Pricing Conventions, Discounting & Arbitrage:

1. If 1-year rates are 5 percent, 1-year rates one year from now are expected to be 5.75 percent,
and 1-year rates two years from now are expected to be 6.25 percent, then the unbiased
expectations theory of interest rates would indicate current 3-year rates should be

[1 + r(3)]^3 = (1.05)(1.0575)(1.0625), which generates a current 3-year rate of 5.67 percent.

2. Zero coupon bonds always sell below their par value, or at a discount prior to maturity. The
amount of the discount may change as interest rates change, but a zero coupon bond will
always be priced less than par.

3. STRIPS have some disadvantages, which include the following:

They can be illiquid.

Shorter-term C-STRIPS tend to trade rich.
Longer-term C-STRIPS tend to trade cheap.
P-STRIPS typically trade at fair value.

4. Look at this calculation of forward rates &spot rate:

5. The value of a 1.5-year, 6 percent semi-annual coupon, $100 par value bond is closest to:
 6. The rate of interest an investor could invest at today until some point in the future is the spot
rate.

The interest rate that makes an investor indifferent to investing over a long time period or
investing over two or more shorter time periods.

7. Principal STRIPS typically trade at fair value. Shorter term coupon STRIPS typically trade
rich. Longer term coupon STRIPS tend to trade cheap.

8. The Treasury does not issue zero-coupon notes or bonds.

A 5-year Treasury note can be stripped into 11 zero coupon securities, consisting of its 10
coupon payments and the principal repayment.

9. The Treasury spot rate yield curve is closest to Zero-coupon bond yield curve.

Bonds, Yields & Returns Calculations:

1. When investing in Treasury bonds, downgrade and default risk are not relevant. Interest
rate risk is not important because the investor plans to hold the bond until maturity.
 Reinvestment risk is the most important. Liquidity risk is also not a concern with Treasury
bonds.

2. An investor in a fixed-coupon bond can usually eliminate price risk by holding a bond until
maturity, the same is not true for reinvestment risk.

An investor concerned about reinvestment risk is most concerned with a decrease in interest
rates.

3. Reinvestment risk means that a bond investor risks having to reinvest bond cash flows (both
coupon and principal) at a rate lower than the promised yield.

"Short-term bonds should be purchased if the investor anticipates higher reinvestment

rates.”

"If an investor anticipates lower reinvestment rates-- low coupon bonds should be
purchased”

Reinvestment risk increases with longer maturities and higher coupons, and decreases
for shorter maturities and lower coupons.

4. A bond investor can eliminate price risk by holding a bond until maturity, he usually cannot
eliminate bond reinvestment risk.

5. Zero coupon bonds have no reinvestment risk over their term if the investor holds the
bond until maturity.

6. What is the yield to maturity (YTM) of a 20-year, U.S. zero-coupon bond selling for $300?

N = 40; PV = 300; FV = 1,000; CPT → I = 3.055 × 2 = 6.11.

7. The semi-annual-pay bond equivalent yield of an annual-pay bond

= 2 × [(1 + yield to maturity on the annual-pay bond) 0.5 − 1] = 12.14%.

8. Reinvestment risk is higher for high-coupon, long maturity bonds.

In addition, callable bonds have more reinvestment risk than noncallable bonds.

9. An investment pays $75 annually into perpetuity and yields 5%. Price is:

PV = C / I = $75 / 0.05 = $1,500.

10. A bond with a 12% coupon, 10 years to maturity and selling at 88 has a yield to maturity of:

PMT = 120; N = 10; PV = −880; FV = 1,000; CPT → I = 14.3

11. The risk that an investor will earn less than the quoted yield-to-maturity on a fixed-coupon
bond due to a decrease in interest rates is known as: Reinvestment risk.

12. When a bond is selling at a premium, the current yield will be larger than the YTM.
 Reinvestments occur at the YTM. The YTM will nd the present value of a future value and
associated payments.

Applying Duration, Convexity, DV01

1. Positive convexity means that: as interest rates change, bond prices will increase at an
increasing rate and decrease at a decreasing rate.

2. The graph of a callable bond flattens out as the market value approaches the call price.

3. The price of a fixed-coupon bond is inversely related to changes in interest rates.

4. There are three features that determine the magnitude of duration:

 The lower the coupon, the greater the bond price volatility.
 The longer the term to maturity, the greater the price volatility.
 The lower the initial yield, the greater the price volatility.
The bond with the 30-year maturity will have a greater price impact than the 10-
year maturity.
The bond selling at the greatest discount will have a large price impact, a discount
means that the coupon payments are low, or the initial yield is low.

5. Portfolio duration = 8 × (1050 / 3000) + 6 × (1000 / 3000) + 4 × (950 / 3000) = 2.8 + 2 + 1.27
= 6.07.

(The prices of the 3 different bonds in a portfolio are $1,050, $1,000, and $950 respectively.
The durations are 8, 6, and 4 respectively)

6. Modified duration is a good approximation of price changes for an option-free bond only for
relatively small changes in interest rates.

7. Convexity is important because: the slope of the price yield curve is not linear.

The error in the estimate is due to the curvature of the actual price path. This is the degree of
convexity.

8. The goal of computing effective duration is to get a: It is better measure of the bond's price
sensitivity to interest rate changes when embedded options exist.

