Financial Risk Management 2010-11 Topics

T1 Stock index futures

Duration, Convexity, Immunization

T2 Repo and reverse repo

Futures on T-bills
Futures on T-bonds
Delta, Gamma, Vega hedging

T3 Portfolio insurance
Implied volatility and volatility smiles

T4 Modelling stock prices using GBM

Interest rate derivatives (Bond options, Caps, Floors, Swaptions)

T5 Value at Risk

T6 Value at Risk: statistical issues

Monte Carlo Simulations
Principal Component Analysis
Other VaR measures

T7 Parametric volatility models (GARCH type models)

Non-parametric volatility models (Range and high frequency models)
Multivariate volatility models (Dynamic Conditional Correlation DCC models)

T8 Credit Risk Measures (credit metrics, KMV, Credit Risk Plus, CPV)

T9 Credit derivatives (credit options, total return swaps, credit default swaps)
Asset Backed Securitization
Collateralized Debt Obligations (CDO)

* This file provides you an indication of the range of topics that is planned to be covered in the
module. However, please note that the topic plans might be subject to change.
 Topics
Financial Risk Management
Futures Contract:

Speculation, arbitrage, and hedging
Topic 1

Stock Index Futures Contract:
Managing risk using Futures
Reading: CN(2001) chapter 3
Hedging (minimum variance hedge
ratio)

Hedging market risks

Futures Contract

Agreement to buy or sell “something” in the future at
a price agreed today. (It provides Leverage.)

Speculation with Futures: Buy low, sell high

Futures (unlike Forwards) can be closed anytime by taking
an opposite position
Speculation with Futures

Arbitrage with Futures: Spot and Futures are linked
by actions of arbitragers. So they move one for one.

Hedging with Futures: Example: In January, a farmer
wants to lock in the sale price of his hogs which will
be “fat and pretty” in September.

Sell live hog Futures contract in Jan with maturity in Sept
 Speculation with Futures Speculation with Futures

Purchase at F0 = 100

Hope to sell at higher price later F1 = 110
Profit/Loss per contract

Close-out position before delivery date. Long future

Obtain Leverage (i.e. initial margin is ‘low’) $10

Example:
Example: Nick Leeson: Feb 1995 F1 = 90
0

F0 = 100

Long 61,000 Nikkei-225 index futures (underlying F1 = 110 Futures price
value = $7bn).
-$10

Nikkei fell and he lost money (lots of it)

- he was supposed to be doing riskless ‘index Short future
arbitrage’ not speculating

Speculation with Futures

Profit payoff (direction vectors)
F increase F increase
then profit increases then profit decrease

Profit/Loss Profit/Loss
Arbitrage with Futures
-1
+1
Underlying,S
+1 or Futures, F -1

Long Futures Short Futures

or, Long Spot or, Short Spot
 Arbitrage with Futures Arbitrage with Futures

At expiry (T), FT = ST . Else we can make riskless
General formula for non-income paying security:
profit (Arbitrage). F0 = S0erT or F0 = S0(1+r)T

Forward price approaches spot price at maturity

Futures price = spot price + cost of carry
Forward price, F
Forward price ‘at a premium’ when : F > S (contango)

For stock paying dividends, we reduce the ‘cost of
carry’ by amount of dividend payments (d)

F0 = S0e(r-d)T
0 Stock price, St
T
At T, ST = FT
For commodity futures, storage costs (v or V) is
negative income
Forward price ‘at a discount’, when : F < S (backwardation)

F0 = S0e(r+v)T or F0 = (S0+V)erT

Arbitrage with Futures Arbitrage with Futures

For currency futures, the ‘cost of carry’ will be
Arbitrage at t<T for a non-income paying security:
reduced by the riskless rate of the foreign currency
If F0 > S0erT then buy the asset and short the futures
contract
(rf)

If F0 < S0erT then short the asset and buy the futures

F0 = S0e(r-rf)T
contract

For stock index futures, the cost of carry will be
Example of ‘Cash and Carry’ arbitrage: S=£100,
reduced by the dividend yield r=4%p.a., F=£102 for delivery in 3 months.
0.04×0.25

F0 = S0 e(r-d)T
We see Fɶ = 100 × e = 101 £

Since Futures is over priced,
time = Now time = in 3 months
•Sell Futures contract at £102 •Pay loan back (£101)
•Borrow £100 for 3 months and buy stock •Deliver stock and get agreed price of £102
 Hedging with Futures

F and S are positively correlated

To hedge, we need a negative correlation. So we
long one and short the other.
Hedging with Futures
Hedge = long underlying + short Futures

Hedging with Futures Hedging with Futures

Simple Hedging Example:
F1 value would have been different if r had changed.

You long a stock and you fear falling prices over the
This is Basis Risk (b1 = S1 – F1)
next 2 months, when you want to sell. Today (say

Final Value = S1 + (F0 - F1 ) = £100.7
January), you observe S0=£100 and F0=£101 for
April delivery. = (S1 - F1 ) + F0
so r is 4% = b1 + F0

Today: you sell one futures contract

In March: say prices fell to £90 (S1=£90). So where “Final basis” b1 = S1 - F1
F1=S1e0.04x(1/12)=£90.3. You close out on Futures.

At maturity of the futures contract the basis is zero

Profit on Futures: 101 – 90.3 = £10.7
(since S1 = F1 ). In general, when contract is closed

Loss on stock value: 100 – 90 =£10
out prior to maturity b1 = S1 - F1 may not be zero.

Net Position is +0.7 profit. Value of hedged portfolio
However, b1 will usually be small in relation to F0.
= S1+ (F0 - F1) = 90 + 10.7 = 100.7
 Stock Index Futures Contract

Stock Index Futures contract can be used to
eliminate market risk from a portfolio of stocks
F0 = S0 × e( r − d )T

If this equality does not hold then index arbitrage
Stock Index Futures Contract (program trading) would generate riskless profits.

Risk free rate is usually greater than dividend yield

Hedging with SIFs (r>d) so F>S

Hedging with Stock Index Futures Hedging with Stock Index Futures

Example: A portfolio manager wishes to hedge her
The required number of Stock Index Futures contract
portfolio of $1.4m held in diversified equity and to short will be 3
S&P500 index  TVS 0   $1, 400, 000 
Total value of spot position, TVS0=$1.4m NF = −  = −  = − 3.73

S0 = 1400 index point  FVF0   $375, 000 

Number of stocks, Ns = TVS0/S0 = $1.4m/1400
In the above example, we have assumed that S and
=1000 units F have correlation +1 (i.e. ∆ S = ∆ F )

We want to hedge Δ(TVSt)= Ns . Δ(St)

In reality this is not the case and so we need

Use Stock Index Futures, F0=1500 index point, z= minimum variance hedge ratio
contract multiplier = $250

FVF0 = z F0 = $250 ( 1500 ) = $375,000
 Hedging with Stock Index Futures Hedging with Stock Index Futures

Minimum Variance Hedge Ratio
To obtain minimum, we differentiate with respect to Nf
2
∆V = change in spot market position + change in Index Futures position (∂σ V / ∂N
f
= 0) and set to zero
= Ns . (S1-S0) + Nf . (F1 - F0) z
= Ns S0. ∆S /S0 + ∆F /F0) z
Nf F0. (∆ N f ( F V F0 ) 2 σ ∆2 F / F = −TVS
0
⋅ F V F ⋅ σ ∆ S / S ,∆ F / F
0
= TVS0 . ∆S /S0 + ∆F /F0)
Nf . FVF0 . (∆
 TVS0 
where, z = contract multiple for futures ($250 for S&P 500 Futures); ∆S = N f = −   ( σ ∆ S / S ,∆ F / F 2
σ ∆F / F )
S1 - S0, ∆F = F1 - F0  F V F0 
 TVS0 
=−  β ∆ S / S ,∆ F / F
The variance of the hedged portfolio is
2 2 2 2
σ V = (TVS 0 ) σ ∆S / S + ( N f ) ( FVF ) σ ∆F / F
2 2  F V F0 
0 where Ns = TVS0/S0 and beta is regression coefficient of the
+ 2N TVS 0 FVF0 . σ ∆S / S , ∆F / F regression
f (∆S / S ) = α 0 + β ∆S / ∆F ( ∆ F / F ) + ε

Hedging with Stock Index Futures Hedging with Stock Index Futures

SUMMARY 2 Application: Changing beta of your portfolio: “Market
∂σV / ∂N = 0 implies Timing Strategy”
f TVS
Nf = 0
.( β h − β p )
TVS 0 FVF0
Nf = − .β p
Example: βp (=say 0.8) is your current ‘spot/cash’ portfolio of stocks
FVF0 But

 Value of Spot Position 

= − 
 FaceValue of futures at t = 0


βp • You are more optimistic about ‘bull market’ and desire a higher exposure of
βh (=say, 1.3)
• It’s ‘expensive’ to sell low-beta shares and purchase high-beta shares

If correlation = 1, the beta will be 1 and we just have • Instead ‘go long’ more Nf Stock Index Futures contracts
TVS0
Nf = − Note: If βh= 0, then Nf = - (TVS0 / FVF0) βp
FVF0
 Hedging with Stock Index Futures Hedging with Stock Index Futures
Application: Stock Picking and hedging market risk

If you hold stock portfolio, selling futures will place a
You hold (or purchase) 1000 undervalued shares of Sven plc
hedge and reduce the beta of your stock portfolio.

If you want to increase your portfolio beta, go long V(Sven) = $110 (e.g. Using Gordon Growth model)
futures.
P(Sven) = $100 (say)

Example: Suppose β = 0.8 and Nf = -6 contracts would
make β = 0. Sven plc are underpriced by 10%.

If you short 3 (-3) contracts instead, then β = 0.4 Therefore you believe Sven will rise 10% more than the market over the next
3 months.

If you long 3 (+3) contracts instead, then β = 0.8+0.4
= 1.2 But you also think that the market as a whole may fall by 3%.

The beta of Sven plc (when regressed with the market return) is 2.0

Hedging with Stock Index Futures Hedging with Stock Index Futures
Can you ‘protect’ yourself against the general fall in the market and hence any Application: Future stock purchase and hedging market
‘knock on’ effect on Sven plc ? risk
Yes . Sell Nf index futures, using: You want to purchase 1000 stocks of takeover target with βp = 2, in 1
month’s time when you will have the cash.
TVS
N f = − 0
.β p
You fear a general rise in stock prices.
FVF 0 Go long Stock Index Futures (SIF) contracts, so that gain on the futures will
offset the higher cost of these particular shares in 1 month’s time.
If the market falls 3% then TVS
N f = 0
.β p
Sven plc will only change by about 10% - (2x3%) = +4% FVF 0

SIF will protect you from market risk (ie. General rise in prices) but not from
But the profit from the short position in Nf index futures, will give you an specific risk. For example if the information that you are trying to takeover
additional return of around 6%, making your total return around 10%. the firm ‘leaks out’ , then price of ‘takeover target’ will move more than that
given by its ‘beta’ (i.e. the futures only hedges market risk)
 Topics
Financial Risk Management
Duration, immunization, convexity

Repo (Sale and Repurchase agreement)
Topic 2 and Reverse Repo
Managing interest rate risks
Reference: Hull(2009), Luenberger (1997), and CN(2001)

Hedging using interest rate Futures

Futures on T-bills

Futures on T-bonds

Readings

Books

Hull(2009) chapters 6

CN(2001) chapters 5, 6

Luenberger (1997) chapters 3

Journal Article Hedging Interest rate risks: Duration

Fooladi, I and Roberts, G (2000) “Risk Management with Duration Analysis”
Managerial Finance,Vol 25, no. 3
 Duration Duration (also called Macaulay Duration)
Duration measures sensitivity of price changes (volatility) with
Duration of the bond is a measure that summarizes
changes in interest rates approximate response of bond prices to change in yields.
1 Lower the coupons
A better approximation could be convexity of the bond .
T for a given time to n

PB = ∑ C t t + ParValue T maturity, greater B = ∑ c i e − y ti

(1+ r )
weight
t =1 (1+ r )
T change in price to i =1
change in interest n
rates
∑ t i ⋅ c i e − y ti n
 c e − y ti 
T
2 Greater the time to D = i =1
= ∑ ti  i 
PB = ∑ C t t + ParValue T
maturity with a given B i =1  B 
coupon, greater
t =1 (1+ r ) (1+ r )
T
change in price to
Duration is weighted average of the times when payments
change in interest are made. The weight is equal to proportion of bond’s total
rates present value received in cash flow at time ti.
3 For a given percentage change in yield, the actual price increase is
Duration is “how long” bondholder has to wait for cash flows
greater than a price decrease

Macaulay Duration Modified Duration and Dollar Duration

For a small change in yields ∆ y / d y
For Macaulay Duration, y is expressed in continuous
compounding.
dB
∆B = ∆y
When we have discrete compounding, we have Modified
dy Duration (with these small modifications)

Evaluating d B :  n

If y is expressed as compounding m times a year, we divide D
dy ∆ B =  − ∑ t i c i e − y ti  ∆ y by (1+y/m) ∆B = − B ⋅ D
 i =1  ⋅ ∆y
(1 + y / m)
= −B ⋅ D ⋅∆y
∆B = − B ⋅ D* ⋅ ∆y
∆B
= −D ⋅∆y
B
Dollar Duration, D$ = B.D

D measures sensitivity of percentage change in bond
That is, D$ = Bond Price x Duration (Macaulay or Modified)
prices to (small) changes in yields
∆B = − D$ ⋅ ∆y
∆B

Note negative relationship between Price (B)
So D$ is like Options Delta D$ = −
∆y
and yields (Y)
 Duration Duration -example

Example: Consider a trader who has $1 million in Example: Consider a 7% bond with 3 years to maturity. Assume that the bond
is selling at 8% yield.
bond with modified duration of 5. This means for
A B C D E
every 1 bp (i.e. 0.01%) change in yield, the value of
the bond portfolio will change by $500. Present value Weight =
Year Payment Discount A× E
∆B = − ( $1, 000, 000 × 5 ) ⋅ 0.01% = −$500 =B× C D/Price
factor 8%

A zero coupon bond with maturity of n years has a 0.5 3.5 0.962 3.365 0.035 0.017
Duration = n 1.0 3.5 0.925 3.236 0.033 0.033

A coupon-bearing bond with maturity of n years will 1.5 3.5 0.889 3.111 0.032 0.048
have Duration < n 2.0 3.5 0.855 2.992 0.031 0.061
2.5 3.5 0.822 2.877 0.030 0.074

Duration of a bond portfolio is weighted average of
3.0 103.5 0.79 81.798 0.840 2.520
the durations of individual bonds Sum Price = 97.379 Duration = 2.753
D p o r tfo lio = ∑ (B
i
i / B )⋅ D i
Here, yield to maturity = 0.08, m = 2, y = 0.04, n = 6, Face value = 100.

Qualitative properties of duration Properties of duration

Duration of bonds with 5% yield as a function of
maturity and coupon rate. 1. Duration of a coupon paying bond is always less
than its maturity. Duration decreases with the increase
Coupon rate of coupon rate. Duration equals bond maturity for non-
Years to 1% 2% 5% 10% coupon paying bond.
maturity
1 0.997 0.995 0.988 0.977 2. As the time to maturity increases to infinity, the
2 1.984 1.969 1.928 1.868
5 4.875 4.763 4.485 4.156
duration do not increase to infinity but tend to a finite
10 9.416 8.950 7.989 7.107 limit independent of the coupon rate.
25 20.164 17.715 14.536 12.754
50 26.666 22.284 18.765 17.384 1 + mλ
Actually, D → where λ is the yield to maturity
100 22.572 21.200 20.363 20.067 λ
Infinity 20.500 20.500 20.500 20.500 per annum, and m is the number of coupon
payments per year.
 Properties of Duration Changing Portfolio Duration

3. Durations are not quite sensitive to increase in Changing Duration of your portfolio:
coupon rate (for bonds with fixed yield). They don’t
If prices are rising (yields are falling), a bond
vary huge amount since yield is held constant and
trader might want to switch from shorter
it cancels out the influence of coupons.
duration bonds to longer duration bonds as
4. When the coupon rate is lower than the yield, the longer duration bonds have larger price
duration first increases with maturity to some changes.
maximum value then decreases to the asymptotic
limit value.
Alternatively, you can leverage shorter
maturities. Effective portfolio duration =
5. Very long durations can be achieved by bonds with ordinary duration x leverage ratio.
very long maturities and very low coupons.

Immunization (or Duration matching) Immunization

This is widely implemented by Fixed Income Practitioners.
Matching present values (PV) of portfolio and obligations

This means that you will meet your obligations with the cash
time 0 time 1 time 2 time 3 from the portfolio.

If yields don’t change, then you are fine.
0 pay $ pay $ pay $
If yields change, then the portfolio value and PV will both change

You want to safeguard against interest rate increases. by varied amounts. So we match also Duration (interest rate risk)

A few ideas: PV1 + PV2 = PVobligation
1. Buy zero coupon bond with maturities matching timing of
Matching duration
cash flows (*Not available) [Rolling hedge has reinv. risk]
Here both portfolio and obligations have the same sensitivity to
interest rate changes.
2. Keep portfolio of assets and sell parts of it when cash is

If yields increase then PV of portfolio will decrease (so will the PV
needed & reinvest in more assets when surplus (* difficult as
of the obligation streams)
Δ value of in portfolio and Δ value of obligations will not

If yields decrease then PV of portfolio will increase (so will the PV
identical)
of the obligation streams)
3. Immunization - matching duration and present values D1 PV1 + D 2 PV2 = Dobligation PVobligation
of portfolio and obligations (*YES)
 Immunization Immunization
Example Suppose only the following bonds are available for its choice.
coupon rate maturity price yield duration
Suppose Company A has an obligation to Bond 1 6% 30 yr 69.04 9% 11.44
pay $1 million in 10 years. How to invest Bond 2 11% 10 yr 113.01 9% 6.54
in bonds now so as to meet the future Bond 3 9% 20 yr 100.00 9% 9.61

obligation? • Present value of obligation at 9% yield is $414,642.86.

• An obvious solution is the purchase of a • Since Bonds 2 and 3 have durations shorter than 10 years, it is not
simple zero-coupon bond with maturity 10 possible to attain a portfolio with duration 10 years using these
two bonds.
years.
Suppose we use Bond 1 and Bond 2 of amounts V1 & V2,
* This example is from Leunberger (1998) page 64-65. The numbers V1 + V2 = PV
are rounded up by the author so replication would give different P1V1 + D2V2 = 10 × PV
numbers.
giving V1 = $292,788.64, V2 = $121,854.78.

