Provides an escimace of tail loss by averaging rhe ranking for period i. tree:
VaRs for increasing confidence levels in the cail. Step 1: Price the bond value at each node using
Kendall's T
Weighted Historical Simulation the projected interest rates.
Approaches
'T
= _ c _, n,_
n" ,d _
n(n  1) I 2
Step 2: Calculate the intrinsic value of che
Ageweighted: adjuses the most recent (distant) derivative at each node at maturity.
observations co be more (less) heavily weighted. Step 3: Calcltlace the expected discounted value of
Where the number of concordant pairs is
Volatilityweighted: replaces historic returns with represented as nc (pair rankings in agreement), the derivative at each node using the risk
vo latility adj ust ed returns; actual procedure of

and the number of discordant pairs is represented neutral probabilities and work backward
estimating VaR is unchanged. as nd (pair rankings not in agreement). through the tree.
Compares the number of instances when losses All else held equal, che value of convexity
Correlation Swap
exceed the VaR level (exceptions) with the number increases wi ch maturity and volatility.
Used to trade a fixed correlation between cwo or
predicted by the model at tl1e chosen level of 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
confidence.
assuming risk neutrality Probability ofdefault (PD): likelihood that a Credit Risk Portfolio Models
r =current interest rate level borrower will default within a specified time These models attempt to estimate a portfolio's credit
horizon. value at risk. Credit VaR differs from market VaR
Model 3: assigns a specific parameterization of
Loss gi.ven default (LGD): amount of creditor loss in that it measures losses that are due specifically to
timedependent volatility:
in the event of a default. In percent terms, it is default risk and credit deterioration risk.
dr =A(t)dt + cre...o.dw
equal to 1 minus the recovery rate (i.e., 1 RR). CreditRisk+: determines default probability
where:
Exposure at default: amount of money the lender correlations and default probabilities by using a
a =volatility at t = 0, which decreases
can lose in the event of a borrower's default. set of common risk factors for each obligor.
exponentially to 0 for a > 0
The Merton Model CreditMetrics: uses historical data to estimate
CoxIngersollRoss (CIR) model meanreverting the probability of a bond being upgraded or
A valuebased model where the value of the firm's
model with constant volatility, cr, and basispoint downgraded using historical transition matrices.
outstanding debt (D) plus equity (E) is equal to
volatility, crJ;, that increases at a decreasing rate: the value of the firm CV). KMY Portfolio Manager: default probability is
dr = k(0r)dt + crJ;dw
The value of the debt can serve as an indicator of a function of firm asset growth and the level of
firm default risk. debt. The higher the growth and lower the debt
Model 4 (lognormal model): yield volatility, Since E and D are co nti ngent claims, option
level, the lower the default probability.
is constant, but basispoint volatility, crr, pricing can be used to determine their values as CreditPortfolio View: multifactor model for
a,
increases with the level of the shortterm rate. follows: simulating joint conditional distributions of
There are two lognormal models of importance: payment to shareholders: max(VMDM, 0) credit migration and default probabilities that
(1) lognormal with deterministic drift and
payment to debtholders: incorporates macroeconomic factors.
(2) lognormal with mean reversion.
DM max(D M  VM' 0) Credit Derivatives
Overnight Indexed Swaps (OIS) A credit derivative is a contract with payoffs
Interest rate swap in which a fixed interest rate
Equity is similar to a long call option on the value
of a firm's assets where face value of debt is the contingent on a specified credit event. Credit
is swapped for a floating interest rate. The OIS
strike price of the option. events include:
rate is the best proxy for the riskfree rate in the
Debt is similar to a riskfree bond and short put
Failure to make required payments.
valuation of collateralized derivatives portfolios. Restructuring that harms the creditor.
option on the value of a firm's assets where face
Types of credit risky securities include: corporate The hazard rate (default intensity) is represented
and sovereign debt, credit derivatives, and instruments have the same maturity.
by the (constant) parameter A and the probability
of default over the next, small time interval, dt, ABS/MBS Performance Tools Threshold: an exposure level below which
is >..dt. Auto loans: loss curves, absolute prepayment speed. collateral is not called. It represents an amount of
Cumulative PD Credit card debt: delinquency ratio, default ratio, uncollateralized exposure.
If the time of the default event is denoted t*, monthly payment rate. Minimum transfer amount: the minimum quantity
the cumulative default time distribution F(t) Mortgages: debt service coverage ratio, weighted or block in which collateral may be transferred.
represents the probability of default over (O, t): average coupon, weighted average maturity, Quantities below this amount represent
weighted average life, single monthly mortality, uncollateralized exposure.
P(t* < t ) = F(t) = 1  e><
constant prepayment rate, Public Securities Independent amount: an amount posted
The survival distribution is: Association. independently of any subsequent collateralization.
P(t* > t) = 1  F(t) = e>c Subprime Mortgage Market This is also referred to as the initial margin.
