Core Readings:
1. Hull, John, Options, Futures, and Other Derivatives, Sixth Edition, Prentice Hall,
New York, 2006, Chapter 19, Estimating Volatilities and Correlations

2. Allen, Linda, Jacob Boudoukh, and Anthony Saunders, Understanding Market,
Credit, and Operational Risk: The Value at Risk Approach, Blackwell Publishing,
Oxford, 2004, Chapter 2, Quantifying Volatility in VaR Models

3. Spiegel, Murray R., John Schiller, and R. Alu Srinivasan, Probability and Statistics,
Schaum’s Outlines, Second Edition, McGraw-Hill, New York, 2000
3.A. Chapter 1, Basic Probability
3.B. Chapter 2, Random Variables and Probability Distributions
3.C. Chapter 3, Mathematical Expectation
3.D. Chapter 4, Special Probability Distributions
3.E. Chapter 5, Sampling Theory
3.F. Chapter 6, Estimation Theory
3.G. Chapter 7, Tests of Hypotheses and Significance
3.H. Chapter 8, Curve Fitting, Regression, and Correlation

1. Estimating Volatilities and Correlations
You should know how to:

• discuss how historical data and various weighting schemes can be used in estimating volatility
• describe the exponentially weighted moving average (EWMA) model of volatility estimation
• describe the generalized autoregressive conditional heteroskedastic (GARCH)(1,1) model in volatility estimation;
• determine when and whether a GARCH or EWMA model should be used in volatility estimation
• discuss how GARCH model parameters are estimated, and explain how GARCH models perform in volatility forecasting
• discuss how correlations and covariances are calculated, and indicate the importance of the consistency condition in calculating covariances.
  

2. Quantifying Volatility in VaR Models
You should know how to:

• identify the ways that distributions of asset returns tend to deviate from a normal distribution
• discuss potential reasons for the existence of “fat tails” in a return distribution and the implications of “fat tails” for analyzing distributions of asset returns
• discuss the implications of regime switching for quantifying volatility
• explain the various approaches for estimating VAR
• compare and contrast parametric approaches for estimating conditional volatility, including the historical standard deviation approach, the RiskMetrics approach, and the GARCH approach
• discuss the advantages and disadvantages of nonparametric methods for forecasting volatility, including the historic simulation, multivariate density estimation, and hybrid methods
• explain return aggregation in the context of volatility forecasting methods
• explain how implied volatility can be used as a predictor of future volatility, and discuss the advantages and disadvantages of using implied volatility to predict future volatility
• discuss the implications of mean reversion in returns and return volatility for forecasting VAR over long time horizons
• discuss the implications of using nonsynchronous data for estimating correlations, and describe ways to mitigate the impact of nonsynchronous data when estimating risk.
  

3.A. Basic Probability
You should know how to:

• apply theorems of probability to two or more events;
• determine the conditional probability of an event;
• determine the probability of occurrence for three independent events;
• use Bayes’ theorem to determine the probability of causes for a given event;
• determine the number of possible permutations of n objects taken r at a time;
• determine the number of possible combinations of n objects taken r at a time.
  

3.B. Random Variables and Probability Distributions
You should know how to:

• distinguish between discrete random variables and continuous random variables
• contrast the probability distributions of discrete random variables with continuous random variables
• determine the joint probability of two discrete random variables
• discuss the probability distribution function for random variables
• calculate the conditional probability function for two variables
• describe the continuous uniform distribution and its cumulative density function.
  

3.C. Mathematical Expectation
You should know how to:

• apply the three theorems on expectations for two independent variables
• apply the four theorems on variance for two independent variables
• apply the four theorems on the variance for joint distributions for two independent variables
• calculate the correlation coefficient for two dependent variables
• determine the percentage of a distribution that lies a stated number of deviations from the mean using Chebyshev’s inequality
• calculate and interpret the following measures: population mean, sample mean, arithmetic mean, mode, and median
• define the law of large numbers
• describe and interpret measures of skewness and kurtosis.
  

3.D. Special Probability Distributions
You should know how to:

• calculate probabilities for binomial random variables given a binomial probability distribution
• calculate the expected value and variance of a binomial random variable
• identify the key properties of the normal distribution
• calculate probabilities based on a standard normal distribution
• calculate the expected value and variance of the Poisson distribution
• compare and contrast the binomial, normal, and Poisson distributions.
  

3.E. Sampling Theory
You should know how to:

• define a population, a parameter, and a sample
• discuss the properties of the sampling distribution of means, proportions, differences and sums, and variances
• calculate the variance and standard deviation of a population
• calculate the variance and standard deviation of a sample
• construct a frequency distribution
• calculate relative frequencies from a frequency distribution
• illustrate the use of a histogram and a frequency polygon to present data.
  

3.F. Estimation Theory
You should know how to:

• compare and contrast a point estimate with a confidence interval
• identify and describe the properties of an efficient estimate
• state the central limit theorem, and describe its importance
• calculate and interpret the standard error of the sample mean
• calculate and interpret a confidence interval for a population mean, given a normal distribution with a known population variance
• calculate and interpret a confidence interval for a population mean, given a normal distribution with an unknown population variance
• calculate a confidence interval for a proportion and for differences and sums.
  

3.G. Tests of Hypotheses and Significance
You should know how to:

• explain the difference between a Type I and a Type II error and how the probabilities of Type I and Type II errors are affected by the choice of significance level
• define the p-value in hypothesis testing
• determine the appropriate test statistic for both a known and unknown variance of a normally distributed population mean
• construct a hypothesis, and determine whether it should be rejected
• determine whether two population means are statistically different from each other, assuming each population is normally distributed
• conduct a chi-square test for a single population variance
• conduct a chi-square test for goodness of fit
• conduct an equality-of-variance test for two normally distributed populations.
  

3.H. Curve Fitting, Regression, and Correlation
You should know how to:

• calculate the standard error of estimate (SEE)
• calculate the coefficient of determination
• conduct a test for significance for regression coefficients, and construct a corresponding confidence interval
• calculate a predicted value for the dependent variable, given output from a regression model and stated values for independent variables
• calculate the covariance between two random variables and the covariance for two dependent variables
• calculate a correlation coefficient, and determine whether it is significantly different from zero.

Core Readings:
1. Saunders, Anthony, Financial Institutions Management, Fourth Edition, McGraw-
Hill, New York, 2003
1.A. Chapter 10, Market Risk
1.B. Chapter 15, Foreign Exchange Risk

2. Tuckman, Bruce, Fixed Income Securities, Second Edition, Wiley, New York, 2002
2.A. Chapter 1, Bond Prices, Discount Factors, and Arbitrage
2.B . Chapter 2, Bond Prices, Spot Rates, and Forward Rates
2.C . Chapter 3, Yield to Maturity
2.D . Chapter 4, Generalizations and Curve Fitting
2.E. Chapter 5, One-Factor Measures of Price Sensitivity
2.F. Chapter 6, Measures of Price Sensitivity Based on Parallel Yield Shifts
2.G. Chapter 7, Key Rate and Bucket Exposures
2.H. Chapter 9, The Science of Term Structure Models
2.I. Chapter 21, Mortgage-Backed Securities

3. Hull, John, Options, Futures, and Other Derivatives, Sixth Edition, Prentice Hall,
New York, 2006
3.A. Chapter 2, Mechanics of Futures Markets
3.B. Chapter 4, Interest Rates
3.C. Chapter 5, Determination of Forward and Futures Prices
3.D Chapter 7, Swaps
3.E. Chapter 8, Mechanics of Options Markets
3.F. Chapter 9, Properties of Stock Options
3.G. Chapter 10, Trading Strategies Involving Options
3.H. Chapter 11, Binomial Trees
3.I. Chapter 13, The Black-Scholes-Merton Model
3.J. Chapter 15, The Greek Letters
3.K. Chapter 16, Volatility Smiles
3.L. Chapter 22, Exotic Options

