Visit FinancialEbooks.NET for more financial information“Lieary of Congress Cataloging in Publication Data Sexion, Paippe aie a isk: the mew benchmark for managing Sane isk / Pipe Jason —2nd ISBN 0.07-135500.2 Fanci fren 2, Rk management 1 Tile'The ew henchst fr managing ‘euch ML Tie. 26 346892000 estis's—aeat on-o3m39 McGraw-Hill a [A Division of The Me Gi ill Compares ‘Copyght © 2001, 1997 by McCraw AL Al sighs reserve, Pred in he United States of “Amerie, xcept permited under th Unite Sates Copyright Ax of 1975, no pa of is ‘bition maybe repre or dite in any fro by any means, stored in database fr eeal system, oubou the pier wien persion of tps 1234567¥90 Docmoc 06543210 188 0.07-135502:2 ‘The spensorng eto for thi took was Cuherve Schvent the ein supervisor Was ‘Ruth W Maan, a he production supervinor was izabes Sange art n L/13 Tames Roman by ATU. Prins and bound by R.R: Donley & Sons Company ‘This pian i designed to provide seeurate and ahora information regu oe sajet ater covered Is Sold wih the understanding that er the autor nor the publisher is ‘nated in endrng leg scountng. or oter profesional ere. I eal aie oe her eapet siice 6 requed th services ofa competent professional peson shouldbe sough. “ram a Declaration of Pricpes ol aopted by Comma ofthe American Bar ‘Assocation and a Commie of Publishers ‘Mera toot re ave at speci quant discos we as premiums ud sales romions, oor se incorporate ining prograns. For mor formation, pias wit the Director of Special Sls, Professions Publishing, McGraw-Hill To Penn Para, New York, NY 10121-2208, Or comet your fel Boston “Ths ook eprint on soy ute pape smi minmn of SO eyed einked terContents in Preface xxi Pur Owe Mornanion 1 {Chapter 1 The Need for Rik Management 3 Chapter 2 Lessons from Financial Disasters | 31 Chapter 3 Regulatory Capital Standards with VAR 51 Par Two Bunowne Biocxs 79 Chapter 4 Measuring Financial Risk 81 Chapter 5 Computing Value at Risk 107 Chapter 6 Backtesting VAR Models 129 Chapter 7 Portfolio Risk: Analytical Methods 147 Chapter 8 Forecasting Risks and Correlations 183 Parr Tuner VaLur-ar-Risk Systems 203 Chapter 9 VAR Methods 205 Chapter 10 Stress Testing 231 Chapter 11 Implementing Delta-Normal VAR 255 Chapter 12 Simulation Methods 291 Chapter 13 Credit Risk 313 (Chapter 14 Liquidity Risk 339 Par Four _APrticarions oF Risk-MANAGEMENT Systems 359 (Chapter 15 Using VAR to Measure and Control Chapter 16 Using VAR for Active Risk Management 383, Chapter 17 VAR in Investment Management 407 Chapter 18 The Technology of Risk 431 Chapter 19 Operational Risk Management 447 Chapter 20 Integrated Risk Management 467 Par Five THe RISK-MANAGEMENT PROFESSION 481 Chapter 21 Risk Management: Guidelines and Pitfalls 483 Chapter 22 Conclusions $11 References 521 Index 531ABOUT THE AUTHOR Philippe Jorion is currently Professor of Finance at the University of Cal= ifornia, Irvine. He has also taught at Columbia University, Northwestern University, the University of Chicago, and the University of Britist Co Jumbia, He received his M.B.A. and Ph.D. from the University of Chicago, ‘and-a-master’s degree in engineering fromr the University of Brussels, Dr. Jorion has written two books, Big Bets Gone Bad: Derivatives and Bankruptcy in Orange County (Academic Press, 1995) and Financial Risk Management: Domestic and International Dimensions (co-authored with S. Khoury; Blackwell, 1995), and more than SO publications directed to academics and practitioners om the topics of risk management and in- ternational finance. His recent work addresses the issue of forecasting risk and return in global financial markets. He is on the editorial board of a umber of finance journals and is editor-in-chief of the Journal of Risk Dr. Jorion has received prestigious academics awards and has served as a consultant to various institutions. He is a frequent speaker at aca- demic and professional conferences.Contents Preface xxi Part One MOTIVATION 1 Chapter 1 ‘The Need for Risk Management 3 LI Financial Risks 3 1.1.1 Change:"The Only Constant 4 1.1.2. But Where Is Risk Coming From? 7 1.13 The Toolbox of Risk Management 10 112 Derivatives and Risk Management 11 2.4 What Are Derivatives? 11 1.22 Types of Derivatives 12 1.23 Derivatives Markets: How Big? 12 413 Types of Financial Risks 15, 13.) Market Risk 15 132 Credit Risk 16 133 Liquidity Risk 17 134 Operational Risk 18 135 Legal Risk 20 1.36 Integrated Risk Measurement 21 14 In Brief, What Is VAR? 21 14.1 Definition of VAR 22 14.2 Mlustation of VAR 22 115 VAR and the Evolution of Risk Management 25 ‘Chapter 2. Lessons from Financial Disasters 31 24 Lessons from Recent Losses 32 2.1.1 Losses Auributed to Derivatives 33, 2.1.2 Perspective an Financial Losses 34 22 Case Studies in Risk 36 2.21 Barings’ Fal: A Lesson in Risk 36 2.2.2 Metallgesellschalt 38 2.23 Orange County 40 2.24 Daiwa's Lost Billion 41 2.25 Lessons from Case Studies 42 23 Private Sector Responses 43 23.1 G30Repon 43 2.32 Derivatives Policy Group 43 2.33 LP. Morgan's RiskMetries 44 2.34 Global Association of Risk Professionals (GARP) 45 2.4 The View of Regulators 45 24.1 General Accounting Office (GAO) 46 2.42 Financial Accounting Stndards Board (FASB) 46 243 Securities and Exchange Commission (SEC) 47 25 Conclusions 49 Chapter 3 Regulatory Capital Standards with VAR 51 3.1 Why Regulation? 