Financial Market Risks &

Management
Liquidity Risk

Concept & Terminology

Liquidity is an elusive concept. It is not observed
directly but rather has a number of aspects that
cannot be captured in a single measure.
Stock liquidity, which is defined as the ease and
speed at which one can trade stocks in the market.

Macroeconomic Liquidity
Market Liquidity
Funding Liquidity
Trading Liquidity

Concept & Terminology

Liquidity of a stock is defined as the ability to trade
large volumes with minimal price impact, cost and
delay.
Multi-dimensional characteristics
Depth
Breadth
Resiliency
Tightness
Immediacy

Low frequency Liquidity Proxy

Amihud (2002) illiquidity ratio
Trading Volume
Turnover
Turnover ratio
4

High frequency Liquidity

Proxy

Quoted Spread
Log absolute spread
Proportional Quoted Spread
Depth
Rupee Depth
Relative Spread
Effective Spread
5

Cost of Liquidity
Extra premium paid for purchasing a
demanding a stock.
Discount the trader bear while selling
a stock.
Cost of liquidity = Proportional Spread
* Value
Proportional Spread= (Offer-Bid)/ Mid
Price
Mid Price = (Bid+Offer)/2

Problem
Suppose that financial institution has
bought 10 million shares of one
company and 50 million ounces of a
commodity. The shares are bid at $
89.5, offer $90.5 and the commodity
is bid $15 and offer $15.1. Estimate
the cost of liquidity of the position.

Liquidity Pattern
Relationship between liquidity and
time
Over the period the shape of the
liquidity curve
Literature mentioned U-Shaped LShaped
Shape has something to do with
trading pattern or evolvement of
liquidity.

Returns Sensitivity to Liquidity

Liquidity Beta is the Sensitivity of returns to stock
liquidity ().

Liq
i

Liquidity Beta can be estimated stock-wise and also

industry group together.
Stability of the Beta can be checked by running ADF
Test over a long period of time.

Liquidity Determinants
Common Factors
Firm Specific
Factors

PE ratio
PB ratio
Dividend yield
Institutional
Holdings
Free
float
outstanding
Stock Beta
Leverage Ratio

to

Index of Industrial
Production (IIP)
GSEC10
years
yield (YLD)
Net FII Inflow (NFII)
Return
on
Gold
(GSDR)
Trading pattern
Settlement pattern

Liquidity Determinants
Macroeconomic Factors:

Index of Industrial Production

(IIP)
GSEC- 10 years yield (YLD)
Net FII Inflow (NFII)
Return on Gold (GSDR)

Firm Specific Factors:

PE ratio (PE)
PB ratio (PB)
Dividend yield (DIY)
Institutional Holdings (IHS)
Free float to outstanding (FOS)
Stock Beta ()
Leverage Ratio (DE)

Dummy
for
the
Corporate
Action
(CAD)

International
14
i0 Cij X j

Lit Factors:
t k it
j 1

Monthly Returns on
NYSE (NYSER)

All Sectors put together

Sector-wise independently
11

Commonality in Liquidity
Is there commonality in liquidity of the stocks listed on NSE ?
DL j, t j1DL M, t 2 DL M, t 1 3DL M, t 1 j, t

Commonality affects individual stock of different sector

differently i.e. Is commonality varies with the Industry? ,
Phukthuanthong-Le and Visaltanachoti (2009)
DLi, t i 1 DL M, t 2 DL M, t 1 3 DL M, t 1 1 DL Ind, t 2 DL Ind,t 1 3 DL Ind, t 1 i, t

12

CAPM Model with Liquidity

premium
Augmented Carhart (1997) four
factor model
Stocks sorted- decreasing order of
liquidity
Decile portfolios (13)
10 portfolios for each year (10 years)
RP jt RF t a j b j EMR t s j SMB t H h HML t m j WML t i j LHP t e jt

13

Example
For the given data set estimate the
CAPM with liquidity augmentation.

Traders Risk
Option Greek

Option Greeks
Each Greek letter measures different
dimension of risk in option position.
Risk dimension in option includes:
Price change of underlying assets
Change in the value of option with
respect to time
Change in implied volatility
Change in risk-free interest rate

Example
A bank has sold a European call option on
100,000 shares of a non-dividend paying
stock
S0 = 49, K = 50, r = 5%, = 20%,
T = 20 weeks,
Expected return on stock = 13%

Naked & Covered Positions

Naked position
Take no action

Covered position
Buy 100,000 shares today

What are the risks associated with these

strategies?

