PART 1_ SCHWESER’ FOUNDATIONS OF RISK Nel ae Risk and Return of Portfolios of Risky Assets Fora portfolio of I securities, the expected portfolio return is ren) The variance of recurs for a portfolio of evo risky securities isnot simple weighted average of the variances ofthe wo securities. Te depends on how the returns on the securities move together, which is measured by the covariance of the reruns on the two securities. of = who} + who} +20 qmgCovRy Ry) EIRp) since cottelation equals = py, vatiance can alo be writen as of = whok + whoh + 2WawpPA.BOAoR Diversifiable and Systematic Risk ‘The part ofthe volatility of a single security’ returns that i uncorrelated with the volaticy ofthe market porfli is that secuiy’s dlvesfable risk, ‘The part ofan individual security’ risk that arises because ofthe postive covariance of that security's reeuras with overall market returns is called its systematic rik A standardized messue of systematic tsk is bet ber = CMB aD) oe Capital Asset Pricing Model (CAPM) In equltvium al investors hold a porfalio of sky ase that has the same weights a the market portfolio, The CAPM is expressed in the equation of the security market line (SML). For any single security of portfolio of securities, the ‘expected rerum in equilibrium i= E{R))=Rp + beta ERyq)—Re] CAPM Assumptions "Investors seco maimize the expected uty cf thei wealth athe end ofthe psig, and all inveorshave th same invenment horizon. Investors atk wen Investor only consider the mean and standard deviation of rer (which impli astume the ase run ar normaly disbuted). + Tver can borrow and lend a the ame fie Investors have the same expectations concerning + Thereate neither tres nor trnacions cos, and ase at infinitely vile. This often sefered toss esc martes” Price and Quantity of Risk “The sk premium of an asset is [E(Ry) ~ Ry. ‘The quantity of risks 3. eo ‘The price of tisk isthe market risk premi (ER -Ry) Firm Value Using CAPM firm cash low T+ CAPM rere current value of equity = If the im reduces ite systematic tsk though financial markers, the decrease in cashflows (the ‘hedging costs) will be just offset by the lower required rate of return, and the value of the firm is unchanged, ‘Measures of Performance ‘The Treynor measure is equal ro the risk premium divided by besa, or systematic risk: ‘Treynor measure = | (Rr) Re % “The Sharpe measure i qual tthe risk premium divided by the standard deviation, or ‘al risk: ‘The Jensen measure (a. Jensen alpha or just, alpha) isthe ase exces rerrn over the return predicted by the CAPM: Jensen measure = cap =E(Rp) ~ (Ry +89(E(Ry) Rel) ‘The information ratio i esenilly the alpha of the managed pordolio slave its benchmark divided by the tracking enor. ip — [ERE ‘wackingerot ‘The Sorin ratio is similar ro the Sharpe rato except we replace the rk Fie rate with a minimum accepabl recurn, denoted Rand we replace the standard deviation with a ype of semistandard deviation. Sorin ratio = ERP) = Rain ‘emi-standard devistion Arbitrage Pricing Theory (APT) ‘The APT assumes that returns can be modeled with a mulkifcror regression model ofthe following form: Ry =RptXqy Xb; +--+ Kg Xby tay Factor exposure for stock earn for factor & iosyncrati return for stock ‘The APT defines the structure of returns but does not define which factors should be used in the model. The CAPM is special case of APT with only one factor exposure—the market risk premium. Case Studies ‘Metalgeselichfe:shore-serm futures contacts ‘used to hedge long-term exposure inthe pevroleum matkes stack-and-rll hedging strategy; marking to market on futures caused hhuge cash flow problems. Sumitomo: trader attempted to corner the copper ‘marker by buying larg quantities of physical copper and log futures positions copper prices plunged, causing huge loses; lesson isthe lack of operational and risk controls chat allowed this scheme to go undetected. Long-Term Capital Management: bedge fund ‘that used relative value stratepes with enormous amounts of leverage; when Russia defaulted on its debt in 1998, the increase in yield spreads caused huge loses and enormous cashflow problems from realising masking wo market losses: lesions include lack of diversification, model risk, leverage, and funding and