GSIEF 208b – Risk Management
Semesters Taught (Summer 1999, Summer 2000)
Professor Ron D’Vari, Ph.D., CFA
Adjunct Professor, Graduate School of Economic and International Finance, Brandeis University
Sr. Vice President, Portfolio Manager, and Head of Quantitative Research
State Street Research and Management
Email: rdvari@ssrm.com
The problem with the future is uncertainty – so we look for clues in the past. The objective of this class is to
introduce students to various types of risks and their management. Here emphasis is given to financial risk
management and particularly market and credit risks. Some aspects of operational, legal (compliance and
regulatory), and strategic risk management for financial institutions are also explored.
Text Books and References:
- Philippe Jorion, Value at Risk, IRWIN Professional Publishing, 1997
- RiskMetricsTM Technical Document, RiskMetrics Group, Fourth Edition, 1996.
- CreditMetricsTM Technical Document, RiskMetrics Group, April 2,1997.
- Regulatory publications (see attached list)
(RiskMetricsTM and CreditMetricsTM documents to be downloaded from www.riskmetrics.com)
Optional Additional Readings:
- Bernstein, Peter, Against the Gods, John Wiley & Sons, 1996
Prerequisites: Some level of familiarity with:
Basic Quantitative Analysis: Time value of money, probability distributions and their properties,
variance/covariance analysis, correlation and regression analysis and forecasting.
Capital Markets: Fixed income derivatives; Foreign exchange derivatives; Futures, forwards,
swaps, and options; Equity derivatives; Commodity derivatives; Emerging markets
Class Grading:
 Participation in class discussions
 Team Project
 Class Presentation
 Final
10%
40%
20%
30%
Office Hours: After each class or by appointment.
Summary of Topics Discussed
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Multi-factor Models for Measuring Investment Portfolio Risk
 Multi-factor Performance Measurement and Attribution
Value at Risk
 Definition and Computation
 Treatment of Derivatives
 Different Approaches to Measuring VAR
 Forecasting Risks and Correlations
 Computation, Benefits, and Limitations of Risk-Adjusted Return on Capital (RAROC)
Risk Metrics and Credit Metrics
Comprehensive methodology for measuring market risk
Identification, Quantification, and Management of Operational Risk
Risk-Adjusted Capital Framework – Operational Risk, Credit Risk, Market Risk

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Classification of Risks Confronting Financial Intermediaries – Lending, Trading, Operating Services,
Deposit Gathering, Treasury, Capital Market Activities
General Objectives of Enterprise-wide Risk Management – Balance Sheet Management, Performance
Measurement, Motivation and Compensation, Strategic Decision Support
Identification and Measurement of Non-financial Risks (Risk of Lost Opportunities)
Role of Information Flow and Visibility in Risk Management
Implementation Issues For Transitioning to An Enterprise Risk Management
 Culture
 System
 Information flow and visibility
 Training
 Management Commitment
Role of an Appropriate Benchmark for Measuring Relative Risk
Session 1: Introduction to Risk Management
1.
2.
3.
4.
5.
The Need for Risk Management
Lessons from Financial Disasters
The Concept of Hedging, Diversification and Insurance
Risk Management Not Just for Trading
Significant Changes to the Financial Markets – Securitization and Move to Risk-adjusted Performance
Measurement
6. Types of Risks: Business, Strategic, Financial Risk, Operational Risk, Legal Risks
7. Types of Financial Risks: Market Risk, Credit Risk, Liquidity Risk
8. Conventional Market Risk Measures: Duration, Beta, Historical Volatility, Sector Exposure, Currency
Exposure, Market Exposure, and Greeks for Derivatives
9. Evolution from Asset Liability Management to Value-At-Risk
10. The Risk Management Cycle: Identify, Measure, Manage, Evaluate, Improve
11. Role of Transparency of Risk
12. Role of Professional Judgement and Experience in Managing Risk
Reading Assignments: Chapters 1-3 (PJ), RiskMetrics TD, Part I: Risk Measurement Framework
Session 2: An Introduction to Value at Risk
1.
Two Modern Approaches to Market Risk Management: Statistical Approach and Scenario Stress
Testing
2. Historical Perspective of VaR
3. Definition of Value at Risk (VaR)
4. Simple Examples of VaR Calculations Using Normally Distributed Financial Variables
5. VaR for A Portfolio of Non-normally Distributed Assets
6. Limitations of VaR
7. Application of VaR: Risk Control, Senior Management Reporting, Capital Allocation, Performance
Measurement; Regulatory Compliance
8. Banking Regulatory Initiatives on VaR
9. Sound Risk Management Practices
10. Proactive Risk Management – Just Say No!
Reading Assignments: Chapters 4 and 5 (PJ), RiskMetrics TD, Part I: Risk Measurement Framework
Project Milestones: Form a Project Team, Select a Particular Industry or Institution to Analyze.