4. Jorion, Philippe, Value at Risk, Second Edition, McGraw-Hill, New York, 2001
4.A. Chapter 11, Implementing Delta-Normal VaR
4.B. Chapter 12, Simulation Methods

5. Allen, Linda, Jacob Boudoukh, and Anthony Saunders, Understanding Market,
Credit, and Operational Risk: The Value at Risk Approach, Blackwell Publishing,
Oxford, 2004
5.A. Chapter 1, Introduction to Value at Risk (VaR)
5.B. Chapter 3, Putting VaR to Work

6. Pearson, Neil D., Risk Budgeting: Portfolio Problem Solving with Value-at-Risk,
Wiley, New York, 2002
6.A Chapter 5, The Delta-Normal Method for a Fixed Income Portfolio
6.B. Chapter 9, Stress Testing
6.C. Chapter 10, Decomposing Risk
6.D. Chapter 12, Aggregating and Decomposing the Risks of Large Portfolios
6.E. Chapter 16, Extreme Value Theory and VaR

7. Stulz, Rene, Risk Management & Derivatives, South-Western, Mason, OH, 2003
7.A. Chapter 4, A Firm-Wide Approach to Risk Management
7.B. Chapter 8, Identifying and Managing Cash Flow Exposures
7.C. Chapter 15, The Demand and Supply for Derivative Products

8. McDonald, Robert L., Derivatives Markets, Addison Wesley, Boston, 2003, Chapter 6, Commodity Forwards and Futures

1.A. Market Risk
You should know how to:

• describe five reasons market risk measurement is important
• list the models being used to calculate market risk exposure;
  

1.B. Foreign Exchange Risk
You should know how to:

• describe the different sources of foreign exchange risk exposure
• explain the different types of foreign trading activities
• explain the sources of most profits and losses on foreign exchange trading
• describe foreign exchange exposure resulting from mismatches between foreign financial asset and liability portfolios
• explain how returns and risks of foreign investing can impact returns
• explain on-balance-sheet hedging
• explain off-balance-sheet hedging with forwards
• explain why diversification in multi-currency foreign asset-liability positions could reduce portfolio risk.
  

2.A. Bond Prices, Discount Factors, and Arbitrage
You should know how to:

• generate the discount function given a series of coupon bond prices
• use the discount function to determine whether a bond is trading cheap or rich
• describe the arbitrage trade necessary to exploit violations of the law of one price, and compute the profit or loss of the arbitrage strategy
• compare and contrast the structure of Treasury coupon bonds and Treasury STRIPS, and differentiate between P-STRIPS and C-STRIPS.
  

2.B. Bond Prices, Spot Rates, and Forward Rates
You should know how to:

• calculate a series of spot rates given the appropriate discount factors or STRIPS prices
• calculate forward rates from a series of spot rates
• calculate the price of a bond using discount factors, spot rates, or forward rates.
  

2.C. Yield to Maturity
You should know how to:

• calculate a bond’s yield to maturity (YTM) using a calculator with time value functions
• describe the price of a bond relative to its par value when (i) coupon rate = YTM, (ii) coupon rate > YTM, and (iii) coupon rate < YTM
• calculate the price of an annuity and a perpetuity using a calculator with time value functions
• describe reinvestment risk.
  

2.D. Generalizations and Curve Fitting
You should know how to:

• calculate the accrued interest and invoice price on a coupon bond
• calculate simple, semiannual, monthly, daily, and continuously compounded rates given a discount factor or market interest rate for a specified interval
• explain the linear yield interpolation and piecewise cubics methods for estimating complete discount functions.
  

2.E. One-Factor Measures of Price Sensitivity
You should know how to:

• calculate the dollar value of an 01 (DV01) of a security, given a change in yield and the resulting change in price
• calculate the face amount of one security required to hedge a position in a second security, given the DV01 of each
• calculate and interpret the effective duration of a security, given a change in yield and the resulting change in price
• calculate and interpret the convexity of a security, given a change in yield and the resulting change in price
• estimate the price change of a security given the DV01, the duration, and the convexity
• interpret convexity in the contexts of investment management and assetliability management
• calculate the duration of a portfolio
• interpret the impact of changes in maturity, yield, and rating on a bond’s duration.
  

2.F. Measures of Price Sensitivity Based on Parallel Yield Shifts
You should know how to:

• define, interpret, and calculate the yield-based DV01, the modified duration, and the Macaulay duration of a security
• explain how Macaulay duration and DV01 vary with changes in coupon rate, maturity, and yield
• explain how yield-based convexity changes for changes in maturity
• describe the construction of a barbell and a bullet portfolio, and compare and contrast the convexity of the two portfolios.
  

2.G. Key Rate and Bucket Exposures
You should know how to:

• describe the major weakness attributable to single-factor approaches when hedging portfolios or implementing asset\liability techniques
• define the key rate shift technique in multifactor hedging applications, and discuss four appealing characteristics of this approach
• calculate the key rate exposures for a given security
• calculate the appropriate hedging positions required, given a specific key rate exposure profile
• discuss why hedges based on key rates only approximate an immunized position in the underlying assets
• explain the main differences between using the key rate shift approach and the bucket shift approach for managing interest rate risks
• explain how key rate and bucket analysis may be applied in estimating portfolio volatility.
  

2.H. The Science of Term Structure Models
You should know how to:

• calculate the value of a derivative on a fixed-income security, given an interest rate tree and the risk-neutral probabilities
• discuss the advantages and disadvantages of reducing the size of the time steps
• explain why the Black-Scholes-Merton model is not appropriate for valuing derivatives on fixed-income securities
• explain the impact of embedded options on a fixed-income security’s price.
  

2.I. Mortgage-Backed Securities
You should know how to:

• describe the basic features of a fixed-rate, level-payment mortgage, including the prepayment option
• discuss the factors that affect mortgage prepayments;
• discuss the advantages and disadvantages of static cash flow models, implied models, and prepayment models
• describe the Monte Carlo simulation method for valuing mortgage-backed securities
• describe the characteristics of the price-rate curve of a mortgage pass-through security
• describe the prepayment risk of planned amortization class (PAC) bonds, support bonds, principal-only (PO) strips, and interest-only (IO) strips.

3.A. Mechanics of Futures Markets
You should know how to:

• distinguish between a long futures position and a short futures position
• describe the characteristics of a futures contract
• explain how futures positions are settled
• describe the marking-to-market procedure, the initial margin, and the maintenance margin
• compute the variation margin
• explain the role of the clearinghouse.
  

3.B. Interest Rates
You should know how to:

• distinguish between Treasury rates, London Interbank Offered Rate (LIBOR), and repo rates
• compute a continuously compounded rate that is equivalent to a discretely compounded rate
• compute a discrete compounding rate of m times a year from a continuously compounded rate
• compute a bond price using zeros or spot rates
• compute spot rates from coupon bonds using the bootstrapping framework
• compute forward rates from spot rates
• compute the payoff and value of a forward rate agreement (FRA)
• calculate the duration and modified duration of a bond
• explain the following theories of the term structure: expectations theory, market segmentation theory, and the liquidity preference theory.
  

3.C. Determination of Forward and Futures Prices
You should know how to:

• state and explain the cost-of-carry model for forward prices using both assets that have interim cash flows and assets that do not have interim cash flows
• compute the forward price given both the price of the underlying and the appropriate carrying costs of the underlying
• describe the differences between forward and futures contracts
• calculate the value of a forward contract
• describe and formulate a beta-adjusting strategy using index futures
• explain the relationship between the cost-of-carry model and interest rate parity for currency futures
• explain the role of the convenience yield in commodity futures
• explain the concepts of contango and normal backwardation.

