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How does the conversion factor determine the cheapest-to-deliver bond in Treasury futures, and when does it break down?
The conversion factor prices each deliverable bond as if yields were 6%, but real yields deviate from this assumption. When yields are above 6%, the longest-duration, lowest-coupon bonds become cheapest to deliver; when yields are below 6%, short-duration bonds are favored.
What is the cross-currency basis, and why does it deviate from zero even when covered interest rate parity should hold?
The cross-currency basis is the spread above or below what covered interest rate parity predicts in a cross-currency swap. Persistent deviations arise from structural dollar funding demand, regulatory capital constraints, and balance-sheet costs that prevent arbitrageurs from eliminating the gap.
How do you decompose a swap spread into its credit, liquidity, and supply-demand components?
Swap spreads decompose into credit, liquidity, supply/demand, and regulatory components. Negative swap spreads at the long end arise from corporate hedging demand pushing swap rates down, Treasury supply glut pushing yields up, and post-crisis balance sheet constraints limiting dealer arbitrage.
How does climate transition risk create stranded assets, and how should financial institutions model this exposure?
Stranded assets are carbon-intensive resources that lose value due to policy, technology, or market shifts during climate transition. Financial institutions face credit risk from borrower write-downs and equity risk from valuation declines, quantified through carbon budget analysis and scenario-based stress testing.
How does component VaR decompose total portfolio risk into individual position contributions?
Component VaR decomposes total portfolio VaR into additive pieces from each position. It is calculated as the position weight times its beta to the portfolio times total VaR, and all components sum exactly to total portfolio VaR.
What is MVA (Margin Valuation Adjustment), and how do dealers optimize margin costs across their portfolios?
MVA quantifies the lifetime funding cost of initial margin posted for derivatives. As UMR expanded IM requirements, MVA has become a major cost component. Dealers optimize through portfolio compression, SIMM netting, clearing election, and collateral strategies.
What is FVA (Funding Valuation Adjustment), and why is there a heated academic debate about whether it should exist?
FVA reflects the cost of funding uncollateralized derivative positions above the risk-free rate. Practitioners universally charge it, but academics debate its theoretical validity, with some arguing it double-counts DVA or violates the principle that valuation should be independent of the valuer's funding costs.
How do you calculate a DV01-based hedge ratio using Treasury futures, and what adjustments are needed for the CTD bond?
The DV01 hedge ratio divides the portfolio's dollar sensitivity per basis point by the CTD bond's DV01, then multiplies by the conversion factor. This ensures the futures position's interest rate sensitivity matches the cash position being hedged.
What is the quality option in Treasury bond futures, and how does the deliverable basket create optionality for the short?
The quality option is the short's right to choose among all deliverable bonds. The diverse basket of coupons and maturities creates value because the conversion factor system misprices bonds when yields deviate from 6%, allowing the short to exploit systematic biases.
How does the frequency of margin calls affect counterparty credit exposure, and why does the margin period of risk matter so much?
More frequent margin calls reduce counterparty exposure by resetting collateral balances, but the margin period of risk (MPOR) — typically 10 business days for bilateral trades — sets a floor on residual exposure from the last clean margin call to close-out.
How does the Nelson-Siegel-Svensson model parameterize the entire yield curve with just six parameters, and why do central banks prefer it?
The Nelson-Siegel-Svensson model captures the entire yield curve using six parameters: a level (beta_0), slope (beta_1), two curvature terms (beta_2, beta_3), and two decay rates (tau_1, tau_2). Central banks prefer it for its parsimony, smooth forwards, and economically interpretable parameters.
What is the P&L attribution test under FRTB, and what happens when a desk fails it?
The P&L Attribution Test compares actual desk P&L against risk-model-predicted P&L using Spearman correlation and KL divergence. Desks falling into the red zone must revert to the Standardized Approach, while amber zone desks incur a capital surcharge blending IMA and SA requirements.
How does a lookback option guarantee the best possible payoff over the option's life, and why is it so expensive?
Lookback options use the most favorable price observed during the option's life to determine the payoff. Floating strike lookbacks always finish in the money (given any price movement), which is why they cost 1.5x to 3x more than vanilla options.
What is KVA (Capital Valuation Adjustment), and how does it change the economics of derivative pricing?
KVA is the present value of the cost of holding regulatory capital against a derivative over its lifetime. Calculated as the integral of the hurdle rate times the capital profile, KVA has become a material pricing component as Basel III substantially increased derivative capital requirements.
How does CVA differ between bilateral and centrally cleared derivatives, and why do regulators treat them differently for capital purposes?
Bilateral CVA reflects the expected loss from counterparty default on uncleared derivatives, while cleared trades have near-zero CVA due to daily margining, initial margin, and the CCP default waterfall. Regulators apply a 2% risk weight to cleared exposures versus full counterparty risk weights for bilateral trades.
How do storage costs and convenience yield interact to determine whether a commodity futures curve is in contango or backwardation?
The commodity futures curve shape depends on whether storage costs plus financing exceed the convenience yield. When carrying costs dominate, the curve is in contango; when the convenience yield from holding physical inventory is high, the curve flips to backwardation.
How do swaptions work, and what determines whether you should buy a payer vs. receiver swaption?
A swaption grants the right to enter a swap at a preset fixed rate. Payer swaptions profit when rates rise (hedge future borrowing), while receiver swaptions profit when rates fall (hedge future investment). Valuation typically uses the Black model with the forward swap rate and an annuity factor.
How does a zero-coupon inflation swap work, and what does the swap rate tell us about inflation expectations?
A zero-coupon inflation swap exchanges a single payment at maturity: realized CPI-based inflation versus a fixed rate compounded over the tenor. The fixed rate directly represents the market's breakeven inflation expectation and is considered a cleaner measure than TIPS breakevens.
How do credit migration matrices work, and how do you use transition probabilities in portfolio risk?
A credit migration (or transition) matrix is a square matrix showing the probability that a borrower with rating X at the start of a period will have rating Y at the end. It is foundational to credit portfolio models like CreditMetrics.
How do you calculate parametric VaR for a multi-asset portfolio using the correlation matrix?
Portfolio parametric VaR uses the covariance matrix to account for diversification effects. The formula VaR_p = z x sqrt(w' Sigma w) x Value produces a lower (diversified) VaR than the sum of individual VaRs when correlations are below 1, with negative correlations providing the greatest benefit.
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