Market Risk Measurement: MSC in Financial Markets

Market Risk
Measurement
Lecture 1:
Basic Concepts of
Risk Management
Romain DEGUEST
Market Risk Measurement

MSc in Financial Markets
Romain DEGUEST
(EDHEC-Risk Institute)
romain.deguest@edhec.edu
Lecture 1:
Basic Concepts of Risk Management
1/50
Market Risk
Outline Measurement
Lecture 1:
Basic Concepts of
Risk Management
Romain DEGUEST
1 Definition of Risk
2 Famous Financial Disasters
3 A Fast Market Evolution
4 Need for Risk Management
5 Value-at-Risk
6 Creation of Regulations in Finance and Insurance Activities
2/50
Market Risk
Definition of Risk Measurement
Lecture 1:
General Definition Basic Concepts of
Risk Management
Romain DEGUEST
Definition of Risk
The notion of risk is difficult to define formally. Famous Financial
Disasters
A few attempts:
A Fast Market
The Concise Oxford English Dictionary defines risk as “hazard, a Evolution
chance of bad consequences, loss or exposure to mischance.” Need for Risk
Markowitz (1952) said: “If the term risk is replaced by variance Management
little change of apparent meaning would result.” Value-at-Risk

“Risk can be defined as the volatility of unexpected outcomes.” Creation of
(Jorion (2007)) Regulations in Finance
and Insurance
“Risk is the potential that a chosen action or activity (including the Activities
choice of inaction) will lead to a loss (an undesirable outcome).”
(Wikipedia)
While a general functional definition of risk seems to be out of
reach, key words are:
bad, loss, mischance, variance, volatility, unexpected, undesirable
How is risk related to chance?
3/50
Market Risk
Lecture 1:
Risk versus Chance Basic Concepts of
Risk Management
Romain DEGUEST
Definition of Risk
Famous Financial
Disasters
A Fast Market
Evolution
Are these people dealing with risk or chance? Need for Risk
Management
Value-at-Risk
1 A person who buys a lottery ticket; Creation of
Regulations in Finance
2 A person who buys house insurance; and Insurance
Activities
3 A person who invests in the stock market.
4/50
Market Risk
Lecture 1:
Sources of Risks Basic Concepts of
Risk Management
Romain DEGUEST
Risk can be man-made: wars, attempt, fraud.

Definition of Risk
Risk can be generated by natural phenomena: earthquakes, Famous Financial
Disasters
volcanoes, extreme weather.
A Fast Market
Risk can arise from changes in supply and demand: technological Evolution
innovations may create dislocations in employment, business cycles. Need for Risk
Management
Risk can arise from changes in governments’ policies: euro crisis. Value-at-Risk
Creation of
and Insurance
Activities
Financial companies can provide protection to the risks that have a
direct impact on traded asset prices (usually they can handle pretty
well risks of small changes in day-to-day asset prices).
Insurance companies, however, can cover other risks linked to
natural phenomena (usually risks of heavy losses in case of
extreme/rare events).
Some risks might never be hedged: income risk, unemployment
risk.
5/50
Market Risk
Lecture 1:
Risks Faced by Companies Basic Concepts of
Risk Management
Generally, companies are exposed to 2 types of risk: Romain DEGUEST
business risk;
Definition of Risk
financial risk.
Famous Financial
Business risk includes: Disasters
business decisions: investment decisions, product development A Fast Market

Evolution
choices, marketing strategies, company structure, any kind of
strategic risk; Need for Risk
Management
business environment: competition and broad macroeconomic risk.
Value-at-Risk
Financial risk is defined as possible losses resulting from financial Creation of
market activities, e.g. equity, interest rate movements or even Regulations in Finance
and Insurance
defaults. Activities
Can you imagine situations where both business and financial risks
are intertwined?
Industrial companies are very exposed to business risk, and usually
try to limit their exposure to financial risk.
Financial companies, on the other hand, are mostly exposed to
financial risk.
This course will not cover business risk but focus on financial risk.
6/50
Market Risk
Lecture 1:
Financial Risk Basic Concepts of
Risk Management
Romain DEGUEST
Definition of Risk
Famous Financial
Disasters
Generally, financial risk can be decomposed into the broad categories of: A Fast Market
Evolution
Need for Risk