3.D. Swaps
You should know how to:

• illustrate the mechanics of a plain vanilla interest rate swap
• compute the cash flows of a plain vanilla interest rate swap
• explain how an interest rate swap can be combined with an existing asset or liability to transform the interest rate risk
• explain the advantages and disadvantages of the comparative advantage argument often used for the existence of the swap market
• explain how the discount rates in a swap are computed
• explain how a swap can be interpreted as two simultaneous bond positions or as a sequence of forward rate agreements (FRAs)
• calculate the value of an interest rate swap
• explain the mechanics of a currency swap
• calculate the value of a currency swap
• explain the role of credit risk inherent in an existing swap position.
  

3.E. Mechanics of Options Markets
You should know how to:

• explain the specifications of exchange-traded stock options including strike, expiration dates, terminology, dividend and stock split adjustments, and position limits
• describe a flex option and long-term equity anticipation securities (LEAPSR)
• explain why margin is required for the writer of options but not for owners of options
• explain the differences between exchange-traded options and warrants, executive stock options, and convertible bonds.
  

3.F. Properties of Stock Options
You should know how to:

• identify the six factors that affect an option’s price
• explain how the six factors affect an option’s price for both European and American options
• identify the upper and lower pricing bounds for both European and American options
• explain put-call parity, and use it to compute option values
• explain the difference between a European and American call on a non dividend-paying stock
• contrast and explain the early exercise features of American call and put options on a non-dividend-paying stock
• explain the relationship between the prices of American call and put options on a non-dividend-paying stock within the context of a put-call parity relationship.
  

3.G. Trading Strategies Involving Options
You should know how to:

• illustrate and explain why an investor would write a covered call or a protective put strategy
• illustrate and explain why an investor would enter into a spread strategy (e.g., bull spread, bear spread, calendar spread, or butterfly spread)
• illustrate and explain why an investor would enter into a combination strategy (e.g., straddles, strangles, strips, or straps).
  

3.H. Binomial Trees
You should know how to:

• calculate the value of a European call or put option using a one-step and a two-step binomial model
• calculate the value of an American call or put option using a two-step binomial model.
  

3.I. The Black-Scholes-Merton Model
You should know how to:

• discuss the lognormal property of stock prices
• demonstrate how to estimate volatility using historical data
• develop and explain the delta-neutral or riskless portfolio used to derive the Black-Scholes-Merton partial differential equation
• identify the Black-Scholes-Merton partial differential equation
• explain the risk-neutral valuation framework
• compute the value of a European option using the Black-Scholes-Merton model
• identify the complications involving the valuation of warrants outline how to compute implied volatility from market prices of options using the Black-Scholes-Merton model
• explain how dividends affect the early exercise decision for American call and put options.
  

3.J. The Greek Letters
You should know how to:

• discuss the risks of naked and covered positions
• describe how naked and covered positions can be used to generate a stop-loss trading strategy
• describe the characteristics of delta hedging for option, forward, and futures contracts
• discuss the dynamic aspects of delta hedging
• define the delta of a portfolio
• define and discuss “theta” for option positions
• define and discuss “gamma” for option positions
• describe how to create and maintain a gamma-neutral position
• discuss the relationship between delta, theta, and gamma
• define and discuss “vega” for option positions
• define and discuss “rho” for option positions
• describe how hedging activities take place in practice, and discuss how scenario analysis can be used to formulate expected gains and losses with option positions
• define and discuss how portfolio insurance can be created through option instruments and stock index futures.
  

3.K. Volatility Smiles
You should know how to:

• explain how put-call parity indicates that the same implied volatility used to price calls is the one used to price puts
• explain why a volatility smile may exist in foreign currency options
• explain why a volatility smile may exist in equity options
• describe how the volatility term structure and volatility surfaces may be used when pricing options
• describe how the volatility smile affects calculation of option Greeks
• discuss how the implied volatility of an option might be affected by jumps in asset prices
• discuss the general empirical testing results of the Black-Scholes-Merton option pricing model.
  

3.L. Exotic Options
You should know how to:

• define and illustrate the use of packages in formulating a zero-cost product
• list and describe how various option characteristics can transform standard American options into nonstandard American options
• describe the characteristics of forward start options
• describe how compound options are created
• discuss the characteristics of a chooser option
• describe the characteristics of barrier options
• describe how binary options generate discontinuous payoff profiles
• discuss the various factors affecting lookback options
• describe the characteristics of a shout option
• describe an Asian option, and discuss the factors impacting Asian options
• describe the workings of options used to exchange one asset for another
• define basket options
• discuss the issues impacting hedging concerns when dealing with exotic options, and explain the use of static option replication in hedging exotic options.
  

4.A. Implementing Delta-Normal VaR
You should know how to:

• describe the two components of the typical VAR model
• explain the use of a correlation matrix in calculating VAR
• discuss the three qualities of successful futures contracts and why these are desired in the chosen risk factors
• discuss how the residual specific risk is related to the number of risk factors
• explain the three approaches for mapping a portfolio onto the risk factors
• explain what is meant by benchmarking a portfolio, and define tracking error
• explain why the delta-normal method can provide accurate estimates of VAR for many types of financial instruments
• discuss why caution must be used in applying delta-normal VAR methods to derivatives and options, and describe when this is appropriate
• describe the beta model.
  

4.B. Simulation Methods
You should know how to:

• describe the procedure for simulating a price path using a discrete approximation to geometric Brownian motion (GBM)
• identify the four steps in computing value at risk (VAR) using Monte Carlo simulation
• describe how the Monte Carlo method is used in option pricing
• discuss the tradeoff between speed and accuracy in Monte Carlo models
• explain how to account for correlations among the variables in simulations with multiple variables
• describe two techniques used to simplify the simulation process in simulations with multiple variables
• describe various models of interest rate dynamics.
  

5.A. Introduction to Value at Risk
You should know how to:

• discuss reasons for the widespread adoption of VAR as a measure of risk
• define value at risk (VAR)
• calculate VAR for a single asset on both a dollar and percentage basis
• convert a daily VAR measure into a weekly, monthly, or annual VAR measure
• discuss assumptions underlying VAR calculations
• explain why it is best to use continuously compounded rates of return when calculating VAR
• calculate portfolio VAR
• describe the primary factors that affect portfolio risk
• discuss the role of correlation in the downfall of Long-Term Capital Management (LTCM).
  

5.B. Putting VAR to Work
You should know how to:

• differentiate between linear and non-linear derivatives
• describe the calculation of VAR for a linear derivative
• explain how the addition of second-order terms through the Taylor approximation improves the estimate of VAR for non-linear derivatives
• discuss why the Taylor approximation is ineffective for certain types of securities
• explain the differences between the delta-normal and full-revaluation methods for measuring the risk of non-linear derivatives
• describe the structured Monte Carlo (SCM) approach to measuring VAR, and identify the advantages and disadvantages of the SCM approach
• discuss the implications of correlation breakdown for scenario analysis
• describe the primary approaches to stress testing and the advantages and disadvantages of each approach
• describe the worst case scenario (WCS) measure as an extension to VAR.
  

6.A. The Delta-Normal Method for a Fixed Income Portfolio
You should know how to:

• decompose a fixed-income portfolio into positions in the standard instruments
• calculate the VAR of a fixed-income portfolio using the delta-normal method, given the expected change in portfolio value and the standard deviation
• describe the procedure for mapping interest rate swaps and options.
  

6.B. Stress Testing
You should know how to:

• discuss the additional information provided by stress testing in addition to the VAR estimate
• discuss examples of actual past market events often used as stress scenarios
• compare and contrast the use of zero-out stress scenarios, anticipatory stress scenarios, predictive stress scenarios, and anticipatory stress scenarios with stress correlations, and describe the advantages and disadvantages of each
• interpret a stressed VAR.
  

