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# Financial Risk Management

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1. Financial Risk Management Zvi Wiener Following P. Jorion,Financial Risk Manager Handbook FRM

2. FRM 2000 • Capital Markets Risk Management 20 • Legal, Accounting and Tax 6 • Credit Risk Management 36 • Operational Risk Management 8 • Market Risk Management 35 • Quantitative Analysis 23 • Regulation and Compliance 12 Zvi Wiener

3. Quantitative Analysis Jorion, Value-at-Risk. Jorion, Financial Risk Manager Handbook Hull, Options, Futures and Other Derivatives. Fabozzi F., Bond Markets: Analysis and Strategies. Fabozzi F., Fixed Income Mathematics. Golub B., Risk Management. Crouchy, Galai, Mark, Risk Management. Zvi Wiener

4. Quantitative Analysis • Bond fundamentals • Fundamentals of probability • Fundamentals of Statistics • Pricing Techniques Zvi Wiener

5. Chapter 1Quantitative AnalysisBond Fundamentals Following P. Jorion 2001 Financial Risk Manager Handbook FRM

6. Bond Fundamentals Discounting, Present Value Future Value Zvi Wiener

7. Compounding US Treasuries market uses semi-annual compounding. Continuous compounding Zvi Wiener

8. A bond pays \$100 in ten years and its price is \$55.9126. This corresponds to an annually compounded rate of 6% using PV=CT/(1+y)10, or (1+y) = (CT/PV)0.1. This rate can be transformed into semiannual compounded rate, using (1+ys/2)2 = (1+y), or ys = ((1+0.06)0.5-1)*2 = 5.91%. It can be transformed into a continuously compounded rate exp(yc) = 1+y, or yc = ln(1+0.06) = 5.83%. Zvi Wiener

9. Note that as we increase the frequency of the compounding the resulting rate decreases. Intuitively, since our money works harder with more frequent compounding, a lower rate will achieve the same payoff. Key concept: For a fixed present and final values, increasing the frequency of the compounding will decrease the associated yield. Zvi Wiener

10. FRM-99, Question 17 Assume a semi-annual compounded rate of 8% per annum. What is the equivalent annually compounded rate? A. 9.2% B. 8.16%C. 7.45% D. 8% Zvi Wiener

11. FRM-99, Question 17 (1 + ys/2)2 = 1 + y (1 + 0.08/2)2 = 1.0816 ==> 8.16% Zvi Wiener

12. FRM-99, Question 28 Assume a continuously compounded interest rate is 10% per annum. What is the equivalent semi-annual compounded rate? A. 10.25% per annum. B. 9.88% per annum. C. 9.76% per annum. D. 10.52% per annum. Zvi Wiener

13. FRM-99, Question 28 (1 + ys/2)2 = ey (1 + ys/2)2 = e0.1 1 + ys/2 = e0.05 ys = 2 (e0.05 - 1) = 10.25% Zvi Wiener

14. Price-Yield Relationship Here Ct is the cashflow t - number of periods to each payment T number of periods to maturity y - the discount factor. Zvi Wiener

15. Face value, nominal. Bond that sells at face value is called par bond. A bond has a 8% annual coupon and IRR of 8%. What is the price of the bond? Is this always true? Zvi Wiener

16. Price-yield Relationship \$ Price of a straight bond as a function of yield y Zvi Wiener

17. FRM-98, Question 12 A fixed rate bond, currently priced at 102.9, has one year remaining to maturity and is paying an 8% coupon. Assuming that the coupon is paid semiannually, what is the yield of the bond? A. 8% B. 7% C. 6% D. 5% Zvi Wiener

18. FRM-98, Question 12 ys = 5% Zvi Wiener

19. Taylor Expansion To measure the price response to a small change in risk factor we use the Taylor expansion. Initial value y0, new value y1, change y: Zvi Wiener

20. Derivatives F(x) x Zvi Wiener

21. Properties of derivatives Zvi Wiener

22. Bond Price Derivatives D* - modified duration, dollar duration is the negative of the first derivative: Dollar convexity = the second derivative, C - convexity. Zvi Wiener

23. Duration of a portfolio Zvi Wiener

24. Macaulay Duration Modified duration Zvi Wiener

25. Bond Price Change Zvi Wiener

26. Example 10 year zero coupon bond with a semiannual yield of 6% The duration is 10 years, the modified duration is: The convexity is Zvi Wiener