Subprime borrowers have a history of either default Rounding. the process by which a collateral call
Probability of Default or strong indicators of possible future default. amount will be adjusted (rounded) to a certain
Indicators of future default: past delinquencies,
The probability of default (PD) of a debt security mcrement.
OriginatetoDistribute Model Expected MtM: forward or expected value of a Incremental and Marginal CVA
Incremental CVA calculates the cost of a new trade
Enables lenders to originate a loan based on transaction at a given point in the future.
risk/reward pricing and then outsource the risk Expected exposure (EE): amount that is expected versus an existing one to determine the effect
through various channels. This provides better to be lost (positive MtM only) if the counterparty that the new trade has on CVA The formula is
access to capital for less creditworthy borrowers defaults. identical to standalone CVA, except for the use of
and more diversification options for investors. Potentialfuture exposure (PFE): worst exposure incremental expected exposure.
Collateralized Debt Obligations that could occur at a given time in the future at a
Marginal CVA is used for trade level attribution.
General term for an assetbacked security that given confidence level. The formula is identical to standalone CVA,
issues securities that pay principal and interest from Expected positive exposure (EPE): average EE except for the use of marginal expected exposure.
a collateral pool of debt instruments. through time. RiskNeutral Default Probability
In order to create a CDO, the issuer packages a Effective EE: equal to nondecreasing EE. Represents estimates of default probability based
series of debt instruments and splits the package Effective EPE: average of effective EE. on observed market prices of securities (e.g.,
into several classes of securities called tranches. Maximum PFE: highest PFE value over a stated bonds, credit default swaps).
The largest part of a CDO is typically the senior time frame. riskneutral default probability realworld
tranche, which usually carries an AA or AAA credit
=
Credit enhancements include overcollateraliution, Certain parameters impact the effectiveness of The RAROC measure is essential to successful
subordinating note classes, margin stepup, and collateral in lessening credit exposure. These integrated risk management. Its main function
excess spread. parameters are as follows: is to relate the return on capital to the riskiness
The firstloss piece (equity piece) absorbs initial Remargi.n period: the time between the call for of firm investments. The RAROC is risk
losses and is often held by the originator. collateral and its receipt. adjusted return divided by riskadjusted capital
(i.e., economic capital).
RAROC= 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:
revenues  costs EL tues +
meet the Ba.sel 11 operational risk standards for
rcrurn on economic capital uansfcrs
Dctenninc the firm's ac.ccptoblc lcvd ofrisk. regulatory capital. The LOA has several steps:
economic capital
Based on the firm's target debt rating, c:Stimore the
Organize and group loss data into a business line/
=  
Give individual managers the information and the fur each bW1iness line.
incen tive they n eed to make decisions ppropriate
ModdRisk Frequency Distributions
to maint2in the risk/capitol tradeof!:
LOA models most ofren use the Poisson
Risk associated with using financial models to
Identify the risks ofthe firm.
The implementation steps ofERM arc as follows: distribution, the negative binomial distribution, or
simulate complex relationships. Sources ofmodel
each produce ics own VaR measures. distribution, such os a lognormal distribution or a
lbe lack ofa market for a security to prevent i t Due to diversification dfcccs, firmwide VaR will be Weibull distribution.
(askprice  bidprice )
Operational Risk Data Elements Operational Risk Governance
ead
spr The four data elements that a bank m ust use in
The Basel Committee recognizes three common
whe re:
Employment Practices and Workplace Safety.
scenarios and maps out a strategy fur achieving chat
Z:,
Busin"" Oi.sruption and System r..Uures.
perspective.
spread confidence param eter Execution, Delivery, and Process Management.
Maximum likely cash oudlow over the horizon uncxpcacd and greatly improving a firm's saatcgic
period at a specified confidence lc:vtl. descriptions and analyses of operational risk planning and tactical decisionmaking.
Also kn own as cash l!CJW at risk (CFR). events derived from legal and regulatory sources Basd II: Three Pillars
Pillar 1: Minimum capital requirements. Banks
A p ositive (negative) value for Lall means rhe and n ews articles.
worst outcome. will be assoca i ted with an outflow OpemtilJnal Rik
s data eXchange Association should maintain a minimum level of capital to
(in8ow) ofcash. (ORX): consortiumbased risk event service; cover credit, market, and operati onal risks.
Pillar 2: Suisory rroinu proce.n. Banks should
LaR i.s similar to VaR, but nsi tead of a chnge in
gathers anonymous operational risk events from
assess the adequacy ofcapital relative to risk, and
valu e, it deals with cash l!CJWS.
members.
supervisors should review and take corrective Within each business line, gross income will
Established Financial Stability Oversight Council
action if problems occur. be multiplied by a fixed beta factor. The capital (FSOC).
Pillar 3: Market discipline. Risks should be charge for operational risk is the sum of eacl1 Establ is h ed Office of Financial Research (OFR).
adequately disclosed in order to allow market business line's cl1arges. The beta factors for the
Established Volker Ruic, intend ed to curtail
participants to assess a bank's risk profile and the eight business lines are as follows: proprietary trading by banks.