52 3.2 The 1988 Basel Accord 55, 32.1 The Cooke Ratio 55 3.2.2 Activity Restrictions 57 3.2.3 Criticisms of the 1988 Approsch 57 3.3 The 1996 Amendment on Market Risks 60 3.3.1 The Standardized Method 61 33.2 The Intemal Models Approach 63 3.33 The Procommitment Model 65omens & 33-4 Comparison of Approaches 66 3.35 Example 68 34 The 1999 Credit Risk Revisions 68 3.41 The Revisions 70 3.42 Overall Assessment 70 3.5 Regulation of Nonbanks 72 43511 Securities Firms 72 3.5.2 Insurance Companies 74 3.5.3 Pension Funds 75 36 Conclusions 75 ja BUILDING BLOCKS 79 Couper Measuring Financial 4. Market Risks 82 4.2 Probability Distribution Functions 86 42.1 A Gambler's Experiment 86 4.2.2 Properties of Expectations 89 4.23 The Normal Distribution 91 4.2.4 Other Distributions 93, 43 Risk 95 43.1 Risk as Dispersion 95 43.2 Quantiles 95 444 Asset Retums 98 44.1 Measuring Retums 98 4.42 Sample Estimates 101 45 Time Aggregation 102 4.5.1 Aggregation with LLD. Returns 102 4.52 Aggregation with Correlated Retums 104 45.3 The Effect of the Mean at Various Horizons 105x Content Computing Value at Risk 107 5.1 Computing VAR 108 5.1.1 Steps in Constructing VAR 108 5.12 VAR for General Distributions 109 5.1.3. VAR for Paramettic Distributions 110 5.14 Comparison of Approaches 113, 5.1.5 VAR asa Risk Measure 114 5.2 Choice of Quantitative Factors 116 5.2.1 VAR asa Benchmark Measure 116 5.2.2 VAR as a Potential Loss Measure 117 5.2.3 VAR as Equity Capital 117 5.24 Criteria for Backtesting 119 5.2.5 swpplication: The Base! Parameters 119 5.2.6 Conversion of VAR Parameters 121 5.3 Assessing VAR Precision 122 5.3.1 The Problem of Measurement Errors 122 5.3.2 Estimation Errors in Means and Variances 123 5.3.3 Estimation Error in Sample Quantiles 125 5.3.4 Comparison of Methods 126 54 Conclusions 128 Chapter 6. Backtesting VAR Models 129 6.1 Setup for Backtesting 130 6.11 An Example 130 6.12 Which Return? 131 6.2 Model Backtesting with Exceptions 132 6.2.1 Model Verification Based on Failure Rates 132 622 The Basel Rules 136 6.23 Conditional Coverage Models 140Contents % 6.3 Mode! Verification: Other Approaches 142 63.1 Distribution Forecast Models 142 63.2 Parametric Models 143 63.3 Comparison of Methods 144 64 Conclusions 145 ——— Portfolio Risk: Analytical Methods 147 7.1 Portfolio VAR 148 7.2 VAR Tools 153 72.1 Marginal VAR 154 722 Incremental VAR 155 723 Component VAR 159 724 Summary 161 7.3 Examples 162 7.3.1 A Global Ponfolio Equity Report 163 7.32 Barings: An Example in Risks 165 74 Simplifying the Covariance Matrix 167 17.4.1 Why Simplifications? 167 742 Zero VAR Measures 168 7.4.3 Diagonal Model 169 7.4.4 Factor Models 171 7.45 Comparison of Methods 175 15 Conclusions 177 ‘Appendix 7A: Matrix Multiplication 178 Appendix 7B (Advanced): Principal-Componeat Analysis 179 Chapter 8. Forecasting Risks and Correlations 183, 8.1 Time-Varying Risk or Outliers? 184 8.2 Modeling Time-Varying Risk 186 82.1 Moving Averages 186 8.22 GARCH Estimation 187 8.23 Long-Horizon Forecasts with GARCH 189 8.24 The RiskMetries Approach 193a“ CConens 8.3 Modeling Correlation 196 8.3.1 Moving Averages 196 8.3.2 Exponential Averages 197 8.3.3 Crashes and Correlations 198 8.4 Using Options Data 199 8.4.1 Implied Volailties 200 8.42 ISD as Risk Forecasts 200 85 Conclusions 202 Part Three, VALUE-AT-RISK SYSTEMS 203 Chapter 9. VAR Methols 205 9.1 Local versus Full Valuation 206 9.1.1 Delta-Normal Valuation 206 9.1.2 Full Valuation 209 9.1.3 Delts-Gamma Approximations (the “Greeks”) 211 9.1.4 Comparison of Methods 214 9.1.5 An Example: Leeson’s Straddle 215 9.2 Delta-Normal Method 219 9.2.1 Implementation 219 9.2.2 Advantages 220 9.23 Problems 220 9.3 Historical Simulation Method 221 9.3. Implementation 221 9.3.2 Advantages 222 9.3.3 Problems 223 9.4 Monte Carlo Simulation Method 224 9.4.1 Implementation 224 9.4.2 Advantages 225 9.43 Problems 226 9.5 Empirical Comparisons 227 9.6 Summary 229comes si Chapter 10, 7 Stress Testing 231 10.1 Why Stress Testing? 232. 10.2 Implementing Scenario Analysis 235 10.3 Generating Unidimensional Scenarios 235 103.1 Stylized Scenarios 235, 10.32 An Example: The SPAN System 237 10.4 Multidimensional Scenario Analysis 239 10.4.1 Unidimensional versus Multidimensional 239 10.4.2 Prospective Scenarios 239 10.43 Factor Push Method 240 10.4.4 Conditional Scenario Method 240 10.45 Historical Scenarios 242 10.4.6 Systematic Scenarios 245 105 Stress-Testing Model Parameters 245 10.6 Managing Suess Tests 247 10.6.1 Scenario Analysis and Risk Models 247 10.62 Management Response 247 10.7 Conclusions 248 ‘Appendix: Extreme Value Theory 249 Chapter 11, Implementing Delta-Normal VAR 255 11 Overview 256 11.2 Application to Currencies 257 11.3 Choosing “Primitive” Securities 259 113.1 Lessons