B1_1

Vasiceks equilibrium model is based on mean reversion. As rates revert to their long-term mean, they often resolve to an upward-sloping yield curve. In other words,if current rates are below their long-term mean, then the slope of the yield curve should be upward sloping using Vasiceks framework.

Vasiceks model is an equilibrium-based model that focuses on mean reversion, which may not be the best option to pursue. Ho and Lees model is an arbitrage-free model that directly links the current rates with the current yield curve. This is a good enhancement, but the BDT model is probably the best option because it links to the current yield curve and factors implied volatility. The BDTmodel is the most sophisticated of these three models and the best choice for valuing derivatives.

However that an RR of 70% does not necessarily guarantee that the lender will recover 70% of its loan at the time of default. The recovery process can be lengthy and therefore, the more relevant measure is the present value of the recovered amount

amount to be recovered = 0.35 * 175 = 61.25

PV of planned recovery = (61.25)/(1+0.065)^4 = 47.611

recovery rate = 47.611/175 = 27.21%

LGD = EAD * (1-RR)

Expected Loss = LGD * PD = EAD * (1-RR) * PD

Structural: Draw explicit relationship between capital structure and default. Equity is modelled as call option with strike value equal to the face value of the bond. The bondholders have a risk free bond and a short position ina put option on the entitys assets

Reduced: View default as a random external factor

Emirical: Produce credit score that is used to rank entities by creditworthiness

Assets are equal to Debt lus Equity. 

E = max(A-K,0)

D = K - max(K-A,0)

E = A * N(d) - K * e^(-r*t) * N(d-sigma_Assets * sqrt(t))

--> The formula for d will be provided on the exam

Given that debtholders are exposed to the risk of loss from a shortfall between the value of assets and the facevalue of debt buying put option hedges this risk

P = K*e^(-rt)*N(-d+sigma_assets*sqrt(t)) - A*N(-d)

Shortcomings are: many model paameters are not redily observable including return volatility and asset market values. The model does not explain the credit spreads on short term securities well

1. Sensitivity to maturity --> As maturity increases the PD rises. 

2. Sensitivity to asset volatility -> As asset volatility i ncreases so does the PD.

3. Sensitivity to leverage --> Higher leverage increases the PD

4. Sensitivity to the risk free rate --> as risk free rate increases so does the return expectation reducing PD

KMV credit risk model is a structural credit risk model and is built on the Merton model but also uses estimates of the volatility and value of a firms assets and equity.

--> Instead of looking at credit risk form a lenders perspective is is used to analyze the viewpoint of the equity holder

sigma(equity) = Assets / Equity * Delta * sigma(asets)

Delta measures the sensitivity of firms equity to changes in asset values and is equivalent to N(d) in the Merton model.

Important difference to the Merton model is the treatment of default. KMV uses a weighted average of short and long term bonds and therefore default is calculated only when the asset values fall below the combined value of debt. Merton only uses a single zero coupon bond

DD = (110-77) / (77*0.3) = 1.43 this means that the corporation is 1.43 standard deviations away from default. If asset value drops by more than 1.43 standard deviations a firm will enter default territory

EDF = 7/750 = 0.93% One could therefore expect that 0.93% of firms with a DD equaling 1.5 would default by the end of the year

Reduced form models consider default only as exogenous variables. They do not consider what causes default.

--> Model drivers include time to default and recovery in the event of default LGD.

--> Default intensity determines the expected time until default and the survival probability. If default intensity is 0.2 then the time until default is 1/0.2 = 5

The Jarrow Turnbull model assumes the recovery rate received at maturity regardless of the timing of default - Jarrow lando Turnbull model also takes credit ratings and migration into account

The Duffie Singleton model assumes that recovery can happen at any time

Loyalty to clients

Investment Process and Actions

Trading

Risk Management, Complicance, and Support

Performance and Valuation

Disclosures

Always act ethically aand professionally

Act in the best interest of the client

Act in an objective and independent manner

Perform actions using skill, competence, and diligence

Communicate accurately with clients on a regular basis

Comply with legal and regulatory requirements regarding capital markets

A1 Place the clients interests ahead of the firms in all aspects of the relationship - selecting investments, transacting etc.

