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 The Professional Risk Managers’ Handbook
A Comprehensive Guide to Current Theory and Best Practices

___________________________________________________

Edited by Carol Alexander and Elizabeth Sheedy

Introduced by David R. Koenig

The Official Handbook for the PRM Certification

 The PRM Handbook

Contents
Author Biographies

Introduction David R. Koenig

SECTION I - FINANCE THEORY, FINANCIAL INSTRUMENTS AND MARKETS

Preface I Zvi Wiener

A – FINANCE THEORY

I.A.1 Risk and Risk Aversion

Jacques Pezier

I.A.1.1 Introduction
I.A.1.2 Mathematical Expectations: Prices or Utilities?
I.A.1.3 The Axiom of Independence of Choice
I.A.1.4 Maximising Expected Utility
I.A.1.4.1 The Four Basic Axioms
I.A.1.4.2 Introducing the Utility Function
I.A.1.4.3 Risk Aversion (and Risk Tolerance)
I.A.1.4.4 Certain Equivalence
I.A.1.4.5 Summary
I.A.1.5 Encoding a Utility Function
I.A.1.5.1 For an Individual
I.A.1.5.2 For a Firm
I.A.1.5.3 Ironing out Anomalies
I.A.1.6 The Mean–Variance Criterion
I.A.1.6.1 The Criterion
I.A.1.6.2 Estimating Risk Tolerance
I.A.1.6.3 Applications of the Mean–Variance Criterion
I.A.1.7 Risk-Adjusted Performance Measures
I.A.1.7.1 The Sharpe Ratio
I.A.1.7.2 RAPMs in an Equilibrium Market
I.A.1.7.2.1 The Treynor Ratio and Jensen’s Alpha
I.A.1.7.2.2 Application of the Treynor Ratio
I.A.1.7.2.3 Application of Jensen’s Alpha
I.A.1.7.3 Generalising Sharpe Ratios
I.A.1.7.3.1 The Generalised Sharpe Ratio
I.A.1.7.3.2 The Adjusted Sharpe Ratio
I.A.1.7.4 Downside RAPMs
I.A.1.7.4.1 RAROC
I.A.1.7.4.2 Sortino Ratio, Omega Index and other Kappa indices
I.A.1.8 Summary
Appendix I.A.1.A: Terminology
Appendix I.A.1.B: Utility Functions
I.A.1.B.1 The Exponential Utility Function
I.A.1.B.2 The Logarithmic Utility Function
I.A.1.B.3 The Quadratic Utility Function
I.A.1.B.4 The Power Utility Function

I.A.2 Portfolio Mathematics

Paul Glasserman

I.A.2.1 Means and Variances of Past Returns

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I.A.2.1.1 Returns
I.A.2.1.2 Mean, Variance and Standard Deviation
I.A.2.1.3 Portfolio Mean, Variance and Standard Deviation
I.A.2.1.4 Correlation
I.A.2.1.5 Correlation and Portfolio Variance
I.A.2.1.6 Portfolio Standard Deviation
I.A.2.2 Mean and Variance of Future Returns
I.A.2.2.1 Single Asset
I.A.2.2.2 Covariance and Correlation
I.A.2.2.3 Mean and Variance of a Linear Combination
I.A.2.2.4 Example: Portfolio Return
I.A.2.2.5 Example: Portfolio Profit
I.A.2.2.6 Example: Long and Short Positions
I.A.2.2.7 Example: Correlation
I.A.2.3 Mean-Variance Tradeoffs
I.A.2.3.1 Achievable Expected Returns
I.A.2.3.2 Achievable Variance and Standard Deviation
I.A.2.3.3 Achievable Combinations of Mean and Standard Deviation
I.A.2.3.4 Efficient Frontier
I.A.2.3.5 Utility Maximization
I.A.2.3.6 Varying the Correlation Parameter
I.A.2.4 Multiple Assets
I.A.2.4.1 Portfolio Mean and Variance
I.A.2.4.2 Vector Matrix Notation
I.A.2.4.3 Efficient Frontier
I.A.2.5 A Hedging Example
I.A.2.5.1 Problem Formulation
I.A.2.5.2 Gallon-for-Gallon Hedge
I.A.2.5.3 Minimum-Variance Hedge
I.A.2.5.4 Effectiveness of the Optimal Hedge
I.A.2.5.5 Connection with Regression
I.A.2.6 Serial Correlation
I.A.2.7 Normally Distributed Returns
I.A.2.7.1 The Distribution of Portfolio Returns
I.A.2.7.2 Value-at-Risk
I.A.2.7.3 Probability of Reaching a Target
I.A.2.7.4 Probability of Beating a Benchmark

I.A.3 Capital Allocation

Keith Cuthbertson, Dirk Nitzsche

I.A.3.1 An Overview
I.A.3.1.1 Portfolio Diversification
I.A.3.1.2 Tastes and Preferences for Risk versus Return
I.A.3.2 Mean–Variance Criterion
I.A.3.3 Efficient Frontier: Two Risky Assets
I.A.3.3.1 Different Values of the Correlation Coefficient
I.A.3.4 Asset Allocation
I.A.3.4.1 The efficient frontier: n risky assets
I.A.3.5 Combining the Risk-Free Asset with Risky Assets
I.A.3.6 The Market Portfolio and the CML
I.A.3.7 The Market Price of Risk and the Sharpe Ratio
I.A.3.8 Separation Principle
I.A.3.9 Summary
Appendix: Mathematics of the Mean–Variance Model

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I.A.4 The CAPM and Multifactor Models

Keith Cuthbertson, Dirk Nitzsche

I.A.4.1 Overview
I.A.4.2 Capital Asset Pricing Model
I.A.4.2.1 Estimating Beta
I.A.4.2.2 Beta and Systematic Risk
I.A.4.3 Security Market Line
I.A.4.4 Performance Measures
I.A.4.4.1 Sharpe Ratio
I.A.4.4.2 Jensen’s ‘alpha’
I.A.4.5 The Single-Index Model
I.A.4.6 Multifactor Models and the APT
I.A.4.6.1 Portfolio Returns
I.A.4.7 Summary

I.A.5 Basics of Capital Structure

Steven Bishop

I.A.5.1 Introduction
I.A.5.2 Maximising Shareholder Value, Incentives and Agency Costs
I.A.5.2.1 Agency Costs
I.A.5.2.1.1 Agency Cost of Equity
I.A.5.2.1.2 Agency Costs of Debt
I.A.5.2.2 Information Asymmetries
I.A.5.3 Characteristics of Debt and Equity
I.A.5.4 Choice of Capital Structure
I.A.5.4.1 Do not think debt is attractive because the interest rate is lower
than the cost of equity!
I.A.5.4.2 Debt can be attractive
I.A.5.4.2.1 Differential treatment of payments to debt-holders and
shareholders
I.A.5.4.2.2 Greater Flexibility
I.A.5.4.2.3 Monitoring ‘improves’ performance and reduces the
negative aspect of information asymmetry
I.A.5.4.2.4 Debt enforces a discipline of paying out operating earnings
I.A.5.4.2.5 Debt financing avoids negative signals about
management’s view of the value of equity
I.A.5.4.3 Debt can also be unattractive
I.A.5.4.3.1 Exposure to bankruptcy costs
I.A.5.4.3.2 Exposure to financial distress costs
I.A.5.4.3.3 Agency costs
I.A.5.4.4 Thus choose the point where disadvantages offset advantages
I.A.5.5 Making the capital structure decision
I.A.5.5.1 Guidelines
I.A.5.5.2 What do CFOs say they consider when making a capital structure choice?
I.A.5.6 Conclusion

I.A.6 The Term Structure of Interest Rates

Deborah Cernauskas, Elias Demetriades

I.A.6.1 Compounding Methods

I.A.6.1.1 Continuous versus Discrete Compounding
I.A.6.1.2 Annual Compounding versus More Regular Compounding
I.A.6.1.3 Periodic Interest Rates versus Effective Annual Yield
I.A.6.2 Term Structure – A Definition

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I.A.6.3 Shapes of the Yield Curve

I.A.6.4 Spot and Forward Rates
I.A.6.5 Term Structure Theories
I.A.6.5.1 Pure or Unbiased Expectations
I.A.6.5.2 Liquidity Preference
I.A.6.5.3 Market Segmentation
I.A.6.6 Summary

I.A.7 Valuing Forward Contracts

Don Chance

I.A.7.1 The Difference between Pricing and Valuation for Forward Contracts
I.A.7.2 Principles of Pricing and Valuation for Forward Contracts on Assets
I.A.7.2.1 The Value at Time 0 of a Forward Contract
I.A.7.2.2 The Value at Expiration of a Forward Contract on an Asset
I.A.7.2.3 The Value Prior to Expiration of a Forward Contract on an Asset
I.A.7.2.4 The Value of a Forward Contract on an Asset when there are
Cash Flows on the Asset during the Life of the Contract
I.A.7.2.5 Establishing the Price of a Forward Contract on an Asset
I.A.7.2.6 Pricing and Valuation when the Cash Flows or Holding Costs are
Continuous
I.A.7.2.7 Numerical Examples
I.A.7.3 Principles of Pricing and Valuation for Forward Contracts on Interest Rates
I.A.7.3.1 The Value of an FRA at Expiration
I.A.7.3.2 The Value of an FRA at the Start
I.A.7.3.3 The Value of an FRA During Its Life
I.A.7.3.4 Pricing the FRA on Day 0
I.A.7.3.5 Numerical Examples
I.A.7.4 The Relationship Between Forward and Futures Prices

I.A.8 Basic Principles of Option Pricing

Paul Wilmott

I.A.8.1 Factors Affecting Option Prices

I.A.8.2 Put–Call Parity
I.A.8.3 One-step Binomial Model and the Riskless Portfolio
I.A.8.4 Delta Neutrality and Simple Delta Hedging
I.A.8.5 Risk-Neutral Valuation
I.A.8.6 Real versus Risk-Neutral
I.A.8.7 The Black–Scholes–Merton Pricing Formula
I.A.8.8 The Greeks
I.A.8.9 Implied Volatility
I.A.8.10 Intrinsic versus Time Value

B – FINANCIAL INSTRUMENTS

I.B.1 General Characteristics of Bonds

Lionel Martellini, Philippe Priaulet

I.B.1.1 Definition of a Bullet Bond

I.B.1.2 Terminology and Convention
I.B.1.3 Market Quotes
I.B.1.3.1 Bond Quoted Price
I.B.1.3.2 Bond Quoted Yield
I.B.1.3.3 Bond Quoted Spread
I.B.1.3.4 Liquidity Spreads

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I.B.1.3.5 The Bid–Ask Spread

I.B.1.4 Non-bullet Bonds
I.B.1.4.1 Strips
I.B.1.4.2 Floating-Rate Notes
I.B.1.4.3 Inflation-Indexed Bonds
I.B.1.5 Summary

I.B.2 The Analysis of Bonds

Moorad Choudhry

I.B.2.1 Features of Bonds

I.B.2.1.1 Type of Issuer
I.B.2.1.2 Term to Maturity
I.B.2.1.3 Principal and Coupon Rate
I.B.2.1.4 Currency
I.B.2.2 Non-conventional Bonds
I.B.2.2.1 Floating-Rate Notes
I.B.2.2.2 Index-Linked Bonds
I.B.2.2.3 Zero-Coupon Bonds
I.B.2.2.4 Securitised Bonds
I.B.2.2.5 Bonds with Embedded Options
I.B.2.3 Pricing a Conventional Bond
I.B.2.3.1 Bond Cash Flows
I.B.2.3.2 The Discount Rate
I.B.2.3.3 Conventional Bond Pricing
I.B.2.3.4 Pricing Undated Bonds
I.B.2.3.5 Pricing Conventions
I.B.2.3.6 Clean and Dirty Bond Prices: Accrued Interest
I.B.2.4 Market Yield
I.B.2.4.1 Yield Measurement
I.B.2.4.2 Current Yield
I.B.2.4.3 Yield to Maturity
I.B.2.5 Relationship between Bond Yield and Bond Price
I.B.2.6 Duration
I.B.2.6.1 Calculating Macaulay Duration and Modified Duration
I.B.2.6.2 Properties of the Macaulay Duration
I.B.2.6.3 Properties of the Modified Duration
I.B.2.7 Hedging Bond Positions
I.B.2.8 Convexity
I.B.2.9 A Summary of Risks Associated with Bonds

I.B.3 Futures and Forwards

Keith Cuthbertson, Dirk Nitzsche

I.B.3.1 Introduction
I.B.3.2 Stock Index Futures
I.B.3.2.1 Contract Specifications
I.B.3.2.2 Index arbitrage and program trading
I.B.3.2.3 Hedging Using Stock Index Futures
I.B.3.2.4 Tailing the Hedge
I.B.3.2.5 Summary
I.B.3.3 Currency Forwards and Futures
I.B.3.3.1 Currency Forward Contracts
I.B.3.3.2 Currency Futures Contracts
I.B.3.3.3 Hedging Currency Futures and Forwards
I.B.3.3.4 Summary

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I.B.3.4 Commodity Futures

I.B.3.5 Forward Rate Agreements
I.B.3.5.1 Settlement Procedures
I.B.3.6 Short-Term Interest-Rate Futures
I.B.3.6.1 US T-bill Futures
I.B.3.6.2 Three-Month Eurodollar Futures
I.B.3.6.3 Sterling Three-Month Futures
I.B.3.6.4 Hedging Interest-Rate Futures
I.B.3.6.5 Hedge Ratios
I.B.3.6.6 Hedging Using US T-bill Futures
I.B.3.6.7 Summary
I.B.3.7 T-bond Futures
I.B.3.7.1 Contract Specifications
I.B.3.7.1.1 UK Long Gilt Futures Contract
I.B.3.7.1.2 US T-bond Futures Contract
I.B.3.7.2 Conversion Factor and Cheapest to Deliver
I.B.3.7.3 Hedging Using T-bond Futures
I.B.3.7.4 Hedging a Single Bond
I.B.3.7.5 Hedging a Portfolio of Bonds
I.B.3.7.6 Summary
I.B.3.8 Stack and Strip Hedges
I.B.3.9 Concluding Remarks

I.B.4 Swaps
Salih Neftci

I.B.4.1 What is a Swap?

I.B.4.2 Types of Swaps
I.B.4.2.1 Equity Swaps
I.B.4.2.2 Commodity Swaps
I.B.4.2.3 Interest Rate Swaps
I.B.4.2.4 Currency Swaps
I.B.4.2.5 Basis Swaps
I.B.4.2.6 Volatility Swaps
I.B.4.3 Engineering Interest-Rate Swaps
I.B.4.4 Risk of Swaps
I.B.4.4.1 Market Risk
I.B.4.4.2 Credit Risk and Counterparty Risk
I.B.4.4.3 Volatility and Correlation Risk
I.B.4.5 Other Swaps
I.B.4.6 Uses of Swaps
I.B.4.6.1 Uses of Equity Swaps
I.B.4.7 Swap Conventions

I.B.5 Vanilla Options

Paul Wilmott

I.B.5.1 Stock Options – Characteristics and Payoff Diagrams

I.B.5.2 American versus European Options
I.B.5.3 Strategies Involving a Single Option and a Stock
I.B.5.4 Spread Strategies
I.B.5.4.1 Bull and Bear Spreads
I.B.5.4.2 Calendar Spreads
I.B.5.5 Other Strategies
I.B.5.5.1 Straddles and Strangles
I.B.5.5.2 Risk Reversal

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I.B.5.5.3 Collars
I.B.5.5.4 Butterflies and Condors

I.B.6 Credit Derivatives

Moorad Choudhry

I.B.6.1 Introduction
I.B.6.1.1 Why Use Credit Derivatives?
I.B.6.1.2 Classification of Credit Derivative Instruments
I.B.6.1.3 Definition of a Credit Event
I.B.6.2 Credit Default Swaps
I.B.6.3 Credit-Linked Notes
I.B.6.4 Total Return Swaps
I.B.6.4.1 Synthetic Repo
I.B.6.4.2 Reduction in Credit Risk
I.B.6.4.3 Capital Structure Arbitrage
I.B.6.4.4 The TRS as a Funding Instrument
I.B.6.5 Credit Options
I.B.6.6 Synthetic Collateralised Debt Obligations
I.B.6.6.1 Cash Flow CDOs
I.B.6.6.2 What is a Synthetic CDO?
I.B.6.6.3 Funding Synthetic CDOs
I.B.6.6.4 Variations in Synthetic CDOs
I.B.6.6.5 Use of Synthetic CDOs
I.B.6.6.6 Advantages and Limitations of Synthetic Structures
I.B.6.7 General Applications of Credit Derivatives
I.B.6.7.1 Use of Credit Derivatives by Portfolio Managers
I.B.6.7.1.1 Enhancing portfolio returns
I.B.6.7.1.2 Reducing credit exposure
I.B.6.7.1.3 Credit switches and zero-cost credit exposure
I.B.6.7.1.4 Exposure to market sectors
I.B.6.7.1.5 Trading Credit spreads
I.B.6.7.2 Use of Credit Derivatives by Banks
I.B.6.8 Unintended Risks in Credit Derivatives
I.B.6.9 Summary

I.B.7 Caps, Floors & Swaptions

Lionel Martellini, Philippe Priaulet

I.B.7.1 Caps, Floors and Collars: Definition and Terminology

I.B.7.2 Pricing Caps, Floors and Collars
I.B.7.2.1 Cap Formula
I.B.7.2.2 Floor Formula
I.B.7.2.3 Market Quotes
I.B.7.3 Uses of Caps, Floors and Collars
I.B.7.3.1 Limiting the Financial Cost of Floating-Rate Liabilities
I.B.7.3.2 Protecting the Rate of Return of a Floating-Rate Asset
I.B.7.4 Swaptions: Definition and Terminology
I.B.7.5 Pricing Swaptions
I.B.7.5.1 European Swaption Pricing Formula
I.B.7.5.2 Market Quotes
I.B.7.6 Uses of Swaptions
I.B.7.7 Summary

