Course Outline 16 January 2012
The course will focus on the practices of the specialist market and credit risk functions at large financial institutions. Many of the ideas and techniques used at large financial institutions are also applicable at smaller institutions and more specialized financial organizations such as proprietary trading firms and asset management companies. The topics covered will include the statistical techniques for risk measurement such as value-at-risk, credit risk measurement, the management of vanilla and exotic options risk, operational risk, and model risk.
There are two sections, both of which meet on Mondays and Wednesdays:
(a) FIN 580 Section RM (MSFE) meets from 9:30-10:50 in room 166 Wohlers Hall; and (b) FIN 580 Section RM2 (MSF and MBA) meets from 12:30-1:50 in room 243 Wohlers
Hall. Requirements
The textbook is Risk Management and Financial Institutions by John C. Hull (Prentice Hall, 2010 (2nd edition)). This is simple, straightforward book that covers most risk management topics. You are responsible for everything in this book, regardless of whether we discuss the material in class. Related to this, some of the questions on the midterm and final opportunities will be taken from the end-of-chapter questions. These questions on the midterm and final opportunities might include material that is in the textbook but we did not discuss in class.
In addition, we will talk about some material from the book by Steven Allen titled Financial Risk Management: A Practitioner’s Guide to Managing Market and Credit Risk (Wiley, 2003). Some other readings will also be assigned.
The course requirements consist of various homework assignments during the semester (20% weight in determination of the course grade), a group project (20% weight), a midterm opportunity to display your knowledge and excellence on Monday, 12 March, from 7:00-9:00 p.m. (20% weight), and a final opportunity to display your knowledge and excellence (40% weight in the determination of the course grade). The date, time, and location of the final opportunity will be announced at a later date.
The topic of the group project is anything related to risk management, subject to the approval of the instructor. I will suggest various topics during the course of the semester. Your group will present your analysis to the class on either class 25, 26, or 27 (18, 23, or 25 April). Based on feedback from the instructor and your fellow class members, you will correct your errors and oversights and submit a written report on Wednesday, 2 May.
If you cannot identify a good project of your own choice, then the “default” project is to select a financial disaster that occurred during the past 20 years, research it, become expert on it, and analyze the mistakes that were made and how the disaster could have been avoided.
The various problem sets and the project may be done in groups, where the maximum group size is four students. The groups need not be the same for each of the homework assignments and your project group need not be the same as your homework group.
Other Relevant Information
I may be found in room 419 Wohlers Hall, e-mail pearson2@illinois.edu, telephone 217 244 0490. Office hours are Monday, 2:00–3:00 p.m., and by appointment.
The teaching assistant is Yang LIU, e-mail yangliu4@illinois.edu. Her office hours are Tuesday from 8:30-10:30, in the BIF Atrium.1
Homework assignments and some other materials will be distributed through Illinois Compass (https://compass2g.illinois.edu/) in the form of pdf (Adobe Acrobat) or PowerPoint files.
Topics, Schedule, and Reading Assignments
The topics and reading assignments are listed below. Hull means the textbook, Risk Management and Financial Institutions. Allen means Financial Risk Management: A Practitioner’s Guide to Managing Market and Credit Risk (Wiley, 2003). Please read the assigned materials prior to class. Throughout, Section x.y means Chapter x, Section y.
Some classes might be rescheduled.