from Exchanges 262 11.32 Specific Risk 263 Ia Fixed Income Portfolios 264 11.4.1 Mapping Approaches 264 11.42 Risk Factors 264 11.43 Comparison of Mapping Approaches 266 11.44 Assigning Weights to Vertices 269 11.45 Benchmarking a Portfolio 271tr Cones 115 Linear Derivatives 274 11.5.1 Forward Contracts 274 11.5.2 Commodity Forwards 278 11.523 Porward Rate Agreements 279 11.5.4 Interest Rate Swaps 282 11.6 Derivatives: Options 285 11,7 Equity Portfolios 287 Chapter 12. Simulation Methods 291 12.1. Simulations with One Random Variable 292 12.1.1 Simulating a Price Path 292 12.1.2 Creating Random Numbers 295 12.13 The Bootstrap 296 12.14 Computing VAR 298 12.1.5 Risk Management and Pricing Methods 298, 122 Speed versus Accuracy 299 1221 Accuracy 300 12.22 Acesleration Methods 301 123 Simulations with Multiple Variables 302 123.1 From Independent to Correlated Variables 302 1232 The Cholesky Factorization 303 123.3 Number of Independent Factors 304 124 Deterministic Simulation 306 125 Scenario Simulation 307 126 Choosing the Model 309 127 Conclusions 311 Chapter 13, Credit Risk 313 13.1 The Nature of Credit Risk 314 13.1.1 Sources of Risk 314 13.1.2 Crodit Risk as @ Short Option “316 13.13 Time and Portfolio Effects 31613.2 Default Risk 318 13.2.1 Default Rates 318 13.2.2 Recovery Rates 321 13.23 Estimating Default Risk 321 13.3 Credit Exposure 323, 13.3.1 Bonds versus Derivatives 323 13.3.2 Expected and Worst Exposure 325 134 Netting Amangements 327 13.5 Measuring and Managing Credit Risk 329 13.5.1 Expected and Unexpected Credit Loss 329 13.52 Pricing Credit Risk 330 13.53 Portfolio Credit Risk 332 13.54 Managing Credit Risk 333 135.5 Horizon and Confidence Level 334 136 The Basel Risk Charges for Derivatives 334 13.7 Portfolio Credit Risk Models 336 138 Conclusions 337 Chapter 14 Liquidity Risk 339 14.1 Defining Liquidity Risk 340 14.1.1 Asset Liquidity Risk 340 14.1.2 Funding Liquidity Risk 342 14.2 Dealing with Asset Liquidity Risk 343 14.2.1 Bid-Ask Spread Cost 344 142.2 Trading Strategies 346 14.23 Practical Issues 349 143 Gauging Funding Liquidity Risk 351 14.4 Lessons fromLTCM 352 14.4.1 LTCM’s Leverage 353 144.2 LTCM’s “Bulletproofing” 353 14.4.3 LTCM’s Downfall 354 1444 LTCM’s Liquidity 355 145 Conclusions 357APPLICATIONS OF RISK-MANAGEMENT SYSTEMS 359 Chapter 15, Using VAR to Measure and Control Risk 361 15.1 Who Can Use VAR? 363 15.1 The Trend to Global Risk Management 363 15.1.2 Proprictary Trading Desks 365 15.1.3 Nonfinancial Corporations 366 15.2 VAR as an Information-Reporting Too! 370 15.2.1 Why Risk-Management Disclosures? 371 1522 Trends in Disclosure 373 15.23 Diselosure Examples 375 153 VAR as a Risk-Control Tool 376 153.1. Adjusting Firm-Wide VAR 377 1532 Adjusting Unit-Level VAR 379 15.4 Conclusions 381 Chapter 16. Using VAR for Active Risk Management 383 16.1 Risk Capital 384 16.1.1 VAR as Risk Capital 384 16.1.2 Choosing the Confidence Level 385 16.2 Risk-Adjusted Performance Measurement 387 16.3 Eamings-Based RAPM Methods 389 164 VAR-Based RAPM Methods 391 16.5 Firm-Wide Performance Measurement 394 16.6 VAR as a Strategie Tool 398 166.1 Shareholder Value Analysis 398 16.6.2. Choosing the Discount Rate 400 166.3 Implementing SVA 401 16.7 Conclusions 402 Appendix: A Closer Look at Economie Capital 403,omens at (Chapter 17 _ ‘VAR in Investment Management 407 17.1 Is VAR Applicable to Investment Management? 408. 17.2 What Are the Risks? 410 172.1 Absolute and Relative Risks 411 17.22 Policy Mix and Active Management Risk 411 17.23 Fonding Risk 413 17.24 Sponsor Risk 414 173 Using VAR to Monitor and Control Risks 415 17.3.1 Using VAR to Check Compliance 416 17.32 Using VAR to Design Guidelines 417 17.3.3 Using VAR to Monitor Risk 418 1734 The Role of the Global Custodian 419 17.35 The Role of the Money Manager 420 17.4 Using VAR to Manage Risks 420 TTA, Strategic Asset Allocation 420 1742 VAR as a Guide to Investment Decisions 422 174.3 VAR for Risk-Adjusted Returns 424 ITAA Risk Budgeting 425 175 The Risk Standards 426 176 Conclusions 428 Chapter 18, The Technology of Risk 431 18.1 Systems 432 18.2 The Need for Integration 434 18.3 The Risk-Management Industry 438 18.4 How to Suucture VAR Reports 442 185 AnApplication 443 18.6 Conclusions 445 Ch vs. Operational Risk Management 447 19.1 ‘The Importance of Operational Risk 448 19.2 Defining Operational Risk 449sil conten 19.3 Approaches to Operational Risk 451 194 Measuring Operational Risk 452 19.4.1 Top-Down versus Bottom-Up Approaches 453 19.42 Loss Distributions 453 194.3 The Data Challenge 457 19.5 Managing Operational Risk 459 19.5.1 Expected versus Unexpected Losses 460 195.2 Controlling Operational Risk 460 19.5.3 Funding Operational Risk 461 19.6 Conclusions 462 Appendix: Constructing Loss Distributions 463 Chapter 20. Integrated Risk Management 467 20.1 The Galaxy of Risks 468 20.2 Event Risks 469 20.2.1 Legal Risk 469 202.2 Reputational Risk 470 20.2.3 Disaster Risk 470 20.2.4 Regulatory and Political Risk 470 203 Integrated Risk Management 472 203.1 Measuring Fitm-Wide Risk 472 203.2 Controlling Firm-Wide Risk 473 203.3 Managing Firm- Wide Risk: The Final Frontier 474 20.44 Why Risk Management? 