ARM Module 1

United Nations Institute for Training and Research
UNITAR e-Learning course on Advance Risk Management Module 1: Review of Basic Knowledge: Statistics, Basic Matrix Algebra Operations and Mathematics of Finance
e-Learning Course on
Advanced Risk Management
Module 1: Review of Basic Knowledge: Statistics, Basic Matrix Algebra Operations and Mathematics of Finance
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Author: Dr. E. Cosio-Pascal
Module 1: Goals and Objectives
MODULE 1
GOALS The course aims at providing the student with medium to advanced level knowledge of financial risk management and its applications to the field of finances. In order to be able to apply the risk management tools, it is necessary to have a minimum background on quantitative fields like linear algebra, calculus, statistics and mathematics of finance. Module 1 of the course aims to putting all participants at the same operational level in these fields.
LEARNING OBJECTIVES
By the end of this module you will be able to:

Construct histograms and frequency tables from empirical data; Compute and interpret major statistical distributions and their parameters used in risk management; Solve systems of simultaneous equations using determinants; Compute basic matrix algebra operations; Compute the inverse of a matrix and finding its Eigenvalues and Eigenvectors; Calculate simple and compound interest applying different rules for counting days in the financial year; Calculate annuities certain and solve generic problems concerning annuities; Calculate and build different types of amortisation tables using annuities.
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Table of Content
ABBREVIATIONS AND ACRONYMS STATISTICS o o Statistical Parameters used in Risk Management Theoretical Distributions that are used to Analyse Risk Statistical Tools that are used in Risk Analysis
MATRIX ALGEBRA o o Basic Concepts Operations with Matrices
MATHEMATICS OF FINANCE o o Basic Concepts Annuities-Certain and Amortisation Schedules
BIBLIOGRAPHY ARTICLES OR SHORT PUBLICATIONS BOOKS
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Abbreviations and Acronyms
ALCO: ALM: ATM: CaT: CBDMS: COSO: CIR: DMO: DOD: EC: EL: GAO: INTOSAI: IMF: JCR: MPL: NII: NW: PE Ratio: RAROC: ROE: SAI: SDR: S & P: UL: USD: VaR:
Asset Liability Management Committee. Asset Liability Management. Average time to maturity. Cost-at-Risk. Computer Based Debt Management System. Committee of Sponsoring Organisations of the Tradeway Commission. Cox-Ingersoll-Ross Model. Debt Management Office. Debt Outstanding and Disbursed, nominal value of outstanding debt. Economic Capital Expected Loss. US Government Accountability Office (previous Accounting Office). International Organisation of Superior Audit Institutions. International Monetary Fund. Japan Credit Rating Agency. Maximum Probable Loss Net interest income. Net worth. Shares Price per Earnings Ratio. Economic capital and risk-adjusted return on capital. Return on Equity. Superior Audit Institution Special Drawing Rights, unit of account of the IMF. Standard & Poors. Unexpected Loss United States Dollar. Value-at-Risk.
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1.
Statistics
1.1. Probability Densities
1.1.1
Construction of Histograms and Percentages from Empirical Data
Statistics is a science that finds its roots on empirical observation: the number of times that a certain events are repeated. This is obviously linked to the units in which the observed events are measured: it can belong to the set of integer numbers or real numbers. For instance, if we are dealing with loans, bonds or securities, they are measured in integer numbers, as it is impossible, at least theoretically, to issue half a financial instrument. Now, if we are measuring the worth of each financial instrument, this measure belongs to real numbers, because this is measured in monetary units which, for practical purposes, can be seen as a continue variable. Statistical calculations are highly facilitated by the use of computers, and it is assumed in this course that the e-Students have a computer and that are literate using a calculation spreadsheet, and it is highly recommended to reproduce all the numerical examples on a spreadsheet in order to assure the understanding of the different concepts that will be presented all along the course. Let us take an example for presenting graphically some numeric data. Let assume that the cash flow payments on the debt of a given debtor agency is given in Table 1.1.1. Table 1.1.1 contains four loans which the three first ones are reimbursed in equal annual instalments, and the last one is a bullet payment at five years. It is assumed that the payments are made end of period, i.e. end of each year, for principal and interest payments. Table 1.1.1 will allow explaining how a weight average is calculated: for the average rate of interest and the average maturity the weights that are used are the total cash flow for each one of the loans. It has to be noted that very often the face value or the debt outstanding and disbursed (DOD), in other words the stock of outstanding debt, may be used instead. In the present case we are using the cash flow because it takes into account in the allocated weights the interest payments that are not necessarily negligible. If we denote by calculated as :
1
w i the weight associated to value v i , then the weighted average is
(1.1.1)
wa =
w v
i =1 n i
w
i =1
A barred letter denoting a variable means the weighted average of that variable.
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Table 1.1.1 Loans' Cash Flow = principal + interest 1,000 of Monetary Units Loan 1 Loan 2 Loan 3 Loan 4 Total 1,000.00 2,500.00 1,750.00 2,000.00 7,250.00 10.00% 8.50% 7.50% 9.50% 8.74% 10 5 20 5 9.31 200.00 712.50 218.75 190.00 1,321.25 190.00 670.00 212.19 190.00 1,262.19 180.00 627.50 205.63 190.00 1,203.13 170.00 585.00 199.06 190.00 1,144.06 160.00 542.50 192.50 2,190.00 3,085.00 150.00 0.00 185.94 0.00 335.94 140.00 0.00 179.38 0.00 319.38 130.00 0.00 172.81 0.00 302.81 120.00 0.00 166.25 0.00 286.25 0.00 0.00 159.69 0.00 159.69 0.00 0.00 153.13 0.00 153.13 0.00 0.00 146.56 0.00 146.56 0.00 0.00 140.00 0.00 140.00 0.00 0.00 133.44 0.00 133.44 0.00 0.00 126.88 0.00 126.88 1,440.00 3,137.50 2,592.19 2,950.00 10,119.69 Total cash flow for the period 10,119.69
Year Face V. Rate Maturity 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 2023 Total
The average interest rate r is calculated as the weighted average of the individual rates weighted by the face value, the result is then:
r=
w r
i =1 4
i i
w
i =1
1,000.00 10% + 2,500.00 8.5% + 1750.00 7.5% + 2000.00 9.5% = 8.74% 7, 250.00
Similarly, the average maturity is calculated as2:
m=
w m
i =1 4 i
w
i =1
1,000.00 10 + 2,500.00 5 + 1,750.00 20 + 2,000.00 5 = 9.31 7, 250.00
Once the average parameters of the data are determined, it is also important to have an idea of the distribution of the data as well. This is undertaken by means of a graphic representation of the data. In this particular case, in which we are dealing with a debt service cash flow, this is called the Redemption Profile when it shows only the amortisation of capital or Cash Flow Profile when interest payments are also included, as is the case in Table 1.1.1. This is represented in the form of a histogram that is represented in Figure 1.1.1.
The reader should not confuse this concept with the risk indicator Average Time to Maturity (ATM) that will be explained latter in the course.
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Figure 1.1.1 Loans Cash Flow Profile

3,500.00 1,000 Monetary Units 3,000.00 2,500.00 2,000.00 1,500.00 1,000.00 500.00 0.00 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 2023 Loan 1 Loan 2 Loan 3 Loan 4 Total
Years
Figure 1.1.1 is extremely useful for the debt manager as it shows very clearly where maturities are bunching and can become a risk. In this specific case, Figure 1.1.1 shows that year 2013 can present this risk. In order to complement the analysis shown in Figure 1.1.1 it is also useful to transform the data into percentages in order to obtain more information. In our present case, the percentage will be calculated in respect to the total cash flow in the period: 10,119.69. This is to be found in Table 1.1.2. It is also useful to produce a graphic representation of the relative figures of debt service, in order to assess the same risk as it was assessed in Figure 1.1.1 but now with relative figures, i.e. percentages. This is represented in Figure 1.1.2 which is the graphic representation of figures of Table 1.1.2. It can be seen in Figure 1.1.2 that the bunching of maturities is confirmed and that practically 30.5 percent, i.e. almost one third, of the total cash flow has to be paid in year 2013. This is obviously a serious liquidity and rollover risk indicator for the debt or the risk manager, as this bunching of maturities implies a heavy draw on resources in order to pay the debt service in that year, and either we could have not the liquid resources available or we could have difficulties in rolling over the debt falling due in that year. It is useful to show with formulae how Table 1.1.2 is calculated. In fact this will also be useful to recall how a double sum operates. If we denote the cash flow of loan j at year i cf ij , then the percentage of total cash flow to be honoured in year i due to loan j is denoted
pij , that is calculated in our case as: cf ij
(1.1.2)
pij =
w
i =1 j=1
15
ij
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Table 1.1.2 Cash Flow of Loans in Percentage of total Cash Flow Loan 1 Loan 2 Loan 3 Loan 4 Total 1.98% 7.04% 2.16% 1.88% 13.06% 1.88% 6.62% 2.10% 1.88% 12.47% 1.78% 6.20% 2.03% 1.88% 11.89% 1.68% 5.78% 1.97% 1.88% 11.31% 1.58% 5.36% 1.90% 21.64% 30.49% 1.48% 1.84% 3.32% 1.38% 1.77% 3.16% 1.28% 1.71% 2.99% 1.19% 1.64% 2.83% 1.58% 1.58% 1.51% 1.51% 1.45% 1.45% 1.38% 1.38% 1.32% 1.32% 1.25% 1.25%
Year 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 2023
Figure 1.1.2 Loans Cash Flow Profile in Percentage
35.00% Percentage of total debt 30.00% 25.00% 20.00% 15.00% 10.00% 5.00% 0.00%
20 09 20 10 20 11 20 12 20 13 20 14 20 15 20 16 20 17 20 18 20 19 20 20 20 21 20 22 20 23
Loan 1 Loan 2 Loan 3 Loan 4 Total
Years
Formula (1.1.2) should not present any difficulty, in fact the first index i, denotes the order of the row in the table: if we fix the year, for instance for 2009 which is the first row, i.e. i=1, we have summing on j, i.e. on the columns j for i=1, we calculate the cash flow corresponding to all four loans in 2009:
w
j=1
1j
= 200.00 + 712.50 + 218.75 + 190.00 = 1,321.25
And obviously in our case:
w
i =1 j=1
15
ij
= 10,119.69
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The reader should note that for obtaining the above result, first we fix the row to obtain the cash flow by year, and then we sum the result of each year over the rows, i.e. fifteen years. Therefore, for instance, the first percentage of year 2009, year 1, for Loan 1, j=1, in Table 1.1.2 is obtained as:
p11 =
cf11
w
i =1 j=1
15
=
ij
200 *100 = 1.98% 10,119.69
Obviously, the ratio has to be multiplied by 100 in order to express values in percentage. The reader should note that obviously:
p
i =1 j=1
15
ij
= 100%
1.1.2 Cumulative Histograms To complete the analysis, the calculation of cumulated percentages of the cash flow implied by the debt service can be compiled. This is represented in Table 1.1.3, where the cumulated amounts have to add up to 100 percent as it is shown in the last column of the table. Table 1.1.3 is extremely instructive as it shows the relative percentage of the total cash flow for the period paid until a given year. For instance, Table 1.1.3 adds the valuable information that with the present redemption profile, we would have paid 79.2 percent of the total due cash flow by the end of 2013. This is to say that almost 80 percent of the required cash flow for fifteen years has to be paid in the first five years. This is also a valuable risk indicator. These calculations can also be represented graphically, which is represented in Figure 1.1.3. Figure 1.1.3 also shows that by 2013 around 80 percent of the total cash flow of the period would have been paid. This implies a heavy service in the first third of the period compared to the total horizon of fifteen years. Formulae for calculating Table 1.1.3 are as follows:
CP11 = pi1 = 1.98%

i =1
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Table 1.1.3 Cumulated Cash Flow of Loans in Percentage Loan 1 Loan 2 Loan 3 Loan 4 Total 1.98% 7.04% 2.16% 1.88% 13.06% 3.85% 13.66% 4.26% 3.76% 25.53% 5.63% 19.86% 6.29% 5.63% 37.42% 7.31% 25.64% 8.26% 7.51% 48.72% 8.89% 31.00% 10.16% 29.15% 79.21% 10.38% 12.00% 82.53% 11.76% 13.77% 85.68% 13.04% 15.48% 88.68% 14.23% 17.12% 91.50% 18.70% 93.08% 20.21% 94.60% 21.66% 96.04% 23.04% 97.43% 24.36% 98.75% 25.62% 100.00%
Year 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 2023
Figure 1.1.3 Cumulated Loans Redemption Profile in Percentage
120.00% Cumulated percentages 100.00% 80.00% 60.00% 40.00% 20.00% 0.00%

20 09 20 10 20 11 20 12 20 13 20 14 20 15 20 16 20 17 20 18 20 19 20 20 20 21 20 22 20 23
Loan 1 Loan 2 Loan 3 Loan 4 Total
Years
Where
CP11 stands for the cumulated percentage for the first year of the first loan, similarly,
CP21 which is the cumulated percentage for the second year of the first loan is calculated as:
CP21 = pi1 = 1.98% + 1.88% = 3.85%
i =1 2
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1.2. Statistical Parameters used in Risk Management