trading liquiiry risks Barings: rogue tradet, Nick Leeson, took speculative derivative positions (Nikkei 225 atures) in an attempt to cover trading loses, Leeson had dual responsibilities of trading and supervising setlement operations allowing him to hide trading loses lessons include separation of duties and management oversight. Drdale Sect: borrowed $300 million in tuasecured funds from Chase Manhattan by exploiting a law inthe system for computing the value of collateral Kidder Peabods: Joseph Jet, reported substantial artificial profits after the fake profits were ‘detected, $350 million in previously eported fins had wo be reversed. Allied Irish Bank: acusrency wade, John Rasnak, hid $691 million in loses; Rusnak bullied back-ofie workers into not following- up on trade confirmations for fake trades Bankers Tru: developed derivative sructures that were intentionally complex in aped phone ‘convenations sta bragged about how badly they fooled cen. Enterprise Risk Management + Integrated risk management at opposed to managing individual risk separately + Big-picrure approach that postively impacts decision making throughout the organization ‘+ ERM famewor coves four types of isk (1) hazard risk, (2) financial isk, (3) operational risks, and (4) seg ks. Role of Risk Management 1. Assesall rks faced bythe frm. 2. Communicate thes sks to risk-taking decision makers 3. Monitor and manage these rss ‘Objective of risk management isto recognize that large loises ae posible and to developcontingeney plans that deal with such loses if they should aca GARP Code of Conduct ‘The Code of Conduct es forth principles seated o ethic behavior within the agement profesion, I sree ethical behavior inthe following aes: Principles 1, Profesional inepriy and ethical conduct. 2, Confit of ners 3. Confidential Professional Standards 1. Fundamencl responsibil. 2 Adherence wo hex practices Violtions ofthe Code of Condit may result in temporary suspension or permanent removal from GARP membership. In addition, velations ‘could lead to 3 revocation ofthe right to we the FRM designation CAULEY Ain) Expected Value ‘The expected vale is the weighted average of the posible outcomes ofa rnd viable, whee the weights ate che probabliies that the outcomes will occur. EO) = Plaids; = Pla +P): +. +POo Variance The variance provide measure ofthe extent ofthe dsperon inthe values ofthe random ‘arable sound the mean The square oo ofthe ‘variance is called the standard deviation. varianee(X) = E((X —)"] Covariance Covariance isthe expected value of the product ‘of the deviations of two random variables from. their respective expected vals Cov(Ri Rj) = EMR; ~ ECR )1R; ECR) ‘Sums of Random Variables IfXand Yaze any random vatiables: E(X + Y) = E(X) + EY) 1Xand Yareindependent random vasiables ‘Var(X + ¥) » Var(X) + Var(Y) 1Xand Yare NOT independent ‘Var(X + ¥) = Var(X) + Var(¥) + 2 x CoviX.Y) Simple Random Sampling + Selecting a sample otha exch item in che population as te same likelihood of beng included inthe sample. + The individual items drawn forthe sample ae known 3s independently and identically dlisted (iid) random variables, + Sampling cor it the difference beeen 3 sample sai and is coesponding population parameter. Desirable Properties of an Estimator + An unbiied estimator is one for which the expected vale ofthe extimator sual the parameter you ae tying to cximate, + An unbiased eximaoris also efcienif the variance of it sapling disibaton i smaller than ll the other unbiased estimator ofthe parameter you are tying 0 eximat + Remain eximator sone for which the accuracy ofthe parameter eximate increases 8 the sample sie increases. Population and Sample Variance ‘The population variance is defined as the average of the squared deviations from the mean. ‘The population standard deviation isthe square 108 a the population variance ‘ So -w? = ‘The sample variance, i the measure of dispersion cha applies when we ae evaluating 4 sample of» observations from a population. Using a— 1 instead of nin the denominator impro he nil rope oan Qa Skewness and Kurtosis Skewness, or skew, refers tothe extent t0 which a distbution i noe symmetrical. The skewness oF normal distribution sequal to zero. 1A pitied skewed ssbution i