science of term structure models

[rickm123]

Hi David:

The chapter in tuckman regarding term structure is quite detailed. I do understand the main point behind the theory but am struggling to determine what GARP will test on. Your practice questions on this topic use a lot of spreadsheets.

What do you suggest, know the overall theory or know the detail ? How can they test on this?

thanks

 

[David Harper CFA FRM]

Hi Rick,

I just recorded the 5b video which finishes on Tuckman 9 Term Structure, and I expressed (in the video) a reservation similar yours. Tuckman's Term Structure is a big example of a vexing assignment (in fact, I am going to add it, en masse, to the running feedback for GARP in the forum below: it persists a significant assignment but seems to be neglected in terms of the exam). My PQ do use a lot of XLS, sorry, but the nature of the chapter is to employ the interest rate tree ...

The irony is that GARP assigns fully eleven (11?) AIMs to Tuckman's Term Structure ... as if it were relatively important to P2 (!?).
Historically, GARP has barely tested it. I would predict more of the same, in part because (as you suggest) it is inherently difficult to reduce the binomial pricing into brief questions. From a pure exam agenda, I would not frankly spent a lot of time on it.

Although I do recall they've queried the risk neutral probabilities. So, my best guidance would be to focus on the ELEMENTS (i.e., binomial path, up/down, risk-neutral vs. real world probabilities) or, put another way, the ingredients, but give less attention to the full recipes of pricing instruments. I hope that helps,

 

[Aleksander Hansen]

Hi Rick,

I just recorded the 5b video which finishes on Tuckman 9 Term Structure, and I expressed (in the video) a reservation similar yours. Tuckman's Term Structure is a big example of a vexing assignment (in fact, I am going to add it, en masse, to the running feedback for GARP in the forum below: it persists a significant assignment but seems to be neglected in terms of the exam). My PQ do use a lot of XLS, sorry, but the nature of the chapter is to employ the interest rate tree ...

The irony is that GARP assigns fully eleven (11?) AIMs to Tuckman's Term Structure ... as if it were relatively important to P2 (!?).
Historically, GARP has barely tested it. I would predict more of the same, in part because (as you suggest) it is inherently difficult to reduce the binomial pricing into brief questions. From a pure exam agenda, I would not frankly spent a lot of time on it.

Although I do recall they've queried the risk neutral probabilities. So, my best guidance would be to focus on the ELEMENTS (i.e., binomial path, up/down, risk-neutral vs. real world probabilities) or, put another way, the ingredients, but give less attention to the full recipes of pricing instruments. I hope that helps,

I'll provide a slightly different angle, or perspective:

I would say that, while it may not be something that is easy to test on an exam, it is nevertheless crucial to understanding an important aspect of finance/economics and risk management.

Thus, I would say that it firmly belongs in the 'toolbox' of a risk manager worth his or her salt, and I'm guessing that is why this is included. After all, the main purpose of the FRM is to gain an understanding of the pillars upon modern financial theory rests - from a practical perspective. Passing the exam and getting the title can be important, but the title will be of little value if one afterwards is only able to answer rather basic multiple choice questions.

You should study to pass the test, but if you think about it, if you study so you understand the material you'll pass the test with ease.

 

[David Harper CFA FRM]

ahansen,

Your answer is better than mine, easily. What a relief to read it. I swear I started with that view, I just get distracted by the passing mentality, prevalent, I admit.
(In some candidates' defense, time is short). But still, thank you for a superior perspective!

 

[Aleksander Hansen]

ahansen,

Your answer is better than mine, easily. What a relief to read it. I swear I started with that view, I just get distracted by the passing mentality, prevalent, I admit.
(In some candidates' defense, time is short). But still, thank you for a superior perspective!

Naturally, as a test prep provider you have to think in those terms in order to deliver a quality product and provide a valuable service.

Importantly, I think your material is very much in line with what one ought to know - and e.g. the sample spreadsheets [which I have not seen] but from what I understand, several of them contain a wealth of important material which you point out may have low testability - is a testament to the fact that you do give candidates the option to explore less testable topics in-depth.

Now, whether candidates go beyond what you properly point out is most relevant from an exam perspective rests on their shoulders.

At the end of the day, providing a 900 page theory-heavy book would not make sense for Bionic Turtle [one can go through Darrel Duffies Asset pricing book for that]. Rather providing a well thought through, clear and concise explanation of the material - in documents, videos, Q&As, spreadsheets and through interaction with candidates does.

It helps those who want a refresher, as well as those who are relatively inexperienced or have had less exposure to math or finance to grasp concepts that certain writers seem to intent on making obscure.

But candidates should keep in mind that low testability is not synonymous with low relevance.

Now if you only had study notes on how to deal with procrastination.....

 

[Galaxy]

Hi David/Dear ALL,

I have been reading through various Tuckman's chapters and watched David's great videos on these readings. However, it remains unclear in my mind what the "scientific" aspect(s) in Chapter 7 ("The Science of Term Structure Models") versus the "artistic" aspect(s) in Chapter 9 ("The Art of Term Structure Models: Drift") and Chapter 10 ("The Art of Term Structure Models: Volatility and Distribution") is/are. Whilst all these term structure models are some kind of binomial trees models (as I understand), why is it important to draw the "science" and "art" of these models please?

Thank you!

Galaxy

 

[David Harper CFA FRM]

Hi @Galaxy In all honesty, I never gave that any thought! Let's see what Tuckman says at the beginning of Chapter 9 (emphasis mine):

"Chapters 7 and 8 show that assumptions about the true and risk-neutral short-term rate processes determine the term structure of interest rates and the prices of fixed income derivatives. The goal of this chapter is to describe the most common building blocks of short-term rate models. Selecting and rearranging these building blocks to create suitable models for the purpose at hand is the art of term structure modeling. This chapter begins with an extremely simple model with no drift and normally distributed rates. The next sections add and discuss the implications of alternate specifications of the drift: a constant drift, a time-deterministic shift, and a mean-reverting drift." -- Tuckman, Bruce; Serrat, Angel. Fixed Income Securities: Tools for Today's Markets (Wiley Finance) (p. 251). Wiley. Kindle Edition.

So if I understand him, and I think he might be engaging in a bit of poetical/metaphorical license, the "science" concerns the fundamental, mathematical building blocks of term structures: risk-neutral probabilities, volatility dynamics, risk premium. The "art" concerns the construction of, and selection among, the different possible models. Although the models can be parsed in different ways (equilibrium vs. arbitrage), they are also presented in increasing sophistication. I do think myself that choosing a model and deciding "how much sophistication do I want?" is more art than science. I hope that's interesting, thanks!

 

[Galaxy]

Thanks very much @David Harper CFA FRM! Your interpretation makes a lot of sense. As I am trying to link various "sub-topics" in my head to paint a big picture, this is something that has been bothering me. Tuckman, imo, is a tough book. The more I can understand how he develops his logic/thinking between the chapters, the "easier" it gets (relatively speaking!)