475 204.1 Why Bother? 475 20.4.2 Why Hedge? 477 205 Conclusions 478Part Five, ‘THE RISK-MANAGEMENT PROFESSION 481 Chapter 21. _ Risk Management: Guidelines and Pitfalls 483 21.1 Milestone Documents in Risk Management 484 21.1.1 “Best Practices” Recommendations from G-30 484 21.1.2 The Bank of England Report on Barings 486 21.1.3 The CRMPG Report on LTCM 486 21.2 Limitations of VAR 488 21.2.1 Risk of Exceedences 488 21.2.2 Changing Positions Risks 488 21.2.3 Event and Stability Risks 489 21.24 Transition Risk 491 21.28 Data-Inadequacy Risks 492 21.2.6 Model Risks 492 213 Side Bffects of VAR 498 21.3.1 The “Man in the White Coat” Syndrome 498 21.3.2 Traders Gaming the System 499 21.33 Dynamic Hedging 502 214 Risk-Management Lessons from LTCM 503 214.1 LTCM’s Risk Controls 503 21.42 Portfolio Optimization S04 21.43 LTCM’s Short Option Position 507 215 Conclusions 508 Chapter 22 Conclusions S11 22.1 The Evolution of Risk Management $12 22.2 The Role of the Risk Manager 513 2.1 Controlling Trding $13 22.2.2 Organizational Guidelines S14 22.2.3 Risk Managers 516 22.3 VAR Revisited 517 REFERENCES 521 INDEX $31PREFACE THE RISK MANAGEMENT REVOLUTION Risk management has truly experienced a revolution in the last few years. ‘This was started by value at risk (VAR), a new method to measure fi- nancial market risk that was developed in response to the financial dis- asters ofthe early 1990s, By now, the VAR methodology has spread well beyond derivatives and is totally changing the way institutions approach their financial risk. ‘The fist edition of this book provided the first comprehensive de- scription of value at risk. It quickly established itself as an indispensable reference on VAR, and has been called the “industry standard.” Transla- tions into Chinese, Hungarian, Japanese, Korean, Polish, Portuguese, and Spanish soon followed ‘The last few years, however, have seen such advances in the field of risk management that a new edition became necessary. Initially confined to measuring market risk, VAR is now being used to control and manage risk actively, both credit risk and operational risk. The VAR methodol- ogy is now leading to the holy grail of firm-wide risk management. This book is a completely revised version of the previous edition. ‘The revision parallels the enormous increase in the body of knowledge in risk management. Just the number of references, for instance, has bal- Jooned from 80 to more than 200. For many of these, the book now pro- vides Web addresses for convenient updates. Brand new chapters have been added on the topics of backtesting, stress testing, liquidity risk, operational risk, and integrated risk manage- ment. Applications of VAR have also been further developed, with sepa- rate chapters on using VAR to measure and control risk, to manage risk, and in investment management. An entire chapter is devoted to the tech- nology of risk. The last chapters describe the rapidly evolving function of the financial risk manager. The text also contains new material on prin- cipal components, extreme value theory, and loss distributions. Since the last edition, unfortunately, there have been new occur- rences of financial disasters. This book draws lessons from these crises, in particular from Long-Term Capital Management (LTCM). Finally, the ‘book has thoroughly updated the relevant regulatory requirements and ‘now uses terms and definitions that have become industry standards, Al in all, the book has been expanded more than 60 percent. ‘The broader scope of this book is reflected in its new subtitle. It has been changed from The New Benchmark for Controlling Market Risk to The New Benchmark for Managing Financial Risk ait Preface WHAT IS VAR? VAR (value at risk) traces its roots to the infamous financial disasters of the early 1990s that engulfed Orange County, Barings, Metallgesellschat, Daiwa, and so many others. The common lesson of these disasters is that billions of dollars can be lost because of poor supervision and manage- rent of financial risks, Spurred into action, financial institutions and reg ulators tured to value at risk, an easy-to-understand method for quanti- fying market risk. ‘What is VAR? VAR is a method of assessing risk that uses standard statistical techniques routinely used in other technical fields. Formally, VAR measures the worst expected loss over a given horizon under nor- ‘mat market conditions at a given confidence level. Based on firm scien- tific foundations, VAR provides users with a summary measure of mar- ket risk. For instance, a bank might say that the daily VAR of its trading portfolio is $35 million at the 99 percent confidence level. In other words, there is only 1 chance in a 100, under normal market conditions, for a loss greater than $35 million to occur. This single number summarizes the bank's exposure to market risk as well as the probability of an ad- verse