Immunization Immunization
Yield
9.0 8.0 10.0
Bond 1
Difficulties with immunization procedure
Price 69.04 77.38 62.14 1. It is necessary to rebalance or re-immunize the
Shares 4241 4241 4241 portfolio from time to time since the duration depends
Value 292798.64 328168.58 263535.74 on yield.
Bond 2 2. The immunization method assumes that all yields
Price 113.01 120.39 106.23 are equal (not quite realistic to have bonds with
Shares 1078 1078 1078 different maturities to have the same yield).
Value 121824.78 129780.42 114515.94
Obligation 3. When the prevailing interest rate changes, it is
value 414642.86 456386.95 376889.48 unlikely that the yields on all bonds change by the
Surplus -19.44 1562.05 1162.20 same amount.
Observation: At different yields (8% and 10%), the value of the
portfolio almost agrees with that of the obligation.
 Duration for term structure Duration for term structure

We want to measure sensitivity to parallel shifts in the spot
rate curve

Consider parallel shift in term structure: st
i
changes to sti + ∆y ( )

Then PV becomes

For continuous compounding, duration is called Fisher-
Fisher-Weil n
( )
P ( ∆y ) =
− sti + ∆ y ⋅ti
duration.
duration ∑x
i=0
ti ⋅e

If x0, x1,…, xn is cash flow sequence and spot curve is st where
t = t0,…,tn then present value of cash flow is
Taking differential w.r.t ∆y in the point ∆y=0 we get
n
dP ( ∆ y ) n

∑
− sti ⋅ti
| ∆ y = 0 = − ∑ t i x t i ⋅ e ti i
− s ⋅t
PV = xti ⋅ e
i=0 d ∆y i=0

The Fisher-Weil duration is
So we find relative price sensitivity is given by DFW

n
1 1 dP (0)
∑t
− sti ⋅ti
D FW = ⋅ x ti ⋅ e ⋅ = − D FW
PV i=0
i
P (0) d ∆ y

Convexity Convexity

Duration applies to only small changes in y
Convexity for a bond is
n

Two bonds with same duration can have different
1 d 2B ∑ t i2 ⋅ c i e − y t i n
 c e − y ti 
change in value of their portfolio (for large changes C =
B dy 2
= i =1

B
= ∑ t i2  i 
in yields) i =1  B 

Convexity is the weighted average of the ‘times squared’
when payments are made.

From Taylor series expansion
dB 1 d 2B
∆ B = ∆ y + (∆ )
2
y
dy 2 dy 2
∆ B 1
= − D ⋅ ∆ y + C ⋅ (∆ )
2
y
B 2

First order approximation cannot capture this, so we

So Dollar convexity is like Gamma measure in
take second order approximation (convexity)
options.
 Short term risk management using Repo

Repo is where a security is sold with agreement to buy it back at
a later date (at the price agreed now)

Difference in prices is the interest earned (called repo rate)
rate

It is form of collateralized short term borrowing (mostly overnight)

Example: a trader buys a bond and repo it overnight. The
REPO and REVERSE REPO money from repo is used to pay for the bond. The cost of this
deal is repo rate but trader may earn increase in bond prices
and any coupon payments on the bond.

There is credit risk of the borrower. Lender may ask for

margin costs (called haircut) to provide default protection.

Example: A 1% haircut would mean only 99% of the value of
collateral is lend in cash. Additional ‘margin calls’ are made if
market value of collateral falls below some level.

Short term risk management using Repo

Hedge funds usually speculate on bond price differentials
using REPO and REVERSE REPO

Example: Assume two bonds A and B with different prices (say price(A)<price(B)) but
similar characteristics. Hedge Fund (HF) would like to buy A and sell B
simultaneously.This can be financed with repo as follows:

(Long position) Buy Bond A and repo it. The cash obtained is used to pay for Interest Rate Futures
the bond. At repo termination date, sell the bond and with the cash buy
bond back (simultaneously). HF would benefit from the price increase in
bond and low repo rate (Futures on T-Bills)

(short position) Enter into reverse repo by borrowing the Bond B (as
collateral for money lend) and simultaneously sell Bond B in the market. At
repo termination date, buy bond back and get your loan back (+ repo
rate). HF would benefit from the high repo rate and a decrease in price of
the bond.
 Interest Rate Futures Interest Rate Futures
In this section we will look at how Futures contract written on a
Treasury Bill (T-Bill) help in hedging interest rate risks So what is a 3-month T-Bill Futures contract?
At expiry, (T), which may be in say 2 months time
Review - What is T-Bill?
the (long) futures delivers a T-Bill which matures at

T-Bills are issued by government, and quoted at a discount
T+90 days, with face value M=$100.

Prices are quoted using a discount rate (interest earned as % of
face value) As we shall see, this allows you to ‘lock in’ at t=0, the forward

Example: 90-day T-Bill is quoted at 0.08.
0.08 This means annualized rate, f12
return is 8% of FV. So we can work out the price, as we know FV.
T-Bill Futures prices are quoted in terms of quoted index, Q
  d   90  (unlike discount rate for underlying)
P = F V 1 −   
  100   360  Q = $100 – futures discount rate (df)

Day Counts convention (in US)

So we can work out the price as
1. Actual/Actual (for treasury bonds)
  d f   90 
2. 30/360 (for corporate and municipal bonds) F = F V 1 −   
3. Actual/360 (for other instruments such as LIBOR)   100   360 

Hedge decisions Cross Hedge: US T-Bill Futures

Example:
When do we use these futures contract to hedge?

Today is May. Funds of $1m will be available in August to
Examples: invest for further 6 months in bank deposit (or commercial bills)
1) You hold 3m T-Bills to sell in 1-month’s time ~ fear price fall ~ spot asset is a 6-month interest rate
~ sell/short T-Bill futures
Fear a fall in spot interest rates before August, so today BUY T-
bill futures
2) You will receive $10m in 3m time and wish to place it on a Eurodollar bank
deposit for 90 days ~ fear a fall in interest rates Assume parallel shift in the yield curve. (Hence all interest rates
~ go long a Eurodollar futures contract move by the same amount.)
~ BUT the futures price will move less than the price of the
3) Have to issue $100m of 180-day Commercial Paper in 3 months time (I.e. commercial bill - this is duration at work! higher the maturity, more
borrow money) ~ fear a rise in interest rates sensitive are changes in
~ sell/short a T-bill futures contract as there is no commercial bill futures prices to interest rates
contract (cross hedge)
Use Sept ‘3m T-bill’ Futures, ‘nearby’ contract
~ underlying this futures contract is a 3-month interest rate
 Cross Hedge: US T-Bill Futures Cross Hedge: US T-Bill Futures
Question: How many T-bill futures contract should I purchase?
3 month Desired investment/protection
exposure period period = 6-months
We should take into account the fact that:
1. to hedge exposure of 3 months, we have used T-bill futures
with 4 months time-to-maturity
May Aug. Sept. Dec. Feb.
2. the Futures and spot prices may not move one-to-one
Maturity of ‘Underlying’
We could use the minimum variance hedge ratio:
in Futures contract
TVS0
Nf = .β p
FVF0
Purchase T-Bill Known $1m Maturity date of Sept.

However, we can link price changes to interest rate
future with Sept. cash receipts T-Bill futures contract
delivery date changes using Duration based hedge ratio
Question: How many T-bill futures contract should I purchase?

Duration based hedge ratio Duration based hedge ratio

Using duration formulae for spot rates and futures:
Expressing Beta in terms of Duration:

∆S ∆F  TVS0 
= − DS ⋅ ∆ys = − DF ⋅ ∆yF Nf =   .β p
S F  FVF0 
We can obtain

So we can say volatility is proportional to Duration:  ∆S ∆F  last term by
Cov  , 
 ∆S   ∆F   TVS0   S F  regressing
σ2  = DS ⋅ σ ( ∆ys ) σ2  = DF ⋅ σ ( ∆yF ) =
2 2 2 2
 ∆yS = α0 + βy∆yF + ε
 S   F   FVF0  σ 2  ∆F 
 
 ∆S ∆F   F 
Cov  ,  = Ε ( − DS ⋅ ∆ys )( − DF ⋅ ∆yF ) 
 S F   TVS0  Ds  σ ( ∆ys ∆yF ) 
=   2 
= DS ⋅ DF ⋅ σ ( ∆ys ∆yF ) FVF D σ ( ∆y )
 0  F  F 
 Duration based hedge ratio Cross Hedge: US T-Bill Futures
Example

Summary: REVISITED
3 month Desired investment/protection
 TVS0   Ds 
Nf = .  βy  exposure period period = 6-months

 FVF0   DF 
May Aug. Sept. Dec. Feb.
where beta is obtained from the regression of yields

∆yS = α0 + β y ∆yF + ε Maturity of ‘Underlying’

in Futures contract

Purchase T-Bill Known $1m Maturity date of Sept.

future with Sept. cash receipts T-Bill futures contract
delivery date
Question: How many T-bill futures contract should I purchase?

Cross Hedge: US T-Bill Futures Cross Hedge: US T-Bill Futures

Suppose now we are in August:
May (Today). Funds of $1m accrue in August to be invested for 6- months
3 month US T-Bill Futures : Sept Maturity
in bank deposit or commercial bills( Ds = 6 )
Spot Market(May) CME Index Futures Price, F Face Value of $1m
Use Sept ‘3m T-bill’ Futures ‘nearby’ contract ( DF = 3) (T-Bill yields) Quote Qf (per $100) Contract, FVF

May y0 (6m) = 11% Qf,0 = 89.2 97.30 $973,000

Cross-hedge.
August y1(6m) = 9.6% Qf,1 = 90.3 97.58 $975,750
Here assume parallel shift in the yield curve Change -1.4% 1.10 (110 ticks) 0.28 $2,750
(per contract)

Qf = 89.2 (per $100 nominal) hence: Durations are : Ds = 0.5, Df = 0.25

Amount to be hedged = $1m. No. of contracts held = 2
F0 = 100 – (10.8 / 4) = 97.30
F

FVF0 = $1m (F0/100) = $973,000
Key figure is F1 = 97.575 (rounded 97.58)

Gain on the futures position
Nf = (TVS0 / FVF0) (Ds / DF ) = TVS0 (F1 - F0) NF = $1m (0.97575 – 0.973) 2 = $5,500
= ($1m / 973,000) ( 0.5 / 0.25) = 2.05 (=2)
 Cross Hedge: US T-Bill Futures

Invest this profit of $5500 for 6 months (Aug-Feb) at y1=9.6%:
= $5500 + (0.096/2) = $5764

Loss of interest in 6-month spot market (y0=11%, y1=9.6%)

= $1m x [0.11 – 0.096] x (1/2) = $7000 Interest Rate Futures

Net Loss on hedged position $7000 - $5764 = $1236
(so the company lost $1236 than $7000 without the hedge)
(Futures on T-Bonds)
Potential Problems with this hedge:
1. Margin calls may be required
2. Nearby contracts may be maturing before September. So we may have to roll
over the hedge
3. Cross hedge instrument may have different driving factors of risk

US T-Bond Futures US T-Bond Futures

Contract specifications of US T-Bond Futures at CBOT:
Conversion Factor (CF):
(CF): CF adjusts price of actual bond to be
Contract size $100,000 nominal, notional US Treasury bond with 8% coupon delivered by assuming it has a 8% yield (matching the bond to
Delivery months March, June, September, December the notional bond specified in the futures contract)
Quotation Per $100 nominal
Price = (most recent settlement price x CF) + accrued interest
Tick size (value) 1/32 ($31.25)
Last trading day 7 working days prior to last business day in expiry month

Example: Possible bond for delivery is a 10% coupon (semi-
Delivery day Any business day in delivery month (seller’s choice)
annual) T-bond with maturity 20 years.
Settlement Any US Treasury bond maturing at least 15 years from the
contract month (or not callable for 15 years)
The theoretical price (say, r=8%):
40
5 100

Notional is 8% coupon bond. However, Short can choose to P=∑ i
+ = 119.794
deliver any other bond. So Conversion Factor adjusts “delivery i =1 1.04 1.0440
price” to reflect type of bond delivered
Dividing by Face Value, CF = 119.794/100 = 1.19794 (per

T-bond must have at least 15 years time-to-maturity $100 nominal) If Coupon rate > 8% then CF>1

Quote ‘98-
‘98-14’ means 98.(14/32)=$98.4375 per $100 nominal If Coupon rate < 8% then CF<1
 US T-Bond Futures Hedging using US T-Bond Futures

Cheapest to deliver:
deliver:
Hedging is the same as in the case of T-bill Futures (except
In the maturity month, Short party can choose to deliver any Conversion Factor).
bond from the existing bonds with varying coupons and
maturity. So the short party delivers the cheapest one.
For long T-bond Futures, duration based hedge ratio is given
by:

Short receives:
 TVS0   Ds 
(most recent settlement price x CF) + accrued interest Nf =  
. β y  ⋅ CFCTD
 FVF D
0   F 

Cost of purchasing the bond is:
Quoted bond price + accrued interest where we have an additional term for conversion factor for
the cheapest to deliver bond.

The cheapest to deliver bond is the one with the smallest:
Quoted bond price - (most recent settlement price x CF)
Financial Risk Management

Topic 3a
Managing risk using Options
Readings: CN(2001) chapters 9, 13; Hull Chapter 17
 Topics

Financial Engineering with Options

Black Scholes

Delta, Gamma, Vega Hedging

Portfolio Insurance
 Options Contract - Review

An option (not an obligation), American and European

Put Premium

-
 Financial Engineering with options

Synthetic call option

Put-Call Parity: P + S = C + Cash

Example: Pension Fund wants to hedge its stock holding
against falling stock prices (over the next 6 months) and
wishes to temporarily establish a “floor value” (=K) but also
wants to benefit from any stock price rises.
 Financial Engineering with options

Nick Leeson’s short straddle

You are initially credited with the call and put premia C + P (at t=0) but if at expiry
there is either a large fall or a large rise in S (relative to the strike price K ) then you
will make a loss
(.eg. Leeson’s short straddle: Kobe Earthquake which led to a fall in S
(S = “Nikkei-225”) and thus large losses).
 Black Scholes
d1 − σ T

BS formula for price of European Call option d 2 =D2=d1
− rT
c = S 0 N (d 1 ) − K e N (d 2 )

Probability of call option being in-the-money and getting stock

Present value of the strike price

Probability of exercise and paying strike price

c = expected (average) value of receiving the stock in the event of

exercise MINUS cost of paying the strike price in the event of exercise
 Black Scholes
where S   σ2   S0   σ2 
ln  0 +r +  T ln  +r − T
K   2  ;d =  K   2 
d1 = or d 2 = d1 − σ T
σ T σ T
2
 Sensitivity of option prices
Sensitivity of option prices (American/European non- non-
dividend paying)

c = f ( K, S0, r, T, σ )
This however can be negative for
- + ++ + dividend paying European options.
Example: stock pays dividend in
2 weeks. European call with 1

p = f ( K, S0, r, T, σ ) week to expiration will have more
+ - - + + value than European call with 3
weeks to maturity.

Call premium increases as stock price increases (but less than

one-for-one)

Put premium falls as stock price increases (but less than one-
for-one)
 Sensitivity of option prices
The Greek Letters

Delta, ∆ measures option price change when stock
price increase by $1

Gamma, Γ measures change in Delta when stock
price increase by $1

Vega, υ measures change in option price when there
is an increase in volatility of 1%

Theta, Θ measures change in option price when
there is a decrease in the time to maturity by 1 day

Rho, ρ measures change in option price when there
is an increase in interest rate of 1% (100 bp)
 Sensitivity of option prices
∂f ∂2 f ∂f ∂f ∂f
∆ = ;Γ = ;υ = ;Θ = ;ρ =
∂S ∂S 2
∂σ ∂T ∂r

Using Taylor series,

1
df ≈ ∆ ⋅dS + Γ ⋅ (d S ) + Θ ⋅dt + ρ ⋅dr + υ ⋅dσ
2

Read chapter 12 of McDonald text book “Derivative Markets” for more about Greeks
 Delta

The rate of change of the option price with respect
to the share price

e.g. Delta of a call option is 0.6

Stock price changes by a small amount, then the option
price changes by about 60% of that

Option
price

Slope = ∆ = ∂c/ ∂ S
C

S Stock price
 Delta

∆ of a stock = 1
∂C

∆ call = = N ( d1 ) > 0
∂S (for long positions)
∂P

∆ put = = N ( d1 ) − 1 < 0
∂S

If we have lots of options (on same underlying) then
delta of portfolio is
∆ portfolio = ∑ N k ⋅ ∆ k
k
where Nk is the number of options held. Nk > 0 if long
Call/Put and Nk < 0 if short Call/Put
 Delta

So if we use delta hedging for a short call position, we
must keep a long position of N(d1) shares

What about put options?

The higher the call’s delta, the more likely it is that the
option ends up in the money:

Deep out-of-the-money: Δ ≈ 0

At-the-money: Δ ≈ 0.5

In-the-money: Δ≈1

Intuition: if the trader had written deep OTM calls, it
would not take so many shares to hedge - unlikely the
calls would end up in-the-money
 Theta

The rate of change of the value of an option with

respect to time

Also called the time decay of the option

For a European call on a non-dividend-paying stock,

S0 N '(d1 )σ − rT 1 −
x2
Θ=− − rKe N (d 2 ) where N '( x) = e 2

2T 2π

Related to the square root of time, so the relationship is
not linear
 Theta

Theta is negative: as maturity approaches, the option

tends to become less valuable

The close to the expiration date, the faster the value of
the option falls (to its intrinsic value)

Theta isn’t the same kind of parameter as delta

The passage of time is certain, so it doesn’t make
any sense to hedge against it!!!

Many traders still see theta as a useful descriptive statistic
because in a delta-neutral portfolio it can proxy for
Gamma
 Gamma

The rate of change of delta with respect to the

share price: ∂ 2
f
∂S 2

Calculated as Γ = N '(d1 )
S0σ T

Sometimes referred to as an option’s curvature

If delta changes slowly → gamma small → adjustments
to keep portfolio delta-neutral not often needed
 Gamma

If delta changes quickly → gamma large → risky to
leave an originally delta-neutral portfolio unchanged for
long periods:

Option
price

C''
C'
C

S S' Stock price

 Gamma
Making a Position Gamma-
Gamma-Neutral

We must make a portfolio initially gamma-neutral as well as delta-neutral
if we want a lasting hedge

But a position in the underlying share can’t alter the portfolio gamma
since the share has a gamma of zero

So we need to take out another position in an option that isn’t linearly
dependent on the underlying share

If a delta-neutral portfolio starts with gamma Γ, and we buy wT options
each with gamma ΓT, then the portfolio now has gamma
Γ + wT Γ T

We want this new gamma to = 0:
Γ + wT Γ T = 0
−Γ

Rearranging, wT =
ΓT
 Delta-Theta-Gamma
For any derivative dependent on a non-dividend-paying stock,
Δ , θ, and Г are related

The standard Black-Scholes differential equation is
∂f ∂f 1 2 2 ∂ 2 f
+ rS + σ S = rf
∂t ∂S 2 ∂S 2

where f is the call price, S is the price of the underlying

share and r is the risk-free rate

But Θ = ∂ f ∂f ∂ 2
f
, ∆= and Γ =
∂t ∂S ∂S 2
1 2 2

So Θ + rS ∆ + Θ S Γ = rf
2

So if Θ is large and positive, Γ tends to be large and negative,
and vice-versa

This is why you can use Θ as a proxy for Γ in a delta-neutral
portfolio
 Vega

NOT a letter in the Greek alphabet!

