Measurement of Market Risk Theory and Practice (Including Scenario Analysis of Major Market Crashes)

Abstract

This report covers the topic of market risk measurement from two points of view, theory and practice. The theoretical aspect discusses the development of the recent work of Coherent Risk Measures and how the traditional VaR methodology fits in with this new development. It points out that VaR as a risk measure has some crucial shortcomings and gives an overview of two new risk measures, the Expected Shortfall and the Spectral Risk measure, that satisfy all the properties of being Coherent. In practice, VaR and Stress Testing are still the favorite and most common risk measurement tools in the financial industry. The report discusses the process of computation of VaR numbers for portfolios and the three prominent VaR methodologies, Delta-Normal, Historical and Monte Carlo along with their advantages and disadvantages. The final topic covered is Stress Testing. We discuss what these tests are, their role in risk management, and how they are set up. Stress Tests, more than the other measures of risk, depend heavily on qualitative decisions.

ii

Table of Contents
Abstract ........................................................................................................................................... ii Table of Contents........................................................................................................................... iii List of Tables .................................................................................................................................. v List of Figures ................................................................................................................................ vi Introduction..................................................................................................................................... 1 Coherent Risk Measures ................................................................................................................. 3 Acceptance Sets .......................................................................................................................... 3 Measure of Risk .......................................................................................................................... 4 Axioms of Coherency ................................................................................................................. 4 Value at Risk (VaR)........................................................................................................................ 7 Advantages of VaR ..................................................................................................................... 8 Drawbacks of VaR...................................................................................................................... 9 The Expected Shortfall ................................................................................................................. 11 Advantages of ES over VaR ..................................................................................................... 12 Spectral Risk Measures................................................................................................................. 14 Computation of VaR ..................................................................................................................... 17 Delta-normal method ................................................................................................................ 20 Advantages............................................................................................................................ 21 Disadvantages ....................................................................................................................... 21 Historical Simulation Method................................................................................................... 22 Advantages............................................................................................................................ 23 Disadvantages ....................................................................................................................... 23 Monte Carlo Simulation method............................................................................................... 24 Advantages............................................................................................................................ 25 Disadvantages ....................................................................................................................... 25 Stress Testing ................................................................................................................................ 26 Procedure .................................................................................................................................. 26 Stylized Scenarios................................................................................................................. 27 Actual Historical Events ....................................................................................................... 28 Difficulties with Stress Testing................................................................................................. 29 Stress testing Vs VaR................................................................................................................ 29 Stress Testing Implementation...................................................................................................... 30 Algorithm for Stress Testing and Scenario Analysis................................................................ 31 Methodology in Detail .............................................................................................................. 32 Testing Period ....................................................................................................................... 32 Equity Shocks ....................................................................................................................... 32 Equity Implied Volatility Shocks.......................................................................................... 33 Corporate and Sovereign Credit Shocks ............................................................................... 35 Government Bond Yield Shocks .......................................................................................... 35 Commodity Exposure and Volatility Shocks........................................................................ 35 Settle Date............................................................................................................................. 36 iii

Conclusion .................................................................................................................................... 37 References..................................................................................................................................... 39 Appendix I Historic Stress Event Examples.............................................................................. 40 October 1987 Crash .................................................................................................................. 40 First Gulf War 1990 .................................................................................................................. 43 The Asian Currency Crisis........................................................................................................ 45 The Russian Default/ LTCM Collapse ..................................................................................... 47 The World Trade Center Attack ............................................................................................... 52 Argentina Debt Default............................................................................................................. 53 Appendix II Examples of Instrument Stress Testing ................................................................. 55 Example 1: Equity Positions..................................................................................................... 55 Example 2: Corporate Bonds\ CDS .......................................................................................... 55 Example 3: Options (Equities and Fx)...................................................................................... 56 Appendix III Effect of an Event Shock on the Implied Volatility Term Structure................. 57 Appendix IV Bloomberg Data Sources ..................................................................................... 62

iv

List of Tables
Table 1 Instrument Risk Factors ................................................................................................... 30 Table 2 Time to Maturity Modifier for Implied Volatility ........................................................... 34 Table 3 Commodity Conditions.................................................................................................... 36 Table 4 Factor Movement during the Oct '87 Crash..................................................................... 42 Table 5 Factor Movement during Gulf War I............................................................................... 44 Table 6 Factor Movement during the Asian Crisis....................................................................... 46 Table 7 Factor Movement during the Russian Crisis.................................................................... 51 Table 8 Factor Movement during the WTC Attach Scenario ....................................................... 52 Table 9 Sample Fx Volatility Surface Data .................................................................................. 57 Table 10 Regression Betas for different maturities Implied Vol .................................................. 60

List of Figures
Figure 1 Value-at-Risk.................................................................................................................... 8 Figure 2 VaR Example 1............................................................................................................... 10 Figure 3 VaR Example 2............................................................................................................... 10 Figure 4 Comparison of VaR and ES for a Standard Normal Distribution .................................. 13 Figure 5 Linear Mapping Function ............................................................................................... 18 Figure 6 Non-Linear Mapping Function....................................................................................... 19 Figure 7 Delta-Normal VaR.......................................................................................................... 21 Figure 8 Historical VaR ................................................................................................................ 23 Figure 9 Monte Carlo VaR ........................................................................................................... 24 Figure 10 Stylized Stock Moves ................................................................................................... 27 Figure 11 Stylized Credit Spread Moves (Bps) ............................................................................ 28 Figure 12 Implied Volatility adjustment factor (See Appendix-II) .............................................. 34 Figure 13 S&P500 Level and P/E Ratios before the 1987 Crash ................................................. 40 Figure 14 Normalized Graphs for the Dow, USD-JPY X Rate and US 10Yr Rates .................... 41 Figure 15 Normalized US Cross Rate against Pound and Yen during 1987 ................................ 41 Figure 16 US WTI Crude Prices................................................................................................... 43 Figure 17 Rolling Front Month WTI Volatility............................................................................ 44 Figure 18 Asian Currency X-Rates during 1997 .......................................................................... 45 Figure 19 Equity Markets in 1997 ................................................................................................ 46 Figure 20 Russian Ruble / USD - 01/08/1998 to 30/09/1998....................................................... 47 Figure 21 Equity Markets during 1998......................................................................................... 48 Figure 22 US. Japan Equity Markets, X-Rate and US 10Yr Interest Rates during 1998 ............. 49 Figure 23 Asian Credit Spreads 1998 and beyond........................................................................ 50 Figure 24 Latin American Credit Spreads 1998 and beyond........................................................ 51 Figure 25 Currency Devaluation Timeline ................................................................................... 53 Figure 26 CDS Spreads LATAM, Senior Govt Bonds................................................................. 54 Figure 27 US, Argentina and Brazil Equity Markets 2001-02 ..................................................... 54 Figure 28 Argentina Credit Spread and Rates 2001-02 ................................................................ 54 Figure 29 Argentina Fx Reserves ................................................................................................. 54 Figure 30 Implied Vol for different maturities and moneyness.................................................... 59 Figure 31 Comparison of Regession Betas with 1/sqrt(Maturity) ................................................ 60 Figure 32 SPX Regression Beta and 1/Sqrt(Maturity) ................................................................. 61 Figure 33 Regression Beta for different Moneyness .................................................................... 61

vi

Introduction
It is human nature to hate uncertainty and since ages people have tried to come up with techniques to mitigate, if not eliminate, the effect of uncertainty on their lives. This single quest has spawned many famous advances in the theory of mathematics, probability, insurance and finance. History is replete with tales such as those of traders pooling money together to buffer losses from sinking or looting of their ships. Mathematicians have spent great lengths of time to study events of chances so that they could understand and quantify uncertainty. In the past few decades these advances have come together under a formal field called Risk Management. Across the spectrum, from business schools, finance departments to big banks and investment firms, Risk Management is now viewed as a separate entity in itself.

Risk, in general, is a very broad and open concept. All unforeseen losses from undesirable events fall under the category of risk. For the purpose of our study, we will consider the definition of risk from the point of view of an investment firm. In this case, risk is categorized into Quantifiable Risks and NonQuantifiable risks. Quantifiable Risks, as the name suggests, are the risks faced by the firm which can be quantified into a number easily. These include risks from market events, credit defaults, and risks from the firms operations. The Non-Quantifiable Risks a firm faces are such as those coming from political and legal regulations, market illiquidity etc.

The decision of a firm to concentrate on specific risk management depends critically on its business and operations. For an investment firm, the major sources of risk are Market Risks, Credit Risks and Liquidity Risk. Measurements of these different types of risks are done using very different techniques.

Credit Risk is measured by studying the specifics of bonds/ loans terms, covenants and the financial health of the underlying corporation. Liquidity risk involves knowing the terms of the deals and the depth/ breadth of markets for different instruments. Marker Risk analysis involves understanding the mathematical properties of different instruments with regards to its underlying and other market factors and using statistical techniques to measure different risk parameters. This report is focused entirely on addressing the issue of market risk measurement.

Our discussion will start with the introduction of the theory of Coherent Risk Measures. This is the first attempt to formalize the theory of risk measurement in the language of precise mathematics. We will see

how the theory is constructed from very natural assumptions and how any measure of risk in the future has to satisfy the axioms proposed by this theory or else have very obvious shortcomings. Once the Axioms of Coherency have been established, we will see how VaR measures up with this new theory and the severe limitations that are exposed. To finish the discussion on the theory of risk measurement we will see two new risk measures that are designed to overcome the limitations of VaR.

The theory of Coherent Risk Measure is relatively new, and VaR is still the favorite risk measure for the financial industry. It has the backing of regulatory institutions and central banks as an acceptable risk management tool. The second part of the report gives details on the VaR computation process and the different approaches to doing that. The three popular VaR methodologies are Delta-Normal, Historical and Monte-Carlo method. Each of these methods is based on different assumptions and has its advantages and limitations. We will discuss these in detail.

The final section is on the topic of Stress Testing. Stress Testing as a methodology is simple and straightforward, but the difficulty lies in the implementation. Well implemented Stress Tests require experience and making reasonable qualitative calls. We will walk through the methodology used by me to design Stress Tests for the portfolios at __________ and round off with brief descriptions of some major financial events of the past.

Coherent Risk Measures

The theory of Coherent Risk Measures was proposed by Artzner et al in their seminal work [1, 2], and it became a path-breaking event in the field of risk management. For the first time, the problem of risk measurement was given a formal mathematical foundation to stand on. It was true that most professionals in the financial community had an intuitive sense of what financial risk entailed but it was difficult to give a quantitative assessment of financial risk without rigorously specifying what was meant by a measure of financial risk. Artzner et al postulated a set of axioms the Axioms of Coherency and worked out the implications for any risk measure satisfying these axioms. In the section below we go over the theoretical arguments leading to the formulation of the axioms, starting with the concept of acceptance sets and how that leads to the definition of a measure of risk.

Acceptance Sets

Artzner et al considered it best to relate risk to the future value of the investment rather than to the P/L of the position. They did this by considering the future value of the portfolio as a random variable on the set of states of nature at a future date. According to them, the first crude measurement of risk for any position would be to see whether its future value belongs to the subset of acceptable risk, as decided by a person in-charge of managing risk for that position. Such a person could be acting in the capacity of: 1. A Regulator, who has to take into account the unfavorable states when allowing a risky position which may draw on the resources of the government, for example as a guarantor of the last resort. 2. An Exchanges Clearing Firm, which has to make good on the promise to all parties, of transactions being securely completed. 3. An Investment Manager, who knows that his firm has basically given to its traders an exit option where the strike price consists on being fired in the event of big trading losses on ones position. Once they had the concept of acceptable risk, they define the acceptance set as the set of all acceptable future net worth for the portfolio. All risks that are unacceptable or positions that have an unacceptable

future net worth cannot not be held in their current form. One remedy is to alter the position. Another one is to look for some commonly accepted instruments which, when added to the current positions, makes its future value become acceptable to the regulators/ risk managers. The current cost of getting enough of this or these instrument(s) should be good indicator of the risk associated with the initial unacceptable position.

Measure of Risk
Based on acceptance set, Artzner et al define a measure of risk (.) for a risky position as the minimum amount of extra cash that has to be added to the risky position and invested prudently in some reference asset to make the risky position be acceptable. If (.) is negative, its negativity can be interpreted as the maximum amount that can be safely withdrawn, and still leave the position acceptable. To express the risk measure (.) mathematically, let be the set of future states of nature (assumed finite). For each element of , there is an associated net worth of the portfolio, a random variable denoted by X . Call G as the set of all risks i.e. the set of all real valued functions on . Since is assumed to be finite, G can be identified with n , where n=card( ). Definition: A measure of risk, (.) , is a mapping from G into The above definition simply means giving a real number value to quantify the set of all risks faced by the portfolio. Having a definition for a measure of risk was the first step for Artzner et al. They also proposed properties that should be satisfied by such a risk measure so as to be acceptable as a realistic measure from a practical point of view. They called these properties the Axioms of Coherency and any risk measure satisfying these axioms, a Coherent Risk Measure.

Axioms of Coherency
1. Monotonicity: For all X and Y G with X Y , we have (Y ) ( X ) .