Before application of statistics, there is necessary to recall some basic notions which are basic for assessment of risk: economic capital and risk-adjusted return on capital (RAROC). Economic capital gives a common framework for measurement of risk, as well as other applications as to calculate the amount of equity capital that, for instance, a bank should hold. In the banking activity RAROC has become the standard for measuring risk-adjusted profitability, i.e. it allows the comparison of profitability of different transactions. In order to explain all these concepts, this section will start with an introduction to economic capital and the relationship between capital, risk and probability of default3. 1.2.1 Examples of Risk Loss Distribution The difference between assets values minus liabilitys values is called capital. This is a relative straightforward concept; however, in reality the value of assets and liabilities varies on daily basis affecting the value of capital, which has an incidence in the capacity of an institution to honour its debts. Therefore, there is a direct relationship between the amount of capital that an institution holds, the amount of risk it takes and the probability of the institutions defaulting. In order to illustrate this, consider an example in which the activity is to set up a bank. In order to do so, let us assume that there are 5 million that are put by a group of investors that are eager to share profits (or losses), the shareholders, as their participation is through purchasing of shares. In addition to the equity that is put by the shareholders, the new bank borrows 95 million from investors that want a relative safe return on their investment: they do not share profits or losses; they are paid on a fixed income basis spelled out on the terms of the loan. Therefore, the bank has 100 million to operate (5 million in shares + 95 million borrowed). Let us assume that the rate of interest that the 95 million loan bears is 5 percent per annum. In that case, at the end of the year the bank has to pay to its creditors is 99.8 million:
95 1.05 = 99.75
The bank in order to make a profit has to invest the total of resources 100 million at a rate of return higher than 5 percent. Let us assume that the bank can buy corporate bonds that pay 6 percent interest. In that case, if none of the corporations that have issued those bonds defaults, the bank will give to the shareholders the difference between the income of corporate bonds minus the payment to the creditors of the 95 million. In order to measure the profitability of the operation for the shareholders, we calculate the Return on Equity (ROE), expressed in percentage, and which is defined as: (1.2.1) Where:
ROE t =
E t E t 1 100 E t 1
ROE t : Return on Equity in period t Et : Equity at end of period t E t 1 : Equity at beginning of period t
RAROC will be dealt with in the following Module, in this section the examples would be bound to losses on assets and the related Economic Capital (EC) to minimise the probability of loss.
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In our example, ROE is calculated as follows: The bank receives 106 million and has to pay to creditors 99.75, thus there is now an equity end of period of 6.25 million. ROE is of 25 percent for the period:
ROE1 =
E1 E 0 6.25 5.00 100 = 100 = 25.00% E0 5.00
In order to obtain the above result it is necessary that all corporations paid back the banks investment. But what would happen if there is a percentage of default on the invested values? For instance, what would happen if only 99 percent of the investment is repaid? In that case, (106 0.99) 99.75 = 5.19 and ROE would fall to 3.8 percent:
ROE1 =
E1 E 0 5.19 5.00 100 = 100 = 3.80% E0 5.00
If at the end of the period the losses may be even worst if the percentage of default increases. If the percentage of default increases to 2 percent, then ROE decreases to 17.40 , i.e. there is a loss for the shareholders of 17.4 percent. And if there is a percentage of default of 10 percent among the issuers of the corporate bonds, the shareholders will loose more than the value of their equity and the bank goes out of business. In order to analyse and assess the probability of bankruptcy of the bank, it is possible to elaborate different scenarios. This is shown in Table 1.2.1. Table 1.2.1 Results of Ten Possible Equity Variation Scenarios for the Bank: Equity 5 and Borrowed Funds 95 Scenario % of Loans Repaid 84.00% 90.00% 95.00% 96.00% 96.50% 97.00% 97.50% 98.00% 99.00% 100.00% Asset Value End of Period 89.04 95.40 100.70 101.76 102.29 102.82 103.35 103.88 104.94 106.00 Equity End of Period 0.00 0.00 0.95 2.01 2.54 3.07 3.60 4.13 5.19 6.25 Return on Equity (ROE) in % -100.00% -100.00% -81.00% -59.80% -49.20% -38.60% -28.00% -17.40% 3.80% 25.00%
1 2 3 4 5 6 7 8 9 10
As we do not have any inference on the frequency on which each occurrence may arrive, let us assume that all the ten have the same probability to occur. Under that assumption, it is possible to plot the possible outcomes in a histogram, making intervals of occurrences. The data are summarised in Table 1.2.2.
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Table 1.2.2 Frequency of Occurrences: Asset Variation Scenarios End of Period Interval of Asset Value End of Period 89<x<95 95<x<100 100<x<101 101<x<103 103<x<105 105<x<106 Frequency of Occurrence 1 1 1 3 2 2
The histogram using data of Table 1.2.2 is represented in Figure 1.2.1. Figure 1.2.1 Frequency of Occurrences: Asset Variation Scenarios End of Period
89-95 95-100 100-101 101-103 103-105 105-106
The histogram in Figure 1.2.1 gives a rough indication of the probability distribution for the asset value end of period. It shows, for example, that there is a 20 percent probability that the asset value will be less than 100 at end of period, i.e. that there is 20 percent chances that the bank will go bankrupt. The conclusion stated in the above paragraph is obtained by taking the number of cases in which the asset value is less than 100 and divided by the totality of cases in the scenario:
2 100 = 20% 10
This would be more evident if we calculate the cumulated frequencies implied by the ten scenarios. This is summarised in Table 1.2.3.
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Table 1.2.3 Cumulated Frequency of Occurrences: Asset Variation Scenarios End of Period Interval of Asset Value End of Period 89<x<95 x<100 x<101 x<103 x<105 x<106 Cumulated Frequency of Occurrence 1 2 3 6 8 10
The cumulated histogram plotted with the data shown in Table 1.2.3 are shown in Figure 1.2.2. Figure 1.2.2 Cumulated Frequency of Occurrences: Asset Variation Scenarios End of Period
10 9 8 7 6 5 4 3 2 1 0 89<x<95 x<100 x<101 x<103 x<105 x<106
But one would be interested in knowing what would happen if the bank would operate with a larger share of equity. Let us see how these scenarios and the final result would be affected in case the bank would operate with an initial equity of 10 and would be borrowing only 90 instead of 95. In that case, the same ten scenarios are represented in Table 1.2.4, that shows that ROE would be less important in case of non-default by creditors. However, the probability of the bank going bankrupted decreases from 20 to 10 present, which is a substantial increase in security margin.
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Table 1.2.4 Results of Ten Possible Equity Variation Scenarios for the Bank: Equity 10 and Borrowed Funds 90 Scenario % of Loans Repaid 84.00% 90.00% 95.00% 96.00% 96.50% 97.00% 97.50% 98.00% 99.00% 100.00% Asset Value End of Period 89.04 95.40 100.70 101.76 102.29 102.82 103.35 103.88 104.94 106.00 Equity End of Period 0.00 0.90 6.20 7.26 7.79 8.32 8.85 9.38 10.44 11.50 Return on Equity (ROE) -100.00% -91.00% -38.00% -27.40% -22.10% -16.80% -11.50% -6.20% 4.40% 15.00%
1 2 3 4 5 6 7 8 9 10
In reality, there are an infinite number of possible values for the asset value end of period, which implies that instead of working with an histogram it would be more practical to use probability density functions for which there are tables in order to build our tests and confidence intervals. This will be dealt with in the next section. The example given above shows that there is a close relationship between initial capital, the risk taken and the probability that the bank would going bankrupted. Economic capital4 is one of the most important variables because it provides a unique framework to measure risks with a single metric5. Therefore, economic capital (EC) is the net value the bank must have at beginning of period to ensure that there is only a small probability of defaulting within that period. The net value is the value of assets minus liabilities, as it was said before. The small probability is the probability that that corresponds to the banks credit rating. For instance, an A-rated financial institution is assumed to have less than 0.1 percent probability of default within a given year. It is impossible to actually observe the probability of default of a single bank, because any single bank would either default or not default. However, by looking at the average default rate of all banks in a given rating grade, it is possible to link the credit rating to a probability of default. This is illustrated in Table 1.2.56.
4Economic capital is the amount of capitalassessed on a realistic basiswhich a firm requires to cover the risks that it is running such as market, credit and operational risks. It is the amount of money which is needed to secure survival in a worst case scenario. Firms and financial services regulators should then aim to hold risk capital of an amount at least equal to economic capital. Typically, economic capital is calculated by determining the amount of capital that the firm needs to ensure that its realistic balance sheet stays solvent over a certain time period with a pre-specified probability. Therefore, economic capital is often calculated as value at risk. The concept of economic capital differs from regulatory capital in the sense that regulatory capital is the mandatory capital the regulators require to be maintained while economic capital is the best estimate of required capital that financial institutions use internally to manage their own risk and to allocate the cost of maintaining regulatory capital among different units within the institution. 5 Metric is used with the meaning of standard of measurement. 6 Example taken from Marrison (2002).
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Table 1.2.5 Correspondence between Credit Rating and Annual Probability of Default
S&P Rating AAA AA A BBB BB B CCC Default
Probability of Default 0.01% 0.04% 0.12% 0.50% 3.00% 11.00% 28.00% 100.00%
Linking the examples given above with the definition of capital, it is clear that the shareholders equity is a good shield against default, becauseas shown in the numerical examplethe larger the equity the smaller the probability of default. In fact, EC is the amount that shareholders must invest into the bank at beginning of period, so that the bank can carry out its planned business and maintain its targeted credit rating. 1.2.2 Economic Capital for Different Types of Risks
For the credit risk of lending operations, as the examples given in the previous section, the requirement of EC depends on the probability distribution of the losses as it was illustrated with the numerical examples. But let us define first what is understood by credit risk: Credit Risk It is the risk of non-performance by borrowers on loans or other financial assets or by a counterparty in financial contracts. Actually, the examples given in the previous section were dealing with this kind of risk, as we were taking into account the probability of non-repayment, i.e. the percentage of non-performing bonds. Therefore, if the reader understood the calculations explained in that section, there would be any difficulty in understanding the formal mathematical manipulations of this concept. There are three key variables to describe the risk loss distribution: the expected loss (EL), the unexpected loss (UL) and the maximum probable loss (MPL). The statistical interpretation of these statistics will be deal with later, for the moment let us say that EL is the mean of the loss and UL is the standard deviation. The bank should expect to loose, on average, EL per period and the MPL is the bound of a confidence interval that implies that there is a very small probability that the losses that may arrive should be larger than MPL. The value of the purchased bonds at the end of period will depend on the coupon rate, on one hand, and on the other hand on the percentage of bonds that default. This relationship can be expressed as: (1.2.2) And (1.2.3)
A t = A t 1 (1 + i A )(1 )
D t = D t 1 (1 + i D )
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Where: At :
Value of assets end of period t Value of assets beginning of period t Value of debt end of period t Value of debt beginning of period t Coupon rate for period t Percentage of the bonds that default in period t Interest rate paid on debt for period t
A t 1 : Dt : D t 1 : iA : : iD :
The economic capital remaining at the end of the year is the value of the assets minus the repayable debt. This is expressed as: (1.2.4) Where: EC t :
EC t = A t D t
Economic capital at end of period t Due debt, including interest, at end of period t
Dt :
Replacing (1.2.2) and (1.2.3) into (1.2.4) we can write: (1.2.5)
EC t = A t 1 (1 + i A )(1 ) D t 1 (1 + i D )
Given that the banks goal is to avoid bankruptcy, the minimum value of EC t that it can afford is zero, i.e. the maximum bearable loss without incurring bankruptcy would be equal to the equity end of period; but actually, this precisely the maximum possible loss (MPL) that the bank could incur. Therefore, the maximum valuein order to avoid bankruptcythat can take in (1.2.5) should be equal to MPL expressed as a percentage of A t 1 , that will be denoted as MLP , where: (1.2.6) Then, we can write (1.2.5) as:
MLP =
MPL A t 1
0 = A t 1 (1 + i A )(1 MPL ) D t 1 (1 + i D )
And then to obtain the value of D t 1 : (1.2.7)
D t 1 =
A t 1 (1 + i A )(1 MPL ) (1 + i D )
But the required capital beginning of period is: (1.2.8)
EC t 1 = A t 1 D t 1
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Replacing (1.2.7) into (1.28) and rearranging terms, we can write: (1.2.9)
EC t 1 = A t 1
( i D i A ) + MPL (1 + i A ) (1 + i D )
In (1.2.9), ( i D i A ) represents the debt interest that must be paid minus the interest earned from assets, i.e. the smaller this difference the smaller the required initial amount of capital.
MLP represents the worst-scenario loss of assets, therefore, MPL (1 + i A ) implies that a
high risk increases the required initial amount of capital, and the other way around. The term
(1 + i D )
in the denominator means that the highest i D the highest the required initial amount
of capital. The expression in (1.2.9) is quite complex, however, making some hypotheses it can be simplified. Let assume that i A is the average interest needed in order to cover EL. Then, we can write: (1.2.10)
iA = iD + EL A t 1
EL = iD + A t 1
Where =
Replacing (1.2.10) into (1.2.9) we find: (1.2.11)
1 + iD + EC t 1 = A t 1 MPL 1 + iD
But actually, if we expect to be small, and then we can write:
MPL EL 1 + iD + 1 EC t 1 A t 1 ( MPL ) = A t 1 1 + iD A t 1 A t 1
Then, we conclude that: (1.2.13)
EC t 1 MPL EL
(1.2.13) is a very intuitive logical conclusion: the economic capital is the difference between the maximum possible loss, MPL, minus the expected loss, EL. In fact, we can deduct from (1.2.9) the exact value of EC t 1 in similar terms as in (1.2.13):
EC t 1 = A t 1
( i D i A ) + MPL (1 + i A ) = A MPL (1 + i A ) A ( i D i A ) t 1 t 1 A t 1 (1 + i D ) (1 + i D ) (1 + i D )
(1 + i A ) A ( i D i A ) (1 + i D ) t 1 (1 + i D )
(1.2.14)
EC t 1 = MPL
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shows exactly the same result as (1.2.13). Market Risk
i A , is such that it equals the rate needed to honour the borrowed funds, i D , (1.2.14) is equal to MPL . However, the economic capital takes already into account the expected loss, EL , and it has to be subtracted to MPL , in which case (1.2.14)
If the rate on the bonds,
Market risk is associated with changes in market prices, such as interest rates, exchange rates, and commodity prices. Therefore, market risks are associated with trading and investing, in a general sense. Market risks require also an economic capital (EC) to play the role of a contingent reserve. The required economic capital can be considered to be the amount of money that the shareholders put in reserve at the beginning of the period so that the trading operation can carry out its strategy and maintain the desired debt rating. The trading of a financial institution will imply taking market risks through carrying out a set of investment strategies within predefined limits. The profitability of each strategy has a probability distribution. In fact, this is associated to the technique called value-at-risk, which will be dealt with in the third module, and we would need to determine the probability distribution and to calculate the lower bound of the set of maximum losses. For sake of simplicity and to help the reader to understand concepts before going into the detail of calculations, let us assume that we have the distribution, a normal curve, and that we have calculated the lower bound of the set of maximum losses. This is represented in Figure 1.2.3. Figure 1.2.3 represents the distribution of profits, which is symmetric in relation to the average profits, i.e. we have the same probability of making more or less than this average: slightly less than 50 percent on each side, because the probability of obtaining the average profit is not nil. Figure 1.2.3 Lower Bound of the Set of Maximum Losses for Market Risk
Figure 1.2.3 illustrates that there is a probability over a period that the loss will be worst than W. This is expressed in mathematical notation as:
P [ profit < W ] =
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Where P stands for density probability function. The example would be enough for the reader to understand the methodology, let us add that the techniques of value-at-risk would allow as to find the value for W. Once W is estimated, then the determination of the required economic capital is straightforward too, the simplest way to cope with this risk is to invest W or if we want to increase safeness, a multiple of Wat the risk-free rate in the market, i f , like in a savings account deposit at the beginning of period. In that case the required EC is calculated as follows: (1.2.15)
EC =
W 1 + if
Implying that at the end of the period the reserve is enough to cover the risk: (1.2.16)
EC (1 + if ) = W
The reader should notice that (1.2.15) and (1.2.16) assume a very simple investment decision: investing at the risk-free rate. However, alternative investment assumptions may be taken into account in the analysis in order to calculate EC. Operational Risk Operational risks include a range of risks, such as errors in the various stages of executing and recording transactions; inadequacies or failures in internal controls or in systems and services; reputational risk; legal risk; security breaches; or natural disasters that affect business activity. Conceptually, the calculation of the required economic capital for covering operational risks is similar to the one used for market risks, however, the probability distribution may have a different shape. The most challenge issue in order to estimate the required economic capital for operational risks is to find the dataaccurate enoughin order to be able to estimate the characteristics of the probability distribution for dealing with this kind of risk.
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1.3. Theoretical Distributions that are used to Analyse Risk