Vega measures, the sensitivity of an option’s
price to volatility:
volatility

υ =
∂f
∂σ
υ = S0 T N '(d1 )

High vega → portfolio value very sensitive to

small changes in volatility

Like in the case of gamma, if we add in a traded
option we should take a position of – υ/υT to
make the portfolio vega-neutral
 Rho

The rate of change of the value of a portfolio of

options with respect to the interest rate
∂f
ρ= ρ = KTe− rT N (d 2 )
∂r

Rho for European Calls is always positive and Rho for
European Puts is always negative (since as interest rates
rise, forward value of stock increases).

Not very important to stock options with a life of a few
months if for example the interest rate moves by ¼%

More relevant for which class of options?
 Delta Hedging

Value of portfolio = no of calls x call price + no of stocks x
stock price

V = NC C + NS S
∂V ∂C

= N C ⋅ + N S ⋅1 = 0
∂S ∂S
∂C
NS = −NC ⋅
∂S
N S = − N C ⋅ ∆ c a ll

So if we sold 1 call option then NC = -1. Then no of stocks to
buy will be NS = ∆call

So if ∆call = 0.6368 then buy 0.63 stocks per call option
 Delta Hedging

Example: As a trader, you have just sold (written)
100 call options to a pension fund (and earned a
nice little brokerage fee and charged a little more
than Black-Scholes price).

You are worried that share prices might RISE,
RISE hence
the call premium RISE, hence showing a loss on your
position.

Suppose ∆ of the call is 0.4. Since you are short,

your ∆ = -0.4 (When S increases by +$1 (e.g. from
100 to 101), then C decrease by $0.4 (e.g. from 10
to 9.6)).
 Delta Hedging
Your 100 written (sold) call option (at C0 = 10 each option)
You now buy 40-shares
Suppose S FALLS by $1 over the next month
THEN fall in C is 0.4 ( = “delta” of the call)
So C falls to C1 = 9.6
To close out you must now buy back at C1 = 9.6 (a GAIN of $0.4)

Loss on 40 shares = $40

Gain on calls = 100 (C0 - C1 )= 100(0.4) = $40
Delta hedging your 100 written calls with 40 shares means that
the value of your ‘portfolio is unchanged.
 Delta Hedging
Call Premium
∆ = 0.5

B
∆ = 0.4 .
A

0
.
100 110 Stock Price

As S changes then so does ‘delta’ , so you have to rebalance your portfolio.

E.g. ‘delta’ = 0.5, then you now have to hold 50 stocks for every written call.
This brings us to ‘Dynamic Hedging’, over many periods.

Buying and selling shares can be expensive so instead we can maintain the
hedge by buying and selling options.
 (Dynamic) Delta Hedging

You’ve written a call option and earned C0 =10.45 (with K=100,
σ = 20%, r=5%, T=1)

At t = 0: Current price S0 = $100. We calculate ∆ 0 = N(d1)= 0.6368.

So we buy ∆0 = 0.6368 shares at S0 = $100 by borrowing debt.
Debt, D0 = ∆0 x S0 = $63.68

At t = 0.01: stock price rise S1 = $100.1. We calculate ∆ 1 = 0.6381.

So buy extra (∆ 1 – ∆ 0) =0.0013 no of shares at $100.1.
Debt, D1 = D0 ert + (∆ 1 – ∆ 0) S1 = $63.84

So as you rebalance, you either accumulate or reduce debt

levels.
 Delta Hedging

At t=T, if option ends up well “in the money”

Say ST = 163.3499. Then ∆ T = 1 (hold 1 share for 1 call).

Our final debt amount DT = 111.29 (copied from Textbook page 247)

The option is exercised. We get strike $100 for the share.

Our Net Cost: NCT = DT – K = 111.29 – 100 = $11.29

How have we done with this hedging?

At t = 0,
0 we received $10.45 and at t = T we owe $11.29

% Net cost of hedge, % NCT = [ (DT – K )-C0 ] / C0 = 8%
(8% is close to 5% riskless rate)
 Delta Hedging
One way to view the hedge:
The delta hedge is supposed to be riskless (i.e. no change in value of portfolio of
“One written call + holding ∆ shares” , over any very small time interval )

Hence for a perfect hedge we require:

dV = NS dS + (NC ) dC ≈ NS dS + (-1) [ ∆ dS ] ≈ 0

If we choose NS = ∆ then we will obtain a near perfect hedge

(ie. for only small changes in S, or equivalently over small time intervals)
 Delta Hedging
Another way to view the hedge:
The delta hedge is supposed to be riskless, so any money we borrow (receive)
at t=0 which is delta hedged over t to T , should have a cost of r

Hence:
For a perfect hedge we expect: NDT / C0 = erT so, NDT e-r T - C0 ≈ 0

If we repeat the delta hedge a large number of times then:

% Hedge Performance, HP = stdv( NDT e-r T - C0) / C0

HP will be smaller the more frequently we rebalance the portfolio (i.e. buy or sell
stocks) although frequent rebalancing leads to higher ‘transactions costs’ (Kuriel
and Roncalli (1998))
 Gamma and Vega Hedging
∂2 f ∂f
Γ = υ =
∂S 2 ∂σ

Long Call/Put have positive Γ andυ

Short Call/Put have negative Γ and υ

Gamma /Vega Neutral: Stocks and futures have

Γ ,υ = 0
So to change Gamma/Vega of an existing options
portfolio, we have to take positions in further (new)
options.
 Delta-Gamma Neutral

Example: Suppose we have an existing portfolio of options, with a value of
Γ = - 300 (and a ∆ = 0)

Note: Γ = Σi ( Ni Γi )

Can we remove the risk to changes in S (for even large changes in S ? )

Create a “Gamma-Neutral” Portfolio

Let ΓZ = gamma of some “new” option (same ‘underlying’)

For Γport = NZ ΓZ + Γ = 0

we require: NZ = - Γ / ΓZ “new” options
 Delta-Gamma Neutral

Suppose a Call option “Z” with the same underlying (e.g. stock) has a delta =
0.62 and gamma of 1.5

How can you use Z to make the overall portfolio gamma and delta neutral?

We require: Nz Γz + Γ = 0
Nz = - Γ / Γz = -(-300)/1.5 = 200

implies 200 long contracts in Z (ie buy 200 Z-options)

The delta of this ‘new’ portfolio is now ∆ = Nz.∆z = 200(0.62) = 124

Hence to maintain delta neutrality you must short 124 units of the underlying -
this will not change the ‘gamma’ of your portfolio (since gamma of stock is
zero).
 Delta-Gamma-Vega Neutral

Example:You hold a portfolio with
∆ port = − 500, Γ port = − 5000, υ port = − 4000

We need at least 2 options to achieve Gamma and Vega neutrality. Then

we rebalance to achieve Delta neutrality of the ‘new’ Gamma-Vega
neutral portfolio.

Suppose there is available 2 types of options:

Option Z with ∆ Z = 0.5, Γ Z = 1.5, υ Z = 0.8

Option Y with ∆ Y = 0.6, Γ Y = 0.3, υ Y = 0.4

We need N Z υ Z + N Y υ Y + υ port = 0
N Z Γ Z + N Y Γ Y + Γ port = 0
 Delta-Gamma-Vega Neutral

So
N Z ( 0.8 ) + N Y ( 0.4 ) − 4000 = 0
N Z (1.5 ) + N Y ( 0.3 ) − 5000 = 0

Solution:
N Z = 2222.2 N Y = 5555.5

Go long 2222.2 units of option Z and long 5555.5 units of option Y to
attain Gamma-Vega neutrality.

New portfolio Delta will be:

2222.2 × ∆ Z + 5555.5 × ∆ Y + ∆ port = 3944.4

Therefore go short 3944 units of stock to attain Delta neutrality
Portfolio Insurance
 Portfolio Insurance

You hold a portfolio and want insurance against
market declines. Answer: Buy Put options

From put-call parity: Stocks + Puts = Calls + T-bills
Stock+Put = {+1, +1} + {-1, 0} = {0, +1} = ‘Call payoff’

This is called Static Portfolio Insurance.

Alternatively replicate ‘Stocks+Puts’ portfolio price movements

with
‘Stocks+T-bills’ or
‘Stocks+Futures’. [called Dynamic Portfolio Insurance]

Why replicate? Because it’s cheaper!
 Dynamic Portfolio Insurance
Stock+Put (i.e. the position you wish to replicate)
N0 = V0 /(S0 +P0) (hold 1 Put for 1 Stock)

N0 is fixed throughout the hedge:

At t > 0 ‘Stock+Put’ portfolio:

Vs,p = N0 (S + P)

Hence, change in value:

∂Vs, p  ∂ P
= N0 1+  = N0 (1+ ∆ p )
∂S  ∂S
This is what we wish to replicate
 Dynamic Portfolio Insurance
Replicate with (N0*) Stocks + (Nf) Futures:

N0* = V0 / S0 (# of index units held in shares)

N0* is also held fixed throughout the hedge.
Note: position in futures costs nothing (ignore interest cost on margin funds.)

At t > 0: VS,F = N0* S + Nf (F zf) F = S ⋅ e r (T − t )

∂ F F r (T − t )
∂ VS , F =e
Hence: ∂ F  ∂S
= N 0* + z f N f  
∂S ∂S 
Equating dV of (Stock+Put) with dV(Stock+Futures) to get Nf :

= [N (1 + ∆ ) − N ] * e − r (T − t )
Nft 0 p t 0
zf
 Dynamic Portfolio Insurance
Replicate with ‘Stock+T-Bill’

VS,B = NS S + NB B
∂ VS , B
= Ns
∂S
(V s , p ) t − ( N S ) t S t
NB,t =
Bt

Equate dV of (Stock+Put) with dV(Stock+T-bill)

( N s ) t = N 0 (1 + ∆ p )
t
= N 0 (∆ c ) t
 Dynamic Portfolio Insurance

Example:
Value of stock portfolio V0 = $560,000
S&P500 index S0 = 280
Maturity of Derivatives T - t = 0.10
Risk free rate r = 0.10 p.a. (10%)
Compound\Discount Factor er (T – t) = 1.01
Standard deviation S&P σ = 0.12

Put Premium P0 = 2.97 (index units)

Strike Price K = 280
Put delta ∆p = -0.38888
(Call delta) (∆c = 1 + ∆p = 0.6112)

Futures Price (t=0) F0 = S0 er(T – t ) = 282.814

Price of T-Bill B = Me-rT = 99.0
 Dynamic Portfolio Insurance
Hedge Positions
Number of units of the index held in stocks = V0 /S0 = 2,000 index units

Stock-Put Insurance
N0 = V0 / (S0 + P0) = 1979 index units

Stock-Futures Insurance
Nf = [(1979) (0.6112) - 2,000] (0.99/500) = - 1.56 (short futures)

Stock+T-Bill Insurance

No. stocks = N0 ∆c = 1979 (0.612) = 1,209.6 (index units)

NB = 2,235.3 (T-bills)
 Dynamic Portfolio Insurance

1) Stock+Put Portfolio
Gain on Stocks = N0.dS = 1979 ( -1) = -1,979
Gain on Puts = N0 dP = 1979 ( 0.388) = 790.3
Net Gain = -1,209.6

2) Stock + Futures: Dynamic Replicatin

Gain on Stocks = Ns,o dS = 2000 (-1) = -2,000
Gain on Futures = Nf.dF.zf = (-1.56) (-1.01) 500 = +790.3
Net Gain = -1,209.6
 Dynamic Portfolio Insurance
3) Stock + T-Bill: Dynamic Replication
Gain on Stocks = Ns dS = 1209.6 (-1) = -1,209.6
Gain on T-Bills = 0
(No change in T-bill price)

Net Gain = -1,209.6

The loss on the replication portfolios is very close to that

on the stock-put portfolio (over the infinitesimally small time period).

Note:We are only “delta replicating” and hence, if there are large changes in S or changes in
σ, then our calculations will be inaccurate

When there are large market falls, liquidity may “dry up” and it may not be possible to
trade quickly enough in ‘stocks+futures’ at quoted prices (or at any price ! e.g. 1987 crash).
Financial Risk Management

Topic 3b
Option’s Implied Volatility
 Topics

Option’s Implied Volatility

VIX

Volatility Smiles
 Readings
Books

Hull(2009) chapter 18

VIX

http://www.cboe.com/micro/vix/vixwhite.pdf

Journal Articles

Bakshi, Cao and Chen (1997) “Empirical Performance of Alternative
Option Pricing Models”, Journal of Finance, 52, 2003-2049.
Options Implied Volatility
 Estimating Volatility
Itō’s Lemma: The Lognormal Property

If the stock price S follows a GBM (like in the BS model),
then ln(
ln(ST/S0) is normally distributed.
 σ2  
ln S T − ln S 0 = ln( S T / S T ) ≈ φ  µ − T , σ T 
2

 2  

The volatility is the standard deviation of the

continuously compounded rate of return in 1 year

The standard deviation of the return in time ∆t
is σ ∆t

Estimating Volatility: Historical & Implied – How?

 Estimating Volatility from Historical Data

Take observations S0, S1, . . . , Sn at intervals of t years

(e.g. t = 1/12 for monthly)

Calculate the continuously compounded return in each
interval as:
u i = ln( S i / S i −1 )

Calculate the standard deviation, s , of the ui´s

1 n
s= ∑ i
n − 1 i =1
( u − u ) 2

The variable s is therefore an estimate for σ ∆t

So:
σˆ = s / τ
 Estimating Volatility from Historical Data
Price Relative Daily Return
Date Close St/St-1 ln(St/St-1)

For volatility estimation 03/11/2008 4443.3
(usually) we assume 04/11/2008
05/11/2008
4639.5
4530.7
1.0442
0.9765
0.0432
-0.0237
that there are 252 06/11/2008 4272.4 0.9430 -0.0587
07/11/2008 4365 1.0217 0.0214
trading days within one 10/11/2008 4403.9 1.0089 0.0089
11/11/2008 4246.7 0.9643 -0.0363
year 12/11/2008 4182 0.9848 -0.0154
13/11/2008 4169.2 0.9969 -0.0031
14/11/2008 4233 1.0153 0.0152
mean -0.13% 17/11/2008 4132.2 0.9762 -0.0241
18/11/2008 4208.5 1.0185 0.0183
stdev (s) 3.5% 19/11/2008 4005.7 0.9518 -0.0494
20/11/2008 3875 0.9674 -0.0332
τ 1/252 21/11/2008 3781 0.9757 -0.0246
24/11/2008 4153 1.0984 0.0938
σ(yearly) s / sqrt(ττ) = 55.56% 25/11/2008 4171.3 1.0044 0.0044
26/11/2008 4152.7 0.9955 -0.0045
27/11/2008 4226.1 1.0177 0.0175
28/11/2008 4288 1.0146 0.0145
01/12/2008 4065.5 0.9481 -0.0533

Back or forward looking 02/12/2008

03/12/2008
4122.9
4170
1.0141
1.0114
0.0140
0.0114

7 volatility measure? 04/12/2008 4163.6 0.9985 -0.0015

05/12/2008 4049.4 0.9726 -0.0278
08/12/2008 4300.1 1.0619 0.0601
 Implied Volatility
BS Parameters
Observed Parameters: Unobserved Parameters:

S: underlying index value Black and Scholes

X: options strike price σ: volatility

T: time to maturity

r: risk-free rate • Traders and brokers often quote implied volatilities

q: dividend yield rather than dollar prices

How to estimate it?

 Implied Volatility

The implied volatility of an option is the volatility

for which the Black-Scholes price equals (=) the
market price

There is a one-to-one correspondence between
prices and implied volatilities (BS price is
monotonically increasing in volatility)

Implied volatilities are forward looking and price
traded options with more accuracy

Example: If IV of put option is 22%, this means
that pbs = pmkt when a volatility of 22% is used in
the Black-Scholes model.
9
 Implied Volatility

Assume c is the call price, f is an option pricing
model/function that depends on volatility σ and other
inputs:
c = f (S , K , r , T , σ )

Then implied volatility can be extracted by inverting the

formula:
σ = f −1 (S , K , r , T , c mrk )

where cmrk is the market price for a call option.

The BS does not have a closed-form solution for its inverse
function, so to extract the implied volatility we use root-
finding techniques (iterative algorithms) like Newton-
Newton-
Raphson method
10
f (S , K , r , T , σ ) − c mrk = 0
 Volatility Index - VIX

In 1993, CBOE published the first implied
volatility index and several more indices later on.

VIX:
VIX 1-month IV from 30-day options on S&P

VXN:
VXN 3-month IV from 90-day options on S&P

VXD:
VXD volatility index of CBOE DJIA

VXN:
VXN volatility index of NASDAQ100

MVX:
MVX Montreal exchange vol index based on
iShares of the CDN S&P/TSX 60 Fund

VDAX:
VDAX German Futures and options exchange vol
index based on DAX30 index options
11
Others: VXI, VX6, VSMI, VAEX, VBEL, VCAC
Volatility Smile
 Volatility Smile

What is a Volatility Smile?

It is the relationship between implied
volatility and strike price for options with a
certain maturity

The volatility smile for European call
options should be exactly the same as
that for European put options

13
 Volatility Smile

Put-call parity p +S0e-qT = c +Ke–r T holds for market

prices (pmkt and cmkt) and for Black-Scholes prices
(pbs and cbs)

It follows that the pricing errors for puts and calls
are the same: pmkt−pbs=cmkt−cbs

When pbs=pmkt, it must be true that cbs=cmkt

It follows that the implied volatility calculated from a
European call option should be the same as that
calculated from a European put option when both
have the same strike price and maturity
14
 Volatility Term Structure

In addition to calculating a volatility

smile, traders also calculate a
volatility term structure

This shows the variation of implied
volatility with the time to maturity of
the option for a particular strike

15
 IV Surface

16
 IV Surface

17
 IV Surface

Also known as:

Volatility
18 smirk
Volatility skew
 Volatility Smile
Implied Volatility Surface (Smile) from Empirical
Studies (Equity/Index)

Bakshi, Cao and Chen (1997) “Empirical Performance of Alternative

19
Option Pricing Models ”, Journal of Finance, 52, 2003-2049.
 Volatility Smile
Implied vs Lognormal Distribution

20
 Volatility Smile

In practice, the left tail is heavier and the right tail is less
heavy than the lognormal distribution

What are the possible causes of the Volatility Smile
anomaly?