move. Equally important, it measures risk using the same units as, the bank’s bottom line—dollars. Shareholders and managers can then de- cide whether they feel comfortable with this level of risk. If the answer is no, the process that led to the computation of VAR can be used to de~ ide where to trim the risk. In contrast with traditional risk measures, VAR provides an aggre- gate view of a portfotio’s risk that accounts for leverage, correlations, and current positions. As a result, it is truly a forward-looking risk measure. VAR, however, applies not only to derivatives but to all financial instru- ‘ments. Furthermore, the methodology can also be broadened from mar~ ket risk to other types of financial risks. ‘The VAR revolution has been brought about by a convergence of factors. These include (1) the pressure from regulators for better control of financial risks, (2) the globalization of financial markets, which has led to exposure to more sources of risk, and (3) technological advances, which have made enterprise-wide risk management a not-so-distant reality. WHO CAN USE VAR? Basically, VAR should be used by any institution exposed to financial risk, ‘We can classify applications of VAR methods as follows1 Passive: information reporting The earliest application of VAR was for measuring aggregate risk. VAR can be used to apprise senior management of the risks run by trading and investment operations. VAR also communicates the financial risks of a cor poration to its shareholders in nontechnical, user-friendly terms 1 Defensive: controlling risk The next step was to use VAR to set position limits for traders and business units. The advantage of VAR is that it creates a common denominator with which to compare risky activities in diverse markets. 1 Active: managing risk VAR is now increasingly used to allo- cate capital across traders, business units, products, and even to the whole institution. This process starts with adjusting returns for risk. Risk-adjusted performance measures (RAPM) automat- ically correct incentives for traders to take on extra risk due to the optionlike feature of bonuses. Once implemented, risk-based capital charges can guide the institution toward a better risk! return profile. The VAR methodology can also assist portfolio managers in making better decisions by offering a comprehen- sive view of the impact of a trade on portfolio risk. Ultimately, it will help to create greater shareholder value added (SVA), As aresult, VAR is being adopted en masse by institutions all over the world. These include: ® Financial institutions Banks with large trading portfolios have been at the vanguard of risk management, Institutions that deal with numerous sources of financial risk and complicated insiru- ments are now implementing centralized risk management sys- tems. Those that do not expose themselves to expensive fail- ures, such as those that occurred with Barings and Daiwa. * Regulators The prudential regulation of financial institutions requires the maintenance of minimum levels of capital as re serves against financial risks. The Basel Committee on Banking Supervision, the U.S. Federal Reserve Bank, the U.S. Securities and Exchange Commission, and regulators in the European Union have converged on VAR as a benchmark risk measure * Nonfinancial corporations Centralized tisk management is, useful to any corporation that has exposure to financial risks Multinationals, for instance, have cash inflows and outflows de-ty Preface ‘nominated in many currencies, and suffer from adverse currency swings. “Cash flow at risk analysis” can be used to tell how likely a firm will be to face a critical shortfall of funds. ™ Asset managers Institutional investors are now turning to VAR to manage their financial risks. The director of the Chrysler pension fund, for instance, stated that after the purchase of a VAR system, “We can now view our total capital at risk on a portfolio basis, by asset class and by individual manager. Our ‘main goal was to . . . have the means to evaluate our portfolio isk going forward.” VAR also has direct implications for the recent crisis in Asia. One widespread interpretation is that the crisis was made worse by the “opac- ity” and poor risk-management practices of financial institutions. If this theory is correct, VAR systems would have helped. Professor Dombusch (1998a) recently argued that “An effective supervisory system would, at the least, put in place a mandatory VAR analysis not only for the indi- ‘vidual financial institutions (as is in place in the US, for example) but in fact for the entire country.” By drawing attention to potentially dangerous scenarios, a VAR analysis would induce countries to consider hedging for- eign currency liabilities, lengthening debt maturities, and taking other measures to reduce risk levels. Some have even proposed judging the ered- ibility of central banks by asking them to report their VAR." Many derivatives and banking disasters could have been avoided if reporting systems