Session 3: Risk Measurement Framework
We discuss a practical framework on how to think about market risks, how to apply that thinking in practice, and
how to interpret the results. Different approaches to risk estimation are discussed. We show how the
calculations work on simple examples and discusses how the results can be used in limit management,
performance evaluation, and capital allocation.
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
11.
General VaR Framework: Mark-to-Market, Calculate Distribution of Values at Horizon, Calculate VaR
Specifying Risk Horizon Time and Confidence Level
Specifying Risk Factors in A Portfolio and Their Distribution
Mapping Assets to Risk Factors, i.e. Calculating Exposure to Factors
Vary Risk Factors
Estimate The Changes in Value of Instruments
Calculate VaR
VaR for Parametric Distributions
Conversion of VaR Parameters
Reality Checks – How to Verify VaR
Application of Risk Measures
Reading Assignments: Chapters 5 (PJ), RiskMetrics TD, Part I: Risk Measurement Framework
Project Milestones: Initiate Setting Objectives for Your Project, Identify How You Plan to Gather
Information or Data.
Session 4: Statistics of Financial Market Returns
This part requires an understanding and interest in statistical analysis. We review the assumptions behind the
statistics used to describe financial market returns and how distributions of future returns can be estimated.
1.
2.
3.
4.
5.
Definition of financial price changes and returns
Modeling financial prices and returns
Investigating the random-walk model
A review of historical observations of return distributions
RiskMetrics model of financial returns: A modified random walk
Reading Assignments: Chapters 9 (PJ), RiskMetrics TD, Part II: Statistics of Financial Market Returns
Project Milestones: Finalize Setting Objectives for Your Project. Initiate Fact and Data Gathering.
Perform a Literature Search.
Session 5: Risk Management for Derivatives
Guest Lecturer: Harry Markopolos
1.
2.
3.
4.
5.
6.
7.
Linear (future, swap, forward, etc.) and Nonlinear Derivative Instruments (Options)
Role of Derivatives in Risk Management
Hedging Using Futures and Options
Delta-Gamma VaR Analysis
Role of Implied Volatility in Risk Management of Derivatives
Use of Volatility Swaps as a Hedging Tool
Role of Total Return Swaps in Risk Management
Reading Assignments: Chapters 6-7 (PJ), RiskMetrics TD, Part II: Risk Measurement Framework
Project Milestones: Study Key Literature. Identify Major Risks Addressed in Your Case. Outline Current
Approaches to Measure and Manage Risk in the Selected Industry or Institution. Identify and Evaluate Risk
Management Systems Currently Used.
Session 6: Implementation of Risk Management at A Financial Institutions
Guest Lecturer: Edward Dumas
Reading Assignments: Chapters 6-7 (PJ), RiskMetrics TD, Part II: Risk Measurement Framework
Project Milestones: Study Strengths and Weaknesses of Current Approaches and Practices to Measure and
Manage Risk in Your Industry. Identify Key Risk Management Experts in Your Selected Industry or
Institution.
Session 7. Estimation and Forecast
1.
2.
3.
4.
Forecasts from implied versus historical information
RiskMetrics forecasting methodology
Estimating the parameters of the RiskMetrics model
Summary and concluding remarks
Reading Assignments: Chapters 9 (PJ), RiskMetrics TD, Part II: Statistics of Financial Market Returns
Project Milestones: Prepare a List of Key Questions. Arrange and Conduct Personal Interviews with Key
Experts on History, Status, and the Direction of Future Risk Management Practice as It Relates to Your
Specific Industry or Institution.
Sessions 8-9: Portfolio VaR and Different Approaches to Measuring VaR
1.
2.
3.
4.
5.
6.
7.
8.
9.
How to Vary Risk Factors: Variance/Covariance; Implied Variance/Covariance; Historical Simulation;
Monte Carlo; Structured Monte Carlo
How to Estimate The Changes in Value of Instruments – Local valuation; Full Valuation
Dealing with Nonlinear Positions, e.g. options
Market risk methodology
Step 1—Identifying exposures and cash flows
Step 2—Mapping cash flows onto RiskMetrics vertices
Step 3—Computing Value-at-Risk
Examples
Monte Carlo
Scenario generation
Portfolio valuation
Reading Assignments: Chapters 10-11 (PJ), RiskMetrics TD, Part III: Risk Modeling of Financial
Instruments
Project Milestones: Identify Future Improvements in Risk Management Practices in your Selected Industry
or Institution. Identify Challenges in Implementing the Described Improvements. Identify The Benefits of
the Proposed Improvements
Sessions 10. Credit Risk Management
Reading Assignments: Chapters 12 (PJ), CreditMetrics TD.
Project Milestones: Report Preparation
Sessions 11 Operational Risk Management
Assignments: Related Articles. Final take-home exam to be handed out.
