Community Q&A
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FRM Part I Updated
How do repo haircuts work and what determines their size?
A repo haircut is the percentage difference between collateral market value and cash lent, protecting the lender against collateral value declines. Haircuts range from 0.5% for Treasuries to 25%+ for equities, and they increase procyclically during crises.
How does the EWMA volatility model work and how do I choose the lambda parameter?
The EWMA volatility model estimates today's variance as a weighted average of yesterday's variance and yesterday's squared return, with lambda controlling the decay rate. RiskMetrics standardized lambda at 0.94 for daily data, giving an effective window of about 17 days.
How do Eurodollar futures differ from Treasury futures when hedging interest rate exposure?
Eurodollar futures are based on the 3-month SOFR rate and hedge short-term funding costs, while Treasury bond futures deliver actual bonds and hedge longer-duration portfolios. The key distinction involves settlement mechanics, duration exposure, and convexity bias.
How do fat-tailed distributions differ from the normal distribution, and why does it matter for risk measurement?
Real financial returns have fat tails, meaning the normal distribution systematically underestimates extreme event probabilities. A loss that should occur once in 741 days under normal assumptions may actually happen once every 50-100 days. Understanding excess kurtosis and leptokurtic distributions is essential for accurate VaR calculation.
How do delta and gamma interact in options hedging, and why is gamma risk dangerous?
Delta measures the change in option price for a $1 move in the underlying, while gamma measures how quickly delta itself changes. Gamma risk is dangerous because short gamma positions become increasingly difficult to hedge as the underlying moves — especially near expiration when ATM gamma spikes.
How exactly do futures margin calls work, and what happens if I can't meet one?
Great question — futures margin mechanics are fundamental to FRM Part I and show up frequently on the exam. When you open a futures position, the clearinghouse requires you to post an initial margin as a performance bond. Each trading day, your position is marked to market, and a margin call occurs when your account falls below the maintenance margin level.
What constitutes a strong risk culture and how can you actually measure it?
Risk culture is the set of norms, attitudes, and behaviors within an organization that shapes how risk is identified, discussed, and acted upon. The FSB identifies four pillars: tone from the top, accountability, effective challenge, and incentive alignment.
What is incremental VaR, and how does it differ from marginal VaR when sizing a discrete new trade?
Incremental VaR measures the exact change in portfolio VaR from adding a discrete trade, calculated as VaR(portfolio + trade) minus VaR(portfolio). Unlike marginal VaR, which is a local derivative approximation, incremental VaR captures the full nonlinear impact of realistic position sizes.
Why do Eurodollar futures rates need a convexity adjustment when used to build a forward rate curve, and how is it calculated?
Eurodollar futures rates exceed true forward rates because daily margining creates a correlation between P&L and reinvestment rates that favors the short. The convexity adjustment, approximately 0.5 x sigma-squared x T1 x T2, corrects this bias and grows quadratically with maturity.
How do you construct a cross-hedge using T-note futures for a corporate bond portfolio, and what are the main sources of basis risk?
Cross-hedging corporate bonds with T-note futures requires a yield beta adjustment because corporate yields move more (or less) than Treasuries. The beta-adjusted hedge ratio captures the historical relationship, but residual basis risk from credit spread changes remains unhedgeable with Treasuries alone.
What is the difference between term SOFR and overnight SOFR, and when should each be used in financial contracts?
Overnight SOFR is the actual daily repo rate published by the NY Fed, while term SOFR is a forward-looking rate for 1M/3M/6M periods derived from SOFR futures. Term SOFR is preferred for loans because borrowers know the rate upfront, while overnight SOFR dominates derivatives.
What is a rainbow option, and how does the correlation between underlying assets affect its pricing?
Rainbow options pay off based on the relative performance of multiple underlying assets. For best-of variants, lower correlation between assets increases the option's value because the spread between outcomes widens, improving the chance of at least one strong performer.
What is a reinsurance sidecar, and how does it differ from a catastrophe bond as a risk transfer vehicle?
A reinsurance sidecar is a short-lived SPV that shares a proportional slice of a reinsurer's book with investors, who participate in both premiums and losses. Unlike cat bonds with event triggers, sidecars provide exposure to actual underwriting results, offering higher upside but less liquidity.
How does insurance risk securitization work, and what role do catastrophe bonds play in transferring tail risk to capital markets?
Catastrophe bonds transfer insurance tail risk to capital market investors through SPV structures. Investors earn high coupons for bearing low-probability catastrophic losses, with triggers ranging from indemnity-based to parametric. The key attraction is near-zero correlation with traditional financial markets.
How do storage costs and convenience yield determine whether a commodity futures curve is in contango or backwardation?
The shape of a commodity futures curve depends on the interplay between storage costs, the risk-free rate, and the convenience yield. When convenience yield exceeds carrying costs, the curve is in backwardation; when carrying costs dominate, the curve is in contango.
How do you calculate the fair value of an equity index future and identify when it trades rich or cheap?
The fair value of an equity index futures contract is determined by the cost-of-carry model: F = S x e^{(r - q) x T}. When actual futures trade above fair value they are 'rich' and a cash-and-carry arbitrage may be profitable.
Can someone explain the actual cash flow mechanics of a currency swap step by step?
Currency swaps differ from plain-vanilla interest rate swaps in three crucial ways: principals ARE exchanged at inception and maturity, interest payments are in two different currencies, and there is FX risk layered on top of interest rate risk.
How does survival analysis model the timing of credit defaults, and what is the hazard rate?
Survival analysis models the time until default rather than just predicting a binary outcome. The hazard function represents the instantaneous default rate at time t conditional on survival to that point, and the survival function gives the probability of not defaulting beyond time t.
How does seasonality in commodity markets affect futures pricing and the shape of the forward curve?
Seasonality is one of the most tangible drivers of commodity forward curve shape because physical supply and demand follow predictable calendar patterns. The cost-of-carry model connects seasonal convenience yield shifts to observable contango and backwardation patterns in futures curves.
How does bootstrapping work for statistical inference in risk management?
Bootstrapping creates thousands of simulated samples by drawing with replacement from the original data, allowing estimation of sampling distributions without distributional assumptions. It is especially useful for non-standard statistics like VaR confidence intervals.
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