CornerstoneFRM® glossary
126 terms, each written to be read cold. The same glossary is free in the app, with search.
Adverse selection
The problem that arises when the party with better information self-selects into a transaction, leaving the counterparty with the worse risks.
Exam angle: Distinct from moral hazard: adverse selection happens before the contract, moral hazard after it.
Agency problem
The conflict that arises when managers act in their own interest rather than that of the owners who employ them.
Exam angle: Also runs between shareholders and bondholders — asset substitution after a leveraged deal is the classic case.
Arbitrage pricing theory
Also: APT
A model deriving expected returns from exposures to multiple systematic factors, assuming no arbitrage rather than a single market portfolio.
Exam angle: More general than CAPM but silent about what the factors are. That silence is both its strength and its practical weakness.
Arithmetic mean
Also: average
The sum of the observations divided by their number.
Exam angle: The right estimate of a single future period’s return. For growth already achieved over several periods, the geometric mean is the honest number.
Backtesting
Comparing realised losses with the VaR forecasts that preceded them, to check that breaches occur about as often as the confidence level implies.
Exam angle: Basel’s traffic light approach escalates the capital multiplier as exceptions accumulate. Too few breaches signals an over-conservative model, not a good one.
Bank run
A self-fulfilling withdrawal of funding from an institution, where the rational individual choice to withdraw first makes failure certain collectively.
Exam angle: Modern runs happen through wholesale funding and uninsured deposits, at digital speed. Solvency does not prevent one.
Basel Accords
The international framework for bank capital and liquidity regulation, issued by the Basel Committee on Banking Supervision.
Exam angle: Basel I set risk-weighted capital, Basel II added three pillars and internal models, Basel III added leverage and liquidity ratios after 2008.
Basis risk
The risk that a hedge and the exposure it hedges do not move together, leaving a residual.
Exam angle: Arises from mismatched underlying, maturity or location. A hedge is a swap of price risk for basis risk, not an elimination of risk.
Beta
The sensitivity of an asset’s return to the market’s return — its share of systematic risk.
β = Cov(R_i, R_m) / Var(R_m)
Exam angle: A beta above one amplifies market moves in both directions. Estimated betas are unstable and are often adjusted toward one.
Black–Scholes–Merton model
Also: BSM, Black-Scholes
A closed-form model for European option prices, assuming lognormal prices, constant volatility and continuous frictionless trading.
Exam angle: Its assumptions are known to be wrong — constant volatility most obviously, which is why the implied volatility smile exists at all.
Bootstrap
Resampling the observed data with replacement to estimate the sampling distribution of a statistic, without assuming a parametric form.
Exam angle: Distinct from bootstrapping a spot curve in fixed income, which is a different operation entirely under the same word.
Bootstrapping (yield curve)
Deriving spot rates sequentially from the prices of coupon bonds, using each solved rate to strip the next.
Exam angle: A different operation from the statistical bootstrap, which resamples data. Same word, unrelated technique.
Business risk
The uncertainty in operating income arising from the nature of the business itself, before any financing decision.
Exam angle: Financial risk is what leverage adds on top. Keeping the two separate is the point of the distinction.
Call option
The right, without the obligation, to buy an asset at the strike price by expiry.
Exam angle: The buyer’s loss is capped at the premium; the naked writer’s loss is unbounded. That asymmetry drives most option exam questions.
Capital asset pricing model
Also: CAPM
A model stating that an asset’s expected return equals the risk-free rate plus beta times the equity risk premium.
E(R) = R_f + β × [E(R_m) − R_f]
Exam angle: Prices systematic risk only. Its empirical record is poor, which is why multifactor models exist — but it remains the exam’s default.
Carry trade
Borrowing in a low interest rate currency to invest in a high interest rate one, profiting if the exchange rate does not move against you.
Exam angle: Returns are negatively skewed: long stretches of small gains punctuated by sharp unwinds. A textbook case of a strategy whose Sharpe ratio flatters it.
Central counterparty
Also: CCP, clearing house
An entity that interposes itself between the two sides of a trade, becoming buyer to the seller and seller to the buyer.
