FOREWORD

It is our pleasure to present “Risk-O-Pedia” a Glossary of risk management terminologies.

Deregulation and globalization of financial services along with increasing sophistication

of technology are making banking operations more diverse and complex. Accompanying
these trends, it has become more important than ever for banks to appropriately manage
the various types of risks they confront such as Credit, Market and Operationalrisks.

The foundation of Risk Management begins with an understanding of its terminologies,

which necessitates a high degree of time commitment and specialization. Given the
increasing level of competitive pressures today’s bankers work under, it was time the
complicated language of RISK was de-mystified and presented in a comprehensive
manner.

We at CRISIL have constantly endeavored to deliver timely solutions to our esteemed

clientele and also strived to serve the banking community. For the first time, we have put
together analphabetical compilation of contemporary and relevant terminologies that are
related to the risk management arena. We have strived to keep the language as simple
as possible in order to reach a vast majority of members among the banking community.

We hope “Risk-O-Pedia”from CRISIL will provide a better understanding ofrisk

management related terminologies and we believe “Risk–O-Pedia”will help you in giving
simple and meaningful understandings.

I sincerely wish to thank my team members, viz., Chandru Badrinarayanan,Krishna Kumar

Variar, Shariful Alam, Bhavna Pursnani, Dhawal Madlani and Manisha Sarkar who strived
to make “Risk-O-Pedia” a reality.

Happy referencing,

D Ravishankar
Director
CRISIL Investment and Risk Management Services
(dravishankar@crisil.com)
 GLOSSARY
1. Absolute Risk _________________________________________________ 1
2. Accounting Risk _______________________________________________ 1
3. Algoritham ____________________________________________________ 1
4. Alpha ________________________________________________________ 1
5. Arch (AutoRegressive Conditional Heteroscedasticity) _______________ 1
6. Asset-Liability Management _____________________________________ 2
7. Asymmetric Correlation _________________________________________ 2
8. Audit Risk ____________________________________________________ 2
9. Auto-correlation _______________________________________________ 2
10. Back testing __________________________________________________ 2
11. Bank Capital Adequacy Requirements _____________________________ 3
12. Basis Point ___________________________________________________ 3
13. Basis Risk ____________________________________________________ 3
14. Bayes’ Theorem _______________________________________________ 3
15. Behavioural Finance____________________________________________ 3
16. Bell Curve ____________________________________________________ 3
17. Beta _________________________________________________________ 3
18. Black-Scholes Model ___________________________________________ 4
19. Bootstrapping _________________________________________________ 4
20. Capital Adequacy ______________________________________________ 4
21. Capital Asset Pricing Model (CAPM) ______________________________ 5
22. Chaos Theory _________________________________________________ 5
23. Confidence Interval ____________________________________________ 5
24. Convexity (Amex def) ___________________________________________ 6
25. Correlation ____________________________________________________ 6
26. Cost of Carry __________________________________________________ 6
27. Counterparty Risk ______________________________________________ 6
28. Country Risk __________________________________________________ 7
29. Co-variance ___________________________________________________ 7
30. Credit Derivative _______________________________________________ 7
31. Credit Risk ____________________________________________________ 7
32. Credit Scoring _________________________________________________ 7
33. Credit Swap ___________________________________________________ 7
34. Cross-currency settlement risk___________________________________ 7
35. Current Yield __________________________________________________ 8
36. Curve Risk ____________________________________________________ 8
37. Daily Earnings at Risk (DEaR) ____________________________________ 8
38. Daylight Risk Exposure _________________________________________ 8
39. Decision Tree _________________________________________________ 8
40. Default Correlation _____________________________________________ 8
41. Default Probability _____________________________________________ 8
42. Delta _________________________________________________________ 8
43. Derivative _____________________________________________________ 9
44. Dirty Price ____________________________________________________ 9
45. Distribution ___________________________________________________ 9
46. Duration ______________________________________________________ 9
47. Duration gap __________________________________________________ 9
48. Duration Risk Management ______________________________________ 9
49. Economic Capital ______________________________________________ 9
50. Elasticity _____________________________________________________ 9
51. Embedded Option ______________________________________________ 9
52. Enterprise- wide Risk Management (ERM) ________________________ 10
53. Ex-ante ______________________________________________________ 10
54. Ex-post ______________________________________________________ 10
55. Extreme Value Theory (Amex def) _______________________________ 10
56. Factor Model _________________________________________________ 10
57. Foreign exchange risk _________________________________________ 10
58. Forward Rate Agreement (FRA) _________________________________ 10
59. Forward Yield Curve ___________________________________________ 10
60. Frequency Distribution ________________________________________ 11
61. Funding Risk _________________________________________________ 11
62. Fuzzy Logic __________________________________________________ 11
63. Gap Analysis _________________________________________________ 11
64. Geometric Average ____________________________________________ 11
65. Geometric Distribution _________________________________________ 11
66. Hedge _______________________________________________________ 11
67. Herstatt Risk _________________________________________________ 11
68. Histogram ___________________________________________________ 11
69. Historical volatility ____________________________________________ 12
70. Hurdle Rate __________________________________________________ 12
71. Historical Simulation __________________________________________ 12
72. Historical Volatility ____________________________________________ 12
73. Immunization of a portfolio _____________________________________ 12
74. Implied Zero Coupon Swap Curve _______________________________ 12
75. Interest rate swap _____________________________________________ 12
76. Interest rate risk ______________________________________________ 13
77. Internal Rate Return (IRR) ______________________________________ 13
78. Interpolation _________________________________________________ 13
79. Implied forward curve _________________________________________ 13
80. Implied volatility ______________________________________________ 13
81. Kurtosis _____________________________________________________ 13
82. Lambda _____________________________________________________ 13
83. Least Squares Regression Line _________________________________ 14
84. Legal Risk ___________________________________________________ 14
85. Linear Interpolation ___________________________________________ 14
86. Linear Programming __________________________________________ 14
87. Liquidity Risk ________________________________________________ 14
88. Lognormal distribution ________________________________________ 15
89. Mark to Market _______________________________________________ 15
90. Market Risk __________________________________________________ 15
91. Maturity Gap _________________________________________________ 15
92. Mean ________________________________________________________ 15
93. Median ______________________________________________________ 16
94. Modified Duration _____________________________________________ 16
95. Monte Carlo Simulation ________________________________________ 16
96. Multiple Regression ___________________________________________ 16
97. Natural Logarithm _____________________________________________ 16
98. Net present value _____________________________________________ 16
99. Normal Density Function _______________________________________ 17
100. Normal Distribution ___________________________________________ 17
101. Null Hypothesis _______________________________________________ 17
102. Obligor ______________________________________________________ 17
103. Off Balance sheet instrument ___________________________________ 17
104. One factor model _____________________________________________ 17
105. Operational Risk ______________________________________________ 17
106. Option ______________________________________________________ 18
107. Parametric ___________________________________________________ 18
108. Price Risk ___________________________________________________ 18
109. Par yield curve _______________________________________________ 18
110. Prepayment Risk ______________________________________________ 18
111. R2 – Coefficient of Determination ________________________________ 18
112. Random Numbers _____________________________________________ 18
113. Random Variable ______________________________________________ 19
114. RAROC (Risk Adjusted Return on Capital) ________________________ 19
115. RORAC (Return on Risk Adjusted Capital) ________________________ 19
116. Risk averse __________________________________________________ 19
117. Reinvestment Risk ____________________________________________ 19
118. Regulatory Arbitrage __________________________________________ 19
119. Regulatory Capital ____________________________________________ 19
120. Replacement Cost ____________________________________________ 19
121. Risk Management _____________________________________________ 19
122. Scenario Analysis _____________________________________________ 20
123. Settlement Risk _______________________________________________ 20
124. Sigma _______________________________________________________ 20
125. Skew ________________________________________________________ 20
126. Specific Risk _________________________________________________ 20
127. Standard Deviation ____________________________________________ 20
128. Stochastic Process ____________________________________________ 21
129. Stress Testing ________________________________________________ 21
130. Swap _______________________________________________________ 21
131. Synthetic Bond _______________________________________________ 21
132. Systemic Risk ________________________________________________ 21
133. Translation Risk ______________________________________________ 21
134. Two Factor Model _____________________________________________ 21
135. Unexpected Loss _____________________________________________ 21
136. Utility Function _______________________________________________ 21
137. Utility Theory _________________________________________________ 22
138. Value at Risk _________________________________________________ 22
139. Variance _____________________________________________________ 22
140. Volatility _____________________________________________________ 22
141. Yield to maturity (IRR) _________________________________________ 22
142. Yield Curve __________________________________________________ 23
143. Zero Coupon Bond ____________________________________________ 23
144. Zero Coupon Yield Curve _______________________________________ 21
1. Absolute Risk
a) The volatility of an asset’s absolute return as opposed to its return relative
to a benchmark.
b) The loss in value of an asset when the yield curve shifts 100 basis points
or 1% in a parallel manner.