characte by many utes in the uppe eon, right + A regal seved dsbuton has 0Tiled tea: es whether valu is diferent fiom another value. For example Hy y= Overs Hy we ‘Type I and Type II Errors “Typed err Rejection ofthe nul hypothesis when iis actualy tre. The significance lee is the probability of making a Type lear Type Il exo. Flue eject the null hypothesis when itis actualy fale. The power 4 tris one minus the probaly of making a Typell eno. ‘The Binomial Distribution Evaluates random variable with wo posible outcomes ove a sete of wal. The probability of succes on ech ial equal: po = {umber of ways to choot from a) — p)"* Fora binomial nndom varie: expected value= np vafnee = mp(l—p) ‘The Poisson Distribution Poisson random variable X ees to the number of saccees per unit. The parameter lambda (X) refers vo the average numberof success per unt For the disbucon, both ee mean and vatiance are equal tothe paramett Mem PX=2)= Simple Linear Regression YinB,+B,xX,+6, whet: Y, = dependent or explained variable X, = independent or explanatory variable 8, = imecep coef B= slope coefcene Total Sum of Squares Fo the dependent viable in a represion mode, theres total sm of quaes (TSS) around the sample mean, total sum of quares = explained sum of squares + sum of squared residuals TSS = ESS «SSR Dou De-W Dou Coefficient of Determination Represented by R?, itis a measure of the scan esa ga pn ESS Ts ethan ete serene of isc cation octane (errs X tnd, te lon poe ee eve Linear Regression Assumptions * Alina relatonsip cts beween the dependent tnd te independen able. + Theindependent vale is uncoreltd withthe +The expected vale ofthe ror emis, + The vatane of he ror em constant forall independent vals + No seal conraton ofthe eor ems. + The mode is corey specified (does nor omit variables) Regression Assumption Violations ecrrkedsict occurs when the variance ofthe revi not the same acros all observations in the sample ‘Mukiclineeriy refers tothe condition when two cor more ofthe independent variables, o linear combinations ofthe independent variables, in multiple regression ae highly corelated with cach other. Seal corlavion refers to the seston in which the residual terms are correlated with one another. Standard Error of Estimate (SEE) Measuces the degre of varisility ofthe staal Yaalues relative ta the estimated Y-vahes from 4 regression equation. The SEE gauges the “t" ofthe regression line. The smaller che standard ‘ero; the better the fi ‘Multiple Linear Regression Asinple egesions the two-variable regesion with one dependent variable, Y, and one independent vaiale, X.A multivariate mreaion has more than one independent variable 9 +B, XX +B) Xp +E, ‘The F-statistic “The Ftatisicallows fr the vesting ofthe joint hypothesis that multiple slope coefficients equal ‘ero, Ie can be calculated 35: Adjusted R-Squared “AdjnedR? i acd wo analyze the importance of fan added independent variable ro a epresion, adjusted R?=1= = R?) ak EWMA Model ‘The exponentially weighted moving average (EWMA) model assumes weights decline exponentially back through time. This sumption reals in a specific relationship for variance in the mode: of =X + 0h, Soo Sasi (Gemecn so andone) High values of \ will minimize the effec of daily percentage returns, whereas low vals of wil tend wo increase the efecto daly peeenage recuns on the cutentvolaity estimate ARCH Model AGARCH(,1) model incorporates the most recent esimates of variance and squared return, bt also a variable chat accounts for lange-eun average level of variance. oh =u tard, +Boh.4 ‘a. = weighting on previous period's return weighting on previous volatility estimate weighted long-run vatiance long-run average variance +8<1 for stability i-a-6 “The EWMA is nothing othe than a speci case of GARCH(1.) volatility proces, wich = 0 ae l-dvandB =X The sum a+ is called the perisenc, and ifthe ‘model isto be stationary overtime (with evesion to the mean), che sum must be les han ve Monte Carlo Simulation Sup I: Choose a stochastic proces and it paramcten (eg, an approximation w Brownian motion), ‘Sup 2: Generates pseudosequence of random ‘aviables (using aandom number generator oF bootstrapping) and use these inputs to the model simulate price path ‘Sue 3 Calelae thease value foe this price pach at the end ofthe investment horizon Sec 4 Rn lage numberof rations of steps 2and aL VE EU Ce Ly PRODUCTS Futures Market Participants “Hedge lock-in a fined pice in advance, Spent: accept the pice sk hat hedges ate unwilling to beat, Avbirageurtsnerested in markt ineciencies brain less profit Option and Forward Contract Payofs ‘The payoff on all option tothe option buyers calculated as follows: C,=max(0, $,-X) The price paid for the cll option, Cis feed toasthe all premium. Thus, he profit othe option buyer is calcuated a follows profir= C.