IEOR E4723: Topics In Quantitative Finance
Financial Risk Management
Summer 2008, Instructor: Allan M. Malz, 1.5 credits DRAFT Syllabus
Course description
This course introduces students to the understanding and management of financial risk. Its objec-tive is to familiarize students with the risks faced by financial and nonfinancial firms, particularly the former, and with the tools practitioners use to measure and control risks. We will study the ben-efits and pitfalls of contemporary risk measurement models. Much of the course will be devoted to detailed examples of how particular tools and techniques are applied to particular problems.
Prerequisites
The course assumes basic familiarity with probability and statistics, the instruments of the financial markets, and asset pricing models.
Textbooks and resources
There is no required textbook, but two suggested ones. Hull (2006) is a good guide to the algebra and analytics. Crouhy, Mark & Galai (2000b) contains a lot of valuable institutional information and has an emphasis on credit risk. The bookstore will stock both. You probably should buy one. Pick the one that appeals to you. If you happen already to own another one, that’s fine, too. Bernstein (1996) provides good background and is fun to read.
For each topic, the Readings section below tells you where it is covered in the lecture notes, which are posted onCourseWorks.
Students (and everyone else involved in risk management) should be aware of some rich resources on the Internet. Here are a few:
GloriaMundi makes available for download a colossal amount of risk management research, news, documents issued by regulatory authorities and industry groups, and other informa-tion, athttp://www.gloriamundi.
Bank for International Settlements is a services provider to the world’s central banks. It invests reserves on behalf of some central banks. It also has a research department of its own and hosts regulator groups and research conferences. A large number of key regulatory
docu-Central banks such as the Bank of England and the European Central Bank have large research departments that publish research and surveys related to risk management. Almost all of it can be downloaded from the Internet. A good starting point is the BIS’ links collection http://www.bis.org/cbanks.htm.
The Federal Reserve System is worth singling out;http://www.frbsf.org/publications/ fedinprint/is a handy search tool.
RiskMetrics Group is a risk measurement analytics firm that conducts original research and posts technical papers athttp://www.riskmetrics.com/research.html/.
A selection of technical documents from these sources and survey material on financial markets and risk published by major banks and broker-dealers are posted onCourseWorks.
Session 1
May 27, 2007The scope of financial risk
The subprime crisisTypology of financial risks Financial market participants
Why is risk a separate discipline today?
Readings
Lecture notes 1; other readings TBD.
Market risk
Standard model of asset prices Portfolio risk
Readings
Lecture notes 2; other readings TBD.
Credit risk
Defining credit risk Credit risk models
Readings
Lecture notes 3; Crouhy, Mark & Galai (2000a); Moody’s Investors Service (2007); Standard & Poor’s (2006); Finger (1999); Credit Suisse First Boston (2004), ch. 1, 2, Appendix; O’Kane & Schloegl (2001).
Value at Risk
Value-at-RiskVolatility estimation: RiskMetrics and GARCH
Modes of computation: parametric, historical and Monte Carlo simulation Expected shortfall
Readings
Lecture notes 4; Duffie & Pan (1997); Morgan Guaranty Trust Company (1996) ch. 1, 5; Mina & Xiao (2001) ch. 2.2-2.3.
Mapping and treatment of bonds and options
Duration and interest-rate volatilityNonlinearity and convexity risk The delta-gamma approach Vega risk
Readings
Lecture notes 5-6; Mina & Xiao (2001) ch. 3, 5; Morgan Guaranty Trust Company (1996) ch. 6-7; Crouhy et al. (2000b) app. to ch. 5; Malz (2000/2001).
Session 3
June 10, 2008Portfolio VaR
Delta-normal VaRPortfolio VaR via Monte Carlo simulation
Readings
Risk capital and portfolio construction
Concept of economic capital and risk contributionMeasuring diversification with VaR; marginal and incremental VaR Implied views
Readings
Lecture notes 7; Mina & Xiao (2001) ch. 2.
The quality of VaR estimates
BacktestingVariability of VaR estimates Coherence of VaR estimates Readings
Lecture notes 8; Kupiec (1995b); Lopez (1999); Dan`ıelsson (2002); Beder (1995).
Session 4
June 17, 2008Portfolio credit risk measurement
Default correlation and default distributions VaR with the single-factor credit risk model Credit VaRCopula models Readings
Lecture notes 9; Lucas (1995); Credit Suisse First Boston (2004), ch. 2; O’Kane & Schloegl (2001), pp. 36–38; Finger (1999); Lehman Brothers (2003), pp. 38–42.
Alternatives to the standard market risk model
Real-world asset price behaviorThe evidence in option prices
Modeling approaches for non-normality; jump-diffusion and stochastic volatility models Readings
Lecture notes 10; Jackwerth (1999); Merton (1976); de Vries (1994).
Liquidity risk
Transaction cost liquidity, funding liquidity and systemic liquidity Liquidity-adjusted VaR
Readings
Lecture notes 11; Malz (2003); Bank for International Settlements (1999); Bangia, Diebold, Schuermann & Stroughair (1999).
Stress testing
Historical stress tests
Scenario analysis and scenario design principles Readings
Lecture notes 12; Mina & Xiao (2001) ch. 4; Kupiec (1995a); Boyer, Gibson & Loretan (1997); Loretan & English (2000).
