Management of Financial Risk

FM202
Analysis and Management of Financial Risk
Georgy Chabakauri Cameron Peng
London School of Economics

Summer School 2018
© (2018) Chabakauri & Peng – 1

⊲ Administrative Details
Description
Instructors
Assessment
Readings
Topics
Topic 1: Foundations
Topic 2: Hedging in equity
and fixed income markets
Topic 3: Endogenous risk
and limits to arbitrage
Topic 4: Value at Risk

Administrative Details
Topic 5: Credit risk
Topic 6: Credit derivatives
and asset-backed
securities
Topic 7: Regulation and
the credit crisis

Course description
⊲ Description
This course gives an introduction to the analysis and management of
Instructors risk in the context of financial institutions.
Assessment
Readings
Topics
First, we will discuss risk on portfolios of options and fixed income
securities and their derivatives.
and limits to arbitrage We will talk about merits and shortcomings of risk measures, cover
Topic 4: Value at Risk endogenous risk and limits to arbitrage.
and asset-backed
Then we will talk about credit risk, the modeling of credit risk, and
securities
credit derivatives.
the credit crisis
The final topic will cover regulation and the credit crisis.

Contact information
Description
Lecturers:
⊲ Instructors
Dr Georgy Chabakauri
Assessment
Readings g.chabakauri@lse.ac.uk
Topics
http://personal.lse.ac.uk/chabakau/
and fixed income markets Dr Cameron Peng

and asset-backed
securities
the credit crisis

Assessment
Description
2 hour written midterm examination on Wednesday, July 18 (40%)
Instructors
⊲ Assessment
Readings 2 hour written final examination on Friday, July 27 (60%)
Topics
Calculators allowed for the exams
and limits to arbitrage Lecture notes and additional course material will be posted on Moodle

and asset-backed
securities
the credit crisis

Recommended readings
Description
John Hull: Risk Management and Financial Institutions, Wiley,
Instructors 2015, 4th edition
Assessment
⊲ Readings
Topics Michel Crouhy, Dan Galai and Robert Mark: Risk Management,
Topic 1: Foundations McGraw Hill, 2001
Philippe Jorion: Value at Risk, McGraw Hill, 2007, 3rd edition
all about VaR, very easy read

John Hull: Options, Futures, and Other Derivatives, Pearson, 2011, 8th
and asset-backed edition
securities
the standard textbook for options and derivatives
the credit crisis
Jón Danı́elsson: Financial Risk Forecasting, Wiley, 2011

good reference for practical implementation of risk forecasts
Zvi Bodie, Alex Kane and Alan Marcus: Investments, McGraw Hill,
2014, 10th edition

Course topics
Description
Instructors
Assessment
Readings
⊲ Topics Topic 2: Hedging in equity and fixed income markets
Topic 3: Endogenous risk and limits to arbitrage
Topic 5: Credit risk Topic 4: Value at Risk

and asset-backed
securities
Topic 7: Regulation and Topic 5: Credit risk
the credit crisis
Topic 6: Credit derivatives and asset-backed securities
Topic 7: Regulation and the credit crisis

Description
Risksharing and aggregate risk
Instructors
Assessment
Readings
⊲ Topics Basic principles of diversification and hedging
The Capital Asset Pricing Model
Topic 5: Credit risk Why manage financial risk?

and asset-backed
securities
Topic 7: Regulation and Types of financial risks
the credit crisis
Overview of financial instruments
Risk management failures and key lessons

Topic 2: Hedging in equity and fixed income markets
Description
The Black-Scholes formula and the Greeks
Instructors
Assessment
Readings
⊲ Topics Dynamic replication, delta hedging and portfolio insurance
Practical issues and risk management of option portfolios
Topic 5: Credit risk Measurement and hedging of interest rate risk, duration and convexity
and asset-backed
securities
the credit crisis

Description
Endogenous and exogenous sources of risk and the Millenium Bridge
Instructors
Assessment
Readings Portfolio insurance and the 1987 stock market crash
⊲ Topics
Mortgage-backed securities hedging and interest rate volatility
and limits to arbitrage Carry trades
Topic 5: Credit risk Market efficiency and empirical challenges

and asset-backed
securities
Noise trader risk
the credit crisis
Outside capital and limits to arbitrage
The technology “bubble”

Description
Statistical properties of asset prices and volatility modeling
Instructors
Assessment
Readings
⊲ Topics Risk measures and definition of Value at Risk
Implementing risk forecasts
Topic 5: Credit risk Backtesting and stress testing

and asset-backed
securities
the credit crisis

Description
Ratings based models and Credit Value at Risk
Instructors
Assessment
Readings
⊲ Topics Structural form models and credit risk on portfolios
Reduced form models

and asset-backed
securities
the credit crisis

Description
Credit default swaps
Instructors
Assessment
Readings
⊲ Topics Securitization
Collateralized debt obligations
Topic 5: Credit risk Mortgage-backed securities

and asset-backed
securities
the credit crisis

Description
Originate & distribute and the housing bubble
Instructors
Assessment
Readings
⊲ Topics The credit crisis
Existing regulation and proposals for regulatory reforms
Topic 5: Credit risk Basel III and Dodd-Frank

and asset-backed
securities
the credit crisis

⊲ Topic 1: Foundations
Risksharing
Risk and diversification
CAPM
“Time diversification”
Risk management
Classification
Financial markets and
instruments
Failures

and asset-backed
securities
the credit crisis

Outline
Risksharing
Risk and diversification Risksharing and aggregate risk
CAPM
Risk management
Classification Basic principles of diversification and hedging
instruments
Failures
The Capital Asset Pricing Model
Why manage financial risk?

and asset-backed
Types of financial risks
securities
the credit crisis Overview of financial instruments
Risk management failures and key lessons

Hedging, risk sharing and aggregate risk: Examples
Three individuals:
⊲ Risksharing
Risk and diversification Entrepreneur 1
CAPM
“Time diversification” – wealth = 100 if project succeeds
Risk management
Classification
Financial markets and – wealth = 0 if project fails
instruments
Failures Entrepreneur 2
– wealth = 100 if project succeeds

– wealth = 0 if project fails
Topic 5: Credit risk Entrepreneur 3
and asset-backed
securities
– wealth = 50
the credit crisis

Example 1: No aggregate risk
Suppose that
⊲ Risksharing
CAPM
entrepreneur 1 succeeds if and only if entrepreneur 2 fails and
Risk management
Classification each of the two states occurs with probability 1/2.
instruments
Failures
Topic 2: Hedging in equity s f
Entrepreneur 1 100 0
and asset-backed
securities
the credit crisis

Example 1 (cont.)
Entrepreneurs 1 and 2 can hedge their risk by buying stakes in each
⊲ Risksharing other’s firms.
CAPM By exchanging 50% stakes in each other’s firms, the following final
Risk management
payoffs are obtained:
Classification
instruments s f
Failures
and fixed income markets Entrepreneur 2 50 50
and limits to arbitrage Entrepreneur 3 50 50

In this case perfect risksharing is possible: the risk borne by each
Topic 6: Credit derivatives individual can be eliminated completely through financial transactions.
and asset-backed
securities
An equivalent way of achieving this outcome is through trade in state
the credit crisis contingent claims.
A state contingent claim or Arrow-Debreu security is a security that
pays out 1 if a given state of nature occurs and 0 otherwise.

Example 2: Aggregate risk
Now, entrepreneur 1’s project is independent of entrepreneur 2’s
⊲ Risksharing project:
CAPM (s,s) (s,f) (f,s) (f,f)
Risk management
Entrepreneur 1 100 100 0 0
Classification
instruments
Failures
Topic 3: Endogenous risk Suppose that entrepreneurs 1 and 2 trade 50 contingent claims for

states (s,f) and (f,s) at a rate of one for one.
This allows them to share some of the risk and achieve the following
and asset-backed
securities
allocation:
the credit crisis
(s,s) (s,f) (f,s) (f,f)

Example 2: (cont.)
Entrepreneurs 1 and 2 alone cannot reduce risk any further (they have
⊲ Risksharing the same allocation).
CAPM
Risk management
In order to achieve further reduction in risk, they must bring in
Classification
entrepreneur 3.
instruments
Failures
However entrepreneur 3 has a perfectly safe portfolio.
Topic 4: Value at Risk Assuming that entrepreneur 3 is risk averse, entrepreneur 3 will only
Topic 5: Credit risk accept to bear some risk if the state price for state (f,f) is higher than
and asset-backed
the state price for state (s,s).
securities
the credit crisis

Example 2: (cont.)
Suppose there is some number λ > 1 such that an exchange rate of λ
⊲ Risksharing state (s,s) tickets for one state (f,f) ticket is acceptable to all
CAPM
individuals for a transfer by entrepreneur 3 of n state (s,s) tickets each
“Time diversification” to entrepreneur 1 and entrepreneur 2.
Risk management
Classification
instruments
Then the final allocation is:
Failures
Topic 2: Hedging in equity (s,s) (s,f) (f,s) (f,f)
Entrepreneur 1 100−λn 50 50 n
Entrepreneur 2 100−λn 50 50 n
Entrepreneur 3 50+2λn 50 50 50−2n
and asset-backed
securities In the final outcome, everyone bears some risk.
the credit crisis
Entrepreneur 3 is compensated for bearing some risk by getting an
expected payoff that is larger than 50.
There is a limit to risksharing when there is aggregate risk.

Quantifying risk
Common wisdom: “The greater the risk, the higher the (potential)
Risksharing return.”
⊲ Risk and diversification
CAPM
“Time diversification” Hence, trade-off between risk and return.
Risk management
Classification
instruments One way of quantifying risk: Volatility (standard deviation) of returns.
Failures
and fixed income markets Characterize investments by their (expected) return and the standard
deviation of returns.
Topic 5: Credit risk Using a universe of assets, finding the highest expected return for a
and asset-backed
given level or risk leads to the efficient frontier (Markowitz, 1952).
securities
the credit crisis

Mean-variance example: 2 assets
Two individuals 1, 2
Risksharing
Endowments {xi } for i = 1, 2
CAPM
Risk management
Classification – mean payoff µi
instruments
Failures
– variance of payoff σi2
– where µ1 = µ2 = µ and σ12 = σ22 = σ 2
Topic 5: Credit risk Suppose that the two individuals pool their endowments by creating a
and asset-backed
mutual fund. Each individual holds a half share of the mutual fund.
securities
the credit crisis

Mean-variance example: 2 assets (cont.)
The expected payoff for each individual is still µ.
Risksharing
But the variance of the payoff for each individual is now given by
CAPM
Risk management
Classification

Financial markets and 1 1 1 1 11
instruments V ar x1 + x2 = V ar(x1 ) + V ar(x2 ) + 2 cov(x1 , x2 )
Failures 2 2 4 4 22
1 1
= σ 2 + cov(x1 , x2 )
2 2
1
Topic 4: Value at Risk = σ 2 (1 + ρ)
Topic 5: Credit risk 2
and asset-backed
≤σ 2
securities
the credit crisis
where ρ denotes the correlation coefficient between x1 and x2 .

Mean-variance example: 2 assets (cont.)
Limit case 1: ρ = 1
Risksharing
⊲ Risk and diversification 1 1
CAPM V ar x1 + x2 = σ2
“Time diversification” 2 2
Risk management
Classification
Financial markets and In this case there is no benefit to diversification/risksharing.
instruments
Failures Limit case 2: ρ = −1
Topic 3: Endogenous risk 1 1
and limits to arbitrage V ar x1 + x2 =0
2 2
In this case the variance of the payoff from the mutual fund is reduced
and asset-backed
securities
to 0.
the credit crisis

Mean-variance example: n assets
Now suppose that there are n individuals and let xi be the endowment
Risksharing of the ith individual.
CAPM Suppose that the endowments have identical means µi = µ and
Risk management
identical variances σi2 = σ 2 .
Classification
instruments
Suppose that any two endowments have the same correlation ρ.
Failures
Individuals pool their endowments to form a mutual fund, with each
and fixed income markets individual holding equal shares.
Expected payoff on the mutual fund:
Topic 5: Credit risk n

! n
1X 1X 1
and asset-backed E xi = E(xi ) = nµ = µ
securities n i=1 n i=1 n
the credit crisis

Mean-variance example: n assets (cont.)
Variance of payoff on the mutual fund:
Risksharing !  
⊲ Risk and diversification n n
CAPM 1X 1 X X
V ar xi = 2
V ar(xi ) + cov(xj , xk )
Risk management
n i=1 n i=1 j6=k
Classification
1 2 2

instruments
= 2
nσ + n(n − 1)ρσ
Failures
n
and fixed income markets 1 2 1
Topic 3: Endogenous risk = σ + 1− ρσ 2
and limits to arbitrage n n

Topic 6: Credit derivatives As n becomes large, the variance of the payoff goes to ρσ 2 . In the
and asset-backed
securities special case where ρ = 0 and there is a large number of assets, all the
the credit crisis
risk can be diversified away. When ρ = 1, all risk is systematic and
there is no benefit to diversification. Note that the case where ρ = −1
cannot exist (it can be shown formally). It is simply not possible to
construct a very large number of random variables that are, on average
negatively correlated with each other.

Mean-variance portfolio choice
Three assets: two risky, one risk-free
Risksharing
Portfolio consisting of
CAPM
“Time diversification” – a1 of asset 1
Risk management
Classification – a2 of asset 2
instruments
Failures – (1 − a1 − a2 ) of risk-free asset (possibly negative)
and fixed income markets The objective is to maximize
1
Topic 4: Value at Risk U = E(r) − V ar(r)
2τ
and asset-backed where r denotes the return on the portfolio and τ is a parameter
securities
measuring the investor’s risk tolerance.
the credit crisis

Mean-variance portfolio choice (cont.)
Unlimited borrowing and lending at risk-free rate r0
Risksharing
Let ri denote the return on asset i, i = 1, 2
CAPM
Risk management
Classification Let µi = E(ri ), σi2 = V ar(r), and σ12 = Cov(r1 , r2 )
instruments
Failures
Then
1 2 2 2 2

U = (1 − a1 − a2 )r0 + a1 µ1 + a2 µ2 − a σ + a2 σ2 + 2a1 a2 σ12
2τ 1 1
1 2 2 2 2

Topic 5: Credit risk = r0 + a1 (µ1 − r0 ) + a2 (µ2 − r0 ) − a σ + a2 σ2 + 2a1 a2 σ12
2τ 1 1
and asset-backed
securities
the credit crisis

First order conditions:
Risksharing
⊲ ∂U 1
= (µ1 − r0 ) − (a1 σ12 + a2 σ12 ) = 0
CAPM
∂a1 τ
Risk management ∂U 1
Classification = (µ2 − r0 ) − (a2 σ22 + a1 σ12 ) = 0
Financial markets and ∂a2 τ
instruments
Failures
Topic 2: Hedging in equity This gives us a system of two equations with two unknowns: a1 and a2
In matrix notation:

Topic 5: Credit risk µ1 − r 0 1 σ12 σ12 a1
=
and asset-backed µ2 − r 0 τ σ12 σ22 a2
securities
the credit crisis

The optimal portfolio weights are given by
Risksharing −1
⊲ Risk and diversification a1 σ12 σ12 µ1 − r 0
CAPM =τ
“Time diversification” a2 σ12 σ22 µ2 − r 0
Risk management
Classification
Financial markets and Provided that the variance-covariance matrix is non-singular.
instruments
Failures
It follows that, regardless of their degree of risk tolerance, all investors
Topic 3: Endogenous risk hold the two risky assets in the same proportions: a1 /a2 does not
depend on τ .

This is a special case of the Mutual Fund Theorem (Tobin, 1958)
and asset-backed
securities
the credit crisis

Mean-variance portfolio choice: Example 2
Suppose
Risksharing
µ1 = 0.1, µ2 = 0.05, r0 = 0.02 (annual)
σ12 = σ22 = 0.04 (annual volatility of 20%)
CAPM
Risk management
Classification σ12 = 0.037 (ρ = 0.037/0.04 = 0.925)
instruments
Failures τ = 0.25
Topic 3: Endogenous risk Remember Cramer’s rule:
a b
Topic 4: Value at Risk Suppose A = and let det(A) = ad − bc 6= 0
Topic 5: Credit risk c d
and asset-backed 1 d −b
securities then A−1 = ad−bc
−c a
the credit crisis

Mean-variance portfolio choice: Example 2 (cont.)
For this example, the optimal portfolio weights on the two risky assets
Risksharing are given by
CAPM −1
“Time diversification” a1 0.04 0.037 0.08 2.2619
= 0.25 =
Risk management
Classification
a2 0.037 0.04 0.03 −1.9047
instruments
Failures → the investor sells short asset 2.
and limits to arbitrage The optimal weight on the risk-free asset is given by
Topic 5: Credit risk 1 − a1 − a2 = 0.6428

and asset-backed
securities → 64% of initial wealth is held in the safe asset.
the credit crisis

You can solve without matrix algebra, just by solving the system of two
Risksharing equations with two unknowns:
CAPM
“Time diversification” 0.04a1 + 0.037a2 = 0.25 × 0.08,
Risk management
Classification 0.037a1 + 0.04a2 = 0.25 × 0.03.
instruments
Failures Solving this system of equations we obtain a1 = 2.2619, a2 = −1.9047.

and asset-backed
securities
the credit crisis

Expected return on the portfolio:
Risksharing
⊲ Risk and diversification r0 + a1 (µ1 − r0 ) + a2 (µ2 − r0 ) ≈ 0.144
CAPM
Risk management
Classification
Financial markets and Variance of portfolio return:
instruments
Failures
Topic 2: Hedging in equity a21 σ12 + a22 σ22 + 2a1 a2 σ12 ≈ 0.031
Topic 4: Value at Risk Volatility of portfolio return ≈ 0.176

and asset-backed The expected return on the portfolio is higher than either of the two
securities
risky assets, while the volatility is lower than either of them.
the credit crisis

Efficient frontier with N stocks
Formally, the problem of finding the efficient frontier of n-stock
Risksharing portfolios is as follows:
v
CAPM uN N
“Time diversification” uX X
Risk management
σp = min t wi wj σi σj ρij
Classification w1 ,w2 ,...wN
Financial markets and i=1 j=1
instruments
Failures
Topic 2: Hedging in equity subject to:
w1 + · · · + wN = 1,
Topic 4: Value at Risk w 1 µ1 + · · · + w N µN = µp

Investor achieves minimal risk for given expected return µp . Hence, the
and asset-backed
securities
optimal portfolio is on the efficient frontier.
the credit crisis
This optimization problem can be solved explicitly. However, this is
beyond our scope. You can use Excel solver to solve for optimal weights
wp and σp given µp .

Properties of efficient frontiers
Among all possible portfolios with a given expected return the portfolios
Risksharing on the efficient frontier have the lowest variance.
CAPM
If portfolios A and B lie on the frontier, then all portfolios that invest
Risk management w% in A and (1 − w)% in B also lie on the frontier.
Classification
instruments
Failures
Portfolios on the N -stock efficient frontier dominate the portfolios on
Topic 2: Hedging in equity 2-, 3-, . . . , N -1 stock frontiers:

and asset-backed
securities
the credit crisis

Lending and borrowing allowed
Lending or borrowing at the risk free rate (r0 ) allows us to achieve the
Risksharing returns beyond the efficient frontier, i.e. higher returns for a given risk, or
lower risk for a given return. E.g. you can lend by investing in Treasury
CAPM
“Time diversification” bills, or borrow money which is equivalent to shorting Treasury bills.
Risk management
Classification
instruments
Failures

and asset-backed
securities
the credit crisis

The Capital Asset Pricing Model (CAPM)
Developed by Sharpe (1964), Mossin (1966), Lintner (1965) and
Risksharing Treynor (1961, 1962).
⊲ CAPM
“Time diversification” Model for pricing individual securities or portfolios.
Risk management
Classification
instruments Assumptions:
Failures
and fixed income markets – Static: investors care about one-period returns.
Topic 4: Value at Risk – Unlimited borrowing and lending at the riskfree rate.
and asset-backed
– No taxes, transactions costs, or nontraded assets (e.g. human
securities
capital).
the credit crisis
– All investors use mean-variance analysis with the same estimates of

means, variances and covariances to choose their portfolio.

CAPM: Implications
Administrative Details It follows that:

Risksharing
– All investors choose a mean-variance efficient portfolio.
⊲ CAPM
“Time diversification” – All investors hold risky assets in the same proportions to each other.
Risk management
Classification
instruments
– Thus, the market portfolio must be mean-variance efficient.
Failures
The expected return on any security is related to the expected return
and fixed income markets on the market and the riskfree rate as follows:

E[ri ] = r0 + βi (E[rM ] − r0 )
where cov(ri , rM )
and asset-backed βi = 2
securities σM
the credit crisis
Hence, exposure to the systematic risk factor (the market) is priced.
Idiosyncratic risk is not priced.

CAPM: Market portfolio
Now we will characterize the supply of stocks.
Risksharing
Risk and diversification Suppose, there are N stocks in the economy and stock i has market
⊲ CAPM
capitalization (number of shares times share price) Vi .
Risk management
Classification
– Total value of all stocks in the market is V = V1 + V2 + · · · + VN .
instruments
Failures – The proportion of wealth allocated to asset i is given by:
and fixed income markets Vi
Topic 3: Endogenous risk wiM =
and limits to arbitrage V1 + · · · + VN
Topic 5: Credit risk The portfolio of stocks that has weights wiM is called market portfolio.
and asset-backed
securities Market portfolio we can approximate by S&P 500 portfolio.
the credit crisis

CAPM: Market portfolio (cont.)
Now we will characterize the demand for stocks.
Risksharing
⊲ CAPM
As we discussed, all investors hold a combination of safe asset and
“Time diversification” tangency portfolio.
Risk management
Classification
Financial markets and – If we add up all investors and consider them as a single group, this
instruments
Failures group invests in riskless asset and tangency portfolio.
– Hence, the total demand for risky assets will be represented by a
and limits to arbitrage tangency portfolio.
Topic 5: Credit risk Matching demand and supply we see that market portfolio is a
and asset-backed
tangency portfolio. Hence, the returns on market and tangency
securities
portfolios are the same:
the credit crisis rM = rT

CAPM: Proof
Proof:
Risksharing
⊲ CAPM
Starting from an initial efficient portfolio p, add a share ai of asset i, which
“Time diversification” you finance by borrowing at the riskless interest rate. This increases the
Risk management
Classification expected return on portfolio by
instruments
Failures ai (µi − r0 )
Topic 4: Value at Risk The variance on the new portfolio is given by

Topic 6: Credit derivatives V ar[rp + ai (ri − r0 )] = V ar[rp ] + a2i σi2 + 2ai Cov(ri , rp )
and asset-backed
securities
the credit crisis

CAPM: Proof (cont.)
Hence for small ai , the change in variance is approximately equal to
Risksharing
Risk and diversification 2ai Cov(ri , rp )
⊲ CAPM
Risk management
Classification
instruments
Now consider two such portfolio shifts ai and aj , and choose them in such
Failures a way that the overall variance of the portfolio is unaffected.
This requires:
Topic 3: Endogenous risk ai Cov(ri , rp ) + aj Cov(rj , rp ) = 0

and asset-backed
securities
the credit crisis

CAPM: Proof (cont.)
The resulting change in the expected return on the portfolio is given by
Risksharing
Risk and diversification µi − r 0 µj − r 0
⊲ CAPM ai (µi − r0 ) + aj (µj − r0 ) = ai Cov(ri , rp ) −
“Time diversification” Cov(ri , rp ) Cov(rj , rp )
Risk management
Classification
instruments
Failures If the original portfolio is mean-variance efficient, we must have
µi − r 0 µj − r 0
Topic 3: Endogenous risk =
and limits to arbitrage Cov(ri , rp ) Cov(rj , rp )

and asset-backed Or else it would be possible to increase the mean of the portfolio without
securities
Topic 7: Regulation and increasing its variance.
the credit crisis

CAPM: Proof (cont.)
In particular, choosing asset j to be the original portfolio, we get that for
Risksharing any asset i,
⊲ CAPM µi − r 0 µp − r 0
“Time diversification” =
Risk management Cov(ri , rp ) V ar(rp )
Classification
instruments
Failures
Topic 2: Hedging in equity Finally, we note that the market portfolio must be mean-variance efficient.
Topic 3: Endogenous risk Hence:
Topic 4: Value at Risk Cov(ri , rM )

µi − r 0 = (µM − r0 )
V ar(rM )
and asset-backed
securities where µM = E[rM ] Definition of beta:
the credit crisis
Cov(ri , rM )
β=
V ar(rM )

CAPM: Proof (cont.)
If β < 0 then µi < r0 because the asset decreases the riskiness of the
Risksharing market portfolio.
⊲ CAPM – Hence, asset is more valuable and the investors will be buying it
Risk management
even if the return is lower than on the riskless asset.
Classification
instruments If β = 0 then µi = r0 because the asset has only individual risk that
Failures
can be diversified away.
– Risks associated with this asset do not contribute to the riskiness of
the portfolio and hence investors do not require risk premium.
Topic 5: Credit risk If β > 0 then µi > r0 because the asset increases the riskiness of the
and asset-backed market portfolio.
securities
Topic 7: Regulation and – Hence, investors require higher compensation for risks.
the credit crisis

CAPM: Empirical tests
Performance of the CAPM:
Risksharing
– Unconditionally, the empirical relationship seems to be “too flat”.
⊲ CAPM Low beta stocks offer higher returns than the model would predict.
Risk management
Classification
– Size effect: small stocks outperform large stocks (relative to what
instruments
the CAPM would predict.)
Failures
Topic 2: Hedging in equity – Value effect: value stocks (low price-dividend or high
book-to-market stocks) outperform growth stocks.
Topic 4: Value at Risk – Momentum effect: stocks that have outperformed over the past year
Topic 5: Credit risk tend to continue outperforming over the short term.
and asset-backed
securities
These are really joint tests since we do not observe the true market
Topic 7: Regulation and portfolio and a stock index is only a proxy (Roll critique).
the credit crisis
Data mining?
More general model of risk and return.

CAPM: Extensions
Three-factor model of Fama and French (1993, 1996).
Risksharing
⊲ CAPM
Differences between borrowing and lending rates (Black, 1972).
Risk management
Classification Intertemporal CAPM (ICAPM) (Merton, 1973; Campbell and Viceira,
instruments 2002).
Failures
and fixed income markets Human capital and other non-tradable assets (e.g. privately held
businesses).
Topic 5: Credit risk Cashflow beta vs. discount rate beta (Campbell and Vuolteenaho,
and asset-backed
2004).
securities
the credit crisis Liquidity (Amihud and Mendelson, 1986; Acharya and Pedersen, 2005).
Stochastic Volatility (Campbell, Giglio, Polk and Turley, 2012 & Bansal,
Yaron, Kiku and Shalistovich, 2013)

Risksharing More common wisdom: Stocks are safer in the long run because of
CAPM
“time diversification”.
⊲ “Time diversification”
Risk management
Classification
The idea is that in the long run, positive and negative returns cancel
instruments
Failures
each other out.
Topic 3: Endogenous risk The “time diversification” argument is only valid if there is

mean-reversion in stock returns, i.e., returns are negatively correlated.
This means that if there is a positive return in one day, the next day, we
Topic 6: Credit derivatives expect a negative return.
and asset-backed
securities
the credit crisis

“Time diversification”: Evidence
Administrative Details Positive correlation: Research has shown that in the short run, stock
Topic 1: Foundations returns are positively serially correlated. If the S&P closed high today,
Risksharing
it will most likely be higher tomorrow, as long as there isn’t some bad
CAPM news. Conversely, if the market closed lower, it will most likely follow its
⊲ “Time diversification”
Risk management downward trend. This is how trend-followers make money. So time
Classification
Financial markets and diversification doesn’t work in the short run.
instruments
Failures No correlation: If stock prices follow a random walk, i.e. stock
and fixed income markets returns are serially uncorrelated, time diversification still does not work.
Investing over a long horizon may increase your returns over a long
Topic 4: Value at Risk time, but it also increases your risk relative to expected returns. The
Topic 5: Credit risk saying ”markets can remain irrational longer than you can remain
and asset-backed
liquid” holds true here—if prices follow a random walk and drift
securities downwards for 10 years and upwards for 12 years, your return might be
the credit crisis positive but your variance is huge.
Negative correlation: In the long run, stocks tend to exhibit
negative correlation. So time diversification does help to lower your
risk relative to expected return.

“Time diversification”: Debate
In “Stocks for the Long Run”, Jeremy Siegel states that for investment horizons of at
least 15 years, historical returns suggest that stocks produce positive real returns in
excess of both bonds and Treasury bills.
In addition, Siegel adds “it is little known that in the long run, the risks in stocks are
less than those found in bonds and even bills!”
Thus, younger investors should favor a portfolio heavily weighted in stocks to capitalize
on the equity risk premium relative to bonds and Treasury bills. Over long enough
horizons, this equity risk premium seems to be reliable.
More recently, Pastor and Stambaugh (2012) argue that it is not only the future
volatility which matters for investments but also the uncertainty about the parameters
governing returns and their volatility.
They find that even when using 200 years of data, we still cannot precisely estimate
expected returns.
While it is true that mean reversion contributes to a lower volatility in the long run,
the effect is offset by the uncertainty about parameters, especially the size of the
equity premium.
What does that imply for a buy and hold strategy?

Why manage financial risk?
Investor can diversify idiosyncratic risk away. Hence, all that should
Risksharing matter is systematic risk.
CAPM
“Time diversification” Consequentially, nonsystematic risk should be ignored when evaluating
⊲ Risk management
investment projects in order to act in the best interest of the
Classification
instruments
shareholders.
Failures
and fixed income markets Yet, for example, most companies insure against the risk of their
buildings being burnt down.
Topic 5: Credit risk In general, corporations try to avoid taking high risks and often hedge
and asset-backed
against exposures to exchange rates, interest rates, commodity prices
securities and other market variables.
the credit crisis
Why? Are managers not acting in the interest of their shareholders?

Bankruptcy costs and other reasons
What are potential gains from risk management?
Risksharing
Risk and diversification – Bankruptcy costs: Legal and accounting, loss of brand name and
CAPM
other intangible assets, fire sales etc.
⊲ Risk management
– Cash flow variability and cost of internal vs. external financing
Classification
instruments
(Froot, Scharfstein and Stein, 1993).
Failures
– Managerial concerns, payments to “stakeholders”
Appropriate management of risks is in the best interest of shareholders.

and asset-backed
However, which risks should a corporation assume? Business vs.
securities financial risk.
the credit crisis

Hedging and competitors
Optimal hedging policy may be a function of the hedging policies of
Risksharing competitors.
CAPM
If hedging is not the norm, it may not make sense to be different.
⊲ Risk management
Classification
In some industries, fluctuations in raw material costs are passed on to
instruments
Failures
the purchasers of the end product.
and fixed income markets The price of the end product fluctuates and reflects raw material costs,
and limits to arbitrage interest rates, and so on. Without hedging, the profit margin is
Topic 4: Value at Risk expected to remain roughly constant.
Topic 6: Credit derivatives In such an environment, hedging will induce fluctuations in the
and asset-backed
securities profit margin and increase risks!
the credit crisis
(see gold jewelry example in Hull: Options, Futures, and Other Derivatives, p.
50f).

Classifications of financial risk
Market risk
Risksharing
CAPM Credit risk
Risk management
⊲ Classification
Liquidity risk
instruments
Failures
and fixed income markets Operational risk
Topic 4: Value at Risk Model risk

and asset-backed
securities
the credit crisis

Market risk
Risk to a financial portfolio from movements in market prices such as
Risksharing equity prices, exchange rates, interest rates, commodity prices.
CAPM
Financial institutions take on market risk as their business risk.
Risk management However, they typically choose the exact type of risk they want to be
⊲ Classification
Financial markets and exposed to.
instruments
Failures
Topic 2: Hedging in equity – The expertise of option traders is volatility, not market direction.
Hence, they may want their portfolio to be immune to directional
and limits to arbitrage changes in the underlying securities.
Topic 5: Credit risk Absolute risk (measured in dollar terms) vs. relative risk (measured
and asset-backed
relative to a benchmark index).
securities
the credit crisis
Directional risk (exposure to directional movements) vs.
nondirectional risk (includes nonlinear exposures, volatility risk and
basis risk).

Credit risk
Risk that a counterparty may become less likely to fulfill its
Risksharing obligation in part or in full on the agreed upon date.
CAPM Credit risk losses can occur before actual default. Changes in market
Risk management prices of debt due to market perception regarding default can be viewed
⊲ Classification
as credit risk, creating overlap between credit and market risk.
instruments
Failures
Traditionally, commercial banks take on a lot of credit risk through
and fixed income markets their loan portfolios.
Credit risk includes sovereign risk, the risk that sovereign borrowers do
not honor their obligations.
and asset-backed
Settlement risk is also a form of credit risk, which occurs when two
securities
payments are exchanged on the same day. One counterparty may
the credit crisis default after the other has already made the payment. Before the
settlement day, the exposure is equal to the netted value, while on
settlement day, the exposure to counterparty default is the full value of
the payment.

