1.LectureIntroduction_RAM

Introduction to Risk Analysis Gianluca Fusai Cass Business School MSc Mathematical Trading and Finance Risk Analysis and Modeling Academic Year 2012-13 These notes can be freely distributed under the solely requirement that the authors’s name is explicitly cited. c©Gianluca Fusai (Cass Business School) Introduction to Risk Analysis SMM609 Risk Analysis 1 / 18 Introduction to Risk Analysis We will introduce the course by setting the scene for: What financial risk analysis deals with, Where it is used, The main different types of financial risk, Risk in context: some historical landmarks, and What makes risk analysis difficult. I will describe the structure of the course. We will also consider: Some of the relevant history and A flavor of recent experiences. c©Gianluca Fusai (Cass Business School) Introduction to Risk Analysis SMM609 Risk Analysis 2 / 18 Structure of the course Two main topics 1 Market Risk: Value at Risk as measure of risk; Estimating VaR: parametric and non parametric approaches; Estimating VaR for portfolios: bottom up and top down; Monte Carlo Simulation; Backtesting VAR; Derivative positions. 2 Credit Risk: Credit Derivatives and models; Commercial Models; Counterparty exposure. c©Gianluca Fusai (Cass Business School) Introduction to Risk Analysis SMM609 Risk Analysis 3 / 18 Reading List There are many texts that cover risk topics but the most useful resources are: Main References 1 Jorion, P. (2007). Value at Risk, McGraw-Hill, 3rd Edition. 2 Christoffersen, P, (2003). Elements of Financial Risk Management, Academic Press. 3 RiskMetrics Technical Document, available on the Moodle system 4 CreditMetrics Technical Document, available on the Moodle system Additional Useful References 1 Alexander, C. (2008). Market Risk Analysis, Volume IV, Wiley. 2 Dowd, K, (2005). Measuring Market Risk + CD-ROM , 2nd Edition, Wiley. c©Gianluca Fusai (Cass Business School) Introduction to Risk Analysis SMM609 Risk Analysis 4 / 18 What is Risk Analysis? Definition Risk Analysis seeks to measure financial risks so that they may be controlled. It quantifies: The exposures to various risk factors (such as interest rates and equity indexes), and the prospective distribution of gains or losses at a specific horizon. Once measured, the risk can be controlled: by constructing hedges against the major exposures, and by imposing limits on the remaining exposures. If a risk limit is breached then appropriate action will be taken immediately. c©Gianluca Fusai (Cass Business School) Introduction to Risk Analysis SMM609 Risk Analysis 5 / 18 Where is Risk Analysis Used? I Risk analysis also forms the basis of: Regulation and capital adequacy requirements, Internal controls, and Communication with clients. It is equally relevant in: Banking, Insurance, and Investment c©Gianluca Fusai (Cass Business School) Introduction to Risk Analysis SMM609 Risk Analysis 6 / 18 Where is Risk Analysis Used? II Example (Risk Analysis in Investment) In many types of fund management, including pension funds, unit trusts (mutual funds) a great deal of emphasis is placed on risk budgeting. A detailed plan is prepared of what risks need to be taken in order to reach a particular expected return goal. The fund is committed to stay within the budgeted risk limits, which are either negotiated with clients or communicated to them (either directly or indirectly). Typically (but not always!) the risks are adequately controlled within the budget – while the expected return premium may or may not be achieved. c©Gianluca Fusai (Cass Business School) Introduction to Risk Analysis SMM609 Risk Analysis 7 / 18 The Main Types of Risk It is usual to distinguish among the following kinds of risk: 1 Market risk (due to changes in market values), 2 Credit risk (of credit contingent claims, including sub-prime debt, CDOs, CDSs etc). 3 Liquidity Risk (risk of markets drying up and large bid/ask spreads appearing). 