FMP
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Hedging in a practical world (Basis Risk) Basis = spot price of asset – futures price contract • Basis = 0 when spot price = futures price
Future Price Spot Price
Time
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Choice of contracts • Optimal Hedge Ratio:
h
S F
Where • σS is the standard deviation of δS, the change in the spot price during the hedging period • σF is the standard deviation of δF, the change in the futures price during the hedging period • ρ is the coefficient of correlation between δS and δF
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Optimal number of contracts The optimal number of contracts (N*) to hedge a portfolio consisting of NA number of units and where Qf is the total number of futures being used for hedging N*
h * NA Qf
In order to change the beta (β) of the portfolio to (β*), we need to long or short the (N*) number of contracts depending on the sign of (N*) N* β
P A
N * ( * - )
P A
Negative sign of (N*) indicates shorting the contracts © EduPristine For FMP-I (Confidential)
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Determination of Forward Price The price of a forwards contract is given by the equation below: • F0 = S0ert in the case of continuously compounded risk free interest rate, r • F0 = S0(1+r )t in the case of annual risk free interest rate, r • Where: – F0: forward price – S0: Spot price – t: time of the contract
Known income from underlying • If the underlying asset on which the forward contract is entered into provides an income with a present value, I, then the forward contract would be valued as: – F0 = (S0 – I )ert
Known yield from underlying • If the underlying asset on which the forward contract is entered into provides a continuously compounded yield, q, then the forward contract would be valued as: – F0 = S0e(r-q)t
q: continuously % of return on the asset divided by the total asset price
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Value of forward contracts At the time on entering into a forward contract, long or short, the value of the forward is zero This is because the delivery price (K) of the asset and the forward price today (F0) remains the same The value of the forward is basically the present value of the difference in the delivery price and the forward price Value of a long forward, f, is given by the PV of the pay off at time T: •
ƒ = (F0 – K )e–rT
K is fixed in the contract, while F0 keeps changing on an everyday basis For continuous dividend yielding underlying •
f = S0e-qt – Ke-rt
For discrete dividend paying stock •
f = S0 – I – Ke-rt
Index futures: A stock index can be considered as an asset that pays dividends and the dividends paid are the dividends from the underlying stocks in the index If q is the dividend yield rate then the futures price is given as: •
F0= S0e(r-q)t
Index Arbitrage •
When F0 > S0e(r-q)T an arbitrageur buys the stocks underlying the index and sells futures
•
When F0 < S0e(r-q)T an arbitrageur buys futures and shorts or sells the stocks underlying the index
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Futures and Forwards on Currencies Interest rate Parity
F0 S 0 e
( rbc r fc ) T
Formula to remember: • If Spot rate is given in USD/INR terms then take American Risk-free rate as the first rate • In other words, individual who is interested in USD/INR rates would be an American (Indian will always think in Rupees not dollars!!!!!), which implies foreign currency (rf) in his case would be rINR ( rUSD rINR )T USD USD INR INR
F
S
e
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The Cost of Carry The cost of carry, c, is the storage cost plus the interest costs less the income earned For an investment asset F0 = S0ecT For a consumption asset F0 ≤ S0ecT The convenience yield on the consumption asset, y, is defined so that: F0 = S0 e(c–y )T
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Calculation of interest rates Amount compounded annually would be given by: • A = P (1+ r)t – – – –
A terminal amount P principal amount r annual rate of interest t number of years for which the principal is invested
If amount compounded n times a year then: • A = P ( 1+ r/n )nt
When n ∞ then we call it continuous compounding: • A = Pert (this formula is derived using limits and continuity)
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Bond pricing The price of a bond is the present value of all the coupon payment and the final principal payment received at the end of its life T
B Ce rt Pe rT t 1
•
B the bond price
•
C coupon payment
•
r zero interest rate at time t
•
P bond principal
•
T time to maturity
1 1 (1 YTM) n B I YTM
1 F (1 YTM) n
The yield of a bond is the discount rate (applied to all future cash flows) at which the present value of the bond is equal to its market price •
Yield to Maturity = Investor’s Required Rate of Return
The par yield is the coupon rate at which the present value of the cash flows equal to the par value (principal value) of the bond If we are looking at a semi-annual 5 year coupon bond with a par value of $100 then the coupon payment would be solved using the following equation: 5
100 (C / 2)e rt 100e 5 r t 1
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Forward rate agreements (FRAs) In general:
Ft1, t2
R 2 T2 R 1T1 T2 T1
Payment to the long at settlement = Notional Principal X (Rate at settlement – FRA Rate) (days/360) ---------------------------------------------------------1 + (Rate at settlement) (days / 360)