2. Accounting Risk
Potential loss arising from decisions taken due to misreading or misinterpreting
accounting or financial statements

3. Algorithm
A formula or set of rules used to solve a problem. The algorithm usually simplifies
a real world relationship. For e.g., dividend discount models are common
algorithms for the valuation of common stock.

4. Alpha
Each security or asset is expected to yield a certain return in tune with its risk.
The return (higher or lower) given by a security from this expectation is
measured as Alpha.

5. ARCH (AutoRegressive Conditional Heteroscedasticity)

Researchers engaged in forecasting financial time series such as stock prices,
inflation rates, foreign exchange rates, etc. have observed that their ability to
forecast such variables varies considerably from one time period to another.
This variability could be very well due to volatility in financial markets, sensitive
as they are to rumours, political upheaval, changes in government monetary
and fiscal policies. This would suggest that the variance of forecast errors is
not constant but varies from period to period, that is, there is some kind of
autocorrelation in the variance, which can be seen in the behaviour of the
(regression) disturbances (error terms in the regression equation). Also
heteroscedasticity is a common problem at the time of modelling with these
types of financial time series data. To capture this correlation and handle the
heteroscedasticity problem, the ARCH model was developed.

Risk-O-Pedia from CRISIL 8

The ordinary regression model is:

Y = X ′β + ε Here dependent variable is time period independent

Here dependent variable is time period independent
where the basic assumption of this model is ε ~ N (0, σ 2 ) . Note that here σ
is constant (time invariant).
Obviously this assumption is not realistic for financial time series data. In
financial time series data generally varies with time; it depends upon few
past error terms, thus more realistic model is

Yt = X t′β + ε t Here dependent variable is time period dependent

Note: Here σ is not

q constant; its depend
ε t ~ N (0,σ t 2 ) σ t 2 = α 0 + ∑ α i ε t2−i upon previous error
where i =1 terms in a automatic
fashion.