Management
market risk;
Value-at-Risk
operational risk; Creation of
and Insurance
credit risk, aka counter-party risk or default risk; Activities
liquidity risk;
model risk.
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Market Risk
Lecture 1:
Market Risk Basic Concepts of
Risk Management
Romain DEGUEST
Definition of Risk
Definition
Famous Financial
Disasters
Market risk is the risk of losses from the movements of market prices.
A Fast Market
Evolution
Need for Risk

Market risk can be divided into: Management
Value-at-Risk
Creation of
Equity risk – associated with positions in equity markets. Regulations in Finance
and Insurance
Foreign Exchange (FX) risk – associated with foreign and Activities
cross-currency positions.
Fixed-Income risk – associated with positions in fixed income
instruments or interest rate derivatives.
Commodity risk – associated with agricultural, energy, metals, and
similar positions.
Other – volatility, weather and catastrophe instruments.
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Market Risk
Lecture 1:
Operational Risk Basic Concepts of
Risk Management
Romain DEGUEST
Definition Definition of Risk
Operational risk is the risk of losses from inadequate or failed internal Famous Financial
Disasters
processes, people, and systems or from external events.
A Fast Market
Evolution
Need for Risk

Inadequate or failed processes can cause breakdowns in transaction Management
processing, settlement systems or more generally in back-office Value-at-Risk
operations, e.g. Creation of

and Insurance
wrong data used for calibration/pricing/hedging; Activities
reporting errors.
Different aspects of operational risks include:

People risk – e.g. internal or external fraud, rogue traders;
Legal risk – e.g. illegal contract/counter-party, deals that do not
respect the regulations, risk of changes in the legislation/regulation
during the life of a contract.
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Market Risk
Lecture 1:
Credit Risk Basic Concepts of
Risk Management
Romain DEGUEST
Definition
Definition of Risk
Credit risk is the risk of counter-parties being unwilling or unable to
Famous Financial
fulfill their contractual obligations. Disasters
A Fast Market
Evolution
Need for Risk

A credit loss may concern the cash flows and/or the principal. Management
Value-at-Risk
A recovery rate is often applied to the loss in order to reduce it.
Creation of
This rate is often defined in the contract but it may change at the Regulations in Finance
and Insurance
default date given the conditions of the borrower. Activities
Credit risk can concern anyone:

a country (sovereign risk), e.g. the “default” of Greece in the euro
crisis;
a financial institution (settlement risk), e.g. the subprime crisis;
a company;
any person.
There is some overlap between credit risk and market risk – mainly
because changes in credit rating causes changes in market prices
(see how CDS spreads impact stock prices)
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Market Risk
Lecture 1:
Liquidity Risk Basic Concepts of
Risk Management
Definition Romain DEGUEST
Liquidity risk is the lack of marketability of an investment that cannot Definition of Risk
be bought or sold quickly enough. Famous Financial

Disasters
A Fast Market
Evolution
Need for Risk

This risk is highly present in exotic derivatives, over-the-counter Management
products (OTC), emerging market equities. Value-at-Risk
Not being able to sell/buy an asset quickly can lead to severe Creation of
losses. and Insurance
Activities
Sometimes, assets can become completely non-tradable: no offer,
or no demand (e.g. some credit derivatives after the subprime crisis
have been labeled as “toxic”).
This risk has to be carefully evaluated when one deals with dynamic
strategies that require selling/buying assets as time evolves.
There is some overlap between liquidity risk and market risk, e.g.
prices decrease to 0 as assets become illiquid from a lack of
demand.
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Market Risk
Lecture 1:
Model Risk Basic Concepts of
Risk Management
Model risk is the risk of losses caused by flawed valuation models. Definition of Risk
Famous Financial
Disasters
A Fast Market
This risk occurs when several models can be considered to Evolution
compute a price or an asset allocation. Need for Risk
Management
In option pricing, model risk can be observed when several models Value-at-Risk
can reproduce the same price for a set of vanilla traded assets but Creation of
different prices for OTC, exotic derivatives. Regulations in Finance
and Insurance
Losses will be incurred because of an incorrect hedging strategy Activities
suggested by one of the chosen model.

