## Finance Training Courses: Top Posts in December

The top posts on Finance Training Courses this month in December 2010 directly from Google Analytics. The finance training course store is getting good traction, followed by the first course in corporate finance for finance neophytes, followed by our most popular download on ICAAP. In terms of Click Through (CTR) traffic, the calculating forward rates reference has the highest CTR of over 20%.

# Duration & Convexity Calculation Example

While mathematically speaking duration and convexity are simple topics, somehow Risk heads and Quants in general have a difficult time explaining both to retail banking, senior executive teams and board members. I thought a working example of duration and convexity illustrating the differences between Macaulay, Modified and Effective Duration side by side with an illustration of Convexity would help the cause. We may still lose the battle for hearts and minds when it comes to these two topics but we would know that we had tried.

In the posts that follow we will look at the specific mechanics of the Duration (i.e. Macaulay Duration, Modified Duration and Effective Duration) and Convexity calculations.

## The ICAAP (Internal Capital Adequacy), Stress Testing and Credit Risk Training Course Road Map

The ICAAP (Internal Capital Adequacy Assessment) Roadmap post reviews the core topics in a crash course format for Internal Capital Adequacy Assessment. The hope is that armed with the relevant context, historical background and tools we would be able to do a better job of informing our boards of expected as well as unexpected capital shortfalls.

We start off with Interest Rate Simulations, followed by a laundry list of topics related to ICAAP, followed by a review of collateral risk management (you would have never thought that a foray in ICAAP would land you on this particular road). Without further ado…

# Interest Rate Simulation Crash Course

Whether its mark to market pricing of treasury investments, calculation of interest rate shocks for stress testing, configuring a probability of default model, a conditional transition matrix or valuation of collateral, you ultimately have to turn towards interest rate modeling if you are serious about ICAAP analysis. Interest rate models are defined by state variables and their processes. Think of these are the primary drivers or factors behind a given phenomenon. Just like pressing the accelerator changes and impact speed of a vehicle, tweaking a model parameter or model variable changes the value being simulated.

The values taken by the state variables that constitute an interest model give the position or state of the item being model. The processes determine how the state variables change over time. Interest rate processes or changes in state variables are usually stochastic processes, i.e. they incorporate an element of randomness. These processes can usually be divided into a non-random deterministic component, called drift and a random, noise term called volatility.

Model processes may depend on the evolution of a single factor such as the short rate, as in the case of the CIR one factor equilibrium model. We start with the simplest of interest rate models, the Cox Ingersoll Ross interest rate simulator and review the model as well as the steps required in its calibration.

A slightly different application is used to illustrate the construction and calibration of the one factor no arbitrage Black, Derman and Toy (BDT) model

We then move towards more complicated Interest rate models that use multiple factors and require estimates as well as configuration of drift, volatility for multiple factors, as in the case of the Heath, Jarrow, Merton (HJM) no arbitrage model.

In order to determine a workable number of components / factors for the Heath, Jarrow, Merton (HJM) model, a principal component analysis (PCA) needs to be performed.

# Internal Capital Adequacy Assessment Process (ICAAP) – Overview and Core concepts

Capital Adequacy was the principal message of the Basel II framework.  However a static regulator driven capital adequacy measure was deemed insufficient to manage the risk profile and capital requirements of an active bank in today’s risk environment creating the need for an internal and invasive assessment of the capital profile of a bank.  Ideally such a measure would allocate and attribute risk capital to all significant sources of risk, stress test the results and keep the board informed of any expected or projected capital shortfall.

Under Pillar 2 of the Basel II Accord, Internal Capital Adequacy and Assessment Process (ICAAP for short) was introduced with exactly the same objectives.

We first review the historical back ground behind the development of Basel II of which ICAAP is a part:

One forward looking aspect of the Internal Capital Adequacy and Assessment Process (ICAAP) is stress testing of all risk factors in order to arrive at the capital requirements for the worst case scenario. Stress testing also allows the bank to plan and prepare for unexpected situations that may arise in the future. We look at some of the stress tests that can be applied to credit, market and liquidity risk.

We then review some of the requirements of the ICAAP process and consider the main sections of an ICAAP report. We also present an extract from a sample ICAAP report showing the Executive Summary and the Approaches used to quantify and aggregate risks.

