FRM Formulas

FMP
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For FMP-I (Confidential)
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FMP
Hedging in a practical world (Basis Risk)
Basis = spot price of asset futures price contract
Basis = 0 when spot price = futures price
Future
Price
Spot Price
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For FMP-I (Confidential) 1
Time
Choice of contracts
Optimal Hedge Ratio:
Where

S
is the standard deviation of S, the change in the spot price during the hedging period

F
is the standard deviation of F, the change in the futures price during the hedging period
is the coefficient of correlation between S and F
F
h
o
o
o
o
S
=
-
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Optimal number of contracts
The optimal number of contracts (N*) to hedge a portfolio consisting of NA number of units and
where Qf is the total number of futures being used for hedging
In order to change the beta () of the portfolio to (*), we need to long or short the (N*) number
of contracts depending on the sign of (N*)
A
P
* N =
f
A
Q
N * h
* N =
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A
P
* N =
A
P
) - * ( * N | | =
Negative sign of (N*) indicates shorting the contracts
Determination of Forward Price
The price of a forwards contract is given by the equation below:
F
0
= S
0
e
rt
in the case of continuously compounded risk free interest rate, r
F
0
= S
0
(1+r )
t
in the case of annual risk free interest rate, r
Where:
F
0
: forward price
S
0
: Spot price
t: time of the contract
Known income from underlying
If the underlying asset on which the forward contract is entered into provides an income with a present
value, I, then the forward contract would be valued as:
F
0
= (S
0
I )e
rt
Known yield from underlying
If the underlying asset on which the forward contract is entered into provides a continuously compounded
yield, q, then the forward contract would be valued as:
F
0
= S
0
e
(r-q)t
q: continuously % of return on the asset divided by the total asset price
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The price of a forwards contract is given by the equation below:
F
0
= S
0
e
rt
in the case of continuously compounded risk free interest rate, r
F
0
= S
0
(1+r )
t
in the case of annual risk free interest rate, r
Where:
F
0
: forward price
S
0
: Spot price
t: time of the contract
Known income from underlying
If the underlying asset on which the forward contract is entered into provides an income with a present
value, I, then the forward contract would be valued as:
F
0
= (S
0
I )e
rt
Known yield from underlying
If the underlying asset on which the forward contract is entered into provides a continuously compounded
yield, q, then the forward contract would be valued as:
F
0
= S
0
e
(r-q)t
q: continuously % of return on the asset divided by the total asset price
Value of forward contracts
At the time on entering into a forward contract, long or short, the value of the forward is zero
This is because the delivery price (K) of the asset and the forward price today (F0) remains the same
The value of the forward is basically the present value of the difference in the delivery price and the forward price
Value of a long forward, f, is given by the PV of the pay off at time T:
= (F
0
K )e
rT
K is fixed in the contract, while F
0
keeps changing on an everyday basis
For continuous dividend yielding underlying
f = S
0
e
-qt
Ke
-rt
For discrete dividend paying stock
f = S
0
I Ke
-rt
Index futures: A stock index can be considered as an asset that pays dividends and the dividends paid are the
dividends from the underlying stocks in the index
If q is the dividend yield rate then the futures price is given as:
F
0
= S0e
(r-q)t
Index Arbitrage
When F
0
> S
0
e
(r-q)T
an arbitrageur buys the stocks underlying the index and sells futures
When F
0
< S
0
e
(r-q)T
an arbitrageur buys futures and shorts or sells the stocks underlying the index
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At the time on entering into a forward contract, long or short, the value of the forward is zero
This is because the delivery price (K) of the asset and the forward price today (F0) remains the same
The value of the forward is basically the present value of the difference in the delivery price and the forward price
Value of a long forward, f, is given by the PV of the pay off at time T:
= (F
0
K )e
rT
K is fixed in the contract, while F
0
keeps changing on an everyday basis
For continuous dividend yielding underlying
f = S
0
e
-qt
Ke
-rt
For discrete dividend paying stock
f = S
0
I Ke
-rt
Index futures: A stock index can be considered as an asset that pays dividends and the dividends paid are the
dividends from the underlying stocks in the index
If q is the dividend yield rate then the futures price is given as:
F
0
= S0e
(r-q)t
Index Arbitrage
When F
0
> S
0
e
(r-q)T
an arbitrageur buys the stocks underlying the index and sells futures
When F
0
< S
0
e
(r-q)T
an arbitrageur buys futures and shorts or sells the stocks underlying the index
Futures and Forwards on Currencies
Interest rate Parity
Formula to remember:
If Spot rate is given in USD/INR terms then take American Risk-free rate as the first rate
In other words, individual who is interested in USD/INR rates would be an American (Indian will
always think in Rupees not dollars!!!!!), which implies foreign currency (r
f
) in his case would be r
INR
T r r
fc bc
e S F
) (
0 0
-
=
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Interest rate Parity
Formula to remember:
If Spot rate is given in USD/INR terms then take American Risk-free rate as the first rate
In other words, individual who is interested in USD/INR rates would be an American (Indian will
always think in Rupees not dollars!!!!!), which implies foreign currency (r
f
) in his case would be r
INR
T r r
INR
USD
INR
USD
INR USD
e S F
) ( -
=
The Cost of Carry
The cost of carry, c, is the storage cost plus the interest costs less the income earned
For an investment asset F
0
= S
0
e
cT
For a consumption asset F
0
S
0
e
cT
The convenience yield on the consumption asset, y, is defined so that: F
0
= S
0
e
(cy )T
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The cost of carry, c, is the storage cost plus the interest costs less the income earned
For an investment asset F
0
= S
0
e
cT
For a consumption asset F
0
S
0
e
cT
The convenience yield on the consumption asset, y, is defined so that: F
0
= S
0
e
(cy )T
Calculation of interest rates
Amount compounded annually would be given by:
A = P (1+ r)
t
A terminal amount
P principal amount
r annual rate of interest
t number of years for which the principal is invested
If amount compounded n times a year then:
A = P ( 1+ r/n )
nt
When n then we call it continuous compounding:
A = Pe
rt
(this formula is derived using limits and continuity)
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Amount compounded annually would be given by:
A = P (1+ r)
t
A terminal amount
P principal amount
r annual rate of interest
t number of years for which the principal is invested
If amount compounded n times a year then:
A = P ( 1+ r/n )
nt
When n then we call it continuous compounding:
A = Pe
rt
(this formula is derived using limits and continuity)
8
Bond pricing
The price of a bond is the present value of all the coupon payment and the final principal payment received at the end
of its life
B the bond price
C coupon payment
r zero interest rate at time t
P bond principal
T time to maturity
The yield of a bond is the discount rate (applied to all future cash flows) at which the present value of the bond is
equal to its market price
Yield to Maturity = Investors Required Rate of Return
The par yield is the coupon rate at which the present value of the cash flows equal to the par value (principal value) of
the bond
If we are looking at a semi-annual 5 year coupon bond with a par value of $100 then the coupon payment would be
solved using the following equation:
YTM) (1
1
F
YTM
YTM) (1
1
1
I B
n
n
+
+
(
(
(
(
+
-
=
=
- -
+ =
T
t
rT rt
Pe Ce B
1
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The price of a bond is the present value of all the coupon payment and the final principal payment received at the end
of its life
B the bond price
C coupon payment
r zero interest rate at time t
P bond principal
T time to maturity
The yield of a bond is the discount rate (applied to all future cash flows) at which the present value of the bond is
equal to its market price
Yield to Maturity = Investors Required Rate of Return
The par yield is the coupon rate at which the present value of the cash flows equal to the par value (principal value) of
the bond
If we are looking at a semi-annual 5 year coupon bond with a par value of $100 then the coupon payment would be
solved using the following equation:
9
=
- -
+ =
5
1
5
100 ) 2 / ( 100
t
r rt
e e C
Forward rate agreements (FRAs)
In general:
Payment to the long at settlement = Notional Principal X (Rate at settlement FRA Rate) (days/360)
----------------------------------------------------------
1 + (Rate at settlement) (days / 360)
1 2
1 1 2 2
t2 t1,
T T
T R T R
F
-
-
=
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Duration
Macaulays duration: is the weighted average of the times when the payments are made. And the
weights are a ratio of the coupon paid at time t to the present bond price
Where:
t = Respective time period
C = Periodic coupon payment
y = Periodic yield
n = Total no of periods
M = Maturity value
price bond Current
y
M n
y
C t
Duration Macaluay
n
n
t
t
) 1 (
*
) 1 (
*
1
+
+
+
=