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Duration Macaulay’s duration: is the weighted average of the times when the payments are made. And the weights are a ratio of the coupon paid at time t to the present bond price t *C n*M t (1 y ) n t 1 (1 y ) Macaluay Duration Current bond price n
Where: • t = Respective time period • C = Periodic coupon payment • y = Periodic yield • n = Total no of periods • M = Maturity value
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Duration contd… A bond’s interest rate risk is affected by: • Yield to maturity • Term to maturity • Size of coupon From Macaulay’s equation we get a key relationship: B DY B
In the case of a continuously compounded yield the duration used is modified duration given as: D*
Macaulay Duration r 1 n
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Convexity Convexity is a measure of the curvature of the price / yield relationship
1 d 2B C B dy 2 Note that this is the second partial derivative of the bond valuation equation w.r.t. the yield Hence, convexity is the rate of change of duration with respect to the change in yield
Bond price ($)
P*
Actual bond price Tangent Y*
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Yield
13
…Convexity The convexity of the price / YTM graph reveals two important insights: • The price rise due to a fall in YTM is greater than the price decline due to a rise in YTM, given an identical change in the YTM • For a given change in YTM, bond prices will change more when interest rates are low than when they are high
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Calculating Bond Price Changes We can approximate the change in a bond’s price for a given change in yield by using duration and convexity:
V B D M o d i V B 0 .5 C V B i
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15
Theories of the Term Structure Three theories are used to explain the shape of the term structure
(1 ilt ) n (1 ist
year 1
)(1 ist
year 2
)...(1 ist
yearn
)
yearn
)
Expectations theory The long rate is the geometric mean of expected future short interest rates Liquidity preference theory Investors must be paid a “liquidity premium” to hold less liquid, long-term debt Market segmentation theory
(1 ilt ) n rpn (1 ist
year 1
)(1 ist
year 2
)...(1 ist
Where rpn is the risk premium associated with an n year bond
Investors decide in advance whether they want to invest in short term or the long term Distinct markets exist for securities of short term bonds and long term bonds Supply demand conditions decide the prices © EduPristine For FMP-I (Confidential)
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Day count conventions Day count defines the way in which interest is accrued over time. Day count conventions normally used in US are: • Actual / actual treasury bonds • 30 / 360 corporate bonds • Actual/360 money market instruments
The interest earned between two dates =
(Number of days between dates)*(Interest earned in reference period)
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(Number of days in reference period)
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Cheapest to deliver bond The party with the short position can chose to deliver the cheapest bond when it comes to delivery, hence he would chose the cheapest to deliver bond Net pay out for delivery ( he has to buy a bond and deliver it): • Quoted bond price – (settlement price * conversion factor)
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DV01 – Application to hedging Hedge ratio is calculated using DV01 with the help of following relation
HR
DVO1( per$100 of initial position) DV 01( per$100 of hedging instrument)
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Duration based hedging strategies Number of contracts to hedge is given by the equation:
N*
PDP FC DF
• FC
Contract price for interest rate futures
• DF
Duration of asset underlying futures at maturity
• P
Value of portfolio being hedged
• DP
Duration of portfolio at hedge maturity
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Key Rate ‘01 and Key Rate Durations Key Rate ‘01 measures the dollar change in the value of the bond for every basis point shift in the key rate • Key Rate ‘01 = (-1/10,000) * (Change in Bond Value/0.01%)
Key rate duration provides the approximate percentage change in the value of the bond • Key Rate Duration = (-1/BV) * (Change in Bond Value/Change in Key rate)
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Put Call parity Expressed as: • Value of call + Present value of strike price = value of put + share price
Put-call parity relationship, assumes that the options are not exercised before expiration day, i.e. it follows European options
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Bounds and Option Values Option
Minimum Value
Maximum Value
European call (c)
ct ≥ Max(0,St-(X/(1+RFR)t)
St
American Call (C)
Ct ≥ Max(0, St-(X/(1+RFR)t)
St
European put (p)
pt ≥Max(0,(X/(1+RFR)t)-St)
X/(1+RFR)t
American put (P)
Pt ≥ Max(0, (X-St))
X
Where t is the time to expiration
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Binomial Method • Assuming the price of the underlying asset can take only two values in any given interval of time – Risk Neutral Method
p
Su p
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IV1 = Max[(Su2-X), 0]
1-p
S0 1-p
Su 2
p Su
1-p
Sud
Sd 2
IV2
IV3
