STRESS TESTING AND OTHER RISK MANAGEMENT TOOLS

--------------------------------------------------------------------
Differences between stress testing and var / economic capital EC:

1. VAR EC point to economic losses and ST to accounting losses

2. Time horizon of ST is large
3. ST donot use numeric or cardinal probabilities. THEY use ordinal probabilities - base case, best case and worst case
4. ST uses conditional cases. VAR EC analyses are unconditional
5. In practice, stress tests focus on a few scenarios, whereas VaR measures commonly utilize a very large number of scenarios.
--------------------------------------------------
Advantages and disadvantage of such stress test metrics:
The advantage is that the risk metric with a stressed input will be more conservative. Disadvantage is that the risk metric is not
responsive to the current/real market condition.
--------------------------------------------------
What is the standard to calculate stressed VAR - SVAR?
10-day || 99 percent || one tailed VAR
Trick: VAR IS always one-tailed, so no issues there. the standard has to be the strictest among the 3 known % vars. so use 99%. 10-
day should be a good time to buy/sell assets, so use 10 day.
--------------------------------------------------
Which Basel standard mandates stressed inputs and for measuring which risk?
Basel III and Counterparty RISK (Subset of credit risk)
--------------------------------------------------
What is CVA?
Credit Valuation Adjustments - Expected Value of the price of counterparty credit risk
--------------------------------------------------
Use of stress test in CVA:
ST is used to compute capital charge for CVAs. Unstressed VAR of CVA is always LOWER than stressed VAR of CVA. This is made by
adjusting the stress period while calculating the stressed VAR of CVA.
--------------------------------------------------
How are stress test results implemented? HOW to ingrate var with stress tests?
In an attempt to assign a probability to a hypothetical or historical stress scenario, one could determine where the stress test losses
fall within the VaR/EC loss distribution. By assigning probabilities to outcomes, the calculated probability from the loss distribution
facilitates the implementation of stress test results.
--------------------------------------------------
If a bank uses PD-LGD approach to calculate stress losses, which of the following input can change?
a) An abrupt drop in exposures (EAD); e.g., EADs drop by 30.0%
b) Transition to lower rating buckets; e.g., $500 million transitions to Rating 7
c) Stressed default probabilities (PDs); e.g., for Rating bucket 3 the PD spikes to 4.0%
d) Stressed loss given default (LGD); e.g., LGD increases by 10.0% for all rating buckets

A: PD, LGD can change as per the stress in the market. EAD cannot change.
--------------------------------------------------
Mention 1st, 2nd and 3rd lines of defense in ST governance.
1st line of defense: Business owners (Senior mgmt and BOD)
2nd line of defense: Risk management function
3rd line of defense: Audit
--------------------------------------------------
STRESS TESTING COVERAGE INCLUDES:
1. Documentation of which assets/factors/exposures are included for ST and which are not.
2. Which levels (institution/sub-institution) is ST applicable
3. Detection of risk concentrations
4. Correlations among different risk types and exposures
5. Coverage on long term and short term basis
--------------------------------------------------
CAPITAL AND LIQUIDITY STRESS TESTING INCLUDES:
1. CL ST should be in sync with overall strategy
2. CL ST should include simultaneous impact of all risks and on all aspects of money - profits, cashflows, liquidity, capital
3. CL ST should aid in contigency planning (raising capital) by identifying excess exposures and scope for strengthening liquidity and
capital positions
4. CL ST should consider impact on subsidiaries
5. Should include scenarios: an institution may need to sell assets at depressed market prices or incur funding costs at above-market
rates.
6. FIN Institutions should clearly state their objectives wrt capital and liquidity funding costs.
--------------------------------------------------
ST TYPES AND APPROACHES:
1. cumulative knock on effects should be considered.
2. scenarios should include dirm specific as well as system wide impact
3. scenarios should include both - historical and hypothetical scenarios
4. For a firm-wide analysis, all departments should use same assumptions
5. ST should include BREAK THE BANK or REVERSE ST techniques.
6. scenarios should be robust to both internal and external stakeholders

PRINCIPLES OF STRESS TESTING

Parameters of 1-d stress testing scenarios:
1. Yield curve shift 4. Equity index change
2. Yield curve twist 5. Implied volatility changes
3. Exchange rate increase 6. Swap rates changes

Role of stress testing:

1. Internal and external communication
2. Risk tolerance
3. Contingency planning in stressed situations
4. Forward looking view
5. Capital and Liquidity planning
6. Overcoming limitations of models
-------------------------------------------------
4 areas in which weaknesses and recommendations are discussed:
ST in risk governance R
ST methodologies M
ST scenarios S
ST for special products P
----------------------------------
ARBITRAGE PRICING THEORY

Is there an arbitrage opportunity?