1.3.1 Mean, Variance, Standard Deviation, Skew and Kurtosis The properties of numerical observations, like those presented in the last section, can be described as random variables that follow a specific probability distribution. The properties of the random variable can be quantified in terms of specified parameters, namely mean, variance, standard-deviation, skew and kurtosis. We have to bear in mind, however, that there are two different concepts regarding these parameters. The first concept is the set of parameters that describe the actual underlying process that produces the random results, which we may identify as the theoretical distribution that describes the observed results. The second concept is the set of parameters that we can calculate from our sample, therefore producing estimations or estimates of mean, variance, standard-deviation, skew and kurtosis. These estimates will approach with a certain degree of confidence the true theoretical values, but they are not necessarily exactly equal to those. In the real world, we cannot know the true probabilistic distribution, we can only observe and calculate results obtained from samples of the underlying statistical process, and then use these as the best estimates to understand the underlying process. We will use Greek letters to denote the theoretical values and Latin letters to denote the estimates of those parameters. Mean of a Distribution The mean represents the centre of gravity of a distribution, i.e. the weighted observations are equally distributed below and above the mean value. The mean is, normally, denoted by the Greek letter . This letter denotes, in general, the theoretical mean value of a probability distribution. Assuming that f (x) is the probability density function for x, and probability of x falling in the range dx, we can write: (1.3.1)
f (x)dx is the
xf (x)dx
This would imply the knowledge of the real probabilistic distribution f(x), fact that in reality seldom happens. This is because we have only limited information, for instance a sample of a larger population. Therefore, one of the statistician tasks is to, first, estimate the parameters of a distribution, and second, to deduce the type of the distribution he is dealing with. This may sound quite difficult; however, we will see that this is a manageable problem. As we calculated in Section 1.1 the average rate of interest and the average maturity of a set of loans, we calculate in the same way an estimation of the value of . This is expressed in (1.3.2): (1.3.2)
x=
i =1
ni 1 m xi = nixi n n i=1 n = ni
i =1 m
Where:
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The meaning of (1.3.2) is that we calculate an estimation of the mean observations, of which the value
using a sample of n
x i has been observed n i times and we have m clusters of n same observed values. Actually, i is an estimation of the probability f (x)dx for x i to fall in n the range dx, i.e. to be observed n i times out of n in our sample. The formula expressed in (1.3.2) is called an estimator of . When this estimator is applied to values and x takes a numerical value, this value is called an estimate or estimation of .
It can be shown, that (1.3.2) is an unbiased estimator of tends in probability to , and is expressed as: (1.3.3)
7. This means, roughly, that x
E (x) =
Formula (1.3.3) reads that the mathematical expectation of x equals . This result justifies the application of (1.3.2) for estimating the theoretical value of a distribution. Let us take the asset values of Table 1.2.4, where observed only once:
x= 1 (89.04 + 95.40 + 100.70 + 101.76 + 102.29 + 102.82 + 103.35 + 103.88 + 104.94 + 106.00 ) = 101.02 10
n i =1 for all x i , as each value has been
The value x = 101.02 means that the weights of the values observed are in equilibrium below and above this value. If we look at Figure (1.2.1) we can see that the value 101.02 is at the beginning of the class 101-103, and intuitively we can see that at the left and the right of this value the weights, which are represented by the surface of the rectangles on the figure, are evenly distributed. Variance and Standard Deviation of a Distribution The standard deviation gives a measure of the degree to which the random results may be distributed away from the mean. This is a key statistics, in particular for risk measurement, because it gives a way to measure how different the outcomes might be from the desired result, i.e. to avoid a certain loss. In order to measure how far the results may be away from the mean, we have to take the differences of the observed values minus the estimation of the mean. However, if we do that with the values as such, given that the mean is the centre of gravity, the sum of differences equals zero:
(x
i =1
x) = 0
Therefore, in order to measure the dispersion around the mean we have to avoid minus sings in the differences. We obtain this by taking the square value of the differences and calculating the mean of these differences. The statistics calculated in this way is called variance and for the theoretical distribution is calculated as follows:
The demonstration of this statment is beyond the aim of our course. For the student it is enough to know that the proposed estimator is an unbiased estimator of the theoretical mean.
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(1.3.4) The estimator of the variance is:
2 =
( x )2 f (x) dx
(1.3.5)
s =
2 i =1
( xi x )
n 1
Where n is defined as in (1.3.2). It can be demonstrated that s is an unbiased estimator of
2 , and this is expressed as:

(1.3.6)
E ( s2 ) = 2
2 2
Formula (1.3.6) reads that the mathematical expectation of s equals . This result justifies the application of (1.3.5) for estimating the theoretical value of a distribution.
2
The standard deviation is defined as the square root of the variance: (1.3.7)
= 2
Because (1.3.6), it is considered that (1.3.5) can be utilised as an estimator of the standard deviation by taking the square root:
(1.3.8)
s=
i =1
( xi x )
n 1
Let us take the asset values of Table 1.2.4, where n i =1 for all x i , as each value has been observed only once. It is more practical to calculate the estimation of the variance with a calculation table. The calculations are shown in Table 1.3.1. Table 1.3.1 Estimation of the Variance and Standard Deviation Scenario 1 2 3 4 5 6 7 8 9 10 Asset Value End of Period 89.04 95.40 100.70 101.76 102.29 102.82 103.35 103.88 104.94 106.00 Total
( xi x )
143.47 31.56 0.10 0.55 1.62 3.25 5.44 8.19 15.38 24.82 234.38
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Where x = 101.02 and hence:
s2 =
234.38 = 26.04 10 1
and
s = 26.04 = 5.10
Skew of a Distribution The skew is a measure of the asymmetry of a distribution. As far as risk measurement is concerned, it tells us whether the probability of winning is similar to the probability of losing. The smaller the absolute value of the skew, the smallest the asymmetry of the distribution, hence higher the probability of observe even cases, i.e. the same probability of losing or winning the same amount. The skew is defined as follows:
(1.3.9)
x i 3 f x = ( ) dx
The estimator of (1.3.9) is:
(1.3.10)
x i x 3 z= ( n 1)( n 2 ) i =1 s n
n
Where n is defined as in (1.3.2). It can be demonstrated that , and this is expressed as: (1.3.11)
z is an unbiased estimator of
E (z ) =
Formula (1.3.11) reads that the mathematical expectation of the application of (1.3.11) for estimating the theoretical value Let us take the asset values of Table 1.2.4, where
z equals . This result justifies of a distribution.
observed only once. It is more practical to calculate the estimation of the skew with a calculation table. The calculations are shown in Table 1.3.2. Table 1.3.2 Estimation of the Skew Scenario 1 2 3 4 5 6 7 8 9 10 Asset Value End of Period 89.04 95.40 100.70 101.76 102.29 102.82 103.35 103.88 104.94 106.00 Total
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-12.931 -1.334 0.000 0.003 0.015 0.044 0.095 0.176 0.454 0.930 -12.547
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Where x = 101.02 and s = 5.10 , hence:
z=
Kurtosis of a Distribution
10 ( 12.547 ) = 1.743 9 8
The kurtosis is useful describing extremes events, i.e. losses that are so bad that can happen only with very little probability. However, they may happen. Let us assume that this bad event has a probability of 1 to 1000 to happen. In order to understand the application of kurtosis, let us take two hypothetical portfolios, both with the same mean, standard deviation and skew, but with different kurtosis. Every 1000 days, the portfolios might be expected to suffer a bad loss. In these extreme events, the portfolio with the higher kurtosis may be expected to suffer worse losses than the one with lower kurtosis. The kurtosis is defined as follows:
4 x f (x) dx =
(1.3.12)
The estimator of (1.3.12) is:
(1.3.13)
k=
4 n n ( n + 1) xi x ( n 1)( n 2 )( n 3) i =1 s
Where n is defined as in (1.3.2). It can be demonstrated that k is an unbiased estimator of , and this is expressed as: (1.3.14)
E (k) =
Formula (1.3.14) reads that the mathematical expectation of k equals . This result justifies the application of (1.3.14) for estimating the theoretical value of a distribution. Let us take the asset values of Table 1.2.4, where
observed only once. It is more practical to calculate the estimation of the kurtosis with a calculation table. The calculations are shown in Table 1.3.3.
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Table 1.3.3 Estimation of the Kurtosis Scenario 1 2 3 4 5 6 7 8 9 10 Total Where x = 101.02 and s = 5.10 , hence: Asset Value End of Period 89.04 95.40 100.70 101.76 102.29 102.82 103.35 103.88 104.94 106.00
xi x s
30.350803 1.468791 0.000015 0.000447 0.003860 0.015547 0.043606 0.098926 0.348870 0.908339 33.239204
k=
1.3.2 Normal Distribution
10 11 ( 33.239204 ) = 7.25 987
The Normal Distribution, also known as the Gaussian Distribution8 having a bell shape, is the most commonly used distribution to describe random changes in market risk factors, such as exchange rates, interest rates and equity prices. This distribution is very commonly used because the Central Limit Theorem, which states that if the number of elements in our sample grows infinitely, then the distribution will tend go be normally distributed. In real life, however, infinity may be quite small and the theorem is applicable very often. The probability distribution of random variable x normally with mean and standard deviation is:
1 e 2 ( x )2 2 2
(1.3.15)
f (x) =
The cumulative distribution being:
(1.3.16)
f (x)dx =
1 2
( x )2 2 2
dx = 1
Because the German mathematician E. Gauss introduced this distribution in the 18th century.
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The probability of x taking a value between a and b, where a<b, P(a < x < b) , is calculated as:
(1.3.17)
1 2
( x )2 2 2
dx = P(a < x < b)
In practice it is not necessary to calculate the definite integral given in (1.3.17) because there are tables for different values of the density distribution that are of simple use. If a random variable x has a normal distribution with mean and standard deviation , this is expressed synthetically with the following notation: (1.3.18) x ~ N(,)
The tables for the normal distribution are calculated for a random variable with mean 0 and standard deviation 1. Therefore we have to make a variable transformation to use the tables, but this is not a serious constraint. The kurtosis of a normal distribution is constant and equals 3. This distribution is so commonly used that it is defined excess kurtosis the value found in the sample minus 3. Distributions that have a kurtosis larger than 3, are said to have leptokurtosis. If we denote the excess kurtosis , then it is calculated as:
x )2 4 ( 2 1 2 x e dx 3 2
(1.3.19)
= 3=
It can be shown that d is an unbiased estimator of , i.e. that E ( d ) = , where d is calculated as:
2 4 n n ( n + 1) n 1) ( xi x (1.3.20) d = 3 s ( n 1)( n 2 )( n 3) ( n 2 )( n 3) i =1
For the numerical example of the previous section, where we found that k = 7.25 , the application of (1.3.20) gives:
d = 7.25 3
92 = 2.91 87
This result shows that the kurtosis of our distribution is very large and in consequence, of losses larger than expected have to be taken into account.
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1.3.3
Log-Normal Distribution
When dealing with variables that cannot take negative values, like interest rates or stock and commodity prices, the Log-Normal Distribution is preferred to the normal distribution. If the random variable is log-normally distributed, then the logarithm of the variable will be normally distributed:
1.3.4 Beta Distribution The Beta Distribution is useful in cases like the credit-risk losses, which are typically highly skewed. The formula of the Beta distribution is a complex mathematical expression; however, its calculation is available in most spreadsheets applications. It only requires two parameters, and , to define the shape of the distribution. They are calculated and estimated as follows:
2 (1 ) = 2
and
(1 ) = + ( 1) 2
2
The estimators for and are defined as follows:
x 2 (1 x ) (1.3.21) a = x s2
1.4.
and
x (1 x ) b= + ( x 1) s2
2
Statistical Tools that are used in Risk Analysis
1.4.1 Confidence Intervals, Confidence Levels and Percentiles Confidence Intervals provide tools to use probability distributions to assess the possibility of future events to materialise. If we assume a normal distribution, a confidence interval is given by (1.3.17), i.e. the probability P(a < x < b) of x taking a value between a and b, where a<b. However, in risk management, we are more concerned by Confidence Levels rather than interval levels. This is because we are dealing with extreme cases, as in Section 1.2.2 when calculating the minimum of the worst loss represented in Figure 1.2.3. Actually, Figure 1.2.3 represents a normal distribution, and the confidence level W with a probability of to occur is calculated as:
P [ profit < W ] =
1 2
( x )2 2 2
dx =
If we assume that x ~ N(0,1), the confidence levels are shown in Table 1.4.1.
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Table 1.4.1 Confidence Levels for x ~ N(0,1) Confidence Level -1.00 -1.64 -1.96 -2.00 -2.32 -2.50 -3.00 Probability % 15.90 5.00 2.50 2.30 1.00 0.60 0.10
The most used confidence level is 2.32, which implies a probability of 1 percent, i.e. a probability of 99 percent of a favourable outcome. Using a N(0,1) distribution is not a major problem, as all variable x following a normal distribution can be reduced to a N(0,1) through a change of origin and scale: subtracting the mean to all observations and dividing the results by the standard deviation. The Percentile is the inverse of the confidence level, e.g. the 1%percentile is 2.32 times the standard deviation. This percentile, as its corresponding confidence level, is used very often as it implies a probability (or percentile) of 99 percent favourable cases. 1.4.2 Correlation and Covariance In the preceding sections we have been analysing the behaviour of a single variable. However, very often we need to analyse the joint behaviour of a couple of variables. For instance, changes in interest rates and changes in commodity prices, or changes in interest rates and changes in exchange rates. These changes and their interrelation are measured with two statistics: the covariance and the correlation coefficient. The covariance is calculated in a similar way as the variance. Notwithstanding, as we are dealing with two different variables, instead of taking the square value of the difference between the variable and its mean, we take the multiplication of the difference between the two variables and their means. The estimator of the covariance between two random variables, x and y, is expressed in (1.4.1). (1.4.1)
s xy =
1 n ( x i x )( yi y ) n 1 i =1
Let us take a hypothetical example of the variation of loans volume of a bank in relation with the rate of interest applied to the funds lent. This is summarised in Table 1.4.2.
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Table 1.4.2 Covariance between Rates of Interest and Volume of Loans Rate of Interest 0.030 0.035 0.040 0.045 0.050 0.055 0.060 0.065 0.070 0.075 0.525 0.053 Volume of Loans Million USD 159 155 140 140 138 130 120 110 100 85 1,277 128
N 1 2 3 4 5 6 7 8 9 10 Total Mean
( xi x )
-0.022500 -0.017500 -0.012500 -0.007500 -0.002500 0.002500 0.007500 0.012500 0.017500 0.022500
( yi y )
31 27 12 12 10 2 -8 -18 -28 -43
( x i x )( yi y )
-0.70 -0.48 -0.15 -0.09 -0.03 0.01 -0.06 -0.22 -0.48 -0.96 -3.173 -0.35
Covariance
Table 1.4.2 illustrates the behaviour of the covariance: when one variable increases and the other decreases the covariance is negative, and the other way around as it is in our example. If the rate of interest increases there is a decrease in the volume of loans made by the bank. If the variation of one of the variables implies sometimes a variation with different sign, the covariance tends to be small. In our case, the covariance is calculated as:
s xy =
3.173 = 0.35 10 1
However, we cannot tell when the covariance is large or small in order to draw a conclusion on the joint behaviour of the variables. This is because the size of the covariance is affected by the units in which the variables are measured, in our case by million of dollars and percentages, which are of very different dimension. In order to be able to draw a conclusion on the cause and effect of one variable on the other, the concept of Coefficient of Correlation has been introduced. The Coefficient of Correlation is defined by normalising the covariance dividing it by the individual standard deviations, by doing so we eliminate the effect of units of measure of the variables on the statistics. The coefficient of correlation is expressed in (1.4.2). (1.4.2)
xy =
xy x y
The unbiased estimator of (1.4.2) is calculated as follows: (1.4.3)
rxy =
s xy sxsy
It can be shown that:
1 rxy 1
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Table 1.4.3 Coefficient of Correlation between Rates of Interest and Volume of Loans N 1 2 3 4 5 6 7 8 9 10 Total Rate of Interest Percentage 0.030 0.035 0.040 0.045 0.050 0.055 0.060 0.065 0.070 0.075 Variance: Volume of Loans Million USD 159 155 140 140 138 130 120 110 100 85
( xi x )
( yi y )
980 745 151 151 106 5 59 313 767 1,823 5,102 567
0.000506 0.000306 0.000156 0.000056 0.000006 0.000006 0.000056 0.000156 0.000306 0.000506 0.002063 0.000229
Therefore, (1.4.3) allows drawing conclusions on the joint behaviour of the two variables: If rxy is close to 1, the variables are highly correlated and vary in the same sense If rxy is close to the other In order for the statistician to know when rxy is sufficiently close to 1, levels can be fixed using probabilities. Table 1.4.3 shows the calculations for example in Table 1.4.2 in order to obtain the estimate of the correlation coefficient. The steps for calculating the estimate of the coefficient of correlation with our sample are:
1 , the variables are highly correlated and vary in contrary sense
If rxy is close to 0, the variables are not correlated and vary independently the one to
1 or 0, confident
sx =
Therefore:
0.002063 = 0.015138 10 1
and
sy =
5,102 = 23.809662 10 1
rxy =
0.35 = 0.97798 0.000229 567
The above numerical result allows us to conclude that the variations of rate of interest have a strong effect on the volume of loans, and this effect is negative, i.e. if the rate of interest increases, the volume of loans decreases, or if the rate of interest decreases the volume of loans increases. This last statement is important because it implies that:
rxy = ryx
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Sum of Random Variables Those results will allow us to deal with the measurement of the sum of random variables, which is a problem that we will come across very often. For example, the probability of loss on a portfolio is the sum of the probabilities of loss of the instruments that compose the portfolio. Similarly, the probability of a trading loss over a year is the sum of the probabilities of trading losses on individual days in the year. Let us take as an example the case in which our random variable y is the sum of two random variables, z i = x i + y i , then: (1.4.4)
2 2 z i = x i + yi z = x + y s2 z = s x + s y + 2s xy
The reader should be able to verify the result given in (1.4.4) without any difficulty. However, there is another way, which may be more practical for our purposes, to write the variance of z expressed in (1.4.4) using (1.4.3): (1.4.5)
2 2 s2 z = s x + s y + 2rxys x s y
In the case in which we have more than two variables in the sum composing another random variable, let us assume m variables, we can generalise the results obtained in (1.4.4) and (1.4.5) as follows: (1.4.6)
z i = x i z = x i s2 z = rijs is j
i =1 i =1 i =1 j=1
One common and useful application of (1.4.6) is when the correlation between the variables x i is zero, i.e. they are independent. This is the assumption made for daily changes in market variables, for instance, for calculating the variance of the loss over multiple days, for which we assume that market variations are independent from one day to another. Making this assumption, the variance of the loss over K days is the sum of the variances of each one the losses for each one of the K days: (1.4.7) If we further assume that: s1
2
2 2 s2 = s1 + s2 + ... + s2 K K
2 = s2 2 = ... = s K , i.e. that the variance of the loss is the same for
each day, then (1.4.7) becomes: (1.4.8)
s2 = Ks2 K s K = sK K K
The relation expressed in (1.4.8) shows that the standard deviation of the loss over K days, under the hypotheses made, is the standard deviation of the loss over one day, multiplied by the square root of K. This relationship is very often used in the management of risk on cumulative losses over multiple days, i.e. to predict how bad the cumulative losses over K days might be.
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1.4.3
Random Time Series Equations
Many phenomena that are needed to observe for risk management, like interest rates or equity prices, the value in one time period depends on the value in previous periods. This field of risk management requires a solid knowledge of statistical and econometric tools; therefore, we will limit this section to general notions of the subject. For instance, one model for stock prices is to say that the price is random walk in which the stock price, SP, on any given date is equal to the previous days price plus a random number xt : (1.4.9)
SPt = SPt 1 + x t
An assumption often made is that the random number is drawn from a normal distribution, multiplied by the required standard deviation: If t ~ N(0,1), then: x t = s t T SPt = SPt 1 + s t T Here s is the standard deviation of the variation of the stock price over one period, and and the time steps days, then steps years, then
is the number of time steps between each period. If s would be the daily standard deviation
T = 1. If s was the daily standard deviation and the time
T = 250, the number of trading days in a year.
In practice, the random walk of equities is closer to being a geometric process, i.e. as the stock price increases, the size of the random changes also increases. This geometric process is included in the model expressed in (1.4.10): (1.4.10)
SPt = SPt 1 + SPt 1s t T
The model can be further refined by adding a mean expected growth rate (1.4.11)
SPt = SPt 1 + SPt 1T + SPt 1s t T
(1.4.11) is not appropriate for describing the evolution of interest rates. Interest rates have not a long-term expected growth, but rather over long periods then tend to return to a set level called the long-term interest rate average rm . There are many models for describing random interest rates process. The Cox-Ingersoll-Ross (CIR) model: (1.4.12)
rt = rt 1 + c(rm rt 1 ) + rts r rt 1
Where rt is the rate of interest at time t, c is the rate of convergence towards rm : if rt 1 is grater than rm the term c(rm
rt 1 ) becomes negative, moving down the rates of interest.
The square root of rt 1 scales the disturbances, so that when rates are low, the disturbance will be low. There is, however, a possibility of creating negative interests rates.
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2.
Matrix Algebra
2.1. Basic Concepts
2.1.1
Where does the Concept of Matrix come from?
Matrices are just tables of numbers or variables, like the ones presented in Section 1, e.g. Tables 1.1, 1.2 and 1.3. As in those cases, rows and columns are numbered in order to locate each element in the matrix with the indexes, i for the row and j for the column. This means that, as the examples presented with the cash flows the element in the matrix e ij , where e stands for element, means that it is located in the ith row and the jth column. 2.1.2 Basic Matrix and Vectors Operations: Additions and Subtractions
Matrices form a non-commutative algebra. This means that not all operations are commutative like in the real numbers algebra. An operation is commutative if:
a b = ba
The above equality is not necessarily true for matrices, and the reader should be very attentive to this fact. In this section we will be giving the rules for matrix operations without mathematical demonstrations, because this is a course on risk management and not on linear algebra. Matrices have the four basic operations: addition, subtraction, multiplication and division. A set of numbers, in order to form an Algebra, have a neutral element for a specific operation. In the case of real numbers, the neutral element for addition is zero, because for any number r belonging to the set of real numbers:
r+0= r
Also, the inverse element of addition is the opposite of any number, that is, adding the opposite of any number to the number itself will yield the neutral element for the addition: 0. For example, the opposite of r is r , so r + ( r) = 0 . Subtraction is not commutative. For that reason, it is often helpful to look at subtraction as addition of the minuend and the opposite of the subtrahend, that is: a b = a + ( b) . When a subtraction is written as a sum, then the commutability of addition holds. Also for the set of real numbers, the neutral element for multiplication is one, because for any number belonging to the set of real numbers:
r 1 = r
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Also, the multiplicative inverse is the reciprocal of any number, that is, multiplying the reciprocal of any number by the number itself will yield the multiplicative identity:
1 r = r r 1 = 1 r
Division is not commutative, and as it is helpful to look at subtraction as addition, it is helpful to look at division as multiplication of the dividend times the reciprocal of the divisor, that is:
a 1 = a = a b 1 . When a division is written as a product, it will obey all the properties of b b

