Finance Topics and Case Studies For Risk Manager 3.7

Finance Topics and Case Studies for RiskManager 3.
Table Of Contents
Financial Instrument Topics............................................................................................................. 1 Fixed Income Instrument Coverage ...............................................................................................1 FX, Equity, and Commodities Coverage .......................................................................................... 2 RM3.4 Changes to Swaption Asset Type ......................................................................................... 3 Summary ................................................................................................................................... 4 This specification gives the specs for the yield-based formulae for cap and floor, as well the delta calculation.................................................................................................................................. 4 Credit Default Swaps ................................................................................................................... 6 Summary ................................................................................................................................ 6 What is a credit default swap?.................................................................................................... 6 Model definitions ...................................................................................................................... 7 Analytics ................................................................................................................................. 7 Mandatory Convertibles ............................................................................................................... 9 Summary to RM3.6 Instrument - Mandatory Convertible Bonds...................................................... 9 What are mandatory converts? .................................................................................................. 9 RML Fields Definitions ............................................................................................................... 9 Model Definitions.................................................................................................................... 10 Analytics ............................................................................................................................... 10 Repurchase Agreement .............................................................................................................. 13 Repo Transactions .................................................................................................................. 13 Equity Option............................................................................................................................ 15 European Equity Call Option .................................................................................................... 15 Equity Option Position ............................................................................................................. 16 Equity Option Risk Settings...................................................................................................... 17 Equity Option PV Report Layout................................................................................................ 18 Equity Option PV Report .......................................................................................................... 19 Equity Option VaR Report Layout.............................................................................................. 20 Equity Option VaR Report ........................................................................................................ 21 Excel of Option Price Calculation............................................................................................... 22 Excel of Historical Simulation ................................................................................................... 23 Rank Ordering of Historical Returns showing 95% VaR Level........................................................ 24 Spread Options ......................................................................................................................... 25 Spread Option........................................................................................................................ 25 Addendum to Spread Option .................................................................................................... 30 FRN Case Study ........................................................................................................................ 34 Floating Rate Note Case Study ................................................................................................. 34 FRN Underlying settings and market data .................................................................................. 37 FRN PV Analysis ..................................................................................................................... 38 FRN Interest Rate Sensitivity and VaR analysis .......................................................................... 40 FRN Start Date and First Coupon Date ...................................................................................... 43 FX Forward............................................................................................................................... 44 FX Forward Example ............................................................................................................... 44 FX Forward Position Screen ..................................................................................................... 46 FX Forward Risk Settings......................................................................................................... 47 FX Forward Report Details ....................................................................................................... 49 FX Exotic Options ...................................................................................................................... 51 Reverse Knockout Option ........................................................................................................ 51 Use the RiskManager position type Foreign Exchange Single Barrier Option, exactly as per the field descriptions in RiskManager. Direction is determined by whether the spot is above or below the barrier. Below is an example of an RKO. Note that todays spot rate is .68 USD/CAD, so the direction is rebate is up. .................................................................................................................... 51 One-Touch options ................................................................................................................. 53 Digital Knockout Option........................................................................................................... 56 Digital Options ....................................................................................................................... 59 Callable Bonds .......................................................................................................................... 62 Callable Bond Decomposition Introduction ................................................................................. 62 Callable Bond Decomposition Examples ..................................................................................... 63 Callable Bond Decomposition Conclusion ................................................................................... 64 High Grade or High Yield Bond .................................................................................................... 67 Corporate Bond Example ......................................................................................................... 67 Corporate Bond Position Editor Screen ...................................................................................... 69 Corporate Bond Report Preparation........................................................................................... 70 Corporate Bond Report Details ................................................................................................. 72
Table Of Contents
Corporate Bond Position - RML ................................................................................................. 74 Interest Rate Swap.................................................................................................................... 75 RiskManager Swap Example (1) ............................................................................................... 75 RiskManager Swap Example (2) ............................................................................................... 76 RiskManager Swap Example (3) ............................................................................................... 77 Excel Swap Example ............................................................................................................... 78 Swaps with Accrued Interest.................................................................................................... 79 Addendum to RiskManager Specifications Bulletin....................................................................... 80 Liffe SwapNote Futures .............................................................................................................. 84 Liffe SwapNote Futures ........................................................................................................... 84 Mortgage Backed Securities........................................................................................................ 85 Summary of Mortgage Backed Functionality............................................................................... 85 Mortgage Example Positions .................................................................................................... 88 Mortgage Example Positions (2) ............................................................................................... 90 mbsName.............................................................................................................................. 92 Mortgage Example Position XML ............................................................................................. 110 Mortgage Example Risk Report............................................................................................... 111 Mortgage Example Yield Shift Impact ...................................................................................... 112 Pfandbrief European Mortgage Bonds......................................................................................... 113 Pfandbrief European Mortgage Bonds ...................................................................................... 113 Case Studies in Using RiskManager3 ............................................................................................ 115 Risk Attribution for Asset Managers ........................................................................................... 115 Objectives of Risk Attribution ................................................................................................. 115 Relative VaR and Risk Attribution Foundations ......................................................................... 120 Risk Attribution Report and Examples ..................................................................................... 135 Drill Down Reporting................................................................................................................ 151 Introduction......................................................................................................................... 151 Review Positions .................................................................................................................. 152 Edit from the Position Interface .............................................................................................. 153 Search for a Position ............................................................................................................. 154 Open a Position for Edit......................................................................................................... 155 Custom Bucket Interface ....................................................................................................... 156 Create Reports Using Tags..................................................................................................... 157 Single Statistic Report........................................................................................................... 158 Customizable Table Report .................................................................................................... 159 Create a Benchmark ............................................................................................................. 160 Add Benchmark to a Report ................................................................................................... 161 Relative VaR Report .............................................................................................................. 162 Fixed Income Statistics in Reports ............................................................................................. 163 Fixed Income Report Statistics ............................................................................................... 163 Section 1: Value at Risk and Marginal Value at Risk .................................................................. 164 Section 2: Duration and Stress Tests ...................................................................................... 166 Section 3:Bond Equivalents ................................................................................................... 169 Global Bank ............................................................................................................................ 171 Global Bank Example ............................................................................................................ 171 Historical Simulation ............................................................................................................. 172 Monte Carlo Simulation ......................................................................................................... 173 Corporate Level Reporting ..................................................................................................... 174 Corporate Level Reporting (2) ................................................................................................ 176 Stress Testing ...................................................................................................................... 177 Stress Testing (2)................................................................................................................. 178 Stress Testing (3)................................................................................................................. 179 Business Unit Level Reporting ................................................................................................ 180 Business Unit Level Reporting (2) ........................................................................................... 181 Sources of Diversification ...................................................................................................... 182 Portfolio Level Reporting ....................................................................................................... 183 Portfolio Level Reporting (2) .................................................................................................. 184 Portfolio Level Reporting - Stress Tests ................................................................................... 185 Analysis of Multiple Strategies .................................................................................................. 186 Examples of Common Strategies ............................................................................................ 186 Strategy Case Study Position Import xml ................................................................................ 187 Bond Strategy - Bond Arbitrage.............................................................................................. 193 Bond Strategy - Corporate Spread .......................................................................................... 194 Equity Strategy - General ...................................................................................................... 195 Equity Strategy - Technology ................................................................................................. 196 Equity Strategy - Multi-Class.................................................................................................. 197
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Table Of Contents
Option Strategy - Convert Arbitrage ....................................................................................... 199 Option Strategy - Covered Call............................................................................................... 200 Structured Strategy - Eurodollar Hedge................................................................................... 201 Structured Strategy - Swaps.................................................................................................. 202 Index ....................................................................................................................................... 203
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Financial Instrument Topics

Fixed Income Instrument Coverage
Fixed Income Cash Market & Futures Bonds Bond Futures Zero Coupon Bonds Cash Cashflow Streams Money Markets Interest Rate Futures Inflation Linked Bonds (TIPS) Inflation Linked Gilts (UK) Mortgage Backed Securities Convertible Bonds FRN FRA Swaps Amortizing Swaps Overnight Interest Rate Swaps CAP, Floor, Collars Swaption Option Derivatives American & European Bond Options Options on Bond Futures Options on Interest Rate Futures
Finance Topics and Case Studies for RiskManager 3.7
FX, Equity, and Commodities Coverage

Foreign Exchange, Equities, and Commodities FX Forward Multi-currency Cash and Cashflow streams Equities FX Option FX Average Rate Option Equity Option Equity Average Rate Option Equity Futures Options on Equity Futures Commodity Option Commodity Average Rate Option Commodity Futures Options on Commodity Futures
Commodities
RM3.4 Changes to Swaption Asset Type

This note describes the changes made to the asset type Swaption in RM3.4. 1. 2. 3. 4. 5. A new yield-based pricing approach is offered, with the existing price-based formula still available for backward compatibility. For positions that have a specified underlying swap rate, a bug has been fixed. The start dates for both fixed and float legs, and the first coupon date for float leg, have been dropped. Existing positions with such dates specified are still acceptable but those dates are ignored. The first coupon date for the fixed leg, if specified, now has to be later than the option expiration date. This constraint was not in previous versions. The option expiration date is now taken as the start date for both legs. For positions which have no specified start dates for the legs (fixed or float), the first coupon amounts calculated will be different when the option expiration date is not on a regular coupon payment date. This in turn will alter the inputs to the internal option model (strike price, underlying price, etc.). Consequently, for such positions the PV and VAR results will be different. We now only handle European type Swaptions. Any existing American type Swaptions are still be acceptable but are treated as European type now, i.e. with the American type ignored.
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Valuation of Caps and Floors Using Yield-based Approach
Summary This specification gives the specs for the yield-based formulae for cap and floor, as well the delta calculation.
In the price-based approach, an interest rate cap can be regarded as a portfolio of European put options on zero-coupon bonds. In the yield-based approach, however, it can be modelled as a portfolio of European call options on LIBOR rates, with the valuation given by (Black 76 model):
where
, Cumulative distribution function of the standard normal distribution Notional of the cap/floor Number of interest payments Start time of the k-th interest pay period, ( Forward rate between Cap or floor rate Volatility of Discount Factor at k = . ,( = for all k, since we use the flat volatility) and , maturity of the cap/floor)
Analogously, a floor can be modelled as a portfolio of European call options on zerocoupon bonds or a portfolio of put options on interest rates. The yield-based valuation is
Deltas are given individually for each caplet or floorlet ,

,
(1
n):
for caplets,
for floorlets.
Credit Default Swaps
Summary
This specification discusses the implementation of CDS in RiskManager. It will be implemented in conjunction with the CreditGrades model which supplies default probability term structure.
What is a credit default swap?

In a credit defaults swap (CDS) one party (protection buyer) pays a periodic premium (spread) in exchange for the right to sell to the other party (protection seller) a bond issued by a reference entity at par in the event that the reference entity defaults. Download Example Spreadsheet RML Fields Definitions (revision Jan 17, 2003) <creditDefaultSwap> <positionName> <positionId> <notional> <currency> <spread> <fairSpread> <spreadFrequency> <pretectionSide> <seller> <buyer> </pretectionSide> <bondCoupon> <discountCurve> <maturityDate> <settlementDate> <settlementPrice> <creditGradeModel> <issuerEquityName> <issuerBeta> <issuerEquityPrice> <issuerEquityCurrenc y> <issuerVolatility> <issuerVolatilitySeries Example CDS RML Position <creditDefaultSwap> <positionName>Sample CDS template</positionName> <positionId>6252086</positionId> <notional>10000000</notional> <currency>USD</currency> <spread>62</spread> <fairSpread>65</fairSpread> <spreadFrequency> <quarterly/> </spreadFrequency> <protectionSide> <buyer/> </protectionSide> <BondCoupon>5</BondCoupon> <discountCurve>USD Swap</discountCurve> <maturityDate>20120301</maturityDate> <settlementDate>20030301</settlementDate> <settlementPrice>72.38</settlementPrice> <creditGradeModel> <issuerEquityName exchange="NYS" identtype="RMLONG">NYSE - Lucent Technologies Inc</issuerEquityName> <issuerBeta>0.9</issuerBeta> <issuerEquityPrice>1.22</issuerEquityPrice> <issuerEquityCurrency>USD</issuerEquityCurrency>
> <issuerUseHistoricalV ol> <issuerDebtPerShare > <issuerBondRecovery Rate> </creditGradeModel> <customBucketList> <ignoreFXRisk> <fxHedgingPercent> </creditDefaultSwap>
<issuerVolatility>82.4</issuerVolatility> <issuerVolatilitySeries>EquityVol.AMS.ASM</issuerVolatil itySeries> <issuerUseHistoricalVol/> <issuerDebtPerShare>2.58</issuerDebtPerShare> <issuerBondRecoveryRate>50</issuerBondRecoveryRate > </creditGradeModel> <ignoreFXRisk/> <fxHedgingPercent>20</fxHedgingPercent> <customBucketList> <customBucket> <customDimensionName>Portfolio</customDimensionNa me> <customBucketValue>CDS</customBucketValue> </customBucket> </customBucketList> </creditDefaultSwap> </positions>
Fields with bold-face characters are required, they are optional otherwise.
Model definitions
s: f: spread spread frequency spread payment dates
ti(i=1,2,, N): R: D(ti): F(ti):
bond recovery rate discount factor for t= ti , using the LIBOR rate. CreditGrades cumulative default probability
Analytics
The present value of a CDS for the protection buyer (the opposite for a protection seller) is: PV = Discounted Expected Loss Discounted Expected Spread Payments which translates into (1)
There
(2) The cumulative default probability F(ti) is obtained from the CreditGrades model in the same way as it is done for Corporate Bond. Since CDS is normally written against an issuer name instead of a specific asset, the bond coupon and bond coupon frequency are defined on a weighted-average base. We assume the coupon frequency is identical to the CDS spread frequency. If the user leaves the bond coupon field blank, well calculate the par coupon under the assumptions that: (1) Coupon frequency is the same as the CDS spread frequency; (2) Bond maturity is the same as the CDS expiry. Fair spread s* is defined as the value of spread that make the PV of the CDS equal to zero.
(3) When user specifies s*, well calibrate against equity volatility.
Mandatory Convertibles
Summary to RM3.6 Instrument - Mandatory Convertible Bonds

This specification defines the mandatory convertible bond instrument, specifically its two varieties, DECS and PERCS.
What are mandatory converts?

Mandatory convertibles are bonds that automatically convert into stock on a specified date (i.e. maturity date). At maturity, the number of shares (i.e. the conversion ratio) that the investor receives in exchange for face value (the principal of the bond) is contingent on the then prevailing share price. The number of shares that the face value can buy at price at issuance is called the maximum conversion ratio. The number of shares that the face value can buy at conversion price is called the minimum conversion ratio. Conversion price is greater than the price at issuance. At maturity, if the share price is below or equal the price at issuance, the bond converts at the maximum conversion ratio. The conversion ratio declines as the share price increases, keeping the conversion at face value. Above the conversion price, the bond converts at minimum conversion ratio regardless of share price. This is what is so called DECS. When conversion price goes up to infinity, it becomes PERCS.
RML Fields Definitions

<mandatoryConvertibleBond> <positionName> <positionId> <notional> <currency> <discountCurve> <discountCurveSpread> <coupon> <couponFrequency> <startDate> <firstCouponDate> <faceValue> <equityName> <dividendYield> <beta> <equityPrice> <volatility>
<dateOfIssuance> <issuePrice> <conversionPrice> <maturityDate> <marketPrice> <customBucketList> <ignoreFXRisk> <fxHedgingPercent> </ mandatoryConvertibleBond > The <conversionPrice> tag is optional. If user specifies it, then this is in effect a DECS; Otherwise, if the user leaves it blank, then it is considered a PERCS position.
Model Definitions
F Cj DFj S0 S Sc r T CR0 CR9 C P (.) - face value (bond principal). - jth coupon payment. - jth discount factor off risky curve. - equity price at issuance. - current equity price. - conversion price. - implied volatility of equity. - dividend yield of equity. - risk-free interest rate. - time to maturity. - minimum conversion ratio. - maximum conversion ratio. - European call price. - European put price. - standard normal cdf.
Analytics
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Synthetically, a mandatory converts can be decomposed into a bond, a long call, and short put on the underlying equity (DECS); or into a bond and a short put on the underlying (PERCS). (i) PV(DECS) = Bond + minimum conversion ratio * call struck at the conversion price - maximum conversion ratio * put struck at the issue price or
(1) (ii) PV(PERCS) = Bond - conversion ratio * put struck at the issue price Or
(2) where C is the Black-Sholes call price with an underlying S, a strike of Sc, and a volatility of , (3) P is the Black-Sholes put price with an underlying S, a strike of S0, and a volatility of ,
(4)
, ( 5) Notice that in equation (1) and (2), the coupons of the bond are discounted using the risky rate whereas the principal of the bond is discounted using risk-free rate. This is because the principal is pledged to buy the shares at maturity thus can be deemed as cash. Issues outstanding Normal mandatory convertibles convert at face value when , thus
holds. However, Jorge has observed from the condition website a position that breaks this condition, hence our pricing formular. Do such beasts really exist in the market? How should we handle them if they do? For normal mandatory convertibles, since the above mentioned condition holds, user only need specify either the conversion ratio or the conversion price, not both. Which one should we allow them specify in the interface?
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Repurchase Agreement
Repo Transactions
How can I represent Repo Transactions in RM? Repos can be input as one or more transactions depending on the nature of the repo business you are trying to model. Lending money to the Repo market If you repo in securities for overnight lending to a counterparty, then you are essentially engaging in a short-term deposit where the security itself is held only for collateral. For credit risk purposes the nature of the security is relevant (in case of a default), but from a market risk (interest rate) perspective it is not very significant. Therefore you could enter these transactions as Money Market deposits tied to the relevant Money Market curve. This would be the case even for term repos. When inputting these as MM transactions, the rate should be equal to the annualized rate at which funds were lent, and the deposit should mature at the same time as the repo. If funds were lent on a discount basis, one can alternatively enter these as zero-coupon bonds with the expiration date set as the term date of the repo. These are mathematically equivalent. Financing positions with Repos If you purchase and hold securities for investment and immediately repo them out for financing, then the nature of the security itself is important. VaR of the underlying security is the relevant risk you need to measure. Therefore you should enter these as owning the bonds themselves. When you repo out a bond, you still receive the cashflows and are therefore subject to the full risk of the bond. To represent the financing component, you should additionally enter a short MM deposit (or zero-coupon bond) as described above. This additional MM position has little effect on VaR (especially for overnight repos) but will have a significant impact on the net present value of your portfolio. However, if you repo out foreign bonds then financing does effect VaR since you will not be subject to FX risk during the term of the repo and must include the short foreign MM deposit. A shortcut method for canceling FX risk for a bond is also available by turning on the FX hedge flag when defining the bond. This preserves all interest rate risk but filters out FX risk. The RM Import Specifications Guide explains how to activate this field.
Example: On May 22, 2000 you buy 1 million CAD face value of 10 year CAD Bonds for a total price of 975,000 CAD. To finance this position you repo out the bonds at 5% for 30 days. You would enter this transaction in two parts. The first is the bond set (nominal = 1 million CAD). The second is a short MM deposit at 5% with a deposit date of May 22, 2000 and a maturity date of June 21, 2000. Your net risk will be a combination of bond risk (major contribution) and financing risk (minor contribution). Your net present value will be near zero since you are long a bond but short cash. Flow Diagram: Repo flows in red. Interest flow in yellow. The two initial cash flows of paying for the bond and cash received on the start of the repo cancel out.
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Equity Option
European Equity Call Option
RML of position 10 Call Options on FTSE 100 Strike Price 5600 Strike Date 31 Aug 2001 All dates are in the yyyymmdd format
Description Position Opening Tag Instrument Type Instrument Name Equity Name Number Shares Strike Expiry Date Option Type Exercise Type Dividend Close Instrument Tag
Close Positions Tag
rml code <positions> <equityOption> <positionName>My equity option position</positionName> <equityName>FTSE 100</equityName> <numberOfShares>10</numberOfShares> <strikePrice>5600</strikePrice> <optionExpiryDate>20010831</optionExpiryDate> <optionType><call></call></optionType> <exerciseType><european></european></exerciseType> <dividendYield>0</dividendYield> </equityOption> <groupCustomBucketList><groupCustomBucket> <customDimensionName>Asset Type</customDimensionName> <customBucketValue>equityOption</customBucketValue> <positionNameList> <positionName>My equity option position</positionName> </positionNameList> </groupCustomBucket> </groupCustomBucketList> </positions>
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Equity Option Position