9. A major problem with the use of duration in interest rate risk management is that it assumes:

Duration assumes only a single and parallel shift in interest rates over the interest rate
management planning horizon.

10. Price-yield relationship is: concave for low yields for the callable bond and always
convex for the option free bond.
Since the issuer of a callable bond has an incentive to call the bond when interest rates are
very low in order to get cheaper financing, this puts an upper limit on the bond price for low
interest rates and thus introduces the concave relationship between yields and prices.

11. The negative convexity of bond prices means that bond prices as a function of interest
rates approach a ceiling as interest rates fall.

Positive convexity in bond prices implies:

 As yields increase, changes in yield have a smaller effect on bond prices.
 The price volatility of non-callable bonds is inversely related to the level of market
yields.
 As yields decrease, changes in yield have a larger effect on bond prices.

12. Price value of a basis point (PVBP) means DV01, it is always absolute value.
13. All noncallable bonds exhibit the trait of being positively convex and callable bonds have
a negative convexity.

Callable bonds have a negative convexity because once the yield falls below a certain point,
as yields fall, prices will rise at a decreasing rate, thus giving the curve a negative convex
shape.

14. Fixed income securities can have a negative convexity. The only type of fixed income
security with a negative convexity will be callable bonds.

15. When compared to modified duration, effective duration: factors in how embedded options
will change expected cash flows.

16. Question: A 10-year maturity Treasury bond has a par value of $10,000 and a 5 percent
coupon. The yield on the bond is 4.5 percent. Assume that the yield can fall to 4.45 percent or
rise to 4.55 percent.

N = 20; I/Y = 4.45 / 2; PMT = 500 / 2; FV = 10,000; CPT PV = 10,440.05 = V− N = 20; I/Y =
4.55 / 2; PMT = 500 / 2; FV = 10,000; CPT PV = 10,358.33 = V+ N = 20; I/Y = 4.50 / 2;
PMT = 500 / 2; FV = 10,000; CPT PV = 10,399.09 = V0.

We’re not given the semi-annual thing still it is being used in the answer. Figure it out.

LEARN THESE FORMULAS.

17. Coverage of liabilities with significant convexity may be more effectively matched with a:

Barbell portfolio with positive convexity.

18. Market values (not book values) should be used to calculate effective portfolio duration.

(35 / 85 × 4.7) + (50 / 85 × 5.9) = 5.41

19. Portfolio duration is a measure of interest rate risk.

20. Convexity is more important when rates are: unstable.

Since interest rates and the price of bonds are inversely related, unstable interest rates will
lead to larger price fluctuations in bonds.

The larger the change in the price of a bond the more error will be introduced in determining
the new price of the bond if only duration is used because duration assumes the price yield
relationship is linear when in fact it is a curved convex line.

21. Associated PPC = DV01 / V0 = 1.37 / 1,125.51 = 0.0012

(associated percentage price change).

22. With respect to an option-free bond, when interest-rate changes are large, the duration
measure will overestimate the: fall in a bond's price from a given increase in interest
rates.

23. Modified duration assumes that all the cash flows on the bond will not change, while
effective duration considers expected cash flow changes that may occur with embedded
options.

24. The convexity of shorter-term coupon bonds is generally less than the convexity of
longer term bonds. That is because convexity increases with the square of maturity.

25. A barbell strategy is where a manager uses bonds with short and long maturities— forgoing
any intermediate-term bonds.

A bullet strategy is when managers buy bonds concentrated in the intermediate maturity
range. Therefore, the barbell will tend to have the greater convexity due to the
exponential (squared) influence of the longer-term bonds.

26. Since duration is linearly related to maturity, it is possible for a bullet and a barbell
strategy to have the same duration.

27. For convexity, change in yield used in calculations is arbitrary – so we use 100 bps in our
calculations.

28. Positive convexity: Price increases when yields drop are greater than price decreases when
yields rise by the same amount.

29. Convexity is to the advantage of the bond holder because a high-convexity bond's price
will decrease less when rates increase and will increase more when rates decrease than a
low-convexity bond's price.

For a bond with high convexity investors will require: a lower yield.

30. Since the holder of a putable has an incentive to exercise his put option if yields are high and
the bond price is depressed, this puts a lower limit on the price of the bond when interest rates
are high. The lower limit introduces a higher convexity of the putable bond compared to
an option-free bond when yields are high.
 The price-yield relationship is: more convex at some yields for the putable bond than for
the option-free bond.

31. Inverse relationships exist between price and yields on bonds. The larger the PVBP, the more
volatile the bond's price.

32. the higher the coupon, the lower the convexity, so convexity of the 10-year zero-coupon
bond is greater than the convexity of the 6% coupon bond of 10-year duration and the callable
6% coupon bond of 10-year duration.

33. A barbell portfolio will have greater convexity than a bullet portfolio, so convexity of the
barbell portfolio is greater than the convexity of the 10-year zero-coupon bond.

34. Effective duration is an approximation not exact because the duration calculation ignores the
curvature in the price/yield graph.

35. Duration is a measure of percentage change in price for a given change in yield.

36. Duration of a coupon bond is higher when the bond's YTM is lower.

37. PVBP = (0.0001) × D × (price + accrued interest) × 10,000

Note: The 10,000 is to convert the price to $1,000,000 par to match the PVBP units.

38. Change in portfolio value = −0.001 × duration × portfolio value

Change in portfolio value = −0.001 × 8.88438 × $100,000,000 = −$888,438

0.001 is the basis change.