Monotonicity means that random cash flows or future value Y that is always greater than X should have a lower risk: this makes sense, because it means that less has to be added to Y than to X to make it acceptable, and the amount to be added is the risk measure. 2. Translation Invariance: For all X G and real number n , ( X + n ) = ( X ) n This axiom ensures that for each X , ( X + ( X )) = 0 , which says if we add a cash amount equal to

( X ) , the risk measure associate with X , then the risk of the portfolio is 0. This equality has a
natural interpretation in terms of acceptance set associated with , and is exactly what the definition of a risk measure is. 3. Subadditivity: For all X and Y G , ( X + Y ) ( X ) + (Y ) .

The axiom says, a merger does not create risk and on the contrary, risk should come down due to the benefits of diversification. A few examples below shows why this is regarded to be the most important axiom to be specified by Artzner et al and why any risk measure not satisfying this property should be regarded with suspicion.

Any non-subadditive risk measures will tempt traders on an organized exchange to break up their accounts, with separate accounts for separate risks, in order to reduce margin requirements. This is a concern for the exchange since the margin requirements on the separate accounts will no longer cover the combined risks, and leave the exchange itself exposed to possible losses.

If regulators use non-subadditive risk measures to set capital requirements, then a financial firm might be tempted to break itself to reduce its regulatory capital requirements, because the sum of the capital requirements of the smaller units would be less than the capital requirement of the firm as a whole.

If risks are subadditive, adding risks together would give us an over-estimate of combined risk, and this means that we can use sum of risks as a conservative estimate of combined risk. This facilitates decentralized decision making within a firm. If risks are not subadditive, adding them together gives us an underestimate of the combined risks, which makes sum of risks incorrect and therefore effectively useless as a back of the envelope measure.

4. Positive Homogeneity: For all X G and n > 0 , (nX ) = n ( X ) . The subadditivity axiom says that ( X + X + ... + X ) = (nX ) n ( X ) , but if we think in terms of liquidity concerns where, as the position size becomes bigger the risk increases or

( X + X + ... + X ) = (nX ) n ( X ) . Combining these two results gives us the Positive

Homogeneity Axiom.

With these four primary axioms, Artzner et al, put down the ground-work for future research into measures of financial risks. In the next section, we will discuss the most common risk measure used in the industry, the Value-at-Risk (VaR). VaR satisfies all of the above axioms except subadditivity, but its ease of use and interpretation makes it favorite among management.

Value at Risk (VaR)

Value-at-Risk (VaR) as a risk measurement tool predates the theory of coherent risk measure. It was first used by major financial firms in the late 1980s to measure risk exposure to their trading portfolios. In the early 90s various banks started adopting VaR as a key component of management of market risk. The final boost came when the Basel Committee on Banking Supervision chose VaR as an international standard for external regulatory purpose. In recent years, the use of VaR for risk management and capital allocation has been used increasingly by hedge funds, traders and companies for risk measurement.

Simply put VaR is the worst loss over a target horizon with a given level of target probability. It aims to answer the question: How much can the portfolio lose with X% probability over a pre-set horizon. The reason for the popularity of VaR is that it summarizes the entire risk into one dollar number. This is easy to understand for all levels of the management and act on accordingly.

First let us put the definition of VaR in a more formal frame-work. X is the random variable associated with the future net worth of our current portfolio. The current value of the portfolio is x0 . From a mathematical point of view, VaR is just a quantile of the distribution of the variable X . Define

x = q ( X ) = inf {x : P[ X x ] }
As the - quantile of X,

VaR is the absolute value of the worst loss not to be exceeded with a probability of at least 1 . Its
formal definition is

VaR = x0 x1

0.045 0.04 0.035 0.03 0.025 0.02 0.015 0.01 0.005 0

f X (x )

-3 -2 .3 5 -1 .7 -1 .0 5 -0 .4 0. 25

0. 9 1. 55 2. 2 2. 85 3. 5 4. 15 4. 8 5. 45

Figure 1 Value-at-Risk

The properties of VaR as a risk measure are listed below. A conspicuous absence in the properties below is the property of subadditivity. This makes VaR a non-coherent risk measure. Let (0,1] be fixed. Consider X , Y G the risk measure given by

( X ) = VaR ( X )
Then has the following properties: 1. Monotonicity: if X Y , then ( X ) (Y ) ; 2. Positive Homogeneity: (hX ) = h ( X ) , for h 0 ; 3. Translation Invariance: ( X + a ) = ( X ) a, for a ;

4. Law Invariance: If P[X t ] = P[Y t ] for all t , then ( X ) = (Y )

Advantages of VaR
There are two principal reasons that make VaR so popular amongst the management as well as regulatory authorities. The first is the ease of interpretation. VaR gives a risk measure in terms of currency units, which can be easily related to firm capital and availability of liquidity. The other advantage of VaR is the ease of implementation. Most of the computation in VaR is straightforward making it easy for management to understand and justify to their seniors.

6. 1 6. 75

Drawbacks of VaR
The biggest problem with VaR as a risk measure is the lack of subadditivity. Only in the very special case in which the joint distribution of the returns of portfolio constituents is elliptical is VaR subadditive. This will seldom hold, and particularly in stress situations, when VaR is needed most, returns are generally far from normal. As pointed out in the section of coherent risk measures, Non-subadditivity means that the risk of portfolio may be larger than the sum of stand-alone risks of its component. There upon it could happen that a well diversified portfolio requires more regulatory capital than a less diversified portfolio. The stark consequence of this is managing risk by VaR may fail to stimulate diversification. Besides being non-subadditive, VaR is also a non-convex risk measure. This will cause it to have many local extremes, making it impossible to rank risky portfolios based on VaR numbers. Given below is an example of how VaR fails to be subadditive even for a simple portfolio:

Consider two identical bonds, A and B. Each with default probability 4%, and we get a loss of 100 when default occurs, and a loss of 0 if no default occurs. The 95% VaR of each bond is therefore 0, so VaR(A)=VaR(B)=VaR(A)+VaR(B)=0. Now suppose that defaults are independent. Calculations then establish that we get a loss of 0 with probability 0.96 with a probability of
2

= .9216 , a loss of 200 with probability 0.04 2 = 0.0016 , and a loss of 100

1,9216 .0016 = .0768 . Hence VaR(A+B)=100. Thus VaR(A+B)=100>VaR(A)+VaR(B), and

the VaR violates subadditivity. Hence VaR is not subadditive.

Another drawback with VaR is that it is only concerned about the frequency of losses, not the size of losses. Hence its critics call is an all-or-nothing risk measure. For example the two figures below show two portfolios which have the same VaR , and so will require identical capital to be allocated to the two portfolios. But it is clear from the distributions that the portfolio in figure 3 has much higher probability associated with a big loss as compared to the portfolio in figure 2.

0.045 0.04 0.035 0.03 0.025 0.02 0.015 0.01 0.005 0

f X (x )

0.045 0.04 0.035 0.03 0.025 0.02 0.015 0.01 0.005 0

-0 .4 0. 25

0. 9 1. 55

2. 2 2. 85

4. 8 5. 45

-3 -2 .3 5

-1 .7 -1 .0 5

Figure 3 VaR Example 2

10

6. 1 6. 75

3. 5 4. 15

-3 .3 5 -1 .7 -1 .0 5 -0 .4 0. 25 0. 9 1. 55 2. 2 2. 85 3. 5 4. 15 4. 8 5. 45 6. 1 6. 75 -2

Figure 2 VaR Example 1

f X (x )

The Expected Shortfall

The previous section showed the shortcomings of VaR as a risk measure, namely lack of sub-additivity and the all-or-nothing approach. The all-or-nothing approach comes from the fact that VaR is designed to answer the question, what is the minimum loss incurred in x% worst cases of our portfolio? Whatever losses are sustained beyond the VaR measure is never considered. A better question to pose would be: What is the expected loss incurred in x% worst cases of our portfolio? This question is a more natural one when considering the risks of a specified sample of worst cases, and it leads to the definition of a sub-additive risk measure. If the distribution function for the future portfolio value is continuous, then the statistic which answers the second more relevant question is the conditional expected value below the quantile. This is known as the Tail Conditional Expectation or TCE

TCE ( X ) = E X | X x ( )

Expected Shortfall is a risk measure which is based on the idea of TCE but has been designed to be more robust and overcome deficiencies of the TCE model, especially in the case of non-continuous or discrete distributions. The Expected Shortfall risk measure is defined as the average of the worst 100(1 )% of losses:

is the confidence level and q p is the pth quantile of the portfolio P/L
If the loss distribution is discrete, then the ES is the discrete equivalent of the above equation:

1 ES = q p dp , where 1

ES =

1 [pth highest loss] [probability of pth highest loss] 1 p =0

To show that the ES measure is sub-additive, consider if we have N equal probability quantiles in a discrete P/L distribution, then:

ES ( X ) + ES (Y ) = [mean of N highest losses of X ] + [mean of N highest losses of Y ]

[mean of N highest losses of ( X + Y ) ] = ES ( X + Y )
11

In general the mean of the N worst cases of X and the mean of the N cases of Y will be bigger than the mean of the N worst cases of ( X + Y ) , except in the special case where the worst X and Y occur in the same N events, and in this case the sum of the means will equal the mean of the sums. ES also satisfies all the other properties of being coherent [3]

Advantages of ES over VaR

The most important advantage of ES is that it is coherent. Being coherent implies ES is sub-additive. This is not the case with VaR and we have already seen the drawbacks associated with a risk measure not being sub-addtive. Unlike VaR, which gives us no idea about what to expect from a loss higher than the VaR itself, the ES tells us what to expect in bad states. Finally sub-additivity of ES implies that the portfolio risk surface will be convex, and convexity ensures that portfolio optimization problems using ES measures will always have a unique well behaved optimum. This is not true for VaR based portfolio optimization.

The figure below presents a simple comparison between a 95% VaR numbers and a 95% ES number. The 95% VaR is obtained by solving for x the following equation
x

f ( x)dx = .05

whereas the 95% ES number is obtained by

x

xf ( x)dx = .05

12

Profit/Loss 0.45 0.4

95% Var=1.645

0.35 0.3 0.25 0.2 0.15 0.1 0.05 0 -4 -3 -2 -3.5 -2.5 -1.5 -1 -0.5 0 1 2 3 0.5 1.5 2.5 -0.05 3.5 4
95% ES=2.063

Figure 4 Comparison of VaR and ES for a Standard Normal Distribution

13

Spectral Risk Measures

The final topic on the theory of coherent market risk measurement is on Spectral Risk Measures. The definition of these measures involve going back to first principle and defining a general risk measure

M that are weighted averages of the quantiles of the loss distribution:

M = ( p )q p dp
0

where the weighting function, ( p ) remains to be determined. ( p ) is also known as the risk spectrum or risk aversion function and we will see why. Both the ES and VaR are special cases of the above risk measure. The ES is obtained by setting ( p ) to the following:

( p) =

p < 0 if p 1 (1 )

The ES gives tail losses an equal weight of 1 (1 ) , and other quantile a weight of 0. The VaR is also a special case, a highly degenerate one of M . Because the VaR is just a single quantile, the spectral risk measure is the VaR if ( p ) takes the form of a Dirac delta. This is degenerate because is gives infinite value to the pdf at p and a zero value to the pdf everywhere else. So ES places equal weight on tail losses whereas VaR puts no weight at all on them. To obtain a broader class of risk measures, the weighting function ( p ) has to satisfy a set of conditions that would make M coherent. These conditions are [4]: 1. Non-negativity: ( p ) 0 for all p [0,1] . 2. Normalization: ( p )dp = 1 .
1

3. Weakly Increasing: If some probability p2 exceeds another probability p1 , then p2 must have a weight bigger than or equal to that of p1 .

14

The first two conditions simply require that weights are positive and sum to one. The critical condition is the third one. This condition reflects risk aversion, requiring weights attached to higher losses should be given higher than or certainly no less than, the weights attached to the lower losses. Since this condition ensures coherence, it suggests that the key to coherence is that the risk measure must give higher losses at least the same weight as lower losses. The higher weights attached to higher losses in spectral risk measures are a reflection of the users risk aversion. If the risk aversion function is well-behaved, then the weights will rise smoothly, and the rate at which the weights rise will be related to the degree of risk aversion: the more risk-averse the user, the more rapidly the weights will rise. The connection between the ( p ) weights and risk aversion highlights the inadequacies of the ES and VaR. ES is characterized by all losses in the tail region having the same weight. If we interpret the weights as reflecting the users attitude towards risk, these weights imply that the user is risk neutral between all tail region outcomes. Since usually agents are risk-averse, this would make ES not a good risk measure, despite being coherence. If a user is risk averse, it should have a weighting function that gives higher losses a higher weight.

The implications for VaR are much worse, and we can see that the VaRs inadequacies are related to its failure to satisfy the increasing weight property. With the VaR, we give a large weight to the loss associated with a p-value equal to , and we give lower (actually, zero) weight to any greater loss. The implication is that the user is actually risk loving (i.e. has negative risk-aversion) in the tail loss region. To make matters worse since the weight drops to zero, we are talking about risk loving of a very aggressive sort. The blunt fact is that with the VaR weighting function, we give a large weight to a loss equal to the VaR itself, and we dont care at all about any loss exceeding VaR.