Entry into RiskManager3 10 Call Options on FTSE 100 Strike Price 5600 Strike Date 31 Aug 2001 All dates are in the yyyymmdd format
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Equity Option Risk Settings

Establish a Risk Setting that our Risk Reports will reference Named Risk Setting: Equity Option GBP Analysis Date - Jul 11th 2001. Note that for this European user, RiskManager picks up the regional date settings from NT or Windows 2000. Horizon Period - How much could we lose in 1 day? Look-back Period is a one year period relative to the date of the last downloaded market data. Decay factor - Here we have chosen to equally weight returns (decay factor = 1). Reporting Currency - GBP in this case.
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Equity Option PV Report Layout

PV report is Asset type (columns) by Position (rows). Report will display the value (in GBP) of the position.
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Equity Option PV Report

PV Report results - The option position is valued at GBP 728.06 on July 11th 2001. Note the Risk Settings are repeated at the bottom of the report. See Option pricing details and how 728.06 is calculated.
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Equity Option VaR Report Layout

Historical VaR Report of 95% confidence. Drill down is "Asset Type" on the columns and "Portfolio" on the rows. Note - for this position, the portfolio tag was not set --> see the RML . For this reason, we will see "unspecified" for the portfolio aggregation.
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Equity Option VaR Report

Historical Simulation VaR report - see detail in excel spreadsheet See details of sorted returns and the 292.5 level of VaR 95%.
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Excel of Option Price Calculation

Black-Scholes option pricing details of the FTSE 100 call option position gives value at 728.06 as seen in the PV report.
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Excel of Historical Simulation

Historical Simulations on the FTSE 100 Equity Call Option with strike of 5600. Underlying is at 5392 and 51 days left to expiration. Details are in the table below:
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Rank Ordering of Historical Returns showing 95% VaR Level

Take all the Historical returns of the FTSE 100 Equity Call Option Sort ascending. Examine the 95 percentile level is a loss of 292.55
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Spread Options
Spread Option
Summary to RM3.6 Instrument

This specification defines the spread option in its general form as well as its implementations for commodity spread option and commodity futures spread option.

Commodity spread option and commodity futures spread options are based on commodity option and commodity futures option, respectively. Since there are two underlyings in a spread option, we need a complex tag to describe the underlyings, one called <longLeg>, the other <shortLeg>. <commoditySpreadOption> <positionName> <positionId> <longLeg> <commodityName> <underlyingPrice> <volatility> </longLeg > <shortLeg> <commodityName> <underlyingPrice> <volatility> </shortLeg > <longFactor> <shortFactor> <numberOfUnits> <strikePrice> <optionExpiryDate> <marketPrice> <correlation> <optionType> <settlementDate> <settlementPrice> <commodityCurrency> <customBucketList> <ignoreFXRisk> <fxHedgingPercent> </commoditySpreadOption> <commodityFutureSpreadOption>
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<positionName> <positionId> <longLeg> <commodityName> <numberOfUnits> <underlyingPrice> <volatility> <futuresExpiryDate> </longLeg > <shortLeg> <commodityName> <numberOfUnits> <underlyingPrice> <volatility> <futuresExpiryDate> </shortLeg > <longFactor> <shortFactor> <numberOfContracts> <strikePrice> <optionExpiryDate> <marketPrice> <correlation> <optionType> <settlementDate> <settlementPrice> <commodityCurrency> <customBucketList> <ignoreFXRisk> <fxHedgingPercent>
</commodityFutureSpreadOption> Model Definitions

S0(1) S0(2) 1 2 1 2 underlyings. r T - risk-free interest rate. - time to option expiry. - initial price for long underlying. - initial price for short underlying. - volatility of long underlying. - volatility of short underlying. - convenience yield for long underlying. - convenience yield for short underlying. - correlation between returns of long and short
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K a b C P (.) (.)
- strike price - long factor. - short factor. - European call price. - European put price. - standard normal pdf. - standard normal cdf.
Analytics
(i) When strike price K>=0, the call price is (refer to Jorges note)
(1) where V(X2) is the Black-Scholes formula for a call with an underlying S*, a strike of b*S(2)+K, and a volatility of , , (2)
, (3) , (4)
. (5) The put price can be obtained using call-put parity . (6) (ii) When strike price K<0, we make the observation that . (7)
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This will bring us back to case (i).
Implementation
It finally boils down to calculating the integral in (1). This integral can be done fast numerically using Gaussian Quadratures. N-points Gauss-Hermite Integration is given by
(8) In our case, If we choose N=30, then the abscissas xk and the corresponding weights w(xk) are given by k 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 xk -6.86334529353 -6.13827922013 -5.53314715155 -4.98891896861 -4.48305535708 -4.00390860387 -3.54444387315 -3.09997052959 -2.66713212453 -2.24339146776 -1.8267411436 -1.4155278002 -1.00833827105 -0.603921058626 -0.201128576549 0.201128576549 0.603921058626 1.00833827105 1.4155278002 1.8267411436 2.24339146776 2.66713212453 3.09997052959 3.54444387315 4.00390860387 4.48305535708 4.98891896861 5.53314715155 6.13827922013 6.86334529353 w(xk) 0.834247471 0.649097982 0.569402692 0.522525689 0.491057996 0.468374813 0.451321036 0.438177023 0.427918063 0.419895004 0.413679364 0.408981575 0.405605123 0.403419817 0.402346067 0.402346067 0.403419817 0.405605123 0.408981575 0.413679364 0.419895004 0.427918063 0.438177023 0.451321036 0.468374813 0.491057996 0.522525689 0.569402692 0.649097982 0.834247471
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These xk and w(xk) shall be hard-coded. Issues outstanding Convenience yields. In the case for futures underlyings, ; In the case for commodity underlyings, shall we use the spot and futures prices S and F to back out the convenience yield from ? Currently our practice is to set =0. Currently we do not handle American spread option. So we take the <exerciseType> tag out for now. We can put it back on in the future when we handle American spread options.
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Addendum to Spread Option
Commodity Spread Option RML Fields Definitions

The highlighted fields are required; the others are optional: <commoditySpreadOption> <positionName> <positionId> <longLeg> <commodityName> <underlyingPrice> <volatility> </longLeg > <shortLeg> <commodityName> <underlyingPrice> <volatility> </shortLeg > <longFactor> <shortFactor> <numberOfUnits> <strikePrice> <optionExpiryDate> <marketPrice> <correlation> <optionType> <settlementDate> <settlementPrice> <commodityCurrency> <customBucketList> <ignoreFXRisk> <fxHedgingPercent> </commoditySpreadOption>
If underlyingPrice is omitted, it is calculated as for the underlyingPrice of a Commodity Option: the spot price of the commodity. If underlyingPrice is given, the price derived as above is scaled to produce the given value. If volatility is omitted, it is calculated as for the volatility of a Commodity Option: the historical volatility of a spot commodity. If correlation is omitted and marketPrice is also omitted, correlation is computed as the historical correlation between prices of two spot commodities. If correlation is omitted and marketPrice is given, correlation is calibrated to produce marketPrice.
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If correlation and marketPrice are both given, marketPrice is disregarded.
Commodity Future Spread Option RML Fields Definitions

The highlighted fields are required; the others are optional: <commodityFutureSpreadOption> <positionName> <positionId> <longLeg> <commodityName> <numberOfUnits> <underlyingPrice> <volatility> <futuresExpiryDate> </longLeg > <shortLeg> <commodityName> <numberOfUnits> <underlyingPrice> <volatility> <futuresExpiryDate> </shortLeg > <longFactor> <shortFactor> <numberOfContracts> <strikePrice> <optionExpiryDate> <marketPrice> <correlation> <optionType> <commodityCurrency> <customBucketList> <ignoreFXRisk> <fxHedgingPercent>
</commodityFutureSpreadOption> If underlyingPrice for a leg is omitted, it is calculated as for the underlyingPrice of a Commodity Future Option with the same details as the leg (commodityName and futuresExpiryDate). If underlyingPrice is given, the price derived as above is scaled to produce the given value. If volatility for a leg is omitted, it is calculated as for the volatility of a Commodity Future Option with the same details as the leg. If correlation is omitted and marketPrice is also omitted, correlation is computed as the historical correlation between prices of commodity futures.
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If correlation is omitted and marketPrice is given, correlation is calibrated to produce marketPrice. If correlation and marketPrice are both given, marketPrice is disregarded. Commodity Future Spread Options do not have settlement dates or settlement prices. Sample Commodity Spread Option <commoditySpreadOption> <positionName>cso test</positionName> <positionId>cso test</positionId> <longLeg> <commodityName>NYMEX - NY Harbor Unleaded Gasoline</commodityName> <underlyingPrice>50</underlyingPrice> <volatility>50</volatility> </longLeg> <shortLeg> <commodityName>NYMEX - WTI Light Sweet Crude</commodityName> <underlyingPrice>75</underlyingPrice> <volatility>75</volatility> </shortLeg> <longFactor>1</longFactor> <shortFactor>1</shortFactor> <numberOfUnits>100</numberOfUnits> <strikePrice>5</strikePrice> <optionExpiryDate>20030415</optionExpiryDate> <correlation>0.6</correlation> <optionType> <call/> </optionType> </commoditySpreadOption> Analysis date: 10/15/2002 Continuous risk free rate: 1.653897% Price for call (above): 142.14 Price for put (change <call/> to <put/>): 3,138.04 Sample commodity future spread option <commodityFutureSpreadOption> <positionName>cfso test</positionName> <positionId>cfso test</positionId> <longLeg>
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<commodityName>NYMEX - NY Harbor Unleaded Gasoline</commodityName> <numberOfUnits>100</numberOfUnits> <underlyingPrice>50</underlyingPrice> <futuresExpiryDate>20030630</futuresExpiryDate> <volatility>50</volatility> </longLeg> <shortLeg> <commodityName>NYMEX - WTI Light Sweet Crude</commodityName> <numberOfUnits>150</numberOfUnits> <underlyingPrice>75</underlyingPrice> <futuresExpiryDate>20030630</futuresExpiryDate> <volatility>75</volatility> </shortLeg> <longFactor>2</longFactor> <shortFactor>3</shortFactor> <numberOfContracts>100</numberOfContracts> <strikePrice>900</strikePrice> <optionExpiryDate>20030415</optionExpiryDate> <correlation>0.6</correlation> <optionType> <call/> </optionType> </commodityFutureSpreadOption> Analysis date: 10/15/2002 Continuous risk free rate: 1.653897% Price for call (above): 229.99 Price for put (change <call/> to <put/>): 101,888.16
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FRN Case Study

Floating Rate Note Case Study
Introduction The following case study details how RiskManager evaluates the floating side of any position it can capture. This includes swap and FRN structures, both standard and amortising. The technical note General FRNs describes the underlying theory and formulae behind using different reference and discount curves within a floating leg. This case study uses an FRN to explain how the analysis is carried out in practice, without attempting to re-iterate the mathematics detailed in the technical document. The position
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This is a standard FRN, starting on May 1st, 2002 and maturing in 2 years. There are semiannual coupon payments. The rate at which the coupon is paid is calculated from the US Corporate All Industries Baa curve, whilst the calculation of the coupons present value is based upon the USD Swap curve. For a swap inside RiskManager, each leg can be defined as floating, and users can define specific reference and discount curves on both sides. If either the reference or discount curve is not specified, RiskManager will default to the risk-free curve in that currency, which could have a significant impact upon your results.
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FRN Underlying settings and market data

The analysis date is May 1st, 2002, whilst the base currency is USD. Below are the underlying returns and (daily price) volatilities that will be used by the system, based upon the standard market data available.
Discount Curve USD Swap Nodes Years Semiannual Rate Continuous Rate Volatility 6m 0.500 2.0920 2.08 0.0229 1Y 1.000 2.6351 2.62 0.0396 2Y 2.000 3.5872 3.56 0.0546 3Y 3.000 4.2203 4.18 0.0548 0 0.000 5.3317 5.26 0.0478 Reference Curve USD Corp. Ind. Baa 2Y 2.000 5.3317 5.26 0.0478 3Y 3.000 5.9969 5.91 0.0491
The continuous rate is calculated from semi-annual rates using the formula:
As there are cashflows between the analysis date and two years forward, RiskManager, as explained in Return to RiskMetrics Evolution of a Standard {Mina, Xiao (2001)}, will create a clone of the reference curves 2Y point at time t=0. This will produce a flat (in terms of interest rates) reference curve between 0 and 2Y. Please refer to the section below.
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FRN PV Analysis
Discount Curve USD Swap Nodes Years Semiannual Rate Continuous Rate Volatility 6M 0.500 2.0920 2.08 0.0229 1Y 1.000 2.6351 2.62 0.0396 2Y 2.000 3.5872 3.56 0.0546 3Y 3.000 4.2203 4.18 0.0548 0 0.000 5.3317 5.26 0.0478 Reference Curve USD Corp. Ind. Baa 2Y 2.000 5.3317 5.26 0.0478 3Y 3.000 5.9969 5.91 0.0491
PV Analysis Date Notional
01/05/2002 5,000,000
Flow Dates 01/11/2002 01/05/2003 01/11/2003 01/05/2004
Days 184 365 549 731
Years 0.504 1.000 1.504 2.003
Discount Rate Forward Rate 0.02085 0.02617 0.03090 0.03557 0.05261 0.05261 0.05261 0.05263
Flows 134,402.52 132,182.47 134,402.52 5,133,104.57
PV 132,996.91 128,767.00 128,297.84 4,780,141.28
TOTAL
5,170,203.03
The reference and discount curves are built as shown in the last section, converting semi-annual rates into continuous rates. Please note the clone at 0 for the reference curve.
For each cashflow date, the system will then calculate the estimated forward and discount rates using, interpolating between the appropriate points on the curves.
For example for the flow on the 1st of November, the continuous discount rate is calculated as follows:
Based upon the estimated forward rate, the future coupons (Flows) are calculated. These are then discounted back to the analysis date using the discount rate. Thus the present value is calculated.
Also please note: The final flow takes into account the principal exchange at maturity. The number of years is calculated by dividing the number of days by 365 (Act/365). The coupon value is an intermediate value used only for calculation
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Note on bucketing in RiskManager RiskManager buckets are defined as greater than or equal to the bucket start date, and less than the bucket end date If users are reporting PV by maturity, then the PV will be attributed to the maturity date of the FRN as shown below.
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FRN Interest Rate Sensitivity and VaR analysis

The interest rate sensitivity analysis performed by the system looks at the effect of moving the underlying rate by a specified number of basis points (PVBP delta statistic), usually one, as shown in the portion of the spreadsheet below.
For each risk factor, the original rate is moved up and down one basis point, and the system will calculate the corresponding PV. Based upon these values, a gradient is calculated and scale to one basis point to give you the PVBP Delta. Therefore, for the FRN as a whole, the following is observed.
Rate of Factor Value of FRN Disc. Curve Risk Factor 2.092 6M 2.102 2.082 2.635 1Y 2.645 2.625 3.587 2Y 3.597 3.577 4.220 3Y Ref. Curve Risk Factor 5.332 2Y 5.342 5.322 5.997 3Y 6.007 5.987 5,170,203.03 5,171,164.73 5,169,242.28 5,170,203.03 5,170,205.57 5,170,200.48 2.55 21 961.23 7586 4.230 4.210 5,170,203.03 5,170,196.43 5,170,209.59 5,170,203.03 5,170,180.78 5,170,225.20 5,170,203.03 5,169,259.96 5,171,154.86 5,170,203.03 5,170,200.45 5,170,205.59 -2.57 23 -947.45 8530 -22.21 145 -6.58 25 Delta PVBP 95 % VaR at Point
For Parametric VaR calculations, the absolute PVBP delta is multiplied by the risk factor (price) volatility and scaled by the number of standard deviations in a normal distribution to get to the relevant confidence level. For 95% PVaR, the factor is 1.65.
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As you can see above, the PVBP delta calculated against the six-month point on the discount curve is attributed to the 6M-9M bucket, whilst the delta against the one-year point goes into the 12M-18M bucket, and so on.
The system looks at each cashflow individually for analysis purposes. On a spreadsheet, this would look like the following, with the PV of each cashflow being recalculated for delta (PVBP) analysis.
Curve Risk Factor Rate of Factor Value of Cashflow 1 2.092 Discount 6M 2.102 2.082 2.635 Discount 1Y 2.645 2.625 5.332 Reference 2Y 5.342 5.322 132,996.91 132,990.31 133,003.47 132,996.91 132,996.86 132,996.96 132,996.91 133,246.51 132,747.56 249.47 1969 -0.05 0.4 -6.58 25 Delta PVBP 95 % VaR at Point
Curve
Risk Factor
Rate of Factor Value of Cashflow 2 2.635 $ 128,767.00 128,754.27 128,779.68 $ 128,767.00 129,008.60 128,525.63
Delta PVBP -12.71
95 % VaR at Point
Discount
1Y
2.645 2.625 5.332
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Reference
2Y
5.342 5.322
241.49
1906
and so on for the other flows. The bucketing is similar to that for PVBP delta analysis, but now risk factor correlations are also taken into account, and the VaR is not additive.
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For simulation based VaR analysis (i.e. Historical and Monte Carlo), the underlying risk factors are stressed. The subsequent PV losses/gains are ordered, and then based upon the specified confidence level(s), the position's VaR is derived.
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FRN Start Date and First Coupon Date