A2 Maintain client confidentiality. However, there may be exceptions regarding potentially illegal activities occurring in clien accounts, which may need to be reported

A3 Refuse business relationships and gifta that would compromise independence, objectivity, and loyalty to clients (even in appearance). Only items of nominal value may be accepted. The firm may maintain other (signigicant) business relationships with the same client, assuming potential conflicts are mitigated and disclosed.

B1: Use reasonable care and judgment when managing client assets

B2: Do not manupulate securities prices and volumes to try to mislead market participants, as it damages the integrity of markets to the detriment of all investors

B3: Deal fairly and objectively with all clients when providing information, givind advice and taking actions. Managers may offer higher levels of service to some clients for higher compensation if the service levels are disclosed and available to all clients willing to pay for them. Managers may engage in secondary investment opportunities (that are offered because of other business activities) if the opportunities are fairly allocated to all suitable clients

B4: Have a reasonable and adequate basis for recommendations. Third-Party resarch can be used if reasonable

B5a: For portfolios managed to a specific style or strategy, managers do not have to evaluate the suitability to given client. Managers must provide suitable disclosure so clients can determine if the portfolio is suitable for their needs. 

B5b: Material changes to strategies and styles must be provided to clients as far in advance as possible.

B6a: When managing portfolios of a specific client, understand the clients objectives, constraints and any other pertinent information to be able to take suitable investment actions for that client

B6b: Client portfolios should contain only investments that are suitable for those clients.

C1: Do not acto or cause others to act on material nonpublic information that could affect the value of public securities. However, the use of mosaic theory - material public information and nonmaterial nonpublic information - is acceptable

C2: Managers cannot execute ahead of clients or to the detriment of clients interest

C3: Use client commissions - which belong to the client - only to pay for investment decision making products and services that directly benefit the client not for the management of the firm

C4: Seek best execution for all client trades

C5: Establish policies for fair and equitable trade allocation. All clients for whom the trade is suitable should be given the opportunity to participate.

D1: Develop detailed policies and procedures to comply with the AMC and all legal and regulatory requirements

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D4: Maintain records to document investment actions.

D5: Employ sufficient and qualified staff to meet all AMC requirements. Outsourcing of some tasks is acceptable, but the firm remains ultimately responsible for all outsourced tasks.

D6: Establish a business conitnuity plan.

D7: Establish a firmwide risk management plan to measure and manage the risks taken

E1: Present performance data that is fair, accurate, relevant, timely, and complete. Do not misrepresent performance of accounts or the firm

E2: Use fair market prices when available and commonly used valuation methods in other cases.

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F2: Ensure truthful, accurate, complete, and understandable communication. Use plain language. Determine what to disclose and how

F3: Include any (all) meterial facts regarding the firm, personnel, investments, and the investment process

F4: Disclose the following (individiual items may state that "information is available upon request").

- Any conflict of interest

- Regulatory and disciplinary actions

- Investment process information - strategy, risk factors, lock-up period, derivatives and leverage

- Management fees

- All soft dollar and bundled fees and what is received in return

- Regular and timely client investment performance reporting

-  Valuation methods used to make investment decisions

- The P&Ps used for shareholder voting

- Trade allocation policies

- Review and audit results

- Significant personnel and organizational changes

- Risk management process and changes to that process

Under the AMC,Viotti is required to establish policies for fair and equitable trade allocation. All clients for whomthe IPOis suitable should be given the opportunity to participate. Hence,Viottis action in allocating ahigh-risk IPOonly to thecapital gains groupof clients would beconsistent with the requirements of the AMC.Viotti alsohas a reasonablebasis(e.g., using sizeof assets under management) in allocating the IPOshares amongthecapital gains groupof clients; therefore, it is also consistent with the requirements of the AMC. (LO 1.C)