=
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Macaulays duration: is the weighted average of the times when the payments are made. And the
weights are a ratio of the coupon paid at time t to the present bond price
Where:
t = Respective time period
C = Periodic coupon payment
y = Periodic yield
n = Total no of periods
M = Maturity value
Duration contd
A bonds interest rate risk is affected by:
Yield to maturity
Term to maturity
Size of coupon
From Macaulays equation we get a key relationship:
In the case of a continuously compounded yield the duration used is modified duration given as:
Y D
B
B
A - =
A
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A bonds interest rate risk is affected by:
Yield to maturity
Term to maturity
Size of coupon
From Macaulays equation we get a key relationship:
In the case of a continuously compounded yield the duration used is modified duration given as:
n
r
1
Duration Macaulay
D*
+
=
Convexity
Convexity is a measure of the curvature of the price / yield relationship
2
2
dy
B d
B
1
C =
Note that this is the second partial derivative of the bond valuation equation w.r.t. the yield
Hence, convexity is the rate of change of duration with respect to the change in yield
Bond price ($)
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Yield Y*
P*
Actual bond price
Tangent
Convexity
The convexity of the price / YTMgraph reveals two important insights:
The price rise due to a fall in YTM is greater than the price decline due to a rise in YTM, given an
identical change in the YTM
For a given change in YTM, bond prices will change more when interest rates are low than when they
are high
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Calculating Bond Price Changes
We can approximate the change in a bonds price for a given change in yield by using
duration and convexity:
, ,
,
A A A V D i V C V i
B Mod B B
= - + 0 5
2
.
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Theories of the Term Structure
Three theories are used to explain the
shape of the termstructure
Expectations theory
The long rate is the geometric mean of
expected future short interest rates
Liquidity preference theory
Investors must be paid a liquidity
premium to hold less liquid, long-term
debt
Market segmentation theory
Investors decide in advance whether they
want to invest in short term or the long
term
Distinct markets exist for securities of
short termbonds and long termbonds
Supply demand conditions decide the
prices
Where rp
n
is the risk premium associated
with an n year bond
) 1 )...( 1 )( 1 ( ) 1 (
2 1 yearn
st
year
st
year
st
n
lt
i i i i + + + = +
) 1 )...( 1 )( 1 ( ) 1 (
2 1 yearn
st
year
st
year
st n
n
lt
i i i rp i + + + + = +
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Three theories are used to explain the
shape of the termstructure
Expectations theory
The long rate is the geometric mean of
expected future short interest rates
Liquidity preference theory
Investors must be paid a liquidity
premium to hold less liquid, long-term
debt
Market segmentation theory
Investors decide in advance whether they
want to invest in short term or the long
term
Distinct markets exist for securities of
short termbonds and long termbonds
Supply demand conditions decide the
prices
Where rp
n
is the risk premium associated
with an n year bond
Day count conventions
Day count defines the way in which interest is accrued over time. Day count conventions normally
used in US are:
Actual / actual treasury bonds
30 / 360 corporate bonds
Actual/360 money market instruments
The interest earned between two dates
(Number of days between dates)*(Interest earned in reference period)
(Number of days in reference period)
=
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(Number of days in reference period)
=
Cheapest to deliver bond
The party with the short position can chose to deliver the cheapest bond when it comes to
delivery, hence he would chose the cheapest to deliver bond
Net pay out for delivery ( he has to buy a bond and deliver it):
Quoted bond price (settlement price * conversion factor)
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DV01 Application to hedging
Hedge ratio is calculated using DV01 with the help of following relation
) instrument hedging of 100 $ ( 01
) osition initial of 100 $ ( 1
per DV
p per DVO
HR =
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Duration based hedging strategies
Number of contracts to hedge is given by the equation:
F
C
Contract price for interest rate futures
D
F
Duration of asset underlying futures at maturity
P Value of portfolio being hedged
D
P
Duration of portfolio at hedge maturity
F C
P
D F
PD
N = *
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Number of contracts to hedge is given by the equation:
F
C
Contract price for interest rate futures
D
F
Duration of asset underlying futures at maturity
P Value of portfolio being hedged
D
P
Duration of portfolio at hedge maturity
Key Rate 01 and Key Rate Durations
Key Rate 01 measures the dollar change in the value of the bond for every basis point shift
in the key rate
Key Rate 01 = (-1/10,000) * (Change in Bond Value/0.01%)
Key rate duration provides the approximate percentage change in the value of the bond
Key Rate Duration = (-1/BV) * (Change in Bond Value/Change in Key rate)
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Put Call parity
Expressed as:
Value of call + Present value of strike price = value of put + share price
Put-call parity relationship, assumes that the options are not exercised before expiration day, i.e. it
follows European options
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Bounds and Option Values
Option Minimum Value Maximum Value
European call (c) c
t
Max(0,S
t
-(X/(1+RFR)
t
) S
t
American Call (C) C
t
Max(0, S
t
-(X/(1+RFR)
t
) S
t
European put (p) p
t
Max(0,(X/(1+RFR)
t
)-S
t
) X/(1+RFR)
t
American put (P) P
t
Max(0, (X-S
t
)) X
Where t is the time to expiration
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Where t is the time to expiration
Binomial Method
Assuming the price of the underlying asset can take only two values in any given interval of time
Risk Neutral Method
S
0
S
u
S
u
2
S
ud
IV
1
= Max[(S
u
2
-X), 0]
IV
2
p
p
1 - p
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S
0
S
ud
S
u
S
d
2
IV
2
IV
3
1 - p
1 - p
p
Black and Scholes Model
Black and Scholes formula allows for infinitesimally small intervals as well as the need to revise
leverage for European options on Non Dividend paying stocks
The formula is:
Where,
Log is the natural log with base e
N (d) = cumulative normal probability density function
X = exercise price option;
T = number of periods to exercise date
P =present price of stock
= standard deviation per period of (continuously compounded) rate of return on stock
Value of Put =
T d d
T
T R
X
P
d
f
o
o
o
- =
+ +
=
1 2
)] 5 . 0 ( [ ] ln[
1
2
] ) 2 ( [ ] ) 1 ( [
T R
f
e X d N P d N
-
-
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Black and Scholes formula allows for infinitesimally small intervals as well as the need to revise
leverage for European options on Non Dividend paying stocks
The formula is:
Where,
Log is the natural log with base e
N (d) = cumulative normal probability density function
X = exercise price option;
T = number of periods to exercise date
P =present price of stock
= standard deviation per period of (continuously compounded) rate of return on stock
Value of Put =
25
T d d
T
T R
X
P
d
f
o
o
o
- =
+ +
=
1 2
)] 5 . 0 ( [ ] ln[
1
2
] )} 1 ( 1 [{ }] 2 ( 1 { [ P d N d N e X
T R
f
- - -