Start Date and First Coupon Date There are two settings, startDate and firstCouponDate. If you give neither, we start at the maturity date and work backward until we find the first coupon that starts to accrue on or before the business date. The date on which that coupon starts to accrue is the start date and the date on which that coupon is paid is the first coupon date. By definition, then the start date is on or before the business date, the first coupon date is after the business date, and the term between them is equal to one "coupon term". In that case, the first coupon will not be a stub, and neither will the last coupon. If you give a firstCouponDate, but no startDate, we will come up with a start date one coupon term before the first coupon date, and then work forward until we find a coupon date on or after the maturity date. If the last date is after the maturity date, we move it to the maturity date and that makes the last coupon a stub. However, the first coupon is not a stub. If you give a startDate, then that is the start date for the first coupon. You can give a firstCouponDate or not. If you don't give a firstCouponDate, we start at the maturity date and work backward as above, so the first coupon will be a stub if the given start date is later than the start date that would have been calculated above. And if you give a firstCouponDate, then the first coupon will be a stub if the term between the given firstCouponDate and the given startDate is less than one coupon term. (The last coupon may also be a stub if you give a firstCouponDate.) If the first coupon is a stub, we can either prorate it or not. If we prorate it, we compute the length of one full coupon term (FC), and the stub coupon term between the start date and the first coupon date (SC) and take the ratio: SC/FC. The value of the first coupon cashflow (computed as a normal, non-stub coupon) is multiplied by this ratio. If we don't prorate the first coupon, then we don't multiply by the ratio. In terms of how much difference this makes, it partly depends on the size of the stub. If the stub is very close to a full coupon, then treating it as a full coupon won't make much difference. If it is very short, then treating it as a full coupon will make a big difference. The amount of the difference will not exceed the value of one coupon, but the difference as a percentage of PV will vary depending on factors like: (1) how many coupons are left (if there are three left, the first will make a bigger difference than if there are thirty left); (2) whether the instrument PV is near zero. This isn't the case with an FRN, where there is no offsetting value to reduce the PV, but it is the case with swaps. A swap may be very near zero PV because the two legs offset almost perfectly, so a small change in the value of the first coupon (depending on whether it is or is not prorated) can produce a very large difference as a percentage of the total PV.
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FX Forward
FX Forward Example
Consider a straightforward transaction of buying GBP 1,000,000 in exchange for JPY at a rate of 177.25 JPY/GBP on 26th October, 2001. The following steps will demonstrate how a Foreign Exchange Forward can be set up within RiskManager3 and also how a PV report can be run with this position. Using the above information, the details for the trade can be inserted into the Foreign Exchange Forward position window in RM3 as displayed below (note the descriptions of the fields in the position window are also given below). Once satisfied that all information is correct then save the position.
Position Name Notional Forward Currency Settle Currency Forward Price Forward Date
Value 1mm GBP JPY 177.25 26 Oct 2001
Insert a descriptive name for the position. Amount, in Forward Currency, to be bought or sold on the Forward Date. Can be positive or negative depending on whether buying or selling the Forward Currency. Must be non-zero number. Currency to be bought or sold on Forward Date. Currency in which the forward is priced and settled. Price, in terms of the Settle Currency, at which the Forward Currency will be bought or sold. Must be a positive number. Date on which the Forward Currency will be bought.
An explanation for the fields can be seen in the Position Import Specification Help
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FX Forward Position Screen

In the position window in RM3 the single Foreign Exchange Forward position appears as follows (note that for this example the screen has been set up specifically to view Foreign Exchange Forward positions only):
From the report screen (see "Reports", "Risk Settings") it is possible to set up the risk settings required for a particular report.
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FX Forward Risk Settings

In this example, we will establish two risk settings: 1. 2. 1 year lookback relative to "today". 1 year lookback relative to today for historical data but setting the analysis date forward to one day before the FX forward date (October 25th, 2001).
Risk Settings for "today" used for the FX Forward Position 1. 2. 3. 4. 1-Day Horizon GBP Base Reporting Currency One year lookback period In this example, "today" is July 6 2001. This is a relative setting.
Risk Settings for October 25, 2001 - One day before the forward date of Oct 26th.
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1. 2. 3. 4.
1-Day Horizon GBP Base Reporting Currency One year lookback period In this example, the analysis date is fixed at Oct 25, 2001. October 25th is one day before the forward date. We would expect to see the PV of the position approaching zero.
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FX Forward Report Details

PV Report Layout Manager template for a PV report using two risk settings.
Report output - Note the two columns of PV. Each of the Risk Settings are side by side. Risk Setting 1: The fx forward position is valued as of July 6, 2001 (today's date in this case). Risk Setting 2: The fx forward position is valued as of October 25, 2001 (one day before the forward date). Note the Analysis Dates for Risk Settings below the report (circled).
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FX Exotic Options
Reverse Knockout Option
In this type of option, if the price touches the barrier, the option ceases to exist (knockout). If it does not, then at expiry the option acts like an ordinary European option. Reverse indicates that the Barrier of the RKO is triggered at a level when the option is in-the-money: for a call the barrier would be above spot, for a put below spot. If the barrier is not triggered the pay out is the same as for a Vanilla option.
Use the RiskManager position type Foreign Exchange Single Barrier Option, exactly as per the field descriptions in RiskManager. Direction is determined by whether the spot is above or below the barrier. Below is an example of an RKO. Note that todays spot rate is .68 USD/CAD, so the direction is rebate is up.
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One-Touch options
One-Touch fxoptions pay a rebate if the barrier is touched, then the option disappears. They can be entered into RiskManager using the RM position type FX Single Barrier Option, where barrier type is knockout. In the case of a call, set the strike price to a very high number, in direction to up, so that the option will never actually be called. In my example I will use 999,999,999. (In the case of a put set the strike price to a very low number like .000001 and the direction to down). Set the rebate to the payout amount, expressed in settlement currency. Example: Expiration date April 11, 2003 If GBP/EUR rate rises and touches .7, then receive rebate of 250,000 EUR (The GBP/EUR spot rate is currently .6880329)
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Using this method requires all numbers except notional to be in terms of SettleCurrency. If the barrier had been given by the terms of the contract in GBP, then we would be forced to invert this contract to enter it into RiskManager. A call in currency x/currency y can be expressed as a put in currency y/currency x. If the rebate had been stipulated as 200,000 GBP, then we could invert the trade as follows.
Inverting an Option to satisfy RiskMetrics conventions

Reverse the Option Currency and Settle Currency. Call becomes Put. Change the strike price to .0001 Direction becomes down Barrier becomes 1/barrier Rebate is expressed in the new Settle Currency
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Digital Knockout Option

This option can be entered exactly as the Digital Option above, with the following additions: -Use FX Single Barrier Options instead of plain FX Options -Set the Barrier Types to Knockout -Set the Barrier of both pieces to equal each other. Example: CAD/USD Digital Knockout Put Option Barrier 1.505 CAD/USD Strike 1.41 CAD/USD Payout 100,000 USD (currentspot exchange rate is 1.49 CAD/USD) If the price goes up to 1.505, the barrier is hit and the option no longer exists. If the price goes down to 1.41 on expiry date, the put excercisesand we make a profit of 100,000 USD. Since the known quantity of the payout is in USD, then the settle currency of the options we use must be USD. We therefore must invert this trade as above, and express everything in settlement currency: USD. It now looks like this: USD/CAD Digital Knockout Call Option Barrier .6644 CAD/USD Strike .7092 CAD/USD Payout 100,000 USD
If the price goes down to .6644, the barrier is hit and the option no longer exists. If the price goes up to .7092 on expiry date, the call excercisesand we make a profit of 100,000 USD.
We enter the two Foreign Exchange Single Barrier Options side A and B as follows: Side A
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Side B
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Digital Options
RiskMetrics will soon add a security type for Digital Options in version 3.7, however for now we can get a very good approximation of a digital option by combining two ordinary european call options. We do this by creating a bull-spread for digital call options and a bear-spread for digital put options. For the digital call option (bull-spread) we buy a call with a strike price p1 and sell a call with a higher strike price p2. The distance between p1 and p2 should be very narrow, to minimize the possibility that the calls will expire and the spot will fall between them. The notional amount on both call options should be set to notional = payoff/(p2-p1) The two options should be given the same tag to indicate that they are a pair. Example 1: Long Digital Call option pays 200,000 EUR with strike at 2.0 EUR/GBP Create two FX Options. The currency of the payoff determines the settlement currency.
Option 1
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Option 2:
Same as above except Strike: 2.0 Notional: -2,000,000
Example 2: To create the short digital option (the counterpartys view of the trade above) we need a negative payoff. Simply reverse the signs of the notional amounts on the two above trades. Example 3: If the payoff were expressed in the other currency (GBP), for example 200,000 GBP, then we would be required to invert the currencies of this trade making the GBP the settle currency. This is analogous to a long bear spread, where we buy a put at a strike price p2 and sell a put at lower strike price p1. (It is also the proper treatment for a Long Digital Put Option.)
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This is the same as example 1 except: -Use puts instead of calls -Invert the strike price, for example use = .5 for the short put and 1/1.9 = .5263 for the long put strike prices. -Notional = payout/(p2-p1) = 200,000/(.5263-.5) = 7,600,000
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Callable Bonds
Callable Bond Decomposition Introduction
Callable bond is a bond that contains provisions allowing the issuing firm to buy back the bond at a predetermined price at certain times in the future. The holder of such a bond has essentially sold a call option to the issuer. The strike price or call price in the option is the predetermined price that must be paid by the issuer to the holder. In RiskManager, the call schedule is described by a series of callDate and callPrice. (Refer to RML guide for explanation on how call schedule is specified in RiskManager.) In light of the callable feature of the bond, one interesting exercise is to decompose the callable bond into a underlying bond plus a short call option on that bond, or in other words, create a synthetic callable bond by constructing a portfolio consists of a bond and a short call option, and then examine how well the two compare with one another. Although it sounds like a plausible idea, there are two issues we need to address which render the comparison only approximate. 1. The replicating portfolio is not exact. In the original callable bond, the bond is callable in the course from 2/27/2003 to its maturity 8/27/2004. This call schedule cannot be replicated by either an European or American bond option. As a best approximation, we use a European call that expires on the first call date. 2. In RiskManager, the models we employ to price bond option is different from that to price more complex interest rate derivatives such as callable bond. We employ Black76 model to price bond option, in which case the forward bond price is assumed to be log-normal at expiry. However, for interest rate derivative thats path-dependent, we also need to model the dynamics of the interest rate process. Black-Derman-Toy model (BDT tree) is employed for this purpose. The difference here is directly linked with the difference in the first item.
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Callable Bond Decomposition Examples

Now lets look at our example. A 50MM callable bond, 2.7% coupon paying semi-annually, maturity date 8/27/2004, callable since 2/27/2003 at a price of $96 until maturity. The synthetic portfolio consists of a non-callable bond with a European call option written (short call) against it for 2/27/2003 at $96. The original callable bond is a short position so that the overall portfolio is almost in perfect hedge. Then we run a multi-risk setting report that reports PV, 1Y look-back historical VaR, and Monto Carlo VaR with 1000 simulations at analysis dates 8/30/02, 9/30/02, and 10/21/02, respectively. Here are some highlights from the results (see figure1): 1. The present values of the callable and the synthetic portfolio are very close. Looking at All Positions row, they almost cancel out in comparison with the notional of 50MM (about 0.04% of the notional). 2. In both historical VaR and Monto Carlo VaR reports, the risks for callable and synthetic portfolio are close. Again looking at the All Positions row, the risk of the overall portfolio is small compared with that of each individual (10% on average), indicating the hedging effect. Nevertheless, it is not a perfect hedge due to the reasons stated in the section above. 3. The difference between the two VaR numbers for callable from the two methodologies are larger on 8/30/2002 than on the other two dates, indicating a further-away-fromnormal distribution of the one-year look back log-returns on that date. Figure 2 shows the comparison. Blue curve is the historical density whereas the red one is the normal density with the same volatility. Notice the fat tails of the historical density on both ends.
4. The historical VaR for the callable is larger on 8/30/2002 than on the other dates. That is mainly due to the fact that there are some abrupt jumps in the interest rates in August, 2001, which were factored into the historical simulation and produced large adverse returns.
In this example above, the call option is in-the-money. As it goes more towards out-of-the-money, the synthetic portfolio departs further away from the original callable. In other words, the difference between the two models grows larger. This can be seen from the next example.
The second example is very similar to the first one except that the call prices for both the callable bond and the bond option are set to $100. Compare the results here (Figure 3) with that from the previous example (Figure 1), we see that: 1. In PV report, the synthetic callable worth less than the original callable bond, indicating that the bond option priced using Black76 is more expensive than that from the BDT model. 2. Consistently in both VaR reports, the VaRs for the synthetic callable is higher than that for the callable bond. Hence we can see the difference between these two models. From the replicating portfolios viewpoint, the difference can probably be attributed to the optimal exercise time. As the option goes more towards out-of-the-money, the optimal date for the issuer to call back the bond probably goes further away from the first call date, which is the assumption we made for our bond option.
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Callable Bond Decomposition Conclusion

The purpose of this exercise is to test the validity of replicating a callable bond with a portfolio of the bond plus a call option written against that bond in RiskManager and how well this approximation is for risk purpose. What we found is that 1. The replicating portfolio is not exact, both in terms of the feature of these instruments and in terms of the models we use to price them. 2. The approximation is relatively sound when the embedded option is in-the-money. There the PVs of the two counterparts are close to each other. And the risk of the total portfolio is low, indicating the hedging effect. 3. When the embedded option in the callable bond goes more towards out-of-the-money, the two models departs further away and the embedded option tends to be overvalued by the Black76 model. This is demonstrated consistently in both the PV and the two VaR reports. 4. The VaR from historical simulation is different from that of Monto Carlo on certain dates, suggesting a greater departure of the real distribution of look-back period from the normal distribution with the same volatility.
Figure 1: Report that compare the callable bond with the synthetic portfolio. X=$96.
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Figure 2: Simulated returns for the callable bond based on one-year history between 8/30/2001 to 8/30/2002. Blue line is the historical density. Red line the normal density.
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Figure 3: Report that compare the callable bond with the synthetic portfolio. X=$100.
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High Grade or High Yield Bond

Corporate Bond Example
Consider a straightforward transaction of buying USD $1MM Eli Lilly & Co 7.125 due 6/01/2025 corporate bond on 25th July, 2001 at 103.25.
The following steps will demonstrate how a corporate bond position, using the above example security, can be set up within RiskManager3 and also how a PV report can be run for this position. Using the specifications for the bond (along with price capture information and trade details) one has the necessary information to input numbers into RiskManager3 software. The description of the fields are given immediately below. An explanation for the fields can be seen in the Position Import Specification Help
Position Name
Eli Lilly&Co, 7.125%, 06/01/2025, USD 1,000,000
A descriptive name for the position. Principal amount of bond, in currency, due on maturity date. Must be non-zero. A positive number indicates a long position and a negative number indicates a short position. Currency of bond. Must be a currency code which matches one currently defined in the market database. Yield curve to use for discounting all future coupon and principal payments. Must match a yield curve currently defined in the market database. A parallel shift, in basis points, that is applied to the Discount Curve for discounting purposes. May be positive or negative number to reflect raising or lowering the discount curve. For a bond without callable features, if this field is specified, RiskServer will calibrate its risk model based on this adjustment, and if this field is left blank, a spread will be computed internally. For a bond with callable features, if this field is specified, it is used to create a BDT tree, and left blank the default is 0. Interest on bond, as an annual percentage. Must be greater than or equal to zero. The frequency of coupon payments (defaults to semi-annual unless specified). The date at which interest begins to accumulate for the first coupon. If left blank, assumed value is one normal pay period, as based on frequency, prior to the first coupon. The date on which the first coupon is paid. If left blank, a normal coupon schedule based on Frequency and Maturity Date is assumed.
Notional
Currency
USD
Discount Curve
US Corp All Industry Aa
Discount Spread
65.00 bp
Coupon Frequency
7.125 Semi-annual
Start Date
First Coupon Date Maturity Date 01/06/2025
Date that principal will be paid back. Latest closing market price (clean) of the bond. For a bond without callable features, if this field is specified, RiskServer calibrates its risk model to match this clean price by adjusting the discount curve spread. For a bond with callable features, if this field is specified, RiskServer calibrates the BDT
Bond Price
103.25
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Accrued Interest
Settlement Date
27/08/2025
Settlement Price
tree to produce this clean price by adjusting the option-adjusted spread. If left blank, current market price is computed from appropriate historical time series. Current accrued interest of the bond. If specified, RiskServer adjusts the clean price of the bond by this field. If left blank, accrued interest is computed from the coupon schedule of the bond. Note this field is only applicable if a Bond Price has been specified. The date on which the purchase (or sale) of this bond settles. If left blank, RiskServer assumes the bond has already settled. If a settlement date has been specified, then this field is the clean price paid (or received) for the bond on that date. RiskServer automatically adds accrued interest to this price. If left blank, RiskServer will assume a settlement Price that is equal to the current fair market value of the bond. Note this field is only applicable if a settlement date has been specified.
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Corporate Bond Position Editor Screen

Entering the Bond's fields into the position editor, we see:
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Corporate Bond Report Preparation

In the position window in RM3, the single Eli Lilly & Co Corporate Bond position appears as follows (note that for this example the screen has been set up specifically to view our own tag-dimension Corporate Bond positions only). For reporting, we can select this same tag dimension to run Risk or Stress reports.
From the report screen (see "Reports ", "Risk Settings ") it is possible to set up the risk settings required for a particular report.
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Corporate Bond Report Details

Multiple Statistics Report Layout Manager template for a simple PV report by position using one risk setting.
PV Report Results
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Report Risk Settings Summary
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Corporate Bond Position - RML

Description Position opening Tag Instrument Type Instrument Name Notional amount Currency Discount curve (must match one currently in database) Spread Coupon Frequency (default is semiannual) Maturity date Market price Close bond position Open custom bucket list (list of TAGs) Open group custom bucket (first drilldown) First drilldown name Vale for first drilldown (first TAG value) Open position name list Position name Close position name list Close group custom bucket Open group custom bucket (second drilldown) Second drilldown name Value for second drilldown (second TAG value) Close group custom bucket (second drilldown) Close group custom bucket list Close positions RML <positions> <bond> <positionName>Eli Lilly & Co, 7.125, 6/01/2025, USD</positionName> <notional>1000000</notional> <currency>USD</currency> <discountCurve>US Corp All Industry Aa</discountCurve> <discountCurveSpread>65</discountCurveSpread> <coupon>7.125</coupon> <couponFrequency><semiannual></semiannual></couponFrequency> <maturityDate>20250601</maturityDate> <marketPrice>103.25</marketPrice> </bond> <groupCustomBucketList> <groupCustomBucket> <customDimensionName>Asset Type</customDimensionName> <customBucketValue>bond</customBucketValue> <positionNameList> <positionName>Eli Lilly & Co, 7.125, 6/01/2025, USD</positionName> </positionNameList> </groupCustomBucket> <groupCustomBucket> <customDimensionName>Portfolio</customDimensionName> <customBucketValue>Corporate Bonds</customBucketValue> </groupCustomBucket> </groupCustomBucketList> </positions>
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Interest Rate Swap

RiskManager Swap Example (1)
Risk Settings in RiskManager Analysis Date 19 Jun 2001 Pricing Date 23 Oct 2000
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Pay Leg Fixed 6% semi-annual maturing 19 Jun 2004 Receive Leg floating (6% in Oct 2000)
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RiskManager PV report output
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Excel Swap Example

Interest Rate USD Swap example: Paying 6% fixed semi-annual to Jun 19, 2004 and receiving floating Analysis date June 19, 2001 Pricing date Oct 23, 2000 Download this spreadsheet
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Swaps with Accrued Interest
Summary to RM3.6 Release Swaps Instrument Extension

This specification extends the current swaps model to incorporate swaps with accrued interest.
What is it ?
An easy way to think of it is to compare it with the old swaps model that has the same <referenceFrequency>, and whose <couponFrequency> is the same as the new models <resetFrequency>. On each reset date, instead of paying the coupon out, one retains the coupon, let it accrue interest along with the principal till the new models coupon payment dates, on which date all the coupons as well as their accrued interests are paid out.