Example: using the Black and Scholes model to price and hedge an
exotic option when obviously log-returns are not Gaussian.
In portfolio optimization, model risk can come from the multiple
choices for the optimization criteria (objective function).
There is some overlap between model risk and market risk, e.g.
hedging strategies, depending on the model used, might be more or
less sensitive to market fluctuations.
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Market Risk
Famous Financial Disasters Measurement
Lecture 1:
Barings’ Rogue Trader Basic Concepts of
Risk Management
Romain DEGUEST
On Feb 26, 1995 Barings Bank (233-year-old bank) went bankrupt Definition of Risk
because of a single trader (28-year-old Nicholas Leeson) who lost Famous Financial
Disasters
$1.3 billion.
A Fast Market
Recipe for disaster: Evolution
Leeson had been accumulating positions in stock index futures on Need for Risk
Management
the Nikkei 225. The notional positions added up to several billion
dollars. Value-at-Risk
As the market fell more than 15% between Jan and Feb 1995, Creation of
Leeson suffered losses but kept increasing the size of the positions. and Insurance
Unable to make the margin calls required by future contracts, the Activities
bank went under.
Important preconditions
Leeson had a control on both the trading desk and the back-office –
practically no supervision as he was a star trader!
Barings fell victim to fraud (operational risk) and market risk. ING
acquired Barings for 1 pound, $1 billion of market capitalization
was wiped out.
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Market Risk
Lecture 1:
Metallgeselschaft Basic Concepts of
Risk Management
Romain DEGUEST
Definition of Risk
In Dec 1993 MG, Germany’s 14-th largest industrial group, almost
Famous Financial
went bankrupt because of losses of $1.3 billion of its US subsidiary. Disasters
Recipe for disaster: A Fast Market

Evolution
Long-term contracts for oil products were offered letting customers
lock in fixed prices. Need for Risk
Management
By 1993 the contracts involved 180 million barrels of oil products
Value-at-Risk
(85 days of Kuwait’s oil production).
A natural hedge for MS: long-term forward contracts on oil Creation of
matching the maturity and the commitments. and Insurance
Unfortunately, there was no viable market for long-term forward, Activities
leading to a rolling-over of short-term future contracts.

The supply for such contracts was not enough since MG had 180
million barrels of oil in his book.
Moreover, margin calls of such future contracts were impossible to
pay (in case of oil price drop).
The positions were liquidated. MG fell victim to market and
liquidity risk.
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Market Risk
Lecture 1:
Orange County Basic Concepts of
Risk Management
Romain DEGUEST
Definition of Risk
In Dec 1994, Orange County, a prosperous district of California,
Famous Financial
went bankrupt after suffering losses of $1.6 billion. Disasters
Recipe for disaster: A Fast Market