multiplication. An (n, m) matrix consists of a rectangular array with n rows and m columns, in which the elements are either numbers or algebraic expressions. An example of a matrix given below:
(3 3) is
(2.1.1)
a11 a12 a 21 a 22 a 31 a 32
a13 a 23 a 33
It has to be noted that each element in the matrix has two indexes, the first one indicates the row order number and the second the column order number. For instance a 23 indicates the element in second row, third column. 2.1.3 Systems of Simultaneous Equations and Determinants
Actually, the invention of matrices comes from a form of synthetic writing for dealing with systems of simultaneous equations, as we will see in the next section. Let us take one example of three simultaneous equations with three unknowns.
3x + y z = 1
(2.1.2)
2x 3y + 5z = 2 x+y+z =6
Mathematicians found that it would be easier to manipulate these kinds of problems if the above system is written as:
(2.1.3)
3 1 1 x 1 2 3 5 y = 2 1 1 1 z 6
This is because it is easier to write than the original detailed system: (2.1.4) Where:
AX = B
3 1 1 A= 2 3 5 ; 1 1 1
x X= y ; z
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1 B= 2 6
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The synthetic notation expressed in (2.1.4) means that in order to solve the system (2.1.2) we need to find a matrix A such that A A = I , where I is the neutral element for multiplications of matrices, then the solution of the system of equations given in (2.1.2) would be written as: (2.1.5)
1 1 1
X = A 1B
The matrix A is called the inverse of A. The calculations for obtaining such a matrix will be dealt with in the following section. For the moment, we will be solving the system (2.1.2) using determinants. The method, probably the most used to solve a system like the one in (2.1.2), is by substitution. This means that we find the value of one of the unknowns in one of the equations and replace its value into both remaining equations: this brings a system of three equations and three unknowns to a system of two equations and two unknowns. Then, the method is repeated: we obtain the value of one of the unknowns in function of the other in one equation and we replace in the remaining one: we have then one equation with one unknown that is solved. The value obtained for this unknown is replaced into the other equations and the process continues until the three unknowns are determined. Mathematicians have created a short-cut for this methoda recipe in factthat will save work and diminish probability of calculation errors. This solving method is called by determinants. The determinant of a system of equations is the group of coefficients in the equations for each one of the unknowns. In fact matrix A contains the determinant of the system. The determinant of A defined by (2.1.2) is written as:
3
(2.1.6)
1 5 1
A = 2 3 1 1
In order to calculate A , let first see how a determinant of dimension
(2 2) , which is called
a second-order determinant, is calculated. For example, the second-order determinant in (2.1.7) is calculated below: (2.1.7)
1 2 = (1 4) (2 3) = 2 3 4
The rule is that the diagonal left to rightin redbears a plus sign and the diagonal right to leftin bluebears a minus sign. Therefore, the value of the second-order determinant in (2.1.7) is equal to 2 . In order to calculate the third-order determinant defined in (2.1.6) following the method called expanding a determinant by minors 9, we have to decompose it into second-order determinants, i.e. decomposing it in a series of determinants of a minor order. To do that, we have to choose a row or a column for finding the minors. Let us take the 3rd row in (2.1.6) to find the minors. It comes:
3
(2.1.8)
A = 2 3 1 1
1 1 3 1 3 1 5 =1 1 +1 3 5 2 5 2 3 1
We follow the method expanding the determinant by minors. There is another method by the French mathematician Gabriel Cramr published in 1750, but which is valid only for determinants of a maximum dimension of (3x3).
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Each one of the minors is obtained by eliminating in the third-order determinant all the elements in the row and the column of the element. This is shown in (2.1.8) showing the respective colours for each one of the minors element. Then the value of A is: (2.1.9) A = 1 (1 5) ( 1 3) 1 ( 3 5) ( 1 2) + 1 ( 3 3) (1 2) Therefore:
A = 26
The elements between parenthesis in (2.1.9)which are in fact two-order determinantsare called the Cofactors of the of the original three-order determinant (or matrix) element. For instance, in our example, that we find the minors of the last row, the cofactor are: Cofactor of a 31 : C31 =
1 1 = (1 5) ( 1 3) =2 3 5 3 1 = ( 3 5) ( 1 2) = 17 2 5
Cofactor of a 32 : C32 =
Cofactor of a 33 : C33 =
3 1 = ( 3 3) (1 2) = 11 2 3
It has to be noted that the cofactor C32 bears a minus sign. Actually, there is a rule for assigning the correct sign to the cofactors. If the sum of the indexes i+j is even, the cofactor sign is plus, if it is odd the sign of the cofactor is minus. In practice this is translated as:
Cij = ( 1)i + j M ij
Where M ij denotes the determinant minor of a ij . Determinants of higher order can be calculated by successive expansions of this type. By choosing rows of columns containing zeros, some terms can be eliminated. There are various rules for transforming a given determinant, which can be used to obtain a row or column most of whose elements are zeros. Determinants have many applications in mathematics and other fields, e.g., in the solution of simultaneous linear equations, which is going back to the system of simultaneous equations expressed in (2.1.2). The recipe to solve (2.1.2) has the following steps: 1. Calculate the determinant of the system A . The determinant of the system has to be different to zero for the system to have a solution10 2. Calculate the determinant of each one of the unknowns of the system 3. The solution of the system for each unknown is the determinant of the unknown divided by the determinant of the system How to do step 1 has been explained above. Now we are going to deal with steps 2 and 3.
10
The solution of the system geometrically gives the point in three dimensions (x, y, z), where the three equations intersect each other. If the determinant of the system is equal to zero, this means that at least two of the equations are parallel, therefore they do not cross each other and there is no common point (x, y, z) that satisfies the three equations simultaneously.
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Step 2: calculate the determinant of the unknowns of the system Each one of the columns of A , see (2.1.8), are composed by the coefficients of each one of the unknowns in each one of the equations: column 1 is composed of the coefficients multiplying x , column 2 is composed of the coefficients multiplying y and column 3 is composed of the coefficients multiplying z . The determinant of each one of the unknowns is defined as the determinant of the system where the column corresponding to the unknown searched is replaced by the vector B defined in (2.1.4). Then we have:
1 5 =0 1
x = 2 3 6 1
3 1 1 y=2 2 1 6 3 1 5 = 91 1 1
z = 2 3 2 = 65 1 1 6
In each one of the above determinants the coefficients of the concerned variables have been replaced by vector B elements that are printed in red. The value of the determinant of each variable has been calculated using the same method as the one exposed in (2.1.9). Step 3: calculate the value of the unknowns of the system:
x=
x 0 = =0 A 26 y 91 = = 3.5 A 26 z 65 = = 2.5 A 26
y=
z=
Replacing the values into (2.1.2) it easily verified that the triplet satisfies the system .
11
( x = 0; y = 3.5;z = 2.5)
11
The reader is invited to verify all the calculations. It has to be noted that it is easy to create a template in Excel in order to solve a third-order determinant by expanding it to second-order determinants. For higher order determinants, there is also possible to programme an Excel spreadsheet.
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2.2. Operations with Matrices

One of the important notions that we have to keep in mind when operating with matrices is the dimension of the matrix. The dimension of the matrix is defined as the number of rows and the number of columns that compose the matrix. For instance, in the system written in (2.1.4) matrix A is of dimension (3 3) , matrices X and B are of dimension (3 1) 12. This is written as
A (33) , X(31) , and B (31) when it is necessary to indicate the
dimension of the matrices, but in general the dimension is omitted, however, we have to bear always in mind the dimension of the matrices we are working with in order to avoid errors. 2.2.1 Adding and Transposing Matrices
For instance, a 21 is the element of the matrix situated in the second row, first column, and in general the element a ij denotes the element situated in the ith row and the jth column. A matrix can be multiplied by a constant, for instance:
(2.2.1)
a11 a12 k a 21 a 22 a 31 a 32
a13 ka11 ka12 a 23 = ka 21 ka 22 a 33 ka 31 ka 32
ka13 ka 23 ka 33
For instance, a practical example of (2.2.1) is:
5 1 5 5 5 1 1 1 5 1 5 ( 1) 5 50 5 ( 1) 2 0 1 = 5 2 = 10 0 5 1 1 1 5 1 5 1 5 ( 1) 5 5 5
Matrices can be added, but they have to be of the same dimension, because each element of each matrix is added to the corresponding element of the other matrix, as shown in (2.2.2): (2.2.2)
a11 a12 b11 b12 a11 + b11 a12 + b12 a + = 21 a 22 b21 b22 a 21 + b21 a 22 + b22
2 + 0 7 2 3 2 4 0 3 + 4 4 1 + 2 3 = 4 + ( 2) 1 + 3 = 2 4
Finally, the transpose of a matrix M (nm) is the (m n) matrix formed by interchanging the elements of the rows and columns of M. It is denoted by M. The jth row of M is the transpose of the jth column of M and vice versa. An example is given below:
12
The reader should note that we use bold letters to denote matrices, in order to differentiate those from single scalars or variables.
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(2.2.3)
m11 M = m 21 m 31
m12 m m 22 M ' = 11 m12 m32
m 21 m 22
m31 m32
5 2 5 3 1 M = 3 0 M' = 2 0 4 1 4
2.2.2 Dimension and Conformability of Matrices
The way to write the system of equations (2.1.2) in the form of (2.1.4) gives straightforward the rule for multiplications of matrices: in order to obtain the first equation of system (2.1.2) we need to multiply each element of the first row of matrix A by each element of the first column of matrix X13, and subsequently for the two other equations. The example allows us to define the rule for multiplying matrices: the pre-multiplier, i.e. the left matrix in the operation, has to contain the same number of columns as the post-multiplier, i.e. the right matrix in the operation. In our case this is true, because the dimension of A is (3 3) , i.e. three rows and three columns, and X is
(3 1) , i.e. three rows and one column. It has to be noted that the result of the multiplication is B, which dimension is (3 1) , i.e. the result has
the same number of rows that the pre-multiplier and the same number of columns as the post-multiplier. Writing the dimension of each matrix as an index, we have: (2.2.4)
A (33) X(31) = B (31)
The operation that is expressed in (2.2.4) is non-commutativebecause given the matrices dimensionswe can multiply AX, but not XA. If the pre-multiplier matrix has the same number of columns as the post-multiplier matrix has rows, it is said that the matrices are conformable. Therefore, the operation AX is possible because in that order, A first and X second, are conformable, whereas the operation XA is not conformable and thus impossible to perform. In addition to that, the result of the multiplication has a dimension equal to the number of rows of the pre-multiplier matrix and to the number of columns of the post-multiplier matrix. Let us take another example with three matrices, for instance M and N as multipliers and Q as the result of the multiplication. Let us assume that M and N are conformable, in particular they dimensions are respectively (3 3) and (3 2) . Then we can write, along what has been explained, that: (2.2.5)
M (33) N (32) = Q (32)
That is, Q has the same number of rows as M and the same number of columns as N. Now, let us see how the detailed operations work. In fact they are very much as the operation implicitly shown in (2.1.2):
13
In fact a matrix that contains only one row or one column is a vector, but the algebra of matrices is applicable to vectors, making those a type of matrix for calculation purposes.
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(2.2.6)
m11 m12 m 21 m 22 m 31 m 32
m13 n11 n12 q11 q12 m 23 n 21 n 22 = q 21 q 22 m33 n 31 n 32 q 31 q 32
Following the implicit rule of (2.1.2), i.e. that each of the elements of the first row of M is multiplied by each of the elements of the first column of N, and their sum will give the first element in the first row and first column of Q. This is written as:
m
h =1
1h
n h1 = q11
Writing i for the row and j for the column, then we can generalise and write the general formula in order to calculate each element of Q: (2.2.7)
m
h =1
ih
n hj = q ij
Let us take a numerical example in order to calculate q ij :
(2.2.8)
2 3 1 1 2 q11 q12 6 1 2 2 2 = q 21 q 22 3 5 1 1 3 q 31 q 32
Let us take for instance q 21 , element of Q. Following the rule expressed in (2.2.7), it comes that:
q 21 = ( 6) 1 + 1 2 + 2 1 = 2
Repeating the operation for each one of the elements of Q, we obtain:
2 3 1 1 2 7 7 Q = 6 1 2 2 2 = 2 4 3 5 1 1 3 8 7
Variance-Covariance Matrix One common application of matrixes in statistics is the calculation of the variancecovariance matrix. In Section 1.4.2 we defined the covariance between two random variables. This is written as:
Sxy =
1 ( x1 x ) L n 1 ( y1 y ) L
( xi x ) ( yi y )
( x1 x ) M L (xn x ) (x x ) L ( yn y ) i M (x x ) n
M s2 x ( yi y ) = s xy M ( yn y )
( y1 y )
s xy s2 y
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Where Sxy is the estimator of xy , the theoretical variance-covariance matrix. Sxy is the product of two matrixes, the elements of each of them is the difference of the value taken by the variable minus the estimation of its mean. In the case, in which we have two variables as in Section 1.4.2, the dimension of the first matrix is dimension
(2 n) ,
where n is the number of
observations in our sample. The second matrix, which is the transpose of the first one, has a
( n 2) .
Therefore the dimension of Sxy in our case is
(2 2) ,
and is a
symmetric square matrix. The matrix is symmetric because s xy = s yx . In the case in which we deal with m random variables in our sample, the dimension of Sxy is also a symmetric square matrix. 2.2.3 Inverse of a Matrix
( m m ) , which is
The system of equations written in matrix form in (2.1.4):
AX = B
Means that we need to find a matrix A such that A A = I , where I is the neutral element for multiplications of matrices, then the solution of the system of equations given in (2.1.2) would be written as in (2.1.5):
1 1
X = A 1B
Matrix A is called the Inverse Matrix of A . The calculation of A is very similar to the calculations for solving the system (2.1.2). We will give the steps to follow in order to inverse a matrix without giving a formal mathematic demonstration. Inverse of a matrix The inverse of a matrix is the transposed cofactors matrix divided by the determinant of the matrix. Therefore, a matrix can be inversed only if its dimension is squareit has the same number of rows as number of columnsand if its determinant is different from zero. Let us take matrix A of system (2.1.2) to show the steps in order to calculate A .
1 1 1
3 1 1 A = 2 3 5 1 1 1
Step 1: Calculate the Determinant of A This has been calculated in Section 2.1, in particular in (2.1.9) and the result that was found is:
A = 26
We have to recall that the necessary and sufficient condition for a system of equations to have a solution is that:
A 0
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Step 2: Calculate the Matrix of Cofactors This is similar to the calculation of a three-order determinant, but we need to calculate the cofactors for ALL the elements of A, not only one row or column as in (2.1.8) and (2.1.9). Also, we have to respect the rules for the sign of the cofactor given in Section 2.1: (2.2.9)
Cij = ( 1)i + j M ij
For instance the cofactor C11 of element a11 = 3 is calculated as follows:
C11 = ( 1)1+1
3 5 = ( 1) 2 ( ( 3) 1) ( 5 1) = 8 1 1
For cofactor C21 of element a 21 = 2 :
C21 = ( 1) 2+1
1 1 = ( 1)3 (1 1) ( ( 1) 1) = 2 1 1
Repeating the operation for each one of the elements of A, we find the matrix of cofactors CA of A:
C11 C12 CA = C21 C22 C 31 C32
C13 8 3 5 C23 = 2 4 2 C33 2 17 11
Step 3: Transpose the Matrix of Cofactors The rule for transposing matrices has been given in (2.2.3). The transpose of matrix CA is matrix CA formed by interchanging the elements of the rows and columns of CA :
'
C11 C = C12 C 13
' A
C21 C22 C23
C31 8 2 2 C32 = 3 4 17 C33 5 2 11
Step 4: Divide the Transpose of the Matrix of Cofactors by the Determinant of A We have finally that:
0.3077 0.0769 0.0769 1 A 1 = C'A = 0.1154 0.1538 0.6538 A 0.1923 0.0769 0.4231
Taking equality (2.1.5):
X = A 1B
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We can now find the values of the unknowns of system (2.1.2) using A :
x 0.3077 0.0769 0.0769 1 0 y = 0.1154 0.1538 0.6538 2 = 3.5 z 0.1923 0.0769 6 2.5 0.4231
The reader should have already verified that those values satisfy system (2.1.2) We can also find the third-order matrix that is the multiplicative identity:
AA 1 = I
Then it comes:
3 1 1 0.3077 0.0769 0.0769 1 0 0 I = 2 3 5 0.1154 0.1538 0.6538 = 0 1 0 1 1 1 0.1923 0.0769 0.4231 0 0 1