Delta (cont.)
The delta of a portfolio of derivatives (such as options) with the same underlying asset, can
be found out if the deltas of each of these derivatives are known
i
n
i
i portfolio
W A = A

= 1
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Theta (cont.)
We have theta of call given by:
Where:
For a put option, theta is given by:
Where:
S
0
= Stock price at time 0, i.e. present price of the
stock
d
1
and d
2
are as defined in the Black-Scholes
Pricing formula earlier
= Stock price volatility
K = Strike price
T = Time of maturity of the option measured in
years, so that 6 months will be 0.5 years
r = Risk neutral rate of interest
) (
2
) ( '
) (
2
1 0
d N rKe
T
d N S
Call
rT -
-
-
= 0
o
r 2
) ( '
2 / ) 2 ^ ( x
e
x N
-
=
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We have theta of call given by:
Where:
For a put option, theta is given by:
Where:
S
0
= Stock price at time 0, i.e. present price of the
stock
d
1
and d
2
are as defined in the Black-Scholes
Pricing formula earlier
= Stock price volatility
K = Strike price
T = Time of maturity of the option measured in
years, so that 6 months will be 0.5 years
r = Risk neutral rate of interest
27
) (
2
) ( '
) (
2
1 0
d N rKe
T
d N S
Put
rT
- +
-
= 0
-
o
Gamma (cont.)
Calculation of Gamma
Gamma for European options can be calculated using the following formula:
Where symbols have their usual meaning
T S
d N
o
0
) 1 ( '
= l
Gamma (ATM) vs. Time
0.45
Gamma (Call / Put)
0.07
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0
0.05
0 0.2 0.4 0.6 0.8 1.0 1.2
0.10
0.15
0.20
0.25
0.30
0.35
0.40
0.45
0
0.01
0.02
0.03
0.04
0.05
0.06
0.07
1 4 7 10 13 16 19 22 25 28 31 34 37 40 43 46 49
Vega
The Vega of a derivative portfolio is the rate of change of the value of the portfolio with the change in
the volatility of the underlying assets. It can be expressed as:
V= , where is the value of the portfolio, and is the volatility in the price of the underlying.
For European options on a stock that does not pay dividends, Vega can be found by:
V=S
0
by:
The Vega of a long position is always positive
A position in the underlying asset has a zero Vega
Thus its behavior is similar to gamma
Vega is maximum for options that are at the money
o o
o l
r 2
) 1 ( '
2 / ) 2 ^ 1 ( d
e
d N
-
=
16
Vega
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The Vega of a derivative portfolio is the rate of change of the value of the portfolio with the change in
the volatility of the underlying assets. It can be expressed as:
V= , where is the value of the portfolio, and is the volatility in the price of the underlying.
For European options on a stock that does not pay dividends, Vega can be found by:
V=S
0
by:
The Vega of a long position is always positive
A position in the underlying asset has a zero Vega
Thus its behavior is similar to gamma
Vega is maximum for options that are at the money
29
r 2
) 1 ( '
2 / ) 2 ^ 1 ( d
e
d N
-
=
1471013161922252831343740434649
0
4
6
8
10
12
14
16
2
Rho
Rho of a portfolio of options is the rate of change of its value with respect to changes in the
interest rate
Rho = , where is the value of the portfolio, and r is the rate of interest
For European options on non dividend paying stocks, we have;
Rho (call) = KTe
-rT
N(d2), where the symbols carry their usual meanings
Also, Rho (put) = -KTe
-rT
N(-d2), the symbols carrying their usual meanings
r o
o l
30
Rho (Call / Put)
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1 4 7 10 13 16 19 22 25 28 31 34 37 40 43 46 49
-30
-10
0
10
20
30
-20
Rho (Call)
Rho (Put)
Rho (Call / Put)
Valuation of swaps
Hence the value of the swap can be given as:
V = B
fix
B
fl
Where:
B
fix
= PV of payments
B
fl
= (P+AI)e
-rt
Value of a floating bond is equal to the par value at coupon reset dates and equals to the Present
Value of Par values (P) and Accrued Interest (AI)
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Commodity Forwards
Commodity forward prices can be described using the same formula as used for financial
forward prices
For financial assets, o is the dividend yield
For commodities, o is the commodity lease rate
The lease rate is the return that makes an investor willing to buy and lend a commodity
Some commodities (metals) have an active leasing market
Lease rates can typically only be estimated by observing forward prices
F
0 , T
= S
0
e
( r - ) T
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Commodity forward prices can be described using the same formula as used for financial
forward prices
For financial assets, o is the dividend yield
For commodities, o is the commodity lease rate
The lease rate is the return that makes an investor willing to buy and lend a commodity
Some commodities (metals) have an active leasing market
Lease rates can typically only be estimated by observing forward prices
32
Futures term structure
The set of prices for different expiration dates for a given commodity is called the forward
curve (or the forward strip) for that date
If on a given date the forward curve is upward-sloping, then the market is in contango
If the forward curve is downward sloping, the market is in backwardation
Note that forward curves can have portions in backwardation and portions in contango
Since r is always positive, assets with o =0 display upward sloping (contango) futures termstructure
With o >0, termstructures could be upward or downward sloping
F
0 , T
= S
0
e
( r - ) T
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The set of prices for different expiration dates for a given commodity is called the forward
curve (or the forward strip) for that date
If on a given date the forward curve is upward-sloping, then the market is in contango
If the forward curve is downward sloping, the market is in backwardation
Note that forward curves can have portions in backwardation and portions in contango
Since r is always positive, assets with o =0 display upward sloping (contango) futures termstructure
With o >0, termstructures could be upward or downward sloping
33
F
0 , T
= S
0
e
( r - ) T
Commodity loan
With the addition of the lease payment, NPV of loaning the commodity is 0
The lease payment is like the dividend payment that has to be paid by the person who
borrowed
a stock
Therefore:
Where is lease rate
F
0 , T
= S
0
e
( r - ) T
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With the addition of the lease payment, NPV of loaning the commodity is 0
The lease payment is like the dividend payment that has to be paid by the person who
borrowed
a stock
Therefore:
Where is lease rate
34
Forward Prices and the Lease Rate
The lease rate has to be consistent with the forward price
Therefore, when we observe the forward price, we can infer what the lease rate would have
to be if a lease market existed
The annualized lease rate
The effective annual lease rate
l
= r -
1
T
In ( F
0 , T
/ S )
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l
= r -
1
T
In ( F
0 , T
/ S )
l
=
( 1 + r )
( F
0 , T
/ S )
1 / T
- 1
Storage Costs and Forward Prices
One will only store a commodity if the PV of selling it at time T is at least as great as that of
selling it today
Whether a commodity is stored is peculiar to each commodity
If storage is to occur, the forward price is at least
Where (0,T) is the future value of storage costs for one unit of the commodity from time 0
to T
F
0 , T
> S
0
e
r T
+ ( 0 , T )
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F
0 , T
> S
0
e
r T
+ ( 0 , T )
Storage Costs and Forward Prices (contd)
Convenience Yield
Some holders of a commodity receive benefits fromphysical ownership (e.g., a commercial user)
This benefit is called the commoditys convenience yield
The convenience yield creates different returns to ownership for different investors, and may or may