39. The formula for the percentage price change is:

(price when yields fall – price when yields rise) / 2 × (initial price) × 0.005

This formula is also referred to as the bond's effective duration.

40. Since the bond is selling at par, its yield = coupon rate = 8%.

V0 = Par = 100 I/Y = 7.00; FV = 100; N = 12; PMT = 0.08 × 100 = 8

PV = V− = 107.94
Since the call price is 102 which is lower than 107.94, we use V− = 102

(A 12-year, 8 percent annual coupon bond with $100 par value currently sells at par. The bond
is callable at 102)

41. Negative convexity for a callable bond is most likely to be important when the:

Price of the bond approaches the call price.

The convex curve that we generally see for non-callable bonds bends backward to become
concave (i.e., exhibit negative convexity) as the bond approaches the call price.
42. When bond prices go up faster than they go down, it is called positive convexity.
E.g. Non-Callable bonds.

43. Convexity is inversely related to yield. Convexity is the second derivative of price with
respect to yield, which means that convexity measures the rate of change in duration.
Convexity increases with the square of maturity.

44. One characteristic of all noncallable bonds is that they have positive convexity and U.S.
Treasury bonds are noncallable bonds.

45. When convexity is higher, duration will be less accurate in predicting a bond's price for a
given change in interest rates.

Short term bonds generally have low convexity.

46. For negative convexity in bond prices as interest rates fall, the bond's price increases at a
decreasing rate.

47. Negative convexity bonds: High yield bonds, MBS, Callable bonds.

48. Mortgage backed securities (MBS) may have negative convexity because when interest rates
fall mortgage owners will refinance for lower rates, thus prepaying the outstanding principal
and increasing the interest rate risk that investors of MBS may incur.

49. Negative convexity is the idea that as interest rates decrease, they get to a certain point where
the value of certain bonds (bonds with negative convexity) will start to increase in value at a
decreasing rate.

50. For a given bond and yield, the dollar value of a one basis point change in yield is typically:
greater for a yield decrease.

51. The price increase when interest rates decline must be greater than the price decrease
when interest rates rise.

(She considers a $1,000 face value, option-free bond issued at par. Which of the following
statements about the bond's dollar price behaviour is most likely accurate when yields rise and
fall by 200 basis points, respectively? Price will: decrease by $124, price will increase by
$149.)

52. The most commonly used measure of interest-rate risk is: duration.
External & Internal Credit Rating:

1. Technical default usually refers to an issuer's violation of bond covenants, such as debt
ratios.

2. An increase in spot price is the most likely effect of an upgrade in the rating of the bond.
Increased call risk may be possible if the rating upgrade was due to an improved financial
situation for the company, but without more information this cannot be determined.

3. Bonds rated Baa and above are considered investment grade, and those rated Ba and below
are non-investment grade.

4. Bond prices are more affected by ratings changes than stock prices.

5. The highest (least risky) speculative rating as assigned by S&P is BB. Ba is the least risky
speculative rating assigned by Moody's.

6. The at-the-point (internal rating credit system) approach is more likely to be procyclical
because of their short term focus.

7. The at-the-point approach predicts credit quality over a relatively short horizon, while
through-the-cycle methodology focuses on a long time horizon.

8. Internal ratings by banks tend to: lag behind the economic cycle.

9. A bond downgrade produces a downward movement in the stock price, and an upgrade
produces little or no movement.
Measuring Credit Risk:

1. Reducing the recovery rate increases the variability around the expected loss level,
increasing standard deviation (unexpected loss).

2. Expected loss is calculated as follows:

EL = AE × LGD × EDF
Therefore, increasing LGD directly increases expected loss.

3. Unexpected loss is defined as the standard deviation of the expected or average loss
level.

4. A wrong-way risk emerges when the probability of default of counterparties increases as a

result of general market conditions.

Another example of a wrong way risk is when a company writes an option on its own stock.

5. Unexpected loss is the possibility that actual losses are significantly larger than expected, i.e.
mathematical average.

6. Increasing the recovery rate and decreasing the probability of default will decrease expected
loss.

7. EL = Exposure × (1 − Recovery rate) × Probability of default.

8. Economic capital represents the capital a bank sets aside to cover losses in atypical
conditions. Thus, economic capital will reasonably be set above the unexpected loss level.

9. LGD = 1 – RR

10. Formula for Unexpected loss:

 (If the adjusted exposure for Bank X is $15 million, the probability of default is 2%, the
recovery rate is 20%, and the standard deviation of EDF and LGD is 5% and 3%,
respectively. What is the unexpected loss for Bank X)

11. The type of capital used to buffer a bank from unexpected losses is known as: Economical
capital.

Operational Risk:

1. It is common to use a Poisson distribution to model loss frequency.

2. The use of scorecard data usually results in a lower capital charge than the use of
historical loss data.

It is forward looking rather than backward looking.

It is more subjective because it relies upon the judgment of business line managers.

3. An RCSA provides no independent verification of risk measurement and identification.

4. Scorecard data is developed by surveying the institution's business line managers.

Country Risk:

1. A large proportion of sovereign defaults are foreign currency defaults.

2. Countries are more likely to default on funds borrowed from banks than on sovereign bond
issues.

3. Over the last 200 years there have been many instances of default.

4. One must consider not only the country's debts to foreign banks and investors, but also the
amount the country owes its own citizens when evaluating default risk. Countries with greater
pension commitments and health care commitments have higher default risk. The greater the
tax receipts, the more able a country is to make debt payments. Countries with more
diversified economies are more likely to have stable tax receipts.