Ans: Yes, an arbitrage includes buying portfolio (B) and selling a combination of (A)
and (C)
There is no arbitrage opportunity if all three well-diversified portfolios plot on the security market line (SML). This can be
tested by calculating their respective Treynor ratios. But in this case, it is not true that all portfolios have the same
Treynor:
(9.0% - 1.0%)/1.60 =? (7.0% - 1.0%)/1.10 =? (4.0% - 1.0%)/0.60 as the Treynor (A) and Treynor (C) = 0.050 but the
Treynor (B) = 0.0545;
i.e., our arbitrage is to buy the "cheap" Portfolio B (with the higher Treynor) and sell the "expensive" blend of Portfolios
(A) and (C).
Specifically, as Portfolio (B) has a higher Treynor measure, we can create a portfolio consisting of 50% of Portfolio (A)
and 50% of Portfolio (C) such that, This blended portfolio has expected return = (50% * 9.0%) + (50% * 4.0%) = 6.50%
and beta = (50% * 1.60) + (50% * 0.60) = 1.10.
The arbitrage is possible because we have two well-diversified portfolios with identical betas but different expected
returns:
 50/50 blend of Portfolios (A) and (C): beta of 1.10 and E(r) = 6.50%, but
 Portfolio (B): beta of 1.10 and E(r) = 7.0%; same beta but higher expected return

A trader has a put option contract to sell 100 shares of a stock for a strike price of $50.00. Each of the following is true EXCEPT which
is not?

a) If there is a 4-for-1 stock split, the option contract becomes one to sell 400 shares with an exercise price of $12.50
b) If there is an 10.0% stock dividend, the option contract becomes one to sell 90.0 shares with an exercise price of $55.56
c) If there is $2.00 cash dividend declared, there is no effect on the contract
d) If there is a reverse 1-for-5 stock split, the option contract becomes one to sell 20 shares with an exercise price of $250.00

Ans: (b) If there is a 10.0% stock dividend, the option contract becomes one to sell 100*(1+10%) = 110 shares with an exercise price
of $50/(1+10%) = $45.45

Consider an exchange-traded call option contract to buy 500 shares with a strike price of $40 and maturity in four months. Explain
how the terms of the option contract change when there is
a) A 10% stock dividend
b) A 10% cash dividend
c) A 4-for-1 stock split
Answers:
a) The option contract becomes one to buy 500 x 1.1= 550 shares with an exercise price 40/1.1=36.36.
b) There is no effect. The terms of an options contract are not normally adjusted for cash dividends.
c) The option contract becomes one to buy 500 x 4 = 2 000 shares with an exercise price of 40/4 = $10.
A trader has a put option contract to sell 100 shares of a stock for a strike price of $60. What is the effect on the terms of the
contract of:
a) A $2 dividend being declared
b) A $2 dividend being paid
c) A 5-for-2 stock split
d) A 5% stock dividend being paid.

Answers:
a) No effect
b) No effect
c) The put option contract gives the right to sell 250 shares for $24 each
d) The put option contract gives the right to sell 105 shares for 60/1.05 = $57.14

An increase in time to expiration (T) implies an increase in the option price for ALL OPTIONS EXCEPT DIVIDEND PAYING EUROPEAN
PUTS AND DIVIDENT PAYING EUROPEAN CALLS.

The lower bound for a European call option is equal to the Black-Scholes-Merton option value where the volatility input is zero.
Input used for BSM is the historical volatility, and not the implied volatility. So, the 2 volatilities are disparate and have no relation.

COMMODITY FUTURES:

Commodtities which are subject to large demand and supply shocks have a higher convenience yield.

Commodities expected to be in short supply have a higher incentive to be stored than to be traded. Thus they have a
higher convenience yield. Not sure about the ones which have a higher demand (shorter supply)

There is inverse relationship between inventory levels and convenience yield. Higher the inventory levels, lower is the
convenience yield.

The price of renewable commodities (I,e, wheat, corn, which can be grown endlessly) depends on the ability to produce.

The price of NON renewable commodities (i.e. crude oil and minerals) depends on investor demand.

What is the disadvantage, as an investor, if you choose to invest in a stock of a commodity company rather than buying
the commodity itself? Answer: Low corelation of stock price with changing commodity prices.

Contago vs normal contango:

Contago is when futures price > spot price.

This happens when cost is higher than the benefit of convenience yield. F = S + costs – benefits.

Norman Contango happens when:

1. There are more long position takers in commodity futures than short position takers.
2. Say the expected price of commodity if 110 after 1 year and spot is 100.
3. But due to shortage of short position takers, speculators enter the market and provide liquidity. For this, they charge a
premium and take short position only if the futures price is artificially inflated to 120.
4. Thus the entire market increases the futures price to 120 which is > the expected spot price of future (110) This is normal c.