not be reflected in the forward price
Convenience and leasing
If someone lends the commodity they save storage costs, but lose the convenience
Stated as ( c)
Therefore, commodity borrower pays a lease rate that covers the lost convenience less the storage
costs:
o = c
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Convenience Yield
Some holders of a commodity receive benefits fromphysical ownership (e.g., a commercial user)
This benefit is called the commoditys convenience yield
The convenience yield creates different returns to ownership for different investors, and may or may
not be reflected in the forward price
Convenience and leasing
If someone lends the commodity they save storage costs, but lose the convenience
Stated as ( c)
Therefore, commodity borrower pays a lease rate that covers the lost convenience less the storage
costs:
o = c
37
Pricing with convenience
So, if:
And if, = c
Then, F
0,T
= S
0
e
(r+ -c)T
F
0 , T
= S
0
e
( r - ) T
EduPristine
No-Arbitrage with Convenience
From the perspective of an arbitrageur, the price range within which there is no arbitrage is:
Where c is the continuously compounded convenience yield
The convenience yield produces a no-arbitrage range rather than a no-arbitrage price. Why?
There may be no way for an average investor to earn the convenience yield when engaging
in arbitrage
S
0
e
( r + - c ) T
s F
0 , T
s S
0
e
( r + ) T
EduPristine
From the perspective of an arbitrageur, the price range within which there is no arbitrage is:
Where c is the continuously compounded convenience yield
The convenience yield produces a no-arbitrage range rather than a no-arbitrage price. Why?
There may be no way for an average investor to earn the convenience yield when engaging
in arbitrage
39
Interest rate parity
Interest Rate Parity (IRP)
Where; r
DC
= Domestic currency rate
r
FC
= Foreign currency rate
T
FC
DC
r
r
Spot Forward
(
+
+
=
1
1
EduPristine
Where; r
DC
= Domestic currency rate
r
FC
= Foreign currency rate
Default rates
Issuer default rate =
Number of issuers that default
Total number of issuers at the beginning of issue
Dollar default rate =
Cumulative dollar value of all defaulted bonds
Cumulative $ value of all issuance *
Weighted Avg. number of years outstanding
EduPristine
Cumulative $ value of all issuance *
Weighted Avg. number of years outstanding
Cumulative annual default rate =
Cumulative dollar value of all defaulted bonds
Cumulative dollar value of issue
Foundation of Risk Management
EduPristine
Foundation of Risk Management
Expected Return and Standard Deviation of Portfolio
Return of Portfolio
Standard Deviation of Portfolio
; { N to 1 k R W R
k k p
= =
EduPristine
, , { ; i k N; to 1 i N; to 1 k P W W W
ki i k i k
2
k k
= = = + =
p
o
Portfolio Variance for two asset portfolio
For two-asset portfolio
Var(w
A
k
A
+ w
B
k
B
) = w
A
2
A
2
+ w
B
2
B
2
+ 2 w
A
w
B
AB
Where is correlation coefficient between A and B
w
A
,w
B
are weights of the asset A and B
If =1
Var(w
A
k
A
+ w
B
k
B
) = (w
A
A
+ w
B
B
)
2
If <1
Var(w
A
k
A
+ w
B
k
B
) < (w
A
A
+ w
B
B
)
2
So there is a risk reduction from holding a portfolio of assets if assets do not move in
perfect unison
EduPristine
For two-asset portfolio
Var(w
A
k
A
+ w
B
k
B
) = w
A
2
A
2
+ w
B
2
B
2
+ 2 w
A
w
B
AB
Where is correlation coefficient between A and B
w
A
,w
B
are weights of the asset A and B
If =1
Var(w
A
k
A
+ w
B
k
B
) = (w
A
A
+ w
B
B
)
2
If <1
Var(w
A
k
A
+ w
B
k
B
) < (w
A
A
+ w
B
B
)
2
So there is a risk reduction from holding a portfolio of assets if assets do not move in
perfect unison
44
Correlation and Portfolio Diversification
Perfect Positive Correlation
=1 & Var (w
A
k
A
+ w
B
k
B
)= (w
A
A
+ w
B
B
)
2
Perfect Negative Correlation
=-1 & Var (w
A
k
A
+ w
B
k
B
) = (w
A
A
- w
B
B
)
2
Zero Correlation
Correlation between two assets is zero
Moderate Positive Correlation
Correlation between two assets lies between 0 and 1
EduPristine
Perfect Positive Correlation
=1 & Var (w
A
k
A
+ w
B
k
B
)= (w
A
A
+ w
B
B
)
2
Perfect Negative Correlation
=-1 & Var (w
A
k
A
+ w
B
k
B
) = (w
A
A
- w
B
B
)
2
Zero Correlation
Correlation between two assets is zero
Moderate Positive Correlation
Correlation between two assets lies between 0 and 1
45
Capital Market Line
Capital Market Line: A line used in the capital asset pricing model to illustrate the rates of return
for efficient portfolios depending on the risk-free rate of return and the level of risk
(standard deviation) for a particular portfolio
Represents all possible combinations of the market portfolio (P) and risk free asset
,
p
s
f f
s
R ) E(R R ) E(R - + = p
CML
Risk Free Asset Introduced
EduPristine
Rf
Efficient Frontier
CML
Return
Volatility
Pe
Capital Asset Pricing Model (CAPM)
As per CAPM, stocks required rate of return = risk-free rate of return + market risk premium
R
m
- R
f
: Risk Premium
: Quantity of Risk
,
f m f s
R R R R - + =
EduPristine
,
,
m
m i
i
R Var
R , R cov
=
Relaxing Assumptions of CAPM
CAPM equation is adjusted to include dividend yield on the market portfolio and the stock
{ ;
factor tax T
i stock for yield dividend
portfolio market of yield dividend
) ( ) ( ) ) ( ( ) E(R
p
=
=
=
- 1 + - 1 - - + =
i
M
F i F M F M F
R R R R E R
o
o
o o
EduPristine
Beta
Sensitivity of the return of the asset to the market return is known as Beta
Beta is calculated as follows:-
,
,
m
m i
i
R Var
R , R cov
=
EduPristine
Portfolio Beta
Beta can also be calculated for portfolio
Portfolio Beta is the weighted average of the betas of individual assets in the portfolio
Beta
Sharpe ratio:
Sharpe ratio
R
p
= portfolio return, Rf = risk free return
The higher the Sharpe measure, the better the portfolio
,
p
f p
R R -
=
Treynor ratio:
Treynor ratio
R
p
= portfolio return, R
f
= risk free return
The higher the Treynor measure, the better the portfolio
However, this measure should be used only for well-diversified portfolio
,
Beta
R R
f p
-
=
EduPristine
Treynor ratio:
Treynor ratio
R
p
f
= risk free return
The higher the Treynor measure, the better the portfolio
However, this measure should be used only for well-diversified portfolio
,
Beta
R R
f p
-
=
Jensons alpha:
Jensons alpha
R
p
c
= return predicted by CAPM
Positive alpha (portfolio with positive excess return) is always preferred over negative alpha
c p
R R - =
Measures of performance
Tracking Error (TE):
(Std. dev. of portfolios excess return over Benchmark index)
Where E
p
= R
P
R
B
R
P
B
= benchmark return
Lower the tracking error lesser the risk differential between portfolio and the benchmark index
Information Ratio (IR):
Measure of risk-adjusted return for a portfolio, defined as expected active return per unit of tracking error
Higher IR indicates higher active return of portfolio at a given risk level
Sortino Ratio (SR):
MAR is Minimum Accepted Return. SSD is standard deviation of returns below MAR. (Or) SSD is the Semi Standard Deviation
from MAR where R
p
<MAR
Higher the Sortino Ratio, lower is the risk of large losses
P
E
TE o =
EduPristine
Tracking Error (TE):
(Std. dev. of portfolios excess return over Benchmark index)
Where E
p
= R
P
R
B
R
P
B
= benchmark return
Lower the tracking error lesser the risk differential between portfolio and the benchmark index
Information Ratio (IR):
Measure of risk-adjusted return for a portfolio, defined as expected active return per unit of tracking error
Higher IR indicates higher active return of portfolio at a given risk level
Sortino Ratio (SR):
MAR is Minimum Accepted Return. SSD is standard deviation of returns below MAR. (Or) SSD is the Semi Standard Deviation
from MAR where R
p
<MAR
Higher the Sortino Ratio, lower is the risk of large losses
51
,
TE
R R
IR
b p
-
=
,
SSD
MAR R
SR
p
-
=
, ,
- = , MAR R 1/t SSD