-C, The payoff on a pu option i calculated a follows Ps max(0,X-5)) “The payoff to a long psion ina forward contac iscaleulaed a allows aol =S, where: spt price at matutiny K = dalvery price Basis “The bats ina hedge defined athe diffrence brerween the spor price ona hedged act and the future pice ofthe hedging instrument (eg fatuzes contra), When the hedged set and the se underlying the hedging insument ate the same, the basis wil be zto at maturity ‘Minimum Variance Hedge Ratio "The hedge ratio minimizes the variance ofthe ‘combined hedge position. Ths is als the beca of spor prices with respect co Futures contact prices. teks ye * Hedge Effectiveness “Measutes the variance thats reduced by implementing the optimal hedge. This cffecivness can be evaluated with a coefficient of determination (R?) term where the independent variable is the change in futures prices, nd the dependent variable isthe change in spc prices.Hedging With Stock Index Futures porrfolio value futures price x ccontrace multiplier Adjusting Portfolio Beta If he bea of the capital asset pricing models used asthe systematic risk measure, chen hedging bolls down toa reduction ofthe portfolio beta. # of contracts = (anger beta— portfolio ber) Pomtolio vale. undedying asset, Forward Interest Rates Forward rates ae interest rates implied by the spor curve fora specified Future period. The forward rte berween T, and T, can be calculated # of contracts= (bp x| RoI -RiT, Boh 2 +R -a»{ 3] 7-7 Forward Rate Agreement (FRA) Cash Flows ‘An FRA ie forward contac obligating two patties o agre hata cereain interes ete will apply to principal amount duing a specified future ime. The cash low of an FRA that promises the receipe or payment of Ri ‘ash low (if receiving Rx) = TxiRy “Rx Tt athflow Gf paving Ry) = Lx(R-Rq)»(T3— 1) where LS principal annualized rate on L annualized accual rate time j expressed in years Cost-of-Carry Model Forward pice when underlying asset does not have cath lowe: R=Se7 Forward price when underlying asset has cash flow: Fy=Gy—DeT Forward price with continuous dividend yield) Hast Forwatd price with storage costs: Foe asthe Fy = Gy + UT oF = Se Forward pice with convenience yield Rose Forward foreign exchange rate sng interest rte parity (RP): Bose Arbirge: Remember to buy lo, sll high “+ If Fy > Sye™, borrow, buy spor, sll forward today deliver set repay lan tend IF Fy max(Xe"T —$,,0) Rules for Exercising American Options + Tes neve opcimal exerci an American cll ona non-dividend paying ack before is expntion cate + American prs can be optimally exerced eaey if they ae sulin n-the-money + An American cll on dividend-paying stock may be exeried erly ifthe dividend exceeds the amount of forgone intrest. Put-Call Parity p+Sp=ctXe"T Covered Call and Protective Put Covered call Long stock pus shor cal Proective pur Long stock plus long, put. Also YTM, bond price will be greater than par value: premium bond. [feoupon rate < YTM, bond price will be les than par value: dicount bond fcoupon rate = YTM, bond price will be equal to parvalue: par bond. Dollar Value of a Basis Point The price value ofa basis point (PVBP) or the dollar value of basis poine (DVO) isthe absolute change in bond price from a one bass point change in yield DVO1 =| price at YTM — price at YTM, | YTM, = YTM one basis point bove or below YTMp DV01 Hedge with Options (option value) DVOl(option position) = ‘DVOI(bond postion) x (bond value) Effective Duration and Convexity Duration: fst deivave ofthe prcelyeld relationship; most widely used measure of bond price volatility the longer shorter) che duration, the moe (es) sensi the bond! price to changes in interes rates can be used