Enormous number of empirical and theoretical papers
to answer this …

21
 Volatility Smile
Possible Causes of Volatility Smile

Asset price exhibits jumps rather than continuous changes
(e.g. S&P 500 index)
Date Open High Low Close Volume Adj Close Return
04/01/2000 1455.22 1455.22 1397.43 1399.42 1.01E+09 1399.42 -3.91%
18/02/2000 1388.26 1388.59 1345.32 1346.09 1.04E+09 1346.09 -3.08%
20/12/2000 1305.6 1305.6 1261.16 1264.74 1.42E+09 1264.74 -3.18% -ve Price jumps
12/03/2001 1233.42 1233.42 1176.78 1180.16 1.23E+09 1180.16 -4.41%
03/04/2001 1145.87 1145.87 1100.19 1106.46 1.39E+09 1106.46 -3.50%

10/09/2001 1085.78 1096.94 1073.15 1092.54 1.28E+09 1092.54 0.62%

Trading was
17/09/2001 1092.54 1092.54 1037.46 1038.77 2.33E+09 1038.77 -5.05% suspended

16/03/00 1392.15 1458.47 1392.15 1458.47 1.48E+09 1458.47 4.65%

15/10/02 841.44 881.27 841.44 881.27 1.96E+09 881.27 4.62%
05/04/01 1103.25 1151.47 1103.25 1151.44 1.37E+09 1151.44 4.28%
14/08/02 884.21 920.21 876.2 919.62 1.53E+09 919.62 3.93% +ve price jumps
01/10/02 815.28 847.93 812.82 847.91 1.78E+09 847.91 3.92%
11/10/02 803.92 843.27 803.92 835.32 1.85E+09 835.32 3.83%
22
24/09/01 965.8 1008.44 965.8 1003.45 1.75E+09 1003.45 3.82%
 Volatility Smile
Possible Causes of Volatility Smile

Asset price exhibits jumps rather than continuous changes

Volatility for asset price is stochastic

In the case of equities volatility is negatively related to stock
prices because of the impact of leverage. This is consistent with
the skew (i.e., volatility smile) that is observed in practice

23
 Volatility Smile

24
 Volatility Smile
Possible Causes of Volatility Smile

Asset price exhibits jumps rather than continuous changes

Volatility for asset price is stochastic

In the case of equities volatility is negatively related to stock
prices because of the impact of leverage. This is consistent with
the skew that is observed in practice

Combinations of jumps and stochastic volatility

25
 Volatility Smile
Alternatives to Geometric Brownian Motion

Accounting for negative skewness and excess kurtosis by
generalizing the GBM

Constant Elasticity of Variance

Mixed Jump diffusion

Stochastic Volatility

Stochastic Volatility and Jump

Other models (less complex → ad-hoc)

The Deterministic Volatility Functions (i.e., practitioners Black
and Scholes)
(See chapter 26 (sections 26.1, 26.2, 26.3) of Hull for
these alternative specifications to Black-Scholes)
26
 Topic # 4: Modelling stock
prices, Interest rate
derivatives
Financial Risk Management 2010-11
February 7, 2011

FRM c Dennis PHILIP 2011

1 Modelling stock prices 2

1 Modelling stock prices

Modelling the evolution of stock prices is
about introducing a process that will explain
the random movements in prices. This ran-
domness is explained in the E¢ cient Market
Hypothesis (EMH) that can be summarized
in two assumptions:

1. Past history is re‡ected in present price

2. Markets respond immediately to any
new information about the asset

So we need to model arrival of new infor-

mation that a¤ects price (or much more re-
turns).

If asset price is S. Suppose price changes

to S + dS in a small time interval (say dt).
Then we can decompose returns dS S
into de-
terministic/anticipated part and a random
part where prices changed due to some ex-
ternal unanticipated news.
dS
= dt + dW
S

FRM c Dennis PHILIP 2011

1 Modelling stock prices 3

The randomness in the random part is ex-

plained by a Brownian Motion process and
scaled by the volatility of returns.

We can introduce time subscripts and re-

arrange to get

dSt = St dt + St dWt

This process is called the Geometric Brown-

ian Motion.

Why have we used Brownian Motion process

to explain randomness?

– In practice, we see that stock prices be-

have, atleast for long stretches of time,
like random walks with small and fre-
quent jumps
– In statistics, random walk, being the
simplest form, have limiting distribu-
tions and since BM is a limit of the
random walk, we can easily understand
the statistics of BM (use of CLT)

FRM c Dennis PHILIP 2011

1 Modelling stock prices 4

Next we see, what is this W (and in turn

what is dW)?

Brownian motion is a continuous time (rescaled)

random walk.

Consider the iid sequence "1 ; "2 ; ::: with mean

and variance 2 : Consider the rescaled ran-
dom walk model
1 X
Wn (t) = p "j
n 1 j nt

The interval length t is divided into nt equal

subintervals of length 1=n and the displace-
ments / jumps "j ; j = 1; 2; :::; nt in nt steps
are mutually independent random variables.

Then for large n; according to Central Limit

Theorem: W (t) N ( t; 2 t) :

FRM c Dennis PHILIP 2011

1 Modelling stock prices 5

Special cases: Standard Brownian Motion

arises when we have = 0; and = 1.

W is a Standard Brownian Motion if

1. W (0) = 0
2. W has stationary (for 0 s t; Wt
Ws and Wt s have the same distrib-
D
ution. That is, Wt Ws = Wt s
N (0; t s))
3. W has independent increments (for s
t; Wt Ws is independent of past his-
tory of W until time s)
4. Wt N (0; t)

FRM c Dennis PHILIP 2011

1 Modelling stock prices 6

For a Brownian Motion only the present value

of the variable is relevant for predicting the
future [also called Markov property]. There-
fore BM is a markov process.

It does not matter how much you zoom in,

it just looks the same. That is, the random-
ness does not smooth out when we zoom in.

BM …ts the characteristics of the share price.

Imagine a heavy particle (share price) that
is jarred around by lighter particles (trades).
Trades a¤ect the price movement.

what is this dW?

Consider a small increment in W

W (t + t) = W (t) + "(t + t)

where "(t + t) iidN (0; t) [Std BM].

FRM c Dennis PHILIP 2011

1 Modelling stock prices 7

Taking limit as ! 0; the change in W (t)

is

dWt = lim W (t + dt) W (t)

dt!0
= lim "(t + dt)
dt!0
iidN (0; dt)

So in the di¤erential form, we can write the

Standard Brownian motion process as
p
dWt = et dt where et N (0; 1)

FRM c Dennis PHILIP 2011

1 Modelling stock prices 8

Stochastic processes used in Finance

Arithmetic Brownian Motion for a share

price

A stock price does not generally have a mean

zero and atleast would grow on average with
the rate of in‡ation. Therefore we can write
dSt = (St ; t) dt + (St ; t)dWt
= drif t term + dif f usion term
= E(dS) + Stddev(dS)

When the drift function (St ; t) = and

di¤usion function (St ; t) = ; both con-
stants, we have the Arithmetic BM.
dSt = dt + dWt
p
= dt + et dt

In the case of ABM, S may be positive or

negative. Since prices cannot be negative,
we generally use the Geometric BM for asset
prices and made the drift and volatility as
functions of the stock price.

FRM c Dennis PHILIP 2011

1 Modelling stock prices 9

Geometric Brownian Motion

dSt = St dt + St dWt

If S starts at a positive value, then it will re-

main positive. The solution of the SDE St is
an exponential function which is always pos-
itive. Also, note that S will be lognormally
distributed.

GBM is related to ABM according to

dSt
= dt + dWt
St
where is the instantaneous share price volatil-
ity, and is the expected rate of return

The Hull and White (1987) Model uses GBM.

FRM c Dennis PHILIP 2011

1 Modelling stock prices 10

Ornstein-Uhlenbeck (OU) Process

The Arithmetic Ornstein-Uhlenbeck process

is given by

dSt = ( St ) dt + dWt

where is the long run mean and ( > 0)

is the rate of mean reversion. The drift term
is the mean reversion component, in that
the di¤erence between the long run mean
and the current price decides the upward or
downward movement of the stock price to-
wards the long run mean : Over time, the
price process drifts towards its mean and
the speed of mean reversion is determined
by :

This is an important process to model in-

terest rates that show mean reversion where
prices are pulled back to some long-run av-
erage level over time.

The Vasicek Model uses this kind of process.

FRM c Dennis PHILIP 2011

1 Modelling stock prices 11

A special case is when the mean is zero.

Then we can write the OU process as

dSt = St dt + dWt

In the OU process, the stock price can be

negative. Therefore we can introduce the
Geometric OU process

The Geometric OU process is given by

dSt = ( St ) St dt + St dWt

where the asset prices St would always be

positive.

So we can model asset prices using the Geo-

metric OU process and their log returns will
then follow an Arithmetic OU process.

dSt = ( St ) St dt + St dWt
dSt
= ( St ) dt + dWt
St

FRM c Dennis PHILIP 2011

1 Modelling stock prices 12

Square Root Process

A square root process satis…es the SDE

p
dSt = St dt + St dWt

This type of process generates positive prices

and used for asset prices whose volatility
does not increase too much when St increases.

Cox-Ingersoll-Ross (CIR) process

The CIR combines mean reversion and square

root process and satis…es the SDE
p
dSt = ( St ) dt + St dWt

This process was introduced in the Hull and

White (1988), and Heston (1993) stochas-
tic volatility models. This class of mod-
els generated strictly non-negative volatility
and accounted for the clustering e¤ect and
mean reversion observed in volatility.

FRM c Dennis PHILIP 2011

1 Modelling stock prices 13

Also used to model short rates features pos-

itive interest rates, mean reversion, and ab-
solute variance of interest rates increases with
interest rates itself.

Solving the Stochastic Di¤erential Equa-

tions

Consider the GBM

dSt = St dt + St dWt

In the integral form

ZT ZT ZT
dSt = St dt + St dWt
0 0 0
ZT ZT
ST = S0 + St dt + St dWt
0 0
= reimann integ + It^
o integ

So we have to solve the intergrals to get a

closed form solutions to this SDE.

FRM c Dennis PHILIP 2011

1 Modelling stock prices 14

We use Ito-lemma to solve this problem.

Not all SDE’s have closed form solutions.

When there are no solutions, we have to
do numerical approximations for these in-
tegrals.

Examples:

Geometric Brownian Motion

dSt = St dt + St dWt

has the solution

1
St = S0 e( )t+
2 Wt
2

Ornstein-Uhlenbeck (OU) Process

dSt = ( St ) dt + dWt

has the solution

Zt
t t (t s)
S t = S0 e + 1 e + e dWs
0

FRM c Dennis PHILIP 2011

1 Modelling stock prices 15

Consider the following process

dSt = St dt + dWt

has the solution

Zt
St = S 0 e t + e (t s)
dWs
0

Simulating Geometric Brownian Motion

1 2
We can write St = S0 e( 2 )t+ Wt in dis-
crete time intervals and substituting for Wt
as 1 2
p
St = St 1 e( 2 ) t+ et t
where et N (0; 1)

So we randomly draw et and …nd the value

of St

FRM c Dennis PHILIP 2011

2 Interest Rate Derivatives 16

2 Interest Rate Derivatives

The payo¤ of interest rate derivatives would
depend on the future level of interest rates.

The main challenge in valuing these deriv-

atives are that interest rates are used both
for discounting and for de…ning payo¤s.

For valuation, we will need a model to de-

scribe the behavior of the entire yield curve.

Black’s Model to price European Options

Consider a call option on a variable whose

value is V:

To calculate expected payo¤, the model ass-

sumes:

1. VT has lognormal distribution with

2
V ar(lnVT ) = T

2. E(VT ) = F0

FRM c Dennis PHILIP 2011

2 Interest Rate Derivatives 17

The payo¤ is max(VT K; 0) at time T .

We discount the expected payo¤ at time T
using the risk-free rate given by P (0; T )

We will use the key result that you know

from Derivatives:
If V is lognormally distributed and stan-
dard deviation on ln(V ) is s, then

E[max ( V K; 0)] = E[ V ] N (d1 ) KN (d2 )

where
ln(E[ V ]=K) + s2 =2
d1 =
s
ln(E[ V ]=K) s2 =2
d2 =
s

Therefore, value of the call option is given

by

c = P (0; T ) [F0 N (d1 ) KN (d2 )]

FRM c Dennis PHILIP 2011

2 Interest Rate Derivatives 18

where
2
ln(F0 =K) + T =2
d1 = p
T
and
ln(F0 =K) 2
T =2 p
d2 = p = d1 T
T
where

– F is forward price of V for a contract

with maturity T
– F0 is value of F at time zero
– K is strike of the option
– is volatility of forward contract

Similarly, for a put option

p = P (0; T ) [KN ( d2 ) F0 N ( d1 )]

FRM c Dennis PHILIP 2011

2 Interest Rate Derivatives 19

European Bond Options

Bond option is an option to buy or sell a

particular bond by a certain date for a par-
ticular price.
Callable bonds and Puttable bonds are ex-
amples of embedded bond options.
The payo¤ is given by max(BT K; 0) for
a call option.
To price an European Bond Option:

– we assume bond price at maturity of

option is lognormal
– we de…ne such thatp standard devia-
tion of ln(BT ) = T
– F0 can be calculated as
B0 I
F0 =
P (0; T )
where B0 is bond (dirty) price at time
zero and I is the present value of coupons
that will be paid during the life of op-
tion

FRM c Dennis PHILIP 2011

2 Interest Rate Derivatives 20

– Then using Black’s model we price of a

bond option

Interest Rate Caps and Floors

An interest rate Cap provides insurance against

the rate of interest on a ‡oating-rate note
rising above a certain level (called Cap rate).

Example:
Principal amount = $10 million
Tenor = 3 months (payments made every
quarter)
Life of Cap = 5 years
Cap rate = 8%

If the ‡oating-rate exceeds 8 %, then you

get cash of the di¤erence.

Suppose at a reset date, 3-month LIBOR is

9%, the ‡oating-rate note would have to pay

0:25 0:09 $10million = $225; 000

FRM c Dennis PHILIP 2011

2 Interest Rate Derivatives 21

and with the Cap rate at 8%, the payment

would be

0:25 0:08 $10million = $200; 000

Therefore the Cap provides a payo¤ of $25,000

to the holder.

Consider a Cap with total life of Tn ; a Prin-

cipal of L, Cap rate of RK based on a refer-
ence rate (say, on LIBOR) with a month
maturity denoted by R(t) at date t.

The contract follows the schedule:

t T0 T1 T2 Tn
C1 C2 Cn
T0 is the starting date. For all j = 1; :::; n,
we assume a constant tenor Tj Tj 1 =

On each date Tj ; the Cap holder receives a

cash ‡ow of Cj

Cj = L max [R(Tj 1 ) RK ; 0]

The Cap is a portfolio of n such options and

each call option is known as the caplets.

FRM c Dennis PHILIP 2011

2 Interest Rate Derivatives 22

Lets now consider a Floor with the same

characteristics. On each date Tj ; the Floor
holder receives a cash ‡ow of Fj

Fj = L max [RK R(Tj 1 ); 0]

The Floor is a portfolio of n such options

and each put option is known as the ‡oor-
lets.

FRM c Dennis PHILIP 2011

2 Interest Rate Derivatives 23

Interest rate Caps can be regarded as a port-

folio of European put options on zero-coupon
bonds.

Put-Call parity relation:

Consider a Cap and Floor with same strike
price RK . Consider a Swap to receive ‡oat-
ing and pay a …xed rate of RK , with no ex-
change payments on the …rst reset date. The
Put-Call parity states:

Cap price = Floor price + value of Swap

FRM c Dennis PHILIP 2011

 2 Interest Rate Derivatives 24

Collar

A Collar is designed to guarantee that the

interest rate on the underlying ‡oating-rate
note always lie between two levels.

Collar = long position in Cap + short posi-

tion in Floor

It is usually constructed so that the price of

Cap is equal to price of the ‡oor. Then the
cost of entering into a Collar is zero.

Valuation of Caps and Floors

If the rate R(Tj ) is assumed to be lognormal

with volatility j , the value of the caplet
today (t) for maturity Tj is given by
Caplett = L P (t; Tj ) FTj 1 ;Tj
N (d1 ) RK N (d2 )

where
ln(FTj 1 ;Tj
=RK ) + 2j (Tj 1 t) =2
d1 = p
(Tj 1 t)

FRM c Dennis PHILIP 2011

 2 Interest Rate Derivatives 25

and q
d2 = d1 j (Tj 1 t)
where FTj 1 ;Tj is the forward rate underlying
the Caplet from Tj 1 to Tj :

Similarly,
F loorlett = L P (t; Tj ) RK N ( d2 ) FTj 1 ;Tj
N ( d1 )

FRM c Dennis PHILIP 2011

Financial Risk Management

Lecture 5
Value at Risk
Readings: CN(2001) chapters 22,23; Hull_RM chp 8

1
 Topics

Value at Risk (VaR)

Forecasting volatility

Back-testing

Risk Grades

VaR: Mapping cash flows

2
 Value at Risk

Example:
If at 4.15pm the reported daily VaR is $10m (calculated at 5%
tolerance level) then:
I expect to lose more than $10m only 1 day in every 20 days
(ie.
ie. 5% of the time)

The VaR of $10m assumes my portfolio of assets is fixed

Exactly how much will I lose on any one day?

Unknown !!!

3
 Value at Risk

Statement (how bad can things get?):
“We are x% certain that we will not loose more than V dollars in
the next N days”

V dollars = f(x%, N days)

Suppose asset returns is niid, then risk can be measured by

variance/S.D.

From Normal Distribution critical values table, we can work out
the VaR.