Liquidity risk
Trading liquidity risk:
Topic 1: Foundations – Concerned with the ease with which positions in the trading book can be
Risksharing
Risk and diversification unwound. Liquidity can be measured by the bid-ask spread.
CAPM
“Time diversification” – The price at which a particular asset can be sold depends on (i) the
Risk management
⊲ Classification
estimate of the fair value of the asset, (ii) the quantity to be sold, (iii) the
Financial markets and required speed of the sale, and (iv) the economic environment.
instruments
Failures
Funding liquidity risk:
– Concerned with being able to meet cash needs as they arise.
– Even solvent institutions can fail because of liquidity problems. In order to

meet cash needs (funding liquidity), an institutions may have to liquidate
some of its assets.
and asset-backed
securities – Main sources of liquidity for a financial institution are (i) holdings of cash
the credit crisis
and securities, (ii) ability to liquidate trading book positions, (iii) ability
to borrow money at short notice, (iv) ability to attract depositors at short
notice, (v) ability to securitize assets at short notice, an (vi) borrowing
from the central bank.

Operational risk
“The risk of loss due to inadequate or failed internal processes, people
Topic 1: Foundations and systems or from external events.”
Risksharing (Basel Committee on Banking Supervision, 2001)
CAPM
Operational risk (Op risk) includes legal risk, which arises from
Risk management exposure to fines, penalties, or punitive damages resulting from
⊲ Classification
instruments
supervisory actions, as well as private settlements. However, the
Failures definition does not include reputation risk and the risk resulting from
strategic decisions.
and limits to arbitrage Categorization of operational risk: (i) Internal fraud; (ii) external fraud;
Topic 4: Value at Risk (iii) employment practices and workplace safety; (iv) clients, products
Topic 5: Credit risk and business practices; (v) damage to physical assets; (vi) business
and asset-backed disruptions and system failures; (vii) execution, delivery, and process
securities
management.
the credit crisis
Op risk should be mitigated and at best eliminated altogether as there
is essentially no upside to being exposed to it.
Op risk is typically very hard to hedge and difficult to model. It is
usually managed using self-insurance or third-party insurance.

Model risk
Model risk is part of the inadequate internal process and thus part of
Risksharing Op risk. However, model risk has become very important during the
CAPM
financial crisis.
Risk management Models in finance are different from physical sciences as they are
⊲ Classification
Financial markets and ultimately models of human behavior. They are at best approximations
instruments
Failures and occasionally, there are regime shifts in the data.
For actively traded products, models are used for communicating
and limits to arbitrage prices and hedging.
Topic 5: Credit risk For very complex or illiquid products, models are used for pricing. It is
and asset-backed
good practice to use several models and assumptions to get a range for
securities
pricing and to better understand the model risks.
the credit crisis
Marking to market vs. marking to model.

Markets
Exchange-traded markets:
Risksharing
– Traditionally exchanges have used the open-outcry system, but
CAPM electronic trading has now become the norm.
Risk management
Classification
– Contracts are standard; there is virtually no credit risk (central
⊲
instruments
counterparty, daily mark to market).
Failures
Topic 2: Hedging in equity Over-the-counter (OTC) markets:
– A computer- and telephone-linked network of dealers at financial
institutions, corporations, and fund managers.
– Contracts can be non-standard; there is some counterparty risk.
and asset-backed
securities Long vs. short positions.
the credit crisis
Notional amounts outstanding of OTC derivatives market USD 650tr in
2011. Gross market values of almost USD 30tr (global equity market
capitalization per 2011 is USD 47tr).

Plain vanilla derivatives
Forward contracts
Risksharing
CAPM
Futures contracts
Risk management
Classification
⊲ instruments Swaps
Failures
Topic 3: Endogenous risk Options (next topic)

and asset-backed
securities
the credit crisis

Forward contracts
Agreement to buy or sell an asset at a given price at a certain future
Risksharing date.
CAPM
Risk management Forwards trade in the over-the-counter market.
Classification
⊲ instruments
Failures
They are particularly popular for currencies and interest rates and they
and fixed income markets can be used to hedge foreign exchange or interest rate risk.
Topic 5: Credit risk No money changes hand at inception.

and asset-backed
securities
the credit crisis

Example: Currency forwards
Table 1: Foreign Exchange Quotes for GBP (24 August 2011)
Risksharing
Risk and diversification Bid Offer
CAPM
Risk management
Spot 1.6398 1.6402
Classification
1-month forward 1.6392 1.6397
⊲ instruments 3-month forward 1.6382 1.6387
Failures
1-year forward 1.6328 1.6334
and limits to arbitrage Suppose the treasurer of a US corporation knows that in one year it will
Topic 4: Value at Risk pay GBP 1m.
and asset-backed
If the treasurer wants to hedge against exchange rate moves it can buy
securities GBP 1m one year forward at an exchange rate of 1.6334 by trading
the credit crisis with the bank.
What are the possible payoffs?

A forward on a non-dividend-paying stocks
Consider a forward contract with forward price F maturing at time T .
Risksharing
– The underlying asset does not pay dividends and its market price at
CAPM maturity is ST ;
Risk management
Classification
⊲
instruments
The forward contract generates the following payoffs:
Failures
– Buyer’s gain at maturity is ST − F , while seller’s gain is −(ST − F );
– If the price of underlying falls below F buyer loses and seller gains,
and vice versa if underlying is above F .
and asset-backed
securities
the credit crisis

Payoff profile at maturity
The payoff diagrams are as follows:
Payoff Payoff
0 ST 0 ST
F F
Payoff = ST − F Payoff = −(ST − F )

Finding the price of the forwards
Forward price F is set at date 0 in such a way that it costs nothing to
Risksharing enter into this contract.
CAPM
The value of the forward contract at time 0 is given by:
Risk management
Classification F
⊲
Financial markets and V =S− .
instruments
Failures
(1 + r)T
Topic 3: Endogenous risk Forward price found from the condition V = 0 is given by:

F = S × (1 + r)T ,
and asset-backed
securities
where S is the current price of asset.
the credit crisis Note that forward price depends on asset price.
- Hence, the forward price changes with the asset price.

No-arbitrage pricing
Time-zero value of forward contract V can be derived by no-arbitrage.
Risksharing
Risk and diversification Consider replicating portfolio:
CAPM
“Time diversification” – Buy one share of stock;
Risk management
Classification
Financial markets and – Borrow F/(1 + r)T USD. (Equivalently, sell F/100 T -year
⊲ instruments
zero-coupon bonds with face value 100.)
Failures
Payoffs at t = T : Forward and Replicating Portfolio

underlying price Forward Replicating portfolio
and asset-backed ST ST − F ST − F
securities
the credit crisis
Value of forward equals the value of replicating portfolio:
F
V =S− T
.
(1 + r)

Futures contracts
Futures contract is an agreement to buy or sell an asset or commodity
Risksharing in the future for a fixed price.
CAPM - The difference between futures and forwards is that futures are
Risk management
traded on an exchange (futures exchange);
Classification
⊲
instruments
- Unlike forwards, futures contracts eliminate the counterparty risk;
Failures
Topic 2: Hedging in equity - Futures contracts are traded differently and are marked to market.

and asset-backed
securities
the credit crisis

Futures contracts (cont.)
To prevent default futures exchanges require buyers and sellers to
Risksharing deposit funds in a margin account.
CAPM There is low counterparty risk in futures contracts since the
Risk management
intermediary (“clearing house”) is very heavily insured.
Classification
⊲ instruments
Failures Futures contracts can be easily re-sold and hence have higher liquidity
and fixed income markets than forward contracts.

and asset-backed
securities
the credit crisis

Futures contracts (cont.)
Buyers and sellers exchange cash flows on a daily basis.
Risksharing
CAPM
Suppose, a cereal maker and a farmer growing wheat agree that the
Risk management delivery futures price is £100.
Classification
⊲
instruments - If next day futures price goes up by £2 cereal maker gains £2 and
Failures farmer loses £2;
Topic 3: Endogenous risk - Then, £2 is transferred from the farmer’s margin account to the
cereal maker’s margin account;
Topic 5: Credit risk - If day later the futures price goes down by £1 then £1 is transferred
and asset-backed from cereal maker’s to farmer’s margin account;
securities
the credit crisis
- Cash transfers are arranged by futures exchange;
- Settling profits and losses each day helps futures exchange protect
itself from potential defaults.

Example: Futures
Farmer and cereal maker agree in June 2018 to trade 1 ton of corn at
Risksharing £100 per ton in September 2018.
CAPM - The table shows the stream of cash flows given changes in futures
Risk management
prices for 1 ton of corn in September 2018;
Classification
⊲
instruments
- Suppose, at terminal date (75 days later) market price is £95.
Failures
Time in Days 0 1 2 3 ... 74 75 Total

Futures price 100 102 101 104 91 95
short gain/loss 0 -2 1 -3 ... -4 +5
and asset-backed
securities long gain/loss 0 2 -1 +3 ... +4 -5
the credit crisis

Example: Futures (cont.)
- Total gains/losses on short position over the life of the contract equal
Risksharing the difference between the futures price (£100) and the market price at
CAPM
expiration (£95);
Risk management
Classification - After that, as in the case with forwards, farmer sells while cereal maker
⊲ instruments buys corn at £95 in the market;
Failures
Topic 3: Endogenous risk The parties effectively traded at price £100 as agreed:
Topic 4: Value at Risk - Farmer receives £100 (sells corn for £95 and receives £5 from cereal
Topic 5: Credit risk maker);
and asset-backed
securities - Cereal maker pays £100 (buys corn for £95 and pays the farmer £5);
the credit crisis

Interest rate swaps
A plain vanilla fixed-for-floating interest rate swap contract is an
Topic 1: Foundations agreement between two counterparties in which one counterparty agrees
Risksharing
to make n fixed payments per year at an (annualized) rate c on a
CAPM notional N up to a maturity date T , while at the same time the other
Risk management
counterparty commits to make payments linked to a floating rate
Classification
index rn (t).
⊲ instruments
Failures Denote by T1 , T2 , . . ., TM the payment dates, with Ti = Ti−1 + ∆.
and fixed income markets The net payment between the two counterparties at each of these dates
and limits to arbitrage is
Topic 4: Value at Risk N × ∆ × [rn − c]
and asset-backed If such a rate exists, it should also be related to a discount factor, just
securities
as it occurs with normal interest rates.
the credit crisis
The constant c is called swap rate.
Interest rate swaps have become the dominant interest rate OTC
security with a total market value in December 2008 of USD 8tr.

Interest rate swaps: Example
A borrows 5-year fixed at 12%
Risksharing
CAPM
B borrows 5-year floating at LIBOR +1%
Risk management
Classification Enter into swap transaction with AAA swap dealer
⊲ instruments
Failures
Assume 5-year T-note yields 11%
and limits to arbitrage In the swap B will receive LIBOR and pay T+30bp
Topic 5: Credit risk A will pay LIBOR and receive T+20bp

and asset-backed
securities
When does this make sense for both counterparties?
the credit crisis

Interest rate swap: Cash flows
Example: receive 6-month LIBOR & pay fixed rate of 5% per annum
Risksharing every 6 months for 3 years on a notional principal of USD 100m,
CAPM
settlement date 05/03/2007.
Risk management
Classification
Table 2: Cash flows for interest rate swap
⊲ instruments
Failures
Date 6m LIBOR Floating CF Fixed CF Net CF
Topic 3: Endogenous risk 05/03/2007 4.20
05/09/2007 4.80 +2.10 -2.50 -0.40

05/03/2008 5.30 +2.40 -2.50 -0.10
Topic 6: Credit derivatives 05/09/2008 5.50 +2.65 -2.50 0.15
and asset-backed
securities 05/03/2009 5.60 +2.75 -2.50 0.25
the credit crisis
05/09/2009 5.90 +2.80 -2.50 0.30
05/03/2010 6.40 +2.95 -2.50 0.45
Source: Hull, Risk Management and Financial Institutions, Prentice Hall

Where risk management failed
Rogue traders:
– Barings was wiped out by Nick Leeson in 1995. Close to USD 1bn losses trading in Nikkei 225
futures.
– UBS lost USD 2.3bn due to unauthorized positions by Kweku Adoboli in 2011.
Wrong or faulty models:
– In 1994, Joseph Jett lost USD 350m for Kidder Peabody because the system failed to account for
funding costs.
– National Westminster Bank lost USD 130m using a wrong model for swaptions in 1997.
Failure to carry out scenario analysis or stress tests:
– Procter & Gamble lost USD 90m in an exotic interest rate swap.
– Subprime mortgage losses in 2007.
Hubris or failure to understand risks in the trades:
– In 1994, Robert Citron lost USD 2bn for Orange County betting against a rise in interest rates.
– In 1998, LTCM almost brought down the financial system when it lost almost USD 4bn when
there was a flight to quality after the Russian default.

Two examples
Orange County’s yield curve plays (see handout).
Risksharing
CAPM
Procter and Gamble “5/30” swap (from: Hull, p. 113, see .xls file).
Risk management – 5-year swap with semiannual payments, notional $200m.
Classification
instruments
– Bankers Trust (BT) pays 5.3% p.a.
⊲ Failures
– P&G pays average 30-day CP rate minus 75bp plus a spread, where
the spread is the following decimal interest rate:
 
Topic 4: Value at Risk 5y CMT%
98.5 − 30y TSY price 
Topic 5: Credit risk  5.78%
Topic 6: Credit derivatives spread = max  0,

and asset-backed 100 
securities
the credit crisis
– If spread is 0 then P&G gets funding 75bp below CP rate.

– If interest rates fall and bond prices go up then rate can be very
high.

Key lessons
Define risk limits and set up procedures to ensure limits are adhered to.
Risksharing
Make sure hedgers cannot become speculators.
CAPM
“Time diversification” Do not blindly trust models, carry out scenario analysis and stress tests.
Risk management
Classification Beware of easy profits and of profits based on marking to model.
instruments
⊲ Failures Take liquidity risk into account and beware when everybody is following
Topic 2: Hedging in equity the same strategy.
Be conservative in using short-term funding for long-term needs.
Lessons for nonfinancial corporations:
Topic 6: Credit derivatives – Understand the trades.
and asset-backed
securities
– Try not to outguess the market.
the credit crisis
– Don’t turn treasury department into a profit center.

Hedging risks
Options basics
Black-Scholes-Merton
Greeks
Dynamic replication
Bonds
Yields and discount
factors
Topic 2: Hedging in equity and fixed income
Forward rates
Duration markets
Convexity
Nonparallel shifts
Practice
FI derivatives

and asset-backed
securities
the credit crisis

Topic 2: Hedging in equity and fixed income markets
Outline
Topic 2: Hedging in How should market risks be hedged?
equity and fixed
⊲ income markets
Hedging risks Options basics
Options basics
Greeks The Black-Scholes-Merton model
Dynamic replication
Bonds
Yields and discount The Greeks
factors
Forward rates
Duration Dynamic replication and hedging
Convexity
Nonparallel shifts
Practice Yields and discount factors
FI derivatives
Duration

Convexity
and asset-backed
securities
Nonparallel interest rate shifts
the credit crisis

How should market risks be hedged?
Table 3: Summary of gold portfolio (in USD)
Topic 1: Foundations Position Value

and fixed income markets Spot gold 180,000
Hedging risks
Options basics
Forwards -60,000
Black-Scholes-Merton Futures 2,000
Greeks
Dynamic replication Swaps 80,000
Bonds
Yields and discount Options -110,000
factors
Forward rates
Exotics 25,000
Duration
Convexity Total 117,000
Nonparallel shifts
Practice
FI derivatives
Assume price of gold goes up by 10 cents from USD 1,800 per ounce.
Topic 3: Endogenous risk Further assume the value of the portfolio drops to USD 116,900.
Topic 4: Value at Risk Sensitivity of the portfolio to the price of gold:

−100
= −1, 000
and asset-backed
securities 0.1
the credit crisis
How can the exposure be eliminated?

Delta hedging and linear instruments
The delta of a portfolio with respect to a market variable is:
∆P ∂P
⊲ or Delta =
Hedging risks
Options basics
∆S ∂S
Greeks When the hedging trade is combined with the portfolio, the resulting
Dynamic replication
Bonds
portfolio is referred to as delta neutral.
Yields and discount
factors
Forward rates
Duration When the price of a product is linearly dependent on the price of an
Convexity
Nonparallel shifts
underlying asset, a hedge and forget strategy can be used.
Practice
FI derivatives
Topic 3: Endogenous risk Non-linear products require the hedge to be rebalanced to preserve

delta neutrality.
and asset-backed
securities
the credit crisis

Introduction to options and notation
A call option gives the right to buy an underlying asset with current
price St at a pre-specified strike price K.
⊲ Hedging risks A put option gives the right to sell an underlying asset at a
Options basics
Black-Scholes-Merton pre-specified strike price.
Greeks
Dynamic replication
Bonds
Additional parameters:
Yields and discount
factors – T − t: time to expiration
Forward rates
Duration
Convexity
– r: riskless rate of interest (continuous compounding)
Nonparallel shifts
Practice – σ: volatility of the underlying
FI derivatives
Topic 3: Endogenous risk European option: can only be exercised at the expiration date
(denoted c and p).

American option: can be exercised at any date prior to expiration
and asset-backed (denoted C and P ).
securities
the credit crisis
Moneyness: in-the-money, at-the-money, out-of-the-money.

Option payoffs
Payoff for a European call option at expiration:
and fixed income markets max(ST − K, 0),
Hedging risks
⊲ Options basics
Black-Scholes-Merton where ST is the price of the underlying asset at expiration and K is the
Greeks
Dynamic replication
strike price.
Bonds
Yields and discount
factors
Forward rates Payoff for a European put option at expiration:
Duration
Convexity
Nonparallel shifts max(K − ST , 0)
Practice
FI derivatives

and asset-backed
securities
the credit crisis

Payoff for call and put options
Long call Short call
Topic 1: Foundations 50 0

Hedging risks
⊲
Payoff
Payoff
Options basics
25 −25
Greeks
Dynamic replication
Bonds
Yields and discount
factors 0 −50
0 25 50 75 100 0 25 50 75 100
Forward rates S S
T T
Duration
Convexity Long put Short put
Nonparallel shifts 50 0
Practice
FI derivatives
Payoff
Payoff
25 −25

and asset-backed
0 −50
securities 0 25 50 75 100 0 25 50 75 100
Topic 7: Regulation and ST ST
the credit crisis

Exotic options
Asian options
and fixed income markets Barrier options
Hedging risks
⊲ Options basics
Basket options
Greeks
Dynamic replication
Bonds
Binary options
Yields and discount
factors
Forward rates
Compound options
Duration
Convexity
Nonparallel shifts
Lookback options
Practice
FI derivatives Example: If a company earns revenue month by month in many different
and limits to arbitrage currencies Asian basket put options can provide an appropriate hedge.

and asset-backed
securities
the credit crisis

Option prices in one-period model
Call option can be priced by replication.

- Buy ∆ units of stock and B units of bond to replicate call payoffs.
stock bond
Su = u · S £100 Cu = max(0, uS − K)
£100
S C =?
1+r
Sd = d · S £100 Cd = max(0, dS − K)
t=0 t=1 t=0 t=1 t=0 t=1

Note that to avoid arbitrage we must have:
d<1+r <u

Option prices in one-period model
We construct the replicating portfolio by matching the payoffs at
maturity:
Hedging risks
⊲ Options basics
Black-Scholes-Merton Matching payoffs at maturity
Greeks
Dynamic replication
Bonds
Replicating Portfolio Call Option
Yields and discount
factors
Forward rates
up: ∆ × uS + B × £100 = Cu
Duration
Convexity down: ∆ × dS + B × £100 = Cd
Nonparallel shifts
Practice
FI derivatives

Solving these equations we find the replication strategy:
Cu − Cd uCd − dCu
∆= , B=
and asset-backed
securities (u − d) × S (u − d) × 100
the credit crisis

Option prices in one-period model (cont.)
Call price is then given by:
100
C =∆×S+B×
Hedging risks
⊲ Options basics
1+r
Greeks Cu − Cd uCd − dCu 100
Dynamic replication = ×S+ ×
Bonds (u − d) × S (u − d) × 100 1 + r
Yields and discount
factors
Forward rates qCu + (1 − q)Cd 1+r−d
Duration = , where q = .
Convexity 1+r u−d
Nonparallel shifts
Practice
FI derivatives
qCu + (1 − q)Cd 1+r−d
Topic 3: Endogenous risk C= , where q = .
1+r u−d

and asset-backed
securities
the credit crisis

Two-Period Example
Consider option pricing in a two-period model.
Hedging risks Example: The stock price of Heavy Metal changes only once a month:
⊲ Options basics
Black-Scholes-Merton either it goes up by 15% or it falls by 10%. Its price now is $40. The
Greeks
Dynamic replication
interest rate is 12% per year, or 1% per month.
Bonds
Yields and discount
factors
Forward rates
a) What is the value of a two-month call option with an exercise price
Duration of $40?
Convexity
Nonparallel shifts
Practice b) What is the value of a two-month put option with an exercise price
FI derivatives
of $40?

and asset-backed
securities
the credit crisis

Two-Period Example (cont.)
N = 2, u = 1.15, d = 0.9, r = 1%(per period), K = $40
Suu = 52.9 Cuu = 12.9
Su = 46 Cu =?
S = 40 Sud = Sdu = 41.4 C =? Cud = Cdu = 1.4
Sd = 36 Cd =?
Sdd = 32.4 Cdd = 0

t=0 t=1 t=2 t=0 t=1 t=2
Risk neutral probability:

1 + 0.01 − 0.9
q= = 0.44
1.15 − 0.9

We solve the model backwards, by first finding Cu and Cd :
Cuu = 12.9 Cdu = 1.4
Cu =? Cd =?
Cud = 1.4 Cdd = 0
t=0 t=1 t=0 t=1
qCuu + (1 − q)Cud 0.44 × $12.9 + 0.56 × $1.4

Cu = = = $6.396
1+r 1 + 0.01
qCdu + (1 − q)Cdd 0.44 × $1.4 + 0.56 × $0
Cd = = = $0.61
1+r 1 + 0.01

After finding Cu and Cd we can find C:
Hedging risks
⊲ Options basics
Cu = 6.396
Greeks
Dynamic replication
Bonds
Yields and discount
C =?
factors
Forward rates
Duration
Convexity
Cd = 0.610
Nonparallel shifts
Practice
FI derivatives t=0 t=1

qCu + (1 − q)Cd 0.44 × $6.396 + 0.56 × $0.61
Topic 5: Credit risk C= = = $3.125
1+r 1 + 0.01
and asset-backed
securities
the credit crisis

Risk-neutral probabilities
Since d < 1 + r < u it follows that:
Topic 2: Hedging in equity 1+r−d
0<q= < 1.
Hedging risks u−d
⊲ Options basics
Greeks Therefore, q can be given an interpretation of probability.
Dynamic replication
Bonds
Yields and discount
- q is called risk-neutral probability (RNP) of an up move;
factors
Forward rates - 1 − q is called risk-neutral probability of a down move.
Duration
Convexity
Nonparallel shifts
Practice
FI derivatives The expression for the option price can be interpreted as discounted
and limits to arbitrage expected option payoff under RNP:
Topic 5: Credit risk qCu + (1 − q)Cd E ∗ [C1 ]

C= =
and asset-backed
1+r 1+r
securities
the credit crisis

Boundary conditions and put-call parity
Denote the value of a zero coupon bond B(t, T ) = e−r(T −t) .
and fixed income markets Assume no dividends.
Hedging risks
⊲ Options basics
Black-Scholes-Merton Upper bounds:
Greeks
Dynamic replication
Bonds
– c≤C≤S
Yields and discount
factors
Forward rates – p ≤ KB(t, T ) and P ≤ K
Duration
Convexity
Nonparallel shifts
Lower bounds:
Practice
FI derivatives
– c > max(S − KB(t, T ), 0)
Topic 4: Value at Risk – p > max(KB(t, T ) − S, 0) and P ≥ max(K − S, 0)

Topic 6: Credit derivatives c = C and p < P without dividends and r > 0.
and asset-backed
securities
the credit crisis

Put-call parity
Consider the following portfolio at time t:
Topic 2: Hedging in equity – Write a European call option c(S, T, K).
Hedging risks
⊲ Options basics – Buy a European put option with the same characteristics,
Greeks
p(S, T, K).
Dynamic replication
Bonds
Yields and discount – Buy one share of stock St .
factors
Forward rates
Duration
– Borrow the amount KB(t, T ).
Convexity
Nonparallel shifts Portfolio Cash at t ST ≤ K ST > K
Practice
FI derivatives Short call c 0 −(ST − K)
Long put −p K − ST 0
Long stock −St ST ST
Topic 5: Credit risk Borrow KB(t, T ) −K −K
and asset-backed
Total c − p − St + KB(t, T ) 0 0
securities
the credit crisis No arbitrage implies: c + KB(t, T ) = St + p

Put-call parity violation
St = 110
and fixed income markets c = 17
Hedging risks
⊲ Options basics
Greeks
p=5
Dynamic replication
Bonds
Yields and discount R = 5% (annual compounding)
factors
Forward rates
Duration
Convexity
T − t = 1 year
Nonparallel shifts
Practice
FI derivatives K = 105

c + KB(t, T ) > St + p
and asset-backed
117 > 115
securities
the credit crisis

The Black-Scholes-Merton assumptions
The stock price follows a geometric Brownian motion with drift µ and
volatility σ.
Hedging risks
⊲ Options basics Continuous trading.
Greeks
Dynamic replication No transactions costs.
Bonds
Yields and discount
factors
Forward rates No restrictions on short sales.
Duration
Convexity
Nonparallel shifts No taxes.
Practice
FI derivatives
Constant riskless rate of interest.

and asset-backed
securities
the credit crisis

The Black-Scholes-Merton insight
By combining a position in the option with a position in the underlying
security, it is possible to create a portfolio which is riskless over an
and fixed income markets infinitesimal time period.
Hedging risks
Options basics
⊲ Black-Scholes-Merton
No arbitrage implies that, over this infinitesimal time period, the return
Greeks
Dynamic replication on this portfolio must be equal to the riskless rate of interest.
Bonds
Yields and discount
factors
Forward rates These prices do not depend on:
Duration
Convexity
Nonparallel shifts
– Risk preferences.
Practice
FI derivatives
– The expected return on the underlying security.

So-called “risk neutral” valuation methods are based on this
Topic 6: Credit derivatives observation.
and asset-backed
securities
the credit crisis

A note on the derivation
Consider a portfolio consisting of one long option position (say, a call) and short
position in some quantity ∆ of the stock: Π = c(S, t) − ∆ × S.
Consider the change in value of Π from t to t + dt. This change is partly due to the
change in the option value and partly due to the change in the stock.
Also, the change in value is composed of a deterministic part associated with dt and a
random part associated with the risk of the stock.
Since the value of the option is dependent on the value of the stock, we can eliminate
the random part by choosing an appropriate ∆.
Now we have a portfolio whose change in value is completely deterministic and thus
riskless.
Together with assumptions on the stochastic process that the stock follows we can
derive the B-S formula.

Black-Scholes formula
Call:
= SN (d1 ) − Ke−r(T −t) N (d2 )

and fixed income markets c
Hedging risks
S
Options basics ln( K ) + (r + 21 σ 2 )(T − t)
⊲ Black-Scholes-Merton d1 = √
Greeks σ T −t
Dynamic replication √
Bonds d2 = d1 − σ T − t
Yields and discount
factors
Forward rates
Duration
and N (.) is the c.d.f. of a standard normal.
Convexity
Nonparallel shifts
Practice Put:
FI derivatives
and limits to arbitrage p = Ke−r(T −t) N (−d2 ) − SN (−d1 )

and asset-backed
securities
the credit crisis

Call and put prices (K=50)
50
Hedging risks
Call
Options basics 25
Greeks
Dynamic replication
Bonds
Yields and discount 0
factors 0 25 50 75 100
Forward rates Spot price
Duration
Convexity
50
Nonparallel shifts
Practice
FI derivatives
Put
25

and asset-backed
securities 0
0 25 50 75 100
Topic 7: Regulation and Spot price
the credit crisis

Option sensitivities
Topic 2: Hedging in equity European call European put
Hedging risks
Options basics
Spot price + -
Greeks Strike price - +
Dynamic replication
Bonds Volatility + +
Yields and discount
factors Riskless rate of interest + -
Forward rates
Duration
Time to expiration ? ?
Convexity Future dividends - +
Nonparallel shifts
Practice
FI derivatives

and asset-backed
securities
the credit crisis

Option sensitivities: Delta (∆)
Delta measures the sensitivity of the option’s price to changes in the
price of the underlying security:
Hedging risks ∂P
Options basics Delta ≡ ∆ =
Black-Scholes-Merton ∂S
⊲ Greeks
Dynamic replication
Bonds For European options on non-dividend-paying stocks:
Yields and discount
factors
Forward rates ∂P
Duration Delta(call) = = N (d1 )
Convexity ∂S
Nonparallel shifts
∂P
Practice
Delta(put) = = N (d1 ) − 1
FI derivatives ∂S
Topic 4: Value at Risk Taylor series expansion for approximating the change in a function given
Topic 5: Credit risk the change in the underlying:
and asset-backed
securities ∂P ∂P 1 ∂2P 2 1 ∂2P 2 ∂2P
∆P = ∆S + ∆t + ∆S + ∆t + ∆S∆t + . . .
the credit crisis ∂S ∂t 2 ∂S 2 2 ∂t2 ∂S∂t

Delta (K=50)
Call
Topic 1: Foundations 1

Hedging risks
Options basics
Delta
0.5
⊲ Greeks
Dynamic replication
Bonds
Yields and discount
factors 0
0 25 50 75 100
Forward rates
Spot price
Duration
Convexity Put
Nonparallel shifts 0
Practice
FI derivatives
Delta
−0.5

and asset-backed
securities −1
0 25 50 75 100
the credit crisis

Option sensitivities: Gamma (Γ)
Gamma measures the sensitivity of the option’s delta to changes in
the price of the underlying security:
Hedging risks
∂∆ ∂2P
Options basics Gamma ≡ Γ = =
Black-Scholes-Merton ∂S ∂S 2
⊲ Greeks
Dynamic replication
Bonds
Yields and discount
For European call or put options on non-dividend-paying stocks:
factors
Forward rates N ′ (d1 ) ′ 1 − x2
Duration Gamma = p where N (x) = √ e 2
Convexity
Nonparallel shifts
Sσ (T − t) 2π
Practice
FI derivatives For a delta neutral portfolio:
∂P 1 ∂2P 2 1 2
∆P = ∆t + ∆S = Θ∆t + Γ∆S
Topic 5: Credit risk ∂t 2 ∂S 2 2
and asset-backed
securities
What is the relationship between changes in the underlying and the
Topic 7: Regulation and portfolio value now?
the credit crisis

Option sensitivities: Vega (V)
Vega measures the sensitivity of the option’s price to changes in the
volatility of the underlying security:
Hedging risks ∂P
Options basics Vega ≡ V =
Black-Scholes-Merton ∂σ
⊲ Greeks
Dynamic replication
Bonds
For European options on non-dividend-paying stocks:
Yields and discount
factors
Forward rates p
Duration V = S (T − t)N ′ (d1 )
Convexity
Nonparallel shifts
Practice
FI derivatives

and asset-backed
securities
the credit crisis

Gamma and Vega (K=50)
Gamma
Hedging risks
Options basics
⊲ Greeks
Dynamic replication
Bonds
Yields and discount
factors 0 25 50 75 100
Forward rates Spot price
Duration
Convexity
Nonparallel shifts
Practice
FI derivatives
Vega

and asset-backed
securities
0 25 50 75 100
the credit crisis

Option sensitivities: Rho (ρ) and Theta (Θ)
Rho measures the sensitivity of the option’s price to changes in the
riskless interest rate.
Hedging risks
Options basics
Black-Scholes-Merton Theta measures the sensitivity of the option’s price to the passage of
⊲ Greeks
time (“time decay”).
Dynamic replication
Bonds ∂P
Yields and discount Theta ≡ Θ =
factors ∂t
Forward rates
Duration
Convexity
Nonparallel shifts
Practice
FI derivatives

and asset-backed
securities
the credit crisis

Dynamic replication or dynamic hedging
Following the Black-Scholes-Merton insight, you can replicate an option
by a dynamic trading strategy involving the underlying security and
and fixed income markets the riskless asset.
Hedging risks
Options basics
Black-Scholes-Merton Equivalently, you can hedge the risk on an existing option position by
⊲ Greeks
trading dynamically in the underlying security and the riskless asset
Dynamic replication
Bonds
Yields and discount
(“delta hedging”).
factors
Forward rates
Duration
Assume the following parameters for a European put option: S = 100,
Convexity K = 90, σ = 25%, T − t = 20 weeks, r = 0%.
Nonparallel shifts
Practice
FI derivatives What position do you need to take in the underlying in order to
replicate the put option?

– The Delta of the put option is −0.225. Sell 0.225 of the underlying
Topic 6: Credit derivatives in the first week.
and asset-backed
securities – The price of the underlying drops to 91.85. The new Delta is
the credit crisis −0.417. Sell an additional 0.192 of the underlying. And so on.

