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Risk Management (GSIEF 208b) - Risk Management and Quantitative

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Risk Management (GSIEF 208b) - Risk Management and Quantitative

GSIEF 208b Risk Management

    Semesters Taught (Summer 1999, Summer 2000)

    Professor Ron D’Vari, Ph.D., CFA Adjunct Professor, Graduate School of Economic and International Finance, Brandeis University

    Sr. Vice President, Portfolio Manager, and Head of Quantitative Research

    State Street Research and Management

    Email: rdvari@ssrm.com

The problem with the future is uncertainty so we look for clues in the past. The objective of this class is to

    introduce students to various types of risks and their management. Here emphasis is given to financial risk

    management and particularly market and credit risks. Some aspects of operational, legal (compliance and

    regulatory), and strategic risk management for financial institutions are also explored.

    Text Books and References: - Philippe Jorion, Value at Risk, IRWIN Professional Publishing, 1997 TM- RiskMetrics Technical Document, RiskMetrics Group, Fourth Edition, 1996. TM- CreditMetrics Technical Document, RiskMetrics Group, April 2,1997. - Regulatory publications (see attached list)

     TM TM(RiskMetrics and CreditMetrics documents to be downloaded from www.riskmetrics.com)

Optional Additional Readings:

    - Bernstein, Peter, Against the Gods, John Wiley & Sons, 1996

Prerequisites: Some level of familiarity with:

    Basic Quantitative Analysis: Time value of money, probability distributions and their properties,

    variance/covariance analysis, correlation and regression analysis and forecasting.

    Capital Markets: Fixed income derivatives; Foreign exchange derivatives; Futures, forwards,

    swaps, and options; Equity derivatives; Commodity derivatives; Emerging markets

Class Grading:

    ? Participation in class discussions 10%

    ? Team Project 40%

    ? Class Presentation 20%

    ? Final 30%

Office Hours: After each class or by appointment.

Summary of Topics Discussed

    ? Multi-factor Models for Measuring Investment Portfolio Risk

    ? Multi-factor Performance Measurement and Attribution

    ? Value at Risk

    ? Definition and Computation

    ? Treatment of Derivatives

    ? Different Approaches to Measuring VAR

    ? Forecasting Risks and Correlations

    ? Computation, Benefits, and Limitations of Risk-Adjusted Return on Capital (RAROC)

    ? Risk Metrics and Credit Metrics

    ? Comprehensive methodology for measuring market risk

    ? Identification, Quantification, and Management of Operational Risk

    ? Risk-Adjusted Capital Framework Operational Risk, Credit Risk, Market Risk

? Classification of Risks Confronting Financial Intermediaries Lending, Trading, Operating Services,

    Deposit Gathering, Treasury, Capital Market Activities

    ? General Objectives of Enterprise-wide Risk Management Balance Sheet Management, Performance

    Measurement, Motivation and Compensation, Strategic Decision Support

    ? Identification and Measurement of Non-financial Risks (Risk of Lost Opportunities) ? Role of Information Flow and Visibility in Risk Management

    ? Implementation Issues For Transitioning to An Enterprise Risk Management

    ? Culture

    ? System

    ? Information flow and visibility

    ? Training

    ? Management Commitment

    ? Role of an Appropriate Benchmark for Measuring Relative Risk

Session 1: Introduction to Risk Management

    1. The Need for Risk Management

    2. Lessons from Financial Disasters

    3. The Concept of Hedging, Diversification and Insurance

    4. Risk Management Not Just for Trading

    5. Significant Changes to the Financial Markets Securitization and Move to Risk-adjusted

    Performance Measurement

    6. Types of Risks: Business, Strategic, Financial Risk, Operational Risk, Legal Risks 7. Types of Financial Risks: Market Risk, Credit Risk, Liquidity Risk

    8. Conventional Market Risk Measures: Duration, Beta, Historical Volatility, Sector Exposure, Currency

    Exposure, Market Exposure, and Greeks for Derivatives

    9. Evolution from Asset Liability Management to Value-At-Risk

    10. The Risk Management Cycle: Identify, Measure, Manage, Evaluate, Improve 11. Role of Transparency of Risk

    12. Role of Professional Judgement and Experience in Managing Risk

Reading Assignments: Chapters 1-3 (PJ), RiskMetrics TD, Part I: Risk Measurement Framework

Session 2: An Introduction to Value at Risk

    1. Two Modern Approaches to Market Risk Management: Statistical Approach and Scenario Stress

    Testing

    2. Historical Perspective of VaR

    3. Definition of Value at Risk (VaR)

    4. Simple Examples of VaR Calculations Using Normally Distributed Financial Variables 5. VaR for A Portfolio of Non-normally Distributed Assets

    6. Limitations of VaR

    7. Application of VaR: Risk Control, Senior Management Reporting, Capital Allocation, Performance

    Measurement; Regulatory Compliance

    8. Banking Regulatory Initiatives on VaR

    9. Sound Risk Management Practices

    10. Proactive Risk Management Just Say No!

Reading Assignments: Chapters 4 and 5 (PJ), RiskMetrics TD, Part I: Risk Measurement Framework

    Project Milestones: Form a Project Team, Select a Particular Industry or Institution to Analyze.

