I don't think it's either decrease lambda (which would weight recent returns more heavily) nor volatility weight (again if you volatility weight it would scale historical vols by current vol).
I can't remember the other options though.
@Juan B that was the approach I used for that problem.
2 other questions I remembered related to a tail-loss/VaR table:
1. ES 95% is approx equal to VaR 97.5%
2. Over the next 10 days lowest return is 2.59%, new 95% VaR I got ~4%
Yeah for scds it hinders liquidity, negative basis trades were still possible when naked shorts were banned. Negative basis is long the bond and buying protection. Naked short ban only eliminated buying protection without owning the bond...in a negative basis trade you own the bond so it's ok.
In the MBS question, yields are definitely higher because of negative convexity due to the short call option embedded in MBS. As rates fall, borrowers are more likely to prepay so the MBS does not profit as much as a similar treasury security (where there is no prepayment option).
The reason the 'subprime borrowers get prime loans' is incorrect is because prime loans have better terms and rates than subprime. If you gave a subprime borrower prime rates that would be the opposite of predatory lending (ie they should be paying 800bps but only pay 450bps for a prime loan)
The bond option question you need to calculate the risk-neutral probs:
So solve 952.48 = [950 * p + 970 * (1-p)]*1/1.01
P = .4 (probability of ir up move)
Finally, solve for option price: 10 * .6 * 1/1.01 = 5.94
It did say if you priced using log normal. The vol on the equity option would be overstated in log normal vol surface (remember it is a high strike option so market imp vol would be lower) thus I think log normal would overstate the option price because it would use a higher vol than market...
Also I think the exam had a few mistakes from the question developers (someone correct me if they see a problem in the logic below):
1. The MVaR question -- when calculating MVaR as VaR/P * Beta for A and for B, the VaR (which should be portfolio VaR) was different when using A and using B --...
Chouchouc: another question about Lognormal and B&S and IMplied volatility. I marked that "both the equity option and the currency option will be underpriced when we use Lognormal". Is that correct ?
The question said that both an equity call and ccy option were OTM. Equity call out of the...