Positive and negative Gamma
Positive gamma (long call)
Hedging risks
Options basics delta
Black-Scholes-Merton gamma
Greeks
⊲ Dynamic replication
Bonds
Yields and discount
factors
0 25 50 75 100
Forward rates
Spot price
Duration
Convexity Negative gamma (short call)
Nonparallel shifts
Practice
FI derivatives
delta
Topic 4: Value at Risk gamma

and asset-backed
securities
0 25 50 75 100
the credit crisis

Delta hedging
When gamma is positive, delta hedging involves “buying on the way
down and selling on the way up.”
Hedging risks
Options basics
Black-Scholes-Merton When gamma is negative, delta hedging involves “buying on the way up
Greeks
⊲ Dynamic replication and selling on the way down.”
Bonds
Yields and discount
factors
Forward rates
Duration
Convexity
Nonparallel shifts
Practice
FI derivatives

and asset-backed
securities
the credit crisis

Practical issues with dynamic replication/delta hedging
Continuous trading.
Hedging risks Transactions costs.
Options basics
Greeks
Jumps in asset prices.
Bonds
Yields and discount
factors
Forward rates
Duration
Convexity
Nonparallel shifts
Practice
FI derivatives

and asset-backed
securities
the credit crisis

Bonds: Definitions
Face value (or principal)
and fixed income markets Coupons
Hedging risks
Options basics
Greeks
Coupon frequency (e.g. annual or semi-annual)
Bonds
Yields and discount Zero coupon bonds
factors
Forward rates
Duration
Convexity
Current price
Nonparallel shifts
Practice
FI derivatives Issuers:
and limits to arbitrage – Governments

– Corporations
and asset-backed
securities
the credit crisis

Why are bonds risky?
Two main sources of risk:
Hedging risks Price risk (or interest rate risk)
Options basics
Greeks
– The value of a bond depends on how its coupon compares to
Dynamic replication “current interest rates”
⊲ Bonds
Yields and discount
factors – Bond prices fluctuate with fluctuations in “interest rates”
Forward rates
Duration
Convexity
Nonparallel shifts
Practice Default risk (or credit risk)
FI derivatives
Topic 3: Endogenous risk – For now, we will abstract from this and assume that there is no
default risk
Topic 5: Credit risk – U.K. or U.S. Treasury bonds

and asset-backed
securities
– We will return to credit risk later in the course
the credit crisis

Bond price and yield to maturity
Bond price P :
Topic 1: Foundations T
X Coupon t Principal
and fixed income markets P = +
Hedging risks
t=1
(1 + y)t (1 + y)T
Options basics
Greeks
where: y = yield to maturity (YTM).
Dynamic replication
⊲ Bonds
Yields and discount
factors YTM is the rate that equalizes the present value of the coupons and
Forward rates the principal to the market price of the bond.
Duration
Convexity
Nonparallel shifts
Practice
In reality, there is not a single interest rate but an entire yield curve,
FI derivatives corresponding to bonds of different maturities.
Topic 4: Value at Risk How do you value a coupon bond when yields vary across maturities?
and asset-backed
securities
the credit crisis

Zero coupon curve
Assume today’s date is 0.
and fixed income markets δt is the discount factor for maturity date t: δt is the price today of a
Hedging risks
Options basics
zero-coupon bond (“zero”) that pays principal of 1 at time t in the
Black-Scholes-Merton future.
Greeks
Dynamic replication
Bonds The spot rate (or zero-coupon rate) for maturity t can be expressed
Yields and discount
⊲ factors with discrete or continuous compounding.
Forward rates
Duration
Convexity
– Denote rt the continuously compounded yield on a maturity t
Nonparallel shifts zero-coupon bond: B(0, t) = δt = e−rt t .
Practice
FI derivatives
Topic 3: Endogenous risk – Denote Rt the yield on a maturity t zero-coupon bond with annual
and limits to arbitrage 1
compounding: B(0, t) = δt = (1+R t)
t.

and asset-backed
securities
the credit crisis

U.S. Treasury yield curve (26 June 2014)
Topic 1: Foundations 2.00

Hedging risks 0.00
Options basics
Greeks -2.00
3M 6M 12M 2Y 5Y 10Y 30Y
Dynamic replication
Bonds
Yields and discount
⊲ factors
Forward rates
Duration
Convexity
Nonparallel shifts
Practice
FI derivatives

and asset-backed
securities Blue: current, purple: 1M ago, turquoise: 1Y ago.
Topic 7: Regulation and Source: Bloomberg (www.bloomberg.com/markets/rates-bonds/government-bonds/us/)
the credit crisis

Which interest rates?
To price financial contracts, we need a risk-free rate.
and fixed income markets For financial institutions, the LIBOR or swap yield curve provides the
Hedging risks
Options basics
appropriate rate.
Greeks Treasury rates are too low—banks cannot finance themselves at this
Dynamic replication
Bonds rate. Besides, Treasury securities have multiple roles and hence they are
Yields and discount
⊲ factors in high demand.
Forward rates
Duration
Convexity
The overnight indexed swap (OIS) is a swap where a fixed rate is
Nonparallel shifts exchanged for the geometric average of overnight rates during the
Practice
FI derivatives period. The overnight rates are the rates where banks borrow/lend
excess reserves (Fed funds rate in the US).

The OIS allows overnight borrowing/lending to be swapped for a fixed
Topic 6: Credit derivatives rate. The LIBOR-OIS spread is an indicator for stresses in the financial
and asset-backed
securities sector.
the credit crisis

Discounting
Many academic studies assume that the Treasury rate is the risk-free
rate.
Hedging risks Pre-crisis practitioners assumed that a risk-free zero curve can be
Options basics
calculated from LIBOR rates, Eurodollar futures, and swap rates.
Greeks
Dynamic replication Post-crisis most banks have started using the OIS rates for discounting
Bonds
Yields and discount
collateralized transactions and LIBOR/swap rates for discounting
⊲ factors
non-collateralized transactions.
Forward rates
Duration
Convexity Why the change? Banks became increasingly reluctant to lend to each
Nonparallel shifts
Practice
other during the crisis. The TED spread was very high during the crisis
FI derivatives reaching 450 basis points in October 2008. The LIBOR-OIS spread
reached a record 364 basis points.
LIBOR is not risk-free! LIBOR rates are the unsecured short-term
borrowing rates of AA-rated financial institutions. Swap rates
and asset-backed
securities
correspond to the risk in a series of short-term loans to AA-rated
Topic 7: Regulation and financial institutions.
the credit crisis

Bond pricing
Let (c1 , c2 , . . . , cT ) be the stream of payoffs from a bond.
and fixed income markets cT includes the coupon plus repayment of principal, the earlier
Hedging risks
Options basics
payments are the coupons on the bond.
Greeks The market price of the bond is given as the sum of the discounted
Dynamic replication
Bonds payoffs:
Yields and discount
⊲ factors
Forward rates T T
Duration X Coupont Principal X ct
Convexity P = t
+ T
= t
Nonparallel shifts
t=1
(1 + Rt ) (1 + R T ) t=1
(1 + R t )
Practice
FI derivatives T
X
and limits to arbitrage = c1 δ1 + c2 δ2 + . . . + cT δT = δt ct
Topic 4: Value at Risk t=1
Topic 6: Credit derivatives where Rt and is the discretely compounded spot (zero-coupon) rate
and asset-backed
securities (NOT equal to the yield on a t-year coupon bond!)
the credit crisis

Bond Pricing: Example
Calculate the price of the following 3-year bond:
Topic 2: Hedging in equity Face value = $ 100
Hedging risks
Options basics
Annual coupon of 4%
Greeks
Dynamic replication
Bonds Assume that the spot (zero-coupon) curve is given by:
Yields and discount
⊲ factors
1yr = 5%
Forward rates
Duration
Convexity 2yr = 6%
Nonparallel shifts
Practice 3yr = 7%
FI derivatives

and asset-backed
securities
the credit crisis

Bootstrapping
Discount factors can be calculated from market prices provided there is
a sufficient spread of bonds across maturities.
Hedging risks Example: 3 coupon bonds of different maturities:
Options basics
    
Greeks P1 c11 δ1
Dynamic replication  P2  =  c21 c22   δ2 
Bonds
⊲
Yields and discount
factors
P3 c31 c32 c33 δ3
Forward rates
Duration
Convexity
where cij is the payment of bond i at date j.
Nonparallel shifts
Practice Discount factors can be backed out from the market prices:
FI derivatives
Topic 3: Endogenous risk    −1  
and limits to arbitrage δ1 c11 P1
Topic 4: Value at Risk  δ2  =  c21 c22   P2 
δ3 c31 c32 c33 P3
and asset-backed
securities
Topic 7: Regulation and All spot and forward rates can then be calculated from these discount
the credit crisis
factors.

Bootstrapping
This is equivalent to the following system of equations:
and fixed income markets c11 δ1 = P1
Hedging risks
Options basics c21 δ1 + c22 δ2 = P2
Greeks c31 δ1 + c32 δ2 + c33 δ3 = P3
Dynamic replication
Bonds
⊲
Yields and discount
factors
This system is easy to solve:
Forward rates
Duration
Convexity
δ1 = P1 /c11
Nonparallel shifts
Practice
δ2 = (P2 − c21 δ1 )/c22
FI derivatives
δ3 = (P3 − c31 δ1 − c32 δ2 )/c33

and asset-backed
securities
the credit crisis

YTM: Example
Suppose that:
and fixed income markets – 1-year spot rate is 5%.
Hedging risks
Options basics
Greeks
– 2-year coupon bond with annual coupon of 6% trades “at par” in
Dynamic replication the market (i.e. price = face value).
Bonds
Yields and discount
⊲ factors
Forward rates Questions:
Duration
Convexity
Nonparallel shifts 1. Is the 2-year spot rate higher or lower than 6%?
Practice
FI derivatives
2. Calculate the 2-year spot rate.
Topic 4: Value at Risk 3. Now suppose that there is another 2-year coupon bond with an
Topic 5: Credit risk annual coupon of 7%. What should be its price?
and asset-backed
securities
the credit crisis

Example: Answers
2-year spot rate is the solution to:
6 106
100 = +
Hedging risks
Options basics
1.05 (1 + r2 )2
Greeks ⇒ r2 ≈ 6.03%
Dynamic replication
Bonds
Yields and discount
⊲ factors
Forward rates
Duration
Convexity
The price of the 7% coupon bond should be:
Nonparallel shifts
Practice 7 107
FI derivatives P = + 2
≈ 101.84
Topic 3: Endogenous risk 1.05 (1 + r2 )

and asset-backed
securities
the credit crisis

Forward rates
Consider 1-year and 2-year zeroes with current spot rates 5% and 6%,
respectively.
Hedging risks 0 s=1 t=2
Options basics
Greeks r1 5%
Dynamic replication
Bonds r2 6%
Yields and discount
⊲ factors
Forward rates Suppose my horizon is 2 years. The total return over two years from
Duration
Convexity
investing in the 2-year zero is (1.06)2 − 1 = 12.36%
Nonparallel shifts
Practice The forward rate f1,2 is a “break even rate” that makes one indifferent
FI derivatives
Topic 3: Endogenous risk between the 1-year zero and 2-year zero investment opportunities over
two years:

2 (1 + r2 )2
Topic 6: Credit derivatives (1 + r2 ) = (1 + r1 )(1 + f1,2 ) =⇒ 1 + f1,2 =
and asset-backed
securities
1 + r1
the credit crisis

Forward rates (cont.)
More generally, forward rates can be found from the following equation:
(1 + rs )s (1 + fs,t )t−s = (1 + rt )t
Hedging risks
Options basics
Greeks
Dynamic replication Otherwise, arbitrage is possible
Bonds
Yields and discount
factors – E.g., suppose (1 + rs )s (1 + fs,t )t−s > (1 + rt )t
⊲ Forward rates
Duration
Convexity – To make arbitrage borrow 1 at rate rt for t years, lend 1 at rate rs
Nonparallel shifts
Practice
for s years, and then (1 + rs )s at rate fs,t for (t - s) years
FI derivatives

and asset-backed
securities
the credit crisis

Yield to maturity revisited
Remember: the yield to maturity y on a bond is its internal rate of
return—the discount rate that would equate the present value of the
and fixed income markets stream of payoffs with its market price.
Hedging risks
Options basics
T
Black-Scholes-Merton X ct
Greeks
P =
Dynamic replication
Bonds t=1
(1 + y)t
Yields and discount
factors
⊲ Forward rates Alternative way of quoting bond prices.
Duration
Convexity
Nonparallel shifts It is NOT, in general, equal to the return on the bond.
Practice
FI derivatives
It is inappropriate, in general, to use yield to maturity to make
and limits to arbitrage investment decisions!

and asset-backed
securities
the credit crisis

Example
Suppose that all bonds have a face value of 100.
and fixed income markets – The price of a 1-yr zero-coupon bond is 95.2381.
Hedging risks
Options basics
– The price of 2-yr coupon bond with an annual coupon of 6% is 100.
Greeks
Dynamic replication
Bonds
Questions:
Yields and discount
factors
⊲ Forward rates
1. Calculate the 1-yr spot rate.
Duration
Convexity
2. What is the YTM on the 2-yr bond?
Nonparallel shifts
Practice 3. Now suppose that in addition a 2-yr zero coupon bond trades in
FI derivatives
the market at 88.9829.
Topic 4: Value at Risk – What is this bond’s YTM?

Topic 6: Credit derivatives – Is the bond “cheap” or “expensive” compared to the other
and asset-backed
securities bonds?
the credit crisis

Example: Answers
1-yr spot rate = 5%.
and fixed income markets YTM on the 2-yr bond = 6%.
Hedging risks
Options basics
Greeks
For the 2-yr zero coupon bond:
Dynamic replication
Bonds
Yields and discount – YTM = 6.01%.
factors
⊲ Forward rates
Duration
Convexity
– Remember that the prices of the first two bonds imply a 2-yr spot
Nonparallel shifts rate of 6.03%.
Practice
FI derivatives
– This implies a price for the third bond of 88.95 < 88.98.
Topic 5: Credit risk – The third bond is expensive even though it has a high YTM!
and asset-backed
securities
the credit crisis

Bond prices and interest rates
Assume that interest rates are independent of maturity (flat term
Topic 1: Foundations structure): rt = r.
Topic 2: Hedging in equity PN
and fixed income markets Bond price: P = i=1 ci e−rti
Hedging risks
Options basics
Black-Scholes-Merton Bond convexity
280
Greeks
Dynamic replication
260
Bonds
Yields and discount
factors 240
⊲ Forward rates
Duration 220
Convexity
Nonparallel shifts 200
Price
Practice
FI derivatives 180
160
140
120
and asset-backed
securities
100
Topic 7: Regulation and 0.01 0.02 0.03 0.04 0.05 0.06 0.07 0.08 0.09 0.1
the credit crisis rt

Duration: Derivation
Taylor expansion:
and fixed income markets ′ (x − x0 )2 ′′
Hedging risks f (x) = f (x0 ) + (x − x0 )f (x0 ) + f (x0 ) + . . .
Options basics
2!
Greeks
Dynamic replication First order approximation:
Bonds
Yields and discount
factors
⊲ Forward rates
f (x) − f (x0 ) ≈ f ′ (x0 )(x − x0 )
Duration
Convexity
Nonparallel shifts
Bond price wrt a discrete change in yield ∆P ≈ dP dr ∆r.
Practice P
FI derivatives Differentiate bond price P = N i=1 ci e
−rti
wrt to yield:
N
Topic 4: Value at Risk dP X
=− ti ci e−rti
dr i=1
and asset-backed
securities
the credit crisis

Duration: Definition
Duration (continuous compounding):
N
1 X 1 dP
Hedging risks D ≡ ti ci e−rti = −
Options basics P i=1 P dr
Greeks
dP
Dynamic replication
∆P ≈ ∆r = −P D∆r
Bonds
Yields and discount
dr
factors ∆P
Forward rates and rewrite as: R(Bond) = ≈ −D∆r
⊲ Duration P
Convexity
Nonparallel shifts
Practice Relationship between percentage changes in a bond price and changes
FI derivatives
in interest rates.
∆P −D∆R
Compounding frequency m then P ≈ (1+R/m)
Modified duration (also: price sensitivity wrt to yield):
and asset-backed
securities
D
Topic 7: Regulation and DMod =
the credit crisis 1 + R/m

Duration of a bond with annual compounding
Macaulay duration:
Topic 2: Hedging in equity N N
and fixed income markets 1 X −rti 1 X ti c i
Hedging risks DMac = ti c i e =
Options basics P i=1 P i=1 (1 + R)ti
Greeks
Dynamic replication
Bonds
Yields and discount
factors
Forward rates
Modified Duration:
⊲ Duration
DMac
DMod =
Convexity
Nonparallel shifts
1 + R/m
Practice
FI derivatives

Dollar Duration (Delta):
dP
Topic 6: Credit derivatives D$ = − =P ×D
and asset-backed
securities
dr
the credit crisis

Interest rate changes and bond prices: Example
20-year bond
and fixed income markets R = 5% (annual compounding)
Hedging risks
Options basics
Greeks
Coupon 10%
Dynamic replication
Bonds
Yields and discount Par value 100
factors
Forward rates
⊲ Duration
Current price: 162.3, modified duration: 10.93
Convexity
Nonparallel shifts
Practice
FI derivatives ∆R = 0.001 ∆R = 0.01 ∆R = 0.1
Actual decline -1.76 -16.43 -93.60
Topic 4: Value at Risk Estimated decline -1.77 -17.74 -177.45
and asset-backed
securities
the credit crisis

Duration: Example
What is the duration of a five-year bond with 10% annual coupon if the
term structure is flat with R = 5%?
Hedging risks
Options basics
Black-Scholes-Merton t ct P V (ct ) P V (ct )/P V P V (ct )/P V × t
Greeks
Dynamic replication
Bonds
Yields and discount
1 10 9.524 0.078 0.078
factors
Forward rates 2 10 9.070 0.074 0.149
⊲ Duration
Convexity
Nonparallel shifts
3 10 8.638 0.071 0.213
Practice
FI derivatives 4 10 8.227 0.067 0.271
5 110 86.187 0.709 3.543

P = P V = 121.647 D = 4.253
and asset-backed
securities
the credit crisis

Duration: Example (cont.)
How does the bond price change if R goes up from 5% to 6%? What
change does the duration model predict?
Hedging risks - Pnew = 116.8495 (computed using P V formula)
Options basics
Greeks
- Hence, percentage change in bond price is:
Dynamic replication
Bonds Pnew − P
Yields and discount
= −3.9%
factors
Forward rates
P
⊲ Duration
Convexity - Modified duration is DMod = D/(1 + R) = 4.05
Nonparallel shifts
Practice
FI derivatives
- Duration predicts the following change in prices:
and limits to arbitrage Pnew − P
Topic 4: Value at Risk ≈ −DMod × change in R
P
and asset-backed = −4.05%
securities
the credit crisis

Example 1: Portfolio immunization
Consider a portfolio that consists of two bonds
and fixed income markets Approximate change in the market value of the portfolio for a small
Hedging risks
Options basics parallel shift in the yield curve:
Greeks
Dynamic replication −P1 x1 DMod,1 dy − P2 x2 DMod,2 dy
Bonds
Yields and discount
factors where Pi is the price and xi the holding of bond i
Forward rates
⊲ Duration
Convexity
Nonparallel shifts
The portfolio can be immunized to small, parallel changes in interest
Practice rates by choosing the hedge ratio
FI derivatives
and limits to arbitrage x1 P2 DMod,2
=−
Topic 4: Value at Risk x2 P1 DMod,1
and asset-backed
securities
the credit crisis

Example 2: Immunization
Many firms, pension funds and insurance companies have assets and
Topic 2: Hedging in equity liabilities that are sensitive to interest rate changes.
Hedging risks
Options basics
Greeks By carefully choosing the structure of assets it is possible to reduce the
Dynamic replication
Bonds interest rate sensitivity of net worth (= asset value - liability value).
Yields and discount
factors
Forward rates
⊲ Duration
Convexity This is achieved by matching the durations of assets and liabilities.
Nonparallel shifts
Practice Hence, net worth is not sensitive to interest rate fluctuations and firms
FI derivatives
Topic 3: Endogenous risk do not lose money because of interest rate fluctuations.

and asset-backed
securities
the credit crisis

Example 2: Immunization (cont.)
Suppose, you are a manager of an insurance company.
and fixed income markets – Your liabilities consist of four £10m payments in years 5, 6, 7 and 8
Hedging risks
Options basics from now.
Greeks
Dynamic replication
– The current interest rate (which is also your discount rate) is R =
Bonds
Yields and discount 5%.
factors
Forward rates
⊲ Duration – However, you are concerned that the interest rates may go down.
Convexity
Nonparallel shifts What is the immunization strategy in year t = 0?
Practice
FI derivatives
and limits to arbitrage Balance Sheet
Assets Liabilities
Topic 6: Credit derivatives £30m £10m in years 5, 6, 7, 8
and asset-backed
securities
the credit crisis

Net worth W is defined as the difference between the values of assets
and liabilities:
Hedging risks 10 10 10 10
Options basics W = 30 − − − −
Black-Scholes-Merton (1 + 0.05)5 (1 + 0.05)6 (1 + 0.05)7 (1 + 0.05)8
Greeks
Dynamic replication
Bonds = £0.82m
Yields and discount
factors
Forward rates If R falls to 4% W becomes:
⊲ Duration
Convexity
10 10 10 10
Nonparallel shifts
W = 30 − − − −
Practice
FI derivatives
(1 + 0.04)5 (1 + 0.04)6 (1 + 0.04)7 (1 + 0.04)8
= −£1.02m

and asset-backed The company loses money if the interest rate drops!
securities
the credit crisis

Suppose, to immunize the net worth the manager invests £30m and
Topic 2: Hedging in equity buys x3 units of 3-year zeros at price P3 and x10 units of 10-year zeros
Hedging risks at price P10 .
Options basics
Greeks
Dynamic replication
Bonds 3-year and 10-year bonds both pay £100 at expiration. Hence, their
Yields and discount
factors
Forward rates
prices are given by:
⊲ Duration
Convexity
100 100
Nonparallel shifts
P3 = 3
= 86.384, P10 = 10
= 61.391.
Practice (1 + 0.05) (1 + 0.05)
FI derivatives
Need to find x3 and x10 such that the net worth is not sensitive to
Topic 5: Credit risk interest rates.

and asset-backed
securities
the credit crisis

Modified duration of the stream of liabilities is: DMod,L = 6.13.
Topic 2: Hedging in equity Hence, changes in liabilities are given by:
Hedging risks
Options basics ∆L ≈ −DMod,L L∆R
Greeks
Dynamic replication The value of assets is given by:
Bonds
Yields and discount
factors
Forward rates
A = P3 x3 + P10 x10
⊲ Duration
Convexity
Nonparallel shifts
Approximate change in asset value is given by:
Practice
FI derivatives
∆A ≈ − DMod,3 P3 x3 ∆R − DMod,10 P10 x10 ∆R
| {z } | {z }
change in value change in value
of 3-year zeros of 10-year zeros
and asset-backed
securities
the credit crisis

Objective: choose x3 and x10 such that:
and fixed income markets ∆W = ∆A − ∆L ≈ 0
Hedging risks
Options basics
Greeks
Dynamic replication
Bonds
Yields and discount
Hence:
factors DMod,3 P3 x3 + DMod,10 P10 x10 = DMod,L L
Forward rates
⊲ Duration
Convexity
Nonparallel shifts
Practice
FI derivatives Moreover, we should have enough money to buy zeros:

P x +P x =
| 3 3 {z 10 10} |£30m
{z }
Topic 5: Credit risk total investment money available
and asset-backed
securities
the credit crisis

Putting numbers to these equations we get:
and fixed income markets 246.811x3 + 584.676x10 = 178.899m,
Hedging risks
Options basics 86.384x3 + 61.391x10 = 30m.
Greeks
Dynamic replication Hence, x3 = 185, 476 , x10 = 227, 684.
Bonds
Yields and discount
factors
Net worth (=assets-liabilities) the same as before: W = £0.82m. How
Forward rates does it change when R = 4%?
⊲ Duration
Convexity
Nonparallel shifts 18.547 22.768
Practice W = +
FI derivatives (1 + 0.04)3 (1 + 0.04)10
Topic 3: Endogenous risk 10 10 10 10
− − − −
Topic 4: Value at Risk (1 + 0.04)5 (1 + 0.04)6 (1 + 0.04)7 (1 + 0.04)8
Topic 6: Credit derivatives = £0.842m we no longer lose money when R ↓ !
and asset-backed
securities
the credit crisis

Note that immunization is a dynamic strategy and has to be revised at
Topic 2: Hedging in equity future dates.
Hedging risks
Options basics This is because as time passes 3-year and 10-year bonds become 2-year
Greeks
Dynamic replication
and 9-year bonds and hence their durations change.
Bonds
Yields and discount
factors Duration of the liabilities also changes when 1 year passes. In
Forward rates
⊲ Duration particular, the stream of liabilities becomes:
Convexity
Nonparallel shifts
Practice
FI derivatives
year: 4 5 6 7
Topic 4: Value at Risk £10 £10 £10 £10
Topic 5: Credit risk | {z }
Topic 6: Credit derivatives P V = L = 32.269
and asset-backed
securities
the credit crisis

Example: Pension fund
A pension fund manager has a known stream of liabilities over time (we
abstract away from shifts in mortality risks, etc.)
Hedging risks
Options basics This stream of liabilities must be met from the assets held by the
Greeks
pension fund
Dynamic replication
Bonds
Yields and discount In some countries, pension funds must mark to market their liabilities
factors
Forward rates (e.g. U.K. FRS 17)
⊲ Duration
Convexity
Nonparallel shifts Thus, liabilities have a well-defined duration. By holding assets of the
Practice
FI derivatives same duration, the fund manager can hedge against small parallel shifts
in interest rates.

and asset-backed
securities
the credit crisis

Convexity: Definition
Convexity:
Topic 2: Hedging in equity N
and fixed income markets 1 d2 P 1 X 2 −rti
Hedging risks C = = t ci e
Options basics P dr 2 P i=1 i
Greeks N
Dynamic replication 1 X 2
Bonds = ti ci Pz (t, ti )
Yields and discount P i=1
factors
Forward rates
⊲ Duration
Convexity
Nonparallel shifts
Practice Convexity with annual compounding
FI derivatives
Topic 3: Endogenous risk T
and limits to arbitrage 1 X t(t + 1)ct
Topic 4: Value at Risk C=
P t=1 (1 + R)t+2
and asset-backed
securities
the credit crisis

Convexity: Definition (cont.)
Dollar Convexity (Gamma):
and fixed income markets d2 P
Hedging risks C$ =
Options basics dr 2
Greeks
Dynamic replication
Bonds
Yields and discount
factors
Given a particular duration, convexity is highest when payments are
Forward rates spread evenly over a long period.
Duration
⊲ Convexity
Nonparallel shifts
Practice
FI derivatives

and asset-backed
securities
the credit crisis

Duration, convexity and parallel shifts
For discrete changes in yield: ∆P = P (r + ∆r) − P (r).
and fixed income markets A second order Taylor approximation around r gives:
Hedging risks
Options basics
dP 1 d2 P 2
∆P ≈ ∆r + ∆r
Greeks
Dynamic replication
dr 2 dr 2
Bonds ∆P 1
Yields and discount Then: ≈ −D∆r + C(∆r)2
factors P 2
Forward rates
Duration
⊲ Convexity The duration and convexity of a portfolio is the weighted average of
Nonparallel shifts
Practice the durations and convexities of the individual assets.
FI derivatives
A portfolio can be protected against small parallel shifts of yields by
Topic 4: Value at Risk ensuring that the duration is zero, while a convexity of zero insures
Topic 5: Credit risk against large parallel shifts.
and asset-backed
securities What about non-parallel shifts?
the credit crisis

Example: Convexity
Assume that the spot (zero-coupon) curve is flat at 4%.
Topic 2: Hedging in equity Calculate the convexity of the following 3-year bond:
Hedging risks
Options basics
– Face value 100.
Greeks – Annual coupon of 4%.
Dynamic replication
Bonds
Yields and discount
Answers:
factors
Forward rates – Coupon bond (P = 100):
Duration
⊲ Convexity
4 4 104
Nonparallel shifts
C = 1×2 2
+2×3 3
+3×4 4
= 10.98
Practice
FI derivatives
1.04 × 100 1.04 × 100 1.04 × 100

and asset-backed
securities
the credit crisis

Parallel shift in the yield curve
Hedging risks
Options basics
Greeks
Dynamic replication
Bonds
Yields and discount
factors
Forward rates
Duration
⊲ Convexity
Nonparallel shifts
Practice
FI derivatives

and asset-backed
securities Source: Hull, Risk Management and Financial Institutions, Wiley
the credit crisis

Non-parallel interest rate shifts
In reality, there are many non-parallel shifts to interest rates (flattening,
steepening, increase or decrease in curvature).
Hedging risks
Options basics Duration and convexity hedging can lead to poor results in such cases.
Greeks
Dynamic replication Exposure to such shifts is captured by partial durations:
Bonds
Yields and discount
factors 1 dP
Forward rates Di = −
Duration P dri
⊲ Convexity
Nonparallel shifts ∆P
Practice = −D1 ∆r1 − · · · − DN ∆rN .
FI derivatives P
The sum of partial durations equals the usual duration measure:
D = D1 + · · · + DN
and asset-backed
Alternatively, you can divide the curve into a number of “buckets” and
securities calculate the exposure bucket by bucket.
the credit crisis

Partial shift in the yield curve
Hedging risks
Options basics
Greeks
Dynamic replication
Bonds
Yields and discount
factors
Forward rates
Duration
Convexity
⊲ Nonparallel shifts
Practice
FI derivatives

and asset-backed
securities
the credit crisis Source: Hull, Risk Management and Financial Institutions, Wiley

Rotation in the yield curve
Hedging risks
Options basics
Greeks
Dynamic replication
Bonds
Yields and discount
factors
Forward rates
Duration
Convexity
Practice
FI derivatives

and asset-backed
the credit crisis

Exposure to rotations in the yield curve
Assume the following partial durations:
and fixed income markets Maturity 1 2 3 4 5 7 10 Total
Hedging risks
Options basics
Duration 0.2 0.6 0.9 1.6 2.0 -2.1 -3.0 0.2
Greeks
Dynamic replication Define a rotation as the following changes to the interest rates:
Bonds
Yields and discount
factors −3e, −2e, −e, 0, e, 3e, 6e
Forward rates
Duration
Convexity For a parallel shift e, the percentage change in the portfolio value is
Practice 0.2e.
FI derivatives
Topic 3: Endogenous risk The percentage change in value from the rotation is:

−[0.2 × (−3e) + 0.6 × (−2e) + 0.9 × (−e) + 2 × e
Topic 6: Credit derivatives −2.1 × 3e − 3 × 6e] = 25e
and asset-backed
securities
the credit crisis

Change with bucketing approach
Hedging risks
Options basics
Greeks
Dynamic replication
Bonds
Yields and discount
factors
Forward rates
Duration
Convexity
Practice
FI derivatives

and asset-backed
the credit crisis

Which delta?
DV01: change in portfolio value for one basis point (0.01%) parallel
shift in yield curve.
Hedging risks
Options basics
Traders calculate several deltas to reflect exposures to all different ways
Black-Scholes-Merton the yield curve can move (via partial duration, bucketing).
Greeks
Dynamic replication
Bonds Also calculate deltas with respect to the underlying instruments. I.e., a
Yields and discount
factors trader responsible for interest rate caps and swaptions will calculate
Forward rates
Duration
exposures to movements in the Eurodollar futures and the swap rates.
Convexity
⊲ Nonparallel shifts However: This may lead to calculating 10 to 15 Deltas per zero curve.
Practice
FI derivatives
Topic 3: Endogenous risk How to facilitate the analysis?

and asset-backed
securities
the credit crisis

Principal components analysis
Exploit fact that yields across maturities are highly correlated and
extract factors that drive the maximum variation in the overall term
and fixed income markets structure.
Hedging risks
Options basics
Standard statistical procedure: PCA
Greeks
Dynamic replication – Transform possibly correlated variables into uncorrelated PCs.
Bonds
Yields and discount
factors
– Transformation is defined such that first PC accounts for as much of
Forward rates the variability in the data as possible.
Duration
Convexity
Nonparallel shifts
– Each succeeding component has the highest variance possible under
⊲ Practice the constraint that it be orthogonal to the preceding components.
FI derivatives
The first three factors are labeled level, slope and curvature. They
account for almost 99% of all the variation.
Use the factors to model interest rate moves and focus on the factors
and asset-backed that the portfolio is most sensitive to.
securities
the credit crisis

Gamma and Vega
Given that you have several delta measures, there are many possible
gammas (including cross-gammas!).
Hedging risks
Options basics
One approach is to ignore the cross-gammas and only look at the
Black-Scholes-Merton second partial derivative with respect to a particular instrument.
Greeks
Dynamic replication
Bonds Alternatively, calculate a single gamma for the portfolio directly with
Yields and discount
factors respect to parallel shifts (i.e., dollar convexity).
Forward rates
Duration
Convexity
Yet another option is to calculate gammas with respect to the principal
Nonparallel shifts components.
⊲ Practice
FI derivatives
Topic 3: Endogenous risk Similar issues for vega. Again, calculate a single vega for the portfolio
or consider a PCA to calculate factors that reflect the volatility changes

across instruments.
and asset-backed
securities
the credit crisis

Hedging options in practice
In practice, similar simplifications are in place for option portfolios.
and fixed income markets Traders usually rebalance once a day in the underlying to make the
Hedging risks
Options basics
portfolio delta neutral.
Greeks This can be costly for a single option but for a large portfolio with
Dynamic replication
Bonds many (potentially offsetting positions) it becomes feasible.
Yields and discount
factors
Forward rates Achieving zero gamma and zero vega is more complicated as non-linear
Duration
Convexity
instruments are needed to make the hedge perfect. These instruments
Nonparallel shifts may not be easily available and liquid.
⊲ Practice
FI derivatives
Topic 3: Endogenous risk Financial institutions often sell options close to the money (when
gamma and vega are largest). Thus, the exposures may decline

naturally depending on the underlying.
and asset-backed In order to monitor the risks, limits on the delta, gamma and vega
securities
Topic 7: Regulation and exposures are defined.
the credit crisis

Interest rate derivatives
Interest rate swaps (previously discussed)
Hedging risks Caps
Options basics
Greeks
Dynamic replication
Bonds
Floors
Yields and discount
factors
Forward rates
Duration Swaptions
Convexity
Nonparallel shifts
⊲ Practice
FI derivatives

and asset-backed
securities
the credit crisis

Caps and floors
A cap is a portfolio of call options (caplets) on LIBOR.
and fixed income markets It can be used to cap future interest payments at a certain level.
Hedging risks
Options basics
Greeks
A floor is a portfolio of put options (floorlets) on LIBOR.
Dynamic replication
Bonds
Yields and discount A collar is a combination of a long position in a cap and a short
factors
Forward rates position in a floor, often set up to be zero-cost at initiation.
Duration
Convexity
Nonparallel shifts Spot volatilities and the volatility hump, flat volatility.
Practice
⊲ FI derivatives

and asset-backed
securities
the credit crisis

Swaptions
A swaption gives the right to enter into an interest rate swap at a
future date.
Hedging risks
Options basics Payer swaption: right to pay fixed in a swap.
Greeks
Dynamic replication
Bonds
Yields and discount
Receiver swaption: right to receive fixed in a swap.
factors
Forward rates
Duration
Convexity
Nonparallel shifts
Practice
⊲ FI derivatives

and asset-backed
securities
the credit crisis

Millennium Bridge
Portfolio insurance
1987 crash
MBS
Carry trades
Market efficiency Topic 3: Endogenous risk and limits to arbitrage
Empirical challenges
Noise trader risk
Limited capital
Synchronization risk
Tech bubble

and asset-backed
securities
the credit crisis

Outline
An example: The Millennium Bridge
Topic 3: Endogenous
risk and limits to
Portfolio insurance and the 1987 stock market crash
⊲ arbitrage
Millennium Bridge
Portfolio insurance
Hedging of mortgage-backed securities
1987 crash
MBS Carry trades
Carry trades
Market efficiency
Empirical challenges Market efficiency
Noise trader risk
Limited capital
Synchronization risk Empirical challenges
Tech bubble
Topic 4: Value at Risk Noise trader risk

and asset-backed
Outside capital and limits to arbitrage
securities
the credit crisis
The technology “bubble”

Endogenous risk
Danielsson and Shin (2003):
and fixed income markets “Endogenous risk refers to the risk from shocks that are generated and
and limits to arbitrage amplified within the system. It stands in contrast to exogenous risk,
Millennium Bridge which refers to shocks that arrive from outside the system.”
Portfolio insurance
1987 crash
MBS
Carry trades
Market efficiency
Noise trader risk
Limited capital
Tech bubble

and asset-backed
securities
the credit crisis

An example: The Millennium Bridge
Opened in June 2000. When pedestrians started using the bridge in
large numbers, it began to shake violently.
Topic 3: Endogenous risk The bridge had to be closed and it took over 18 months to fix the
Millennium Bridge problem.
Portfolio insurance
1987 crash
MBS What happened?
Carry trades
Market efficiency
The “wobble” was caused by horizontal vibrations at 1 hertz.
Noise trader risk
Limited capital
Normal walking pace produces vertical vibrations at about 2 hertz.
Tech bubble
Topic 4: Value at Risk However, walking also produces a small sideways force every two steps
Topic 5: Credit risk (1 hertz).
and asset-backed
securities These forces do not matter as long as the force to the left by one
the credit crisis
person is canceled by the force to the right of another person.
It becomes a problem when people walk in step.

http://www.youtube.com/watch?v=gQK21572oSU

An example: The Millennium Bridge (cont.)
What is the probability that a large number of pedestrians will end up
walking exactly in step?
and limits to arbitrage Amplification mechanism:
⊲ Millennium Bridge
Portfolio insurance
1987 crash
Gust of wind (trigger) → Bridge moves a little → All pedestrians adjust
MBS their step in the same direction → bridge moves more → further
Carry trades
Market efficiency adjustment in step → Wobble is amplified
Noise trader risk
Limited capital Bridge is at risk because of a gust of wind and the ensuing endogenous
Tech bubble
response.
Topic 5: Credit risk Contrast this with a perfect storm (exogenous).

and asset-backed
securities
the credit crisis

The Millennium Bridge and financial markets
Similar feedback effects are likely to be relevant in financial markets
because often the outcome for one participant depends on the actions
and fixed income markets of others.
⊲ Millennium Bridge
Four examples:
Portfolio insurance
1987 crash
MBS
Carry trades – Portfolio insurance (LOR case study).
Market efficiency
Noise trader risk – Hedging of mortgage-backed securities.
Limited capital
Tech bubble – Carry trades.