6.C. Decomposing Risk
You should know how to:

• explain why risk decomposition is necessary for risk budgeting
• explain how a risk decomposition is interpreted
• explain why an expected-returns model is important for estimating value at risk (VAR).
  

6.D. Aggregating and Decomposing the Risks of Large Portfolios
You should know how to:

• interpret the risk contributions of the individual securities in a portfolio, given a risk decomposition by securities
• interpret the risk contributions of sub-portfolios, given a risk decomposition in terms of groups of assets
• interpret the risk contributions of factors and securities, given a risk decomposition in terms of factors and securities
• interpret the risk contributions of factors and sub-portfolios, given a risk decomposition in terms of factors and portfolios.
  

6.E. Extreme Value Theory and VAR
You should know how to:

• explain why the normal distribution is often a poor proxy for risk modeling
• describe the problem with value-at-risk (VAR) estimation for which extreme value theory (EVT) provides a potential solution
• describe the generalized Pareto distribution and its use in estimating VAR
• describe the generalized extreme value distribution and its use in stress testing
• discuss the limitations of EVT in computing VAR.
  

7.A. A Firm-Wide Approach to Risk Management
You should know how to:

• calculate the VAR (CAR) for a firm with normally distributed value (cash flows) for any period, given the expected return and volatility of firm value, and interpret the VAR (CAR) measure
• describe the characteristics of firms for which VAR is the more appropriate measure of risk
• describe the characteristics of firms for which CAR is the more appropriate measure of risk
• given the cost per dollar of VAR and the relevant betas, expected returns, and correlations, calculate the VAR impact and expected net gain of a project/trade that is not large relative to the firm’s portfolio of projects
• evaluate the impact of a project that is large relative to the firm’s portfolio of projects on CAR, and explain how the cost of additional CAR impacts the capital budgeting decision
• explain how to allocate CAR and VAR to the existing activities of the firm and how to use these allocations to improve the evaluation of the economic profitability of these activities (projects, divisions, and trading)
• discuss how a firm can reduce the cost of VAR/CAR
• explain the limitations on project selection and the use of derivative instruments as ways to decrease VAR/CAR.
  

7.B . Identifying and Managing Cash Flow Exposures
You should know how to:

• distinguish among transaction exposure, contractual exposure, and competitive exposure to exchange rate fluctuations
• explain the interaction of price risk and quantity risk in terms of the additional challenges to hedging using examples of industries where the association between price and quantity of the risky factor is negative and where it is positive
• explain the implications of perfect positive correlation, zero correlation, and perfect negative correlation between price risk and quantity risk for the optimal hedge ratio and the risk of the hedged versus the unhedged cash flows
• describe how the exposure of cash flow to a risk factor, such as exchange rate risk, is measured
• using supply (marginal cost) and demand analysis, illustrate the competitive exposure to exchange rate risk for an exporting firm, considering changes in (i) exchange rates between the firm’s currency and the currency of the importing country and (ii) exchange rates between the currency of a third country (that has exporters that compete with the firm) and the currency of the importing country
• outline the steps in determining cash flow exposure from a pro forma analysis when the correlation of the quantity sold with the risk factor is zero, positive, and negative
• explain how the optimal hedge ratio is determined in the context of pro forma cash flow analysis with one risk factor
• illustrate the concept of the delta exposure of cash flow, and describe how it is estimated in practice for non-linear exposure to a risk factor
• describe the steps in using Monte Carlo simulation to estimate the volatility minimizing hedge ratio and the circumstances under which this approach has significant advantages.
  

7.C. The Demand and Supply for Derivative Products
You should know how to:

• define exotic derivatives, and briefly describe the four primary issues to be considered when evaluating alternative approaches to taking a position in exotic derivatives
• compare and contrast exchange-traded options, over-the-counter options, dynamic replication, and static replication in regard to their advantages, costs, and risks to the user
• discuss the various roles that financial intermediaries can take with respect to the derivative products they sell in terms of their risk position and comparative advantage
• explain how financial engineering and innovation in derivative products can solve risk management problems and the role of competition in the profitability and availability of new products
• discuss the reasons that some derivatives are embedded in other securities or bundled with other derivatives
• given the tradeoffs involved in selecting the optimal derivative instrument or replicating strategy, provide a framework for selecting the optimal instrument or strategy to hedge a particular risk.
  

8. Commodity Forwards and Futures
You should know how to:

• explain the derivation of the basic equilibrium formula for pricing commodity forwards and futures
• define lease rates, and discuss the importance of lease rates for determining no-arbitrage values for commodity futures and forwards
• calculate the implicit lease rate given a commodity’s forward price
• explain how lease rates determine whether a forward market is in contango or backwardation
• explain how storage costs impact commodity forward prices, and calculate the forward price of a commodity with storage costs
• explain how a convenience yield impacts commodity forward prices, and determine the no-arbitrage bounds for the forward price of a commodity when the commodity has a convenience yield
• discuss the factors that impact the pricing of gold, corn, natural gas, and oil futures
• describe and calculate a commodity spread
• define basis risk, and explain how basis risk can occur when hedging commodity price exposure
• differentiate between a strip hedge and a stack hedge.
  

Core Readings:
1. De Servigny, Arnaud and Olivier Renault, Measuring and Managing Credit Risk,
Mc-Graw-Hill, New York, 2004
1.A. Chapter 2, External and Internal Ratings
1.B. Chapter 3, Default Risk: Quantitative Methodologies
1.C. Chapter 4, Loss Given Default
1.D. Chapter 6, Credit Risk Portfolio Models
1.E. Chapter 7, Credit Risk Management and Strategic Capital Allocation

2. Ashish Dev, ed., Economic Capital, Risk Books, London, 2004, Chapter 7, Economic
Capital for Counterparty Credit Risk, by Evan Picoult and David Lamb

3. Canabarro, Eduardo and Darrell Duffie, “Measuring and Marking Counterparty
Risk,” ALM of Financial Institutions, ed. Leo Tilman, Institutional Investor Books, 2004

4. Meissner, Gunter, Credit Derivatives, Application, Pricing and Risk Management,
Blackwell Publishing, Malden, MA, 2005
4.A. Chapter 2, Credit Derivatives Products
4.B. Chapter 3, Synthetic Structures
4.C. Chapter 4, Application of Credit Derivatives
4.D. Chapter 6, Risk Management with Credit Derivatives

5. Hull, John, Options, Futures, and Other Derivatives, Sixth Edition, Prentice Hall,
New York, 2006, Chapter 21, Credit Derivatives

6. Saunders, Anthony, Financial Institutions Management, Fourth Edition, McGraw-
Hill, New York, 2003
6.A. Chapter 11, Credit Risk: Individual Loan Risk
6.B. Chapter 12, Credit Risk: Loan Portfolio and Concentration Risk
6.C. Chapter 16, Sovereign Risk
6.D. Chapter 27, Loan Sales and Other Credit Risk Management Techniques

7. Moody’s Investors Services, “Demystifying Securitization,”
www.GARPDigitalLibrary.org

8. Stulz, Rene, Risk Management and Derivatives, South-Western, Mason, OH, 2003,
Chapter 18, Credit Risks and Credit Derivatives

1.A. External and Internal Ratings
You should know how to:

• describe external rating scales, the rating process, and the link between ratings and default
• discuss the impact of time horizon, economic cycle, industry, and geography on external ratings
• review the results and explanation of the impact of ratings changes on bond and stock prices
• explain and compare the through-the-cycle and at-the-point approaches to score a company
• explain how internal ratings models may create a procyclicality effect.
  