Project Milestones: Report Preparation
Session 12. Summary and Conclusion
1. Project Presentations.
Assignments: Project report and final examination due.
Useful References:
1.
2.
Value at Risk (August 1996), by Philippe Jorion
Managing Financial Risk : A Guide to Derivative Products, Financial Engineering and Value (3rd
edition, July 1998), by Charles W. Smithson and Clifford W. Smith
3. Derivatives Handbook (May 1997), by Robert Schwartz and Clifford W. Smith, Jr.
4. Swap & Derivative Financing : The Global Reference to Products, Pricing, Applications and Markets
(Revised edition, August 1994), by Satyajit Das
5. Options, Futures, and Other Derivatives (3rd w/ disk edition, April 1997), by John C. Hull
6. Managing Credit Risk : The Next Great Financial Challenge (Wiley Frontiers in Finance), by John B.
Caouette, Edward I. Altman, Paul Narayanan
7. Handbook of Emerging Fixed Income and Currency Markets (August 1998), by Frank J. Fabozzi
(Editor), Alberto Franco (Editor)
8. Fixed Income Mathematics : Analytical & Statistical Techniques (October 1996), by Frank J. Fabozzi
9. Managing Bank Capital: Capital Allocation and Performance Measurement (August 1996), by Chris
Matten (SBC)
10. Dynamic hedging (December 1996), by Nassim Taleb
11. CreditMetrics Technical Document - http://www.riskmetrics.com
12. RiskMetrics Technical Document - http://www.riskmetrics.com
Regulatory publications:
1. Risk Management and Control Guidance for Securities Firms and their Supervisors IOSCO, May 98,
http://risk.ifci.ch/144020.htm
2. Risk Management Guidelines for Derivatives BIS - Basle Committee, Jul. 1994,
http://risk.ifci.ch/RMGL.htm
3. Derivatives: Practices and Principles G30 / Global Derivatives Study Group, Jul. 1993,
http://risk.ifci.ch/136160.htm
4. Operational Risk Management BIS - Basle Committee, Sept. 1998, http://risk.ifci.ch/144400.htm
5. Capital Adequacy Principles BIS - Basle Committee, Feb. 1998, http://risk.ifci.ch/143520.htm
8. Report of the Committee on Interbank Netting Schemes BIS - Committee on Payment and Settlement
Systems of the G-10, Nov. 1990 http://risk.ifci.ch/140810.htm
GARP’s Financial Risk Management (FRM) Certification Program
The FRM Exam is designed to test for an admixture of basic analytical skills , general knowledge and
intuitive capability acquired through experience in capital markets. It focuses on the core body of
knowledge required for independent risk management analysis and decision making. This outline
establishes the topics in financial risk management with relative weights of those topics in the FRM Exam.
Within each topic, general concepts and techniques are also listed.
FRM candidates are given 5 hours to complete the examination.
1999 Examination Topics
Topic
I. Quantitative Analysis
II. Capital Markets
III. Market Risk Management
IV. Credit Risk Management
V. Operational & Integrated Risk Management
VI. Legal, Accounting, and Tax Risk Management
VII. Regulation and Compliance
Total
I. Quantitative Analysis
Time value of money
Probability distributions and their properties
Correlation and regression analysis
Correlation and regression forecasting
II. Capital Markets
Fixed income derivatives
Foreign exchange derivatives
Futures, forwards, swaps, and options
Equity derivatives
Commodity derivatives
Emerging markets
III. Market Risk Management
Interest rate, foreign exchange, equity, commodity risks
Emerging market risk
Liquidity risk
Derivatives risk
Portfolio risk
VaR
Approaches to VaR
Parametric VaR
Delta-Normal VaR
Simulation VaR
Stress Testing
IV. Credit Risk Management
Credit exposure and credit risk
Counterparty exposure and countparty risk
Default probability and recovery rate
Credit rating migration
Netting
Margin and Collateral Requirements
Percentage
15%
15%
25%
25%
5%
5%
10%
100%
Pre Settlement Risk
Settlement Risk
Counterparty Risk
Portfolio credit risk
Measuring and managing credit risk
Credit derivatives
V. Operational & Integrated Risk Management
Operational risk
Policies and procedures
Best practices
Business structure
Firmwide risk management
Calculation of risk capital
RAROC
Model risk
Other risks
VI. Legal, Accounting, and Tax Risk Management
Legal, Accounting, and Tax aspects
Legal risk
Accounting risk
Tax risk
VII. Regulation and Compliance
BIS Capital Accord (1988)
BIS Market Risk Amendment (1996)
EU Capital Adequacy Directive
Fed Pre-Commitment Model
As a practitioner oriented exam, reading textbooks alone will not generally be sufficient to pass the FRM
Examination. However, the FRM Examination is based upon the following required references in
combination with practical skills and techniques which may not be covered in those references. Familiarity
with regulatory publications, such as those listed here, is expected. Optional references maybe used to in the
exam to supplement the required references on the general concepts and techniques listed in the FRM
Examination Outline.