The reader should verify that the matrix I is the multiplicative identity for all third-order matrix.
2.2.4
Eigenvalues and Eigenvectors of a Matrix
Given a square matrix A , an Eigenvalue and its associated Eigenvector V are, by definition, a pair obeying the relation14: (2.2.10)
A = V
Any non-zero vector V satisfying (2.2.10) is called and Eigenvector of Eigenvalue . Equivalently, (2.2.10) can be written as: (2.2.11)
A belonging to the
( A I ) V = 0
Where I is the identity matrix of the same dimension as A . Therefore, matrix I is a diagonal matrix where the diagonal are the Eigenvalues of A . However there is a condition for this which is related to is an extremely useful theorem for risk management, in particular for Monte Carlo simulation that reads as follows. Theorem on Existence and Properties of Eigenvalues and Eigenvectors A squared matrix A (nn ) is similar to a diagonal matrix if and only if A has n linearly independent Eigenvectors. In this case, the diagonal elements of
1
are the
corresponding Eigenvalues, and = B AB , where B is the matrix whose columns are the Eigenvectors of A . The demonstration of this theorem is beyond the aim of this course; therefore, we will accept it without demonstration. It has to be noted that the property = B AB implies that matrix
1
14
The terms Characteristic Value and Characteristic Vector, or Proper Value and Proper Vector are sometimes used instead of Eigenvalue and Eigenvector.
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A can be diagonalised, where diagonal factorisation:

(2.2.12)
is the diagonal. Then A has an extremely useful
A = BB 1
Using this factorisation, the algebra of A reduces to the algebra of the diagonal matrix , which can be deducted in a relatively easier manner. For instance, let us take a matrix A (22) as follows:
4 2 A= 3 1
Step 1: Finding the Eigenvalues of A Applying (2.2.11) we deduct that the determinant of vector V is not nilthen:
( A I )
should be zerobecause the
( A I ) =
Hence:
2 4 (1 + ) 3 = 0 2 3 10 = 0
A I =
4 3
2 (1 + )
This shows that in order to find the Eigenvalues of
A we have to solve a polynomial of second degree, and in general, calculating the Eigenvalues of a matrix of dimension ( n n )
is equivalent to finding the n roots of an n-degree polynomial. In our example, the polynomial is easily factorised as:
( 5 )( + 2 ) = 0 , thus the Eigenvalues of
A are: 1 = 5 and
2 = 2 . It has to be noted that in cases where factorisation is less obvious, the roots can
b b 2 4ac be found by applying the quadratic equation formula: = , where: 2a a 2 + b + c = 0 .
Step 2: Finding the Eigenvectors of
In order to find an Eigenvector of A belonging to the Eigenvalue 1 = 5 , we have to subtract Eigenvalue 5 down the diagonal of
A to find the matrix:

2 1 2 45 = 1 5 3 6 3
( A 1I ) =
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And to solve a system of equations such that:
( A 1I ) V1 = 0
Or (2.2.13)
1 2 v11 = 0 3 6 v12
v11 + 2v12 = 0 3v11 6v12 = 0
The system (2.2.13) has only one free equation, because if we multiply the first equation by 3 we find the second equation. Hence, the system has several non-zero solutions, for example the couple 2 and 1:
2 V1 = 1
V1 is an Eigenvector of A belonging to the Eigenvalue 1 = 5 .

In order to find an Eigenvector of A belonging to the Eigenvalue 2 = 2 , we proceed as before: subtracting 2 down the diagonal of A , and we find the system of equations in order to find the elements of V2 : (2.2.14) Therefore:
6v12 + 2v 22 = 0 3v12 + v 22 = 0 1 V2 = 3
V2 is an Eigenvector of A belonging to the Eigenvalue 2 = 2 .

Step 3: Factorisation and Diagonalisation of
A 1 Now we have to find a matrix B that satisfies = B AB :

v B = 11 v12 v12 2 1 = v 22 1 3
And so
3 7 B = 1 7
1 7
2 7
And we can verify that the theorem applies:
3 = B AB = 71 7
1
1 7 2 7
4 2 2 1 5 0 = 3 1 1 3 0 2
Unfortunately, this method has some limitations. A general polynomial of order n>4 cannot be solved by a finite sequence of arithmetic operations and radicals. Therefore, general Eigenvalue algorithms are expected to be iterative. But fortunately, there are many software packages that contain algorithms for calculation of Eigenvalues and Eigenvectors.
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Symmetric Matrices, Eigenvalues and Eigenvectors An important property of the factorisation of matrices concern symmetric matrices. A symmetric matrix is a square matrix that is equal to its transpose, and it happens that covariance and correlation matrices are symmetric, because the covariance and the correlation between x and y are exactly equal to the covariance and the correlation between y and x. The properties of symmetric matrices facilitate the calculations for finding the Eigenvalues and Eigenvectors of this type of matrices. Theorem on Symmetric Matrices, Eigenvalues and Eigenvectors A square A (nn ) symmetric matrix has n linearly independent Eigenvectors. Moreover, these Eigenvectors can be chosen such that they are linearly independent to each other. Thus a symmetric matrix A can be decomposed as A = BB ' , where B is an orthogonal matrix which columns are the Eigenvectors of A, and is real and diagonal, where the diagonal is composed of the Eigenvalues of A. Definition of an Orthogonal Matrix An orthogonal matrix is such a matrix that its transpose is equal to its inverse:
B ' = B 1 B ' B = BB ' = I

Therefore, in the case of symmetric matricescovariance and correlation matricesthe calculations are highly simplified, as for obtaining the inverse of the Eigenvectors matrix it suffices to transpose it. The covariance matrixor correlation matrixfactorisation is necessary for Monte Carlo simulations, as matrix B keeps the correlation structure among the different variables and this is very important for the consistency of simulation scenarios.
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3.
3.
Mathematics of Finance
3.1. Basic Concepts

The payment of interest as reward for the use of capital is an established part of economic life. It may be regarded as a reward paid by the borrower, who is given the use of capital, to the creditor, the owner of the capital. In financial theory both capital and interest are expressed in terms of monetary units. In practice the interest which it has been agreed will be paid for the use of capital is payable at stated intervals of time. The rate of interest which operates during one on these intervals is found to by dividing the amount of interest agreed to be paid in relation to the capital invested. The formal definition of a rate of interest is: RATE OF INTEREST: The amount contracted to be paid in one unit interval of time for each unit of capital invested The general financial practice is to make the unit interval of time a year, and this unfortunately tends to induce the preconceived idea that rates of interest must be annual rates. It is indeed customary to describe rates of interest per annum when in fact they are not. Effective Rate of Interest The effective rate of interest during any period is the one that satisfies the definition of rate of interest given above. Let us state that if one period the rate of interest applied is i, then the effective rate of interest is i as long as at the end of the period, one unit of capital has accrued from 1 to 1+i. Nominal Rate of Interest The common financial practice is to express rates of interest per annum, even though the interest is paid more than frequently than once per year. For instance, a US Treasury bond is paid on quarterly basis and in spite of this the rate is said to be per annum. In those cases, actually, what really happens is that the rate expresses as per annum is called nominal rate and the effective rate is calculated as the nominal rate divided by the number of times the rates accrues in the year. The nominal rate of interest, which is annual, is denoted i if it accrues m times a year. The effective rate of interest is the one applied to each accrual period and denoted i =
( m)
i( m) . The interest payment may be made several times per annum, m

The case where m=p The case where m>p and m/p is and integer The case where m<p and p/m is an integer The case where m/p or p/m is not integer
let us say p times. Four cases can be distinguished:
For sake of simplicity, in this course the normal case would be m=p, i.e. that the payment date coincides with the accrual periodicity of the interest rate. Consequently, in this course the
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nominal rate of interest will be expressed as i calculated as i =
( p)
= i( m) and the effective rate of interest will be
i( p) i( m) . = p m
3.1.1
Simple Interest and Number of Day Rules in the Financial Year
The number of days, which is the time unit of account for calculation of interest, takes a paramount importance in Mathematics of Finance as there are different working hypotheses in different parts of the world, and therefore for applicable to different currencies. The counting of days is used mainly in short-term transactions15, though not necessarily limited to those. Simple Interest Future Value Let us assume that the annual nominal rate of interest to be applied on s monetary units over a certain number of days is i. Then the interest accrued on s, let us say 15 days in a year, would be S and is calculated as follows: (3.1.1)
i 15 S = s 1 + 365
S is said to be calculated by simple interest by opposition to compound interest that will be dealt with in the next section. Table 3.1.1 shows the different conventions for counting the days for interest calculations around the world. The convention to apply has to be very clearly defined in order to calculate accurately the corresponding accrued interest. Table 3.1.1 Convention of Number of Days in Interest Calculations Type yb_US Vale 0 Description US (NASD) 30/360 - As with the European 30/360 yb_EU, with the additional provision that if the end date occurs on the 31st of a month it is moved to the 1st of the next month if the start date is earlier than the 30th. Uses the exact number of elapsed days between the two dates, as well as the exact length of the year. Uses the exact number of elapsed days between two dates but assumes the year only have 360 days Uses the exact number of elapsed days between two dates but assumes the year always has 365 days European 30/360 - Each month is assumed to have 30 days, such that the year has only 360 days. Start and end dates that occur on the 31st of a month become equal to the 30th of the same month.
yb_Act yb_Act360 yb_Act365 yb_EU
1 2 3 4
The first column of Table 3.1.1 shows the notation for the convention utilised. The second column shows the value of the parameter that is assigned to the convention when using computerised algorithms and the third column describes the application of the convention. For instance, as the calculation is expressed in (3.1.1). The convention applied could be yb_Act if the year is not leap, or if it is it could be yb_Act365. If yb_Act360 or yb_EU is applied, then (3.1.1) would be calculated as:
15
A transaction is considered short-term if it is carried on a maximum of one year: 365 days or 366 for lap years. In this course, any transaction above one year will be considered as a long-term transaction.
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(3.1.2)
i 15 S = s 1 + 360
It has to be noted that the difference in calculations between some of the conventions would appear only when the accrual period is larger than one calendar month. Let us take a numerical example for calculating (3.1.2) assuming s=100 and a nominal rate of interest of 5 percent.
0.05 15 S = 100 1 + = 100.21 360

The reader is encouraged to make the same calculations assuming the yb_Act convention, and he will find that (3.1.2) gives a higher interest amount for the same rate and the same period than (3.1.1) for periods larger than one month. Simple Interest Present Value The calculation expressed in (3.1.1) and (3.1.2) imply a forward vision, i.e. the future value S of an invested amount s. If the problem we are facing is the opposite, for instance what amount s should we invest todaypresent valueto obtain an amount of S in 15 days, this would be calculated as:
(3.1.3)
s=
S i 15 = S 1 + 365 i 15 1 + 365
Let us take a numerical example for calculating (3.1.3) assuming that we want to know what amount s we have to invest today in order to obtain S=100 in 15 days assuming a nominal rate of interest of 5 percent.
0.05 15 s = 100 1 + = 99.79 365

3.1.2 Compound Interest: Future and Present Values
Compound interest means that interest is re-invested and becomes part of principal16. There are also two different, but complementary, ways of look at compound interest. One is forward looking, i.e. calculating future values, and the other one is calculating present values, i.e. calculating the todays value of future amounts of money. Future Value Future value allows us to calculate the future worth of and investment made today, or in a series of deposits from today to the maturing date. Let us start calculating the future value of an invested amount of s monetary units at a rate of i per period at date 0 and maturing at date 1. (3.1.4)
S1 = s + is = s(1 + i)
16
In all the sections dealing with composed interest we assume that the days convention is yb_EU.
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At end of period 1, (3.1.4) gives the future value: S1 . Assuming the amount is re-invested for another period, a second period, the future amount at end of period 2 is calculated as: (3.1.5)
S2 = s(1 + i) + s(1 + i) i = s(1 + i) 2
If the future value at the end of each period is re-invested until the end of period n, then the formula to calculate the future value maturing at the end of the n period is: (3.1.6)
Sn = s(1 + i) n
The calculation of the future value using formula (3.1.6) is called compound interest by opposition to simple interest that was deal in Section 3.1.1. Let us take a numerical example: how much is the future value in 10 periods of an amount s=100 at an effective rate of interest of 5 percent per period:
S10 = 100(1 + 0.05)10 = 162.89

It has to be noted that the future value has a forward approach: by investing a known amount today the calculation gives the future value after n periods. Present Value Present value allows us to calculate the present worth of an amount to be obtained at a given future date, or of a series of amounts from today to the maturing date. Let us start calculating the present value, at date 0, of an amount of a monetary units at a rate of i per period at date 1. We want to find the value A 0 to be invested at a rate i that will accrue amount a at the end of the period. Following (3.1.4), we can write: (3.1.7)
A 0 (1 + i) = a
From (3.1.7), we find the amount A 0 that invested at beginning of period will accrue to the amount a at end of period: (3.1.8)
A0 =
a = a(1 + i) 1 (1 + i)
If we increase the number of periods, proceeding as in the developments shown in (3.1.5) and (3.1.6), we find the general formula for present value: (3.1.9)
A0 =
a = a(1 + i) n n (1 + i)
For the numerical example let us find what amount we have to invest today in order to obtain a= A 0 100 monetary units in 10 periods at a compound rate of interest of 5 percent. The calculation applying (3.1.9) gives:
A 0 = 100(1 + 0.05) 10 = 61.39
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Comparing Future Value and Present Value Taking formulae (3.1.6) and (3.1.9) it is clearly seen that future value has a forward vision and present value a backward vision: In the case of future value, we invest an amount s to obtain Sn at the end of n periods; therefore future value has a forward vision because brings the value from date 0 to date n in the future. In the case of present value, we calculate how much we need to invest at date 0, A 0 , in order to obtain an amount of a in n periods; therefore present value has a backward vision, because brings the value from date n, in the future, to date 0, today.
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3.2. Annuities-Certain and Amortisation Schedules