Exam angle: Concentrates counterparty risk rather than removing it. A CCP is itself systemically important, which is why its default waterfall and margin model matter.
Central limit theorem
Also: CLT
For a large enough sample, the distribution of the sample mean approaches normal regardless of the shape of the underlying population.
Exam angle: Thirty observations is the conventional threshold. It justifies using normal-based confidence intervals on means — not on individual observations.
Coefficient of determination
Also: R-squared, R2
The fraction of the dependent variable’s variation explained by the regression.
Exam angle: Never falls when a variable is added, however useless that variable is. Adjusted R² penalises extra regressors and is the honest comparison between models of different size.
Coherent risk measure
A risk measure satisfying monotonicity, subadditivity, positive homogeneity and translation invariance.
Exam angle: Subadditivity is the one VaR fails — and it is the property that says diversification should never increase measured risk.
Collateral
Assets pledged to secure an exposure, reducing loss if the counterparty defaults.
Exam angle: Converts credit risk into liquidity and operational risk — the obligation to post more collateral at short notice is itself a failure mode.
Confidence interval
A range that will contain the true parameter in a stated proportion of repeated samples.
Exam angle: It is a statement about the procedure, not about this one interval. “95% probability the mean is in this range” is the classic misreading.
Contango and backwardation
Contango is a futures price above the spot price; backwardation is a futures price below it.
Exam angle: A long roll in contango loses as the contract converges to spot. This is why commodity index returns diverge so far from spot commodity prices.
Continuous compounding
Compounding over infinitely small intervals. The limit of periodic compounding as the number of periods per year goes to infinity.
FV = PV × e^(r × t)
Exam angle: The default convention in derivatives pricing and in most FRM formulas, which is why the same position can look differently priced in two parts of the curriculum.
Convexity
The curvature of the price–yield relationship — how duration itself changes as yields move.
Exam angle: Positive convexity is good for the holder: prices rise more than duration predicts and fall less. Callable bonds and MBS exhibit negative convexity as rates fall.
Correlation
Also: correlation coefficient
Covariance divided by the product of the two standard deviations, giving a unit-free number between −1 and +1.
ρ = Cov(X, Y) / (σₓ × σᵧ)
Exam angle: Measures linear association only. A perfect non-linear relationship can show near-zero correlation, and correlation tends to rise sharply in a crisis — exactly when diversification was being relied on.
Counterparty credit risk
The risk that the other side of a derivative defaults before settling, when the contract has positive value to you.
Exam angle: Two-sided and stochastic, unlike a loan: exposure moves with the market, so it must be modelled over time rather than measured once.
Covariance
A measure of how two variables move together. Positive means they tend to move the same way; its size depends on the units of both variables.
Exam angle: Unbounded and therefore hard to interpret on its own. Correlation is covariance scaled to [−1, 1], which is why correlation is what gets quoted.
Credit default swap
Also: CDS
A contract in which the buyer pays a periodic premium and receives compensation if a specified borrower suffers a credit event.
Exam angle: Buying protection is economically like shorting the credit. The spread is a market-implied view of default probability and recovery together, not of default alone.
Credit spread
The extra yield a borrower pays over a risk-free benchmark of the same maturity, compensating for default and liquidity risk.
Exam angle: Widening spreads hurt even when the issuer never defaults, and spread duration measures that exposure separately from rate duration.
Credit valuation adjustment
Also: CVA
The reduction in a derivative’s value to reflect the possibility that the counterparty defaults.
Exam angle: DVA is the mirror image for your own default risk, and has the uncomfortable property that your deteriorating credit produces a profit.
Data mining
Also: data snooping
Searching a dataset repeatedly until a relationship appears, then presenting it as though it had been hypothesised in advance.
Exam angle: Test on out-of-sample data. A relationship with no economic rationale that only shows up after many passes is the definition of the problem.
Delta
The change in an option’s value for a small change in the underlying price.
Exam angle: Ranges 0 to 1 for a call and −1 to 0 for a put. Roughly the hedge ratio, and loosely read as the risk-neutral probability of finishing in the money.
Delta hedging
Offsetting an option position with the underlying so the combined position is insensitive to small price moves.