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 The PRM Handbook

I.B.8 Convertible Bonds

Izzy Nelken

I.B.8.1 Introduction
I.B.8.1.1 Convertibles – a definition
I.B.8.1.2 Convertible Bond Market Size
I.B.8.1.3 A Brief History
I.B.8.2 Characteristics of Convertibles
I.B.8.2.1 Relationship with Stock Price
I.B.8.2.2 Call and Put Features
I.B.8.2.3 Players in the Convertible Bond Market
I.B.8.2.4 Convertible Bond Funds
I.B.8.2.5 Convertible Arbitrage Hedge Funds
I.B.8.3 Capital Structure Implications (for Banks)
I.B.8.4 Mandatory Convertibles
I.B.8.5 Valuation and Risk Assessment
I.B.8.6 Summary

I.B.9 Simple Exotics

Catriona March

I.B.9.1 Introduction
I.B.9.2 A Short History
I.B.9.3 Classifying Exotics
I.B.9.4 Notation
I.B.9.5 Digital Options
I.B.9.5.1 Cash-or-Nothing Options
I.B.9.5.2 Asset-or-Nothing Options
I.B.9.5.3 Vanillas and Digitals as Building Blocks
I.B.9.5.4 Contingent Premium Options
I.B.9.5.5 Range Notes
I.B.9.5.6 Managing Digital Options
I.B.9.6 Two Asset Options
I.B.9.6.1 Product and Quotient Options
I.B.9.6.2 Exchange Options
I.B.9.6.3 Outperformance Options
I.B.9.6.4 Other Two-Colour Rainbow Options
I.B.9.6.5 Spread Options
I.B.9.6.6 Correlation Risk
I.B.9.7 Quantos
I.B.9.7.1 Foreign Asset Option Struck in Foreign Currency
I.B.9.7.2 Foreign Asset Option Struck in Domestic Currency
I.B.9.7.3 Implied Correlation
I.B.9.7.4 Foreign Asset Linked Currency Option
I.B.9.7.5 Guaranteed Exchange Rate Foreign Asset Options
I.B.9.8 Second-Order Contracts
I.B.9.8.1 Compound Options
I.B.9.8.2 Typical Uses of Compound Options
I.B.9.8.3 Instalment Options
I.B.9.8.4 Extendible Options
I.B.9.9 Decision Options
I.B.9.9.1 American Options
I.B.9.9.2 Bermudan Options
I.B.9.9.3 Shout Options
I.B.9.10 Average Options
I.B.9.10.1 Average Rate and Average Strike Options

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I.B.9.10.2 Motivations and Uses

I.B.9.10.3 Other Options Involving Averages
I.B.9.10.4 Pricing and Hedging Average Options
I.B.9.11 Options on Baskets of Assets
I.B.9.11.1 Basket Options
I.B.9.11.2 Pricing and Hedging Basket Options
I.B.9.11.3 Mountain Options
I.B.9.12 Barrier and Related Options
I.B.9.12.1 Single-Barrier Options
I.B.9.12.2 No-Touch, One-Touch and Rebates
I.B.9.12.3 Partial-Barrier Options
I.B.9.12.4 Double-Barrier Options
I.B.9.12.5 Even More Barrier Options
I.B.9.12.6 Relationships
I.B.9.12.7 Ladders
I.B.9.12.8 Lookback and Hindsight Options
I.B.9.13 Other Path-Dependent Options
I.B.9.13.1 Forward Start Options
I.B.9.13.2 Reset Options
I.B.9.13.3 Cliquet Options
I.B.9.14 Resolution Methods
I.B.9.15 Summary

C - MARKETS

I.C.1 The Structure of Financial Markets

Colin Lawrence, Alistair Milne

I.C.1.1 Introduction
I.C.1.2 Global Markets and Their Terminology
I.C.1.3 Drivers of Liquidity
I.C.1.3.1 Repo Markets
I.C.1.4 Liquidity and Financial Risk Management
I.C.1.5 Exchanges versus OTC Markets
I.C.1.6 Technological Change
I.C.1.7 Post-trade Processing
I.C.1.8 Retail and Wholesale Brokerage
I.C.1.9 New Financial Markets
I.C.1.10 Conclusion

I.C.2 The Money Markets

Canadian Securities Institute

I.C.2.1 Introduction
I.C.2.2 Characteristics of Money Market Instruments
I.C.2.3 Deposits and Loans
I.C.2.3.1 Deposits from Businesses
I.C.2.3.2 Loans to Businesses
I.C.2.3.3 Repurchase Agreements
I.C.2.3.4 International Markets
I.C.2.3.5 The London Interbank Offered Rate (LIBOR)
I.C.2.4 Money Market Securities
I.C.2.4.1 Treasury Bills
I.C.2.4.2 Commercial Paper
I.C.2.4.3 Bankers’ Acceptances
I.C.2.4.4 Certificates of Deposit

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I.C.2.5 Summary

I.C.3 The Bond Market

Moorad Choudhry, Lionel Martellini, Philippe Priaulet

I.C.3.1 Introduction
I.C.3.2 The Players
I.C.3.2.1 Intermediaries and Banks
I.C.3.2.2 Institutional Investors
I.C.3.2.3 Market Professionals
I.C.3.3 Bonds by Issuers
I.C.3.3.1 Government Bonds
I.C.3.3.2 US Agency Bonds
I.C.3.3.3 Municipal Bonds
I.C.3.3.4 Corporate Bonds
I.C.3.3.5 Eurobonds (International Bonds)
I.C.3.4 The Markets
I.C.3.4.1 The Government Bond Market
I.C.3.4.2 The Corporate Bond Market
I.C.3.4.2.1 The market by country and sector
I.C.3.4.2.2 Underwriting a new issue
I.C.3.4.3 The Eurobond Market
I.C.3.4.4 Market Conventions
I.C.3.5 Credit Risk
I.C.3.6 Summary

I.C.4 The Foreign Exchange Market

Canadian Securities Institute, Toronto

I.C.4.1 Introduction
I.C.4.2 The Interbank Market
I.C.4.3 Exchange-Rate Quotations
I.C.4.3.1 Direct Dealing
I.C.4.3.2 Foreign Exchange Brokers
I.C.4.3.3 Electronic Brokering Systems
I.C.4.3.4 The Role of the US Dollar
I.C.4.3.5 Market and Quoting Conventions
I.C.4.3.6 Cross Trades and Cross Rates
I.C.4.4 Determinants of Foreign Exchange Rates
I.C.4.4.1 The Fundamental Approach
I.C.4.4.2 A Short-Term Approach
I.C.4.4.3 Central Bank Intervention
I.C.4.5 Spot and Forward Markets
I.C.4.5.1 The Spot Market
I.C.4.5.2 The Forward Market
I.C.4.5.2.1 Forward Discounts and Premiums
I.C.4.5.2.2 Interest-Rate Parity
I.C.4.6 Structure of a Foreign Exchange Operation
I.C.4.7 Summary/Conclusion

I.C.5 The Stock Market

Andrew Street

I.C.5.1 Introduction
I.C.5.2 The Characteristics of Common Stock
I.C.5.2.1 Share Premium and Capital Accounts and Limited Liability

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I.C.5.2.2 Equity Shareholder’s Rights and Dividends

I.C.5.2.3 Other Types of Equity Shares – Preference Shares
I.C.5.2.4 Equity Price Data
I.C.5.2.5 Market Capitalisation (or ‘Market Cap’)
I.C.5.2.6 Stock Market Indices
I.C.5.2.7 Equity Valuation
I.C.5.3 Stock Markets and their Participants
I.C.5.3.1 The Main Participants – Firms, Investment Banks and Investors
I.C.5.3.2 Market Mechanics
I.C.5.4 The Primary Market – IPOs and Private Placements
I.C.5.4.1 Basic Primary Market Process
I.C.5.4.2 Initial Public Offerings
I.C.5.4.3 Private Placements
I.C.5.5 The Secondary Market – the Exchange versus OTC Market
I.C.5.5.1 The Exchange
I.C.5.5.2 The Over-the-Counter Market
I.C.5.6 Trading Costs
I.C.5.6.1 Commissions
I.C.5.6.2 Bid–Offer Spread
I.C.5.6.3 Market Impact
I.C.5.7 Buying on Margin
I.C.5.7.1 Leverage
I.C.5.7.2 Percentage Margin and Maintenance Margin
I.C.5.7.3 Why Trade on Margin?
I.C.5.8 Short Sales and Stock Borrowing Costs
I.C.5.8.1 Short Sale
I.C.5.8.2 Stock Borrowing
I.C.5.9 Exchange-Traded Derivatives on Stocks
I.C.5.9.1 Single Stock and Index Options
I.C.5.9.2 Expiration Dates
I.C.5.9.3 Strike Prices
I.C.5.9.4 Flex Options
I.C.5.9.5 Dividends and Corporate Actions
I.C.5.9.6 Position Limits
I.C.5.9.7 Trading
I.C.5.10 Summary

I.C.6 The Futures Market

Canadian Securities Institute

I.C.6.1 Introduction
I.C.6.2 History of Forward-Based Derivatives and Futures Markets
I.C.6.3 Futures Contracts and Markets
I.C.6.3.1 General Characteristics of Futures Contracts and Markets
I.C.6.3.2 Settlement of Futures Contracts
I.C.6.3.3 Types of Orders
I.C.6.3.4 Margin Requirements and Marking to Market
I.C.6.3.5 Leverage
I.C.6.3.6 Reading a Futures Quotation Page
I.C.6.3.7 Liquidity and Trading Costs
I.C.6.4 Options on Futures
I.C.6.5 Futures Exchanges and Clearing Houses
I.C.6.5.1 Exchanges
I.C.6.5.2 Futures Exchange Functions
I.C.6.5.3 Clearing Houses
I.C.6.5.4 Marking-to-Market and Margin

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I.C.6.6 Market Participants – Hedgers

I.C.6.7 Market Participants – Speculators
I.C.6.7.1 Locals
I.C.6.7.2 Day Traders
I.C.6.7.3 Position Traders
I.C.6.7.4 Spreaders
I.C.6.7.4.1 Intramarket Spreads
I.C.6.7.4.2 Intercommodity Spreads
I.C.6.7.4.3 Intermarket Spreads
I.C.6.7.4.4 Commodity Product Spread
I.C.6.8 Market Participants – Managed Futures Investors
I.C.6.9 Summary and Conclusion

I.C.7 The Structure of Commodities Markets

Colin Lawrence, Alistair Milne

I.C.7.1 Introduction
I.C.7.2 The Commodity Universe and Anatomy of Markets
I.C.7.2.1 Commodity Types and Characteristics
I.C.7.2.2 The Markets for Trading
I.C.7.2.3 Delivery and Settlement Methods
I.C.7.2.4 Commodity Market Liquidity
I.C.7.2.5 The Special Case of Gold as a Reserve Asset
I.C.7.3 Spot–Forward Pricing Relationships
I.C.7.3.1 Backwardation and Contango
I.C.7.3.2 Reasons for Backwardation
I.C.7.3.3 The No-Arbitrage Condition
I.C.7.4 Short Squeezes, Corners and Regulation
I.C.7.4.1 Historical Experience
I.C.7.4.2 The Exchange Limits
I.C.7.5 Risk Management at the Commodity Trading Desk
I.C.7.6 The Distribution of Commodity Returns
I.C.7.6.1 Evidence of Non-normality
I.C.7.6.2 What Drives Commodity Prices?
I.C.7.7 Conclusions

I.C.8 The Energy Markets

Peter Fusaro

I.C.8.1 Introduction
I.C.8.2 Market Overview
I.C.8.2.1 The Products
I.C.8.2.2 The Risks
I.C.8.2.3 Developing a Cash Market
I.C.8.3 Energy Futures Markets
I.C.8.3.1 The Exchanges
I.C.8.3.2 The Contracts
I.C.8.3.3 Options on Energy Futures
I.C.8.3.4 Hedging in Energy Futures Markets
I.C.8.3.5 Physical Delivery
I.C.8.3.6 Market Changes: Backwardation and Contango
I.C.8.4 OTC Energy Derivative Markets
I.C.8.4.1 The Singapore Market
I.C.8.4.2 The European Energy Markets
I.C.8.4.3 The North American Markets
I.C.8.5 Emerging Energy Commodity Markets

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I.C.8.5.1 Coal Trading

I.C.8.5.2 Weather Derivatives
I.C.8.5.3 Green Trading
I.C.8.5.4 Freight-Rate Swaps
I.C.8.5.5 Derivative Forward Price Curves
I.C.8.6 The Future of Energy Trading
I.C.8.6.1 Re-emergence of Speculative Trading?
I.C.8.6.2 Electronic Energy Trading
I.C.8.6.3 Trading in Asian Markets
I.C.8.7 Conclusion

SECTION II – MATHEMATICAL FOUNDATIONS OF RISK MEASUREMENT

Preface II Carol Alexander

II.A Foundations
Keith Parramore, Terry Watsham

II.A.1 Symbols and Rules

II.A.1.1 Expressions, Functions, Graphs, Equations and Greek
II.A.1.2 The Algebra of Number
II.A.1.3 The Order of Operations
II.A.2 Sequences and Series
II.A.2.1 Sequences
II.A.2.2 Series
II.A.3 Exponents and Logarithms
II.A.3.1 Exponents
II.A.3.2 Logarithms
II.A.3.3 The Exponential Function and Natural Logarithms
II.A.4 Equations and Inequalities
II.A.4.1 Linear Equations in One Unknown
II.A.4.2 Inequalities
II.A.4.3 Systems of Linear Equations in More Than One Unknown
II.A.4.4 Quadratic Equations
II.A.5 Functions and Graphs
II.A.5.1 Functions
II.A.5.2 Graphs
II.A.5.3 The Graphs of Some Functions
II.A.6 Case Study − Continuous Compounding
II.A.6.1 Repeated Compounding
II.A.6.2 Discrete versus Continuous Compounding
II.A.7 Summary

II.B Descriptive Statistics

Keith Parramore, Terry Watsham

II.B.1 Introduction
II.B.2 Data
II.B.2.1 Continuous and Discrete Data
II.B.2.2 Grouped Data
II.B.2.3 Graphical Representation of Data
II.B.2.3.1 The Frequency Bar Chart
II.B.2.3.2 The Relative Frequency Distribution
II.B.2.3.3 The Cumulative Frequency Distribution
II.B.2.3.4 The Histogram
II.B.3 The Moments of a Distribution

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II.B.4 Measures of Location or Central Tendency – Averages

II.B.4.1 The Arithmetic Mean
II.B.4.2 The Geometric Mean
II.B.4.3 The Median and the Mode
II.B.5 Measures of Dispersion
II.B.5.1 Variance
II.B.5.2 Standard Deviation
II.B.5.3 Case Study: Calculating Historical Volatility from Returns Data
II.B.5.4 The Negative Semi-variance and Negative Semi-deviation
II.B.5.5 Skewness
II.B.5.6 Kurtosis
II.B.6 Bivariate Data
II.B.6.1 Covariance
II.B.6.2 The Covariance Matrix
II.B.6.3 The Correlation Coefficient
II.B.6.4 The Correlation Matrix
II.B.6.5 Case Study: Calculating the Volatility of a Portfolio

II.C Calculus
Keith Parramore, Terry Watsham

II.C.1 Differential Calculus

II.C.1.1 Functions
II.C.1.2 The First Derivative
II.C.1.3 Notation
II.C.1.4 Simple Rules
II.C.1.4.1 Differentiating Constants
II.C.1.4.2 Differentiating a Linear Function
II.C.1.4.3 The Gradient of a Straight Line
II.C.1.4.4 The Derivative of a Power of x
II.C.1.4.5 Differentiating a scalar multiple of a function
II.C.1.4.6 Differentiating the Sum of Two Functions of x
II.C.1.4.7 Differentiating the Product of Two Functions of x
II.C.1.4.8 Differentiating the Quotient of Two Functions of x
II.C.1.4.9 Differentiating a Function of a Function
II.C.1.4.10 Differentiating the Exponential Function
II.C.1.4.11 Differentiating the Natural Logarithmic Function
II.C.2 Case Study: Modified Duration of a Bond
II.C.3 Higher-Order Derivatives
II.C.3.1 Second Derivatives
II.C.3.2 Further Derivatives
II.C.3.3 Taylor Approximations
II.C.4 Financial Applications of Second Derivatives
II.C.4.1 Convexity
II.C.4.2 Convexity in Action
II.C.4.3 The Delta and Gamma of an Option
II.C.5 Differentiating a Function of More than One Variable
II.C.5.1 Partial Differentiation
II.C.5.2 Total differentiation
II.C.6 Integral Calculus
II.C.6.1 Indefinite and Definite Integrals
II.C.6.2 Rules for Integration
II.C.6.3 Guessing
II.C.7 Optimisation
II.C.7.1 Finding the Minimum or Maximum of a Function of One Variable
II.C.7.2 Maxima and Minima of Functions of More than One Variable

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II.C.7.3 Optimization Subject to Constraints: Lagrange Multipliers