Evolution
The county had $7.5 billion in deposit (belonging to schools, cities).
Need for Risk
The county treasurer Bob Citron leveraged this pool to $20 billion Management
(borrowing almost $2 for every $1 deposit).
Value-at-Risk
Then he invested in interest rate derivatives that were indexed on
short-term rates. Creation of
In Feb 1994, the FED started raising interest rates causing many of and Insurance
the securities to fall in value. Activities
As news for the losses spread, local investors wanted to pull out
their money, which together with the margin calls, resulted in lack
of liquidity (in that case: lack of cash to pursue Citron’s investment
strategy).
Citron was holding the securities to maturity and was not required
by law to record “paper” gains or losses.
Orange County was victim of market, and liquidity risk.
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Market Risk
A Fast Market Evolution Measurement
Lecture 1:
Increased Volatility and Extreme Events since 1970s Basic Concepts of
Risk Management
Romain DEGUEST
Definition of Risk
The fixed exchange rate system broke down in 1971 leading to Famous Financial
flexible and volatile exchange rates. Disasters
A Fast Market
The oil price shocks starting in 1973 were accompanied by high Evolution
inflation and volatile interest rates. Need for Risk
Management
On Black Monday (19-Oct-1987) U.S. stocks collapsed by 23% Value-at-Risk
wiping out $1 trillion. Creation of
The Russian default in 1998 sparked a global crisis that almost led and Insurance
to the default of LTCM. Activities
On Sep 11, 2001 financial markets froze for 6 days.

The subprime crisis of 2008 led to Lehman Brothers’ bankruptcy
(highest volatility observed in modern time finance!)
The euro/debt crisis of 2011 was accompanied by a significant
increase in market volatility.
16/50
Market Risk
Lecture 1:
Movements in the Dollar Basic Concepts of
Risk Management
Romain DEGUEST
Definition of Risk
Famous Financial
Disasters
A Fast Market
Evolution
Need for Risk

Management
Value-at-Risk
Creation of
and Insurance
Activities
17/50
Market Risk
Lecture 1:
Movements in U.S. Interest Rates Basic Concepts of
Risk Management
Romain DEGUEST
Definition of Risk
Famous Financial
Disasters
A Fast Market
Evolution
Need for Risk

Management
Value-at-Risk
Creation of
and Insurance
Activities
18/50
Market Risk
Lecture 1:
Movements in Oil Prices Basic Concepts of
Risk Management
Romain DEGUEST
Definition of Risk
Famous Financial
Disasters
A Fast Market
Evolution
Need for Risk

Management
Value-at-Risk
Creation of
and Insurance
Activities
19/50
Market Risk
Lecture 1:
Movements in Stock Prices Basic Concepts of
Risk Management
Romain DEGUEST
Definition of Risk
Famous Financial
Disasters
A Fast Market
Evolution
Need for Risk

Management
Value-at-Risk
Creation of
and Insurance
Activities
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Market Risk
Need for Risk Management Measurement
Lecture 1:
Any idea to manage and measure risks? Basic Concepts of
Risk Management
Romain DEGUEST
Definition of Risk
Famous Financial
The fast evolution of financial markets requires to be able to Disasters
quantify market risks in an efficient way. A Fast Market
Evolution
Indeed, the market has become more and more connected
Need for Risk
(internationalization of the financial market): increasing number of Management
deals, and increasing sizes of deals. Value-at-Risk
This high degree of connection spreads easily the risk of any Creation of
particular actor to the entire financial system. and Insurance
Activities
This phenomenon is often called systemic risk, and it was
particularly noticed when Lehman Brothers collapsed: chain
reaction of bankruptcies.
How would you manage and/or measure market risks? Any idea?
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Market Risk
Lecture 1:
1st Idea: Derivative instruments Basic Concepts of
Risk Management
Romain DEGUEST
Definition
Definition of Risk
A derivative instrument is a contract between two parties that specifies Famous Financial
Disasters
conditions (e.g. dates, underlying variables, and notional amounts)
A Fast Market
under which payments, or payoffs, are to be made between the parties. Evolution
Need for Risk

Derivatives are used by investors for the following: Management
Value-at-Risk
Provide leverage, such that a small movement in the underlying
Creation of
value can cause a larger difference in the value of the derivative. Regulations in Finance
and Insurance
Speculate and make a profit if the value of the underlying asset Activities
moves the way they expect (e.g., moves in a given direction, stays
in or out of a specified range, reaches a certain level).
Obtain exposure to the underlying where it is not possible to trade
in the underlying (e.g., weather derivatives).
Allow some risks related to the price of the underlying asset to be
transferred to another party.
This is obviously the last purpose that should get our attention in this
course.
22/50
Market Risk
Lecture 1:
Call Option Payoff Basic Concepts of
Risk Management
Romain DEGUEST
Definition of Risk
Famous Financial
Disasters
A Fast Market
Evolution
Need for Risk