Exam angle: Only holds locally and only for an instant. Gamma is precisely the reason it has to be rebalanced, and rebalancing is what costs money.
Derivative
A contract whose value depends on the price of something else — an asset, a rate, an index or an event.
Diversification
Combining imperfectly correlated assets so that portfolio risk falls below the weighted average of the individual risks.
Exam angle: The benefit comes from correlation below one, not from the number of holdings. Twenty correlated positions diversify less than five uncorrelated ones.
Duration
The sensitivity of a bond’s price to a change in yield, and equivalently the weighted average time to receiving its cash flows.
Exam angle: Macaulay duration is in years; modified duration is the percentage price change per one percent yield move. Effective duration is the one to use when cash flows are not fixed.
DV01
Also: PV01, basis point value, BPV
The change in a position’s value for a one basis point change in yield, expressed in currency.
Exam angle: The practitioner’s hedging unit: hedge ratios are DV01 of the exposure divided by DV01 of the hedge. FRM uses it far more than duration.
Economic capital
The capital a firm judges it needs to absorb unexpected losses at a chosen confidence level, computed internally.
Exam angle: Distinct from regulatory capital, which is prescribed. Where the two differ materially, that difference is itself a signal.
Effective duration
Duration measured by repricing the bond under small parallel shifts in the benchmark curve, so that changes in cash flows are captured.
Exam angle: The only valid duration for callable, putable and mortgage-backed bonds, where the cash flows themselves depend on rates.
Expected loss
Also: EL
The average credit loss anticipated over a horizon.
EL = PD × LGD × EAD
Exam angle: Covered by provisions and priced into the spread. Capital exists for unexpected loss — the variation around this mean — not for this.
Expected shortfall
Also: ES, conditional VaR, CVaR, expected tail loss
The average loss in the cases where the VaR threshold is breached — the expected size of a bad day, given that it is a bad day.
Exam angle: Coherent, unlike VaR, and therefore subadditive. Basel’s market risk framework moved from 99% VaR to 97.5% expected shortfall for exactly this reason.
Exposure at default
Also: EAD
The amount outstanding when default occurs.
Exam angle: Higher than current drawings for revolving facilities: distressed borrowers draw their lines before they fail.
Factor investing
Also: smart beta
Building portfolios around systematic return drivers — value, size, momentum, quality, low volatility — rather than around individual security selection.
Exam angle: Factor premia are long-horizon and endure long stretches of underperformance. A factor that never hurts is usually a factor that has been fitted.
Forward contract
A private agreement to buy or sell an asset at a set price on a future date. Customisable, and settled once at expiry.
Exam angle: Carries counterparty risk that builds over the life of the contract, because nothing is exchanged until the end.
Forward rate
The interest rate agreed today for borrowing or lending over a future period, implied by today’s spot curve.
Exam angle: Implied forwards are break-even rates, not forecasts. A curve that implies rising rates is telling you what must happen for two strategies to tie, not what the market predicts.
Funding liquidity risk
The risk of being unable to meet obligations as they fall due without incurring unacceptable losses.
Exam angle: Distinct from market liquidity risk, and the two amplify each other: forced sales move prices, which triggers more margin calls.
Futures contract
A standardised, exchange-traded forward, marked to market daily through a clearing house.
Exam angle: Daily settlement is the whole difference: it strips out counterparty risk and it makes the cash flow timing different from an otherwise identical forward.
Gamma
The rate at which delta changes as the underlying moves.
Exam angle: Highest at the money and near expiry. High gamma means a delta hedge goes stale quickly and must be rebalanced more often.
Geometric mean
The constant rate that would produce the observed compound growth over the whole period.
Geometric mean = [(1 + r₁)(1 + r₂)…(1 + rₙ)]^(1/n) − 1
Exam angle: Always ≤ the arithmetic mean, and strictly less whenever returns vary. The gap widens with volatility — which is why volatile strategies advertise the arithmetic figure.
Hedge fund replication
Reproducing hedge fund returns using liquid instruments and factor exposures, rather than by paying for the funds themselves.
Exam angle: Works to the extent returns come from factors rather than skill. The residual is what the fee was supposedly buying.