II.C.7.4 Applications

II.D Linear Algebra

Keith Parramore, Terry Watsham

II.D.1 Matrix Algebra

II.D.1.1 Matrices
II.D.1.2 Vectors and Transposes
II.D.1.3 Manipulation of Matrices
II.D.1.4 Matrix Multiplication
II.D.1.5 Inverting a Matrix
II.D.2 Application of Matrix Algebra to Portfolio Construction
II.D.2.1 Calculating the Risk of an Existing Portfolio
II.D.2.2 Deriving Asset Weights for the Minimum Risk Portfolio
II.D.2.3 Hedging a Vanilla Option Position
II.D.2.3.1 Calculating the position delta
II.D.2.3.2 Establishing the delta-neutral hedge
II.D.2.3.3 Gamma neutrality
II.D.2.3.4 Vega neutrality
II.D.2.3.5 Hedging a short option position
II.D.3 Quadratic Forms
II.D.3.1 The Variance of Portfolio Returns as a Quadratic Form
II.D.3.2 Definition of Positive Definiteness
II.D.4 Cholesky Decomposition
II.D.4.1 The Cholesky Arithmetic
II.D.4.2 Simulation in Excel
II.D.5 Eigenvalues and Eigenvectors
II.D.5.1 Matrices as Transformations
II.D.5.2 Definition of Eigenvector and Eigenvalue
II.D.5.3 Determinants
II.D.5.4 The Characteristic Equation
II.D.5.4.1 Testing for Positive Semi-definiteness
II.D.5.4.2 Using the characteristic equation to find the eigenvalues of a
covariance matrix
II.D.5.4.3 Eigenvalues and eigenvectors of covariance and correlation matrices
II.D.5.5 Principal Components

II.E Probability Theory in Finance

Keith Parramore, Terry Watsham

II.E.1 Definitions and Rules

II.E.1.1 Definitions
II.E.1.1.1 The classical approach
II.E.1.1.2 The Bayesian approach
II.E.1.2 Rules for Probability
II.E.1.2.1 (A or B) and (A and B)
II.E.1.2.2 Conditional Probability
II.E.2 Probability Distributions
II.E.2.1 Random Variables
II.E.2.1.1 Discrete Random Variables
II.E.2.1.2 Continuous Random Variables
II.E.2.2 Probability Density Functions and Histograms
II.E.2.3 The Cumulative Distribution Function
II.E.2.4 The Algebra of Random Variables
II.E.2.4.1 Scalar Multiplication of a Random Variable

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II.E.2.5 The Expected Value of a Discrete Random Variable

II.E.2.6 The Variance of a Discrete Random Variable
II.E.2.7 The Algebra of Continuous Random Variables
II.E.3 Joint Distributions
II.E.3.1 Bivariate Random Variables
II.E.3.2 Covariance
II.E.3.3 Correlation
II.E.3.4 The Expected Value and Variance of a Linear Combination of Random
Variables
II.E.4 Specific Probability Distributions
II.E.4.1 The Binomial Distribution
II.E.4.1.1 Calculating the ‘Number of Ways’
II.E.4.1.2 Calculating the Probability of r Successes
II.E.4.1.3 Expectation and Variance
II.E.4.2 The Poisson Distribution
II.E.4.2.1 Illustrations
II.E.4.2.2 Expectation and Variance
II.E.4.3 The Uniform Continuous Distribution
II.E.4.4.1 Normal Curves
II.E.4.4.2 The Standard Normal Probability Density Function
II.E.4.4.3 Finding Areas under a Normal Curve Using Excel
II.E.4.5 The Lognormal Probability Distribution
II.E.4.5.1 Lognormal Curves
II.E.4.5.2 The Lognormal Distribution Applied to Asset Prices
II.E.4.5.3 The Mean and Variance of the Lognormal Distribution
II.E.4.5.4 Application of the Lognormal Distribution to Future Asset Prices [not
in PRM exam]
II.E.4.6 Student’s t Distribution
II.E.4.7 The Bivariate Normal Distribution

II.F Regression
Keith Parramore, Terry Watsham

II.F.1 Simple Linear Regression

II.F.1.1 The Model
II.F.1.2 The Scatter Plot
II.F.1.3 Estimating the Parameters
II.F.2 Multiple Linear Regression
II.F.2.1 The model
II.F.2.2 Estimating the Parameters
II.F.3 Evaluating the Regression Model
II.F.3.1 Intuitive Interpretation
II.F.3.2 Adjusted R2
II.F.3.3 Testing for Statistical Significance
II.F.4 Confidence Intervals
II.F.4.1 Confidence Intervals for the Regression Parameters
II.F.5 Hypothesis Testing
II.F.5.1 Significance Tests for the Regression Parameters
II.F.5.2 Significance Test for R2
II.F.5.3 Type I and type II errors
II.F.6 Prediction
II.F.7 Breakdown of the OLS Assumptions
II.F.7.1 Heteroscedasticity
II.F.7.2 Autocorrelation
II.F.7.3 Multicollinearity
II.F.8 Random Walks and Mean-Reversion

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II.F.9 Maximum Likelihood Estimation

II.F.10 Summary

II.G Numerical Methods

Keith Parramore, Terry Watsham

II.G.1 Solving (Non-differential) Equations

II.G.1.1 Three Problems
II.G.1.2 Bisection
II.G.1.3 Newton–Raphson
II.G.1.4 Goal Seek
II.G.2 Numerical Optimisation
II.G.2.1 The Problem
II.G.2.2 Unconstrained Numerical Optimisation
II.G.2.3 Constrained Numerical Optimisation
II.G.2.4 Portfolio Optimisation Revisited
II.G.3 Numerical Methods for Valuing Options
II.G.3.1 Binomial Lattices
II.G.3.2 Finite Difference Methods
II.G.3.3 Simulation
II.G.4 Summary

SECTION III – RISK MANAGEMENT PRACTICES

Preface III Elizabeth Sheedy

III.0 Capital Allocation and Risk Adjusted Performance

Andrew Aziz, Dan Rosen

III.0.1 Introduction
III.0.1.1 Role of Capital in Financial Institution
III.0.1.2 Types of Capital
III.0.1.3 Capital as a Management Tool
III.0.2 Economic Capital
III.0.2.1 Understanding Economic Capital
III.0.2.2 The Top-Down Approach to Calculating Economic Capital
III.0.2.2.1 Top-Down Earnings Volatility Approach
III.0.2.2.2 Top-Down Option-Theoretic Approach
III.0.2.3 The Bottom-Up Approach to Calculating Economic Capital
III.0.2.4 Stress Testing of Portfolio Losses and Economic Capital
III.0.2.5 Enterprise Capital Practices – Aggregation
III.0.2.6 Economic Capital as Insurance for the Value of the Firm
III.0.3 Regulatory Capital
III.0.3.1 Regulatory Capital Principles
III.0.3.2 The Basel Committee of Banking Supervision and the Basel Accord
III.0.3.3 Basel I Regulation
III.0.3.3.1 Minimum Capital Requirements under Basel I
III.0.3.3.2 Regulatory Arbitrage under Basel I
III.0.3.3.3 Meeting Capital Adequacy Requirements
III.0.3.4 Basel II Accord – Latest Proposals
III.0.3.4.1 Pillar 1 - Minimum Capital Requirements
III.0.3.4.2 Pillar 2 - Supervisory Review
III.0.3.4.3 Pillar 3 - Market Discipline
III.0.3.5 A Simple Derivation of Regulatory Capital
III.0.4 Capital Allocation and Risk Contributions

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III.0.4.1 Capital Allocation

III.0.4.2 Risk Contribution Methodologies for EC Allocation
III.0.4.2.1 Stand-alone EC Contributions
III.0.4.2.2 Incremental EC Contributions
III.0.4.2.3 Marginal EC Contributions
III.0.4.2.4 Alternative Methods for Additive Contributions
III.0.5 RAROC and Risk-Adjusted Performance
III.0.5.1 Objectives of RAPM
III.0.5.2 Mechanics of RAROC
III.0.5.3 RAROC and Capital Allocation Methodologies
III.0.6 Summary and Conclusions

A – MARKET RISK

III.A.1 Market Risk Management

Jacques Pezier

III.A.1.1 Introduction
III.A.1.2 Market Risk
III.A.1.2.1 Why is Market Risk Management Important?
III.A.1.2.2 Distinguishing Market Risk from Other Risks
III.A.1.3 Market Risk Management Tasks
III.A.1.4 The Organisation of Market Risk Management
III.A.1.5 Market Risk Management in Fund Management
III.A.1.5.1 Market Risk in Fund Management
III.A.1.5.2 Identification
III.A.1.5.3 Assessment
III.A.1.5.4 Control/Mitigation
III.A.1.6 Market Risk Management in Banking
III.A.1.6.1 Market Risk in Banking
III.A.1.6.2 Identification
III.A.1.6.3 Assessment
III.A.1.6.4 Control/Mitigation
III.A.1.7 Market Risk Management in Non-financial Firms
III.A.1.7.1 Market Risk in Non-Financial Firms
III.A.1.7.2 Identification
III.A.1.7.3 Assessment
III.A.1.7.4 Control/Mitigation
III.A.1.8 Summary

III.A.2 Introduction to Value at Risk Models

Kevin Dowd, David Rowe

III.A.2.1 Introduction
III.A.2.2 Definition of VaR
III.A.2.3 Internal Models for Market Risk Capital
III.A.2.4 Analytical VaR Models
III.A.2.5 Monte Carlo Simulation VaR
III.A.2.5.1 Methodology
III.A.2.5.2 Applications of Monte Carlo simulation
III.A.2.5.3 Advantages and Disadvantages of Monte Carlo VaR
III.A.2.6 Historical Simulation VaR
III.A.2.6.1 The Basic Method
III.A.2.6.2 Weighted historical simulation
III.A.2.6.3 Advantages and Disadvantages of Historical Approaches
III.A.2.7 Mapping Positions to Risk Factors

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III.A.2.7.1 Mapping Spot Positions

III.A.2.7.2 Mapping Equity Positions
III.A.2.7.3 Mapping Zero-Coupon Bonds
III.A.2.7.4 Mapping Forward/Futures Positions
III.A.2.7.5 Mapping Complex Positions
III.A.2.7.6 Mapping Options: Delta and Delta-Gamma Approaches
III.A.2.8 Backtesting VaR Models
III.A.2.9 Why Financial Markets Are Not ‘Normal’
III.A.2.10 Summary

III.A.3 Advanced Value at Risk Models

Carol Alexander, Elizabeth Sheedy

III.A.3.1 Introduction
III.A.3.2 Standard Distributional Assumptions
III.A.3.3 Models of Volatility Clustering
III.A.3.3.1 Exponentially Weighted Moving Average (EWMA)
III.A.3.3.2 GARCH Models
III.A.3.4 Volatility Clustering and VaR
III.A.3.4.1 VaR using EWMA
III.A.3.4.2 VaR and GARCH
III.A.3.5 Alternative Solutions to Non-Normality
III.A.3.5.1 VaR with the Student’s-t distribution
III.A.3.5.2 VaR with EVT
III.A.3.5.3 VaR with Normal Mixtures
III.A.3.6 Decomposition of VaR
III.A.3.6.1 Stand Alone Capital
III.A.3.6.2 Incremental VaR
III.A.3.6.3 Marginal Capital
III.A.3.7 Principal Component Analysis
III.A.3.7.1 PCA in Action
III.A.3.7.2 VaR with PCA
III.A.3.8 Summary

III.A.4 Stress Testing

Barry Schachter

III.A.4.1 Introduction
III.A.4.2 Historical Context
III.A.4.3 Conceptual Context
III.A.4.4 Stress Testing in Practice
III.A.4.5 Approaches to Stress Testing: An Overview
III.A.4.6 Historical Scenarios
III.A.4.6.1 Choosing Event Periods
III.A.4.6.2 Specifying Shock Factors
III.A.4.6.3 Missing Shock Factors
III.A.4.7 Hypothetical Scenarios
III.A.4.7.1 Modifying the Covariance Matrix
III.A.4.7.2 Specifying Factor Shocks (to ‘create’ an event)
III.A.4.7.3 Systemic Events and Stress-Testing Liquidity
III.A.4.7.4 Sensitivity Analysis
III.A.4.7.5 Hybrid Methods
III.A.4.8 Algorithmic Approaches to Stress Testing
III.A.4.8.1 Factor-Push Stress Tests
III.A.4.8.2 Maximum Loss
III.A.4.9 Extreme-Value Theory as a Stress-Testing Method

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III.A.4.10 Summary and Conclusions

B – CREDIT RISK

III.B.1 Credit Risk Management

Author to be confirmed

III.B.2 Foundations of Credit Risk Modelling

Philipp Schönbucher

III.B.2.1 Introduction
III.B.2.2 What is Default Risk?
III.B.2.3 Exposure, Default and Recovery Processes
III.B.2.4 The Credit Loss Distribution
III.B.2.5 Expected and Unexpected Loss
III.B.2.6 Recovery Rates
III.B.2.7 Conclusion

III.B.3 Credit Exposure

Philipp Schönbucher

III.B.3.1 Introduction
III.B.3.2 Pre-settlement versus Settlement Risk
III.B.3.2.1 Pre-settlement Risk
III.B.3.2.2 Settlement Risk
III.B.3.3 Exposure Profiles
III.B.3.3.1 Exposure Profiles of Standard Debt Obligations
III.B.3.3.2 Exposure Profiles of Derivatives
III.B.3.4 Mitigation of Exposures
III.B.3.4.1 Netting Agreements
III.B.3.4.2 Collateral
III.B.3.4.3 Other Counterparty Risk Mitigation Instruments

III.B.4 Default and Credit Migration

Philipp Schönbucher

III.B.4.1 Default Probabilities and Term Structures of Default Rates

III.B.4.2 Credit Ratings
III.B.4.2.1 Measuring Rating Accuracy
III.B.4.3 Agency Ratings
III.B.4.3.1 Methodology
III.B.4.3.2 Transition Matrices, Default Probabilities and Credit Migration
III.B.4.4 Credit Scoring and Internal Rating Models
III.B.4.4.1 Credit Scoring
III.B.4.4.2 Estimation of the Probability of Default
III.B.4.4.3 Other Methods to Determine the Probability of Default
III.B.4.5 Market Implied Default Probabilities
III.B.4.5.1 Pricing the Calibration Securities
III.B.4.5.2 Calculating implied default probabilities
III.B.4.6 Credit rating and credit spreads
III.B.4.7 Summary

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III.B.5 Portfolio Models of Credit Loss

Michel Crouhy, Dan Galai, Robert Mark

III.B.5.1 Introduction
III.B.5.2 What Actually Drives Credit Risk at the Portfolio Level?
III.B.5.3 Credit Migration Framework
III.B.5.3.1 Credit VaR for a Single Bond/Loan
III.B.5.3.2 Estimation of Default and Rating Changes Correlations
III.B.5.3.3 Credit VaR of a Bond/Loan Portfolio
III.B.5.4 Conditional Transition Probabilities– CreditPortfolioView
III.B.5.5 The Contingent Claim Approach to Measuring Credit Risk
III.B.5.5.1 Structural Model of Default Risk: Merton’s (1974) Model
III.B.5.5.2 Estimating Credit Risk as a Function of Equity Value
III.B.5.6 The KMV Approach
III.B.5.6.1 Estimation of the Asset Value VA and the Volatility of Asset Return
III.B.5.6.2 Calculation of the ‘Distance to Default’
III.B.5.6.3 Derivation of the Probabilities of Default from the Distance to
Default
III.B.5.6.4 EDF as a Predictor of Default
III.B.5.7 The Actuarial Approach
III.B.5.8 Summary and Conclusion

III.B.6 Credit Risk Capital Calculation

Dan Rosen

III.B.6.1 Introduction
III.B.6.2 Economic Credit Capital Calculation
III.B.6.2.1 Economic Capital and the Credit Portfolio Model
III.B.6.2.1.1 Time Horizon
III.B.6.2.1.2 Credit Loss Definition
III.B.6.2.1.3 Quantile of the Loss Distribution
III.B.6.2.2 Expected and Unexpected Losses
III.B.6.2.3 Enterprise Credit Capital and Risk Aggregation
III.B.6.3 Regulatory Credit Capital: Basel I
III.B.6.3.1 Minimum Credit Capital Requirements under Basel I
III.B.6.3.2 Weaknesses of the Basel I Accord for Credit Risk
III.B.6.3.3 Regulatory Arbitrage
III.B.6.4 Regulatory Credit Capital: Basel II
III.B.6.4.1 Latest Proposal for Minimum Credit Capital requirements
III.B.6.4.2 The Standardised Approach in Basel II
III.B.6.4.3 Internal Ratings Based Approaches: Introduction
III.B.6.4.4 IRB for Corporate, Bank and Sovereign Exposures
III.B.6.4.5 IRB for Retail Exposures
III.B.6.4.6 IRB for SME Exposures
III.B.6.4.7 IRB for Specialised Lending and Equity Exposures
III.B.6.4.8 Comments on Pillar II
III.B.6.5 Basel II: Credit Model Estimation and Validation
III.B.6.5.1 Methodology for PD Estimation
III.B.6.5.2 Point-in-Time and Through-the-Cycle Ratings
III.B.6.5.3 Minimum Standards for Quantification and Credit Monitoring Processes
III.B.6.5.4 Validation of Estimates
III.B.6.6 Basel II: Securitisation
III.B.6.7 Advanced Topics on Economic Credit Capital
III.B.6.7.1 Credit Capital Allocation and Marginal Credit Risk Contributions
III.B.6.7.2 Shortcomings of VaR for ECC and Coherent Risk Measures
III.B.6.8 Summary and Conclusions

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C – OPERATIONAL RISK

III.C.1 The Operational Risk Management Framework

Michael Ong

III.C.1.1 Introduction
III.C.1.2 Evidence of Operational Failures
III.C.1.3 Defining Operational Risk
III.C.1.4 Types of Operational Risk
III.C.1.5 Aims and Scope of Operational Risk Management
III.C.1.6 Key Components of Operational Risk
III.C.1.7 Supervisory Guidance on Operational Risk
III.C.1.8 Identifying Operational Risk – the Risk Catalogue
III.C.1.9 The Operational Risk Assessment Process
III.C.1.10 The Operational Risk Control Process
III.C.1.11 Some Final Thoughts

III.C.2 Operational Risk Process Models

James Lam

III.C.2.1 Introduction
III.C.2.2 The Overall Process
III.C.2.3 Specific Tools
III.C.2.4 Advanced Models
III.C.2.4.1 Top-down models
III.C.2.4.2 Bottom-up models
III.C.2.5 Key Attributes of the ORM Framework
III.C.2.6 Integrated Economic Capital Model
III.C.2.7 Management Actions
III.C.2.8 Risk Transfer
III.C.2.9 IT Outsourcing
III.C.2.9.1 Stakeholder Objectives
III.C.2.9.2 Key Processes
III.C.2.9.3 Performance Monitoring
III.C.2.9.4 Risk Mitigation

III.C.3 Operational Value-at-Risk

Carol Alexander

III.C.3.1 The ‘Loss Model’ Approach

III.C.3.2 The Frequency Distribution
III.C.3.3 The Severity Distribution
III.C.3.4 The Internal Measurement Approach
III.C.3.5 The Loss Distribution Approach
III.C.3.6 Aggregating ORC
III.C.3.7 Concluding Remarks

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Introduction
If you're reading this, you are seeking to attain a higher standard. Congratulations!