To obtain a spectral risk measure, we must specify some form of a risk aversion function. This decision is subjective but can be guided by the economic literature on utility function theory. A favorite example is the exponential risk-aversion function:

( p) =

e (1 p ) / (1 e 1/ )

Here (0, ) reflects the users degree of risk-aversion: a smaller reflecting a greater degree of risk aversion. This function satisfies the condition required of a spectral risk measure, but it is also attractive

15

because it is a simple function that depends on a single parameter , which gets smaller as users become more risk averse.

The use of a risk aversion function indicates that there is an optimal risk measure for each user, depending on their risk aversion. Two users might have identical portfolios, but their risks, as measured by a coherent risk measure, can be very different. Hence Spectral Risk Measures are very powerful by letting us define risk aversion function differently for different individuals/ portfolios. Moreover, VaR and Expected Shortfall are special cases of Spectral Risk Measures.

The theory of Coherent Risk Measure and Spectral Risk Measures are still very new to the risk management practitioners and it will take time for these tools to be adopted in industry, but given the sound theoretical foundation and the drawbacks with VaR, the change is surely going to happen.

16

Computation of VaR

Earlier in the report, VaR was defined as the maximum loss not exceeded with a given probability (called confidence level), over a pre-defined period of time. There are three parameters which need to be provided for the definition to be complete. 1. The Holding Period: The time horizon for computing the VaR number. Typical periods for using VAR are 1 day, 10 days or 1 year depending on criteria such as time required to liquidate or minimum holding period required. 2. The Confidence Level: This is the probability at which the VaR will not be exceeded by the maximum loss. The most common used intervals are 99% and 95%. 3. Currency Units: VaR is given in currency units and not in a standardized measure such as percentages. Hence it is important to state the currency that the VaR number is in.

An example of how the VaR number will be quoted is The daily VaR for the portfolio is 5 million dollar with 95% confidence. The interpretation of this number is that the portfolio will not lose more than 5 million dollars in a day with 95% probability, or equivalently, the portfolio will lose more than 5 million dollars in a day only 5% of the time i.e. once in twenty days.

To compute VaR for a portfolio, we need to decide the holding period for the portfolio and confidence level. The length of the holding period depends on the financial activities of the institution. For example, in bank supervision the interval is usually short, close to ten days. In other areas of market risk, such as asset-liability measurement for pension funds and insurance companies, the time horizon is much longer. The time horizon and the confidence level depend upon the risk managers tolerance for loss, the particular asset whose risk is being measured, or the business divisions contribution to the firms overall operations.

The next and arguably the toughest step is to come up with the distribution for the net worth of the portfolio at the end of the holding period. If the portfolio is extremely small, it might be possible to approximate the end of period distribution of the portfolio directly but this is generally not the case. Most often the portfolio will consist of large number of instruments which derive their values from common underlying factors such as interest rates, currency exchange rates, credit spreads, implied and realized

17

market volatility. In this case it is preferred to find the future values of the underlying factors and then calculate the value of the portfolio based on these factors. Since these market factors are random variables themselves the best that can be done is to approximate a joint probability distribution function from which returns of these factors could be drawn over the next period. The approximation of these density functions can be as straightforward as assuming the variables to be jointly normal or it can be extremely complicated with user defined densities and correlation.

Once the joint distribution is obtained it needs to be converted into a density function for the end of period portfolio values. This is done through what is called a mapping function. The future value of the portfolio, X , can be written as a function of the factor joint density function D,

X = f (D )
The portfolio mapping maps the N-dimensional space of the risk factors to the one-dimensional space of the portfolio future value. It depends on the kinds of instruments in the portfolio i.e. whether they are linearly related to the underlying factor or non-linearly. If this function is linear and the risk factors are assumed to be jointly normally distributed, then X is also normally distributed. This makes the process very simple and will be discussed more in the Delta-Normal VaR method. For example let D be a one dimensional normal density function. If the mapping function f is linear, then the distribution of X is also normal, as shown below

Figure 5 Linear Mapping Function

On the other hand if this function is non-linear then the multivariate distribution is distorted when it passes through this function.

18

Figure 6 Non-Linear Mapping Function

The portfolio mapping function is closely related to the method of security valuation, linear or full valuation, used in the VaR process. A linear valuation values the new security price as a linear function of the underlying risk factor. An example of linear valuation is the calculation of new option prices based on its greeks i.e.

C1 = C0 + dS
Where C1 is new option price, C0 is the initial option price, is the delta of the option, dS is the change in underlying asset price.

Full Valuation is when the new value is re-calculated based on the new values of the underlying risk factors. The biggest drawback of full valuation is the computation time required, but if the portfolio contains significant amount of non-linear instruments such as mortgage backed securities, options, full valuation is the preferred approach. In the following sections the following common VaR methodologies are discussed along with the advantages and disadvantages of these different methods. 1. Parametric - Delta-Normal method (local valuation method) - Monte Carlo simulation (full valuation method) 2. Nonparametric - Historical Simulation (full valuation method)

19

Delta-normal method

The first and the simplest VaR computation method is the Delta-Normal Method. It is a parametric, analytic technique where the distributional assumption made is that the daily geometric returns of the market variables or risk factors are multivariate normally distributed with mean return zero. Historical data is used to measure the major parameters: means, standard deviations, correlations. This method is most appropriate for portfolios which have positions whose values change linearly with respect to underlying risk factors.

More precisely, let X , be the future value of our portfolio. We can write X as a function of the risk factor joint density function D,

X = f (D )
Since the delta normal function assumes a joint normal distribution structure for the underlying factors,

D here is a joint normal distribution. Additionally, if the portfolio mapping function f () is linear, the
density D , when mapped to X results in a normal density for X . The only parameters necessary then to describe the future distribution of our portfolio value are the mean, X and standard deviation, 2 X for

X . In most cases for short holding period X is considered to be zero, and 2 X is calculated by taking
advantage of the joint normal structure of the distribution.
2 X = hChT = hi h j ij = hi h j ij i j i j i j

h = Nx1 vector of asset weights C = NxN covariance matrix for asset returns

ij = ij i j introduces the correlation

Finally the VaR number is calculated using the formula:

VaR = Z1 X
In this formula 1.65 below the mean gives 5 % level or the 95% VaR and 2.33 gives the 1 % level or 99% VaR.

20

Historical Data

Volatility, correlation model

Securities Delta Model

Estimated future volatilities and correlations

Delta Positions

Delta Valuation

Estimated Value changes

Figure 7 Delta-Normal VaR

Advantages
The Delta-Normal method is easy to implement and computationally very fast. This is because all security valuations are replaced by their linear approximations, which are easily performed as matrix multiplications. In most situations where portfolio constituents are linear functions of their under lire the delta-normal method provides an adequate measurement of market risks.

Disadvantages
The Delta-Normal method is based on an assumption of normal distribution for the underlying risk factor. It has been well documented that financial variables have fat tails i.e. there is significant amount of kurtosis in the distribution of risk factors making extreme events much more likely than what a normal distribution will suggest. These fat tails are particularly worrisome precisely because VaR attempts to capture the behavior of the portfolio return in the left tail. In this situation, a model based on a normal distribution would underestimate the proportion of outliers and hence the true Value-at-Risk. Another

21

issue with the Delta-Normal method is lack of support for nonlinear instruments, such as options or mortgages. Under the delta Delta-Normal, options positions are represented by their deltas relative to the underlying asset. Hence the Delta-Normal is not capable of capturing effects such as asymmetric return distributions of options or the associated convexity or returns.

Historical Simulation Method

The next and maybe the most commonly used VaR method is the Historical Method. It is based on the assumption that historical movements of the risk factors gives a good description on how much the risk factor is likely to move in the future. The length of historical data to consider depends on the instruments that comprise the portfolio. For example, looking at long term historical equity moves for a company that is in merger talks is going to have obvious data issues. Long data history will generally lead to factor returns that are not relevant in the current economic environment. On the other hand, a short window will not capture enough market variations to give robust VaR numbers. Hence the decision for the length of history to use is very critical and as much a qualitative decision as a quantitative one. In most cases anywhere from two to four years of history is considered reasonable.

The next step to approximate the future distribution of the portfolio involves evaluating all the position using factor returns corresponding to each of the historical points. The valuation of positions is usually done using a full valuation model since there is no assumption on the joint distribution of factor returns. Often it is easier to calculate VaR by converting this distribution into the distribution of change in portfolio value by subtracting the starting portfolio value. Some of the returns will lead to profit numbers while others will lead to losses. The VaR-95 number is obtained by ordering there P/L numbers in decreasing order and choosing the 5th percentile from the bottom, representing the maximum loss with 95% confidence. To get the VaR-99 number, the 1st percentile from the bottom is chosen.

22

Historical Returns

Securities Model

Full Valuation

Portfolio Positions

Distribution of Values Figure 8 Historical VaR

Advantages
The main advantage of historical simulation is that it makes no assumptions about risk factor returns being drawn from a particular distribution. Therefore, this methodology is consistent with the risk factor changes being from any distribution. Another important advantage is that historical simulation does not involve the estimation of any statistical parameters, such as variance or covariance, and is consequently exempt from inevitable estimation errors. It is also a methodology that is easy to explain and defend to a non-technical and important audience, such as a corporate board of directors.

Disadvantages
The most obvious disadvantage is that historical simulation, in its purest form, can be very difficult to accomplish because it requires data on all risk factors to be available over a reasonably long historical period in order to give a good representation of what might happen in the future. Another disadvantage is that historical simulation does not involve any distributional assumptions; the scenarios that are used in computing VaR are limited to those that occurred in the historical sample.

23

Monte Carlo Simulation method

The Monte Carlo simulation is considered the most powerful but the most complex of VaR methodologies. The power of this method lies in its flexibility to take into account all non-linearities of the portfolio value with respect to its underlying risk factors, and to incorporate all desirable distributional properties.

The Monte Carlo method works by generating thousands of hypothetical factor returns for the holding period. These returns are generated by using random number generators to pull out realizations from a pre-decided joint probability structure for all the return factors. Once these returns have been generated, the Monte Carlo method works exactly like the historical VaR method where the portfolio value profit and loss are calculated for each simulation result and the distribution of these P/L numbers is constructed. Of course, in the Monte Carlo method this return distribution is an anticipated hypothetical distribution whereas in the historical simulation, the distribution is based on actual factor returns.

Historical/Implied Data

Model Parameters

Stochastic Model

Simulated Risk Factors

Securities Model

Full Valuation

Portfolio Positions

Distribution of Values Figure 9 Monte Carlo VaR

24

Advantages
As already mentioned, the main attraction of the Monte Carlo method is its immense power as far as modeling returns from any joint distribution framework. Few common distributional properties that are used are fat tailed distributions and distributions with time varying volatilities. Due to this, Monte Carlo simulations can be extended to apply over longer holding periods, making it possible to use these techniques for measuring credit risk.

Disadvantages
The power of the Monte Carlo simulations is also its big drawback. To get reasonable models, one has to come up with good joint distribution functions for all the underlying risk factors. This means each market variable has to be modeled according to an estimated distribution and the relationships between distributions (such as correlation or less obvious non-linear relationships) has to be established. Using the Monte Carlo approach means one is committed to the use of such distributions and the estimations one makes. These distributions can become outdated and inappropriate. To build and keep current a Monte Carlo risk management system requires continual re-estimation, a good reserve of analytic and statistical skills, and non-automatic decisions. The other drawback that prevents more use of the Monte Carlo method is the large amount of computational resources that this method requires.

25

Stress Testing
Stress Tests are set of procedures that attempt to gauge the impact of future hypothetical events on the portfolio and are designed to answer the question: What if happens? The different measures of risk discussed till now all involve finding the complete distribution of the future portfolio value. Stress Testing is different in that it is concerned with finding a single point on the future portfolio distribution, the point corresponding to a particular event.

Stress Testing methodologies have existed as back of the envelope exercises for a long time with the management paying only limited attention to the results. But after the events of 1998 and the belated recognition that good stress testing might have helped institutions avoid some of the painful losses, the importance of stress testing within investment firms has grown in importance. Recently, Stress Testing for risk measurement has received support from two sources. From the regulatory standpoint the Amended Basel Accord of 1996 requires that banks which seek to have their capital requirements based on their internal models should have in place a rigorous and comprehensive stress testing program, and this program should include tests of the portfolio against past significant disturbances. Stress tests have also been used by organized exchanges to set their margin requirements, a good example of which is the SPAN stress testing system used by the Chicago Mercantile Exchange.

The other backing received by stress testing was when the theory of Coherent Risk Measures validated stress test results as being coherent. Losses during stress situations can be regarded as tail drawings from the relevant distribution function, and their expected value is the ES associated with this distribution function. Earlier we showed that the ES is a coherent risk measure, hence the outcome of scenario analysis are also coherent.

Procedure
From pure computational standpoint, Stress Testing are simple procedures. The first step is to identify the sources of risk to the different instruments in the portfolio. Stress tests are then conducted by shocking one or more of these underlying risk factors according to either historical events or potential future events

26

that are can cause big losses. Depending on how many risk factors are shocked simultaneously or how the shock magnitudes are decided, Stress Tests are broadly categorized as follows:

Stylized Scenarios
Stylized scenarios try to simulate major movements in one or two risk factors such as interest rates, equity etc. These scenarios can range from moderate changes to extreme values. Some possible scenarios include parallel yield curve shift up and down of 100 basis points, stock index changes of plus or minus 10%, volatility change of plus and minus 20%. Stylized Scenarios are most often used to obtain graphical description of portfolio risk to one risk factor at a time. These are very popular with management and traders to get a quick sense of portfolio exposures. For example, figure 10 shows portfolio P/L if the stock market moves different amount. A quick glance tells us that the portfolio is long equity exposure and at the same time well hedged for very big equity downside moves. Similarly figure 11 shows P/L corresponding to credit moves and informs that the portfolio is short credit, i.e. a credit blowout will make profit.

