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com QQ106454842 CFA FRM+
MARKET RISK MEASUREMENT
ANDMAN E NT
Value at Risk (VaR)
VaR for a given confidence level occurs at the
cutoff point that separates the tail losses from the
remaining distribution.
Historical simulation approach: order return
observations and find the observation chat
corresponds co the VaR loss level.
Parametric estimation approach: assumes a
distribution for the underlying observations.
Normal distribution assumption:
VaR =
(-r + ar X ZC't'.)
Lognormal distribution assumption:
VaR = (l - ellr-OrXZ(\)
Expected Shortfall
Provides an escimace of tail loss by averaging rhe
VaRs for increasing confidence levels in the cail.
Weighted Historical Simulation
Approaches
Age-weighted: adjuses the most recent (distant)
observations co be more (less) heavily weighted.
Volatility-weighted: replaces historic returns with
vo latility adj ust ed returns; actual procedure of
-
estimating VaR is unchanged.
Correlation-weighted: updates the variance
covariance matrix between assets in me portfolio.
Filtered historical simulation: relies on
bootstrapping of standardized returns based on
volatility forecasts; able co capture conditional
volatility, volatility clustering, and/or data
asymmetry.
Peaks-Over-Threshold (POT)
Application of extreme value theory (EVT) co the
distribution of excess losses over a high threshold.
One of the goals of using the POT approach is
to compute VaR. From estimates of VaR, we can
derive the expected shortfall (ES).
Backtesting VaR
Compares the number of instances when losses
exceed the VaR level (exceptions) with the number
predicted by the model at tl1e chosen level of
confidence.
Failure rate: num b er of exceptions/nu1nber of
observations.
The Basel Committee requires backcescing at che
99o/o confidence level over one year; establishes
zones for the number of exceptions wim
corresponding penalties (increases in me capital
multiplier).
Mapping
Mapping involves finding common risk factors
among positions in a given portfolio. It may be
difficult and time consuming co manage che risk
of each individual position. One can evaluate the
value of portfolio positions by mapping chem
onto common risk faccors.
Pearson Correlation Coefficient
A Gaussian default rime copula can be used for
Commonly used co measure the linear measuring the joint probability of default between
relationship between two variables: cwo assets.
Regression-Based Hedge
PXY =
covxv
axay pR x OVOlN
FN
=
x
ovo1R
Spearman's Rank Correlation
Step 1: Order the set pairs of variables X and Y where:
with respect co sec X. fR =face amount of hedging instrument
Step 2: Determine the ranks of X and Y for each fN =face amount of initial position
I I
time period i.
Bond Valuation Using Binomial Tree
Step 3: Calculate the difference of the variable
Using backward induction, the value of a bond at
rankings and square the difference.
a given node in a bino1nial tree is the average of
6
n
I: dr the present values of the two possible values from
the next period. The appropriate discount rate is
Ps = 1- n(n2 -1) i=I
the forward rare associated with the node under
analysis.
Where n is the number of observations for each There are three basic steps co valuing an option
variable and d is the difference between the on a fixed-income instrument using a binomial
I
ranking for period i. tree:
Step 1: Price the bond value at each node using
Kendall's T
the projected interest rates.
'T
= _ c -_, n,_
n-"- ,d _
n(n - 1) I 2
Step 2: Calculate the intrinsic value of che
derivative at each node at maturity.
Step 3: Calcltlace the expected discounted value of
Where the number of concordant pairs is
represented as nc (pair rankings in agreement), the derivative at each node using the risk
and the number of discordant pairs is represented neutral probabilities and work backward
as nd (pair rankings not in agreement). through the tree.
Interest Rate Expectations
Mean Reversion
In1plies char over time variables or returns regress Expectations play an important role in
back co the 1nean or average return. determining the shape of the yield curve and
Mean reversion race, a, is expressed as: can be illustrated by examining yield curves that
Sc - Sc-I =a( - Sc-I) are Rae, upward-sloping, and downward-sloping.
The coefficient of a regression is equal co me If expected 1-year spot rates for the next three
negative of the mean reversion race. years are r1, r2, and r3, tl1en the 2-year and 3-year
Autocorrelation spot rares are computed as:
Measures the degree mac a variable's current value r(2)
=
J(l + r1 )(I + rz) - l
is correlat ed co past values.
Has che exact opposite properties of mean
.
reversion.
The sum of the mean reversion rate and the one
period autocorrelation race will always equal one. Convexity Effect
All else held equal, che value of convexity
Correlation Swap
increases wi ch maturity and volatility.
Used to trade a fixed correlation between cwo or
Term Structure Models
1nore assets with a realized correlation.
Realized correla tion for a portfolio of n assets: Model 1: assumes no drift and that interest rares
2
are normally discribuced:
Prealizcd LPi,j
=
2
n - n .. dr =adw
1> J
Model 2: adds a positive drift cerm co Model l
Payoff f or correlation swap buyer: char can be interpreted as a positive risk premium
notional amount x (P,...i; - pfixed) associated with longer rime horizons:
dr =A.de + crdw
Gaussian Copula
where:
Indireccly defines a correlation relationship
becween cwo variables. A =inceresc race drift
Maps the marginal distribution of each variable
Ho-Lee Model: generalizes drifc co incorporate
to a standard normal distribution (done on
rime-dependency:
percencile co percencile basis).
dr =A.(c)dc + adw
- -
The ne\>V joint distribution is a multivariate
standard normal distribution.
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Vasicek Model: assumes a mean-reverting process
for short-term interest rates:
dr =k(9 - r)dt + crdw
where:
k =a parameter that measures the speed of
reversion adjusonent
e =long-run value of the short-term
assuming risk neutrality
r =current interest rate level