– Long-Term Capital Management (Case study).
and asset-backed
securities
the credit crisis

Portfolio insurance
Protection on stock market investments in the form of a put option on
a stock index.
Topic 3: Endogenous risk The idea is to replicate the put option through dynamic trading in the
⊲ Millennium Bridge underlying.
Portfolio insurance
1987 crash
MBS – For simplicity, assume that the riskless rate of interest is zero.
Carry trades
Market efficiency
– Suppose that an investor starts with a cash balance of zero.
Noise trader risk
Limited capital
– The investor can borrow and lend unlimited amounts at the riskless
Tech bubble rate.
Topic 5: Credit risk Consider the following two strategies:

and asset-backed
securities – Strategy 1: borrow and buy a put at price p.
the credit crisis
– Strategy 2: sell −∆ (delta of the put option) of the underlying asset
and invest the proceeds −S∆ at the riskless rate.

Leland O’Brien Rubinstein Associates
What type of investors may be interested in portfolio insurance?
and fixed income markets – Risk averse investors: Managers of institutional portfolios (eg.
Topic 3: Endogenous risk pension plans) may have high intolerance for losses. They have
Millennium Bridge asymmetric incentives and a poor performance might cost them the
⊲ Portfolio insurance
job.
1987 crash
MBS
Carry trades
Market efficiency
– Investors who expect to outperform the market: Would like to
Empirical challenges eliminate market risk and focus on generating α. Have less incentive
Noise trader risk
Limited capital
to purchase portfolio insurance if they are already evaluated relative
Synchronization risk to a benchmark.
Tech bubble

How does portfolio insurance work?
and asset-backed
securities
the credit crisis

LOR: Index futures and portfolio insurance
Consider forward contracts:
Topic 2: Hedging in equity – By no arbitrage: F = Ser(T −t)
– ∆S translates to ∆F = ∆Ser(T −t) .
Millennium Bridge
⊲ Portfolio insurance – Instead of shorting ∆ = (1 − N (d1 )) of the underlying, sell
1987 crash
MBS
e−r(T −t) (1 − N (d1 )) of the forward.
Carry trades
Market efficiency In practice, the strategy is executed using index futures contracts.
Noise trader risk
Limited capital
– Using futures can introduce basis risk.
Tech bubble – Increase in volatility can make strategy suddenly more costly (vega
Topic 4: Value at Risk risk).
and asset-backed
Limits to dynamic replication with large movements.
securities
Topic 7: Regulation and Liquidity needs.
the credit crisis

Put price and Delta (K=50)
Put price
Topic 1: Foundations 50

25
Millennium Bridge
1987 crash
MBS
Carry trades
0
Market efficiency 0 25 50 75 100
Empirical challenges Spot price
Noise trader risk
Limited capital Delta (put, K=50)
0
Tech bubble

−0.5
and asset-backed
securities
the credit crisis
−1
0 25 50 75 100
Spot price

Portfolio insurance: Price changes
What happens to the value of the two portfolios when the price of the
underlying changes to S ′ ?
Topic 3: Endogenous risk – Portfolio 1:
Millennium Bridge
⊲ Portfolio insurance p′ − p
1987 crash
MBS put cash
Carry trades
Market efficiency
Noise trader risk
Limited capital – Portfolio 2:
Tech bubble S ′ ∆ − S∆ ≈ p′ − p

stock cash
and asset-backed
securities
where the last approximation is good for small price changes.
the credit crisis Thus, the change in value of the two portfolios is approximately equal
for small changes in the price of the underlying.

Portfolio insurance: Rebalancing
After the price change, the investor needs to rebalance the position in
the underlying asset in portfolio 2.
and limits to arbitrage The investor needs to sell −(∆′ − ∆) additional units of the underlying
Millennium Bridge
⊲ Portfolio insurance asset at price S ′ . (Positive quantity if price of underlying falls.)
1987 crash
MBS
Carry trades The new portfolio 2 is given by:
Market efficiency
Noise trader risk
Limited capital ∆’ stock
Tech bubble −S∆ − S ′ (∆′ − ∆) ≈ −S ′ ∆′ + (p′ − p) cash

Topic 6: Credit derivatives Continue to rebalance portfolio 2 until the expiration date.
and asset-backed
securities
the credit crisis

Portfolio insurance: Payoffs at maturity
If the option is in the money at expiration, portfolio 2 has a value of
K − ST − p0 and the following composition:
Topic 3: Endogenous risk −1 stock
Millennium Bridge ST + (K − ST − p0 ) cash,
1987 crash
MBS If the option is out of the money at expiration, the value of portfolio 2
Carry trades
Market efficiency is −p0 and the composition is given by:
Noise trader risk
Limited capital 0 stock
Tech bubble
(0 − p0 ) cash,
Topic 5: Credit risk The value of portfolio 2 at expiration can thus be written:
and asset-backed
securities max[K − ST − p0 , −p0 ]
the credit crisis
Same as final payoff on portfolio 1, which consists of buying a put at

time 0 at price p0 , and holding it to maturity.

Portfolio insurance and endogenous risk
Feedback effect:
Topic 3: Endogenous risk Stock index falls → Initial hedge too small
Millennium Bridge
↑ ↓
⊲ Portfolio insurance More price pressure ← Need to sell more
1987 crash
MBS
Carry trades
Market efficiency
Empirical challenges In the case of portfolio insurance, dynamic replication involves buying
Noise trader risk
Limited capital
high and selling low.
Tech bubble
Topic 4: Value at Risk If this strategy is followed by a substantial fraction (wealth-weighted) of

Topic 5: Credit risk market participants, it has the potential of exacerbating price volatility.
and asset-backed
securities
the credit crisis

The stock market crash of 1987
There was a substantial selling pressure on the NYSE at the open on
Monday, October 19.
Topic 3: Endogenous risk While futures markets opened on time, many specialists in the stocks
Millennium Bridge did not open for trading in the first hour.
1987 crash
MBS Futures contracts sold at substantial discounts to cash markets.
Carry trades
Market efficiency
Trading volume was around three times higher than usual and
Noise trader risk executions were reported up to an hour late.
Limited capital
Tech bubble Investors at times didn’t know whether limit orders were executed or
Topic 4: Value at Risk not.
and asset-backed
Top ten sellers accounted for 50% of non-market-maker volume.
securities
the credit crisis
The Dow Jones Industrial Average fell by 22%. S&P500 futures
contracts fell by more than 28%.

Timeline
S&P 500 index around the time of the crash

350
5−minute intervals
Commerce report 1:09 News report 8:41 (line at 9:30)

on trade deficit of SEC Chairman’s Federal Reserve
325
comments announcement
9:30 NYSE
opens but 11:45
many prices CBOE suspends trading
stale 300
12:15
CME suspends trading
Reports that a
House committee 1:04 275
filed legislation CBOE & CME reopen
to eliminate tax
benefits associated
with financing mergers 250
225
200
Oct. 14 Oct. 15 Oct. 16 Oct. 19 Oct. 20 Oct. 21
Source. Market data.

The role of portfolio insurance
It is estimated that at the time of the crash, around 60-90 billion dollars
of capital were committed to formal portfolio insurance schemes
and fixed income markets (around 3% of the total market capitalization).
Millennium Bridge The market declined by around 10% from Wednesday, October 14, to
Portfolio insurance
⊲ 1987 crash
Friday, October 16.
MBS
Carry trades
Market efficiency
This should have led to sales of around 12 billion dollars by portfolio
Empirical challenges insurers. Actual sales were only around 4 billion dollars over this
Noise trader risk
Limited capital
three-day period.
Tech bubble
There was substantial pent-up sales pressure on Monday morning.

In addition, other market participants were trying to sell, perhaps in
and asset-backed anticipation of the large sales by portfolio insurers.
securities
the credit crisis Impossible to replicate put dynamically. Example where the real and the
synthetic put do not lead to the same payoffs (Grossman, 1988)!

Other factors in the crash
Margin calls: Even if investors had offsetting positions, they first needed
to post margin on the positions that lost value.
and limits to arbitrage Uncertainty and herd behavior: Information about current market
Millennium Bridge
Portfolio insurance
conditions was difficult to obtain. Generalized panic selling was one
⊲ 1987 crash consequence and market participants reacted to price movements rather
MBS
Carry trades than any particular news (Leland & Rubinstein, 1988; Shiller, 1989).
Market efficiency
Noise trader risk International phenomenon whereas portfolio insurance was mostly a
Limited capital
U.S. based activity.
Tech bubble

and asset-backed
securities
the credit crisis

Circuit-breakers
Prices not informative on October 19.
and fixed income markets Index futures sold at large discount relative to cash market on Monday
and limits to arbitrage and Tuesday.
Millennium Bridge
Portfolio insurance
⊲ 1987 crash Unjustified (ex post) concerns about widespread failure of
MBS
Carry trades clearinghouses and other market participants.
Market efficiency
Noise trader risk Panic selling.
Limited capital
Tech bubble Rationale for intervention in the form of an “informative trading halt”
(e.g. Greenwald & Stein, 1988).
and asset-backed
securities
the credit crisis

Hedging of mortgage-backed securities
Typical U.S. mortgage: 30-year fixed rate with embedded prepayment
option.
and limits to arbitrage The prepayment option allows the borrower to pay off the debt early at
Millennium Bridge
Portfolio insurance par value.
⊲ 1987 crash
MBS
Carry trades
Market efficiency Mortgage-backed securities are securitized pools of these mortgages.
Noise trader risk
Limited capital
Tech bubble

and asset-backed
securities
the credit crisis

Perli & Sack (2003)
“Does Mortgage Hedging Amplify Movements in Long-term Interest
Rates?”
and limits to arbitrage Optimal to re-finance mortgage (exercise the prepayment option) when
Millennium Bridge
Portfolio insurance interest rates fall enough.
1987 crash
⊲ MBS
Carry trades
Market efficiency Therefore, as interest rates fall, the duration of mortgage backed
Noise trader risk
securities can fall!
Limited capital
Tech bubble This is the opposite of conventional bonds, where as interest rates fall,
duration rises.
and asset-backed
securities
the credit crisis

Perli & Sack (2003) (cont.)
Dealers who hold MBSs short Treasury bonds (or pay on swaps) in
order to hedge their aggregate interest rate risk.
Millennium Bridge
They need to adjust their hedge positions as interest rates change.
Portfolio insurance
1987 crash
⊲ MBS This can lead to feedback effects:
Carry trades
Market efficiency
Noise trader risk
Limited capital
Fall in interest rates → Duration mismatch
Synchronization risk ↑ ↓
Tech bubble
Treasury prices rise ← Buy Treasury bonds

and asset-backed
securities
the credit crisis

Uncovered interest rate parity (UIP)
A key relationship in international finance is Uncovered Interest Rate
Parity (UIP).
Millennium Bridge An approximated version of this relationship is:
Portfolio insurance
1987 crash
⊲ MBS Et st+1 − st = rt − rt⋆ ,
Carry trades
Market efficiency
Empirical challenges where st is the log nominal exchange rate, rt and rt⋆ are domestic and
Noise trader risk
Limited capital
foreign one period nominal interest rates.
Tech bubble
Topic 4: Value at Risk It means that an expected depreciation should be compensated by an

interest rate differential. It also implies that there should be no
and asset-backed expected excess return from arbitraging across currencies.
securities
the credit crisis

Carry trades in currencies
Borrow in currencies with low interest rates.
Invest in currencies with high interest rates.
Millennium Bridge
Portfolio insurance
1987 crash
MBS
⊲ Carry trades
If the exchange rate remains unchanged, earn the interest rate
Market efficiency differential (carry).
Noise trader risk
Limited capital
Tech bubble In fact, high yielding currencies tend to appreciate against low yielding
Topic 4: Value at Risk currencies (violation of Uncovered Interest Parity).
and asset-backed
securities
the credit crisis

Foreign exchange futures or forwards
Foreign exchange futures are very important in financial markets.
Topic 2: Hedging in equity - Let S denote the current price of ¥ (Japanese yen) expressed in £
(pound sterling) (i.e. spot exchange rate);
Millennium Bridge
Portfolio insurance - Let F denote the futures price of ¥ expressed in £;
1987 crash
MBS
⊲ Carry trades - Let r£ and r¥ denote riskless rates in UK and Japan.
Market efficiency
Noise trader risk
Limited capital
Tech bubble
Then, no-arbitrage pricing implies that:
1 + r£
Topic 5: Credit risk F =S .
Topic 6: Credit derivatives 1 + r¥
and asset-backed
securities
the credit crisis

Foreign exchange futures or forwards (cont.)
Suppose,
Topic 1: Foundations 1 + r£
Topic 2: Hedging in equity F <S
and fixed income markets 1 + r¥
and limits to arbitrage Then, arbitrage can be constructed as follows:
Millennium Bridge
Portfolio insurance
1987 crash 1. At t = 0 borrow 1 ¥ at interest rate r¥ ;
MBS
⊲ Carry trades
Market efficiency 2. At t = 0 convert 1 ¥ into S £, lend S £ in UK (or buy 1-year zero
Noise trader risk
Limited capital
with payoff in £) at interest rate r£ ;
Tech bubble
3. At t = 0 take long position in currency forward (i.e. commit to buy
Topic 4: Value at Risk ¥ in one year at price F £);
4. At t = 1 convert your profit in £ into ¥ at futures price and repay
and asset-backed
securities your loan.
the credit crisis

Foreign exchange futures or forwards (cont.)
In year 1 the investor will receive S(1 + r£ ).
Topic 2: Hedging in equity - Then, investor will buy S(1 + r£ )/F yen;
and limits to arbitrage - In year 1 need to repay (1 + r¥ ) in yen;
Millennium Bridge
Portfolio insurance
1987 crash
- Net profit: S(1 + r£ )/F − (1 + r¥ ) > 0.
MBS
⊲ Carry trades
Market efficiency Similarly, it is possible to construct an arbitrage opportunity if
Noise trader risk
Limited capital
1 + r£
F >S
Tech bubble
1 + r¥
Topic 5: Credit risk Consequently, in the absence of arbitrage

and asset-backed
securities 1 + r£
F =S
the credit crisis
1 + r¥

An example: Dollar-Yen in the late nineties
During 1995–1998:
Topic 3: Endogenous risk High interest rates in the US (around 6%).
Millennium Bridge
Portfolio insurance
1987 crash
MBS Very low interest rates in Japan (around 2.5%).
⊲ Carry trades
Market efficiency
Noise trader risk
Limited capital At the same time the dollar kept appreciating against the yen, reaching
Tech bubble
a high of 147 ¥/$ in August of 1998.

and asset-backed
securities
the credit crisis

Japanese interest rates
3
JPY 10−year yield
2.8
2.6
2.4
2.2
1.8
1.6
1.4
1.2
1
Jan−97 Apr−97 Jul−97 Oct−97 Jan−98 Apr−98 Jul−98 Oct−98 Jan−99

US interest rates
7.5
UST 1yr
UST 10yrs
7
6.5
5.5
4.5
3.5

USD-JPY exchange rate
150
145
140
135
130
125
120
115
110
Jan−97 Apr−97 Jul−97 Oct−97 Jan−98 Apr−98 Jul−98

The USD-JPY carry trade
The following trade was very popular at the time:
Topic 3: Endogenous risk Borrow in Japanese yen.
Millennium Bridge
Portfolio insurance
1987 crash
MBS Invest in US dollar assets.
⊲ Carry trades
Market efficiency
Noise trader risk
Limited capital Gain both on the interest rate differential and the appreciation of the
Tech bubble
dollar.

and asset-backed
securities
the credit crisis

USD-JPY exchange rate
150
145
140
135
130
125
120
115
110

USD-JPY in October 1998 and currency crashes
The dollar collapsed against the yen over the two-day period of October
7 and October 8, falling from 131 ¥/$ to 112 ¥/$.
Millennium Bridge Prior to these two days, the fall in the dollar was moderate: less than
Portfolio insurance
1987 crash
10% since mid-August.
MBS
⊲ Carry trades
Market efficiency
Noise trader risk
Limited capital
Tech bubble Decline in dollar → Margin calls on carry trades
Topic 4: Value at Risk ↑ ↓
Topic 5: Credit risk Unwind: sell dollar assets, convert dollars into yen to repay yen debt
and asset-backed
securities
the credit crisis

US interest rates
5.5
UST 1yr
5.3 UST 10yrs
5.1
4.9
4.7
4.5
4.3
4.1
3.9
3.7
3.5
01−Sep−98 11−Sep−98 21−Sep−98 01−Oct−98 11−Oct−98 21−Oct−98 31−Oct−98

JPY-NZD exchange rate
100
90
80
70
60
50
40
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

Carry trades are very profitable
Even considering crashes, the carry trade is extremely profitable on
average.
Millennium Bridge
Using a cross-section of emerging markets currencies and interest rates
Portfolio insurance (1990–2010), a long-short portfolio of currencies beats the equity index
1987 crash
MBS by a factor of 4
⊲ Carry trades
Market efficiency
Noise trader risk Table 4: Summary statistics of currency portfolios (1990-2010)
Limited capital
Tech bubble Equity Index Pf1 Pf2 Pf3 Pf4 HML

Mean 2.70 -0.33 1.67 3.54 10.31 10.65
Topic 6: Credit derivatives StDev 17.03 8.00 9.83 9.90 13.63 11.08
and asset-backed
securities Sharpe Ratio 0.16 -0.04 0.17 0.36 0.76 0.96
the credit crisis
Skewness -0.62 0.29 -0.19 -0.64 -0.30 -0.58
Kurtosis 0.71 2.67 3.52 7.05 4.16 5.01

“Carry Trades, Monetary Policy & Speculative Dynamics” Plantin & Shin (2011)
Failure of Uncovered Interest Parity may be reinforced by carry traders:
“One obvious possibility is that the actions of carry traders are
and fixed income markets self-fulfilling; when they borrow the yen and buy the dollar, they drive
and limits to arbitrage the former down and the latter up.” (The Economist, 22/02/2007)
Millennium Bridge
Portfolio insurance
1987 crash In the aftermath of the 2008 financial crisis, interest rates in developed
MBS
⊲ Carry trades markets are close to zero: Press writes about currency wars and hence
Market efficiency
speculative carry trades that destabilize markets.
Noise trader risk
Limited capital
Plantin and Shin ask in their paper whether speculators in FX markets
Synchronization risk have a stabilizing or destabilizing effect.
Tech bubble
Topic 4: Value at Risk Milton Friedman: Stabilizing effect of speculation when arbitrageurs
speed up reversion to fundamental value.
and asset-backed
securities
the credit crisis

“Carry Trades, Monetary Policy & Speculative Dynamics” (cont.)
The model allows for both stabilizing and destabilizing effect where
speculators’ actions to engage in a carry trade take on attributes of
and fixed income markets strategic complements (i.e. the fact that others trade the carry makes it
and limits to arbitrage more attractive to oneself).
Millennium Bridge
Portfolio insurance The main idea of the paper is that whether speculative activity is
1987 crash
MBS stabilizing or destabilizing depends on the monetary policy rule of the
⊲ Carry trades
central bank.
Market efficiency
Noise trader risk If monetary policy (i.e. inflation targeting) is very sensitive, then
Limited capital greater capital inflow fuels an increase in interest rates and hence and
Tech bubble increase in the attractiveness of the carry trade.

Example: Iceland’s central bank was following an inflation target since
Topic 6: Credit derivatives 2001. Interest rates were relatively high and fueled large capital inflows
and asset-backed
securities through so called Glacier bonds. These bonds represented 30% of GDP.
the credit crisis All of a sudden there was a sharp appreciation of the Krona

Forecasting prices and efficient markets
A definition of market efficiency (Malkiel, 1992):
– “A capital market is said to be efficient if it fully and correctly
Millennium Bridge
reflects all relevant information in determining security prices.
Portfolio insurance Formally, the market is said to be efficient with respect to some
1987 crash
MBS
information set...if security prices would be unaffected by revealing
⊲ Carry trades that information to all participants. Moreover, efficiency with
Market efficiency
Empirical challenges respect to an information set...implies that it is impossible to make
Noise trader risk
Limited capital
economic profits by trading on the basis of [that information set].”
Tech bubble
Topic 4: Value at Risk Classification of market efficiency (Roberts, 1967)

Topic 6: Credit derivatives – Weak-form efficiency: history of prices
and asset-backed
securities
– Semistrong-form efficiency: all publicly available information
the credit crisis
– Strong-form efficiency: all (including private) information

Arbitrage
Textbook arbitrage: “the simultaneous purchase and sale of the same,
or essentially similar, security in two different markets at
and fixed income markets advantageously different prices” (Sharpe and Alexander, 1990)
Millennium Bridge
Portfolio insurance
1987 crash
The traditional argument is that the forces of arbitrage should ensure
MBS that security prices are in line with fundamental value.
Carry trades
⊲ Market efficiency
Noise trader risk
Limited capital
According to the EMH view, this should hold even if some investors are
Synchronization risk irrational, as long as securities have close substitutes. The idea is that
Tech bubble
irrational investors should lose money over time and eventually

disappear from the market (Friedman, 1953).
and asset-backed
securities
the credit crisis

Twin shares (Froot and Dabora, 1999)
Closed end funds (Lee, Shleifer and Thaler, 1991)
Millennium Bridge
Portfolio insurance
1987 crash
Stock index inclusions (e.g. Shleifer, 1986)
MBS
Carry trades
⊲ Market efficiency Momentum in the short run (e.g. Jegadesh and Titman, 1993)
Noise trader risk
Limited capital
Synchronization risk Mean reversion in the long run (e.g. De Bondt and Thaler, 1985)
Tech bubble

and asset-backed
securities
the credit crisis

Royal Dutch and Shell
Royal Dutch and Shell merged their operations in 1907. Agreement
that all future cash flows would be split on a 60:40 basis.
Topic 3: Endogenous risk Hence, if the prices of these companies were equal to the present values
Millennium Bridge of their future cash flows, the Royal Dutch share price should equal 1.5
Portfolio insurance
1987 crash
times the price of Shell.
MBS
Carry trades
Market efficiency
In reality the ratio of the two share prices fluctuates significantly around
⊲ Empirical challenges the value of 1.5. There are periods where Royal Dutch trades at a
Noise trader risk
Limited capital
significant discount (up to 35%) and other periods where it traded at a
Synchronization risk premium (up to 10%) relative to Shell.
Tech bubble

Royal Dutch trades mostly in the United States and the Netherlands,
while Shell trades primarily in the United Kingdom.
and asset-backed
securities
Other examples: ADRs (American Depository Receipts). There are
the credit crisis cases where identical shares trade at different prices in the United
States and the home market.

Royal Dutch and Shell: Deviations from parity
0.3
0.2
0.1
0.1
0.2
0.3
0.4

Closed end funds
A closed end fund, like an open end fund, is a mutual fund that
typically holds shares of other publicly traded companies.
and limits to arbitrage Unlike an open end fund, a closed end fund issues a fixed number of
Millennium Bridge
Portfolio insurance shares that are traded on an exchange.
1987 crash
MBS
Carry trades
Market efficiency In order to get out of the fund, investors needs to sell their shares in the
⊲ Empirical challenges
fund to other investors.
Noise trader risk
Limited capital
Tech bubble Closed end fund shares typically do not trade at prices equal to the per
share market value of the assets held by the fund.
and asset-backed
securities Discounts of 10–20% are not uncommon.
the credit crisis

Stock index inclusions
When a stock is included for the first time in the S&P500 index, its
price rises on average by 3.5%.
and limits to arbitrage Need to separate announcement and inclusion day returns.
Millennium Bridge
Portfolio insurance
1987 crash
MBS Inclusion in the index leads to heavy mechanical buying by index funds,
Carry trades
Market efficiency which are just trying to replicate the return on the index.
Noise trader risk
Limited capital
However, according to the efficient markets view, as long as there is no
Tech bubble news about the fundamentals of the company, this should not lead to a
price increase since current owners of the stock should be happy to sell
and move into substitutes.
and asset-backed
securities
the credit crisis

Momentum and mean reversion
Positive or negative excess returns over the previous 6 to 12 months
tend to be followed by excess returns of the same sign in the short-run
and fixed income markets (momentum).
Millennium Bridge
Portfolio insurance
1987 crash In contrast, there is ample evidence of mean reversion in the long-run.
MBS
Carry trades
De Bondt and Thaler (1985) use data over a three year period to form
Market efficiency “loser” and “winner” portfolios. Over the five years following portfolio
Noise trader risk formation, the “loser portfolio” significantly outperforms the “winner
Limited capital
portfolio”.
Tech bubble

These patterns may be interpreted as underreaction to news in the
and asset-backed short-run and overreaction in the long-run.
securities
the credit crisis

Cross-sectional momentum
Time-series momentum tells us that a security’s own past return

predicts its future return, but there is also cross-sectional momentum
which means that a securities out-performance relative to peers predicts
and fixed income markets relative future performance.
Millennium Bridge
The high returns in momentum portfolios is not just a phenomenon in
Portfolio insurance equity markets but more generally across different assets. Moskowitz,
1987 crash
MBS Ooi, and Pedersen (2012) find high abnormal returns when building
Carry trades
Market efficiency
time-series momentum portfolios. Asness, Moskowitz, and Pedersen
⊲ Empirical challenges (2013) find that cross-sectional momentum is found in individual stocks
Noise trader risk
Limited capital in the United States, the United Kingdom, continental Europe, and
Tech bubble
Japan; but also in country equity index futures, government bonds,
currencies, and commodity futures.
Moreover, there is strong co-movement between the different strategies,
and asset-backed which suggests that a small number of factors can explain their
securities
variation.
the credit crisis
Funding liquidity risk can explain partially the premia earned in
momentum portfolios.

Price = fundamental value?
Behavioural finance is based on the observation that real-world
arbitrage is risky.
and limits to arbitrage Often securities do not have close substitutes (e.g. the aggregate stock
Millennium Bridge
Portfolio insurance market).
1987 crash
MBS
Carry trades
Market efficiency Even when there are perfect substitutes, an arbitrageur is exposed to
the risk that the mispricing may get worse before it gets better (“noise
Noise trader risk
Limited capital trader risk”).
Tech bubble

Capital limits and finite horizons can therefore seriously limit the
arbitrageurs’ ability to force prices to equal fundamental value, even in
and asset-backed cases where the prices of two securities ultimately converge with
securities
probability 1.
the credit crisis

Noise trader risk
This section is based on De Long, Shleifer, Summers, & Waldmann
(Journal of Political Economy, 1990) and Shleifer (2000), chapter 2.
Millennium Bridge Two groups of investors:
Portfolio insurance
1987 crash
MBS
Carry trades – Rational arbitrageurs.
Market efficiency
Noise trader risk
Limited capital
– Noise traders.
Tech bubble
Topic 5: Credit risk Noise traders have erroneous beliefs about future return distributions.
and asset-backed
securities
the credit crisis

Noise trader risk: A model
Two-period overlapping generations model where agents choose a
portfolio in the first period and consume their entire wealth in the
and fixed income markets second period.
Millennium Bridge Two assets s and u that pay identical dividends.
Portfolio insurance
1987 crash – Asset s is the safe asset.
MBS
Carry trades
Market efficiency
⊲ Perfectly elastic supply.
⊲ Noise trader risk ⊲ Pays a dividend equal to the riskless interest rate r.
Limited capital
Synchronization risk ⊲ Can be exchanged for one unit of consumption good (the
Tech bubble

numeraire) at any date.
Topic 5: Credit risk ⊲ Hence its price is always equal to 1.
and asset-backed
securities
– Asset u is the risky asset.
the credit crisis ⊲ Pays exactly the same dividends as asset s.
⊲ It is in fixed supply of 1 unit.

