Blog Week in Risk (ending September 24th)

[David Harper CFA FRM]

New practice questions

• P1.T3.727. Option spread strategies (Hull Chapter 12) http://trtl.bz/2wQGhr0
• P1.T3.728. Option combination strategies (Hull Chapter 12) http://trtl.bz/2wNK7pS
• P2.T7.706. Economic capital http://trtl.bz/2ynFajK
• P2.T7.707. Leverage, liquidity risk, and liquidity-adjusted value at risk (LVaR) http://trtl.bz/2xr8Way

In the forum this week (selected only)

• [P1.T1] An FRM candidate needs to know the relationship between correlation and volatility https://forum.bionicturtle.com/threads/p1-t1-58-portfolio-possibilities-curve-elton.5228/#post-52420
• [P1.T2] Probability terminology in Bayes (prior versus posterior) https://forum.bionicturtle.com/threads/p1-t2-501-more-bayes-theorem-miller.8324/
• [P1.T3] Derivatives are the quintessential leverage instrument, notional is reference rather than principal is invested https://forum.bionicturtle.com/thre...-forwards-futures-hull.4339/page-2#post-52410
• [P1.T3] @Bucephalus asks good questions about the factors that inform the desirability of early exercise http://trtl.bz/2xzcarw
• [P1.T3] Illustration of higher bond convexity as coupon decreases such that zero-coupon bonds have the highest convexity (aside from an an inverse floater which is leveraged) https://forum.bionicturtle.com/threads/convexity-in-hull.4731/#post-52362
• [P1.T4] Is lognormal distribution defined for y = 0? https://forum.bionicturtle.com/thre...-prices-under-gbm-hull.4763/page-3#post-52413
• [P1.T4] Using bond prices to infer forward rates https://forum.bionicturtle.com/threads/p1-t4-205-fixed-income-topic-review.6232/#post-52404
• [P1.T4] How important is stress-testing with respect to the exam? https://forum.bionicturtle.com/threads/stress-testing-jorions-frm-handbook-q26-14-3.6833/#post-52403
• [P1.T4] Thank you @sharman.jamie for noticing that I mispoke about a Black-Scholes assumption https://forum.bionicturtle.com/thre...-p1-t4-valuation-risk-models.8757/#post-52390
• [P1.T4] Tuckman’s replicating portfolio is non-trival https://forum.bionicturtle.com/threads/p1-t4-11-treasury-strips-tuckman.4898/page-2#post-52360
• [P2.T5] Bin width and confidence interval of VaR quantile https://forum.bionicturtle.com/threads/confidence-interval-for-var.9298/
• [P2.T5] An Excel illustration of bootstrapping https://forum.bionicturtle.com/threads/dowd-chapter-4-non-parametric-bootstrapping.9340/#post-52412
• [P2.T5] What is asymptotic dependency? https://forum.bionicturtle.com/threads/l2-t5-85-tail-dependence-dowd.3849/
• [P2.T5] Can anybody help with great question by @onion: Doesn’t the default risk charge (aka, IDR) in FRTB overlap with the CVA charge? https://forum.bionicturtle.com/threads/counterparty-credit-risk-in-frtb-and-cva.10723/
• [P2.T5] My view is that the Vasicek is an equilibrium model https://forum.bionicturtle.com/threads/tuckman-equilibrium-vs-arbitrage-free.7249/
• [P2.T6] Impact of default correlation on first to default (1TD) CDS basket spread https://forum.bionicturtle.com/threads/first-to-default-put-crouhy.10728/
• [P2.T6] Impact of funding cost on CDS-bond basis https://forum.bionicturtle.com/thre...-cds-and-credit-spread-curve.7801/#post-52369

Banking and Regulatory (including BIS)