1.B. Default Risk: Quantitative Methodologies
You should know how to:

• explain the Merton model as an example of a structural model, including its relationship to the Black-Scholes-Merton model
• illustrate and interpret security-holder payoffs based on the Merton model
• explain the linkage between Merton and KMV’s equity models to EDF’s, as well as some problems in using these models to assess required capital
• define and differentiate a) linear discriminant analysis, b) parametric discrimination, c) k-nearest neighbor, and d) support vector machines as credit scoring models
• define and differentiate the following decision rules: a) minimum error, b) minimum risk, c) Neyman-Pearson, and d) minimax for classification purposes
• compare and contrast receiver operating characteristic and cumulative accuracy profile as user-independent performance measures
• discuss the problems and tradeoffs between classification and prediction models of performance.
  

1.C. Loss Given Default
You should know how to:

• list the four factors that may lead to suboptimal loan recovery rates
• know and discuss the factors affecting recovery rates of traded bonds
• discuss the beta distribution, kernel modeling, and conditional recovery modeling as estimates of a recovery function.
  

1.D. Credit Risk Portfolio Models
You should know how to:

• explain the four main reasons banks have developed credit portfolio tools
• discuss how the three risk drivers are modeled in the CreditMetrics model
• list the four steps included in CreditMetrics
• describe Portfolio Manager and its similarity to CreditMetrics
• list the improvements and novelties that apply to the Portfolio Risk Tracker
• explain how CreditPortfolioView models default risk
• explain CreditRisk+ and its weaknesses
• define expected loss, unexpected loss, value at risk, economic capital, and expected shortfall
• explain, including equations, the individual contribution to unexpected losses.
  

1.E. Credit Risk Management and Strategic Capital Allocation
You should know how to:

• define strategic capital allocation
• discuss the top-down and bottom-up approaches to capital allocation, including the difference between product and business risk
• define and compare the six methods of allocating economic capital
• explain how liquidity and information affect strategic capital allocation
• discuss the strengths and weaknesses of linking RAROC and EVA to develop a dynamic capital allocation model.
  

2. Economic Capital for Counterparty Credit Risk
You should know how to:

• describe the differences between lending risk and counterparty credit risk
• define current exposure, and discuss total current exposure for a counterparty including netting and margins
• describe the simple transaction and portfolio simulation methodologies, including advantages and disadvantages of each
• explain the steps necessary to compute economic capital for counterparty risk using default only, full simulation
• define credit value adjustment, and explain both unilateral and bilateral models of estimation
• explain the factors in hedging changes in credit value adjustment under both unilateral and bilateral estimation.
  

3. Measuring and Marking Counterparty Risk
You should know how to:

• define terms related to counterparty risk
• identify and explain the steps of using a Monte Carlo simulation engine to model potential future exposure to a counterparty, and discuss considerations for applying such a model to various market instruments
• identify and discuss the primary uses for potential future exposure models
• describe how a credit valuation adjustment is made to an over-the-counter (OTC) derivatives portfolio
• define a risk-neutral mean loss rate
• describe the procedures for computing the market value of credit risk when one or both counterparties in the derivatives transaction has credit exposure.
  

4.A. Credit Derivatives Products
You should know how to:

• define a default swap
• list the ISDA events that trigger a default swap
• calculate the cash settlement amount when a reference bond defaults
• explain the main types of default swaps
• define and explain the payments of a total rate of return swap (TROR)
• define a credit spread option, including a description of the payoffs for both parties;
• calculate the payoff for a credit spread option and whether the bond holder is over/under hedged
• describe a credit spread forward and a credit spread swap.
  

4.B. Synthetic Structures
You should know how to:

• describe a credit-linked note, including risks and benefits
• explain the structure of a typical cash collateralized debt obligation (CDO), including the use of a special purpose vehicle (SPV)
• describe the difference between a cash and synthetic CDO
• state the defining characteristics of a) tranched portfolio default swaps (TPDS), b) tranched basket default swaps (TBDS), and c) collateralized debt obligation squared (CDO2s)
• describe the initial structure, current success, and the relevant differences between BISTRO and J-Port.
  

4.C. Application of Credit Derivatives
You should know how to:

• explain which risks each credit derivative hedges
• calculate and explain the payoff resulting from a total rate of return (TROR) hedge of operational risk
• calculate and explain the yield enhancement on a credit spread option and the underlying debt
• calculate and explain the benefits of a TROR hedge and credit spread option in cost reduction
• calculate and explain the profits using TROR, default swaps, and credit spread options to exploit arbitrage opportunities
• list the risk weights under Basel II for sovereigns, banks, and corporations using internal grading systems versus the standardized approach
• calculate and explain the benefits of using default swaps to reduce regulatory capital.
  

4.D. Risk Management with Credit Derivatives
You should know how to:

• calculate the market VAR for a portfolio of options
• calculate the Credit at Risk (CAR) for an investment-grade bond
• calculate and explain the CAR for a portfolio and a portfolio hedged with default swaps or total rate of return swaps (TRORs)
• discuss how the different credit risk models estimate default probability, default correlation, and recovery rates.
  

5. Credit Derivatives
You should know how to:

• calculate and explain the valuation of credit default swaps (CDS)
• calculate and explain the marked-to-market value of a CDS
• calculate and explain the valuation of a binary CDS
• discuss single tranche trading, and use tranche quotes to explain payments
• explain the valuation of a basket CDS and a CDO tranche.
  

6.A. Credit Risk: Individual Loan Risk
You should know how to:

• compute the contractually promised gross return on a loan given the contractual rate and noninterest charges
• discuss the relationship between the promised return and the expected return on a loan
• compute the probability of default for a borrower given a linear probability model and the borrower’s relevant financial variables
• compute the probability of default (marginal default probability) for 1-year corporate debt using Treasury- and corporate-bond yield curves
• compute the cumulative default probability over a multiyear period given the marginal default probability for each year
• compute a marginal default probability using the term structure approach
• critique the mortality rate approach to deriving credit risk
• illustrate and explain the payoff to the stockholders and bondholders of firms that hold debt.
  

6.B. Credit Risk: Loan Portfolio and Concentration Risk
You should know how to:

• discuss how migration analysis is used to measure credit risk
• compute a concentration limit for a given borrower
• identify the inputs required to compute the expected return and variance of a loan or bond portfolio
• illustrate the concept of diversification within a modern portfolio theory (MPT) framework
• describe the KMV portfolio manager model
• explain how loan volume data can be used to measure loan concentration
• explain how loan loss ratios can be used to measure concentration risk.
  

6.C. Sovereign Risk
You should know how to:

• describe the difference between credit risk and sovereign risk
• describe debt repudiation and debt rescheduling
• describe the five key economic variables in measuring the probability of rescheduling
• describe the six major problems of using traditional country risk analysis (CRA) models and techniques
• describe the different mechanisms for dealing with sovereign risk exposure.
  

6.D. Loan Sales and Other Credit Risk Management Techniques
You should know how to:

• distinguish between loans that are sold with and without recourse
• describe two major segments of the loan sales market
• contrast the characteristics of loans sold as participations and those sold as assignments
• identify the buyers and sellers of loans, and briefly discuss their motives for doing so.
  

7. Demystifying Securitization
You should know how to:

• define the securitization process
• list the types of assets available for securitization
• describe the players in the securitization marketplace, and explain their motivations for securitizing assets
• describe the process of how a loan is securitized
• explain how credit support can affect securitized asset tranches
• illustrate how securitization may affect the financial condition of the originator.
  

8. Credit Risks and Credit Derivatives
You should know how to:

• discuss the roles that credit risks play in a risk management program
• calculate the value of a firm’s debt and equity and the volatility of firm value using the Merton model
• discuss the valuation of subordinated debt in the context of option pricing
• explain how interest rate dynamics and the interaction with firm value affect the price of debt
• identify difficulties in applying the Merton model to debt valuation, and discuss the results of empirical studies that use the Merton model to value debt
• calculate probability of default (PD) and loss given default (LGD)
• describe the CreditRisk+, CreditMetrics, and KMV models for measuring credit risk, and discuss the limitations of such models
• define a credit derivative, and list occurrences that qualify as credit events
• explain the workings of a credit default swap
• explain the workings of a total return swap
• define a vulnerable option, and explain how credit risk can be incorporated in determining the option’s value
• discuss how to account for credit risk exposure in valuing a swap.
  