4 Operational Risk (of all other kinds of mishaps and disasters), and We shall be primarily concerned with market and credit risks, without denying the importance of other risks. c©Gianluca Fusai (Cass Business School) Introduction to Risk Analysis SMM609 Risk Analysis 8 / 18 Some Historical Landmarks Financial Bubbles and Crashes ..are as old as the hills: 1634-7 Tulip mania 1711 South Sea bubble 1926-9 Bull market leading to crash and the great depression [City of London deregulation 1986] 1987 Black Friday (/Monday) crash(es) 2000-2 Dot com bubble 2007-? Banking meltdown 2010-? Sovereign crisis [More about this on Jorion, chapter 2] c©Gianluca Fusai (Cass Business School) Introduction to Risk Analysis SMM609 Risk Analysis 9 / 18 Evolution of Analytical Techniques 1938 Bond duration 1952 Markowitz mean-variance analysis 1966 Multi-factor equity models 1973 Black-Scholes option pricing, and “Greeks” 1993 Value at Risk (VaR) 1994 RiskMetrics (for market risk) 1997 CreditMetrics (for credit risk) [see Jorion’s more complete list] c©Gianluca Fusai (Cass Business School) Introduction to Risk Analysis SMM609 Risk Analysis 10 / 18 Landmarks in Regulation of Commercial Banks 1988 Basel I Accord (fully implemented 1992) Minimum capital ratios to cover credit risk, as Risk Capital ≥ 8% of Risk-Weighted Assets, but led to increased regulatory arbitrage. 1996 Added charge for market risks attributable to proprietary trading, Internal models approach introduced VaR to determine the capital required. 1999 Repeal of the Glass-Steagall Act, which separated banking and securities functions in the US. 2004 Basel II Accord (implemented 06-09) introduced 3 pillars: Minimum regulatory requirements, Supervisory review, and Market discipline also Quantified Operational Risk.. 2010 Basel III framework published December 2010. c©Gianluca Fusai (Cass Business School) Introduction to Risk Analysis SMM609 Risk Analysis 11 / 18 Why is Risk Analysis Difficult? Never make forecasts, especially about the future (Samuel Goldwyn) The stock market will fluctuate (J. P. Morgan) Problem How well can you navigate ahead using only the rear view mirror? c©Gianluca Fusai (Cass Business School) Introduction to Risk Analysis SMM609 Risk Analysis 12 / 18 Limitations of Risk Models Among the many reasons for this: Asset prices follow rather unstable processes; Derivatives contracts often make payoffs extraordinarily complex functions of the underlying factors; We are dealing with very large numbers of risk factors and security holdings; It is difficult to model many factors at once; A lot of computation may be required to analyze a large portfolio of holdings. c©Gianluca Fusai (Cass Business School) Introduction to Risk Analysis SMM609 Risk Analysis 13 / 18 SP500 2000-2004. And afterwards? 2004 2004 2005 2005 2006 2006 2007 1050 1100 1150 1200 1250 1300 1350 1400 1450 1500 1550 SP500 Index: 2004−July 2007 Time c©Gianluca Fusai (Cass Business School) Introduction to Risk Analysis SMM609 Risk Analysis 14 / 18 What happened next 2006 2006 2007 2007 2008 2009 600 700 800 900 1000 1100 1200 1300 1400 1500 1600 SP500 Index: 2004−2009 Time c©Gianluca Fusai (Cass Business School) Introduction to Risk Analysis SMM609 Risk Analysis 15 / 18 SP500 1950-2011 1954 1960 1965 1971 1976 1982 1987 1993 1998 2004 2009 0 200 400 600 800 1000 1200 1400 1600 SP500 Index: 1950−2011 Time c©Gianluca Fusai (Cass Business School) Introduction to Risk Analysis SMM609 Risk Analysis 16 / 18 Multiplicity of Factors We need a large number of risk factors to represent the risks of bonds, equities and currencies in today’s world. Simply from a statistical point of view, this makes life difficult. The empirical observations that we have don’t amount to much if we need to model the joint behavior of a hundred or so risk factors. Multivariate space is only sparsely inhabited by the data. Many statistical papers on “multivariate techniques” mean considering at most 3 or 4 variables! c©Gianluca Fusai (Cass Business School) Introduction to Risk Analysis SMM609 Risk Analysis 17 / 18 Conclusions: Learning outcomes On completion of this module students will be able to: demonstrate systematic and comprehensive knowledge of the different sources and types of financial risk demonstrate sound appreciation of the different purposes of risk analysis and modelling and the steps involved in defining, measuring and managing risk appreciate the importance of risk management for a wide range of stakeholders at trader, corporation and institution level respect and value the role of financial regulation and understand the issues related to its reform. c©Gianluca Fusai (Cass Business School) Introduction to Risk Analysis SMM609 Risk Analysis 18 / 18 Introduction