Required references:
13. Value at Risk (August 1996), by Philippe Jorion
14. Managing Financial Risk : A Guide to Derivative Products, Financial Engineering and Value (3rd
edition, July 1998), by Charles W. Smithson and Clifford W. Smith
15. Derivatives Handbook (May 1997), by Robert Schwartz and Clifford W. Smith, Jr.
16. Swap & Derivative Financing : The Global Reference to Products, Pricing, Applications and Markets
(Revised edition, August 1994), by Satyajit Das
17. Options, Futures, and Other Derivatives (3rd w/ disk edition, April 1997), by John C. Hull
18. Managing Credit Risk : The Next Great Financial Challenge (Wiley Frontiers in Finance), by John B.
Caouette, Edward I. Altman, Paul Narayanan
19. Handbook of Emerging Fixed Income and Currency Markets (August 1998), by Frank J. Fabozzi
(Editor), Alberto Franco (Editor)
20. Fixed Income Mathematics : Analytical & Statistical Techniques (October 1996), by Frank J. Fabozzi
Optional references:
21. Managing Bank Capital: Capital Allocation and Performance Measurement (August 1996), by Chris
Matten (SBC)
22. Dynamic hedging (December 1996), by Nassim Taleb
23. CreditMetrics Technical Document - http://www.riskmetrics.com
24. RiskMetrics Technical Document - http://www.riskmetrics.com
Regulatory publications:
1. Risk Management and Control Guidance for Securities Firms and their Supervisors IOSCO, May 98,
http://risk.ifci.ch/144020.htm
2. Risk Management Guidelines for Derivatives BIS - Basle Committee, Jul. 1994,
http://risk.ifci.ch/RMGL.htm
3. Derivatives: Practices and Principles G30 / Global Derivatives Study Group, Jul. 1993,
http://risk.ifci.ch/136160.htm
4. Operational Risk Management BIS - Basle Committee, Sept. 1998, http://risk.ifci.ch/144400.htm
5. Capital Adequacy Principles BIS - Basle Committee, Feb. 1998, http://risk.ifci.ch/143520.htm
8. Report of the Committee on Interbank Netting Schemes BIS - Committee on Payment and Settlement
Systems of the G-10, Nov. 1990 http://risk.ifci.ch/140810.htm
The Practitioner’s Handbook of Financial Risk Management
Edited by Marc Lore and Lev Borodovsky
Forward ____________________________________________________________ 8
Preface _____________________________________________________________ 8
Executive Summary ___________________________________________________ 8
Introduction to Financial Risk Management _______________________________ 8
What is Financial Risk Management? _______________________________________ 8
Definition _____________________________________________________________________ 8
A Risk Managers Perspective ___________________________________________________ 8
A Traders Perspective _________________________________________________________ 8
A Senior Management Perspective _______________________________________________ 8
A Regulator’s Perspective ______________________________________________________ 8
Risk Control vs. Risk Measurement/Analysis _________________________________________ 8
What are the Responsibilities of the Risk Manager? ___________________________ 8
Understanding the Markets _______________________________________________________ 8
Fixed Income ________________________________________________________________ 8
Equity _____________________________________________________________________ 8
Commodities ________________________________________________________________ 8
Foreign Exchange ____________________________________________________________ 8
Emerging Markets ____________________________________________________________ 8
Understanding the Businesses _____________________________________________________ 8
Market Making ______________________________________________________________ 8
Proprietary Trading ___________________________________________________________ 8
Brokerage __________________________________________________________________ 8
Underwriting / Syndication _____________________________________________________ 8
Lending ____________________________________________________________________ 8
Asset Management ____________________________________________________________ 8
Understanding the Risks _________________________________________________________ 9
Market Risk _________________________________________________________________ 9
Credit Risk __________________________________________________________________ 9
Settlement Risk ______________________________________________________________ 9
Liquidity Risk _______________________________________________________________ 9
Operational Risk _____________________________________________________________ 9
Systems Risk ________________________________________________________________ 9
Documentation Risk __________________________________________________________ 9
Use of VaR? _____________________________________________________________ 9
Risk Control___________________________________________________________________ 9
Senior Management Reporting ____________________________________________________ 9
Capital Allocation ______________________________________________________________ 9
Performance Measurement _______________________________________________________ 9
Regulatory Compliance __________________________________________________________ 9
Implementing a Firm-Wide Risk Management Framework _____________________ 9
The Foundation ________________________________________________________________ 9
The People __________________________________________________________________ 9
The Systems _________________________________________________________________ 9
Senior Management Support ____________________________________________________ 9
The Key Challenges _____________________________________________________________ 9
Risk Primer_________________________________________________________ 10
Quantitative Basics ______________________________________________________ 10
Time Value of Money __________________________________________________________ 10
Present Value _______________________________________________________________ 10
Annuities __________________________________________________________________ 10
Perpetuities ________________________________________________________________ 10
Amortization _______________________________________________________________ 10
Applied Probability ____________________________________________________________ 10
Types of Distributions __________________________________________________________ 10
Normal ____________________________________________________________________ 10
Log Normal ________________________________________________________________ 10
Binomial __________________________________________________________________ 10
Variance/Covariance ___________________________________________________________ 10
Properties of Expectation________________________________________________________ 10
Mean and Standard Deviation ____________________________________________________ 10
Regression/Correlation _________________________________________________________ 10
Skew and Kurtosis _____________________________________________________________ 10
Capital Markets Basics __________________________________________________ 10