Session 3: Risk Measurement Framework

    We discuss a practical framework on how to think about market risks, how to apply that thinking in practice, and

    how to interpret the results. Different approaches to risk estimation are discussed. We show how the

1. General VaR Framework: Mark-to-Market, Calculate Distribution of Values at Horizon, Calculate calculations work on simple examples and discusses how the results can be used in limit management, VaR performance evaluation, and capital allocation. 2. Specifying Risk Horizon Time and Confidence Level

    3. Specifying Risk Factors in A Portfolio and Their Distribution

    4. Mapping Assets to Risk Factors, i.e. Calculating Exposure to Factors

    5. Vary Risk Factors

    6. Estimate The Changes in Value of Instruments

    7. Calculate VaR

    8. VaR for Parametric Distributions

    9. Conversion of VaR Parameters

    10. Reality Checks How to Verify VaR 11. Application of Risk Measures

    Reading Assignments: Chapters 5 (PJ), RiskMetrics TD, Part I: Risk Measurement Framework Project Milestones: Initiate Setting Objectives for Your Project, Identify How You Plan to Gather Information or Data.

Session 4: Statistics of Financial Market Returns

    This part requires an understanding and interest in statistical analysis. We review the assumptions behind the

    statistics used to describe financial market returns and how distributions of future returns can be estimated.

1. Definition of financial price changes and returns

    2. Modeling financial prices and returns

    3. Investigating the random-walk model

    4. A review of historical observations of return distributions

    5. RiskMetrics model of financial returns: A modified random walk

Reading Assignments: Chapters 9 (PJ), RiskMetrics TD, Part II: Statistics of Financial Market Returns

    Project Milestones: Finalize Setting Objectives for Your Project. Initiate Fact and Data Gathering. Perform a Literature Search.

Session 5: Risk Management for Derivatives

     Guest Lecturer: Harry Markopolos

1. Linear (future, swap, forward, etc.) and Nonlinear Derivative Instruments (Options)

    2. Role of Derivatives in Risk Management

    3. Hedging Using Futures and Options

    4. Delta-Gamma VaR Analysis

    5. Role of Implied Volatility in Risk Management of Derivatives

    6. Use of Volatility Swaps as a Hedging Tool

    7. Role of Total Return Swaps in Risk Management

Reading Assignments: Chapters 6-7 (PJ), RiskMetrics TD, Part II: Risk Measurement Framework

    Project Milestones: Study Key Literature. Identify Major Risks Addressed in Your Case. Outline Current Approaches to Measure and Manage Risk in the Selected Industry or Institution. Identify and

    Evaluate Risk Management Systems Currently Used.

Session 6: Implementation of Risk Management at A Financial Institutions

     Guest Lecturer: Edward Dumas

    Reading Assignments: Chapters 6-7 (PJ), RiskMetrics TD, Part II: Risk Measurement Framework Project Milestones: Study Strengths and Weaknesses of Current Approaches and Practices to Measure and Manage Risk in Your Industry. Identify Key Risk Management Experts in Your Selected Industry or

    Institution.

Session 7. Estimation and Forecast

1. Forecasts from implied versus historical information

    2. RiskMetrics forecasting methodology

    3. Estimating the parameters of the RiskMetrics model

    4. Summary and concluding remarks

    Reading Assignments: Chapters 9 (PJ), RiskMetrics TD, Part II: Statistics of Financial Market Returns Project Milestones: Prepare a List of Key Questions. Arrange and Conduct Personal Interviews with Key Experts on History, Status, and the Direction of Future Risk Management Practice as It Relates to Your

    Specific Industry or Institution.

