risk management. risk management readings “beyond value at risk” kevin dowd wiley 1998...
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Risk Management Readings
• “Beyond Value at Risk” Kevin Dowd Wiley 1998
• “Mastering Risk Volume 1 and 2” FT Prentice Hall 2001
• “Risk Management for Company Executives” John Smullen FT Prentice Hall 2000
Risk Management Readings
• “The Revolution in Risk Management” Anthony Santomero in “Mastering Finance” FT Prentice Hall 1998
• “A Brief History of Downside Risk Measures” David Nawrocki Journal of Investing 1999
A Story• In 1530 Atahuallpa defeated his half brother Huascar to
gain control of the Inca Empire• He had conquered what he thought was the overwhelming
bulk of the civilised world and ruled an Empire some have compared to the Roman Empire in Size
• He let Francisco Pizarro with 100 soldiers and 60 horsemen meet him at the village of Cajamar which he surrounded with 40,000 troops
• The Spanish were surrounded but they attacked and killed 6-7,000 within a day.
• That led to the demise of the Inca Empire
Risk Related Thoughts
• Lightning Strikes• The Arrogance of Success Leads to Risk
Taking• Cultures may be Brittle• Other individuals and organisations may see
things radically differently• Technological Change can have major
impacts
The Continuum of Risks
• A Sensible Vision of Outcomes and Their Probabilities - Day to Day Movements in Equities
• A Sensible Vision of Outcomes but not Their Probabilities - Collapse in Housing Market
• No Vision of Outcomes or their Probabilities - Chicago Board of Trade 1992
The Sources of Risk
• Market Risk - Interest Rate, Forex, Commodity, Equity, Liquidity Risk (?), etc.
• Credit Risk - Risk of Counterparty Default
• Operational Risk - All other Risks
Risk Measures and Attitudes to Risk
Returns in % terms reflecting distribution from which returnsdrawn
Year 1 2 3 4 5 6 7 8 9 10
A 10 11 10 11 11 10 11 2 10 11B 5 13 5 9 7 12 9 6 14 9
E(Ra) = 9.7 SD(Ra) = 2.61E(Rb) = 9.2 SD(Rb) = 2.87
Consider Data on Last Slide and Evaluate the Nature of the Choice between the two
distributions of Returns ?
Attitudes to Risk
• Utility Function - Defined over a probability distribution of returns.
• Mean and Variance - an approximation see Blake pp 461-468.
• Time• Higher Moments• Downside Measures• Psychological Issues
Real Returns on US Assets 1802-1996
AverageReal Retrun
SD One YearHolding
SD TwentyYear Holding
Stocks 6.9 18 2.7
Bonds 3.4 8.5 3
Bills 2.9 6 2.8
Moments – To what extent is investor utility defined over
moments• 1st. Mean
• 2nd. Variance
• 3rd. Skewness – Degree of Asymmetry
• 4th. Kurtosis – Degree of Peakedness
VAR Definition
The Value at Risk (VAR) is the level of expected loss over a
given time horizon which will only be exceeded in a specified
proportion of instances.J.P.Morgan’s 4.15 Report
Expected Tail Loss
• When the outturn is worse than the VAR cut-off value what is the average loss
• Focuses on tail of distribution
• Better on discontinuous distributions
Time Period
• Liquidity of Portfolio
• Regulatory Framework
• Measurement Technique – Does one Assume Normality
• How does one deal with portfolio composition
• Required Data for Testing
Confidence Level
• Risk Management/Capital Requirement
• Regulatory Requirement (1%)
• Testing – Higher so more extreme observations
• Accounting and Comparison
Issues with Value at Risk and ETL
• How does it deal with non-normality?
• How does it deal with financial crises ?
• How does it deal with shifting parameter values?
• What types of risk is it best applied to?
• If distributions are normal VAR and ETL are just a multiples of the standard deviation
Risk Measures and Attitudes to Risk
Asset A B
E(R) 9.7 9.2SD(R) 2.61 2.873rd .Moment (44.54) (5.25)4th. Moment 352.96 122.61Worst Case 2 5Semi-Variance 59.29 6.78VAR (-0.3) 3.2ETL 2 5
Psychological Issues
• Economic Man
• Cognitive Dissonance
• Depends on Situation
• Too focused on Recent Data
Definition and Measurement of Risk
• Distributional Measures of Risk
• Calculus Based Measures of Risk
• Some Speciality Measures like Gap Analysis for Particular Risks
Calculus Based Measures of Risk
• First Derivative measures the rate with which the value of an obligation changes with changes in an Underlying Risk Factor
• Second Derivative Measure how sensitive is the First Derivative Measure to changes in the Underlying Risk Factor
Issues in Relation to Calculus Calculus Based Measures
• Need to Specify Mathematical Relationship so require a Pricing Model - Bond Valuation, Option Pricing Models
• Thus difficult to apply to complicated portfolios of obligations
• Applies to Localised Measurement of Risk
• An approximation of the function