2
p
Quantitative Analysis
EduPristine
Quantitative Analysis
Counting Principle
Number of ways of selecting r objects out of n objects
n
C
r
n!/(r!)*(n-r)!
Number of ways of giving r objects to n people, such that repetition is allowed
N
r
EduPristine
Some definitions and properties of Probability
Definitions
Mutually Exclusive: If one event occurs, then other cannot occur
Exhaustive: All exhaustive events taken together form the complete sample space (Sum of probability = 1)
Independent Events: One event occurring has no effect on the other event
The probability of any event A:
If the probability of happening of event A is P(A), then the probability of A not happening is
(1-P(A))
For example, if the probability of a company going bankrupt within one year period is 20%, then
the probability of company surviving within next one year period is 80%
] 1 , 0 [ ) ( e A P
EduPristine
Definitions
Mutually Exclusive: If one event occurs, then other cannot occur
Exhaustive: All exhaustive events taken together form the complete sample space (Sum of probability = 1)
Independent Events: One event occurring has no effect on the other event
The probability of any event A:
If the probability of happening of event A is P(A), then the probability of A not happening is
(1-P(A))
For example, if the probability of a company going bankrupt within one year period is 20%, then
the probability of company surviving within next one year period is 80%
54
) ( 1 ) ( A P A P - =
'
Sum Rule & Bayes Theorem
The unconditional probability of event B is equal to the sum of joint probabilities of event (A,B)
and the probability of event (A,B). Here A is the probability of not happening of A
The joint probability of events A and B is the product of conditional probability of B, given A has occurred
and the unconditional probability of event A
We know that P(AB) = P(B/A) * P(A)
Also P(BA)= P(A/B) * P(B)
Now equating both P(AB) and P(BA) we get:
P(B) can be further broken down using sum rule defined above:
) ( ) / ( ) ( ) / ( ) ( ) ( ) (
c c c
A P A B P A P A B P B A P B A P B P + = + =
) (
) ( * ) / (
) / (
B P
A P A B P
B A P =
EduPristine
The unconditional probability of event B is equal to the sum of joint probabilities of event (A,B)
and the probability of event (A,B). Here A is the probability of not happening of A
The joint probability of events A and B is the product of conditional probability of B, given A has occurred
and the unconditional probability of event A
We know that P(AB) = P(B/A) * P(A)
Also P(BA)= P(A/B) * P(B)
Now equating both P(AB) and P(BA) we get:
P(B) can be further broken down using sum rule defined above:
55
) (
) ( * ) / (
) / (
B P
A P A B P
B A P =
) ( ) / ( ) ( ) / (
) ( ) / (
) / (
c c
A P A B P A P A B P
A P A B P
B A P
+
=
Mean
The expected value(Mean) measures the central tendency, or the center of gravity of the
population
It is given by:
The graph shows the mean of normal distributions
N
x
X E
n
i
i
=
= =
1
) (
0.45
0.40
0.35
EduPristine
Standard Normal Distribution
= 0, o = 2
= 1, o = 1
0 2 4 -4 -2
0.40
0.35
0.30
0.25
0.20
0.15
0.10
0.05
0
Geometric Mean
Geometric Mean: is calculated as:
Where there are n observations and each observation is Xi
Compound Annual Growth Rate(CAGR): Its the geometric mean of the returns
n
n
X X X X G ...
3 2 1
=
EduPristine
Properties of Expectation
E(cX) = E(X) x c
E(X+Y) = E(X) + E(Y)
E(X2) [E(X)]2
E(XY) = E(X) x E(Y) [if X and Y are independent]
EduPristine
E(cX) = E(X) x c
E(X+Y) = E(X) + E(Y)
E(X2) [E(X)]2
E(XY) = E(X) x E(Y) [if X and Y are independent]
58
Variance & Standard deviation
Variance is the squared dispersion around the mean.
The standard deviation, which is the square root of the Variance, is more convenient to use,
as it has the same units as the original variable X
SD(X) =
N
x
VAR
n
i
i
=
-
=
1
2
) (
EduPristine
Variance is the squared dispersion around the mean.
The standard deviation, which is the square root of the Variance, is more convenient to use,
as it has the same units as the original variable X
SD(X) =
59
) ( x VAR
N
x
n
i
i
=
-
= =
1
2
) (
o
Covariance & correlation
Covariance describes the co-movement between 2 random numbers, given as:
Cov(X
1
, X
2
) =
12
Correlation coefficient is a unit-less number, which gives a measure of linear dependence
between two random variables.
(X
1
, X
2
) = Cov(X
1
, X
2
) /
1
2
Correlation coefficient always lies in the range of +1 to -1
A correlation of 1 means that the two variables always move in the same direction
A correlation of -1 means that the two variables always move in opposite direction
If the variables are independent, covariance and correlation are zero, but vice versa
is not true
Y X
Y X
XY E Y X Cov
Y X E Y X Cov

- =
- - =
) ( ) , (
)] )( [( ) , (
EduPristine
Covariance describes the co-movement between 2 random numbers, given as:
Cov(X
1
, X
2
) =
12
Correlation coefficient is a unit-less number, which gives a measure of linear dependence
between two random variables.
(X
1
, X
2
) = Cov(X
1
, X
2
) /
1
2
Correlation coefficient always lies in the range of +1 to -1
A correlation of 1 means that the two variables always move in the same direction
A correlation of -1 means that the two variables always move in opposite direction
If the variables are independent, covariance and correlation are zero, but vice versa
is not true
60
Some Properties of Variance
Variance of a constant = 0
Covariance between same variables is also their variance
For independent or uncorrelated variables,
covariance or correlation = 0
) ( ) (
2
X Var a b aX Var = +

= =
=
n
i
i
n
i
i
X Var X Var
1 1
) ( ) (

= = =
=
n
i
n
j
j i
n
i
i
X X Cov X Var
1 1 1
) , ( ) (
EduPristine
Variance of a constant = 0
Covariance between same variables is also their variance
For independent or uncorrelated variables,
covariance or correlation = 0
61

