Blog Week in Risk (August 26th)

[David Harper CFA FRM]

Welcome to our newly upgraded forum, we hope you like it! (did you notice that it's faster? among other advantages ....)

New Practice Questions

• P1.T4.814. The lognormal property of stock prices and the assumptions of Black-Scholes-Merton (BSM) https://trtl.bz/2P8G9fV
• P2.T7.807. Estimating liquidity-adjusted value at risk (LVaR) (Dowd) https://trtl.bz/2PcNSdd

New YouTube

• US T-bond futures conversion factor (CF, FRM T3-25) https://trtl.bz/2wopCwT
• US T-bond futures cheapest to deliver (CTD, FRM T3-26) https://trtl.bz/2whfbMb

In the Forum This Week (selected only)

• [GARP] How long does it typically take GARP to verify work experience? https://trtl.bz/2NjA3sO
• [GARP] An interesting revision (from 2015 to 2018) in a VaR mapping question https://trtl.bz/2P5GPTi
• [FRM] Terrific attention to detail by @pengfrm catching an error in Saunders' EOC practice question 13.10 https://trtl.bz/2NhVRVK
• [P1.T1] Bowing to pressure I attempted to illustrate/interpret Crouhy's economic versus accounting earnings example https://forum.bionicturtle.com/threads/economic-earning-accounting-earning.10625/
• [P1.T1] If you only know one calculus rule, make it the power rule https://trtl.bz/2P5BThe
• [P1.T1] Going deep trying to understanding Long Term Capital Management's (LTCM) LIBOR/T-bond repo trade https://forum.bionicturtle.com/threads/l1-t1-54-long-term-capital-management-ltcm-allen.3587/
• [P1.T2] Thank you @Vinobe for insightful conversation about integral versus anti-derivative of a probability density function (pdf) https://trtl.bz/2NkGKdU
• [P1.T2] Key features of a probability matrix https://trtl.bz/2Nn4fTI
• [P1.T3] Why it's an important concept that "hedging often leads to a WORSE outcome" https://forum.bionicturtle.com/threads/p1-t3-707-hedging-versus-speculation-hull-chapter-1.10530/
• [P1.T3] Interesting USDMXN FX futures margin account question https://forum.bionicturtle.com/threads/help-with-margin-account.14079/
• [P1.T3] The total basis change, ΔB = ΔS - ΔF is the sum of expected basis change (which is the hedge's intention) plus unexpected basis strengthening or weakening https://trtl.bz/2P7qrlc
• [P1.T3] Thank you Adele (@a.bologna295) for catching my contango/backwardation typo https://trtl.bz/2NiMWmM
• [P1.T3] Can two individuals trade a forward contract? https://forum.bionicturtle.com/threads/concept-of-forward-and-future-contracts.10245/
• [P1.T3*] An usual (for the FRM) but interesting hedge question https://trtl.bz/2wdLfRe
• [P1.T3*] Pension benefit calculation https://trtl.bz/2wdM9x6
• [P2.T5] Static versus dynamic value at risk (VaR) https://forum.bionicturtle.com/threads/market-risk-calculation-and-interpretation.14073/
• [P2.T5] Explaining Jorion's Figure 6-3 which illustrates a Type 2 error https://forum.bionicturtle.com/threads/jorion-chapter-6-figure-6-3.14080/
• [P2.T5*] What is the easiest way to calculate the expected shortfall (ES) of a portfolio of 20 stocks? https://trtl.bz/2P7FF9T
• [P2.T5*] Contrasting behavior of junior versus senior tranche with respect to default risk https://trtl.bz/2wcVFjM
• [P2.T5] Vasciek model https://forum.bionicturtle.com/threads/vasciek-model.13921/
• [P2.T6*] What is the impact of wrong-way counterparty risk on CVA? https://trtl.bz/2P86wmf
• [P2.T8] The counterintuitive concept behind a good question by Schweser about factor theory https://forum.bionicturtle.com/threads/question-from-schweser-62-factor-theory.14081/

External

Economics and world

• Investing in a Geopolitical Age https://blogs.cfainstitute.org/investor/2018/08/24/investing-in-a-geopolitical-age/ "Five years ago, the primary topic was monetary and central bank policy. Now the conversation has shifted to tax policy and what’s happening on the fiscal side with discussion on government budgets in the US and other countries. The second new topic of discussion has been the importance of geopolitical risk."
• The Hutchins Center Explains: The Phillips Curve https://trtl.bz/2Nax7yD
• America First Risks Making U.S. Assets a Costly Last Resort https://trtl.bz/2LiDOwO