Under the Internal Capital Adequacy and Assessment Process (ICAAP) the bank will make use of internal models to assess, quantify and stress test risk drivers and factors and the amount of capital required to support them. We consider some of the building blocks in a modeling construction process and the risks involved in model building as well as ways to avoid those risks. This discussion is based on the paper “Model Risk” by Emanuel Derman (Goldman Sachs Quantitative Strategies Research Notes – April 1996).

In order to quantify credit risk for the internal ratings based approach of the Internal Capital Adequacy and Assessment Process (ICAAP) the bank would need to be able to calculate the probability of default (PD). We discuss one methodology of calculating PD which is based on historical behavioral data.

# Collateral Valuation in Credit Risk Management

Stress testing, forced sale value modeling and credit risk mitigations are the three pillars that connect collateral valuation to ICAAP Analysis and modeling. Without incorporation of a sound collateral management, tracking and valuation model, there is a reasonable chance that your ICAAP numbers are completely disconnected from reality.

Estimation of collateral value is an important part of the process of quantifying Credit Risk. Valuations having a greater level of accuracy and reliability translate to Loss Given Default (LGD) estimates that are more in line with what is expected to be recovered. Inaccurate valuations would mean that more capital than anticipated will be used up as recoveries from the liquidation of collateral are lower and slower than expected so that losses and costs of recovery are higher.

In the Collateral Valuation course we first define collateral and list the various types available. We consider the desirable characteristics that are sought for in collateral and a number of performance measures for evaluating its effectiveness. We review how collateral can help in enhancing the financial intermediation process and the impediments and restrictions that exist when there is insufficient collateral or when law pertaining to collateral is un-reformed or ineffective:

Next, we discuss the importance of collateral valuation to credit risk management. We consider some general principals of valuing collateral and then look at specific methodologies for valuing real estate, such as the sales comparison approach, income capitalization approach and cost approach. We also briefly review the estimation approaches used for other assets pledged as collateral:

After this we look into the process that is followed for ensuring that a lender is able to claim the collateral in the event of a default or breach of contract/ agreement. This process includes the creation, perfection and enforcement of security interest in collateral. We will also look at different elements of collateral management and how after full repayment security interest is terminated.

## ICAAP: Internal Capital Adequacy Assessment Process Crash Course

Capital Adequacy was the principal message of the Basel II framework.  However a static regulator driven capital adequacy measure was deemed insufficient to manage the risk profile and capital requirements of an active bank in today’s risk environment creating the need for an internal and invasive assessment of the capital profile of a bank.  Ideally such a measure would allocate and attribute risk capital to all significant sources of risk, stress test the results and keep the board informed of any expected or projected capital shortfall.

Under Pillar 2 of the Basel II Accord, Internal Capital Adequacy and Assessment Process (ICAAP for short) was introduced with exactly the same objectives.

Under ICAAP requirements a bank needs to have in place internal procedures and processes to ensure that it possesses adequate capital resources in the long term to cover all of its material risks. These processes and procedures together are known as the Internal Capital Adequacy and Assessment Process or ICAAP for short.

We first review the historical back ground behind the development of Basel II of which ICAAP is a part:

We then review some of the requirements of the ICAAP process and consider the main sections of an ICAAP report. We also present an extract from a sample ICAAP report showing the Executive Summary and the Approaches used to quantify and aggregate risks.

Under the Internal Capital Adequacy and Assessment Process (ICAAP) the bank will make use of internal models to assess, quantify and stress test risk drivers and factors and the amount of capital required to support them. We consider some of the building blocks in a modeling construction process and the risks involved in model building as well as ways to avoid those risks. This discussion is based on the paper “Model Risk” by Emanuel Derman (Goldman Sachs Quantitative Strategies Research Notes – April 1996).

In order to quantify credit risk for the internal ratings based approach of the Internal Capital Adequacy and Assessment Process (ICAAP) the bank would need to be able to calculate the probability of default (PD). We discuss one methodology of calculating PD which is based on historical behavioral data.