Since this is a natural extension from our current swaps model, we only need to add another field, <resetFrequency>, whose default will be the same as the <couponFrequency> if user does not specify one, onto the existing interface for swaps. But we need to make sure that <couponFrequency> is a multiple of <resetFrequency>. For instance, if <couponFrequency> is </quarterly>, then <resetFrequency> can be </monthly>, but not </bimonthly>.
Implementation
This model can be extended from the current swaps model. On the floating side, on each reset dates, first add coupon from the last reset period onto the principal so that it also accrues interest in the next reset period. Then check if the current reset date is also a coupon payment date. If so, the current principal minus the notional gives the coupon payment that should be paid out on that day and principal is reduced back to notional amount. Otherwise if this reset date is not a coupon payment date, then calculate the coupon for the next reset period the same way as what we did before based on the aggregated principal. This coupon will be added onto the principal on next reset date. This new model introduces no new questions in the case of pay in arrears.
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Addendum to RiskManager Specifications Bulletin
Summary to Addendum to RM3.6 Release Swaps Instrument Extension

This addendum discusses the problem of the very first coupon for an instrument with reset frequency different from coupon frequency. The issue is what to do with accrued interest.
Statement of Problem
The diagram above illustrates an FRN with first coupon payment on 9/1, coupon frequency semiannual, and reset frequency monthly. The first coupon payment is of normal length, so it has five resets before the final payment. The business date is 6/15, so three resets have already occurred and we are partway through the fourth. On 4/1, a coupon of c1 was accrued on notional n. On 5/1, a coupon of c2 was accrued on (n + c1). On 6/1, a coupon of c3 was accrued on (n + c1 + c2). On 6/1, accruedInterest = c1 + c2 + c3 + currentRate (n + c1 + c2 + c3) (14 days). In general, we can compute: accruedInterest = accruedCoupon + currentRate (notional + accruedCoupon) partialTerm where partialTerm is the interval from the last reset date to the business date. The user is permitted to enter accruedCoupon, currentRate, and accruedInterest. The notional and partialTerm can be regarded as fixed. What do we do if the user enters values for these three variables that do not satisfy this equation? The three relevant variables, accruedCoupon, currentRate, and accruedInterest, are all optional and all have default values as follows: The accruedCoupon will be computed using historical rates from the relevant dates, with reset spread added if non-zero. The accruedCoupon will always be zero if the reset frequency is equal to the coupon frequency. The currentRate will be determined from historical data, with reset spread added if non-zero. (As a side note, if the user specified a currentRate, the reset spread will not be added to it.)
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The accruedInterest will be determined from equation (1). The accrued interest enters into the pricing only insofar as it forms part of the dirty price used for calibration. If the market price is not entered, the accrued interest should not be entered either, and indeed a user-input accrued interest will be disregarded and a new accrued interest will be computed from equation (1). Therefore, if accrued interest is specified, the most important goal is to keep the dirty price as entered by the user, even if that means moving some of the value from accrued interest to market price.
Discussion
This discussion concerns only the situation where the user entered an accrued interest (and therefore also a market price).
If position is inArrears If the position is inArrears, then the accrual date and the payment date of the next coupon (or reset) are the same, and are in the future. Therefore, the currentRate is effectively zero and accruedInterest must be equal to accruedCoupon. If the user enters either value, the other will be set to match. If the user enters both values, and they are different, then we must pick one or the other. We chose to use the accruedCoupon, and so the accruedInterest will be set to the accruedCoupon and the marketPrice will be adjusted to produce the same dirty price. A warning will be given, explaining the change. If the position is not in arrears If the position is not in arrears, we have four possible cases: neither of the other two factors was given, one or the other was given, both were given. Neither given: We try to get the currentRate from the historical data and solve for the accruedCoupon in equation (1), so accruedCoupon will not come from historical data. If the accruedCoupon is negative in this case, then instead the accruedCoupon will be computed using historical rates. If the accruedCoupon is less than the accruedInterest, we can solve for the currentRate in equation (1). In that case, currentRate will not be taken from the historical data. If the accruedCoupon exceeds the accruedInterest, however, we cannot use historical data and have no reasonable values for either variable. We therefore arbitrarily set accruedCoupon to 0 and solve for currentRate in equation (1). Note that accruedCoupon is always considered to be given as 0 if reset frequency is equal to payment frequency. Current rate only: If the currentRate only is given, we have two cases, depending on whether the reset frequency is equal to the coupon frequency or not.
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If the reset frequency is equal to the coupon frequency, then the accruedCoupon must be zero. The accruedInterest should therefore be equal to the product of the currentRate and the partialTerm. If it is not, we will change the accruedInterest and adjust the marketPrice to match. A warning will be given. If the reset frequency is different from the coupon frequency, we can solve for the accruedCoupon in equation (1). If the result is less than 0, then again we will change the accruedInterest to make equation (1) true, adjust the marketPrice, and give a warning. Note that accruedCoupon is always considered to be given as 0 if reset frequency is equal to payment frequency. Accrued coupon only: We can solve for the currentRate from equation (1). Current rate and accrued coupon: This is the worst case, where the user has entered all variables. If equation (1) is not satisfied, we will change the accruedInterest to make equation (1) true, adjust the marketPrice, and give a warning. Effect of solving for current rate In the past, we have always obtained then current rate from the historical data, even if this means that there is no relationship between the current rate and the user-entered accrued interest. If the user has entered an accrued interest which is wildly wrong relative to the historical current rate, solving for the current rate will produce a wildly wrong current rate. Since we will then proceed to calibrate the position to produce the right dirty price, the position will still likely have the right price, but the VaR by yield curve will be a bit different from a position that has the right current rate and accrued interest. We could perhaps always correct the accrued interest to match the current rate, but the accrued interest given by the user does give information about the current rate, which may be better information than we can obtain from the historical data. So should we honor it, knowing that perhaps it will produce a bad current rate, or disregard it except as a component of the dirty price? Outstanding issue What do we do if the reset frequency and payment frequency are not equal, the user gave us an accrued interest and nothing else, and the accrued coupon came out negative when we solved for it using the historical current rate? As things stand, we then try getting the accrued coupon from historical data and solving for the current rate. This gives the historical accrued coupon control over the current rate, but is that really appropriate? The user has an accrued interest, which he presumably got from a current rate which he neglected to tell the engine, and it might be that current rate is close to the rate we got from the historical data. If the accrued coupon is way off based
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on the historical current rate and accrued interest, maybe the real problem is that the user neglected to give us a good start date. So fixing the accrued coupon at zero and computing a current rate from the accrued interest may be the solution most likely to produce a reasonable number for the value of the first coupon, even though it fails to make use of some of the historical data that we actually have.
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Liffe SwapNote Futures

Liffe SwapNote Futures
Description:
Swapnote contracts are traded in Liffe Connect - started on 20 March 2001 2, 5, and 10 year contract notes are listed Delivery months are March, June, September and December with third Wednesday as the delivery date. Unit of trading is Euro 100,000
Motivation:
Since responsibility of monetary policy to the European Central Bank, respective govt bonds have lost their benchmark status. Further reduction of govt debt issuance is placing increased pressure on govt bond markets via supply/demand imbalances and distortions resulting in price uncertainties As a result, market participants using futures contracts referenced against the govt. curves to hedge credit and interest risks are subject to higher basis risk. A futures contract referenced against the swap proves reduced basis risk and a better hedge (provides from 2 year to 10 year maturity) The swap curve has become the benchmark for the whole spectrum of the European Fixed Income Market while the correlation between govt. bonds and non-govt. credit securities have deteriorated.
Types of instruments better correlated to Euro Swap Curve than govt. bond curves (source, Liffe):
Corporate bonds eurobonds Pfandbriefe bonds Lower credit euro-govt bonds OTC swaps Swaptions
Modelling in RiskManager:
As Commodity Future & Commodity Future Option The Euro Swapnote contracts are supported.
Modelled as a forward starting swap Forward Starting Date is the expiry of the Future (and starting of the swap. e.g. 19 Dec 2001) Fixed rate is always at 6% Swap payments is annual for the Euro Swap Both legs mapped to the Euro Swap Curve Maturity Date is 2, 5 or 10 years from the forward starting date Full notional to be input (e.g. 2 contracts means 200,000 euros).
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Mortgage Backed Securities

Summary of Mortgage Backed Functionality
US Agency Mortgage Backed Securities RiskManager can compute the risk of various types of Mortgage-Backed Securities (MBS) issued by US Agencies Fannie Mae, Ginnie Mae, and Freddie Mac. Current coverage includes pass-throughs on Conventional Fixed-Rate Mortgages (FRMs), Balloon Mortgages, and Stripped FRMs, where the investor received either Principle or Interest payments only. Mortgage pools are identified to RiskManager by a generic set of parameters, which must be supplied by the user. These parameters specify: 1. 2. 3. 4. 5. 6. The agency issuing the mortgage pool (Fannie Mae, Ginnie Mae, or Freddie Mac). The type of mortgage pool (Pass-Through, I/O, or P/O). The original term of the underlying mortgages (30Y, 15Y, or Balloon). The Maturity Date of the mortgage pool. The coupon of the mortgage pool. Issue Date of the mortgage pool.
The user can optionally specify a price for each MBS pool held in which case that price is used to calibrate the MBS model. If no price is specified RiskManager uses an indicative price for each pool. From the parameters above, RiskManager maps each MBS pool to a series of Partial Derivatives representing first- and second-order price sensitivities to various points on the US Swap Curve. As scenarios for US Swap Curve moves are generated in the normal course of RiskManager calculations, distributions of MBS price changes are computed in a correlated fashion with all other asset classes. All of the usual VaR and Stress-Tests statistics available in RiskManager can therefore be computed for individual MBS as well as multi-asset portfolios containing MBS. Partial Derivatives are computed with regard to the pre-payment risk associated with each generic MBS pool. Calculations of the Partials for each generic pool are computed nightly based on current US Swap curve levels and volatilities. A Derivative Solutions Calculation Server performs the actual computation of all Partial Derivatives. The Partial Derivatives for each generic pool are loaded into RiskMetrics DataMetrics infrastructure for daily delivery to RiskManager clients along with other Market Data to which they subscribe. For complete details on the method of computing MBS risk using Partial Derivatives, and its accuracy for modeling pre-payment risk, please refer to RiskMetrics Journal, Spring 2001, pp. 45-69.
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MBS Module for RiskManager powered by DERIVATIVE
SOLUTIONS
1.
Who is Derivative Solutions? - Derivative Solutions, Inc. is a leading provider of analytical software for fixed income securities, with a strong focus on mortgage backed securities, structured products including CMOs and Asset Backed Securities and complex derivatives. Their software is widely used by traders, analysts, portfolio managers, strategists and risk managers at leading dealer, investor, and issuer institutions. Their Mortgage and ABS analytics are also used by other Software Companies in commercially available products that traditionally lacked analytics for these instruments. The firms goal is to provide the most comprehensive set of analytics, link it with the best data sources and deliver it in the right technology. Derivative Solutions, founded in 1991, has offices in Chicago and New York City.
2.
Why is mortgage VaR so hard? Accurate VaR for mortgages depends on generating monte-carlo simulations of interest rates to determine the potential price distribution. However, the pricing of mortgages is itself a monte-carlo process. VaR of MBS has traditionally been a monte-carlo process on a monte-carlo process, and thus computationally unrealistic.
3.
What is the solution? Based on joint research between Derivative Solutions and Riskmetrics, we have developed a computationally efficient and accurate way to determine the sensitivity of mortgages to changes in interest rates. These sensitivities are accurate across changes in yield curve levels and shapes. Details can be found in our joint paper, Comparing methods to approximate mortgage-backed security VaR, published in the Spring 2001 Riskmetrics Journal.
4.
For which securities is VaR available? VaR is available for

the full universe of fixed-rate, agency-backed mortgage securities, including 30-, 20-, and 15-year mortgages and balloons. Also,
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selected IOs and POs are included. In phase II, user-specified securities will be added, including CMOs and ABS.
5.
What models does Derivative Solutions provide? Two
models are required for accurate mortgage analysis. First, an optionpricing model is needed to generate the arbitrage-free interest rates. Second, a prepayment model is needed to evaluate how homeowners will exercise their refinancing option at different interest rates through time. Derivative Solutions provides a proprietary, twofactor monte-carlo option-pricing model, calibrated to Riskmetrics volatilities, for full, option-adjusted valuation. Derivative Solutions also provides a proprietary prepayment model for each of the different types of mortgages described above. The models reflect the effects of housing turnover, refinancing behavior, burnout and seasonality.
6.
library of securities calculations in an easy to use COM object to Riskserver. Riskserver calculates the sensitivities every night based on Riskmetrics market data. Riskmetrics has integrated this single object into their software, so that users can work with mortgages as if they were any other security in Riskserver.
How is the link between Derivative Solutions and Riskmetrics accomplished? Derivative Solutions has provided a
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Mortgage Example Positions

Example compares a 5yr note with a high PSA FNMA 7% 30yr Pass Through Mortgage Compare $1MM 5yr with a $1MM FNMA 7% 30yr. From the Wall Street Journal we obtain quotes for a Generic FNMA:
Friday, October 5, 2001
Mortgage-Backed Securities
Indicative, not guaranteed; from Bear Stearns Cos./Street SoftwareTechnology Inc. Price Price Avg Spread To Spread Change Life Avg Life Change PSA Yield
(Pts-32ds)
(32ds)
(Years)
(Bps)
(Prepay to * Spread) Maturity
30-YEAR FMAC 6.5% GOLD FMAC 7.0% GOLD FMAC 7.5% GOLD FNMA 6.5% FNMA 7.0% FNMA 7.5% GNMA 6.5% GNMA 7.0% GNMA 7.5% 15-YEAR FMAC 6.5% 103-12 GOLD FNMA 6.5% 103-09 GNMA 6.5% 103-31 unch unch unch 4.2 4.2 4.2 196 unch 193 unch 180 1 300 300 300 5.53 5.51 5.36 102-07 103-23 104-03 102-03 103-18 104-02 102-15 103-22 104-11 -01 unch -01 -01 unch unch -01 -01 -01 3.8 2.4 1.8 3.7 2.3 1.9 6.8 4.7 2.6 238 237 232 238 233 226 198 227 260 7 2 2 6 3 1 2 unch 3 460 735 863 476 805 862 226 343 614 5.79 5.24 4.97 5.77 5.16 4.92 6.03 6.02 5.53
*Extrapolated from benchmarks based on projections from Bear Stearns prepayment model, assuming interest rates remain unchanged. Treasury Quotes
U.S. Government Bonds and Notes

Representative Over-the-Counter quotation based on transactions of $1 million or more. Treasury bond, note and bill quotes are from midafternoon. Colons in bond and note bid-and-asked quotes represent 32nds; 101:01 means 101 1/32. Net change in 32nds. n-Treasury Note. i-Inflation-indexed issue. Treasury bill quotes in hundredths, quoted in terms of a rate of discount. Days to maturity calculated from settlement date. All yields are to maturity and based on the asked quote. For bonds
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callable prior to maturity, yields are computed to the earliest call date for issues quoted above par and to the maturity date for issues quoted below par. *-When issued. Daily change expressed in basis points. Rate 4 5/8 Maturity Mo/Yr May 06n Bid 103:21 Asked 103:24 Chg .... Asked Yield 3.73
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Mortgage Example Positions (2)