5. Sharp currency devaluations often follow defaults.

6. Countries that default on debt are more likely to see a change in the president or prime
minister (a 45% increase in the probability of a change) and the top nance minister or head of
the central bank (a 64% increase in the probability of a change).

7. Sovereign default can cause trade retaliation.

8. Gross domestic product (GDP) growth falls between 0.5% and 2.0% following a sovereign
default and the decline is short-lived.

9. Regarding political risk, one component of political risk is the continuity of risks versus
discontinuous risks. Risks in democracies are continuous but generally low. In contrast, risks
in dictatorships are discontinuous (i.e., policy changes are less frequent, but often more
severe). Regarding economic growth life cycle, more mature markets and companies within
those markets are less risky than those rms and countries in the early stages of growth.
Regarding legal risks, the protection of property rights and the speed with which disputes are
settled affect default risk. Regarding economic structure, a disproportionate reliance on a
single commodity or service in an economy increases a country's risk exposure.

10. Advantage of using the sovereign default risk spread as a predictor of defaults:
As bonds trade and bond yields rise and fall, default risk spreads change, revealing
information about the market’s perception of risk.

Market-based spreads are more dynamic than ratings.

In order to calculate a default risk spread, there must be a risk-free security in the
currency in which the bonds are issued.

Default risk spreads are volatile and changes in spreads may be affected by variables that
are unrelated to the default risk of the sovereign.

Local currency bonds do not have a risk-free security with which to compare.
Binomial option pricing:

1. American options full two steps questions steps:

 You need to use a two-step binomial model and consider the possibility of early
exercise.
 First calculate the stock price tree. You have S0 = 20, so the first step results in either
SU = 20(1.2) = 24 or SD=20(0.8) = 16 at the end of year one.
 At the end of the second year the possible outcomes are SUU = 24(1.2) = 28.80, SUD
= SDU = 24(0.8) = 19.20, or SDD = 16(0.8) = 12.80.
 The PV of the expected payoff in the up node is e −0.05 [0.00(0.65) + 4.80(0.35)] =
$1.60.
 The payoff from early exercise in the up node is max{24-24, 0} = 0. Since the PV
of the expected payoff exceeds the payoff from early exercise, early exercise in
the up node is not optimal.
 In the down node the PV of the expected payoff is e −0.05 [4.80(0.65) + 11.20(0.35)]
= $6.70.
 The payoff from early exercise in the down node is max{24 − 16, 0} = $8.00. So
early exercise is optimal in the down node.
 The value of the option can now be calculated as the PV of the expected payoffs
at the end of the first year, or as e −0.05 [1.60(0.65) + 8.00(0.35)] = $3.65.
 If the option is exercised early at the initial node, it is worth $4 (= $24 − 20). This
value is greater than $3.65; thus, the option should be exercised early at Node 0 and
will be worth $4.

2. As the number of periods in the binomial options-pricing model is increased toward

infinity, it converges to the Black- Scholes-Merton option-pricing model.

As the option period is divided into more/shorter periods in the binomial option-pricing
model, we approach the limiting case of continuous time and the binomial model results
converge to those of the continuous-time Black-Scholes-Merton option pricing model.

3. For European put:

Given an up-move factor of 1.15, the down-move factor is simply the reciprocal 1 / 1.15 =
0.87.
Two down moves produce a stock price of 38 × 0.87 2 = 28.73 and a put value at the end of
two periods of 6.27.
An up and a down move, as well as two up moves leave the put option out of the money.

The value of the put option is: [0.32^2 × 6.27] / 1.06^2 = $0.57

I FORGOT TO DISCOUNT BY 1.06^2 IN PRACTICE.

4. Under put-call parity, the value of the call = put + stock – PV(exercise price).

Therefore, the equilibrium value of the call = $0.40 + $56 − $55e –0.04 * 0.5 = $2.49.

Thus, the call is overpriced, and arbitrage is available. If Bingly sells the call for $2.50 and
borrows $53.91 = $55e –0.04 * 0.5 , he will have $56.41 > $56.40 (= $56 + $0.40), which is
the price he would pay for the protective put position.
The arbitrage profit is the difference ($0.01 = $56.41 − $56.40).

5. πU = (1 + 0.04 − 0.833) / (1.2 − 0.833) = 0.564.

This happens when risk free rate is not given continuously compounded.

6. The BSM model requires many assumptions, e.g., the distribution of stock prices is
lognormal and the risk-free rate is known and constant. Other assumptions are frictionless
markets, the options are European, and the volatility is known and constant. Also it is
assumed that there are no cash flows over the term of the options.

7. The assumption of a known and constant risk free rate means the BSM is not useful for
pricing options on bond prices and interest rates.

8. The assumption of a known and constant asset return volatility makes the BSM not useful in
situations where the volatility is not constant which occurs much of the time.

9. The BSM is designed to price European options and not American options.

10. If volatility for a stock is significantly greater than that implied by the prices of the puts
and calls of the stock, we can conclude that: puts and calls are underpriced.

11. All else being equal, the greater the dividend paid by a stock the: lower the call price and
the higher the put price.