Example: For 90% certainty, we can expect actual return to be
between the range { µ − 1 .6 5 σ , µ + 1 .6 5 σ }

4
 Value at Risk

Normal Distribution (N(0,σ))
Probability Mean = 0

5% of the area

5% of the area

-1.65σ 0.0 +1.65σ

Return
Only 5% of the time will the actual % return R be below:
“ R = µ - 1.65 σ1” where µ = Mean (Daily) Return.
5 If we assume µ=0, VaR = $V (1.65 σ1)
 VaR for single asset
Example:
Mean return = 0 %. Let σ1 = 0.02 (per day)
Only 5% of the time will the loss be more than 3.3% (=1.65 x 2%)

VaR of a single asset (Initial Position V0 =$200m in equities)

VaR = V0 (1.65 σ1 ) = 200 ( 0.033) = $6.6m
That is “(dollar) VaR is 3.3% of $200m” = $6.6m
VaR is reported as a positive number (even though it’s a loss)

Are Daily Returns Normally Distributed? - NO

• Fat tails (excess kurtosis), peak is higher and narrower, negative skewness,
small (positive) autocorrelations, squared returns have strong
autocorrelation, ARCH.
• But niid is a (reasonable) approx for portfolios of equities, long term
6 bonds, spot FX , and futures (but not for short term interest rates or options)
 VaR for portfolio of assets

7
 VaR for portfolio of assets

8
 VaR for portfolio of assets

9
 VaR for portfolio of assets

10
 VaR for portfolio of assets

Summary: Variance – Covariance method

If Vp is the market value of your portfolio of n assets and wi is

the proportionate weight in each asset i then

VaR p = V p [ zCz ']

1/2

where
z =  w1 (1.65σ 1 ) , w2 (1.65σ 2 ) ,… , wn (1.65σ n ) 
 1 ρ12 … ρ1n 
ρ ⋱ 
C =  21 
 ⋮ 
 
 ρ n1 1 
11
 Forecasting

12
 Forecasting σ

Simple Moving Average ( Assume Mean Return = 0 )
σ2 t+1|t = (1/n) Σi R2t-i

Exponentially Weighted Moving Average EWMA

σ2 t+1|t = Σi wi R2t-i wi = (1-λ) λi

It can be shown that this may be re-written:

σ2t+1|t = λ σ2t| t-1 + (1- λ) Rt2

Longer Horizons: T -rule - for iid returns.

σΤ = T σ
13
 Forecasting σ

Exponentially Weighted Moving Average (EWMA)
σ2t+1|t = λ σ2t| t-1 + (1- λ) Rt2

How to estimate λ?
1. Use GARCH models to estimate λ
2. Minimize forecast error Σ (Rt+12 – σ2 t+1|t) where the sum is
over all assets, and say 100 days
3. λ = 0.94 as by JPMorgan

Suppose λ = 0.94 then weights decline as 0.94, 0.88, 0.83,….

and past observations are given less weight than current
forecast of variance.
14
 Back-testing

In back-testing, we compare our (changing) daily
forecast of VaR with actual profit or loss over some
historic period.

Example: For a portfolio of assets,

• forecast all the individual VaRi = Vi1.65 σt+1|t ,

• calculate portfolio VaR for each day:

VaRp = [Z C Z’]1/2

• then see if actual portfolio losses exceed this only 5% of the

time (over some historic period, e.g. 100 days).

15
 Back-testing
Daily $m profit/loss
= forecast
= actual

Days

Only 6 violations out of

16
100 = just ‘OK’
 VaR and Capital Adequacy-Basle
Basle uses a more ‘conservative’ measure of VaR than J. P. Morgan

Calc VaR for worst 1% of losses over 10 days

Use at least 1-year of daily data to estimate σt+1|t
VaRi = 2.33 10 σ
( 2.33 = 1% left tail critical value, σ = daily vol ) Internal Models
approach
Capital Charge KC
KC = Max ( Avg. of previous 60-days VaR x M, previous day’s VaR)
M = multiplier (min = 3) Pre-commitment
approach

• KC set equal to max. forecast loss over 20 day horizon = pre-

announced $VaR
17
• If losses exceed VaR, more than 1 day in 20, then impose a penalty.
 VaR and Coherent Risk Measures

Risk measures that satisfy all the following 4 conditions are called as a
Coherent Risk Measure.

Monotonicity: X 1 ≤ X 2 ⇒ R ( X 1 ) ≤ R ( X 2 )
(higher the riskiness of the portfolio, higher should be risk capital)

Translation invariance: R ( X + k ) = R ( X ) − k ∀k ∈ ℝ
(if cash k is added to portfolio, risk should go down by k)

Homogeneity: R ( λ X ) = λ R ( X ) ∀λ ≥ 0
(if you change portfolio by a factor of λ, risk is proportionally increased)

Subadditivity: R ( X + Y ) ≤ R ( X ) + R (Y )
18 (diversification leads to less risk)
 VaR and Coherent Risk Measures

VaR violates the subadditivity condition and therefore not
coherent. VaR cannot capture the benefits of diversification.

VaR can actually show negative diversification benefit!

VaR only captures the frequency of default but not the size
of default. Even if the largest loss is doubled, the VaR figure
could remain the same.

Other measures such as Expected Shortfall are coherent

measures.
19
 Risk Grades

20
 Risk Grades

RG helps to calculate changing forecasts of risks (volatilities)

RG quantifies volatility/risk (similar to variance, std. deviation,
beta, etc)

RG can range from 0 to over 1000, where 100 corresponds to

the average risk of a diversified market-cap weighted index of
global equities.

So if two portfolio’s have RG1 = 100 and RG2 = 400, portfolio 2
is four times riskier than portfolio 1

RG scales all assets to a common scale and so it is able to
compare risk across all asset classes.

21
 Risk Grades
RG of a single asset
σi 252 σi 252
RG = σ ×100 = ×100
i 0.20
base
σi is the DAILY standard deviation
σbase is fixed at 20% per annum (= 5 yr. av. for international portfolio of
stocks)

Formula looks complex but RG is just a “scaled” daily standard deviation

e.g. If RG = 100% then asset has 20% p.a. risk

RG of a portfolio of assets
RG 2 = ∑ w i2 RG i2 + ∑ ∑ w i w j ρ RG i RG j
22 P
 Risk Grades

Risk Grades in 2009

www.riskgrades.com
23
 Risk Grades
Risk Grades
in 2009 of
indices
heating up
and cooling
off

24
 VaR Mapping
(VaR for different assets)

25
 VaR for different assets
PROBLEMS

STOCKS : Too many covariances [= n(n-1)/2 ]

FOREIGN ASSETS : Need VaR in “home currency”

BONDS: Many different coupons paid at different times

DERIVATIVES: Options payoffs can be highly non-

linear (ie. NOT normally distributed)

SOLUTIONS = “Mapping”
(RiskMetricsTM produce volatility & correlations for various assets
26 across 35 countries and useful for “Mapping”)
 VaR for different assets

STOCKS
Within each country use “single index model” SIM

FOREIGN ASSETS
Treat one asset in foreign country as = “local currency risk”+ spot
FX risk (like 2-assets, with equal weight)

BONDS
Consider each bond as a series of “zeros”

OTHER ASSETS
Forward-FX, FRA’s, Swaps: decompose into ‘constituent parts’

27
DERIVATIVES(non-linear)
 Mapping Stocks
Consider ‘p’ = portfolio of stocks held in one country with (Rm , σm)
(for e.g. S&P500 in US)

Problem : Too many covariances to estimate

Soln. All n(n-1)/2 covariances “collapse or mapped” into σm

and the asset betas (“n” of them)

Single Index Model:

Ri = ai + bi Rm + εi
Rk = ak + bk Rm + εk

assume Eεi εk = 0 and cov (Rm , ε ) = 0

28
All the systematic variation in Ri AND Rk is due to Rm

 Mapping Stocks
1) In a portfolio idiosyncratic risk εi is diversified away = 0

2) Then each return-i depends only on the market return (and

beta). Hence ALL variances and covariances also only depend
on these 2 factors. It can be shown that
σp = bp σm
(i.e. Calculation of portfolio beta requires, only n-beta’s and σm )

3) Also, ρ = 1 because (in a well diversified portfolio) each return

moves only with Rm

4) We end up with VaRp = VP 1.65 ( bP σm )

or equivalently VaRp = (Z C Z’ )1/2

where Z = [ VaR1, VaR2 …. } C is the unit matrix

29
 Mapping Foreign Assets
(Mapping foreign stocks into domestic currencyVaR)

30
 Mapping Foreign assets
Example:
US resident holds a diversified portfolio of German stocks
equivalent to German stocks + Euro-USD, FX risk

Use SIM to obtain stdv of foreign (German) portfolio returns,

σG

Then treat ‘foreign portfolio’ as (two) equally weighted

assets:
= $V in German asset + $V foreign currency position

Then use standard VaR formula for 2-assets

31
 Mapping Foreign assets

US based investor: with €100m in a German stock portfolio
σG = βP σDAX
Sources of risk:
a) Stdv of the German portfolio (‘local currency’ portfolio)
b) Stdv of €/$ exchange rate ( σFX )
c) one covariance/correlation coefficient ρ (between DAX and FX rate)

e.g. Suppose when German stock market falls then the € also falls -
‘double whammy’ for the US investor, from this positive correlation, so
foreign assets are very risky (in terms of their USD ‘payoff’)

Let : S = 1.2 $/ €

Dollar initial value Vo$ = 100m x 1.2 = $120m

Linear dVP = V0$ (RG + RFX)

32 above implies wi = Vi / V0$ = 1

 Mapping Foreign assets

Dollar-VaRp = Vo$ 1.65 σp

σp = (
σG
2
+ σ FX
2
+ 2 ρσ Gσ FX )1
2

No ‘relative weights’ appear in the formula

Matrix Representation: Dollar VaR

Let Z = [ V0,$ 1.65 σG , V0,$ 1.65 σFX ]

=[ VaR1 , VaR2 ]

V0,$ = $120m for both entries in the Z-vector (i.e. equal amounts)

Then VaRp = (Z C Z’ )1/2

33
 Mapping Bonds
(Mapping coupon paying bonds)

34
 Mapping Coupon paying Bonds
Example:
Coupons paid at t=5 and t=7
Treat each coupon as a separate zero coupon bond

100 100
P= +
(1 + y5 ) (1 + y7 )7
5

P = V5 + V7

P is linear in the ‘price’ of the zeros, V5 and V7

We require two variances of “prices” V5 and V7 and

covariance between these prices.
Note: σ5(dV5 / V5) = D σ(dy5)
but Risk Metrics provides the price volatilities, σ5(dV5 / V5)
35
 Mapping Coupon paying Bonds
Treat each coupon as a zero
Calculate:
price of zero, e.g. V5 = 100 / (1+y5)5
VaR5 = V5 (1.65 σ5)
VaR7 = V7 (1.65 σ7)

VaR (both coupon payments):

VaRp = (Z C Z’ )1/2

= [ VaR + VaR + 2 ρ VaR 5VaR 7 ]

2
5
2
7
1/ 2

r = correlation: bond prices at t=5 and t=7

(approx 0.95 - 0.99 )
36
 Mapping FRA

37
 Mapping FRA

To calculate VaR for a FRA, we break down cash flows into
equivalent synthetic FRA and use spot rates only (since we do
not know the forward volatilities)

Example: Consider an FRA on a notional of $1m that involves

lending $1m in 6 months time for a future of 6 months.
Receipt of $1m + Interest

0 6m 12m
Lend $1m

Let y6 = 6.39%, y12 = 6.96% and there are 182 days in the first
leg and 183 days in the second leg (day count: actual/365).

The implied f6,12 = 7.294% and therefore the 12 month investment
will give $1,036,572 return (with round off error).
38
 Mapping FRA

The original FRA Receipt of $1,036,572

0 6m 12m
Lend $1m

Synthetic FRA
Receipt of $1,036,572
Borrow at 6 month rate from 12 month lending

0 6m 12m
Repay 6
Lend at 12 month rate month loan
of $1m

So at time 0, we borrow $969,121 [=1m / 1+(y6*182/365)] and lend

this money at a 12 month rate leading to $1,036,572
[=$969,121*(1+y12)]
39
 Mapping FRA

Suppose the standard deviation of the prices for 6 month asset is
0.1302% and for 12 month asset is 0.2916%. Suppose ρ = 0.7

To calulate the VaR for each of these positions:

VaR6 = $969,121 (1.65) (0.1302%) = $2082

VaR12 = $969,121 (1.65) (0.2916%) = $4663

VaR = [ VaR + VaR + 2 ρ ( −VaR 6 ) VaR12 ]

2
6
2
12
1/ 2

= $3534

40
 Mapping FX Forwards

41
 Mapping FX Forwards

Consider a US resident who holds a long forward contract to
purchase €10million in 1 year.

What is the VaR for this contract?

We map Forward into  two spot rates and one spot FX rate.

Then we calculate VaR from the VaR of each individual mapped
asset.

Mapping a forward contract

42
 Mapping FX Forwards

43
 Mapping FX Forwards

44
 Mapping Options

45
 Mapping Options

46
 Mapping Options

47
 Mapping Options

48
 Mapping Options

49
Financial Risk Management

Topic 6
Statistical issues in VaR
Readings: CN(2001) chapters 24, Hull_RM chp 8,
Barone-Adesi et al (2000)
RiskMetrics Technical Document (optional)

1
 Topics

Value at Risk for options

Monte Carlo Simulation

Historical Simulation

Bootstrapping

Principal component analysis

Other related VaR measures

Marginal VaR, Incremental VaR, ES
2
 MCS - VaR of Call option

Option premia are non-linear (convex) function of
underlying

Distribution of gains/losses is not normally distributed

Therefore dangerous to use Var-Cov method

Assets Held: One call option on stock

Here, Black-Scholes is used to price the option during the
Monte Carlo Simulation (MCS).

Problem
Find the VaR over a 5-day horizon
3
 MCS - VaR of Call option

If V is price of the option (call or put) and P is price of
underlying asset in the option contract (stock)

V will change from minute to minute as P changes. For an

equal change in P of +1 or -1 ,the change in call premia are
NOT equal: this gives “non-normality” in distribution of the
4
change in call premium
 MCS - VaR of Call option

To find VaR over a 5-day horizon:
1) Given P0 calculate the option price, V0 = BS(P0, K, T0 …..)
This is fixed throughout the MCS

2) MCS = Simulate the stock price and calculate P5

3) Calculate the new option price, V5= BS(P5, K, T0 – 5/365, …..)

4) Calculate change in option premium

∆V(1) = V5 – V0
5) Repeat steps 2-4, 1000 times and plot a histogram of the change
in the call premium. We can then find the 5% lower cut-off point
for the change in value of the call (i.e. it’s VaR).
5
 MCS - VaR of Call option

20

18

16
5% of area
14
Frequency

12

10

0
-10 -8 -6 -4 -2 0 2 4 6 8 10 More
$-VaR is $5m
Change in Call Premium
6
 MCS - VaR of Call option

Simulate stock prices using
P(t+1) = P(t) exp[ (µ - σ2/2) ∆t + σ (∆t)1/2 εt+1 ]

To generate 5-day prices from daily prices, you can use the
root-T rule
∆t = 5/365 (or 5/252) ( ie. five day)

Alternatively, we can generate Tt+5 directly.

If P0 is today’s known price. Use a ‘do-loop’ over 5 ‘periods’
to get P5 (using 5 - ‘draws’ of εt+1 )

7
 MCS - VaR of Call option

Stock price paths generated

8
 Monte Carlo Simulation for Two Assets
(two call options on different underlying assets)

9
 Simulating correlated random variables

10
 Simulating correlated random variables

11
 Simulating correlated random variables

12
 MCS and VaR: two asset example

13
 MCS and VaR: two asset example

14
 MCS and VaR: two asset example

15
 MCS and VaR: two asset example

16
 MCS and VaR: two asset example

17
 MCS and VaR: two asset example

18
 MCS and VaR: two asset example

19
 Comparing VaR forecasts

20
 Comparing VaR forecasts

21
 Historical Simulation
(Historical simulation + bootstrapping)

22
 Historical Simulation (HS)
Suppose you currently hold $100 in each of 2 assets
Day = 1 2 3 4 5 6 …1000
R1(%) +2 +1 +4 -3 -2 -1 +2
R2(%) +1 +2 0 -1 -5 -6 -5
_____________________________________________________
∆Vp($) +3 +3 +4 -4 -7 -7 -5

Order ∆Vp in ascending order (of 1000 numbers) e.g.

-12, -11, -11 -10, -9, -9, -8, -7, -7, -6 | -5, -4, -4, …. +8, ……. +14
VaR forecast for tomorrow at 1% tail (10th most negative)
= -$6
23
Above is equivalent to the histogram
 Historical Simulation (HS)

This is a non parametric method since we do not estimate any
variances or covariances or assume normality.

We merely use the historic returns, so our VaR estimates encapsulate

whatever distribution the returns might embody ( e.g. Student’s t) as
well as any autocorrelation in individual returns.

Also, the historic data “contain” the correlations between the returns
on the different assets, their ‘own volatility’ and their own
autocorrelation over time

It does rely on ‘tomorrow’ being like ‘the past’.

24
 HS + Bootstrapping

Problems:

Is data >3 years ago useful for forecasting tomorrow?

Use most recent data - say last 100 days ?
1% tail: Has only one number in this tail, for the actual data !

Extreme case !
Actual data might have largest negative (for 100 days ago) of
minus 50%
- this would be your forecast VaR for tomorrow using historic
simulation approach. Is this okay or not?
25
 HS + Bootstrapping

You have “historic” daily data on each of 10 stock returns (i.e.
your portfolio )

But only use last 100 days of historic daily returns, So we have
a data matrix of 10 x 100.

We require VaR at the 1st percentile (1% cut off)

We sample “with replacement” from these 100 observations,

giving equal probability to each ‘day’ , when we sample.

This allows any one day’s returns to be randomly chosen more
than once (or not at all).

It is as if we are randomly ‘replaying’ the last 100 days of
26
history, giving each day equal probability
 HS + Bootstrapping
The Bootstrap

Draw randomly from a uniform distribution with an equal probability of
drawing any number between 1 and 100.

If you draw “20” then take the 10-returns in column 20 and revalue the
portfolio. Call this $-value, ∆VP(1)

Repeat above for 10,000 “trials/runs” (with replacement), obtaining

10,000 possible (alternative) values ∆VP (i)

“With replacement” means that in the 10,000 runs you will “choose” some of
the 100 columns more than once.

Plot a histogram of the 10,000 values of ∆VP(i) - some of which will be

negative

Read off the “1% cut off” value (=100th most negative value). This is
VaRp
27
 Filtered Historical Simulation (FHS)

28
 FHS

HS assumes risk factors are i.i.d however this is usually not the case.

HS assumes that distribution of returns are stable and that the past and
present moments of the density function of returns are constant and
equal.

The probability of having a large loss is not equal across different days.
There are periods of high volatility and periods of low volatility (volatility
clustering).