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Black and Scholes Model Black and Scholes formula allows for infinitesimally small intervals as well as the need to revise leverage for European options on Non Dividend paying stocks The formula is:
[ N ( d 1) P ] [ N ( d 2) X e
R f T
• Where,
]
P ln[ ] [Rf (0.5 2 )]T d1 X T d 2 d1 T
Log is the natural log with base e • • • • •
N (d) = cumulative normal probability density function X = exercise price option; T = number of periods to exercise date P =present price of stock σ = standard deviation per period of (continuously compounded) rate of return on stock
Value of Put = [ X e
R f T
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{1 N (d 2}] [{1 N (d1)} P]
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Delta (cont.) The delta of a portfolio of derivatives (such as options) with the same underlying asset, can be found out if the deltas of each of these derivatives are known
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portfolio
n
i1
W i
i
26
Theta (cont.) We have theta of call given by: S 0 N ' ( d 1 ) rKe 2 T
( Call )
Where: rT
N (d 2 )
• K = Strike price • T = Time of maturity of the option measured in years, so that 6 months will be 0.5 years
• Where:
rT
• d1 and d2 are as defined in the Black-Scholes Pricing formula earlier • σ = Stock price volatility
e (x^2)/2 N '(x) 2
S 0 N ' ( d 1 ) ( Put ) rKe 2 T
• S0 = Stock price at time 0, i.e. present price of the stock
N ( d 2 )
• r = Risk neutral rate of interest
For a put option, theta is given by:
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Gamma (cont.) Calculation of Gamma • Gamma for European options can be calculated using the following formula:
N ' ( d 1) S 0 T
• Where symbols have their usual meaning
Gamma (ATM) vs. Time 0.45 0.40 0.35 0.30 0.25 0.20 0.15 0.10 0.05 0
Gamma (Call / Put) 0.07 0.06 0.05 0.04 0.03 0.02 0.01
0
0.2
0.4
0.6
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0.8
1.0
1.2
0
1 4 7 10 13 16 19 22 25 28 31 34 37 40 43 46 49
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Vega The Vega of a derivative portfolio is the rate of change of the value of the portfolio with the change in the volatility of the underlying assets. It can be expressed as: • V=
, where Π is the value of the portfolio, and σ is the volatility in the price of the underlying.
For European options on a stock that does not pay dividends, Vega can be found by: • V=S0 by:
e (d 1^ 2 ) / 2 N ' ( d 1) 2 The Vega of a long position is always positive A position in the underlying asset has a zero Vega Thus its behavior is similar to gamma Vega is maximum for options that are at the money
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16 14 12 10 8 6 4 2 0
Vega
1 4 7 1013161922252831343740434649
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Rho Rho of a portfolio of options is the rate of change of its value with respect to changes in the interest rate
Rho =
r
, where Π is the value of the portfolio, and r is the rate of interest
For European options on non dividend paying stocks, we have; • Rho (call) = KTe-rTN(d2), where the symbols carry their usual meanings • Also, Rho (put) = -KTe-rTN(-d2), the symbols carrying their usual meanings
Rho (Call / Put)
30 20 10
Rho (Call)
0
Rho (Put)
-10 -20 -30
1 4 7 10 13 16 19 22 25 28 31 34 37 40 43 46 49
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Valuation of swaps Hence the value of the swap can be given as: • V = Bfix – Bfl • Where: – Bfix = PV of payments – Bfl = (P+AI)e-rt • Value of a floating bond is equal to the par value at coupon reset dates and equals to the Present Value of Par values (P) and Accrued Interest (AI)
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Commodity Forwards Commodity forward prices can be described using the same formula as used for financial forward prices
F
0 , T
S
0
e
( r
) T
For financial assets, is the dividend yield • For commodities, is the commodity lease rate • The lease rate is the return that makes an investor willing to buy and lend a commodity • Some commodities (metals) have an active leasing market • Lease rates can typically only be estimated by observing forward prices
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Futures term structure The set of prices for different expiration dates for a given commodity is called the forward curve (or the forward strip) for that date If on a given date the forward curve is upward-sloping, then the market is in contango If the forward curve is downward sloping, the market is in backwardation Note that forward curves can have portions in backwardation and portions in contango
(r )T
F0,T S0e
• Since r is always positive, assets with =0 display upward sloping (contango) futures term structure • With >0, term structures could be upward or downward sloping
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Commodity loan With the addition of the lease payment, NPV of loaning the commodity is 0 The lease payment is like the dividend payment that has to be paid by the person who borrowed a stock Therefore:
F0 ,T S 0 e ( r )T Where δ is lease rate
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Forward Prices and the Lease Rate The lease rate has to be consistent with the forward price Therefore, when we observe the forward price, we can infer what the lease rate would have to be if a lease market existed The annualized lease rate The effective annual lease rate
1 l r In (F0 ,T / S ) T
(1 r ) l 1 1/T (F0 ,T / S )
