Absolute Market Risk Risk associated with the change in value of a position or a portfolio resulting from changes in market conditions, that is, yield levels or prices. Absolute Return Measure of net economic return. Takes into account all costs (for example, cost of funding, balance sheet charges, administrative expenses). Accrual Accounting Accounting convention recognizes revenues when sales are made or services are rendered, whether or not cash has been received. Applied to bonds, accrual accounting recognizes periodic interest payments based on a notional book value and does not revalue positions based on market value (or replacement cost), as in mark-to-market accounting. Accrual accounting generally understates economic volatility of securities such as bonds because mark-to-market price fluctuations are not taken into account. Asset Any possession that has value Asset Allocation The decision regarding how an investor’s funds should be distributed among the major assets (e.g. equities, bonds, money markets, commodities). Risk and Performance Asset Class A way to categorize assets. Some examples are: Large-Cap Blend, Large-Cap Growth, Large-Cap Value, Medium-Cap Blend, Medium-Cap Growth, Medium-Cap Value, Small-Cap Blend, Small-Cap Growth, and Small-Cap Value At-the-Money When the strike price of an option is the same as the price of the underlying. At-the-Money Forward When the strike price of an option is the same as the forward price of the underlying. Autocorrelation (serial correlation) When observations are correlated over time. In other words, the covariance between data recorded on the same series sequentially in time is nonzero. Average Exposure Credit exposure arising from market-driven instruments will have an ever-changing mark-to-market exposure amount. The amount of exposure relevant to a credit analysis is the time-bucketed average exposure in each forward period across the life of the transaction across all—probability weighted—market rate paths. (See CreditMetrics Technical Document, page 49.) Average RiskGrade The mathematical mean RiskGrade over a specified period of time Base Currency Your local currency. For example, an American’s base currency is the U.S. dollar. Benchmarks The performance of a predetermined set of securities, used for comparison purposes. Such sets may be based on published indexes or may be customized to suit an investment strategy. Absolute vs Relative Returns Beta The measure of a fund’s or stocks risk in relation to the market, or an alternative benchmark. A beta of 1.5 means that a stock’s excess return is expected to move 1.5 times the market excess returns. E.g. if market excess return is 10% then we expect, on average, the stock return to be 15%. Beta is referred to as an index of the systematic risk due to general market conditions that cannot be diversified away. Black Scholes Option Pricing Formula Model developed by Fischer Black and Myron Scholes to gauge whether option contracts are fairly valued. It incorporates such factors as the volatility of a security’s return, the level of interest rates, the relationship of the underlying stock’s price to the strike price of the option, and the time remaining until the option expires. Bonds A bond is debt issued for a period of more than one year. The U.S. government, local governments, water districts, companies and many other types of institutions sell bonds. When an investor buys bonds, he or she is lending money. The seller of the bond agrees to repay the principal amount of the loan at a specified time. Interest-bearing bonds pay interest periodically. Sources of Risk