Here auto regressive indicates that variance depends upon few past error
term and conditional heteroscedasticity means variance is constant (fixed)
within one time period but varies between time periods.

6. Asset-Liability Management
A practice followed to maximize returns and minimize interest rate risks by
matching the maturity (time buckets) of assets and liabilities and also the
cash flows under each maturity.

7. Asymmetric Co-rrelation
A correlation between two or more financial assets, which is not the same
under various market conditions. For e.g., the debt and equity markets are
negatively correlated according to theory. However, both markets are at present
moving in the same direction now, exhibiting Asymmetric Correlation.

8. Audit Risk
The risk that an auditor fails to qualify his opinion when financial statements
are materially misleading. This can occur because of inadequate controls in
the operation or by failure of the auditor to detect a problem.

9. Auto-correlation
A time series is autocorrelated if future returns are correlated with past returns.
It is also called as serial correlation, at times. If a financial time series such as
a record of stock prices, for example, exhibits autocorrelation, then it may be
possible to use historical data to predict future price changes.

10. Back Testing

Back Testing is a process of optimization of any strategy using historical data
and then verifying whether it has predictive validity on current data.

Risk-O-Pedia from CRISIL 9

11. Bank Capital Adequacy Requirements
The minimum capital set aside by banks, as required by the regulator. Such
capital to be set aside is a ratio of the bank’s assets and the assets’ risk. The
assets’ risk is prescribed by the regulator in the form of weights.

12. Basis Point

1/100 of a percentage point, also expressed as 0.01%. When applied to a
price rather than a rate, the term is often expressed as annualized basis
points.

13. Basis Risk

A possibility of loss when the future contract does not move in line with the
underlying exposure, affecting the ‘basis’ of the hedge. The basis can be affected
due to shifts or change in the shape of the yield curve, change in expectations,
etc.

14. Bayes’ Theorem

One of the fundamental theorems of probability, the theorem is used to estimate
the probability of the cause of an ‘event’. E.g. In case of an accident, it could
be due to bad driving and/or bad roads. Using Bayes’ theorem, the probability
of the accident due to a) bad roads and bad driving b)bad road and good
driving c)good road and bad driving and d)good road and good driving, can all
be estimated.

15. Behavioural Finance

A theory stating that there are important psychological and behavioural
variables involved in investing in the stock market that provide opportunities
for smart investors to profit. For example, when a certain stock or sector
becomes “hot” and prices increase substantially without a change in the
company’s fundamentals, behavioural finance theorists would attribute this to
mass psychology. They therefore might short the stock in the long term,
believing that eventually the psychological bubble will burst and they will profit.

16. Bell Curve

See Normal Density Function & Normal Distribution. (Please refer page .....)

17. Beta
a) A measurement of stock price volatility relative to a broad market
index. Beta of a company indicates the company’s stock price volatility
relative to market index. It essentially measures the correlation between
the company’s stock prices with market index. If a stock moves up and
down twice as much as the market, it has a beta of 2. If it moves one-half
as much as the market, its beta is 0.5. Because beta assumes a linear
relationship, it can be seriously misleading if used in stock option evaluation
or comparison.

Risk-O-Pedia from CRISIL 10

 b) The slope of a regression line.

18. Black-Scholes Model

A model developed in 1973 by M/s Fischer Black & Myron Scholes. The formula
is widely used to find the fair value of used to calculate the value of an option,
by considering the stock price, strike price and expiration date, risk-free return,
and the standard deviation of the stock’s return. Black-Scholes Model introduced
the key concept of dynamic hedging, whereby the option pay is replicated by
a trading strategy in the underlying asset.

19. Bootstrapping
An iterative calculation technique using sampling with replacement often used
in the construction of specialized time series. For example, the calculation of
forward rates from traditional yield curves uses an iterative process to extract
the implied rate for each forward period.

20. Capital Adequacy

A risk management concept requiring that the capital of a financial organization
be sufficient to protect its counterparties and depositors from on- and off-
balance sheet market risks, credit risk, etc.

Risk-O-Pedia from CRISIL 11

21. Capital Asset Pricing Model (CAPM)
An asset valuation model describing the relationship between expected risk
and expected return for marketable assets.

22. Chaos Theory

A branch of mathematics which deals with systems not linear in nature and
which appear to produce events at random. However under Chaos theory,
such events occur due to a linkage of very small events, which in isolation
cause little effect, but have a devastating effect when acting in concert.

23. Confidence Interval

A statistical term that is used to indicate the range of an estimated variable.
In finance there are several variables like stock market return, VaR for which
we forecast an expected value (point estimate) along with a range. Confidence
interval is used to describe the range in a meaningful way. For example if we
say the forecasted market index in the next month is 4210 with 95% Confidence
Interval [4080, 4340] that means the expected (or most likely) market index
in the next month will be 4210 and it is 95% confident (sure) that the actual
index will not cross the range [4080, 4340].

Alternative definition

A term in statistics often used in value-at-risk measurements. It signifies the

confidence level of a prediction. A 99% confidence interval signifies that the
prediction of loss would be accurate on 99 out of 100 occasions.