Heteroskedasticity
Regression errors whose variance is not constant across observations.
Exam angle: Coefficients stay unbiased; the standard errors do not. So t-statistics are wrong and inference is unreliable — the fix is robust standard errors, not a different slope.
Historical simulation
Estimating VaR by revaluing the current portfolio using actual historical changes in risk factors.
Exam angle: Assumes no distribution and captures real fat tails, but can only produce losses that have already happened. A quiet lookback window understates risk.
Illiquidity premium
The extra expected return demanded for holding an asset that cannot be sold quickly at a fair price.
Exam angle: Reported private-market volatility is understated because valuations are smoothed and infrequent, which flatters risk-adjusted measures.
Implied volatility
The volatility that, put into an option pricing model, returns the option’s observed market price.
Exam angle: A price quoted in volatility units rather than a forecast. Plotting it against strike gives the smile or skew.
Inflation
A sustained rise in the general price level, reducing the purchasing power of money.
Exam angle: Distinguish demand-pull from cost-push: the policy response differs, and a central bank tightening into a supply shock is a recognised error.
Initial and variation margin
Initial margin is the good-faith deposit required to open a futures position; variation margin is the daily cash transfer that settles the day’s gain or loss.
Exam angle: Falling below the maintenance margin triggers a call back to the initial level, not to the maintenance level.
Interest coverage ratio
EBIT divided by interest expense — how many times earnings cover the interest bill.
Exam angle: A primary input to credit ratings and to covenant tests.
Interest rate parity
Also: covered interest rate parity, IRP
The condition that the forward exchange rate differs from the spot rate by exactly the interest rate differential, so hedged returns are equal across currencies.
Exam angle: Covered parity is an arbitrage relationship and holds tightly. Uncovered parity is an expectation and does not — that gap is what the carry trade harvests.
Key rate duration
Also: partial duration
Sensitivity to a change in one segment of the yield curve, holding the other segments fixed.
Exam angle: Needed because real curves twist and steepen. A portfolio can be duration-neutral overall and still lose heavily on a curve reshaping.
Kurtosis
Also: excess kurtosis, fat tails
The weight of a distribution’s tails. Excess kurtosis is kurtosis minus 3, so a normal distribution has excess kurtosis of zero.
Exam angle: Leptokurtic — positive excess kurtosis — means extreme outcomes are likelier than normal. Financial returns are reliably leptokurtic, which is why normal-based VaR understates the tail.
Leverage ratio
Capital divided by total exposure, without risk weighting — a backstop to the risk-weighted requirement.
Exam angle: Exists because risk weights can be gamed and because a model that says an exposure is riskless has been wrong before.
Linear regression
Also: ordinary least squares, OLS
Fitting a straight line through data by minimising the sum of squared residuals, to explain a dependent variable by one or more independent variables.
Liquidity coverage ratio
Also: LCR
The requirement that a bank holds enough high-quality liquid assets to survive a thirty-day stress scenario.
Exam angle: The NSFR is its structural companion, requiring stable funding over a one-year horizon.
Liquidity-adjusted VaR
VaR extended to include the cost of closing the position — the bid–ask spread and the market impact of exiting at size.
Exam angle: The gap between VaR and its liquidity-adjusted version widens sharply for concentrated or illiquid books, which is exactly when it matters.
Lock-up period
The period during which an investor may not redeem from a fund.
Exam angle: Gates and side pockets do a similar job in a crisis, and all three are liquidity risk rather than fine print.
Lognormal distribution
The distribution of a variable whose natural logarithm is normally distributed. Bounded below by zero and right-skewed.
Exam angle: Used for asset prices because a price cannot go negative, while continuously compounded returns can be modelled as normal. That pairing is the basis of Black–Scholes–Merton.
Loss given default
Also: LGD
The proportion of exposure lost when a borrower defaults, after recoveries.
LGD = 1 − recovery rate
Exam angle: Correlated with PD: recoveries are worst in the downturns when defaults cluster, so multiplying independent averages understates loss.
Margin (equity trading)
Borrowing from a broker to buy securities, using the securities as collateral.