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Storage Costs and Forward Prices One will only store a commodity if the PV of selling it at time T is at least as great as that of selling it today Whether a commodity is stored is peculiar to each commodity If storage is to occur, the forward price is at least Where (0,T) is the future value of storage costs for one unit of the commodity from time 0 to T
F0 ,T S 0 e rT (0,T )
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Storage Costs and Forward Prices (cont’d) Convenience Yield • Some holders of a commodity receive benefits from physical ownership (e.g., a commercial user) • This benefit is called the commodity’s convenience yield • The convenience yield creates different returns to ownership for different investors, and may or may not be reflected in the forward price
Convenience and leasing • If someone lends the commodity they save storage costs, but lose the ‘convenience’ – Stated as ( –c) • Therefore, commodity borrower pays a lease rate that covers the lost convenience less the storage costs:
– =c–
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Pricing with convenience So, if:
F0 ,T S 0 e ( r )T And if, = c – Then, F0,T = S0e(r+ -c)T
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No-Arbitrage with Convenience From the perspective of an arbitrageur, the price range within which there is no arbitrage is:
S0 e
( r c )T
F0 ,T S 0 e
( r )T
Where c is the continuously compounded convenience yield The convenience yield produces a no-arbitrage range rather than a no-arbitrage price. Why? There may be no way for an average investor to earn the convenience yield when engaging in arbitrage
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Interest rate parity Interest Rate Parity (IRP)
1 rDC Forward Spot 1 rFC
T
Where; rDC = Domestic currency rate rFC = Foreign currency rate
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Default rates
Issuer default rate =
Dollar default rate =
Cumulative annual default rate =
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Number of issuers that default Total number of issuers at the beginning of issue
Cumulative dollar value of all defaulted bonds Cumulative $ value of all issuance * Weighted Avg. number of years outstanding
Cumulative dollar value of all defaulted bonds Cumulative dollar value of issue
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Foundation of Risk Management
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Expected Return and Standard Deviation of Portfolio Return of Portfolio
k 1 to N
R p Wk R k
Standard Deviation of Portfolio
p
Wσ WWσ σ P 2
k k
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k
i k i ki
k 1toN;i 1toN;k i
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Portfolio Variance for two asset portfolio For two-asset portfolio • Var(wAkA+ wBkB) = wA2 σA2 + wB2 σB2 + 2 wA wB σA σB ρAB
Where ρ is correlation coefficient between A and B wA ,wB are weights of the asset A and B • If ρ =1 – Var(wAkA + wBkB) = (wAσA + wBσB)2 • If ρ <1 – Var(wAkA+ wBkB) < (wAσA+ wBσB)2
So there is a risk reduction from holding a portfolio of assets if assets do not move in perfect unison
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Correlation and Portfolio Diversification Perfect Positive Correlation • ρ =1 & Var (wAkA+ wBkB)= (wAσA + wBσB)2
Perfect Negative Correlation • ρ =-1 & Var (wAkA + wBkB) = (wAσA - wBσB)2
Zero Correlation • Correlation between two assets is zero
Moderate Positive Correlation • Correlation between two assets lies between 0 and 1
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Capital Market Line Capital Market Line: A line used in the capital asset pricing model to illustrate the rates of return for efficient portfolios depending on the risk-free rate of return and the level of risk (standard deviation) for a particular portfolio Represents all possible combinations of the market portfolio (P) and risk free asset E(R s ) R f E(R p ) R f
σs σp
Risk Free Asset Introduced CML Return Pe
Efficient Frontier
Rf
Volatility © EduPristine For FMP-I (Confidential)
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Capital Asset Pricing Model (CAPM) As per CAPM, stock’s required rate of return = risk-free rate of return + market risk premium
R s R f βR m R f Rm- Rf: Risk Premium β: Quantity of Risk
covR i , R m βi VarR m
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Relaxing Assumptions of CAPM CAPM equation is adjusted to include dividend yield on the market portfolio and the stock
E(R
p
) R F ( E ( R M ) R F ) ( M R F ) ( i R F )
M dividend yield of market portfolio i dividend yield for stock i T tax factor
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Beta Sensitivity of the return of the asset to the market return is known as Beta Beta is calculated as follows:-
cov R i , R m βi Var R m
Portfolio Beta Beta can also be calculated for portfolio Portfolio Beta is the weighted average of the betas of individual assets in the portfolio
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Beta Sharpe ratio: Sharpe ratio
R R p
f
σp • Rp = portfolio return, Rf = risk free return • The higher the Sharpe measure, the better the portfolio
Treynor ratio: Treynor ratio
R
p
Rf
Beta • Rp = portfolio return, Rf = risk free return
• The higher the Treynor measure, the better the portfolio • However, this measure should be used only for well-diversified portfolio