Those of us who have been a part of financial risk management for the past twenty years, have
seen it change from an on-the-fly profession, with improvisation as a rule, to one with
substantially higher standards, many of which are now documented and expected to be followed.
It’s no longer enough to say you know. Now, you and your team need to prove it.

As its title implies, this book is the Handbook for the Professional Risk Manager. It is for those
professionals who seek to demonstrate their skills through certification as a Professional Risk
Manager (PRM) in the field of financial risk management. And it is for those looking simply to
develop their skills through an excellent reference source.

With contributions from nearly 40 leading authors, the Handbook is designed to provide you
with the materials needed to gain the knowledge and understanding of the building blocks of
professional financial risk management. Financial risk management is not about avoiding risk.
Rather, it is about understanding and communicating risk, so that risk can be taken more
confidently and in a better way. Whether your specialism is in insurance, banking, energy, asset
management, weather, or one of myriad other industries, this Handbook is your guide.

We encourage you to work through it sequentially. In Section I, we introduce the foundations of

finance theory, the financial instruments that provide tools for the mitigation or transfer of risk,
and the financial markets in which instruments are traded and capital is raised. After studying this
section, you will have read the materials necessary for passing Exam I of the PRM Certification
program.

In Section II, we take you through the mathematical foundations of risk assessment. While there
are many nuances to the practice of risk management that go beyond the quantitative, it is
essential today for every risk manager to be able to assess risks. The chapters in this section are
accessible to all PRM members, including those without any quantitative skills. The Excel
spreadsheets that accompany the examples are an invaluable aid to understanding the
mathematical and statistical concepts that form the basis of risk assessment. After studying all
these chapters, you will have read the materials necessary for passage of Exam II of the PRM
Certification program.

In Section III, the current and best practices of Market, Credit and Operational risk management
are described. This is where we take the foundations of Sections I and II and apply them to our

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profession in very specific ways. Here the strategic application of risk management to capital
allocation and risk-adjusted performance measurement takes hold. After studying this part, you
will have read the materials necessary for passage of Exam III of the PRM Certification program.

Those preparing for the PRM certification will also be preparing for Exam IV - Case Studies,
Standards of Best Practice Conduct and Ethics and PRMIA Governance. This is where we study
some failed practices, standards for the performance of the duties of a Professional Risk
Manager, and the governance structure of our association, the Professional Risk Managers’
International Association. The materials for this exam are freely available on our web site (see
http://www.prmia.org/pdf/Web_based_Resources.htm) and are thus outside of the Handbook.

At the end of your progression through these materials, you will find that you have broadened
your knowledge and skills in ways that you might not have imagined. You will have challenged
yourself as well. And, you will be a better risk manager. It is for this reason that we have created
the Professional Risk Managers’ Handbook.

Our deepest appreciation is extended to Prof. Carol Alexander and Prof. Elizabeth Sheedy, both
of PRMIA’s Academic Advisory Council, for their editorial work on this document. The
commitment they have shown to ensuring the highest level of quality and relevance is beyond
description. Our thanks also go to Laura Bianco, President of PRMIA Publications, who has
tirelessly kept the work process moving forward and who has dedicated herself to demanding the
finest quality output. We also thank Richard Leigh, our London-based copyeditor, for his skilful
and timely work.

Finally, we express our thanks to the authors who have shared their insights with us. The
demands for sharing of their expertise are frequent. Yet, they have each taken special time for
this project and have dedicated themselves to making the Handbook and you a success. We are
very proud to bring you such a fine assembly.

Much like PRMIA, the Handbook is a place where the best ideas of the risk profession meet. We
hope that you will take these ideas, put them into practice and certify your knowledge by attaining
the PRM designation. Among our membership are over 300 Chief Risk Officers / Heads of Risk
and 800 other senior executives who will note your achievements. They too know the importance
of setting high standards and the trust that capital providers and stakeholders have put in them.
Now they put their trust in you and you can prove your commitment and distinction to them.

We wish you much success during your studies and for your performance in the PRM exams!

David R. Koenig, Executive Director, PRMIA

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Section I

Finance Theory, Financial Instruments and

Markets

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Preface to Section I: Finance Theory, Financial Instruments and

Markets
Section I of this Handbook has been written by a group of leading scholars and practitioners and
represents a broad overview of the theory, instruments and markets of finance. This section
corresponds to Exam I in the Professional Risk Manager (PRM) certification programme.

The modern theory of finance is the solid basis of risk management and thus it naturally
represents the basis of the PRM certification programme. All major areas of finance are involved
in the process of risk management: from the expected utility approach and risk aversion, which
were the forerunners of the capital asset pricing model (CAPM), to portfolio theory and the risk-
neutral approach to pricing derivatives. All of these great financial theories and their interactions
are presented in Part I.A (Finance Theory). Many examples demonstrate how the concepts are
applied in practical situations.

Part I.B (Financial Instruments) describes a wide variety of financial products and connects them
to the theoretical development in Part I.A. The ability to value all the instruments/assets within a
trading or asset portfolio is fundamental to risk management. This part examines the valuation of
financial instruments and also explains how many of them can be used for risk management.

The designers of the PRM curriculum have correctly determined that financial risk managers
should have a sound knowledge of financial markets. Market liquidity, the role of intermediaries
and the role of exchanges are all features that vary considerably from one market to the next and
over time. It is crucial that professional risk managers understand how these features vary and
their consequences for the practice of risk management. Part I.C (Financial Markets) describes
where and how instruments are traded, the features of each type of financial asset or commodity
and the various conventions and rules governing their trade.

This background is absolutely necessary for professional risk management, and Exam I therefore
represents a significant portion of the whole PRM certification programme. For a practitioner
who left academic studies several years ago, this part of the Handbook will provide efficient
revision of finance theory, financial instruments and markets, with emphasis on practical
application to risk management. Such a person will find the chapters related to his/her work easy
reading and will have to study other topics more deeply.

The coverage of financial topics included in Section I of the Handbook is typically deeper and
broader than that of a standard MBA syllabus. But the concepts are well explained and

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appropriately linked together. For example, Chapter I.B.6 on credit derivatives covers many
examples (such as credit-linked notes and credit default swaps) that are not always included in a
standard MBA-level elective course on fixed income. Chapter I.B.9 on simple exotics also
provides examples of path-dependent derivatives beyond the scope of a standard course on
options. All chapters are written for professionals and assume a basic understanding of markets
and their participants.

Finance Theory
Chapter I.A.1 provides a general overview of risk and risk aversion, introduces the utility function
and mean–variance criteria. Various risk-adjusted performance measures are described. A
summary of several widely used utility functions is presented in the appendix.

Chapter I.A.2 provides an introduction to portfolio mathematics, from means and variances of
returns to correlation and portfolio variance. This leads the reader to the efficient frontier,
portfolio theory and the concept of portfolio diversification. Eventually this chapter discusses
normally distributed returns and basic applications for value-at-risk, as well as the probability of
reaching a target or beating a benchmark. This chapter is very useful for anybody with little
experience in applying basic mathematical models in finance.

The concept of capital allocation is another fundamental notion for risk managers. Chapter I.A.3
describes how capital is allocated between portfolios of risky and riskless assets, depending on
risk preference. Then the efficient frontier, the capital markets line, the Sharpe ratio and the
separation principle are introduced. These concepts lead naturally to a discussion of the CAPM
model and the idea that marginal risk (rather than absolute risk) is the key issue when pricing
risky assets. Chapter I.A.4 provides a rigorous description of the CAPM model, including betas,
systematic risk, alphas and performance measures. Arbitrage pricing theory and multifactor
models are also introduced in this chapter.

Capital structure is an important theoretical concept for risk managers since capital is viewed as
the last defence against extreme, unexpected outcomes. Chapter I.A.5 introduces capital
structure, advantages and costs related to debt financing, various agency costs, various types of
debt and equity, return on equity decomposition, examples of attractive and unattractive debt,
bankruptcy and financial distress costs.

Most valuation problems involve discounting future cash flows, a process that requires
knowledge of the term structure of interest rates. Chapter I.A.6 describes various types of

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interest rates and discounting, defines the term structure of interest rates, introduces forward
rates and explains the three main economic term structure theories.

These days all risk managers must be well versed in the use and valuation of derivatives. The two
basic types of derivatives are forwards (having a linear payoff) and options (having a non-linear
payoff). All other derivatives can be decomposed to these underlying payoffs or alternatively
they are variations on these basic ideas. Chapter I.A.7 describes valuation methods used for
forward contracts. Discounting is used to value forward contracts with and without intermediate
cash flow. Chapter I.A.8 introduces the principles of option pricing. It starts with definitions of
basic put and call options, put–call parity, binomial models, risk-neutral methods and simple delta
hedging. Then the Black–Scholes–Merton formula is introduced. Finally, implied volatility and
smile effects are briefly described.

Financial Instruments
Having firmly established the theoretical basis for valuation in Part I.A, Part I.B applies these
theories to the most commonly used financial instruments.

Chapter I.B.1 introduces bonds, defines the main types of bonds and describes the market
conventions for major types of treasuries, strips, floaters (floating-rate notes) and inflation-
protected bonds in different countries. Bloomberg screens are used to show how the market
information is presented. Chapter I.B.2 analyses the main types of bonds, describes typical cash
flows and other features of bonds and also gives a brief description of non-conventional
instruments. Examples of discounting, day conventions and accrued interest are provided, as
well as yield calculations. The connection between yield and price is described, thus naturally
leading the reader to duration, convexity and hedging interest-rate risk.

While Chapter I.A.7 explained the principles of forward valuation, Chapter I.B.3 examines and
compares futures and forward contracts. Usage of these contracts for hedging and speculation is
discussed. Examples of currency, commodity, bonds and interest-rate contracts are used to
explain the concept and its applications. Mark-to-market, quotation, settlements and other
specifications are described here as well. The principles of forward valuation are next applied to
swap contracts, which may be considered to be bundles of forward contracts. Chapter I.B.4
analyses some of the most popular swap varieties, explaining how they may be priced and used
for managing risk.

The remaining chapters in Part I.B all apply the principles of option valuation as introduced in
Chapter I.A.8. The power of the option concept is obvious when we see its applications to so

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many instruments and risk management problems. Chapter I.B.5 begins with an analysis of
vanilla options. Chapter I.B.6 covers one of the newer applications of options: the use of credit
risk derivatives to manage credit risk. Chapter I.B.7 addresses caps, floors and swaptions, which
are the main option strategies used in interest-rate markets. Yet another application of the option
principle is found in Chapter I.B.8 – convertible bonds. These give investors the right to convert
a debt security into equity. Finally, Chapter I.B.9 examines exotic option payoffs. In every case
the author defines the instrument, discusses its pricing and illustrates its use for risk management
purposes.

Financial Markets
Financial risk management takes place in the context of markets and varies depending on the
nature of the market. Chapter I.C.1 is a general introduction to world financial markets. They
can be variously classified – geographically, by type of exchange, by issuers, liquidity and type of
instruments – all are provided here. The importance of liquidity, the distinction between
exchange and over-the-counter markets and the role of intermediaries in their various forms are
explained in more detail.

Money markets are the subject of Chapter I.C.2. These markets are of vital importance to the
risk manager as the closest thing to a ‘risk-free’ asset is found here. This chapter covers all short-
term debt securities, whether issued by governments or corporations. It also explains the repo
markets – markets for borrowing/lending on a secured basis. The market for longer-term debt
securities is discussed in Chapter I.C.3, which classifies bonds by issuer: government, agencies,
corporate and municipal. There is a comparison of bond markets in major countries and a
description of the main intermediaries and their roles. International bond markets are introduced
as well.

Chapter I.C.4 turns to the foreign exchange market – the market with the biggest volume of
trade. Various aspects of this market are explained, such as quotation conventions, types of
brokers, and examples of cross rates. Economic theories of exchange rates are briefly presented
here along with central banks’ policies. Forward rates are introduced together with currency
swaps. Interest-rate parity is explained with several useful examples.

Chapter I.C.5 provides a broad introduction to stock markets. This includes the description and
characteristics of several types of stocks, stock market indices and priorities in the case of
liquidation. Dividends and dividend-based stock valuation methods are described in this
chapter. Primary and secondary markets are distinguished. Market mechanics, including types of

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orders, market participants, margin and short trades, are explained here with various examples
clarifying these transactions. Some exchange-traded options on stocks are introduced as well.

Chapter I.C.6 introduces the futures markets; this includes a comparison of the main exchange-
traded markets, options on futures, specifications of the most popular contracts, the use of
futures for hedging, trade orders for futures contracts, mark-to-market procedures, and various
expiration conventions. A very interesting description of the main market participants concludes
this chapter.

Chapter I.C.7 introduces the structure of the commodities market. It starts with the spot market
and then moves to commodity forwards and futures. Specific features, such as delivery and
settlement methods, are described. The spot–forward pricing relationship is used to decompose
the forward price into spot and carry. Various types of price term structure (such as
backwardation and contango) are described, together with some economic theory. The chapter
also describes short squeezes and regulations. Risk management at the commodity trading desk
is given at a good intuitive level. The chapter concludes with some interesting facts on
distribution of commodity returns.

Finally, Chapter I.C.8 examines one of the most rapidly developing markets for risk – the energy
markets. These markets allow participants to manage the price risks of oil and gas, electricity,
coal and so forth. Some other markets closely linked with energy are also briefly discussed here,
including markets for greenhouse gas emissions, weather derivatives and freight. Energy markets
create enormous challenges and opportunities for risk managers – in part because of the extreme
volatility of prices that can occur.

As a whole, Section I gives an overview of the theoretical and practical aspects of finance that are
used in the management of financial risks. Many concepts, some quite complex, are explained in
a relatively simple language and are demonstrated with numerous examples. Studying this part of
the Handbook should refresh your knowledge of financial models, products and markets and
provide the background for risk management applications.

Zvi Wiener, Co-chair of PRMIA’s Education and Standards Committee

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Section II

Mathematical Foundations of Risk

Measurement

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Preface to Section II: Mathematical Foundations of Risk

Measurement
The role of risk management in financial firms has evolved far beyond the simple insurance of
identified risks. Today it is recognised that risks cannot be properly managed unless they are
quantified. And the assessment of risk requires mathematics. Take, for instance, a large portfolio
of stocks. The relationship between the portfolio returns and the market returns – and indeed
other potential risk factor returns – is typically estimated using a statistical regression analysis.
And the systematic risk of the portfolio is then determined by a quadratic form, a fundamental
concept in matrix algebra that is based on the covariance matrix of the risk factor returns.

Volatility is not the only risk metric that financial risk managers need to understand. During the
last decade value-at-risk (VaR) has become the ubiquitous tool for risk capital estimation. To
understand a VaR model, risk managers require knowledge of probability distributions,
simulation methods and a host of other mathematical and statistical techniques. Market VaR is
assessed by mapping portfolios to their risk factors and forecasting the volatilities and
correlations of these factors. The diverse quantitative techniques that are commonly applied in
the assessment of market VaR include eigenvectors and eigenvalues, Taylor expansions and
partial derivatives. Credit VaR can be assessed using firm-value models that are based on the
theory of options, or statistical and/or macro-econometric models. Probability distributions are
even applied to operational risks, though they are very difficult to quantify because the data are
sparse and unreliable. Indeed, the actuarial or loss model approach has been adopted as industry
standard for operational VaR models.

Even if not directly responsible for designing and coding a risk capital model, middle office risk
managers must understand these models sufficiently well to be competent to assess them. And
the risk management role encompasses many other responsibilities. Ten years ago my best
students aspired to become traders because of the high salaries and status – risk management was
viewed (by some) as a ‘second-rate’ job that did not require very special expertise. Now, this
situation has definitely changed. Today, the middle office risk manager’s responsibility has
expanded to include the independent validation of traders’ models, as well as risk capital
assessment. And the role of risk management in the front office itself has expanded, with the
need to hedge increasingly complex options portfolios. So today, the hallmark of a good risk
manager is not just having the statistical skills required for risk assessment – a comprehensive
knowledge of pricing and hedging financial instruments is equally important.

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No wonder, therefore, that the PRM qualification includes an entire exam on mathematical and
statistical methods. However, we do recognise that many students will not have degrees in
mathematics, physics or other quantitative disciplines. So this section of the Handbook is aimed
at students having no quantitative background at all. It introduces and explains all the
mathematics and statistics that are essential for financial risk management. Every chapter is
presented in a pedagogical manner, with associated Excel spreadsheets explaining the numerous
practical examples. And, for clarity and consistency, we chose two much respected authors of the
highly acclaimed textbook Quantitative Methods in Finance to write the entire section. Keith
Parramore and Terry Watsham have put considerable effort into making the PRM material
accessible to everyone, irrespective of their quantitative background.

