Study Notes: Risk Management and Financial Institutions
By Zhipeng Yan
Risk Management and Financial Institutions
By John C. Hull
Chapter 3
How Traders manage Their Exposures .
.......................................................................
2
Chapter 4
Interest Rate Risk.
........................................................................................................
3
Chapter 5
Volatility.
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5
Chapter 6
Correlations and Copulas.
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7
Chapter 7
Bank Regulation and Basel II .
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9
Chapter 8
The VaR Measure.
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11
Chapter 9
Market Risk VaR: Historical Simulation Approach .
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14
Chapter 10
Market Risk VaR: ModelBuilding Approach.
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16
Chapter 11
Credit Risk: Estimating Default Probabilities.
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17
Chapter 12
Credit Risk Losses and Credit VaR.
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20
Chapter 13
Credit Derivatives .
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22
Chapter 14
Operational Risk.
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24
Chapter 15
Model Risk and Liquidity Risk.
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25
Chapter 17
Weather, Energy, and Insurance Derivatives.
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27
Chapter 18
Big Losses and What We Can Learn From Them.
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28
T1
Bootstrap.
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30
T2
Principal Component Analysis.
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30
T3
Monte Carlo Simulation Methods.
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31
 1 
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View Full DocumentStudy Notes: Risk Management and Financial Institutions
By Zhipeng Yan
Chapter 3
How Traders manage Their Exposures
1.
Linear products
: a product whose value is linearly dependent on the value of the
underlying asset price. Forward, futures, and swaps are linear products; options
are not.
E.g. Goldman Sachs have entered into a forward with a gold mining firm. Goldman
Sachs borrows gold from a central bank and sell it at the current market price. At the
end of the life of the forward, Goldman Sachs buys gold from the gold mining firm
and uses it to repay the central bank.
2.
Delta neutrality
is more feasible for a large portfolio of derivatives dependent on
a single asset. Only one trade in the underlying asset is necessary to zero out delta
for the whole portfolio.
3.
Gamma
: if it is small, delta changes slowly and adjustments to keep a portfolio
delta neutral only need to be made relatively infrequently.
Gamma =
2
2
S
∂Π
∂

Gamma is
positive for a long position in an option (call or put)
.

A linear product has zero Gamma
and cannot be used to change the gamma of a
portfolio.
4.
Vega

Spot positions, forwards, and swaps
do not
depend on the volatility of the
underlying market variable, but options and most exotics do.

ν
σ
∂Π
=
∂

Vega is positive for long call and put
;

The volatilities of shortdated options tend to be more variable than the volatilities
of longdated options.
5.
Theta: time decay of the portfolio
.

Theta is usually negative for an option
. An exception could be an inthemoney
European put option on a nondividendpaying stock or an inthemoney European
call option on a currency with a very high interest rate.

It makes sense to hedge against changes in the price of the underlying asset, but it
does not make sense to hedge against the effect of the passage of time on an
option portfolio. In spite of this, many traders regard theta as a useful statistic. In a
delta neutral portfolio, when theta is large and positive, gamma tends to be large
and negative, and vice versa.
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 Spring '10
 NanLi
 Normal Distribution, ........., Risk Management and Financial Institutions, Zhipeng Yan

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