Core Readings:
1. Culp, Christopher L., The Risk Management Process; Business Strategy and Tactics,
John Wiley & Sons, Hoboken, 2001, Chapter 17, Identifying, Measuring, and
Monitoring Liquidity Risk

2. De Servigny, Arnaud and Olivier Renault, Measuring and Managing Credit Risk,
McGraw-Hill, New York, 2004, Chapter 10, Regulation

3. Dowd, Kevin, Measuring Market Risk, John Wiley & Sons, 2005, Chapter 16, Model
Risk

4. Allen, Linda, Jacob Boudoukh, and Anthony Saunders, Understanding Market,
Credit, and Operational Risk: The Value at Risk Approach, Blackwell Publishing,
Oxford, 2004, Chapter 5, Extending the VaR Approach to Operational Risk

5. Crouhy, Michael, Dan Galai, and Robert Mark, Risk Management, McGraw-Hill,
New York, 2001, Chapter 14, Capital Allocation and Performance Measurement

6. Gallati, Reto, Risk Management and Capital Adequacy, McGraw-Hill, New York, 2003
6.A. Chapter 4, Operational Risk
6.B. Chapter 6, Case Studies

7. Rebonato, Riccardo, Theory and Practice of Model Risk Management, Quantitative
Research Centre (QUARC) of the Royal Bank of Scotland, Oxford Financial
Research Centre—Oxford University, www.GARPDigitalLibrary.org

8. Litan, Robert E. and Richard Herring, eds., Brookings-Wharton Papers on Financial
Services, Brookings Institution Press, 2003, Risk Measurement, Risk Management,
and Capital Adequacy in Financial Conglomerates, by Andrew Kuritzkes, Til
Schuermann, and Scott M. Weiner

9. Bliss, Robert R. and George G. Kaufman, Derivatives and Systemic Risk: Netting,
Collateral and Closeout, Federal Reserve Bank of Chicago, WP2005-03, 2005

10. Saunders, Anthony, Financial Institutions Management, Fourth Edition, McGraw-
Hill, New York, 2003, Chapter 14, Technology and Other Operational Risks

11. Stulz, Rene, Risk Management & Derivatives, South-Western, Mason, OH, 2003
11.A. Chapter 2, Investors and Risk Management
11.B. Chapter 3, Creating Value with Risk Management

12. Toward Greater Financial Stability: A Private Sector Perspective, “The Report of the
Counterparty Risk Management Policy Group II,” July 27, 2005,www.GARPDigitalLibrary.org

1. Identifying, Measuring, and Monitoring Liquidity Risk
You should know how to:

• explain the interrelationship between funding liquidity risk and market liquidity risk
• describe alternative methods for measuring liquidity risk
• discuss factors that impact an asset’s liquidation cost
• discuss problems with using the bid-ask spread as a measure of liquidity
• calculate liquidity-adjusted VAR (LVAR)
• discuss ways firms can minimize their exposure to liquidity risk
• identify and discuss lessons learned about liquidity risk management from the case of Metallgesellschaft.
  

2. Regulation
You should know how to:

• identify the primary justifications for the existence of banking regulation
• discuss the potential moral hazard issues associated with deposit insurance
• discuss the benefits and weaknesses of the original 1988 Basel Accord
• identify the primary goals of the Basel Committee in developing the Basel II Accord
• describe the three pillars of the Basel II Accord
• describe how the necessary components for calculating capital requirements are determined under the standardized and internal ratings-based (IRB) approaches
• discuss how Basel II accounts for credit risk mitigation
• discuss the treatment of securitization under Basel II
• discuss the five common criticisms of the Basel II framework.
  

3. Model Risk
You should know how to:

• define model risk
• identify and discuss sources of model risk
• discuss the challenges involved with quantifying model risk
• describe methods for estimating model risk, given an unknown component from a financial model
• identify ways risk managers can protect against model risk
• discuss the role of senior managers in managing model risk
• discuss procedures for vetting and reviewing a model
• discuss the function of an independent risk oversight (IRO) unit.
  

4. Extending the VaR Approach to Operational Risk
You should know how to:

• compare and contrast top-down and bottom-up approaches to measuring operational risk
• list and describe examples of top-down models for measuring operational risk
• list and describe examples of bottom-up models for measuring operational risk
• list and describe ways a firm can hedge against catastrophic operational losses
• describe the characteristics of catastrophe options and catastrophe bonds
• discuss limitations to operational risk hedging.
  

5. Capital Allocation and Performance Measurement
You should know how to:

• distinguish between economic and regulatory capital
• describe the relationship between economic capital and risk-adjusted return on capital (RAROC)
• compute the RAROC for a loan
• explain how capital is attributed to market, credit, and operational risk
• calculate the capital charge for market risk and credit risk
• describe how economic capital is allocated for nonloan types of bank products
• explain why the RAROC approach may lead to incorrect economic capital allocation decisions and how the second-generation RAROC approach addresses this issue
• calculate a project’s adjusted RAROC to determine whether the project should be accepted.
  

6.A. Operational Risk
You should know how to:

• explain the link between operational risk management initiatives and shareholder value
• cite the BIS definition of operational risk, and summarize the controversy regarding this definition
• distinguish between direct and indirect impacts from causes of operational risk
• identify types of risk that are explicitly included or excluded from the BIS operational risk definition
• identify and discuss the five stages in the evolution of operational risk management
• identify the essential elements of an operational risk management framework
• distinguish between top-down and bottom-up approaches for managing operational risk
• describe qualitative and quantitative top-down approaches for measuring operational risk
• describe qualitative and quantitative bottom-up approaches for measuring operational risk
• summarize current regulatory and industry discussions regarding the treatment of operational risk
• discuss the advantages and disadvantages of mainstream approaches for measuring operational risk
• discuss the treatment of operational risk under the Basel II Accord
• describe the basic indicator, standardized, and internal measurement approaches for assessing operational risk under Basel II
• identify the operational risk standards required under Basel II.
  

6.B. Case Studies
You should know how to:

• identify and discuss the factors that led to the financial crisis at Metallgesellschaft
• explain a stack-and-roll hedging strategy, and identify why using such a strategy was ineffective for Metallgesellschaft
• identify and discuss the factors that led to huge losses at Sumitomo, and describe measures that may have prevented those losses
• identify and discuss the factors that led to the collapse of Long-Term Capital Management (LTCM)
• identify and discuss the factors that led to the bankruptcy of Barings
• identify risk management measures that may have prevented Barings’ bankruptcy.
  

7. Theory and Practice of Model Risk Management
You should know how to:

• cite Rebonato’s definition of model risk, and discuss the definition’s implications for pricing financial instruments
• discuss the implications of the assumption of efficient markets for the source and management of model risk
• discuss factors outside of the efficient market hypothesis (EMH) assumption that may impact financial instrument prices
• discuss the implications of the assumption that financial instrument prices deviate from their fundamental values for the source and management of model risk
• discuss the role of the model risk manager given the view that the methods of arriving at financial instrument prices may change in the future.
  

8. Risk Measurement, Risk Management, and Capital Adequacy in Financial
Conglomerates
You should know how to:

• explain the silo approach to capital regulation for financial conglomerates, and discuss its limitations
• summarize the recent regulatory debate regarding risk and capital frameworks for financial conglomerates
• describe the special challenges a conglomerate creates for capital management
• discuss how economic capital can serve as a common standard for assessing risk in a conglomerate
• describe the building-block approach for aggregating risks at a financial conglomerate
• discuss the factors that determine the diversification benefits from risk aggregation
• discuss the diversification benefits achieved at each of the three levels of aggregation for a financial conglomerate
• discuss current industry practices for risk modeling and capital management, and describe the “hub and spoke” organizational model for conglomerates
• discuss the “3+1 pillars” approach for capital regulation of financial conglomerates in accordance with the New Basel Accord.
  