12. See question number 14.

13. Two up moves produce a stock price of 40 × 1.44 = 57.60 and a call value at the end of two
periods of 20.60.

An up and a down move leave the stock price unchanged at 40 and produce a call value of 3.
Two down moves result in the option being out of the money.
The value of the call option is discounted back one year and then discounted back again to
today.
The calculations are as follows:
C + = [20.6(0.67) + 3(0.33)] / 1.08 = 13.6962
C − = [3(0.67) + 0 (0.33)] / 1.08 = 1.8611
Call value today = [13.696(0.67) + 1.8611(0.33)] / 1.08 = 9.07

I ALWAYS FORGET THIS CALCULATION WHILE CALCULATING PRICE,

REMEMBER THIS.
14. For volatility:

To calculate the size of an upward movement as e^σ√t = e (0.1825)(1) = 1.20.

 15. As the length of the time intervals approaches zero, the binomial model converges to the
continuous-time Black- Scholes model.

BSM Pricing:
1. Since an option has limited risk but significant upside potential, its value always increases
when the volatility of the underlying asset increases.

2. If we use four of the inputs into the Black-Scholes-Merton option-pricing model and solve for
the asset price volatility that will make the model price equal to the market price of the
option, we have found the: implied volatility.

3. Implied volatility of interest rates can be best computed using interest rate option
contracts.

Forward or futures contract pricing models do not have interest rate volatility as an input.
S&P 500 option contracts have the volatility of the S&P 500 index (and not interest rates) as
an input.

4. The Black-Scholes formula for pricing a put is P = Xe (−rT) N(−d2) − SoN(−d1)

Don’t forget the – sign in power of e as it is discounting, we’re bringing it back to present
value.

5. Remember this calculation of d1 & d2:

Formula learn:
 6. For BSM model, the yield curve is assumed to be flat so that the risk-free rate of interest is
known and constant over the term of the option.

7. The BSM model assumes there are no cash flows on the underlying asset hence no dividends.

8. The BSM model assumes that volatility is known and constant. The term predictable
would allow for non-constant changes in volatility. Also, the risk-free rate of interest is
known and does not change over the term of the option.

9. The value of a put option will be higher if, all else equal, the:

underlying asset has positive cash flows. Positive cash flows in the form of dividends will
lower the price of the stock making it closer to being "in the money" which increases the
value of the option as the stock price gets closer to the strike price.

10. Compared to the value of a call option on a stock with no dividends, a call option on an
identical stock expected to pay a dividend during the term of the option will have a:

lower value in all cases.

11. Solve question number 13 again.

12. Dividends on a stock can be incorporated into the valuation model of an option on the stock
by: subtracting the present value of the dividend from the current stock price.

13. Methods used for estimating volatility inputs for the Black Scholes model:

Using exponentially weighted historical data.

Using long term historical data.
Using the most current historical data.

Greeks:
1. Gamma-neutral hedging: decreases sensitivity to large changes in asset prices.

2. Delta-neutral hedging: designed to protect against small changes in asset prices.

3. Gamma is the rate of change in delta. It measures how fast the price sensitivity changes as
the underlying asset price changes.

4. If the investor has written 5,000 call options, he then must go long 0.5 × 5,000 = 2,500 shares
to create a delta neutral position since the delta of a share is 1.

5. Delta is the change in the option price for: an instantaneous change in price of the underlying
stock.

Delta is the slope of the price function of the call option payoff diagram.

6. When an option's gamma is higher: a delta hedge will perform more poorly over time.

Gamma measures the rate of change of delta (a high gamma could mean that delta will be
higher or lower) as the asset price changes and, graphically, is the curvature of the option
price as a function of the stock price.

The greater gamma is (the more delta changes as the asset price changes), the worse a
delta hedge will perform over time.

7. Minimum and maximum bounds for the put option delta: −1 and 0.

The lower bound is achieved when the put option is far in the money so that it moves exactly
in the opposite direction as the stock price. When the put option is far out of the money, the
option delta is zero.

8. Gamma becomes larger as the changes in stock price increase in absolute value.

Gamma hedging requires less frequent rebalancing than delta hedging.

Less frequent rebalancing in a gamma hedge can result in higher returns but also
increases the position's volatility.

9. Long stock, long put strategy (portfolio insurance):

The loss is limited to the cost of the option while the potential upside profit is unlimited.
Note that the portfolio insurance payoff diagram is identical to the profit / loss diagram
for a long call option.

10. The deltas of puts and calls are most sensitive to changes in the underlying when:
both calls and puts are at-the-money.
11. Call and put option values are most sensitive to changes in the volatility of the underlying
when: both calls and puts are at-the-money.

This is due to Vega; Vega measures the sensitivity of the option value to changes in
volatility. Vega is at a maximum when calls and put options are at-the-money.
 12. Delta of forwards is one. The delta of futures is not usually one.

Two problems using stop-loss trading on naked options are transaction costs and stock price
uncertainty.

13. For a delta-neutral portfolio, although opposite in sign, theta can serve as a proxy for
gamma.

14. Gamma is largest when options are at-the-money.

15. The gamma of an option is computed as follows: Gamma = change in delta / change in the
price of the underlying = (0.7 − 0.6) / (110 − 100) = 0.01

16. As the value of the underlying increases, the delta of a call option increases. This means
more of the underlying asset is needed to hedge the position.