Management
Value-at-Risk
Creation of
and Insurance
Activities
Immunizes against an increase of the underlying security price if

one is thinking of buying the security at maturity.
Unbounded gain when the underlying rises.
23/50
Market Risk
Lecture 1:
Put Option Payoff Basic Concepts of
Risk Management
Romain DEGUEST
Definition of Risk
Famous Financial
Disasters
A Fast Market
Evolution
Need for Risk

Management
Value-at-Risk
Creation of
and Insurance
Activities
Immunizes against a decrease of the underlying security price if one

is thinking of selling the security at maturity.
Bounded gain no matter what the underlying does.
24/50
Market Risk
Lecture 1:
Call Spread Option Payoff Basic Concepts of
Risk Management
Romain DEGUEST
Definition of Risk
Famous Financial
Disasters
A Fast Market
Evolution
Need for Risk

Management
Value-at-Risk
Creation of
and Insurance
Activities
Immunizes against an increase of the underlying security price if

one is thinking of buying the security at maturity.
Bonded gain no matter what the underlying does (cheaper than a
regular call).
25/50
Market Risk
Lecture 1:
Butterfly Option Payoff Basic Concepts of
Risk Management
Romain DEGUEST
Definition of Risk
Famous Financial
Disasters
A Fast Market
Evolution
Need for Risk

Management
Value-at-Risk
Creation of
and Insurance
Activities
Immunizes against low volatility regimes.

Bounded gain (much cheaper than a regular call, or even a call
spread).
26/50
Market Risk
Lecture 1:
Straddle Option Payoff Basic Concepts of
Risk Management
Romain DEGUEST
Definition of Risk
Famous Financial
Disasters
A Fast Market
Evolution
Need for Risk

Management
Value-at-Risk
Creation of
and Insurance
Activities
Immunizes against an increase or a decrease of the stock (against

high volatility regimes).
Unbounded gain (very expensive option).
27/50
Market Risk
Lecture 1:
Risk Management
In mid-1980s, the futures industry was concentrated in Chicago. Romain DEGUEST
Now futures are exchanged all over the world. Definition of Risk
The total dollar value of outstanding positions on Famous Financial

Disasters
exchanged-traded derivatives (ETD), and over-the-counter OTC
A Fast Market
derivatives grew from: Evolution
Need for Risk

$1.1 trillion in 1986 to $343 trillion in 2005. Management
Value-at-Risk
The derivative markets are bigger than the value of global stocks Creation of
and bonds ($85 trillion). The GDP of the US in 2005 was about Regulations in Finance
and Insurance
$12 trillion. Activities
For risk management purposes these numbers are misleading

because notional amounts do not describe market risk.
Indeed, some of these positions neutralize each other’s risks:
risks(X1 ) + risks(X2 ) ≥ risks(X1 + X2 )
This intuitive property of risks is called subadditivity, and is

supported by the idea that pooling risks helps to diversify a
portfolio.
28/50
Market Risk
Lecture 1:
Risk Management
Romain DEGUEST
1972 Foreign currency futures 1990 Equity index options
Definition of Risk
1973 Equity options 1991 Differential swaps
Famous Financial
1975 Treasury bond futures 1994 Credit default swaps Disasters
1981 Currency swaps 1996 Electricity futures A Fast Market
Evolution
1982 Interest-rate swaps 1997 Weather derivatives
Need for Risk
1985 Swaptions 2001 Single stock futures Management
1987 Compound options 2004 Volatility index futures Value-at-Risk
Creation of
Table: The evolution of derivatives markets Regulations in Finance
and Insurance
Activities
A derivative instrument should be seen as a transfer of market risks

from the investor to the financial institution.
Derivatives can be used to transfer a variety of different risks:
Equity, FX, FI, Commo, weather ...
Since financial engineers (aka quants) know how to manage the
market risk of a derivative, then the bank (through its traders) can
sell this instrument and accept to bear the risks.
29/50
Market Risk
Lecture 1:
Risk Management
Pros: Romain DEGUEST
Derivatives are designed to manage some of the underlying’s risks Definition of Risk
in an efficient way. Famous Financial

