II. 1. A. Market Risk II. 1. B. Foreign Exchange Risk II. 2. A. Bond Prices, Discount Factors, and Arbitrage II. 2. B. Bond Prices, Spot Rates and Forward Rates II. 2. C. Yield-To-Maturity (YTM) II. 2. D. Generalizations and Curve Fitting II. 2. E. One-Factor Measures of Price Sensitivity II. 2. F. Measures of Price Sensitivity Based on Parallel Yield Shifts II. 2. G. Key Rate and Bucket Exposures II. 2. H. The Science of Term Structure Models II. 2. I. Mortgage-Backed Securities II. 3. A. Mechanics of Futures Markets II. 3. B. Interest Rates II. 3. C. Determination of Forward &Futures Prices II. 3. D. Swaps II. 3. E. Mechanics of Options Markets II. 3. F. Properties of Stock Options II. 3. G. Trading Strategies Involving Options II. 3. H. Introduction to Binomial Trees II. 3. I. The Black–Scholes Model II. 2. J. The Greek Letters II. 3. K. Volatility Smiles II. 3. L. Exotic Options II. 4. A. Implementing Delta-Normal VAR 3 9 13 16 20 24 26 33 36 40 43 47 50 58 65 73 75 78 82 85 93 100 103 112
Section II.1 (1)
II. 4. B. Simulation Methods II. 5. A. Introduction to VAR II. 5. B. Putting VAR to Work III. 6. A. The Delta-Normal Method for a Fixed Income Portfolio II. 6. B. Stress Testing II. 6. C. Decomposing Risk II. 6. D. Aggregating and Decomposing the Risks of Large Portfolios II. 6. E. Extreme Value Theory and VAR II. 7. A. A Firm-Wide Approach to Risk Management II. 7. B. Identifying and Managing Cash Flow Exposures II. 7. C. The Demand and Supply for Derivative Products II. 8. Commodity Forwards & Futures
116 122 128 132 135 138 140 144 148 153 159 163
Section II.1 (2)
II. 1. A. Market Risk
1. Describe five reasons why market risk measurement is important 2. List the models being used to calculate market risk exposure
• • • Daily earnings at risk: Market risk exposure over 24 hours Horizontal offsets: Additional capital charges assigned to instruments with different maturities that neither (perfectly) hedge nor correlate Vertical offsets: Additional capital charges assigned to long & short positions of different instruments (but in the same maturity bucket) that are imperfect offsets
Investment vs. Trading Book
A trading portfolio differs from an investment portfolio by: (1) time horizon and (2) liquidity. The trading portfolio is quickly traded on exchanges. The investment portfolio or “banking book” contains assets and liabilities that are relatively less liquid and held longer. The trend is toward increased securitization and more liquid (more tradable) assets.
Market Risk Measurement (MRM)
AIM: Describe five reasons why market risk measurement (MRM) is important 1. MRM gives senior managers information about risk exposures. 2. MRM helps set logical position limits. 3. Resource allocation: Because it compares return-versus-risk across asset classes, helps allocate capital effectively. 4. Performance evaluation: Rather than pay traders merely for taking on more risk, considers the return-risk ratio, and therefore helps for more rational compensation scheme. 5. Regulation: Because regulations may tend to over-price some risks, the use of internal models may lead to superior capital allocation.
Section II.1 (3)
Three Types of Market Risk Models
AIM: List the models being used to calculate market risk exposure Three market risk models are the RiskMetrics model; the historic (or back simulation) model; and the Monte Carlo simulation. 1st Model: RiskMetrics Model for Daily Earnings at Risk (DEAR) Market risk, as defined by daily earnings at risk (DEAR), has three components:
Daily Earnings at Risk
Dollar Market Value of Position Dollar Market Value of Position
Price Sensitivity of Position
Potential Adverse Yield Move
Daily Earnings at Risk
DEAR: Market Risk of Fixed-Income Securities
Daily Price Volatility = (-MD) x (Adverse daily yield move)
DEAR = (Dollar value...