Stop-Loss Strategy
This involves:
Buying 100,000 shares as soon as price
reaches $50
Selling 100,000 shares as soon as price falls
below $50

Option Delta
Delta () is the rate of change of the
option price with respect to the price of the
underlying asset
Call option
price

Slope =

B
A

Stock price

Position Hedge
Suppose :
Stock price: 100 Option price : 10
Financial institution is selling 20 call option
contract of size 100 share per contract.
Option delta is 0.6
Position would be hedged by buying:
0.6*20*100 shares. ( 1200 shares)
If stock price goes up by 2

Position Hedge
Gain/loss on the option position is offset
by loss/gain on stock position
Delta changes as stock price changes and
time passes
Hedge position must therefore be
rebalanced

Delta Hedging
This involves maintaining a delta neutral
portfolio
The delta of a European call on a nondividend paying stock is N (d 1)
The delta of a European put on the stock
is
N (d 1) 1

Delta Hedging
Delta negative means:
Long position in put should be covered with
long position in the underlying stock
Short position in put should be covered with
short position in the underlying stock

Theta
Theta (Q) of a derivative (or
portfolio of derivatives) is the
rate of change of the value with
respect to the passage of time
The theta of a call or put is
usually negative. This means
that, if time passes with the
price of the underlying asset and
its volatility remaining the same,
the value of a long call or put

Gamma
Gamma () is the rate of change of delta
() with respect to the price of the
underlying asset
Gamma is the curvature risk of delta

Gamma Addresses Delta Hedging Errors Caused By

Curvature

Call
price
C''
C'
C
Stock price

S'
27

Relationship Between Delta,

Gamma, and Theta
For a portfolio of derivatives on a
stock paying a continuous dividend
yield at rate q it follows from the
Black-Scholes-Merton
differential
1
rS S r
equationthat
2
2

Vega
Vega () is the rate of change of the value
of a derivatives portfolio with respect to
volatility

Managing Delta, Gamma, &

Vega
Delta can be changed by taking a position
in the underlying asset
To adjust gamma and vega it is necessary
to take a position in an option or other
derivative

Hedging in Practice
Rho is the rate of change of the value of a
derivative with respect to the interest rate.
Traders usually ensure that their portfolios
are delta-neutral at least once a day
Whenever the opportunity arises, they
improve gamma and vega
There are economies of scale
As portfolio becomes larger hedging becomes
less expensive per option in the portfolio

Greek Letters for European Options on an Asset that Provides a Yield at Rate q

Greek Letter

Call Option

Put Option

Delta

e qT N (d1 )

e qT N (d1 ) 1

Gamma

N (d1 )e qT
S 0 T

N (d1 )e qT
S 0 T

Theta
Vega
Rho

S 0 N (d1 )e qT 2 T

qS 0 N (d1 )e qT rKe rT N (d 2 )
S 0 T N (d1 )e qT
KTe rT N (d 2 )

S 0 N (d1 )e qT 2 T

qS 0 N (d1 )e qT rKe rT N (d 2 )
S 0 T N (d1 )e qT
KTe rT N ( d 2 )

32

Problem
1. What does it mean to assert that the delta
of a call option is 0.7? How can a short
position in 1,000 options be made delta
neutral when the delta of each option is
0.7?
2. Calculate the delta of an at-the-money
six-month European call option on a nondividend-paying stock when the risk-free
interest rate is 10% per annum and the
stock price volatility is 25% per annum.
33

Problem
3. What is the delta of a short position in
1,000 European call options on silver
futures? The options mature in eight
months, and the futures contract
underlying the option matures in nine
months. The current nine-month futures
price is $8 per ounce, the exercise price of
the options is $8, the risk-free interest rate
is 12% per annum, and the volatility of
silver
is
18%
per
annum.
34

Problem
4. A financial institution has just sold
1,000 seven-month European call
options on the Japanese yen. Suppose
that the spot exchange rate is 0.80 cent
per yen, the exercise price is 0.81 cent
per yen, the risk-free interest rate in the
United States is 8% per annum, the riskfree interest rate in Japan is 5% per
annum, and the volatility of the yen is
15% per annum. Calculate the delta,
gamma, vega, theta, and rho of the
financial institutions position. Interpret
35
each
number.