Model 3: assigns a specific parameterization of
time-dependent volatility:
dr =A(t)dt + cre...o.dw
where:
a =volatility at t = 0, which decreases
exponentially to 0 for a > 0
Cox-Ingersoll-Ross (CIR) model mean-reverting
model with constant volatility, cr, and basis-point
volatility, crJ;, that increases at a decreasing rate:
dr = k(0-r)dt + crJ;dw
Model 4 (lognormal model): yield volatility,
is constant, but basis-point volatility, crr,
a,
increases with the level of the short-term rate.
There are two lognormal models of importance:
(1) lognormal with deterministic drift and
(2) lognormal with mean reversion.
Overnight Indexed Swaps (OIS)
Interest rate swap in which a fixed interest rate
is swapped for a floating interest rate. The OIS
rate is the best proxy for the risk-free rate in the
valuation of collateralized derivatives portfolios.
Put-Call Parity
c-p=S-Xe-rT
where:
=price of a call
c
p =price of a put
S =price of the underlying security
r =risk-free rate
T =time left to expiration expressed n
i years
Volatility Smiles
Currency options: implied volatility is lower for
at-the-money options than it is for away-from
the-money options. If the implied volatilities for
actual currency options are greater for away-from
the-money than at-the-money options, currency
traders must think there is a greater chance of
extreme price movements than predicted by a
lognormal distribution.
Equity options: higher implied volatility for low
strike price options. The volatility smirk (half
smile) exhibited by equity options translates into
a left-skewed implied distribution of equity price
changes. This indicates that traders believe the
probability of large down movements in price
is greater than large up movements in price, as
compared with a lognormal distribution.
CREDIT RISK MEASUREMENT
AND MANAGEMENT
Credit Risk
Credit risk is either the risk of economic loss from
default, or changes in credit events or credit ratings.
Types of credit risky securities include: corporate
and sovereign debt, credit derivatives, and
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structured credit products. Their interest rates
include a credit spread above credit risk-free
secur1t1es.
Expected Loss (EL)
Expected value of a credit loss:
EL=PD (1 -RR) exposure = PD LGD
rate
x x x
Probability ofdefault (PD): likelihood that a
borrower will default within a specified time
horizon.
Loss gi.ven default (LGD): amount of creditor loss
in the event of a default. In percent terms, it is
equal to 1 minus the recovery rate (i.e., 1 -RR).
Exposure at default: amount of money the lender
can lose in the event of a borrower's default.
The Merton Model
A value-based model where the value of the firm's
outstanding debt (D) plus equity (E) is equal to
the value of the firm CV).
The value of the debt can serve as an indicator of
firm default risk.
Since E and D are co nti ngent claims, option
pricing can be used to determine their values as
follows:
payment to shareholders: max(VM-DM, 0)
payment to debtholders:
DM -max(D M - VM' 0)
Equity is similar to a long call option on the value
of a firm's assets where face value of debt is the
strike price of the option.
Debt is similar to a risk-free bond and short put
option on the value of a firm's assets where face
value of debt is the strike price of the option.
The KMV Model
Built on the Merton model and tries to adjust
for some of its shortcomings. Assumes there are
only two debt issues. The default threshold is a
linear combination of these values and is equal
to the par value of the firm's liabilities. A rule for
determining the default threshold is:
short-term liabilities + 0.5 long-term liabilities
x
The distance to default (DD) calculates the
number of standard deviations between the mean
of the asset distribution and the default threshold.
pected asset value -
------
ex
default threshold
DD=
standard deviation of
expected asset value
Once DD is computed, the probability of default
can be found by evaluating the DD of other
firms that have defaulted.
Credit Scoring Models
Fisher linear discriminant analysis: segregates a
larger group into homogeneous subgroups.
Parametric discrimination: uses a score function
determine the members of the subgroups. The
to
score determines which subgroup the observation is
placed in (likely-to-default or not-likely-to-default
group).
K-nearest neighbor: categorizes a new entrant by how
closely it resembles members already in groups.
Support vector machines: divides larger group into
subgroups using hyperplanes.
Credit Spread
Difference between the yield on a risky bond
(e.g., corporate bond) and the yield on a risk
free bond (e.g., T-bond) given that the two
instruments have the same maturity.
CS=-
(T-t)
l ] ()
x1n D -Rp
F
where:
D =current value of debt
F =face value of debt
Credit Risk Portfolio Models
These models attempt to estimate a portfolio's credit
value at risk. Credit VaR differs from market VaR
in that it measures losses that are due specifically to
default risk and credit deterioration risk.
CreditRisk+: determines default probability
correlations and default probabilities by using a
set of common risk factors for each obligor.
CreditMetrics: uses historical data to estimate
the probability of a bond being upgraded or
downgraded using historical transition matrices.
KMY Portfolio Manager: default probability is
a function of firm asset growth and the level of
debt. The higher the growth and lower the debt
level, the lower the default probability.
CreditPortfolio View: multifactor model for
simulating joint conditional distributions of
credit migration and default probabilities that
incorporates macroeconomic factors.
Credit Derivatives
A credit derivative is a contract with payoffs
contingent on a specified credit event. Credit
events include:
Failure to make required payments.
Restructuring that harms the creditor.
Invocation of cross-default clause.
Bankruptcy.
Credit default swap (CDS): like insurance; party
selling the protection receives a fee, pays based on
swap's notional amount in the case of default.
First-to-default put: CDS variation where a party
pays an insurance premium in exchange for being