Portfolio P/L $60,000 $40,000 $ P/L $20,000 $0 ($20,000) ($40,000) -30% -20% -10% 0% 10% 20% 30% Stock Moves

Figure 10 Stylized Stock Moves

27

Portfolio P/L $60,000 $40,000 $20,000 $ P/L $0 ($20,000) ($40,000) ($60,000) -300 -200 -100 0 100 200 300 Credit Spread Moves (Bps)

Figure 11 Stylized Credit Spread Moves (Bps)

The limitation of this approach is that moving one factor at a time becomes unmanageable for large number of risk factors. Moreover since the effect of move in all factors is not considered, it becomes difficult to draw conclusions and get the overall sense of portfolio risk.

Actual Historical Events

If more than one factors need to be shocked together, often there are assumptions on how they move together. Rather than creating artificial correlations, an alternate approach is to use actual historical moves in the risk factor. This has the advantage of reducing arbitrariness and giving the scenario certain credibility that is harder to dismiss. The results are also straightforward to interpret i.e. If a World Trade Center attack type event were to happen again, what would be the impact on the entire portfolio. Appendix-I has a list of some major financial events of the past along with moves in common risk factors. The difficulty with historical simulation is choosing what events to study and how to define the start and end of the event for the purpose of calculating risk factor movement. Often major moves in different risk factors wont coincide over the same time horizon. For example the equity market might see a major correction on a certain date but the credit spread doesnt move till one week later. Depending on how strictly one wants to follow historical data and how one perceives factors to move in the future, there is considerable scope to play with the parameters.

28

Difficulties with Stress Testing

As pointed out, stress testing is based on large number of decisions such as choice of scenarios, choice of risk factors, time frame of study and how different risk factors should be combined. This makes Stress Testing very subjective, based on the judgment and experience of people carrying out the test. This is a set back since Stress Tests are most often conducted for scenarios which are very unlikely to happen and hard to predict. When the scenarios are complex it also becomes difficult to shortlist which risk factor to consider.

Stress testing Vs VaR

A final point is the comparison of VaR with Stress Testing as alternate risk measurement tools. VaR gives us an idea from a probabilistic viewpoint about the distribution of our returns and more specifically, the confidence level with which we wont lose more than a certain amount but as mentioned before, it fails to give us worst case numbers beyond the VaR number. Listing the differences between the two measures: Most of the VaR implementations in industry are based on recent historical returns. More often than not, these data do not contain any major financial event or crisis. For example, historical data might have low levels of volatility for a long time but these values will suddenly spike up when there is crisis in the market. Stress Test on the other hand is designed specifically to address the consequences arising from major events where the normal correlations in the market might break down. Stress tests explicitly give us numbers of how much we can expect to lose in specific situations. In this sense, Stress Test is a natural complement of VaR analysis. VaR gives us the maximum likely loss at certain probability, but gives us no idea of the loss we might suffer if we experience a loss in excess of VaR. By contrast, stress testing can give us a lot of information about bad states but is not designed to tell us the likelihood of these losses. The process of setting up the Stress Test reveals as much as the result itself. It can help identify major contributors of risk as well as hidden sources of risk such as liquidity risk, risk from specific counterparty default etc. It can also help the firm identify whether it can withstand very short term market shocks in a generally good market environment and if they need to take preemptive actions.

29

Stress Testing Implementation

The final section of the report discusses the exact procedures used by me to design Stress Test Simulations for the portfolios at ____. The table below lists primary risk sources for some of the common instrument types which make up the different portfolios at the firm.
Table 1 Instrument Risk Factors Instrument Type Underlying Spot Prices Principal Risk Factors Implied Credit Volatility Spread

Convertible Bonds Corporate Bonds Credit Default Swaps Forwards Futures Interest Rate Swaps Options Stocks Sovereign Bonds Treasury Bonds Variance Swaps Volatility Swaps Warrants

Time to Maturity

Interest Rates

All the Stress Tests that have been created are based on historical events and the data is obtained primarily from the Bloomberg database. Movement in each of the risk factors is studied during the historical event and effort is made to simulate the effect of the event on the current portfolio. This is done by applying the observed risk factor change to all the instruments in the portfolio and estimate profit or loss. First an algorithmic overview is provided followed by detailed discussion on shocking the individual risk factor.

30

Algorithm for Stress Testing and Scenario Analysis

1. Locate each instrument in the system and retrieve the following information: Market country and Currency of the instrument. Date of maturity. The latest trader mark price. The spot price of the underlying (If applicable). The regression beta of the underlying with major equity and currency indices. The yield curve for the instrument currency. 2. Calibrate to Model: Calculate the level of implied volatility by using the trader mark and the pricing model. This has to be done for Options, Convertible Bonds, Volatility and Variance Swaps. Calculate the level of implied credit spread using the trader mark and pricing model. This has to be done for corporate bonds, Convertible Bonds, CDS. 3. Apply the Shocks to the following risk factors as dictated by the Stress Testing Model: Underlying spot price. Implied Volatility. Credit Spread. Yield Curve. Time to Maturity. 4. Send the new information to the pricing model for a full revaluation of the instrument under the stress condition. 5. Calculate the change in instrument value from pre-stress level and multiply by the quantity in hand to obtain a profit/ loss number.

6. Aggregate across all instruments to obtain net P/L number for the Stress Test.

31

Methodology in Detail
The stress testing algorithm on the previous page gives an overview of the procedure but the actual implementation involves taking care of all the small details and keeping track of the assumptions that go into building the test. Here we detail one by one all the decisions that have to be tackled to complete the procedure.

Testing Period
For all of the scenarios, the percentage change in risk factors is computed over a pre-specified period starting from the date of the event. For our current tests the period being used is ten trading days. The reason for choosing a ten day period is to filter out daily noisy movements and evaluate the effects of shocks that persist for some time. For factors for which data is not available, a close substitute is used.

Equity Shocks
The first step in the process of shocking equity positions is the calculation of movements in the local equity indices for all the major countries the fund is exposed to. Once this data is available, individual country specific positions are shocked by a multiple times the change in the local index for that country. The multiple here is the regression coefficient of daily stock returns with the return for the local index. Securities for which regression beta has not been calculated for lack of price history, a beta coefficient of 1 is used. Specifically,

ri = rm , where ri = Return on equity position i

= Regression coefficient of individual stock against the county index

rm = Movement in country index
Special consideration is given to cash Risk Arb deals. After the deal has been announced, the equity price for the company being acquired is anchored close to the deal price and any drop in the index level is expected to have a limited impact on the stock price. The rule of thumb we follow is to use a factor of .25 to dampen any index move in the range index down 0% to index down 10%. For the range index down

32

10% to down 15%, we increase the factor to .5, and for any index move down more than 15%, the factor is 1 indicating the view that most of the deals would in trouble following such an event.

Equity Implied Volatility Shocks

To measure how the equity implied volatilities in different countries behaved, the change in the implied vols for country specific equity indices is considered. These shifts are obtained from two sources. For US, the percentage change in the VIX (Volatility) index is used while for the other countries the change in the Bloomberg Call Historical Implied Volatility is taken. These numbers reflect the implied volatility for close to At-the-money Options with one month to maturity.

Once the shifts in implied volatility for equity indices has been calculated, a methodology to shock the vols for individual positions has to be devised. One approach could be similar to equity positions i.e. use a factor to adjust index vol moves to obtain individual equity vol moves. The factor in this case can be the ratio of the historic volatility for the individual company stock returns with respect to the historic volatility of the local country equity index (volatility ratio).

i = m , where i = Shock to implied volatility of equity i

= Ratio of individual equity implied vol move to index implied vol move
m = Movement in county equity index implied volatility
There were a couple of drawbacks of using the volatility ratio, firstly our scenario engine only allows us to use one modifier at a time and using the volatility ratio meant we could not factor in a time to maturity condition. Not being able to factor in this condition meant that the volatility for all options from a month out to five years out was shocked by the same amount. A second concern against using the volatility ratio value was that these values are computed using data for regular financial conditions and the entire idea of stress testing is to capture the effects when most of the traditional relationships break down. Demand for index options, for the purpose of portfolio insurance, soar during stress conditions making them expensive compared to single name options. This causes bigger spikes in the implied vol for equity indices in comparison to individual companies. Another point against the volatility ration approach is that individual options, which already have higher implied volatilities, will not be expected to rise much more on a percentage term as compared to the index. This is the same effect that is seen in credit spreads. For

33

junk bonds, which already have very high spreads, there is not much room for credits to rise in percentage terms as compared to those bonds which have high credit rating.

To overcome the limitations mentioned above, the value that is computed for the index is used without any adjustment factor to shock the individual name vols. We still use a time to maturity modifier to dampen the vol as the maturity of options and convertible bonds increase. This modifier takes the 30 day implied volatility as the basis and implieds for longer maturity options are adjusted downward by dividing by a square root of time factor. If the 30 day option sees a 1% change in implied, the change for 60 and 90

1 1 % % day maturity options will see a 2 and 3 change respectively. The entire modifier table is given
below. Appendix-II validates the result empirically and figure 12 below the table shows the empirical results.

Table 2 Time to Maturity Modifier for Implied Volatility

Year\Months 0 1 2 3 4 5 0-1 1.00 0.28 0.20 0.16 0.14 0.13 1-2 0.71 0.27 0.20 0.16 0.14 0.13 2-3 0.58 0.26 0.19 0.16 0.14 0.13 3-4 0.50 0.25 0.19 0.16 0.14 0.13 4-5 0.45 0.24 0.19 0.16 0.14 0.12 5-6 0.41 0.24 0.18 0.15 0.14 0.12 6-7 0.38 0.23 0.18 0.15 0.13 0.12 7-8 0.35 0.22 0.18 0.15 0.13 0.12 8-9 0.33 0.22 0.17 0.15 0.13 0.12 9-10 0.32 0.21 0.17 0.15 0.13 0.12 10-11 0.30 0.21 0.17 0.15 0.13 0.12 11-12 0.29 0.20 0.17 0.14 0.13 0.12

1.2 1/sqrt(t) 1 0.8 SX5E FTSE SP X

Regression Beta

0.6 0.4 0.2 0 1M onth 3M onth 6M onth 12 M onth 18 M onth

Maturity

Figure 12 Implied Volatility adjustment factor (See Appendix-II)

34

Corporate and Sovereign Credit Shocks

The third important factor after equity and implied volatility is the shift in credit spreads. Taking into consideration the limitations of the simulation engine and data availability, only parallel moves in the credit spread curve is considered and the same shift is applied to all credit positions irrespective of rating and maturity. The following sources are used as proxy for the shift in credit for different regions.

US: Morgan Stanley Capital International (MSCI) Eurodollar Corporate Credit 3 to 5 years Spread.
Europe: MSCI Euro Corporate Credit 3 to 5 years Spread. UK: MSCI Euro-Sterling Corporate Credit 3 to 5 years Spread. Asia and Latin America: JP Morgan Emerging Markets USD CDS Spreads. The JP Morgan USD CDS spreads are used for shocking the sovereign bonds as well as individual corporate credit for the emerging markets.

Government Bond Yield Shocks

Bloomberg functions GGR (Generic Government Rates) and the Bloomberg Fair Value Curves are used to compute shifts in the treasury rates for different countries. These curves are provided for different countries and different maturities. For our tests, the five year rate is used and the yield curve is shifted in parallel.

Commodity Exposure and Volatility Shocks

Simulating shocks to commodity positions is difficult due to presence of numerous types of commodity contracts plus the added complexity of local supply-demand and seasonality conditions. Our scenario simulation uses the shifts in the price and volatilities implied by the Generic Futures contracts provided by Bloomberg. Use of these futures contract for different maturities helps us simulate the shock to the forward curve. For our simulations, contracts up to two years out are used. Commodities for which the available contracts are for less than two years out, the change in exposure and volatility for the last month where we have data is extrapolated till month 24. The table below lists the Generic Futures contract.

35

Table 3 Commodity Conditions Generic Futures Contract Light Sweet Crude Oil Natural Gas Heat Oil Gold Copper Aluminum Soybean Sugar Corn Wheat Cotton Bloomberg Symbol CL1 CL24 NG1 NG24 HO1 HO24 GC1 GC19 HG1 HG24 AL1 AL24 S 1 S12 SB1 SB8 C 1 C 14 W 1 W 10 CT1 CT10

Settle Date

The final factor that we adjust is the settle date for contracts. Since our scenarios are based on two week moves in asset prices and rates, we move the settle date of all the contracts up by fourteen days (two weeks). For contracts that expire within fourteen days, the settle date is set to one day before date of maturity. The importance of moving the settle date is to capture the theta of the portfolio, specially the contribution from the large positions in index options as a part of the portfolio hedging positions.