• The Fed, a Decade After the Crisis, Is About to Embark on the Great Unwinding (wsj.com) http://trtl.bz/2wQQBiH
• The great unwind begins http://econbrowser.com/archives/2017/09/the-great-unwind-begins “The Federal Reserve announced today that it will begin reducing the size of its balance sheet next month in very modest and deliberate steps. One reason the Fed is moving so slowly is that they don’t want a repeat of the May 2013 taper tantrum, in which a surprise hint that the Fed might slow the rate at which it would be growing its balance sheet led to a spike up in long-term interest rates. But there may also be another reason why the Fed is contracting its balance sheet so cautiously.”
• [BIS] Basel III definition of capital - Frequently asked questions (FAQ) https://www.bis.org/bcbs/publ/d417.htm
• Banking remains far too undercapitalised for comfort (Leverage ratios closer to 5:1 will help give creditors confidence in liabilities) https://www.ft.com/content/9dd43a1a-9d49-11e7-8cd4-932067fbf946

International

• How Venezuela went from a rich democracy to a dictatorship on the brink of collapse (The government’s response to economic crisis is reshaping the nation) https://www.vox.com/world/2017/9/19/16189742/venezuela-maduro-dictator-chavez-collapse “The country entered a deep recession in 2014 spurred by the drop in global oil prices, and cumbersome regulations on its currency are helping produce record-breaking inflation. The International Monetary Fund estimates that prices in Venezuela are set to increase more than 700 percent this year. Seventy-five percent of the country’s population has lost an average of 19 pounds of bodyweight between 2015 and 2016 due to food shortages throughout the country.”

Technology, including FinTech and Cybersecurity

• We’ve Been Breached: Inside the Equifax Hack (The crisis has sent shock waves through the industry, spooked consumers and sparked investigations) https://www.wsj.com/articles/weve-been-breached-inside-the-equifax-hack-1505693318
• Crisis of the Week: Equifax Hit With Massive Reputation Breach http://trtl.bz/2jYJYdc “Just terrible. Equifax’s public response to its breach affecting 143 million Americans remains one of the worst yet, serving only to exacerbate the crisis–and the company took over a month to plan it. It made pretty much every crisis communications gaffe in the book, systematically destroying public trust with every move,” says Davia Temin, CEO of Temin and Co.
• [GARP] Signs of Acceptance and Maturity for the FAIR Model http://trtl.bz/2fjfjBP The FAIR model is briefly explained in this blog post https://www.risklens.com/blog/the-fair-model-in-90-seconds (for much more detail see http://trtl.bz/2hrt7LA)

Data science (primarily R), including Alternative Data

• Selling data to feed hedge fund computers is one of the hottest areas of finance right now https://qz.com/1082389/quant-hedge-...rnative-data-in-pursuit-of-an-investing-edge/

Books etc

• A First-Class Catastrophe: The Road to Black Monday, the Worst Day in Wall Street History http://amzn.to/2y22Ii2
• Latest issue of Exposure http://www.rms.com/blog/2017/09/22/exposure-magazine-essential-insight-for-changing-times/

Enterprise risk management (ERM) including Governance

• How well did COSO address comments on the ERM draft? (by Norman Marks) https://normanmarks.wordpress.com/2017/09/22/how-well-did-coso-address-comments-on-the-erm-draft/

Case Studies and Companies, including Strategic or Reputation risk

• Heavy Debt Crushed Owners of Toys ‘R’ Us https://www.wsj.com/articles/heavy-debt-crushed-owners-of-toys-r-us-1505863033; and Bain, KKR, Vornado Suffer Wipeout in Toys ‘R’ Us Bankruptcy http://trtl.bz/2fqhhEk

Risk Foundations (FRM P1.T1)

• On Complacency | Why Risk Management Always Matters https://www.commonfund.org/2017/09/14/post-on-complacency-why-risk-management-always-matters/ “Don’t let widening spreads, struggling banks or investment manager fraud be your impetus for thinking about risk. Risk is cyclical. Ironically, complacency in risk management is itself a cyclical risk. The longer that a benign period persists, the greater and nearer the risk of taking your eye off the ball becomes.”