made whole for the first default from a basket of
assets. More cost effective option than CDS if
assets have uncorrelated default risks.
Total return swap: total return on an asset {bond)
is exchanged for a fixed {or variable) payment;
total return receiver gets any appreciation (capital
gains and cash flows), pays any depreciation;
payments take place whether or not a credit
event occurs. Buyer exchanges credit risk of issuer
defaulting for the combined risk of the issuer and
the derivative counterparty.
Vulnerable option: option with default risk; holder
receives promised payment only if seller of the
option is able to make the payment.
Asset-backed credit-linked note: embeds a default
swap into a debt issuance. It is a debt instrument
with its coupon and principal risk tied to an
underlying debt instrument (e.g., bond or loan).
Spread Conventions
Yield spread: ITM risky bond-ITM benchmark
government bond
i-spread: ITM risky bond-linearly interpolated
ITM on benchmark government bond
z-spread: basis points added co each spot rate on a
benchmark curve
CDS spread: market premium of CDS of issuer
bond
Hazard Rates
The hazard rate (default intensity) is represented
by the (constant) parameter A and the probability
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of default over the next, small time interval, dt,
is >..dt.
Cumulative PD
If the time of the default event is denoted t*,
the cumulative default time distribution F(t)
represents the probability of default over (O, t):
P(t* < t ) = F(t) = 1 - e->-<
The survival distribution is:
P(t* > t) = 1 - F(t) = e->-c
Probability of Default
The probability of default (PD) of a debt security
can be calculated by using the following equation:
CS
PD=
LGD
CS represents the credit spread, which is the
difference between the yield on risky debt and the
risk-free rate. Loss given default (LGD) is equal to
one minus the recovery rate.
Single-Factor Model
Examines the impact of varying default
correlations based on a credit position's beta. Each
individual firm or credit, i, has a beta correlation,
/3., with the market, m. Firm i's individual asset
'
return is defined as:
aI = A.m
1-'1 +Ji A7E.
1-'1 I
where:
Ji f3r = firm's standard deviation of
idiosyncratic risk
E; = firm's idiosyncratic shock
Originate-to-Distribute Model
Enables lenders to originate a loan based on
risk/reward pricing and then outsource the risk
through various channels. This provides better
access to capital for less creditworthy borrowers
and more diversification options for investors.
Collateralized Debt Obligations
General term for an asset-backed security that
issues securities that pay principal and interest from
a collateral pool of debt instruments.
In order to create a CDO, the issuer packages a
series of debt instruments and splits the package
into several classes of securities called tranches.
The largest part of a CDO is typically the senior
tranche, which usually carries an AA or AAA credit
rating, regardless of the quality of the underlying
assets in the pool.
Synthetic CDO: originator retains reference assets
on balance sheet but transfers credit risk to an
SPY, which then creates the tradable synthetic
CDO. This product bets on the default of a pool
of assets, not on the assets themselves.
Securitization
Transforms the illiquid assets of a financial
institution into a package of asset-backed
securities (ABSs) or mortgage-backed securities
(MBSs). A third party uses credit enhancements,
liquidity enhancements, and structuring to issue
securities backed by the pooled cash flows (of the
same underlying assets).
Credit enhancements include overcollateraliution,
subordinating note classes, margin step-up, and
excess spread.
The first-loss piece (equity piece) absorbs initial
losses and is often held by the originator.
QQ106454842 CFA FRM+
ABS/MBS Performance Tools
Auto loans: loss curves, absolute prepayment speed.
Credit card debt: delinquency ratio, default ratio,
monthly payment rate.
Mortgages: debt service coverage ratio, weighted
average coupon, weighted average maturity,
weighted average life, single monthly mortality,
constant prepayment rate, Public Securities
Association.
Subprime Mortgage Market
Subprime borrowers have a history of either default
or strong indicators of possible future default.
Indicators of future default: past delinquencies,
mcrement.
judgments, foreclosures, repossessions, charge-offs,
and bankruptcy filings; low FICO scores; high debt
service ratio of 50o/o or more.
The vast majority of subprime loans are adjustable
rate mortgages.
Counterparty Risk
The risk that a counterparty is unable or
unwilling to live up to its contractual obligations.
Credit exposure: loss that is "conditional" on the
counterparty defaulting.
Recovery: measured by the recovery rate, which
is the portion of the outstanding claim actually
recovered after default.
Wrong-way exposures: exposures that are negatively
correlated with the counterparty's credit quality.
They increase expected credit losses.
Mark-to-market (MtM): accrual accounting
measure that is equal to the sum of the MtM
values of all contracts with a given counterparty.
Credit Exposure Metrics
Expected MtM: forward or expected value of a
transaction at a given point in the future.
Expected exposure (EE): amount that is expected
to be lost (positive MtM only) if the counterparty
defaults.
Potentialfuture exposure (PFE): worst exposure
that could occur at a given time in the future at a
given confidence level.
Expected positive exposure (EPE): average EE
through time.
Effective EE: equal to non-decreasing EE.
Effective EPE: average of effective EE.
Maximum PFE: highest PFE value over a stated
time frame.
Credit Mitigation Techniques
Netting: a legally binding agreement that enables
counterparties with multiple derivative contracts
to net their obligations (e.g., Party A owes Party B
$50 million; Party B owes Party A $40 million, so
Party A pays a net $10 million to Party B).
Colla.tera/ization: if the value of derivative
contracts is above a stated threshold, collateral
must equal the difference between the value of
the contracts and the threshold level. Collateral