Sessions 8-9: Portfolio VaR and Different Approaches to Measuring VaR

1. How to Vary Risk Factors: Variance/Covariance; Implied Variance/Covariance; Historical Simulation;

    Monte Carlo; Structured Monte Carlo

    2. How to Estimate The Changes in Value of Instruments Local valuation; Full Valuation

    3. Dealing with Nonlinear Positions, e.g. options

    Market risk methodology

    4. Step 1Identifying exposures and cash flows

    5. Step 2Mapping cash flows onto RiskMetrics vertices

    6. Step 3Computing Value-at-Risk

    7. Examples

    Monte Carlo

    8. Scenario generation

    9. Portfolio valuation

    Reading Assignments: Chapters 10-11 (PJ), RiskMetrics TD, Part III: Risk Modeling of Financial Instruments

    Project Milestones: Identify Future Improvements in Risk Management Practices in your Selected Industry or Institution. Identify Challenges in Implementing the Described Improvements. Identify The

    Benefits of the Proposed Improvements

Sessions 10. Credit Risk Management

    Reading Assignments: Chapters 12 (PJ), CreditMetrics TD. Project Milestones: Report Preparation

Sessions 11 Operational Risk Management

    Assignments: Related Articles. Final take-home exam to be handed out.

    Project Milestones: Report Preparation

Session 12. Summary and Conclusion

    1. Project Presentations.

    Assignments: Project report and final examination due.

Useful References:

    1. Value at Risk (August 1996), by Philippe Jorion

    2. Managing Financial Risk : A Guide to Derivative Products, Financial Engineering and Value (3rd

    edition, July 1998), by Charles W. Smithson and Clifford W. Smith

    3. Derivatives Handbook (May 1997), by Robert Schwartz and Clifford W. Smith, Jr.

    4. Swap & Derivative Financing : The Global Reference to Products, Pricing, Applications and Markets

    (Revised edition, August 1994), by Satyajit Das

    5. Options, Futures, and Other Derivatives (3rd w/ disk edition, April 1997), by John C. Hull

    6. Managing Credit Risk : The Next Great Financial Challenge (Wiley Frontiers in Finance), by John B.

    Caouette, Edward I. Altman, Paul Narayanan

    7. Handbook of Emerging Fixed Income and Currency Markets (August 1998), by Frank J. Fabozzi

    (Editor), Alberto Franco (Editor)

    8. Fixed Income Mathematics : Analytical & Statistical Techniques (October 1996), by Frank J. Fabozzi

    9. Managing Bank Capital: Capital Allocation and Performance Measurement (August 1996), by Chris

    Matten (SBC)

    10. Dynamic hedging (December 1996), by Nassim Taleb

    11. CreditMetrics Technical Document - http://www.riskmetrics.com

    12. RiskMetrics Technical Document - http://www.riskmetrics.com

    Regulatory publications:

    1. Risk Management and Control Guidance for Securities Firms and their Supervisors IOSCO, May 98,

    http://risk.ifci.ch/144020.htm

    2. Risk Management Guidelines for Derivatives BIS - Basle Committee, Jul. 1994,

    http://risk.ifci.ch/RMGL.htm

    3. Derivatives: Practices and Principles G30 / Global Derivatives Study Group, Jul. 1993,

    http://risk.ifci.ch/136160.htm

    4. Operational Risk Management BIS - Basle Committee, Sept. 1998, http://risk.ifci.ch/144400.htm

    5. Capital Adequacy Principles BIS - Basle Committee, Feb. 1998, http://risk.ifci.ch/143520.htm

    8. Report of the Committee on Interbank Netting Schemes BIS - Committee on Payment and Settlement

    Systems of the G-10, Nov. 1990 http://risk.ifci.ch/140810.htm

    GARP’s Financial Risk Management (FRM) Certification Program

The FRM Exam is designed to test for an admixture of basic analytical skills , general knowledge and

    intuitive capability acquired through experience in capital markets. It focuses on the core body of

    knowledge required for independent risk management analysis and decision making. This outline

    establishes the topics in financial risk management with relative weights of those topics in the FRM Exam.

    Within each topic, general concepts and techniques are also listed.

FRM candidates are given 5 hours to complete the examination.

