RM and Derivatives Flashcards

1
Q

Risk Management

A

understand risks; determine when it’s appropriate to take risk

  1. identify risks
  2. set risk tolerances
  3. report risk to stakeholders
  4. monitor
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2
Q

Risk Governance

A

policies and procedures establishing risk management

  • structure - centralized (best), decentralized
  • reporting
  • methologies
  • infrastructure needs
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3
Q

Enterprise Risk Management

A

centralized risk management

  1. identify risk factors
  2. quantify risk
  3. aggregate to measure firm wide risk
  4. report/ allocate risk
  5. monitor
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4
Q

Financial Risk

A

due to events external to firm, in financial markets

  1. market risk
  2. credit risk
  3. liquidity risk

mitigate with derivatives (options, swaps)

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5
Q

Market Risk

A
  1. interest rate risk
  2. exchange rate risk
  3. equity price risk
  4. commodity price risk
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6
Q

Nonfinancial Risk

A
  1. operational risk
  2. settlement/ perf netting risk - one party pays, other defaults
  3. model risk - GIGO
  4. sovereign risk
  5. regulatory risk
  6. tax, accounting, political risk

mitigate with insurance

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7
Q

VaR

A

probability of expected loss over a specified time; comparable across asset classes, not managers

  1. analytical: VaR = [R - z * σ] V
  2. historical
  3. monte carlo simulation
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8
Q

One Tail SD

A
  • 5% = 1.65 SD
  • 1% = 2.33 SD
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9
Q

VaR Complements

A
  • incremental VaR: risk from additional factor
  • cash flow/ earnings at risk: min CF loss for given prob over time
  • tail value at risk (TVaR): avg outcomes in tail
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10
Q

Credit Risk

A

possibility counterparty defaults; current and potential credit risk

prob default * PV losses

PV rec - PV paid

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11
Q

Credit Risk of Currency Forwards

A

long base currency

S0 / ( 1 + b )t - Ft / ( 1 + p )t

highest credit risk in middle of forward’s life

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12
Q

Credit Risk of Currency Swaps

A

highest credit risk btwn middle/end of swap’s life

PV rec - PV pay

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13
Q

Credit Risk of Options

A

long position = credit risk

current credit risk when option is exercised

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14
Q

Managing Credit Risk

A
  1. limiting exposure
  2. marking to market
  3. collateral
  4. netting payments
  5. closeout netting
  6. credit derivatives
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15
Q

Risk Budgeting Factors

A

must consider correlation of risk in diff units

  1. VaR limits
  2. position limits
  3. liquidity limits
  4. performance stopout
  5. risk factor limits
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16
Q

Sortino Ratio

A

ratio of excess return to risk; doesn’t penalize manager for good performance

( Rp - MAR ) / downside deviation

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17
Q

Forward vs Future

A

Forward: custom, high default risk, less liquidity; currency, int payments

Futures: standardized, trade on exchange, low default risk; bond, equity

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18
Q

Modifying Equity Beta

A

contracts = ( Δβ / βf ) * ( Vp / Vf )

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19
Q

β

A

covi,m / σm2

20
Q

Effective Beta

A

%Δ value of portfolio / %Δ value of index

21
Q

Why Effective Beta Deviates

A

basis risk = imperfect hedge

  • num/ demon based on diff items
  • evaluating before expiration
  • # contracts rounded
  • F and S not priced correctly
22
Q

Modifying Bond Duration

A

contracts = βyield * ( ΔMD / MDf ) * ( Vp / Vf )

23
Q

Synthetic Stock

A

beta = 1

repliate buying contracts; buy futures contract, long T-bills

  • Nf = FVVp / Vf
  • terminal shares replicated = Nf * mult (beg = discount by div yield)
  • initial eqty eq = PV( Nf * mult * price ) [terminal = FV]
24
Q