In FHS, historical returns are first standardized by volatility estimated on

that particular day (hence the word Filtered).

The filtering process yields approximately i.i.d returns (residuals) that are
suited for historical simulation.

29
read Barone-Adesi et al (2000) paper in DUO on FHS
 Principal Component Analysis
(Estimating risk factors using PCA)

30
 Estimating risk factors using PCA

31
 Estimating risk factors using PCA

32
 Estimating risk factors using PCA

33
 Estimating risk factors using PCA

34
 Estimating risk factors using PCA

35
 Estimating risk factors using PCA

36
 Estimating risk factors using PCA

37
 PCA and risk management

38
 PCA and risk management

39
 Other related VaR measures

40
 Other related VaR measures

41
 Other related VaR measures

42
 Other related VaR measures

43
 Other related VaR measures

44
 Other related VaR measures

45
 Other related VaR measures

46
 Other related VaR measures

47
 Topic # 7: Univariate and
Multivariate Volatility
Estimation
Financial Risk Management 2010-11
February 28, 2011

FRM c Dennis PHILIP 2011

1 Volatility modelling 2

1 Volatility modelling

Volatility refers to the spread of all likely

outcomes of an uncertain variable.
It can be measured by sample standard de-
viation
v
u
u 1 X T
^=t (rt )2
T 1 t=1

where rt is the return on day t, and is the

average return over the T day period.
But this statistic only measures the spread
of a distribution and not the shape of a dis-
tribution (except normal and lognormal).
Black Scholes model assumes that asset prices
are lognormal (which implies that returns
are normally distributed).
In practice, returns are however non-normal
and also the return ‡uctuations are time vary-
ing.

FRM c Dennis PHILIP 2011

1 Volatility modelling 3

Example: daily returns of S&P 100 show

features of volatility clustering

Therefore Engle (1982) proposed Autoregres-

sive Conditional Heteroscedasticity (ARCH)
models for modelling volatility
Other characteristics documented in litera-
ture

FRM c Dennis PHILIP 2011

1.1 Parametric volatility models 4

– Long memory e¤ect of volatility (au-

tocorrelations remain positive for very
long lags)
– Squared returns proxy volatility
– Volatility asymmetry / leverage e¤ect
(volatility increases if the previous day
returns are negative)

1.1 Parametric volatility models

ARCH model

‘Autoregressive’because high/low volatility

tends to persist, ‘Conditional’ means time-
varying or with respect to a point in time,
and ‘Heteroscedasticity’is a technical jargon
for non-constant volatility.
Consider previous t day’s squared returns
("2t 1 ; "2t 2 ; :::) that proxy volatility.
It makes sence to give more weight to recent
data and less weight to far away observa-
tions.

FRM c Dennis PHILIP 2011

1.1 Parametric volatility models 5

Suppose we are assuming that previous q ob-

servations a¤ect today’s returns. So today’s
volatility can be
q
X
2 2
t = j "t j
j=1

Pq
where i < j for i > j and j=1 j =1

Also we can include a long run average vari-

ance that should be given some weight as
well q
X
2 2
t = V0 + j "t j
j=1

where
Pq V0 is average variance rate and +
j=1 j = 1

The weights are unknown and needs to be

estimated.

This is the ARCH model introduced by En-

gle (1982)

FRM c Dennis PHILIP 2011

1.1 Parametric volatility models 6

ARCH (1)

An ARCH(1) model is given by

2
rt = + "t "t N 0;
2 2
t = 0 + 1 "t 1

Since 2t is variance and has to be positive,

we impose the condition

0 0 and 1 0

Generalization: ARCH(q) model

2 2 2
t = 0 + 1 "t 1 + ::: + q "t q

where shocks up to q periods ago a¤ect the

current volatility of the process.

FRM c Dennis PHILIP 2011

1.1 Parametric volatility models 7

EWMA

Exponentially weighted moving average (EWMA)

model is the same as the ARCH models but
the weights decrease exponentially as you
move back through time.

The model can be written as

2 2
t = t 1 + (1 )u2t 1

where is the constant decay rate, say 0.94.

To see that the weights cause an exponential

decay, we substitute for 2t 1 :

2 2
t = t 2 + (1 )u2t 2 + (1 )u2t1
2 2
= (1 ) u2t 1 + (1 ) u2t 2 + t 2

With =0.94

2
t = (0:06) u2t 1 + (0:056) u2t 2 + (0:883) 2
t 2

2
Substituting for t 2 now:

FRM c Dennis PHILIP 2011

1.1 Parametric volatility models 8

2 2
t = (1 ) u2t 1 + (1 ) u2t 2 + 2
t 3 + (1 )u2t 3
2 3 2
= (1 ) u2t 1 + (1 ) u2t 2 + (1 )u2t 3 + t 3

With =0.94

2
t = (0:06) u2t 1 + (0:056) u2t 2 + (0:053) u2t 3 + (0:83) 2
t 3

Risk Metrics uses EWMA model estimates

for volatility with = 0.94.

FRM c Dennis PHILIP 2011

1.1 Parametric volatility models 9

Generalized ARCH (GARCH) model

This model generalizes the ARCH speci…ca-

tion.

As one increase the q lags in an ARCH model

for capturing the higher order ARCH e¤ects
present in data, we loose parsimonity.

Bollerslev (1986) proposed GARCH(p; q)

q p
X X
2 2 2
t = 0 + j "t j + j t j
j=1 j=1

where the weights 0 0; j 0 and j

0: Further, for stationarity of this autore-
gressive model, we need the condition
q p
!
X X
j + j <1
j=1 j=1

In this model, today’s volatility is explained

by the long run variance rate, the past squared
observations, and the past volatility history.

FRM c Dennis PHILIP 2011

1.1 Parametric volatility models 10

Special case: GARCH(1,1)

2 2 2
t = 0 + 1 "t 1 + 1 t 1

where 0 ( 1 + 1) < 1:

To see that the weights cause an exponential

decay, consider a GARCH(1,1) process
2 2 2
t = 0 + 1 "t 1 + 1 t 1

2
We substitute for t 1:

2 2 2 2
t = 0 + 1 "t 1 + 1 0 + 1 "t 2 + 1 t 2
2 2 2 2
= 0 + 0 1 + 1 "t 1 + 1 1 "t 2 + 1 t 2

2
Substituting for t 2 now:
2
t = 0 + + 1 "2t 1 +
0 1
2
1 1 "t 2 +
2 2 2
1 0 + 1 "t 3 + 1 t 3
2 2 2
= 0+ 0 1+ 0 1+ 1 "t 1 + 1 1 "t 2 +
2 2 3 2
1 1 "t 3 + 1 t 3

i 1
So the weight applied to "2t i is 1 1 : The
weights decline at rate :

FRM c Dennis PHILIP 2011

1.1 Parametric volatility models 11

GARCH is same as EWMA in assigning ex-

ponentially declining weights to past obser-
vations. However, GARCH also assigns some
weight to the long-run average variance rate.

When the intercept parameter 0 = 0 and

1 + 1 = 1; then GARCH reduces to a
EWMA.

A GARCH(1,1) model can be interpreted as

an 1 order ARCH.

To see this, consider a ARCH(1)

2 2 2 2
t = 0 + 1 "t 1 + 2 "t 2 + ::: + 1 "t 1

Problem of how to estimate this

– Use the Koyck transform

Assume 1 is declining

– E¤ect of lagged residuals falls as time

goes by
1 > 2 > 3 > ::: > 1

FRM c Dennis PHILIP 2011

1.1 Parametric volatility models 12

Also assume a geometric decline in 1 such

that
k
k = a

where 0 < <1

Gives conditional variance equation as:

2
t = 0+ a "2t 1 + a 2 "2t 2 + ::: + a 1 "2t 1
= 0+a "2t 1 + 2 "2t 2 + ::: + 1 "2t 1

Now consider one lag of the variance equa-

tion 2t 1
2 2 2 1 2
t 1 = 0 +a "2t 2 + "t 3 + ::: + "t 1

Multiply by through
2 2 2 1 2
t 1 = 0 +a "2t 2 + "t 3 + ::: + "t 1

2 2
Now derive t t 1 using the above equa-
tions
2 2
2
t
2
t 1 = 0 +a "2t 1 + "t 2 + ::: + 1 "2t 1
0 +a "2t 2 + 2 "2t 3 + ::: + 1 "2t 1

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1.1 Parametric volatility models 13

Solving
2 2
t t 1 = ( 0 0 ) + a "2t 1
2
t = ( 0 0 ) + a "2t 1 + 2
t 1

GJR model or TARCH model

Introduced by Glosten, Jagannathan, Run-

kle (1993). Hence called GJR model.
Also called Threshold ARCH (TARCH) model.
Asymmetries in conditional variances could
also be introduced by distinguishing the sign
of the shock.
We can therefore separate the positive and
negative shock and allow for di¤erent coef-
…cients in a GARCH framework.
q q p
X 2
X 2
X
+
2
t = 0+ j "+
t j + j "t j + j
2
t j
j=1 j=1 j=1

If +
j = j for j = 1; 2; :::; q then this re-
duces to a GARCH(p,q) model.

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1.1 Parametric volatility models 14

GJR(1993) proposed keeping the original GARCH

framework and adding an extra component
that captures the negative shocks. This is
because bad news usually has a greater im-
pact on volatility than good news.
The GJR(1,1) model is
2 + 2 2 2
t = 0 + 1 "t 1 + T " t 1 Dt 1 + 1 t 1

where
1 for "t 1 <0
Dt 1 =
0 for "t 1 0

Remarks:

– For testing symmetry, we consider test-

ing H0 : T = 0: The leverage e¤ect is
seen in T > 0:
+
– 1 is the coe¢ cient for positive shocks.
+
– + T = 1 is the coe¢ cient for
1
negative shocks.
– For positivity of the conditional vari-
ances, we require 0 > 0; + 1 0; and
+
1 + T 0. Hence, T is allowed to
be negative provided + 1 > j Tj:

FRM c Dennis PHILIP 2011

1.1 Parametric volatility models 15

Exponential GARCH (EGARCH)

Recall that in the case of (G)ARCH models,

we provided certain coe¢ cient restrictions in
order to ensure 2t (conditional variance of
"t ) is non-negative with probability one.

An alternative way of ensuring positivity is

specifying an EGARCH framework for 2t :

Another characteristic of the model is that

it allows for positive and negative shocks
to have di¤erent e¤ects on conditional vari-
ances (unlike GARCH).

The model re‡ects the fact that …nancial

markets respond asymmetrically to good news
and bad news.

EGARCH(p,q) model is
q q
X "t j
X "t j
2
ln t = 0 + j + j
j=1 t j j=1 t j
p
X
2
+ j ln t j
j=1

FRM c Dennis PHILIP 2011

1.1 Parametric volatility models 16

where if theh error

i terms
q "t = t N (0; 1)
then = E "tt = 2

Remarks:

– We can use other fat failed distribu-

tions such as student t; or GED in the
case of non-normal errors. In this case,
will take other forms.
– Specifying the model as a logarithm en-
sures positivity of 2t : Therefore the lever-
age e¤ect is exponential rather than quadratic.
– We divide the errors by the conditional
standard deviations, "tt : Therefore we
standardize (scale) the shocks.
"t
– t
captures the relative size of the shocks
and j captures the sign of the relative
shocks
– The magnitude is captured by the vari-
able that substracts the mean from the
absolute value of the scaled shocks.

Example:

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1.1 Parametric volatility models 17

– Suppose we specify a EGARCH(0,1)

2
ln t = 0 + 1 t 1 + 1 [j t 1j ]

where t 1 = "t 1 = t 1:

– Consider the estimated component:

^1 t 1 + ^ 1 [j t 1j ]

where ^ 1 = 0:3; ^ 1 = 0:6 and = 0:85:

– Case 1: impact of positive scaled shock
+1:0

0:3 (1) + 0:6 [j1j 0:85] = 0:39

Case 2: impact of negative scaled shock

1:0

0:3 ( 1) + 0:6 [j 1j 0:85] = 0:21

We see that positive shock has a greater im-

pact than negative shock for ^ 1 positive. If
we have ^ 1 negative, say ^ 1 = 0:3; a +1:0
shock will have an impact of 0:21 and a
1:0 shock will have an impact of 0.39.

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1.2 Non-parametric volatility models 18

Thus, ^ 1 allows for the sign of the shock to

have an impact on the conditional volatility;
over and above the magnitude captured by
^ 1:

1.2 Non-parametric volatility mod-

els

Range-based estimators

Suppose log prices of assets follow a Geo-

metric Brownian Motion (GBM). The vari-
ous variance estimators have been proposed
in literature.

Notation:

– volatility to be estimated
– Ct closing price on date t
– Ot opening price on date t
– Ht high price on date t
– Lt low price on date t

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1.2 Non-parametric volatility models 19

– ct = ln Ct ln Ot , the normalized clos-

ing price
– ot = ln Ot ln Ct 1 , the normalized
opening price
– ht = ln Ht ln Ot , the normalized high
price
– lt = ln Lt ln Ot , the normalized low
price

The classical sample variance estimator of

variance 2 is

1 X
T
2
2
^ = [(oi + ci ) (o + c)]
T 1 i=1

where

1X
T
(o + c) = (oi + ci )
T i=1

and T is the total number of days consid-

ered. So this is the average volatility over T
days.

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1.2 Non-parametric volatility models 20

Parkinson (1980) introduced a range estima-

tor of daily volatility based on the highest
and lowest prices on a particular day.

He used the range of log prices to de…ne

1
^ 2t = (ht lt )2
4 ln 2
since it can be shown that E (ht lt )2 =
4 ln(2) 2t

Garman and Klass (1980) extended Parkin-

son’s estimator where information about open-
ing and closing prices are incorporated as
follows:

^ 2t = 0:5 (ht lt )2 [2 ln 2 1] c2t

Parkinson (1980) and Garman and Klass (1980)

assume that the log-price follows a GBM
with no drift term. This means that the
average return is assumed to be equal to
zero. Rogers and Satchell (1991) relaxes this
assumption by using daily opening, high-
est, lowest, and closing prices into estimat-
ing volatility.

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1.2 Non-parametric volatility models 21

Rogers and Satchell (1991) estimator is given

by
^ 2t = ht (ht ct ) + lt (lt ct )
This estimator performs better than the es-
timators proposed by Parkinson (1980) and
Garman and Klass (1980).
Yang and Zhang (2000) proposed a re…ne-
ment to Rogers and Satchell (1991) estima-
tor for the presence of opening price jumps.
Due to overnight volatility, the opening price
and the previous day closing price are mostly
not the same. Estimators that do not incor-
porate opening price jumps underestimate
volatility.
Yang and Zhang (2000) estimator is given
by
^ 2 = ^ 2open + k^ 2close + (1 k)^ 2RS
where ^ 2open and ^ 2close are the classical sam-
ple variance estimators with the use of daily
opening and closing prices, respectively. ^ 2RS
is the average variance estimator introduced
by Rogers and Satchell (1991).

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1.2 Non-parametric volatility models 22

The constant k is set to be

0:34
k=
1:34 + (T + 1)=(T 1)

where T is the number of days.

Realized Volatility

Realized volatility is referred to volatility es-

timates calculated using intraday squared
returns at short intervals such as 5 or 15
minutes.

For a series that has zero mean and no jumps,

the realized volatility converges to the con-
tinuous time volatility.

Consider a continuous time martigale process

for asset prices

dpt = t dWt

where dWt is a standard brownian motion.

FRM c Dennis PHILIP 2011

1.2 Non-parametric volatility models 23

Then the conditional variance for one-period

returns, rt+1 pt+1 pt is
Z t+1
2
s ds
t

which is called the integrated volatility (or

the true volatility) over the period t to t + 1:
2
We don’t know what t is. So we estimate
it.

Let m be the sampling frequency such that

there are m continuously compounded re-
turns in one unit of time (say, one day).

The j th return is given by

rt+j=m pt+j=m pt+(j 1)=m

The realized volatility (in one unit of time)

can be de…ned as
X
2
RVt+1 = rt+j=m
j=1;:::;m

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1.2 Non-parametric volatility models 24

Then from the theory of quadratic variation,

if sample returns are uncorrelated,
Z t+1 !
X
2 2
p lim s ds rt+j=m =0
m!1 t j=1;:::;m

As we increase sampling frequency, we get a

consistent estimate of volatility.

In the presence of jumps, RV is no longer a

consistent estimator of volatility.

An extension to this estimator is the stan-

dardized Realized Bipower Variation mea-
sure de…ned as

[a;b] 1
[1 (a+b)=2] X
m
a b
BVt+1 = rt+j=m rt+(j 1)=m
m j=1

for a; b > 0:

When jumps are large but rare, the simplest

case where a = b = 1 captures the jumps
well.

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1.2 Non-parametric volatility models 25

High frequency returns measured below 5

minutes are a¤ected by market microstruc-
ture e¤ects including nonsynchronous trad-
ing, discrete price observations, intraday pe-
riodic volatility patterns and bid–ask bounce.

FRM c Dennis PHILIP 2011

2 Multivariate Volatility Models 26

2 Multivariate Volatility Mod-

els

Multivariate modelling of volatilities enable

us to study movements across markets and
across assets (co-volatilities).
Applications in …nance: asset pricing and
portfolio selection, market linkages and in-
tegration between markets, hedging and risk
management, etc.
Consider a n-dimensional process fyt g : If we
denote as the …nite vector of parameters,
we can write
yt = t ( ) + "t
where t ( ) is the conditional mean vector
and
1=2
"t = H t ( ) zt
1=2
where Ht ( ) is an N N positive de…nite
matrix.
The N 1 vector zt is such that
zt iidD (0; IN )

FRM c Dennis PHILIP 2011

2 Multivariate Volatility Models 27

where IN is the identity matrix of order N:

The matrix Ht is the conditional variance
matrix of yt
How do we parameterize Ht ?

Vech Representation

Bollerslev, Engle and Wooldridge (1988) pro-

pose a natural multivariate extension of the
univariate GARCH(p; q) models where
q p
X 0
X
vech (Ht ) = W + Ai vech "t i "t i + j vech (Ht j )
i=1 j=1

where vech is the vector-half operator, which

stacks the lower triangular elements of an
N N matrix into a [N (N + 1) =2] 1 vec-
tor.
The challenge in this parameterization is to
ensure Ht is positive de…nite covariance ma-
trix. Also, as the number of assets N in-
crease, the number of parameters to be esti-
mated is very large.

FRM c Dennis PHILIP 2011

2 Multivariate Volatility Models 28

f"t g is covariance stationary if all the eigen-

values of A and B are less than 1 in mod-
ulus.