= =
=
n
i
i
n
i
i
X Var X Var
1 1
) ( ) (
) , ( 2 ) ( ) ( ) (
2 2
Y X abCov Y Var b X Var a bY aX Var + + = +
Skewness
Skewness describes departures from symmetry
Skewness can be negative or positive.
Negative skewness indicates that the distribution
has a long left tail, which indicates a high probability
of observing large negative values.
If this represents the distribution of profits and
losses for a portfolio, this is a dangerous situation.
3
1
3
) (
o
=
-
=
n
i
i
k
x
S
Symmetric Distribution
EduPristine
Skewness describes departures from symmetry
Skewness can be negative or positive.
Negative skewness indicates that the distribution
has a long left tail, which indicates a high probability
of observing large negative values.
If this represents the distribution of profits and
losses for a portfolio, this is a dangerous situation.
Negatively Skewed Distribution
Positively Skewed Distribution
Kurtosis
Kurtosis describes the degree of flatness of a distribution, or width of its tails
Because of the fourth power, large observations in the tail will have a large weight and hence
create large kurtosis. Such a distribution is called leptokurtic, or fat tailed
A kurtosis of 3 is considered average
High kurtosis indicates a higher probability
of extreme movements
4
1
4
) (
o
=
-
=
n
i
i
x
K
EduPristine
Kurtosis describes the degree of flatness of a distribution, or width of its tails
Because of the fourth power, large observations in the tail will have a large weight and hence
create large kurtosis. Such a distribution is called leptokurtic, or fat tailed
A kurtosis of 3 is considered average
High kurtosis indicates a higher probability
of extreme movements
0
0.05
0.1
0.15
0.2
0.25
0.3
0.35
0.4
0.45
-4 -3 -2 -1 0 1 2 3 4
Platykurtic
K<3
Leptokurtic
K>3
Mesokurtic
K=3
Errors in estimation
Type I and Type II Errors
Type I error occurs if the null hypothesis is rejected
when it is true
Type II error occurs if the null hypothesis is not rejected
when it is false
Significance Level
o -> Significance level
the upper-bound probability of a Type I error
1 - o ->confidence level
the complement of significance level
Actual
Inference
H
0
is True H
0
is False
H
0
is True
Correct Decision
Confidence
Level = 1-
Type-II Error
P(Type-II Error)
=
H
0
is False
Type-I Error
Significance
Level =
Power=1-
EduPristine
Type I and Type II Errors
Type I error occurs if the null hypothesis is rejected
when it is true
Type II error occurs if the null hypothesis is not rejected
when it is false
Significance Level
o -> Significance level
the upper-bound probability of a Type I error
1 - o ->confidence level
the complement of significance level
Hypothesis tests for variances
Hypothesis Test of Variances Hypothesis Test of Variances
Test for
Single Population Variance
Test for
Single Population Variance
Test for
Two Population Variances
Test for
Two Population Variances
EduPristine
Example Hypothesis Example Hypothesis
H
0
:
2
=
0
2
H
A
:
2

0
2
Chi-Square Test
Statistic
Chi-Square Test
Statistic
2
0
2
2
) 1 ( ,
) 1 (
o
_
o
s n
n
-
=
-
Example Hypothesis Example Hypothesis
H
0
:
1
2

2
2
= 0
H
A
:
1
2

2
2
0
F-test Statistic F-test Statistic
2
2
2
1
, ,
s
s
F
ddf ndf
=
o
Test for single population variance
Single population variance test has 3
different forms:
Two Tailed Test:
Lower Tail test:
Upper Tail Test
H
0
:
2
=
0
2
H
A
:
2

0
2
H
0
:
2
>
0
2
H
A
:
2
<
0
2
o
o/2
o/2
EduPristine
Single population variance test has 3
different forms:
Two Tailed Test:
Lower Tail test:
Upper Tail Test
H
0
:
2
>
0
2
H
A
:
2
<
0
2
H
0
:
2

0
2
H
A
:
2
>
0
2
o
Chi-square test statistic
The chi-squared test statistic for a
Single Population Variance is:
Where
_
2
= standardized chi-square variable
n = sample size
s
2
= sample variance
2
= hypothesized variance
2
2
2
1)s (n -
= _
EduPristine
The chi-squared test statistic for a
Single Population Variance is:
Where
_
2
= standardized chi-square variable
n = sample size
s
2
= sample variance
2
= hypothesized variance
Finding the critical value
The critical value,
2
, is found from the chi-square table:

o
H
0
:
2

0
2
H
A
:
2
>
0
2
Upper tail test:
EduPristine
_
2
Do not reject H
0
Reject H
0
o
Lower tail or two tailed Chi-square tests

H
0
:
2
=
0
2
H
A
:
2

0
2
H
0
:
2
>
0
2
H
A
:
2
<
0
2
o o/2
o/2
Lower tail test: Two tail test:
EduPristine
Do not reject H
0
Reject
2
1-
_
2
2
/2
Do not
reject H
0
Reject
2
1-/2
_
2
Reject
F-test for difference in two population variances
Two population variance test has 3
different forms:
Two Tailed Test:
Lower Tail test:
Upper Tail Test
H
0
:
1
2

2
2
= 0
H
A
:
1
2

2
2
0
H
0
:
1
2

2
2
> 0
H
A
:
1
2

2
2
< 0
o
o/2
o/2
EduPristine
Two population variance test has 3
different forms:
Two Tailed Test:
Lower Tail test:
Upper Tail Test
H
0
:
1
2

2
2
> 0
H
A
:
1
2

2
2
< 0
H
0
:
1
2

2
2
0
H
A
:
1
2

2
2
> 0
o
F-test for difference in two population variances (cont.)
The F test statistic is:
= Variance of Sample 1
(n1 1) = numerator degrees of freedom
(n2 1) = denominator degrees of freedom
2
1
s
2
2
2
1
s
s
F =
EduPristine
The F test statistic is:
(n1 1) = numerator degrees of freedom
(n2 1) = denominator degrees of freedom
2
1
s
2
2
s
Chebyshevs inequality
Chebyshev's inequality says that at least 1 - 1/k
2
of the distribution's values are within k
standard deviations of the mean.
Where k is any positive real number greater than 1
EduPristine
Population linear regression
Random Error for
this x value
Y
Observed Value of
Y for X
i
Predicted Value of
Y for X
i
Slope =
1
u X Y + + =
1 0
| |
EduPristine
Mean marks for hours of study
Individual persons marks
Random Error for
this x value
Predicted Value of
Y for X
i
x
i
Intercept =
0
u
i
x
Population regression function
Population
y intercept
Population
Slope
Coefficient
Random
Error
term, or
residual
Dependent
Variable
Independent
Variable
u X Y
1 0
+ + =
EduPristine
But can we actually get this equation?
If yes what all information we will need?
Linear component
Random Error
component
u X Y
1 0
+ + =
Sample regression function
Random Error for
this x value
Y
Observed Value of
Y for X
i
Predicted Value of
Y for X
i
Slope =
1
e x b b y
1 0
+ + =
e
i
EduPristine
Random Error for
this x value
Predicted Value of
Y for X
i
x
i
Intercept =
0
x
Sample regression function
Estimate of the
regression
intercept
Error term
Estimated
(or predicted)
y value
Estimate of the
regression
slope
Independent
variable
e x b b y
1 0 i
+ + =
EduPristine
Notice the similarity with the Population Regression Function
Can we do something of the error term?
e x b b y
1 0 i
+ + =
One method to find b
0
and b
1
Method of Ordinary Least Squares (OLS)
b
0
and b
1
are obtained by finding the values of b
0
and b
1
that minimize the sum of the
squared residuals
2
1 0
2 2
x)) b (b (y
) y
(y e
+ - =
- =

EduPristine
2
1 0
2 2
x)) b (b (y
) y
(y e
+ - =
- =

OLS regression properties
The sum of the residuals from the least squares regression line is 0
The sum of the squared residuals is a minimum
Minimize ( )
The simple regression line always passes through the mean of the y variable and the mean
of the x variable
The least squares coefficients are unbiased estimates of
0
and
1
0 ) ( = -
y y
2
) ( y y
-
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The sum of the residuals from the least squares regression line is 0
The sum of the squared residuals is a minimum
Minimize ( )
The simple regression line always passes through the mean of the y variable and the mean
of the x variable
The least squares coefficients are unbiased estimates of
0
and
1
78
The least squares equation
The formulas for b
1
and b
0
are:
-
- -
=
2
1
) (
) )( (
x x
y y x x
b
Algebraic equivalent:

-
-
=
n
x
x
n
y x
xy
b
2
2
1
) (
And
x b y b
1 0
- =
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-
-
=
n
x
x
n
y x
xy
b
2
2
1
) (
x b y b
1 0
- =
Interpretation of the Slope and the Intercept
b
0
is the estimated average value of y when the value of x is zero. More often than not it
does not have a physical interpretation
b
1
is the estimated change in the average value of y as a result of a one-unit change in x
y
X b b Y
1 0
+ =
slope of the line(b