    1999 Examination Topics

    Topic Percentage

    I. Quantitative Analysis 15%

    II. Capital Markets 15%

    III. Market Risk Management 25%

    IV. Credit Risk Management 25%

    V. Operational & Integrated Risk Management 5%

    VI. Legal, Accounting, and Tax Risk Management 5%

    VII. Regulation and Compliance 10%

    100% Total

I. Quantitative Analysis

    Time value of money

    Probability distributions and their properties

    Correlation and regression analysis

    Correlation and regression forecasting

II. Capital Markets

    Fixed income derivatives

    Foreign exchange derivatives

    Futures, forwards, swaps, and options

    Equity derivatives

    Commodity derivatives

    Emerging markets

III. Market Risk Management

    Interest rate, foreign exchange, equity, commodity risks

    Emerging market risk

    Liquidity risk

    Derivatives risk

    Portfolio risk

    VaR

    Approaches to VaR

    Parametric VaR

    Delta-Normal VaR

    Simulation VaR

    Stress Testing

IV. Credit Risk Management

    Credit exposure and credit risk

    Counterparty exposure and countparty risk

    Default probability and recovery rate

    Credit rating migration

    Netting

Margin and Collateral Requirements

    Pre Settlement Risk

    Settlement Risk

    Counterparty Risk

    Portfolio credit risk

    Measuring and managing credit risk

    Credit derivatives

V. Operational & Integrated Risk Management

    Operational risk

    Policies and procedures

    Best practices

    Business structure

    Firmwide risk management

    Calculation of risk capital

    RAROC

    Model risk

    Other risks

VI. Legal, Accounting, and Tax Risk Management

    Legal, Accounting, and Tax aspects

    Legal risk

    Accounting risk

    Tax risk

VII. Regulation and Compliance

    BIS Capital Accord (1988)

    BIS Market Risk Amendment (1996)

    EU Capital Adequacy Directive

    Fed Pre-Commitment Model

    As a practitioner oriented exam, reading textbooks alone will not generally be sufficient to pass the FRM Examination. However, the FRM Examination is based upon the following required references in

    combination with practical skills and techniques which may not be covered in those references.

    Familiarity with regulatory publications, such as those listed here, is expected. Optional references maybe used to in the exam to supplement the required references on the general concepts and techniques listed in the FRM Examination Outline.

    Required references:

    13. Value at Risk (August 1996), by Philippe Jorion

    14. Managing Financial Risk : A Guide to Derivative Products, Financial Engineering and Value (3rd

    edition, July 1998), by Charles W. Smithson and Clifford W. Smith

    15. Derivatives Handbook (May 1997), by Robert Schwartz and Clifford W. Smith, Jr. 16. Swap & Derivative Financing : The Global Reference to Products, Pricing, Applications and Markets

    (Revised edition, August 1994), by Satyajit Das

    17. Options, Futures, and Other Derivatives (3rd w/ disk edition, April 1997), by John C. Hull 18. Managing Credit Risk : The Next Great Financial Challenge (Wiley Frontiers in Finance), by John B.

    Caouette, Edward I. Altman, Paul Narayanan

    19. Handbook of Emerging Fixed Income and Currency Markets (August 1998), by Frank J. Fabozzi

    (Editor), Alberto Franco (Editor)

    20. Fixed Income Mathematics : Analytical & Statistical Techniques (October 1996), by Frank J. Fabozzi Optional references:

    21. Managing Bank Capital: Capital Allocation and Performance Measurement (August 1996), by Chris

    Matten (SBC)

22. Dynamic hedging (December 1996), by Nassim Taleb

    23. CreditMetrics Technical Document - http://www.riskmetrics.com 24. RiskMetrics Technical Document - http://www.riskmetrics.com Regulatory publications:

    1. Risk Management and Control Guidance for Securities Firms and their Supervisors IOSCO, May 98,

    http://risk.ifci.ch/144020.htm

    2. Risk Management Guidelines for Derivatives BIS - Basle Committee, Jul. 1994,

    http://risk.ifci.ch/RMGL.htm

    3. Derivatives: Practices and Principles G30 / Global Derivatives Study Group, Jul. 1993,

    http://risk.ifci.ch/136160.htm

    4. Operational Risk Management BIS - Basle Committee, Sept. 1998, http://risk.ifci.ch/144400.htm

    5. Capital Adequacy Principles BIS - Basle Committee, Feb. 1998, http://risk.ifci.ch/143520.htm

    8. Report of the Committee on Interbank Netting Schemes BIS - Committee on Payment and Settlement

    Systems of the G-10, Nov. 1990 http://risk.ifci.ch/140810.htm

    The Practitioner’s Handbook of Financial Risk Management

    Edited by Marc Lore and Lev Borodovsky

Forward ____________________________________________________________ 8

    Preface _____________________________________________________________ 8

    Executive Summary ___________________________________________________ 8

    Introduction to Financial Risk Management _______________________________ 8

    What is Financial Risk Management? ________________________________________ 8

    Definition ____________________________________________________________________ 8

    A Risk Managers Perspective ___________________________________________________ 8

    A Traders Perspective _________________________________________________________ 8

    A Senior Management Perspective _______________________________________________ 8