17. Rho values for put options are always negative and approach zero as the option nears
maturity.

Measures of Financial risk:

1. According to Markowitz portfolio theory, if stocks, are perfectly correlated, there is no

benefit from diversification. So, invest in the stock with the lowest risk.

2. The Markowitz efficient frontier is the set of possible portfolios that provide the highest
return for each level of risk, or the lowest risk for each level of return.
3. Subadditivity: The risk of a portfolio is at most equal to the risk of the assets within the
portfolio.

4. Translation invariance: the risk of a portfolio is dependent on the assets within the
portfolio.

5. Homogeneity − the size of a portfolio will impact the size of its risk.

6. Monotonicity − a portfolio with greater future returns will likely have less risk.

7. The delta-normal VAR model assumes a normal distribution.

8. Delta normal method disadvantages:

II. Adjusts for non-normal distributions. III. Adjusts for option-like payoffs. IV. Adjusts for
fat-tail distributions.

9. There are benefits to diversification as long as: the correlation coefficient between the assets
is less than 1.

10. The efficient set is the set of portfolios that dominate all other portfolios as to risk and return.
That is, they have highest expected return at each level of risk.

11. Efficient frontier:

Portfolio B cannot lie on the frontier because its risk is higher than that of Portfolio A's with
lower return. Portfolio C cannot lie on the frontier because it has higher risk than Portfolio D
with lower return. Portfolio F cannot lie on the frontier cannot lie on the frontier because its
risk is higher than Portfolio D.

So, not a part of efficient frontier: B,C & F.

Expect a question on this, on how to find which portfolio is a part of efficient frontier or
not.
Applying VaR:

1. The Taylor Series approximation is not useful when the underlying asset is a callable
bond or MBS. The Taylor Series approximation only works well for a "well-behaved"
quadratic function that can be approximated by a polynomial of order two.

2. For calculation of VAR for a linear derivative on the S&P 500 Index:

For a futures contract, multiply the VAR of the S&P 500 Index by a sensitivity factor
reflecting the percent change in the value futures contract for a one percent change in the
index value.
 The following formula is used to calculate the VAR for a linear derivative: VARP = ΔVARf
the delta in the formula is a sensitivity factor that reflects the change in value of the
derivatives contract for a given change in the value of the underlying.

3. The weekly volatility is approximately equal to 2.77% a week (0.20 / √52). The 5% VAR for
the stock price is equivalent to a standard deviation move for a normal curve. The 5% VAR of
the underlying stock is 0 − 2.77%(1.65) = −4.57%. A −1% change in the stock price results in
a 9.91% change in the call option value, therefore, the delta = −0.0991 / −0.01 = 9.91. For
small moves, delta can be used to estimate the change in the derivative given the VAR for the
underlying asset as follows:
VARCall = ΔVARStock = 9.91(4.57%) = 0.4529, or 45.29%
In words, the 5% VAR implies there is a 5% probability that the call option value will decline
by 45.29% or more over one week.

SEE QUESTION NUMBER 3

4. The one percent VAR assuming normality corresponds to −2.33 and over the next 100 trading
periods a return worse than −2.33 is expected to occur two times.

5. The biggest disadvantage of using historical events or historical simulations for stress testing
is that it is limited to only evaluating events that have actually occurred. The stress scenario
approach has the advantage of not being limited to analysing only events that actually
have occurred.

6. linear or approximately linear derivative instruments: Forward on commodity, Futures on

equity index, Currency swap.

Not linear: Swaption, Interest rate cap.

7. The Taylor Series approximation adds a second order term (i.e., the second derivative of the
value function) to the slope (i.e., the rst derivative of the value function) to estimate the rate
of change in the value of the non-linear derivative. Doing so improves the estimated value
change for large changes in the underlying asset value.
8. The delta-normal approach to estimating the VAR of a non-linear derivative adjusts the VAR
of the underlying asset for the delta (slope) and gamma (curvature) of the relationship
between the derivative and the underlying.

The VAR of the underlying asset can be calculated using parametric methods (assuming a
normal distribution) or using historical methods (which does not assume a normal
distribution).

9. Disadvantages of stress scenarios include its inability to account for assetclass-specific risk
factors and its tendency to produce deceptive risk measures.

10. An advantage of the historical crisis approach is that it requires no assumptions regarding
the underlying distribution of portfolio returns.

11. A disadvantage of the Simulated monte Carlo approach is that in some cases it may not
produce an accurate forecast of future volatility, and increasing the number of simulations
will not improve the forecast.

12. In SMC, the general equation assumes the underlying asset has normally distributed returns
with a mean of μ and a standard deviation of σ.

13. The structured Monte Carlo (SMC) approach can address multiple assets with multiple risk
exposures by generating correlated scenarios based on a statistical distribution.

14. The weekly volatility is approximately equal to 2.08 percent a week (0.15/ √52 ).

The 5 percent VAR for the stock price is equivalent to a one standard deviation move, or 1.65
for the normal curve.

The 5 percent VAR of the underlying stock is 0 − 2.08%(1.65)= −3.432%. A one percent
change in the stock price results in a 11.92 percent change in the call option value, therefore,
the delta = 0.1192 / 0.01 = 11.92.
For small moves, delta can be used to estimate the change in the derivative given the
VAR for the underlying asset as follows: VARCall = ΔVARStock = 11.92(3.432%) = 0.409 or
40.9% In words, the 5 percent VAR implies there is a 5 percent probability that the call option
value will decline by 40.9% or more.