agreements have two major benefits: (1) expand
the list of potential counterparties because credit
rating is a less important concern and (2) reduce
economic capital requirements.
Modeling Collateral
Certain parameters impact the effectiveness of
collateral in lessening credit exposure. These
parameters are as follows:
Remargi.n period: the time between the call for
collateral and its receipt.
Threshold: an exposure level below which
collateral is not called. It represents an amount of
uncollateralized exposure.
Minimum transfer amount: the minimum quantity
or block in which collateral may be transferred.
Quantities below this amount represent
uncollateralized exposure.
Independent amount: an amount posted
independently of any subsequent collateralization.
This is also referred to as the initial margin.
Rounding. the process by which a collateral call
amount will be adjusted (rounded) to a certain
Central Counterparties
The main role of a central counterparty (CCP)
is to manage and control systemic risk. The CCP
performs the following functions: valuation and
settlement in OTC markets, trade compression
and netting, collateral managem ent, increase
transparency, loss mutuali:zation, a.nd auction
process for defaulted members.
Credit Value Adjustment {CVA)
Expected value or price of counterparty credit
risk. A positive value represents a cost to the
counterparty that bears a greater propensity
to default. The CVA should account for the
counterparty's default probability, the transaction
in question, netting, collateral, and hedging.
m
CVALGDx L: d(t i)xEE(t i)xPD(t i-1' ti)
i 1
=
where:
d(t) discount factors
=
Incremental and Marginal CVA
Incremental CVA calculates the cost of a new trade
versus an existing one to determine the effect
that the new trade has on CVA The formula is
identical to stand-alone CVA, except for the use of
incremental expected exposure.
Marginal CVA is used for trade level attribution.
The formula is identical to stand-alone CVA,
except for the use of marginal expected exposure.
Risk-Neutral Default Probability
Represents estimates of default probability based
on observed market prices of securities (e.g.,
bonds, credit default swaps).
risk-neutral default probability real-world
=
default probability + liquidity premium + default
risk premium
Wrong-Way Risk vs. Right-Way Risk
Wrong-way risk increases counterparty risk
[increases credit value adjustment (CVA) and
decreases debt value adjustment (DVA)].
Right--way risk decreases counterparty risk
(decreases CVA and increases DVA).
Risk-Adjusted Return on Capital
The RAROC measure is essential to successful
integrated risk management. Its main function
is to relate the return on capital to the riskiness
of firm investments. The RAROC is risk
adjusted return divided by risk-adjusted capital
(i.e., economic capital).
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RAROC=
revenues - costs- EL- tues +
rcrurn on economic capital uansfcrs
economic capital
An adj usted RAROC (ARAROC) measure was
de veloped to better align the risk ofthe busin ess
with the risk of the firm's equity.
Adjusted llAROC RAROC e(l\., il,, )
= - -
ModdRisk
Risk associated with using financial models to
simulate complex relationships. Sources ofmodel
risk include model errors, errors in assumptions,
and errors i n implementation. Common model
errors include u nderestimating risk fuctors,
misapplying a mode l, and assuming con stan t
volatility, nor mal distributions, perfect markets,
and adequa te liquidity.
liquidity Risk
lbe lack ofa market for a security to prevent i t
from being bought or sold quickly enough to
prevent or minimize a loss. It could result from
asse t allocation, funding strategies, collareral
policies, or mismanagement of risks.
Transactions liquidity risk: ri sk that the act o f
b uying or selling an asset will resul t in an adverse
Funding liquidity risk: results when a borrower's
price move.
credit position s
i either deteriorating or
is perceived by market participants to be
deteriorating.
liquidity-Adjusted VaR
The constant spread approach calculates liquidity
adjusted Vall (LVaR) assuming the bid-ask spread
is co n stant .
LVaR = (V xz.,, x " + (o.5 x V x spread)
) Transaction Cost
VaR + liqwdicy oost
LVaR =
where:
V asset value
>. VaR confidence parameter
a standard deviation ofreturns
(askprice - bidprice )
ead
spr
(ask price + bid price) I 2
LVaR can also be calculated given the
distributional charaaeristics ofthe spread. This
is known as the =>gmtruSpreadapp roarh. Ifyou
arcgiven the mean and standard d eviation of the
spread, apply the following formula:
LVaR = VaR + 0.5 x(5 + z xas) x V
whe re:
s spread mean
spread standard deviation
as
Z:,
spread confidence param eter
liquidity at Risk (LaR)
Maximum likely cash oudlow over the horizon
period at a specified confidence lc:vtl.
Also kn own as cash l!CJW at risk (CFR).
A p ositive (negative) value for Lall means rhe
worst outcome. will be assoca i ted with an outflow
(in8ow) ofcash.
LaR i.s similar to VaR, but nsi tead of a chnge in
valu e, it deals with cash l!CJWS.
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Enterprise Risk Management (ERM) Loss Distribution Approach
In developing an ERM system, management The loss distribution apptoach (LOA) is used to
should follow the following framework:
meet the Ba.sel 11 operational risk standards for
Dctenninc the firm's ac.ccptoblc lcvd ofrisk. regulatory capital. The LOA has several steps:
Based on the firm's target debt rating, c:Stimore the
Organize and group loss data into a business line/
(i.e., buA'er) required to support the curre.nt
capitol a-cnt type mauix.
level of risk in che firm's operations.
W eight every data point in the matrix.
Determine <he ideal mix ofcapitol and risk that will
Model a loss diS<rihurion in each cell of the matrix.
Determine <he operational risk capital requireme n ts
achieve the appropriate debt r a ting .
Give individual managers the information and the fur each bW1iness line.
incen tive they n eed to make decisions ppropriate
Frequency Distributions
to maint2in the risk/capitol trade-of!:
LOA models most ofren use the Poisson
Identify the risks ofthe firm.
The implementation steps ofERM arc as follows: distribution, the negative binomial distribution, or
the binomial distribution.
Oe>-dop a consistent method to evaluate the firm's
Practitionert suggest only using internal data
exposure to the idencified risks. because it is most relevant and it i.s difficult tO
Firm-Wide VaR ensure the completeness ofexternal data.
Firms that use value a t risk (VaR) to assess poten tial
Modeling the frequency distribution requires less
loss amounts will have m ultip le VaR measures <o da ta when compared to modeling severity.
manage. Severity Distributions
Market risk, credit risk, and operational rik
s will The sc:vcrity ofeach event follows a parametric
each produce ics own VaR measures. distribution, such os a lognormal distribution or a
Due to diversification dfcccs, firm-wide VaR will be Weibull distribution.
less than me sum oftheVaRs from each risk cagoty.
Severity distributions arc generally conside red morc
Leverage Ratio important than frequency distributions.
recen t internal loss data may not be sufficient for
A firm's leverage ratio is equal to its assets divided
One problem with modeling severity is that
by equ ity:
A (E+D) D calibrating <he <ails of <he distribution.
L=-- = l+ .,-
Using extern! data usually requires scaling the data
E E E
and oombining data from several soured.
Leverage Effect
Repurchase Agreements (Repos)
Return on equity (ROE) is higher as leverage
or a spcc:ilicd price with a commitment to buy bade
Bilateral conaaru where one pany sells a JCCUrity
increases, as long as the firm's return on assctS
(ROA) cxoecds t h e cost ofborrowing funds. m e the security at a furore dace at a higher price.
relatively chep sources ofshon-tc.rm funds.
leverage effect can be expressed as:
From the perspective of the borrower. rcpos oA'er
ROE= (leverage rati o x ROA) -
((leverage ratio- I) x cost of debt)
From the perspective ofthe lender. reverse repos arc
used for ei<her investing or financing purposes.
Capital Plan Rule
The 99% confidence n
i terval on transoction cost is:
2.33a) adequacy.
Mandates thor bnk holding companies develop a
+I- P x (s +
capitol plan and evaluate capital
Capitol adequacy process includes: risk
where:
management foundation, resource and loss
P estirrw:e ofthe next day asset midprice
estimation me thods, impact on capitol adcqucy,
=
s bid-ask spread
2.33a) 99% spread risk factor
capital plnning and internal controls policies, and
=
(s +
gCJVcrnance CJVtrsight.
Operational Risk Data Elements Operational Risk Governance
The four data elements that a bank m ust use in
The Basel Committee recognizes three common
various com bin ation s to calculate the opera tio n al
lines of defense used <O control operational risks:
risk capital charge based on the AMA framework
(I) business line management, (2) independen t
(I) internal loss data, (2) external loss data,
(3) scenario analysis, and (4) business environment
are
operational risk management function, and
(3) independent reviews ofoperational risks and
and internal control faaors (BElCFs).
risk m anagement.
Basel II Operational Risk Event Types
Risk Ap p etite Framework (RAF)
Internal Fraud.
l
Sets in p ae
c dear, fu<ure-oriented perspcccivc of
External Fraud.
the firm s target risk profile in a number of diA'erent
'
Employment Practices and Workplace Safety.
scenarios and maps out a strategy fur achieving chat
Damage to Physical Assets.
Clien<s Products, and Business Practices.
risk profile.
,
is essentially a mission statement from a risk
Should start with a risk appetite state ment that
Busin"" Oi.sruption and System r..Uures.
perspective.
Execution, Delivery, and Process Management.
Enemal Loss Data
Benefits include assisting fums in preparing for the
IBMAlgo F!RS7: subscription database; includes
uncxpcacd and greatly improving a firm's saatcgic
descriptions and analyses of operational risk planning and tactical decision-making.
events derived from legal and regulatory sources Basd II: Three Pillars
Pillar 1: Minimum capital requirements. Banks
and n ews articles.
OpemtilJnal Rik
s data eXchange Association should maintain a minimum level of capital to
(ORX): consortium-based risk event service; cover credit, market, and operati onal risks.
Pillar 2: Suisory rroinu proce.n. Banks should
gathers anonymous operational risk events from
assess the adequacy ofcapital relative to risk, and
members.
www.mxkaozi.com
supervisors should review and take corrective
action if problems occur.
Pillar 3: Market discipline. Risks should be
adequately disclosed in order to allow market
participants to assess a bank's risk profile and the
adequacy of its capital.
Basel II: Forms ofCapital
Tzer I: shareholder's equity, retained earnings;
nonredeemable, noncumulative preferred stock.
Tzer 2: undisclosed reserves, revaluation reserves,
general provisions/general loan-loss reserves,
hybrid debt capital instruments, and s ubordinated
term debt.
Credit Risk Capital Requirements
The standardized approach incorporates
risk weights based on external credit rating
assessments. The amount of capital that a bank
must hold is specific to the risk of credit-risky
assets, the type of institution the claim is written
on, and the maturity of those assets.
The internal ratingr-based (IRE) approaches
(foundation and advanced) use a bank's own
internal estimates of creditworthiness to determine
the risk weightings in the capital calculation.
Foundation approach: bank estimates probability of
default (PD}.
Advanced approach: bank estimates not only PD,
bu t also loss given default (LGD), exposure at
default (EAD), and elfectivc mat ity (M).
ur
Market Risk Capital Requirements
Standardi.udmethod: determines capital charges
associated with various market risk exposures
(equity risk, interest rate risk, foreign exchange
risk, commodity risk, and option risk). The
market risk capital charge for eacl1 market risk is
computed as 8% of its market-risky assets.
Internal models approach (IMA): allows a bank
to use its own risk management systems to
determine its market risk capital charge. The