Fixed Income _________________________________________________________________ 10
Term Structure of Interest Rates ________________________________________________ 10
Zero Coupon Curves _______________________________________________________ 10
Forward Curves ___________________________________________________________ 10
Bond Sensitivities ___________________________________________________________ 10
Properties of Duration ______________________________________________________ 10
Properties of Convexity _____________________________________________________ 10
Dollar Value of a Basis Point ________________________________________________ 10
Derivatives ___________________________________________________________________ 10
Option Sensitivities __________________________________________________________ 10
Option Mechanics ___________________________________________________________ 10
Futures/Forwards ____________________________________________________________ 10
Swaps _____________________________________________________________________ 10
Market Risk Management Framework ___________________________________ 11
Choosing Appropriate Model Parameters ___________________________________ 11
Confidence Level ______________________________________________________________ 11
Holding Period _______________________________________________________________ 11
Volatility/Correlation___________________________________________________________ 11
GARCH ___________________________________________________________________ 11
Implied ____________________________________________________________________ 11
Historical __________________________________________________________________ 11
Observation Period ________________________________________________________ 11
Weighting _______________________________________________________________ 11
Yield Curves _________________________________________________________________ 11
Beta ________________________________________________________________________ 11
Risk Measurement Methods ______________________________________________ 12
Fixed Income Risk _____________________________________________________________ 12
Covariance Approach ________________________________________________________ 12
Duration Bucketing ________________________________________________________ 12
Cash Flow Bucketing _______________________________________________________ 12
Principle Component Analysis (PCA) ____________________________________________ 12
Historical Simulation _________________________________________________________ 12
Equity Risk __________________________________________________________________ 12
Single Factor Model _________________________________________________________ 12
Multi-Factor Model __________________________________________________________ 12
FX Risk _____________________________________________________________________ 12
Commodity Risk ______________________________________________________________ 12
Gamma Risk _________________________________________________________________ 12
Delta Normal _______________________________________________________________ 12
Taylor Series _______________________________________________________________ 12
Exact Delta-Gamma __________________________________________________________ 12
Full - Repricing _____________________________________________________________ 12
Vega Risk ___________________________________________________________________ 12
Factor Push ________________________________________________________________ 12
Volatility of Implied Volatility _________________________________________________ 12
Pre-payment Variance Risk ______________________________________________________ 12
Specific Risk _________________________________________________________________ 12
Bond Specific Model _________________________________________________________ 12
Equity Specific Model ________________________________________________________ 12
Other Specific Risk Models (Real Estate, etc.) _____________________________________ 12
Concentration Risk ____________________________________________________________ 12
Practical Application of Market Risk Management Methods ___________________ 13
Foreign Exchange _____________________________________________________________ 13
Exotic Currencies ___________________________________________________________ 13
Convertibility Risk _________________________________________________________ 13
Basket Currencies ___________________________________________________________ 13
Pegged Currencies ___________________________________________________________ 13
Event Risk _______________________________________________________________ 13
Currency Swaps _____________________________________________________________ 13
Spot/Forward/Currency Futures _________________________________________________ 13
Tail Risk ________________________________________________________________ 13
Risk of Currency Crosses (Cross gamma/vega, etc.) _______________________________ 13
Equity ______________________________________________________________________ 13
Convertible Bond Risk Components _____________________________________________ 13
Deal Break-up Risk __________________________________________________________ 13
Index Arbitrage _____________________________________________________________ 13
Tracking Risk ____________________________________________________________ 13
Basis Risk _______________________________________________________________ 13
ADRs inherent F/X Risk ______________________________________________________ 13
Country of Issue vs. Country of Exchange_________________________________________ 13
Fixed Income _________________________________________________________________ 13
Global Government Securities Risk ______________________________________________ 13
Repurchase Market “Repos” _________________________________________________ 13
Mortgage-Backed Securities ___________________________________________________ 13
Mortgage-Backed Bonds ____________________________________________________ 13
Pass-Through Securities ____________________________________________________ 13
Collateralized Mortgage Obligations ___________________________________________ 13
Stripped-Mortgage Backed Securities __________________________________________ 13
Corporate Bonds Spread Risk __________________________________________________ 13
Interest Rate Swaps __________________________________________________________ 13
Emerging Markets _____________________________________________________________ 13
Brady Bonds/Eurobonds ______________________________________________________ 13
Local Currency Debt _________________________________________________________ 13
Event Risk _________________________________________________________________ 13
Derivatives ___________________________________________________________________ 13
Stock Index Options _________________________________________________________ 13
Vanilla Options _____________________________________________________________ 13
Bond Future Options _________________________________________________________ 13
Barrier Options _____________________________________________________________ 13