had been more transparent. Time and again, losses are allowed to accumulate because’ positions are reported at book value, or at cost. When market values are available, tis is inexcusable. Simply mark- ing-to-market brings attention to potential problems. VAR goes one step further, asking what could happen under changes in market values. In the end, the greatest benefit of VAR probably lies in the imposi- tion of a structured methodology for critically thinking about risk. Insti- tutions that go through the process of computing their VAR are forced to confront their exposure to financial risks and set up an independent risk- ‘management function supervising the front and back offices. Thus the process of getting to VAR may be as important as the number itself. In- deed, judicious use of VAR may have avoided many of the financial dis- "Se Bljer and Schumacher (199),Preface = asters experienced over the past years. There is no doubt that VAR is here to stay. PURPOSE OF THE BOOK ‘The purpose of this book is t© provide a comprehensive presentation of the measurement and applications of value at risk. It is targeted to practitioners, students, and academics interested in understanding the recent revolution in financial risk management. This book can also serve as a text for advanced graduate seminars on risk management. The first edition, for instance, has been used in business schools all over the world. To reap maximum benefit from this book, readers should have had the equivalent of an MBA-level class on investments. In particular, read cers should have some familiarity with concepts of probability distribution, statistical analysis, and portfolio risk. Prior exposure to derivatives and the fixed-income market is also a plus. The book provides a brief review of these concepts, then extends the analysis in the direction of measuring aggregate financial risks ‘The variety of these topics reflects the fundamental nature of risk ‘management, which is integration, Risk managers must be thoroughly fa- miliar with a variety of financial markets, with the intricacies of the trad- ing process, and with financial and statistical modeling. Risk management integrates fixed-income markets, currency markets, equity markets, and commodity markets. In each of these, financial instruments must be de- composed into fundamental building blocks, then reassembled for risk ‘measurement purposes. No doubt this is why risk management has been called “the theory of particle finance.” All of this information then coa- lesces into one single number, a firm’s VAR. The approach to this book reflects the trend and motivation to VAR. [As VAR is based on firm scientific foundations, { have adopted a rigor- ‘ous approach 0 the topic. Yet the presentation is Kept short and enter- taining. Whenever possible, important concepts are illustrated with ex- amples. In particular, the recent string of financial disasters provides a ‘wealth of situations that illustrate various facets of financial risks. These ‘can serve as powerful object lessons in the need for better risk manage- mentsai Pretice STRUCTURE OF THE BOOK ‘The book is broadly divided into five parts: 1. Motivation, Chapters 1 t0 3 describe the evolving environment that has led to the widespread acceptance of VAR. Building blocks. Chapters 4 to 8 provide a statistical and finan- cial foundation for the quantification of risk. 3. Value-at-risk systems. Chapters 9 t0 14 compare and analyze in detail various approaches to financial risk measurement. 4. Applications of risk-management systems. Chapters 15 to 20 discuss applications of VAR systems, from measuring risk to managing market risk to enterprise-wide risk-management. 5. The risk-management profession. Finally, the last two chapters, 21 and 22, discuss common pitfalls in risk management and provide some thought on the rapid evolution of the risk-man- agement profession, 2. Chapters 6, 10, 14, 16, 17, 18, 19, and 20 are completely new to this edition, Most other chapters have been substantially improved. Chapters 5 and 6, which in the last edition introduced fixed-income markets and derivatives, have been dropped, as they were relatively elementary. Going into more detail concerning the structure of the book, Chap- ter 1 paints a broad picture of the evolution of risk management, which is inextricably linked to the growth of the derivatives markets. The chap- ter describes the types of financial risks facing corporations and provides 2 brief introduction to VAR. ‘Chapter 2 draws lessons from recent financial disasters. It presemts the stories of Barings, Metallgesellschaft, Orange County, and Daiwa. The only constant across these hapless cases is the absence of consistent risk- management policies. These losses have led to increasing regulatory ac- tivity as well as notable private-sector responses, such as J.P, Morgan’s, RiskMetries systems? Chapter 3 analyzes recent regulatory initiatives for using VAR, We discuss the Basel Agreement and the Capital Adequacy Directive