    A Regulator’s Perspective ______________________________________________________ 8

    Risk Control vs. Risk Measurement/Analysis _________________________________________ 8 What are the Responsibilities of the Risk Manager? ____________________________ 8

    Understanding the Markets _______________________________________________________ 8

    Fixed Income ________________________________________________________________ 8

    Equity _____________________________________________________________________ 8

    Commodities ________________________________________________________________ 8

    Foreign Exchange ____________________________________________________________ 8

    Emerging Markets ____________________________________________________________ 8 Understanding the Businesses _____________________________________________________ 8

    Market Making ______________________________________________________________ 8

    Proprietary Trading ___________________________________________________________ 8

    Brokerage __________________________________________________________________ 8

    Underwriting / Syndication _____________________________________________________ 8

    Lending ____________________________________________________________________ 8

    Asset Management ___________________________________________________________ 8 Understanding the Risks _________________________________________________________ 9

    Market Risk _________________________________________________________________ 9

    Credit Risk__________________________________________________________________ 9

    Settlement Risk ______________________________________________________________ 9

    Liquidity Risk _______________________________________________________________ 9

    Operational Risk _____________________________________________________________ 9

    Systems Risk ________________________________________________________________ 9

    Documentation Risk __________________________________________________________ 9 Use of VaR? _____________________________________________________________ 9

    Risk Control __________________________________________________________________ 9 Senior Management Reporting ____________________________________________________ 9 Capital Allocation ______________________________________________________________ 9 Performance Measurement _______________________________________________________ 9 Regulatory Compliance __________________________________________________________ 9 Implementing a Firm-Wide Risk Management Framework _______________________ 9

    The Foundation ________________________________________________________________ 9

    The People __________________________________________________________________ 9

    The Systems_________________________________________________________________ 9

    Senior Management Support ____________________________________________________ 9 The Key Challenges ____________________________________________________________ 9 Risk Primer _________________________________________________________ 10

Quantitative Basics ______________________________________________________ 10

    Time Value of Money __________________________________________________________ 10

    Present Value_______________________________________________________________ 10 Annuities __________________________________________________________________ 10 Perpetuities ________________________________________________________________ 10 Amortization _______________________________________________________________ 10 Applied Probability ____________________________________________________________ 10

    Types of Distributions __________________________________________________________ 10

    Normal ____________________________________________________________________ 10 Log Normal ________________________________________________________________ 10 Binomial __________________________________________________________________ 10 Variance/Covariance ___________________________________________________________ 10

    Properties of Expectation _______________________________________________________ 10

    Mean and Standard Deviation____________________________________________________ 10

    Regression/Correlation _________________________________________________________ 10

    Skew and Kurtosis _____________________________________________________________ 10

    Capital Markets Basics ___________________________________________________ 10

    Fixed Income _________________________________________________________________ 10

    Term Structure of Interest Rates ________________________________________________ 10

    Zero Coupon Curves _______________________________________________________ 10

    Forward Curves ___________________________________________________________ 10 Bond Sensitivities ___________________________________________________________ 10

    Properties of Duration ______________________________________________________ 10

    Properties of Convexity _____________________________________________________ 10

    Dollar Value of a Basis Point ________________________________________________ 10 Derivatives ___________________________________________________________________ 10

    Option Sensitivities __________________________________________________________ 10 Option Mechanics ___________________________________________________________ 10 Futures/Forwards ____________________________________________________________ 10 Swaps _____________________________________________________________________ 10

    Market Risk Management Framework ___________________________________ 11

    Choosing Appropriate Model Parameters ____________________________________ 11

    Confidence Level ______________________________________________________________ 11

    Holding Period _______________________________________________________________ 11

    Volatility/Correlation __________________________________________________________ 11

    GARCH ___________________________________________________________________ 11 Implied ___________________________________________________________________ 11 Historical __________________________________________________________________ 11

    Observation Period ________________________________________________________ 11

    Weighting _______________________________________________________________ 11 Yield Curves _________________________________________________________________ 11

    Beta ________________________________________________________________________ 11

    Risk Measurement Methods _______________________________________________ 12

    Fixed Income Risk _____________________________________________________________ 12

    Covariance Approach ________________________________________________________ 12

    Duration Bucketing ________________________________________________________ 12

    Cash Flow Bucketing ______________________________________________________ 12 Principle Component Analysis (PCA) ___________________________________________ 12 Historical Simulation ________________________________________________________ 12 Equity Risk __________________________________________________________________ 12

    Single Factor Model _________________________________________________________ 12 Multi-Factor Model __________________________________________________________ 12

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