Exam angle: A margin call comes when equity falls below the maintenance margin. Leverage magnifies both the return and the speed of the call.
Marginal VaR
The change in portfolio VaR from a small increase in one position — the position’s contribution to total risk at the margin.
Exam angle: Component VaR sums to total VaR and is what risk budgeting allocates. Standalone VaR does not sum, and using it overstates the whole.
Market impact
The adverse price move caused by the act of trading itself.
Exam angle: Rises with order size relative to normal volume. Trading more slowly reduces impact and increases the risk of the price moving away meanwhile.
Market liquidity risk
The risk that a position cannot be sold quickly without moving the price against you.
Exam angle: Measured through bid–ask spread, market depth and resilience. Liquidity-adjusted VaR adds the cost of exiting to the price risk.
Model risk
The risk of loss from using a model that is wrong, or right but used outside the conditions it was built for.
Exam angle: Independent validation and clear statements of limitation are the controls. LTCM is the standard case study.
Modified duration
The approximate percentage change in a bond’s price for a one percentage point change in yield.
Modified duration = Macaulay duration / (1 + y/m)
Exam angle: A linear approximation. It always overstates the loss from a rise in yields and understates the gain from a fall, because the true relationship is convex.
Monetary policy
A central bank’s management of money supply and interest rates to pursue price stability and, in some mandates, employment.
Exam angle: Works with long and variable lags, which is why policy is set on forecasts rather than on today’s data.
Monte Carlo simulation
Estimating a distribution of outcomes by repeatedly drawing random inputs from assumed distributions and recomputing the result.
Exam angle: The output is only as good as the assumed input distributions and correlations. It generates precision, not accuracy.
Moral hazard
The incentive to take more risk once someone else bears the consequences.
Exam angle: Central to both economics and risk management: deposit insurance, bailouts and bonus structures are the standard examples.
Multicollinearity
Two or more independent variables in a regression that are highly correlated.
Exam angle: The giveaway is a high R² with individually insignificant t-statistics. The regression as a whole explains plenty; it cannot attribute the explanation.
Multifactor model
A model explaining returns by exposure to several systematic factors rather than to the market alone.
Exam angle: Fama–French adds size and value to the market factor; Carhart adds momentum. Each factor is a claim that a risk is priced, and each is contested.
Netting
Offsetting positive and negative exposures with the same counterparty so that only the net amount is at risk.
Exam angle: Only reduces exposure where the netting agreement is legally enforceable in the counterparty’s jurisdiction. That enforceability is the whole point.
Normal distribution
Also: Gaussian distribution, bell curve
A symmetric, bell-shaped distribution fully described by its mean and variance.
Exam angle: Approximately 68% of outcomes fall within one standard deviation, 95% within two and 99% within 2.58. Those three numbers appear constantly in VaR and confidence-interval questions.
Notional principal
The reference amount used to compute a derivative’s payments, which is usually never exchanged.
Exam angle: Notional wildly overstates economic exposure. Comparing a derivatives book’s notional with a balance sheet is a category error.
Null hypothesis
Also: H0
The statement a test assumes true until the data give sufficient reason to reject it. Always the one containing equality.
Exam angle: Failing to reject is not the same as proving. The null survives for want of evidence, not because it was shown to be true.
Operational risk
The risk of loss from failed internal processes, people and systems, or from external events. Includes legal risk; excludes strategic and reputational risk.
Exam angle: That exclusion is the Basel definition and is examined directly.
Option-adjusted spread
Also: OAS
The spread over the benchmark curve once the value of any embedded option has been stripped out, making bonds with and without options comparable.
Exam angle: Model-dependent: it moves with the volatility assumption. Two desks can compute different OAS on the same bond and both be right.
p-value
The smallest significance level at which the null could be rejected — the probability of a result at least this extreme if the null were true.
Exam angle: Not the probability the null is true. Reject when p < α.
Parametric VaR
Also: variance-covariance VaR, delta-normal VaR
Estimating VaR from an assumed distribution, usually normal, using the portfolio’s volatility and correlations.
Exam angle: Fast and analytic, but wrong twice over for options books: returns are not normal, and a linear delta approximation ignores gamma.