27. Example If the yield changes to 7% the price change is Zvi Wiener

28. Duration-Convexity Price of a straight bond as a function of yield \$ y Zvi Wiener

29. Effective duration Effective convexity Zvi Wiener

30. Effective Duration and Convexity Consider a 30-year zero-coupon bond with a yield of 6%. With semi-annual compounding its price is \$16.9733. We can revalue this bond at 5% and 7%. Zvi Wiener

31. Zvi Wiener

32. 5% 6% 7% Zvi Wiener

33. Coupon Curve Duration If IR decrease by 100bp, the market price of a 6% 30 year bond will go up close to the price of a 30 years 7% coupon bond. Thus we associate a higher coupon with a drop in yield equal to the difference in coupons. This approach is useful for mortgages. Zvi Wiener

34. FRM-98, Question 20 Coupon curve duration is a useful method to estimate duration from market prices of MBS. Assume that the coupon curve of prices for Ginnie Maes is as follows: 6% at 92, 7% at 94, 8% at 96.5. What is the estimated duration of the 7s? A. 2.45 B. 2.4 C. 2.33 D. 2.25 Zvi Wiener

35. FRM-98, Question 20 Zvi Wiener

36. FRM-98, Question 21 Coupon curve duration is a useful method to estimate duration from market prices of MBS. Assume that the coupon curve of prices for Ginnie Maes is as follows: 6% at 92, 7% at 94, 8% at 96.5. What is the estimated convexity of the 7s? A. 53 B. 26 C. 13 D. -53 Zvi Wiener

37. FRM-98, Question 21 Zvi Wiener

38. Duration of a coupon bond Zvi Wiener

39. Exercise Find the duration and convexity of a consol (perpetual bond). Answer: (1+y)/y. Zvi Wiener

40. Convexity Exercise: compute duration and convexity of a 2-year, 6% semi-annual bond when IR=6%. Zvi Wiener

41. FRM-99, Question 9 A number of terms in finance are related to the derivative of the price of a security with respect to some other variable. Which pair of terms is defined using second derivatives? A. Modified duration and volatility B. Vega and delta C. Convexity and gamma D. PV01 and yield to maturity Zvi Wiener

42. FRM-98, Question 17 A bond is trading at a price of 100 with a yield of 8%. If the yield increases by 1 bp, the price of the bond will decrease to 99.95. If the yield decreases by 1 bp, the price will increase to 100.04. What is the modified duration of this bond? A. 5.0 B. -5.0 C. 4.5 D. -4.5 Zvi Wiener

43. FRM-98, Question 17 Zvi Wiener

44. FRM-98, Question 22 What is the price of a 10 bp increase in yield on a 10-year par bond with a modified duration of 7 and convexity of 50? A. -0.705 B. -0.700 C. -0.698 D. -0.690 Zvi Wiener

45. FRM-98, Question 22 Zvi Wiener

46. FRM-98, Question 29 A and B are perpetual bonds. A has 4% coupon, and B has 8% coupon. Assume that both bonds are trading at the same yield, what can be said about duration of these bonds? A. The duration of A is greater than of B B. The duration of A is less than of B C. They have the same duration D. None of the above Zvi Wiener

47. FRM-97, Question 24 Which of the following is NOT a property of bond duration? A. For zero-coupon bonds Macaulay duration of the bond equals to time to maturity. B. Duration is usually inversely related to the coupon of a bond. C. Duration is usually higher for higher yields to maturity. D. Duration is higher as the number of years to maturity for a bond selling at par or above increases. Zvi Wiener

48. FRM-99, Question 75 You have a large short position in two bonds with similar credit risk. Bond A is priced at par yielding 6% with 20 years to maturity. Bond B has 20 years to maturity, coupon 6.5% and yield of 6%. Which bond contributes more to the risk of the portfolio? A. Bond A B. Bond B C. A and B have similar risk D. None of the above Zvi Wiener

49. Portfolio Duration and Convexity Portfolio weights Zvi Wiener

50. Example Construct a portfolio of two bonds: A and B to match the value and duration of a 10-years, 6% bond with value \$100 and modified duration of 7.44 years. A. 1 year zero bond - price \$94.26 B. 30 year zero - price \$16.97 Zvi Wiener