imposed by the European Union, both of which use VAR to determine minimum ‘capital requirements for commercial banks. The regulation of other insti- Fiske and CrodiMric re trdemarks of LP Morgan, CoporteMetris i trademark of the Riskmetries Croup,oo a tutions, pension funds, insurance companies, and securities firms is also briefly presented. ‘Chapter 4 explains how to characterize financial risks. We discuss risk and returns and the statistical concepts that underlie the measurement of VAR. Initially, only one source of financial risk is considered Chapter 5 tums to a formal definition of VAR. We show how VAR can be estimated from a normal distribution or from a completely general distribution. The chapter also discusses the choice of quantitative param- eters, such as the confidence level and target horizon. ‘Next, Chapter 6 tums to the verification of VAR models. Backtest- ing consists of systematically matching the history of VAR forecasts with their associated portfolio returns. This process enables the checking of the accuracy of VAR forecasts and also provides ideas for model improve- ment. ‘Chapter 7 then tums to analytical methods for portfolio risk. We show how to build VAR using a variance-covariance matrix. To manage risk, however, we also need to understand what will reduce it. Thus the chapter provides a new analysis of VAR tools, such as marginal VAR, in- cremental VAR, and component VAR. These tools have become essential to control and manage portfolio risk. Given that the dimensions of VAR risk structures can quickly become cumbersome, we also discuss meth- ods to simplify the covariance matrix used in VAR computations. Chapter 8 discusses the measurement of dynamic inputs. The chap- ter covers the latest developments in the modeling of volatility and cor relations, including moving averages and GARCH. Particular attention is, paid to the model used by RiskMetrics ‘The next six chapters tur to the measurement of VAR for complex portfolios. Chapter 9 first compares the different methods available to Compute VAR. The first and easiest method is the delta-normal approach, which assumes that all instruments are linear combinations of primitive factors and relies on delta valuation, For nonlinear instruments, however, the linear approximation is inadequate. Instead, risk should be measured with a full valuation method, such as historical simulation or Monte Carlo simulation. The chapter discusses the pros and cons of each method, as, well as situations where some methods are more appropriate. Chapter 10 is an entirely new chapter devoted to stress testing, which has received increased attention recently and is a complement to tradi- tional probability-based VAR methods. Chapter 11 develops applications of the delta-normal method, some-times called the variance-covariance method. We show how to decom- pose portfolios of bonds, derivatives, and equities into sets of payoffs on “primitive” factors for the purpose of computing VAR Chapter 12 then turns to simulation methods. Monte Carlo methods simulate risk factors with random numbers, from which complex portfo- lios ean be priced, Because of its flexibility, Monte Carlo is by far the ‘most powerful method (0 compute value at risk. I can potentially account for a wide range of risks, including price risk, volatility risk, credit risk, and model risk. This flexibility, however, comes at a heavy cost in terms of intellectual and systems development. Chapter 13 tackles an increasingly important topic, the quantitative measurement of credit risk. Credit risk encompasses both default risk and market risk. The potential loss on a derivatives contrac, for instance, de- pends both on the value of the contract and on the possibility of default Its only recently that the banking industry has leamed to measure credit risk in the context of a portfolio. Once measured, credit risk ean be man- aged and better diversified, like any financial risk. One of the lessons of the LTCM disaster is the importance of li 4quidity risk. This is why Chapter 14 is an entirely new chapter devoted to this topic. The next six chapters are new, dealing with applications of VAR, @ topic barely touched upon in the frst edition of the book. Applications range from passive to defensive to active. Chapter 15 shows how VAR ccan be used to quantify and t0 contol risk, while Chapter 16 explains how VAR can be used to manage risk actively. For the firs time, intiu- tions have a consistent measure of risk that can be used to compute risk- adjusted performance measures such as risk-adjusted return on capital (RAROC). This is because VAR can be viewed as a measure of “eco nomic” risk capital necessary to support a postion VAR applications are not limited tothe banking sector, however. VAR is now slowly spreading to the investment management industry, as it pro- vides a consistent method for setting risk limits and risk budgeting. Ap- plications, however, must be tailored to the specific needs of this industry. Chapter 18 discusses