3.2.1 Annuities-Certain
An annuity is a series of payments at fixed periods of time continuing during the existence of a given status, for instance, during the lifetime of a person, or to a widow as long she has children under a certain age, or more simply, for a fixed period of time, independent of any contingency. In this last case, the series of payments is called annuity-certain. These series of payments are concerned by the theory of compound interest as seen in the previous paragraph. However, we will restrict our exposition to annuities-certain as defined above. For sake of simplicity, we will restrict our annuities-certain analysis to the convention yb_EU, i.e a year with 360 days and 12 months with 30 days each. The analysis of annuities-certain can be extended to other conventions, however, it happens very seldom. Future Value of Annuities-Certain Let us assume that we commit, at date 0, to deposit at the end of each period an amount of 1 monetary unit during n periods at a compound rate of interest i. In that case, the future value of the annuity will be calculated as: (3.1.10)
Sn = (1 + i) n 1 + (1 + i) n 1 + ... + (1 + i) + 1
Where Sn denotes the future value of an annuity of 1 per annumpayable for a term certain of n periodsthe symbol
n
being used to denote a fixed period of time, in this case n
periods. The series in the right side of (3.1.10) is the sum of the first n terms of a geometrical series. The calculation of the sum, Z n , of the first n terms of a geometrical series, assuming that the geometrical reason is q, is calculated as follows: (3.1.11)
Z n = q 0 + q1 + q 2 + ... + q n 1 = 1 + q + q 2 + ... + q n 1
Multiplying Z n by q, we obtain: (3.1.12)
qZ n = q + q 2 + ... + q n
And subtracting (3.1.11) from (3.1.12): (3.1.13)
qZ n Z n = q n 1 Z n =
qn 1 q 1
In (3.1.10) q = (1 + i) , therefore applying the result obtained in (3.1.13) to (3.1.10):
(3.1.14)
Sn =
(1 + i) n 1 i
It has to be noted that (3.1.14) is applied when the payment is made end of period. In case the payment is made beginning of period, which in most of the cases of future value
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calculations happens. In that case, there is, for each of the payments one more period for the interest to accrue. In that case the future value is simple calculated as: (3.1.15)
&& Sn = (1 + i)Sn
Sn denotes the future value of a series of n payments of one monetary unit during n Where &&
periods, made beginning of period, and accruing at an effective rate of interest i. The formula in (3.1.14) is for an effective rate i. When dealing with nominal rates, i.e. a nominal rate i calculated as:
( p)
for a payment of one monetary unit p times a year, (3.1.14) shall be
(3.1.16)
Snp
i ( p) 1 + p 1 = ( p) i p
np
Let us take a numerical example. We want to calculate the future value S of a series of payments of 100 monetary units during 10 years made semi-annually beginning of period at a nominal rate of interest of 8 percent. In that case:
n = 10 p=2 i ( p) = 0.08 s = 100

Therefore, the calculation to be made is:
&& = 100(1 + 0.04)S = 100(1 + 0.04) S = 100S 20 20
(1 + 0.04) 20 1 = 3,096.92 0.04
It has to be noted that the fact of paying beginning of period will result in a higher accrued future value, as each payment has one more period to accrue. To show this statement let us proceed to do the same calculations as before but with payments end of period:
S = 100S20 = 100
(1 + 0.04) 20 1 = 2,977.81 0.04
Present Value of Annuities-Certain In this case, the question that we wish to answer is what amount do we have to invest today, an , in order to obtain a series of payments of one monetary unit during n periods, payable end of period, at a given effective rate of interest i. This is calculated as follows: (3.1.17)
2 n 1 an = (1 + i) 1 + (1 + i) 2 + .. + (1 + i) n = (1 + i) 1 1 + (1 + i) + .. + (1 + i)
The series shown between brackets in the right side of (3.1.17) is the sum of the first n terms of a geometrical series where q = (1 + i) . In this case, in order to calculate the value of this sum, it is more practical to subtract (3.1.12) from (3.1.11):
1
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(3.1.18)
Z n qZ n = 1 q n Z n =
1 qn 1 q
Thus, applying (3.1.18) to the sum between brackets in (3.1.17): (3.1.19)
1 + (1 + i) 2 + .. + (1 + i) n 1 =
1 (1 + i) n 1 (1 + i) 1
Replacing (3.1.19) into (3.1.17) we have: (3.1.20)
a n = (1 + i) 1
1 (1 + i) n (1 + i) 1 1 (1 + i) n = 1 1 (1 + i) 1 1 (1 + i) (1 + i)
Simplifying (3.1.20) we obtain the final result: (3.1.21)
an =
1 (1 + i) n i
( p)
As in the case of future value, the formula in (3.1.21) is for an effective rate i. When dealing with nominal rates, i.e. a nominal rate i (3.1.21) shall be calculated as: for a payment of one monetary unit p times a year,
1 (1 +
(3.1.22)
a np =
i ( p) np ) p
i ( p) p
Let us take a numerical example. We want to calculate the present value A of a series of payments of 100 monetary units during 10 years made semi-annually end of period at a nominal rate of interest of 8 percent. In that case:
n = 10 p=2 i ( p) = 0.08 a = 100

Therefore, the calculation to be made is:
A = 100a20 = 100
1 (1 + 0.04) 20 = 1,359.03 0.04
The interpretation of the above result is that we need 1,359.03 monetary units today, at a prevailing nominal rate of interest of 8 percent per annum, in order to receive 100 monetary units at end of semi-annual periods during 10 years. Obviously, if the series of payments is to be made beginning of period, then the present value is calculated as follows: (3.1.23)
&& = (1 + i)a a n n
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&& denotes the present value of a series of n payments of one monetary unit during n Where a n
periods, made beginning of period, and accruing at an effective rate of interest i. This type of annuity-certain is called an annuity-due. It has to be noted that by paying beginning of period, the required amount will decrease by one monetary unit, as it is de facto subtracted from the initial amount. The series of payment will also have one period less to accrue interest. Actually, (3.1.23) can be written as: (3.1.24)
&& = 1 + a a n n 1
This means that by using a present value of an annuity-certain paid beginning of period, from the practical point of view, we are making a down payment that is subtracted from our initial investment and we obtain a shorter annuity: a n 1 . The needed investment will be smaller than in the case of payments end of period. In order to show this point let us calculate the same numerical example as above under the hypothesis of payments beginning of period.
&& = 100 (1 + 0.04) A = 100a n

3.2.3
1 (1 + 0.04) 20 = 1, 413.39 0.04
Types of Problems Concerning Annuities-Certain
There are four types of problems concerning annuities-certain: 1. 2. 3. 4. Given s or a, i and n find S or A Given S or A, i and n find s or a Given (S, s) or (A, a) and i find n Given (S, s) or (A, a) and n find i
First Type of Problem The first type of problem was given and solved as numerical examples in the previous section. In this section we will be solving the other three types of problems by giving numerical examples of the solution. Second Type of Problem: Future Value Given S, i and n find s: What is the amount s to be deposited at the end of each semester in order to obtain 1,000.00 monetary units in ten years at a nominal rate of interest of 8 percent? The solution is given by (3.1.16):
1,000.00 = sS20
(1 + 0.04) 20 1 1,000.00 =s s= = 33.58 0.04 (1 + 0.04) 20 1 0.04
Second Type of Problem: Present Value Given A, i and n find a: If we deposit today 1,000.00 monetary units, what amount a paid semi-annually during ten years at a nominal rate of interest of 8 percent will be obtain?
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The solution is given by (3.1.22):
1,000.00 = aa20 = a
1 (1 + 0.04) 20 1,000.00 a = = 73.58 0.04 1 (1 + 0.04) 20 0.04
Third Type of Problem: Future Value Given S, s and i find n. We wish to obtain 1,000.00 monetary units at the end of the accrual periods by investing 50.00 monetary units at the end of each period. Given that the effective rate of interest is 4 percent, in how many periods will we obtain the desired future value? The solution is given by (3.1.16):
1,000.00 = 50.00Sn = 50.00

Therefore:
(1 + 0.04) n 1 1,000.00 0.04 + 1 = (1 + 0.04) n 0.04 50.00
However, the calculations can be carried forward more accurately. In fact, the value for n shown above is rounded to the nearest entire number but actually its exact value is n = 14.9866 . In that case, once we got this value, we can deduct that in order to have the exact desired amount we have to make 14 deposits of 50 monetary units at the end of each one of the periods, plus a smaller payment at the end of the 15th period. This last payment is calculated as follows:
1, 000.00 = 50.00S14 (1 + 0.04 ) + x x = 1,000.00 50.00S14 (1 + 0.04 )
x = 1,000.00 50.00 18.29191 1.04 = 48.82

The answer to our problem is that under the hypothesis made on the nominal rate of interest, in order to obtain 1,000.00 monetary units we need to make 14 deposits of 50.00 monetary units end of period, and a last deposit of 48.82 monetary units at the end of the 15th period. Third Type of Problem: Present Value Given A, a and i find n: If we deposit today 1,000.00 monetary units, and we wish to obtain an amount of 50.00 monetary units paid at the end of each period. Given that the effective rate of interest is 4 percent, during how many periods will we get the periodical payment? The solution is given by (3.1.22):
1,000 = 50an = 50
1 (1 + 0.04) n 1,000 0.04 (1 + 0.04) n = 1 0.04 50
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Therefore:
As in the same type of problem for FV, we can find a more accurate answer to this type of problem. In fact, the exact value of n is n=41.0354. This means that the amount of 1,000 monetary units deposited initially will allow us to get 40 payments of 50 and one more of a slightly different value. This is calculated as follows:
1, 000 = 50a40 + x (1 + 0.04 )
41
x = (1 + 0.04 )
41
(1,000 50a )
40
x = 1.0441 (1,000 989.64 ) = 51.73

The answer to our problem is that under the hypothesis made on the nominal rate of interest, the 1,000.00 monetary units deposited initially, will allow us to get 50.00 monetary units end of period during 40 periods, and a last payment of 51.73 monetary units at the end of the 41st period. Fourth Type of Problem: Future Value Given S, s and n find i. We wish to obtain 1,000.00 monetary units at the end of the 10 accrual periods by investing 75.00 monetary units at the end of each period. At what effective rate of interest do we have to invest in order to obtain the desired future value? The solution is given by (3.1.16):
(1 + i)10 1 1,000 (1 + i)10 1 1,000.00 = 75S10 = 75 = i 75 i

Therefore:
(1 + i)10 1 13.3333 = i
The above equation in i is difficult to solve by applying algebra. It is more practical to proceed by iterations and interpolation. We need a value of i that will give a value smaller than 13.3333, but close to it, and a value of i that will give a value larger than 13.3333, but close to it. Proceeding by iterations we find:
13.30525 =
(1 + 0.062)10 1 0.062
and
13.33657 =
(1 + 0.0625)10 1 0.0625
With these values we can find a closer value of i by interpolation:
i 0.062 0.0625 0.062 = 13.3333 13.30525 13.33657 13.30525 i = 0.062 +
(13.3333 13.30525) ( 0.0625 0.062 ) = 0.0624

13.33657 13.30525
The desired rate is i=6.24%

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The reader should notice that it might be that we cannot invest at exactly the rate that we need, for instance in practice it might be difficult to find a nominal rate i=6.24%. However, we may find a rate i=6.25. In that case, the problem can be adjusted for the last payment to be different to the others as we did with the third type of problem solution. Fourth Type of Problem: Present Value Given A, a and n find i: If we deposit today 1,000.00 monetary units, and we wish to obtain an amount of 150.00 monetary units paid at the end of each period during ten periods. At what effective rate of interest do we have to invest in order to obtain the desired series of payments? The solution is given by (3.1.22):
1,000 = 150a10 = 150

Therefore:
1 (1 + i) 10 1,000 1 (1 + i) 10 = i 150 i
6.6667 =
1 (1 + i) 10 i
As in the previous case, the above equation in i is difficult to solve by applying algebra. It is more practical to proceed by iterations and interpolation. We need a value of i that will give a value smaller than 6.6667, but close to it, and a value of i that will give a value larger than 6.6667, but close to it. Proceeding by iterations we find:
1 (1 + 0.0725) 10 6.943128 = 0.0725
and
1 (1 + 0.082) 10 6.649969 = 0.082
With these values we can find a closer value of i by interpolation:
i 0.0725 0.082 0.0725 = 6.6667 6.943128 6.649969 6.943128 i = 0.0725 +
( 6.6667 6.943128) ( 0.082 0.0725) = 0.0811

6.649969 6.943128
The desired rate is i=8.11% Here the same remark as in the case of FV is applicable: it might be that we cannot invest at exactly the rate that we need, for instance in practice it might be difficult to find a nominal rate i=8.11%. But, we may find a rate i=8.125. In that case, the problem can be adjusted for the last payment to be different to the others as we did with the third type of problem solution. However, in this case we may have more flexibility, as this may be applicable to purchases of bonds, in which case the desired rate can be interpreted and calculated as the yield of our investment. This will be deal with in the next module. 3.2.4 Amortisation of Loans and Annuities-Certain
Formulae (3.1.21) and (3.1.22) is the present value of a series of payments of one monetary unit per annum for n periods, and means that if a purchaser invests a n he will secure a yield of at the rate i on his capital during n periods. The payment he receives is one per annum, and it must be clear that he cannot regard this payment purely as income, or interest,
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because if he did not reinvest any part of it, then at the end of n periods when the annuity ceased he would find that ne had none of his original capital left. Hence each payment of one monetary unit must comprise: Interest on the capital invested, and A portion representing a repayment of principal
In the above paragraph the transaction has been considered as the purchase of a given series of payments for the price of a n . It would lead to exactly the same result if the transaction was described as a loan of a n to be repaid by n periodical instalments of one monetary unit. From the point of view of the purchaser, or the lender, as the case may be, the transaction is still the investment of capital sum of a n . From the point of view of the vendor, or the borrower, the transaction is in each case an undertaking to provide a series of n periodical payments of one monetary unit in return for the cash payment of a n at the outset. Let us calculate an amortisation table using an annuity-certain: we borrow 10 million monetary units at a nominal rate of 8 percent per annum to be repaid in semi-annual instalments during five years. The loan is fully disbursed on 15 October 2009. First, we need to calculate the amount of the annuity payment. This is calculation is achieved applying (3.1.22):
10,000,000 = aa10 = a
Hence:
1 (1 + 0.04) 10 0.04
a=
10,000,000 = 1, 232,909.44 1 (1 + 0.04) 10 0.04
Therefore, we have to pay ten semi-annual instalments of 1, 232,909.44 in order to reimburse the 10 million including the interest at a nominal interest rate of 8 percent. Now we can construct the amortisation schedule for the loan, which appears in Table 3.2.1. Table 3.2.1 Annuity-Certain end of Period: Loan Amortisation Schedule Period 0 1 2 3 4 5 6 7 8 9 10 Date 15-Oct-09 15-Apr-10 15-Oct-10 15-Apr-11 15-Oct-11 15-Apr-12 15-Oct-12 15-Apr-13 15-Oct-13 15-Apr-14 15-Oct-14 Outstanding 10,000,000.00 9,167,090.56 8,300,864.74 7,399,989.88 6,463,080.03 5,488,693.79 4,475,332.10 3,421,435.94 2,325,383.94 1,185,489.85 0.00 TOTALS Principal 832,909.44 866,225.82 900,874.85 936,909.85 974,386.24 1,013,361.69 1,053,896.16 1,096,052.01 1,139,894.09 1,185,489.85 10,000,000.00 Interest 400,000.00 366,683.62 332,034.59 295,999.60 258,523.20 219,547.75 179,013.28 136,857.44 93,015.36 47,419.59 2,329,094.43 Annuity 1,232,909.44 1,232,909.44 1,232,909.44 1,232,909.44 1,232,909.44 1,232,909.44 1,232,909.44 1,232,909.44 1,232,909.44 1,232,909.44 12,329,094.43
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As indicated, the payment is constant. However, the shares that are devoted to pay interest and principal vary. Let us analyse how Table 3.2.1 is built: the disbursement is made on 15 October and the first instalment on 15 April, six months later. The share corresponding to the interest payment is calculated by applying the effective interest rate per period, 4 percent, to the outstanding amount beginning of period:
10,000,000.00 0.04 = 400,000.00