The Positions are entered into RiskManager each having $1MM notional. The current 5yr (as of Oct 5, 2001) had about the same duration as the FNMA 7's.
Mapping your specific mortgage bond to a generic issue. To do this, your can refer to the topic mbsName. FNMA 7% 30yr Pass Through position is shown below.
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UST 5yr
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mbsName
Field 1 FNFH - which covers two agencies: FNMA - Federal National Mortgage Association. FHLMC - Federal Home Loan Mortgage Corporation. GNMA Government National Mortgage Association Field 2 PT - Pass Through IO - Interest Only PO - Principal Only Field 3 15Y - Fifteen Year Mortgage 30Y - Thirty Year Mortgage
Field 4 Coupon in % x.x (one decimal place)
Table of Generics as of December 13, 2002 This table changes over time as old mortgages expire and new issuance. Download this table
FNFH-IO-15Y-6.5-1994 FNFH-IO-30Y-6.0-1994 FNFH-IO-30Y-6.0-1999 FNFH-IO-30Y-6.0-2001 FNFH-IO-30Y-6.5-1994 FNFH-IO-30Y-6.5-1999 FNFH-IO-30Y-6.5-2001 FNFH-IO-30Y-7.0-1993 FNFH-IO-30Y-7.0-1994 FNFH-IO-30Y-7.0-1996 FNFH-IO-30Y-7.0-1997 FNFH-IO-30Y-7.0-2000 FNFH-IO-30Y-7.0-2001 FNFH-IO-30Y-7.5-1993 FNFH-IO-30Y-7.5-1997 FNFH-IO-30Y-7.5-1999 FNFH-IO-30Y-7.5-2000 FNFH-IO-30Y-8.0-1991 FNFH-IO-30Y-8.0-1992
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FNFH-IO-30Y-8.0-1993 FNFH-IO-30Y-8.0-1994 FNFH-IO-30Y-8.0-1995 FNFH-IO-30Y-8.0-1996 FNFH-IO-30Y-8.0-1997 FNFH-IO-30Y-8.0-2000 FNFH-IO-30Y-8.5-1994 FNFH-IO-30Y-8.5-1995 FNFH-IO-30Y-8.5-1996 FNFH-IO-30Y-8.5-1997 FNFH-IO-30Y-9.0-1995 FNFH-PO-15Y-6.5-1994 FNFH-PO-30Y-6.0-1994 FNFH-PO-30Y-6.0-1999 FNFH-PO-30Y-6.0-2001 FNFH-PO-30Y-6.5-1994 FNFH-PO-30Y-6.5-1999 FNFH-PO-30Y-6.5-2001 FNFH-PO-30Y-7.0-1993 FNFH-PO-30Y-7.0-1994 FNFH-PO-30Y-7.0-1996 FNFH-PO-30Y-7.0-1997 FNFH-PO-30Y-7.0-2000 FNFH-PO-30Y-7.0-2001 FNFH-PO-30Y-7.5-1993 FNFH-PO-30Y-7.5-1997 FNFH-PO-30Y-7.5-1999 FNFH-PO-30Y-7.5-2000 FNFH-PO-30Y-8.0-1991 FNFH-PO-30Y-8.0-1992 FNFH-PO-30Y-8.0-1993 FNFH-PO-30Y-8.0-1994 FNFH-PO-30Y-8.0-1995 FNFH-PO-30Y-8.0-1996 FNFH-PO-30Y-8.0-1997 FNFH-PO-30Y-8.0-2000 FNFH-PO-30Y-8.5-1994 FNFH-PO-30Y-8.5-1995 FNFH-PO-30Y-8.5-1996 FNFH-PO-30Y-8.5-1997 FNFH-PO-30Y-9.0-1995 FNFH-PT-05Y-5.0-1997 FNFH-PT-05Y-5.0-1998 FNFH-PT-05Y-5.0-1999 FNFH-PT-05Y-5.0-2001
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FNFH-PT-05Y-5.0-2002 FNFH-PT-05Y-5.5-1997 FNFH-PT-05Y-5.5-1998 FNFH-PT-05Y-5.5-1999 FNFH-PT-05Y-5.5-2000 FNFH-PT-05Y-5.5-2001 FNFH-PT-05Y-5.5-2002 FNFH-PT-05Y-6.0-1997 FNFH-PT-05Y-6.0-1998 FNFH-PT-05Y-6.0-1999 FNFH-PT-05Y-6.0-2000 FNFH-PT-05Y-6.0-2001 FNFH-PT-05Y-6.0-2002 FNFH-PT-05Y-6.5-1997 FNFH-PT-05Y-6.5-1998 FNFH-PT-05Y-6.5-1999 FNFH-PT-05Y-6.5-2000 FNFH-PT-05Y-6.5-2001 FNFH-PT-05Y-6.5-2002 FNFH-PT-05Y-7.0-1997 FNFH-PT-05Y-7.0-1998 FNFH-PT-05Y-7.0-1999 FNFH-PT-05Y-7.0-2000 FNFH-PT-05Y-7.0-2001 FNFH-PT-05Y-7.5-1997 FNFH-PT-05Y-7.5-2000 FNFH-PT-05Y-7.5-2001 FNFH-PT-07Y-5.0-1996 FNFH-PT-07Y-5.0-1998 FNFH-PT-07Y-5.0-1999 FNFH-PT-07Y-5.0-2000 FNFH-PT-07Y-5.0-2001 FNFH-PT-07Y-5.0-2002 FNFH-PT-07Y-5.5-1995 FNFH-PT-07Y-5.5-1996 FNFH-PT-07Y-5.5-1997 FNFH-PT-07Y-5.5-1998 FNFH-PT-07Y-5.5-1999 FNFH-PT-07Y-5.5-2000 FNFH-PT-07Y-5.5-2001 FNFH-PT-07Y-5.5-2002 FNFH-PT-07Y-6.0-1995 FNFH-PT-07Y-6.0-1996 FNFH-PT-07Y-6.0-1997 FNFH-PT-07Y-6.0-1998
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FNFH-PT-30Y-9.0-1998 FNFH-PT-30Y-9.0-1999 FNFH-PT-30Y-9.0-2000 FNFH-PT-30Y-9.0-2001 FNFH-PT-30Y-9.5-1984 FNFH-PT-30Y-9.5-1985 FNFH-PT-30Y-9.5-1986 FNFH-PT-30Y-9.5-1987 FNFH-PT-30Y-9.5-1988 FNFH-PT-30Y-9.5-1989 FNFH-PT-30Y-9.5-1990 FNFH-PT-30Y-9.5-1991 FNFH-PT-30Y-9.5-1992 FNFH-PT-30Y-9.5-1994 FNFH-PT-30Y-9.5-1995 FNFH-PT-30Y-9.5-1996 FNFH-PT-30Y-9.5-1999 FNFH-PT-30Y-9.5-2000 FNFH-PT-30Y-9.5-2001 GNMA-IO-30Y-6.5-1993 GNMA-IO-30Y-6.5-1994 GNMA-IO-30Y-8.0-1992 GNMA-IO-30Y-8.0-1997 GNMA-IO-30Y-8.5-1992 GNMA-IO-30Y-8.5-1993 GNMA-PO-30Y-6.5-1993 GNMA-PO-30Y-6.5-1994 GNMA-PO-30Y-8.0-1992 GNMA-PO-30Y-8.0-1997 GNMA-PO-30Y-8.5-1992 GNMA-PO-30Y-8.5-1993 GNMA-PT-15Y-5.5-1993 GNMA-PT-15Y-5.5-1994 GNMA-PT-15Y-5.5-1996 GNMA-PT-15Y-5.5-1998 GNMA-PT-15Y-5.5-1999 GNMA-PT-15Y-5.5-2001 GNMA-PT-15Y-5.5-2002 GNMA-PT-15Y-6.0-1993 GNMA-PT-15Y-6.0-1994 GNMA-PT-15Y-6.0-1995 GNMA-PT-15Y-6.0-1996 GNMA-PT-15Y-6.0-1997 GNMA-PT-15Y-6.0-1998 GNMA-PT-15Y-6.0-1999
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GNMA-PT-15Y-6.0-2000 GNMA-PT-15Y-6.0-2001 GNMA-PT-15Y-6.0-2002 GNMA-PT-15Y-6.5-1992 GNMA-PT-15Y-6.5-1993 GNMA-PT-15Y-6.5-1994 GNMA-PT-15Y-6.5-1995 GNMA-PT-15Y-6.5-1996 GNMA-PT-15Y-6.5-1997 GNMA-PT-15Y-6.5-1998 GNMA-PT-15Y-6.5-1999 GNMA-PT-15Y-6.5-2000 GNMA-PT-15Y-6.5-2001 GNMA-PT-15Y-6.5-2002 GNMA-PT-15Y-7.0-1992 GNMA-PT-15Y-7.0-1993 GNMA-PT-15Y-7.0-1994 GNMA-PT-15Y-7.0-1995 GNMA-PT-15Y-7.0-1996 GNMA-PT-15Y-7.0-1997 GNMA-PT-15Y-7.0-1998 GNMA-PT-15Y-7.0-1999 GNMA-PT-15Y-7.0-2000 GNMA-PT-15Y-7.0-2001 GNMA-PT-15Y-7.0-2002 GNMA-PT-15Y-7.5-1990 GNMA-PT-15Y-7.5-1991 GNMA-PT-15Y-7.5-1992 GNMA-PT-15Y-7.5-1993 GNMA-PT-15Y-7.5-1994 GNMA-PT-15Y-7.5-1995 GNMA-PT-15Y-7.5-1996 GNMA-PT-15Y-7.5-1997 GNMA-PT-15Y-7.5-1998 GNMA-PT-15Y-7.5-1999 GNMA-PT-15Y-7.5-2000 GNMA-PT-15Y-7.5-2001 GNMA-PT-15Y-7.5-2002 GNMA-PT-15Y-8.0-1990 GNMA-PT-15Y-8.0-1991 GNMA-PT-15Y-8.0-1992 GNMA-PT-15Y-8.0-1993 GNMA-PT-15Y-8.0-1994 GNMA-PT-15Y-8.0-1995 GNMA-PT-15Y-8.0-1996
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GNMA-PT-30Y-9.5-1979 GNMA-PT-30Y-9.5-1980 GNMA-PT-30Y-9.5-1981 GNMA-PT-30Y-9.5-1982 GNMA-PT-30Y-9.5-1983 GNMA-PT-30Y-9.5-1984 GNMA-PT-30Y-9.5-1985 GNMA-PT-30Y-9.5-1986 GNMA-PT-30Y-9.5-1987 GNMA-PT-30Y-9.5-1988 GNMA-PT-30Y-9.5-1989 GNMA-PT-30Y-9.5-1990 GNMA-PT-30Y-9.5-1991 GNMA-PT-30Y-9.5-1992 GNMA-PT-30Y-9.5-1993 GNMA-PT-30Y-9.5-1994 GNMA-PT-30Y-9.5-1995 GNMA-PT-30Y-9.5-1996 GNMA-PT-30Y-9.5-1997 GNMA-PT-30Y-9.5-2000 GNMA-PT-30Y-9.5-2001
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Mortgage Example Position XML

XML of the Treasury and Mortgage positions are as follows:
<positions> <mortgageBackedSecurity> <positionName>FNMA Pass Through 7% 30yr</positionName> <mbsName>FNFH-PT-30Y-7.0-2001</mbsName> <notional>1000000</notional> <maturityDate>20311211</maturityDate> <marketPrice>103.5625</marketPrice> </mortgageBackedSecurity> <bond> <positionName>UST 4 5/8% May 2006</positionName> <notional>1000000</notional> <currency>USD</currency> <discountCurve>USD Govt</discountCurve> <coupon>4.625</coupon> <couponFrequency> <semiannual/> </couponFrequency> <maturityDate>20060515</maturityDate> <marketPrice>103.75</marketPrice> <accruedInterest>1.927</accruedInterest> </bond> <groupCustomBucketList> <groupCustomBucket> <customDimensionName>Asset Type</customDimensionName> <customBucketValue>bond</customBucketValue> <positionNameList> <positionName>UST 4 5/8% May 2006</positionName> </positionNameList> </groupCustomBucket> <groupCustomBucket> <customDimensionName>Asset Type</customDimensionName> <customBucketValue>mortgageBackedSecurity</customBucketValue> <positionNameList> <positionName>FNMA Pass Through 7% 30yr</positionName> </positionNameList> </groupCustomBucket> <groupCustomBucket> <customDimensionName>Portfolio</customDimensionName> <customBucketValue>Mortgage example</customBucketValue> <positionNameList> <positionName>UST 4 5/8% May 2006</positionName> <positionName>FNMA Pass Through 7% 30yr</positionName> </positionNameList> </groupCustomBucket> </groupCustomBucketList> </positions>
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Mortgage Example Risk Report

Create a Multi-column report 1. 2. 3. 4. 5. 6. 7. 8. PV (as of Oct 5, 2001) VaR Historical 95% (1-Day) Duration PV01 - Value shift of 1 basis point increase in yield. PV +/- 100 bps PV +/- 75 bpps PV +/- 50 bps PV +/- 10 bps
Duration is a useful measure for measuring risk for small changes in interest rates. Duration will not capture convexity shifts or non-parallel term structure changes. By using the PVBP delta statistic with a scale of values we can see that the FNMA mortgage bond goes up less as yields drop and goes down more as yields increase. We can see the negative convexity of the security relative to the US Treasury issue. This Report has been run using a value date of Oct 5, 2001. With the 2001 Federal Reserve rate drops due to the softening economy and the WTC attack effects, the PSA of this issue has climbed to over 800 as reported by the Wall Street Journal. This is so extreme that the duration of the FNMA issue (3.89 years) is less than the 5yr Treasury note (4.36 years). As rates rise, the duration of the bond increases causing the price to fall faster than the 5yr US Treasury note. Report output is shown below and graphed in Excel from a tab-delimited export from RiskManager on the next page.
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Mortgage Example Yield Shift Impact
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Pfandbrief European Mortgage Bonds

Pfandbrief European Mortgage Bonds
Pfandbriefes are European mortgage-backed bonds with a fixed interest rate issued by a mortgage bank or public credit institution. They have grown to be incredibly popular with both individual and institutional investors for 3 main reasons: 1. 2. 3. Pfandbriefes offer a modest yield pickup over the yield of equivalent government bonds. Pfandbriefes are an incredibly safe investment, reflecting the AAA rating they have generally been awarded. In fact, they are considered to be a safer investment than some of the smaller European countries. The mortgage bank has assumed all default risk and all prepayment risk. The Pfandbriefe market is extremely large and liquid; it is, in fact, the largest European bond market. Furthermore, at least 3 underwriting banks make markets in these popular securities.
Background on Pfandbriefe The most important difference [from US MBS securities] is that Pfandbriefe carry no prepayment risk since they remain on the balance sheet of the issuing institution. Therefore, their spreads over sovereign bonds are attributable to liquidity and credit quality alone. In fact, Pfandbriefe are highly rated and have relatively small spreads. These low spreads are more a reflection of the quality of the collateral pool (which is subject to strict government regulation) than the perceived quality of the issuing agent. BIS Article: http://www.bis.org/publ/bispap05b.pdf Pfandbrief-style products in Europe by Orazio Mastroeni, European Central Bank Abstract The Pfandbrief bond market is the biggest segment of the euro-denominated private bond market in Europe and rivals in size the individual European government bond markets. The fact that it developed mainly in a single country as a purely domestic product until the mid-1990s obscured the strong growth of this market segment, regarded as illiquid and arcane by international investors. Following the strong development in issuance of, in particular, the German Jumbo, a number of jurisdictions in Europe (including many eastern European countries) have now established the regulatory framework for Pfandbrief-style products or are preparing to do so in the near future. This note describes the nature and the main characteristics of Pfandbrief-style products in a number of European countries and concentrates the analysis in particular on Jumbo products, which were launched within a relatively short period of time in Germany, France, Spain and Luxembourg. The existing differences in the national jurisdictions, and the fact that their further harmonisation in the near future is unlikely, should not prevent a successful establishment of the Pfandbrief as an asset class in its own right, both within and outside the European Union. In this respect, the application of Article 22(4) of the EU UCITS Directive, which sets out criteria for defining a common class of assets, could provide the basis for ensuring a minimum level of homogeneity of this type of assets.
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Also take a look at: http://www.pfandbrief.org
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Case Studies in Using RiskManager3

Risk Attribution for Asset Managers
Objectives of Risk Attribution
Objectives of Risk Attribution
Risk Attribution segments the relative risk of a portfolio into components that correspond to active investment decisions. Use as a diagnostic tool to measure the forward looking risk of each decision. Estimates the forward looking risk tracking error. Assist in portfolio construction and rebalancing. Companion to performance attribution to measure risks taken to generate excess returns. Communication tool to enable investors to review risks of decisions.
Editor's Note: In the Risk Attribution Section, we examine an example of a simple portfolio and benchmark containing four stocks. In the portfolio, bets are taken at the security level and at the sector level. We examine all the risk attribution calculations in a companion spreadsheet (right click this link and save as...) and discuss the Risk Attribution report output straight from RiskManager. The example also follows the white paper on Risk Attribution by Jorge Mina (2002). Objectives of Risk Attribution Risk Attribution Complements Performance Attribution Risk Attribution Decision Process Relative VaR and Risk Attribution Foundations Relative Value-at-Risk Objectives Performance Evaluation Triangle Applying the Evaluation Triangle to Portfolio Managers VaR Calculations start with Risk Factor Returns Forecast Future Price Changes and Volatility Decay Factor Controls the Weighting Scheme Decay Factors and Half Life Trading Days to Reach Time-Weighted Decay Level Applying a Decay Factor to Returns and Estimating Volatility: AT&T Common Aggregate Securities & Sectors Correlation of returns Compute the potential loss over the next horizon period Measure Losses Relative to a Benchmark Risk of Under-Performing the Benchmark A Word on Mechanics: Performance and Risk Attribution must share Dimensions Risk Attribution Reports Risk Attribution Reports and Examples Tracking Error Definitions
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Fully Worked Example: Simple Equity Portfolio Sector and Security Investments Four Equity Incremental Tracking Error Volatilities, Correlations, and Covariance Bets, Gradients and Relative Incremental VaR Total Tracking Error and Relative IVaR Equivalence Sector Allocation for Systems Hardware Sector Allocation Contribution for Systems Hardware Security Selection Contribution for Systems Hardware Security Selection Contribution for Dell and Sector Level Security Selection risk at the Sector Level Constant Portfolio BackTesting TE Historical Backtesting TE
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Risk Attribution Complements Performance Attribution

RiskManager handles the whole risk attribution process. Both performance and risk attribution tie back to the investment process. Many asset managers divide the investment process into a security selection, sector allocation, and country allocation for global investments shown on the left of figure 1. At the bottom of the process, security analysts pick stocks or bonds. They over-weight or underweight securities vis--vis the benchmark. They may also to choose to invest out of benchmark or even choose to have no investment at all of a benchmark security. Non-investments are effectively shorts against the benchmark. The risks of securities not invested in must be measured along side benchmark securities. Out of benchmark securities must be measured as well. At the security level in RiskManager, it is best to create a Security dimension and each stock or bond has the name of the security as the value for that dimension. The benchmark and the managed accounts share these security names so they can be aggregated. At the sector allocation level, many asset managers have sector analysts. These analysts must be assessed for the risks they have taken as compared to the benchmark. RiskManager may accept any dimension name or value. Clients may wish to repeat well-known sector names or use their own proprietary names. It is completely up to the user what these names contain. The objective is to match the performance attribution levels and names. Fixed Income accounts may use sectors of the market according to credit quality or sectors of the yield curve (or both). At the highest level, the country allocation level for global accounts, there may be a third group of analysts or allocation managers that determine the over-under weight on a country basis. The naming convention, again, is purely up to the user. The objective is to match the performance attribution process. The performance attribution process is handled externally (pictured in yellow in figure 1). Many RiskMetrics clients have this process in place already. The risk attribution process complements the reporting process of performance attribution. Each of the RiskManagerrisk reports can be structured to match the dimensions measured in the performance process. The risk attribution reports are a companion set of reports of the performance process. The glue that binds the investment process and the attribution process are the accounts and benchmarks themselves.
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Figure 1
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Risk Attribution Decision Process

The entire risk attribution decision process revolves around the portfolio manager and his clients (shown in figure 2). Objectives are set as to the investments to be made, what benchmarks are track, and now, what risk limits are to be adhered to. Market price action and economic conditions fuel this objective setting process and subsequent reviews (performance and risk). Market data time series are stored in a database and feed to the RiskManagerapplication through DataMetrics which publishes daily price data to the application. The portfolio manager takes the objectives and market information to construct or rebalance the clients accounts. In the past, only performance attribution contributed information to this process. Now, risk attribution enters the picture. Performance is just a part of the whole picture. Results from the portfolio construction process or rebalance are rendered as the account holdings. These portfolios are stored along with their corresponding benchmarks in a database. RiskManager takes the historical price data along with the portfolio and benchmark and measures an accurate picture of the risks being taken. Reports decompose the risks into the security, sector, and country dimensions.
Figure 2
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Relative VaR and Risk Attribution Foundations