9. Derivatives and Systemic Risk: Netting, Collateral and Closeout
You should know how to:

• discuss the economic role of netting, collateral, and closeout in regards to derivative securities
• define ISDA and its role
• explain the arguments used to justify the special legislative treatment of derivatives in insolvency resolution
• summarize the impact of netting and collateral on risk management.
  

10. Technology and Other Operational Risks
You should know how to:

• describe two risks of implementing technological innovation
• define economies of scale, and explain why they exist
• describe and discuss the shape of the average cost curve in banking
• explain economies of scope
• discuss whether economies of scale and scope sufficiently explain cost differences among banks
• explain how daylight overdraft risk arises.
  

11.A. Investors and Risk Management
You should know how to:

• explain how expected return and returns variance are used to describe the returns distributions for a security or portfolio of securities
• demonstrate how a probability distribution of returns can be used to make inferences about the statistical likelihood of specific returns outcomes
• describe how the covariance/correlation of returns between securities affects the returns distribution of a portfolio of securities
• describe the efficient frontier and the asset allocation decision both with and without the presence of a riskless asset
• summarize the concepts of beta, the security market line, and the CAPM, and describe how they are related to the determination of the expected return of a security or portfolio of securities
• explain why strategies that reduce the firm’s diversifiable risk do not increase firm value
• differentiate between firm strategies and policies to reduce the firm’s systematic risk that will increase firm value and those that will not
• using the concepts of arbitrage and investor hedging, demonstrate that hedging a firm’s price risk with respect to its output will not affect firm value
• state the irrelevance proposition regarding hedging activities by a firm.

11.B. Creating Value with Risk Management
You should know how to:

• explain the circumstances under which risk management can reduce the present value of potential costs of financial distress
• explain why risk management may lower a firm’s tax bill, incorporating the ideas of tax carryforwards and carrybacks
• demonstrate how risk management may increase firm value by changing the optimal capital structure of the firm
• describe the circumstances under which the value of the firm may be increased or decreased by risk reduction that benefits a large shareholder
• explain the relationship between risk management, managerial incentives, and the structure of management compensation
• describe debt overhang, and explain how risk management can increase firm value by reducing the probability of debt overhang
• explain how risk management can reduce the problem of information asymmetry and increase firm value.
  

12. The Report of the Counterparty Risk Management Policy Group II
You should know how to:

• identify the common traits associated with past major financial shocks
• list and discuss ten fundamentals for anticipating financial shocks and limiting their severity
• list and discuss recommendations and guiding principles concerning risk management and risk-related disclosure practices
• list and discuss recommendations and guiding principles concerning financial infrastructure
• list and discuss recommendations and guiding principles concerning complex financial products
• list and discuss recommendations and guiding principles concerning four emerging issues in financial markets
• discuss the four supervisory challenges identified by the CRMPG.
  

Basel Core Readings:

• New capital requirements for credit institutions (Basel II), Deutsche Bundesbank,
  Monthly Report, September 2004, www.GARPDigitalLibrary.org
• “Basel II: International Convergence of Capital Measurement and Capital Standards:
  A Revised Framework,” November 2005, www.GARPDigitalLibrary.org
• Overview of the Amendment to the Capital Accord to Incorporate Market Risks,
  January 1996, www.GARPDigitalLibrary.org
• Amendment to the Capital Accord to Incorporate Market Risks, January 1996,
  www.GARPDigitalLibrary.org
• “Supervisory Framework for the Use of ‘Backtesting’ in Conjuction with the Internal
  Models Approach to Market Risk Capital Requirements,” January 1996,
  www.GARPDigitalLibrary.org
  

“Basel II Core Readings”
You should know how to:

• discuss the criticisms of the 1988 Basel I Accord and the objectives of the new Basel II Capital Accord
• describe the three pillars that are central to the Basel II Accord
• discuss the scope of the Basel II Accord and how it applies to various bank subsidiaries or business relationships
• define the types of capital, and discuss how each type is used to meet capital requirements under Basel II
• describe the Basel II Accord’s requirements for calculating risk weights using both the standardized and internal ratings-based (IRB) approaches when accounting for credit risk
• discuss the concepts of expected loss, unexpected loss (UL) calibration, and downturn loss given default (LGD) that are part of the IRB approach
• explain how credit risk mitigation techniques are addressed in the Basel II Accord
• discuss the Basel II Accord’s standardized and IRB treatments of asset securitization
• discuss the supervisory backtesting framework used in conjunction with an institution’s internal models
• describe the three-zone supervisory framework for evaluating backtesting results
• discuss the three methods for addressing operational risk under the Basel II Accord
• discuss the “evolutionary aspect” of the risk measurement procedures addressed in the Basel II Accord
• describe the four principles of the Basel II Accord’s Second Pillar
• describe specific issues that should be addressed as part of the supervisory review process
• discuss the purpose of the Third Pillar, and describe the procedures for addressing the concept of market discipline.
  

Core Readings:
1. Hsieh, David and William Fung, “The Risk in Fixed-Income Hedge Fund Strategies,”
Journal of Fixed Income, 12, 2002: 6–27

2. Jaeger, Lars, ed., The New Generation of Risk Management for Hedge Funds and
Private Equity Investments, Euromoney Books, London, 2003
2.A. Chapter 6, Funds of Hedge Funds, by Sohail Jaffer
2.B. Chapter 27, Style Drifts: Monitoring, Detection and Control, by Pierre-Yves Moix

3. Jaeger, Lars, Through the Alpha Smoke Screens, A Guide to Hedge Fund Return
Sources, Euromoney Institutional Investor, New York, 2005
3.A. Chapter 5, Individual Hedge Fund Strategies
3.B. Chapter 9, Benchmarking Hedge Fund Performance

4. Tilman, Leo M., ed., Asset/Liability Management of Financial Institutions,
Euromoney, London, 2003, Chapter 18, Rethinking Asset Allocation for Pension
Plans: Using Risk as the Primary Driver, by Joanna Bewick and Derek Young

5. Rahl, Leslie, Risk Budgeting: A New Approach to Investing, Risk Books, London,
2000, Chapter 6, Risk Budgeting for Pension Funds and Investment Managers Using
VAR, by Michelle McCarthy

6. Amenc, Noel, and Veronique Le Sourd, Portfolio Theory and Performance Analysis,
Wiley, West Sussex, 2003
6.A. Chapter 4, The Capital Asset Pricing Model and Its Application to
Performance Measurement, Sections 4.1.1, 4.1.2, and 4.2.1 through 4.2.8, pp.
95-102, pp. 108-116
6.B. Chapter 6, Multi-Factor Models and Their Application to Performance Measurement
6.C. Chapter 8, Fixed Income Security Investment

7. Pearson, Neil D., Risk Budgeting: Portfolios of Problem Solving with Value-at-Risk,
Wiley, New York, 2002
7.A. Chapter 2, Value-at-Risk of a Simple Equity Portfolio
7.B. Chapter 7, Using Factor Models to Compute the VaR of Equity Portfolios
7.C. Chapter 11, A Long-Short Hedge Fund Manager
7.D. Chapter 13, Risk Budgeting and the Choice of Active Managers

8. Jaffer, Sohail, ed., Funds of Hedge Funds, Euromoney Books, London, 2003, Chapter
17, Risk Control Strategies, The Manager’s Perspective, by Pierre-Yves Moix

1. The Risk in Fixed-Income Hedge Fund Strategies
You should know how to:

• define convergence trading, and discuss how it applies to fixed-income investments
• discuss how a trend-following strategy and a convergence strategy can be represented through a combination of options
• identify the five primary HFR fixed-income index categories, and discuss characteristics of each
• discuss actual and hypothetical performance of fixed-income hedge funds during market extremes
• discuss implications of identifying fixed-income hedge fund asset-based style (ABS) factors for investors, counterparties, and regulators.
  

