Introduction

ANDREA BERARDI - FRANCESCO ROSSI�

In recent years, risk management technology has undergone a dramatic

process of innovation. Every day, new sophisticated methods for measuring

and controlling market and credit risk are created, allowing ®nancial institu-

tions to put into practice mark-to-market risk management and deal with

adverse events, such as defaults and market losses.

The widespread use of ®nancial engineering techniques in risk manage-

ment has also given banks several new instruments to enhance internal models

and determine the adequate level of capital needed against market and credit

risk, so as to satisfy the requirements imposed by bank regulators.

Measuring credit risk is intrinsically more complicated than measuring

market risk, as data on credit events are much more limited than market data.

In fact, estimating and validating default risk models requires many years of

observations, whereas a vast amount of market data is available every day.

For this reason, market risk and default risk have usually been modelled

separately and many credit risk models ignore the strong intersection between

them assuming that current market variables are either constant or known with

certainty. However, as shown by Jarrow and Turnbull (2000), this simplifying

assumption implies that standard approaches to risk management, such as

CreditMetrics, CreditRisk� and KMV, fail in measuring market and credit risk

of portfolios of interest rate sensitive instruments.

Recent experiences, such as the 1998 Russia's default, have pointed out

that short-term market-driven variables can have a signi®cant impact on default

risk. Introducing marking to market in credit risk management can be an

important step towards an integrated and more ef®cient method built on the

close relationship between market and default risk.

The need for an integrated risk management system has recently become

crucial for some large banks, which are allowed to calculate capital require-

ments for their market and credit risk exposures using internal models rather

than the BIS regulatory model. (Recently, the Basle Committee on Banking

Supervision (BIS, 2001) has released a proposal for a new Capital Accord

which should replace the 1988 Accord.)

The Department of Financial Studies of the University of Verona hosted

on 25±26 May 2000 the ®rst international conference on `Managing Credit

and Market Risk. New Techniques for New Sources of Risk' to provide a

# Banca Monte dei Paschi di Siena SpA, 2001. Published by Blackwell Publishers,108 Cowley Road, Oxford OX4 1JF, UK and 350 Main Street, Malden, MA 02148, USA.

Economic Notes by Banca Monte dei Paschi di Siena SpA, vol. 30, no. 2-2001, pp. 163±166

� UniversitaÁ di Verona, Dipartimento Studi Finanziari, Nia Giardino Guisti 2-37129 Verona.

E-mail: Andrea.Berardi@univre.it and farossi@chiostro.univr.it

comprehensive view of recent developments in managing both market and

credit risk.

The conference looked at risk management from a variety of perspectives

and was designed to focus on all the important issues facing industry profes-

sionals in this ®eld. It brought together a panel of leading academics and

practitioners giving in-depth insights into the latest techniques for implement-

ing value-at-risk (VaR) systems, measuring default risk and pricing credit

derivatives.

The papers published in this special issue were all presented at the

conference and illustrate a number of new techniques for evaluating and

managing market and credit risk more ef®ciently.

Giovanni Barone-Adesi and Kostas Giannopoulos (pp. 167±81) present a

clear description of the `®rst generation' techniques for VaR applying back-

testing procedures to the most popular models. The article proposes a `second-

generation' volatility ®ltering method, which provides a low-cost improvement

in the VaR assessments.

The articles by Fulvio Corsi, Gilles Zumbach, Ulrich MuÈller and Michel

Dacorogna (pp. 183±204) and Andrea Beltratti and Claudio Morana (pp. 205±

33) show the progresses in volatility measurement which can be obtained using

high-frequency data. Their ®ndings indicate a drastic improvement towards a

consistent statistical estimation of volatility.

Umberto Cherubini and Elisa Luciano (pp. 235±56) illustrate an innova-

tive non-parametric description of the correlation among extreme losses. The

theory of dependence using copulas is shown to provide an elegant and

ef®cient alternative to the standard linear correlations approach, which usually

fails under stress testing.

Claudio Tebaldi (pp. 257±79) investigates a simulation approach to the

hedging of derivative portfolios which takes full advantage of the recent

progresses in consistent volatility estimation and bridges the gap between

scenario simulation and analytic computation of portfolio sensitivities.

Lane Hughston and Stuart Turnbull (pp. 281±92) address in their article

several relevant issues in credit risk. In particular, they consider: the valuation

of corporate bonds when the claim in the event of default is limited to the

bond's principal; the pricing of revolver loans; the implied correlation of

default probabilities; and the valuation of the collateral option.

Umberto Cherubini and Giovanni Della Lunga (pp. 293±312) propose a

VaR measure which takes into account market liquidity through the decoupling

of the discount factors for long and short positions, and their volatilities. The

method is shown to be well suited to price options when the distribution of the

underlying asset is not known precisely.

Conference participants also listened to presentations by Stephen Schaefer

(London Business School), Oldrich Vasicek (KMV Corporation) and Zahra El-

Mekkawy (BIS). Stephen Schaefer and Oldrich Vasicek gave keynote lectures

on recent developments in modelling and implementing credit risk models and

164 Economic Notes 2-2001: Review of Banking, Finance and Monetary Economics

# Banca Monte dei Paschi di Siena SpA, 2001.

in measuring and managing default risk, respectively. Zahra El-Mekkawy

presented the view of the Basle Committee on Banking Supervision on the

internal ratings-based approach for credit risk capital charges. Their remarks

are not reproduced in this volume.

Most of the papers were explicitly written for the conference. For this

reason, and for the enthusiasm shown in accepting our invitation, we express

our deepest gratitude to all the speakers.

165A. Berardi and F. Rossi: Introduction

# Banca Monte dei Paschi di Siena SpA, 2001.

REFERENCES

BIS (BANK FOR INTERNATIONAL SETTLEMENTS) (2001), The New Basel Capital Accord,

BIS, Basle.

R. A. JARROW ± S. M. TURNBULL (2000), `The Intersection of Market and Credit Risk',

Journal of Banking and Finance, 24, pp. 271±99.

166 Economic Notes 2-2001: Review of Banking, Finance and Monetary Economics

# Banca Monte dei Paschi di Siena SpA, 2001.