for linar estimates of bond price changes. BV_ay ~BVeay fective duratios 2BVy Ay Convevty measure ofthe degree of curvature (Gecond derivative) ofthe priceyield relationship; accounts for eror in price change esimates fom duration. Convexity always ha favorable impact on bond BV_g, +BV,, BVo x Ay? Bond Price Changes With Duration and Convexity percentage bond price change = duration effect + convexity effect convexity AB 1 2 SF =~ uration Ay +5 xconveniyx y* Bonds With Embedded Options allable boa issuerhas the right buy back the bond inthe future a a sex price; as yields fal, bond is likely eo be called: prices wll se ata decreasing rate—negative convey Putable bend: bondbolder has the right to sll bond back tothe issuer at a set pric. Binomial Option Pricing Model ‘A one-step binomial mode is best described within aurworstate world where the price of a stock wil either go up once or down once, and the change will occur one step ahead atthe end of the holding petiod Inthe tae-peried binomial model and mult petiod models, the tree is expanded to provide for a greater numberof potential outcomes Siep 1: Calealate option payofls tend in all sates. ‘Siep 2 Calculate option Vales using risk-neutral probabilities. sizeof up mov size of down move =D 3 ©" U-D Sup 3: Discount ro today wsing rikfie rate Black-Scholes-Merton Model XNG))—XeFTNG,) HN (-d2)—S)Nd) S+fet05xo%fer oxiT time to maturity asset price cereise price cfree rate stock return volailicy cumulative normal probability ele: estimates the change inva for an option for aonc-uni change in stock pric. + Call deka berweenO and +1; nese as tok + Cal del eer 0 for faroueof the money lls lose to 1 for dep inthe-money ells + Purdetaberween =I and Ot ineresies fom —1 100 as rock rice increase + Pardee one 0 for fr ou-ofhe-money puts close t~1 for deep in-the money pus. + The deka of forward contact equal 1 1+ The dla of furore contrac is gual 0+ When the weyng ae pay a dividend the dela mus be adja dividend yi xi, dela ofl equal ex N(), dof pur equals ex IN(d) =I, dla of forward equa and dela cf fires equal €, Ther sie decay change in value ofan option fora one unt change in time; mos negative when option is at-the-money and dose to cxpiation. Gama ate of change in dle underlying crock price changes largest when option is aahe- sone Vege: change in value of an option fra one-unit «hang in voaily legs when option i a- themoney ose oO when option i deep in- or utofthe- money. ‘Bbe:sestvy of options pric to changes inthe tsk ate; large for in-the money options Delta-Neutral Hedging + To comple hedge ong ocho cal poston, purchase sare of wack qual wo deka x umber of options sod. Only appropriate fr small change in the value of the undedying ase. Gama can correct hedging err by protecting span large moverents a set pc. Garant potions ae ected by entching ortolo gamma with an ofeting optom postion. ‘Value at Risk (VAR) Minimum amount one could expect wo oe with a given probably over a specif peiod of time. VAR(X%)= 2390 Use the square 0 of ime to change daly 0 ‘monthly or annual VAR VAR(X®) an = VARCKY dy VF VAR Methods ‘The delta-normal method (a.k.a. the variance- covariance method for estimating VAR requires the astumption of «normal dtibution, The rncthod ules the expected return and standard deviation of eeurns “The historical simulation meted for eximating ‘VAR uses historical dia or example, 0 calealte the 5% daily VAR, you accumulate a numberof pst daly reruns, rank the retune from highest to lowest, and then identify the lowest 59% of rer “The Monte Care simulation method lee co computer sofware that generates many posible outcome from the disribuion of Inputs specified by the wer. All ofthe examined portfolio resume wil form a dissibuion, which vil approximate the noomal disbution, VAR i then eluted inthe sme way a withthe dlt- oral method Stress Testing. YAR tel the probably of exceeding given loss ‘but fails to incorporate the possible amount of a Jos that esl from an exteme amount. Se eng complements VAR by providing information about the magnitude of loses that ‘may oscur in extreme market conditions Expected Shorefall (ES) * Arrage or expected vale fl lowes greater han the VAR Ely > VAR + Popular easier epor along with