Inverse Relationship Between Interest Rates and Bond Prices Call Option A call option is the right, but not the obligation, to buy an asset at a prespecified price on, or before, a prespecified date in the future. CAPM Capital Asset Pricing Model. A model that relates the expected return on an asset to the expected return on the market portfolio. Caps and Floors Interest rate options. Caps are an upper limit on interest rates (if you buy a cap, you make money if interest rates move above cap strike level). Floors are a lower limit on interest rates (if you buy a floor, you make money if interest rates move below floor strike level). Cash-Flow-at-Risk Estimated potential cash flow loss (through reduction in revenues or increase in outgoings) due to adverse market movements (for example, unfavorable movements in interest rates, exchange rates, commodity prices, and other markets) within a specific time horizon and subject to a given confidence level. Commitment A legally binding obligation (subject usually both to conditions precedent and to continuing conditions) to make available loans or other financial accommodation for a specified period; this includes revolving facilities. Even during publicly known credit distress, a commitment can be legally binding if it is drawn down before it is formally withdrawn for cause. Commodity A commodity is food, metal, or another physical substance that investors buy or sell, usually via Commodity futures contracts. See below. Market Risk Commodity Futures / Commodity Futures Contract An agreement to buy a specific amount of a commodity at a specified price on a particular date in the future, allowing a producer to guarantee the price of a product or raw material used in production. Commodity Risk The risk arising from fluctuating commodity prices, such as oil, gold or copper. Market Risk Concentration Risk Portfolio risk resulting from increased exposure to one risk category or groups of correlated risk factors. Diversification Convertible Bond A bond with an imbedded option that allows the holder to convert the bond to common stock. Correlation A linear statistical measure of the comovement between two random variables. A correlation (Greek letter r, pronounced rho) will range from +1.0 to -1.0. For market risk, international equity markets rising and falling together is an example of positive correlation. In credit risk, clumps of firms defaulting together by industry or geographically is an example of positive correlation of default events. Counterparty / Counterparty Risk The partner in a credit facility or transaction in which each side takes broadly comparable credit risk to the other. When a bank lends a company money, the borrower (not counterparty) has no meaningful credit risk to the bank. When the same two agree on an at-the-money forward exchange contract or swap, the company is at risk if the bank fails just as much as the bank is at risk if the counterparty fails (although for the opposite movement in exchange or interest rates). After inception, swap positions often move in/out-of-the-money and the relative credit risk changes accordingly. (See CreditMetrics Technical Document, page 47.) Country Risk Developments in a national economy that can affect the outcome of an international financial transaction. Event Risk Coupon The periodic interest payment made to the bondholders during the life of the bond Sources of Risk

Inverse Relationship Between Interest Rates and Bond Prices Credit Capital Capital allocated to cover potential (or unexpected) credit losses. For example, a firm might set aside 5% of its loan portfolio as capital to cushion against unexpected losses due to counterparties defaulting. Credit Distress A firm can have many types of credit obligations outstanding. These may be of all manner of seniority, security, and instrument type. In bankruptcy proceedings, it is not uncommon for different obligations to realize different recovery rates, including perhaps 100% recovery—zero loss. In our terminology, it is the obligor that encounters credit distress carrying all of his or her obligations with him or her even though some of these may not realize a true default (that is, some may have zero loss). (See CreditMetrics Technical Document, page 65.) Event Risk Credit Exposure The amount subject to changes in value upon a change in credit quality through either a market-based revaluation in the event of an up(down)grade or the application of a recovery fraction in the event of default. Event Risk Credit Quality Generally meant to refer to an obligor’s relative chance of default, usually expressed in alphabetic terms (for example, Aaa, Aa, A). CreditMetrics makes use of an extended definition that includes also the volatility of up(down)grades. Event Risk Credit Rating An evaluation of an individual’s or company’s ability to repay obligations or its likelihood of not defaulting (creditworthiness). Event Risk Credit Risk The chance of loss due to default or change of credit worthiness of a counterparty. Market Risk

RiskGrades Capture Currency Risk Credit Scoring Generically, credit scoring refers to the estimation of the relative likelihood of default of an individual firm. More specifically, this is a reference to the application of linear discriminant analysis to combine financial rations to predict the relative chance of default quantitatively. (See CreditMetrics Technical Document, page 57.) Cross Market Correlations Correlations across different markets, for example, correlation between U.S. stock market and Japanese stock market. Current Exposure For market-driven instruments, the amount it would cost to replace a transaction today should a counterparty default. If there is an enforceable netting agreement with the counterparty, then the current exposure would be the net replacement cost; otherwise, it would be the gross amount. Currency Risk Currency risk; risk of loss due to movements in currency rates. Decision Theory Theory of making rational decisions, given a set of defined outcomes and probabilities. Default Failure of a debtor to make timely payments of prinipal and interest as they come due or to meet other provisions of a bond indenture. Default Probability The likelihood that an obligor or counterparty will encounter credit distress within a given time period. Credit distress usually leads to either an omitted delayed payment or distressed exchange that would impair the value to senior unsecured debt holders. Note that this leaves open the possibilities that subordinated debt might default without impairing senior debt value and transfers and clearing might continue even with a senior debt impairment. (See CreditMetrics Technical Document, page 65.) Delta Equivalent Cash Flow In situations when the underlying cash flows are uncertain (for example, option), the Delta equivalent cash flow is defined as the change in an instrument’s fair market value when its respective discount factor changes. These cash flows are used to find the net present value of an instrument. Derivatives Derivatives are securities, such as options, futures, and swaps, whose value is derived in part from the value and characteristics of another underlying security. Dirty Price Inclusion of the accrued value of the coupon in the quoted price of a bond. For instance, a 6 percent annual coupon bond trading at par would have a dirty price of $106 just prior to coupon payment. CreditMetrics estimates dirty prices because the coupon is paid in nondefault states. Discount The difference between a bond’s current market price and its face or redemption value. Or (2) a manner of selling securities such as Treasury Bills which are issued at less than face value and are redeemed at at face value. Diversification Reduces risk by holding a large collection of independent assets. Unique versus Systemic Risk