Relative Value-at-Risk Objectives
Estimate by how much the current portfolio will under-perform the benchmark. At a given level of confidence (1 standard deviation, 95%, 99%). Over the next horizon period (year). Decompose this number into Country, Sector, and Security levels.
Key advantages of the value-at-risk approach Measures equally well across all asset classes. The value-at-risk methodology is not segmented into asset classes. Unlike risk modeling of the past, equities, fixed income, commodities trading and FX market positions can be combined into the same reporting framework. Uses daily returns for highest accuracy. We have more powerful computers now so well make good use of them. The modeling techniques of twenty years ago constrained us to daily or weekly data. VaR draws upon daily data. Measures equally well for International, Small Cap, Mid-Cap, and Large Cap stocks. The sectors of an individual market dont matter. VaR techniques can combine all markets and rank the risk of every position on an equal basis. Method stays close to the original price data. Draws upon 500,000+ time series. RiskManager draws from a price database of individual equities, FX spot rates, commodity prices, volatility surfaces. Analysis can be done real-time. Assumptions can be revised at any time. With the data always available, any assumption underlying the risk reporting can be altered. The RiskManagerVaR system recalculates numbers from original price data, not an intermediate dataset.
VaR Ingredients Daily price returns of each fundamental risk factor (time series). Risk Factors: The market data, individual equities, FX rates, key fixed income spot rates, futures, and commodities. Apply a decay factor to returns. Give more recent returns more emphasis than old returns. Volatility the standard deviation of market data returns. The calculated value is daily price volatility. Correlations between risk factors. Aggregate distributions to sector and country levels. Equity sectors will follow benchmark standards or may be proprietary sectors. Fixed Income sectors may follow credit ratings or maturity sections of the yield curve.
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Performance Evaluation Triangle
These ideas can be applied to portfolio manager investments compared to benchmarks. Here the position taking talent is security selection, sector allocation, and country allocation for global portfolios. To quote the 1996 RiskMetricsTechnical Document Fourth Edition: To date, trading and position taking talent have been rewarded to a significant extent on the basisof total returns. Given the high rewards bestowed on outstanding trading talent this may bias thetrading professionals towards taking excessive risks. It is often referred to as giving traders a freeoption on the capital of your firm. The interest of the firm or capital provider may be getting out ofline with the interest of the risk taking individual unless the risks are properly measured andreturns are adjusted for the amount of risk effectively taken. To do this correctly one needs a standard measure of risks. Ideally risk taking should be evaluated on the basis of three interlinked measures: revenues, volatility of revenues, and risks. Including estimated (ex ante) and realized (ex post) volatility of profits adds an extra dimension to performance evaluation. The ratio of P&L over risk (risk ratio) and of P&L over volatility (Sharpe ratio) can be combined into what we define as a traders efficiency ratio (estimated risk/realized volatility) that measures an individuals capacity to translate estimated risk into low realized volatility of revenues.
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Applying the Evaluation Triangle to Portfolio Managers

If you were to compare the performance of two portfolio managers without a risk system, you can only examine the history of their respective returns compared to the benchmarks. This process accurately measures their performance and volatility of excess returns, but says nothing about the risks each portfolio manager took to obtain their results. With risk information you can compare the portfolio manager more effectively. The next chart shows the risk ratio, Sharpe ratio, and efficiency ratio for the two portfolio managers over time.
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VaR Calculations start with Risk Factor Returns

We start with an example of AT&T Common Stock. We instruct RiskManagerto locate this time series in its price database. We setup an assumption list, the risksettings, that instruct the application to pull the price series from the most recent date back a certain period of time. We call this the look-back period. This period of time is listed as the time-series dates. For our example, this period is two years. If we examine the returns of our investment over the two year period, we could plot out the distribution of gains and losses. The RiskManagerreport, the portfolio simulated returns report, does exactly this. We can show, in graphical form, the return distribution for our AT&T investment. The graphics module allows us to superimpose the normal distribution on top of the empirical histogram of returns. In addition, we can show the actual mathematical historical distribution of the empirical distribution. The red line is the normal distribution. The blue line is the mathematical density function of the empirical distribution (shown by the green bars).
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Forecast Future Price Changes and Volatility

The next step in the value-at-risk calculation is to forecast price changes:
1. We forecast each of a portfolios underlying instruments future price changes using only past changes to construct these forecasts. 2. Use a random walk model that describes the evolution of price returns. 3. Variance is modeled as a function of past variances as shown below: Pt = + Pt-1 + tt where t = N(0,1) & =0
Forecasting Volatility RiskMetrics uses the exponentially weighted moving average model (EWMA). The latest observations carry the highest weight in the volatility estimate. Following a shock (a large return), the volatility declines exponentially as the weight of the shock observation falls. In contrast, the use of a simple moving average (SMA) leads to relatively abrupt changes in the standard deviation once the shock falls out of the measurement sample. The graph below shows this effect upon returns.
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Decay Factor Controls the Weighting Scheme

The exponentially weighted moving average model depends on the parameter (0<<1) which is often referred to as the decay factor. This parameter determines the relative weights that are applied to past observations (returns) and the effective amount of data used in estimating volatility. What is the appropriate decay factor ?
To answer this question we must explore the impact of various decay factors on the lookback period. In the graph below, the decay factor found to work best for 1-day risk horizons is 0.94. The best decay factor for monthly horizons is 0.97. These empirical values follow research and methods explained in the RiskMetrics Technical Document (1996), Appendix C, pp 243-246. Note that the weight of the daily returns approaches zero in about 80 days for the 0.94 decay and about 130 days for the 0.97 decay factor. We conclude that a longer risk horizon requires a wider look-back period. We need more historical data.
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Decay Factors and Half Life

The half-life is defined as the time taken to reach 50% weighting of returns. As the decay factor approaches equal weighting, or 1.0, the half-life becomes longer and longer. This is shown in the graph on the left where the decay factor is the horizontal and the numbers of trading days to reach 50% weighting are the vertical. The table on the right quantifies the half life in trading days and years for various decay factors. The closer the decay factor approaches 1.0, the higher the half-life and the longer the look-back period for returns is required.
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Trading Days to Reach Time-Weighted Decay Level

Another way of looking at decay factors and look-back periods is to examine the number of trading days to reach a certain level of weighting. The use of a 0.99 decay factor for a one-year risk horizon requires that we use more than one year of returns for our look-back period. Even at the 10% weighting level, we require 229 trading days. We suggest a two year look back period for decay factors of 0.99.
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Applying a Decay Factor to Returns and Estimating Volatility: AT&T Common

Once we can visualize what the decay factor is doing, the next step is to follow a full example on how RiskManagerestimates volatility. The following table is a spreadsheet that records the daily closing prices (column 2) of AT&T Common Stock from Nov 22, 2001 to Nov 22, 2002. The third column is the return being the natural log of prices today over yesterday. If we then apply a 0.94 decay factor to the returns, we see that the oldest returns (above the red line) are extremely small. Returns below the red line are recent and show a much higher weighting. The calculation is explained on pages 14-15 of the Return to RiskMetrics: Evolution of a Standard. The volatility is calculated as: SQRT(sum of rows*(1-decay factor)/(1-POWER(decay factor, M +1))) Download spreadsheet Computation of Daily Returns over Look Back Period Application of the Decay Factor to Weight Recent Data Calculation of Volatility of Weighted Daily Returns Prices P[t] Date 11/22/2001 11/23/2001 11/26/2001 11/20/2002 11/21/2002 11/22/2002 AT&T 34.7065 34.932 35.0755 27.66 28 27.97 LN(P[t]/P[t-1]) Return Log of Returns Number 0.648% 0.410% 1.677% 1.222% -0.107% 1 2 259 260 261 Index [i] 260 259 2 1 0 sum of rows decay^i*r(t-i)^2 4.32413E-12 1.84327E-12 0.000248508 0.000140304 1.14919E-06 1.030% decay factor M t = m+1 0.94 260 261
Source: Return to RiskMetrics (2001) pp 14-15
standard deviation 2.4860% volatility annualized v * sqrt(t) 40.163%
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Aggregate Securities & Sectors

RiskManager calculates the returns for every risk factor in the portfolio and benchmark. For equity portfolios, the individual stocks are analyzed. For fixed income, key spot rates contribute to each cash flow. RiskManager calculates the returns for each key spot rate. For international positions, FX rate returns are also calculated. The next task is to aggregate all the securities into sectors and portfolios. A portfolio return, rp, is a weighted average of continuously compounded returns.
rpt = wirit
i=1
Where w are the weights, r are the log returns across N assets. Aggregation may be done at any level (country, sector, etc.). To illustrate this visually, we aggregate two stocks (LEH and JPM) of 50% weighting into a sector (Capital Markets). The graphics were produced by the RiskManager report Simulated Portfolio Returns histogram. The 50-50 weighting blend was created using the index builder. Normally, the weights are set by investment decisions or by the index weights.
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Correlation of returns
Next, the correlations between position returns are calculated. The positions themselves are weighted combinations of the underlying stock risk factors. Here, we run a RiskManagerreport Portfolio Correlations and Volatilities to compute the correlations between the two stock positions.
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Compute the potential loss over the next horizon period

RiskManager pulls all the information we have already reviewed into a VaRcalculation. The report shows a potential loss of $3,724 for a joint 50% position of $5000 invested in both stocks. The report also shows we are exposed to $2,390 to JPM alone. The level of loss is shown at a given confidence level. Here, we show the loss at a one standard deviation of confidence (or 84.13%). This means that we have a 15.8% chance we could lose at least $3,724 in the next horizon period.
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Measure Losses Relative to a Benchmark

Asset managers must measure the level of potential loss relative to a benchmark portfolio. To do this, we must take the benchmark holdings and negate them. If your investments equaled your benchmark, there would be no tracking error. All positions would cancel. In the chart below, we illustrate the original two security portfolio compared against the Capital Markets sector of the S&P 500 index. If we suppose this sector serves as our benchmark, we note the joint distributions of returns: the long positions of our two stock holdings and the short positions from all stocks in the Capital Markets sector. The benchmark is scaled to match the market value of the portfolio.
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Risk of Under-Performing the Benchmark

For Risk Tracking Error, we are interested in the loss tail of the joint distribution of the portfolio and benchmark. Definitions: Relative VaR: The percentile of excess returns at a certain confidence level. Risk Tracking Error: Special case of relative VaRunder normality assumptions when the confidence level is one standard deviation (84.13%).
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A Word on Mechanics: Performance and Risk Attribution must share Dimensions

Measurement dimensions used in Performance Attribution should be used in Risk Attribution. This is a fundamental requirement for any attribution program. The risk side of the equation must be measured along the same lines as performance. In RiskManager, we call these attributes dimensions. Examples of dimensions we have seen used in risk attribution are: Country Sector Industry Group Asset Class Region Security
Portfolio and Benchmark must share dimensions RiskMetrics uses tags to allow users describe these dimensions. Tags are just text labels of any dimension or category you wish to use and are attached to each investment holding. Each benchmark holding must share the same dimensions of the investment portfolio. In RiskManagersposition import format, RM3D, the tag dimensions would appear as shown below. Here we have an attribution name, a delimiter, and the attribution value.
Portfolio| SP500 |Security|MICROSOFTCORP|Country|US|Sector|Software & Services
Extending this concept to all holdings 1. 2. Lists of portfolio and benchmark holds are formatted in either XML or text. Text is TAB or COMMA delimited in RM3D format.
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Risk Attribution Report and Examples
Tracking Error Definitions

Tracking Error Standard deviation of daily excess returns over a one year time horizon Indicates level of risk in each position Always positive Not additive due to diversification Incremental Tracking Error: Change in risk due to a small change in position size Indicates level of sensitivity of risk to changes in holdings Additive May be negative
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Risk Attribution Reports
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Fully Worked Example: Simple Equity Portfolio

In this example we take a simple portfolio and benchmark containing the same four stocks. In the portfolio, bets are taken at the security level and at the sector level. We examine all the risk attribution calculations in a companion spreadsheet and discuss the Risk Attribution report output straight from RiskManager.
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Sector and Security Investments

The left side of the Risk Attribution report shows the weights of the portfolio and benchmark at both the Sector level and Security level. In addition, the bets taken at all levels are shown. The bet is the simple subtraction of Portfolio Benchmark weights. In the simple equity example of four stocks, we have no bet in General Motors, hence a zero weight. In the same sector of Consumer Cyclical, we have a 5% positive bet in Ford. This set the sector bet to 5% overweight as well. In the systems hardware sector, we are overweight Dell Computer by 10% and underweight IBM by 15%. The net bet for Systems Hardware is -5%.
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Four Equity Incremental Tracking Error

In this section we examine the incremental tracking error and its decomposition. The report follows a bottom-up approach favored by many asset managers. We will walk through the report in a bottom up fashion. This review follows the RiskMetrics Group Working Paper, Risk Attribution, by Jorge Mina (2002). The discussion also follows a spreadsheet replication of the calculations. Download Risk Attribution Spreadsheet Bottom-Up: The Security Selection Level If we examine our investment in Dell Computer where we had a positive 10% bet over the benchmark, we see the following numbers in the Risk Attribution report: Here we have Dell contributing 239 basis points of Security Selection Tracking Error risk. How are these numbers calculated?
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Volatilities, Correlations, and Covariance

We start with return volatilities and correlations of the individual stocks. In this example, we use a Risksetting with a two year look-back period and a 0.99 decay factor along with a 252 trading day analysis horizon. The date rate is August 30, 2000 to August 30, 2002. Running the RiskManager report Market Data Volatilities and Correlations, we obtain the following matrix: Correlation Matrix GM Dell 0.657546907 0.384795582 1 0.489804751 0.489804751 1 0.454240831 0.616614103 Volatility 252d IBM 0.354449447 0.454240831 0.616614103 1 40.80802775% 37.71998490% 50.58543551% 38.33783913%
Ford Ford GM Dell IBM 1 0.657546907 0.384795582 0.354449447
We can transform this information back into the covariance matrix by computing: Correlation of stock A with Stock B * Volatility of Stock A * Volatility of Stock B to obtain the covariance matrix:
Ford Ford GM Dell IBM 0.166529513 0.101214761 0.079433039 0.055453318
Covariance Matrix GM Dell 0.101214761 0.079433039 0.142279726 0.093458756 0.093458756 0.255888629 0.06568789 0.119582211
IBM 0.055453318 0.06568789 0.119582211 0.146978991
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Bets, Gradients and Relative Incremental VaR

If we recall our equity bets, we computed our bet in Dell by subtracting the benchmark weight from the portfolio weight, arriving at the 10% bet. Benchmark Weights Consumer Cyclical Ford Motor General Motors Systems Hardware Dell Computer IBM 19.5596% 8.6619% 10.8977% 80.4404% 28.0522% 52.3882% Portfolio Weights 24.5596% 13.6619% 10.8977% 75.4404% 38.0522% 37.3882% Bets = W vector 5.00% 5.00% 0.00% -5.00% 10.00% -15.00%
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Total Tracking Error and Relative IVaR Equivalence

The sum of the relative IVaRs is equal to the total relative VaR (tracking error) of the portfolio. We can check this in the spreadsheet. Cell G10 is the right hand side of the equivalency equation 34 in the Risk Attribution paper, namely:
wTw
The sum of the relative IVaRs (H9 in the spreadsheet) matches the Total Tracking error of 515bps.
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Sector Allocation Contribution for Systems Hardware

Completing equation 38 in the spreadsheet by combining the Gradient and the Systems Hardware vector as a proportion of the total TE,
and in the RiskManagerreport, the 12bps of Systems Hardware sector allocation risk is shown below. Also shown is the total amount of security selection risk within systems hardware. The next pages show how this is calculated with our example spreadsheet.
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Sector Allocation for Systems Hardware

The sector allocation contribution for Systems Hardware (A) can be calculated as:
AT
(equation 38)
where, for stock s,
A (s) = (PA BA) (BS/BA BS) if S is a member of sector A

and (PA BA)BS if S is out of sector
The portfolio positions for sector A minus the benchmark positions for sector A times the ratio of Benchmark position for stock S to the Benchmark positions for sector A minus the benchmark positions for stock S. Is shown in the spreadsheet, for Dell Computer in Systems Hardware, the sector allocation vector element for Dell,
Systems Hardware (Dell):
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Security Selection Contribution for Systems Hardware

The security selection contribution for Systems Hardware (A) can be calculated as:
AT
(equation 39)
where, for the sector level security selection:
A(s) = (PS BS * PA/BA) if S is a member of Sector A

and 0 if S is out of sector.
for the bottom-up security selection method for stock s (equation 20),
S (i) = (PS BS) * (1 PS/BA) if S is a member of sector A

and 0
vector element for Dell, Dell :
if S is out of sector
Is shown in the spreadsheet, for Dell Computer in Systems Hardware, the security selection
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Security Selection Contribution for Dell and Sector Level

Completing equation 39 in the spreadsheet by combining the Gradient and the Dell security vector as a proportion of the total TE,
and in the RiskManager report, we see the 239bps of security selection risk for Dell.
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Security Selection risk at the Sector Level

At the Systems Hardware sector level, the Security Selection (SS) risk contribution is sum of the SS of the individual stocks (Dell and IBM):
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Constant Portfolio BackTesting TE

There are two types of backtesting: a) constant portfolio and b) historical. In constant portfolio backtesting, we test todays portfolio against many blocks of returns. In RiskManager, we can do this by shifting the window of returns one-month at a time to calculate TE. If we were to use daily or weekly shifts, we could show even more detail. Each block of returns contains varying volatilities and correlations. Here, each block of returns is two years of daily observations.
If we calculate the todays portfolio TE over these multiple blocks of returns and plot the values over time, where each TE is synchronized with the last date in each return block, we show the constant portfolio backtesting of the portfolio.
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Historical Backtesting TE
To perform historical backtesting, users of RiskManager must store account tracking error values on a daily basis. The changes in the portfolio and benchmark will be reflected in the TE numbers. Next, plot the values over time for each account portfolio and compare the TE drift against a risk target. Daily storage of TE values can be accomplished through a batch facility called RMX Server. RMX is orchestrates the process of: a) b) c) d) e) f) Managing multiple accounts and benchmarks. Directing the translation from tab-delimited to RML conversion (Data Translator). Dividing the blocks of accounts into individual calculations (Divider). Managing the calculation process (RiskServer Director) Managing the Risk Attribution report generation (Risk Reports) Storing parsed elements of the calculations in a results database.
It is the results database we can draw upon to plot historical tracking error.
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Drill Down Reporting

Introduction
In the following example, I provide information on how RiskManager can be used to measure the risk of an equity portfolio. To illustrate, I created a fictitious portfolio of North American equities. These equities include blue chip companies, high tech start-ups and small cap issues. With this portfolio, I can show how to create and edit tags and as well as how to incorporate benchmark reporting. I will cover 3 points:
How to edit using the position interface. To illustrate I walk through an example of how to edit a tag value for a position that already exists in our database. How to create reports using tags. Tags provide the capability to divide a portfolio or groups of portfolios into may sectors, regions, strategies etc. In my example, I show how two sets of tags can be used to depict risk concentrations. How benchmarks are created and how they are incorporated into reports. Benchmarks are important to many users as they assess the risk of underperformance relative to another portfolio.
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Review Positions
In my example I have two portfolios, my diversified equity portfolio and a benchmark portfolio consisting of the stocks in the S&P 500. The benchmark portfolio was constructed using the true SIC codes for each instrument. The SIC code is passed to the import file as a nested tag. A nested tag is written with a backslash separator, for example, Consumer Discretionary\Consumer Durables & Apparel. This allows the reports to have multiple levels of drilldowns without specifying each tag separately. Below I have run a sample Multiple Statistics report to make sure I have specified my nested tags correctly. I click on the Expand All arrow and I can see how each position rolls up into an industrial sector. In the report screen below, the Fortune Brands, Inc position is mapped to the Consumer Discretionary\Automobiles & Components\Auto Components\Auto Parts & Equipment industry group. In this case, the Fortunes stock is incorrectly mapped to this SIC code and I need to edit the tag of this position. To do this I return to the position interface screen and search for Fortune Brand
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Edit from the Position Interface