Noise trader risk: Key driver
Let the price of asset u at time t be denoted by pt .
Topic 3: Endogenous risk If prices were equal to the net present value of future cash flows, then
Millennium Bridge the price of both securities should always equal 1.
Portfolio insurance
1987 crash
MBS
Carry trades This model illustrates that this does not necessarily hold in the presence
Market efficiency
Empirical challenges of noise traders.
⊲ Noise trader risk
Limited capital
Tech bubble Note that the argument relies on limited riskbearing capacity of
Topic 4: Value at Risk arbitrageurs as a whole.
and asset-backed
securities
the credit crisis

Noise trader risk: Agents
Arbitrageurs are denoted by a. There is a measure (1 − µ) of them.
and fixed income markets Noise traders are denoted by n. There is a measure µ of them.
Millennium Bridge
Portfolio insurance
Noise traders misperceive the expected price of the risky asset by an
1987 crash i.i.d. normal random variable:
MBS
Carry trades
Market efficiency
ρt ∼ i.i.d. N (ρ∗ , σ 2 )
Limited capital
Tech bubble
Both types choose their portfolio in the first period to maximize their
expected utility in the second period. Assume constant absolute risk
aversion utility:
and asset-backed
securities
Ut = − exp(−2γwt )
the credit crisis

Noise trader risk: Pricing function
Taking first order conditions and imposing market clearing gives the
price for the risky asset:
and limits to arbitrage µ(ρt − ρ∗ ) µρ∗ µ2 σ 2
Millennium Bridge pt = 1 + + − 2γ
Portfolio insurance 1+r r r(1 + r)2
1987 crash
MBS
Carry trades
Market efficiency
As ρt converges to a point mass at zero, the price converges to 1.
The second term gives the fluctuation in the price due to noise trader
Limited capital
Synchronization risk misperceptions.
Tech bubble
Topic 4: Value at Risk The third term captures average bullishness or bearishness of the noise
Topic 5: Credit risk traders.
and asset-backed
securities
the credit crisis

Noise trader risk: Pricing function (cont.)
Price for the risky asset:
and fixed income markets µ(ρt − ρ∗ ) µρ∗ µ2 σ 2
Topic 3: Endogenous risk pt = 1 + + −2γ
and limits to arbitrage 1+r r r(1 + r)2
Millennium Bridge
Portfolio insurance
1987 crash
MBS The final term captures the essence of the model.
Carry trades
Market efficiency
Empirical challenges Since arbitrageurs are risk averse, they are not willing to hold the risky
asset unless they are compensated for the random variations in its price
Limited capital
Synchronization risk induced by the noise traders.
Tech bubble

Noise traders “create their own space”: the risk introduced by shocks
to their beliefs drives the equilibrium price of the asset down (and its
and asset-backed expected return up).
securities
the credit crisis This holds in spite of the fact that there is no fundamental risk in this
economy.

The closed end fund puzzle revisited
The noise trader model can potentially explain four salient facts about
closed end funds:
and limits to arbitrage – Closed end funds start out at a premium of around 10%.
Millennium Bridge
Portfolio insurance
1987 crash
MBS – They move to an average discount of 10% in the first 120 days of
Carry trades
Market efficiency trading.
Limited capital
– The discounts fluctuate widely over time.
Tech bubble

– On announcement of fund termination, the discounts typically
Topic 6: Credit derivatives shrink to small magnitudes.
and asset-backed
securities
the credit crisis

Arbitrage with limited capital
Arbitrage requires capital and in practice this is largely provided by
outside investors. This creates an agency relationship between the
and fixed income markets owners and the managers of the arbitrage capital.
Millennium Bridge
If capital is limited, arbitrage ability is limited, and liquidity provision is
Portfolio insurance not perfect.
1987 crash
MBS
Carry trades
Shleifer & Vishny (1997, or see Shleifer, 2000, chapter 4) postulate that
Market efficiency mutual/hedge fund investors redeem their capital following losses. This
⊲ Noise trader risk fact constraints arbitrageurs’ ability to correct mispricing, triggers
Limited capital liquidations and amplification.
Tech bubble
Shleifer & Vishny show that these constraints limit liquidity provisions

not only when they are binding but also when there is a chance that
Topic 6: Credit derivatives they will bind in the future. That is, arbitrageurs fear that future losses
and asset-backed
securities will cause forced liquidations. So, they limit their exposure to risky
Topic 7: Regulation and assets.
the credit crisis
Risk management emerges as a response to capital constraints.

Arbitrage with limited capital: Main idea
Suppose that the outside investors do not have a full understanding of
the strategies pursued by the manager.
Topic 3: Endogenous risk In this case, it may be rational for investors to allocate funds based on
Millennium Bridge past performance of the manager and to withdraw some capital after a
Portfolio insurance
1987 crash
poor performance (“performance based arbitrage”).
MBS
Carry trades
Market efficiency
This means that the arbitrageurs may face capital constraints precisely
Empirical challenges when their investments have the best prospects, i.e. when the
Noise trader risk
⊲ Limited capital
mispricing they bet against initially deepens.
Tech bubble
Anticipating these potential capital constraints, rational arbitrageurs
will be less aggressive in their initial bets against a mispricing.
and asset-backed As a result, arbitrage may not fully enforce market efficiency.
securities
the credit crisis

Setup of the model
Three types of traders:
Topic 2: Hedging in equity – Noise traders.
– Rational arbitrageurs.
Millennium Bridge
Portfolio insurance – Rational investors in arbitrage funds.
1987 crash
MBS One asset with fundamental value V . The arbitrageurs know V , but the
Carry trades
Market efficiency investors do not.
Noise trader risk There are three periods. The price of the asset in period t is denoted by
⊲ Limited capital
Synchronization risk pt .
Tech bubble
Topic 4: Value at Risk At time t = 3, V becomes known to the noise traders as well as the
Topic 5: Credit risk arbitrageurs. Hence p3 = V .
and asset-backed
securities
– Hence there is no long-run risk!
the credit crisis Noise traders generate pessimism shocks in periods 1 and 2, driving the
price below the fundamental value.

Solution of the model
Arbitrageurs have limited funds under management (Ft ).
and fixed income markets At the intermediate date, investors need to update their beliefs about
expected returns of the arbitrageur going forward.
Millennium Bridge
Portfolio insurance They do not know or understand the strategy followed by the
1987 crash
MBS arbitrageur and they base their update purely on the performance of the
Carry trades
Market efficiency
arbitrageur during the first period (“performance based arbitrage”).
Noise trader risk A high pessimism shock in period 2 means that noise trader
⊲ Limited capital
Synchronization risk misperception of the value deepens before converging to V at t = 3.
Tech bubble

and asset-backed
securities
the credit crisis

Solution of the model (cont.)
Signal extraction problem for the investor. Poor performance in the
intermediate date may be due to:
Topic 3: Endogenous risk – Random shock
Millennium Bridge
Portfolio insurance – Deepening of the mispricing
1987 crash
MBS
Carry trades – Lack of skill
Market efficiency
Noise trader risk If the supply of funds is a function of the performance, funds are
⊲ Limited capital
withdrawn when the arbitrageur has the highest expected returns, i.e.
Tech bubble when the mispricing deepens in the short-run.
Topic 5: Credit risk Solve model backwards to maximize final wealth of arbitrageurs.
and asset-backed
securities
the credit crisis

Propositions (Shleifer, 2000)
Proposition 3:
– Arbitrageurs face fund withdrawals in response to an adverse price
and fixed income markets shock. If fully invested initially, they need to liquidate some of their
position. They have to do so in spite of the fact that their initial
Millennium Bridge trade now has a higher expected return than before.
Portfolio insurance
1987 crash
MBS
– Full investment at t = 1 is sufficient but not necessary for this to
Carry trades occur.
Market efficiency
Noise trader risk
Proposition 4:
⊲ Limited capital
– When arbitrageurs are fully invested, prices fall more than one for
Tech bubble one with the shock to noise trader misperceptions.
Topic 5: Credit risk – Arbitrageurs reduce their positions as the price moves further away
Topic 6: Credit derivatives from fundamental value.
and asset-backed
securities
It is thus possible that the stabilizing effect of arbitrageurs on prices is
the credit crisis
weakest when prices are furthest away from fundamental value.

Abreu and Brunnermeier (2002) postulate that arbitrageurs have
limited capital. So a single arbitrageur cannot correct mispricing alone.
Topic 3: Endogenous risk Also, arbitrageurs are not simultaneously aware about profit
Millennium Bridge
opportunities.
Portfolio insurance
1987 crash So they do not necessarily jump in together to correct mispricing.
MBS
Carry trades Finally, there are holding costs. That is, it is costly to hold open
Market efficiency
Empirical challenges positions in the expectation that mispricing will be corrected.
Noise trader risk
⊲ Limited capital As a result, mispricing can last for some time because arbitrageurs fail
Tech bubble to coordinate in entering the market.
Kondor (2009) similarly generates persistent price divergence from the
dynamic choices of arbitrageurs that need to decide when to enter the
and asset-backed
securities
market.
the credit crisis

Brunnermeier & Nagel (2004): Summary
The efficient market hypothesis is based on the presumption that

rational investors prevent price bubbles by trading against mispricing.
BN establish two main facts for the 2000 technology bubble:
1. Hedge funds were riding the technology bubble, not attacking it.
Millennium Bridge Hedge fund stock portfolios were tilted towards tech stocks.
Portfolio insurance
1987 crash 2. On a stock-by-stock basis, hedge funds reduced their holdings
MBS
Carry trades
before prices collapsed. Within the technology segment—and only
Market efficiency there—they outperformed standard characteristics- matched
Noise trader risk benchmarks. Evidence that hedge fund managers understood that
Limited capital
⊲ Synchronization risk
prices of these stocks would eventually deflate.
Tech bubble

BN conclude that investor sentiment, which was driving the technology
bubble was predictable to some extent and that hedge funds were
Topic 6: Credit derivatives exploiting this opportunity. Under these conditions, riding a bubble for
and asset-backed
securities a while can be the optimal strategy for rational investors (as in Abreu
the credit crisis
and Brunnermeier, 2003).

The 2000 tech bubble
Technology stocks on Nasdaq rose to unprecedented levels during the
two years leading up to March 2000.
Topic 3: Endogenous risk Valuations were implicitly assuming growth rates of earnings exceeding
Millennium Bridge what was previously experienced even by the fastest growing stocks.
Portfolio insurance
1987 crash
MBS High price to sales stocks (mostly tech stocks) experienced a four-fold
Carry trades
Market efficiency
price increase and huge correction after March 2000.
Noise trader risk These valuations appear to be another example of an asset price bubble.
Limited capital
⊲ Tech bubble

and asset-backed
securities
the credit crisis

Research questions
Stylized facts seem manifestation of investor irrationality.
and fixed income markets However, this cannot survive without limits to arbitrage.
Millennium Bridge
Portfolio insurance
What were arbitrageurs doing during this period?
1987 crash
MBS
Carry trades BN look at the trading behavior of the most sophisticated investor
Market efficiency
class: hedge funds (HFs).
Noise trader risk
Limited capital
Synchronization risk They draw data from 13F filings: all institutions with more than USD
⊲ Tech bubble 100m in U.S. equity have to report their end-of-quarter long positions.

Did HFs attack or ride the bubble?
and asset-backed
securities
the credit crisis

Weights of HFs in the tech sector
Millennium Bridge
Portfolio insurance
1987 crash
MBS
Carry trades
Market efficiency
Noise trader risk
Limited capital
⊲ Tech bubble

Topic 6: Credit derivatives HFs were overweight in tech stocks at least until the peak of the
and asset-backed
securities Nasdaq (March 2000).
the credit crisis They did not attack the bubble, rather they were riding it.

Individual HFs behavior and consequences
Soros was riding the bubble especially after June 1999. Tiger was a value manager,
definitely not riding the bubble. Exposure to tech stocks went to zero in June 1999.
Diverging paths.
Soros did well during the bubble. Investors kept pouring in money. As Tiger’s
performance was poor during the bubble, it suffered from redemption.
Eventually, Tiger fund was liquidated in March 2000 because its asset base eroded too
much. Just before the bubble burst!

Brunnermeier & Nagel (2004): Conclusion
HF managers timed the market correctly. On average they got out
before decline.
and limits to arbitrage Evidence is consistent with synchronization risk (Abreu &
Millennium Bridge
Portfolio insurance
Brunnermeier, 2002 & 2003).
1987 crash
MBS
Carry trades Not only do we observe that arbitrageurs do not correct mispricing (as
Market efficiency
predicted by financial constraints) but...
Noise trader risk
Limited capital we also see that arbitrageurs ride the bubble, possibly because they
⊲ Tech bubble
anticipated that it will continue for some time.
The example about Tiger is consistent with the limits to equity capital
as described in Shleifer & Vishny (1997).
and asset-backed
securities
Topic 7: Regulation and That is, temporary losses trigger redemptions that prevent arbitrageurs
the credit crisis
to hold on to a strategy that would pay off in the longer run.


Definition
VaR
Coherence
ES
Stylized facts
Volatility modeling
Implementing VaR
Backtesting
RAROC
VaR upper bound

and asset-backed
securities
the credit crisis

Outline
Define and measuring risk
and limits to arbitrage Value at Risk
⊲ Topic 4: Value at Risk
Definition Coherent risk measures
VaR
Coherence
ES Expected shortfall
Stylized facts
Volatility modeling
Implementing VaR
Volatility modeling
Backtesting
RAROC Implementing VaR
VaR upper bound
Topic 5: Credit risk Back testing and stress testing

and asset-backed
securities RAROC
the credit crisis
Upper bound for VaR

Defining and measuring risk
Danielsson (2010)
Topic 2: Hedging in equity Risk measure: “mathematical concept for understanding risk”
Risk measurement: “number that captures risk”
Definition
VaR
Coherence
Problems:
ES
Stylized facts Underlying distribution unknown
Volatility modeling
Implementing VaR
Backtesting Cannot measure risk directly
RAROC
VaR upper bound

and asset-backed
securities
the credit crisis

Notation
p Probability
q Profit and loss (P/L)
⊲ Definition VaR Value at Risk
VaR
Coherence
ES ES Expected Shortfall
Stylized facts
Volatility modeling
Implementing VaR ϕ(·) Risk measure
Backtesting
RAROC
VaR upper bound
w Vector of portfolio weights
and asset-backed
securities
the credit crisis

Distribution free risk measures
Distribution of financial returns usually unknown and hard (if not
impossible) to accurately identify.

Suggests use of distribution-free risk measures.
⊲ Definition
VaR
Coherence
ES Most common risk measures:
Stylized facts
Volatility modeling – Volatility
Implementing VaR
Backtesting
RAROC
– Value at Risk
VaR upper bound
– Expected Shortfall or Tail Loss
and asset-backed
securities
the credit crisis

Volatility as a measure of risk
If financial returns are i.i.d. normal
then the first two moments completely describe the distribution

⊲ Definition and volatility is the measure of risk.
VaR
Coherence
ES
Stylized facts Alternatively, for an agent with mean-variance preferences, volatility is
Volatility modeling
Implementing VaR
also a sufficient measure of risk.
Backtesting
RAROC
VaR upper bound Unfortunately, this is not true...
and asset-backed
securities
the credit crisis

Value at Risk, VaR
VaR is a quantile on the distribution of profit and loss.
Topic 3: Endogenous risk Mathematically (use minus sign because VaR is a positive number):
Topic 4: Value at Risk Z −VaR(p)

⊲ Definition
VaR Pr[q ≤ −VaR(p)] = p = f (q)dq
Coherence −∞
ES
Stylized facts
Volatility modeling
Implementing VaR
Backtesting
RAROC “VaR summarizes the worst loss over a target horizon that will not be
VaR upper bound
exceeded with a given level of confidence” Jorion (2007)
and asset-backed
securities
“VaR: The loss on a trading portfolio such that there is a probability p
the credit crisis of losses equalling or exceeding VaR in a given trading period and a
(1 − p) probability of losses being lower than VaR” Danielsson (2010)

VaR inputs
Probability (p)
Topic 2: Hedging in equity – Most common level is 1% (equivalent: confidence level c = 99%).
Topic 4: Value at Risk Holding period

Definition
⊲ VaR – Time period over which losses can occur.
Coherence
ES
Stylized facts
– Must be long enough for corrective measures and needs to reflect
Volatility modeling illiquidity of assets.
Implementing VaR
Backtesting
RAROC
– Usually one day.
VaR upper bound
– Longer holding periods more realistic for institutional investors,
shorter (intra-day) VaR for proprietary trading desks.
and asset-backed
securities
the credit crisis Probability distribution
– Estimate using past observations and statistical model.

Interpreting VaR
VaR numbers are meaningless without probability and holding period.
Capital required against failure and for internal controls. VaR violation occurs when
trading losses exceed VaR:
– For 1% daily VaR: we expect to lose less than VaR 99 days out of 100.
– For 250 trading days per year, the expected number of violations is then 2.5.
Facilitates comparisons between asset classes: risks summarized in a single number.
Is VaR positive or negative?

– VaR can be presented as positive or negative number.
– Probabilities can be stated as close to one or close to zero (VaR(95%) or
VaR(5%)).
– Safer to say numbers are more/less extreme.

VaR and Basel I
Required capital against market risk: based on VaR (since 1996 amendment to 1988
Basel I).
Inputs:
– Probability: 1%
– Holding period: 10 days or two calendar weeks.
– Observation period based on at least a year of data, updated at least once a
quarter.
Regulatory framework allows capital to depend on accuracy of VaR model—this can

have important consequences if the VaR model is defective.
– Capital is higher of previous day’s VaR and average VaR over last 60 business days
times a “multiplier” k (k ≥ 3).
– Higher k imposed by regulators if backtesting reveals many exceptions.
Required capital against credit and operational risk: based on a one-year VaR with
99.9% confidence level (Basel II).

Coherent risk measures (Artzner et al 1999)
1. Monotonicity:
Topic 2: Hedging in equity X≤Y ⇒ ϕ(X) ≥ ϕ(Y )
and limits to arbitrage 2. Subadditivity:
Definition
ϕ(X + Y ) ≤ ϕ(Y ) + ϕ(X)
⊲ VaR
Coherence
ES
3. Positive homogeneity:
Stylized facts
Volatility modeling
ϕ(cX) = cϕ(X) c > 0
Implementing VaR
Backtesting
RAROC
4. Translation invariance:
VaR upper bound
ϕ(X + c) = ϕ(X) − c
and asset-backed
securities
the credit crisis

Violating coherence
Is volatility subadditive? Is it coherent?
Topic 3: Endogenous risk VaR is not a coherent risk measure as it violates subadditivity.
Topic 4: Value at Risk – If returns are normal, VaR is a coherent risk measure.
Definition
VaR
⊲ Coherence – Subadditivity only violated for very fat tails.
ES
Stylized facts
Volatility modeling
Implementing VaR
– Examples of assets/areas with occasional very large negative returns:
Backtesting pegged currencies, electricity prices, defaultable bonds, insurance.
RAROC
VaR upper bound

Homogeneity can be violated if there is liquidity risk.
and asset-backed
securities
the credit crisis VaR can be manipulated.

VaR and subadditivity
2 assets:
and fixed income markets – A, B, independent and with same distribution
Topic 4: Value at Risk ⊲ 4.9% chance for return −100

Definition
VaR
⊲ Coherence ⊲ 95.1% chance return is 0
ES
Stylized facts
Volatility modeling
Implementing VaR
– VaR(5%) = 0, VaR(1%) =100
Backtesting
RAROC
VaR upper bound Equally weighted portfolio with A and B:
Topic 6: Credit derivatives VaR(5%)(0.5A + 0.5B) = 50 > VaR(5%)(A) + VaR(5%)(B) = 0
and asset-backed
securities
the credit crisis
For sufficiently fat tails, subadditivity is violated

Expected shortfall or tail loss
“Expected shortfall (ES) is the expected loss conditional on VaR being
violated” Danielsson 2010
Mathematically:
and limits to arbitrage R −VaR(p)
Topic 4: Value at Risk −∞
qf (q)dq
Definition ES = E [loss|loss ≥ VaR(p)] = − R −VaR(p)
VaR −∞
f (q)dq
⊲ Coherence Z −VaR(p)
ES 1
Stylized facts =− qf (q)dq
Volatility modeling p −∞
Implementing VaR
Backtesting
RAROC
ES takes the shape of the tail distribution into account while VaR does
VaR upper bound not.
ES is a coherent risk measure, complement to VaR.
and asset-backed
securities Useful especially for option positions, fat tails.
the credit crisis
May be hard to implement in practice.

Distributions with the same VaR but different ES

Definition
VaR VaR
Coherence
⊲ ES
Stylized facts
Volatility modeling
Implementing VaR
Backtesting
RAROC
VaR upper bound

Topic 6: Credit derivatives VaR
and asset-backed
the credit crisis

Basel III and VaR
The Basel III accord – which will be phased in through 2019 – requires
banks to maintain top-quality capital equivalent to 7% of their
and fixed income markets risk-weighted assets.
Banks using in-house mathematical models to value their trading book
Definition
risks should also use a standardized approach as backstop. The
VaR standardized approach refers to measuring credit risk on assets by using
Coherence
⊲ ES credit ratings from rating agencies.
Stylized facts
Volatility modeling After the financial crisis, a number of weaknesses have been identified
Implementing VaR
Backtesting with using VaR for determining regulatory capital requirements, include
RAROC
VaR upper bound
its inability to capture tail risk. For this reason, the relevant risk metric
Topic 5: Credit risk is the expected shortfall rather than VaR.
and asset-backed Tougher boundary between a bank’s trading book and its banking book
securities
to reduce regulatory arbitrage. This would prevent lenders from shifting
the credit crisis assets between books to try to lower their capital requirements.

Example 9.6 (Hull)
Two $10m one-year loans.
Probability of default on each loan of 1.25%.

Definition Assume that if one loan defaults, the other does not.
VaR
Coherence
⊲ ES
Stylized facts In case of default, recovery value is uniformly distributed on [0; 100%].
Volatility modeling
Implementing VaR
Backtesting
RAROC If a loan does not default, a profit of $0.2m is made.
VaR upper bound

and asset-backed
securities
the credit crisis

Example 9.6 (Hull): Solution
For each individual loan, the one-year 1% VaR is $2m.
Topic 2: Hedging in equity – Unconditional probability of a loss greater than $2m is 0.0125 × 0.8
Topic 3: Endogenous risk = 0.01.
Topic 4: Value at Risk For the portfolio of both loans, the one-year 1% VaR is $5.8m:
Definition
VaR – 2.5% probability of one loan defaulting.
Coherence
⊲ ES
– unconditional probability of a loss greater than $6m on the
Stylized facts
Volatility modeling defaulting loan is 0.025 × 0.4 = 0.01.
Implementing VaR
Backtesting
RAROC
– profit on the other loan of $0.2m.
VaR upper bound
Total VaR of the two loans separately: $4m < $5.8m.
and asset-backed
In spite of diversification benefits, portfolio VaR is higher in this case
securities (fails subadditivity).
the credit crisis
Incentive to break up portfolios.

Example 9.8 (Hull)
The one-year 1% tail loss on a single loan is equal to $6m.
and fixed income markets – Expected value of the loss conditional on the loss being greater than
and limits to arbitrage $2m).
Definition
VaR The one-year 1% tail loss on the portfolio of two loans is equal to
Coherence
⊲ ES
$7.8m.
Stylized facts
Volatility modeling
Implementing VaR – Portfolio VaR is $5.8m.
Backtesting
RAROC
VaR upper bound – If one loan defaults, the other does not.
and asset-backed – Hence loss on portfolio, conditional on the loss being greater than
securities
$5.8m is uniformly distributed on [5.8; 9.8].
the credit crisis
Tail loss satisfies subadditivity (6 + 6 > 7.8).

Holding periods and scaling
Choice of holding period:

– One day most common.
Topic 2: Hedging in equity – Shorter holding periods for risk management on trading floor
(mostly 90% VaR).
and limits to arbitrage – Longer holding periods for financial institutions, institutional
Definition
investors.
VaR
Coherence
Long holding periods are hard to estimate.
⊲ ES
Stylized facts Estimate for shorter periods and then use scaling law.
Volatility modeling
Implementing VaR Square-root-of-time rule:
Backtesting
RAROC
VaR upper bound
– V ar(xt + xt+1 ) = V ar(xt ) + V ar(xt+1 ) = 2σ 2
⊲ Assumes iid data, regardless of distribution.
and asset-backed
√
securities – VaRN days = VaR1 day × N
the credit crisis ⊲ Only correct with iid normal data.
– Dangerous to use square-root-of-time rule in practice.

Impact of autocorrelation
Table 5: Ratio of N-day VaR to 1-day VaR
N =1 N =2 N =5 N = 10 N = 50 N = 250
ρ=0 1.0 1.41 2.24 3.16 7.07 15.81
ρ = 0.05 1.0 1.45 2.33 3.31 7.43 16.62
ρ = 0.1 1.0 1.48 2.42 3.46 7.80 17.47
ρ = 0.2 1.0 1.55 2.62 3.79 8.62 19.35
Source: Hull, Risk Management and Financial Institutions, Wiley

Stock index: S&P 500
Value-weighted (eg. S&P 500) vs. price weighted (eg. DJIA)
and fixed income markets Broad-based index vs. sector indices
Topic 4: Value at Risk S&P 500

Definition
VaR
Coherence
– “Widely regarded as the best single gauge of the U.S. equities
⊲ ES market, this world-renowned index includes 500 leading companies
Stylized facts
Volatility modeling in leading industries of the U.S. economy.” (Standard & Poors
Implementing VaR
Backtesting
website)
RAROC
VaR upper bound
– Represents approximately 75% of US market cap
– Important benchmark for portfolio managers and trading volume for
and asset-backed SPDRs is highest for any US stock
securities
the credit crisis
– Does not include dividends.

S&P 500 1950–2016: index level
Administrative Details 2200

Topic 2: Hedging in equity 2000
Topic 3: Endogenous risk 1800
Topic 4: Value at Risk 1600

Definition
VaR
1400
Coherence
ES
⊲ Stylized facts 1200
Volatility modeling
Implementing VaR 1000
Backtesting
RAROC
800
VaR upper bound
Topic 5: Credit risk 600

and asset-backed
400
securities
the credit crisis 200
0
1950 1960 1970 1980 1990 2000 2010

S&P 500 1950–2016: log returns
Administrative Details 0.1

0
Definition
VaR
Coherence
ES
⊲ Stylized facts
Volatility modeling
Implementing VaR
-0.1
Backtesting
RAROC
VaR upper bound

and asset-backed
securities
-0.2
Topic 7: Regulation and 1950 1960 1970 1980 1990 2000 2010
the credit crisis
Simple (normal) returns: Rt = (Pt − Pt−1 )/Pt−1

Continuously compounded (log) returns: rt = log(Pt /Pt−1 )

S&P 500 1950–2016: histogram
Topic 3: Endogenous risk 200

Definition
VaR 150
Coherence
ES
⊲ Stylized facts
Volatility modeling 100
Implementing VaR
Backtesting
RAROC
VaR upper bound
50
and asset-backed
securities
0
Topic 7: Regulation and -0.05 -0.04 -0.03 -0.02 -0.01 0 0.01 0.02 0.03 0.04 0.05
the credit crisis

S&P 500 1950–2016: summary statistics
Table 6: Daily log returns 03/01/1950–01/06/2016
and fixed income markets Mean 0.03% (7.39% annualized)
and limits to arbitrage StdDev 0.97% (15.34% annualized)
Topic 4: Value at Risk Min -22.90% (19 Oct 1987)
Definition
VaR
Max 10.96% (28 Oct 2008)
Coherence Skewness -1.02
ES
⊲ Stylized facts Kurtosis 30.33
Volatility modeling
Implementing VaR
Autocorr(1) 2.84%
Backtesting Autocorr(1) squared returns 14.46%
RAROC
VaR upper bound

and asset-backed
securities
the credit crisis

S&P 500 1950–2016: QQ plots
Topic 1: Foundations QQ Normal
QQ t(4)
and fixed income markets 6
4
Definition
VaR
Coherence 2
ES
⊲ Stylized facts
Volatility modeling 0
Implementing VaR
Backtesting
RAROC -2
VaR upper bound

-4
and asset-backed
securities
Topic 7: Regulation and -6
the credit crisis
-8
-8 -6 -4 -2 0 2 4 6 8

Stylized facts
Daily mean return is close to zero, standard deviation is much higher.
Occasionally there are large negative drops, distribution is negatively
and limits to arbitrage skewed.
Definition
VaR
Coherence
Fat tails.
ES
⊲ Stylized facts
Volatility modeling
Implementing VaR
Time-varying volatility and volatility clustering.
Backtesting
RAROC
VaR upper bound Time-varying correlation and higher correlation during downturns.
and asset-backed
securities
Autocorrelation for returns is low.
the credit crisis
Autocorrelation for squared returns is positive.

Distribution of returns
Table 7: Probability distribution of return in Real World
and fixed income markets Real World (%) Normal Model (%)
and limits to arbitrage >1 SD 25.04 31.73
Definition
>2 SD 5.27 4.55
VaR >3 SD 1.34 0.27
Coherence
ES >4 SD 0.29 0.01
⊲ Stylized facts
>5 SD 0.08 0.00
Volatility modeling
Implementing VaR >6 SD 0.03 0.00
Backtesting
RAROC
VaR upper bound Source: Hull, Risk Management and Financial Institutions, Wiley
and asset-backed
securities
the credit crisis

Stepwise distribution modeling
Topic 2: Hedging in equity 1. Establish and evaluate volatility forecasting model.

Definition
VaR 2. Link individual volatility forecasts with correlation model to get
Coherence
ES
time-varying covariance model.
⊲ Stylized facts
Volatility modeling
Implementing VaR
Backtesting
RAROC
VaR upper bound 3. Model additional conditionally non-normal aspects of assets in portfolio.
and asset-backed
securities
the credit crisis

Univariate volatility models
Moving average (MA)
Exponentially weighted moving average (EWMA)

Definition GARCH type models
VaR
Coherence
ES
⊲ Stylized facts Stochastic volatility
Volatility modeling
Implementing VaR
Backtesting
RAROC Implied volatility
VaR upper bound

Topic 6: Credit derivatives Realized volatility
and asset-backed
securities
the credit crisis

Notation
and fixed income markets ht = σt2 Conditional variance of returns
Topic 4: Value at Risk W Estimation window

Definition
VaR
Coherence λ Decay factor in EWMA
ES
Stylized facts
⊲ Volatility modeling θ Parameter vector
Implementing VaR
Backtesting
RAROC z Residuals
VaR upper bound

and asset-backed
securities
the credit crisis

Conditional variance
Log returns:
rt = log(Pt /Pt−1 )
∼ N (0, σt2 )
and limits to arbitrage – Assume that daily mean return is zero.
Definition
– Returns are conditionally normal and unconditionally non-normal.
VaR
Coherence Conditional variance:
ES
Stylized facts
⊲ Volatility modeling
σt2 = ht = f (r1 , . . . , rt−1 )
Implementing VaR
Backtesting – At time t we have all necessary information to estimate ht+1 .
RAROC
VaR upper bound – f (·) is estimated using a sample of return observations over an
Topic 5: Credit risk estimation window.
and asset-backed
securities Residuals are iid random variable:
Topic 7: Regulation and rt
the credit crisis zt = √
ht
p
rt = ht zt

Moving average (MA) models
W −1
1 X 2
ht+1 = r
Topic 1: Foundations W i=0 t−i
and fixed income markets 100
Topic 3: Endogenous risk 5 week
50
Definition
VaR
0
Coherence 2000 2010
ES
100
Stylized facts
⊲ Volatility modeling 10 week
Implementing VaR
50
Backtesting
RAROC
VaR upper bound
0
2000 2010
Topic 6: Credit derivatives 100
and asset-backed 20 week
securities
Topic 7: Regulation and 50
the credit crisis
0
2000 2010

Exponentially weighted moving average (EWMA)
Weights: λ, λ2 , λ3 , . . .
Topic 2: Hedging in equity ∞ ∞
and fixed income markets X
i λ 1−λ X i
Topic 3: Endogenous risk λ = , so λ =1
i=1
1 − λ λ i=1
Definition Variance:
VaR
Coherence ∞ ∞
ES 1−λ X i 2 2 1−λX i 2
Stylized facts ht = λ rt−i = (1 − λ)rt−1 + λ rt−i
⊲ Volatility modeling λ i=1 λ i=2
Implementing VaR
Backtesting
∞
X
2
RAROC = (1 − λ)rt−1 + (1 − λ) λi rt−1−i
2
VaR upper bound
i=1
2
Topic 6: Credit derivatives = (1 − λ)rt−1 + λht−1
and asset-backed
securities
the credit crisis
λ is the decay factor.
RiskMetrics: λ = 0.94 for daily data.

GARCH
Generalized ARCH
GARCH(p,q):

q
X p
X
2
Definition
VaR
ht = ω+ αi rt−i + βi ht−i , ω, ∀αi , ∀βi > 0
Coherence i=1 i=1
ES
Stylized facts
GARCH(1,1)
Implementing VaR
Backtesting 2
RAROC
ht = ω + αrt−1 + βht−1 , ω, α, β > 0
VaR upper bound
ω
Topic 5: Credit risk E(ht ) = E(h) = ω + αE(h) + βE(h) = 1−α−β
and asset-backed
securities
Topic 7: Regulation and Covariance stationary iff α + β < 1
the credit crisis

S&P 500 1990–2016: GARCH volatility
Annualized GARCH Volatility in %, 1990-2016
100
90
Topic 4: Value at Risk 80

Definition
VaR
Coherence 70
ES
Stylized facts
⊲ Volatility modeling 60
Implementing VaR
Backtesting
RAROC
50
VaR upper bound

and asset-backed
securities
the credit crisis
20
1990 1995 2000 2005 2010 2015

Stochastic volatility
Used in continuous time finance
and fixed income markets drt = µ(rt , t)dt + σ(rt , t)dWt + dZt

Definition σ(rt , t) is the stochastic volatility.
VaR
Coherence
ES Potentially, you can also have jumps in the volatility.
Stylized facts
Implementing VaR
Backtesting
More general than GARCH. ht+1 has an innovation term that is
RAROC unknown at time t.
VaR upper bound

Much harder to estimate and to forecast volatility.
and asset-backed
securities
Topic 7: Regulation and Little evidence that it produces superior volatility forecasts.
the credit crisis

Implied volatility
Recall the BS formula:

Topic 1: Foundations c(S, t, X, T ) = SN (d1 ) − Xe−r(T −t) N (d2 )

S
ln( X ) + (r + 12 σ 2 )(T − t) √
Topic 3: Endogenous risk d1 = √ , d2 = d1 − σ T − t
and limits to arbitrage σ T −t
Definition
VaR
The BS model has only one free parameter, the asset return volatility σ.
Coherence
ES Call and put option values increase monotonically with increasing σ.
Stylized facts
At-the-money (ATM) option prices are approximately linear in volatility.
Implementing VaR
Backtesting
Given the contract specifications (X, T ) and the current market
RAROC observations (St , r), the mapping between the option price and σ is a
VaR upper bound
unique one-to-one mapping.
Topic 6: Credit derivatives The σ input into the BS formula that generates the market observed
and asset-backed
securities option price is referred to as the implied volatility (IV).
the credit crisis Practitioners often quote IV instead of the option price.