Synthetic Cash

A

beta = -1

replicate selling contracts; long equity, short futures contract

  • Nf = - FVVp / Vf
  • initial cash eq = PV( Nf * mult * price ) [terminal = FV]
  • terminal shares = Nf * mult
25
Exchange Rate Risks
1. transaction risk 2. economic risk 3. translation risk (translating financial statements)
26
Hedging Currency Positions
* receiving foreign curr = sell forward * paying foreign curr = buy forward
27
Covered Call
long stock, short call; exp lower volatility * payoff: St - max( 0, St - X ) - S0 + C * max gain: (ex opt) X - S0 + C * max loss: (don't ex opt, St = 0) S0 - C * breakeven: (initial cost) S0 - C
28
Protective Put
long stock, long put; exp higher volatility * payoff: St + max( 0, X - St ) - S0 - P * max gain: unlimited * max loss: (ex opt) S0 + P - X * breakeven: (initial cost) S0 + P
29
Bull Call Spread
long CL, short CH; long PL; short PH; exp inc S * profit: CH - CL + max( 0, S - XL ) - max( 0, S - XH ) * max profit: (both ex) XH - XL + CH - CL * max loss: (neither ex) CL - CH * breakeven: (ex CL) XL + CL - CH
30
Bear Put Spread
long PH, short PL; long CH, short CL; exp dec S * profit: max( 0, XH - S ) - max ( 0, XL - S ) + PL - PH * max profit: (both ex) XH - XL + PL - PH * max loss: (no ex) PH - PL * breakeven: (ex PH) XH + PL - PH
31
Butterfly Spread with Calls
long CL and CH; short 2 CM; exp dec volatility * profit: max( 0, S - XL ) + max( 0, S - XH ) - 2max( 0, S - XM ) + 2CM - CL - CH * max profit: (ex CL, CM) XM - XL + 2CM - CL - CH * max loss: (no ex) CL + CH - 2CM * breakeven: 2CM - CL - CH + 2XM - X * CL + CH - 2CM + XL
32
Butterfly Spread with Puts
long PL and PH; short 2 PM; exp dec volatility * profit: max( 0, XH - S ) + max( 0, XL - S ) - 2max( 0, XM - S ) + 2PM - PL - PH * max profit: (ex PH, PM) XH - XM + 2PM - PL - PH * max loss: (no ex) PL + PH - 2PM * breakeven: PL + PH - 2PM + * 2PM - PL - PH +
33
Straddle
long call and put OR short call and put; exp inc price volatility * profit: max ( 0, S - X ) + max ( 0, X - S ) - C - P * max gain: unlimited * max loss: (inv) C + P * breakeven: X - C - P *or* X + C + P
34
Collar
stock, long PL, short CH; exp low price volatility * profit: max ( 0, XL - S ) + max ( 0, S - XH ) + S - S0 * max profit: XH - S0 * max loss: S0 - XL * breakeven: S0
35
Box Spread
combo of bull and bear spreads; arbitrage opp * profit: XH - XL + PL - PH + CH - CL * compare annualized HPR to rf
36
Interest Rate Call Payoffs
* net loan: loan - FV(premium) * call payoff: NP [max[ 0, LIBOR - X] \* D/ 360 ] * eff $ int cost = loan int - call payoff * EAR: [(loan + eff $ int cost) / net loan]365/D - 1
37
Interest Rate Put Payoffs
* net loan: loan + FV(premium) * put payoff: NP [max[ 0, X - LIBOR] \* D/ 360 ] * eff $ int cost = loan int + put payoff * EAR: [(loan + eff $ int cost) / net loan]365/D - 1
38
Interest Rate Cap
payment when rate \> X series of int rate calls; caplets good for floating rate payer
39
Interest Rate Put
payment when X \< rate series of int rate puts; floorlets good for floating rate receiver
40
Delta
change in option price/ change in underlying
41
Delta Hedging
hedge downside risk of short options (dealers); earn rf stock required = - delta \* # options
42
Gamma
change in delta/ change in underlying
43
Vega
change in underlying/ change in volatility
44
Swap Duration
* fixed duration = 0.75 maturity * floating duration = 0.5 reset period * Dpay floating = Dfixed - Dfloating = +D * Dpay fixed = Dfloating - Dfixed = -D
45
Modifying Swap Duration
NP = [( MD - MD0 )/ MDswap] Vp rec floating = neg swap duration
46
Payer Swaption
buyer = right to be fixed-rate payer, receive floating exp rates to go up
47
Receiver Swaption
buyer = right to be fixed-rate receiver, pay floating exp rates to go down