From the Positions screen below, a sorted listing of instruments with Asset Type, Currency, Amount and Unique Name are shown. The default interface has a top link bar: Working with All Positions. I will click on Working with All Positions because I would like to narrow the view to find Fortune Brands, Inc.
Below I clicked on the Working with All Positions link and chosen Select Position View
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Search for a Position

To find Fortune Brands I need to narrow the selection to the S&P Benchmark portfolio. Below the Position View interface is shown and the sample S&P has been highlighted.
My new position interface screen is now defaulting to the positions that comprise the S&P Benchmark portfolio. Fortune Brands, Inc has been highlighted.
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Open a Position for Edit

Now I can open the Fortune Brands, Inc position for edit. Below is the position with the custom dimensions expanded. The user can change the custom buckets for this position by clicking on the edit key.
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Custom Bucket Interface

Selecting the Edit Key will open another window that contains the custom bucket definitions and the current tag values. In my example, I want to change the dimension for the Fortune Brands, Inc. to Consumer Discretionary/Consumer Durables & Apparel/Housewares & Specialties. From the Custom Bucket Definition screen, I drop through the links until I find Houeswares & Specialties. After this has been saved I am ready to rerun my reports.
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Create Reports Using Tags

In the example above we have reviewed our sample report, discovered an error in tagging and changed the tag value of a position. Now, I can run reports using these tags. To do this I return the reports page and click on the top link to create a new report. There are many report types to choose from (show report reference guide), among them are: Credit Exposure Report A report that quantifies by counterparty the change in value of swap or forward positions over a selected time horizon. Histogram VaR Report A summary of VaR by confidence levels. Customizable Table Report The most flexible layout. Select any number of analytics and risk settings in one report. Also users may choose many levels of drill down dimensions or risk settings. Single Statistic Report This is a legacy report which shows one statistic in columns as well as the rows. It can be customized by drill down dimensions. For our portfolio, I will run a Customizable Table Report and a Single Statistic Report. Later, I will review benchmarking functionality using similar report structures. The first report is a single statistic report. The statistic shows Total VaR. A user can see how each strategy is contributing to risk as well as each sector. The Total VaR below is 351,805 USD; the columns show that each strategy contributes approximately the same risk. However, the rows show that the Information Technology sector is contributing more risk than any other sectors. If I run a customizable table report, I can investigate further how the 102,508 USD compares to the sectors PV.
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Single Statistic Report

The first report is a legacy single statistic report. The statistic shows Total VaR. A user can see how each strategy is contributing to risk as well as each sector. The Total VaR below is 351,805 USD; the columns show that each strategy is making approx. the same contribution to risk. However, the rows show that the Information Technology sector is contributing more risk than any other sectors. If I run a multiple statistic report, I can investigate further how the 102,508 USD compares to the sectors PV.
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Customizable Table Report

Below I have created a report that shows present value plus VaR. The last column shows us the PV/Total VaR as a percentage. This is important for this type of portfolio since the portfolios VaR is directly comparable to the PV. Taking a quick look I can see that most of the sectors VaR is between 0-.20% of the sectors present value. Information Technology is clearly higher at .53%. Since Information Technology has historically been more volatile then other sectors, these numbers appear reasonable. However, from this information a client may decide to reduce its positions in Information Technology to reduce that number.
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Create a Benchmark
To compare our diversified portfolio to the S&P benchmark I have create a weighted benchmark portfolio from a percentage weightings available from S&P (see table below). Please note that these weighting are an indication of the S&P weights but are not exact.
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Add Benchmark to a Report

After the positions were complied I saved them to the S&P benchmark portfolio. This portfolio now becomes a choice in the reporting drop down box. I have edited my VaR by Strategy and Industry report to incorporate a benchmark:
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Relative VaR Report

The report below is useful for managers who are tracked against a benchmark. In total the VaR of my diversified portfolio is 29,011 greater than the S&P benchmark. To investigate further I see that although on a total basis the Long-Short and the Relative Value strategies contributed the same amount of risk, on a relative basis the Long-Short strategy is more risky. It is also interesting to note that the Information Technology sector is not a large contributor to Relative VaR as it was to Total VaR. Therefore if a client is measured on a relative basis they would likely want to reallocate some of their portfolio out of the Healthcare sector.
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Fixed Income Statistics in Reports

Fixed Income Report Statistics
RiskManager has many statistics available for Fixed Income Risk Managers. For this example, we will concentrate on how a Fixed Income Desk would use RiskManager to report:
1. Value at Risk and Marginal Value at Risk 2. Duration and Stress Tests 3. Bond Equivalents
The sample portfolio has several strategies to illustrate the above reports. Position types include treasuries, corporate bonds, municipal bonds, mortgage back securities, Brady Bonds and eurodollar futures. This case study will use the customizable table report template to define the report layouts.
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Section 1: Value at Risk and Marginal Value at Risk

The first report is grouped by strategy. We selected only the present value of the portfolio and Monte Carlo VaR at a 95% confidence level. The sum of each strategys individual VaR ($2.4MM not shown) well exceeds the total portfolio VaR ($.96MM column 2 below). This indicates that we have positions that offset or hedge the risk in this portfolio.
Editors note: The sum of all risks by strategy would be the nondiversified risk by strategy for the total portfolio. In this case the difference of$2.4mm - $.96mm, or $0.404mm, is the diversification by strategy for the total portfolio. Note that there is also diversification within strategy (i.e the longs and the shorts reduce risk at the strategy level).
To illustrate how much each strategy is hedging, we will include a marginal VaR statistic. This statistic will tell us what the change in VaR is by excluding each strategy one by one from the portfolio.
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In the above report, the Marginal VaR of each trade has a positive or negative contribution to the overall VaR of the portfolio. If we exclude the strategy DCB-C Bond, the VaR of the portfolio would decrease $420,288. The report below illustrates, total VaR has dropped to $542,394 a decrease of $420,288.
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Section 2: Duration and Stress Tests

Lets add some additional risk measurements. A popular measure of fixed income risk is duration. The idea behind duration is simple. The portfolio below has a 4.4-year duration. Therefore the portfolio's value will decline 4.4% for each 1% increase in interest rates, or rise 4.4% for each 1% decrease in interest rates.
Judging only from this measure, it could be said that this portfolio is less risky than a portfolio with a 10-year duration. That portfolio is going to decline in value 10% for each 1% rise in interest rates.
To illustrate how duration is effected by interest rates, we add a statistic called PVBP Delta and set the basis point change to positive 10. The 10bp shift equals a -$484k change in portfolio present value. Therefore, if interest rates rise, this portfolio will drop in value $484k. The current present value of -$113M multiplied by the duration .0044 equals approximately -$497K. This is comparable with the -$484K calculated by PVBP Delta.
Typically, a fixed income portfolio's duration tends to be positive. However, instruments such as interest only mortgage backed securities (I/Os) have negative durations. In the example below, the duration of the I/0 is offset again a long US Government Bond.
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For this exercise we focused solely on duration, but in a separate sections of our help resources, we also introduce the concepts of contributional duration and underlying duration. These duration statistics are especially useful for portfolios that contain swaps, futures or options.
While duration can be applied in a wide variety of situations, it is limited in that it considers only exposure to parallel shifts in the yield curve. It does not address tilts or bends in the yield curve. Indeed, a portfolio could have no duration exposure, but still have significant yield curve risk. To measure this, RiskManager applies its user-defined stress tests to create other yield curve scenarios. In the following scenario, instead of applying a parallel shift, I shifted only the 3-month rate in the respective curves (labeled 3M rates rise-below). This creates significantly different results for this portfolio. We see an increase in value to $661k as opposed to the drop of $484K. Several of the strategies show positive reactions to this short-term rate hike. If we focus specifically on the TIP instruments, the 10-year TIP has a larger positive shift in value compared to the drop in the 30-year TIP instrument.
In addition to creating user-defined moves in interest rates, stress tests can be used to replay events in history. In the report below, August 1, 1998 through August 30, 1998 was selected as the example stress event. The resulting change in present value was $3.25MM. This is over 3 times larger that a loss occurring during normal market conditions. As illustrated, using only VaR statistics, a portfolio manager could be left unaware of potential exposures. Indeed, in this case the portfolio is quite susceptible to loss during a market crisis.
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Section 3:Bond Equivalents

To illustrate the concept of Bond Equivalents we will deviate from our current example portfolio. It is much easier to understand how and why bond equivalents are useful with a simple portfolio. Here we selected a 10-year zero coupon bond.
Editors note: The use of a reference portfolio can contain any reference security (and even multiple securities). Many times, trading desks use the current 2yr note, fives, or 10s as the reference security. In this example, the author illustrates using a zero as the reference bond.
To create a report, start at the report template below. Select the Bond Equivalents Statistic and the Position Group or portfolio that contains the reference security. Notice in this template, I have selected the Bond Equivalents twice. The first statistic is the multiplier and the second statistic is my asNominal selection. This asNominal result is calculated by dividing the multiplier by the nominal amount of the reference portfolio.
In my simple example, I selected a USD 6% bond maturing in 2015 as my base portfolio. This bond is compared to a zero coupon instrument maturing in 10 years. The result of 1.667 (in the report shown below) is the number of 10yr zero coupon units in the reference portfolio. additional amount of reference portfolio that would be needed to hedge the risk of my 6% bond. The asNominal result of $16,998,366 represents the equivalent face amount the 6% 2015 issue in terms of the 10yr zero. Therefore, my $10M notional position would need to be increased $6.9M to effectively hedge this portfolio. Note that there is no present value scaling done on the reference portfolio. If I were to double my notional in the 6% bond, my bond equivalents would need to double to provide the hedging benefit.
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Applying this theory to our portfolio, our reference notional is $76M. Therefore, our notional would need to increase to $55M (-$132MM +$76M) in order to effectively hedge our portfolio.
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Global Bank
Global Bank Example
The example bank ABC is organized in three levels: corporate, business units, and trading desks. Figure 1 represents the organizational chart of ABC bank. If the format and content of each risk report is to be designed to suit the needs of each organizational level, we must consider the bank's positions and identify each one in a meaningful way, so that reports can be generated at each level, and so that information can be sorted and broken out by security type, by geographic zone, by strategy, etc. We can tag each position with as much meaningful identifying information as necessary. See Tagging. Figure 1
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Historical Simulation
An overview of the Bank's P&L at the corporate level can be gained by running a histogram, using a historical simulation, for the trailing year.
This report shows the Present Value of the portfolio, and the VaRs at 95 and 97 percent confidence ($4,563,883 and $4,901,470, respectively). It also reports on the lower and upper confidence levels of the estimates of the VaRs themselves, which can be important because of the small number (approximately 250) of business days in the one-year interval. This curve of historical observations seems skewed left (negatively skewed), reflecting the actual observed returns for the trailing year. No correlations or covariances are used to calculate this simulation. A historical simulation has the disadvantage of being difficult to scale into the future: it strongly reflects the characteristics of period in question. One may wish to run a Monte Carlo simulation for contrast.
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Monte Carlo Simulation

A Monte Carlo Simulation uses a random number generator to generate scenarios, and fully prices each one. This Simulation predicts variance of the bank's portfolio using the variances and covariances of the constituent securities. Note that the VaR's at 95 and 97 are less extreme than the Historical Simulation.
Again, this report shows the Present Value of the portfolio, and the VaR's at 95 and 97 percent confidence ($3,278,546 and $3,779,834, respectively). The lower and upper confidence bands are much narrower than in the prior (historical) run, because this Monte Carlo run used 1,000 trials. The historical run used only 1 year of data, or approximately 250 daily observations.
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Corporate Level Reporting

At the corporate level, senior management may meet daily or less frequently, and needs a firm wide view of risk. They will typically focus on market risk concentrations across business units, as well as global stress test scenarios. At this level, an assessment of total risk can be gained by running a VaR report at the total level, broken down by business unit. If we click on reports, then "defining and running report" and then "create a new report", we get the following menu:
Choose "Multiple Statistics Report" and the menu below will occur. By selecting the desired statistics (present value at level 1, VaR at level 2, and Marginal VaR at level 3) and selecting Business Unit as the sole dimension, we can generate a useful report.
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Corporate Level Reporting (2)

Our report definition will generate the following report:
We can see from this report that although the bulk of the assets are held by the Fixed Income trading desk (column 1), the main sources of risk are the Fixed Income desk and the much smaller holdings of the Proprietary Trading desk (column 2). In addition, we see that the Global Equity desk is contributing some diversification value, actually reducing the total VaR of the bank by $21,761.91 (column 3). We chose Parametric methodology for each of our VaR statistics. It may be illustrative to also do a separate report using the Monte Carlo Simulation method, to capture the convexity of the fixed income instruments, and any non-linear pricing (such as callable bonds or options). It may also be illustrative to compare the results using the historical simulation methodology, to show the distribution of results from recent periods. These can all be run on separate reports, or new columns can be defined on the existing report to compare them side by side.
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Stress Testing
We may want to augment our reports by running some stress scenarios. If we click on "stress testing" we can use RiskMetrics pre-defined scenarios, or we can define our own. To define a new stress test, click on "Create Stress Test Scenarios" and then "Create New". The choices are historical or user defined. To create a historical stress test, simply select the beginning and ending dates of the period you would like to use. Or click on "user-defined" and the following screen will allow you to define the parameters of a test. Below we have selected every point on the USD Government curve and shifted each one upwards 50 basis points. We have selected a Predictive stress test, so that our movement of the curve gets reflected in all other time series. Once we save this test, we can use it in a report.
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Stress Testing (2)

We can set up a multiple statistic report to compare the effects of several stress tests on one page. The report layout manager template would look like the image below. This report will compare four stress tests, side by side.
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Stress Testing (3)

Here is the output from the previous report definition:
We can see that the bank is most vulnerable to a Gulf War type of scenario, and that the Fixed Income business unit would be most at risk. The parallel shift of the interest rate curve would be disastrous to Fixed Income, however it would be mitigated by the diversifying effect of the Proprietary trading books. We will do a number of reports to investigate these effects, and break this down further.
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Business Unit Level Reporting

Managers at each Business Unit may be interested in another level of reporting. We may want some insight into the Fixed Income desk's holdings. We can run the same VaR report as before, selecting the Fixed Income portfolio instead of All Securities. We change the Dimension (rows) to show Portfolio and Position. Global Bank VaR Report layout
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Business Unit Level Reporting (2)

Here is the output from Global Bank VaR Report:
We can see that the corporate portfolio is the largest contributor of VaR (column 3). If we wish to examine the VaR of the individual holdings, we can mouse-click on a sector to expand the tree.
We can see that the VaR's of the portfolios do not add up to the VaR of the total portfolio for the Fixed Income Business Unit. This is because the total gains some diversification benefit from combining portfolios whose covariance is less than 1. Marginal VaR gives a good indication of which sources of risk are acting as diversifiers.
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Sources of Diversification
Creating a scatter plot of VaR versus Marginal VaR can be a revealing exercise
We can see that in four out of five portfolios (red dots) the VaR and Marginal VaR are in close proportion, but in the Emerging Markets portfolio the ratio of Marginal VaR/VaR is lower. This portfolio is providing diversification. Very often Marginal VaR can be negative, indicating that the position is actually decreasing the total portfolio.
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Portfolio Level Reporting

At the portfolio level, managers will want to break down the risks of the constituents to understand the sources or risk. This report definition uses Incremental VaR, which is additive. Unlike a report of VaR, the columns and rows will add up to the total. This report will show very specific sources of risk, by position.
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Portfolio Level Reporting (2)

The report below shows that $252,551 of the total $880,703 risk comes from FX exposure. In addition, the bulk of this comes from the exposure to the Czek Govt bond.
The bulk of the risk in this portfolio comes from exposure to changes in interest rates. But how would different types of shifts in the interest rate curves effect the value of this portfolio? A series of stress tests will help answer that question.
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Portfolio Level Reporting - Stress Tests

A user can define many types of stress tests. Earlier, we defined a parallel shift in the yield curve. The user is free to construct any hypothetical situation, such as tilts and butterflies in the yield curve. By setting up several of these side by side, one can test the sensitivity to these scenarios. This portfolio would be most vulnerable to an environment of steepening yield curves, and would make money in the event of a "butterfly" movement.
Another useful way of evaluating a fixed income portfolio might be to define 13 separate stress tests, each moving only one point on the yield curve. This would illustrate sensitivity to changes at each individual point on the curve. By testing the various methods of VaR, together with a battery of stress tests, each run at various levels of breakout, we can gain a sophisticated understanding of the exact sources of risk throughout the bank's portfolio. We can also test sensitivities to those risks, and reveal the areas where adjustments or hedging could be used to most efficiently mitigate those risks.
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Analysis of Multiple Strategies

Examples of Common Strategies
Eighteen positions were created and analyzed within RiskManager to test various aspects of the following common portfolio strategies: Bond Strategies a. Bond Arbitrage b. Corporate Spread Equity Strategies a. General b. Technology c. Multi-Class Options a. Convert Arbitrage b. Covered Call Structured a. Eurodollar Hedge b. Swaps Each strategy was designed to illustrate how various risk results depend on data availability, accurate instrument modeling, and simulation-based methodologies. The positions were organized by strategy and then grouped by asset class. Some of the positions are in exchange-traded instruments, some in OTC derivatives, and others in hypothetical instruments whose parameters were chosen to specifically test the kinds of analyses that are typically requested. The import file itself is in industry-standard XML and completely describes each position as well as how the groupings into each strategy are formed. Any system that can read XML should be able to parse and process this information (all the underlying Market Data required would of course have to be available for a complete analysis). For systems not conforming to XML standards the file may instead be opened directly using Internet Explorer (just double-click the file icon after saving the file and navigate the XML tree itself). As you can see the XML tags are quite readable and self-explanatory. RiskManager is capable of a producing results with any combination of drill-down analysis such as by currency, maturity, yield curve, risk type, manager, fund, trader, sector, industry, etc. For the purpose of this exercise we chose to report results for each individual position, grouped into appropriate strategies, and further grouped into asset classes. The following topic pages analyze each strategy in isolation. The report presents various VaR statistics (Standalone, Marginal, Incremental) using various methodologies (Parametric, Historical, and Monte Carlo) for each position. A complete description of each statistic (as well as relevant parameters) are listed at the end of the RiskManager report pages.
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Strategy Case Study Position Import xml