Banks considered toobigtofail must be identified
adequacy of its capital. Tradi ng and sales: 18%
Corporate finance: 18%
Basel II: Forms ofCapital judg ecl unacceptable.
Payme nt, settlement: 18%
Tzer I: shareholder's equity, retained earnings;
Commercial banking: 15%
Increas ecl regulation and improved transparency fur
nonredeemable, noncumulative preferred stock.
Agency scrviccs: 15% overthecounter (OTC) derivatives.
Tzer 2: undisclosed reserves, revaluation reserves, Rcrail banking: 12 %
general provisions/general loanloss reserves,
Retail b kerage: 12 %
ro
VaRp=ZcxPx
bu t also loss given default (LGD), exposure at Instit ute policies to address systemic risk and 2w1w2"1 "2P1.2
default (EAD), and elfectivc mat ity (M).
ur interconnectedness.
(equity risk, interest rate risk, foreign exchange Goal: ensure banks have adequate, highquality
risk, commodity risk, and option risk). The liquid assets to survive shortterm stress scenario. V..Rfor Uncorrelated Positions:
market risk capital charge for eacl1 market risk is LCR (stock of highquality liquid ass ets I total net
=
2 2
VaRp= VaR1 + VaR2
computed as 8% of its marketrisky assets. cash ou tAows over next 30 calendar days) > 100
Internal models approach (IMA): allows a bank Net Stable Funding Ratio Marginal VaR: per dollar change in portfolio VaR
to use its own risk management systems to Goal: protect banks over a longer time horizon that occurs from an additional investment in a
determine its market risk capital charge. The than LCR. pos1t1on.
NSF R (available. amount of stable funding I VaRp
market risk charge is the higher of (I) the =
MVaR = xi3
required amount of stable funding) > 100
previous day's VaR or (2) the average VaR over the 1 portfolio value 1
last 60 business days adjusted by a multiplicative Stressed Value at Risk How to use MVaR:
factor (subject to afloor of3). SVaR is calculated by combining current portfolio
Obtain the optimal portfulio: equate the excess
Backtesting VaR performance data with the firm's historical data rcturn/MVaR ratios of all portfulio positions.
An exception occurs if the day's change in value from a significantly financial stressed period in tl1e
Obtain the lowest portfolio VaR: equate just the
exceeded the VaR estimate of the previous day. same portfolio. Calculation of SVaR is defined as MVaRs of all portfolio positions.
When backtesting VaR, the number of exceptions follows: Incremental VaR: change in VaR from the addition
is determined for a 250<lay testing period. Based max (SVaR,_p mulciplicarive factor x SVaR3vg) of a new position in a portfolio.
on the number of exceptions, the bank's exposure Component VaR: amount of risk aparticular fund
is categorized into one of three zones andVaR is Solvency II contributes to a portfolio of funds.
scaled up by the appropriate multiplier (subject to
a floor of 3).
Establishes capital requirements for tl1e operational, CVaRl = MVaR xwl x P =VaR xi3I x wt
investment, and underwriting risks of insurance
increases b etween 0.4 and 0.85. SC R may b e calculated using either standardized
Red zone: Greater than or equal to l0 exceptions,
positions based on a predetermined fund risk
approach or internal models approach.
approach under Basel II. A VaR is calculat edwith whose combined VaRs are less than the total
charge on a firmwide basis. Banks will hold capital a oneyear tim e horizon and a 99.5% confidence allowed.
for operational risk equal to afixed percentage level. Budgeting risk across active managers: the optimal
of the bank's average annual gross income over allocation is achieved with the following formula:
the prior three years. The Basel Committee has DoddFrank Act
Intended to protect consumers from abuses and g
wei ht of portfolio managed b y manager i
proposed a fixed percentage equal to l 5o/o. I ; x portfolio ' s tracking error
R
prevent future bailouts and/or collapses of banks =
Standardi.udapproach: allows banks to divide I Rp x manager's tr acking erro r
activities along standardized business lines. and otl1er financial firms.
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.
Asset allocation attribution equals the difference Use more stress resting scenarios to take int0
X daily volume]
The Sharpt ratio calculates the amount ofexcess Global macro strategy: makes leveraged betS on Lender ofLast Resort (IOLR) Lending
return (over rhe riskfree 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 fixedincome markets, interest rates, foreign Liquidity regulations should complement LOLR
RF = average
riskfree return collateral for protection.
various fixedincome securities.
The 11tynor measure is very similar to the Sharpe
standard deviation ofaccount returns Dimensions ofLiquidity
Immediacy: Time to complete a transaction.
aA
Conwrtiblt arbitrage strategy: investor purchases
ratio cx.ccpt that it uses beta (systematic risk) as rhe 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
measure ofrisk. It shows exce<,< return {over the
riskfree 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 Multidimensional: Combination of factotS. Includes
distressed company and sell short the stock, pricebased 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
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
(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,