The first chapter, II.A (Foundations), reviews the fundamental mathematical concepts: the
symbols used and the basic rules for arithmetic, equations and inequalities, functions and graphs,
etc. Chapter II.B (Descriptive Statistics) introduces the descriptive statistics that are commonly
used to summarise the historical characteristics of financial data: the sample moments of returns
distributions, ‘downside’ risk statistics, and measures of covariation (e.g. correlation) between two
random variables. Chapter II.C (Calculus) focuses on differentiation and integration, Taylor
expansion and optimisation. Financial applications include calculating the convexity of a bond
portfolio and the estimation of the delta and gamma of an options portfolio. Chapter II.D
(Linear Mathematics and Matrix Algebra) covers matrix operations, special types of matrices and
the laws of matrix algebra, the Cholesky decomposition of a matrix, and eigenvalues and
eigenvectors. Examples of financial applications include: manipulating covariance matrices;
calculating the variance of the returns to a portfolio of assets; hedging a vanilla option position;
and simulating correlated sets of returns. Chapter II.E (Probability Theory) first introduces the
concept of probability and the rules that govern it. Then some common probability distributions
for discrete and continuous random variables are described, along with their expectation and
variance and various concepts relating to joint distributions, such as covariance and correlation,
and the expected value and variance of a linear combination of random variables. Chapter II.F
(Regression Analysis) covers the simple and multiple regression models, with applications to the
capital asset pricing model and arbitrage pricing theory. The statistical inference section deals
with both prediction and hypothesis testing, for instance, of the efficient market hypothesis.
Finally, Chapter II.G (Numerical Methods) looks at solving implicit equations (e.g. the Black–
Scholes formula for implied volatility), lattice methods, finite differences and simulation.
Financial applications include option valuation and estimating the ‘Greeks’ for complex options.

Whilst the risk management profession is no doubt becoming increasingly quantitative, the
quantification of risk will never be a substitute for good risk management. The primary role of a

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financial risk manager will always be to understand the markets, the mechanisms and the
instruments traded. Mathematics and statistics are only tools, but they are necessary tools. After
working through this part of the Handbook you will have gained a thorough and complete
grounding in the essential quantitative methods for your profession.

Carol Alexander, Chair of PRMIA’s Academic Advisory Council and co-editor of The PRM Handbook

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Section III

Risk Management Practices

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Preface to Section III: Risk Management Practices

Section III is the ultimate part of The PRM Handbook in both senses of the word. Not only is it
the final section, but it represents the final aims and objectives of the Handbook. Sections I
(Finance Theory, Financial Instruments and Markets) and II (Mathematical Foundations of Risk
Measurement) laid the necessary foundations for this discussion of risk management practices –
the primary concern of most readers. Here some of the foremost practitioners and academics in
the field provide an up-to-date, rigorous and lucid statement of modern risk management.

The practice of risk management is evolving at a rapid pace, especially with the impending arrival
of Basel II. Aside from these regulatory pressures, shareholders and other stakeholders
increasingly demand higher standards of risk management and disclosure of risk. In fact, it
would not be an overstatement to say that risk consciousness is one of the defining features of
modern business. Nowhere is this truer than in the financial services industry. Interest in risk
management is at an unprecedented level as institutions gather data, upgrade their models and
systems, train their staff, review their remuneration systems, adapt their business practices and
scrutinise controls for this new era.

Section III is itself split into three parts which address market risk, credit risk and operational risk
in turn. These three are the main components of risk borne by any organisation, although the
relative importance of the mix varies. For a traditional commercial bank, credit risk has always
been the most significant. It is defined as the risk of default on debt, swap, or other counterparty
instruments. Credit risk may also result from a change in the value of a security, contract or asset
resulting from a change in the counterparty’s creditworthiness. In contrast, market risk refers to
changes in the values of securities, contracts or assets resulting from movements in exchange
rates, interest rates, commodity prices, stock prices, etc. Operational risk, the risk of loss
resulting from inadequate or failed internal processes, people and systems or from external
events, is not, strictly speaking, a financial risk. Operational risks are, however, an inevitable
consequence of any business undertaking. For financial institutions and fund managers, credit
and market risks are taken intentionally with the objective of earning returns, while operational
risks are a by-product to be controlled. While the importance of operational risk management is
increasingly accepted, it will probably never have the same status in the finance industry as credit
and market risk which are the chosen areas of competence.

For non-financial firms, the priorities are reversed. The focus should be on the risks associated
with the particular business; the production and marketing of the service or product in which

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expertise is held. Market and credit risks are usually of secondary importance as they are a by-
product of the main business agenda.

The last line of defence against risk is capital, as it ensures that a firm can continue as a going
concern even if substantial and unexpected losses are incurred. Accordingly, one of the major
themes of Section III is how to determine the appropriate size of this capital buffer. How much
capital is enough to withstand unusual losses in each of the three areas of risk? The measurement
of risk has further important implications for risk management as it is increasingly incorporated
into the performance evaluation process. Since resources are allocated and bonuses paid on the
basis of performance measures, it is essential that they be appropriately adjusted for risk. Only
then will appropriate incentives be created for behaviour that is beneficial for shareholders and
other stakeholders. Chapter III.0 explores this fundamental idea at a general level, since it is
relevant for each of the three risk areas that follow.

Market Risk
Chapter III.A.1 introduces the topic of market risk as it is practised by bankers, fund managers
and corporate treasurers. It explains the four major tasks of risk management (identification,
assessment, monitoring and control/mitigation), thus setting the scene for the quantitative
chapters that follow. These days one of the major tasks of risk managers is to measure risk using
value-at-risk (VaR) models. VaR models for market risk come in many varieties. The more basic
VaR models are the topic of Chapter III.A.2, while the advanced versions are covered in III.A.3
along with some other advanced topics such as risk decomposition. The main challenge for risk
managers is to model the empirical characteristics observed in the market, especially volatility
clustering. The advanced models are generally more successful in this regard, although the basic
versions are easier to implement. Realistically, there will never be a perfect VaR model, which is
one of the reasons why stress tests are a popular tool. They can be considered an ad hoc solution
to the problem of model risk. Chapter III.A.4 explains the need for stress tests and how they
might usefully be constructed.

Credit Risk
Chapter III.B.1 introduces the sphere of credit risk management. Some fundamental tools for
managing credit risk are explained here, including the use of collateral, credit limits and credit
derivatives. Subsequent chapters on credit risk focus primarily on its modelling. Foundations for
modelling are laid in Chapter III.B.2, which explains the three basic components of a credit loss:
the exposure, the default probability and the recovery rate. The product of these three, which
can be defined as random processes, is the credit loss distribution. Chapter III.B.3 takes a more
detailed look at the exposure amount. While relatively simple to define for standard loans,

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assessment of the exposure amount can present challenges for other credit sensitive instruments
such as derivatives, whose values are a function of market movements. Chapter III.B.4 examines
in detail the default probability and how it can evolve over time. It also discusses the relationship
between credit ratings and credit spreads, and credit scoring models. Chapter III.B.5 tackles one
of the most crucial issues for credit risk modelling: how to model credit risk in a portfolio
context and thereby estimate credit VaR. Since diversification is one of the most important tools
for the management of credit risk, risk measures on a portfolio basis are fundamental. A number
of tools are examined, including the credit migration approach, the contingent claim or structural
approach, and the actuarial approach. Finally, Chapter III.B.6 extends the discussion of credit
VaR models to examine credit risk capital. It compares both economic capital and regulatory
capital for credit risk as defined under the new Basel Accord.

Operational Risk
The framework for managing operational risk is first established in Chapter III.C.1. After
defining operational risk, it explains how it may be identified, assessed and controlled. Chapter
III.C.2 builds on this with a discussion of operational risk process models. By better
understanding business processes we can find the sources of risk and often take steps to re-
engineer these processes for greater efficiency and lower risk. One of the most perplexing issues
for risk managers is to determine appropriate capital buffers for operational risks. Operational
VaR is the subject of Chapter III.C.3, including discussion of loss models, standard functional
forms, both analytical and simulation methods, and the aggregation of operational risk over all
business lines and event types.

Elizabeth Sheedy, Member of PRMIA’s Academic Advisory Council and co-editor of The PRM Handbook

2004 © The Professional Risk Managers’ International Association xxxix

 The PRM Handbook -– I.A.1 Risk and Risk Aversion

I.A.1 Risk and Risk Aversion

Jacques Pézier1

I.A.1.1 Introduction
Risk management, in a wide sense, is the art of making decisions in an uncertain world. Such
decisions involve a weighting of risks and rewards, a choice between doing the safe thing and
taking a risk. For example, we may ponder whether to invest in a new venture, whether to
diversify or hedge a portfolio of assets, or at what price it would be worth insuring a person or a
system. Risk attitude determines such decisions. Utility theory offers a rational method for
expressing risk attitude and should therefore be regarded as a main pillar of risk management.
The other two pillars of risk management are the generation of good alternatives – without which
there would be nothing to decide – and the assessment of probabilities – without which we could
not tell the likely consequences of our actions.

Rationality, in the context of utility theory, means simply that decisions should be logically
consistent with a set of preference axioms and in line with patterns of risk attitude expressed in
simple, easily understood circumstances. So, utility theory does not dictate what risk attitude
should be – that remains a personal matter or a matter of company policy – it merely provides a
logical framework to extend risk preferences from simple cases to complex situations.

But why should one seek an axiomatic framework to express risk preferences? Alas, experience
shows that unaided intuition is an unreliable guide. It is relatively easy to construct simple
decision problems where intuitive choices seem to contradict each other, that is, seem to violate
basic rules of behaviour that we hold as self-evident. It seems wise, therefore, to start by
agreeing a basic set of rules and then draw the logical consequences.

Thus, utility theory is neither purely descriptive nor purely normative. It brings about a more
disciplined, quantitative approach to the expression of risk attitude than is commonly found in
everyday life. In other words, where too often risk taking is ‘seat of the pants’ or based on ‘gut
feel’ or ‘nose’, it tries to bring the brain into play. By questioning instinctive reactions to risky
situations, it leads decision makers and firms to understand better what risk attitude they ought to
adopt, to express it formally as an element of corporate policy and to convey it through the
organisation so that decisions under uncertainty can be safely delegated.

1 Visiting Professor, ISMA Centre, University of Reading, UK.

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This chapter introduces some concepts that are absolutely fundamental to the management of
financial risks. Section I.A.1.2 introduces the idea of utility maximisation following Bernoulli’s
original ideas. Section I.A.1.3 discusses the ‘axiom of independence of choice’, one of the basic
axioms that must be satisfied if preferences over risky outcomes are to be represented by a utility
function. Section I.A.1.4 introduces the principle of maximum expected utility and the concept of
risk aversion (and its inverse, risk tolerance). Section I.A.1.5 explains how to encode your
personal attitude to risk in your own utility function. Section I.A.1.6 shows under what
circumstances the principle of maximum expected utility reduces to a mean–variance criterion to
distinguish between different investments. A comprehensive treatment of risk-adjusted
performance measures is given in Section I.A.1.7. We pay particular attention to the
circumstances in which the risks to be compared are not normally distributed and investors are
mainly concerned with downside risks. Section I.A.1.8 summarises and indicates which types of
decision criteria and performance measures may be appropriate in which circumstances.

Much of the material that is introduced in this chapter will be more fully discussed in other parts
of the Handbook. Thus you will find many references to subsequent chapters in Part I.A, Part II
and Part III of the Handbook. A thorough treatment of utility theory, whilst fundamental to our
understanding of risk and risk aversion, is beyond the scope of the PRM exam. However, for
completeness, and for readers seeking to use this chapter as a resource that goes further than the
PRM syllabus, we have provided extensive footnotes of the mathematical derivations.
Furthermore, we have added an Appendix that describes the properties of standard utility
functions. However, it should be stressed that neither the mathematical derivations in the
footnotes nor the material in Appendix B are part of the PRM exam.

I.A.1.2 Mathematical Expectations: Prices or Utilities?

It may seem curious nowadays that early probabilists, who liked to study games of chance, took it
for granted that the mathematical expectation of cash outcomes was the only rational criterion
for choosing between gambles. The expected value of a gamble is defined as the sum of its cash
outcomes weighted by their respective probabilities; the gamble with the highest expected value
was deemed to be the best. Fairness in gambling was the main argument in support of this
principle (among ‘zero-sum’ games, where the gains of one player are the losses of the other, only
zero-expectation games are fair). Another argument drew on the weak law of large numbers, which
implies that, if the consequences of each gamble are small relative to the wealth of the players,
then, in the long run, after many independent gambles, only the average result would matter.

Daniel Bernoulli (1738) was the first mathematician to question the principle of maximising
expected value and to try to justify departures from it observed in daily life. He questioned

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choices that fly in the face of the principle of maximising expected value. For example, he asked,
if a poor man were offered an equal chance to win a fortune or nothing, should he be regarded as
irrational if he tried to negotiate a sure reward of slightly less than half the potential fortune? Or
is it insane to insure a precious asset and thus knowingly contribute an expected profit to the
insurance company and therefore an equivalent expected decrease in one’s wealth? To reconcile
common behaviour with a maximum-expectation principle, Bernoulli suggested applying the
principle not to cash outcomes but to utilities2 associated with cash outcomes. Bernoulli thus
pre-dates by half a century the core tenet of the Utilitarianism school of social philosophy, the
distinction between:
x the utility, i.e. the ‘personal value’ of an asset,
and
x the price, i.e. the ‘exchange value’ of an asset.

Bernoulli’s principle was that actions should be directed at maximising expected utility. The problem
that inspired Bernoulli and which has gained fame under the name of the St Petersburg paradox3
runs as follows: Peter tosses a coin and continues to do so until it should land ‘heads’. He agrees
to give Paul one ducat if he gets ‘heads’ on the very first throw, two ducats if he gets it on the
second, four if on the third, eight if on the fourth, and so on, so that with each additional throw
the number of ducats he must pay is doubled. We seek to determine the value of Paul’s
expectation.

Since, with a fairly tossed, symmetrical coin, the probability of landing heads for the first time on
the kth toss is 2–k and the corresponding reward is 2k – 1 ducats, the contribution to Paul’s
monetary expectation of this outcome is half a ducat. And since there is an infinite number of
possible outcomes k = 1, k = 2, etc., Paul’s monetary expectation is infinite. But, then as now,
gamblers are not willing to pay more than a few ducats for the right to play the game, hence the
paradox.

Bernoulli suggested that the utility of a cash reward depends on the existing wealth of the
recipient. He even made the far stronger assumption that utility is always inversely proportional to
existing wealth, in other words, that a gain of one ducat to someone worth a thousand ducats has
the same utility as a gain of a thousand ducats to someone worth a million ducats.

In this case a small change in utility, du, would be related to a small change in wealth, dx, by
du = dx/x.

2 In the Latin original, to calculate an ‘emolumentum medium’.

3 Simply because Bernoulli’s paper was published in the Commentaries from the Academy of Sciences of St Petersburg.

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This leads, by integration (see Section II.C.6), to a logarithmic utility function,

u(x) = ln (x).

If we apply a logarithmic utility to the St Petersburg paradox, it no longer appears to be a

paradox. For instance, a gambler whose only wealth is the game itself would perceive an expected
utility of ln(2), which is the same as the utility of 2 ducats, and this is quite a small number – far
short of infinity! In general, if the gambler has a logarithmic utility function, the larger the initial
wealth of the gambler, the larger his perceived utility of the game.

I.A.1.3 The Axiom of Independence of Choice

Rarely is the power of a new idea fully understood on first encounter. Bernoulli’s introduction of
a utility function did influence the development of classical economics, where it was transposed
into a deterministic context. But it took more than two hundred years for the concept to be
revived in its original probabilistic context and to be re-erected on a firmer footing. In a seminal
book on games theory the mathematician J. von Neumann and the economist O. Morgenstern
(1947) postulated a basic set of rules from which it will follow that a utility function provides a
complete description of an individual’s risk attitude.4

Bernoulli made a very strong assumption – that the utility of a gain is inversely proportional to
existing wealth. By contrast, von Neumann and Morgenstern only assumed a minimal set of
rules that should appeal to all decision makers and which would result in the existence of utilities
without specifying what these utilities will be. These rules, or ‘preference axioms’, should seem
so fundamental that if, in some circumstances, a decision maker accidentally violates one of
them, she would re-examine her choice and correct it rather than knowingly abuse one of the
rules.

To illustrate this point, consider the following preference axiom:

‘A choice between two gambles should not be influenced by the way the gambles are presented, provided that all
presentations contain the same relevant information.’

This is an axiom because it cannot be derived from more fundamental principles. It is called the
axiom of independence of choice. One is free to accept or reject it, though most decision makers freely
accept it as self-evident. However, this axiom is easily violated by instinctive choices.

4The axiomatic approach pioneered by von Neumann, Morgenstern, Savage and others is often referred to as the
American school of axiomatic utility theory.

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Daniel Kahneman, a Nobel prize winning expert in cognitive psychology, and his long time
colleague Amos Tversky designed the following simple, if somewhat dramatic test to show how a
change of presentation can affect our decisions. Their test consists of presenting two variants of
a choice between two public health programmes that address a threat to the lives of 600 people.
The first variant is:
‘With programme A we know that 200 lives will be saved, whereas with programme B there is a one-third chance
of saving all 600 lives and a two-thirds chance of saving none.’

Kahneman and Tversky found that a clear majority of the people they presented with this choice
preferred A to B.5 The second variant is:
‘With programme C we know that 400 lives will be lost, whereas with programme D there is a one-third chance
that none will die and a two-thirds chance that all 600 people will die.’

A majority of the people presented with this choice prefer D to C. Now, looking at the four
programmes, it becomes clear that, on the one hand, A and C are the same and, on the other
hand, C and D are also the same; the people saved in one presentation are the people not dying
in the other. So, whether one prefers A to B or the reverse, one ought express the same order of
preference between C and D, and that is not the case with many of the people interviewed; these
people are violating the axiom of independence of choice.