36

Conclusion

The goal of this report has been to cover the basics of market risk measurement starting from the recent theory of Coherent Risk Measures to the most popular market practices of Value-at-Risk and Stress Testing.

The publishing of the axiomatic Coherent Risk Measure theory became a seminal event in the field of risk management. For the first time the concept of risk measurement was given a pure mathematic foundation to stand on. Researchers could now build on the theory with full confidence without worrying about questions regarding the fundamentals. A couple of risk measures which were a direct consequence of the theory were the Expected Shortfall and the Spectral Risk Measures. At the same time, the theory clearly highlighted the assumptions behind and the shortcomings of the industry favorite, VaR, as a risk measure. Lack of Sub-additivity meant that VaR was implicitly assuming its users to be extremely risk loving. Practically, this property encourages traders and firms to break up and reduce diversification in order to cut down on margin and capital requirements. This is a nightmare for regulatory agencies and the government as the guardian of the economy.

For all its limitation, VaR is still by far the industry dominant risk measure and capital allocation tool. VaR is easy to implement and has obtained the approval of central banks and international regulatory agencies. Coherent Risk Measures are still relatively new for the financial industry and it will take a long time to replace the existing VaR systems and infrastructure.

The procedure to implement VaR is not unique, and each implementation will give a VaR number that is different than the other. Which method is most suited depends critically on the constituents of the portfolio, historical data availability and computational and analytical resources at disposal. Each method has its own advantages and limitations which have to be kept in mind.

Once the VaR system is implemented, it informs us of the minimum expected loss with a certain probability, but it doesnt tell us how bad things can get or even the expected loss going into tail events. VaR as a stand-alone risk measure will leave our portfolios exposed to very high level of tail risk. Stress Testing and Scenario Analysis fit in perfectly as complement risk measures filling the gaps left by VaR.

37

These tests are designed to answer what if and worst scenario questions and hence ensure that tail risks are taken care of. Another contrast which makes VaR and Stress Test perfect complements is the implementation. Most of the time, VaR implementations are very systematic and automated. The VaR algorithm runs in the background and the management looks at the VaR number without digging into the details. Stress Testing is the opposite, the very procedure for designing there tests force the management to look at the portfolio at the security level to accurately decide on principal risk factors. Once the results of the test come out, all the numbers have to be gone through, to validate the findings of the test. Hence Stress Testing forces a closer look at the portfolio and tail loss events, in the end, helping understand the portfolio composition much better.

These very strengths of Stress Testing also are its limitation. Since there are no fixed algorithms and a lot depends on qualitative judgment, it is easier to disregard Stress Test results as being too unfair or too imprecise. The experience of the management plays a crucial role and they have to make sure the Tests are designed such that results are fair and plausible.

38

References
[1] Artzner, P., Delbaen, F., Eber, J.-M., and Heath, D., Thinking coherently, Risk, 10(1997), 68-71. [2] Artzner, P., Delbaen, F., Eber, J.-M., and Heath, D., Coherent measures of risk, Mathematical Finance, 9(1999), 203-228. [3] Acerbi, C., and Tasche, D., On the coherence of expected shortfall, Journal of Banking & Finance, 26(2002), 1487-1503. [4] Acerbi, C., Spectral measures of risk: a coherent representation of subjective risk aversion, Journal of Banking & Finance, 26(2002), 1505-1518. [5] Cheng S., Liu Y., Wang S., Progress in Risk Measurement, Advanced Modeling and Optimization, Volume 6, Number 1, 2004. [6] J. P. Morgan Co., Riskmetrics-Technical Document, 4th ed, New York, 1996. [7] Dowd K., Measuring Market Risk, John Wiley and Sons Ltd, 2005. [8] Mark Carlson, A Brief History of the 1987 Stock Market Crash with a Discussion of the Federal Reserve Response, Board of Governors of the Federal Reserve, November 2006 [9] Eshan Karunatilleka, The Asian Economic Crisis, Economic Policy and Statistics Section, House of Commons Library, http://www.parliament.uk [10] Torben G. Andersen, Tim Bollerslev, Peter F. Christoffersen, Francis X. Diebold, Practical Volatility and Correlations Modeling for Financial Market Risk Management, NBER Working Paper 11069.

39

Appendix I Historic Stress Event Examples

This appendix contains a collection of some of the major financial events of the past two decades. Each description contains a brief summary along with a sample of some of the factor shocks that have been used to generate the Stress Test results.

October 1987 Crash

Prior to the big crash of 1987, the equity market had been posting very strong gains. Price growth had outpaced earnings growth and the price earning ratios were at historic highs. Demand for equities was also rising because of influx of new investors such as pension funds and favorable tax treatments given to the financing of corporate buyouts. This led many people to warn that the equity market was well overvalued.

Figure 13 S&P500 Level and P/E Ratios before the 1987 Crash

The initial shock to the equity market came in the form of reports that the Ways and Means committee of the US House of Representatives had filed legislations to eliminate tax benefits associated with financing mergers. This caused all investors to revalue their equity positions given that the legislation would have a significant negative effect of M&A activity. The other big news was the announcement of the August trade deficit numbers by the commerce department. These numbers were notably higher than expected. The news led to the further decline in the dollar and increase in the speculation that the Fed will tighten its policies. These events led to the fall in equity markets but the scale of the crash is attributed to program trading and portfolio insurance schemes being used by a number of trading houses and investment firm.

40

These schemes forced the traders to sell during market down events, and the overall consequence was a self fulfilling downward spiral.

Figure 14 Normalized Graphs for the Dow, USD-JPY X Rate and US 10Yr Rates

Figure 11 highlights the Macroeconomic outlook during the months leading to the crash: A. Interest rates were rising globally. US trade deficit and decline in the value of the dollar were leading to concerns about inflation and need for higher interest rates in the US as well. On 10/15/87 the yield on US 10 year treasury reached 10.23%. B. The increase in trade deficit numbers was putting pressure on the USD against other currencies like GBP and YEN.

Figure 15 Normalized US Cross Rate against Pound and Yen during 1987

41

Figure 12 shows the US dollar exchange rate against the British Pound and the Japanese Yen: A. USD Depreciating against major currencies because of higher trade deficit numbers and rising global interest rates. B. The crash caused the US interest rates to drop drastically, leading to further devaluation of the USD

Between 10/14/87 and 10/28/87 the S&P500 fell by 23.37%. All the other major indices were down by similar amount. The table below shows the numbers that are being used to shock all the other factors for the simulation of a market crash scenario.
Table 4 Factor Movement during the Oct '87 Crash
CANADA USA AUSTRIA FRANCE GERMANY SPAIN UNITED KINGDOM GREECE HONG KONG MALAYSIA PHILIPPINES SINGAPORE TAIWAN 10/14/87 10/14/87 10/14/87 10/14/87 10/14/87 10/14/87 10/14/87 10/15/87 10/15/87 10/15/87 10/15/87 10/15/87 10/15/87 10/28/87 10/28/87 10/29/87 10/28/87 10/28/87 10/28/87 10/28/87 11/5/87 11/4/87 10/30/87 10/29/87 10/30/87 10/28/87 -23.70% -23.57% -17.45% -25.73% -23.72% -26.48% -28.61% -27.32% -45.75% -35.03% -13.34% -42.33% -18.03%

42

First Gulf War 1990

The gulf war developed out of the Iraqi invasion of Kuwait on August 2, 1990. America responded by moving troops to Saudi Arabia, initially to defend the country, and later as a part of the UN Coalition force to attack Iraq. The immediate consequence of these developments was spike in the price and volatility of crude. Shown below are the Bloomberg WTI Cushing Crude Oil Spot prices from July 17 1990 to August 24 1990. The next graph shows the front month WTI implied volatility increasing from close to 30 to more than 75 during this period (Source: Goldman Sachs).

Figure 16 US WTI Crude Prices

43

Figure 17 Rolling Front Month WTI Volatility

Table 5 Factor Movement during Gulf War I Factor SPX Index VIX Index US Credit US Rates UKX Index DAX Index EUROPE Vol EUROPE Credit NKY Index KOSPI Index ASIA Vol ASIA Credit MEXBOL Index USCRWTIC Index Crude Vol From 7/31/1990 7/31/1990 7/31/1990 7/31/1990 7/31/1990 To 8/14/1990 8/13/1990 8/15/1990 8/14/1990 8/14/1990 % Move -4.71% 22.00% 20.00% 2.57% -3.96% -10.63% 31.00% 25.00% -8.84% -6.43% 26.00% 25.00% -3.37% 27.69% 150.00%

8/1/1990 8/1/1990

8/15/1990 8/13/1990

7/31/1990 7/31/1990

8/14/1990 8/14/1990

44

The Asian Currency Crisis

During early and mid 1990s, the countries in South East Asia (Thailand, Malaysia, Indonesia, Philippines) had unofficially pegged their currencies to the US dollar. As the US dollar appreciated, currencies of these countries appreciated against third party currencies making their exports less competitive and making it increasingly difficult for these countries to fund their deficits and maintain the dollar peg. Under intense pressure from speculators in the foreign exchange market, the Thai baht was finally devalued in July 1997 which set up a chain of currency devaluations of other Asian countries. The crisis became global in nature on October 27th 1997 when the US markets fell by 7% in one day.

Figure 18 Asian Currency X-Rates during 1997

A. July 2, 1997 - Thailand devalues the baht. News of the devaluation drops the value of the baht by as much as 20% - a record low. The Thai government requests "technical assistance" from the International Monetary Fund (IMF). B. July 11, 1997 - The Philippine peso is devalued. Indonesia widens its trading band for the rupiah in a move to discourage speculators. C. August 14, 1997 - Indonesia abandons the rupiah's trading band and allows the currency to float freely, triggering a plunge in the currency. D. Oct. 8, 1997 - Indonesia asks the IMF and World Bank for help after the rupiah falls more than 30% in two months, despite interventions by the country's central bank to prop up the currency.

45

Figure 19 Equity Markets in 1997

A. Oct. 23, 1997 - Hong Kong's stock index falls 10.4% after it raises bank lending rates to 300% to fend off speculative attacks on the Hong Kong dollar. The plunge on the Hong Kong Stock Exchange wipes $29.3 billion off the value of stock shares. B. Oct. 27, 1997 - Rattled by Asia's currency crisis, the Dow Jones Industrial Average plummets 554. Trading on US stock markets is suspended.
Table 6 Factor Movement during the Asian Crisis Factor SPX Index VIX Index US Credit US Rates UKX Index DAX Index VDAX Index EUROPE Credit NKY Index KOSPI Index ASIA Vol ASIA Credit IBOV Index From 10/17/97 10/17/97 10/17/97 10/17/97 10/17/97 10/17/97 10/17/97 10/17/97 10/17/97 10/17/97 To 10/31/97 10/31/97 10/31/97 10/31/97 10/31/97 10/31/97 10/31/97 10/31/97 10/31/97 10/29/97 % Move -3.13% 61.78% 51.80% -5.57% -8.13% -8.24% 38.91% 41.63% -5.83% -13.47% 79.82% 163.00% -28.04%

10/17/97

10/31/97

46

The Russian Default/ LTCM Collapse

The Asian Currency Crisis of 1997 led to a decrease in world commodity prices and Russia being heavily dependent on the export of raw materials such as oil, natural gas was heavily hit. On August 17th 1998 Russia defaulted on their short term government bonds which led to a sharp devaluation of the ruble (See below). This action of the government caused risk premia, credit spreads and volatility to jump up sharply.

Figure 20 Russian Ruble / USD - 01/08/1998 to 30/09/1998

Source: Central Bank of Russia Website

LTCM Collapse: The downfall of the fund started in May and June 1998 when net returns fell 6.42% and 10.14% respectively, reducing LTCM's capital by $461 million. This was further aggravated by the exit of Salomon Brothers from the arbitrage business in July 1998. The scheme finally unraveled in August and September 1998 when the Russian government defaulted on their government bonds (GKOs). Panicked investors sold Japanese and European bonds to buy U.S. treasury bonds. The profits that were supposed to occur as the value of these bonds converged became huge losses as the value of the bonds diverged. By the end of August the fund had lost $1.85 billion in capital (Source: Wikipedia). On August 21st 1998 LTCM portfolio lost $550 Million in one day.

47

Figure 21 Equity Markets during 1998

Timeline with reference to figure 18: A. May 27, 1998 - Russia's financial system is stretched to the breaking point as panic-stricken stock and bond markets continue to plunge, forcing the central bank to triple interest rates to 150% to avert a collapse of the ruble. June 1, 1998 - Russia's stock market crashes and Moscow's cash reserves dwindle to $14 billion amid unsuccessful attempts to prop up the ruble and pay off burgeoning debts. B. July 6, 1998 - Moscow's markets get pummeled as the government fails to raise cash by selling government shares of a state-owned oil company. C. August 6, 1998 - Asian markets plummet as Hong Kong and China step in to defend their currencies against attack. D. August 11, 1998 - The Russian market collapses. Trading on the stock market is temporarily suspended. World markets are rocked by fears of a financial meltdown in Asia and Russia. August 13, 1998 - Russia's markets collapse on fears that Moscow will run out of money and default.

E. August 17, 1998 - Russia announces a devaluation of the ruble and 90-day moratorium on foreign
debt repayment, triggering panic in Moscow as Russians line up to buy dollars. Latin American stock and bond markets plunge on fears of default and devaluation in South America. August 19, 1998 - Russia fails to pay its debt on GKO or treasury bills, officially falling into default.

