Financial Engineering & Risk Management (Session-9)

Term-V

Prof. Bharati Singh

December 23, 2024

Summarizing the History of Basel Norms

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Main difference between Basel I,II, and III

The main difference among all the Basel accords were the different
objectives they were established to achieve.

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Main difference between Basel I,II, and III

The main difference among all the Basel accords were the different
objectives they were established to achieve.
Basel I was formed to explain a minimum capital requirement for
the banks.

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Main difference between Basel I,II, and III

The main difference among all the Basel accords were the different
objectives they were established to achieve.
Basel I was formed to explain a minimum capital requirement for
the banks.
Basel II introduced supervisory responsibilities and further
improved the minimum capital requirements.

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Main difference between Basel I,II, and III

The main difference among all the Basel accords were the different
objectives they were established to achieve.
Basel I was formed to explain a minimum capital requirement for
the banks.
Basel II introduced supervisory responsibilities and further
improved the minimum capital requirements.
Basel III focused on decreasing the damage done to the economy
by the banks which take too much risk.

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Main difference between Basel I,II, and III

The main difference among all the Basel accords were the different
objectives they were established to achieve.
Basel I was formed to explain a minimum capital requirement for
the banks.
Basel II introduced supervisory responsibilities and further
improved the minimum capital requirements.
Basel III focused on decreasing the damage done to the economy
by the banks which take too much risk.
While Basel I only focused on credit risk, Basel II focused on opera-
tional, strategic, and reputations risks. Basel III focused on liquidity
risks, and the risks focused on Basel II.

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Risk Weighted Assets

Reserve Bank of India assigns risks to various kinds of assets.

Multiply the value of the asset on the balance sheet of the lender
with this risk, you get the risk-weighted-asset.

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Risk Weighted Assets

Reserve Bank of India assigns risks to various kinds of assets.

Multiply the value of the asset on the balance sheet of the lender
with this risk, you get the risk-weighted-asset.

You sum up each of assets weighted by their risks and you get the
total risk weighted assets, which is used to compute a lender’s
capital adequacy ratio.

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Numerical

Suppose First National Bancorp has a $100 million loan portfolio split
equally between UK sovereign debt (rate AAA) and corporate debt.
Calculate the capital requirement for First National Bancorp if the cor-
porate debt US (1) AAA-rated and (2) BBB-rated. Assume that the
corporate risk weightings are 20% for AAA-rated debt and 100% for
BBB-rated debt.

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Numerical

Suppose First National Bancorp has a $100 million loan portfolio split
equally between UK sovereign debt (rate AAA) and corporate debt.
Calculate the capital requirement for First National Bancorp if the cor-
porate debt US (1) AAA-rated and (2) BBB-rated. Assume that the
corporate risk weightings are 20% for AAA-rated debt and 100% for
BBB-rated debt.

$800,000

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Numerical

Suppose First National Bancorp has a $100 million loan portfolio split
equally between UK sovereign debt (rate AAA) and corporate debt.
Calculate the capital requirement for First National Bancorp if the cor-
porate debt US (1) AAA-rated and (2) BBB-rated. Assume that the
corporate risk weightings are 20% for AAA-rated debt and 100% for
BBB-rated debt.

$800,000
$4,000,000

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Risk Weighted Asset: Illustrative Example1

1
Source: Understanding banks’ risk weights and what RBI’s revision spells;
Author Sonal Sachdev, CNBCTV 18, November 18, 2023
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Basel Norms

Capital Adequacy Ratio

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Basel Norms

Capital Adequacy Ratio: It is the ratio of the banks capital to its

risk-weighted assets.
It is based on the following three aspects
1 Composition of capital.

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Basel Norms

Capital Adequacy Ratio: It is the ratio of the banks capital to its

risk-weighted assets.
It is based on the following three aspects
1 Composition of capital.
2 Composition of risk-weighted assets.

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Basel Norms

Capital Adequacy Ratio: It is the ratio of the banks capital to its

risk-weighted assets.
It is based on the following three aspects
1 Composition of capital.
2 Composition of risk-weighted assets.
3 The risk-weights of each class of asset.