15. VARCall = ΔVARStock.

16. Steps in using the SMC approach include:

Simulate thousands of valuation outcomes for the underlying assets based on the assumption
of normality.
The VAR for the portfolio of derivatives is then calculated from the simulated outcomes.

17. SMC approach cannot predict extreme values from correlation breakdowns if the underlying
covariance matrix relies on normal market volatility.

18. The structure Monte Carlo (SMC) approach to estimating VAR simulates portfolio or asset
returns using a stochastic process:
 st+1,i = st × e^(μ + σ × z)

Measuring & Monitoring Volatility:

1. For hybrid approach: Calculate cumulative weight, that is the percentile.

2. VAR = Portfolio value [E (R) − zS]

= 100,000 [0.117 − (1.65)(0.1333)]

= −$10,295

0.1333 is the portfolio standard deviation, 0,117 is the portfolio expected return.

Expected Portfolio return = E(RP) = 0.40(9) + 0.60(6) = 7.20%

3. VAR actually increases with increases in holding period. VAR decreases with lower
confidence levels.

4. VAR measures the amount of loss in the left tail of the distribution and increases with
lower probability levels. VAR increases with lower significance levels.

5. The accuracy of a value at risk (VAR) measure: can only be ascertained after the fact.

6. A 95% one-day portfolio value at risk (VaR) of $50,000 means that in 5 out of 100 (or
one out of 20) days, the value of the portfolio will experience a loss of $50,000 or more.

7. VAR was developed by commercial banks to provide a more accurate measure of their
economic capital requirements, taking into account the effects of diversification.

8. VAR(10%) = $0 indicates that there is a 10% probability that on any given day the dollar loss
will be greater than $0. Alternatively, we can say there is a 90% probability that on any given
day the dollar gain will be greater than $0.

9. Analysts prefer to use Monte Carlo simulation rather than historical simulation because:

past distributions cannot address changes in correlations or events that have not happened
before.

Monte Carlo simulation can be used to model based on parameters that are not limited to past
experience.

10. Nonparametric models do not require assumptions regarding the entire distribution of returns.

11. Data is used more efficiently with parametric methods than nonparametric methods.

12. MDE allows for weights to vary based on how relevant the data is to the current market
environment regardless of the timing of the most relevant data. MDE is also very flexible
in introducing dependence on state variables.

13. The variance / covariance method of VaR estimation relies on the assumption of normality.

14. |One-day VAR(6%)| > |one-day VAR(10%)|.

15. VAR1% = z1% × σ = 2.32 × 0.014 = 0.03248 ≈ 3.25%

VAR10% = z10% × σ × portfolio value = 1.28 × 0.014 × $243 million = $4.35 million

16. The difference between a Monte Carlo simulation and a historical simulation is that a
historical simulation uses randomly selected variables from past distributions, while a Monte
Carlo simulation: uses a computer to generate random variables.

17. the historical standard deviation approach creates a variance-covariance matrix that is
estimated under the assumption that all asset returns are normally distributed.

18. the historical simulation approach weights returns based on market values today, regardless of
the actual allocation of positions K days ago.
19. for well-diversified portfolios, the strong law of large numbers is required to estimate the
volatility of the vector of aggregated returns.

20. Both the RiskMetrics™ and the historical standard deviation approach create
variancecovariance matrices that are estimated under the assumption that all asset returns
are normally distributed.

21. The RiskMetrics™ approach is very similar to the GARCH model.

Exponential smoothing methods and the historical standard deviation methods both apply a
set of weights to recent past squared returns.

22. The Monte Carlo approach uses simulation techniques, repeatedly shocking a model of loss
data in order to produce a range of potential losses. It is more computationally intensive than
either the historical or variance-covariance approaches. The model used can account for
nonlinear risk structures and need not be limited by historical data.

23. Portfolio VaR:

24. A parametric model typically assumes asset returns are normally or lognormally
distributed with time-varying volatility.
The other(multivariate density estimation, hybrid, nonparametric) approaches do not require
assumptions regarding the underlying asset return distribution.

25. VAR is a benchmark that gives an estimate of what magnitude of loss would not be unusual.
The actual loss for any given time period can be much greater.

26. VAR (5%) = z5% × σ × portfolio value = 1.65 × 0.012 × $145 million = $2.871 million.

27. When would a Monte Carlo simulation be preferable to a historical simulation: There is only
a small amount of historical data.

28. Using both RiskMetrics and historical standard deviation, calculate the K-value that equates
the most recent weight between the two models. Assume λ is 0.98.

(1 − λ) λ t = (1 − 0.98)(0.98) 0 = 0.02; 1 / K = 0.02, K = 50

29. The weekly VAR is: 2 million × 1.65 × 0.0065 × √5 = $47,964

30. Historical VaR uses historical realized returns, and Monte Carlo VaR uses returns generated
from a hypothetical model, which requires a significant number of inputs. Neither historical
nor Monte Carlo VaR is a parametric approach.

31. Disadvantages of Monte Carlo simulation include: model risk; sampling variation if
replications are small; and computational time and skill.

32. Disadvantages of the historical simulation method include: lack of historical data; use of
actual data; time variation risk; inability to recognize structural change; and it may not be
able to sufficiently define the distributions tails.