VAR. + ESis alo known as conditional VAR or expected sai los + Unlike VAR, ES has the bili to sai the propery of subadeiiiy. Linear vs. Nonlinear Derivatives * A detvative i decibed elmer when the ‘eationhip eoween an undeying factor andthe derivate’ vale re near in aaa. VAR, = AVAR, + Anontnarderiratives vale i function ofthe change in the value ofthe undying se nd is dependent onthe ate of the undying ase. Operational Risk Operational sis defined at: “The rik of direct and indirect loss resulting from inadequate or filed ime pea, peopl and eno fom Operational Risk Capital Requirements asc indictrepproac: capital charge measured on a frmwide bts at a percentage of annual gos + Stndardized approach banks divide activin among basis lines capital charge = sum for cach busines ln. Capital foreach busines line decrmined with bes factor snd anal gross + Advanced measurement approach baaks ws het own methodologies for aesing operations fic Capital locations Based on the banks opertionl VAR. Loss Frequency and Loss Severity Operational sk losses ae cased along two independent dimensions: Los frequen: the number of losses over specific time peed (typically one year). Often modeled with the Pozon dcribaion a diseibution that ‘models random evens) Loss orig vale of Sania os sured. ‘Ofen modeled with the lognormal distribution (distribution is asymmetrical and has fat tals). Classifications of Operational Risk High frequency low-severty (HFLS) rks occu feequeney bu resale in small asses. Low-fiequeny bigh-sevrty (LEHI) sss ate the greats are of concer for operational rk managers Because hey are rare, there ide svilbl data to analyze sch rhs, and their cot othe frm could be catastopic. ‘Top-Down and Bottom-Up Models Top-down mode examines aggregite impact cof operational flrs, macro view: lis on historia data + Advantages simple to ue, not dat intensive. + Disadvantages doesnot dtingush berween HELS evens and LFHS evens cannot dagnose specie area of wekne; backward looking PN: 32000730 IsBN-13: 9781427730947 ISBN-10. 1427730046, 9!781427!'730947! Us. $4940 ©201 Kaplan, in. Al Rights es Botom-up mode soalyaes si individual 1 eta isioglshes brween HLS events sand LFHS events can diagnose weds in procedures and spges cotectins forward looking + Disadvantages: complex and dts nts. Methods for Hedging Operational Risk + Insurance SeFinsurance. + Desvtive ects Catastrophe Options and Bonds Ga options: publly waded; pay linked ro index (i. underweting oss inthe insurance industry); spread option that has limited upside. Cat bonds bond contract with embedded ‘options cae can be rigged by internal events, ‘external events, othe value ofan index. Internal Credit Acche pine approach goal isto predic he cede. ‘quality over a elatvey short hotzon ofa few months of, more generally, a yest. Through-the-oele approach: focuses ona Jonge ime horizon and includes the ects of forecasted jes. Contingent Claims Analysis (OCA) + Acontngeat chim is any nancial ase whore fucare ayo depends onthe vale of another undelyingaset ot proces + When dealing with cei rit CCA is commonly known athe Meron model + CCA\isable wo caprate the tue economic risk fa sovereign enti Merton Model + Valiebasedl model, wher the value of he Bem’ outstanding debt (D) and equity (E) are eq the vale ofthe Semi ast (V. Given an eimate of anyewo ofthe hee vals (V,E,0rD), we know the vale ofthe tied ‘component. Can be sed to vale the contingent claim on sovereign’ local currency lblts. Expected Loss ‘The expected lo (EL) represent the decrease in value of an asset (portfolio) with a given exposure subject to a posiive probability of deal. ‘expected loss = exponute xls given default « probably of default expected los «adjusted exposute los given default x EDF, ‘Outstandings and Commitments Ouztandings (OS) denote the credit extended 9 the borrower through bonds, loans, or receivables ve. “The commitment (COM) represents the total amount che bank is prepared ro lend vo the borrower (commitment » oustanding + unused portion of commitment “adjusted exposure (AB) = OS + wage given defo COM, Unexpected Loss Unexpected los represents the variably of potential losses and can be modeled using the definition of standard deviation. UL= Abx {EDFxafgp + UGD? xobpe