Implied volatility and return volatility σ
If the real world behaved just like BS, σ would be constant.
and fixed income markets – One σ input would match market quotes on options at all days, all
Topic 3: Endogenous risk strikes, and all maturities and implied volatility is the same as the

security’s return volatility.
Definition
VaR
Coherence
In reality, the BS assumptions are violated. With one σ input, the BS
ES model can only match market quotes at a specific date, strike, and
Stylized facts
maturity.
Implementing VaR
Backtesting
RAROC
– The IVs at different (t, K, T ) are usually different—this is a direct
VaR upper bound evidence that the BS assumptions do not hold in reality.
– IV can no longer be interpreted as return volatility.
and asset-backed
securities – IV still reflects the time value of the option.
the credit crisis – The intrinsic value of the option is model independent. Hence,
modelers should only pay attention to the time value.

Why are we interested in implied volatility?
The IV is calculated using the BS model. However, the fact that practitioners use the BS
model to quote options does not mean that they agree with the BS assumptions.
On the contrary, the very fact that they quote/vary/twist model implied volatility
shows that the BS assumptions are violated.
So why IV? It is much easier to gauge/express views in terms of IV than option prices.
IV is unit-less, option prices are not.

IV does not depend on the intrinsic value, option prices do.
IV has a normal return distribution benchmark (BS model).
→ Deviation from a flat line (across strikes) reveals return deviation from normality.
→ A higher IV for OTM puts than for OTM calls says that the left tails is heavier
than the right tail.
→ Higher IVs for OTM options than for ATM options suggest fat tails.

The information content of the implied volatility surface
At each time, t, we observe options across many strikes X and
maturities τ = T − t.
Topic 3: Endogenous risk When we plot the IV against strike and maturity, we obtain an IV

surface.
Definition
VaR If the BS model assumptions hold in reality, the BS model should be
Coherence
ES
able to match all options with one σ input.
Stylized facts
Implementing VaR – The IV are the same for all X and τ .
Backtesting
RAROC
VaR upper bound
– The surface is flat.
Topic 6: Credit derivatives We can use the shape of the IV surface to determine what BS
and asset-backed
securities assumptions are violated and how to build new models to account for
the credit crisis
these violations.

S&P 500: Implied volatility surface
Implied Volatility Surface SPX 10/29/2010
0.9
Implied Volatility σ(T, M )
0.8
0.7
0.6
0.5
0.4
0.3
0.5
1.5
2 3
2.5
2
2.5 1.5
1
Time to Matutity T S
Moneyness M = K

VIX 1990–2016

and limits to arbitrage 80

Definition 70
VaR
Coherence
60
ES
Stylized facts
Implementing VaR
Backtesting
40
RAROC
VaR upper bound
30
and asset-backed 20
securities
the credit crisis 10
0
1990 1995 2000 2005 2010 2015

Realized volatility
Uses intraday data to calculate volatility.
Topic 3: Endogenous risk Purely data driven.

Definition
VaR Not always easy to get good, clean intraday data for with long time
Coherence
ES
series.
Stylized facts
Implementing VaR
Backtesting Can use realized volatility for volatility forecasts: HAR-RV
RAROC
VaR upper bound
(heterogenous autoregressive RV model).
Topic 6: Credit derivatives RVt+1,1d = α + βD RVt,1d + βW RVt,1w + βM RVt,1m + εt+1,1d ,
and asset-backed
securities
Topic 7: Regulation and where RVt,1d is the daily realized volatility calculated using 5 minute
the credit crisis
returns.

S&P 500 1990–2010: realized volatility
Realized volatility 1990−2010

80

Definition
70
VaR
annualized volatility in %
Coherence 60
ES
Stylized facts
Implementing VaR
Backtesting 40
RAROC
VaR upper bound
30
and asset-backed 20
securities
the credit crisis
0
1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010
time

S&P 500 1990–2010: comparison of volatility models

VIX
RV
Topic 2: Hedging in equity 90 GARCH
and fixed income markets MA
80

Definition
70
VaR
annualized volatility in %
Coherence 60
ES
Stylized facts
Implementing VaR
Backtesting 40
RAROC
VaR upper bound
30
and asset-backed 20
securities
the credit crisis
0
1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010
time

Implementing VaR
Nonparametric methods:
and fixed income markets – Historical simulation (HS).
– No statistical models assumed, no parameter estimates required.
Definition
VaR Parametric methods:
Coherence
ES
Stylized facts – Based on estimating distribution of returns to get risk forecast.
Implementing VaR
Backtesting
– Start with estimate of covariance matrix.
RAROC
VaR upper bound – Use distribution assumption for residuals (normal, Student-t, etc.)
and asset-backed
securities
the credit crisis

Historical simulation
Univariate HS:
Topic 2: Hedging in equity – Sort all historical returns from smallest to largest.
– VaR(p) is pth % smallest value.
Definition
Multivariate HS:
VaR
Coherence – Calculate historical portfolio returns and proceed as above.
ES
Stylized facts Expected shortfall estimation with HS:
Volatility modeling
⊲ Implementing VaR 1. Use HS to get VaR.
Backtesting
RAROC
VaR upper bound
2. Estimate ES by the mean of all observations ≥ VaR.
Importance of window size:
and asset-backed
securities – Tradeoff: sensitivity vs. structural changes.
the credit crisis – Sample size: minimum 3/p

Portfolio VaR
Standard deviation of portfolio return is
√
and fixed income markets σΠ = w′ Hw

Definition
VaR For two risky assets, the standard deviation is
Coherence
ES
Stylized facts
Volatility modeling
s
⊲ Implementing VaR σ12 σ12 w1
Backtesting σΠ = w1 w2
RAROC σ12 σ22 w2
VaR upper bound q
= w12 σ12 + w22 σ22 + 2w1 w2 σ12
and asset-backed
securities
In practice, the covariances must be estimated.
the credit crisis

VaR under normality
Normal density:
1 −(x−µ)2
φ(x) = √ exp 2σ 2
2πσ 2

Definition
VaR
Coherence For 95% confidence level and standard normal:
ES
Stylized facts Z −VaR(5%)
Volatility modeling 1 1 2
⊲ Implementing VaR 0.05 = √ exp− 2 x dx
Backtesting
−∞ 2π
RAROC
VaR upper bound

Normal CDF: Φ(·) and −Φ−1 (5%) = 1.64.
and asset-backed
securities VaR(5%) = −Π × Φ−1 (5%) × σΠ = Π × 1.64 × σΠ ,
2
the credit crisis
with σΠ = w′ Hw

Duration normal VaR
Interest rate volatility σr and bond volatility σb :
σb ≈ |DMod |σr
Assuming normality of the underlying, the approximate VaR of the
Definition bond is:
VaR
Coherence VaRbond ≈ Φ−1 (p) × |DMod | × σr × Π
ES
Stylized facts = |DMod | × VaRyield
Volatility modeling
⊲ Implementing VaR
Backtesting Approximation problems due to assumptions:
RAROC
VaR upper bound
– Linearity.
– Parallel shifts in the yield curve.
and asset-backed
securities Furthermore, we need to know the VaR (and therefore the standard
the credit crisis
deviation) for the yield.
– Easy to obtain for standard maturities.
– To calculate for arbitrary maturities we need to convert to standard
maturities.

Example: VaR of a bond
Suppose that the distribution of (annual) yields next period is
approximately normal with a mean of 5% and a standard deviation of
and fixed income markets 20 basis points (i.e. σR = 0.2%).

Definition Suppose that the Macaulay duration of a bond is 25 years.
VaR
Coherence
ES
Stylized facts
Volatility modeling
What is the 1% VaR of the loss on a holding of bonds with market
⊲ Implementing VaR value of GBP 100m, with current yield of 5%?
Backtesting
RAROC
VaR upper bound

and asset-backed
securities
the credit crisis

Example: VaR of a bond
Since dP ≈ −P DM od dR, for every 1 pound invested in the bond, the
probability distribution over next period’s price is normal with
and limits to arbitrage – mean of 1 pound and
Definition
VaR
Coherence
– standard deviation of: σR DM od = σR D1+R
M ac
.
ES
Stylized facts
Volatility modeling
Thus, the 1% VaR for a GBP 100m holding is:
Backtesting
RAROC 25
VaR upper bound 2.33 × 0.002 100 ≈ 11.1
1.05
and asset-backed or GBP 11.1m pounds.
securities
the credit crisis

VaR with moving average
Univariate MA:
Topic 2: Hedging in equity – Volatility forecast:
W −1
1 X 2
Topic 4: Value at Risk hT +1 = rT −i
Definition W i=0
VaR
Coherence
ES – Normally based on normality assumption.
Stylized facts
Volatility modeling
– Underestimates VaR if fat tails.
Backtesting
RAROC
VaR upper bound −1
p
– VaRT +1 (5%) = −Π × Φ (5%) × hT +1
and asset-backed
securities Multivariate MA:
the credit crisis – Calculate portfolio variance and then proceed as above.

VaR with EWMA
Use EWMA to come up with forecast.
and fixed income markets Usually assume normal distribution.
Topic 4: Value at Risk Calculate variance based on EWMA

Definition
VaR
Coherence hT +1 = (1 − λ)RT2 + λhT
ES
Stylized facts
Volatility modeling
Standard assumption normality.
Backtesting
RAROC
VaR upper bound −1
p
VaRT +1 (5%) = −Π × Φ (5%) × hT +1
and asset-backed
securities
For multiple assets:
the credit crisis – Estimate HT +1 and calculate portfolio variance by w′ HT +1 w.

VaR with GARCH
Estimate GARCH(1,1) model.
and fixed income markets If you have data from t = 1, . . . T then your conditional volatility
and limits to arbitrage forecast is
Definition
VaR
hT +1 = ω + αrT2 + βhT
Coherence
ES
Stylized facts −1
p
Volatility modeling VaRT +1 (5%) = −Π × Φ (5%) × hT +1 for standard normal
residuals.
Backtesting
RAROC
VaR upper bound
For Student-t GARCH use inverse of Student-t CDF:
−1
p
and asset-backed
– VaRT +1 (5%) = −Π × Φt(ν) (5%) hT +1 for t-residuals with ν
securities
degrees of freedom.
the credit crisis
Pick any GARCH model that fits your data to forecast volatility.

VaR estimates for S&P 500
S&P 500 and 95% VaR estimates
Returns
10 HS
MA
EWMA
GARCH
-5
-10
2008 2009 2010 2011 2012 2013 2014 2015


0
Returns
HS
MA
EWMA
-2
GARCH
-4
-6
-8
-10
-12
2008 2009 2010 2011


0
Returns
HS
MA
EWMA
-2
GARCH
-4
-6
-8
-10
-12
Jul Aug Sep Oct Nov Dec

VaR with Monte Carlo
Simulate price path, VaR(p) is p-percentile.
and fixed income markets Do not need to use normal assumption.
Topic 4: Value at Risk For portfolio, simulate P/L.

Definition
VaR
Coherence
ES
To include options, first simulate path of the underlying, then price the
Stylized facts options.
Volatility modeling
Backtesting
RAROC
MC can be time-consuming.
VaR upper bound

and asset-backed
securities
the credit crisis

Extreme value theory (EVT)
Tails of distributions fall in three categories.
and fixed income markets – Weibull — thin tails (finite endpoint)
Topic 4: Value at Risk – Gumbel — normal tails (exponential)

Definition
VaR
Coherence
ES
– Frechet — fat tails (decline by a power)
Stylized facts
Volatility modeling
Distribution of financial data has fat tails.
Backtesting
RAROC
VaR upper bound Assumes iid data.
and asset-backed
Useful for risk management as we are interested in extreme outcomes.
securities
the credit crisis

Applications and limitations
Easy to pick appropriate distribution for tails.
Can ignore true distribution and only need observations in tails.

Definition Estimate probabilities or frequencies of extreme outcomes.
VaR
Coherence
ES
Stylized facts Risk aggregation over time given shape of tails.
Volatility modeling
Backtesting
RAROC
EVT only works in tails.
VaR upper bound

Need enough extreme outcomes to properly estimate.
and asset-backed
securities
the credit crisis

Backtesting and stress testing
Backtesting:
and fixed income markets – Important to assess accuracy of risk forecasts.
Topic 4: Value at Risk – Use historical data to forecast past VaR.

Definition
VaR
Coherence
ES
– Compare forecasts with realizations.
Stylized facts
Volatility modeling
– Assumes no structural break in data.
Backtesting
RAROC
VaR upper bound – Data mining.
and asset-backed
Stress testing
securities
the credit crisis – Create artificial outcomes and see how models cope.
– Difficult to assess probability of test scenario.

Application of VaR: RAROC
Definition: the Risk Adjusted Rate of Return on Capital (RAROC) is
defined as:
and fixed income markets Profit
RAROC =
VaR
Topic 4: Value at Risk Rationale: VaR for a portfolio can be interpreted as the prudent level
Definition
VaR
of capital needed to hold the portfolio. Then Profit/VaR is the rate of
Coherence return on capital.
ES
Stylized facts
Volatility modeling
Implementing VaR
Uses:
⊲ Backtesting
RAROC
VaR upper bound – Allocation of resources across divisions.
and asset-backed
– Internal controls on risk-taking within division.
securities
the credit crisis

Capital budgeting example (Jorion, Box 4-2)
A bank must decide on whether to allocate more capital to the foreign exchange trader trading
EUR/USD, or the bond trader trading short term Treasuries.
The FX trader held an average position of USD 100m dollars notional value of contracts in previous
year.
– Annual volatility of EUR/USD exchange rate: 12%.
– FX trader made profit of USD 10m last year.
→ 1% VaR is 2.33×0.12×100m = 28m
→ RAROC = 10m/28m = 36%
Bond trader held notional amount USD 200m in previous year.

– Annual volatility: 4%
– Bond trader also made profit of USD 10m.
– → 1% VaR is 2.33×0.04×200m = 19m
– → RAROC = 10m/19m = 54%
According to RAROC, more capital should be allocated to the bond trader.

Upper bound for VaR
Suppose that the density of W is symmetric and has finite variance.
and fixed income markets Then, for
Topic 4: Value at Risk – W0 = E(W )

Definition
VaR
Coherence
ES
– Variance σ 2 = E[(W − E(W ))2 ]
Stylized facts
Volatility modeling
Implementing VaR
– Confidence level c
Backtesting
⊲ RAROC
VaR upper bound We have:
σ
Topic 5: Credit risk VaR ≤ p
Topic 6: Credit derivatives 2(1 − c)
and asset-backed
securities
the credit crisis
This upper bound is valid for any symmetric density with finite σ.

Upper bound for VaR: Proof
Proof (Chebyshev’s inequality):
Topic 2: Hedging in equity For some number a > 0, let W∗ and W ∗ be the two solutions to
W − E(W ) 2
and limits to arbitrage = a2
σ
Definition
VaR with W∗ < W ∗
Coherence
ES
Stylized facts
Let g(W ) be the following function:
Volatility modeling 
 1 if W > W
∗
Implementing VaR
Backtesting
RAROC
g(W ) = 0 if W∗ ≤ W ≤ W ∗
⊲ VaR upper bound

1 if W < W∗ .
Topic 6: Credit derivatives By construction:
and asset-backed W − E(W ) 2
securities
≥ a2 g(W )
Topic 7: Regulation and σ
the credit crisis

Upper bound for VaR: Proof (cont.)
Taking expectations:
2
Topic 2: Hedging in equity E (W − E(W ))
≥ a2 E [g(W )]
Topic 3: Endogenous risk σ2

Definition The last inequality can be rewritten as
VaR h i
Coherence 2 ∗
ES 1 ≥ a Prob W ≤ W∗ or W ≥ W
Stylized facts
Volatility modeling
Implementing VaR
Backtesting
From symmetry
RAROC
⊲
h i
VaR upper bound 2
1 ≥2a Prob W ≤ W∗
h i
and asset-backed
=2a Prob W ≤ E(W ) − aσ
securities
the credit crisis
Thus h i 1
Prob W ≤ E(W ) − aσ ≤ 2
2a

Upper bound for VaR: Rule of thumb
For confidence level c, for which
1−c=
Topic 3: Endogenous risk 2a2
Topic 4: Value at Risk we have

Definition σ
VaR VaR ≤ aσ = p
Coherence 2(1 − c)
ES
Stylized facts
Volatility modeling
√σ
Implementing VaR
Backtesting For c = 0.99, the upper bound on VaR is 0.02
≈ 7.1 × σ.
RAROC
⊲ VaR upper bound
Topic 5: Credit risk For normal distribution, VaR ≈ 2.33 × σ. So the upper bound is around
Topic 6: Credit derivatives three times the normal VaR.
and asset-backed
securities
the credit crisis


Introduction
Ratings based models
Credit VaR Topic 5: Credit risk
Structural form models
and asset-backed
securities
the credit crisis

Outline
and fixed income markets Introduction to credit risk
Ratings based models and credit Value at Risk
⊲ Topic 5: Credit risk Structural models

Introduction
Credit VaR Credit risk on portfolios
and asset-backed Reduced form models
securities
the credit crisis Determinants of credit spreads

Credit risk
Two components:
Topic 1: Foundations – Risk of default: measured by probability of default (PD) over a

given horizon.
– Size of loss if default occurs (loss given default, LGD) or,
Topic 4: Value at Risk equivalently, recovery rate conditional on default.
Introduction
Challenges:
Credit VaR – Asymmetry: limited upside but substantial downside.
Topic 6: Credit derivatives – Credit returns are skewed and fat-tailed.
and asset-backed
securities – Defaults are rare: difficult to estimate default probabilities or default
the credit crisis correlations from past data.
– However, measures of credit risk on portfolios of defaultable securities are
extremely sensitive to these correlations.
– Greater reliance on models than in the context of market risk.
– Mark-to-market changes (prior to default) because of changed
expectations regarding default risk or because risk-free term structure
changes.

Approaches to credit risk
Administrative Details – Rely on credit ratings provided by rating agencies.
– Implicit assumption that all relevant information captured by ratings categories
and fixed income markets and transition probabilities.
and limits to arbitrage – Implicit assumption that all firms within a category are homogeneous.
– Typically no adjustment for systematic variation in credit risk over the business
Topic 5: Credit risk cycle.
⊲ Introduction
Ratings based models Structural form models
Credit VaR
Structural form models – Directly relate default probabilities and recovery rates to firm fundamentals.
and asset-backed
securities
– Defaultable debt can be thought of as a combination of safe debt and a put
option on asset value of the firm (Merton 1974).
the credit crisis
– In context of credit portfolios, this allows adjusting for the fact that default
correlations may be higher for firms within same industry or region.
Reduced form models
– Default modeled using an exogenous default intensity process.
– Using this framework, it is possible to map observed credit spreads into a term
structure of default probabilities.
– This approach forms the basis of most credit derivatives pricing models.

Ratings agencies, such as Standard & Poor’s or Moody’s issue ratings on the creditworthiness of
borrowers.
Rating categories:
S&P, Fitch Moody’s
Investment AAA Aaa
grade AA Aa
bonds A A
BBB Baa
Speculative BB Ba
grade B B
(junk) bonds CCC Caa
CC Ca
C C
Bonds in default D D
Ratings agencies use historical data on defaults over a period of more than 20 years.
Debtors are considered in default as soon as they miss a payment obligation on any coupon or principal.
“Pari passu” clauses mean that debtors are considered in default on all their debt obligations as soon
as they default on any particular one and creditors are paid pro rata.
Based on historical data, ratings agencies estimate probability pij of transiting from ratings category i
to ratings category j over a given horizon.

Default rates vary by rating
Source: Moody’s Investor Service (2015)

Correlation between ratings and defaults

Default rates vary over time

Default rates around recessions
Global Speculative-Grade Default Rate Peaks
20%
16%
Default rate
12%
8%
4%
0%
-24 -18 -12 -6 0 6 12 18 24
Months to peak
1933 1991 2001
2008 2009 Forecast

Moody’s transition probabilities
Table 8: Moody’s transition probabilities 2009

From/To: Aaa Aa A Baa Ba B Caa Ca-C Def WR
Aaa 84.07% 10.44% 0.00% 0.55% 0.00% 0.00% 0.00% 0.00% 0.00% 4.95%
Aa 0.13% 80.25% 13.46% 0.38% 0.25% 0.00% 0.13% 0.13% 0.50% 4.78%
A 0.00% 1.37% 87.26% 4.76% 0.16% 0.08% 0.08% 0.00% 0.32% 5.97%
Baa 0.00% 0.18% 2.11% 85.94% 4.31% 0.26% 0.18% 0.00% 0.44% 6.59%
Ba 0.00% 0.00% 0.17% 4.24% 75.25% 9.15% 1.02% 1.36% 1.02% 7.80%
B 0.00% 0.00% 0.17% 0.17% 2.57% 71.44% 14.24% 0.99% 1.90% 8.53%
Caa 0.00% 0.00% 0.00% 0.00% 0.00% 3.21% 67.41% 8.64% 12.10% 8.64%
Ca-C 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 5.26% 26.32% 52.63% 15.79%
Table 9: Moody’s transition probabilities 2015

From/To: Aaa Aa A Baa Ba B Caa Ca-C Def WR
Aaa 97.77% 2.22% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00%
Aa 0.00% 88.70% 6.95% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 4.34%
A 0.00% 2.71% 90.212% 2.71% 0.00% 0.12% 0.00% 0.00% 0.12% 4.25%
Baa 0.00% 0.00% 4.34% 88.75% 2.30% 0.13% 0.00% 0.00% 0.07% 4.40%
Ba 0.00% 0.00% 0.32% 6.08% 77.60% 7.84% 0.32% 0.00% 0.16% 7.68%
B 0.00% 0.00% 0.07% 0.07% 3.21% 75.52% 7.19% 0.00% 0.23% 13.70%
Caa 0.00% 0.00% 0.00% 0.00% 0.00% 6.52% 71.39% 1.55% 5.24% 15.30%
Ca-C 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 4.35% 39.13% 43.48% 13.04%
Source: Moody’s Investor Service

Moody’s transition probabilities (cont.)
Table 10: Average Moody’s 1-year transition probabilities 1970–2015

From/To: Aaa Aa A Baa Ba B Caa Ca-C WR Def
Aaa 87.325% 8.150% 0.621% 0.000% 0.028% 0.002% 0.002% 0.000% 3.873% 0.000%
Aa 0.887% 84.545% 8.446% 0.495% 0.066% 0.021% 0.008% 0.001% 5.510% 0.021%
A 0.047% 2.413% 86.146% 5.538% 0.538% 0.107% 0.033% 0.004% 5.118% 0.057%
Baa 0.035% 0.159% 3.961% 85.420% 3.834% 0.707% 0.148% 0.015% 5.559% 0.162%
Ba 0.007% 0.050% 0.328% 5.592% 75.783% 7.327% 0.584% 0.062% 9.264% 1.004%
B 0.008% 0.025% 0.106% 0.293% 4.421% 73.565% 6.069% 0.546% 11.515% 3.450%
Caa 0.000% 0.014% 0.014% 0.095% 0.365% 8.370% 63.553% 3.447% 12.340% 11.802%
Ca - C 0.000% 0.000% 0.056% 0.000% 0.349% 1.939% 8.915% 36.537% 15.039% 37.165%
Table 11: Average Moody’s 5-year transition probabilities 1970–2015

From/To: Aaa Aa A Baa Ba B Caa Ca-C WR Def
Aaa 51.499% 23.500% 5.207% 0.388% 0.325% 0.036% 0.036% 0.000% 18.922% 0.088%
Aa 2.662% 44.233% 21.701% 4.304% 0.775% 0.289% 0.100% 0.011% 25.601% 0.323%
A 0.182% 7.264% 49.713% 14.618% 2.613% 0.859% 0.190% 0.006% 23.775% 0.779%
Baa 0.172% 0.979% 11.626% 47.929% 8.314% 2.650% 0.529% 0.065% 26.211% 1.525%
Ba 0.039% 0.155% 1.940% 12.010% 26.702% 10.871% 1.479% 0.113% 39.084% 7.606%
B 0.029% 0.041% 0.241% 1.613% 6.395% 21.921% 5.387% 0.616% 45.843% 17.914%
Caa 0.000% 0.000% 0.017% 0.528% 1.480% 8.190% 10.028% 0.977% 43.270% 35.510%
Ca-C 0.000% 0.000% 0.000% 0.000% 0.000% 3.099% 1.852% 3.982% 38.366% 52.701%

Default counts by geographical region
Year Africa & Middle East Asia-Pacific Europe Latin America North America
1990 0 1 0 0 81
1991 0 0 1 0 65
1992 0 0 0 0 31
Topic 2: Hedging in equity 1993 0 0 0 0 19
1994 0 0 1 0 15
Topic 3: Endogenous risk 1995 0 0 0 1 26
1996 0 0 0 1 16
Topic 4: Value at Risk 1997 0 2 0 2 21
Topic 5: Credit risk 1998 0 3 3 0 45
Introduction 1999 0 6 11 6 77
⊲ Ratings based models 2000 0 1 4 1 118
Credit VaR 2001 4 11 18 7 147
Structural form models 2002 0 1 26 18 96
Topic 6: Credit derivatives 2003 0 2 7 10 63
and asset-backed
securities
2004 1 0 3 1 33
2005 0 0 1 1 29
the credit crisis 2006 0 0 7 2 22
2007 0 0 3 0 15
2008 0 3 12 2 86
2009 1 12 37 14 201
2010 0 1 8 3 45
2011 0 0 12 1 26
2012 1 0 12 4 48
2013 0 2 24 9 34
2014 1 5 13 4 32
2015 1 9 27 10 62

Cyclical pattern of upgrades versus downgrades
EXHIBIT 5
Rating Drift Slightly Up in 2013
4%
2%
0%
-2%
-4%
-6%
-8%
-10%
-12%
-14%
-16%
Mar-97
Mar-87
Mar-10
Mar-07
Mar-13
Mar-91
Mar-12
Mar-01
Mar-90
Mar-94
Mar-98
Mar-96
Mar-11
Mar-88
Mar-93
Mar-99
Mar-00
Mar-04
Mar-08
Mar-86
Mar-89
Mar-95
Mar-06
Mar-92
Mar-03
Mar-09
Mar-85
Mar-05
Mar-02
Quarter_End

Limitations
Averages across heterogenous firms (different industries etc.).

Averages over the business cycle, but there are significantly more
Introduction defaults in recessions than there are in booms.
⊲ Ratings based models
Credit VaR
and asset-backed
securities
the credit crisis

Recovery rates
Recovery rates conditional on default:
When the issuer defaults at the end of the period, investors recover
and limits to arbitrage some of their investment.

Introduction The recovery rate depends on the seniority of the instrument held.
Credit VaR
Topic 6: Credit derivatives The ratings agencies provide estimates of recovery rates by seniority
and asset-backed
securities class based on historical experience.
the credit crisis

Moody’s average defaulted bond and loan recovery rates
Year 1st Lien Sr. Sec. Sr. Unsec. Sr. Sub. Sub. Jr. Sub. All Bonds
1991 67.9% 48.4% 36.7% 41.8% 24.4% 7.8% 35.5%
1992 60.6% 62.1% 49.2% 49.4% 38.0% 13.5% 45.9%
1993 53.4% n.a. 37.1% 51.9% 44.2% n.a. 43.1%
1994 67.6% 69.3% 53.7% 29.6% 38.0% 40.0% 45.6%
1995 75.4% 62.0% 47.6% 34.3% 41.5% n.a. 43.3%
1996 85.5% 47.6% 62.8% 43.8% 22.6% n.a. 41.5%
1997 78.8% 75.5% 56.1% 44.7% 33.1% 30.6% 48.8%
1998 56.7% 46.8% 39.5% 45.0% 18.2% 62.0% 38.3%
1999 73.6% 36.0% 38.0% 26.9% 35.6% n.a. 33.8%
2000 68.8% 38.7% 24.2% 20.8% 31.9% 7.0% 25.3%
2001 64.9% 35.0% 21.2% 19.8% 15.9% 47.0% 21.6%
2002 58.8% 49.0% 29.5% 21.4% 24.5% n.a. 29.7%
2003 73.4% 66.3% 41.9% 37.2% 12.3% n.a. 40.4%
2004 87.7% 73.3% 52.1% 42.3% 94.0% n.a. 58.5%
2005 83.8% 71.9% 54.9% 26.1% 51.3% n.a. 56.0%
2006 83.6% 74.6% 55.0% 41.4% 56.1% n.a. 55.0%
2007 68.6% 80.6% 53.7% 56.2% n.a. n.a. 55.1%
2008 61.7% 54.9% 33.2% 23.3% 23.6% n.a. 33.9%
2009 53.6% 37.5% 36.9% 22.7% 45.3% n.a. 33.9%
2010 70.9% 62.5% 51.5% 37.5% 33.7% n.a. 51.8%
2011 70.9% 70.5% 41.3% 36.7% 35.4% n.a. 46.3%
2012 66.4% 60.9% 43.0% 33.7% 37.3% n.a. 44.7%
2013 75.1% 71.4% 45.2% 20.7% 26.4% n.a. 45.6%
2014 78.4% 73.6% 46.4% 39.1% 38.8% n.a. 47.8%
2015 63.4% 53.5% 37.9% 36.6% 58.5% 14.0% 40.9%

Default and recovery rates, and the business cycle
A. Default rates and credit spreads
8 default rates
spreads
%
4
0
1920 1930 1940 1950 1960 1970 1980 1990 2000
B. Recovery rates
90
Moodys Recovery Rates
80 Altman Recovery Rates
70 Long−Term Mean
% of Par
60
50
40
30
20
1985 1990 1995 2000 2005
Source: Chen (2010)

Credit VaR steps 1 and 2: Transition probabilities and horizon
Transition probabilities usually set at one year.
Main constraint is the availability of accounting data.

(n)
Topic 5: Credit risk Let pij be the probability of transition from category i to category j in
Introduction
n periods.
Credit VaR
Topic 6: Credit derivatives For a time homogeneous Markov process:
and asset-backed
securities
(n)
the credit crisis
pij = (Πn )ij
(n)
pij is the (i, j)th entry of Πn

Example: 2-year transition probabilities
Administrative Details (2) P

2 periods: pij = k pik pkj
Topic 3: Endogenous risk Suppose the matrix of transition probabilities is given by:

A B Default
Introduction
A pAA pAB pAD
Ratings based models B pBA pBB pBD
⊲ Credit VaR
Structural form models Default 0 0 1
and asset-backed
securities
the credit crisis
(Default is an absorbing state.)
Then, for example:

(2)
pBD = pBA pAD + pBB pBD + pBD pDD

Credit VaR step 3: Forward pricing model
Use the one-period forward spot curve for each rating category to
calculate the forward price of the bond at date t + 1, conditional on the
and fixed income markets bond being in that particular rating category at date t + 1.

Example:
Introduction
– Forward spot curve for BBB next period (year)
⊲ Credit VaR
Year+1 Year+2 Year+3 Year+4
and asset-backed
securities
Spot rate (%) 4.1 4.67 5.25 5.63
the credit crisis
– The 1-year forward price of a 5-year 6% coupon bond, conditional
on being rated BBB in 1 year, is:
6 6 6 106
VBBB = 6 + + + + 4 = 107.53
1.041 (1.0467)2 (1.0525)
3
(1.0563)

Credit VaR step 4: Distribution of forward prices
Three elements:
Probability of being in a given rating category next period.

Forward price of the bond, conditional on being in that rating category.
Introduction
⊲ Credit VaR
Change in value of the bond, conditional on transiting to that rating
Topic 6: Credit derivatives category.
and asset-backed
securities
the credit crisis

Credit VaR step 5: Calculate VaR
Probability of CCC or Default next period conditional on BBB today is
0.3%.
and limits to arbitrage Probability of B or CCC or Default next period conditional on BBB
Topic 4: Value at Risk today is 1.47%.
Introduction
Ratings based models Hence:
⊲ Credit VaR
Topic 6: Credit derivatives Prob(W − W0 ≤ −23.91) = 0.003 < 0.01 and
and asset-backed
securities Prob(W − W0 ≤ −9.45) = 0.0147 > 0.01
the credit crisis
Using the convention of Crouhy-Galai-Mark, the 1% VaR relative to

current rating is 23.91.
N.B. The convention for calculating VaR in C-G-M is slightly different

from the one seen previously.

Non-normality
The empirical distribution of changes in the portfolio value is
non-normal.
and limits to arbitrage Instead, the empirical distribution looks asymmetric, with a fat left tail.

Introduction Assuming normality for the purpose of VaR calculations would clearly
⊲ Credit VaR be inappropriate in this context.
and asset-backed
securities Such an assumption would lead to a severe underestimation of true
the credit crisis
VaR.