Disasters
It can be used to repackage market risks and get rid of it (e.g. A Fast Market
CDO). Evolution
Need for Risk

Cons: Management
It is easy to see that market risks do not disappear but are simply Value-at-Risk
transferred. Creation of
and Insurance
Second, derivative replication requires borrowing which means the Activities
instrument is leveraged. Leverage makes it more difficult to assess
the true risks of such instruments.
Third, OTC derivatives may suffer from counter-party risk since
they can be exchanged in a non-organized market (no clearing
houses: third party insuring counter-party risk).
Illiquidity issues might also arise in OTC/bespoke product.
Finally, even though derivatives instruments help analyzing and
managing the risks, they cannot be used to measure it.
30/50
Market Risk
Lecture 1:
2nd Idea: Volatility Basic Concepts of
Risk Management
Romain DEGUEST
Definition of Risk
Famous Financial
Disasters
A Fast Market
Evolution
Need for Risk

Management
Value-at-Risk
Creation of
and Insurance
Activities
VIX is a popular measure of the implied volatility of S&P 500 index

options.
It represents one measure of the market’s expectation of stock
market volatility over the next 30 day period.
It is often referred to as the “fear index” or the “fear gauge”.
31/50
Market Risk
Lecture 1:
Which investment is the least risky? Basic Concepts of
Risk Management
Romain DEGUEST
Definition of Risk
Famous Financial
Disasters
A Fast Market
Evolution
Need for Risk

Management
Value-at-Risk
Creation of
and Insurance
Activities
The Fairfield Sentry fund compared to S&P 500.
32/50
Market Risk
Lecture 1:
2nd Idea: Volatility Basic Concepts of
Risk Management
Pros: Romain DEGUEST
Volatility is a good gauge for fear, and therefore can be used to Definition of Risk
measure risks. Famous Financial
Disasters
It can be used to help investors with investment decisions
A Fast Market
(mean-variance portfolio). Evolution
Need for Risk

It has an easy interpretation: a VIX of 15% says that there is a Management
68% chance that the magnitude of theq change in the S&P over the Value-at-Risk
√ 1
next 30 days is less than σ × ∆ = 15 12 ≈ 4.33% (up or down). Creation of
and Insurance
Cons: Activities
Such a quantity does not give information on how to manage

market risk, but can only be used to measure it.
The volatility is a symmetric measure: discarding high vol securities
may be good for risk management perspective, but it also severely
penalizes the profits.
Volatility measures the likelihood of an event with a 68%
probability: not very likely to happen.
This measure does not focus on extreme possible events.
33/50
Market Risk
Lecture 1:
Other Ideas Basic Concepts of
Risk Management
Romain DEGUEST
1992 Stress testing Definition of Risk
1993 Value-at-Risk (VaR ) Famous Financial

Disasters
1998- Integration of credit and market risk A Fast Market
2000- Enterprisewide risk management Evolution
Need for Risk