48

F. Sept. 10, 1998 - The Dow loses 249 points as Brazilian stocks fall 16%, adding to drops that have erased half the Brazil market's value. In Mexico, the Central Bank sells some $50 million in its first attempt to buoy the peso in three years. Sept. 11, 1998 - The IMF announces that the debacle in Latin American markets is "an overreaction to Russian events" and that it is ready to lend Latin American countries, using an emergency line of credit. Investors flee Brazil, drawing out more than $2 billion a day despite an interest rate rise to 50% by the Central Bank. G. Dec. 3, 1998 - In Brazil, the congress rejects a key social security tax increase sought by the IMF, prompting a rout in Brazilian markets and stock sell-offs throughout Latin America and on Wall Street.

Figure 22 US. Japan Equity Markets, X-Rate and US 10Yr Interest Rates during 1998

A. June 12, 1998 - Japan announces that its economy is in a recession for the first time in 23 years. June 17, 1998 - The yen's fall to levels near 144 to the dollar rattles Wall Street, prompting the US Treasury and Federal Reserve to intervene to prop up the yen. Japan and the US spend some $6 billion to buy yen in order to strengthen it. B. August 21, 1998 - Russia's economic crisis shakes world markets, bulldozing stocks and bonds in Latin American and reverberating through the US and Europe. Investors pile into US Treasury bonds as a safe haven from the storm, causing yields to drop to record lows. C. August 31, 1998 - After weeks of decline, Wall Street is overwhelmed by the turmoil in Russia and world markets. The Dow Industrial average plunges 512 points, the second-worst point loss in the Dow's history. D. Sept. 4, 1998 - Federal Reserve Chairman Alan Greenspan says that the US is ready to cut interest rates to keep the crisis from snuffing out US growth. "It is just not credible that the United States can remain an oasis of prosperity," he says.

49

E. Sept. 8, 1998 - The Dow surges 381 points after Greenspan suggests that policy makers are considering an interest cut. F. Sept. 17, 1998 - Tokyo's Nikkei index hits a 12-year low amid steep declines in Hong Kong, France, Britain and the US. The Dow drops 216 points. G. Sept. 24, 1998 - Stocks on Wall Street and in Europe swoon amid fears that the losses suffered by the world's largest banks in the Long Term Capital debacle could put the entire banking system at risk. Sept. 29, 1998 - The Fed cuts interest rates by a quarter point. Sept. 30, 1998 - Worries that the Fed isn't doing enough to rescue the US and global economies cause a 238-point drop in the Dow, for a loss of more than 500 points in a week. Investors around the world flock to US Treasury bonds for safety, causing the yield on 30-year bonds to drop below 5% for the first time in three decades. H. Oct. 15, 1998 - The Fed cuts interest rates for a second time to prevent weak financial markets from tripping the US into a recession. The Dow shoots up 331 points and world markets rally.

Figure 23 Asian Credit Spreads 1998 and beyond

50

Figure 24 Latin American Credit Spreads 1998 and beyond Table 7 Factor Movement during the Russian Crisis Factor SPX Index VIX Index US Credit US Rates UKX Index DAX Index VDAX Index EUROPE Credit NKY Index KOSPI Index ASIA Vol ASIA Credit IBOV Index From 8/17/98 8/17/98 8/17/98 8/17/98 8/17/98 8/17/98 8/17/98 8/17/98 8/18/98 8/18/98 To 8/31/98 8/31/98 8/31/98 8/31/98 9/1/98 8/31/98 8/31/98 8/31/98 9/1/98 8/29/98 % Move -11.66% 38.98% 45.64% -8.70% -5.45% -11.41% 44.05% 29.81% -4.61% 4.68% 60.00% 66.87% -24.83%

8/17/98

8/31/98

51

The World Trade Center Attack

On September 11 2001, the two World Trade Center towers and the Pentagon were attacked by terrorists who hijacked commercial airliners and flew them into these buildings. The attack happened in the morning and trading was suspended on the NYSE, American Stock Exchange and NASDAQ for that day. An attack of such huge proportions in the heart of the financial markets had reverberations throughout the world financial system. When the markets finally opened on September 17 with the S&P500 down 4.92% and the Dow Jones Industrial Average down 7.1% or 628 points, its biggest ever one day point decline. All the other major world indices were also significantly down. The other expected consequences of such an event were: a big spike in the implied vols, widening of credit spreads and rebound in treasury and government bond prices. In the commodity markets, crude markets saw a huge rise in volatility. The first reaction of the market was to price in a prospective war in the Middle East which saw the crude go up, but the subsequent grounding of all airplanes in the US and the drastic fall in air travelers saw crude falling from the pre 9/11 level over the ten day period. All other major commodities also saw a spike in the implied vols. The next few pages gives a detailed listing to what happened to equity, vols, credit, treasury rates and commodity prices after the attack.
Table 8 Factor Movement during the WTC Attach Scenario Factor SPX Index VIX Index US Credit US Rates UKX Index DAX Index V2X Index EUROPE Credit NKY Index KOSPI Index ASIA Vol ASIA Credit IBOV Index From 9/10/01 9/10/01 9/10/01 9/10/01 9/10/01 9/10/01 9/10/01 9/10/01 9/11/01 9/11/01 To 9/24/01 9/24/01 9/24/01 9/24/01 9/24/01 9/24/01 9/24/01 9/24/01 9/26/01 9/25/01 % Move -7.80% 18.56% 20.69% -9.80% -8.34% -13.52% 43.70% 23.73% -6.33% -12.66% 69.00% 21.79% 11.66%

9/10/01

9/24/01

52

Argentina Debt Default

During the 1980s Argentina was suffering from hyperinflation. To overcome that, the government decided to implement a currency board in 1990. Under this set-up the Argentine Peso was fully convertible into USD at a fixed rate. This immediately had an effect of taming inflation and from 1990 till 1997 the Argentine economy grew at a rapid rate. But in 1997 the economy started slowing down. At the same time during the first decade of 1990, the USD appreciated substantially against other major currencies, and the currency board meant the Argentine currency also appreciated and made Argentine exports uncompetitive. To add to their misery, Brazil devalued their Real in January 1999, and Brazil being Argentinas main competitor, this hurt their exports even further.

Figure 25 Currency Devaluation Timeline

A. January 1995 Mexican Peso Devaluation B. 1994 and January 1999 Brazil Real Devaluation C. February 2001 Turkish Lira Devaluation. D. January 2002 Argentine Peso Devaluation. The economic situation in Argentina worsened over 2001, and after several interventions by the IMF, the Argentine government finally devalued their currency in January 2002 and announced a default on their international debt.

53

Figure 26 CDS Spreads LATAM, Senior Govt Bonds

Figure 27 US, Argentina and Brazil Equity Markets 2001-02

Figure 28 Argentina Credit Spread and Rates 2001-02

Figure 29 Argentina Fx Reserves

54

Appendix II Examples of Instrument Stress Testing

Example 1: Equity Positions
Obtain home country of equity position

Obtain the regression Beta of the equity returns with the returns for an equity index from the home country

Apply a Beta adjusted shock to the equity return over the predetermined horizon

Multiply by quantity to obtain portfolio P/L

Example 2: Corporate Bonds\ CDS

Calibrate the credit spread by using the latest mark Use the shock to move the credit spread Move the settle date forward and shock the interest rate

Send the new information to the pricing model

55

Example 3: Options (Equities and Fx)

Option Type (Equity or Fx) Equity Calibrate to an implied vol using the latest mark

Fx

Read the latest implied vol from the implied volatility surface provided by traders

Apply the shock to the implied vol as dictated by the stress test model

Apply shock to spot price and move settle date forward 14 Days

Send the new parameters to the pricing model to obtain the new option price

56

Appendix III Effect of an Event Shock on the Implied Volatility Term Structure
Introduction

The historical data for volatility indices such as VIX and VDAX or data on historical implied volatilities for indices are computed from near month options (approximately with one month to maturity). Studying how these indices move during extreme financial events and applying the same moves to simulate the effect on all option positions, irrespective of their maturity, introduces significant error. The reason being that implieds for long dated options will move much less as compared to short maturity options. The solution is to use a duration adjustment factor for the percentage moves in implied volatility as maturity increases. To come up with a good factor we need to study how the implied volatilities for equity options with different maturities react to event shocks. In particular, we want to find a relationship between jumps in the implied volatility for front month options and jumps for longer dated options. Having such a relationship will enable us to accurately modify moves to longer dated implied volatility based on what is happening to front month volatility.

Data

The data is for the daily observations of the implied volatility surface for following indices: S&P 500, FTSE 100 and Nikkei 225. The length of the series varies from ten to fourteen months. The sample below shows the organization of the data by maturity and strike (moneyness). Moneyness of an option is defined by the ratio K/S where K is the strike price and S is the spot price. Hence a 90% moneyness option is an option with K/S being .90. This option will be an out-of-the-money put or in-the-money call. Similarly a 110% moneyness option will be an in-the-money put or out-of-the-money call. The sample data is for S&P index for two trading days 6/22/06 and 6/23/06.
Table 9 Sample Fx Volatility Surface Data
Moneyness (K/S) Market Date 6/22/2006 6/22/2006 6/22/2006 Months 1 3 6 90 23.73 20.24 19.03 95 18.67 17.34 17 100 13.81 14.41 14.97 105 10.63 11.74 13.03 110 12.63 10.25 11.39

57

6/22/2006 6/22/2006 6/22/2006 6/22/2006 6/22/2006 6/22/2006 6/22/2006 6/22/2006 6/23/2006 6/23/2006 6/23/2006 6/23/2006 6/23/2006 6/23/2006 6/23/2006 6/23/2006 6/23/2006 6/23/2006 6/23/2006

9 12 18 24 36 48 60 72 1 3 6 9 12 18 24 36 48 60 72

18.54 18.21 17.72 18.32 19.27 20.21 21.19 22.04 23.5 20.4 19.05 18.59 18.28 17.96 18.33 19.29 20.22 21.21 22.05

16.94 16.89 16.77 17.43 18.51 19.55 20.62 21.52 18.79 17.48 17.03 17.02 16.96 16.99 17.45 18.52 19.57 20.64 21.54

15.29 15.53 15.81 16.56 17.76 18.92 20.07 21.03 14.04 14.55 15.01 15.39 15.58 15.96 16.58 17.78 18.94 20.09 21.05

13.67 14.18 14.88 15.71 17.03 18.3 19.54 20.56 10.66 11.89 13.07 13.79 14.21 14.91 15.73 17.05 18.32 19.56 20.57

12.2 12.93 13.97 14.89 16.33 17.71 19.03 20.1 11.91 10.54 11.49 12.31 12.92 13.89 14.91 16.35 17.73 19.05 20.12

Graphing data (see below) for 6/23/06 from the above table shows the implied volatility for options with different maturities and moneyness. Some of the trends that are clearly visible in the figure are: The implied volatility for options decreases as the moneyness increases. One reason for such a trend could be because of the big demand for out of the money put options by portfolio managers. This would make such options more expensive leading to a higher implied vol being backed out from the option pricing formula. The implied volatilities for 90% and 95% moneyness options show a smile with respect to time to maturity whereas for the other moneyness options the implieds are monotonically increasing with maturity. For long dated options, the implied volatilities for all options are close together.

58

Implied Vol for different maturities and moneyness

25

20

Implied Vol

15

10

90% Moneyness 5 105% Moneyness

95% Moneyness 110% Moneyness

100% Moneyness

0 1 3 6 9 12 18 24 36 48 60 72 Months to Maturity

Figure 30 Implied Vol for different maturities and moneyness

Analysis

The goal is to see the relation between change in the implied volatility for the front month options and change in implied volatility for options with longer maturity. For this purpose, the following regression is run,

y = + x + , where y = Daily percentage moves for n-month implied vol (n=3, 6, 9, 12 ) x = Daily percentage moves for 1-month implied vol
This regression is done for options of different moneyness and for different indices. Next few tables show all the regression results and the plots of the betas against time to maturity of the options.

Observations

The tables and graphs below show the results of the different regressions. We would expect the percentage moves in implied volatility go down as the maturity of the option increases. This is confirmed by monotonically decreasing regression beta for all the there indices. Hence options with small time to maturity are expected to see big jumps in their implied vols. A surprising result from the next few tables show that keeping time to maturity constant, the shock to the implied vols go up as the moneyness of the options go down. That means a 90% moneyness options should see its implied vol jump up more than

59

what a 110% moneyness option will. The exact reason why we are seeing this is not clear. One potential explanation could again be linked to higher demand for out of the money puts (low moneyness) as compared to out of the money calls (high moneyness). This is especially true in a high vol of vol environment where fund managers are rethinking their hedging strategies and buying more protection. From the graph we see that this result is more pronounced for S&P options as compared to FTSE Index. Interestingly for the Nikkei Index, all the different beta graphs are bunched together very closely.