I. Introduction
Class 1 (18 January): Introduction to Risk Management
Reading: Hull, Chapters 2, 4, 22.2
Other reading (not required): Allen, Chapters 1, 2, and 4
II. Risk Aggregation
A. Value-at-risk, stress testing, and related topics Class 2 (23 January): Value-at-Risk: Simulation Methods
Readings: Hull, Chapters 8, 12; Linsmeier, Thomas J. and Neil D. Pearson, 2000, “Value at Risk,” Financial Analysts Journal (March/April), 47-66; Pearson, Neil D., 2002, Risk
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Budgeting: Portfolio Problem Solving With Value-at-Risk3 (New York: John Wiley & Sons), Chapters 4 and 6
Other readings (not required): Allen, Chapter 11, Sections 1 and 3; Pearson, Neil D., 2002, Risk Budgeting: Portfolio Problem Solving With Value-at-Risk (New York: John Wiley & Sons), Chapter 1
Class 3 (25 January): Value-at-Risk: The Delta-Normal Method
Readings: Hull, Chapter 13; Pearson, Neil D., 2002, Risk Budgeting: Portfolio Problem Solving With Value-at-Risk (New York: John Wiley & Sons), Chapters 2, 3, 5
Class 4 (30 January): Value-at-Risk: The Delta-Normal Method
Readings: Hull, Chapter 13; Pearson, Neil D., 2002, Risk Budgeting: Portfolio Problem Solving With Value-at-Risk (New York: John Wiley & Sons), Chapters 2, 3, 5
Class 5 (1 February): Stress Testing
Readings: Hull, Chapter 17; Pearson, Neil D., 2002, Risk Budgeting: Portfolio Problem Solving With Value-at-Risk (New York: John Wiley & Sons), Chapter 9
Other reading (not required): Allen, Chapter 11, Section 2; UBS, 2008, Shareholder Report on UBS's Write-Downs
Class 6 (6 February): Expected Shortfall (Conditional Value-at-Risk)
Readings: Hull, Sections 8.3, 8.5; Pearson, Neil D., 2002, Risk Budgeting: Portfolio
Problem Solving With Value-at-Risk (New York: John Wiley & Sons), Chapter 19; Acerbi, Carlo and Dirk Tasche, “Expected Shortfall: A Natural Coherent Alternative to Value at Risk,” Economic Notes 31, No. 2 (2002). pp. 379–388
Class 7 (8 February): Risk Decomposition
Reading: Hull, Section 8.7; Pearson, Neil D., 2002, Risk Budgeting: Portfolio Problem Solving With Value-at-Risk (New York: John Wiley & Sons), Chapter 10.
Other readings (not required): Pearson, Neil D., 2002, Risk Budgeting: Portfolio Problem Solving With Value-at-Risk (New York: John Wiley & Sons), Chapters 11, 12, and 13; Litterman, Robert, 1996, Hot Spots and Hedges, Journal of Portfolio Management (special issue); Litterman, Robert, and Kurt Winkelman, Managing Market Exposure: Leveraging Your Covariance Matrix to Control Market Risk, Journal of Portfolio Management (summer); Winkelman, Kurt, 2000, Managing Active Risk at the Total Fund Level (Goldman Sachs)
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B. Measuring Credit Risk
Class 8(a) (13 February) “Short-term Approach” to Measuring Credit Risk
Reading: Hull, Chapter 14; Allen, Section 12.1 (this means Chapter 12, Section 1)
Other reading (not required): UBS, 2008, Shareholder Report on UBS's Write-Downs
Class 8(b) (13 February): The Statistical Approach to Measuring Default Probability and Loss Given Default
Reading: Hull, Chapter 14; Allen, Sections 12.2.1, 12.2.2, 12.2.4, 12.2.5; Moody’s Investors Service, 2010, Corporate Default and Recovery Rates, 1920-2009 (Note: The other rating agencies carry out and publish similar studies.)
For information on the range of default, LGD, and ratings transition studies published by Moody’s, see Moody’s Investor Service, 2010, Guide to Moody's Default Research: April 2010 Update
Class 9 (15 February): The Gaussian Copula
Reading: Hull, Chapter 10; Allen, Section 12.2.2
Class 10 (20 February): The Option-Theoretic Approach
Reading: Hull, Chapter 15; Allen, Section 12.2.3
Class 11 (22 February): “Wrong-Way” Default
Reading: Allen, Section 12.4; Levy, Arnon, 1999, “Wrong Way Exposure-Are Firms Underestimating Their Credit Risk? Assessing Credit Risk when Default and Market Risk are Adversely Related,” Risk (July); Levy, Arnon, and Ronald Levin, 1999, “More on Wrong-Way Exposure,” J.P. Morgan Securities Inc., Derivatives Research
Movie night: 7:00-9:00 p.m., Rogue Trader, a location to be announced.4
Operational Risk
Class 12 (27 February): Operational Risk
Reading: Hull, Chapter 18; either watch the movie Rogue Trader, or read the book by Nick Leesons.
