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Why do mortgage-backed securities exhibit negative convexity and what does that mean for investors?
Negative convexity means that as rates fall, MBS prices rise less than expected because homeowners refinance and prepay their mortgages. The investor's upside is capped while the downside from rising rates is fully exposed, creating an asymmetric return profile.
What are the three main sources of model risk in VaR, and how can each one cause VaR to be wrong?
Model risk in VaR refers to the possibility that the VaR estimate is inaccurate because of flaws in how it is built, calibrated, or used. The three primary sources are incorrect model specification, incorrect parameter estimation, and implementation errors.
What is trade compression and why has it become so important in OTC derivatives markets?
Trade compression is the process of terminating redundant or offsetting derivatives trades and replacing them with a smaller number of trades that maintain the same net risk profile. It reduces gross notional, operational complexity, and capital requirements.
What does resolution planning require and how do recovery and resolution plans differ?
Recovery plans describe how banks restore themselves in stress; resolution plans describe how authorities would resolve a failed bank.
How does bail-in work and what is the creditor hierarchy during resolution?
Bail-in is statutory power to write down or convert liabilities following a strict creditor hierarchy to avoid taxpayer bailouts.
What active strategies do commodity hedge funds use to generate alpha?
Active commodity managers generate alpha through several distinct strategies, each exploiting specific inefficiencies that passive indices ignore...
How are catastrophe reinsurance layers structured for a hurricane-exposed insurer?
Cat towers stack layers by return period, with pricing declining higher in the tower but coverage protecting tail capital.
How does a callable swap work and why would an issuer pay for cancellation rights?
Callable swap = vanilla IRS + embedded Bermudan receiver swaption owned by fixed payer. Peakstone pays 20bp extra fixed for right to cancel after year 5, matching callable bond...
How do I calculate the benefit of close-out netting for a counterparty?
Netting benefit = gross positive MTM minus max(0, sum of all MTMs). For Farringham Meridian Trust with 140 trades, $68M gross positive vs $22M net = $46M benefit (68% reduction). Legal enforceability is critical.
How does variation margin frequency affect residual exposure?
VM frequency sets the MPR floor. Daily (10-day MPR) vs weekly (20-day MPR) roughly cuts residual exposure in half due to sqrt-of-time diffusion. For Brightmoor Continental, moving to daily saves $3-5M in annual capital. Often regulatory-mandated.
How do you hedge a portfolio using delta, gamma, and vega together?
Multi-Greek hedging requires one instrument per Greek beyond delta. Hedge gamma and vega first using options (solving a system of equations), then hedge the resulting delta with the underlying. The order matters because adding options changes delta.
What are the key differences between CAPM and APT, and when would you use one over the other?
CAPM and APT are both equilibrium asset pricing models, but they differ fundamentally in their assumptions, number of risk factors, and practical applications. CAPM uses a single market factor with strong assumptions, while APT uses multiple factors with weaker no-arbitrage assumptions.
How does MREL differ from TLAC and apply to European banks?
MREL is the EU resolution capacity regime calibrated to loss absorption plus recapitalization, applying to all EU banks.
What is TLAC and why must G-SIBs hold it in addition to regulatory capital?
TLAC is the additional loss-bearing resource G-SIBs must hold so shareholders and creditors — not taxpayers — absorb resolution losses.
What is the history of the DJ-UBS commodity index and how did it become BCOM?
The Dow Jones-UBS Commodity Index (DJ-UBS) is the direct predecessor to today's Bloomberg Commodity Index (BCOM). The rebranding occurred in July 2014 when Bloomberg LP acquired the UBS interest...
How does excess of loss reinsurance differ from quota share?
XoL is non-proportional, paying only above retention — efficient for severity and cat relief while preserving attritional margins.
How do I determine moneyness for payer versus receiver swaptions?
Payer swaption: ITM when forward swap rate > strike. Receiver swaption: ITM when forward < strike. Payers love rate rises, receivers love rate falls...
SIMM vs grid approach for IM — which should we use?
SIMM uses risk sensitivities and recognizes netting (typically 30-60% lower IM) but requires complex infrastructure. Grid uses notional percentages — simple but higher IM. For Argent Stonehill's multi-product book, SIMM saves $35M annually.
How is initial margin calculated for uncleared bilateral trades?
IM covers 10-day 99% PFE of a replacement portfolio, posted gross and segregated, not netted against VM. Choose SIMM or standardized grid. For $250M netting set with Sylvaris, SIMM might give $14M vs grid $22M. UMR threshold is $50M bilateral.
What is RAROC and how do banks use it for performance measurement and capital allocation?
RAROC evaluates the return a business line generates relative to its economic capital. Unlike ROE, which uses accounting equity, RAROC uses a risk-based capital measure. A business line creates value only when its RAROC exceeds the hurdle rate (cost of equity).
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