Bollerslev, Engle and Wooldridge (1988) pro-

posed a "Diagonal vech" representation where
Ai and j are diagonal matrices.

Example: For N = 2 assets and a single-

period lag model (p = q = 1),
2 3 2 3 2 32 3
h11;t w1 a11 "21;t 1
4 h21;t 5 = 4 w2 5 + 4 a22 5 4 "2;t 1 ; "1;t 1
5
h22;t w3 a33 "22;t 1
2 32 3
b11 h11;t 1
+4 b22 54 h21;t 1
5
b33 h22;t 1

The diagonal restriction reduces the num-

ber of parameters but the model is not al-
lowed to capture the interactions in vari-
ances among assets (copersistence, causality
relations, asymmetries)
Pq
The
Pp diagonal vech is stationary i¤ i=1 aii +
b
j=1 jj < 1

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2 Multivariate Volatility Models 29

BEKK Representation

Engle and Kroner (1995) propose a BEKK

representation where
q p
X 0
X
0 0
Ht = cc + Ai "t i " t i A0i + j Ht j j
i=1 j=1

where c is a lower triangular matrix and

therefore cc0 will be positive de…nite. Also,
by estimating A and B rather than A and
B ; we ensure positive de…niteness.
In the case of 2 assets:

h11;t h12;t a11 a12 "21;t 1 "1;t 1 ; "2;t 1

= cc0 +
h21;t h22;t a21 a22 "2;t 1 ; "1;t 1 "22;t 1
0
a11 a12 b11 b12
+
a21 a22 b21 b22
0
h11;t 1 h12;t 1 b11 b12
h21;t 1 h22;t 1 b21 b22
To reduce the number of parameters to be
estimated, we can impose a "diagonal BEKK"
model where Ai and Bj are diagonal.

FRM c Dennis PHILIP 2011

2 Multivariate Volatility Models 30

Alternatively, we can have Ai and Bj as

scalar times a matrix of ones. In this case,
we will have a "scalar-BEKK" model.

Diagonal BEKK andP Scalar-BEKK P are co-

variance stationary if qi=1 a2nn;i + pj=1 b2nn;j <
P P
1 8n = 1; 2; :::; N and qi=1 a2i + pj=1 b2j < 1
respectively.

Constant Conditional Correlation (CCC)

Model

Bollerslev (1990), assuming conditional cor-

relations constant, proposed that conditional
covariances (Ht ) can be parameterized as a
product of corresponding conditional stan-
dard deviations.

Ht = Dt RDt
p
= ij hii;t hjj;t
2 p 3
h11;t
6 .. 7
where Dt = 4 . 5; R =
p
hN N;t

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2 Multivariate Volatility Models 31

2 3
1 12 1N
6 .. 7
6 21 1 . 7
6 .. .. 7
4 . . 5
N1 1
Each conditional standard deviations can be
in turn de…ned as any univariate GARCH
model such as GARCH(1,1)

hii;t = wi + i "2i;t 1 + i hii;t 1 i = 1; 2; :::; N

Ht is positive de…nite i¤ all N conditional

covariances are positive and R is positive
de…nite.

In most empirical applications, the condi-

tional correlations are not constant. There-
fore Engle (2002) and Tse and Tsui(2002)
propose a generalization of the CCC model
by allowing for conditional correlation ma-
trix to be time-varying. This is the DCC
model.

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2 Multivariate Volatility Models 32

Tests for Costant Correlations

Tse (2000) proposes testing the null that

p
hijt = ij hiit hjjt
against the alternative that
p
hijt = ijt hiit hjjt
where the conditional variances, hiit and hjjt
are GARCH-type models. The test statistic
is an LM statistic which is asymptotically
2
(N (N 1) =2) :
Engle and Sheppard (2001) propose another
test with the null hypothesis
H0 : Rt = R for all t
against the alternative
H1 : vech (Rt ) = vech R + 1 vech (Rt 1 )+
::: + p vech (Rt p )
The test statistic employed is again chi-squared
distributed.

FRM c Dennis PHILIP 2011

2 Multivariate Volatility Models 33

Dynamic Conditional Correlation (DCC)

model

Tse (2000) and Engle and Sheppard (2001)

propose tests of constant conditional corre-
lation hypothesis.

In most applications, we see the hypothe-

sis of constant conditional correlation is re-
jected.

Engle (2002) propose the DCC framework,

Ht = Dt Rt Dt

where Dt is the matrix of standard devia-

tions (as de…ned in the case of CCC), hii;t
can be any univariate GARCH model and
Rt is the conditional correlation matrix.

We then standardize each return by the dy-

namic standard deviations to get standard-
ized returns. Let
h p i 1
ut = "t diag h11t hN N t

FRM c Dennis PHILIP 2011

2 Multivariate Volatility Models 34

be the vector of standardized residuals of N

GARCH models. These variables now have
standard deviations of one.

We now model the conditional correlations

of raw returns ("t ) by modelling conditional
covariances of standardized returns (ut ).

We de…ne Rt as
1=2 1=2
Rt = diag (Qt ) Qt diag (Qt )

where Qt is an N N symmetric positive

de…nite matrix given by
q p
! q p
X X X X
0
Qt = 1 i j Q+ i ut i ut i + j Qt j
i=1 j=1 i=1 j=1

where
Pq Pp
– i 0; j 0; i=1 i + j=1 j <1
P
– Q = T1 Tt=1 ut u0t is the standardized
unconditional covariance matrix

FRM c Dennis PHILIP 2011

2 Multivariate Volatility Models 35

Example:

Consider the following model:

rt = "t
and
"t N (0; Ht ) where Ht = var (rt j t 1)

We can write Ht as
Ht = Dt Rt Dt
where
2 p 3
h11;t
6 ... 7
– Dt = 4 5 is di-
p
hN N;;t
agonal matrix of conditional standard
deviations. Each hii;t follows a GARCH(1,1)
process
– u t = Dt 1 " t
2 p 3 1 2 p 3 1
q11 q11
6 ... 7 6 ... 7
Rt =4 5 Qt 4 5
p p
qN N t
qN N t
where

FRM c Dennis PHILIP 2011

2 Multivariate Volatility Models 36

h PL PS i P
– Qt = 1 l=1 l s=1 s Q+ Ll=1 l ut l u0t l +
PS
s=1 s Qt s
P
– Qt = Q + Ll=1 l ut l u0t l Q +
PS
s=1 s Qt s Q
– For the case of one lags,
Qt = Q+ 1 ut 1 u0t 1 Q + 1 Qt 1 Q

Remarks:

– Qt is a function of:
1. unconditional covariance matrix Q
of standardized residuals
2. covariance matrix of standardized
residuals u for L lags
3. Qt s i.e s lags of itself
8
>
> uncond. component
>
>
>
> (of resid)
>
<
addl. persistent component
– Q at time t = +
>
> from past L lags (of resid)
>
>
>
> include past S period addl.
>
: + persistent component (of Q)

FRM c Dennis PHILIP 2011

2 Multivariate Volatility Models 37

Two-step Estimation of DCC models

Under the assumption of normality of inno-

vations, Engle and Sheppard show that the
DCC can be estimated in 2 steps.

Let "t N (0; Ht ) : Let be vector of un-

known parameters in matrix Ht :

The log-likelihood function is given by

1X
T
0
l( ) = N log (2 ) + log jHt j + rt Ht 1 rt
2 t=1

1X
T
0
= N log (2 ) + log jDt Rt Dt j +rt Dt 1 Rt 1 Dt 1 rt
2 t=1

1X
T
0
= N log (2 ) +2 log jDt j + log jRt j +ut Rt 1 ut
2 t=1

FRM c Dennis PHILIP 2011

2 Multivariate Volatility Models 38

where ut = Dt 1 rt is the standardized returns.

Adding and substracting u0t ut we get

1X
T
0
l( ) = (N log (2 ) + 2 log jDt j + rt Dt 1 Dt 1 rt
2 t=1
0
u0t ut + log jRt j + ut Rt 1 ut )

Remarks:

– The representation allows us to decom-

pose the log-likelihood l ( ) as a sum
of the volatility part (lV ( )) contain-
ing the parameters in matrix D and the
correlation part (lC ( )) containing the
parameters in matrix R:
– That is, we partition vector of parame-
ters into 2 subsets: = f ; g : The
log-likelihoods can be written as

l ( ) = lV ( ) + lC ( j )

where

1X
T
0
lV ( ) = N log (2 ) + log jDt j2 + rt Dt 2 rt
2 t=1

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2 Multivariate Volatility Models 39

1X
T
0
lC ( j ) = log jRt j + ut Rt 1 ut u0t ut
2 t=1

– The volatility term lV ( ) is apparently

the sum of the individual GARCH like-
lihoods, which is jointly maximized by
seperately maximizing each term. This
gives us the parameters :
– Then the correlation term lC ( j ) is
maximized conditional over the volatil-
ity parameters that were estimated be-
fore.
– In the correlation term, Rt takes the
DCC form diag (Qt ) 1=2 Qt diag (Qt ) 1=2

The two-step estimation procedure:

1. Estimate the conditional variances (volatil-

ity terms ) using MLE. That is, maximize
the likelihood to …nd ^
^ = arg max flV ( )g

2. Then we compute the standardized returns

ut = Dt 1 rt and we estimate the correlations

FRM c Dennis PHILIP 2011

2 Multivariate Volatility Models 40

among the returns "t of several assets. Here

we maximize the likelihood function of the
correlation term ^
n o
^ = arg max lC ^ j

The DCC estimation method employs the

assumption of Normality in conditional re-
turns, which is generally not the case …nan-
cial assets.

One can use alternative fat-tailed distribu-

tions such as student-t, laplace, logistic in
order to represent the data.

FRM c Dennis PHILIP 2011

2 Multivariate Volatility Models 41

Univariate Volatility Models References:

Hull (2010) Risk management and …nancial

institutions, Chapter 9
Christo¤ersen (2003) Elements of …nancial
risk management, Chapter 2
Andersen, T. G. And L. Benzoni (2008), “Re-
alized volatility”, Chapter in Handbook of
Financial Time Series, Springer Verlag.

Additional references:

Andersen, T. G., Bollerslev, T., Diebold,

F. X. and P. Labys (1999), “(Understand-
ing, optimizing, using and forecasting) real-
ized volatility and correlation”, Manuscript,
Northwester University, Duke University and
Pennsylvania University. Published in re-
vised form as “Great realizations” in Risk,
March 2000, 105-108.
Andersen, T., Bollerslev, T., Diebold, F.X.
and Ebens, H. (2001), "The distribution of
stock return volatility" Journal of Financial
Economics, 61, 43-76.

FRM c Dennis PHILIP 2011

2 Multivariate Volatility Models 42

Andersen, T. G., Bollerslev, T., Diebold,

F. X. and P. Labys (2003), “Modelling and
forecasting realized volatility”, Economet-
rica, 71, 529-626.

Andersen, T. G., Bollerslev, T., Diebold,

F. X. and J. Wu (2004), “Realized beta:
persistence and predictability”, Manuscript,
Northwester University, Duke University and
Pennsylvania University.

Multivariate Volatility Models Readings:

Christoggersen (2003) Elements of …nancial

risk management, Chapter 3

Engle, R (2002) Dynamic Conditional Cor-

relation: A Simple Class of Multivariate Gen-
eralized Autoregressive Conditional Heteroskedas-
ticity Models Journal of Business & Eco-
nomic Statistics. vol. 20, no. 3

Bauwens, L; Laurent, S and Rombouts, J

(2006) Multivariate GARCH models: A Sur-
vey Journal of Applied Econometrics. vol.
21 pp. 79–109

FRM c Dennis PHILIP 2011

2 Multivariate Volatility Models 43

Engle, R (2009) Anticipating Correlations:

A New Paradigm for Risk Management Prince-
ton University Press

FRM c Dennis PHILIP 2011

Financial Risk Management

Topic 8a
Credit Risk Measures
Readings: CN(2001) chapters 25
Hull’s (Risk Management) book chapters 14, 15
 Topics
C-Va
R
Credit Risk Measures
4
models

Credit Metrics

KMV Credit Monitor (and Merton
(1974) model)

CSFP Credit Risk Plus

McKinsey’s Credit Portfolio View, CPV

credit rate -> find

change VaR
Credit Metrics Approach
 AAA bond -> AA -> value bond
reduce

-> find final figure of

C-Var
Credit Metrics

CreditMetrics (J.P. Morgan 1997) measures risk,
associated with credit events, for a portfolio of
rated exposures (such as corporate bonds)

We will cover the following topics:

Transition probabilities
1

Valuation what's the value chage (V1 -> V2) how much am i
2 losing?

Joint migration probabilities bc have 3 4 bonds ->
joint

Many Obligors: Mapping and MCS not

normal
 Transition probabilities

Credit ratings measure credit risk. change in
rating

Practical issue: How do we measure changes in credit risk

(i.e. credit ratings)?

Problems not much

data

Lack of historical data to measure proportion of firms that
migrate between each credit ratings

The distribution of credit returns are highly skewed (see graph
on next slide) -> not use standart
deviation

Therefore ‘change in value’ cannot be explained by std. dev.

 Transition probabilities
Frequency Distribution for a 5 year BBB
0.900 BBB bond after 1 year
pro prob that BBB jump to
b A
C-Var can use standart
deviation
histogra
0.100 m
thickness
:
0.075 fal
l A
BB
0.050

0.025 B AA
Default CCC AAA
0.000
50 60 70 80 90 100 110
Revaluation at Risk Horizon
Skewed:
prob(BBB to Default) is low but change in value is large
whereas prob(BBB to A) relatively high but change in value is relatively small
this is assumption that can known by lookig at
this
 Transition probabilities
To calculate Transition Prob: of every rating
bonds

Suppose we have a sample of 1000 firms and their

bond credit ratings from 1980-2000.
do it for all
others

Consider bonds initially rated CCC. default
only
how rate going to

For each year, 1-year marginal mortality
( rate (MMR1) is
change

historic
value of CCC bonds defaulting in 1 year
al
MMR1 =
total value of CCC bonds at beginning of 1 year

Transition probability is average MMR:

2000 weigh by number of (tong Wi

P (CCC to default ) = ∑ i
ALL =1)
t firms
bonds w MMR 1, i
1980
historical for all teh
bonds
 Transition probabilities

We repeat this exercise for CCC-rated bonds moving
to all possible ratings.

Also, we repeat this for all other bonds.

This gives us the Empirical Transition Probabilities

This model assumes probability of transition in any

year is independent of probability in earlier years
(called first-order Markov process).

Survival rates: SRi = 1 − MMRi (use quite much in

practice)
 want to do MSC at the question: if BAD case -> what's the max
end loss?

C-VaR mone
y

We intend to calculate Credit Value at Risk (C-VaR)

Aim is to establish the $-value for 1% tail cut-off, from
histogram of all possible values of firm’s bonds at end-year,
after credit migration
This requires:

calculating the probability of migration between different
credit ratings and the calculation of the expected value of a
single bond in different potential credit ratings.

deriving the possible values of portfolio of n-bonds at year-
end, after all migrations

Calculating the probabilities (likelihood) of joint migration of
n-bonds,. between credit ratings.
under VaR
setting
 C-VaR for One Bond

First consider calculations for a Single Bond e.
g

Possible Transitions

{A stays at A} or { A to B} or {A to D} for example

3 possible
transition

Suppose a bank holds “senior unsecured” A-rated bond with

6% coupon and 7-year maturity.
want to
Credit risk horizon is 1 year ahead (assumed).
calculate

Transition probabilities, calculated using historical data, are:
1
Transition Matrix (Single Bond)

Initial Probability : End-Year Rating (%) Sum

Rating A B D
A pAA = 92 pAB = 7 pAD = 1 100

%
 C-VaR for One Bond

We calculate market value of the bond at the end of 1-year.

Consider a set of forward rates want to calculate market

value
One Year Forward Zero Curves
discount
1yr starting from 4yr start from
back
using different Credit Rating 1y f12 f13 f114 …
forward A 3.7 4.3 4.9 … A better rate than
rate
(get in the B 6.0 7.0 8.0 … B
market)Notes : f = one-year forward rate applicable from the end of year-1 to the end of
12
year-2 etc.

Forward rates for end-year A-rated are lower than for B-

rated ~ reflects different credit risk

If A-rated bond stays A-rated, the value of bond at the end discount
of year 1 is: using
different
$6 $6 $6 $ 1 06
= $6 + + + + ... +
valu rates
V A, A
(1 + f1, 7 ) 6
e 2 3
(1 .03 7) (1 .0 43) (1 .04 9)
(assume 6% annual coupons paid at end of the year)
 C-VaR for One Bond

If A-rated bond migrates to B rating, the value of bond at the
end of year 1 is:
$6 $6 $6 $106
VA, B = $6 + + + + ... +
2
(1.06) (1.07) (1.08) 2
(1 + f1,7 )6
use B
rate

Suppose calculations yield VA,A = $109 and VA,B = $107

If A-rated bond catastrophically defaults, the value of the

bond is the recovery value calculated from the recovery
rates given below. VA,D = 51% of face value = $51
D:
Recovery Rates After Default (% of par value)
default

Seniority Class Mean (%) Standard Deviation (%)

Senior Secured 53 27
Senior Unsecured 51 25
Senior Subordinated 38 24
Subordinated 33 20
Junior Subordinated 17 11
 C-VaR for One Bond

To calculate C-VaR, we have the ingredients:

Transition probabilities
1

Bond values associated to different transitions

2

C-VaR (using standard deviation method): =1.65 σv

Mean and Standard Deviation of end-year Value is
3 waighte
Vm = ∑
i =1
p iVi = 0.92($109) + 0.07($107) + 0.01($51) = $108.28
d

mea
n lay cac gia tri tu slide
3 different b/w V & 3 tren

σv = ∑ p (V − Vm ) = ∑ pV − (Vm ) = $5.78
mean 2 2 2
i i i i multiply
i =1 formular for
i =1 second moment - mean
to
get VaR
volatility square
(we can calculate σ around the mean Vm or around VA,A)
 C-VaR for One Bond

This calculation assumes value of bond in the various
states is known with no uncertainty.

Usually there is uncertainty in value of the bond and so we
associate σ to the three states. not use previous
them std (in
equation

∑ p (V ) − (V )
recommended 3 practice)
σv = +σ
2 2 2
to
use this i i i m
i =1

We know the standard deviation associated to recovery

rates in the event of default (σdefault = 25%)

Another assumption is the distribution of outcomes are

normal and so standard deviation is a good measure.
Alternatively, one can use a particular percentile value as a
measure of C-VaR. historical
simulation
 C-VaR for Two Bonds

We extend previous calculations to the case of two bonds.