market risk charge is the higher of (I) the
previous day's VaR or (2) the average VaR over the
last 60 business days adjusted by a multiplicative
factor (subject to afloor of3).
Backtesting VaR
An exception occurs if the day's change in value
exceeded the VaR estimate of the previous day.
When backtesting VaR, the number of exceptions
is determined for a 250-<lay testing period. Based
on the number of exceptions, the bank's exposure
is categorized into one of three zones andVaR is
scaled up by the appropriate multiplier (subject to
a floor of 3).
Green zone: 0-4 exceptions, increase in exposure
multipli er is 0.
Yellow zone:. 5-9 exceptions, exposure. multiplic.r
increases b etween 0.4 and 0.85.
Red zone: Greater than or equal to l0 exceptions,
multiplier increases by I.
Operational Risk Capital
Requirements
Basic indicator approach: measures the capital
charge on a firm-wide basis. Banks will hold capital
for operational risk equal to afixed percentage
of the bank's average annual gross income over
the prior three years. The Basel Committee has
proposed a fixed percentage equal to l 5o/o.
Standardi.udapproach: allows banks to divide
activities along standardized business lines.
QQ106454842 CFA FRM+
Within each business line, gross income will
Established Financial Stability Oversight Council
be multiplied by a fixed beta factor. The capital (FSOC).
charge for operational risk is the sum of eacl1 Establ is h ed Office of Financial Research (OFR).
business line's cl1arges. The beta factors for the
Established Volker Ruic, intend ed to curtail
eight business lines are as follows: proprietary trading by banks.
Banks considered too-big-to-fail must be identified
Tradi ng and sales: 18%
and could be broken up if their living wills arc
Corporate finance: 18%
judg e-cl unacceptable.
Payme nt, settlement: 18%
Commercial banking: 15%
Increas e-cl regulation and improved transparency fur
Agency scrvicc-s: 15% over-the-counter (OTC) derivatives.
Rcrail banking: 12 %
Retail b kerage: 12 %
ro
Asset management: 12%
AdvancedMeasurement Approach (AMA): lfa bank
can meet more rigorous supervisory standards,
it may use the AMA for operational risk capital
calculations. The capital charge for AMA is
Portfolio Construction Techniques
calculated as the bank's operational value at risk
Screens simply choose assets by ranking alpha.
(OpVaR) with a I-year horizon and a 99.9%
Stratification chooses stocks based on screens.;
confidence level. Having insurance can reduce this includes assets from all asset classes.
capital charge by as much as 20%.
Linear programming attempts to construct a
Basd III Changes portfolio that closely resembles the benchmark.
Raise capital sta
ndar ds (both quality and quantity).
Quadratic programming explicitly considers alpha,
Strengthen risk coverage of capital framework. risk, and transactions costs.
Require k-veragc ratio to supplement capital Portfolio Risk
rcqwrcmcnts. Divenified VaR:
Promote countercyclical bulfers during financial
shocks. w?o?+ wiaI +
VaRp=ZcxPx
Instit ute policies to address systemic risk and 2w1w2"1 "2P1.2
interconnectedness.
Institute global liquidity standard (liquidity, Undiverrifod VaR:
funding, and mon itoring me.tries}.
VaRp = r
_ _ _ _
VaR?_
a_ _ _+_ - _
_R _ _ _ _ _
+V 2VaR1 V a R2
Liquidity Coverage Ratio =VaR1 +VaR2
Goal: ensure banks have adequate, high-quality
liquid assets to survive short-term stress scenario. V..Rfor Uncorrelated Positions:
LCR (stock of high-quality liquid ass ets I total net
=
2 2
VaRp= VaR1 + VaR2
cash ou tAows over next 30 calendar days) > 100
Net Stable Funding Ratio Marginal VaR: per dollar change in portfolio VaR
Goal: protect banks over a longer time horizon that occurs from an additional investment in a
than LCR. pos1t1on.
NSF R (available. amount of stable funding I VaRp
=
MVaR = xi3
re-quired amount of stable funding) > 100
1 portfolio value 1
Stressed Value at Risk How to use MVaR:
SVaR is calculated by combining current portfolio
Obtain the optimal portfulio: equate the excess
performance data with the firm's historical data rcturn/MVaR ratios of all portfulio positions.
from a significantly financial stressed period in tl1e
Obtain the lowest portfolio VaR: equate just the
same portfolio. Calculation of SVaR is defined as MVaRs of all portfolio positions.
follows: Incremental VaR: change in VaR from the addition
max (SVaR,_p mulciplicarive factor x SVaR3vg) of a new position in a portfolio.
Component VaR: amount of risk aparticular fund
Solvency II contributes to a portfolio of funds.
Establishes capital requirements for tl1e operational, CVaRl = MVaR xwl x P =VaR xi3I x wt
investment, and underwriting risks of insurance
companies. Risk Budgeting
Specifics minimum capital requirements (MCR) Manager establishes a risk budget for the entire
and solvency capital requirements (SCR). portfolio and then allocates risk to individual
SC R may b e calculated using either standardized
positions based on a predetermined fund risk
approach or internal models approach.
level. The risk budgeting process differs from
Standardized approach: Intended for k-ss
market value allocation since it involves the
sophis tca
i tc..-d insurance firms; captures the risk
profile ofthe average insurance firm.
allocation of risk.
Budgeting risk across as1et clas1es: selecting assets
lnu:rna/ models approach: Similar to the !RB
approach under Basel II. A VaR is calculat edwith whose combined VaRs are less than the total
a one-year tim e horizon and a 99.5% confidence allowed.
level. Budgeting risk across active managers: the optimal
allocation is achieved with the following formula:
Dodd-Frank Act
Intended to protect consumers from abuses and g
wei ht of portfolio managed b y manager i
I ; x portfolio ' s tracking error
R
prevent future bailouts and/or collapses of banks =
I Rp x manager's tr acking erro r
and otl1er financial firms.
www.mxkaozi.com QQ106454842 CFA FRM+
Liquidity Duration It can be illustrated by comparing the CML for
Approximation ofrhe numb ofdays ncccs.sary the market index and the CAL for the managed
to dispose ofa pcrtfolios holdings wirhout a
' portfolio. The difference in return between the