Kahneman and Tversky (1979) developed a new theory to explain their findings. They suggested
that people are generally risk averse when choosing between a sure gain and a chance of a larger
gain, but the same people may take a chance when forced to choose between a sure loss and only
a probability of a worse loss. The snag is that what appears as a sure gain or a sure loss is often a
question of perspective that can be easily manipulated by the way a problem is presented. Aware of
the importance attached to presentation, we provide in Appendix I.A.1.A a brief glossary of
some of the terms used in this chapter in order to dispel any unintended meaning.

More generally, cognitive psychologists have shown that we, as decision makers, may be swayed
by cognitive biases in the same way as untrained observers may be tricked by optical illusions.
We recognise the possibility of such biases when dealing with unusual events, for example, rare
events or extreme circumstances, or when our thoughts are too accustomed to a status quo, or
when they are blurred by emotions. But it may be unsafe to dismiss all instinctive reactions as
mere ‘biases’. After all, human instincts have evolved over millennia and must have some

5 Similar hypothetical questions were presented to numerous audiences of students and university faculty (the Hebrew
University of Jerusalem, University of Stockholm, University of Michigan, among others) with similar results and
repeated with business men in National Science Foundation sponsored studies.

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survival value; important features of human risk behaviour could be overlooked by a naïve
axiomatic approach.

I.A.1.4 Maximising Expected Utility

There are a few variations of the axiomatic formulation of utility theory. We give here an
intuitive, if less than rigorous presentation.6 For students’ information we give in a footnote the
derivation of the principle of maximum expected utility, but the derivation is not examinable in
the PRM.

I.A.1.4.1 The Four Basic Axioms

(A1) Transitivity of Choice: All possible outcomes of the decision under consideration can
be ranked in order of preference; that is, if among three outcomes A, B and C, we strictly
prefer A to B and B to C then we ought to strictly prefer A to C.
(A2) Continuity of Choice: If among three outcomes A, B, C we strictly prefer A to B and
B to C, then B is the certain equivalent of some lottery between A and C, that is, there
exists a unique probability p for which we should be indifferent between receiving B or
playing a lottery offering A with probability p and C with probability 1 – p.
(A3) Independence of Choice:7 Our preference order between two lotteries should not be
affected if these lotteries are part of the same wider range of possibilities.
(A4) Stochastic Dominance: Between two lotteries offering the same two possible
outcomes, we ought to prefer the lottery offering the larger probability of yielding the
preferred outcome.

Whether these axioms are naïve or reasonable will remain an open debate; they are certainly not
always descriptive of intuitive human behaviour – see Allais (1953) as well as Khaneman – but
they may be useful guides as we try to improve on intuition. What is remarkable is that these
four axioms are sufficient to establish the concept of utility and lead to a unique decision
criterion known as the principle of maximum expected utility (maximum EU, for short), namely: the
lottery with the largest expected utility ought to be preferred over others.8

6 For the original presentation, see von Neumann and Morgenstern (1947). For alternative presentations, see Savage
(1954), Fishburn (1970) or Kreps (1988).
7 The axiom of independence of choice has been formulated in many ways. In this form, it is also known as the axiom

of substitution or simply of no fun in gambling.

8 Suppose we face a choice between two lotteries A and B, each offering some of a finite number of outcomes {x }, i =
i
1 to n. We associate probability pAi to outcome xi in lottery A and pBi in lottery B, respectively. We seek a criterion that
will transform the choice between the two lotteries into determining which of two real numbers is the largest. Axiom
(A1) requires that we should be able to rank all outcomes in a simple preference order and therefore that we should be
able to identify at least one outcome that is not less desirable than any other, call it M, and at least one outcome that is
not more desirable than any other, call it m. Axiom (A2) implies that to any outcome xi corresponds a probability ui
such that xi can be regarded as the certain equivalent of a lottery offering M with probability ui and m with probability 1
– ui. Now, for each prize offered in lotteries A and B, substitute the equivalent lottery between M and m. According to
the axiom of independence of choice (A3), our preference between the new, compounded lotteries, call them AȨ and

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Any decision criterion other than ‘maximum EU’ that leads to a different choice would violate at
least one of the four basic axioms. It is therefore somewhat mystifying that the maximum EU
principle is not routinely used in risk management. We address this paradox in Section I.A.1.9.

I.A.1.4.2 Introducing the Utility Function

Assigning utilities to possible outcomes is the key. We explain how this may be done in the next
section. But let us remark first that, for most financial risks, outcomes are already expressed on a
monetary scale, for instance, company profit or shareholder value. That is no mean feat and one
can only hope that there is no significant loss of information or distortion in the translation
process. Outcomes are generally complex, multi-faceted, and perceived differently by various
interested parties: shareholders, investors, clients, employees, management, etc. We must be
confident that between two outcomes A and B we prefer A to B simply because the cash value of
A is greater than the cash value of B.

Utility theory does not require the expression of all outcomes on a monetary scale and therefore
can address more general decision problems. However, when outcomes are already expressed in
terms of cash, utilities become a function of cash; we limit our discussion to this case.

The utility function u(x), where x is a cash amount expressing wealth and u(x) its utility to the
owner of the wealth, should be a continuous, non-decreasing function of x. It should be
continuous in as much as cash itself can be considered as continuous and a small increase in cash
should produce small increase in utility.9 It should be non-decreasing in as much as more cash is
preferred to less, a proposition that is not necessarily obvious and that is therefore put forward as
an additional axiom, the axiom of non-satiation.

On the other hand, we are free to choose the origin and the unit scale of utility without affecting
preferences. To simplify comparisons, we choose u(0) = 0 and a slope of 1 at the origin, that is
u’(0) = 1.10

BȨ, should be the same as our preferences between A and B. But the compounded lotteries AȨ and BȨ offer the same
two outcomes M and m. To make a choice, according to axiom (A4), we simply have to compare the probabilities of
winning the preferred outcome M. These probabilities are EA[u] = 6 pAixi and EB[u] = 6 pAixi, that is, renaming as
‘utilities’ the probabilities ui, they are the expected utilities of lotteries A and B. Therefore the preferred lottery ought
to be the lottery with maximum expected utility.
9 We ignore pathological cases where, because of crude modelling of outcomes, an infinitesimal increase in cash could

apparently lead to vastly different consequences such as having just enough money to get bail or to buy a new house.
10 . The expectation operator is linear, that is, E[(a.u(X) + b)] = a.E[u(X)] +b, with X a lottery and a and b two scalar

constants. Therefore the order of preference set by the maximum EU principle remains unchanged under a positive
linear transformation (a > 0) of the utility function. Without loss of generality, one may choose a utility scale as in
Figure I.A.1.1 where u(0) = 0 and the first derivative uc(0) = 1, so that for infinitesimal variations around the origin
utility and cash have the same unit.

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It is also common practice to choose the current level of wealth as the origin of the cash scale so
we have zero utility for our current level of wealth. In this case, future wealth is valued against
the current level of wealth rather than in absolute terms. We follow this practice here. But we
should remember that the level of wealth is unlikely to remain unchanged over time, and this may
affect risk attitude. This is not a major drawback as risk attitude may evolve over time anyway
and it is therefore prudent to check regularly whether the utility function being used is still
representative of risk preferences.

I.A.1.4.3 Risk Aversion (and Risk Tolerance)

It is the curvature of the utility function that captures the risk attitude of a decision maker or a
firm. A downward curvature (concave utility function) expresses risk aversion: the minimum selling
price of a risky opportunity is less than its expected value.

Figure I.A.1.1: Describing risk attitude with a utility function

1000

500

0
Utilities

-500
Equal chances of w inning or
losing 500m w ould have a certain
-1000 equivalent of -220m

-1500
-750 -500 -250 0 250 500 750 1000 1250

Million Euros

Example I.A.1.1:
Faced with the prospect of winning or losing €500m with equal probabilities, a firm using the
utility function plotted in Figure I.A.1.1 would perceive an expected utility of –270, the average
of the utilities of the two outcomes read of the curve: u(500) = 280 and u(500) = 820. Now
reading back from the curve (black arrows) we find that –270 is the utility of a sure loss of
€220m. In other words, the firm would be willing to pay up to €220m to have the risky prospect
taken away.

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If the curvature were upwards (convex utility function), a risky opportunity would be perceived as
having greater expected utility than its expected value, which would reveal a risk-seeking attitude.
Finally, no curvature, that is, a straight-line utility function, would reflect a risk-neutral attitude –
the expected value of outcomes is the choice criterion. Risk aversion is the norm, at least for
business decisions, whereas a risk-seeking attitude is usually regarded as pathological.11 We shall
argue later why a utility function should be very smooth (continuous first- and second-order
derivatives) and concave for business decisions.

Mathematically, the curvature of a twice differentiable function is defined as the ratio of its second-
order derivative to its first-order derivative. For a concave utility function such as that in Figure
I.A.1.1 the curvature is negative because ucc(x) < 0. We call minus the curvature the local coefficient
of risk aversion at x. That is:
Local Coefficient of Risk Aversion = – ucc(x)/ uc(x).

Its inverse is called, quite naturally, the local coefficient of risk tolerance at x; it is expressed in the same
monetary units as x and therefore may be easier to interpret.12 According to the age-old principle
of assigning a Greek letter to an unknown parameter, we shall call ƫ the local coefficient of risk
tolerance. Thus
ƫ = – uc (x)/ ucc(x). (I.A.1.1)

Stipulating the coefficient of risk tolerance (or the coefficient of risk aversion) over various levels
of wealth is equivalent to stipulating a utility function (see Pratt, 1964).

I.A.1.4.4 Certain Equivalence

We call the certain equivalent (CE) of a gamble the sure quantity that we would be willing to
exchange for the gamble, (i.e. u(CE(X)) = E[u(X)]). In the previous example, minus €220m is the
certain equivalent of the project. Clearly,choosing the alternative with the maximum EU is
equivalent to choosing the alternative with the maximum CE.

I.A.1.4.5 Summary
Financial risks are gambles. For our purposes, a gamble is a set of cash-value outcomes, with some
probabilities attached to each outcome. Then, rational decisions between financial risks are
achieved by:

11Gambling has always fascinated men. It is not only the subject of gripping stories (such as Dostoyevsky’s The
Gambler) but it also arouses principled and even religious reactions, usually in the form of condemnations. But that is
not to say that rational people should necessarily be risk-averse.

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i. defining a utility function u(x), a monotonically increasing function of cash value x;

ii. calculating the expected utility E[u(X)] of each gamble X;
iii. choosing the gamble that has the maximum expected utility or, equivalently,
choosing the gamble with maximum certain equivalent.

Although the current level of wealth is usually taken as the origin of the scale on which future
outcomes are valued, each new course of action should not be considered independently of the
status quo. The uncertainties we have in the future will depend on what we do today. Each
future choice should therefore be considered in the context of current uncertainties.

I.A.1.5 Encoding a Utility Function

I.A.1.5.1 For an Individual
The first step in implementing utility theory is to draw a utility function over possible states of
wealth of an individual or a firm. It is a tricky exercise best conducted by an experienced and
independent experimentalist.

An individual’s risk attitude can, in theory, be inferred from a series of decisions, provided the
other elements of the decisions (i.e. the outcomes, probabilities, alternatives) are clearly
understood by all. It is best, of course, if the problems submitted for decision are:
i. Realistic. One should avoid game playing with all the distortions it may create (e.g.
displays of bravado).
ii. Meaningful. The range of monetary outcomes should be on a scale of gains and
losses for which we can define a utility function.
iii. Clear and simple. One should avoid ambiguities, or inducements that could lead to
misinterpretations of the problem, or biases. In particular, probabilities should be
clearly stated and these probabilities should not be so extreme that they cannot be
comprehended.

We think of the ‘decision maker’ as a bank executive or a successful trader. We start by defining a
monetary range of interest for our decision maker by choosing a minimum and a maximum cash
amount, say minus €3 million and plus €10 million. This range should cover the personal impact
of decisions she may have to face, for example, insuring her life, deciding whether to accept a
new incentive scheme or even, perhaps, whether to commit her company to a new deal such as
selling a €20 million credit swap, since the outcome could affect her future.

12 Mathematicians usually prefer to use the coefficient of risk aversion whereas practitioners usually prefer to use its

inverse, the coefficient of risk tolerance; which coefficient is used does not really matter. We shall side here with the
practitioners

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But we are not going to use the extremes of the range as a starting point for questioning our
subject. To begin, we centre the questions around more familiar values. We could ask first:

Question 1: If you were offered a once-in-a-lifetime opportunity to win x euros or to lose x/2 euros with equal
chances, for what value of x would you hesitate between taking the gamble and letting the opportunity go by?

Note that most people consider this gamble attractive for small values of x but if x is very large,
the risk becomes a deterrent. The answer will require a good deal of thought and, admittedly, may
not be very precise. All we seek at first is an approximate value. The subject may be encouraged
to think about realistic situations where she would face a similar type of gamble. But it should be
very clear that in the present circumstances the respondent has absolutely no power or
responsibility in determining the event of winning or losing (she is not a wizard) nor any means
of guessing the outcome correctly (she is not a clairvoyant).

Suppose that after much soul-searching the subject feels that her indifference point is at around x
= €500,000. Now without loss of generality assign a utility of 0 to a zero gain and a utility of 1 to
a gain of €500,000. The answer to the first question should be interpreted as assigning a utility of
–1 to a loss of €250,000 since, by equating expected utilities, we must have:
u(0) = ½ u(€500,000) + ½ u(– €250,000)
or
0 = ½ (1 + u(– €250,000)),
that is,
u(– €250,000) = –1.

We would continue by asking for the CE to a few simple gambles and, eventually, push towards
the extremes with questions such as the following:

Question 2: If you were offered (i) a lottery ticket to win €10 million with some probability p, and nothing
otherwise, or (ii) a sure prize of €500,000, for which probability p would you be indifferent between taking the
lottery or settling for the sure prize?

Question 3: If you were asked to pay a €250,000 insurance premium to insure against a potential €3 million
loss, what would be the minimum probability of loss that would justify this premium?

Suppose the answers to questions 2 and 3 are probabilities of one-third and 5%, respectively.
Then the utilities of €10 million and minus €3 million can be derived. We should have from:

Copyright © 2004 Jacques Pézier and The Professional Risk Managers’ International Association 11
Other documents randomly have
different content
Saying, 'Lye ye there till another ane come.'

7
The second sister was on the road,
And there she met with the banished lord.

8
'O will ye consent to lose your life,
Or will ye be a banished lord's wife?'

9
'I'll rather consent to lose my life
Before I'll be a banished lord's wife.'

10
'It's lean your head upon my staff,'
And with his pen-knife he has cutted it aff.

11
He flang her in amang the broom,
Saying, 'Lie ye there till another ane come.'

12
The youngest sister was on the road,
And there she met with the banished lord.

13
'O will ye consent to lose your life,
Or will ye be a banished lord's wife?'

14
'O if my three brothers were here,
Ye durstna put me in such a fear.'

15
'What are your three brothers, altho they were here,
That I durstna put you in such a fear?'
 16
'My eldest brother's a belted knight,
The second, he's a ...

17
'My youngest brother's a banished lord,
And oftentimes he walks on this road.'

* * * * *

D.
Motherwell's MS., p. 174. From the recitation of Agnes
Lyle, Kilbarchan, July 27, 1825.

1
There were three sisters, they lived in a bower,
Sing Anna, sing Margaret, sing Marjorie
The youngest o them was the fairest flower.
And the dew goes thro the wood, gay ladie

2
The oldest of them she's to the wood gane,
To seek a braw leaf and to bring it hame.

3
There she met with an outlyer bold,
Lies many long nights in the woods so cold.

4
'Istow a maid, or istow a wife?
Wiltow twinn with thy maidenhead, or thy sweet life?'

5
'O kind sir, if I hae 't at my will,
I'll twinn with my life, keep my maidenhead still.'
6
He's taen out his we pen-knife,
He's twinned this young lady of her sweet life

7
He wiped his knife along the dew;
But the more he wiped, the redder it grew.

8
The second of them she's to the wood gane,
To seek her old sister, and to bring her hame.

9
There she met with an outlyer bold,
Lies many long nights in the woods so cold.

10
'Istow a maid, or istow a wife?
Wiltow twinn with thy maidenhead, or thy sweet life?'

11
'O kind sir, if I hae 't at my will,
I'll twinn with my life, keep my maidenhead still.'

12
He's taen out his we pen-knife,
He's twinned this young lady of her sweet life.

13
He wiped his knife along the dew;
But the more he wiped, the redder it grew.

14
The youngest of them she's to the wood gane,
To seek her two sisters, and to bring them hame.

15
 There she met with an outlyer bold,
Lies many long nights in the woods so cold.

16
'Istow a maid, or istow a wife?
Wiltow twinn with thy maidenhead, or thy sweet life?'

17
'If my three brethren they were here,
Such questions as these thou durst nae speer.'

18
'Pray, what may thy three brethren be,
That I durst na mak so bold with thee? '

19
'The eldest o them is a minister bred,
He teaches the people from evil to good.

20
'The second o them is a ploughman good,
He ploughs the land for his livelihood.

21
'The youngest of them is an outlyer bold,
Lies many a long night in the woods so cold.'

22
He stuck his knife then into the ground,
He took a long race, let himself fall on.

E.
Kinloch's Ancient Scottish Ballads, p. 212. From
Mearnsshire.
1
The Duke o Perth had three daughters,
Elizabeth, Margaret, and fair Marie;
And Elizabeth's to the greenwud gane,
To pu the rose and the fair lilie.

2
But she hadna pu'd a rose, a rose,
A double rose, but barely three,
Whan up and started a Loudon lord,
Wi Loudon hose, and Loudon sheen.