1
)
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x
b
0
slope of the line(b
1
)
Explained and unexplained variation
y
i
y
y
y
RSS = Residual sum of squares

_
_
TSS = Total sum
of squares
RSS = (y
i
- y
i
)
2
TSS = (y
i
- y)
2
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X
i
x
y
_
y
_
y
ESS = (y
i
- y)
2
_
ESS = Explained Sum of squares
Explained and unexplained variation
Total variation is made up of two parts:
ESS RSS TSS + =
Total sum of Squares Total sum of Squares
Sum of Squares Regression /
Explained Sum of Squares
Sum of Squares Regression /
Explained Sum of Squares
Sum of Squares Error /
Residual Sum of Squares
Sum of Squares Error /
Residual Sum of Squares
- =
2
) ( y y TSS

- =
2
) ( y y RSS

- =
2
) ( y y ESS
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- =
2
) ( y y TSS

- =
2
) ( y y RSS

- =
2
) ( y y ESS
Where:
= Average value of the dependent variable
y = Observed values of the dependent variable
= Estimated value of y for the given x value
y
y
Coefficient of determination, R
2
The coefficient of determination is the portion of the total variation in the dependent
variable that is explained by variation in the independent variable
The coefficient of determination is also called R-squared and is denoted as R
2
SST
SSR
R =
2
1 R 0
2
s s
where
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Coefficient of determination, R
2
Coefficient of determination
Note: In the single independent variable case, the coefficient of determination is
squares of sum total
regression by explained squares of sum
SST
SSR
R = =
2
2 2
r R =
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2 2
r R =
Where:
R
2
= Coefficient of determination
r = Simple correlation coefficient
Calculating the correlation coefficient
Sample correlation coefficient:

- -
- -
=
] ) y y ( ][ ) x x ( [
) y y )( x x (
r
2 2
or the algebraic equivalent:

- -
-
=
] ) y ( ) y ( n ][ ) x ( ) x ( n [
y x xy n
r
2 2 2 2
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- -
-
=
] ) y ( ) y ( n ][ ) x ( ) x ( n [
y x xy n
r
2 2 2 2
Where:
r = Sample correlation coefficient
n = Sample size
x = Value of the independent variable
y = Value of the dependent variable
Standard Error of Estimate
The standard deviation of the variation of observations around the regression line is
estimated by:
1 - -
=
k n
RSS
s
u
Where:
RSS = Residual Sum of Squares (summation of e
2
)
n = Sample size
k = number of independent variables in the model
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Where:
RSS = Residual Sum of Squares (summation of e
2
)
n = Sample size
k = number of independent variables in the model
Standard Error of Estimate (SEE) is another name of Standard Error of regression
The Standard Deviation of the intercept
-
=
2
u
2
i
b
) x (x
s X
s
o
n

-
=
-
=
n
x) (
x
s
) x (x
s
s
2
2
u
2
u
b
1
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Where:
= Estimate of the standard error of the least squares slope
= Sample standard error of the estimate

-
=
-
=
n
x) (
x
s
) x (x
s
s
2
2
u
2
u
b
1
1
b
s
2 n
RSS
s
u
-
=
Multiple Regression
Using more than one explanatory variable in a regression model
Y = b
0
+ b
1
X
1
+ b
2
X
2
+ b
3
X
3
+ u
I
Omitted variable bias
The biasness incurred due to omission of one or more explanatory variable from the model.
Omitted variable bias occurs when two conditions are met:
Omitted variables are correlated with the independent variable
Variables that are not accounted for in the model but affect the dependent variable
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Using more than one explanatory variable in a regression model
Y = b
0
+ b
1
X
1
+ b
2
X
2
+ b
3
X
3
+ u
I
Omitted variable bias
The biasness incurred due to omission of one or more explanatory variable from the model.
Omitted variable bias occurs when two conditions are met:
Omitted variables are correlated with the independent variable
Variables that are not accounted for in the model but affect the dependent variable
88
Multiple Regression Basics
General Multiple Linear Regression model take the following form:
i ki k i i i
X b X b X b b Y c + + + + + = .........
2 2 1 1 0
Where:
Y
i
= i
th
observation of dependent variable Y
X
ki
= i
th
observation of k
th
independent variable X
b
0
= intercept term
b
k
= slope coefficient of k
th
independent variable

i
= error term of i
th
observation
n = number of observations
k = total number of independent variables
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Where:
Y
i
= i
th
observation of dependent variable Y
X
ki
= i
th
observation of k
th
independent variable X
b
0
= intercept term
b
k
= slope coefficient of k
th
independent variable

i
= error term of i
th
observation
n = number of observations
k = total number of independent variables
Estimated Regression Equation
As we calculated the intercept and the slope coefficient in case of simple linear regression
by minimizing the sum of squared errors, similarly we estimate the intercept and slope
coefficient in multiple linear regression
Sum of Squared Errors is minimized and the slope coefficient is estimated.
The resultant estimated equation becomes:
Now the error in the i
th
observation can be written as:
=
n
i
i
1
2
c
ki k i i i
X b X b X b b Y

+ + + + = .........
2 2 1 1 0
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As we calculated the intercept and the slope coefficient in case of simple linear regression
by minimizing the sum of squared errors, similarly we estimate the intercept and slope
coefficient in multiple linear regression
Sum of Squared Errors is minimized and the slope coefficient is estimated.
The resultant estimated equation becomes:
Now the error in the i
th
observation can be written as:
90
ki k i i i
X b X b X b b Y

+ + + + = .........
2 2 1 1 0
|
.
|
'
+ + + + - = - =

ki k i i i i i i
X b X b X b b Y Y Y .........
2 2 1 1 0
c
Estimation of Volatility
Let x
i
be the continuously compounded return during day i (between the end of day
i-1 and end of day I)
Let
n
be the volatility of the return on day n as estimated at the end of day n-1
Variance estimate for next day is usually calculated as:
variance = average squared deviation from average return over last n days
Mean of returns (x-bar) is usually zero, especially if returns are over short-time period
(say, daily returns). In that case, variance estimate for next day is nothing but simple average (equally
weighted average) of previous n days squared returns
,
1 n
x x
Variance
n
1 i
2
i
-
-
=

=
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Let x
i
be the continuously compounded return during day i (between the end of day
i-1 and end of day I)
Let
n
be the volatility of the return on day n as estimated at the end of day n-1
Variance estimate for next day is usually calculated as:
variance = average squared deviation from average return over last n days
Mean of returns (x-bar) is usually zero, especially if returns are over short-time period
(say, daily returns). In that case, variance estimate for next day is nothing but simple average (equally
weighted average) of previous n days squared returns
91
,
1 n
x x
Variance
n
1 i
2
i
-
-
=

=
,
1
1
2
-
=

=
n
x
Variance
n
i
i
What if the volatility is dependent on the values of volatility observed in the recent past?
What if they also depend on the latest returns?
EWMA Model
In an exponentially weighted moving average model, the weights assigned to the u
2
decline
exponentially as we move back through time
This leads to:
2
1
2
1
2
) 1 (
- -
- + o = o
n n n
u
Apply the recursive relationship:
Hence we have
Variance estimate for next day (n) is given by (1-) weight to recent squared return and weight to the previous
variance estimate
Risk-metrics (by JP Morgan) assumes a Lambda of 0.94

2
2
2 2
2
2
1
2
2
1
2
2
2
2
2
) 1 (
) 1 ( ) 1 (
- - -
- - -
+ + - =
- + - + =
n n n n
n n n n
u u
u u
o i i i o
i i io i o
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Apply the recursive relationship:
Hence we have
Variance estimate for next day (n) is given by (1-) weight to recent squared return and weight to the previous
variance estimate
Risk-metrics (by JP Morgan) assumes a Lambda of 0.94