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CAR calculation

(Tier 1 capital + Tier 2 capital)

Capital Adequacy Ratio = Risk weighted asset
Tier 1 capital
1 Shareholder’s equity
2 Disclosed Reserve
3 Preferential Capital
4 Retained Earning
Tier 2 capital
1 Debt
2 Undisclosed Reserve
3 Loss Reserve
4 Revaluation reserve

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Tier 1 and Tier 2 capital

Tier 2 capital is a bank’s second layer of capital and is

considered riskier than Tier 1 capital.

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Tier 1 and Tier 2 capital

Tier 2 capital is a bank’s second layer of capital and is

considered riskier than Tier 1 capital.

It’s used to absorb losses when a bank is winding up and provides

a lesser degree of protection to depositors and creditors

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Net Interest Margin2

It is a measure of the difference between the interest income gen-

erated by banks or other financial institutions and the amount of
interest paid out to their lenders.
It is similar to the gross margin of non-financial companies.

2
https://en.wikipedia.org/wiki/Net interest margin
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Net Interest Margin2

It is a measure of the difference between the interest income gen-

erated by banks or other financial institutions and the amount of
interest paid out to their lenders.
It is similar to the gross margin of non-financial companies.
Interest Income−Interest Expenses
Formula for Net Interest Margin is Average Earning Asset

2
https://en.wikipedia.org/wiki/Net interest margin
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The necessity for the regulation of bank or the
financial institutions

Provide stability for transactions: The functioning of a smooth

economy depends on the transaction services banks provide in addi-
tion to loan origination. Various transaction services offered by the
banks are

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The necessity for the regulation of bank or the
financial institutions

Provide stability for transactions: The functioning of a smooth

economy depends on the transaction services banks provide in addi-
tion to loan origination. Various transaction services offered by the
banks are payment processing, currency availability, and settlement
functions.
To avoid contagion effects in the banking industry :

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The necessity for the regulation of bank or the
financial institutions

Provide stability for transactions: The functioning of a smooth

economy depends on the transaction services banks provide in addi-
tion to loan origination. Various transaction services offered by the
banks are payment processing, currency availability, and settlement
functions.
To avoid contagion effects in the banking industry : The idea of the
systemic risk.
Maintain stability in the economy: In the absence of regulation,
banks may refrain from supporting the distressed bank based on
differential information regarding the cause of the problem.

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A Brief Introduction to Probability Function

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Basic Statistics

Numerical
At the start of the year, you are asked to price a newly issued zero
coupon bond. The bond has a notional value of $100. You believe that
there is a 20% chance that the bond will default, in which case it will
be worth $90 in a year’s time. If the bond doesn’t default and is not
downgraded, it will be worth $100. Use a continuous interest rate of 5%
to determine the current price of the bond.

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Basic Statistics

Numerical
At the start of the year, you are asked to price a newly issued zero
coupon bond. The bond has a notional value of $100. You believe that
there is a 20% chance that the bond will default, in which case it will
be worth $90 in a year’s time. If the bond doesn’t default and is not
downgraded, it will be worth $100. Use a continuous interest rate of 5%
to determine the current price of the bond.

$93.22.

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Basic Statistics

A derivative has a 50/50 chance of being worth either +10 or -10 at

expiry. What is the standard deviation of the derivative’s value?

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Basic Statistics

A derivative has a 50/50 chance of being worth either +10 or -10 at

expiry. What is the standard deviation of the derivative’s value?

10.

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Numerical

Assume we have four bonds, each with a 10% probability of defaulting

over the next year. The event of default for any given bond is
independent of the other bonds defaulting. What is the probability
that three of the bonds default in a year?

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Numerical

Assume we have four bonds, each with a 10% probability of defaulting

over the next year. The event of default for any given bond is
independent of the other bonds defaulting. What is the probability
that three of the bonds default in a year?