Risk-O-Pedia from CRISIL 12

24. Convexity (Amex def)
Convexity is the second order derivative of “Interest Rate sensitivity” of a
bond or an option, while ‘duration’ is the first order derivative.
Convexity can be either positive or negative. An instrument is said to have
positive convexity, if its value increases more than what the ‘duration’ predicts
when interest rates drop and its value decreases less than what the ‘duration’
predicts when interest rates rise.

25. Correlation
i. It measures linear association between two random variables. Essentially
it measures the co-movement (same or opposite direction) of two variables.
If the movement of two variables is on same direction (i.e. if one increase
other also increase) then the correlation is positive. On the other hand if
movement is in opposite direction then correlation is negative.
ii. It does not establish causal relationship.
iii. It cannot capture non-linear relationship.
iv. It’s value ranges from –1 to +1. If correlation is +1and –1 then it is called
perfect relationship in same direction and opposite direction respectively.
Correlation is 0 means there is no linear relationship between the variables.
(Note that in this case non-linear relationship can exist.)
v. If two variables are independent then the correlation among them is 0; but
the converse is not true. [ example : let y= x*x, here correlation between
x and y is zero; but obviously these two variables are not independent.]

26. Cost of Carry

It is the cost of financing an asset. If the cost is lower than the interest
received the asset has a positive cost of carry: if higher, the cost of carry is
negative.

27. Counterparty Risk

The risk that the other party in an agreement will default. In an option contract,
it is the risk to the option buyer that the writer will not buy or sell the underlying
as agreed. In general, counterparty risk can be reduced by having an
organization with extremely good credit act as an intermediary between the
two parties.

Risk-O-Pedia from CRISIL 13

28. Country Risk
Legal, political, settlement, and other risks associated with a cross-border
transaction into a specific country. Also called Geographic Risk and is related
to Sovereign Risk.

29. Co-variance
It measures the linear co-movement of two random variables in same or
opposite direction that essentially indicate the linear relationship between the
random variables. But it is noted that co-variance is not a good measure for
linear relationship between two random variables because it is highly sensitive
on the measuring unit of random variables. For example if we measure one
company’s asset return in Indian Rs.and other company’s asset return in US$
and calculate co-variance then it will not give the true picture of linear
relationship between companies asset return. Thus co-variance is not directly
used to measure linear relationship; in practice we correlation coefficient,
which is nothing but the standardized co-variance.

30. Credit Derivative

A derivative instrument, which enables the credit risk to be shared or distributed
among various holders. It can be structured in many different ways and the
instrument traded in the market.

31. Credit Risk

The risk that a loss will be incurred if a counterparty does not fulfil its financial
obligations in a timely manner.

32. Credit Scoring

A process that uses specific information about would-be borrowers to evaluate
credit applications in a consistent way with the object of predicating debt
repayment. In this process, a creditor will analyze to see what factors have
the most effect on credit worthiness. Once these factors and their relative
importance are established, a quantitative model is developed to calculate a
credit score (a number indicating how credit-worthy the applicant is) for new
applicants. Some of the factors considered when developing a credit scoring
model are outstanding debt, the number of credit accounts maintained, age,
income, credit history, etc.

33. Credit Swap

a) A total return swap with one side’s payment based on the return of an
instrument with some credit risk.
b) An option transaction, also called a default put, with an upfront or
periodic (premium) payment by one party in exchange for the right to
receive a payment contingent on the default of a designated instrument.

34. Cross-Currency Settlement Risk

The risk that one party to a currency swap will default after the other side has
met its obligation, usually due to a difference in time zones.

Risk-O-Pedia from CRISIL 14

35. Current Yield
Annual dividend or interest divided by the current price of a stock or bond.

36. Curve Risk

A measure of interest rate risk that emphasizes exposure to independent
shifts in yield curve time buckets. Each time a bucket is shifted 50 basis points
(0.5%), the simulated loss is measured.

37. Daily Earnings at Risk (DEaR)

A measure of value at risk for a twenty-four-hour period, typically using a
95% confidence level.

38. Daylight Risk Exposure

Expected loss faced during a business day between a party making and receiving
a payment and is a variant of settlement risk.

39. Decision Tree

Schematic way of representing alternative sequential decisions and the possible
outcomes from these decisions.
40. Default Correlation
The likelihood of one obligor defaulting on its credit obligations is affected by
the contemporaneous defaults of other obligor.

41. Default Probability

The chances that the issuer or the borrower will fail to honour his obligation to
repay his debt (interest or principal) according to the contractual terms.

42. Delta

Delta represents first order measure of sensitivity to an underlier. The

information it provides about a particular portfolio is the fact that its value will
increase if the underlier increases, and it will decrease if the underlier decreases.

Risk-O-Pedia from CRISIL 15

43. Derivative
A financial contract whose value is “derived” from another security, such as
stocks, bonds, commodities, or a market index. Basic derivatives include
forwards, futures, swaps, options, warrants and convertible bonds. Generally,
derivatives are risk management tools, however they are also used for
investment or speculative purposes.

44. Dirty Price

It is price of the bond including the accrued interest, which is paid by the bond
buyer.

45. Distribution
A function that describes all the values, a random variable can take and the
probability associated with each. Also called a probability function. Assumptions
about the distribution of the underlying are crucial to option models because
the distribution determines how likely it is that the option will be exercised.

