Instrument Modeling FAQs

How should I model a Repo?

There are two ways to model a repo:

  1. Model a Repo as a "Bond" position type and use the Settle Date and Settle Amount fields to specify the amount of cash you will be delivering when you receive the bond back. This method provides a two-legged transaction: you maintain the risk of the bond you receive as well as the risk of the cash you deliver.
  2. If the bond is already in your portfolio, then adding a new forward-settling bond as described above would double-count the risk of the bond. Instead, you should set up the deliverable arm to represent the loan you have taken (the cash deliverable). You can use Bond, Cashflow or even Money Market position types to set up this loan. Use RiskManager's USD Repo General Collateral (RMName) curve which makes this method slightly more accurate at measuring risk.

How should I model a Contract For Difference (CFD)?

There are two ways to model a CFD:

  1. Model an equity CFD as an Equity Future. Setting the maturity date to the current business day eliminates the interest rate exposure that is usually present in a future position. Using this approach, you must roll the position forward manually every day before running your VAR analysis. In the case of a bond CFD, use a Bond Future and enter the initial bond price at which you enter the CFD. The current bond price will be calculated using the current yield from market data.
  2. Model an equity CFD as an Equity with an offsetting Cash position. This can be accomplished in one of two ways depending on the direction of the trade. An example: Assume the underlying stock has a value S0 = 100 and the size of the contract is for 1 share.

Financing cash flows are not easily calculated but likely to be negligible over time so they can be ignored.

How should I model an ABS floater?

Model an ABS floater as an "Amortizing Bond" with a Prepayment PSA % or a Pay-Down Schedule. One way to handle ABS floaters is to use a hypothetical original Notional assuming the same PSA Prepayment speed.

All ABS prepayment schedules are difficult to predict.The ABS floater is just an ABS with a floating rate coupon. Alternatively, you could use the "Generic Bond" model with a sinking fund schedule to model an ABS because you can proxy Fixed to Float, Step Coupons etc.

Bloomberg includes a "Bulk Wizard" function. If you enter the ISIN of that ABS in Excel and use the Bulk Wizard -> Analytics -> Projected Cash Flows then it will display all future cashflows and the amortizing schedule. This can be used in the sinking fund schedule and is probably the best we have when it comes to these ABS.

How should I model a defaulted corporate bond?

There are 3 options to model a defaulted corporate bond (listed below in order of preference):

  1. Model it as an Equity, mapped to the underlying equity. When the company is in default, you is a piece of the company's assets. Decide how much cash you expect to recover from this defaulted bond and then map the bond as $X of that equity.
  2. Model it as a Bond using the CreditGrades model. Note, however, the asset remains sensitive to interest rates, even though it may not be.
  3. Model it as "Cash". Note that this approach results in the position having no risk (apart from currency risk, if not denominated in the base currency). it will essentially just be a placemarker for the value of the asset.

How should I model an Equity Digital Option?

Create a very narrow bull spread with a very extreme payoff equal to the digital amount. For instance, if the strike price is 100 and the digital rebate is 600,000, create two instruments: A long Equity Option (call) at 99.99 A short "Equity Option" (call) at 100 The payoff will be 100 - 99.99 = .01 times the notional amount, so put $60 million in the Notional field (60,000,000*.01=600,000).

For a digital put, you would create the analogous bear spread (i.e. a long "Equity Option" (put) at X and a short Equity Option (put) at X + .01). How should I model an option on an FRN? The payoff on a putable bond is max(B,x) at every node, where B is the value of the bond, and x is the strike price. If we subtract the value of a zero-coupon bond (a cashflow) with notional equal to strike price x, then the payoff is: Max(B,x) - x = Max (B-x,0) = value of a call option on a bond Max(B,x) - x = Max (B-x,0) = value of a call option on a bond.

Therefore, an option on an FRN can be modelled as a combination of two instruments: a long, putable FRN plus a short zero-coupon with notional X equals a call option on a bond.

How should I model an inverse floater?

Model an inverse floater as a "Generic Bond" position. A general formula for the coupon rate for an inverse floater is Float Offset - Float Multiple * Reference Rate. Suppose the coupon rate is given by 8% - 3 month LIBOR. In this case, you would set the following parameters in the "Generic Bond" model for the float coupon terms:

How should I model a Treasury Futures contract?

RiskManager does not receive individual futures contracts. It uses bootstrapped constant-maturity points to create curves for each future. You have two choices: Model the future as a Commodity Future built on the FUTURES.CBOT.TY (10 Year U.S. Treasury Note) curve. The disadvantage to approach: no linkage exists between the Commodity Future model and the interest rate: shifting interest rates do not directly affect the value of the underlying commodity (the model is agnostic as to whether the underlying commodity is hog bellies, oil, or interest rates). VaR will be accurate because RiskManger uses the standard deviation of the traded contract. Model the future as a Bond Future. This has the following disadvantage: you must supply the terms (maturity date, coupon, conversion ratio, etc) on the cheapest-to-deliver bond. The advantage to this approach: a hard-and-fast linkage exists between interest rates movements and the pricing model for the Bond Future. This enables you to create stress tests by interest rate movement, and view VaR broken out by RiskType. If all you need to report is VaR, use the first option because it is more accurate and far easier to input. But if you need stress tests, or if you want to run VaR broken out by Risk Type (e.g. interest rate risk vs. equity risk vs. commodity risk etc.) then the second option may be preferable. However, this requires that you provide the underlying bond terms and conditions and the conversion factor, as well as the bond price and the future price.

How should I model a Fed Funds Future?

Model it as an Interest Rate Future. RiskManager doesn't create a Fed Funds discount curve but it does include a term structure for repo general collateral. Alternatively, model it as a Commodity Futures and reference FUTURES.CBOT.FF. This method generates no interest rate risk, however it does produce "commodity risk"; which may be undesirable. How should I model a Quanto Equity Swap? A Quanto Equity Swap is an equity swap in a foreign currency, where the holder does not bear the FX risk. A Quanto is sometimes also called an Equity-Linked Forward. If the Quanto is an exchange-traded future, like the Nikkei 225 swap traded on the Chicago Merc in USD, then you can simply enter it as a Commodity Future. If the Quanto is over-the-counter, you can use an "Equity Swap" position and select the "Ignore FX Risk" option; or by selecting the option in the appropriate field when loading the position file.

How should I model a Mexico 5yr TIIE swap?

The "Fixed/Floating Swap" can be modeled as an Interest Rate Swap in RiskManager. The Coupon Frequency should be lunar-bimonthly. This is because payments occur every 28 days because the floating leg is based on the Mexican Interbank TIIE. This translates into 13 months a year and 65 months for a 5 year swap. The floating leg should reference the Mexican Swap curve with a reference term of 28 days. The fixed leg is based off the MPSW5E swap rate. You should also enter this as lunar-bimonthly. How should I model an FX Digital Option if the payout is in a third currency? Use a regular "FX Digital Option" position but update the Cash Pay Out field on a daily basis. The payout is in terms of a third currency, but the "FX Digital Option" position requires it be specified in terms of the Settlement Currency. To account for the true payoff, the Payout field must be kept up-to-date to reflect the current relationship between the Payoff Currency and the Settle Currency.