Financial Risk Management

The Need for Risk Management Following P. Jorion, Value at Risk, McGraw-Hill Chapter 1

•Other main sources: Zvi Wiener

Daniel HERLEMONT

Financial Risks

Risk is the volatility of unexpected outcomes.

Business Risk Financial Risk Legal Risk Operational Risk

Daniel HERLEMONT

Page 1 1

Analytic Risk Management Tools Duration

1938

Markowitz mean-variance

1952

Sharpe’s CAPM

1963

Multiple factor models

1966

Black-Merton-Scholes model

1973

RAROC

1983

Limits by duration buckets

1986

Daniel HERLEMONT

Analytic Risk Management Tools

Risk-weighted assets (banks)

1988

Stress Testing

1992

Value-at-Risk, VaR

1993

RiskMetrics

1994

CreditMetrics

1997

Integration of credit and market

1998-

Enterprisewide RM

2000-

Daniel HERLEMONT

Page 2 2

Derivatives and Risk Management

Stocks and bonds are securities – issued to raise capital.

Derivatives are contracts, agreements used for risk transfer.

Daniel HERLEMONT

Financial Derivatives

Futures, Forwards, Swaps Options European, American, Exotics, ... Call, Put Cap, Floor

Credit derivatives

Daniel HERLEMONT

Page 3 3

Types of Financial Risks

Market Risk Credit Risk Liquidity Risk Operational Risk Legal Risk

Daniel HERLEMONT

What is the current Risk?

Bonds

duration, convexity

Stocks

volatility

Options

delta, gamma, vega

Credit

rating

Forex

target zone

Total

?

Daniel HERLEMONT

Page 4 4

How much can we lose?

Everything correct, but useless answer.

How much can we lose realistically?

Daniel HERLEMONT

Definition

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)

Daniel HERLEMONT

Page 5 5

VaR 1 0.8 0.6 0.4

VaR1%

1%

0.2

Profit/Loss -3

-2

-1

1

2

3

Daniel HERLEMONT

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.

VaR 1%

Daniel HERLEMONT

Page 6 6

Returns

year

1% of worst cases Daniel HERLEMONT

Main Ideas

A few well known risk factors Historical data + economic views Diversification effects Testability Easy to communicate

Daniel HERLEMONT

Page 7 7

Conventional Analysis $

value

scenarios

sensitivity Risk factor Daniel HERLEMONT

VaR approach $

price

yield Risk factor Daniel HERLEMONT

Page 8 8

Important

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.

Daniel HERLEMONT

Page 9 9