Quantitative Analysis (FRM P1.T2)

• Six Common Probability Distributions every data science professional should know https://www.analyticsvidhya.com/blog/2017/09/6-probability-distributions-data-science/ Bernoulli, Uniform, Binomial, Normal, Poisson, Exponential
• The Lie of Averages https://blog.thinknewfound.com/2017/09/the-lie-of-averages/

Financial Markets and Products, including Interest Rates, Commodity Risk, and Foreign Exchange (FX)(FRM P1.T3)

• To hedge (or not to hedge) currency moves https://www.blackrockblog.com/2017/09/21/hedge-currency-moves/
• Insurance companies: amplifiers or the white knights of financial markets? http://trtl.bz/2wQB3LJ

Market risk, including Equity Risk (FRM P1.T5)

• Ep. 28: Larry Summers on Macroeconomics, Mentorship, and Avoiding Complacency https://medium.com/conversations-wi...-blog-secular-stagnation-twitter-421a69ed84c8 “Second, the VIX — people tend to underappreciate this. The volatility of the market moves very much with the level of the market. The reason is that if a company has $100 of debt and $100 of equity, and then the stock market goes up, it’s 50/50 levered. If the stock market goes up by $100, then it has $100 of debt and $200 of equity and it’s only one-third levered. So when the stock market goes up, its volatility naturally goes down. And the stock market has gone way up over the last 10 months. That’s a factor operating to make its volatility go significantly down.” This is the same leverage effect mentioned by Hull as one possible explanation for the implied volatility skew observed for equities.

Credit risk (FRM P1.T6)

• [GARP] Whitepaper: Counterparty Credit Risk in IR and FX Swaps http://trtl.bz/2wQKbA0

Investment risk, including Pensions (FRM P1.T8)

• Wall Street’s Newest Puzzle: What Passive Buying and Selling Means for Individual Stocks (wsj.com) http://trtl.bz/2hmI4SG ETF ownership as a factor

Current issues (FRM P2.T9)

• 10 Years after Northern Rock – is the UK more or less likely to see another bank run? https://bankunderground.co.uk/2017/...-more-or-less-likely-to-see-another-bank-run/ Northern Rock was previous an FRM current issue case study
• The Next Financial Crisis (Long-Term Asset Return Study) by Deutsche Bank http://trtl.bz/2xCisr6 This study is getting some good press

 

[David Harper CFA FRM]

I wanted to briefly draw attention to the Larry Summers interview link above (https://medium.com/conversations-wi...-blog-secular-stagnation-twitter-421a69ed84c8 ) because, as noted, he's consistent with (one of) John Hull's narrative explanations for the equity implied volatility skew. This has been a point of debate over the years in this forum, with not everybody (including me) agreeing that it is so quite so obvious. Most of us are familiar with the idea that increasing financial leverage (i.e., debt service) to boost EPS and/or ROE which reduces net income, and this should cause earnings to become more volatile (so that stock prices driven by EPS changes ought to be more volatile as leverage increases). But these are different versions of financial leverage: it isn't exactly the same to increase leverage by increasing debt, as it is to increase leverage by have the share price (equity market capitalization) decrease.

In any case, I did notice that Hull's longstanding explanation given in the 9th edition (but this same text was used previously):

Hull (9th Ed): "The Reason for the Smile in Equity Options: One possible explanation for the smile in equity options concerns leverage. As a company’s equity declines in value, the company’s leverage increases. This means that the equity becomes more risky and its volatility increases. As a company’s equity increases in value, leverage decreases. The equity then becomes less risky and its volatility decreases. This argument suggests that we can expect the volatility of a stock to be a decreasing function of the stock price and is consistent with Figures 20.3 and 20.4. Another explanation is ‘‘crashophobia’’ (see Business Snapshot 20.2)."

... has been improved in the newest 10th edition (this 10th edition, which I have been using otherwise contains disappointingly very few changes at all):

Hull (10th Ed): "The Reason for the Smile in Equity Options: There is a negative correlation between equity prices and volatility. As prices move down (up), volatilities tend to move up (down). There are several possible reasons for this. One concerns leverage. As equity prices move down (up), leverage increases (decreases) and as a result volatility increases (decreases). Another is referred to as the volatility feedback effect. As volatility increases (decreases) because of external factors, investors require a higher (lower) return and as a result the stock price declines (increases). A further explanation is crashophobia (see Business Snapshot 20.2). Whatever the reason for the negative correlation, it means that stock price declines are accompanied by increases in volatility, making even greater declines possible. Stock price increases are accompanied by decreases in volatility, making further stock price increases less likely. This explains the heavy left tail and thin right tail of the implied distribution in Figure 20.4."