By Inc. BarCharts
This QuickStudy advisor is an overview of the fundamental subject matters taught in Finance classes. as a result of its condensed structure, use it as a writing consultant yet no longer as an alternative for assigned category paintings.
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Extra resources for BarCharts QuickStudy Finance
Therefore the probability of a given number of defaults k, resulting in a portfolio loss of kX, is given by the binomial distribution: n n– k Prob Lp = kX = p k (1 – p) k ( Number of combinations ) Probability that k loans default (3) Probability that other n – k loans do not default The number of combinations represents the number of ways of achieving k defaults. It is given by: n! n k = k! ( n − k )! 01). 4, we show the probability of suffering various losses as given by the binomial distribution.
We also need to estimate the correlation between the FX rates and the spot interest rates. For n different currencies, there will be a total of 2n – 1 rates to be modelled (n interest rates and n – 1 FX rates) and we therefore need to estimate a correlation matrix of dimension 2n – 1. One criticism of the above model is that there is no mean-reversion as there was for interest rates. This means that there is a chance that the FX rates will become unrealistically large or small, especially for long time horizons.
This process determines the evolution of the exposure of the portfolio at hand across time. We need financial models, appropriately calibrated, that will then allow the financial institution to capture the uncertainty of the future exposure, since greater uncertainty will lead to greater risk. Note that generating exposures is inherently different from arbitrage pricing or risk-neutral valuation. For risk management, we are interested in the distribution of the actual exposure in the future. For the technically minded, we point out that the computations are performed under the historical probability and not under the risk-neutral, which is the case for pricing.