Normal contango happens due to extra supply of long positions. Normal Backwardation happens due to extra supply of short
hedgers or short position takers.
Means of returns from commodity futures:

1. Collateral yield: yield generated due to maintaining margins

2. Spot yield
3. Roll yield
4. Rebalancing yield

To find spot yield, ask yourself: Had the spot price at T been the same as it was at t = 0, what is the gain/ loss you would have made?
i.e if the spot prices does not change, the yield earned is the spot yield.

The rest of the yield is roll yield. Eg. If the futures market is in backwardation, then, if current spot is 120, for a long position in
futures (F=110), if spot at t = T changes to 150, total yield = 150 – 110 = 40. Spot yield = 120-10 = 10. Roll yield = 40-10 = 30.

ROLL YIELD OF A LONG FUTIRES POSITION IS POSITIVE WHEN MARKETS ARE IN BACKWARDATION.
ROLL YIELD OF A SHORT FUTURES POSITION IS POSITIVE WHEN MARKETS ARE IN CONTANGO.
----------------------------------------
171.3. The following four bonds can be delivered by the party with the short position in a U.S. Treasury bond futures contract:
Bond A: 15 year maturity and 5.0% semi-annual coupon
Bond B: 20 year maturity and 6.5% semi-annual coupon
Bond C: 25 year maturity and 6.0% semi-annual coupon
Bond D: 30 year maturity and 5.5% semi-annual coupon
Which of these bonds has the HIGHEST conversion factor?

Higher the PV of a bond, higher the conversion factor. In such a question, assume YTM = 6%. No other value, and find PV of each
bond. Observe that bond B has a higher coupon rate than 6% yield, so it will trade at a premium and will have highest PV. ANS: B
-----------------------------------------------
If a bond portfolio with a duration of 9.0 years is hedged with futures contracts in which the underlying asset has a duration of only
3.0 years, but the volatility of the 3-year interest rate is greater than the volatility of the 9-year interest rate, what is the likely
impact on a duration based hedge?

a) The portfolio is likely to be over-hedged, i.e. if we hedge with an instrument of shorter duration and higher volatility, the
portfolio tends to be over-hedged.

CAPM

The Market Portfolio has the highest Sharpe ratio among the efficient portfolios on the efficient frontier.

Sharpe ratio of market portfolio is the slope of CML. Treynor ratio of market portfolio is the slope of SML.

The combinations of two assets can never have more risk than that found on a straight line connecting the two assets in expected
return standard deviation space.

When two assets are combined in a portfolio, there always exists a simple expression for finding the minimum variance portfolio

If the correlation is less the ratio of volatilities, then the portfolio volatility can be less than the volatility of the least risky asset.
For example, if sigma(a) = 10% and sigma(b) = 20%, then any correlation less than 0.5 allows for portfolios with volatility less than
10%, without short selling; e.g., at rho = 0.1, the minimum variance portfolio occurs at ~82.6% invested in asset(a) for a portfolio
volatility of ~9.28%

What is the composition of portfolios with investors when a riskfree asset is introduced to the efficient frontier?
all investors on the CML hold the same risky market portfolio. Moving up/down the CML is a function of the mix between the riskfree
asset and the same risky market portfolio.

Predicted variance is always greater than historical variance because of uncertainty as to the future mean
AS PER CAPM, all portfolios and risky assets MAY OR MAY NOT lie along (on) the capital market line (CML). All non efficient assets lie
below the capital market line, as they would lie under any efficient frontier.

Difference between CML and CAPM:

I. In CAPM, risk is systematic (beta), since it can apply to inefficient portfolios; but
II. in CML, risk is total (volatility) since it only includes efficient portfolios. Trick: CML is an efficient frontier on
introduction of risk free asset, and so CML contains only EFFICIENT PORTFOLOIOS.

Best test of WEAK-FORM EMH Autocorrelation of security returns

Best test of SEMISTRONG-form EMH Price-to-book ratio in Fama-French three factor model
Best test of STRONG-form EMH Returns for professional security analysts and money manager

Which is best for RANKING portfolios with the same beta (within peer groups)? Jensen’s alpha

According to CAPM, what is the expected return of diversifiable (idiosyncratic) risk? Zero

A positive alpha is ABOVE the SML, and thus, should be undervalued by CAPM.

portfolio with beta = 1.2 or any other beta should lie on the SML. SML is the plot of changing betas and corresponding expected
returns.

Information ratio = active return / active risk

Information ratio = residual return / residual risk…………both are true

Price of risk = Rm - Rf quantity of risk = beta of portfolio

MACAULAY’S DURATION IS HIGHEST.

Key rate 01 is the dollar change in bond price if yield changes by .01% i.e. 1 basis point.
Key rate duration is the percent change in bond price if the yield changes by 1%.
Key rate duration = (key rate 01 / initial bond price) * 10,000

Sum of all key rate durations is the DURATION OF THE BOND which assumes parallel shift in yields.

Key rate shifts assume that the rate of given term is affected by only the key rates. In reality, that’s not the case.