Lecture 7

Question 1

What is question in VaR

Answer 1

What loss level are we X% confident of not exceeding in N business days

Question 2

What are two parameters in the VaR

Answer 2

The time horizon

The confidence level

Question 3

What is the difference between the conditional VaR and the “normal” VaR

Answer 3

They answer two different questions

Conditional VaR: If things do get bad, how much can we expect to lose
VaR: How bad can things get

Question 4

What are the main themes of the Basel Accords

Answer 4

• International standards
• Risk-based standards for capital adequacy
• Evolution from standardized to advanced methodologies
• Capital definitions becoming more granular

Question 5

What does Basel I introduce

Answer 5

1988 BIS Accord

• Capital Requirements for credit risk
• Based on (credit) risk weighted assets (cRWA)

RegCapital = 8% * cRWA
In desingated mix of Tier 1 and Tier 2

Capital requirements for market risk in the trading book
Market risk exposures based on value at risk

Question 6

What is Tier 1 and Tier 2

Answer 6

• Tier 1 capital. This consists of items such as equity and noncumulative
  perpetual preferred stock.
• Tier 2 capital. This is sometimes refereed to a Supplementary Capital.
  It includes instruments such as cumulative perpetual preferred stock,
  certain types of 99-year debenture issues, and subordinated debt with
  an original life of more than five years.

Question 7

What did Basel II introduce

Answer 7

Changes to Credit Risk for Banking Book

• Standardized approach: new risk weights
• Internal Ratings based (IRB) approach

New capital requirements for Operational Risk

Basel 2.5 also introduced a stressed VaR in addition to standard VaR

Question 8

What is meant with a “Change in Capital Definition” within Basle III

Answer 8

Tier 1 Capital is now defined as:

• Core: shares, retained earnings
• Additional: non-cumulative preferred shares

Tier 2 Capital:
- Subordinated debt, cumulative preferred stock

Question 9

What are the major changes within Basel III

Answer 9

Definition of Tier 1 and Tier 2 Capital further progressed

Capital Conservation Buffers

• Minimum retained earnings and limits to dividend distribution
• Triggered by Capital Ratios

Liquidity Coverage Ratio

• Solvency is different from Liquidity
• High Grade Liquid Assets > Net Cash Outflows over 1m
• Counter-cyclical buffer

Question 10

What are characteristics of classic convertible bond

Answer 10

• Holder has the (discretionary / American) option to convert into equity
• Exercised when stock price is hgih

Question 11

What are characteristics of a CoCo Bond (Contingent Convertible)

Answer 11

• Automatic conversion into equity when a pre-specified threshold is reached
• Threshold chosen to coincide with financial difficulty (bad times)
  Contingent Capital - automatic recapitalization

Question 12

Why do traders regularly estimate the zero curves for bonds with different maturities

Answer 12

This allows them to estimate probabilities of default in a risk-neutral world

Question 13

Why is it possible to estimate the probability of default through zero curves for bonds

Answer 13

Because bonds, like any other asset, are priced under the

risk-neutral measure and not the subjective one

Question 14

What is the excess of the value of a risk-free bond over a similar corporate bond called

Answer 14

It equals the present value of the cost of defaults which is also known as the Default Premium

Question 15

What is the LIBOR

Answer 15

The rate at which banks in London lend money to each other for the
short-term in a particular currency

New LIBOR rates are calculated every morning by financial data
firm Thomson Reuters based on interest rates provided by members
of the British Bankers Association

Question 16

If the corporate yield equals 5.25% and the risk free yield equals 5%. What is the holder of the corporate bond expected to lose (assuming continuously compounding)

Answer 16

( e^{-0.05} - e^{-0.0525} ) / e^{-0.05}

Question 17

How is the probability of default defined

Answer 17

Prob. of default = (Expected Loss %)/(1-Recovery Rate)

Question 18

Why is the analysis of probability of default assumed to be simplistic

Answer 18

Bonds are assumed to be zero-coupon and it is assumed that the claim in the event of default equals the no-default value of the bond

But you may also loose out on coupons and only get your principal back

Question 19

How can probabilities for a company’s default be estimated

Answer 19

• Historical Data
• Bond prices
• Equity prices via Merton’s model (or its extension)

Question 20

Default probabilities calculated from bond prices are…

1) risk neutral probabilities
2) real world probabilities

Answer 20

Risk Neutral

Question 21

Default probabilities calculated from Historical data are…

1) risk neutral probabilities
2) real world probabilities

Answer 21

Real world probabilities

Question 22

1) Real world
2) Risk neutral
… default probabilities should be for scenario analysis and the calculation of credit VaR

Answer 22

Real World

Question 23

1) Real world
2) Risk neutral
… default probabilities should be used for the valuation of credit sensitive instruments

Answer 23

Risk neutral

Question 24

Are risk neutral or real world default probabilities normally higher

Answer 24

Since risk-neutral default probabilities are calculated based on the
risk-free rate they are usually much higher than real-world default
probabilities which incorporate a risk-adjusted expected rate of
return that is higher than the risk free rate