Jenson’s alpha: Jenson’s alpha α R p R c • Rp = portfolio return, Rc = return predicted by CAPM • Positive alpha (portfolio with positive excess return) is always preferred over negative alpha
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Measures of performance Tracking Error (TE): TE E P (Std. dev. of portfolio’s excess return over Benchmark index) • Where Ep = RP – RB • RP = portfolio return, RB = benchmark return • Lower the tracking error lesser the risk differential between portfolio and the benchmark index
Information Ratio (IR): • Measure of risk-adjusted return for a portfolio, defined as expected active return per unit of tracking error
IR
R
p
Rb
TE • Higher IR indicates higher active return of portfolio at a given risk level
Sortino Ratio (SR): SR
SSD
R
p
MAR
SSD
1/t R p MAR 2 ,
• MAR is Minimum Accepted Return. SSD is standard deviation of returns below MAR. (Or) SSD is the Semi Standard Deviation from MAR where Rp
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Quantitative Analysis
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Counting Principle Number of ways of selecting r objects out of n objects nCr n!/(r!)*(n-r)! Number of ways of giving r objects to n people, such that repetition is allowed Nr
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Some definitions and properties of Probability Definitions • Mutually Exclusive: If one event occurs, then other cannot occur • Exhaustive: All exhaustive events taken together form the complete sample space (Sum of probability = 1) • Independent Events: One event occurring has no effect on the other event
The probability of any event A:
P( A) [0,1]
If the probability of happening of event A is P(A), then the probability of A not happening is (1-P(A)) For example, if the probability of a company going bankrupt within one year period is 20%, then the probability of company surviving within next one year period is 80%
P( A) 1 P( A)
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Sum Rule & Bayes’ Theorem The unconditional probability of event B is equal to the sum of joint probabilities of event (A,B) and the probability of event (A’,B). Here A’ is the probability of not happening of A • The joint probability of events A and B is the product of conditional probability of B, given A has occurred and the unconditional probability of event A
P( B) P( A B) P( Ac B) P( B / A) P( A) P( B / Ac ) P( Ac ) • We know that P(AB) = P(B/A) * P(A) • Also P(BA)= P(A/B) * P(B) • Now equating both P(AB) and P(BA) we get:
P( B / A) * P( A) P( A / B) P( B)
• P(B) can be further broken down using sum rule defined above:
P( A / B)
P( B / A) P( A) P( B / A) P( A) P( B / Ac ) P( Ac )
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Mean The expected value(Mean) measures the central tendency, or the center of gravity of the n population It is given by:
E(X )
x i 1
i
N
The graph shows the mean of normal distributions 0.45 0.40 0.35 0.30 0.25 0.20 0.15 0.10 0.05 0
Standard Normal Distribution = 0, = 2 = 1, = 1
-4
-2
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0
2
4
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Geometric Mean Geometric Mean: is calculated as:
G n X 1 X 2 X 3 ... X n • Where there are n observations and each observation is Xi • Compound Annual Growth Rate(CAGR): It’s the geometric mean of the returns
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Properties of Expectation E(cX) = E(X) x c E(X+Y) = E(X) + E(Y) E(X2) ≠ [E(X)]2 E(XY) = E(X) x E(Y) [if X and Y are independent]
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Variance & Standard deviation Variance is the squared dispersion around the mean. n
VAR
i1
(xi )2 N
The standard deviation, which is the square root of the Variance, is more convenient to use, as it has the same units as the original variable X n
• SD(X) =
VAR ( x )
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i1
(xi )2 N
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Covariance & correlation Covariance describes the co-movement between 2 random numbers, given as: • Cov(X1, X2) = σ12
Cov( X , Y ) E[( X X )(Y Y )] Cov( X , Y ) E ( XY ) X Y Correlation coefficient is a unit-less number, which gives a measure of linear dependence between two random variables. • ρ(X1, X2) = Cov(X1, X2) / σ1σ2
Correlation coefficient always lies in the range of +1 to -1 A correlation of 1 means that the two variables always move in the same direction A correlation of -1 means that the two variables always move in opposite direction If the variables are independent, covariance and correlation are zero, but vice versa is not true
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Some Properties of Variance
Var ( aX b ) a 2Var ( X ) n
n
Variance of a constant = 0
n
Var ( X i ) Cov ( X i , X j ) Covariance between same variables is also their variance i 1
i 1 j 1
n
n
i 1
i 1
Var ( X i ) Var ( X i )
For independent or uncorrelated variables, • covariance or correlation = 0
Var (aX bY ) a 2Var ( X ) b 2Var (Y ) 2abCov( X , Y )
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Skewness Skewness describes departures from symmetry n
Sk
3 ( x ) i i 1
3
Skewness can be negative or positive.
Symmetric Distribution
Negative skewness indicates that the distribution has a long left tail, which indicates a high probability of observing large negative values. Negatively Skewed Distribution
If this represents the distribution of profits and losses for a portfolio, this is a dangerous situation.