Diversification Diversification Benefit Measures risk reduction that arises from holding a collection of assets that are not perfectly correlated. The diversification benefit for your portfolio RiskGrade is the difference between the computed portfolio RiskGrade and the market-value weighted average of the individual asset RiskGrades. The portfolio diversification benefit for Extreme Market Loss is the difference between the computed portfolio Extreme Market Loss and the sum of the individual asset Extreme Market Loss values. Unique versus Systemic Risk

Extreme Market Loss Duration The weighted average term of a security’s cash flows. The longer the duration, the larger the price movement given a 1bp change in the yield. Earnings at Risk Similar to cashflow at risk, except for necessary adjustments due to accounting treatments of cashflows when determining earnings. Typical adjustments include deferral of cashflows that are subject to deferral accounting treatment, advance treatment of cashflows that are accrual accounted, and inclusion of operating cashflow that are hedged. Economic Exposures Or strategic exposures. Market exposures that consider how changes in foreign exchange rates, interest rates, or commodity can affect the overall operating environment of a firm (for example, level of demand for products and services). Equity Ownership interest possessed by shareholders in a corporation, i.e. stocks as opposed to bonds. Market Risk Equity Risk Risk due to fluctuations in stock prices, a component of market risk. RiskGrades Capture Currency Risk Event risk The risk that some unexpected event will cause a substantial decline in the market value of a security, such as natural disasters, technology failures, human error, political upheavals, or war. Event Risk Exponential Weighting A method of applying weights to a set of data points (returns), with the weights declining exponentially over time. In a time series context, this results in weighting recent data more than the distant past. RiskGrades Capture Currency Risk Exposure The size of a position. For credit risk, the amount that would be lost in a default given the worst possible assumptions about recovery in the liquidation or bankruptcy of an obligor. For a loan or fully drawn facility, this is the full amount plus accrued interest; for an unused or partly used facility, it is the full amount of the facility, because the worst assumption is that the borrower draws the full amount and then goes bankrupt. Exposure is not usually a statistical concept; it does not make any attempt to assess the probability of loss, it states only the amount at risk. For market-driven instruments (for example, stcks, foreign exchange, swaps, options, and derivatives), a proxy for exposure is estimated given the volatility of underlying market rates/prices. FTSE The equivalent of S & P in the United States, FTSE focuses its indices in the UK and Europe. People often refer to the FTSE 100 index (an index that tracks the top 100 equities in the London Stock Exchange) as the FTSE. Foreign Exchange Risk Foreign exchange risk; risk of loss due to movements in foreign exchange rates. Futures A term used to designate contracts covering the sale of financial instruments or physical commodities for future delivery on an exchange. Global Equity Markets World stock markets, which are composed of publicly listed companies that the general public can buy or sell on exchanges. Glossary This is the course glossary. GBP An abbreviation for the Great Britain Pound. Gross Payoff Refers to the gross payoff of an option at the expiration date, not taking into account the option premium. The gross payoff of a call option is the price of the underlying minus strike price or zero, whichever is greater. The gross payoff of a put option is the strike price minus the price of the underlying or zero, whichever is greater. Hedge See Hedging. Three Alternatives for Managing Risk Hedge Fund A fund targeted to sophisticated investors that may use a wide range of strategies to earn returns, such as taking long and short positions based on statistical models. Hedging Eliminates an exposure by entering into an offsetting position. For example, a gold mine can hedge exposure to falling prices by selling gold futures. When hedging, we look for highly correlated substitute securities. Three Alternatives for Managing Risk Historical Simulation A nonparametric method of using past data to make inferences about the future. One application of this technique is to take today’s portfolio and revalue it using past historical price and rates data. Implied Volatility Implied volatilities are obtained from observable prices for traded options, and capture the market’s current expectations for the future distribution of market prices. In-the-Money When an option is has positive intrinsic value (that is, for a call option, when the price is above the strike, and for a put option, when the price is below the strike). Independent Implies no correlation, or relationship, between variables. Inflation The rate at which the price that consumers pay for goods and services rises over time. What is Risk?