46. Duration
It is the present value of all cash flows, both principal and interest, weighted
by time. So higher the coupon shorter the duration. It is a measurement
expressed in years, which is generally less than the stated maturity. A zero
coupon bond’s duration would be the same as the maturity date because
there are no coupons to take into account.

47. Duration Gap

A method of quantifying interest rate risk involving a comparison of the potential
changes in value of assets and liabilities that are affected by interest rate
fluctuations over all relevant intervals.

48. Duration Risk Management

The use of modified duration measurements for a group of assets and/or
liabilities to quantify and control exposure to interest rate risk.

49. Economic Capital

Capital employed in internal capital allocation as a proxy for a firm’s ability to
take risk. It is called economic “capital” because its measurement process
involves converting a risk distribution to the amount of capital that is required
to support the risk, in line with the organisation’s financial strength

50. Elasticity
The degree of buyers’ responsiveness to price changes. Elasticity is measured
as the percent change in quantity divided by the percent change in price.

51. Embedded Option

An option that is part of the structure of a bond that gives either the bondholder
or the issuer the right to take some action against the other party, as opposed
to a bare option, which trades separately from any underlying security.

Risk-O-Pedia from CRISIL 16

52. Enterprise-Wide Risk Management (ERM)
Enterprise-wide risk management is a coordinated and focused approach for
evaluating and managing all risks together.

53. Ex-ante
Before the event. The ex ante return is the return expected before the
investment is made.

54. Ex-post
After the fact. The ex poste return is the actual rate earned.

55. Expected Loss and Unexpected Loss

Loss distributio of a portfolio is derived from the anticipated change in ncredit
quality of assets in the portfolio. The mean of such distribution is the “expected
loss” and used tp ‘price’ risk of a portfolio.
There are always possibilities that losses can be more than “expected”. So
portfolio managers anticipate the losses at higher confidence levels (say 99%
or 95%) of the loss distribution curve. This is known as known as “unexpected
loss”. For example an unexpected loss of Rs.68 crores in a portfolio at 99%
confidence level indicates that there is only a 1% chance that actual loss will
exceed Rs.68 crores. Provisions needed to absorb “unexpected losses” are
termed as “Economic Capital”.

56. Extreme Value Theory

An area of statistical research that focuses on modelling the extreme values
of return distributions. EVT examines the shape of the graph of extreme
observations of values versus theoretical expectations in probability terms.

57. Factor Model

A way of decomposing the forces that influence a security’s rate of return into
common and firm-specific influences. Factor models are used to predict portfolio
behaviour, and in conjunction with other tools, to construct customized portfolios
with certain desired characteristics, such as the ability to track the performance
of indexes or other portfolios.

58. Foreign Exchange Risk

The risk that a long or short position in a foreign currency might have to be
closed out at a loss due to an adverse movement in exchange rates.

59. Forward Rate Agreement (FRA)

Agreement to borrow or lend at a specified future date at an interest rate that
is fixed today.

60. Forward Yield Curve

The forward curve shows the implied forward interest rate for each period
covered by the yield curve and is used to price many interest rate derivative
instruments.

Risk-O-Pedia from CRISIL 17

61. Frequency Distribution
The organization of data to show how often certain values or ranges of values
occur.

62. Funding Risk

The potential for unanticipated costs or losses due to a mismatch between
asset yields and liability funding costs. The risk may be due to different
maturities of assets and liabilities, changes in credit quality or inability to
meet cash or collateral requirements, forcing premature liquidation of a position.

63. Fuzzy Logic

Fuzzy logic is a powerful problem-solving methodology with a number of
applications in embedded control and information processing. Fuzzy provides
a remarkably simple way to draw definite conclusions from vague, ambiguous
or imprecise information.

64. Gap Analysis

See Maturity Gap

65. Geometric Average

(See also Mean)
The geometric average is a way to construct an aggregate measure of security
prices. The geometric average multiplies the various prices and takes the nth
root with n equalling the number of stocks (or things) that you are averaging.
Geometric average is the most common method used to measure and compare
investment manager performance for periods over one year.

66. Geometric Distribution

Conceptually Geometric distribution can be viewed as follows: Suppose a sales
man is selling a particular brand of toy and p is the probability (chance) that a
customer will buy a toy. Let X denote the number of customers the salesman
has to visit to buy the toy. Then X can take values 0,1,2,3……with probability
P(X=k) =(1-p)k p. for k=0,1,2,3….. Here the distribution of X is called geometric
distribution as its probabilities generate a geometric sequence.

67. Hedge
A transaction that reduces the price risk of an underlying security or commodity
position by making the appropriate offsetting transaction.

68. Herstatt Risk

See Cross-Currency Settlement Risk, Settlement Risk

69. Histogram
It is similar to bar charts; the only difference is that bar chart does not account
for the total area, whereas histogram always accounts its total area as 1. Thus
the concept of probability distribution can be imposed in a histogram. In practice,
histogram of sample data is drawn to get an idea about the distribution of data.

Risk-O-Pedia from CRISIL 18

70. Historical Volatility
The variance or standard deviation of the change in the underlying’s price,
rate, or return during a designated period in the past over different periods,
60 days, 90 days, 6 months etc.