5. A fund manager has a well-diversified

portfolio that mirrors the performance of
the S&P 500 and is worth $360 million.
The value of the S&P 500 is 1,200, and the
portfolio manager would like to buy
insurance against a reduction of more
than 5% in the value of the portfolio over
the next six months. The risk-free interest
rate is 6% per annum. The dividend yield
on both the portfolio and the S&P 500 is
3%, and the volatility of the index is 30%
per annum. If the fund manager buys
traded European put options, how
much
36

Interest Rates

Types of Rates
Treasury rates
Rates on instruments issued by a government
in its own currency
LIBOR rates
LIBOR is the rate of interest at which a bank is prepared to
deposit money with another bank. (The second bank must
typically have a AA rating)
LIBOR is compiled once a day by the British Bankers
Association on all major currencies for maturities up to 12
months
LIBID is the rate which a AA bank is prepared to pay on
deposits from anther bank

Repo rates
Repurchase agreement is an
agreement where a financial
institution that owns securities
agrees to sell them today for X and
buy them bank in the future for a
slightly higher price, Y
The financial institution obtains a
loan.
The rate of interest is calculated from
the difference between X and Y and
is known as the repo rate

Duration
Duration of a bond that provides cash flow ci at time ti is

ci e yti
D ti

B
i 1

where B is its price and y is its yield (continuously

compounded)

Duration
Duration is important because it leads to
the following key relationship between the
change in the yield on the bond and the
change in its price
B
Dy
B

Duration
Duration is important because it leads to
the following key relationship between the
change in the yield on the bond and the
change in its price
BDy
B
1 y m
D
1 y m

is referred to as the modified

duration

Duration of Portfolio
The duration for a bond portfolio is the
weighted average duration of the bonds in the
portfolio with weights proportional to prices
The key duration relationship for a bond
portfolio describes the effect of small parallel
shifts in the yield curve
What exposures remain if duration of a
portfolio of assets equals the duration of a
portfolio of liabilities?

Convexity
The convexity, C, of a bond is defined as
n

1 2B
C

2
B y

2 yt i
c
t
iie
i 1

This leads to a more accurate relationship

B
1
2
Dy C y
B
2

When used for bond portfolios it allows larger shifts

in the yield curve to be considered, but the shifts still
have to be parallel

Problem
1. A trader has purchased 5 year 11% coupon
payment bond which YTM at present is 10.5%. If
interest rate is increased by 1% how much the
trader would lose / gain if he purchased the
bond?
2. A trader has borrowed Rs.10000/- from Bank at
7.75% for a period of 3 years. He has invested
these funds in the following three bonds.
a) Rs.4000/- for 3 year for 9% coupon
b) Rs.2500/- for 5 year for 12.50% coupon
c) Rs.3500 /- for 4 year for 9.25% coupon
Is there any portfolio duration mismatches?

 A five-year bond with a yield of 11% (continuously

compounded) pays an 8% coupon at the end of each
year.
What is the bonds price?
What is the bonds duration?
Use the duration to calculate the effect on the bonds price
of a 0.2% decrease in its yield.
Recalculate the bonds price on the basis of a 10.8% per
annum yield and verify that the result is in agreement with
your answer to (c).

Value at Risk

VALUE AT RISK
Value at Risk (VaR) is a measure of market risk or the
sensitivity of a portfolio to market changes and the
probability of a given market change.
VaR is the best single risk-measurement technique
available for assessment of risk.
VaR has been adopted by the Basel Committee to set
the standard for the minimum amount of capital to be
held against market risks

VALUE AT RISK
Value at Risk is defined as the value that
can be expected to be lost during severe
adverse market fluctuations.
Typically, a severe loss is defined as a loss
that has a 1% chance of occurring on any
given day
If we are measuring daily losses, this is
equivalent to saying, "On average, we will
lose VaR or more on two to three days per
year

VALUE AT RISK
A common assumption is that movements
in the market have a Normal probability
distribution, meaning there is a 1%
chance that losses will be greater than
2.32 standard deviations.
Assuming a Normal distribution, 99% VaR
can be defined as follows:
standard deviation
of the portfolio's
value
The subscript T in the VaR expression refers to the time period over which
the standard deviation of returns is calculated. VaR can be calculated for any
time horizon. For trading operations, a one-day horizon is typically used.

VALUE AT RISK
For an example of a VaR
statement, consider an equity
portfolio with a daily standard
deviation of $10 million. Using
the assumption of a Normal
distribution, the 99%
confidence interval VaR is $23
million. We would expect that
the losses would be greater
than $23 million on 1% of
trading days, or 2 to 3 days
per year.

