Financial Risk Management
The Need for Risk Management Following P. Jorion, Value at Risk, McGraw-Hill Chapter 1
•Other main sources: Zvi Wiener
Risk is the volatility of unexpected outcomes.
Business Risk Financial Risk Legal Risk Operational Risk
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Analytic Risk Management Tools Duration
Multiple factor models
Limits by duration buckets
Analytic Risk Management Tools
Risk-weighted assets (banks)
Integration of credit and market
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Derivatives and Risk Management
Stocks and bonds are securities – issued to raise capital.
Derivatives are contracts, agreements used for risk transfer.
Futures, Forwards, Swaps Options European, American, Exotics, ... Call, Put Cap, Floor
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Types of Financial Risks
Market Risk Credit Risk Liquidity Risk Operational Risk Legal Risk
What is the current Risk?
delta, gamma, vega
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How much can we lose?
Everything correct, but useless answer.
How much can we lose realistically?
VaR is defined as the predicted worst-case loss at a specific confidence level (e.g. 99%) over a certain period of time.
VaR is the worst loss over a target horizon with a given level of confidence (Jorion definition)
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VaR 1 0.8 0.6 0.4
Meaning of VaR A portfolio manager has a daily VaR equal $1M at 99% confidence level. This means that there is only one chance in 100 that a daily loss bigger than $1M occurs,
under normal market conditions.
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1% of worst cases Daniel HERLEMONT
A few well known risk factors Historical data + economic views Diversification effects Testability Easy to communicate
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Conventional Analysis $
sensitivity Risk factor Daniel HERLEMONT
VaR approach $
yield Risk factor Daniel HERLEMONT
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VaR is a necessary, but not sufficient procedure for controlling risk. It must be supplemented by limits and controls, in addition to an independent risk-management function. Sound risk-management practices.
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