Financial Risk Management

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1 IEOR E4723: Topics In Quantitative Finance Financial Risk Management Summer 2008, Instructor: Allan M. Malz, 1.5 credits DRAFT Syllabus Course description This course introduces students to the understanding and management of financial risk. Its objective is to familiarize students with the risks faced by financial and nonfinancial firms, particularly the former, and with the tools practitioners use to measure and control risks. We will study the benefits and pitfalls of contemporary risk measurement models. Much of the course will be devoted to detailed examples of how particular tools and techniques are applied to particular problems. Prerequisites The course assumes basic familiarity with probability and statistics, the instruments of the financial markets, and asset pricing models. Textbooks and resources There is no required textbook, but two suggested ones. Hull (2006) is a good guide to the algebra and analytics. Crouhy, Mark & Galai (2000b) contains a lot of valuable institutional information and has an emphasis on credit risk. The bookstore will stock both. You probably should buy one. Pick the one that appeals to you. If you happen already to own another one, that s fine, too. Bernstein (1996) provides good background and is fun to read. For each topic, the section below tells you where it is covered in the lecture notes, which are posted on CourseWorks. Students (and everyone else involved in risk management) should be aware of some rich resources on the Internet. Here are a few: GloriaMundi makes available for download a colossal amount of risk management research, news, documents issued by regulatory authorities and industry groups, and other information, at Bank for International Settlements is a services provider to the world s central banks. It invests reserves on behalf of some central banks. It also has a research department of its own and hosts regulator groups and research conferences. A large number of key regulatory documents are posted on its website

2 Central banks such as the Bank of England and the European Central Bank have large research departments that publish research and surveys related to risk management. Almost all of it can be downloaded from the Internet. A good starting point is the BIS links collection The Federal Reserve System is worth singling out; fedinprint/ is a handy search tool. RiskMetrics Group is a risk measurement analytics firm that conducts original research and posts technical papers athttp:// A selection of technical documents from these sources and survey material on financial markets and risk published by major banks and broker-dealers are posted on CourseWorks. 2

3 Session 1 May 27, 2007 The scope of financial risk The subprime crisis Typology of financial risks Financial market participants Why is risk a separate discipline today? Lecture notes 1; other readings TBD. Market risk Standard model of asset prices Portfolio risk Lecture notes 2; other readings TBD. Credit risk Defining credit risk Credit risk models Lecture notes 3; Crouhy, Mark & Galai (2000a); Moody s Investors Service (2007); Standard & Poor s (2006); Finger (1999); Credit Suisse First Boston (2004), ch. 1, 2, Appendix; O Kane & Schloegl (2001). Session 2 June 3,

4 Value at Risk Value-at-Risk Volatility estimation: RiskMetrics and GARCH Modes of computation: parametric, historical and Monte Carlo simulation Expected shortfall Lecture notes 4; Duffie & Pan (1997); Morgan Guaranty Trust Company (1996) ch. 1, 5; Mina & Xiao (2001) ch Mapping and treatment of bonds and options Duration and interest-rate volatility Nonlinearity and convexity risk The delta-gamma approach Vega risk Lecture notes 5-6; Mina & Xiao (2001) ch. 3, 5; Morgan Guaranty Trust Company (1996) ch. 6-7; Crouhy et al. (2000b) app. to ch. 5; Malz (2000/2001). Session 3 June 10, 2008 Portfolio VaR Delta-normal VaR Portfolio VaR via Monte Carlo simulation Lecture notes 7; Mina & Xiao (2001) ch. 3, 5. 4

5 Risk capital and portfolio construction Concept of economic capital and risk contribution Measuring diversification with VaR; marginal and incremental VaR Implied views Lecture notes 7; Mina & Xiao (2001) ch. 2. The quality of VaR estimates Backtesting Variability of VaR estimates Coherence of VaR estimates Lecture notes 8; Kupiec (1995b); Lopez (1999); Danìelsson (2002); Beder (1995). Session 4 June 17, 2008 Portfolio credit risk measurement Default correlation and default distributions VaR with the single-factor credit risk model Credit VaR Copula models Lecture notes 9; Lucas (1995); Credit Suisse First Boston (2004), ch. 2; O Kane & Schloegl (2001), pp ; Finger (1999); Lehman Brothers (2003), pp Session 5 TBD 5

6 Alternatives to the standard market risk model Real-world asset price behavior The evidence in option prices Modeling approaches for non-normality; jump-diffusion and stochastic volatility models Lecture notes 10; Jackwerth (1999); Merton (1976); de Vries (1994). Liquidity risk Transaction cost liquidity, funding liquidity and systemic liquidity Liquidity-adjusted VaR Lecture notes 11; Malz (2003); Bank for International Settlements (1999); Bangia, Diebold, Schuermann & Stroughair (1999). Stress testing Historical stress tests Scenario analysis and scenario design principles Lecture notes 12; Mina & Xiao (2001) ch. 4; Kupiec (1995a); Boyer, Gibson & Loretan (1997); Loretan & English (2000). Session 6 July 1 Financial crises Financial crises, bubbles, and extreme volatility Financial market behavior during extreme events Lecture notes 13; Kindleberger (1978); Garber (1989); Garber (1990). 6