Performance attribution
Decomposing a portfolio’s return relative to its benchmark into the decisions that produced it — typically allocation, selection and interaction.
Exam angle: Brinson attribution is the standard framework. Returns-based attribution infers exposures from return series; holdings-based uses the actual positions.
Prepayment risk
The risk that borrowers repay mortgage principal early, most often when rates fall and refinancing becomes attractive.
Exam angle: The cause of negative convexity in MBS: exactly when a normal bond would rally, the cash flows come back to be reinvested at the new lower rate.
Private credit
Also: direct lending
Lending to companies outside the public bond and syndicated loan markets, usually at floating rates with bespoke covenants.
Exam angle: Return comes from illiquidity and complexity as much as from credit risk. Marks are infrequent, so reported volatility understates the real thing.
Probability of default
Also: PD
The likelihood that a borrower fails to meet its obligations over a given horizon.
Exam angle: Through-the-cycle PDs are stable; point-in-time PDs move with conditions and make capital procyclical.
Procyclicality
The tendency of risk measures and capital requirements to loosen in booms and tighten in busts, amplifying the cycle.
Exam angle: Countercyclical capital buffers exist to offset it. Mark-to-market accounting and point-in-time PDs both contribute.
Put option
The right, without the obligation, to sell an asset at the strike price by expiry.
Put–call parity
The no-arbitrage relationship linking a European call, a European put, the underlying and a risk-free bond of the same strike and expiry.
c + PV(X) = p + S₀
Exam angle: Rearranging it constructs synthetic positions, and a violation is a textbook arbitrage. European options only.
RAROC
Also: risk-adjusted return on capital
Risk-adjusted return divided by economic capital, used to compare business lines on a like-for-like basis and to price risk.
Return smoothing
Understated volatility caused by infrequent or appraisal-based valuations rather than by genuinely stable prices.
Exam angle: Inflates Sharpe ratios and depresses measured correlation with public markets. Unsmoothing the series usually removes most of the apparent diversification benefit.
Rho
The sensitivity of an option’s value to a change in the risk-free rate.
Risk appetite
The amount and type of risk a firm is willing to take in pursuit of its objectives, set by the board and cascaded into limits.
Exam angle: Appetite is the choice; capacity is the maximum survivable. Confusing the two is a governance failure, not a semantic one.
Risk budgeting
Allocating a portfolio’s total risk across strategies or managers, rather than allocating its capital.
Exam angle: Two managers with equal capital rarely consume equal risk. Budgeting by capital and reviewing by risk is how concentration arrives unnoticed.
Rogue trading
Unauthorised positions concealed by an employee, typically enabled by weak separation between the front and back office.
Exam angle: Barings, Société Générale and UBS all trace to someone who had previously worked in settlement and knew which controls would not catch them.
Securitisation
Pooling loans and issuing securities backed by their cash flows, usually through a bankruptcy-remote special purpose vehicle.
Serial correlation
Also: autocorrelation
Regression errors correlated with their own past values.
Exam angle: Common in time series. Positive serial correlation deflates standard errors, which inflates t-statistics and manufactures significance that is not there.
Sharpe ratio
Excess return over the risk-free rate, per unit of total risk.
Sharpe = (R_p − R_f) / σ_p
Exam angle: Uses total risk, so it judges a portfolio held on its own. It flatters strategies with negatively skewed returns, because standard deviation does not see the tail.
Short selling
Selling borrowed securities in the expectation of buying them back cheaper.
Exam angle: Loss is theoretically unlimited, and the borrow can be recalled at the worst moment. That asymmetry is what makes a short squeeze possible.
Skewness
The asymmetry of a distribution. Positive skew has a long right tail; negative skew has a long left tail.
Exam angle: Returns on short-volatility and credit strategies are negatively skewed: many small gains, occasional large losses. Mean and standard deviation alone hide that.
Spot rate
Also: zero rate, zero-coupon rate
The yield on a single cash flow received at one future date, with no intervening coupons.
Exam angle: Valuing a bond off the spot curve rather than a single YTM is what removes the reinvestment assumption.