Avoiding Risk is a Sure Path to Failure Insurance Purchasing insurance involves paying a premium for protection against unfavorable events. Three Alternatives for Managing Risk Interest The cost of using money, expressed as a rate per period of time, usually one year. Interest Rate Cost of using money, expressed as a percentage rate per annum. Sources of Risk

Inverse Relationship Between Interest Rates and Bond Prices Interest Rate Risk Risk arising from fluctuating interest rates. For example, a bond’s price drops as interest rates rise. Market Risk Interest Rate Swap A binding agreement between counterparties to exchange periodic interest payments on a predetermined notional principal amount. For example, one party will pay fixed and receive variable interest rate on a USD 100 million notional principal amount. Investment Manager A manager of a portfolio of investments. JPY An abbreviation for the Japanese Yen. Letter of Credit A promise to lend issued by a bank that agrees to pay the addressee, the beneficiary, under specified conditions on behalf of a third party, also known as the account party (See CreditMetrics Technical Document, page 46). There are different types of letters of credit. A financial letter of credit (also termed a stand-by letter of credit) is used to assure access to funding without the immediate need for funds and is triggered at the obligor’s discretion. A project letter of credit is secured by a specific asset or project income. A trade letter of credit is typically triggered by a non-credit-related (and infrequent) event. Linear Derivatives Derivative security whose value changes linearly with changes in underlying rates. Examples of common linear derivatives are futures, forwards, and swaps. Examples of nonlinear derivatives are options, whose price does not change linearly with changes in the underlying. Liquidity There are two separate meanings: At the enterprise level, the ability to meet current liabilities as they fall due; often measures as the ratio of current assets to current liabilities. At the security level, the ability to trade in volume without directly moving the market price; often measured as bid/ask spread and daily turnover. Loan Exposure The face amount of any loan outstanding plus accrued interest. See dirty price. Long If you buy an asset, you are long the asset. You will benefit if the price goes up. Long Position Opposite of short position—a bet that prices will rise. For example, you have a long position when you buy a stock, and will benefit from prices rising. Mapping The process of translating the cash flow of actual positions into standardized position (vertices). Cash flows can be mapped by duration, principal, and cash flow. Marginal Standard Deviation Effect of a given asset on the total portfolio standard deviation. (See CreditMetrics Technical Document, page 129.) Marginal Statistic A statistic for a particular asset that is the difference between that statistic for the entire portfolio and that statistic for the portfolio not including the asset. Marked-to-Market (MTM) Marked-to-market approach means that, unlike traditional accrual accounting, positions are valued on a replacement cost basis by marking to the current traded market price. Applied to credit risk, this approach can discriminate between a range of different levels of credit quality, not just default. Market-cap Weighted Refers to a market value weighted index. Market value is computed as shares times current market price, converted to a standard currency (e.g. USD). The weighting of each component is its market value divided by the total market value. Introducing RiskGrades Market Exposure For market-driven instruments, there is an amount at risk to default only when the contract is in-the-money (that is, when the replacement cost of the contract exceeds the original value). This exposure/uncertainty is captured by calculating the netted mean and standard deviation of exposure(s). Market Neutral Hedge A hedge that eliminates broad market risk (equity, interest rate, foreign exchange, or commodity), leaving only residual risk. For example, a hedge fund manager can have hedge the market risk of a U.S. stock portfolio by shorting S&P 500 Index futures, leaving only firm-specific residual risk. Market risk Risk that arises from the fluctuating prices of investments as they are traded in the global markets. Market risk is highest for securities with above-average price volatility and lowest for stable securities such as Treasury bills. Market Risk