Risk
significant market impact. tw0 portfolios equals the M' measure.

_ number of shares of a security Performance Atttibution

Best Practices n i Management
LO Use long time periods to spot key trends.
[desired max daily volume (%)

Asset allocation attribution equals the difference Use more stress resting scenarios to take int0
X daily volume]

in returns attributable to active asset allocation account regime changes.

decisions of the portfolio manager.
Do not vic.."W risk-mitigatingactions in isolation.
Time-Weighted and Dollar-Weighted Selection attribution equals rhe difference in
Establish provisions fur loan losses.
Returns returns attributable to superior individual
Clear derivatives through a CCP.
Dollarwtighttd ratt ofreturn: the internal rate of security selection (corr= selection of mispriced
return (IRR) on a portfolio taking into account securities) and sector allocation (correct over and
Funding Mechanisms
Allow institutions to obtain short-term financing
all cash nflows
i and outHows. undCIWCigbt:ing ofsectors within asset classes). for funding requirements. Mechanisms include
Time-wtighttd ratt ofmum: measures compound
Hedge Fund Strategies commercial paper, asset-backed commercial
growth. It s
i rhe rare at which $1 compcunds over
Equity long/short strategy: go long and short paper, money masket mutual funds, repurchase
a specified time horizon. transactions, credit commitments, and dollas
Measures of Performance
similar securities to exploit mispricings
funding ofnonU.S. banks
decreases market risk and generates alpha.
.

