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:

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

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 10%
  • Team Project 40%
  • Class Presentation 20%
  • Final 30%

Office Hours: After each class or by appointment.

Summary of Topics Discussed

  • 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
  • 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. The Need for Risk Management
  2. Lessons from Financial Disasters
  3. The Concept of Hedging, Diversification and Insurance
  4. Risk Management Not Just for Trading
  5. 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. General VaR Framework: Mark-to-Market, Calculate Distribution of Values at Horizon, Calculate VaR
  2. Specifying Risk Horizon Time and Confidence Level
  3. Specifying Risk Factors in A Portfolio and Their Distribution
  4. Mapping Assets to Risk Factors, i.e. Calculating Exposure to Factors
  5. Vary Risk Factors
  6. Estimate The Changes in Value of Instruments
  7. Calculate VaR
  8. VaR for Parametric Distributions
  9. Conversion of VaR Parameters
  10. Reality Checks – How to Verify VaR
  11. 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. Definition of financial price changes and returns
  2. Modeling financial prices and returns
  3. Investigating the random-walk model
  4. A review of historical observations of return distributions
  5. 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. Linear (future, swap, forward, etc.) and Nonlinear Derivative Instruments (Options)
  2. Role of Derivatives in Risk Management
  3. Hedging Using Futures and Options
  4. Delta-Gamma VaR Analysis
  5. Role of Implied Volatility in Risk Management of Derivatives
  6. Use of Volatility Swaps as a Hedging Tool
  7. 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. Forecasts from implied versus historical information
  2. RiskMetrics forecasting methodology
  3. Estimating the parameters of the RiskMetrics model
  4. 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. How to Vary Risk Factors: Variance/Covariance; Implied Variance/Covariance; Historical Simulation; Monte Carlo; Structured Monte Carlo
  2. How to Estimate The Changes in Value of Instruments – Local valuation; Full Valuation
  3. Dealing with Nonlinear Positions, e.g. options
Market risk methodology
  1. Step 1—Identifying exposures and cash flows
  2. Step 2—Mapping cash flows onto RiskMetrics vertices
  3. Step 3—Computing Value-at-Risk
  4. Examples

Monte Carlo

  1. Scenario generation
  2. 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. Value at Risk (August 1996), by Philippe Jorion
  2. 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 -
  12. RiskMetrics Technical Document -

Regulatory publications:

1. Risk Management and Control Guidance for Securities Firms and their Supervisors IOSCO, May 98,

2. Risk Management Guidelines for Derivatives BIS - Basle Committee, Jul. 1994,

3. Derivatives: Practices and Principles G30 / Global Derivatives Study Group, Jul. 1993,

4. Operational Risk Management BIS - Basle Committee, Sept. 1998,

5. Capital Adequacy Principles BIS - Basle Committee, Feb. 1998,

8. Report of the Committee on Interbank Netting Schemes BIS - Committee on Payment and Settlement Systems of the G-10, Nov. 1990

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 / Percentage
I. Quantitative Analysis / 15%
II. Capital Markets / 15%
III. Market Risk Management / 25%
IV. Credit Risk Management / 25%
V. Operational & Integrated Risk Management / 5%
VI. Legal, Accounting, and Tax Risk Management / 5%
VII. Regulation and Compliance / 10%
Total / 100%

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
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:

  1. Value at Risk (August 1996), by Philippe Jorion
  2. 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

Optional references:

  1. Managing Bank Capital: Capital Allocation and Performance Measurement (August 1996), by Chris Matten (SBC)
  2. Dynamic hedging (December 1996), by Nassim Taleb
  3. CreditMetrics Technical Document -
  4. RiskMetrics Technical Document -

Regulatory publications:

1. Risk Management and Control Guidance for Securities Firms and their Supervisors IOSCO, May 98,

2. Risk Management Guidelines for Derivatives BIS - Basle Committee, Jul. 1994,

3. Derivatives: Practices and Principles G30 / Global Derivatives Study Group, Jul. 1993,

4. Operational Risk Management BIS - Basle Committee, Sept. 1998,

5. Capital Adequacy Principles BIS - Basle Committee, Feb. 1998,

8. Report of the Committee on Interbank Netting Schemes BIS - Committee on Payment and Settlement Systems of the G-10, Nov. 1990

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