the technology of risk, an oft-neglected topic, This ranges from the choice of a spreadsheet to large systems that sup Port strategic business initiatives. Global risk-management systems re- quire a central repository for trades, positions, and valuation models, Which allow institutions to measure and manage their risk profile most efficientlyChapter 19 then discusses operational risk, which has defied attempts, at quantification until recently. We are learning (o quantify such risks us- ing tools borrowed from the insurance industry and from VAR techniques. Once quantified, operational risk can be subject to controls and capital charges. ‘The final step is to put together market, credit, and operational risk. Integration of these risks is important, as financial risks tend to slip to- ward areas where they are not measured. Thus the ideas behind the VAR revolution are quickly spreading 10 enterprise-wide risk management, which is described in Chapter 20. all their technical elegance, VAR methods do not, and are not designed (0, measure catastrophic risks. Chapter 21 discusses pitfalls in the interpretation of value at risk. We discuss a notable failure of a sup- posedly sophisticated risk-manazement system, that of LTCM. This is why risk management is still as much an art as a science, Finally, Chapter 22 offers some concluding thoughts. Once the do- main of a few exclusive pioneers, risk management is now wholly em- braced by the financial industry. It is also spreading fast among the cor- porate world. As a result, the financial risk manager function is now acquiring strategic importance within the corporate structure. By promoting sound risk-management practices, this book will hope- fully continue to foster a safer environment in financial markets. Philippe Jorion Irvine, CaliforniaThe Need for Risk Management ‘All of life is the management of risk, not its elimination, Weer Weston former haan of Ctcorp (Corporations are in the business of managing risks. The most adept ones succeed: others fail. Whereas some firms passively accept financial risks, ‘others attempt to create a competitive advantage by judicious exposure to financial risks. In both cases, however, these risks should be monitored carefully because of their potential for damage. ‘This chapter motivates the need for careful management of finan- cial risks. Section 1.1 describes the types of risks facing corporations and argues that financial risks have sharply increased since the breakdown of the fixed exchange rate system. It discusses the factors behind the growth of the risk-management industry. Risk management is the process by which various risk exposures are identified, measured, and controlled. Our ‘understanding of risk has been much improved by the development of de- rivatives markets, which are described in Section 1.2. Value at risk (VAR) is one such recent advance. The main purpose of VAR systems is to as sess market risks, which are due to changes in market prices. However, firms are also subject to other types of financial risks, which are discussed in Section 1.3. Finally, Section 1.4 provides a brief introduction to VAR, 1.1 FINANCIAL RISKS What is exactly risk Risk can be defined as the volatility of unexpected outcomes, generally the value of assets or liabilities of interest. Firms are ‘exposed to various types of risks, which can be broadly classified into business and nonbusiness risks.4 PART Motion Business risks are those which the corporation willingly assumes to create a competitive advantage and add value for shareholders. Business, ‘or operating, risk pertains to the product market in which a firm operates and includes technological innovations, product design, and marketing Operating leverage, involving the degree of fixed versus variable costs, is also largely a choice variable. Judicious exposure to business risk is a “core competency” of all business activity. Business activities also include exposure to macroeconomic risks, which result from economic cycles, oF fluctuations in incomes and monetary policies. Other risks, over which firms have no control, can be grouped into nonbusiness risks, These include strategic risks, which result from fun- damental shifts in the economy or political environment. An example is the rapid disappearance of the threat of the Soviet Union in the late 1980s, which Ted to a gradual decrease in defense spending, directly affecting defense industries. Expropriation and nationalization also fall under the umbrella of strategic risks. These risks are difficult to hedge, except by diversifying across business lines and countries. Finally, financial risks can be defined as those which relate to pos- sible losses in financial markets, such as Losses due to interest rate move- ments or defaults on financial obligations. Exposure to financial risks can bbe optimized carefully so that firms can concentrate on what they do best-—manage exposure 0 business risks. In contrast to industrial corporations, the primary function of finan-