2.A. Funds of Hedge Funds
You should know how to:

• discuss the general structure and objective of a fund of hedge funds
• explain how funds of hedge funds can be classified according to diversification characteristics
• discuss considerations for strategy allocation in a fund of hedge funds
• discuss considerations in the due diligence process of selecting a fund of hedge funds manager
• discuss the objectives of hedge fund investors in seeking disclosure from fund of hedge fund managers and the IRC-recommended alternative to full position disclosure
• discuss risk management and liquidity considerations for a fund of hedge funds manager.
  

2.B. Style Drifts: Monitoring, Detection and Control
You should know how to:

• discuss the differences in how investment style is assessed between hedge funds and traditional long-only investments
• define the concept of style drift as it pertains to hedge funds
• discuss the importance of style drift monitoring for hedge fund investors
• discuss the reasons hedge fund managers may drift from their styles
• discuss approaches for monitoring and detecting style drift.
  

3.A. Individual Hedge Fund Strategies
You should know how to:

• describe an equity long/short strategy
• discuss the major determinants of return for an equity long/short strategy
• describe an equity market-neutral strategy
• define pair trading
• identify examples of market inefficiencies exploited by market-neutral hedge fund managers
• describe an equity market timing strategy
• describe a short-selling strategy
• discuss issues specific to short-selling managers
• describe a convertible arbitrage strategy
• identify and describe the three potential sources of return from a convertible arbitrage strategy
• describe the various forms of a fixed-income arbitrage strategy
• describe the primary sources of risk and return for a fixed-income arbitrage strategy
• describe a volatility arbitrage strategy
• describe a capital-structure arbitrage strategy
• identify types of event-driven strategies
• describe a merger arbitrage strategy
• identify the primary sources of risk and return for a merger arbitrage strategy
• describe a distressed securities strategy
• describe a Regulation D strategy
• identify the primary sources of risk and return for a Regulation D strategy
• describe a global macro strategy
• identify the primary sources of risk and return for a global macro strategy
• differentiate between a systematic and discretionary managed-futures strategy
• describe trend following as a systematic managed-futures strategy
• compare and contrast discretionary managed-futures strategies with global macro strategies.
  

3.B. Benchmarking Hedge Fund Performance
You should know how to:

• discuss the challenges of benchmarking alpha returns
• explain the problems with existing hedge fund indices
• identify the attributes of a good hedge fund index
• discuss considerations for creating a more useful hedge fund index.
  

4. Rethinking Asset Allocation for Pension Plans: Using Risk as the Primary Driver
You should know how to:

• compare the stability of asset class returns and asset class volatility, and discuss the implications for portfolio management
• define risk budgeting, and discuss the steps in the risk budgeting process
• describe the key attributes of risk rebalancing
• compare the effects of portfolio rebalancing strategies on portfolio return, risk, and efficiency.
  

5. Risk Budgeting for Pension Funds and Investment Managers Using VAR
You should know how to:

• discuss how VAR differs from traditional portfolio risk measures
• identify and discuss three common misconceptions about VAR
• list and discuss the key market risks for pension funds and asset management firms
• define risk budgeting, and identify components in an investment process which may be subject to a risk budget
• discuss risk tolerance thresholds, and describe common ways such thresholds are determined
• identify and discuss two factors that differentiate risk budgeting from asset allocation
• discuss considerations for maintaining a quality VAR measure
• identify potential actions to take if risk tolerance thresholds are exceeded
• compare and contrast risk budgeting with traditional means of measuring and controlling risk, including (i) asset allocation, (ii) investment guidelines, (iii) standard deviation, (iv) beta, and (v) duration
• explain how back-testing can be used to calibrate a VAR model.
  

6.A. The Capital Asset Pricing Model and Its Application to Performance Measurement
You should know how to:

• describe the capital market line and the construction of the efficient frontier in the presence of a risk-free asset
• describe the capital asset pricing model (CAPM), and list its underlying assumptions
• explain the price of risk, the quantity of risk (beta), and equilibrium theory
• discuss the contributions of the CAPM as they relate to security valuation and market behavior
• define market efficiency, identify the three forms of market efficiency, and discuss the link between efficiency and the CAPM
• calculate the Treynor measure, the Sharpe measure, and Jensen’s alpha
• compare and contrast the Treynor measure, the Sharpe measure, and Jensen’s alpha
• evaluate portfolio performance using the Treynor measure, the Sharpe measure, and Jensen’s alpha
• discuss extensions to Jensen’s alpha
• calculate and interpret tracking error, the information ratio, and the Sortino ratio.
  

6.B. Multifactor Models and Their Application to Performance Measurement
You should know how to:

• compare and contrast the characteristics of arbitrage and empirical multifactor models
• compare and contrast the explicit and implicit factor methods for determining factors in multifactor models
• identify and discuss three categories of multifactor models, and describe examples of each
• describe how multifactor models can be applied to international portfolios
• discuss the application of multifactor models to portfolio risk analysis, and describe examples of multifactor risk models
• discuss the application of multifactor models to portfolio performance decomposition, and describe examples of multifactor performance analysis models
• compare and contrast returns-based style analysis models with portfolio based style analysis models.
  

6.C. Fixed Income Security Investment
You should know how to:

• identify and discuss two alternatives for modeling a yield curve
• discuss direct and indirect methods for estimating a range of zero-coupon rates given yields to maturity
• describe dynamic interest rate models used to estimate a yield curve, including the Vasicek model, the Cox-Ingersoll-Ross model, and the Heath-Jarrow-Morton model
• identify the two primary risks that explain the variation in bond returns, and describe quantitative models used to assess each of these risks
• describe various strategies employed for managing fixed-income portfolios
• identify and describe models used to analyze and decompose fixed-income portfolio performance.
  

7.A. Value-at-Risk of a Simple Equity Portfolio
You should know how to:

• compute standard VAR and benchmark-relative VAR of a two-asset portfolio
• define, interpret, and describe the uses of marginal VAR.
  

7.B. Using Factor Models to Compute the VaR of Equity Portfolios
You should know how to:

• identify situations in which factor models are appropriate for estimating VAR
• calculate a delta-normal VAR for portfolios with and without options, given the factor loadings
• explain how factor models can be used in Monte Carlo simulation.
  

7.C. A Long-Short Hedge Fund Manager
You should know how to:

• interpret a calculated VAR/tracking error volatility
• interpret a portfolio risk decomposition
• calculate the change in portfolio risk for a given change in an individual position, given a portfolio risk decomposition
• interpret a risk-minimizing trade (a best hedge)
• interpret the implied views of a portfolio
• interpret the return to risk ratios of the individual positions in a portfolio, and explain how the optimal portfolio is determined.
  

7.D. Risk Budgeting and the Choice of Active Managers
You should know how to:

• interpret the risk decomposition of the strategic benchmark
• interpret the risk decomposition of a plan sponsor’s existing manager roster
• interpret the risk decomposition and marginal expected return of an existing manager roster
• explain how the optimal asset allocations for each manager are determined.
  

8. Risk Control Strategies, The Manager’s Perspective
You should know how to:

• identify and discuss the types of risk faced by a fund of hedge funds
• list primary risk factors for various examples of hedge fund strategies
• discuss the role of leverage in defining the risk profile of a hedge fund
• discuss the issue of hedge fund transparency as it pertains to the risk and return goals of an investor
• identify two components of proactive risk management, and discuss how each component addresses a fund of hedge fund’s generic risk
• discuss how ongoing risk monitoring and management should be applied at the investment and portfolio levels of a fund of hedge funds.