Positively Skewed Distribution
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Kurtosis Kurtosis describes the degree of “flatness” of a distribution, or width of its tails n
K
(x i 1
i
)4
4
Because of the fourth power, large observations in the tail will have a large weight and hence create large kurtosis. Such a distribution is called leptokurtic, or fat tailed A kurtosis of 3 is considered average
Platykurtic K<3
0.45
High kurtosis indicates a higher probability of extreme movements
0.4 0.35
Leptokurtic K>3
0.3 0.25 0.2
Mesokurtic K=3
0.15 0.1 0.05 0 -4
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-3
-2
-1
0
1
2
3
4
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Errors in estimation Type I and Type II Errors • Type I error occurs if the null hypothesis is rejected when it is true • Type II error occurs if the null hypothesis is not rejected when it is false
Significance Level • -> Significance level – the upper-bound probability of a Type I error • 1 - ->confidence level – the complement of significance level
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Actual Inference
H0 is True
H0 is False
H0 is True
Correct Decision Confidence Level = 1-α
Type-II Error P(Type-II Error) =β
H0 is False
Type-I Error Significance Level = α
Power=1-β
Hypothesis tests for variances Hypothesis Test of Variances
Test for Single Population Variance
Example Hypothesis
H0: σ2 = σ02 HA: σ2 ≠ σ02
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Test for Two Population Variances
Chi-Square Test Statistic
,( n 1) 2
(n 1) s
02
Example Hypothesis 2
H0: σ1 – σ2 = 0 HA: σ12 – σ22 ≠ 0 2
2
F-test Statistic
F ,ndf ,ddf
s12 2 s2
Test for single population variance Single population variance test has 3 different forms:
/2 /2
• Two Tailed Test:
H0: σ2 = σ02 HA: σ2 ≠ σ02 • Lower Tail test:
H0: σ2 σ02 HA: σ2 < σ02
• Upper Tail Test
H0: σ2 ≤ σ02 HA: σ2 > σ02
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Chi-square test statistic The chi-squared test statistic for a Single Population Variance is: 2 (n 1)s 2 σ2
Where
2 = standardized chi-square variable n = sample size s2 = sample variance σ2 = hypothesized variance
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Finding the critical value The critical value, 2 , is found from the chi-square table:
Upper tail test:
H0: σ2 ≤ σ02 HA: σ2 > σ02
2 Do not reject H0
Reject H0 2
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Lower tail or two tailed Chi-square tests Lower tail test:
H0: σ2 σ02 HA: σ2 < σ02
Two tail test:
H0: σ2 = σ02 HA: σ2 ≠ σ02
/2
/2
2 Reject
Do not reject H0
21-
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2 Reject 21-/2
Do not reject H0
Reject 2/2
F-test for difference in two population variances Two population variance test has 3 different forms:
/2 /2
• Two Tailed Test:
H0: σ12 – σ22 = 0 HA: σ12 – σ22 ≠ 0 • Lower Tail test:
H0: σ12 – σ22 0 HA: σ12 – σ22 < 0
• Upper Tail Test
H0: σ12 – σ22 ≤ 0 HA: σ12 – σ22 > 0
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F-test for difference in two population variances (cont.) The F test statistic is:
s12 F 2 s2 s 12
= Variance of Sample 1 (n1 – 1) = numerator degrees of freedom
s 22
= Variance of Sample 2 (n2 – 1) = denominator degrees of freedom
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Chebyshev’s inequality Chebyshev's inequality says that at least 1 - 1/k2 of the distribution's values are within k standard deviations of the mean. Where k is any positive real number greater than 1
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Population linear regression Y
Y 0 1 X u
Observed Value of Y for Xi
Slope = β1
Predicted Value of Y for Xi Intercept = β0
Random Error for this x value ui xi
x Mean marks for hours of study Individual person’s marks
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Population regression function
Dependent Variable
Population y intercept
Population Slope Coefficient
Independent Variable
Random Error term, or residual
Y β 0 β1X u Linear component
Random Error component
But can we actually get this equation? If yes what all information we will need?
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Sample regression function Y
y b 0 b1x e
Observed Value of Y for Xi
ei
Predicted Value of Y for Xi
Random Error for this x value
Slope = β1
Intercept = β0 xi
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x
75
Sample regression function Estimate of the regression intercept
Estimated (or predicted) y value
y
i
b
Estimate of the regression slope
0
Independent variable
Error term
b 1x e
Notice the similarity with the Population Regression Function Can we do something of the error term?