Table: The Evolution of Analytical Risk Management Tools Management
Value-at-Risk
Creation of
In order to understand the risks of various possible scenarios (e.g. and Insurance
Activities
low or high interest rates), stress-testing has become popular in the
90’s.
Then, Value-at-Risk was first used in 1993 to quantify portfolio
risks in a better way than volatility.
VaR is designed to reflect the variations in the downside of the
P&L distribution. In contrast, stress-tests provide insight into the
tails by specifying extreme values for the risk drivers.
34/50
Market Risk
Value-at-Risk (VaR ) Measurement
Lecture 1:
Portfolio P&L Distribution Basic Concepts of
Risk Management
Romain DEGUEST
Let ∆ be a fixed period of time: 1 day, 1 week, ...
Definition of Risk
Before computing any risk measure, we are interested in computing
the portfolio P&L L∆
t over the period [t; t + ∆].
Famous Financial
Disasters
Denoting by Pt the portfolio value at time t, the portfolio P&L A Fast Market
Evolution
between t and t + ∆ is given by:
Need for Risk
Management
L∆
t = Pt+∆ − Pt Value-at-Risk
Creation of
Note that we treat a loss as a negative quantity, so a positive value Regulations in Finance
of L∆
t denotes a profit.
and Insurance
Activities
In the following, the notation of the portfolio P&L L∆t at time t

over the next ∆ will be simplified into L as long as there is no
ambiguity.
From time t, the P&L over the next ∆ is a random variable: Pt is
known but not Pt+∆ .
We will see later (computation of VaR ) that the main challenge in
risk computation is to estimate the distribution FL of the portfolio
P&L.
35/50
Market Risk
Value-at-Risk Measurement
Lecture 1:
Definition and Illustration Basic Concepts of
Risk Management
The Value-at-Risk at level is defined as minus the -quantile of the Definition of Risk
distribution of the portfolio P&L over a target horizon ∆ Famous Financial
Disasters
VaR (FL ) = −q (FL ) A Fast Market
Evolution
where FL describes the distribution of the portfolio P&L over ∆. Need for Risk
Management
Value-at-Risk
The tail probability is usually chosen to be = 5% or = 1%.
Creation of
An illustration with = 5%: Regulations in Finance
and Insurance
Activities
36/50
Market Risk
Lecture 1:
Quantile Definition Basic Concepts of
Risk Management
Quantiles q are defined such that the probability of taking a value
Romain DEGUEST
below the quantile equals a given number ,
Definition of Risk
q : is the value q s.t. FL (q) = P(L ≤ q) =
Famous Financial
Disasters
Quantiles can also be defined through the inverse cumulative
A Fast Market
distribution function (c.d.f.), Evolution
q (FL ) = FL−1 ()

Need for Risk
Management
where FL−1 () = inf{q : P(L ≤ q) ≥ }. The definition of FL−1 () Value-at-Risk
Creation of
looks involved because FL (q) can have jumps or be piecewise Regulations in Finance
and Insurance
constant. Activities
37/50
Market Risk
Lecture 1:
Linear Property of Quantiles Basic Concepts of
Risk Management
Romain DEGUEST
An important property of quantiles which we will use is linearity:
Definition of Risk
Famous Financial
q (FσL+µ ) = σq (FL ) + µ Disasters
A Fast Market
A proof of this property starts with the quantile definition of Evolution
q (FL ), given by P(L ≤ q (FL )) = . Need for Risk
Management
Multiplying each side of the inequality by a positive σ and adding a Value-at-Risk
real number on both sides does not change anything, Creation of
P(σL + µ ≤ σq (FL ) + µ) = and Insurance
Activities
Therefore, using again the quantile definition, we can conclude that

σq (FL ) + µ is the -quantile of the distribution FσL+µ , which
concludes the proof of the linear property.
Since VaR is defined as: VaR (FL ) = −q (FL ), then the linear
property implies that:
VaR (FσL+µ ) = σVaR (FL ) − µ
38/50
Market Risk
Lecture 1:
Illustration of VaR Basic Concepts of
Risk Management
Consider an investor who holds a $100 million position in S&P500. Romain DEGUEST
What is the 99% daily VaR ?
Definition of Risk
Famous Financial
Disasters
0.15 350 A Fast Market
S&P500 returns S&P500
Evolution
99% VaR 300 99% VaR
0.1 Need for Risk
250 Management
0.05 Value-at-Risk
200
Creation of
150 Regulations in Finance
0
and Insurance
100 Activities
−0.05
50
−0.1 0
−0.1 −0.05 0 0.05 0.1
We estimate the ∆ = 1-day return distribution of the S&P500 by