Swaptions__________________________________________________________________ 13
IR Caps & Floors ____________________________________________________________ 13
Index Principal Swaps and Other Structured Swaps _________________________________ 13
Credit Risk Management Framework ____________________________________ 13
Choosing Appropriate Model Parameters ___________________________________ 14
Obligor Credit Rating __________________________________________________________ 14
Credit Scoring ______________________________________________________________ 14
Rating Agencies _____________________________________________________________ 14
S&P ____________________________________________________________________ 14
Moodys _________________________________________________________________ 14
Probabilities __________________________________________________________________ 14
Credit Migration Probabilities __________________________________________________ 14
Path Dependency of Credit Migration ____________________________________________ 14
Probability of Default ________________________________________________________ 14
Historical Actual __________________________________________________________ 14
Historical Modified ________________________________________________________ 14
Option on Underlying Value _________________________________________________ 14
Cumulative Default Rates _____________________________________________________ 14
Marginal Default Rates _______________________________________________________ 14
Joint Probability of Default ____________________________________________________ 14
Recovery Values ______________________________________________________________ 14
Static Recover Values ________________________________________________________ 14
Subordinated Debt _________________________________________________________ 14
Un-Subordinated Debt ______________________________________________________ 14
Distribution of Recover Values _________________________________________________ 14
Credit Risk Management Methodology _____________________________________ 14
Single Obligor ________________________________________________________________ 14
Expected Loss ______________________________________________________________ 14
Worst Case_________________________________________________________________ 14
Multiple Obligors _____________________________________________________________ 14
Monte Carlo Simulation_______________________________________________________ 14
Basic Approach _____________________________________________________________ 14
Credit Metrics Approach ______________________________________________________ 14
KMV Approach _____________________________________________________________ 14
Credit Enhancements ___________________________________________________________ 14
Collateral __________________________________________________________________ 14
Identifying Appropriate Collateral _____________________________________________ 14
Risk-Free Haircut__________________________________________________________ 14
Margin call/Maintenance Margin______________________________________________ 14
Guarantor __________________________________________________________________ 14
Netting vs. Non-Netting Counterparties ____________________________________________ 14
Bi-Lateral __________________________________________________________________ 14
Multi-Lateral _______________________________________________________________ 14
Pre-Settlement Netting ________________________________________________________ 14
Integrating Market and Credit Risk ________________________________________ 15
Correlation Between Market and Credit Risk ________________________________________ 15
Calculating Potential Exposure ___________________________________________________ 15
Replacement Value Approach __________________________________________________ 15
Mark to Market plus Add-On __________________________________________________ 15
Joint Distribution ____________________________________________________________ 15
Practical Application of Credit Risk Management Methods ____________________ 15
OTC Derivatives ______________________________________________________________ 15
Interest Rate Swaps __________________________________________________________ 15
FX Forwards _______________________________________________________________ 15
Settlement Risk ___________________________________________________________ 15
Options ___________________________________________________________________ 15
Long ____________________________________________________________________ 15
Short ___________________________________________________________________ 15
Emerging Market Derivatives __________________________________________________ 15
Corporate Bonds ______________________________________________________________ 15
Loans _______________________________________________________________________ 15
Non-Performing _____________________________________________________________ 15
Lines of Credit ______________________________________________________________ 15
Reverse Repos ________________________________________________________________ 15
Credit Derivatives _____________________________________________________________ 15
Emerging Market Securities _____________________________________________________ 15
Local Currency _____________________________________________________________ 15
Foreign Currency ____________________________________________________________ 15
Operational Risk Management Framework _______________________________ 15
Operational Risk ________________________________________________________ 15
Operating Leverage _____________________________________________________ 15
Operating Failure _______________________________________________________ 15
Strategic Risk_________________________________________________________________ 15
Business Disruption __________________________________________________________ 15
Competitor Strateg ___________________________________________________________ 15
Political Developments _______________________________________________________ 15
Regulations ________________________________________________________________ 15
Tax _______________________________________________________________________ 16
Business Processing Risk________________________________________________________ 16
Breakdown or Ineffective Process _______________________________________________ 16
Human Errors ______________________________________________________________ 16
Faulty Internal or External Reporting 4Model Risk__________________________________ 16
Model Appropriateness Risk _________________________________________________ 16
Model Accuracy___________________________________________________________ 16
Technology and Infrastructure __________________________________________________ 16
Non Compliance with Laws __________________________________________________ 16
Practical Applications of Operational Risk Management Methods ______________ 16
Operational Risk Policies _______________________________________________________ 16
Model Vetting ______________________________________________________________ 16