71. Hurdle Rate

The required return in capital budgeting. For example, if a project has an
expected rate of return higher than the hurdle rate, the project may be
accepted.

72. Historical Simulation

Historical simulation is the method of prediction in terms of which the forecast
probability density depends directly on the past empirical distribution.
The first step is to record the changes in the relevant market factors over a
given historical period, where each change occurs over a constant holding
period. The next step is to revalue the portfolio for each change in market
factors, as if such change were to occur in the future. The result is a distribution
of possible profits or losses on the portfolio over the holding period, from
which it is possible to calculate the maximum loss at a given confidence level.

73. Historical Volatility

It is a measure of the volatility of an underlying instrument over a past period.
It can be used as a guide to pricing options but isn’t necessarily a good indicator
of future volatility. Volatility is normally expressed as the annualised standard
deviation of the log relative return.

74. Immunization of a Portfolio

A bond portfolio strategy whose goal is to eliminate the portfolio’s risk, in case
of a general change in the rate of interest, through the use of duration.

75. Implied Zero Coupon Swap Curve

A yield curve for zero-coupon notes derived from the traditional yield curve
and used to value fixed-rate swap payments.

76. Interest Rate Swap

An Interest Rate Swap is a transaction in which a fixed rate coupon is exchanged
(swapped) for a floating rate coupon between two parties. In its commonest

Risk-O-Pedia from CRISIL 19

 form, the fixed-floating swap, one counterparty pays a fixed rate and the
other pays a floating rate based on a reference rate, such as Libor. There is no
exchange of principal – the interest rate payments are made on a notional
amount in floating-floating-swaps the two counterparties pay a floating rate
on a different index, such as three-month Libor versus six-month Libor.

77. Interest Rate Risk

The chance that a security’s value will change due to a change in interest
rates. For example, a bond’s price drops as interest rates rise. It can also be
defined as the risk that spread income will suffer because of a change in
interest rates.

78. Internal Rate Return (IRR)

The rate at which a bond’s future cash flows, discounted back to today, equals
its price.

79. Interpolation
A method of inferring a price or yield between two known values, say on a
yield curve. There are various methods of interpolation, the popular one being
‘Linear Interpolation” where the rate of change is considered constant.

80. Implied Forward Curve

The forward curve implied by forward rate agreements (derived from the par
curve) of various maturities. It is normally steeper than the normal yield curve.

81. Implied Volatility

The expected volatility in a stock’s return derived from its option price, maturity
date, exercise price, and riskless rate of return, using an option pricing model
such as Black-Scholes

82. Kurtosis
It is a statistical term which describes the degree of peakedness or flatness of
a probability distribution relative to the benchmark normal distribution.

83. Lambda
The ratio of a change in the option price to a small change in the option
volatility. It is the partial derivative of the option price with respect to the
option volatility.

Risk-O-Pedia from CRISIL 20

84. Least Squares Regression Line
A straight line fitted to a set of data by minimizing the sum of squared deviations
of the observed data from the line.

A regression technique used when the error terms from an ordinary least
squares regression display non-random patterns, such as autocorrelation or
heteroskedasticity is known as Generalized Least Squares.

85. Legal Risk

A description of the potential for loss arising from the uncertainty of legal
proceedings, such as bankruptcy and potential legal proceedings.

86. Linear Interpolation

See Interpolation

87. Linear Programming

A mathematical procedure for optimizing an objective function subject to
inequality constraints and non-negativity restrictions. In portfolio optimization,
an inequality constraint might take the form of a minimum or maximum
allocation to certain assets. A non-negativity restriction implies that negative
allocations are unacceptable. In a linear program, the objective function as
well as the inequality constraints are all linear functions; hence the name.
A mathematical procedure for optimizing an objective function subject to
inequality constraints and non-negativity restrictions. In portfolio optimization,
an inequality constraint might take the form of a minimum or maximum
allocation to certain assets. Put simply, it is a way of finding the best solution
with in a situation with several constraints.

88. Liquidity Risk

The risk that arises from the difficulty to liquidate an asset, when its proceeds
is required the most. It can be thought of as the difference between the “true
value” of the asset and the likely price, less commissions at times of distress..

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89. Lognormal Distribution
Pattern of frequency of occurrence in which the logarithm of the variable follows
a normal distribution. Lognormal distributions are used to describe returns
calculated over periods of a year or more.

90. Mark to Market

Adjustment of the book value or collateral value of a security to reflect current
market value.

91. Market Risk

The potential loss in value in a security from changes in market factors such
as interest rates, foreign currency value, and/or prices of commodities and
equities.

92. Maturity Gap

A method of attempting to quantify interest rate risk by comparing the potential
changes in value to assets and liabilities that are affected by interest rate
fluctuations over all relevant intervals. The maturity of each asset or liability
defines an interval that must be assessed.

93. Mean
The arithmetic average; that is, the sum of the observations divided by the
number of observations.

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94. Median
The middle observation in an ordered distribution and is less sensitive to extreme
values.

95. Modified Duration

The ratio of Macaulay duration to (1 + y), where y = the bond yield. Modified
duration is inversely related to the approximate percentage change in price
for a given change in yield.