Introducing RiskGrades Market Value The price at which a security is trading and could presumably be purchased or sold (that is, replacement cost) Market-Driven Instruments Derivative instruments that are subject to counterparty default (for example, swaps, forwards, options). The distinguishing feature of these types of credit exposures is that their amount is only the net replacement cost—the amount the position is in-the-money—rather than a full notional amount. (See CreditMetrics Technical Document, page 47). Mean A statistical measure of central tendency. Sum of observation values is divided by the number of observations. It is the first moment of a distribution. Volatility

Mean Reversion The statistical tendency in a time series to gravitate back toward a long-term historical level. This is on a much longer scale than another similar measure, called autocorrelation; these two behaviors are mathematically independent of one another. Migration Credit quality migration describes the possibility that a firm or obligor with some credit rating today may move (or migrate) to potentially any other credit rating—or perhaps default—by the risk horizon. (See CreditMetrics Technical Document, page 24.) Modern Portfolio Theory Investment decision approach that permits an investor to classify, estimate and control both the kind and the amount of expected risk and return. Modified Duration An indication of price sensitivity. It is equal to a security’s Macaulay duration divided by 1 plus the yield. Monte Carlo Simulation The process of generating random variables to simulate future price scenarios. NASDAQ National Association of Securities Dealers Automated Quotations system, NASDAQ is a computerized system that provides brokers and dealers with price quotations for securities quoted on the over-the-counter exchange. Net Asset Value (NAV) The market value per share for mutual funds. NAV is each day by aggregating the closing market value of assets and subtracting all liabilities, then dividing the result by the total number of shares outstanding. Net Payoff Refers to the net payoff of an option at the expiration date, taking into account the option premium. Net Present Value Valuing a stream of future cash flows at appropriate (risk-adjusted) discount rates. Netting In the event of counterparty bankruptcy, all transactions or all of a given type are netted at market value. The alternative would allow the liquidator to choose which contracts to enforce and which not to (and thus potentially cherry pick). There are international jurisdictions where the enforceability of netting in bankruptcy has not been legally tested. Nikkei The leading and most respected index of Japanese stocks, which is published by Nihon Keizai Shimbun-Sha. Non-linear Derivatives Derivative security whose value moves discontinuously with changes in the underlying asset, for example, call or put options. Non-linear Exposures Exposures due to nonlinear financial instruments, such as options, whose value moves discontinuously with changes in the underlying asset. Non-parametric Potential market movements are described by assumed scenarios, not statistical parameters. Notional Amount The face amount of a transaction typically used as the basis for interest payment calculations. For swaps, this amount is not itself a cash flow. Credit exposure arises not against the notional but against the present value (market replacement cost) of in-the-money future terminal payment(s). Notional Exposure Refers exposure in the amount of the predetermined dollar principal on which interest payments are based. Obligor A party who is in debt to another: (i) a loan borrower; (ii) a bond issuer; (iii) a trader who has not yet settled; (iv) a trade partner with accounts payable; (v) a contractor with unfinished performance; see Counterparty. (See CreditMetrics Technical Document, page 5.) Options An option is the right, but not the obligation, to buy or sell a reference asset at a prespecified strike price on, or before, a prespecified date in the future. A European style option can be exercised only at maturity, whereas an American style option may be exercised any day before or on maturity. Out-of-the-Money When an option has no intrinsic value (that is, on a call option, when the price is below the strike; on a put option, when the price is above the strike). Parametric When a functional form for the distribution a set of data points is assumed. For example, when the normal distribution is used to characterize a set of returns. Performance Risk Risk that a money manager under-performs his/her pre-established benchmark (e.g. S&P 500). What is Risk?