Economic Capital Modeling
Class 13 (29 February): Economic capital modeling
Reading: Hull, Chapters 11, 21
Risk decomposition
We will only discuss a few topics related to risk decomposition, because this topic is intimately related to derivatives valuation and you will cover the important ideas in your courses on derivatives valuation.
Class 14 (5 March): Vanilla options risk: review of basic ideas
Reading: Hull, Chapter 6
Class 15 (7 March): Risks of dynamic hedging
Reading: Reading: Allen, Sections 9.1-9.3, 9.5
Other readings (not required): Taleb, Nassim, 1997, Dynamic Hedging: Managing Vanilla and Exotic Options,5 Chapter 16 and pages 110-113
Class 16 (12 March): The use of price-volatility matrices and volatility surface sensitivities
Reading: Allen, Sections 9.4, 9.6, 10.1
Midterm opportunity (12 March): The midterm opportunity (for both sections) will be from 7:00-9:00 p.m., in a location to be announced.
Class 17 (14 March): No classthe midterm opportunity was Monday evening. Class 18 (26 March): Measuring Exotic Options Risk
Reading: Allen, Chapter 10, Sections 1-3
Class 19 (28 March): Interest Rate Swaps (background for measuring yield curve risk)
Reading: Hull, Appendix D
Class 20 (2 April): Measuring yield curve risk
Reading: Hull, Chapter 7
Other readings (not required): Allen, Chapter 8.
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Valuation and Model Risk
Class 21 (4 April): (Correct) valuation as the most important risk management practice
Reading: Hull, Chapter 20, Section 22.2; Allen, Chapter 5; Global Derivatives Study Group (“Group of 30”), 1993, Derivatives: Practices and Principles
Other readings (not required): UBS, 2008, Shareholder Report on UBS's Write-Downs; Senior Supervisors Group, 2008, Observations on Risk Management Practices during the Recent Market Turbulence; Institute of International Finance, 2008, Interim Report of the IIF Committee on Market Best Practices
Class 22 (9 April): Model risk and “P/L leaks”
Reading: Hull, Section 22.2; Allen, Chapter 6; Derman, Emanuel, 2001, “Markets and Models,” Risk 7, 48-50
Class 23 (11 April): Problems with CDO valuations during the financial crisis as an example of model risk
Readings: Coval, Joshua, Jakob Jurek, and Erik Stafford, 2009, “The Economics of
Structured Finance,” Journal of Economic Perspectives 23 No. 1, 3-25; Mayer, Christopher, Karen Pence, and Shane M. Sherlund, 2009, “The Rise in Mortgage Defaults,” Journal of Economic Perspectives 23 No. 1, 27-50; Barnett-Hart, Anna Katherine, 2009, The Story of the CDO Market Meltdown: An Empirical Analysis
Class 24 (16 April): Valuing long-dated flows
Reading: Allen, Section 8.2.2
Project Presentations
Class 25 (18 April): Project presentations
Reading: Hull, Chapter 22; Allen, Chapter 4
Class 26 (23 April): Project presentations
Reading: no additional reading
Class 27 (25 April) Project presentations
Class 28 (30 April) Fraudulent returns
Reading: Markopolos, Harry, 2005, “The World’s Largest Hedge Fund is a Fraud: November 7, 2005 Submission to the SEC”; Bollen, Nicolas P.B., and Veronika K. Pool, 2009, “Do Hedge Fund Managers Misreport Returns? Evidence from the Pooled
Distribution,” Journal of Finance 64, 2257-2288, 2009.
Other readings (not required): Bollen, Nicolas P.B. and Veronika K. Pool, 2008, Conditional Return Smoothing in the Hedge Fund Industry, Journal of Financial and Quantitative Analysis 43, 267-298; Dimmock, Stephen,and William C. Gerken, 2010, “Finding Bernie Madoff: Detecting Fraud by Investment Managers.”
Class 29 (2 May): Liquidity risk