And therefore, the share devoted to repay principal is:
1, 232,909.44 400,000.00 = 832,909,.44

The outstanding amount beginning of period on 15 April 2010 is calculated as:
10,000,000.00 832,909,.44 = 9,167,090.56

The remaining cells in Table 3.2.1 are calculated following the three steps described above. Table 3.2.2 Annuity-Certain beginning of Period: Loan Amortisation Schedule Period 0 1 2 3 4 5 6 7 8 9 10 Date 15-Oct-09 15-Apr-10 15-Oct-10 15-Apr-11 15-Oct-11 15-Apr-12 15-Oct-12 15-Apr-13 15-Oct-13 15-Apr-14 15-Oct-14 Outstanding 8,717,774.18 7,784,259.33 6,813,403.88 5,803,714.21 4,753,636.96 3,661,556.62 2,525,793.06 1,344,598.96 116,157.10 0.00 TOTALS Principal 933,514.85 970,855.45 1,009,689.67 1,050,077.25 1,092,080.34 1,135,763.56 1,181,194.10 1,228,441.86 116,157.10 8,717,774.18 Interest 348,710.97 311,370.37 272,536.16 232,148.57 190,145.48 146,462.26 101,031.72 53,783.96 4,646.28 1,660,835.77 Annuity 1,282,225.82 1,282,225.82 1,282,225.82 1,282,225.82 1,282,225.82 1,282,225.82 1,282,225.82 1,282,225.82 120,803.38 0.00 10,378,609.95
Table 3.2.1 has been constructed following (3.1.21) and (3.1.22). But how would the table look if we use (3.1.23) or (3.1.24), an annuity-due, instead? Using these latest formulae mean that the payment is beginning of period, and we would be making a de facto down payment equal to the annuity payment calculated above, 1, 232,909.44 , that has to be subtracted from the original loan amount, 10,000,000.00 , because at date 0, i.e. at 15 April 2009, no interest has accrued. This is represented in Table 3.2.2, where the initial disbursement is:
10,000,000.00 1, 232,909.44 = 8,717,774.18

Besides the above difference, Table 3.2.2 is calculated exactly as Table 3.2.1. Comparing the two tables, it is clear that those formulae (3.1.23) and (3.1.24) are related, namely:
&& = (1 + i)a a n n
and
&& = 1 + a a n n 1
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Grace Period: Deferred Annuity-Certain If the first payment of the annuity-certain is not to be made at the end of the first period, but is to be deferred for m periods from the present time, the annuity is called to be a deferred annuity to distinguish from an immediate annuity, and the symbol used is
m
an . In the case
where the deferred annuity represents the repayment of a loan, the deferral period is called grace period. Table 3.2.3 Deferred Annuity-Certain: Loan Amortisation Schedule
Period 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 Date 15-Oct-09 15-Apr-10 15-Oct-10 15-Apr-11 15-Oct-11 15-Apr-12 15-Oct-12 15-Apr-13 15-Oct-13 15-Apr-14 15-Oct-14 15-Apr-15 15-Oct-15 15-Apr-16 15-Oct-16 15-Apr-17 Outstanding 10,000,000.00 10,000,000.00 10,000,000.00 10,000,000.00 10,000,000.00 10,000,000.00 9,167,090.56 8,300,864.74 7,399,989.88 6,463,080.03 5,488,693.79 4,475,332.10 3,421,435.94 2,325,383.94 1,185,489.85 0.00 TOTALS 832,909.44 866,225.82 900,874.85 936,909.85 974,386.24 1,013,361.69 1,053,896.16 1,096,052.01 1,139,894.09 1,185,489.85 10,000,000.00 400,000.00 400,000.00 400,000.00 400,000.00 400,000.00 400,000.00 366,683.62 332,034.59 295,999.60 258,523.20 219,547.75 179,013.28 136,857.44 93,015.36 47,419.59 2,329,094.43 400,000.00 400,000.00 400,000.00 400,000.00 400,000.00 1,232,909.44 1,232,909.44 1,232,909.44 1,232,909.44 1,232,909.44 1,232,909.44 1,232,909.44 1,232,909.44 1,232,909.44 1,232,909.44 12,329,094.43 384,615.38 369,822.49 355,598.54 341,921.68 328,770.84 974,386.24 936,909.85 900,874.85 866,225.82 832,909.44 800,874.46 770,071.60 740,453.46 711,974.48 684,590.85 8,219,271.07 Principal Interest Annuity Present Value.
The value of an annuity-certain for n periods deferred m periods, i.e. with a grace period of m periods, may be considered either as the present value of a the single sum which represents that value of the annuity at the moment it is entered upon: m periods form the present, or as the difference between the present value of an annuity-certain for (m+n) periods les the present value of the payments in the first m periods which are not received: (3.1.25)
m
a n = (1 + i )
an = an + m am
In the numerical example above:
10,000,000.00 = aa10
Therefore, if we introduce a grace period or a deferral of two years and a half, the value of the annuity would be:
(1 + 0.04 )
10,000,000.00 = 8, 219, 271.07
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The amortisation table for this case is shown in Table 3.2.3. A new column has been added in Table 3.2.3 that is the sum of the present value of the annuity payments. It is clearly shown that the value, we could say market value, of such an operation is 8,219,271.07 monetary units and not 10 million, as the face value would induce. This means that from the point of view of the purchaser, or the lender, the opportunity cost for this operation would be the difference between the present value of the annuity and the face value:
10,000,000.00 8, 219, 271.07 = 1,780,728.93

This amount is precisely the present value of the first five payments of interest during the grace or deferral period:
(1 + 0.04)
h =1
400,000,00 = 1,780,728.93
From the point of view of the borrower, or the vendor, this operation implies an opportunity gain which is exactly equal to the opportunity cost of the purchaser, or the lender. This is in fact the result of the formulae expressed in (3.1.25), which numerical values are:
5
a10 = (1 + 0.04 ) a10 = (1 + 0.04 ) 10,000,000.00 = 8, 219, 271.07

5 5 5
And:
a10 = a15 a5 = 10,000,000.00 1,780,728.93 = 8, 219, 271.07
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Bibliography
Articles or Short Publications Bergstrm, Pl, and Anders Holmlund, (2000), A Simulation Model Framework for Government Debt Analysis. Swedish National Debt Office, 30 November, Stockholm. Blommestein, Hans J., (2005), Overview of Advances in Risk Management of Government Debt, OECD, Paris. Cassard, Marcel, and David Folkers-Landau, (1997), Risk Management of Sovereign Assets and Liabilities, IMF Working Paper WP/97/166, December, Washington. ____________________________________, (1997), Sovereign Debt: Managing the Risks. IMF, Finance and Development, December, Washington. Claessens, Stijn, (2004), Taking Stock of Risk Management Techniques for Sovereigns. Sovereign Debt Project, Initiative for Policy Dialogue, University of Columbia and United Nations, October, New York. Coso-Pascal, Enrique, (2007), Manual on Debt and Risk Indicators, Inter-American Development Bank, Latin-American and Caribbean Debt Group, January, New York and Washington. Currie, Elizabeth, and Antonio Velandia, (2002), Risk Management of Contigent Liabilities Within a Sovereign Asset-Liability Framework. The World Bank, January,Washington. IMF, PDRD, (2000), Debt- and Reserve-Related Indicators of External Vulnerability, 23 March, Washington. Storkey, Ian, (2001), Sovereign Debt Management: A Risk Management Focus. The Finance and Treasury Professional of Australia, May, Melbourne. Velandia, Antonio, (Without date), A Risk Quantification Model for Public Debt Management. The World Bank, Washington. World Bank and IMF, (2001), Guidelines for Public Debt Management, Washington, March. World Bank and the IMF, (2002), Guidelines for Public Debt Management: Accompanying Document, Washington, November. World Bank and IMF, (2003), Amendments to the Guidelines for Public Debt Management, Washington, November. World Bank and IMF, (2007), Strengthening Debt Management Practices: Lessons from Country Experiences and Issues Going Forward, 27 March, Washington. World Bank and IMF, (2007), Strengthening Debt Management PracticesLessons from Country Experiences and Issues Going Forward: Background Paper, 27 March, Washington.
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Books Anderson, Torben Juul, (1993), Currency and Interest Rates Hedging. New York Institute of Finance, New York. Crouhy, Michael, Dan Galai and Robert Mark, (2006), The Essentials of Risk Management. McGraw Hill, New York. Hoercher, Karen A., (2006), Essentials of Managing Treasury, John Wiley & Sons, Hoboken, New Jersey. Hull, John C. (2006), Options, Futures and Other Derivatives. Pearson-Prentice Hall, New Jersey. Ludwig, Mary S. (1993), Understanding Interest Rates Swaps. McGraw Hill, New York. Marrison, Chris, (2002), The Fundamentals of Risk Measurement. McGraw Hill, New York. Piga, Gustavo, (2001) Derivatives and Public Debt Management. International Securities Market Association and Council on Foreign Relations, Zrich and New York. Pitts, Mark and Frank J. Fabozzi, (1990), Interest Rates, Futures and Options. Probus, Chicago. Soler Ramos, Jos A., Kim B. Staking, Alfonso Ayuso Calle, Paulina Beato, Emilio Botn OShea, Miguel Escrig Meli and Bernardo Carrasco, (2000), Financial Risk Management: A Practical Approach for Emerging Markets. John Hopkins, Inter-American Development Bank, Grupo Santander and Caribbean Development Bank, Washington. Wheeler, Graeme, (2004), Sound Practice in Government Debt Management. The World Bank, Washington.
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United Nations Institute for Training and Research

Advanced Risk Management

Author: Dr. E. Cosio-Pascal

Module 1: Goals and Objectives

By the end of this module you will be able to:

MATRIX ALGEBRA o o Basic Concepts Operations with Matrices

MATHEMATICS OF FINANCE o o Basic Concepts Annuities-Certain and Amortisation Schedules

BIBLIOGRAPHY ARTICLES OR SHORT PUBLICATIONS BOOKS

Abbreviations and Acronyms

1.1. Probability Densities

Construction of Histograms and Percentages from Empirical Data

w i the weight associated to value v i , then the weighted average is

Similarly, the average maturity is calculated as2:

1,000.00 10 + 2,500.00 5 + 1,750.00 20 + 2,000.00 5 = 9.31 7, 250.00

Figure 1.1.1 Loans Cash Flow Profile

pij , that is calculated in our case as: cf ij

Figure 1.1.2 Loans Cash Flow Profile in Percentage

Loan 1 Loan 2 Loan 3 Loan 4 Total

= 200.00 + 712.50 + 218.75 + 190.00 = 1,321.25

And obviously in our case:

200 *100 = 1.98% 10,119.69

CP11 = pi1 = 1.98%

Figure 1.1.3 Cumulated Loans Redemption Profile in Percentage

120.00% Cumulated percentages 100.00% 80.00% 60.00% 40.00% 20.00% 0.00%

Loan 1 Loan 2 Loan 3 Loan 4 Total

1.2. Statistical Parameters used in Risk Management

E1 E 0 6.25 5.00 100 = 100 = 25.00% E0 5.00

E1 E 0 5.19 5.00 100 = 100 = 3.80% E0 5.00

89-95 95-100 100-101 101-103 103-105 105-106

10 9 8 7 6 5 4 3 2 1 0 89<x<95 x<100 x<101 x<103 x<105 x<106

S&P Rating AAA AA A BBB BB B CCC Default

Replacing (1.2.2) and (1.2.3) into (1.2.4) we can write: (1.2.5)

But the required capital beginning of period is: (1.2.8)

Replacing (1.2.10) into (1.2.9) we find: (1.2.11)

But actually, if we expect to be small, and then we can write:

shows exactly the same result as (1.2.13). Market Risk

If the rate on the bonds,

1.3. Theoretical Distributions that are used to Analyse Risk

7. This means, roughly, that x

n i =1 for all x i , as each value has been

(1.3.4) The estimator of the variance is:

Where n is defined as in (1.3.2). It can be demonstrated that s is an unbiased estimator of

2 , and this is expressed as:

Where x = 101.02 and hence:

The estimator of (1.3.9) is:

z equals . This result justifies of a distribution.

n i =1 for all x i , as each value has been

Where x = 101.02 and s = 5.10 , hence:

The estimator of (1.3.12) is:

n i =1 for all x i , as each value has been

10 11 ( 33.239204 ) = 7.25 987

The cumulative distribution being:

dx = P(a < x < b)

The estimators for and are defined as follows:

Statistical Tools that are used in Risk Analysis

The unbiased estimator of (1.4.2) is calculated as follows: (1.4.3)

It can be shown that:

1 , the variables are highly correlated and vary in contrary sense

0.35 = 0.97798 0.000229 567

each day, then (1.4.7) becomes: (1.4.8)

Random Time Series Equations

T = 1. If s was the daily standard deviation and the time

T = 250, the number of trading days in a year.