Standard deviation
Also: volatility, vol, sigma
The square root of variance, in the same units as the data. In finance it is the usual proxy for total risk.
Exam angle: Penalises upside and downside equally, which is its main criticism and the motivation for downside measures like semi-deviation and VaR.
Standard error
The standard deviation of a sample statistic, usually of the sample mean.
SE = σ / √n
Exam angle: Falls with the square root of sample size, so quartering the standard error needs sixteen times the data.
Stress testing
Revaluing a portfolio under severe but plausible scenarios, rather than under the distribution of ordinary days.
Exam angle: Complements VaR instead of competing with it: VaR describes the usual, stress testing the unusual. Reverse stress testing starts from the failure and asks what would cause it.
Style drift
A manager gradually moving away from the strategy the mandate describes.
Exam angle: Often invisible in returns until the market turns, because drifting toward whatever is working flatters performance while it lasts.
Survivorship bias
Distortion caused by studying only the entities that lasted long enough to appear in the sample.
Exam angle: Inflates measured fund returns, because closed and merged funds drop out of the index. A staple of both ethics and quant questions.
Swap
An agreement to exchange one stream of cash flows for another over time.
Exam angle: A plain vanilla interest rate swap is a series of forward rate agreements, and can also be read as being long one bond and short another.
Systematic risk
Also: market risk, non-diversifiable risk
Risk affecting the whole market, which cannot be diversified away.
Exam angle: The only risk investors are compensated for. That claim is the foundation of CAPM.
Systemic risk
The risk that the failure of one institution or market propagates through the system as a whole.
Exam angle: Interconnectedness and common exposures drive it. Each firm managing its own risk prudently does not make the system safe — it can synchronise behaviour and make it less so.
Theta
The change in an option’s value from the passage of one day, all else equal.
Exam angle: Negative for a long option: time decay works against the buyer and accelerates into expiry.
Tranche
One slice of a securitisation with a defined priority of payment, so that losses hit the junior slices before the senior ones.
Exam angle: Subordination is the credit enhancement. Correlation between the underlying loans is what determines whether the senior tranche is really safe.
Type I error
Also: false positive, alpha error
Rejecting a true null hypothesis. Its probability is the significance level, α.
Exam angle: Type I and Type II trade off against each other at a fixed sample size. Only more data improves both.
Type II error
Also: false negative, beta error
Failing to reject a false null hypothesis. One minus its probability is the power of the test.
Unexpected loss
Also: UL
The volatility of credit losses around the expected level, which economic capital is held to absorb.
Unsystematic risk
Also: idiosyncratic risk, specific risk
Risk specific to one company or sector, which diversification can remove.
Exam angle: Not rewarded, because it can be eliminated for free. Bearing it is a choice, not a risk premium.
Value at Risk
Also: VaR
The loss that will not be exceeded over a stated horizon with a stated confidence — for example, a 1-day 99% VaR of £1m means losses should exceed £1m on about one day in a hundred.
Exam angle: Says nothing about how bad the breach is when it happens, and is not subadditive, so the VaR of a combined book can exceed the sum of its parts. Both failings motivate expected shortfall.
Variance
The average squared deviation from the mean — the standard measure of dispersion.
Exam angle: A sample variance divides by n − 1, not n. Dividing by n gives a biased estimate, and the correction is examined directly.
Vega
The change in an option’s value for a one point change in implied volatility.
Exam angle: Always positive for a plain long option, call or put. Long options are long volatility.
Wrong-way risk
Exposure to a counterparty that rises precisely as that counterparty’s creditworthiness falls.
Exam angle: Buying protection on a bank from that same bank is the canonical example. Right-way risk is the benign opposite.
Yield curve
The relationship between yield and maturity for bonds of the same credit quality.
Exam angle: Inversion — short rates above long — has preceded most recent recessions and is treated as a leading indicator rather than a cause.
Yield to maturity
Also: YTM, redemption yield
The single discount rate that equates a bond’s price to the present value of its cash flows.
Exam angle: Assumes every coupon is reinvested at the YTM and the bond is held to maturity. Both assumptions usually fail, which is why realised return differs from YTM.
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