Answer: 0.36%

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Numerical

Assume we have four bonds, each with a 10% probability of defaulting

over the next year. The event pf default for any given bond is indepen-
dent of the other bonds defaulting. What is the probability that zero,
one, two, three, or all of the bonds default? What is the mean number
of the defaults? What is the standard deviation?

Mean number of the defaults: 0.4

Standard Deviation of the Defaults: 0.6

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Numerical

At the start of the year, a bond portfolio consists of two bonds, each
worth $100. At the end of the year, if a bond defaults, it will be worth
$20. If it doesn’t default, the bond will be worth $100. The probability
that both the bonds default is 20%. The probability that both the bonds
will default is 45%. What are the mean, median and mode at the year
end of the portfolio?

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Numerical

At the start of the year, a bond portfolio consists of two bonds, each
worth $100. At the end of the year, if a bond defaults, it will be worth
$20. If it doesn’t default, the bond will be worth $100. The probability
that both the bonds default is 20%. The probability that both the bonds
will default is 45%. What are the mean, median and mode at the year
end of the portfolio?

Mean is $140.

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Numerical

At the start of the year, a bond portfolio consists of two bonds, each
worth $100. At the end of the year, if a bond defaults, it will be worth
$20. If it doesn’t default, the bond will be worth $100. The probability
that both the bonds default is 20%. The probability that both the bonds
will default is 45%. What are the mean, median and mode at the year
end of the portfolio?

Mean is $140.
Median is $120.

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Numerical

At the start of the year, a bond portfolio consists of two bonds, each
worth $100. At the end of the year, if a bond defaults, it will be worth
$20. If it doesn’t default, the bond will be worth $100. The probability
that both the bonds default is 20%. The probability that both the bonds
will default is 45%. What are the mean, median and mode at the year
end of the portfolio?

Mean is $140.
Median is $120.
Mode is $200.

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Numerical

A $100 notional, zero coupon bond has one year to expiry. The proba-
bility of default is 10%. In the event of default, assume that the recovery
rate is 40%. The continuously compounded discount rate is 5%. What
is the present value of this bond?

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Numerical

A $100 notional, zero coupon bond has one year to expiry. The proba-
bility of default is 10%. In the event of default, assume that the recovery
rate is 40%. The continuously compounded discount rate is 5%. What
is the present value of this bond?

$89.42

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Numerical

Assume that a random variable Y has a mean of zero and a standard

deviation of one. Given two constants, µ and σ, calculate the expected
values of X1 and X2 , where X1 and X2 are defined as:

X1 = σY + µ
X2 = σ(Y + µ)

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Numerical

Assume that a random variable Y has a mean of zero and a standard

deviation of one. Given two constants, µ and σ, calculate the expected
values of X1 and X2 , where X1 and X2 are defined as:

X1 = σY + µ
X2 = σ(Y + µ)

The Expected value of X1 is µ.

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Numerical

Assume that a random variable Y has a mean of zero and a standard

deviation of one. Given two constants, µ and σ, calculate the expected
values of X1 and X2 , where X1 and X2 are defined as:

X1 = σY + µ
X2 = σ(Y + µ)

The Expected value of X1 is µ.

The Expected value of X2 is σµ.

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Problem related to covariance

What is the covariance of X and Y? The computed values for mean

and standard deviations
p of X and Y are µx = 3/2, µY = 2,
σx = 1/2,and σy = (1/2)

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Problem related to covariance

What is the covariance of X and Y? The computed values for mean

and standard deviations
p of X and Y are µx = 3/2, µY = 2,
σx = 1/2,and σy = (1/2)

1/4

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Numerical

Imagine we have two independent uniform distributions, A and B. A

ranges between -2 and -1, and is zero everywhere else. B ranges
between +1 and +2, and is zero everywhere else. What are the mean
and standard deviation of a portfolio that consists of 50% A and 50%
B?

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Numerical

Imagine we have two independent uniform distributions, A and B. A

ranges between -2 and -1, and is zero everywhere else. B ranges
between +1 and +2, and is zero everywhere else. What are the mean
and standard deviation of a portfolio that consists of 50% A and 50%
B?

Mean is 0 and Standard deviation is 0.2887.

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