3
'Will ye be called a robber's wife?
Or will ye be stickit wi my bloody knife?
For pu'in the rose and the fair lilie,
For pu'in them sae fair and free.'

4
'Before I'll be called a robber's wife,
I'll rather be stickit wi your bloody knife,
For pu'in,' etc.

5
Then out he's tane his little pen-knife,
And he's parted her and her sweet life,
And thrown her oer a bank o brume,
There never more for to be found.

6
The Duke o Perth had three daughters,
Elizabeth, Margaret, and fair Marie;
And Margaret's to the greenwud gane,
To pu the rose and the fair lilie.

7
She hadna pu'd a rose, a rose,
 A double rose, but barely three,
When up and started a Loudon lord,
Wi Loudon hose, and Loudon sheen.

8
'Will ye be called a robber's wife?
Or will ye be stickit wi my bloody knife?
For pu'in,' etc.

9
'Before I'll be called a robber's wife,
I'll rather be stickit wi your bloody knife,
For pu'in,' etc.

10
Then out he's tane his little pen-knife,
And he's parted her and her sweet life,
For pu'in, etc.

11
The Duke o Perth had three daughters,
Elizabeth, Margaret, and fair Marie;
And Mary's to the greenwud gane,
To pu the rose and the fair lilie.

12
She hadna pu'd a rose, a rose,
A double rose, but barely three,
When up and started a Loudon lord,
Wi Loudon hose, and Loudon sheen.

13
'O will ye be called a robber's wife?
Or will ye be stickit wi my bloody knife?
For pu'in,' etc.

14
 'Before I'll be called a robber's wife,
I'll rather be stickit wi your bloody knife,
For pu'in,' etc.

15
But just as he took out his knife,
To tak frae her her ain sweet life,
Her brother John cam ryding bye,
And this bloody robber he did espy.

16
But when he saw his sister fair,
He kennd her by her yellow hair;
He calld upon his pages three,
To find this robber speedilie.

17
'My sisters twa that are dead and gane,
For whom we made a heavy maene,
It's you that's twinnd them o their life,
And wi your cruel bloody knife.

18
'Then for their life ye sair shall dree;
Ye sail be hangit on a tree,
Or thrown into the poisond lake,
To feed the toads and rattle-snake.'

A. a.
"Given from two copies obtained from recitation, which
differ but little from each other. Indeed, the only variation
is in the verse where the outlawed brother unweetingly
slays his sister." [19.] Motherwell.
b.

19.
He's taken out his wee penknife,
Hey how bonnie
And he's twined her o her ain sweet life.
On the, etc.

c.
The first stanza, only:

There were three sisters livd in a bower,

Fair Annet and Margaret and Marjorie
And they went out to pu a flower.
And the dew draps off the hyndberry tree

B. a.
"To a wild melancholy old tune not in any collection."
"N.B. There are a great many other verses which I could
not recover. Upon describing her brothers, the banished
man finds that he has killed his two brothers and two
sisters,—upon which he kills himself." Herd.
22. MS. Quhen.
41, 42, 52, 121, 122, 132, 142. ye, your, yet, MS. ze, zour,
zet. 8, 9, 10 are not written out.
b.
"Of this I have got only 14 stanzas, but there are many
more. It is a horrid story. The banished man discovers that
he has killed two of his brothers and his three (?) sisters,
upon which he kills himself." Jamieson.
The first two stanzas only are cited by Jamieson.
11. three sisters.
 22. up there started.
C.
7-11 and 122 are not written out in the MS. "Repeat as to
the second sister, mutatis mutandis." Motherwell.
D.
9-13 are not written out in the MS. "Same as 1st sister."
Motherwell.
142. bring her.
15,16 are not written out. "Same as 1st and 2d sisters,
but this additional, vizt." M.
222. longe, or large?

FOOTNOTES:

[156] Lyngbye insists on translating vadlarar pilgrims, though his

people understood the word to mean robbers. He refers to the
Icelandic vallari, which, originally a pilgrim, came to mean a
tramp. No one can fail to recognize the character who has
become the terror of our rural districts, and to whom, in our
preposterous regard for the rights of "man," we sacrifice the
peace, and often the lives, of women.
 15
LEESOME BRAND
A. 'Leesome Brand.' a. Buchan's Ballads of the North of
Scotland, I, 38. b. Motherwell's MS., p. 626.
B. 'The Broom blooms bonnie,' etc., Motherwell's MS., p.
365.
This is one of the cases in which a remarkably fine ballad has been
worse preserved in Scotland than anywhere else. Without light from
abroad we cannot fully understand even so much as we have saved,
and with this light comes a keen regret for what we have lost.
A, from Buchan's Ballads of the North of Scotland, is found also in
Motherwell's MS., but without doubt was derived from Buchan.
Though injured by the commixture of foreign elements, A has still
much of the original story. B has, on the contrary, so little that
distinctively and exclusively belongs to this story that it might almost
as well have been put with the following ballad, 'Sheath and Knife,'
as here. A third ballad, 'The Birth of Robin Hood,' preserves as much
of the story as A, but in an utterly incongruous and very modern
setting, being, like 'Erlinton,' C, forced into an absurd Robin Hood
framework.
The mixture of four-line with two-line stanzas in A of course comes
from different ballads having been blended, but for all that, these
ballads might have had the same theme. Stanzas 33-35, however,
are such as we meet with in ballads of the 'Earl Brand' class, but not
in those of the class to which 'Leesome Brand' belongs. In the
English ballads, and nearly all the Danish, of the former class, there
is at least a conversation between son and mother [father], whereas
in the other the catastrophe excludes such a possibility. Again, the
"unco land" in the first stanza, "where winds never blew nor cocks
ever crew," is at least a reminiscence of the paradise depicted in the
beginning of many of the versions of 'Ribold and Guldborg,' and
stanza 4 of 'Leesome Brand' closely resembles stanza 2 of 'Earl
Brand,' A.[157] Still, the first and fourth stanzas suit one ballad as
well as the other, which is not true of 33-35.
The name Leesome Brand may possibly be a corruption of
Hildebrand, as Earl Brand almost certainly is; but a more likely origin
is the Gysellannd of one of the kindred Danish ballads.
The white hind, stanzas 28, 30, is met with in no other ballad of this
class, and, besides this, the last four stanzas are in no kind of
keeping with what goes before, for the "young son" is spoken of as
having been first brought home at some previous period. Grundtvig
has suggested that the hind and the blood came from a lost Scottish
ballad resembling 'The Maid Transformed into a Hind,' D.g.F, No 58.
In this ballad a girl begs her brother, who is going hunting, to spare
the little hind that "plays before his foot." The brother nevertheless
shoots the hind, though not mortally, and sets to work to flay it, in
which process he discovers his sister under the hind's hide. His sister
tells him that she had been successively changed into a pair of
scissors, a sword, a hare, a hind, by her step-mother, and that she
was not to be free of the spell until she had drunk of her brother's
blood. Her brother at once cuts his fingers, gives her some of his
blood, and the girl is permanently restored to her natural shape, and
afterwards is happily married. Stanzas similar to 36-41 of A and 12-
16 of B will be found in the ballad which follows this, to which they
are especially well suited by their riddling character; and I believe
that they belong there, and not here. It is worthy of remark, too,
that there is a hind in another ballad, closely related to No 16 ('The
Bonny Hind'), and that the hind in 'Leesome Brand' may, in some
way not now explicable, have come from this. The confounding of
'Leesome Brand' with a ballad of the 'Bonny Hind' class would be
paralleled in Danish, for in 'Redselille og Medelvold' T (and perhaps
I, see Grundtvig's note, V, 237), the knight is the lady's brother.
The "auld son" in B, like the first bringing home of the young son in
A 45, 47, shows how completely the proper story has been lost sight
of. There should be no son of any description at the point at which
this stanza comes in, and auld son should everywhere be young son.
The best we can do, to make sense of stanza 3, is to put it after 8,
with the understanding that woman and child are carried off for
burial; though really there is no need to move them on that account.
The shooting of the child is unintelligible in the mutilated state of the
ballad. It is apparently meant to be an accident. Nothing of the kind
occurs in other ballads of the class, and the divergence is probably a
simple corruption.
The ballad which 'Leesome Brand' represents is preserved among
the Scandinavian races under four forms.
Danish. I. 'Bolde Hr. Nilaus' Lön,' a single copy from a manuscript of
the beginning of the 17th century: Grundtvig, V, 231, No 270. II.
'Redselille og Medelvold,' in an all but unexampled number of
versions, of which some sixty are collated, and some twenty-five
printed, by Grundtvig, most of them recently obtained from tradition,
and the oldest a broadside of about the year 1770: Grundtvig, V,
234, No 271. III. 'Sönnens Sorg,' Grundtvig, V, 289, No 272, two
versions only: A from the middle of the 16th century; B three
hundred years later, previously printed in Berggreen's Danske
Folkesange, I, No 83 (3d ed.). IV. 'Stalbroders Kvide,' Grundtvig, V,
301, No 273, two versions: A from the beginning of the 17th
century, B from about 1570.
Swedish. II. A, broadside of 1776, reprinted in Grundtvig, No 271,
V, 281, Bilag 1, and in Jamieson's Illustrations, p. 373 ff, with a
translation. B, 'Herr Redevall,' Afzelius, II, 189, No 58, new ed. No
51. C, 'Krist' Lilla och Herr Tideman,' Arwidsson, I, 352, No 54 A. D,
E, F, G, from Cavallius and Stephens' manuscript collection, first
printed by Grundtvig, No 271, V, 282 ff, Bilag 2-5. H, 'Rosa lilla,' Eva
Wigström, Folkvisor från Skåne, in Ur de nordiska Folkens Lif, af
Artur Hazelius, p. 133, No 8. III. A single version, of date about
1650, 'Moder och Son,' Arwidsson, II, 15, No 70.
Norwegian. II. Six versions and a fragment, from recent tradition:
A-E, G, first printed by Grundtvig, No 271, V, 284 ff, Bilag 6-11; F,
'Grivilja,' in Lindeman's Norske Fjeldmelodier, No 121. III. Six
versions from recent tradition, A-F, first printed by Grundtvig, No
272, V, 297 ff, Bilag I-6.
Icelandic. III. 'Sonar harmur,' Íslenzk Fornkvæði, I, 140 ff, No 17,
three versions, A, B, C, the last, which is the oldest, being from late
in the 17th century; also the first stanza of a fourth, D.
All the Scandinavian versions are in two-line stanzas save Danish
272 B, and A in part, and Icelandic 17 C, which are in four; the last,
however, in stanzas of two couplets.
It will be most convenient to give first a summary of the story of
'Redselille og Medelvold,' and to notice the chief divergences of the
other ballads afterwards. A mother and her daughter are engaged in
weaving gold tissue. The mother sees milk running from the girl's
breasts, and asks an explanation. After a slight attempt at evasion,
the daughter confesses that she has been beguiled by a knight. The
mother threatens both with punishment: he shall be hanged
[burned, broken on the wheel, sent out of the country, i.e., sold into
servitude], and she sent away [broiled on a gridiron, burned,
drowned]. Some copies begin further back, with a stanza or two in
which we are told that the knight has served in the king's court, and
gained the favor of the king's daughter. Alarmed by her mother's
threats, the maid goes to her lover's house at night, and after some
difficulty in effecting an entrance (a commonplace, like the ill-boding
milk above) informs him of the fate that awaits them. The knight is
sufficiently prompt now, and bids her get her gold together while he
saddles his horse. They ride away, with [or without] precautions
against discovery, and come to a wood. Four Norwegian versions, A,
B, C, G, and also two Icelandic versions, A, B, of 'Sønnens Sorg,'
interpose a piece of water, and a difficulty in crossing, owing to the
ferryman's refusing help or the want of oars; but this passage is
clearly an infiltration from a different story. Arriving at the wood, the
maid desires to rest a while. The customary interrogation does not
fail,—whether the way is too long or the saddle too small. The
knight lifts her off the horse, spreads his cloak for her on the grass,
and she gives way to her anguish in such exclamations as "My
mother had nine women: would that I had the worst of them!" "My
mother would never have been so angry with me but she would
have helped me in this strait!" Most of the Danish versions make the
knight offer to bandage his eyes and render such service as a man
may; but she replies that she would rather die than that man should
know of woman's pangs. So Swedish H, nearly. Partly to secure
privacy, and partly from thirst, she expresses a wish for water, and
her lover goes in search of some. (This in nearly all the Danish
ballads, and many of the others. But in four of the Norwegian
versions of 'Sønnens Sorg' the lover is told to go and amuse himself,
much as in our ballads.) When he comes to the spring or the brook,
there sits a nightingale and sings. Two nightingales, a small bird, a
voice from heaven, a small dwarf, an old man, replace the
nightingale in certain copies, and in others there is nothing at all;
but the great majority has a single nightingale, and, as Grundtvig
points out, the single bird is right, for the bird is really a vehicle for
the soul of the dead Redselille. The nightingale sings, "Redselille lies
dead in the wood, with two sons [son and daughter] in her bosom."
All that the nightingale has said is found to be true. According to
Danish O and Swedish C, the knight finds the lady and a child,
according to Swedish B and Norwegian A, B, C, the lady and two
sons, dead. In Danish B, L (as also the Icelandic 'Sonar Harmur,' A,
B, and Danish 'Stalbroders Kvide,' A) the knight digs a grave, and
lays mother and children in it; he lays himself with them in A and M.
It is not said whether the children are dead or living, and the point
would hardly be raised but for what follows. In Danish D, P and
Swedish F, it is expressly mentioned that the children are alive, and
in Q, R, S, T, U, six copies of V, and Y, and also in 'Bolde Hr. Nilaus'
Løn,' and in 'Sønnens Sorg,' Danish A, Norwegian A, C, D, E, the
children are heard, or seem to be heard, shrieking from under the
ground. Nearly all the versions make the knight run himself through
with his sword, either immediately after the others are laid in the
grave, or after he has ridden far and wide, because he cannot
endure the cries of the children from under the earth. This would
seem to be the original conclusion of the story; the horrible
circumstance of the children being buried alive is much more likely
to be slurred over or omitted at a later day than to be added.
We may pass over in silence the less important variations in the very
numerous versions of 'Redselille and Medelvold,' nor need we be
detained long by the other three Scandinavian forms of the ballad.
'Sønnens Sorg' stands in the same relation to 'Redselille and
Medelvold' as 'Hildebrand and Hilde,' does to 'Ribold and Guldborg'
(see p. 89 of this volume); that is, the story is told in the first person
instead of the third. A father asks his son why he is so sad,
Norwegian A, B, C, D, Icelandic A, B, C, D. Five years has he sat at
his father's board, and never uttered a merry word. The son relates
the tragedy of his life. He had lived in his early youth at the house of
a nobleman, who had three daughters. He was on very familiar
terms with all of them, and the youngest loved him. When the time
came for him to leave the family, she proposed that he should take
her with him, Danish B, Icelandic A, B, C [he makes the proposal in
Norwegian C]. From this point the narrative is much the same as in
'Redselille and Medelvold,' and at the conclusion he falls dead in his
father's arms [at the table], Norwegian A, B, D, Icelandic A. The
mother takes the place of the father in Danish B and Swedish, and
perhaps it is the mother who tells the story in English A, but the bad
condition of the text scarcely enables us to say. Danish B and the
Swedish copy have lost the middle and end of the proper story:
there is no wood, no childbirth, no burial. The superfluous boat of
some Norwegian versions of 'Redselille' reappears in these, and also
in Icelandic A, B; it is overturned in a storm, and the lady is
drowned.
'Stalbroders Kvide' differs from 'Sønnens Sorg' only in this: that the
story is related to a comrade instead of father or mother.
'Bolde Hr. Nilaus' Løn,' which exists but in a single copy, has a
peculiar beginning. Sir Nilaus has served eight years in the king's
court without recompense. He has, however, gained the favor of the
king's daughter, who tells him that she is suffering much on his
account. If this be so, says Nilaus, I will quit the land with speed. He
is told to wait till she has spoken to her mother. She goes to her
mother and says: Sir Nilaus has served eight years, and had no
reward; he desires the best that it is in your power to give. The
queen exclaims, He shall never have my only daughter's hand! The
young lady immediately bids Nilaus saddle his horse while she
collects her gold, and from this point we have the story of Redselille.
Dutch. Willems, Oude vlaemsche Liederen, p. 482, No 231, 'De
Ruiter en Mooi Elsje;' Hoffmann v. Fallersleben, Niederländische
Volkslieder, 2d ed., p. 170, No 75: broadside of the date 1780.
A mother inquires into her daughter's condition, and learns that she
is going with child by a trooper (he is called both 'ruiter' and
'landsknecht'). The conversation is overheard by the other party,
who asks the girl whether she will ride with him or bide with her
mother. She chooses to go with him, and as they ride is overtaken
with pains. She asks whether there is not a house where she can
rest. The soldier builds her a hut of thistles, thorns, and high stakes,
and hangs his cloak over the aperture. She asks him to go away, and
to come back when he hears a cry: but the maid was dead ere she
cried. The trooper laid his head on a stone, and his heart brake with
grief.
German. A, Simrock, No 40, p. 92, 'Von Farbe so bleich,' from Bonn
and Rheindorf, repeated in Mittler, No 194. The mother, on learning
her daughter's plight, imprecates a curse on her. The maid betakes
herself to her lover, a trooper, who rides off with her. They come to a
cool spring, and she begs for a fresh drink, but, feeling very ill, asks
if there is no hamlet near, from which she could have woman's help.
The aid of the trooper is rejected in the usual phrase, and he is
asked to go aside, and answer when called. If there should be no
call, she will be dead. There was no call, and she was found to be
dead, with two sons in her bosom. The trooper wrapped the children
in her apron, and dug her grave with his sword. B, Reifferscheid,
Westfälische Volkslieder, p. 106, 'Ach Wunder über Wunder,' from
Bökendorf: much the same as to the story. C, Mittler, No 195, p.
175, 'Von Farbe so bleich,' a fragment of a copy from Hesse;
Zuccalmaglio, p. 187, No 90, 'Die Waisen,' an entire copy, ostensibly
from the Lower Rhine, but clearly owing its last fourteen stanzas to
the editor. The trooper, in this supplement, leaves the boys with his
mother, and goes over seas. The boys grow up, and set out to find
their father. In the course of their quest, they pass a night in a hut in
a wood, and are overheard saying a prayer for their father and dead
mother, by a person who announces herself as their maternal
grandmother! After this it is not surprising that the father himself
should turn up early the next morning. The same editor, under the
name of Montanus, gives in Die deutschen Volksfeste, p. 45 f, a part
of this ballad again, with variations which show his hand beyond a
doubt. We are here informed that the ballad has above a hundred
stanzas, and that the conclusion is that the grandmother repents her
curse, makes her peace with the boys, and builds a convent.
French. Bujeaud, Chants et Chansons populaires des provinces de
l'Ouest, A, I, 198, B, I, 200, 'J'entends le rossignolet.' A. This ballad
has suffered injury at the beginning and the end, but still preserves
very well the chief points of the story. A lover has promised his
mistress that after returning from a long absence he would take her
to see his country. While traversing a wood she is seized with her
pains. The aid of her companion is declined: "Cela n'est point votre
métier." She begs for water. The lover goes for some, and meets a
lark, who tells him that he will find his love dead, with a child in her
arms. Two stanzas follow which are to no purpose. B. The other
copy of this ballad has a perverted instead of a meaningless
conclusion, but this keeps some traits that are wanting in A. It is a
two-line ballad, with the nightingale in the refrain: "J'entends le
rossignolet." A fair maid, walking with her lover, falls ill, and lies
down under a thorn. The lover asks if he shall go for her mother.
"She would not come: she has a cruel heart." Shall I go for mine?
"Go, like the swallow!" He comes back and finds his love dead, and
says he will die with his mistress. The absurd conclusion follows that
she was feigning death to test his love.
The names in the Scandinavian ballads, it is remarked by Grundtvig,
V, 242, 291, are not Norse, but probably of German derivation, and,
if such, would indicate a like origin for the story. The man's name,
for instance, in the Danish 'Sønnens Sorg,' A, Gysellannd, seems to
point to Gisalbrand or Gisalbald, German names of the 8th or 9th
century. There is some doubt whether this Gysellannd is not due to a
corruption arising in the course of tradition (see Grundtvig, V, 302);
but if the name may stand, it will account for our Leesome Brand
almost as satisfactorily as Hildebrand does for Earl Brand in No 7.
The passage in which the lady refuses male assistance during her
travail—found as well in almost all the Danish versions of 'Redselille
and Medelvold,' in the German and French, and imperfectly in
Swedish D—occurs in several other English ballads, viz., 'The Birth of
Robin Hood,' 'Rose the Red and White Lily,' 'Sweet Willie,' of Finlay's
Scottish Ballads, II, 61, 'Burd Helen,' of Buchan, II, 30, 'Bonnie
Annie,' No 23. Nearly the whole of the scene in the wood is in
'Wolfdietrich.' Wolfdietrich finds a dead man and a woman naked to
the girdle, who is clasping the stem of a tree. The man, who was her
husband, was taking her to her mother's house, where her first child
was to be born, when he was attacked by the dragon Schadesam.
She was now in the third day of her travail. Wolfdietrich, having first
wrapped her in his cloak, offers his help, requesting her to tear a
strip from her shift and bind it round his eyes. She rejects his
assistance in this form, but sends him for water, which he brings in
his helmet, but only to find the woman dead, with a lifeless child at
her breast. He wraps mother and child in his mantle, carries them to
a chapel, and lays them on the altar; then digs a grave with his
sword, goes for the body of the man, and buries all three in the
grave he has made. Grimm, Altdänische Heldenlieder, p. 508;
Holtzmann, Der grosse Wolfdietrich, st. 1587-1611; Amelung u.
Jänicke,[158] Ortnit u. die Wolfdietriche, II, 146, D, st. 51-75; with
differences, I, 289, B, st. 842-848; mother and child surviving, I,
146, A, st. 562-578; Weber's abstract of the Heldenbuch, in
Illustrations of Northern Antiquities, p. 119, 120.
'Herr Medelvold,' a mixed text of Danish II, Danske Viser, No 156, is
translated by Jamieson, Illustrations, p. 377; by Borrow, Romantic
Ballads, p. 28 (very ill); and by Prior, No 101. Swedish, II, A. is
translated by Jamieson, ib., p. 373.