2
2
2 2
2
2
1
2
2
1
2
2
2
2
2
) 1 (
) 1 ( ) 1 (
- - -
- - -
+ + - =
- + - + =
n n n n
n n n n
u u
u u
o i i i o
i i io i o
2 2
1
1 2
) 1 (
m n
m
i n
m
i
i
n
u
- -
=
-
+
(
- =

o i i i o
EWMA Model
Since returns are squared, their direction is not considered. Only the magnitude is considered
In EWMA, we simply need to store 2 data points: latest return & latest volatility estimate
Consider the equation:
In this equation, variance for time t was also an estimate. So we can substitute for it as follows:
What are the weights for old returns and variance?
is called Persistence factor or even Decay Factor. Higher gives more weight to older data (impact
of older data is allowed to persist). Lower gives higher weight to recent data (i.e. previous data
impacts are not allowed to persist)
Higher means higher persistence or lower decay
Since, (1- ) is weight given to latest square return, it is called Reactive factor
2 2 2
1
94 . 0 ) 94 . 0 1 (
t t t
o o + - =
+

2
1
2
1
2 2
1
94 . 0 ) 94 . 0 1 ( 94 . 0 ) 94 . 0 1 (
- - +
+ - + - =
t t t t
o o
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Since returns are squared, their direction is not considered. Only the magnitude is considered
In EWMA, we simply need to store 2 data points: latest return & latest volatility estimate
Consider the equation:
In this equation, variance for time t was also an estimate. So we can substitute for it as follows:
What are the weights for old returns and variance?
is called Persistence factor or even Decay Factor. Higher gives more weight to older data (impact
of older data is allowed to persist). Lower gives higher weight to recent data (i.e. previous data
impacts are not allowed to persist)
Higher means higher persistence or lower decay
Since, (1- ) is weight given to latest square return, it is called Reactive factor
93
) 94 . 0 * 94 . 0 ( * 06 . 0 * 94 . 0 * 06 . 0
2
1
2
1
2 2
1 - - +
+ + =
t t t t
o o
GARCH (1,1)
GARCH stands for Generalized Autoregressive Conditional Heteroscedasticity
Heteroscedasticity means variance is changing with time.
Conditional means variance is changing conditional on latest volatility.
Autoregressive refers to positive correlation between volatility today and volatility yesterday.
(1,1) means that only the latest values of the variables.
GARCH model recognizes that variance tends to show mean reversion i.e. it gets pulled to
a long-term Volatility rate over time.
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GARCH stands for Generalized Autoregressive Conditional Heteroscedasticity
Heteroscedasticity means variance is changing with time.
Conditional means variance is changing conditional on latest volatility.
Autoregressive refers to positive correlation between volatility today and volatility yesterday.
(1,1) means that only the latest values of the variables.
GARCH model recognizes that variance tends to show mean reversion i.e. it gets pulled to
a long-term Volatility rate over time.
94
2 2 2
1 t t L t
V |o o o + + =
+
Long-term average Volatility
GARCH (1,1)
Generally *V
L
is replaced by
Since the sum of all the weights is equal to 1 we get the following equation as well:
2 2 2
1 t t t
|o o e o + + =
+
| - o -
e
=
1
L
V
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| - o -
e
=
1
L
V
Simulating a Price Path
S is the stock price,
is the expected return,
is the standard deviation of returns,
"t" is time, and
is the random variable
t t
S
S
A + A =
A
oc
Drift Shock
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The first step in simulating a price path is to choose a random process to model changes in
financial assets
Stock prices and exchange rates are modeled by geometric Brownian motion (GBM) shown
in the above equation
Valuations and Risk Models
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Valuations and Risk Models
Measuring Value-at-Risk (VAR)
Mean = 0
0
0.05
0.1
0.15
0.2
0.25
0.3
0.35
0.4
0.45
-4 -2 0 2 4
o * %) (
% % X X
Z in VAR =
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ZX% : the normal distribution value for the given probability (x%) (normal distribution has mean as 0 and
standard deviation as 1)
: standard deviation (volatility) of the asset (or portfolio)
VAR in absolute terms is given as the product of VAR in % and Asset Value:
This can also be written as:
98
Mean = 0
Value Asset in VAR VAR
X
* %) (
%
=
Value Asset Z VAR
X
* *
%
o =
Measuring Value-at-Risk (VAR)
VAR for n days can be calculated from daily VAR as:
This comes from the known fact that the n-period volatility equals 1-period volatility multiplied by
the square root of number of periods(n).
As the volatility of the portfolio can be calculated from the following expression:
The above written expression can also be extended to the calculation of VAR:
n * %) (in VaR %) (in VaR
VaR) (daily days) (n
=
n * Value Asset * * Z %) (in VaR
X% days) (n
o =
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VAR for n days can be calculated from daily VAR as:
This comes from the known fact that the n-period volatility equals 1-period volatility multiplied by
the square root of number of periods(n).
As the volatility of the portfolio can be calculated from the following expression:
The above written expression can also be extended to the calculation of VAR:
99
* * * w 2w w
ab b a b a
2
b
2
b
2
a
2
a portfolio
o o o o o + + = w
* ) (%VAR * ) (%VAR * w 2w ) (%VAR w ) (%VAR %) (in VaR
ab b a b a
2
b
2
b
2
a
2
a portfolio
+ + = w
Expected Loss (EL)
EL = (Assured payment at Maturity Time T )* Loss Given Default * (Probability that the default
occurs before maturity Time T)
The term Assured payment is more relevant for bonds than loans
For Bank Loans the terms Assured Payment is better replaced by Exposure
EL = Exposure * LGD*PD
EL is the amount the bank can lose on an average over a period of time
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Adjusted Exposure
Let the value of bank asset at time T be V
Let the already drawn amount be OS (outstanding)
Let COM be the commitment
Let d be the fraction of the commitment which would be drawn before the default
Portion which is not drawn and risk free = COM*(1-d)
Risky portion = OS + d*COM
This Risky Portion is known as Adjusted Exposure also known as Exposure At Default
EL = Adjusted Exposure*LGD*PD
d is also known as Usage Given Default (UGD)
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Let the value of bank asset at time T be V
Let the already drawn amount be OS (outstanding)
Let COM be the commitment
Let d be the fraction of the commitment which would be drawn before the default
Portion which is not drawn and risk free = COM*(1-d)
Risky portion = OS + d*COM
This Risky Portion is known as Adjusted Exposure also known as Exposure At Default
EL = Adjusted Exposure*LGD*PD
d is also known as Usage Given Default (UGD)
101
Causes of Unanticipated Risk
Two Primary Sources
The occurrence of defaults (PD)
PD is never zero for any rating
PD is calculated using historical data or Analytical methods like Option theory
Unexpected Credit Migration unanticipated change in credit quality
An obligor undergoes financial crisis which deteriorates the credit quality although it is not a default
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Unexpected Loss
UL is the estimated volatility of the potential loss in value of the asset around its EL
UL is the standard deviation of the unconditional value of the asset at the time horizon
UL = s.d. of expected asset value
UL = AE*[EDF* 2
LGD
+LGD
2
*
2
EDF
]
Underlying assumption that EDF is independent of LGD. In case it is not so then correlation between LGD
and EDF terms will come into picture. Though it has been found that they will affect the result only slightly
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FMP

- = , MAR R 1/t SSD

, is found from the chi-square table:

Lower tail or two tailed Chi-square tests

slope of the line(b

RSS = Residual sum of squares

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