Stress Testing Portfolio Context Portfolio context means we take into account portfolio effects. For example, applied to credit risk, we take into account default correlations between obligors that operate same industries and/or countries. Correlations are an essential element of understanding portfolio risk and enable risk managers to quantify the risks of concentration and the benefits of diversification. Taking a portfolio perspective of credit risk means moving away from traditional name-by-name management of credit risk to identify and measure risk concentrations by industry and country. Position The buyer of an asset is said to have a long position and the seller of an asset is said to have a short position. Put Option A put option is the right, but not the obligation, to sell an asset at a prespecified price on, or before, a prespecified date in the future. Principal Amount face value of an obligation (such as a bond or a loan) that must be repaid at maturity, seperate from interest. Regulatory Capital Capital that banks are required to set aside to cover potential losses due to market or credit risk. Relative Market Risk Risk measured relative to an index or benchmark. What is Risk?

Absolute vs Relative Returns Relative Return Measures relative performance. Residual Risk The risk in a position that is issue specific. Return The gain or loss in value of a security in a particular period, usually quoted as a percentage. ReturnGrade A ReturnGrade is a measure of return adjusted for risk. A higher ReturnGrade suggests a superior quality of return (high return, low risk); a lower ReturnGrade implies an inferior quality of return (low return, high risk). ReturnGrade Ranking A comparison of ReturnGrade relative to an external benchmark, such as peers or indices. For example, if your portfolio has a Risk Rank of 32% relative to other sampled portfolios, it means that 68% of these portfolios are riskier than yours. Risk Uncertainty or exposure to a chance of loss or damage. See also Risk Management What is Risk?

Importance of Considering Risk Risk Based Limits Limits for market or credit risk taking that are defined in risk as opposed to notional terms. Risk-based limits have become a necessity for institutions trading a broad range of financial instruments, where the same notional exposure can imply a very different risk (for example, a $1MM notional USD interest rate swap position vs. a $1MM equity swap). Risk Neutral Refers to fair pricing of options. A risk neutral option price is one in which the option seller can derive a fair price because it is possible to hedge the exposure with the underlying asset. RiskGrade The RiskGrade for a single position or portfolio is a ranking which measures the potential volatility of the position or portfolio relative to the volatility of standard benchmark. The benchmark used is the average daily volatility of the market-capitalization weighted average of international equity indices during the period from 1995 — 1999, which is defined to have a RiskGrade of 100. For example, if a position or portfolio has a RiskGrade of 200, the position or portfolio is twice (2x) as volatile as the benchmark. Introducing RiskGrades

Stress Testing Risk Ranking A comparison of RiskGrade relative to an external benchmark, such as peers or indices. For example, if your portfolio has a Risk Rank of 32% relative to other sampled portfolios, it means that 68% of these portfolios are riskier than yours. Efficient Frontier Refers to the maximum return you can expect for any given level of risk, based on historical returns of major asset classes. RiskImpact The RiskImpact for a single position is the percentage amount that the portfolio’s RiskGrade will decrease upon removal of that position. RiskImpact

Diversification S&P 500 Index The Standard and Poor’s 500 Index is a market-capitalization weighted equity index of 500 U.S. stocks. Sector A category of a group of assets. Some examples are: Energy, Materials, Industrials, Consumer Discretionary, Consumer Staples, Health Care, Financials, Information Technology, Telecom Services, and Utilities. Selling Oil Forward Making a future sale of oil, for example through oil futures. This involves making a binding agreement to sell oil at a specified date in the future at a specified price. Oil producers commonly sell oil futures to hedge some of their production. Sharpe Ratio A return on risk ratio named after Nobel laureate and Stanford University professor William F. Sharpe. The Sharpe ratio is defined as annual return minus risk free rate divided by standard deviation of return. Short If you sell an asset short, you are short the asset. You will benefit if the price falls. Short Position Opposite of long position—a bet that prices will fall. For example, a short position in a stock will benefit from the stock price falling. Skewness Characterizes the degree of asymmetry of the distribution around its mean. Positive skews indicate asymmetric tail extending toward positive values (right-hand side). Negative skewness implies asymmetry toward negative values (left-hand side). Standard Deviation A statistical measure that indicates the width of a distribution around the mean. A standard deviation (Greek letter s, pronounced sigma) is the square root of the second moment of a distribution. Volatility

