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Week in Risk Week in Risk (March 10th)

David Harper CFA FRM

David Harper CFA FRM (test)
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In the forum (highlights only)

1. Thank you Evelyn! I wanted to give a shout out to Evelyn P. who wrote two smart forum posts this week. In her first, she spotted an error of mine (https://trtl.bz/2TDCkoS) in my bank balance sheet question that had survived two years. It's a really great catch because it requires us to understand how a loan balance is carried (at book value) on the balance sheet: the bank expenses a Provision for loan losses, which is informed by actual Charge-offs, and the provision informs the Allowance for loan losses that is a contra-asset account. This is realistic knowledge: for my question, I used a stylized version of Bank of America's (BAC) actual balance sheet. And it's topical: banks are getting ready to adopt (https://trtl.bz/2Ql11lo) FASB's new Current Expected Credit Loss (CECL) standard which has a go-live date of December 15, 2019. In her second post, Evelyn P creatively approached the solution to an open interest calculation by tallying by trader. Open interest sounds easy until you go to actually figure it out!

2. Thank you Jorge! Yesterday Jorge asked me a question that, although seemingly straightforward, strangely has not been asked before in the forum. He asked how to reconcile absolute VaR with delta-gamma VaR. https://www.bionicturtle.com/forum/threads/parametric-var.22223/ It gave me pause because, to my knowledge, in over a decade I can't recall any of our FRM authors (including Jorion) performing a formal integration; e.g., a delta-gamma absolute VaR. Sure, at a superficial level, we can plug Taylor Series into any VaR. But why I like his reconciliation question is that it forces us to define exactly what is meant by each word in a phrase like "delta normal absolute VaR." The mathematical reconciliation led me to think the more importance difference is a practical, not theoretical one. You probably already know the VaR is the statistical centerpiece of the FRM and therefore, at least implicitly, it's the favored risk metric (along with expected shortfall). To me what's fascinating is how, on the one hand, VaR is just a quantile, just a feature of a distribution. On the other hand, because we are trying to describe the future, the different issues related to the approach to VaR have filled many bookshelves. Simple but not so easy!

3. When a bond's price is not so obvious! Finally, a couple of posts on so-called basic financial concepts that only seem basic. This is actually one of the joys of hosting the forum: we get to explore concepts in depth that are often taken for granted. I'm amazed by finance, every year some people add new perspectives to old ideas. First, Jack asked how two different commodity backwardation charts can both be true https://www.bionicturtle.com/forum/threads/backwardation-chart.22219/. Normal backwardation baffles everybody. Here's my starter tip: realize that a forward price, F(t), is observed today but we can never know what is the expected future spot price, E[S(t)]. Second, Patrick asked (https://trtl.bz/2J6Uo72) about a very common type of forward bond questions; i.e., cost of carry. It's a question type we've seen dozens of time: compute the price of a 6-month forward on a coupon bond worth $1,000 etc. Patrick asked, is that value a cash (aka, full) or quote (aka, flat) price and what about accrued interest? Does this not matter, or is the question imprecisely written?


1. LIBOR versus SOFR: Basel released their Quarterly Review and it contains Beyond LIBOR: a primer on the new benchmark rates https://www.bis.org/publ/qtrpdf/r_qt1903e.htm. The final reading in the 2019 FRM syllabus is about LIBOR's would-be replacement https://trtl.bz/2Cfhl1I. This is a big deal in financial markets. You've probably read articles about how hundreds of trillions (with a T) of dollars are linked to LIBOR. FRM candidates know that's a notional number, not net market value. Okay, but still, a lot of money is tied to LIBOR. I just wrote my first interest rate swap question that assumed SOFR instead of LIBOR; I couldn't find any actual mechanical examples.

2. MMT for dummies (aka, me!): Modern Monetary Theory (MMT) is not in the FRM syllabus but it's in the press a lot. I confess that despite the fact I majored in Economics, I never understand what the MMT people are exactly saying, but I get the feeling a lot with modern economists. I get stuck at just understanding the argument before I can take a position. Personally, I think one of the pressing problems of modern economics is communication. Why can't it be more accessible? I finally found a helpful explainer by the talented Edward Harrison (@edwardh) who wrote MMT for Dummies at https://www.creditwritedowns.com/p/mmt-for-dummies. (after resisting for so long, super smart Steve Waldman finally caved in https://www.interfluidity.com/v2/7097.html)

3. The CFA is killing it (and literally killing the paper format). Finally, the CFA Institute's published their 2018 Annual Report https://www.cfainstitute.org/about/governance/annual-report and I am just so impressed, again, by their organization and presentation. Did you realize that the CFA administered the exam to 319,200 people in 2018, which was an +18% over the prior year? Impressive. Also, they are transitioning to an electronic exam (aka, CBT, for Level I) in two years https://trtl.bz/2TvxM3U

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