33. Disadvantages of the delta-normal method include: normality assumption results in VAR
estimates that understate true VAR for distributions with fat tails; and it isn't able to
accurately estimate VAR for portfolios with nonlinear characteristics (i.e., portfolios with
option-like positions).

34. VAR^2 portfolio = VAR^2 Stocks + VAR^2 Bonds + 2VARStocksVARBonds ρStocks, Bonds

(1,367,000)^2 = (1,153,000)^2 + VAR^2 Bonds + 2(1,153,000)VARBonds (0) VARBonds =

[(1,367,000)^2 − (1,153,000)^2 ] 0.5 = 734,357

35. One advantage of the Monte Carlo simulation approach over the historical method when
calculating VAR is the simulation approach: incorporates flexibility in modelling price paths.

36. The price value of a basis point (PVBP) of a bond portfolio is $45,000. Given, at 1%
probability level change in interest rates is 1.50% or higher.

Change in Portfolio value for a 150 bps change in rates = 150 × 45000 = 6,750,000
VAR = 6,750,000

37. RiskMetrics does not assign equal weights across observations. Historical standard deviation
is a parametric model.

38. A decreasing λ suggests a higher relative weight on the most recent data for exponential
smoothing models.

39. The most recent weight for GARCH exceeds the most recent weight for historical standard
deviation, assuming the same high number of observations.

40. I. The parametric approach is typically defined by the calculation of the distribution mean
and variance.

II. The nonparametric approach has the advantage of no required asset distribution.

III. The implied-volatility based approach estimates volatility using current market prices.

IV. The GARCH approach is a parametric model that uses time varying weights on historic
returns to calculate distribution parameters.

41. deviations from normality always leads to underestimating the distribution variance: Higher
probability of high returns.
42. RiskMetrics uses a decay factor of 0.94 for daily data and 0.97 for monthly data.

43. EWMA models with a low value for λ (Model 3) will put more weight on the previous day's
return and will lead to volatility estimates that in themselves are highly volatile from day to
day.

44. EWMA models with a low value for λ (Model 3) will put more weight on the previous day's
return and will lead to volatility estimates that in themselves are highly volatile from day to
day.

45. VAR is the market value of the position times the price volatility of the position times the
confidence level, which in this case equals:

46. The form of the basic EWMA model is σn^2 = (1 − λ)μn−1^2 + λσn−1^2 , where λ is the
weight on the previous volatility estimate. EWMA models with a low value for λ (Model 3)
will put more weight on the previous day's return and will lead to volatility estimates
that in themselves are highly volatile from day to day.

EWMA models with a high value for λ (close to 1, such as Model 2) will put less weight on
the previous day's return, and the model will respond more slowly to new data.

47. By definition, VAR is the minimum loss for the worst 5% of the days or the maximum 1-day
loss 95% of days.

48. A distribution is left skewed when the distribution is asymmetrical and there is a higher
probability of large negative returns than there is for large positive returns.

49. Fat-tailed distributions typically have less probability mass in the intermediate range,
around +/− one standard deviation, compared to the normal distribution.
 The first two moments (mean and variance) of the distributions are similar for the fat-
tailed and normal distributions. Fat-tailed distributions have greater mass in the tails and a
greater probability mass around the mean than the normal distribution.

50. VAR for this portfolio would be: −[$520,000 − 1.645($2,275,500)] = $3,223,197.50

(If the expected change in a fixed income portfolio is $520,000 and the standard deviation of
the estimated change in the portfolio is $2,275,500, the 95 percent value-at-risk (VAR) for
this portfolio is closest to)
51. VAR(2.5%)Percentage Basis = z2.5% × σ = 1.96(0.017) = 0.03332 = 3.332%

52. VAR = $100 MM [0.06 − (2.326)(0.08)] = $12.608 MM

99% Confidence level: 2.326

97.5% Confidence level: 1.96

53. The historical standard deviation approach differs from the RiskMetrics™ and GARCH
approaches for estimating conditional volatility, because it: places a lower weight on more
recent data.

All three methods are parametric, use historical data, and apply weights to past squared
returns.

54. First, calculate the standard deviation of the portfolio:

[0.65^2 (0.018^2 ) + 0.35^2 (0.011^2 ) + 2(0.35)(0.65)(0.018)(0.011)(0.43)] 0.5 = 1.38%

Next calculate the portfolio VAR: z2.5% × σ = 1.96(0.0138) = 2.71%

55. Local valuation methods measure portfolio risk by valuing the assets at one point in time,
then making adjustments to relevant risk factors that are expected to cause changes in the
overall portfolio value. The delta-normal valuation method is an example of a local
valuation method.

56. Fat tails, skewness, and other deviations from some assumed distribution are no longer a
concern in the estimation process for nonparametric methods.

Data is used more efficiently with parametric methods than nonparametric methods.

Multivariate density estimation (MDE) allows for weights to vary based on how relevant the
data is to the current market environment, regardless of the timing of the most relevant data.
MDE is also very flexible in introducing dependence on state variables.

57. A fat-tailed distribution: most likely results from time-varying volatility for the unconditional
distribution.

58. A regime-switching volatility model assumes different market regimes exist with high or low
volatility.

The mean is assumed constant, but the volatility depends on the regime. Conditional on the
fact that interest rates are drawn from one regime, the distribution is normally distributed. If
interest rates are drawn from more than one regime, this unconditional distribution need not
be normally distributed.