96. Monte Carlo Simulation

Simulation is a technique to come out with a value of a variable imposing
some criterion on it. Generally in finance, historical data are used to forecast/
predict future value of some important variables like market return, interest
rate etc. But in some cases very few historical data are available to estimate
the future value of a variable. In such a case some general assumption is
made about the nature/character of the variable and simulation technique is
used to generate the value of the variable. Monte Carlo is one such simulation
technique, which can incorporate various scenarios (i.e. assumption about
the nature / character of variables). The name comes from the city of Monte
Carlo, which is known for its casinos. The name and the systematic development
of Monte Carlo methods dates from about 1944.

97. Multiple Regression

A technique for estimating the relationship between a continuous dependent
variable and more than one explanatory variable.

98. Natural Logarithm

Logarithm to the base e (approximately 2.7183).

99. Net present value

The present value of the expected future cash flows minus the cost.

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100.Normal Density Function
It is the derivative of normal distribution function. Generally it is used instead
of a distribution function for any type of calculation. It is very useful to calculate
probability through integration method.

101.Normal Distribution
A probability distribution for a continuous random variable that forms a
symmetrical bell-shaped curve around the mean. This distribution has no
skewness or excess kurtosis.

102.Null Hypothesis
Null Hypothesis is a proposition for a statistical test. This proposition is made
in such a way that there will be no biasness /favourness in it.

103.Obligor
A person who has an obligation to pay off a debt.

104.Off Balance Sheet Instrument

A notional principal contract that changes an economic unit’s risk structure
without appearing as an asset or liability on a traditional balance sheet. Swaps,
forward rate agreements, and various currency contracts are common OBS
instruments.

105.One Factor Model

A model or description of a system where the model incorporates only one
variable or uncertainty: the future price. These are simple models, usually
leading to closed form solutions, such as the Black-Scholes model or the Vasicek
model.

106.Operational Risk
The risk run by a firm that its internal practices, policies and systems are not
rigorous or sophisticated enough to cope with untoward market conditions or
human or technological errors. Although operational risk is not as easy to

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 identify or quantify as market or credit risk, it has been implicated as a major
factor in many of the highly publicised derivatives losses of recent years.
Sources of operational risk include: failure to correctly measure or report risk,
lack of controls to prevent unauthorised or inappropriate transactions being
made, lack of understanding or awareness among key staff.

107.Option
A contract that gives the purchaser the right but not the obligation, to buy or
sell an underlying at a certain price (the exercise or strike price) on or before
an agreed date (the exceed period).

108.Parametric
Description of a relationship by a function. The normal distribution, for example,
implicitly assumes the behaviour of a random variable is well-modelled by
reference to the normal density function.

109.Price Risk
Risk of an impact on the profits of an organisation due to the change in the
market price of a physical commodity or a financial instrument.

110.Par Yield Curve

A graphical representation of the yields constructed by calculating the coupons
necessary for bonds of various maturities to be priced at par.

111.Prepayment Risk
The risk that a value of an asset will change because of an unscheduled early
repayment by the borrower. An early repayment by a borrower would mean
reinvestment of the amounts received, which may be contracted at rates lower
than the earlier contracted rates.

112.R2 – Coefficient of Determination

In regression analysis, the fraction of variation in the dependent variable that
is explained by variation in the independent variable or variables. R2 is
calculated as the ratio of the sum of the squared differences between the
predicted values for the dependent variable, and the average of the observed
values for the dependent variable to the sum of the squared differences between
the observed values for the dependent variable and the average of those
values. R 2 ranges in value from 0 to 1. A high value indicates a strong
relationship between the dependent and independent variables.
R2 = [Ó(Predicted y - Mean y)2]/[Ó(Observed y - Mean y)2]

113.Random Numbers
A sequence of numbers that are independent of each other. Most applications
that require random numbers rely on mathematical techniques to generate
pseudorandom numbers. Though these numbers appear random but in fact
are generated deterministically.

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114.Random Variable
It is not a variable at all. It’s a function event space [roughly speaking event
space is the collection of all possible events of a random experiment] to real
line. Essentially random variable maps the outcome of a random experiment
to a real number.

115.RAROC (Risk Adjusted Return on Capital)

A technique for risk analysis and project evaluation that requires a higher net
return for a riskier project than for a less risky project. The risk adjustment is
performed by reducing the risky return at the project or instrument return
level, rather than by adjusting the capital charge.

116.RORAC (Return on Risk Adjusted Capital)

Similar to risk-adjusted return on capital (RAROC), except that the rate of
return is measured without a risk adjustment, while the capital charge varies
depending on the risk associated with the instrument or project.

117.Risk Averse
An attitude toward risk that causes an investor to prefer an investment with a certain
outcome to an investment with the same expected value but an uncertain outcome.

118.Reinvestment Risk
The risk that an asset manager will be unable to match the yield from an
interest rate instrument when reinvesting its coupon payments and principal
repayments.

119.Regulatory Arbitrage
A financial transaction that allows one or both of the counterparties to
accomplish an operating or financial objective that would be unavailable to
them directly because of regulations: for e.g. a commercial bank entering into
a credit default swap with an OECD bank in order to lower the regulatory
capital that it must hold.

120.Regulatory Capital
The amount of capital that an organization is required to hold as deemed by
its regulator.

121.Replacement Cost
Often used in terms of credit exposure, the replacement cost of a financial
instrument is its current value in the market – in other words, what it would
cost to replace a given contract if the counterparty to the contract defaulted.
Aside from bid-ask conventions, it is synonymous with market value.