Non-normality (cont.)
Imagine assuming normality instead:
and fixed income markets – Mean change in value = –0.46
– Standard deviation of the change in value = 2.99

Introduction
Therefore, the 1% “normal” VaR relative to current rating is:
⊲ Credit VaR
| −0.46 − 2.33 × 2.99 |= 7.43
and asset-backed
securities Assuming normality would in this case give a VaR of 7.43 rather than
the credit crisis
the value of 23.91 which relies on the actual empirical distribution of
changes in value!
Hence, one should not assume normality in the context of credit risk:
the mean and the variance do not contain sufficient information in this
case.

Issues
Transitions are not independent for two bonds—what does this mean
for a portfolio of bonds?
Topic 4: Value at Risk Transition matrix should depend on the business cycle (many more
Topic 5: Credit risk defaults in recessions than in booms).
Introduction
⊲ Credit VaR
Recovery rates also vary across business cycle (lower in recessions).
and asset-backed
securities
the credit crisis

Directly relate default probabilities and recovery rates to firm
fundamentals.

The insight underlying these models is that defaultable debt can be
thought of as a combination of safe debt and a put option on the asset
Introduction value of the firm (Merton, 1974).
⊲ Credit VaR
and asset-backed
Main advantage: probability of default and recovery rate conditional on
securities default are directly related to firm-specific characteristics.
the credit crisis
Main challenge: asset value is not directly observable and can be

difficult to estimate.
Cannot match empirically observed credit spreads.

Merton (1974)
Consider a firm with risky assets with a market value of Vt at time t.
and fixed income markets The firm is financed by debt and equity.
Topic 4: Value at Risk The firm’s outstanding debt is a single ZCB with face value F ,
Topic 5: Credit risk maturing at date T . The market value of the debt at time t is Bt .
Introduction
Credit VaR
⊲ Structural form models
The market value of the firm’s equity at time t is St .
and asset-backed
securities Balance sheet of the firm at time t:
the credit crisis
Assets Liabilities
Risky assets Vt Debt Bt
Equity St
Total Vt Vt

Process for asset value
Merton (1974) assumes that the asset value of the firm follows a
geometric Brownian motion:
Topic 3: Endogenous risk dVt
and limits to arbitrage = µdt + σdWt ,
Topic 4: Value at Risk Vt
Introduction where Wt is a standard Wiener process.
Credit VaR
and asset-backed Under this assumption, it follows that the asset value of the firm at
securities
time t is lognormally distributed:
the credit crisis

σ 2 √
Vt = V0 exp µ− t + σ tZ ,
2
where Z ∼ N (0, 1).

Distance to default
The firm defaults at date T if its asset value falls below the face value
of its debt: VT < F .
and limits to arbitrage From the perspective of date 0, the probability of default is:
2
Introduction ln VF0 + (µ − σ2 )T
Ratings based models Prob(VT < F ) = Prob Z < − √
Credit VaR σ T
Topic 6: Credit derivatives = Φ(−d) or N (−d)
and asset-backed
securities
the credit crisis d is the distance to default:

σ2
ln VF0 + (µ − 2 )T
d= √
σ T
The distance is measured in terms of the number of standard deviations
away from the default point.

Distance to default (cont.)
More generally, the distance to default viewed from date t is :
2
and fixed income markets ln VFt + (µ − σ2 )(T − t)
dt,T = √
σ T −t

Introduction
Distance to default is decreasing in σ, F .
Credit VaR
Distance to default is increasing in µ, Vt .
and asset-backed
securities
Topic 7: Regulation and The effect of T depends on the other parameters.
the credit crisis
However, when Vt > F , the distance to default goes to infinity as

(T − t) becomes small → very short-term debt is almost riskless in the
model (problematic).

Payoff to bondholders
If VT > F , the bondholder receives face value at date T .
If VT < F , the firm defaults. Holders of equity receive nothing.
Topic 4: Value at Risk Bondholders “take over” the firm and have the right to liquidate its
Topic 5: Credit risk assets. Thus, their payoff in the event of default is VT .
Introduction
Credit VaR
and asset-backed
securities
the credit crisis

Pricing
A bondholder can hedge the credit risk on the bond by buying a
European put option on the asset value of the firm with strike price F
and fixed income markets and time to expiration T .

Let P0 denote the price of the put at time 0.
Introduction
Credit VaR The portfolio of risky debt and the put option is riskless. Hence:
and asset-backed B0 + P0 = F e−rT ,
securities
the credit crisis where r denotes the riskless rate of interest.

Pricing (cont.)
Black-Scholes-Merton price of a European put:
P0 = F e−rT N (−d2 ) − V0 N (−d1 )


where
σ2
ln( VF0 ) + (r + 2 )T
Introduction
d1 = √
σ T
Credit VaR
⊲ Structural form models and
σ2 √
Topic 6: Credit derivatives ln( VF0 ) + (r − 2 )T
and asset-backed d2 = √ = d1 − σ T .
securities
σ T
the credit crisis
Φ(.) denotes the c.d.f. of a standard normal random variable.

YTM and default spread
Yield to maturity is given by
and fixed income markets 1 B0 1 F e(−rT ) − P0
yT = − ln = − ln
and limits to arbitrage T F T F
Default spread is defined as sT = yT − r
Introduction
Ratings based models 1 V0
Credit VaR sT = − ln Φ(d2 ) + Φ(−d1 )
⊲ Structural form models T F e(−rT )
and asset-backed
securities Effect of T − t on default spread depends on leverage
the credit crisis – Low leverage: default spread is increasing with maturity.
– High leverage: default spread decreasing with maturity.
– Matches empirical evidence quite well.

Merton example
Consider a firm whose current asset value is 100 with whose only credit
outstanding is a 1-year bond with promised repayment of 77. The
and fixed income markets current risk-free rate is 10% (annually compounded) and the firms asset
and limits to arbitrage volatility is 40% per year.
Topic 4: Value at Risk Thus, V0 = 100, F = 77, r = 0.1, σ = 0.4.
Introduction
Credit VaR
Then, Z = 70, B = 56.1, C = 0.244, P0 = 3.39.
and asset-backed The yield to maturity is 14.47% and the corresponding credit spread is
securities
Topic 7: Regulation and 5.57%.
the credit crisis
Suppose instead of a 1 year bond the obligor has issued a 2 year bond.
Repeat the analysis. Consider a 5 year bond.
The term structure of yield spreads is 4.9% (2 years), 4.25% (3 years)

and 3.37% (5 years).

Limitations of the Merton model
Asset value:
– When both equity and debt of the firm are traded, asset value can
and limits to arbitrage be obtained by summing the market values of equity and debt.

Introduction – In practice, many loans are not traded and often we only observe a
Credit VaR market price for equity.
and asset-backed
securities Constant riskless rate of interest.
the credit crisis
Single debt maturity and no distinction between junior and senior debt.

Some extensions
Models in which default can occur at any time (rather than just at the
maturity date) if the asset value hits a boundary K (Black and Cox,
and fixed income markets 1976).

Stochastic interest rates (Kim, Ramaswamy, and Sundaresan, 1993).
Introduction
Credit VaR Bargaining between debtholders and management in the face of costly
liquidation. The “sharing of the pie” is determined endogenously as the
and asset-backed
securities
outcome of a game (Anderson and Sundaresan, 1996).
the credit crisis
The firm’s option to issue additional equal-priority debt in the future
can significantly increase the credit spreads of previously issued debt
(Collin-Dufresne and Goldstein, 2001).

KMV Methodology
Empirical observation that default tends to occur when asset value is
somewhere between short-term debt and long term liabilities.
and limits to arbitrage This motivates modified measure of distance to default.
Vt
2

Topic 5: Credit risk ln F ∗ + µ − σ2 (T − t)
Introduction
d∗ = p ,
Credit VaR
σ (T − t)
and asset-backed
where F ∗ = short-term debt + 21 long-term debt.
securities
the credit crisis No longer assume probability of default is given by Φ(−d∗ ) but instead
estimate default probabilities for a given distance to default d∗ and a
given time horizon directly using a large dataset on firm defaults.
These estimated probabilities are called expected default frequencies

(EDF).

Example: Enron
Source: Moody’s KMV


and asset-backed
securities
Topic 6: Credit derivatives and asset-backed
CDS
Securitization
securities
CDOs
Correlation
MBS
Duration & convexity
RMBS Market
MBS hedging
the credit crisis

Outline
and fixed income markets Credit default swaps (CDS)
Securitization

Collateralized debt obligations (CDOs)
Topic 6: Credit
derivatives and
⊲ asset-backed securities Mortgage-backed securities (MBS)
CDS
Securitization
CDOs
Correlation
MBS
RMBS Market
MBS hedging
the credit crisis

Credit default swaps (CDS)
A credit default swap (CDS) is the most popular form of credit
derivative.
and limits to arbitrage Protection buyer receives a payoff if a certain credit event related to a
Topic 4: Value at Risk reference entity (company or country) occurs.
and asset-backed If the event occurs, the protection buyer has the right to sell the bonds
securities
CDS
at face value or receives a contingent amount, often specified as the
Securitization difference between the face and market value of the bond at the time of
CDOs
Correlation the event.
MBS
RMBS Market In exchange, the protection buyer pays an annuity, referred to as the
MBS hedging
credit default swap spread, until the time of the credit event or the
the credit crisis maturity date of the swap, whichever comes first.
The CDS spread or CDS rate is expressed in percent per year of the
face value of the underlying credit.

CDS: Motivation
Allow “pure” hedging and trading of credit risk, independently of
market risk (traditional instruments bundle credit and market risk
and fixed income markets together).
Topic 5: Credit risk Allow credit risk transfer to third parties.

and asset-backed
securities
⊲ CDS
Securitization Allow easy construction of a diversified portfolio of credit risks.
CDOs
Correlation
MBS
RMBS Market
MBS hedging
the credit crisis

CDS and bond yields
CDS can be used to hedge position in corporate bond.
Consider portfolio with

– 5-year par yield corporate bond with 7% yield.
– 5-year CDS with a premium of 200bp per year.
and asset-backed
securities
⊲ CDS This is approximately the same as holding a 5-year T-note yielding 5%.
Securitization
CDOs
Correlation
MBS What trading strategy would a risk-free rate of 4.5% suggest?
RMBS Market
MBS hedging
Is this a risk-free arbitrage?
the credit crisis

Basket credit default swaps
An add-up basket CDS pays off when any of the reference entities in
the basket defaults.
and limits to arbitrage A first-to-default CDS pays off when the first default occurs.

Topic 6: Credit derivatives An nth -to-default CDS pays off when the nth default occurs.
and asset-backed
securities
⊲ CDS
Securitization The value of these instruments depends on the correlation of defaults in
CDOs
Correlation the basket
MBS
RMBS Market
MBS hedging
the credit crisis

Securitization
Originator 1 Originator 2 Originator n − 1 Originator n
Topic 3: Endogenous risk Asset Pooling
Topic 5: Credit risk Special Purpose Vehicle

and asset-backed
securities
⊲ CDS Asset Backed Securities
Securitization
CDOs
Correlation
MBS Investors
RMBS Market
MBS hedging Security’s Name Collateral Asset
Residential Mortgage Backed Security (RMBS) Residential mortgages with similar characteristics
Commercial Mortgage Backed Security (CMBS) Commercial mortgages with similar characteristics
the credit crisis
Asset Backed Securities (ABS) Receivables, such as auto loans, credit cards, and so on
Collateralized Debt Obligations (CDO) Investment and high yield corporate bonds, other structured products, CDS
Collateralized Loan Obligations (CLO) Corporate loans

Securitization (cont.)
The originator is the financial institution that wants to pool some assets
to sell separately. The issuer is the party that purchases the assets from
and fixed income markets the originators. The originator often creates a SPV to make the pool
and limits to arbitrage bankruptcy remote.
Topic 5: Credit risk The idea here is to separate the SPV assets – the collateral backing the
and asset-backed
securities – from the balance sheet of the issuer. Trustees are typically
securities also appointed to ensure that the SPV in fact delivers on its contractual
CDS
⊲ Securitization obligations.
CDOs
Correlation
MBS Securitization occurs in the residential mortgage market, in which
RMBS Market
individual savings and loans, thrifts, and other banks pool the mortgage
MBS hedging loans on their assets, and sell them to SPVs in exchange for cash.
the credit crisis
Originators may also sell their mortgage loans to other issuers such as
Freddie Mac or Fannie Mae, in exchange for residential mortgage
backed securities (instead of cash), which then can be sold in the
secondary market or kept on the banks’ assets.

Collateralized debt obligations (CDOs)
Create a pool of underlying securities.
Sell claims to the cashflows on the pool with different seniorities
and limits to arbitrage (“tranches”).

and asset-backed
Simple structure:
securities
CDS
⊲ Securitization “Equity” tranche takes the first default losses.
CDOs
Correlation
MBS
Duration & convexity “Mezzanine” tranche takes the next set of losses.
RMBS Market
MBS hedging
the credit crisis “Senior” tranche takes the final set of losses.

A more realistic structure
High Grade ABS

CDO
Senior
AAA 88%
Junior AAA 5%
AA 3%
A 2%
BBB 1%
ABS
AAA NR 1%
81%
AA 11%
Subprime
A 4% Mezz ABS CDO CDO of CDO
Mortgages
BBB 3% Senior AAA Senior AAA
62% 60%
BB, NR 1% Junior AAA Junior AAA
14% 27%
AA 8% AA 4%
A 6% A 3%
BBB 6% BBB 3%
NR 4% NR 2%
Source: Figure 16.5. Hull, Risk Management and Financial Institutions, Pearson

CDOs: Motivation
In principle, this can lead to a more efficient allocation of credit risk.
– Only about 5% of bonds have the highest possible credit rating (AAA).
– However many institutional investors are required to hold only highly rated bonds.
– CDOs can be used to create AAA tranches even if none of the securities in the
underlying portfolio are AAA.
Can be designed to remove loans from the balance sheet of banks, thereby reducing
the amount of required regulatory capital. In a “synthetic” CDO the actual ownership
of the loans is not transferred (default risk is transferred using credit default swaps).
By retaining a significant fraction of the subordinated tranches, issuers can in principle

mitigate moral hazard and adverse selection problems (mainly relating to monitoring
and asset selection).

Correlation exposure
Default correlation is a key input in the pricing of CDOs.
Different tranches have different exposures to default correlation.

– The value of the senior tranche depends negatively on default
Topic 6: Credit derivatives correlation.
and asset-backed
securities
CDS
Securitization – The value of the equity tranche depends positively on default
⊲ CDOs
correlation.
Correlation
MBS
RMBS Market
MBS hedging
the credit crisis

Issue I: Parameter sensitivity
The effects of errors in assumptions about the risks of the underlying
assets are amplified, particularly in CDO structures (Coval, Jurek and
and fixed income markets Stafford, 2008).

– Correlation parameter.
and asset-backed
securities – Default probability on individual bonds.
CDS
Securitization
CDOs
⊲ Correlation
MBS
RMBS Market
MBS hedging
the credit crisis

Issue II: Systematic risk
Credit ratings are designed to give information about expected payoff
only.
and limits to arbitrage Hence they ignore the fact that CDO tranches give much higher
Topic 4: Value at Risk exposure to systematic risk than single issuer corporate bonds of an
Topic 5: Credit risk equivalent credit rating because they are much more likely to default in
and asset-backed bad times (e.g. recession or times of large stock market declines).
securities
CDS
Securitization Evidence in Coval, Jurek and Stafford (2008) suggests senior CDO
CDOs
⊲ Correlation tranches may not have offered high enough yields to compensate
MBS
investors for this exposure to systematic risk.
RMBS Market
MBS hedging
Theses authors estimate that, by writing out-of-the-money put spreads
the credit crisis on the market, an investor could have earned about 4 or 5 times more
compensation for bearing an equivalent economic risk .

Mortgages and the RMBS market
Homeowners borrow from banks to purchase their home.
Topic 2: Hedging in equity If the borrower fails to make the repayment, the mortgage gives the
lender the right of foreclosure on the loan and he can therefore seize the
and limits to arbitrage property.
Topic 5: Credit risk Through securitization the banks often sell these assets to other
and asset-backed investors to raise capital.
securities
CDS
Securitization The market for mortgage-backed securities serves the important role of
CDOs
⊲ Correlation
transferring risks from those who have it (i.e., small banks, savings &
MBS loans, etc.) to those who are better able to bear it, namely investors.
RMBS Market The latter are more diversified and therefore potentially in a better
MBS hedging
position to assume the risks of lending money to individuals.
the credit crisis
The residential mortgage-backed securities (RMBS) market reached a
size of about USD 8.9tr by the end of 2008. This is almost USD 3tr
larger than the marketable U.S. Treasury debt at the same time.

Mortgage mechanics
m
Consider a 30y fixed rate mortgage, with mortgage rate of r̄12 . The
subscript describes the frequency of compounding. Because mortgage
and fixed income markets coupons are paid at the monthly frequency, the compounding frequency is
and limits to arbitrage 12. The superscript describes that it is a mortgage rate which is different
Topic 4: Value at Risk from the Treasury rate.
Suppose that L is the amount of the mortgage lent from the bank to the
and asset-backed
securities
homeowner. The coupon must satisfy:
CDS
Securitization 30×12
CDOs
X C
Correlation L= m
i .
⊲ MBS
i=1 1+
r̄12
Duration & convexity 12
RMBS Market
MBS hedging
The coupon is then given by:
the credit crisis
L 1
C = P30×12 where A = m
r̄12 .
i=1 Ai 1+ 12

Interest vs. principal
Important distinction between a mortgage and a regular bond:
Topic 2: Hedging in equity In a regular bond, the periodic coupon comprises only the interest of
the bond’s principal, while the principal itself is repaid at maturity.
Topic 4: Value at Risk In a mortgage, the principal is repaid during the life of the mortgage
Topic 5: Credit risk together with the interest. Indeed, the coupon C contains two
and asset-backed
components:
securities
CDS ① One component is the interest payments and
Securitization
CDOs
② the other is the principal repayment.
Correlation
⊲ MBS The fraction of the total coupon that is related to the interest payment
RMBS Market
and the principal repayment varies over time.
MBS hedging
The reason is that the interest amount paid is determined by the
the credit crisis amount of the outstanding principal, which declines over time as
principal payments occur. The larger the outstanding principal, the
larger the amount of interest that has to be paid.

Prepayment option
It’s convenient to think about a mortgage as a special bond with only
Administrative Details regular coupons, and no final lump sum principal payment. As with any
bond, as the interest rate moves, the bond (mortgage) changes its value.
The homeowner may compute the value of his debt to the bank by using
and limits to arbitrage the following formula:
Topic 4: Value at Risk n
X C
Topic 5: Credit risk Value of mortgage debt = P (t) = i
,
m
i=1 (1 + r12 (t, Ti ) /12)
and asset-backed
securities
CDS m
Securitization where n is the number of payments left at time t and r12 (t, Ti ) are the
CDOs
Correlation
appropriate spot rates, related to the current term structure of mortgage
⊲ MBS rates.
RMBS Market At every point in time t, the homeowner can compare the amount of
MBS hedging
principal left to pay, Lt , with the market value of his liability to the bank
the credit crisis
P (t). P (t) increases in value whenever interest rates decline. Thus, when
interest rates decline, the present value of the liability can exceed the
remaining principal and it becomes in the homeowner’s interest to
refinance the mortgage.

Mortgage refinancing & 1m LIBOR: 1990–2012
10000 10
8000 8
Refinancing Index
LIBOR (in %)
and asset-backed
6000 6
securities
CDS
Securitization
CDOs
Correlation
4000 4
⊲ MBS
RMBS Market
MBS hedging
2000 2
the credit crisis
0 0
1990 1995 2000 2005 2010
Source: Bloomberg

Factors affecting refinancing
The general level of interest rates is an important factor of prepayment.
Other factors are ...
Seasonality: Summers are characterized by large prepayments, as this is the
Topic 3: Endogenous risk period for which people move from one place to another for various reasons.
Topic 4: Value at Risk Age of mortgage pools: Young mortgages are characterized by large interest
Topic 5: Credit risk rate payments and low principal. By paying early, homeowners can save the
Topic 6: Credit derivatives interest rate payments. Because refinancing is costly, homeowners tend not to
and asset-backed
securities refinance new or recently refinanced mortgages right away.
CDS
Securitization Family circumstances: Default, disasters, or sale of the house.
CDOs
Correlation Housing prices: If the property value of a house declines, it is more difficult
⊲ MBS
Duration & convexity to refinance and thus prepayments tend to decline.
RMBS Market
MBS hedging Burnout effect: Mortgage pools heavily refinanced in the past tend to be
Topic 7: Regulation and insensitive to interest rates. Chances are that that most or all of the
the credit crisis
homeowners that could take advantage of refinancing opportunities did so
already in the past.

Risk in the prepayment option
The mortgage rate the bank receives is the return on capital on the
investment. The bank would like to receive this return for as long as
and fixed income markets possible.
If the mortgage owner has the choice of closing the mortgage, the bank
will miss this lucrative rate of interest.
and asset-backed
Prepayments bring down the rate of return for a bank:
securities
CDS – When the prepayment option is exercised by the mortgage owner,
Securitization
CDOs
banks loose the stream of high interest payments that are now
Correlation replaced by a lower coupon on the same outstanding loan. The new
⊲ MBS
Duration & convexity mortgage coupon reflects the new, lower interest rate environment.
RMBS Market
MBS hedging Note that there is no default in prepayment, these are different
the credit crisis
concepts.

Mortgage-backed securities
A number of similar mortgages (underlying, collateral, design, rates and maturities) are
pooled together and serve as collateral for a mortgage-backed security (MBS) that is
issued with face value equal to the cumulative outstanding principal of the mortgages
in the pool.
MBS derive their characteristics from the features of the mortgage underlying pool.
Three quantities are important in determining the value of a mortgage-backed security:
① The Weighted Average Maturity of the mortgages in the pool (WAM).
② The Weighted Average Coupon of the mortgages in the pool (WAC).
③ The speed of prepayments.
For each mortgage in the pool we can compute the time to maturity and the coupon,
and then WAM and WAC are simply the weighted averages of time and coupon, where
the weights are relative to the size of each mortgage.
The speed of prepayment is more complicated. The industry practice is to refer to

some average prepayment rates to describe the speed of prepayment. It is customary
to describe the value of a MBS in terms of its speed of prepayment.

Measures of prepayment speed
Administrative Details The two most common measures of prepayment are:

① Constant Maturity Mortality: This measure assumes there is a constant
and fixed income markets probability that the mortgage will be prepaid after the next coupon. If p is
Topic 3: Endogenous risk the probability, we have
Topic 4: Value at Risk P r(Prepayment at time t = 1) = p

Topic 5: Credit risk P r(Prepayment at time t = 2) = (1 − p)p
and asset-backed
P r(Prepayment at time t = 3) = (1 − p)2 p
securities P r(Survival up to time t = 12) = (1 − p)12 = 1 − CPR
CDS
Securitization
The annualized conditional prepayment rate (CPR) is then given by
CDOs
Correlation
⊲ MBS CPR = 1 − (1 − p)12
RMBS Market
MBS hedging ② PSA Experience: The 100% PSA established by the Public Securities
Topic 7: Regulation and Association makes the following assumptions:
the credit crisis
1. CRP = 0.2% of the principal is paid in the first month,

2. CPR increases by 0.2% in each of the following 30 months, and
3. CPR then levels off at a constant annual prepayment rate of 6% until
maturity.

Pass-through securities
A pass-through security is the simplest mortgage-backed security: It
represents a claim to a fraction of the total cash flow that is flowing
and fixed income markets from the homeowners to the pool of mortgages.

This simple structure implies that all investors in pass-through securities
Topic 5: Credit risk are exposed to the prepayment risk.
and asset-backed
securities
Note that the mortgage pool pays WAC, but the holder of the
PT
CDS pass-through security gets the pass-through rate r12 , which is lower
Securitization
CDOs than WAC.
Correlation
⊲ MBS
The difference is the profit for whomever sets up the security.
RMBS Market
MBS hedging
the credit crisis

Valuing pass through securities
Consider an MBS pass through with principal USD 600 million. The
original mortgage pool has a WAM = 360 months (30 years), and WAC
and fixed income markets = 6.5%.
PT
The pass-through security pays a coupon equal to r12 = 6%, lower
than the average coupon rate of the mortgage pool, both to ensure
and asset-backed
securities
there is enough cash available for coupon payments, and also to provide
CDS a compensation for the MBS issuer (e.g. Fannie Mae or Freddie Mac).
Securitization
CDOs
Correlation
⊲ MBS How do we compute the value of the pass through? We can use the
RMBS Market
PSA level to determine the speed of prepayment, and therefore the
MBS hedging timing and size of future cash flows.
the credit crisis Given a PSA level, for instance 200% PSA, we obtain the CPRt for
each month t and thus the corresponding monthly prepayment rate:
pt = 1 − (1 − CPRt )1/12

MBS value and prepayment speed
Table 12: Pass-through security value vs. interest rate and PSA
Constant PSA = 200% Increasing PSA with lower interest rate
Interest rate Value Interest rate PSA Value
Topic 3: Endogenous risk 2.00% 764.57 2.00% 500 687.80
2.50% 740.00 2.50% 450 681.64

3.00% 716.72 3.00% 400 674.76
Topic 6: Credit derivatives 3.50% 694.63 3.50% 350 666.97
and asset-backed
securities 4.00% 673.66 4.00% 300 658.00
CDS 4.50% 653.73 4.50% 250 647.45
Securitization
CDOs 5.00% 634.76 5.00% 200 634.76
Correlation
⊲ MBS
5.50% 616.71 5.50% 150 619.13
Duration & convexity 6.00% 599.50 6.00% 100 599.33
RMBS Market
MBS hedging 6.50% 583.08 6.50% 90 576.96
the credit crisis
7.00% 567.41 7.00% 80 554.53
7.50% 552.44 7.50% 70 532.06
8.00% 538.12 8.00% 60 509.54
8.50% 524.42 8.50% 50 487.01
9.00% 511.30 9.00% 40 466.45

Effective duration
Mortgage refinancing activity increases the conditional prepayment
rate. That is, it increases the PSA, which could easily move from, e.g.,
Topic 1: Foundations 200% to 300%. This change has an impact on the sensitivity of the
pass-through security to interest rates.
When assessing the risk of MBS, it is important to take into account
Topic 4: Value at Risk the variation in prepayment speed due to the change in interest rates.
Since analytical formulas do not exist, we have to rely on
and asset-backed
securities
approximations. This approximation is called effective duration:
CDS
Securitization 1 P (+x bps) − P (−x bps)
CDOs D≡− ,
Correlation P 2 × x bps
⊲ MBS
RMBS Market where P is the current price of the MBS, and P (+x bps) and
MBS hedging
P (−x bps) are the prices of the same security after we shift upward or
the credit crisis downward the yield curve by x basis points, respectively.
Missing the impact of interest rate variation on the speed of
prepayment may grossly overstate the sensitivity of the pass-through
security to interest rates.

Example: Effective duration
Consider the pass-through MBS from before. Assume current interest
rate is 5% and the PSA level is 200%.
The duration assuming that the PSA level is unaffected by the change
in interest rates is D = 5.83.
Topic 5: Credit risk Assume now that interest rates move from to 4.5% and the PSA
and asset-backed
increases to 250%. If interest rates move to 5.5%, PSA decreases to
securities 150%.
CDS
Securitization
CDOs
Using the prices in the table, calculate the effective duration:
Correlation
MBS 1 $619.13 − $647.45
⊲ Duration & convexity D=− = 4.46
RMBS Market $634.76 2 × 50 bps
MBS hedging
the credit crisis Not taking into account the variation in the prepayment speed induced
by interest rate variation may have a serious impact on the performance
of any duration based hedging activity.

Effective convexity
An important characteristic of MBS is negative convexity: If the
Administrative Details interest rate decline results in an increase of the prepayment rate, then
the price of the security does not increase by the same amount as it
and fixed income markets would with a constant prepayment rate.
and limits to arbitrage – Mechanically, the higher prepayment that is induced by lower
Topic 4: Value at Risk interest rates pushes the pass-through price toward its outstanding
principal amount.
and asset-backed – Economically, the investor in a pass-through security has implicitly
securities
CDS written American call options to the homeowners of the mortgages
Securitization
CDOs
in the pool.
Correlation
MBS The effective convexity of a MBS is given by:
⊲ Duration & convexity
RMBS Market
1 P (+x bps) + P (−x bps) − 2 × P
MBS hedging
C≡ 2 ,
Topic 7: Regulation and P (x bps)
the credit crisis
where P is the current price of the MBS and and P (+x bps) and
P (−x bps) are the prices of the same security after we shift upward or
downward the yield curve by x basis points, respectively.

Negative convexity of callable bonds (incl. MBS)

and asset-backed
securities
CDS
Securitization
CDOs
Correlation
MBS
RMBS Market
MBS hedging
the credit crisis

Example: Effective convexity
Consider the pass-through MBS from before. Assume current interest
rate is 5% and the PSA level is 200%.
and limits to arbitrage Using the prices in the table, calculate the effective convexity:
Topic 5: Credit risk 1 $619.13 + $647.45 − 2 × $634.76

Topic 6: Credit derivatives C=− = −184.89
and asset-backed $634.76 (50 bps)2
securities
CDS
Securitization
CDOs
The effective convexity of the MBS is negative.
Correlation
MBS
RMBS Market
MBS hedging
the credit crisis

Major players in the RMBS market
There are two types of residential mortgage-backed securities: Agency MBS
and non-agency MBS. Agency MBS are those ones in which government
and fixed income markets agencies are involved. The major players involved are:
① Ginnie Mae: Government National Mortgage Association
(GNMA). Formed by the U.S. Congress in 1968, Ginnie Mae is a
wholly-owned government corporation within the U.S. Department of
and asset-backed
securities
Housing and Urban Development. In 1970, Ginnie Mae developed and
CDS guaranteed the first mortgage-backed security. Ginnie Mae’s main
Securitization
CDOs function is to guarantee the timely payments of RMBS bakced by loans
Correlation
MBS
through the Federal Housing Administration program. Ginnie Mae does
⊲ Duration & convexity not make or purchase loans, nor does it buy, sell or issue securities.
RMBS Market
MBS hedging Instead it only guarantees MBS that are issued by approved private
Topic 7: Regulation and lending institutions, which pool loans and issue RMBS.
the credit crisis

Major players in the RMBS market (cont.)
② Fannie Mae: Federal National Mortgage Association (FNMA). Initially

created in 1938 as a government agency, it changed in 1968 into a shareholder-owned
company, although with a Federal charter, until the credit crisis of 2007-2009 forced
the U.S. Government to place Fannie Mae in conservatorship (that is, an effective
nationalization). As does Ginnie mae, Fannie Mae provides credit guarantees on
mortgage loans that are securitized through Fannie Mae. as opposed to Ginnie Mae,
Fannie Mae also maintains a large mortgage portfolio and issues debt to finance its
portfolio. By directly operating in the secondary market, Fannie Mae provides liquidity
in the mortgage market, which in turn allows banks to grant mortgages to individual
homeowners at more convenient rates than otherwise possible.
③ Freddie Mac: Federal Home Loan Mortgage Corporation (FHLMC). Also a
stockholder-owned institution until the credit crisis of 2007-2008, Freddie Mac was
chartered by the government in 1970 in order to stabilize U.S. residiential mortgage
markets and expand opportunities for homeownership and affordable rental housing.
Freddie Mac follows the same business model as Fannie Mae.

House Prices 1987–2016

and asset-backed
securities
CDS
Securitization
CDOs
Correlation
MBS
⊲ RMBS Market
MBS hedging
the credit crisis
Source: Standard and Poors

Mortgage related issuance
In addition to the three government institutions, RMBS are also issued

by other institutions. Although the largest share of RMBS is issued by
government-sponsored agencies, nonagency MBS issuance share
increased over time up to 2007. This large increase in the private label
and limits to arbitrage market parallels the acceleration in the U.S. house prices that occurred
Topic 4: Value at Risk from 2000 to 2006.
Topic 6: Credit derivatives Year Agency Nonagency Total Agency Share Nonagency Share
and asset-backed 1996 444.1 98.3 542.3 81.9% 18.1%
securities 1997 544.5 147.3 691.8 78.7% 21.3%
CDS 1998 954.9 293.4 1248.4 76.5% 23.5%
Securitization 1999 887.1 230.2 1117.3 79.4% 20.6%
2000 583.3 188.5 771.8 75.6% 24.4%
CDOs 2001 1480.4 332.3 1812.6 81.7% 18.3%
Correlation 2002 2044.3 448.9 2493.2 82.0% 18.0%
MBS 2003 2757.2 644.8 3402.0 81.0% 19.0%
Duration & convexity 2004 1393.0 948.7 2341.7 59.5% 40.5%
⊲ RMBS Market
2005
2006
1347.7
1239.1
1343.3
1355.2
2691.1
2594.3
50.1%
47.8%
49.9%
52.2%
MBS hedging 2007 1465.6 956.0 2421.6 60.5% 39.5%
Topic 7: Regulation and 2008 1366.8 40.7 1407.5 97.1% 2.9%
the credit crisis 2009 2022.9 18.7 2041.7 99.1% 0.9%
2010 1919.9 37.5 1957.4 98.1% 1.9%
2011 1615.3 39.2 1654.5 97.6% 2.4%
2012 2015.8 42.6 2058.4 97.9% 2.1%
2013 1857.9 96.8 1954.7 95.0% 5.0%
2014 1191.6 154.0 1345.5 88.6% 11.4%
until 06/2015 757.9 30.8 788.7 96.1% 3.9%
Notes: Quantities are in USD billions .