7 Regulation Scope and rationale of regulation Regulatory authorities Methods of regulation; capital standards Lecture notes 14; Bank for International Settlements (1996); Spong (2000). Final exam 7

8 Reading list Bangia, A., Diebold, F. X., Schuermann, T. & Stroughair, J. D. (1999), Modeling liquidity risk with implications for traditional market risk measurement and management, Working Paper 99-06, Wharton Financial Institutions Center. Available at edu/fic/papers/99/p9906.html. Bank for International Settlements (1996), Amendment to the capital accord to incorporate market risks, Basel. Available athttp:// Bank for International Settlements (1999), Market liquidity: research findings and selected policy implications, Technical Report 12, Monetary and Economic Department, Basel. Available at Beder, T. S. (1995), VAR: seductive but dangerous, Financial Analysts Journal 51(5), Bernstein, P. L. (1996), Against the gods: the remarkable story of risk, John Wiley & Sons, New York. Boyer, B. H., Gibson, M. S. & Loretan, M. (1997), Pitfalls in tests for changes in correlations, International Finance Discussion Paper 597, Board of Governors of the Federal Reserve System. Available athttp:// Credit Suisse First Boston (2004), Credit portfolio modeling handbook. Crouhy, M., Mark, R. & Galai, D. (2000a), A comparative analysis of current credit risk models, Journal of Banking and Finance 24(1 2), Crouhy, M., Mark, R. & Galai, D. (2000b), Risk management, McGraw Hill, New York. Danìelsson, J. (2002), The emperor has no clothes: Limits to risk modelling, Journal of Banking and Finance 26(7), de Vries, C. G. (1994), Stylized facts of nominal exchange rate returns, in F. van der Ploeg, ed., The handbook of international macroeconomics, Blackwell, Oxford and Cambridge, U.S. Duffie, D. & Pan, J. (1997), An overview of value at risk, Journal of Derivatives 4(3), Finger, C. C. (1999), Conditional approaches for CreditMetrics portfolio distributions, Credit- Metrics Monitor pp Available at Garber, P. M. (1989), Tulipmania, Journal of Political Economy 97(3), Garber, P. M. (1990), Famous First Bubbles, Journal of Economic Perspectives 4(2), Hull, J. C. (2006), Risk management and financial institutions, Pearson/Prentice Hall, Upper Saddle River, NJ. 8

9 Jackwerth, J. C. (1999), Option-implied risk-neutral distributions and implied binomial trees: a literature review, Journal of Derivatives 7(2), Kindleberger, C. P. (1978), Manias, Panics and Crashes, Basic Books, New York. Kupiec, P. H. (1995a), Stress testing in a value at risk framework, Journal of Derivatives 6(1), Kupiec, P. H. (1995b), Techniques for verifying the accuracy of risk measurement models, Journal of Derivatives 3(2), Lehman Brothers (2003), The Lehman Brothers guide to exotic credit derivatives. Lopez, J. A. (1999), Methods for evaluating value-at-risk estimates, Economic Review (2), Loretan, M. & English, W. B. (2000), Evaluating correlation breakdowns during periods of market volatility, International Finance Discussion Paper 658, Board of Governors of the Federal Reserve System. Available at ifdp658.pdf. Lucas, D. J. (1995), Default correlation and credit analysis, Journal Of Fixed Income pp Malz, A. M. (2000/2001), Vega risk and the smile, Journal of Risk 3(2), Malz, A. M. (2003), Liquidity risk: Current research and practice, RiskMetrics Journal 4(1), Available athttp:// Merton, R. C. (1976), Option pricing when underlying stock returns are discontinuous, Journal of Financial Economics 3(1/2), Mina, J. & Xiao, J. (2001), Return to RiskMetrics: the evolution of a standard, RiskMetrics Group. Available athttp:// Moody s Investors Service (2007), Corporate Default and Recovery Rates, , Technical report. Available athttp:// Morgan Guaranty Trust Company (1996), RiskMetrics Technical Document, 4th edn. O Kane, D. & Schloegl, L. (2001), Modelling credit: theory and practice, Advanced reasearch series, Lehman Brothers. Spong, K. (2000), Banking regulation: Its purposes, implementation, and effects, 5th edn, Federal Reserve Bank of Kansas City. Available at PDF/RegsBook2000.pdf. Standard & Poor s (2006), Annual 2005 Global Corporate Default Study And Rating Transitions, Technical report. 9

10 Version 0.1 April 17,

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