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One method to find b0 and b1 Method of Ordinary Least Squares (OLS) b0 and b1 are obtained by finding the values of b0 and b1 that minimize the sum of the squared residuals 2 e
2 ˆ (y y )
2 (y (b b x)) 0 1
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OLS regression properties The sum of the residuals from the least squares regression line is 0
( y yˆ ) 0 The sum of the squared residuals is a minimum Minimize ( ( y yˆ ) 2 ) The simple regression line always passes through the mean of the y variable and the mean of the x variable The least squares coefficients are unbiased estimates of β0 and β1
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The least squares equation The formulas for b1 and b0 are:
b1
( x x )( y y ) (x x) 2
Algebraic equivalent:
b1
x y xy
n 2 ( x ) x2 n
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And
b 0 y b1 x
79
Interpretation of the Slope and the Intercept b0 is the estimated average value of y when the value of x is zero. More often than not it does not have a physical interpretation b1 is the estimated change in the average value of y as a result of a one-unit change in x y
Y
b
0
b
1
X
slope of the line(b1)
b0 x
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Explained and unexplained variation
y yi
•RSS = Residual sum of squares RSS = (yi - yi )2
TSS = Total sum of squares _ TSS = (yi - y)2 y
_2 ESS = (yi - y)
_ y
•ESS = Explained Sum of squares
Xi
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y
_ y
x
81
Explained and unexplained variation Total variation is made up of two parts:
TSS Total sum of Squares
TSS
2 ( y y )
RSS Sum of Squares Error / Residual Sum of Squares
RSS
2 ˆ ( y y )
ESS Sum of Squares Regression / Explained Sum of Squares
ESS
2 ˆ ( y y )
Where: • y = Average value of the dependent variable • y = Observed values of the dependent variable yˆ • = Estimated value of y for the given x value
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Coefficient of determination, R2 The coefficient of determination is the portion of the total variation in the dependent variable that is explained by variation in the independent variable The coefficient of determination is also called R-squared and is denoted as R2
SSR R SST 2
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where
2
0 R 1
83
Coefficient of determination, R2 Coefficient of determination
SSR sum of squares explained by regression R SST total sum of squares 2
Note: In the single independent variable case, the coefficient of determination is
R2 r2 Where: • R2 = Coefficient of determination • r = Simple correlation coefficient
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Calculating the correlation coefficient Sample correlation coefficient:
r
( x x )( y y ) [ ( x x ) ][ ( y y ) 2
2
]
or the algebraic equivalent:
r
n xy x y
[n( x 2 ) ( x ) 2 ][ n( y 2 ) ( y ) 2 ]
Where: • r = Sample correlation coefficient • n = Sample size • x = Value of the independent variable • y = Value of the dependent variable © EduPristine For FMP-I (Confidential)
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Standard Error of “Estimate” The standard deviation of the variation of observations around the regression line is estimated by:
su
RSS n k 1
Where: • RSS = Residual Sum of Squares (summation of e2) • n = Sample size • k = number of independent variables in the model
Standard Error of Estimate (SEE) is another name of Standard Error of regression © EduPristine For FMP-I (Confidential)
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The Standard Deviation of the intercept
Xi su 2
s bo s b1
n (x x ) 2
su
(x x )
2
su
2 x
( x) 2 n
Where: s b = Estimate of the standard error of the least squares slope • 1
•
su
RSS n2
= Sample standard error of the estimate
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Multiple Regression Using more than one explanatory variable in a regression model • Y = b0 + b1X1 + b2X2 + b3X3 + uI
Omitted variable bias • The biasness incurred due to omission of one or more explanatory variable from the model.
Omitted variable bias occurs when two conditions are met: • Omitted variables are correlated with the independent variable • Variables that are not accounted for in the model but affect the dependent variable
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Multiple Regression Basics General Multiple Linear Regression model take the following form:
Yi b0 b1 X 1i b2 X 2 i ......... bk X ki i Where: • Yi = ith observation of dependent variable Y • Xki = ith observation of kth independent variable X • b0 = intercept term • bk = slope coefficient of kth independent variable • εi = error term of ith observation • n = number of observations • k = total number of independent variables
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Estimated Regression Equation As we calculated the intercept and the slope coefficient in case of simple linear regression by minimizing the sum of squared errors, similarly we estimate the intercept and slope coefficient in multiple linear regression n
• Sum of Squared Errors i i 1
2
is minimized and the slope coefficient is estimated.
The resultant estimated equation becomes:
Yi b0 b1 X 1i b 2 X 2 i ......... b k X ki Now the error in the ith observation can be written as: i Yi Yi Yi b0 b1 X 1i b2 X 2 i ......... bk X ki
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Estimation of Volatility Let xi be the continuously compounded return during day i (between the end of day “i-1” and end of day “I”) Let σn be the volatility of the return on day n as estimated at the end of day n-1 Variance estimate for next day is usually calculated as: • variance = average squared deviation from average return over last ‘n’ days
x n
Variance
i 1
i
x
2
n 1
Mean of returns (x-bar) is usually zero, especially if returns are over short-time period (say, daily returns). In that case, variance estimate for next day is nothing but simple average (equally weighted average) of previous ‘n’ days’ squared returns n
Variance
x i 1
i
2
n 1
What if the volatility is dependent on the values of volatility observed in the recent past? What if they also depend on the latest returns? © EduPristine For FMP-I (Confidential)
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EWMA Model In an exponentially weighted moving average model, the weights assigned to the u 2 decline exponentially as we move back through time This leads to: 2n 2n 1 (1 ) u n2 1 Apply the recursive relationship:
n2 n2 2 (1 ) u n2 2 (1 ) u n21 n2 (1 ) u n21 u n2 2 2 n2 2
Hence we have
2 n
m i 1 2 (1 ) u n i m i 1
2 nm
• Variance estimate for next day (n) is given by (1-λ) weight to recent squared return and λ weight to the previous variance estimate • Risk-metrics (by JP Morgan) assumes a Lambda of 0.94
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EWMA Model Since returns are squared, their direction is not considered. Only the magnitude is considered In EWMA, we simply need to store 2 data points: latest return & latest volatility estimate Consider the equation: t21 (1 0.94) t2 0.94 t2 In this equation, variance for time ‘t’ was also an estimate. So we can substitute for it as follows:
t21 (1 0.94) t2 0.94(1 0.94) t21 0.94 t21
t21 0.06 * t2 0.94 * 0.06 * t21 (0.94 * 0.94 t21 ) What are the weights for old returns and variance? λ is called ‘Persistence factor’ or even “Decay Factor”. Higher λ gives more weight to older data (impact of older data is allowed to persist). Lower λ gives higher weight to recent data (i.e. previous data impacts are not allowed to persist) Higher λ means higher persistence or lower decay Since, (1- λ) is weight given to latest square return, it is called ‘Reactive factor’
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GARCH (1,1) GARCH stands for Generalized Autoregressive Conditional Heteroscedasticity Heteroscedasticity means variance is changing with time. Conditional means variance is changing conditional on latest volatility. Autoregressive refers to positive correlation between volatility today and volatility yesterday. (1,1) means that only the latest values of the variables. GARCH model recognizes that variance tends to show mean – reversion i.e. it gets pulled to a long-term Volatility rate over time.