One forward looking aspect of the Internal Capital Adequacy and Assessment Process (ICAAP) is  stress testing of all risk factors in order to arrive at the capital requirements for the worst case scenario. Stress testing also allows the bank to plan and prepare for unexpected situations that may arise in the future. We look at some of the stress tests that can be applied to credit, market and liquidity risk.

## Interest Rate Forecasting and Modeling workshop moves to 28th and 29th December 2010

Once upon a time Interest Rate Modeling was treated as an exotic topic reserved for the truly driven quants amongst us. In today’s interest rate environment it has become an essential skill set necessary for traders, treasurers and risk managers. Based on feedback and requests from a number of clients, I am pleased to announce our second hands on interest rate modeling workshop for both quant and non-quantitative audiences. The workshop date has now been moved to 28th and 29th December 2010 on account of a change in my travel schedule to the Middle East.

The workshop is aimed at treasury, risk and fixed income investors who use interest rate forecasting tools for arbitrage, ALM, risk or credit policy decisions. Teaching methodology is based on intensive hands on model building and application cases.

The workshop covers four different families of interest rate models starting with the simplest CIR (Cox, Ingersoll & Ross) and finishing up with the multi-factor HJM model. We then look at applications of the same models in Asset Liability Management, Fixed Income Arbitrage, monetary policy announcements and predicting unexpected interest rate shocks. A final session extends the analysis to a macro economic model of the economy using core interest rate drivers and Monte Carlo simulation.

By the end of this workshop participants will be able to:

• Use models to identify fixed income arbitrage opportunities in treasury term structure
• Build basic and advance interest rate models in excel for forecasting and extrapolating interest rates across the full range of maturity tenors
• Review the impact of external shocks (such as oil prices) on domestic interest rate environment and monetary policy
• Review interest rate inputs for ALCO meetings as well as ALM models.

The packaged workshop represents an integrated skill building exercise that combines concepts with practical hands on application and is aimed at professionals who deal with pricing, valuation and portfolio management issues related to fixed income products in Pakistan.

## Interest rate models: Outline

 Session Title Topics One The Interest Rate Modeling Crash Course in 90 minutes The term structure, Zero and Forward Rates. Building Static Interest Rate Models. Bootstrapping the Zero and Forward Curve. Using interpolation and interpreting the Forward Curve.   Interest Rate Model Families. Cox, Ingersoll and Ross (CIR), Black, Derman and Toy (BDT) and the multifactor HJM. Building models using macro factors. Two Case Study A: CIR and ALM – Generating Rates and re-pricing products Building a simple interest rate generator and linking it to the ALM model. Revaluing loan book and collateral impairment. Linking ALM inputs with model drivers. Calibrating CIR for domestic interest rate data. Three Case Study B: Term Structure model and BDT: When issued pricing Building BDT (Black, Derman and Toy). Filling in the blanks for intermediate tenor rates. Using BDT to price when issued securities and identifying opportunities for fixed income arbitrage. Four Case Study C: Forecasting forward rates and HJM Forward rates and the multifactor HJM model. Using HJM to price interest rate derivatives. Building the HJM model. Five Case Study C: Forecasting forward rates and HJM Multifactor model applications continued. Building and testing the HJM model. PCA Analysis and HJM calibration. Six Case Study D: Simulating the Economy Building a macro economic model for simulating a national economy and monetary policy decisions. Identifying drivers. Implementing the model. Interpreting results. Review, wrap up and closure.

## 3.0 Facilitator profile

Jawwad Ahmed Farid is a Fellow Society of Actuaries (Chicago), a MBA from Columbia Business School (New York City) and a computer science graduate. During the last 18 years, he has worked as a consultant in North America, Pakistan and the United Kingdom with a number of blue chip clients including Hartford Life, Aegon, American General, Goldman Sachs, ING, Manu Life, Safeco, Merrill Lynch, Met Life, Sun America, Nationwide, Phoenix Life, Sumitomo Mitsui Bank, Sun Life of Canada, Pacific Life, AllState, Fidelity Investments, Transamerica, Skandia, GE Financial Assurance, Lincoln National, Ohio National, AXA Equitable and Washington Mutual Bank.