Banks

• At Heart of New Fed Debate: Bonds or Bills? https://trtl.bz/2BufKax
• Attacking the cost of cash https://www.mckinsey.com/industries/financial-services/our-insights/attacking-the-cost-of-cash
• A Messy Battle Brews in the Options Market https://www.wsj.com/articles/a-messy-battle-brews-in-the-options-market-1534939201
• National Bank Charters for Fintech Firms https://corpgov.law.harvard.edu/2018/08/22/national-bank-charters-for-fintech-firms/
• Lenders Shunned Risky Personal Loans. Now They’re Competing for Them https://trtl.bz/2MMRULM
• Financial firms are increasingly giving away their services for free https://trtl.bz/2wcRB3g
• Climate
• Behind Most Wildfires, a Person and a Spark: We Bring Fire With Us https://trtl.bz/2Bvp5ix Humans are the peril, climate change is the hazard
• Arctic’s strongest sea ice breaks up for first time on record https://trtl.bz/2w7RZjk
• Extreme weather is triggering climate despair https://trtl.bz/2P2y4tk

Cyber and data science

• The Untold Story of NotPetya, the Most Devastating Cyberattack in History https://www.wired.com/story/notpetya-cyberattack-ukraine-russia-code-crashed-the-world
• Media Coverage of Bitcoin Is Still a Total Disaster https://trtl.bz/2wejnMS
• After the Bitcoin Boom: Hard Lessons for Cryptocurrency Investors https://trtl.bz/2BtTjlV Greed + FOMO
• How Crowded Are Tech Stocks? https://blogs.cfainstitute.org/investor/2018/08/20/how-crowded-are-tech-stocks/
• Airbn Has Implemented Smart Property https://trtl.bz/2LnMsdm
• Machine Learning and AI Foundations: Classification Modeling (lynda.com) https://trtl.bz/2MAnjkr
• A Guide to Machine Learning in R for Beginners: Logistic Regression https://trtl.bz/2wcDRW0
• The top data structures you should know for your next coding interview https://trtl.bz/2NgMe9L

Quantitative

• Materials for Teaching Applied Statistics https://trtl.bz/2BB2l0e Wonderful resource, this teacher's "dedication and energy are apparent in the materials"
• Exploring correlations in R with corrr https://drsimonj.svbtle.com/exploring-correlations-in-r-with-corrr This is such a cool package that simplifies correlation analysis
• Pearson’s Correlation, Linear Regression, And Why ‘Beta’ Grossly Underestimates Portfolio Sensitivity To Market Returns https://trtl.bz/2Na892p This article explains relationship that are fundamental (useful) in the FRM P1.T2 and P2.T6
• Transforming skewed data https://trtl.bz/2LgWrkx
• Power Law, Broccoli, and Billionaires (medium.com) https://trtl.bz/2P5gSTY "Scale invariance is also a defining feature one of the most important mathematical functions in modern society — power law."
• Understanding Probability Theory with Dungeons and Dragons (Chapter 1: Independent Events & The Binomial Distribution) https://trtl.bz/2P4zcg6

Risk/FRM

• [GARP] How Will CECL Perform in a Typical Recession? https://trtl.bz/2NhWePP
• Fraud management: Recovering value through next-generation solutions https://trtl.bz/2Na9rdE
• Two notions of fungibility http://jpkoning.blogspot.com/2018/08/two-notions-of-fungibility.html

Investing

• Paul Singer, Doomsday Investor https://trtl.bz/2BuM39r
• JPMorgan Offers Free Trades, Accelerating a Pricing War https://trtl.bz/2w5laUc
• Don’t Be Fooled by the Yield Curve (Laurence Seigel) https://trtl.bz/2NafkHO
• Taking Stock: Share Buybacks and Shareholder Value https://corpgov.law.harvard.edu/2018/08/19/taking-stock-share-buybacks-and-shareholder-value/
• What Does the Longest Bull Market Mean? A Debate https://trtl.bz/2LmowqF I think this is a useful conversation with a good conclusion.
• Dear Investor, That Cocky Voice in Your Head Is Wrong https://www.wsj.com/articles/dear-investor-that-cocky-voice-in-your-head-is-wrong-1535108459

Other

• CPAs Fight to Protect Part of Their Turf https://trtl.bz/2BucuMf "Caught in the crossfire: companies that more than ever need specialists to help assess hard-to-value assets, like brand names and customer relationships …"
• Gen Z Is Set to Outnumber Millennials Within a Year https://trtl.bz/2vXq1XF Here is the Deloitt Millennial [and Gen Z] Survey 2018 https://trtl.bz/2w5ktu4
• Who Killed Toys ‘R’ Us? Hint: It Wasn’t Only Amazon https://www.wsj.com/articles/who-killed-toys-r-us-hint-it-wasnt-only-amazon-1535034401
• As Veterinary Bills Add Up, More Pet Owners Opt for Insurance https://trtl.bz/2MIgrSb Only 1.0% of dogs and cats are insured but that's $1.0 billion in premiums (+23% YoY)

 

[kate18233]

Would appreciate if the demonstration can be given by using financial calculator instead of excel. For example, to obtain the chapter 6 conversion factor, could you demonstrate how to obtain the PV +0.25 = 125.83 by using financial calculator?