Off-hour Trading ____________________________________________________________ 16
Off-market Trading __________________________________________________________ 16
Off-premises Trading_________________________________________________________ 16
Legal Document Vetting ______________________________________________________ 16
Business Process Maps _________________________________________________________ 16
Reporting and Monitoring _______________________________________________________ 16
Risk Analysis and Stress Testing __________________________________________________ 16
Economic Capital / Operational RAROC ___________________________________________ 16
Management of Operational Risks in Derivatives _____________________________________ 16
Policy _____________________________________________________________________ 16
Structure __________________________________________________________________ 16
Personnel __________________________________________________________________ 16
Reports____________________________________________________________________ 16
Accountability ______________________________________________________________ 16
Management of Operational Risks in Foreign Exchange ________________________________ 16
Deal/Trade Capture __________________________________________________________ 16
Confirmation _______________________________________________________________ 16
Netting ____________________________________________________________________ 16
Settlement _________________________________________________________________ 16
Nostro Reconciliation ________________________________________________________ 16
Accounting/Financial Control __________________________________________________ 16
General Best Practices ___________________________________________________ 16
Testing the Assumptions ______________________________________________ 16
Stress Testing __________________________________________________________ 16
Definition ______________________________________________________________ 17
The Need for Stress Testing _____________________________________________________ 17
Selecting Appropriate Market Events ______________________________________________ 17
Historical __________________________________________________________________ 17
Forward Looking ____________________________________________________________ 17
Worst Case_________________________________________________________________ 17
Types of Scenarios_____________________________________________________________ 17
Macro Economic Scenarios ____________________________________________________ 17
Effects on prices __________________________________________________________ 17
Effects on Interest rates,_____________________________________________________ 17
Effects on F/X rates, _______________________________________________________ 17
Effects on Implied Volatility _________________________________________________ 17
Micro Scenarios _____________________________________________________________ 17
Basis Spreads _____________________________________________________________ 17
Yield Curve/ Commodity Curve Spreads________________________________________ 17
Pre-Payment Rate Assumptions _______________________________________________ 17
Dividend Assumptions ______________________________________________________ 17
Convertibility Assumptions __________________________________________________ 17
Credit Scenarios_____________________________________________________________ 17
Stress Testing the Assumptions ___________________________________________________ 17
Volatility/Correlation _________________________________________________________ 17
Default Probabilities _________________________________________________________ 17
Recover Values _____________________________________________________________ 17
Liquidation Periods __________________________________________________________ 17
Distribution Shape ___________________________________________________________ 17
Back-Testing ___________________________________________________________ 17
Definition ______________________________________________________________ 17
The Need for Back Testing ______________________________________________________ 17
Selecting Appropriate Parameters for Testing ________________________________________ 17
Confidence Level ____________________________________________________________ 17
Time Period ________________________________________________________________ 17
Cleaning P/L _________________________________________________________________ 17
Elimination of Intra-day P/L ___________________________________________________ 17
Synthetic P/L _______________________________________________________________ 17
Analyzing the Results __________________________________________________________ 17
Limitations of Back -Testing _____________________________________________________ 17
Event Risk _________________________________________________________________ 17
Credit Risk _________________________________________________________________ 17
Basis Risk _________________________________________________________________ 17
Intra-day Activity____________________________________________________________ 18
Other Sources of Risk ________________________________________________ 18
Liquidity Risk __________________________________________________________ 18
Adjusting VaR for Market Liquidity _______________________________________________ 18
Funding Liquidity Risk _______________________________________________________ 18
Market Liquidity Risk ________________________________________________________ 18
Bid/Ask Spread ___________________________________________________________ 18
Adjusting VaR for Credit Liquidity Risk ____________________________________________ 18
Securities __________________________________________________________________ 18
Loans _____________________________________________________________________ 18
Systems Risk ___________________________________________________________ 18
Understanding the End-User Needs ________________________________________________ 18
Traders ____________________________________________________________________ 18
Risk Management ___________________________________________________________ 18
Operations and Control _______________________________________________________ 18
Data Issues ___________________________________________________________________ 18
Securing Data ______________________________________________________________ 18
Ensuring Integrity of Data _____________________________________________________ 18
Extracting and Mapping Data __________________________________________________ 18
Aggregating Data ____________________________________________________________ 18
Quantifying Systems Risk _______________________________________________________ 18
Tax Risk _______________________________________________________________ 18
Accounting Risk ________________________________________________________ 18
Accrual vs. Mark to Markets _____________________________________________________ 18
Balance Sheet vs. Trading Accounts _______________________________________________ 18