2 t1
V
L
2 t
2 t
Long-term average Volatility
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GARCH (1,1)
2 t 1
2 t
2 t
Generally γ*VL is replaced by ω Since the sum of all the weights is equal to 1 we get the following equation as well:
VL
1
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Simulating a Price Path
S t S Drift
S is the stock price,
t
μ is the expected return, σ is the standard deviation of returns, "t" is time, and
Shock
ε is the random variable
The first step in simulating a price path is to choose a random process to model changes in financial assets Stock prices and exchange rates are modeled by geometric Brownian motion (GBM) shown in the above equation
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Valuations and Risk Models
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Measuring Value-at-Risk (VAR) 0.45 0.4 0.35 0.3 0.25 0.2 0.15 0.1 0.05 0 -4
-2
VAR X % (in %) Z X % *
0
2
4
Mean = 0
ZX% : the normal distribution value for the given probability (x%) (normal distribution has mean as 0 and standard deviation as 1) σ : standard deviation (volatility) of the asset (or portfolio) VAR in absolute terms is given as the product of VAR in % and Asset Value:
VAR VARX % (in %) * Asset Value This can also be written as:
VAR Z X % * * Asset Value © EduPristine For FMP-I (Confidential)
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Measuring Value-at-Risk (VAR) VAR for n days can be calculated from daily VAR as:
VaR (n days) (in %) VaR (daily VaR) (in %) * n This comes from the known fact that the n-period volatility equals 1-period volatility multiplied by the square root of number of periods(n).
VaR (n days) (in %) ZX% * * Asset Value * n As the volatility of the portfolio can be calculated from the following expression:
portfolio wa2 a2 w 2b b2 2w a w b * a * b * ab The above written expression can also be extended to the calculation of VAR:
VaR portfolio (in %) wa2 (%VARa ) 2 w 2b (%VARb ) 2 2w a w b * (%VARa ) * (%VARb ) * ab © EduPristine For FMP-I (Confidential)
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Expected Loss (EL) EL = (Assured payment at Maturity Time T )* Loss Given Default * (Probability that the default occurs before maturity Time T) The term “Assured payment” is more relevant for bonds than loans For Bank Loans the terms Assured Payment is better replaced by “Exposure” EL = Exposure * LGD*PD EL is the amount the bank can lose on an average over a period of time
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Adjusted Exposure Let the value of bank asset at time T be V Let the already drawn amount be OS (outstanding) Let COM be the commitment Let “d” be the fraction of the commitment which would be drawn before the default Portion which is not drawn and risk free = COM*(1-d) Risky portion = OS + d*COM This Risky Portion is known as Adjusted Exposure also known as Exposure At Default EL = Adjusted Exposure*LGD*PD “d” is also known as Usage Given Default (UGD)
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Causes of Unanticipated Risk Two Primary Sources The occurrence of defaults (PD) • PD is never zero for any rating • PD is calculated using historical data or Analytical methods like Option theory
Unexpected Credit Migration – unanticipated change in credit quality • An obligor undergoes financial crisis which deteriorates the credit quality although it is not a default
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Unexpected Loss UL is the estimated volatility of the potential loss in value of the asset around its EL UL is the standard deviation of the unconditional value of the asset at the time horizon UL = s.d. of expected asset value UL = AE*√[EDF* σ2LGD +LGD2* σ2EDF ] • Underlying assumption that EDF is independent of LGD. In case it is not so then correlation between LGD and EDF terms will come into picture. Though it has been found that they will affect the result only slightly
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