Results
We had set out to see if we could find a relationship between change in implied vols for front month options and change in implied vols for longer dated options. Table 10 along with the figure shows the inverse relation between time to maturity of options and movements in implieds vols. An extra column for 1/sqrt(Maturity) has been added to table 10 to compare with the regression betas. The figure shows that this factor does a very good job of approximating the true dampening factors (regression betas).
Table 10 Regression Betas for different maturities Implied Vol 1 Month 1 1 1 1 3 Month 0.57735 0.593587 0.545737 0.601469 6 Month 0.408248 0.408456 0.352743 0.424272 12 Month 0.288675 0.263929 0.228481 0.221618 18 Month 0.235702 0.203745 0.184547 0.208551

1/sqrt(t) SPX SX5E FTSE

Beta vs Month to Maturity for Different Indices

0.70 0.60 0.50

Beta Factor 1/sqrt(t) SPX Index FTSE Index NKY Index

0.40 0.30 0.20 0.10 0.00 3 6 9 12 18 24 36 48 60

72

120

Month to Maturity

Figure 31 Comparison of Regession Betas with 1/sqrt(Maturity)

60

1.2 1/sqrt(t) 1 0.8 0.6 0.4 0.2 0 1 Month 3 Month 6 Month 9 Month 12 Month 18 Month 24 Month 36 Month 48 Month 60 Month 72 Month 120 Month
1/sqrt(t) 0.70 90% Moneyness ATM 0.60 110% Moneyness 60 72

SP X

Figure 32 SPX Regression Beta and 1/Sqrt(Maturity)

SPX (Different Moneyness) 0.80

0.50 Beta

0.40

0.30

0.20

0.10

0.00 3 6 9 12 18 24 36 48 120 Months to Maturity

Figure 33 Regression Beta for different Moneyness

61

Appendix IV Bloomberg Data Sources

Scenario Data Catalog Region US+CAD Country CANADA EQUITY GOVT Details S$P/ TSX COMPOSITE INDEX BFV CAD EURO GOVT/AGENCY AAA 3 MONTH CANADIAN GOVT BONDS 2YR NOTE CANADIAN GOVT BONDS 5YR NOTE CANADIAN GOVT BONDS 10YR NOTE CAD CANADA SOV IYC7 ZC YIELD 5 YEAR BFV CAD CANADA CORP AA 3 MONTH BFV CAD CANADA CORP A 3 MONTH BFV CAD CANADA CORP BBB 3 MONTH BFV CAD CANADA UTILITY A 3 MONTH BFV CAD CANADA UTILITY BBB 3 MONTH BFV CAD CANADA TELEPHONE A 3 MONTH S&P500 S&P500 BFV USD US TREASURY STRIPS 3 MONTH 6 MONTH 1 YEAR 5 YEAR 10 YEAR BFV BFV BFV BFV BFV BFV BFV BFV S&P S&P S&P S&P USD USD USD USD USD USD USD USD US US US US US US US US US US US US BANK AA 3 MONTH BANK A 3 MONTH BANK BBB 3 MONTH FIN AAA 3 MONTH FIN AA 3 MONTH FIN A 3 MONTH UTIL A 3 MONTH UTIL BBB+ 3 MONTH SPEC GRADE CREDIT INDEX INV GRADE CREDIT INDEX INV GRADE CREDIT SPREAD LEVEL INDEX SPEC GRADE CREDIT SPREAD LEVEL INDEX Bloomberg SPTSX INDEX C4303M INDEX GCAN2YR INDEX GCAN3YR INDEX GCAN10YR INDEX I00705Y INDEX C2863M C2873M C2883M C2953M C2973M C3043M SPX INDEX VIX INDEX C0793M INDEX C0796M INDEX C0791Y INDEX C0795Y INDEX C07910Y INDEX C0683M C0703M C0723M C0213M C0233M C0263M C0363M C0383M INDEX INDEX INDEX INDEX INDEX INDEX INDEX INDEX Start

SOV CORP

7/5/93 6/21/89 6/22/89 6/21/89 12/30/94 3/9/92 3/9/92 3/9/92 3/5/02 3/5/02 2/27/01

US EQUITY EQUITY VOL GOVT RATES

1/2/90 4/16/91 4/16/91 4/16/91 4/16/91 4/16/91 3/10/00 3/10/00 7/10/91 4/16/91 4/16/91 4/16/91 4/16/91 4/16/91 12/31/98 12/31/98 12/31/98 12/31/98 12/31/93

CORP BONDS BANK AA BANK A BANK BBB FIN AAA FIN AA FIN A UTIL A UTIL BBB+ CREDIT

INDUS INDUS INDUS INDUS

SPCISPEC INDEX SPCIINV INDEX SPCIINCS INDEX SPCISPCS INDEX EDCR3SP INDEX

MSCI EURODOLLAR CREDIT CORPORATE 3 TO 5 YR SPRD WEST EUROPE AUSTRIA EQUITY EQUITY VOL GOVT SOV BELGIUM EQUITY GOVT SOV EU

VIENNA STOCK EXCHANGE AUSTRIAN TRADED INDEX HIST CALL IMP VOL FOR ATX INDEX AUSTRIA GOVT BONDS 5 YEAR BFV EUR AUSTRIA SOV 5 YR AUR AUSTRIA SOV FMC 908 ZC YIELD 5 YEAR BRUSSELS STOCK EXCHANGE ALL SHARES RET BELGIUM GOVT BONDS 5 YEAR BFV EUR BELGIUM SOV 5 YEAR

ATX INDEX GAGB5YR INDEX C9085Y INDEX F90805Y INDEX BELSTK INDEX GBGB5YR INDEX C9005Y INDEX

1/8/86 3/1/94 1/20/93 12/9/94 4/30/98 10/3/88 1/4/93 12/9/94

62

EQUITY SOV

CORP

DJ EURO STOXX PRICE INDEX EUR BFV EUR SOV AAA BENCHMARK 3 MONTHS MSCI EURO DEBT EMU SOV AVG YIELD MSCI EURO DEBT EMU SOV 3-5 YR AV YIELD BFV EUR EUROZONE INDUSTRIAL AA+/AA 3 MONTHS BFV EUR EUROZONE INDUSTRIAL AA- 3 MONTHS BFV EUR EUROZONE INDUSTRIAL A 3 MONTHS BFV EUR EUROZONE INDUSTRIAL BBB+ 3 MONTHS BFV EUR EUROZONE INDUSTRIAL BBB 3 MONTHS JPM CREDIT INDEX GOVT SPRD 3 TO 5 YRS MSCI EURO CREDIT CORP 3 TO 5 YRS SRD

SXXE INDEX C9603M INDEX MCSVYL INDEX ME35YL INDEX C4623M INDEX C4633M INDEX C4653M INDEX C4673M INDEX C4683M INDEX JMGSC3 INDEX ECCO3SP INDEX HEX INDEX MCFIEYL INDEX F91903M INDEX MFI3YL INDEX GFIN5YR INDEX CAC INDEX GBTF3MO INDEX GFRN4 INDEX MIB30 INDEX GBTPGR5 INDEX C9055Y INDEX C0595Y INDEX LUXXX INDEX DAX INDEX VDAX INDEX C9103M INDEX GDBR5 INDEX C3193M INDEX C1613M INDEX C1623M INDEX C9223M INDEX C9233M INDEX AEX INDEX GNTH5YR INDEX C9205Y INDEX OBX INDEX GNOR5YR INDEX F26605Y INDEX C2665Y INDEX BVLX INDEX GSPT5YR INDEX C9175Y INDEX

12/31/86 12/9/98 12/31/93 12/31/93 8/30/01 8/30/01 8/30/01 8/30/01 8/30/01 1/4/99 12/31/93 1/2/87 12/31/93 6/18/98 12/31/93 1/8/96 7/9/87 3/1/94 6/15/89 8/6/90 12/31/92 11/17/95 5/7/93 4/28/97 9/4/00

CREDIT

FINLAND EQUITY SOV GOVT FRANCE EQUITY EQUITY VOL GOVT ITALY EQUITY EQUITY VOL GOVT SOV LUXEMBOURG EQUITY GERMANY EQUITY EQUITY VOL GOVT CORP

OMX HELSINKI INDEX MSCI EURO SOV DEBT EMU SOV FINLAND EUR FIN SOV FMC919 ZC YIELD 3MO MSCI FINLAND 3-5 YR AVG YIELD FINLAND GOVT BOND GENERIC 5YR CAC 40 INDEX HIST CALL IMP VOL FOR CAC INDEX FRANCE TRSRY BILLS 3MO FRANCE GOVT OATS/BTAN 5YR BTAN MIB30-MILAN MIB30 INDEX HIST CALL IMP VOL FOR MIB30 INDEX ITALY GOVT BONDS 5 YEAR GROSS YIELD BFV EUR ITALY SOV 5YR BFV USD GLOBAL ITALY SOV 5YR LUXEMBOURG STOCK EXCHANGE LUXX INDEX DEUTSCHE BORSE AG GERMAN STOCK INDEX DAX DEUTSCHE BORSE AG DAX VOL INDEX BFV EUR GERMANY SOV 3 MONTHS GERMAN GOVT BONDS 5YR OBL BFV EUR GERMAN PUBLIC BANKS 3 MONTHS EUR/DEM SCHULDSCHEINDARLEHEN 3 MO EURO PFANDERI.. RENAME RENAME AEX AMSTREDAM EXCHANGE INDEX HIST CALL IMP VOL FOR AEX INDEX NETHERLANDS GOVT 5YR BOND NA BFV EUR NETHERLANDS SOV 5YR OSLO STOCK EXCHANGE HIST CALL IMP VOL FOR OBX INDEX NORWAY GOVT 5YR BOND NO NOK NORWAY SOV FMC266 ZC 5YR YLD BFV NOK NORWAY SOV 5YR BVLX- PSI GENERAL INDEX PORTUGESE GOVT BONDS 5YR NOTE PORTUGAL PL BFV EUR PORTUGAL SOV 5 YEAR

1/2/92 10/3/91 2/19/91 4/27/99 7/1/92 7/1/92 8/25/98 8/25/98 1/3/83 3/4/94 8/6/90 4/16/91 11/5/01 8/24/94 1/8/96 10/30/96 7/10/98 1/5/88 8/18/97 12/9/94

NETHERLANDS EQUITY EQUITY VOL GOVT SOV NORWAY EQUITY EQUITY VOL GOVT SOV PORTUGAL EQUITY GOVT SOV

63

EUR PORTUGAL SOV FMC 917 ZC YIELD 5 YR SPAIN EQUITY GOVT SOV SWITZERLAND EQUITY EQUITY VOL GOVT SOV UK EQUITY EQUITY VOL GOVT CORP IBEX 35 INDEX SPANISH GOVT GENERIC BONDS 5YR NOTE BFV EUR SPAIN SOV 5 YR SWISS MARKET INDEX HIST CALL IMP VOL FOR SMI INDEX SWITZERLAND GOVT BONDS 5YR NOTE GENERIC BID YIELD BFV CHF SWITZERLAND SOV 5YR

F91705Y INDEX IBEX INDEX GSPG5YR INDEX C9025Y INDEX SMI INDEX GSWISS05 INDEX C2565Y INDEX

4/30/98 1/5/87 1/4/93 6/9/93 7/1/88 11/21/94 10/12/94 2/25/94

FTSE100 HIST CALL IMP VOL FOR UKX INDEX BFV GBP UK GILTS 3 MONTHS UK GOVT BONDS 5 YR NOTE GENERIC BID YIELD BFV GBP EURO AAA 3 MONTH BFV GBP EURO AA 3 MONTH BFV GBP EURO A 3 MONTH MSCI EUROSTERLING CREDIT CORP 3 TO 5 YR SPRD CORP

UKX INDEX C1103M INDEX GUKG5 INDEX C4003M INDEX C4023M INDEX C4043M INDEX ESCO3SP INDEX

1/3/84 3/9/94 4/16/91 1/1/92 11/12/92 11/12/92 4/30/93 12/31/93

EAST EUROPE

CZECH REP SOV CORP

BFV BFV BFV BFV

CZK CZK CZK CZK

CZECH REP SOV 3 MONTHS AAA 3 MONTHS AA 3 MONTHS AA 3 MONTHS

C4803M C4813M C4813M C4833M

INDEX INDEX INDEX INDEX

1/20/97 4/7/00 4/7/00 1/23/01 1/2/87 6/22/98 8/1/00 12/31/98 5/29/98 3/4/99 4/16/91 4/16/91 12/31/93 6/20/94 11/17/00 1/2/90 7/5/00 6/30/95 1/1/97 12/9/94 5/29/92 2/13/01 1/1/84 4/16/91 6/16/00 9/8/98 8/23/00

GREECE EQUITY GOVT SOV HUNGARY SOV POLAND SOV CORP EM SOV RUSSIA EQUITY SOV TURKEY EQUITY SOV S AFRICA EQUITY GOVT SOV AUSTRALIA EQUITY EQUITY VOL GOVT SOV CORP