Session 6
July 1Financial crises
Financial crises, bubbles, and extreme volatility Financial market behavior during extreme events Readings
Regulation
Scope and rationale of regulation Regulatory authorities
Methods of regulation; capital standards
Readings
Lecture notes 14; Bank for International Settlements (1996); Spong (2000).
Reading list
Bangia, A., Diebold, F. X., Schuermann, T. & Stroughair, J. D. (1999), Modeling liquidity risk with implications for traditional market risk measurement and management, Working Paper 99-06, Wharton Financial Institutions Center. Available athttp://fic.wharton.upenn. edu/fic/papers/99/p9906.html.
Bank for International Settlements (1996),Amendment to the capital accord to incorporate market risks, Basel. Available athttp://www.bis.org/publ/bcbs24.pdf.
Bank for International Settlements (1999), Market liquidity: research findings and selected policy implications, Technical Report 12, Monetary and Economic Department, Basel. Available at http://www.bis.org/publ/cgfs12.pdf¿.
Beder, T. S. (1995), ‘VAR: seductive but dangerous’,Financial Analysts Journal51(5), 12–24. Bernstein, P. L. (1996),Against the gods: the remarkable story of risk, John Wiley & Sons, New
York.
Boyer, B. H., Gibson, M. S. & Loretan, M. (1997), Pitfalls in tests for changes in correlations, Inter-national Finance Discussion Paper 597, Board of Governors of the Federal Reserve System. Available athttp://www.federalreserve.gov/pubs/ifdp/1997/597/ifdp597.pdf. Credit Suisse First Boston (2004),Credit portfolio modeling handbook.
Crouhy, M., Mark, R. & Galai, D. (2000a), ‘A comparative analysis of current credit risk models’, Journal of Banking and Finance24(1–2), 59–117.
Crouhy, M., Mark, R. & Galai, D. (2000b),Risk management, McGraw–Hill, New York.
Dan`ıelsson, J. (2002), ‘The emperor has no clothes: Limits to risk modelling’,Journal of Banking and Finance26(7), 1273–1296.
de Vries, C. G. (1994), Stylized facts of nominal exchange rate returns,in F. van der Ploeg, ed., ‘The handbook of international macroeconomics’, Blackwell, Oxford and Cambridge, U.S. Duffie, D. & Pan, J. (1997), ‘An overview of value at risk’,Journal of Derivatives4(3), 7–49. Finger, C. C. (1999), ‘Conditional approaches for CreditMetrics portfolio distributions’,
Credit-Metrics Monitorpp. 14–33. Available athttp://www.riskmetrics.com/journals.html. Garber, P. M. (1989), ‘Tulipmania’,Journal of Political Economy97(3), 535–560.
Garber, P. M. (1990), ‘Famous First Bubbles’,Journal of Economic Perspectives4(2), 35–54. Hull, J. C. (2006),Risk management and financial institutions, Pearson/Prentice–Hall, Upper
Jackwerth, J. C. (1999), ‘Option-implied risk-neutral distributions and implied binomial trees: a literature review’,Journal of Derivatives7(2), 66–82.
Kindleberger, C. P. (1978),Manias, Panics and Crashes, Basic Books, New York.
Kupiec, P. H. (1995a), ‘Stress testing in a value at risk framework’,Journal of Derivatives6(1), 73– 84.
Kupiec, P. H. (1995b), ‘Techniques for verifying the accuracy of risk measurement models’, Jour-nal of Derivatives3(2), 7–24.
Lehman Brothers (2003),The Lehman Brothers guide to exotic credit derivatives.
Lopez, J. A. (1999), ‘Methods for evaluating value-at-risk estimates’,Economic Review(2), 3–17. Loretan, M. & English, W. B. (2000), Evaluating “correlation breakdowns” during periods of mar-ket volatility, International Finance Discussion Paper 658, Board of Governors of the Federal Reserve System. Available athttp://www.federalreserve.gov/pubs/ifdp/2000/658/ ifdp658.pdf.
Lucas, D. J. (1995), ‘Default correlation and credit analysis’,Journal Of Fixed Incomepp. 76–87. Malz, A. M. (2000/2001), ‘Vega risk and the smile’,Journal of Risk3(2), 41–63.
Malz, A. M. (2003), ‘Liquidity risk: Current research and practice ’,RiskMetrics Journal4(1), 35– 72. Available athttp://www.riskmetrics.com/journals.html.
Merton, R. C. (1976), ‘Option pricing when underlying stock returns are discontinuous’,Journal of Financial Economics3(1/2), 125–144.
Mina, J. & Xiao, J. (2001),Return to RiskMetrics: the evolution of a standard, RiskMetrics Group. Available athttp://www.riskmetrics.com/pdf/rrmfinal.pdf.
Moody’s Investors Service (2007), Corporate Default and Recovery Rates, 1920-2006, Technical report. Available athttp://www.moodys.com/.
Morgan Guaranty Trust Company (1996),RiskMetrics Technical Document, 4th edn.
O’Kane, D. & Schloegl, L. (2001), Modelling credit: theory and practice, Advanced reasearch series, Lehman Brothers.
Spong, K. (2000),Banking regulation: Its purposes, implementation, and effects, 5th edn, Federal Reserve Bank of Kansas City. Available at http://www.kc.frb.org/BS&S/Publicat/ PDF/RegsBook2000.pdf.
