.

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MONTE CARLO SIMULATIONS & BOOTSTRAPPING

DISADVANTAGES OF MONTE CARLO SIMULATION (MCS) 2. Bootstrapping Techniques –

 Computationally expensive
 Unprecise results
 Experiment specific-Distribution of the underlying random
variable needs to be known
 Hard to replicate.
IID Bootstrap Circular Block Bootstrap
 This method is used  This method is used
For generating data,we can also use boot-strapping as opposed to when data is when we have
MCS.
Disadv of MCS is that it assumes a prob distribution & its independent. dependent data.
parameters.  Step 1: Generate  Step 1: Select block size
Bootstrapping (i.e. sampling data with replacement i.e. resampling Random no’s with q.
the actual data ) can be used,when we don’t know the distribution
replacement.  Step 2: Select the first
of data.
Boot strapping helps to get more details on distribution or  Step 2: Construct block index i from {1,
distribution of mean. Bootstrap sample as 2,… n} & append

DISADVANTAGES OF BOOT STRAPPING

x i 1, xi 2 .......... xim  x , x
i i 1 ,............ xi q  to
 Outliers which are noise can come in our runs which we don’t bootstrap sample where
want & outliers which are genuine may not come in our data indices larger than n
which we actually wanted to come.
wrap around.
 For non-independent data; we need to do boot-strapping in
blocks to maintain correlation btw random variables.  Step 3: Bootstrap
sample has fewer than
m elements, repeat step
2.
 Step 4: If bootstrap
sample has more than m
elements, drop values
from end until sample
size is m.

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MEASURING RETURNS VOLATILITY AND CORRELATION

1. Measuring Returns – 2. Measuring Volatility –

I. Definition:
I. Volatility is measured by standard deviation of returns.
II. Simple Model for Returns:
i. rt     et
Simple Return Log Return
P P  P  Mean of et = 0 Variance of et = 1
Rt  t t 1  rt  Ln  t 
Pt 1  Pt 1 
  ii. Shock is IID, et  N  0,1
 6335 
Ex: rt  Ln   iii. So, returns are also IID.
S.R  6538 
Ex:  3.15% iv. Volatility of Returns   2  
Time Price v. Multi period returns in simple model :
 Price of asset at T
t–1 6538
time t: r0, T      e0,T
t 6335
Pt   Pt 1  e rt i 1

Simple Return (Rt) = Ex: Weekly Return

 Multi – period 5
6335  6538  5    et  i
 3.1% return:
6538 i 1

 Price of asset at time r 0, T   r0,1  r1,2  r2,3 Mean of weekly return = 5

t: ............rT 1 , T Volatility of weekly return  5 2  5
Pt  Pt 1  1  Rt  (Sum of Daily Log vi. Daily volatility to Annualized Volatility:
 Multi-Period Return: Returns)  annual  252   2daily
1  Rt   1  R0, 1   Monthly volatility to Annualized Volatility:
 annual  12   2monthly
   
1  R1, 2  1  R2, 3 ....
III. Volatility:
 1  RT 1, T 
(Product of daily
simple returns factor)
Historical Implied Volatility
II. Relationship between Simple Returns & Log Volatility
Returns:  Variance of  Constructed using option prices.
rt  ln 1  Rt  returns using  Option price:
 estimators: fn  S , E , r , , T  where  i.e. implied
2
Also, called continuously Compounded Returns. 1 T
volatility is calculated using reverse
ˆ 2 
T
  r  ˆ 
t 1
t
engineering.
III. Which One to Choose?  Volatility:  Advantage:
 For short time span, log return (rt) i. Annualized by construction
̂ 2
ii. Forward making measure
approximates to simple return (Rt).
iii. VIX is an alternative measure
 Simple return is bounded by – 100%, while
iv. Option market is a deep liquid
log returns are unbounded. market
 Log returns have additive property.  Disadvantage:
i. Model Dependent
ii. Assumption of constant volatility
as per Black Scholes Model.

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 Summarised by : Karan Aggarwal

3. Distribution of Financial Returns – 5. Covariance and correlation-

 Normal distribution is symmetric and thin tailed  Dependence can be Linear and Non- Linear. Pearson’s
& has no skewness or excess Kurtosis. correlation measures only the Linear dependence.
 However, Returns are generally Negatively
skewed and have fat tails.  Correlation and Regression slope are related:
 Using jerque Bera test to formally test whether If p  0,   0
sample skewness & Kurtosis are compartible with Regression eq: yi     xi  ei if X and y are unstandardized to
assumption of returns being normally distributed. have  x2   y2  1 , the regression slope = correlation.
 ˆ 2 (Kˆ  3)2 
JB test statistic T  1     N 2
2

 24   Structured Correlation Matrices –

H0 :   0 V (w1 x1  w2 x2 )
 = skewness K= kurtosis variance of portfolio =
K 3  w12  x12  w22  x22  2 x x1 x x2
H0 :   0 Alternative,
K 3   x12  x 1 x 2  w1 
Var[Rp]  [w1 w2 ]  2  w 
ˆ2  x 1 x 2  x2   2
   N (0,6) so that  12
6   
 Kˆ  3 Weight covariance-variance weight
2

K  N (3,24) so that  12 Matrix transpose

24
For covariance variance matrix to be valid, it should be
JB test is  distributed
2

POSITIVE DEFINITE ie, for an w, w  w T  0

2

4. Power Law –
 Structure to impose positive definiteness:
 Normal distribution has this tails, so far modelling
of Returns in tails we use power Law.  Set all correlation to be equal.
 Use Factors Model.
P (X   )  K   , K &  are parameters &
constant.
 We compare tail behavior by examining natural
log of tail probably
In (P)  In (K   )
In(P)  ln(K )   ln( )

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NOTES