P2 Focus Review 1st of 8 (Market Risk)

Discussion in 'David's Notebook' started by David Harper CFA FRM, Aug 7, 2012.

  1. David Harper CFA FRM

    David Harper CFA FRM David Harper CFA FRM (test) Staff Member

    About the Part 2 (P2) Focus Review
    We are dividing the Part 2 (P2) 2012 Focus Reviews into eight (8) brief videos. Part 2 will sequence like this:
    1. Market Risk (implied volatility , exotics, single-factor FI sensitivities, MBS)
    2. Market Risk (Jorion on VaR, Dowd beyond VaR)
    3. Credit Risk
    4. Credit Risk
    5. Operational Risk
    6. Basel II/III
    7. Investment Risk
    8. Current Issues
    P2 review, 1st of 8 (first Market Risk): Video, Practice Questions, and Learning spreadsheets
    The video is here at http://www.bionicturtle.com/how-to/video/2012.p2.-focus-review-1/

    We've also revised the Practice Question (PQ) sets that accompany Market Risk. For this first Market Risk Focus Review, the following four Practice Question sets apply:
    • P2.T5. Hull, Chapters 19 & 25
    • P2.T5. Tuckman, Chapters 6, 7, 9 & 21
    • P2.T5. Veronesi, Chapter 8
    • P2.T5. Fabozzi, Chapters 1, 2 & 10
    If you are using the learning spreadsheets, there are five learning XLS associated with these topics (T5.b.1. Tuckman Yields; T5.b.2. Tuckman Durations; T5.b.3. Key Rate Shift; T5.b.4. Tuckman Term Structure; T5.b.5. Veronesi MBS). However, if you want to limit your review, I recommend only two as essential:
    • T5.b.2. Tuckman Durations (because single-factor sensitivities are highly testable in P2, like they were in P1). If you can comprehend all of this (relatively small) 5.b.2. spreadsheet, I would venture to say that you know most of what you need from these Tuckman chapters.
    • T5.b.5. Veronesi MBS (because it probably is easier to "see" the model rather than try to follow the word description. Veronesi's MBS text pretty much is an elaboration on his MBS valuation model).
    Concepts in P2, 1st of 8
    I parsed this Focus Review, which again is only the first part of Market Risk, into the following four areas:
    • Volatility smiles
    • Exotic options
    • Bond sensitivities (single, multi-)
    • MBS (Veronesi, Fabozzi)
    Volatility smiles
    This Hull chapter is only about implied volatility, in contrast to historical volatility captured by moving average (simple standard deviation), GARCH and EWMA. That means a traded option price is required and the y-axis is implied volatility; i.e., the volatility implied by the traded price, such that, if we input the implied volatility into Black-Scholes the model's output price would match the observed market price. In short, implied volatility is the value we find to get the BSM modeled output price to match the observed market price. In the focus review, I boiled this down to the two things that really matter exam-wise:
    1. What the smile or skew (i.e., the lack of a flat line) say about the relative implied volatilities of ITM/OTM/ATM calls and puts
    2. What the smile or skew says about the implied asset price distribution. This is basically the theme of Hull's chapter on implied volatility: BSM assumes a lognormal price distribution, and that we observe an implied volatility skew/smile can be interpreted as the market's belief that the the price is not lognormal (put another way, that log returns are not normal). Keep in mind that higher implied volatility on the left (right) implies heavier tails on the left (right).
    Exotic options
    My view is that you need to deliberately take three or more full study passes through this material. First, you want to grasp the basic MECHANICS of the essential exotics; e.g., how does a barrier option work. But okay, the FRM generally will query a level deeper, so the second and subsequent passes might utilize the practice questions to gain a familiarity with the PERSONALITIES and RISK ATTRIBUTES of the exotics. As I mention in the focus review, there are a few common TRAITS (dimension) that tend to be queried:
    • As options are volatility instruments, what is the option's relationship to volatility? For example, the chooser is long volatility, like the straddle (the chooser is the exotic, the straddle is the combination of two vanilla options).
    • Does the exotic have unique Greek characteristics? For example, the vega of a barrier option can become negative (wow!); why is an Asian option easier to delta hedge?
    • What is the impact of increasing/decreasing the frequency of observation, if applicable? For example, if we increase observation frequency, what is impact on a lookback or Asian option?
    • Is the option path dependent? (famous test question!)
    Bond sensitivities (single, multi-)
    Here's the reality of the three assigned Tuckman chapters, from an exam standpoint only: they are progressively more difficult and less testable. The final (Science of Term Structure) is quite dense but, historically at least, has been tested only superficially. It's an important topic in bond pricing generally (outside the exam), but you don't want to skip other FRM topics because either Chapter 7 (key rates) or Chapter 9 (Term structure) are slowing you down.
    • Single-factor sensitivities: get very comfortable with durations, DV01, and convexity, much of which overlaps with P1. The most important difference here in P2 is that you want to be sufficiently comfortable with DV01 and dollar duration such that you can perform hedging calculations.
    • Key rates: it's probably enough to have a superficial understanding. Why is it? (it's multi-factor, so we can overcome the unrealistic assumption of parallel yield curve shift) How does it work basically? The one additional thing here, that i would understand, is how KR01 and key rate durations are analogous to DV01 and duration.
    • Term structure: understand the logic of the binomial tree, which is similar to Hull's binomial tree for option pricing (except here the underlying risk factor is a mean reverting interest rate rather than a stock price). The FRM historically has mostly, if not almost exclusively, tested one idea here: the calculation/meaning of the risk-neutral probability (p). To my knowledge, much of the depth in Chapter 9 has yet to be tested (such that I requested it be removed last year); this whole chapter historically has been borderline optional w.r.t the exam.
    MBS (Veronesi, Fabozzi)
    As GARP introduced new MBS chapters, going from one to four, we should expect MBS questions. Here's what I think is especially important:
    • Prepayment dynamics (ie.g., what are the causes of prepayment) and the fact that prepayments are the embedded option that creates the unique negative convexity in an mortgage/MBS
    • The PSA model (i.e., 200% PSA doubles the baseline CPR pattern) as varying the PSA assumption with the interest rate is how the negative convexity is created in the model. For example, do you understand why the MBS model assumes a higher PSA at a lower yield and how that creates a negative effective convexity? That's most of this topic in one question.
    • The effective duration (an approximation of modified duration, necessary because of the negative convexity!) and effective convexity formulas
    • Fluency with Fabozzi's four metrics: static cash flow yield, nominal spread, Z-spread, and OAS. Best is to really understand the differences.
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