Sensitivity or Duration
Analysis

Sensitivity Analysis for

Bonds

Sensitivity Analysis for

Bonds

Sensitivity Analysis for

Equities

Sensitivity Analysis for

forwards and Futures

Sensitivity Analysis for

Options

VaR for Bonds

For a bond, VaR can be approximated
by multiplying the dollar duration by
the "worst-case" daily interest move.
This gives the value change in the
"worst case."

VaR for Bonds

the "worst-case" daily interest
move for 1% chance in one day

If we assume that interest-rate

movements have a Normal
probability distribution, then the 1%
worst case will correspond to2.32
standard deviations of the daily
rate movements

VaR for Bonds

If the duration is 7 years, the current price is $100
(the dollar duration is 7X100), and the daily standard
deviation in the absolute level of interest rates is
0.2%, then the VaR is approximately $3.24:
VaR = $100 x 7 x 0.2 x 2.32 = $3.24
The approximations that we made here were as
follows:
the changes in the rate is Normally distributed
The change in the price can be well-approximated
by the linear measure of duration.

VaR for Equities

The VaR for an equity is easy to calculate
If we assume that equity prices have a Normal distribution.
The VaR is then the number of shares held (N), multiplied by
2.32 and the standard deviation of the equity price (E):
VaR = 2.32X E X N
So, for example, if we held 100 shares of IBM, and the daily
standard deviation of the price was 10 cents, the VaR would be
$23.2: VaR = 2.32 x $0.1 x 100 = $23.2

VaR for Options

A simple approximation of the VaR to
an option can be obtained using the
linear sensitivities
The standard deviation of the option
price caused by changes in the stock
price is simply the standard deviation
of the stock price multiplied by delta

VaR for Options

The derivative of value of
option with respect to the
price of underlying stock
The standard error of the
underlying stocks price

The second derivative

The pricing function for a option, for example,

the Black-Scholes equations

General Considerations in
Using VaR
In some cases, we may wish to know the
VaR for the potential losses over multiple
days.
A reasonable approximation to the multi
day VaR is that it is equal to the one-day
VaR multiplied by the square root of the
number of days:

General Considerations in
Using VaR
This relationship requires the
following assumptions:
1. Changes in market factors are
Normally distributed.
2. The one-day VaR is constant over the
time period.
3. There is no serial correlation. Serial
correlation is present if the results on
one day are not independent of the
results on a previous day.

Advantages of VaR
It captures an important aspect of risk
in a single number
It is easy to understand
It asks the simple question: How bad can
things get?

Example
Consider a position of $5 million in AT&T
The daily volatility of AT&T is 1% (approx
16% per year)
The S.D per 10 days is
The VaR is

50,000 10 $158,144

158,114 2.33 $368,405

Portfolio
Now consider a portfolio consisting of both
Microsoft and AT&T
Assume that the returns of AT&T and
Microsoft are bivariate normal
Suppose that the correlation between the
returns

68

S.D. of Portfolio
A standard result in statistics states that
X Y 2 X Y
2
X

2
Y

In this case X = 200,000 andY = 50,000

and = 0.3. The standard deviation of the
change in the portfolio value in one day is
therefore 220,227
69

VaR for Portfolio

The 10-day 99% VaR for the portfolio is
220,227 10 2.33 $1,622,657

The benefits of diversification are

(1,473,621+368,405)1,622,657=$219,369
What is the incremental effect of the AT&T
holding on VaR?

70

Example 1
Consider a position consisting of a
$100,000 investment in asset A and
a $100,000 investment in asset B.
Assume that the daily volatilities of
both assets are 1% and that the
coefficient of correlation between
their returns is 0.3. What is the 5-day
99% VaR for the portfolio?

Example: 2
A financial institution owns a portfolio of
options
on
the U.S. dollarsterling
exchange rate. The delta of the portfolio is
56.0. The current exchange rate is 1.5000.
Derive an approximate linear relationship
between the change in the portfolio value
and the percentage change in the
exchange rate. If the daily volatility of the
exchange rate is 0.7%, estimate the 10day 99% VaR

Example: 3
Consider a position consisting of a
$300,000 investment in gold and a
$500,000
investment
in
silver.
Suppose that the daily volatilities of
these two assets are 1.8% and 1.2%
respectively, and that the coefficient
of correlation between their returns is
0.6. What is the 10-day 97.5% VaR for
the portfolio? By how much does
diversification reduce the VaR?