Table below summarizes transition probabilities and bond

values for an A-rated and B-rated bond: sigma &
Probabilities and Bond Value (Initial A-Rated Bond) migration

Year End Probability $Value

A & B are
Rating % calculat
independent e = 109
A pAA = 92 VAA
to make it simpler B pAB = 7 VAB = 107
don't care about
D pAD = 1 VAD = 51
Cov

Notes : The mean and standard deviation for initial-A rated bond are
Vm,A = 108.28, σV,A = 5.78.

Probability and Value (Initial B-Rated Bond)

historic
Year End Rating Probability
al $Value
A pBA = 3 VBA = 108 use forward
B pBB = 90 VBB = 98 rate

D pBD = 7 VBC = 51
Notes : The mean and standard deviation for initial-B rated bond are
Vm,B = 95.0, σV,B = 12.19.
 C-VaR for Two Bonds

There are 9 possible values for the two-bond portfolio at the
end of 1-year.

Joint year-end values for the two bonds is:
Possible Year End Value (2-Bonds)
9

Obligor-1 (initial-A rated) Obligor-2 (initial-B rated)

1. A 2. B 3. D
VBA = 108 VBB = 98 VBD = 51
1. A VAA = 109 217 207 160 all possible
value
2. B VAB = 107 215 205 158
3. D VAD = 51 159 ad 149 102
Notes : The values in the ith row and jth column
d of the central 3x3 matrix are
simply the sum of the values in the appropriate row and column
(eg. entry for D,D is 102 = 51 + 51).
 C-VaR for Two Bonds

We also need the Joint Likelihoods or probabilities of credit
migration of the two bonds.

If we assume independence between credit migrations of the
two bonds, the calculation is straight forward.

Joint likelihood can be calculated from the transition matrix

Transition Matrix (percent)

Initial End Year Rating Row Sum
Rating
1. A 2. B 3. D
1. A 92 7 1 100
2. B 3 90 7 100
3. D 0 0 100 100
%
Note: If you start in default you have zero probability of any rating
change and 100% probability of staying in default.
 C-VaR for Two Bonds

Joint Likelihoods are calculated under independence.

Example: Prob(‘A remains A’ and ‘B remains B’) = Prob(‘A
remains A’) x Prob(‘B remains B’) = 0.92 x 0.90 = 0.828
assume
similar to

Joint Migration Probabilities : πij(percent)

undependent
value

Obligor-1 (initial-A rated) Obligor-2 (initial-B rated)

1. A 2. B 3. D
p21 = pAB = p22 = pBB = p23 = pBD =
3 90 7
1. A p11 = pAA = 2.76 82.8 6.44
92
2. B p12 = pAB = 0.21 6.3 0.49
7
3. D p13 = pAD = 0.03 0.9 0.07
1
 C-VaR for Two Bonds

C-VaR (using standard deviation method):

The formulae for calculating mean and standard deviation is
the same as in the case of one bond.
bond 1 and bond
2 3 3
Vm , p = ∑∑π
i =1 j =1
ij Vi , j = $203.29

Vi , j − (Vm , p ) = $13.49
3 3

∑ ∑π
2
σ v, p = ij
2

i =1 j =1
second
moment
 similar to historical
simulation

C-VaR for Two Bonds

C-VaR (using percentile method):

Order VA+B in from lowest to highest sor
t

Then add up their joint likelihoods until these reach the 1%
value. 1%
loss
VA+B = {$102, $149, $158, $159, …, $217} sort trang
16

πi,j = {0.07, 0.9, 0.49, 0.43, …, 2.76}

cumulate -> cut off at the
tail

$149 is the ‘unexpected loss’, at 1% level

It is customary to measure the VaR relative to the ‘mean
value’ rather than relative to the ’initial value’ of the
bond/loan portfolio difference b/w expected and
unexpected

Hence: C-VaR = $54.29 (= mean value – 1% extreme
value = $203.29 - $149)
 C-VaR - summary
• C-VaR of a portfolio of corporate bonds depends on the joint migration
likelihoods (probabilities), the value of the obligor (bond) in default (based
on the seniority class of the bond), and the value of the bond in any new
credit rating histor
y
historical data
-> Credit Rating Seniority Credit Spread

Migration Recovery Rate in Value of Bond

Likelihoods Default in new Rating

Standard Deviation or Percentile Level for

C-VaR
Measuring Joint Credit Migration
 Measuring Joint Credit Migration

Three ways:
1. Historic credit migration data (don't have the data -> limit
(problem)
- This becomes difficult when one has to measure correlations
between many rating possibilities
- Lack of data
2. Bond spread data difference bw yield y(AAA) - y(BB) =
spread
- Movements in credit yield spread between two firms reflect
changes in credit quality
- Use bond pricing model to extract probabilities of credit rating
changes from observed changes in credit spreads
3. Asset value approach (concentrate on
this) looking at asset (stock) -> use it to calculate credit
(bond)
- Movements in firm’s stock price reflect changes in credit
quality and hence signal possible change in credit ratings
(we discuss point 3 now…)
 Asset value approach – one stock
One stock example: find the threshold (gioi han) de xac dinh luc nao
chuyen

Consider initial BB-rated firm.

Lower the stock returns, lower it’s credit ratings but there threshol
d
are range of return values where ratings remain the same.

Suppose we assume stock returns are normal and σ is
known.
nguoc de tinh gia

We can ‘Invert’
tri the normal distribution to obtain cut-off find where the bond
going to fall -> get
points for stock returns (R) corresponding to the known the
average
probability of default (e.g. 1.06% below)

Then from normal distribution bell:
Pr(default) = Pr(R<ZDef) = Φ(ZDef/σ) = 1.06%
Hence: ZDef = Φ-1(1.06%) σ = -2.30σ
(In Excel: =NORMSINV(0.0106) = -2.30)
 Asset value approach – one stock
Probability

BB BBB
want to calculate
Probability of default B this
(cut off
=1.06 level)

A
CCC AA
Def AAA
transition
point
Cut-off level: -2.30 -2.04 -1.23 1.37 2.39 2.93 3.43 <- Calc. Z
Transition probability: 1.06 1.00 8.84 80.53 7.73 0.67 0.14 0.03 <- known
know
n use differnt forward
rate
Prob ( BB to CCC) = 1.0

We assume (for simplicity) that the mean return for the stock of an initial
BB-rated firm is zero
 Asset value approach – one stock

If the stock return falls by more than -2.30σ (%) then we
assume transition of the firm from BB to D (and we revalue
the bond using recovery rates in default)

Now lets consider transition from BB to CCC rating.
Suppose 1% is the observed transition probability.
normal
Φ(ZCCC/σ) - Φ(ZDef/σ) = 1.00
Pr(CCC) = Pr(ZDef<R<Zccc) =distribution
cut off
Hence: Φ(ZCCC/σ) = 1.0 + Φ(ZDef/σ) = 1.0+1.06 = 2.06
level

and ZCCC = Φ-1(2.06/ σ) = -2.04σ

If stock return fall by more than -2.04σ (%) then we assume

transition of the firm from BB to CCC (and we revalue the
bond using CCC forward rates)
 Asset value approach – one stock

In a similar fashion, we obtain cut-off points for all credit
rating changes for the initial BB-rated firm, summarized in
the table:
calculate all cut off
levels
 Asset value approach – two stocks

Consider now two stocks: ‘A-rated’ firm along with the
‘BB-rated’ firm.

Denote R’ as it’s asset returns, σ’ as it’s standard deviation,
and Z’Def, Z’CCC, etc as it’s asset return cut-offs/thresholds.

Table summarizes the calculations:
 Asset value approach – two stocks

Until now we have calculated individual obligor credit rating
changes.

To calculate two credit rating changes jointly, we assume
two asset returns are correlated and bivariate normal with
 σ 2
ρσσ '

use Σ= '2 
cholesky
 ρσσ '
σ 

Suppose we wish to calculate P(BBB to BB and A to BBB).
Let’s call this Y%.
joint

P(BBB to BB and A to BBB) = Pr(ZB <R<ZBB, Z’BB

prob

'
Z BB ZBBB
<R’<Z’BBB) = ∫
ZB ∫
Z 'BB
f ( R, R' , Σ)
not known -> use
dR dR’ = Y%
simulate

We use the same procedure to calculate all joint rating
migration πi,j for the two obligors.
 EXAM
THIS

Asset value approach – using MCS

As number of obligors and number of ratings increase, the
dimensions of joint migration likelihood matrix π explode.

Instead, we estimate the distribution of portfolio credit
values using Monte Carlo Simulation (MCS).

MCS

We have already found the ‘cut-off points’ Z for each obligor

Now simulate the joint stock returns (with a known correlation) and
associate these outcomes with a JOINT credit rating

Revalue the n-bonds at these new ratings ~ this is the 1st MCS
outcome, Vp(1)

Repeat above m-times and plot a histogram of Vp(i)

Order the Vp(i) from lowest to highest and read off the $-value of the
portfolio at the 1% left tail cut-off point
Assumes stock return correlations correctly reflect the economic conditions, that
influence credit migration correlations
KMV’s Credit Monitor
 KMV’s Credit Monitor

As in Credit Metrics model, KMV Credit Monitor model also
links stock prices to default probabilities.

It uses Merton (1974) model to make this link.

Unlike Credit Metrics which allows for upgrades and
downgrades, KMV’s model is a default only model.

Next, we will learn about Merton (1974) model and KMV

(see Topic 8b slides)
CSFP Credit Risk Plus
 CSFP Credit Risk Plus
Uses Poisson to give default probabilities and mean default rate µ
can vary with the economic cycle.

Assume bank has 100 loans outstanding and estimated default rate
= 3% p.a. implying µ = 3 defaults per year (from the 100 firms).

Probability of n-defaults e−µ µ n

p (n, defaults ) =
n!

p(0) = = 0.049, p(1) = 0.149, p(2) = 0.224…p(8) = 0.008 etc ~

humped shaped probability distribution (see figure on next slide).

Cumulative probabilities:
p(0) = 0.049, p(0-1) = 0.198, p(0-2) = 0.422, … p(0-8) = 0.996

“p(0-8)” indicates the probability of between zero and eight defaults

Take 8 defaults as approximation to the 99th percentile (1% cut off)

 CSFP Credit Risk Plus
Probability Distribution of Losses

Probability
Expected Loss

0.224
Unexpected Loss

0.049 99th percentile

Economic Capital
Loss in $’s
$30,000 $80,000
 CSFP Credit Risk Plus
Average loss given default LGD = $10,000 then:
Expected loss = (3 defaults) x $10,000 = $30,000

Unexpected loss (99th percentile) = 8 defaults x $10,000 = $80,000

(Note: Line in text p.716 is incorrect)

Capital Requirement = Unexpected loss - Expected Loss

= 80,000 - 30,000 = $50,000
TFOLIO OF LOANS
Suppose the bank also has another 100 loans in a ‘bucket’ with an
average LGD = $20,000 and with µ = 10% p.a.

Repeat the above exercise for this $20,000 ‘bucket’ of loans and derive
its (Poisson) probability distribution.

Then ‘add’ the probability distributions of the two buckets (i.e. $10,000
and $20,000) to get the probability distribution for the portfolio of 200
loans (we ignore correlations across defaults here)
McKinsey’s Credit Portfolio View, CPV
 McKinsey’s Credit Portfolio View, CPV
Mark-to-market model with direct link to macro variables

Explicitly model the link between the transition probability (e.g. p(C to
D)) and an index of macroeconomic activity, y.
pit = f(yt) where i = “C to D” etc.

y is assumed to depend on a set of macroeconomic variables Xit (e.g.

GDP, unemployment etc.)
yt = g (Xit, vt) i = 1, 2, … n

Xit depend on own past values plus other random errors εit.(say
VAR(1))
It follows that:
pit = k (Xi,t-1, vt, εit)

Each transition probability depends on past values of the macro-

variables Xit and the error terms vt, εit. Clearly the pit are correlated.
 CPV
Monte Carlo simulation to adjust the empirical (or average) transition
probabilities estimated from a sample of firms (e.g. as in
CreditMetrics).

Consider one Monte Carlo ‘draw’ of the error terms vt, εit (which
embody the correlations found in the estimated equations for yt and
Xit above).

This may give rise to a simulated probability pis = 0.25, whereas the
historic (unconditional) transition probability might be pih = 0.20 . This
implies a ratio of

ri = pis / pih = 1.25

Repeat the above for all initial credit rating states (i.e. i = AAA, AA, …
etc.) and obtain a set of r’s.
 CPV
Then take the (CreditMetrics type) historic 8 x 8 transition matrix
Tt and multiply these historic probabilities by the appropriate ri so
that we obtain a new ‘simulated’ transition probability matrix, T.

T , now embodies the impact of the macro variables and hence

the correlations between credit migrations

Then revalue our portfolio of bonds using new simulated

probabilities which reflect one possible state of the economy.

This would complete the first Monte Carlo ‘draw’ and give us one
new value for the bond portfolio.

Repeating this a large number of times (e.g. 10,000), provides

the whole distribution of gains and losses on the portfolio, from
which we can ‘read off’ the portfolio value at the 1st percentile.
 SUMMARY

A COMPARISON OF CREDIT MODELS

Characteristics J.P.Morgan KMV CSFP McKinsey

CreditMetrics Credit Monitor Credit Risk Plus Credit Portfolio
View
Mark-to-Market MTM MTM or DM DM MTM or DM
(MTM) or Default
Mode (DM)
Source of Risk Multivariate normal Multivariate normal Stochastic default Macroeconomic
stock returns stock returns rate (Poisson) Variables

Correlations Stock prices Option prices Correlation between Correlation between

Transition Stock price mean default rates macro factors
probabilities volatility

Solution Method Analytic or MCS Analytic Analytic MCS

 Topic # 8b: Merton model
and KMV
Financial Risk Management 2010-11
March 3, 2011

FRM c Dennis PHILIP 2011

 2

Merton (1974) model and KMV

Assume …rm’s balance sheet looks like this:

Consider a …rm with risky assets A; that

follow a GBM.

Suppose …rm is …nanced by a simple capital

structure, namely one debt obligation (D)
and one type of equity (E)

A0 = E0 + D0

where (Et )t 0 is a GBM that describes evo-

lution of equity of the …rm and (Dt )t 0 is
some process that describes market value of
debt obligation of the …rm.

FRM c Dennis PHILIP 2011

 3

Suppose debt holders pay capital D0 at time

t = 0 and get F (includes principal and in-
terest) at time t = T:

For debt holders (lending banks), credit risk

increase i¤

P [AT < F ] > 0

When default probability > 0, we can con-

clude that
D0 < F e rt
where r is the risk free rate. That is, debt
holders would need credit risk premium.

In other words, D0 is smaller, greater the

riskiness of the …rm.

To hedge this credit risk, debt holders go

Long a Put contract on A; with strike F
and maturity T:

This guarantees credit protection against de-

fault of payment:

FRM c Dennis PHILIP 2011

 4

Debt holder’s portfolio consist on a loan and

Put contract.
At t = 0;
D0 + P0 (A0 ; A ; F; T; r)

At t = T; portfolio value is F
Using non-arbitrage principal, at t = 0
rt
D0 + P0 (A0 ; A ; F; T; r) = Fe

So the present value of D0 is

rt
D0 = F e P0 (A0 ; A ; F; T; r) (1)

FRM c Dennis PHILIP 2011

 5

The …gure below summarizes this.

Next, we can think about the value of equity

E0 in terms of a Call option.

Equity holders of the …rm have the right to

liquidate the …rm (i.e. paying o¤ the debt
and taking over remaining assets)

Suppose liquidation happens at maturity date

t = T:

Two Scenarios:

FRM c Dennis PHILIP 2011

 6

1. AT < F : In this case, there is default

and there is not enough to pay the debt
holders. Moreover, equity holders have
a payo¤ of zero.
2. AT F : In this case, there is a net
pro…t for equity holders after paying o¤
the debt (AT F ).

So the total payo¤ to equity holders is

max(AT F; 0)
which is the payo¤ of an European call op-
tion on A with strike F and maturity T:
The present value of equity is therefore
E0 = C0 (A0 ; A ; F; T; r) (2)

Combining equation 1 and 2, we can obtain

A0 = E0 + D0
rt
= C0 (A0 ; A ; F; T; r) + F e
P0 (A0 ; A ; F; T; r)
rt
A0 + P0 (A0 ; A ; F; T; r) = C0 (A0 ; A ; F; T; r) + F e
which is nothing but the put-call parity.

FRM c Dennis PHILIP 2011

 7

The above also shows that equity and debt

holders have contrary risk preferences.

By choosing risky investment in some asset

A, with higher volatility A ; equity holders
will increase the option premium for both
call and put.

This is good for equity holders as they are

long a call and this is bad for debt holders
as they have a short position.

Equity holders have limited downside risk

but unlimited upside potential.

The main application of this Merton’s op-

tion pricing framework is to estimate default
probabilities. This is implemented in the
KMV credit monitor system.

KMV applies Black-Scholes formula in re-

verse.

Conventionally, we observe price of the un-

derlying, strike price, etc and we calculate

FRM c Dennis PHILIP 2011

 8

the value of the derivative. In this applca-

tion, we begin with value of the derivative
(value of equity E0 as a call option) and
given strike F ; and calculate the unobserved
value of A0 :

Another complication: we need the value of

A but since we do not observe value of A,
we have to infer A from volatility of returns
on equity E :

The Black-Scholes gives the value of equity

today as
rT
E0 = A0 N (d1 ) Fe N (d2 ) (3)

where
ln(A0 =F ) + (r + A =2)T
d1 = p
A T

and p
d2 = d1 A T

The value of debt today is

D0 = A0 E0

FRM c Dennis PHILIP 2011

 9

To calculate above we need A0 and A (un-

knowns).

Using Ito lemma, we yield the relationship

between the volatilities at t = 0
@E
E E0 = A A0 (4)
@A

Here @E=@A is the delta of the equity. So

@E=@A = N (d1 )

So we have two equations (3 and 4) and two

unknowns (A0 and A ).

We can use Excel Solver to obtain the solu-

tion to both these equations.

Now we can calculate the default probabili-

ties (called Expected Default frequency, EDF)
as
pi = P [AT < F ]

This can be shown to be

pi = P [Zi < DD]

FRM c Dennis PHILIP 2011

 10

where Zi N (0; 1) and DD is the ‘distance

to default’ (i.e. number of standard devia-
tions the …rm’s assets are away from default)

ln(A0 =F ) + ( A A =2)T
DD = p
A T

where A is the mean return/growth rate of

the assets.

FRM c Dennis PHILIP 2011

 11

FRM c Dennis PHILIP 2011