122.Risk Management
Control and limitation of the risks faced by an organisation due to its exposure
to changes in financial market variables such as forex and interest rates,
equity and commodity prices or counterparty creditworthiness. This maybe

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 because of the financial market impact of an adverse move in the market
variable (market risk), because the organization is ill-prepared to respond to
such a move (operational risk), because a counterparty defaults (credit risk),
or because a specific contract is not enforceable (legal risk).

123.Scenario Analysis
A technique to ascertain impact on the value of the portfolio and the consequent
impact on profits or losses due to the changes in market variables

124.Settlement Risk
Settlement risk is the risk that the counterparty with whom a purchase or sale
transaction of a security is entered into will be unable fulfil its obligation (either
delivery of the security, or payment)

125.Sigma
The standard deviation or volatility of the price or rate of an instrument,
frequently the instrument underlying an option.

126.Skew
A skewed distribution is one which is asymmetric. Skew is a measure of this
asymmetry. A perfectly symmetrical distribution has zero skew, whereas a
distribution with positive / negative skew is one where outliers above / below
the mean are more probable. An e.g. of an asymmetric distribution in the
financial markets is the distribution implied by the presence of a volatility
skew between out-of-the-money call & put options.

127.Specific Risk
Specific risk, also known as non-systematic risk, represents the price variability
of a security that is due to factors unique to that security, as opposed to that
portion that is due to systematic risk, which is generic to the entire market of
such securities.

128.Standard Deviation
The square root of the mean of the squared deviations of members of a
population from their mean.

where ó= standard deviation of population, n = number of observations, Ó =

summation sign, xi = the value of each observation, and ì = mean of population.
Note that the standard deviation for a sample is calculated by substituting n-
1 for n in the denominator.

Essentially it is the square root of variance. The unit of variance is in square

unit, which creates some problem to compare results. Also Variance is not
free from scaling problem. To remove these problems in practical situation

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 generally we deal with SD. It shows the spread of data points in a sample.
Higher value of SD indicates data are more scattered.

129.Stochastic Process
Formally, a process that can be described by the evolution of some random
variable over some parameter, which may be either discrete or continuous,
geometric Brownian motion is an example of a stochastic process parameterised
by time. Stochastic processes are used in finance to develop models of the
future price of an instrument in terms of the spot price and some random
variable; or analogously, the future values of an interest or forex rate.

130.Stress Testing
To perform a stress test on a derivatives position is to stimulate an extreme
market event and examine its behaviour under the stress of that event.

131.Swap
A contractual agreement to exchange a stream of periodic payments with a
counterparty. The stream of cashflows exchanged could be fixed interest payments
for floating interest payments, or vice-versa (implying an interest rate swap), or
exchange one currency for the other at a sequence of forward rates (generic
currency swap), or exchanging an equity index return for a floating interest rate
132.Synthetic Bond
A combination of financial instruments, designed to generate a stream of
cashflows akin to a long-term bond. The financial instruments used may include
money market instruments, bond features, derivatives etc.

133.Systemic Risk
The risk that the financial system as a whole may not withstand the effects of
a market crisis

134.Translation Risk
The likely impact on the accounting profits/returns due to changes in foreign
currency rates

135.Two Factor Model

Any model or description of a system that assumes two sources of uncertainty
or variables, for e.g. an asset price and its volatility (a stochastic volatility
model), or interest rate levels and curve steepness (a stochastic interest rate
model). Two factor models model interest rate curve movements more
realistically than one factor models.

136.Utility Function
The relationship between varying levels of wealth or consumption of goods
and services and the happiness or satisfaction imparted by the different wealth
and consumption levels. A commonly invoked utility function for economic
modelling is the logwealth utility function, which implies that utility increases
at a decreasing rate as wealth increases.

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137.Utility Theory
Utility theory states that rational individuals attempt to maximise their expected
benefit(utility) from every transaction.

138.Value at Risk
Value at Risk is the maximum probable market loss over a given period of
time (known as the holding period or time horizon) expressed as a degree of
certainty. (confidence level)

139.Variance
Square of the standard deviation

Variance is the average of sum of square from mean. It shows the spread of
data points in a sample. Higher value of variance indicates data are more
scattered. In asset return portfolio it is the measure of risk.

140.Volatility
The tendency of a market price or yield varies over time. The statistical measure
of such variables is done by mean and variance (standard deviations). The
mean value is the expected value (it is a point estimate) and variance gives
the idea about spread around mean. Thus Volatility is nothing but variance of
the price, rate, or return. If the price, yield, or return typically changes
dramatically in a short period of time then Volatility will be high. Volatility is
one of the most important elements in evaluating an option, because it is
usually the only valuation variable not known with certainty in advance.

141.Yield to maturity (IRR)

The rate, which will make the present value of future cash flows of a debt
instrument equal to its price or cost. Since the redemption value is also a
future cash flow, capital gain or loss is also factored in.

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142.Yield Curve
A yield curve is a graphical representation of the yields prevailing for a given
debt instrument for various maturities. Typically, a yield curve would be upward
sloping implying increasing interest rates as a function of tenor

143.Zero Coupon Bond

A debt instrument having no interest payments throughout its maturity period
but which is issued at a price below the par value. The redemption is at par, on
maturity

144.Zero Coupon Yield Curve

A graph of the yields prevailing for default free zero coupon bonds of various
tenors.

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