Source: SIFMA.

Hedging of MBS portfolios
Topic 1: Foundations Feedback from dynamic hedging of option positions on volatility in fixed
Topic 2: Hedging in equity income markets is a concern for policymakers.
– Kambhu (FRB NY, 1997), Kambhu & Mosser (FRB NY, 2001),
Perli & Sack (FRB, 2003), Chang, McManus, & Ramagopal
Topic 5: Credit risk (Freddie Mac, 2005), Deutsche Bundesbank report July 2006.
and asset-backed
– More recently, QE3.
securities
CDS
Securitization
Mortgages have negative convexity:
CDOs
Correlation
MBS
Interest rates ↓ =⇒ Prepayment risk ↑ =⇒ Duration ↓
Duration & convexity =⇒ Buy Treasuries =⇒ Interest rates ↓
⊲ RMBS Market
MBS hedging
Topic 7: Regulation and What are implications for bond yield, bond return and option
the credit crisis
implied volatility.

Do mortgage investors actually hedge?
5
MBS duration
1
01/01/90 01/01/95 01/01/00 01/01/05 01/01/10

6 10
5 8
MBS duration
4 6
short rate
3 4
2 2
MBS duration
short rate
1 0
01/01/90 01/01/95 01/01/00 01/01/05 01/01/10

6 10
MBS duration
refin index
5 8
Refin Index (in 1000)

MBS duration
4 6
3 4
2 2
1 0
01/01/90 01/01/00 01/01/10

Bond volatility approaches record low as Fed drains convexity
[...] The Federal Reserve’s decision to hold borrowing costs steady into
2015 and buy mortgage debt each month is reducing bond market volatility
and fixed income markets and demand for options that hedge against changes in interest rates. [...]
Topic 4: Value at Risk [...] ‘‘The combination of the strengthened forward rate
Topic 5: Credit risk guidance from the Fed and a new round of quantitative easing
and asset-backed
is a negative for volatility’’, said Ruslan Bikbov, a fixed-income
securities strategist in New York at Bank of America Corp. ‘‘The perception of
CDS
Securitization a longer Fed-on-hold and the fact that the central bank is
CDOs
Correlation
taking negative convexity out of the mortgage-backed
MBS securities market will cause volatility to decline.’’
RMBS Market
⊲ MBS hedging Bloomberg, 20 September 2012
the credit crisis

September, 14th, 2012: QE 3 announcement
2 1.8
Topic 2: Hedging in equity 15y zero
15y FNMA
1.9 1.6

15y zero yield
and asset-backed 1.8 1.4
15y FNMA
securities
CDS
Securitization
CDOs
Correlation
1.7 1.2
MBS
RMBS Market
⊲ MBS hedging 1.6 1
the credit crisis Bernanke’s speech
1.5 0.8
01/08 01/09 01/10

September, 14th, 2012: QE 3 announcement
80 90
Topic 2: Hedging in equity swaption iv
MOVE
3m10y swaption atm iv

and asset-backed
securities
MOVE
CDS
60 80
Securitization
CDOs
Correlation
MBS
RMBS Market
⊲ MBS hedging
Bernanke speech
the credit crisis
40 70
01/08 01/09 01/10


and asset-backed
securities Topic 7: Regulation and the credit crisis
the credit crisis
Tools of monetary policy
Securitization
Timeline
Amplification
Monetary policy reaction
Basel accords
Proposals
New regulation

Outline
Securitization and the housing bubble
The credit crisis of 2007–2009

Amplification mechanisms
and asset-backed Monetary policy reactions
securities
Topic 7: Regulation
⊲ and the credit crisis Basel II and cyclical aspects of leverage and credit provision
Securitization
Timeline Proposals for regulatory reform
Amplification
Basel accords Dodd-Frank and Basel III
Proposals
New regulation

Goals of U.S. monetary policy
Federal Reserve Act:

– Maximum employment
– Stable prices
⊲ Precondition for maximum sustainable output growth, employment and moderate long-term
interest rates
⊲ Prices are undistorted by inflation and serve as clearer signals and guides to efficient allocation
of resources
⊲ Foster savings and investment
– In the long run stable prices help foster economic activity
– Potential tension between the goals in the short run
⊲ Example: Upward pressure on prices (e.g. spike in energy prices) as output is slowing down
⊲ Either control inflation but hurt output, or tackle unemployment but aggravate inflation
⊲ Policy makers face a dilemma
– Fed also contributes to financial stability by acting to contain financial disruptions

Administrative Details Open market operations

Topic 1: Foundations – Purchases and sales of U.S. Treasury and federal agency securities
and fixed income markets – Principal tool for implementing monetary policy
Topic 3: Endogenous risk – Determine the federal funds rate

– Objective is either quantity or interest rate (in 1995 the Fed began stating it’s target level for the Fed funds rate)
– Open Market Operations either permanent (trading with primary dealer) or temporary (repo auctions)
Topic 6: Credit derivatives Discount window
and asset-backed
securities
– Regional Federal Reserve Bank’s lending facility for commercial banks and other depositary institutions
Topic 7: Regulation and – Three discount window programs are offered:

the credit crisis
⊲ Primary credit—very short term, sound financial condition of borrower
Securitization ⊲ Secondary credit—if not eligible for primary credit or to resolve severe financial difficulties
Timeline
⊲ Seasonal credit—smaller institutions with seasonal liquidity needs
Amplification
Monetary policy reaction – All discount window loans are fully secured
Basel accords
Proposals
– Primary credit was offered at premium of 100bps over the target rate, cut to 25bps above target in March 2008
New regulation Reserve requirements

– Reserve requirements are the amount of funds that a depository institution must hold in reserve against specified deposit
– Within limits specified by law, the Board of Governors has sole authority over changes in reserve requirements
– Depository institutions must hold reserves in the form of vault cash or deposits with Federal Reserve Banks
– Beginning October 2008, the Federal Reserve Banks pays interest on required reserve balances and excess balances

Federal funds rate
Interest rate at which depository institutions lend balances at the
Federal Reserve to other depository institutions overnight.
and fixed income markets When Fed is selling securities it is taking cash out of the system and
and limits to arbitrage draining reserves.
Draining reserves increases the fed funds rate at which banks with
deficit reserves may be able to borrow.
and asset-backed
securities
Borrowing and lending in fed funds market can be done directly by the
Topic 7: Regulation and banks or through brokers.
the credit crisis
Tools of monetary Transactions typically take place overnight, lending and borrowing is
⊲ policy
Securitization unsecured.
Timeline
Amplification Effective Fed funds rate is the the volume weighted Fed funds rate at
Basel accords
which reserves are lent and borrowed.
Proposals Cutting the target rate is viewed as easing credit and increasing target
New regulation
is viewed as tightening credit availability.
Target set at FOMC (Federal Open Market Committee) meetings.

Federal funds rate 1984-2016
ZLB Policy implementation: Dec 2008

First interest rate hike: Dec 2015
Source: Federal Reserve Bank of St. Louis

Banking industry trends
Originate and distribute banking model

Securitization
– Insuring (CDS)
– Pooling
– Tranching (CDO)
Increased leverage/maturity mismatch
– Off-balance sheet (SIVs) raise funds in the asset-backed commercial paper market
– Invested in long-term assets
– Creates funding liquidity risk for banks via credit lines (liquidity backstop)
– I-banks increasingly financed themselves in the overnight repo market (you borrow
funds by selling collateral and agreeing to repurchase at later date)
– I-banks needed to roll over a large part of their funding on a daily basis

Why structured products?
Good reasons
– Transfer credit risk to entity that can best bear it
⊲ Banks hold equity tranche—monitoring
⊲ Pension funds hold AAA rated assets
and limits to arbitrage ⊲ Hedge funds focus on risky assets
Bad reasons
– Regulatory arbitrage—outmaneuver Basel I (esp. reputational liquidity enhancement)
and asset-backed
securities – Rating arbitrage
Topic 7: Regulation and ⊲ Rating at the edge
the credit crisis
Tools of monetary policy ⊲ Transfer assets to SIV and issue AAA rated papers
⊲ Securitization
Timeline ⊲ Buy back AAA for lower capital charge
Amplification
Monetary policy reaction – Naivete, reliance on
Basel accords
Proposals
⊲ past low correlation among regional housing markets.
New regulation ⊲ rating agencies—rating structured products is different.
– Trick your own investors/firm.
⊲ Enhance portfolio returns—extreme tail risk.
⊲ Attraction of illiquidity—mark to model and smooth volatility.

Consequences: Cheap credit and housing boom
Banks focus only on pipeline risk
and fixed income markets Deterioration of lending standards
– Teaser rates

– No documentation mortgages
and asset-backed
securities – Piggyback mortgages
the credit crisis
Tools of monetary policy – NINJA loans (no income, no job or assets)
⊲ Securitization
Timeline
Amplification Housing frenzy
Basel accords
Proposals
People were worried about “liquidity” or “credit” bubble but unwilling
New regulation to bet against it.
Chuck Prince (CEO Citigroup) on July 10, 2007: “... as long as the
music is playing, you’ve got to get up and dance. We’re still dancing.”

House Prices 1987–2016

and asset-backed
securities
the credit crisis
⊲ Securitization
Timeline
Amplification
Basel accords
Proposals
New regulation
Source: Standard and Poors

Summer 2007
Increase in subprime mortgage defaults in early 2007
May 4, 2007: UBS shuts down internal hedge fund
June and July 2007: rating agencies downgrade mortgage-related products

July 31, 2007: Bear Stearns liquidates two hedge funds
Market for ABCO dries up, conduits unable to roll over, draw down credit lines
and asset-backed
securities Fed funds target rate at 5.25%, inflation is still main concern
the credit crisis August 1-9, 2007: quant hedge fund crisis, triggering margin calls and fire
⊲ Securitization sales
Timeline
Amplification August 9, 2007: BNP Paribas halts redemption on three investment funds
Basel accords
Proposals
Interbank market freezes: LIBOR surges, central banks start injecting liquidity
New regulation and Fed reduces discount rate by 50bps
September 14, 2007: Bank run on Northern Rock, Bank of England provides
liquidity
September 18, 2007: Fed funds target rate cut to 4.75%

Commercial paper market
Source: Federal Reserve Bank of St. Louis

TED spread
The TED spread is the interest rate difference between the LIBOR and the Treasury bill rate.

Fall and Winter 2007/2008
October 2007: series of write-down, banks seem to clean their books and raise new capital
October 31, 2007: Fed funds rate cut to 4.5%
November 2007: expected mortgage related losses revised upwards, additional write-downs
December 11, 2007: Fed funds rate cut to 4.25%
December 12, 2007: Fed announces creation of Term Auction Facility (TAF) to address
liquidity crunch—depositary institutions can bid anonymously for 28-day loans against
high-quality collateral
January 2008: worries about potential downgrading of insurers, which were providing
guarantees to structured products and MBS—a downgrade would have resulted in a massive
sell-off
January 18, 2008: Fitch downgrades insurance company Ambac, emerging markets and Asia
lost 15%, Europe was down 5%
January 22, 2008: In an intermeeting call, the FOMC decides to cut the Fed funds rate by
75bps to 3.5%
January 30, 2008: Fed funds rate cut to 3%
February 17, 2008: Northern Rock is taken into state ownership

Spring 2008
March 2008: credit spreads between agency bonds (issued by Freddie Mac and Fannie Mae)
and Treasuries widen again
March 11, 2008: Fed announces creation of Term Securities Lending Facility (TSLF), which
will lend up to $200bn of Treasuries against expanded set of collateral—to deal with shortage
of collateral
March 12, 2008: Bear Stearns, the smallest, most leveraged investment bank with large
mortgage exposure was unable to secure funding in the repo market
March 14, 2008: JPMorgan would acquire Bear Stearns for $2 per share with the help of the
NY Fed
March 16, 2008: Fed establishes the Primary Dealer Credit Facility (PDCF), an overnight
funding facility for investment banks that can be collateralized by broad range of
investment-grade debt securities—temporary “discount window” for large non-depositary
institutions
March 18, 2008: Fed funds rate cut to 2.25%
April 30, 2008: Fed funds rate cut to 2%

Summer 2008
April-June 2008: mortgage delinquency rates continue to rise
June 2008: agency spreads widen further
Topic 3: Endogenous risk July 11, 2008: IndyMac, a large private mortgage broker is put in
conservatorship—focus on Freddie Mac and Fannie Mae

July 13, 2008: U.S. Treasury announces temporary increase in credit lines of
and asset-backed Fannie Mae and Freddie Mac and authorization to purchase equity, and plans
securities
to make implicit government guarantee explicit
the credit crisis
Tools of monetary policy July 15, 2008: SEC prohibits naked short selling in Fannie Mae, Freddie Mac
Securitization
⊲ Timeline
and primary dealers
Amplification
Monetary policy reaction September 8, 2008: Fannie Mae and Freddie Mac are placed in government
Basel accords
Proposals conservatorship, Treasury makes government guarantee explicit
New regulation

Fall 2008
March-September 2008: Lehman Brothers made use of PDCF but did not raise new capital
September 9, 2008: Lehman tried to sell itself to the Korean Development bank but sale fell through
September 12-14, 2008: Geithner, president of NY Fed, met with major banks to find a solution for
Lehman—no one was willing to take over Lehman without government guarantees
September 15, 2008: Lehman files for chapter 11 bankruptcy protection, Merrill Lynch sells itself to
Bank of America
September 16, 2008: AIG stock falls by 90%, the Fed organizes a $85bn bailout for 80% equity
stake—AIG was a major player in the CDS market
September 20, 2008: Paulson drafts proposal for bailout plan, wanting $700bn to purchase illiquid
assets
September 21, 2008: Goldman Sachs and Morgan Stanley become bank holding companies—subject
to tighter regulation and supervision
September 29, 2008: Treasury opens Temporary Guarantee Program for money market funds
October 3, 2008: congress passes Emergency Economic Stabilization Act—establishes the $700bn
Troubled Asset Relief Program (TARP)
October 7, 2008: Fed announces creation of Commercial Paper Funding Facility (CPFF), which
provides liquidity to U.S. issuers of commercial paper
October 8, 2008: Fed funds rate cut to 1.5%
October 29, 2008: Fed funds rate cut to 1%

Winter and Spring 2008/2009
November 20, 2008: Fannie Mae and Freddie Mac announce they will suspend mortgage
foreclosures
November 25, 2008: Fed announces creation of Term Asset-Backed Securities Lending Facility
(TALF), under which NY Fed lends up to $200bn to holders of AAA-rated ABS
December 11, 2008: NBER announces that peak in U.S. economic activity occurred in
December 2007
December 16, 2008: FOMC establishes target range for Fed funds rate of 0% to 0.25%
February 17, 2009: Obama signs $787bn economic stimulus plan into law “American Recovery
and Reinvestment Act of 2009”.
February 18, 2009: Obama announces Homeowner Affordability and Stability Plan, which
includes program that permits refinancing of mortgages owned or guaranteed by Fannie Mae
and Freddie Mac that currently exceed 80% of the value of the underlying home
March 6, 2009: Bank of England announces up to GBP 150bn of quantitative easing.
March 18, 2009: Fed announces it will buy almost $1.25tr worth of agency MBS, up to
$200bn agency debt and up to $300bn long-term Treasuries to help boost lending and
promote economic recovery.
April 2, 2009: Agreement at the G20 summit in London to tackle the global financial crisis
with measures worth $1.1tr.

The aftermath of Lehman
Some money market funds “broke the buck”
and fixed income markets Sharp rise in CDS prices
Topic 4: Value at Risk Non-AB commercial paper market dries up

and asset-backed Extreme spike in the TED spread
securities
the credit crisis Very large aggregate stock market declines
Securitization
⊲ Timeline
Increasing signs of significant spillovers into the real economy
Amplification
Basel accords
Proposals
New regulation

Amplifying mechanisms (Brunnermeier 2009)
How can subprime mortgage market trigger such a crisis?

Topic 1: Foundations – 15% of U.S. mortgage market of roughly $10 trillion

– Assume 50% default, 50% recovery ∼ $375-500bn total losses
– Stock market lost $10 trillion
Topic 4: Value at Risk Need amplification mechanism
– Borrowers’ balance sheet effects
and asset-backed
securities ⊲ Loss spiral: in order to hold leverage constant, investor is forced to cut
Topic 7: Regulation and positions when prices fall, which can lead to further price falls
the credit crisis
Tools of monetary policy ⊲ Margin spiral: lenders tend to increase margin requirements and haircuts
Securitization when there are large price falls, forcing the borrower to reduce leverage
⊲ Timeline
Amplification – Lending channel effects
Basel accords ⊲ When lenders have limited capital, they curtail lending as their own financial
Proposals
New regulation
situation worsens
⊲ Precautionary hoarding (credit lines)
– Run on financial institutions
– Network effects: gridlock risk

Credit easing during the crisis
When interest rates are close to zero, room for further cuts is limited
Central bank needs to expand toolkit using the asset side of Fed
and limits to arbitrage balance sheet

Topic 6: Credit derivatives “Credit easing”—changing the mix of financial assets
and asset-backed
securities
the credit crisis “Quantitative easing”—changing the quantities of reserves
Securitization
Timeline
⊲ Amplification
Basel accords
Proposals
New regulation

Credit easing policy tools
Lending to financial institutions.

– Discount window.
– TAF to overcome stigma problem.
– Shortage of Treasuries as collateral—TSLF and PDCF to expand type of collateral.
Providing liquidity to key credit markets
– Liquidity not transferred to credit markets.
– Lending to financial institutions did not address strains in non-bank markets.
– Liquidity backstop for money market funds.
– CPFF—purchases 3-month commercial paper to make sure financial institutions do not run into
problems rolling over.
– TALF—provide liquidity and capital to consumer and small business loan ABS market.
– Maiden Lane I-III—tied to pools of assets that Fed has lent against (Bear Stearns, AIG).
Purchasing longer-term securities.
– Purchase of direct obligations of housing related GSEs (Fannie Mae, Freddie Mac).
– Purchase of MBS backed by Fannie Mae and Freddie Mac—improve availability of credit for
purchase of houses.

Assets on Fed balance sheet
Source: Federal Reserve Bank of Cleveland

Basel I and Basel II
Basel I
Administrative Details – The 1988 Basel Accord primarily focused on credit risk.
– Assets of banks were classified and grouped in five categories according to credit
and fixed income markets risk, carrying risk weights of 0% (eg. home country sovereign debt) up to 100%
Topic 3: Endogenous risk (most corporate debt).
Topic 4: Value at Risk – Banks with international presence are required to hold capital equal to 8% of the
risk-weighted assets.
and asset-backed
Basel II
securities
– The goal was to come up with an international standard that banking regulators
the credit crisis can use when creating regulations about how much capital banks need to put
Tools of monetary policy aside to guard against the types of financial and operational risks banks face.
Securitization
Timeline – Three pillars:
Amplification
Monetary policy 1. Maintenance of regulatory capital calculated for three major components
⊲ reaction
Basel accords of risk that a bank faces: credit risk, operational risk and market risk. For
Proposals market risk the preferred approach is VaR.
New regulation 2. Supervisory review, giving regulators much improved ’tools’ over those
available to them under Basel I.
3. Market discipline—to promote greater stability in the financial system.

Basel II and cyclical aspects of leverage and credit provision
Basel II requires banks to increase their capital ratios when they face
greater risks.
and limits to arbitrage This may require them to lend less during a recession or a credit
Topic 4: Value at Risk crunch, which could aggravate the downturn.
and asset-backed Danielsson et al. (2001): Procyclicality of ratings (and cyclicality of risk
securities
assessments more generally) induces cyclicality in capital charges,
the credit crisis leading banks to overlend at the height of the cycle and to “underlend
Securitization during the downturn when macroeconomic stabilisation requires an
Timeline
Amplification
expansion of lending.”
⊲ Basel accords
Proposals This can be an important source of endogenous risk, VaR in particular
New regulation
has the potential of inducing crashes.

Proposals for regulatory reform
Micro measures:
and fixed income markets – Liquidity requirements
Topic 4: Value at Risk – Leverage ratios

and asset-backed – Innovations in financing instruments
securities
the credit crisis – “Living wills”, independent capitalization of subsidiaries
Securitization
Timeline
Amplification
Macroprudential regulation:
⊲ Basel accords
Proposals – Transparency: exchange/central clearing
New regulation
– Forward looking measures of contribution to systemic risk
– Improvements to cyclical aspects of regulation

Leverage constraints
Traditional argument against leverage constraints is that they may be
too “blunt”.

Evidence that leverage is strongly procyclical for security brokers and
dealers (Adrian and Shin 2007).
and asset-backed
securities
Raw leverage constraints may be effective to the extent that they limit
the credit crisis
increases in leverage during booms.
Securitization
Timeline
Amplification
Basel accords
⊲ Proposals
New regulation

Hart & Zingales (2009)
Propose requirement for large financial institutions (LFIs):
and fixed income markets If CDS rate rises above a threshold, LFI is forced to issue equity until
CDS rate moves below threshold.

If this does not happen, regulator intervenes:
and asset-backed – If determines that debt is not at risk (CDS was “wrong”), regulator
securities
declares company is adequately capitalized and injects government
the credit crisis
money.
Securitization
Timeline – Otherwise, regulator replaces CEO with a receiver; equityholders are
Amplification
Monetary policy reaction wiped out; haircut imposed on creditors.
Basel accords
⊲ Proposals
Market-based corrective action based on firm-level information.
New regulation
In recent crisis troubled LFIs would have been forced to issue equity
roughly one year before collapse.

Contingent convertible bonds
Debt instruments that convert into equity in “bad states” from the
issuer’s perspective.
Topic 4: Value at Risk For example this can be triggered if core tier one capital falls below a
Topic 5: Credit risk certain threshold, say 5%.
and asset-backed
securities
the credit crisis
Securitization
Timeline
Amplification
Basel accords
⊲ Proposals
New regulation

Exchange/central clearing
Network effects (Brunnermeier, 2009):
Suppose all parties are fully hedged in the sense that multilateral
netting could completely eliminate exposures.

Topic 6: Credit derivatives Because of the over-the-counter nature of the CDS market, individual
and asset-backed
securities parties may not know this since they cannot see the entire picture.
the credit crisis
Securitization In this case a perceived counterparty credit risk can become
Timeline
Amplification
self-fulfilling.
Basel accords
⊲ Proposals Case for centralized clearing/exchange.
New regulation

CoVaR (Adrian & Brunnermeier, 2009)
Institution i’s CoVaR relative to the system is defined as the VaR of the
whole financial sector conditional on institution i being in distress.
Topic 3: Endogenous risk The difference between the CoVaR and the unconditional financial

system VaR captures the marginal contribution of a particular
Topic 5: Credit risk institution to overall systemic risk.
and asset-backed
securities
Provides a measure of systemic risk.
the credit crisis
Macroprudential regulation:
Securitization
Timeline – Internalize systemic risk externalities by relating capital surcharges
Amplification
Monetary policy reaction to contributions to systemic risk.
Basel accords
⊲ Proposals – Countercyclical capital requirements based on predictions of future
New regulation
contributions to systemic risk. Predictions based on firm
characteristics (size, leverage, maturity mismatch etc.).

Kashyap, Rajan & Stein (2008)
Administrative Details “Time-invariant capital requirements are analogous to forcing a

Topic 1: Foundations homeowner to hold a fixed fraction of his house’s value in savings, as a
hedge against storm damage- and then not letting him spend down
Topic 3: Endogenous risk these savings when a storm hits... the homeowner will have no choice

but to sell the damaged house and move to a smaller place”
First suggestion: high capital requirement (say 10% of risk weighted
and asset-backed
securities
assets) during normal times with the understanding that it will be
Topic 7: Regulation and relaxed (to say 8%) during a crisis.
the credit crisis
Securitization Alternative: capital insurance.
Timeline
Amplification
– Bank would buy insurance policy on the occurrence of a systemic event
Basel accords (say a situation where the aggregate write-offs of major financial
⊲ Proposals
institutions during a given period exceed a trigger).
New regulation
– Insurer (say a sovereign wealth or pension fund) would put the potential
insurance payout into a “lock box” for the duration of the contract to
make the scheme default-proof.

Basel 2.5
July 2009: Basel II capital framework enhancements announced by the Basel
Committee
and fixed income markets – Strengthening treatment for certain securitisations in Pillar 1 (minimum
capital requirements): Introduction of higher risk weights for
resecuritisation exposures (so-called CDOs of ABS), requirement of more
rigorous credit analyses of externally rated securitisation exposures.
and asset-backed
– Supplemental guidance under Pillar 2 (the supervisory review process) to
securities address the flaws in risk management practices revealed by the crisis. It
the credit crisis raises the standards for:
Securitization ⊲ firm-wide governance and risk management;
Timeline
Amplification
⊲ capturing the risk of off-balance sheet exposures and securitisation
Monetary policy reaction activities;
Basel accords
⊲ Proposals
⊲ managing risk concentrations; and
New regulation ⊲ providing incentives for banks to better manage risk and returns over
the long term.
Basel 2.5 was due to be implemented no later than 31 December 2011.

Basel III
Strengthens microprudential regulation and supervision, and adds a macroprudential overlay that
includes capital buffers.
Topic 2: Hedging in equity Pillar 1
– Capital.
⊲ Quality and level of capital. Greater focus on common equity. The minimum will be
Topic 4: Value at Risk raised to 4.5% of risk-weighted assets, after deductions.
⊲ Capital loss absorption at the point of non-viability. Capital instruments will include a
Topic 6: Credit derivatives clause that allows write-off or conversion to common shares if the bank is judged to be
and asset-backed
securities non-viable.
Topic 7: Regulation and ⊲ Capital conservation buffer. Comprising common equity of 2.5% of risk-weighted assets,
the credit crisis
bringing the total common equity standard to 7%. Constraint’s and a banks discretionary
Securitization distributions will be imposed when banks fall into the buffer range.
Timeline
⊲ Countercyclical buffer. Imposed within a range of 0-2.5% comprising common equity,
Amplification
when authorities judge credit growth is resulting in an unacceptable build up of systematic
Basel accords
risk.
Proposals
⊲ New regulation

Basel III (cont.)
Pillar 1 (cont.)
– Risk coverage.
Topic 2: Hedging in equity ⊲ Securitisations. Requires banks to conduct more rigorous credit analyses of externally
and fixed income markets rated securitisation exposures
and limits to arbitrage ⊲ Trading book. Significantly higher capital for trading and derivatives activities, as well as
Topic 4: Value at Risk complex securitisations held in the trading book. Introduction of a stressed value-at-risk
framework to help mitigate procyclicality.
Topic 6: Credit derivatives ⊲ Counterparty credit risk. Substantial strengthening of the counterparty credit risk
and asset-backed framework. Includes: more stringent requirements for measuring exposure; capital
securities
incentives for banks to use central counterparties for derivatives; and higher capital for
Topic 7: Regulation and inter-financial sector exposures.
the credit crisis
Tools of monetary policy ⊲ Bank exposures to central counterparties (CCPs.) The Committee has proposed that
Securitization trade exposures to a qualifying CCP will receive a 2% risk weight and default fund
Timeline
exposures to a qualifying CCP will be capitalised according to a risk-based method that
Amplification
consistently and simply estimates risk arising from such default fund.
Basel accords – Containing leverage.
Proposals
⊲ New regulation ⊲ Leverage ratio. A non-risk-based leverage ratio that includes off-balance sheet exposures
will serve as a backstop to the risk-based capital requirement. Also helps contain system
wide build up of leverage.

Basel III (cont.)
Pillar 2: Supplemental requirements for risk management and supervision.

– Address firm-wide governance and risk management; capturing the risk of off-balance sheet
exposures and securitisation activities; managing risk concentrations; providing incentives for
banks to better manage risk and returns over the long term; sound compensation practices;
valuation practices; stress testing; accounting standards for financial instruments; corporate
and limits to arbitrage governance; and supervisory colleges.
Topic 4: Value at Risk Pillar 3: Revised disclosure requirements.
– Requirements relate to securitisation exposures and sponsorship of off-balance sheet vehicles.
Topic 6: Credit derivatives Enhanced disclosures on the detail of the components of regulatory capital and their
and asset-backed
securities reconciliation to the reported accounts, including a comprehensive explanation of how a bank
calculates its regulatory capital ratios.
the credit crisis
Global liquidity standard and supervisory monitoring.
Securitization – Liquidity coverage ratio.
Timeline
Amplification – Net stable funding ratio.
Basel accords – Principles for sound liquidity risk management and supervision.
Proposals
⊲ New regulation
– Supervisory monitoring.
Additional capital requirements for global systemically important financial institutions (SIFIs),
which must have higher loss absorbency capacity.
Implementation starts in 2013 and should be completed by January 2019.

Dodd-Frank
The Dodd-Frank Wall Street Reform and Consumer Protection Act was signed into law in
July 2010.
The highlights of the Act are as follows:
– Identifying and regulating systemic risk. Designate nonbank financial firms as
systemically important, regulate them, and possibly break them up.
– Proposing an end to too-big-to-fail. “Living wills” and orderly liquidation procedures for
unwinding systemically important institutions, ruling out taxpayer funding of wind downs.
– Expanding the responsibility and authority of the Fed. Grants the Fed authority over all
systemic institutions and responsibility for preserving financial stability.
– Restricting discretionary regulatory interventions. Prevents or limits emergency federal
assistance to individual nonbank institutions.
– “Volcker rule”. Limits bank holding companies to de minimis investments in proprietary
trading activities such as hedge funds and private equity, and prohibits them from bailing
out these investments.
– Regulation and transparency of derivatives. Central clearing of standardized derivatives,
regulation of complex derivatives that can remain OTC.

Regulatory changes in Europe
Markets in Financial Instruments Directive (MiFID).

– The cornerstone of the Financial Services Action Plan (FSAP), which is an attempt to
create a single market for financial services in Europe. Effective date 1 November 2007.
– Key aspects of MiFID:
⊲ Authorisation, regulation and passporting. Firms are regulated in home country.
⊲ Client categorisation as “eligible counterparties.”
⊲ Client order handling to ensure firm acts in best interest.
⊲ Pre- and post-trade transparency. Quotes and prices must be made available.
⊲ Best execution and systemic internaliser. Firms need to take all reasonable steps to
obtain best result in execution of an order.
European Market Infrastructure Regulation (EMIR): Introduces reporting and clearing
obligations for OTC derivatives, measures to reduce counterparty credit risk and operational
risk in OTC markets.
European Systemic Risk Board (ESRB): Tasked with the macro-prudential oversight of the
financial system within the EU in order to contribute to the prevention or mitigation of
systemic risks to financial stability in the Union.

Management of Financial Risk

Uploaded by

Document Information

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Management of Financial Risk

Uploaded by

Copyright:

Available Formats

FM202

Analysis and Management of Financial Risk

Georgy Chabakauri Cameron Peng

London School of Economics

© (2018) Chabakauri & Peng – 1

Topic 4: Value at Risk

© (2018) Chabakauri & Peng – 2

© (2018) Chabakauri & Peng – 3

Topic 4: Value at Risk

Topic 5: Credit risk

© (2018) Chabakauri & Peng – 4

Topic 5: Credit risk

© (2018) Chabakauri & Peng – 5

Topic 5: Credit risk

Jón Danı́elsson: Financial Risk Forecasting, Wiley, 2011

© (2018) Chabakauri & Peng – 6

Topic 4: Value at Risk

Topic 5: Credit risk Topic 4: Value at Risk

Topic 6: Credit derivatives and asset-backed securities

Topic 7: Regulation and the credit crisis

© (2018) Chabakauri & Peng – 7

Topic 4: Value at Risk

Topic 5: Credit risk Why manage financial risk?

Overview of financial instruments

Risk management failures and key lessons

© (2018) Chabakauri & Peng – 8

Topic 4: Value at Risk

© (2018) Chabakauri & Peng – 9

Topic 5: Credit risk Market efficiency and empirical challenges

Outside capital and limits to arbitrage

The technology “bubble”

© (2018) Chabakauri & Peng – 10

Topic 4: Value at Risk

Topic 5: Credit risk Backtesting and stress testing

© (2018) Chabakauri & Peng – 11

Topic 4: Value at Risk

Topic 5: Credit risk

© (2018) Chabakauri & Peng – 12

Topic 4: Value at Risk

Topic 5: Credit risk Mortgage-backed securities

© (2018) Chabakauri & Peng – 13

Topic 4: Value at Risk

Topic 5: Credit risk Basel III and Dodd-Frank

© (2018) Chabakauri & Peng – 14

Topic 4: Value at Risk

Topic 5: Credit risk

© (2018) Chabakauri & Peng – 15

Topic 5: Credit risk

Risk management failures and key lessons

© (2018) Chabakauri & Peng – 16

Topic 4: Value at Risk

© (2018) Chabakauri & Peng – 17

© (2018) Chabakauri & Peng – 18

Topic 5: Credit risk

© (2018) Chabakauri & Peng – 19

Topic 4: Value at Risk

© (2018) Chabakauri & Peng – 20

© (2018) Chabakauri & Peng – 21

There is a limit to risksharing when there is aggregate risk.

© (2018) Chabakauri & Peng – 22

© (2018) Chabakauri & Peng – 23

© (2018) Chabakauri & Peng – 24

© (2018) Chabakauri & Peng – 25

© (2018) Chabakauri & Peng – 26