ATHENS STOCK EXCHANGE GENERAL INDEX GREECE GOVT BOND 5YR ACTING AS BENCHMARK EUR GREECE SOV GMC 904 ZC YIELD 5 YR MSCI HUN 3-5YR SOV SPREAD PLN POLAND SOV FMC119 ZC YLD 3M PLAND GOVT BOND 5 YR YIELD BFV PLN AAA 3 MONTHS BFV PLN AA 3 MONTHS MSCI EM LOC SOV 3-5 YRS POL,ZA,CZE,HUN MOSCOW STOCK EXCHANGE ASP GENERAL INDEX BFV USD EURO RUSSIA SOV 3M XU100 ISE NATIONAL 100 INDEX BFV EUR TURKEY SOV 3M JALSH-FTSE/JSE AFRICA ALL SHR SA GOVT BONDS 5 YR NOTE GENERIC BID YIELD BFV ZAR S A SOV 3M S&P AUSTRALIAN STOCK EXCHANGE 200 INDEX HIST CALL IMP VOL FOR AS51 INDEX AUSTRALIA GOVT BONDS GENERIC BID YIELD 5 YR BFV AUD AUSTR SOV 3M BFV AUD AUSTR DOM AAA 3M BFV AUD AUSTR DOM AA 3M BFV AUD AUSTR DOM A 3M

ASE INDEX GGGB5YR INDEX F90405Y INDEX MHU3SP INDEX F11903M INDEX POGB5YR INDEX C1183M INDEX C1213M INDEX MCM3SP INDEX ASPGEN INDEX C8073M INDEX XU100 INDEX C9243M INDEX JALSH INDEX GSAB5YR INDEX C2623M INDEX AS51 INDEX GACGB5 C1273M C3573M C3583M C3593M INDEX INDEX INDEX INDEX INDEX

ASIA

64

CHINA EQUITY GOVT SOV CREDIT HONG KONG EQUITY EQUITY VOL GOVT

SHANGHAI STOCK EXCHANGE COMPOSITE INDEX CHINA GOVT BOND GENERIC BID YIELD 5 YEAR BFV CNY CHINA SOV 5YEAR JP MORGAN ASIA BOND WEIGHTED SPREAD CHINA HONG KONG HANG SENG INDEX HIST CALL IMP VOL FOR HANG SEN INDEX HKMA HONG KONG EXCH FUND BILL 3 MONTH HKMA HONG KONG EXCH FUND BILL 6 MONTH HKMA HONG KONG EXCH FUND BILL 12 MONTH HKMA HONG KONG EXCH FUND NOTES 5 YEAR HKMA HONG KONG EXCH FUND NOTES 10 YEAR HKD HK SOV FMC125 ZC 3M HKD HK SOV FMC125 ZC 6M HKD HK SOV FMC125 ZC 1Y HKD HK SOV FMC125 ZC 5Y HKD HK SOV FMC125 ZC 10Y JP MORGAN ASIA BOND WEIGHTED SPREAD HK NATIONAL STOCK EXCHANGE S&P CNX NIFTY INDEX HIST CALL IMP VOL FOR NIFTY INDEX JP MORGAN ASIA BOND WEIGHTED SPREAD INDIA INDIA GOVT BOND GENERIC BID YIELD 5YR INDIA SOV FMC 123 ZC YIELD 5YR JP JP JP JP JP MORGAN MORGAN MORGAN MORGAN MORGAN ASIA ASIA ASIA ASIA ASIA BOND BOND BOND BOND BOND WEIGHTED WEIGHTED WEIGHTED WEIGHTED WEIGHTED SPREAD SPREAD SPREAD SPREAD SPREAD INDIA INDIA INDIA INDIA INDIA AUTO INDU UTILITY FINANCIAL

SHCOMP INDEX GCNY5YR INDEX C0205Y INDEX CHWDCH Index HSI INDEX GHKTB3M INDEX GHKTB6M INDEX GHKTB12M INDEX GHKGB5Y INDEX GHKGB10Y INDEX F12503M INDEX F12506M INDEX F12501Y INDEX F12505Y INDEX F12510Y INDEX CHWDHK Index NIFTY INDEX CHWDIN INDEX GIND5YR INDEX F12305Y CHWDINAU Index CHWDINPT Index CHWDINQS Index CHWDINUT Index CHWDIN Index JCI INDEX F13203M INDEX CHWDID INDEX NKY INDEX

1/3/95 6/8/05 3/28/03 12/31/98

CREDIT INDIA EQUITY EQUITY VOL SPREAD GOVT SOV SPREAD

10/28/91 10/28/91 10/28/91 9/27/94 10/31/96 7/9/97 7/9/97 7/9/97 7/9/97 7/9/97 12/31/98 7/3/90 7/16/01 12/31/98 5/24/01 11/13/98 12/31/98 12/31/98 12/31/98 12/31/98 12/31/98 4/4/83 12/30/94 12/31/98 1/4/72 7/18/94 5/13/99 7/10/92 11/1/95 4/4/88 10/22/87 9/30/92 6/29/98 1/13/99 6/8/99 5/26/99 5/20/99 6/9/93 6/9/93

CREDIT INDONESIA EQUITY SOV CREDIT JAPAN EQUITY EQUITY VOL GOVT

INDEX JAKARTA SE IDR INDO SOV FMC 132 ZC 3M JP MORGAN ASIA BOND WEIGHTED SPREAD INDONESIA NIKKEI 225 HIST CALL IMP JPN GOVT BOND JPN GOVT BOND JPN GOVT BOND JPN GOVT BOND JPN GOVT BOND BFV JPY JAPAN BFV BFV BFV BFV BFV BFV BFV JPY JPY JPY JPY JPY JPY JPY

VOL FOR NKY INDEX 3 MONTH SIMPLE YIELD 6 MONTH SIMPLE YIELD 1 YEAR SIMPLE YIELD 5 YEAR SIMPLE YIELD 10 YEAR SIMPLE YIELD SOV 10-30 YR 3 MONTH

GJFB3MO INDEX GJTB6MO INDEX GJGB1 INDEX GJGB5 INDEX GJGB10 INDEX C1053M INDEX C2133M C2183M C2033M C2043M C2063M C4203M C4213M INDEX INDEX INDEX INDEX INDEX INDEX INDEX

CORP BANK BANK INDU INDU INDU EURO EURO

A BBB AA A BB AAA AA

JAPAN BANK A 3 MONTH JAPAN BANK BBB 3 MONTH JAPAN INDU AA 3 MONTH JAPAN INDU A 3 MONTH JAPAN INDU BB 3 MONTH EURO AAA 3 MONTH EURO AA 3 MONTH

KOREA EQUITY GOVT

KOREA STOCK EXCHANGE KOSPI INDEX BFV KRW KOREA TSRY 3 MONTH

KOSPI INDEX C2323M INDEX

1/4/80 8/16/99

65

KOREA SEC DEALERS ASS SOUTH KOREA T-BOND 5 YR CORP BFV KRW KOREA INDU AAA 3 MONTH BFV KRW KOREA INDU AA 3 MONTH BFV KRW KOREA INDU A+ 3 MONTH BFV KRW KOREA INDU A 3 MONTH BFV KRW KOREA INDU A- 3 MONTH BFV KRW KOREA INDU BBB+ 3 MONTH BFV KRW KOREA INDU BBB 3 MONTH BFV KRW KOREA INDU BBB- 3 MONTH BFV KRW KOREA ELEC POW 3 MONTH JP MORGAN ASIA BOND WEIGHTED SPREAD JP MORGAN ASIA BOND WEIGHTED SPREAD JP MORGAN ASIA BOND WEIGHTED SPREAD JP MORGAN ASIA BOND WEIGHTED SPREAD JP MORGAN ASIA BOND WEIGHTED SPREAD

GVSK5YR INDEX C4403M INDEX C4433M INDEX C4443M INDEX C4453M INDEX C4463M INDEX C4473M INDEX C4483M INDEX C4493M INDEX C2313M INDEX CHWDKO INDEX CHWDKOEL Index CHWDKOST Index CHWDKOUT Index CHWDKOBK Index

8/7/00 1/14/00 1/14/00 1/14/00 1/14/00 1/14/00 1/14/00 1/14/00 1/14/00 1/14/00 12/31/98 12/31/98 12/31/98 12/31/98 4/25/00

SPREAD

KOREA KOREA KOREA KOREA KOREA

TEL INDU UTILITY FINANCIAL

MALAYSIA EQUITY EQUITY VOL SPREAD GOVT SOV CREDIT

KUALA LUMPUR STOCK EXCHANGE COMPOSITE INDEX HIST CALL IMP VOL FOR KLCI INDEX JP MORGAN ASIA BOND WEIGHTED SPREAD MALAYSIA BANK NEGARA 5YR GOVT SEC INDICATIVE YTM MYR MALAYSIA SOV ZC YIELD 3M JP JP JP JP JP MORGAN MORGAN MORGAN MORGAN MORGAN ASIA ASIA ASIA ASIA ASIA BOND BOND BOND BOND BOND WEIGHTED WEIGHTED WEIGHTED WEIGHTED WEIGHTED SPREAD SPREAD SPREAD SPREAD SPREAD MALAYSIA MAL TEL MAL UTILITY MAL FINANCIAL MAL TRANS

KLCI INDEX CHWDMA INDEX MGIY5Y INDEX F12803M INDEX CHWDMA Index CHWDMATE Index CHWDMAUT Index CHWDMABK Index CHWDMATR Index

1/3/77 12/1/00 12/31/98 6/21/05 9/29/99 12/31/98 12/31/98 12/31/98 6/28/02 7/30/04

PHILIPINES CREDIT SINGAPORE EQUITY GOVT SOV JP MORGAN ASIA BOND WEIGHTED SPREAD PHILIPINES STRAITS TIME INDEX MON AUTH OF SING BENCHMARK GOVT BOND YLD 5YR BFV SGD AAA 3 MONTHS BFV SGD AA 3 MONTHS SING SOV FMC124 ZC 3M JP JP JP JP MORGAN MORGAN MORGAN MORGAN ASIA ASIA ASIA ASIA BOND BOND BOND BOND WEIGHTED WEIGHTED WEIGHTED WEIGHTED SPREAD SPREAD SPREAD SPREAD SINGAPORE SING FINANCIAL SING TEL SING CONGL CHWDPH Index STI INDEX MASB5Y INDEX C1153M INDEX C1163M INDEX F12403M INDEX CHWDSI Index CHWDSIBK Index CHWDSITE Index CHWDSICR Index TWSE INDEX GVTW5YR INDEX F12605Y INDEX CHWDTW Index SET INDEX GVTL5YR INDEX CHWDTH Index MERVAL INDEX 8/31/1999 1/4/85 1/2/98 10/3/91 10/16/97 6/30/98 8/31/1999 8/31/99 10/31/01 10/5/05 1/5/72 12/24/01 8/14/02 3/8/99 3/31/2005 7/2/87 8/7/00 8/31/1999 1/4/88

CREDIT

LATAM

TAIWAN EQUITY EQUITY VOL GOVT SOV CREDIT THAILAND EQUITY GOVT CREDIT ARGENTINA EQUITY

TAIWAN INDEX HIST CALL IMP VOL FOR TWSE INDEX TAIWAN GOVT NOTE GENERIC BID YIELD 5YR TWD TAIWAN SOV FMC 126 ZC YIELD 5 YR JP MORGAN ASIA BOND WEIGHTED SPREAD TAIWAN STOCK EXCHANGE OF THIALAND THAILAND GOVT BOND 5YR NOTE JP MORGAN ASIA BOND WEIGHTED SPREAD THAILAND BUENOS AIRES STOCK EXCHANGE MERVAL INDEX

66

SOV BRAZIL EQUITY EQUITY VOL GOVT

USD ARGENTINA SOV 3M IBOV BRAZIL BOVESPA STOCK IDX HIST CALL IMP VOL FOR IBOV INDEX ANDIMA BRAZIL GOVT BOND FIXED RATE ANDIMA BRAZIL GOVT BOND FIXED RATE ANDIMA BRAZIL GOVT BOND FIXED RATE ANDIMA BRAZIL GOVT BOND FIXED RATE USD BRAZIL SOVEREIGN ZC YLD 1Y USD BRAZIL SOVEREIGN ZC YLD 5Y USD BRAZIL SOVEREIGN ZC YLD 10Y BRAZIL SWAP RATES

C8013M INDEX IBOV INDEX 3 6 1 3 MONTH MONTH YEAR YEAR BZAD3M INDEX BZAD6M INDEX BZAD1Y INDEX BZAD3Y INDEX F80201Y INDEX F80205Y INDEX F80210Y INDEX PREDI360 INDEX

12/22/97

SOV

RATES CHILE EQUITY SOV ECAUDOR

7/19/00 4/3/00 4/3/00 4/3/00 4/3/00 6/30/98 6/30/98 6/30/98 1/2/95

CHILE STOCK MARKET GENERAL BFV CLP CHILE SOV 5 YR CLP CHILE SOV FMC 990 ZC YIELD 5YR

IGPA INDEX C9905Y INDEX F99005Y INDEX

1/1/90 10/19/05 10/7/05

MEXICO EQUITY SOV PERU EQUITY SOV VENEZUELA EQUITY SOV

MEXICAN STOCK EXCHANGE MEXICAN BOLSA INDEX USD MEX SOV FMC 804 ZC YKD BFV USD MEXICO SOV 5Y IGBVL PERU LIMA GENERAL INDEX USD PERU SOV ZC YIELD 5YR CARACAS STOCK EXCHANGE STOCK MARKET INDEX BFV USD VENEZUELA SOV 5YR

MEXBOL INDEX F80403M INDEX C8045Y INDEX IGBVL INDEX I30305Y INDEX IBVC INDEX C8055Y INDEX

1/31/78 6/30/98 12/23/97 1/2/90 2/5/04 12/30/93 7/18/01

67