The Sharpt ratio calculates the amount ofexcess Global macro strategy: makes leveraged betS on Lender ofLast Resort (IOLR) Lending
return (over rhe risk-free rate) earned per unit anticipated price movements in broad equity Can help stem a liquidity crisis before it worsens.
of total risk. It uses standard deviation as the and fixed-income markets, interest rates, foreign Liquidity regulations should complement LOLR

Advantages: {I) liquidity creation for socicral good

relevant measure ofrisk. solutions.
exchange, and commodities.
- -
_ RA - RF M ana
gedfo rum strattgy: focuses on investments
SA - and (2) promotes optimal levels ofliquidity and
oA
in bond, equity, commodity futures, and currency maturity transformation.
markets around the world. Employs a high degree Challenges: (I) potential moral hazard costs,
where: ofleverage because futures contraets are used.
Fixed-income arbitrage strategy: long/short strategy
(2) takes time to determine ifproblem is market
RA average account return wide liquidity event, and (3) taking too much
that looks for pricing n
i efficiencies between

RF = average
risk-free return
The 11-tynor measure is very similar to the Sharpe
standard deviation ofaccount returns
aA
ratio cx.ccpt that it uses beta (systematic risk) as rhe
measure ofrisk. It shows exce<,< return {over the
collateral for protection.
various fixed-income securities.
Dimensions ofLiquidity
Immediacy: Time to complete a transaction.
Conwrtiblt arbitrage strategy: investor purchases
a convcniblc bond and sells short the underlying Depth andmilience: Frequency oflarge trades and
stock. level ofwillingness and interest to transact.
Breadlh: Consincncy in distributing liquidity

risk-free rate) earned per unit ofsystematic risk. Merger arbitrage straugy: involves purchasing
- - shares in a target firm and selling short shares n
i within assets and across maskets.
_ R A -RF
TA - the purchasing firm. lightness: Cost ofcompleting a transaction.
iJA Di.strwed inlNlstingstrategy: purchase bonds of Multi-dimensional: Combination of factotS. Includes
distressed company and sell short the stock, price-based rncasures and market impact rneasures.
where:
anticipating that the shares will eventually be Reforming Benchmark Rates
RA average account return
worthless. In order to make benchmark rates, such as

fJA = average beta

RF
= average risk-free return
Emerging marlrenstrategy: invests in developing LIBOR, less susceptible to manipulation, it is
jmsm's alpha si rhe difference bctwccn actual
recommended to {I) base benchmark rates on
traruactions {rather than submissions) and (2) use
countries' securities or sovereign debt.
Fund ofhe dgefonds: perform screening and due
return and return required to compensate for a second benchmark rate (e.g., frcasury bill rates,
diligence of other funds. Fees can be extensive,
and the due diligence does not always identify
systematic risk. To calculate the measure, subtract rates set by central banks general collateral repo
,

the return calculated by the capiral asset pricing rates, or rhe 01$ rate).
fraud. A key advantage is diversification benefit
model (CAPM) from the account return. without large capital commitment. Central Counterparty Failures
O'.A = RA - E(R.J Measures to decrease the probability or i1npact of
Illiquid A.uet Return Biases a CCP failure include increaserl regulation and
where: Biases that impact repcrted illiquid asset returns: standards for CCPs, recovery planning, emergency
liquidity available through the central bank, bank
O'.A alpha Surviwnhip biln: Poor performing funds ofu:n quit
n:porting results, ulrimatdy fail, or never begin

RA the return on the account

E(RA) R, +!iA[E(R,.,) - R,J n:porting rcturnS because pcrt'orrnancc is weak. resolution planning.
capiral requirements to cover CCP exposures, and

&ltion bias: Asset values and returns tend co be

reported when ihcy arc high.
The infomunion ratio is the ratio of surplus return

Stress Testing Ewlution

Infrequent t:rrtdjng: Betas, volatilities, and In November 20 I I, the Federal Reserve
{in a particular period) to its standard deviation.
It indicates the amount of risk undertaken

(denominator) to achieve a certain level of return correlations arc too low when they arc computed implemented a system ofannual capiral plan
using the reported returns of infrequently traded compliance known as the Comprehensive
above die benchmark (numerator).
-- assets. Capital Analysis and Review (CCAR) process. It
RA -Rs applies to bank holding companies (BHCs) with
IRA =
aA B S50+ billion in consolidated assets. This annual
review process enables the Fed to have more timely
PPN: 32007228
where: information and to properly assess bank health.
ISBN1 3 : 9781 475438208
RA average account return Cybersecurity Framework
Five core functions: (I) identify, (2) protect,

RF average risk-free return

aA " standard deviation of excess returns

(3) detect, (4) respond, and (5) recover.
measured as rhe difference between
Risk asscssmcnr includes classifying informacion,
account and benchmark returns identifying ihrcats and vulnerabilities, measuring
The Msquared (M2) measure compares return risk, and communicating risk.
Protcc.tion measures include customer
7 8 1 4 7 5 438208
earned on the managed portfolio against the

9 authentication, access controls data security, secure

market return, afrer adjusting for differences in
,

configuration, and fucwalls.

standard deviations between the tw0 pcrtfolios.
U.S.$29.00 C2016laplan, Inc. All Rights A