<positions> <bond> <positionName>Long Callable Bond</positionName> <notional>1000000</notional> <currency>USD</currency> <discountCurve>USD Govt</discountCurve> <coupon>5</coupon> <couponFrequency> <semiannual/> </couponFrequency> <maturityDate>20100716</maturityDate> <marketPrice>100.25</marketPrice> <callScheduleList> <callSchedule> <callDate>20000716</callDate> <callPrice>100.5</callPrice> </callSchedule> </callScheduleList> </bond> <convertibleBond> <positionName>Long IBM Convert</positionName> <notional>1000000</notional> <currency>USD</currency> <discountCurve>US Corp All Industry Aa</discountCurve> <coupon>6</coupon> <couponFrequency> <semiannual/> </couponFrequency> <maturityDate>20100716</maturityDate> <faceValue>1000</faceValue> <conversionRatio>9.43</conversionRatio> <equityName>459200101</equityName> </convertibleBond> <bond> <positionName>Long USD Corporate Bond</positionName> <notional>900000</notional> <currency>USD</currency> <discountCurve>USD Swap</discountCurve> <coupon>8</coupon> <couponFrequency> <semiannual/> </couponFrequency> <maturityDate>20100716</maturityDate> </bond> <swap> <positionName>CMT-Fixed Swap</positionName> <receiveLeg> <notional>1000000</notional> <currency>CAD</currency> <paymentType> <float/> </paymentType> <couponFrequency> <quarterly/> </couponFrequency> <referenceCurve>CAD Govt</referenceCurve> <referenceTerm>5Y</referenceTerm> <referenceFrequency> <annual/>
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</referenceFrequency> <resetSpread>50</resetSpread> <discountCurve>CAD Swap</discountCurve> <inArrears/> </receiveLeg> <payLeg> <notional>1000000</notional> <currency>CAD</currency> <paymentType> <fixed/> </paymentType> <couponFrequency> <semiannual/> </couponFrequency> <coupon>5</coupon> <referenceCurve>CAD Swap</referenceCurve> <referenceFrequency> <quarterly/> </referenceFrequency> <discountCurve>CAD Swap</discountCurve> <inArrears/> </payLeg> <maturityDate>20100716</maturityDate> </swap> <bond> <positionName>Short USD Gov't Bond</positionName> <notional>-851614</notional> <currency>USD</currency> <discountCurve>USD Govt</discountCurve> <coupon>8</coupon> <couponFrequency> <semiannual/> </couponFrequency> <maturityDate>20100716</maturityDate> </bond> <equityOption> <positionName>Short Microsoft Call</positionName> <equityName>594918104</equityName> <numberOfShares>-10000</numberOfShares> <strikePrice>66</strikePrice> <optionExpiryDate>20010807</optionExpiryDate> <optionType> <call/> </optionType> <exerciseType> <american/> </exerciseType> </equityOption> <bond> <positionName>Short Non-Callable Bond</positionName> <notional>-1000000</notional> <currency>USD</currency> <discountCurve>USD Govt</discountCurve> <coupon>5</coupon> <couponFrequency> <semiannual/> </couponFrequency> <maturityDate>20100716</maturityDate> <marketPrice>100.25</marketPrice> </bond> <equity> <positionName>Citibank Shares</positionName>
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<equityName>172967101</equityName> <numberOfShares>2040</numberOfShares> </equity> <equity> <positionName>Ford Shares</positionName> <equityName>345370860</equityName> <numberOfShares>4000</numberOfShares> </equity> <equity> <positionName>Short IBM Shares</positionName> <equityName>459200101</equityName> <numberOfShares>-7250</numberOfShares> </equity> <equity> <positionName>IBM Shares</positionName> <equityName>459200101</equityName> <numberOfShares>960</numberOfShares> </equity> <equity> <positionName>Long Lucent Shares</positionName> <equityName>549463107</equityName> <numberOfShares>10000</numberOfShares> </equity> <equity> <positionName>Long Microsoft Shares</positionName> <equityName>594918104</equityName> <numberOfShares>5435</numberOfShares> </equity> <equity> <positionName>Short Nortel Shares</positionName> <equityName>656568102</equityName> <numberOfShares>-8400</numberOfShares> </equity> <equity> <positionName>Long Quebecor A Shares</positionName> <equityName>748193109.TOR</equityName> <numberOfShares>10000</numberOfShares> </equity> <equity> <positionName>Short Quebecor B Shares</positionName> <equityName>748193208.TOR</equityName> <numberOfShares>-10000</numberOfShares> </equity> <moneyMarket> <positionName>Forward 3M Deposit: 100MM</positionName> <notional>100000000</notional> <currency>USD</currency> <discountCurve>USD Swap</discountCurve> <couponFrequency> <quarterly/> </couponFrequency> <compoundingFrequency> <quarterly/> </compoundingFrequency> <coupon>5.6</coupon> <startDate>20080317</startDate> <maturityDate>20080617</maturityDate>
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</moneyMarket> <interestRateFuture> <positionName>Short 70 Eurodollar Futures</positionName> <notional>1000000</notional> <currency>USD</currency> <referenceCurve>USD Swap</referenceCurve> <term>3M</term> <numberOfContracts>-70</numberOfContracts> <futuresExpiryDate>20080317</futuresExpiryDate> <entryPrice>94.4</entryPrice> </interestRateFuture> <groupCustomBucketList> <groupCustomBucket> <customDimensionName>Asset Type</customDimensionName> <customBucketValue>bond</customBucketValue> <positionNameList> <positionName>Long Callable Bond</positionName> <positionName>Long USD Corporate Bond</positionName> <positionName>Short USD Gov't Bond</positionName> <positionName>Short Non-Callable Bond</positionName> </positionNameList> </groupCustomBucket> <groupCustomBucket> <customDimensionName>Asset Type</customDimensionName> <customBucketValue>convertibleBond</customBucketValue> <positionNameList> <positionName>Long IBM Convert</positionName> </positionNameList> </groupCustomBucket> <groupCustomBucket> <customDimensionName>Asset Type</customDimensionName> <customBucketValue>equity</customBucketValue> <positionNameList> <positionName>Citibank Shares</positionName> <positionName>Ford Shares</positionName> <positionName>Short IBM Shares</positionName> <positionName>IBM Shares</positionName> <positionName>Long Lucent Shares</positionName> <positionName>Long Microsoft Shares</positionName> <positionName>Short Nortel Shares</positionName> <positionName>Long Quebecor A Shares</positionName> <positionName>Short Quebecor B Shares</positionName> </positionNameList> </groupCustomBucket> <groupCustomBucket> <customDimensionName>Asset Type</customDimensionName> <customBucketValue>equityOption</customBucketValue> <positionNameList> <positionName>Short Microsoft Call</positionName> </positionNameList> </groupCustomBucket> <groupCustomBucket> <customDimensionName>Asset Type</customDimensionName> <customBucketValue>interestRateFuture</customBucketValue> <positionNameList> <positionName>Short 70 Eurodollar Futures</positionName> </positionNameList> </groupCustomBucket> <groupCustomBucket>
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<customDimensionName>Asset Type</customDimensionName> <customBucketValue>moneyMarket</customBucketValue> <positionNameList> <positionName>Forward 3M Deposit: 100MM</positionName> </positionNameList> </groupCustomBucket> <groupCustomBucket> <customDimensionName>Asset Type</customDimensionName> <customBucketValue>swap</customBucketValue> <positionNameList> <positionName>CMT-Fixed Swap</positionName> </positionNameList> </groupCustomBucket> <groupCustomBucket> <customDimensionName>Strategy</customDimensionName> <customBucketValue>Bond\Bond Arbitrage</customBucketValue> <positionNameList> <positionName>Long Callable Bond</positionName> <positionName>Short Non-Callable Bond</positionName> </positionNameList> </groupCustomBucket> <groupCustomBucket> <customDimensionName>Strategy</customDimensionName> <customBucketValue>Bond\Corporate Spread</customBucketValue> <positionNameList> <positionName>Short USD Gov't Bond</positionName> <positionName>Long USD Corporate Bond</positionName> </positionNameList> </groupCustomBucket> <groupCustomBucket> <customDimensionName>Strategy</customDimensionName> <customBucketValue>Equity\General</customBucketValue> <positionNameList> <positionName>Citibank Shares</positionName> <positionName>Ford Shares</positionName> <positionName>IBM Shares</positionName> </positionNameList> </groupCustomBucket> <groupCustomBucket> <customDimensionName>Strategy</customDimensionName> <customBucketValue>Equity\MultiClass</customBucketValue> <positionNameList> <positionName>Long Quebecor A Shares</positionName> <positionName>Short Quebecor B Shares</positionName> </positionNameList> </groupCustomBucket> <groupCustomBucket> <customDimensionName>Strategy</customDimensionName> <customBucketValue>Equity\Technology</customBucketValue> <positionNameList> <positionName>Long Lucent Shares</positionName> <positionName>Short Nortel Shares</positionName> </positionNameList> </groupCustomBucket> <groupCustomBucket> <customDimensionName>Strategy</customDimensionName> <customBucketValue>Options\Convert Arbitrage</customBucketValue> <positionNameList> <positionName>Long IBM Convert</positionName>
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<positionName>Short IBM Shares</positionName> </positionNameList> </groupCustomBucket> <groupCustomBucket> <customDimensionName>Strategy</customDimensionName> <customBucketValue>Options\Covered Call</customBucketValue> <positionNameList> <positionName>Long Microsoft Shares</positionName> <positionName>Short Microsoft Call</positionName> </positionNameList> </groupCustomBucket> <groupCustomBucket> <customDimensionName>Strategy</customDimensionName> <customBucketValue>Structured\Eurodollar Hedge</customBucketValue> <positionNameList> <positionName>Forward 3M Deposit: 100MM</positionName> <positionName>Short 70 Eurodollar Futures</positionName> </positionNameList> </groupCustomBucket> <groupCustomBucket> <customDimensionName>Strategy</customDimensionName> <customBucketValue>Structured\Swaps</customBucketValue> <positionNameList> <positionName>CMT-Fixed Swap</positionName> </positionNameList> </groupCustomBucket> </groupCustomBucketList> </positions>
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Bond Strategy - Bond Arbitrage

This strategy consists of going long a callable bond and short the same bond but without the embedded call feature. The Present Value of each bond is about $1MM, and the call-price for the callable bond is set to be slightly out-of-the-money. Parametric VaR shows that each bond has about $6600 of risk and combined they offset one another to just $0.34. Monte Carlo and Historical VaR shows that the risk of each bond slightly diverges. More importantly, the offsetting of risk is mostly destroyed---the net Value-at-Risk now being over $4000. The reason is that the call-schedule limits the upside potential for the long bond when interest rates fall but the short bond is not callable and loses much more money. Conclusion: The ability to model a distinct call schedule can be very important. Also, full-valuation simulations models are required to reveal the effects of a call schedule when call-prices are out-of-themoney.
193
Bond Strategy - Corporate Spread

This strategy consists of going long a corporate bond and short a government bond with identical terms and conditions. Both bonds are sized to represent about $1MM of present value (not the same notionals). The models show individual risks of between $6000 and $7000 for each bond separately, and absolute risk differences for each bond separately are between $300 and $500. However the actual net risk for the strategy (bonds evaluated together) is shown to be many times higher at about $3000. This is because corporate yield curves and government yield curves are not perfectly correlated. In fact this results implies the correlation between government and corporate rates must have been approximately 90% during the look-back period. Conclusion: The ability to model bonds using separate yield curves is very important for capturing spread risk.
194
Equity Strategy - General

This strategy consists of about $100,000 worth of three stocks each: Citibank, Ford, and IBM. Separately the risks are between $4000 and $5000. Combined their diversification yields a total strategy risk of about $9000. Note that the Monte Carlo risk is slightly higher than the Historical risk which shows the difference in assuming risk factors are distributed normally (Monte Carlo) versus non-normally (Historical). Also note that the Incremental VaR for IBM is 50% higher than that of Ford though the absolute risks are only 25% apart. Conclusion: The ability to model individual equity time series is very important for capturing accurate diversification benefits.
195
Equity Strategy - Technology

This strategy consists of hedging about $67,000 worth of Lucent shares with and equal dollar amount of Nortel. Though the two stocks both carry between $5000 and $6000 worth of risk (depending on the model metholdology), the net risk of the strategy is a whopping $6000 as well. This shows that even within the same sector correlations can be very low (in this case the correlation implied by these results is only about 0.5). Graphics reveal the low correlation. Conclusion: Individual equity time series are required for accurately capturing risk even when stocks are in the same sector. This is of particular importance when tracking a benchmark by matching sector weights but allowing portfolio managers to choose individual stocks.
196
Equity Strategy - Multi-Class

In this strategy we are long class A shares and short class B shares of the same stock, Quebecor. Though the risk of each class is about $6000, the net risk of the strategy is still $4000 (this implies a correlation of about 80%). Plotting the two time series together reveals that each class generally tracks together but sometimes one will lag behind the other in one direction and then overshoot in the other as arbitrageurs try to trade the differences. Red - Class A shares Blue - Class B shares
Conclusion: Individual equity time series even on the same-stock level is very important for accurate risk measures. Mapping to more general factors would have hidden the true mark-to-market differences that are inherent in the strategy. Even if the strategy were to be held for a long period of time such that these differences were smoothed out, the reporting of monthly or quarterly NAVs would nevertheless be at risk for the full effect of these short-term differences.
197
198
Option Strategy - Convert Arbitrage

In this strategy we are long IBM convertible bonds and short IBM itself. The positions are sized so that the combined sensitivities to equity and interest-rate moves are balanced--Parametric VaR for each being about $37,000. A simple model might show the net risk of the strategy to be zero. However the net Parametric risk is still about $8000 since holding a convertible bond is, of course, not the same as holding the stock itself (interest rate risk is higher and equity risk is lower). The simulation methodologies show even more differences in that the convert has about 10% less absolute risk then does the stock itself. On the other hand the net risk of the strategy under these methodologies is reduced to about $5000. Conclusion: A complete convertible bond model, coupled with simulation-based methodologies, is important to fully understand the risk of these instruments.
199
Option Strategy - Covered Call

This strategy consists of writing a covered call on Microsoft where the positions are sized to be deltaneutral. The Parametric VaR for both the options and the shares themselves are about $18,000 and the net risk of the strategy appears to be near zero. However the simulation-based methodologies reveal quite a different story as the call option is fullyrevalued to show a higher risk of $21,000 for Historical VaR and $23,000 for MonteCarlo VaR (good illustration of the difference between non-normal and normal distribution assumptions). More importantly both simulation-based methodologies reveal a net strategy risk of about $7000---very far from the Parametric result of zero! Conclusion: MonteCarlo and/or Historical simulation methodologies are very important for revealing the true risk of option-based strategies.
200
Structured Strategy - Eurodollar Hedge

In this strategy we have hedged a money-market deposit that starts in 7 years with a short position in Eurodollar futures expiring on the same date in the future. The deposit is for $100MM which might imply that a full hedge would require 100 Eurodollar contracts ($1MM/contract). However the correct hedge ratio for daily (or even quarterly) risk monitoring is shown to be about 70 contracts---the deposit risk being reduced from about $25,000 to just $1,500. Hedging with a full 100 contracts would have resulted in a significant short position rather than a neutral portfolio. The reason why only 70 contracts are required is because exchange-trades futures are markedto-market each day while money-markets deposits are not. Conclusion: Models for futures contracts are important for accurately measuring the risk of these exchange-traded instruments.
201
Structured Strategy - Swaps

This strategy consists of a single CAD Swap in which the holder pays 5% semi-annually in return for quarterly receipts of 50bp above 5-year Canadian Treasury rates. This is a complex instrument involving separate implied cash flows, discount rates, yield-curves, payment schedules, and currency conversions. The CAD 1MM position has a present value of $68,000 and about $3500 of risk. Conclusion: Structured notes require complete models to accurately measure risk.
202
Index
A Arbitrageurs ............................................. 201 B BDT..................................................... 62, 63 Benchmarks .............................. 164, 165, 166 Black76 ............................................... 62, 63 Black-Derman-Toy ...................................... 62 Black-Scholes ............................................. 22 Bond Arbitrage ..................................190, 197 Bond Equivalents ...............................167, 173 Bond Strategies ........................................ 190 Bond Strategy ...................................197, 198 Business Unit Level Reporting..............184, 185 C Callable Bonds .................................62, 63, 64 Caplet .........................................................4 Caps Using Yield-Based Approach ...................4 CDS ............................................................6 Commodities Coverage ..................................2 Convert Arbitrage ..............................190, 203 Corporate Bond Example ............................. 67 Corporate Bond Position............................... 74 Corporate Bond Report Details...................... 72 Corporate Bond Report Preparation ............... 70 Corporate Level Reporting...................178, 180 Corporate Spread...............................190, 198 Covered Call......................................190, 204 Create Reports Using Tags ......................... 161 Create Stress Test Scenarios ...................... 181 Credit Default Swaps .....................................6 Custom Bucket Definition ........................... 160 D Derivative Solutions .................................... 86 Diversification........................................... 186 Drilldowns................................................ 155 Duration ...........................................167, 170 E Edit ......................................................... 159 Equity........................ 2, 16, 17, 18, 19, 20, 21 Equity Option Position ................................. 16 Equity Option PV Report......................... 18, 19 Equity Option PV Report Layout .................... 18 Equity Option Risk Settings .......................... 17 Equity Option VaR Report....................... 20, 21 Equity Option VaR Report Layout .................. 20 Equity Strategies ...................................... 190 Equity Strategy.......................... 199, 200, 201 Eurodollar Hedge ...............................190, 205 European Equity Call Option ......................... 15 European mortgage-backed........................ 114 Excel Historical Simulation................................. 23 Excel ......................................................... 23 F Fixed Income Instrument Coverage.................1 Floors Using Yield-based Approach ..................4 Foreign Exchange Forward position ............... 46 FRN First Coupon Date .................................... 43 Start Date ............................................... 43 FRN........................................................... 43 FRN Case Study.......................................... 34 FRN Interest Rate Sensitivity........................ 40 FRN PV Analysis.......................................... 38 FRN Underlying settings .............................. 37 FX............................................................... 2 FX Forward Example ................................... 44 FX Forward Report Details ........................... 49 FX Forward Risk Settings ............................. 47 G Global Bank ............................................. 185 Global Bank Example ................................ 175 H Historical Returns ....................................... 24 Historical Simulation Excel ...................................................... 23 Historical Simulation ................................... 23 Historical Simulation ................................. 176 I Import .................................................... 191 Incremental VaR....................................... 187 M Mandatory Convertible Bonds ......................... 9 Marginal VaR............................................ 168 MBS Module ............................................... 86 Monte Carlo Simulation ............................. 177 Mortgage Example Position XML ................. 111 Mortgage Example Positions....................88, 90 Mortgage Example Risk Report ................... 112 mortgage-backed securities ......................... 85 mortgages - negative convextiy example ..... 113 O Option Price Calculation ............................... 22 Option Strategy ................................. 203, 204 P Pfandbriefe European Mortgage Bonds ........ 114 Portfolio Level Reporting..............187, 188, 189 Positions Search.................................................. 157 Positions..................................... 69, 155, 156 Positions.................................................. 157 Positions.................................................. 165 Positions.................................................. 175 PV report ................................................... 72 PVBP ....................................................... 170 R Relative VaR ............................................ 166 Repo Transactions ...................................... 13 Report.............................................. 163, 175 Report Statistics ................................ 167, 168 RML .......................................................... 74 S Single Statistic ......................................... 162 Spread Option .......................................25, 30 Stress Testing ............................181, 182, 183 Stress Tests ...................................... 170, 189 Structured Strategy ........................... 205, 206 SwapNote .................................................. 84 Swaps ................................................78, 206 Swaps Instrument Extension ...................79, 80 swaptions .................................................... 3
203
T Tags.................................. 154, 160, 161, 175 U Underlying Duration .................................. 170
X XML ........................................................ 111 xml import example .................................. 191
204

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