 

[Nicole Seaman]

Would appreciate if the demonstration can be given by using financial calculator instead of excel. For example, to obtain the chapter 6 conversion factor, could you demonstrate how to obtain the PV +0.25 = 125.83 by using financial calculator?

Hello @kate18233

Can you please be more specific about which link you are referring to? If it is one of our forum links that are listed above, please comment directly in that forum thread.

Thank you,

Nicole

 

[David Harper CFA FRM]

@Nicole Seaman I think @kate18233 refers to (Hull's Chapter 6) the calculation of a US Treasury bond conversion factor, because simultaneously a similar comment was left at this youtube video, see below

We don't currently have calculator videos planned. If the 2019 syllabus does not significantly change (wink wink), then we could add a path of calculator-specific videos ...

 

[kate18233]

Hi David, thank you for your quick response. I have figured out the calculation, am quite new to the financial calculator so would appreciate if there is a video that shows essential calculator skills for the exam. Nevertheless, I don't understand why in the (if three) full price (PV) T0 which is around $121.832 + 0.25 where excel indicates is 8% x (100/2) =4 so make it up to total of 125.832. Why it is not 8% x 100 x 3/12 for the second part if i understood the calculation correctly? Thank you.

 

[David Harper CFA FRM]

Hi @kate18233 It's tricky because the coupon is given by 8%*100/2 = $4.00 coupon every six months, but 3/12 is the amount of time from today to T(0) + 0.25 and if the yield is 6.0% per annum with semi-annual compounding then we compound a full price forward three months with PV*(1+6.0%/2)^(2*3/12) per FV = PV*(1+y/k)^(k*T). So i think this is just a matter of distinguishing the coupon cash flow from compounding.

The reason that Bond #2 is harder to price is that it rounds to 18.25 (nearest 3 months). The calculator cannot, to my knowledge, price the semi-annual bond at 18.25 because it is between coupons; it can price at 18.0 years (ie, 36 semiannual periods) or 18.5 years (ie, 37 semiannual periods). So the displayed 125.832 at T0 + 25, in excel, is simply adding the $4.00 coupon received "immediately" at T0 + 0.25 years to a 18-year bond that starts receiving $4.00 coupons six months later. By combining the two components (immediate coupon plus "standard" in arrears 18-year bond), it prices a 18.0 year bond but with an "extra" coupon paid immediately. Then the next step discounts this price to T0 with $125.832/(1+6%/2)^(0.25*2) = $123.986.

My excel replicates Hull's approach and the calculator approach to the same is:

• Price of 18.0 year bond: 36 N, 3 Y, 4 PMT, 100 FV and CPT PV = -121.8323, but being mindful this is the price of a "standard bond" that pays the first coupon six months later, so this price omits the first actual coupon....
• When in fact, we are pricing the PV in + 0.25 years, where a coupon is paid immediately, which is not included in the -121.8323. so we need to add the $4.00 semi-annual coupon such that price is -125.8323.
• Then finally we discount this from T0 + 0.25 to T0 to get 123.986

Alternatively, to reinforce an understanding, we can price this bond as of T - 0.25 years; i.e., three months back in time! At that time, it was an 18.5 year bond which can be priced:

• Price of 18.5 year bond: 37 N, 3 Y, 4 PMT, 100 FV and CPT PV = -122.1672 (there is no need to add an extra coupon in this scenario!)
• Now we can compound this bond forward six months, from T0 - 0.25 years to T0 + 0.25 years, with 122.1672*(1 + 0.060/2)^(0.5*2) = 122.1672*(1 + 0.060/2) = $125.83. Notice equivalance!
• But we didn't need to go that far, we could have just compounded to today with 122.1672*(1 + 0.060/2)^(0.5) = $123.986. You see how we can use the calculator on coupon dates (e.g., N = 36, 37) but not really between (N = 36.5). I hope that helps!

 

[kate18233]

Hi @David Harper CFA FRM, thanks so much for the detailed explanation. I appreciate and it helps a lot.