A.
a. Buchan's Ballads of the North of Scotland, I, 38. b. Motherwell's
MS., p. 626.

1
My boy was scarcely ten years auld,
Whan he went to an unco land,
Where wind never blew, nor cocks ever crew,
Ohon for my son, Leesome Brand!

2
Awa to that king's court he went,
It was to serve for meat an fee;
Gude red gowd it was his hire,
And lang in that king's court stayd he.

3
He hadna been in that unco land
But only twallmonths twa or three,
Till by the glancing o his ee,
He gaind the love o a gay ladye.

4
This ladye was scarce eleven years auld,
When on her love she was right bauld;
She was scarce up to my right knee,
When oft in bed wi men I'm tauld.
5
But when nine months were come and gane,
This ladye's face turnd pale and wane.

6
To Leesome Brand she then did say,
'In this place I can nae mair stay.

7
'Ye do you to my father's stable,
Where steeds do stand baith wight and able.

8
'Strike ane o them upo the back,
The swiftest will gie his head a wap.

9
'Ye take him out upo the green,
And get him saddled and bridled seen.

10
'Get ane for you, anither for me,
And lat us ride out ower the lee.

11
'Ye do you to my mother's coffer,
And out of it ye'll take my tocher.

12
'Therein are sixty thousand pounds,
Which all to me by right belongs.'

13
He's done him to her father's stable,
Where steeds stood baith wicht and able.

14
Then he strake ane upon the back,
The swiftest gae his head a wap.

15
He's taen him out upo the green,
And got him saddled and bridled seen.

16
Ane for him, and another for her,
To carry them baith wi might and virr.

17
He's done him to her mother's coffer,
And there he 's taen his lover's tocher;

18
Wherein were sixty thousand pound,
Which all to her by right belongd.

19
When they had ridden about six mile,
His true love then began to fail.

20
'O wae's me,' said that gay ladye,
'I fear my back will gang in three!

21
'O gin I had but a gude midwife,
Here this day to save my life,

22
'And ease me o my misery,
O dear, how happy I woud be!'

23
'My love, we're far frae ony town,
There is nae midwife to be foun.

24
'But if ye'll be content wi me,
I'll do for you what man can dee.'

25
'For no, for no, this maunna be,'
Wi a sigh, replied this gay ladye.

26
'When I endure my grief and pain,
My companie ye maun refrain.

27
'Ye'll take your arrow and your bow,
And ye will hunt the deer and roe.

28
'Be sure ye touch not the white hynde,
For she is o the woman kind.'

29
He took sic pleasure in deer and roe,
Till he forgot his gay ladye.

30
Till by it came that milk-white hynde,
And then he mind on his ladye syne.

31
He hasted him to yon greenwood tree,
For to relieve his gay ladye;

32
But found his ladye lying dead,
Likeways her young son at her head.
33
His mother lay ower her castle wa,
And she beheld baith dale and down;
And she beheld young Leesome Brand,
As he came riding to the town.

34
'Get minstrels for to play,' she said,
'And dancers to dance in my room;
For here comes my son, Leesome Brand,
And he comes merrilie to the town.'

35
'Seek nae minstrels to play, mother,
Nor dancers to dance in your room;
But tho your son comes, Leesome Brand,
Yet he comes sorry to the town.

36
'O I hae lost my gowden knife;
I rather had lost my ain sweet life!

37
'And I hae lost a better thing,
The gilded sheath that it was in.'

38
'Are there nae gowdsmiths here in Fife,
Can make to you anither knife?

39
'Are there nae sheath-makers in the land,
Can make a sheath to Leesome Brand?'

40
'There are nae gowdsmiths here in Fife,
Can make me sic a gowden knife;
41
'Nor nae sheath-makers in the land,
Can make to me a sheath again.

42
'There ne'er was man in Scotland born,
Ordaind to be so much forlorn.

43
'I 've lost my ladye I lovd sae dear,
Likeways the son she did me bear.'

44
'Put in your hand at my bed head,
There ye'll find a gude grey horn;
In it three draps o' Saint Paul's ain blude,
That hae been there sin he was born.

45
'Drap twa o them o your ladye,
And ane upo your little young son;
Then as lively they will be
As the first night ye brought them hame.'

46
He put his hand at her bed head,
And there he found a gude grey horn,
Wi three draps o' Saint Paul's ain blude,
That had been there sin he was born.

47
Then he drappd twa on his ladye,
And ane o them on his young son,
And now they do as lively be,
As the first day he brought them hame.
 B.
Motherwell's MS., p. 365. From the recitation of Agnes
Lyle, Kilbarchan.

1
'There is a feast in your father's house,
The broom blooms bonnie and so is it fair
It becomes you and me to be very douce.
And we'll never gang up to the broom nae mair

2
'You will go to yon hill so hie;
Take your bow and your arrow wi thee.'

3
He's tane his lady on his back,
And his auld son in his coat lap.

4
'When ye hear me give a cry,
Ye'll shoot your bow and let me lye.

5
'When ye see me lying still,
Throw away your bow and come running me till.'

6
When he heard her gie the cry,
He shot his bow and he let her lye.

7
When he saw she was lying still,
He threw away his bow and came running her till.

8
It was nae wonder his heart was sad
When he shot his auld son at her head.

9
He houkit a grave, long, large and wide,
He buried his auld son doun by her side.

10
It was nae wonder his heart was sair
When he shooled the mools on her yellow hair.

11
'Oh,' said his father, 'son, but thou'rt sad!
At our braw meeting you micht be glad.'

12
'Oh,' said he, 'Father, I've lost my knife
I loved as dear almost as my own life.

13
'But I have lost a far better thing,
I lost the sheath that the knife was in.'

14
'Hold thy tongue, and mak nae din;
I'll buy thee a sheath and a knife therein.'

15
'A' the ships eer sailed the sea
Neer'll bring such a sheath and a knife to me.

16
'A' the smiths that lives on land
Will neer bring such a sheath and knife to my hand.'
A. b.
12. he came to.
3
. For wind ... and cock never.
44. bed wi him.
52. His lady's.
222. would I be.
291. deer and doe.
302. And then on his lady he did mind.
311. to greenwood tree.
331. the castle wa.
341. Go, minstrels.
431. lady I 've loved.
448. draps Saint Paul's.
4
. That has.
452. little wee son.
B.
21. Will you.

FOOTNOTES:

[157] And also stanza 3 of Buchan's 'Fairy Knight,' 'The Elfin

Knight,' D, p. 17 of this volume, which runs:

I hae a sister eleven years auld,

And she to the young men's bed has made bauld.

[158] Who suggests, II, xlv, somewhat oddly, that the passage
may have been taken from Revelation, xii, 2 f, 13 f.
 16
SHEATH AND KNIFE
A. a. Motherwell's MS., p. 286. b. 'The broom blooms
bonnie and says it is fair,' Motherwell's Minstrelsy, p. 189.
B. Sharpe's Ballad Book, ed. by D. Laing, p. 159.
C. 'The broom blooms bonie,' Johnson's Museum, No 461.
D. Notes and Queries, First Series, V, 345, one stanza.
The three stanzas of this ballad which are found in the Musical
Museum (C) were furnished, it is said, by Burns. It was first printed
in full (A b) in Motherwell's Minstrelsy. Motherwell retouched a verse
here and there slightly, to regulate the metre. A a is here given as it
stands in his manuscript. B consists of some scattered verses as
remembered by Sir W. Scott.
The directions in 3, 4 receive light from a passage in 'Robin Hood's
Death and Burial:'

'But give me my bent bow in my hand,

And a broad arrow I'll let flee,
And where this arrow is taken up
There shall my grave diggd be.

'Lay me a green sod under my head,' etc.

Other ballads with a like theme are 'The Bonny Hind,' further on in
this volume, and the two which follow it.
Translated in Grundtvig's E. og s. Folkeviser, No 49, p. 308; Wolff's
Halle der Völker, I, 64.

A.
a. Motherwell's MS., p. 286. From the recitation of Mrs
King, Kilbarchan Parish, February 9, 1825. b. 'The broom
blooms bonnie and says it is fair,' Motberwell's Minstrelsy,
p. 189.

1
It is talked the warld all over,
The brume blooms bonnie and says it is fair
That the king's dochter gaes wi child to her brither.
And we'll never gang doun to the brume onie mair

2
He's taen his sister doun to her father's deer park,
Wi his yew-tree bow and arrows fast slung to his back.

3
'Now when that ye hear me gie a loud cry,
Shoot frae thy bow an arrow and there let me lye.

4
'And when that ye see I am lying dead,
Then ye'll put me in a grave, wi a turf at my head.'

5
Now when he heard her gie a loud cry,
His silver arrow frae his bow he suddenly let fly.
Now they'll never, etc.

6
 He has made a grave that was lang and was deep,
And he has buried his sister, wi her babe at her feet.
And they'll never, etc.

7
And when he came to his father's court hall,
There was music and minstrels and dancing and all.
But they'll never, etc.

8
'O Willie, O Willie, what makes thee in pain?'
'I have lost a sheath and knife that I'll never see
again.'
For we'll never, etc.

9
'There is ships o your father's sailing on the sea
That will bring as good a sheath and a knife unto
thee.'

10
'There is ships o my father's sailing on the sea,
But sic a sheath and a knife they can never bring to
me.'
Now we'll never, etc.

B.
Sharpe's Ballad Book, ed. by D. Laing, p. 159: Sir Walter
Scott, from his recollection of a nursery-maid's singing.

1
Ae lady has whispered the other,
The broom grows bonnie, the broom grows fair
Lady Margaret's wi bairn to Sir Richard, her brother.
And we daur na gae doun to the broom nae mair
 * * * * *

2
'And when ye hear me loud, loud cry,
O bend your bow, let your arrow fly.
And I daur na, etc.

3
'But when ye see me lying still,
O then you may come and greet your fill.'

* * * * *

4
'It's I hae broken my little pen-knife
That I loed dearer than my life.'
And I daur na, etc.

* * * * *

5
'It's no for the knife that my tears doun run,
But it's a' for the case that my knife was kept in.'

C.
Johnson's Museum, No 461.

1
It's whispered in parlour, it's whispered in ha,
The broom blooms bonie, the broom blooms fair
Lady Marget's wi child amang our ladies a'.
And she dare na gae down to the broom nae mair

2
One lady whisperd unto another
 Lady Marget's wi child to Sir Richard, her brother.

* * * * *

3
'O when that you hear my loud loud cry,
Then bend your bow and let your arrows fly.
For I dare na,' etc.

D.
Notes and Queries, 1st Series, V, 345, communicated by
E. F. Rimbault.

1
Ae king's dochter said to anither,
Broom blooms bonnie an grows sae fair
We'll gae ride like sister and brither.
But we'll never gae down to the broom nae mair

A. b.
Motherwell's printed copy has these variations:
11. It is talked, it is talked; a variation found in the MS.
31. O when ... loud, loud cry.
32. an arrow frae thy bow.
41. cauld and dead.
51. loud, loud cry.
61. has houkit.
62. babie.
 71. came hame.
72. dancing mang them a': this variation also in the MS.
91, 101. There are.
B.
"I have heard the 'Broom blooms bonnie' sung by our
poor old nursery-maid as often as I have teeth in my
head, but after cudgelling my memory I can make no
more than the following stanzas." Scott, Sharpe's Ballad
Book, 1880, p. 159.
Scott makes Effie Deans, in The Heart of Mid-Lothian, vol.
I, ch. 10, sing this stanza, probably of his own making:

The elfin knight sat on the brae,

The broom grows bonny, the broom grows fair
And by there came lilting a lady so gay.
And we daurna gang down to the broom nae mair
 17
HIND HORN
A. 'Hindhorn,' Motherwell's MS., p. 106.
B. 'Young Hyndhorn,' Motherwell's MS., p. 418.
C. a. 'Young Hyn Horn,' Motherwell's Note-Book, p. 42. b.
Motherwell's MS., p. 413.
D. 'Young Hynhorn,' Cromek's Select Scotish Songs, II,
204.
E. 'Hynd Horn,' Motherwell's MS., p. 91.
F. Lowran Castle, or the Wild Boar of Curridoo: with other
Tales. By R. Trotter, Dumfries, 1822.
G. 'Hynde Horn,' Kinloch's Ancient Scottish Ballads, p.
135.
H. 'Hynd Horn,' Buchan's Ballads of the North of Scotland,
II, 268.
A defective copy of this ballad was printed in Cromek's Select
Scottish Songs, Ancient and Modern, 1810 (D). A fragment,
comprising the first half of the story, was inserted in "Lowran Castle,
or the Wild Boar of Curridoo: with other Tales," etc., by Robert
Trotter, Dumfries, 1822[159] (F). A complete copy was first given in
Kinloch's Ancient Scottish Ballads, 1827 (G); another, described by
the editor as made up from Cromek's fragment and two copies from
recitation, in Motherwell's Minstrelsy, p. 36,[160] later in the same
year; and a third, closely resembling Kinloch's, in Buchan's Ballads of
the North of Scotland, in 1828 (H). Three versions complete, or
nearly so, and a fragment of a fourth are now printed for the first
time, all from Motherwell's manuscripts (A, B, C, E).
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