Stress Testing A process of determining how much the value of a portfolio can fall under abnormal market conditions. Stress testing consists of generating worst-case stress scenarios (for example, stock market crash) and revaluing a portfolio under those stress scenarios. Strike Price The stated price for which an underlying asset may be purchased (in case of a call) or sold (in the case of a put) by the option holder upon exercise of the option contract. Stock Ownership interest possessed by shareholders in a corporation, i.e. stocks as opposed to bonds. Substitute Securities Securities that are identical or comparable to assets you are trying to hedge—for example, government bonds, interest rate swaps, and interest rate futures may be used as substitute securities for hedging purposes. Swaps Derivative contracts whereby two companies agree to exchange cash flows based on different underlying reference assets. The most common swaps are interest rate swaps, where fixed coupon cash flows are exchanged for floating-rate cash flows. Total return swaps can be structured on just about any underlying reference asset or index, for example S&P 500 Equity Index vs. J.P. Morgan EMBI+ Index. Systemic risk The risk of a portfolio after all unique risk has been diversified away. Systemic risks may arise from common driving factors (for example, market and economic factors, natural disasters, or war) and can influence the whole market’s well being. (also systematic risk) Unique versus Systemic Risk Tax Advantaged Debt Refers to the tax advantage of debt vs. equity financing. Interest rate expenses are tax deductible (in the U.S.), whereas equity dividends are not. Tracking Error In an indexing strategy, the difference between the performance of the benchmark and the replicating portfolio. Transaction Exposures Market exposures focused on the direct effect of a price change on a committed transaction, which often arise when there is a mismatch between revenues and expenses. Transition Matrix A square table of probabilities that summarizes the likelihood that a credit will migrate from its current credit rating today to any possible credit rating—or perhaps default—in one period. (See CreditMetrics Technical Document, page 25.) Translation Exposures Reflect the change in the value of a firm’s foreign net equity (for example, assets and liabilities) as it is converted to the home currency. Underlying An asset that may be bought or sold is referred to as the underlying. Unique risk Exposure to a particular company, and is sometimes referred to as firm-specific risk. Unique versus Systemic Risk Unwinding Positions Reversing positions. If you own a security (are long), sell the security (go short). If you have a short position, buy the security back. Value-at-Risk A measure of the maximum potential change in value of a portfolio of financial instruments with a given probability over a preset horizon. Variance A statistical measure that indicates the width of a distribution around the mean. It is the second moment of a distribution. A related measure is the standard deviation, which is the square root of the variance. (See CreditMetrics Technical Document, page 16.) Volatility Means risk, as measured by the standard deviation of a security’s price. Volatility

RiskImpact Volatility Clustering The tendency for unusully large market movements to occur in rapid succession. Evolution of RiskGrades Through Time Weighted Average RiskGrade A RiskGrade calculated ignoring any correlations or diversification in the portfolio. The Weighted Average RiskGrade can be found by multiplying the RiskGrade of each asset by its market value, adding the results and then dividing by the portfolio market value Extreme Market Loss Extreme Market Loss stands for the Loss in Extreme Markets. The Extreme Market Loss for a single position or portfolio is the dollar value by which the position or portfolio’s value could potentially fall during periods of high market volatility. High market volatility periods are defined as months in which market movements are in the 95th percentile or higher in terms of the magnitude. The Extreme Market Loss is calculated by using the expected value of the market moves during these high market volatility periods only. Extreme Market Loss