Hedge Accounting _____________________________________________________________ 18
Option Accounting_____________________________________________________________ 18
Model Risk_____________________________________________________________ 18
Understanding Model Risk ______________________________________________________ 18
Model Error Characteristics______________________________________________________ 18
Assessing the Impact of model Risk _______________________________________________ 18
Risk Capital Framework ______________________________________________ 19
Economic Risk Capital ___________________________________________________ 19
Definition ____________________________________________________________________ 19
Regulatory vs. Economic Risk Capital _____________________________________________ 19
Measuring Economic Capital _____________________________________________ 19
Market Risk Capital ____________________________________________________________ 19
Credit Risk Capital ____________________________________________________________ 19
Other Financial Risks __________________________________________________________ 19
Specific Risk _______________________________________________________________ 19
Liquidity Risk ______________________________________________________________ 19
Other Risks __________________________________________________________________ 19
Operational Risk ____________________________________________________________ 19
Systems Risk _______________________________________________________________ 19
Settlement Risk _____________________________________________________________ 19
Controlling Risk Capital _________________________________________________ 20
Risk Limits __________________________________________________________________ 20
VaR Limits ________________________________________________________________ 20
DV01, 1-year Equivalent, Futures Equivalent ______________________________________ 20
Greek Limits _______________________________________________________________ 20
Credit Based _______________________________________________________________ 20
Position Limits ________________________________________________________________ 20
Market Value _______________________________________________________________ 20
Notional ___________________________________________________________________ 20
Other Limits __________________________________________________________________ 20
Stop-loss Limits _____________________________________________________________ 20
Maturity Gap Limits _________________________________________________________ 20
Liquidity Limits _____________________________________________________________ 20
Counterparty Credit Limits ____________________________________________________ 20
Managing Economic Capital ______________________________________________ 20
Risk Appetite _________________________________________________________________ 20
Attribution of Capital to the Businesses ____________________________________________ 20
Allocation of Economic Capital __________________________________________________ 20
Assessing Risk-Adjusted Performance ______________________________________ 20
Provisioning __________________________________________________________________ 20
Planned Vs Actual Usage _______________________________________________________ 20
Attribution of Income __________________________________________________________ 20
Marginal Risk Capital __________________________________________________________ 20
Linking Capital Allocation and Reward Structures ___________________________ 20
Creating the Right Incentives_____________________________________________________ 20
Trader Bonuses _______________________________________________________________ 20
Regulation _________________________________________________________ 21
Regulatory Approaches to Risk Management ________________________________ 21
Standard Model _______________________________________________________________ 21
Internal Model ________________________________________________________________ 21
Pre-Commitment Model ________________________________________________________ 21
Internal Model Requirements _____________________________________________ 21
Model Parameters _____________________________________________________________ 21
Risk Measurement Methodology __________________________________________________ 21
Specific Risk _______________________________________________________________ 21
Credit Risk _________________________________________________________________ 21
Market Risk ________________________________________________________________ 21
Back-Testing _________________________________________________________________ 21
Stress Testing_________________________________________________________________ 21
Internal Controls ______________________________________________________________ 21
Implications of the Models ________________________________________________ 21
Large Banks __________________________________________________________________ 21
Small Banks __________________________________________________________________ 21
Other Financial Institutions ______________________________________________________ 21
Securities Firms _______________________________________________________________ 21
Investment Funds ______________________________________________________________ 21
Primary Concerns of Regulators __________________________________________ 21
Systemic Risk ________________________________________________________________ 21
Operations Risk _______________________________________________________________ 21
Concluding Remarks _________________________________________________ 21
Lessons from Jerry Corrigan on Financial Crises
Goldman Sachs Conference, May 2, 1999
(Jerry became a Goldman Partner several years ago after 25 years at the federal reserve,
where he served as the head of the highly influential NY Federal reserve Bank. His
mentor was Paul Volker.)
1. Asia, Russian, 1987’s Crash: Events of this nature are not once-in-a-lifetime
events; despite quantitative studies. They will occur again and again.
2. If last Fall was a 6 on the Richter scale, 7’s can occur. (N.B., the Richter scale
is logarithmic.)
3. When the wheels start to come off, all the distinctions between market and
credit risks disappear and the market decline impacts almost everything.
4. When this happens, market and instrument liquidity disappears.
5. This loss of liquidity makes volatility increase and prices drop astronomically.
6. Have to worry about illusion of security e.g., collateral, diversification, etc.
When crises hit, they provide little protection.
7. Any lender who takes comfort in collateral will be very disappointed in reality
when crisis occurs, the value of collateral will not be what you thought it would
be.
8. Quantitative risk numbers like VAR, standard deviation, etc. are still based on
past and therefore subject to likely surprises.
9. Flaws in institutional and legal infrastructures are very significant in causing
crises and are prevalent in emerging market countries and in many so-called
developed countries, e.g., Japan.