Jawwad’s core areas of expertise include Asset/Risk Management, Investments, Product Development & the Financial Services Back Office. Jawwad blends a rare combination of risk management, information systems, international standards, business and product development skill set side by side with his actuarial expertise. His regional client list includes First Gulf Bank, Riyad Bank, Dubai Islamic Bank, Noor Islamic Bank, Dubai Bonds, Deutsche Bank, State Bank of Pakistan, National Bank of Pakistan, Muslim Commercial Bank, Crescent Commercial, MyBank, Dawood Islamic Bank, KASB Bank, United Bank Limited, Pak-Kuwait Investment, Saudi Pak Commercial Bank, ABN AMRO, State Life Insurance, Dawood Family Takaful, Asia Health Care, Adamjee Insurance, Shell Pakistan, International General Insurance and others.

Alchemy Technologies (Pvt.) Ltd.

166 Block 7/8, KMCHS, Karachi

Phone: +9221 3 455 64 31 / 52 Fax: +9221 3 455 6447

## 20,000 page views, Eight thousand visitors and 200 dollars in revenues – Corporate Finance Blog, November update

Some of you have been following the Learning Corporate Finance saga on this blog for the last few months. It is a story that started in February of this year when I finally gave in and started uploading content we generate as part of my risk training practice online. Rather than doing video which is awkward, expensive and difficult, I just took my notes, cleaned them up a bit and dumped them online.

From February to June nothing happened.

Well to be fair in mid June 2010, visitors to Learning Corporate Finance blog crossed the monthly visitors to our primary 7 year old Alchemy Technologies website which was a big deal since total traffic across all the domains we owned had just doubled. But the expected few hundred thousand dollars a month in revenues didn’t materialize. In June I almost shut the business down since I had promised myself that if in the next three months the site didn’t start printing dollars while I slept, I would put the hosting charges to good use elsewhere. I had burnt enough money in the two years that had just gone by and in another life earlier that my threshold for new experiments had come all the way down the sub-100 dollar mark.

Then one fine day in June, traffic to the site doubled and kept on the monthly growth up trend all the way till mid October when the site crossed 7,500 visitors and 15,000 pageviews a month mark.

End September we experimented with our online finance course store when a reader asked for a downloadable pdf file and before we knew it we had our first sale before the first week for the online finance store was out. Within the next few weeks it became apparent that the content plus excel spread sheet approach was working. Slowly but still working. While the amount was only 4 dollars and 99 cents, to see a concept finally generate revenues after ten years of tweaking the business model was a personal first. Just like becoming an actuary after failing one exam after another for eleven years.

While we didn’t win at the Asia Pacific ICT Awards in Kula Lumpur, the event allowed me to finally spend some face time with Zafar and Badar Khushnood. Both suggested that it was time we moved the business from a subdomain on oilinsights.net to its own home at http://financetrainingcourse.com. The next three weeks were a painful exercise in discovering everything I didn’t know about redirecting a sub-domain to its new home. Traffic and advertising revenues plunged as the site went up and down all the time but surprisingly still content sales still held up and crossed a hundred dollars.

November then became our first month at the new home. Course inventory now included courses on Value at Risk, Interest Rate Models and Simulation, ICAAP, Asset Liability Management, Counterparty Limits and Treasury Profitability. Our biggest sale came in at 49 dollars and caused a minor celebration at work. While we were still not breaking even, the few sales a week kept spirits up. As expected the redirection slowed traffic down initially but as soon as the site was up Adsense revenues went through the stratosphere. In September just before the APICTA Awards we had crossed 24 dollars a month. October because of the redirection disruption as well as traffic generation efforts was a disappointment at 17 dollars a month. November just blew past all expectations and closed at 51 dollars. Gross content sales crossed 160 dollars. By end November we had started seeing multiple sales a week up from a single sale a week since the online finance course store went up in late September.

And now standing at the end of the first week of December traffic is finally back at the pre-redirection levels. Today we crossed yet another important milestone when Karachi was unseated as the city with the most visits in a week by London and New York and while at a national level domestic visitors fell to the 5th place.

CTR is slowly climbing up as I experiment with the theme, ad placements and keywords and RPM is down to a dollar per 1,000 adsense views.

So here is why you start reading the post in the first place. I am not sure what has worked or not worked but somethings have certainly done better than others. Here is my list of suspects that I think have helped with traffic, adsense revenues as well as better and higher SERP results.