taking the historical daily returns in the past 5 years; 99% VaR =
4.8% which translates to a VaR of $4,800,000 in dollar terms.
Note that the minus sign in the VaR definition leads to positive
VaR measures since q (FL ) = −4.8%.
39/50
Market Risk
Lecture 1:
Different Representations Basic Concepts of
Risk Management
Romain DEGUEST
In the literature, you will find three different (but equivalent) Definition of Risk
representations of VaR : Famous Financial
Disasters
1 Ours: As minus the -quantile of the distribution of the P&L
A Fast Market
portfolio FPt+∆ −Pt and measured in $. Evolution
Need for Risk

2 As minus the -quantile of the distribution of the future portfolio Management
value FPt+∆ and measured in $. Value-at-Risk
3 As minus the -quantile of the distribution of the portfolio return Creation of
F Pt+∆ −Pt and measured in %. and Insurance
Pt Activities
The representations can be easily transformed into one another using

the linear property of quantile functions,

VaR FPt+∆ −Pt = VaR FPt+∆ + Pt

VaR FPt+∆ −Pt VaR FPt+∆ + Pt
VaR F Pt+∆ −Pt = =
Pt Pt Pt
40/50
Market Risk
Lecture 1:
Different Representations Basic Concepts of
Risk Management
Romain DEGUEST
Definition of Risk
Depending on whether we want to take into account the mean of Famous Financial
Disasters
the P&L in the VaR estimation, we can further distinguish between
A Fast Market
absolute and relative VaR . Evolution
So far, we have only considered absolute VaR without any Need for Risk
Management
reference point.
Value-at-Risk
VaR can be reported with a reference to the mean in which case it Creation of
is called relative. Regulations in Finance
and Insurance
Activities
Once we know the absolute VaR , the relative is calculated using
the linear property by
VaR rel abs

= VaR + mean
Note that VaR , being defined as a quantile in the left tail, is

smaller than the mean. Therefore, VaR rel will always be positive.
41/50
Market Risk
Lecture 1:
VaR in Practice Basic Concepts of
Risk Management
Romain DEGUEST
Definition of Risk
The computation of VaR (covered in detail in Lecture 3) is based
Famous Financial
on statistical methods implemented in a full risk management Disasters
procedure. A Fast Market
Evolution
The objective is to have an accurate estimation of the P&L
Need for Risk
distribution FPt+∆ −Pt at horizon t + ∆ (near future). Management
Value-at-Risk
Then a simple quantile computation is applied to the estimated
Creation of
distribution. Regulations in Finance
and Insurance
The resulting VaR gives the maximum loss that the company may Activities
face in the near future with a (1 − ) confidence. (typically

1 − = 99% or even more extreme 1 − = 99.5% confidence).
Top executives receive on a daily basis VaR reports that summarize
the risk of their entire institution.
VaR reports are also important information that has to be disclosed
to regulators on a regular basis.
42/50
Market Risk
Lecture 1:
Summary Basic Concepts of
Risk Management
Romain DEGUEST
Definition of Risk
VaR has revolutionized the management of financial risks. Famous Financial
Disasters
VaR provides a common consistent measure of risk across different A Fast Market
positions (e.g. equity, fixed-income, derivatives). It allows for risk Evolution
aggregation. Need for Risk

Management
VaR takes full account of all risk factors while traditional Value-at-Risk
approaches either look at risk factors one at a time (sensitivity Creation of
analysis) or resort to simplifications to collapse multiple risk factors and Insurance
into one (duration-convexity). Activities
VaR is expressed in a simple and easy to understand unit of

measure, lost money.
VaR is, however, no panacea. It is only an educated estimate of
market risk and is a necessary but not sufficient procedure. It
should be complemented by other techniques.
43/50
Market Risk
Regulations in Finance & Insurance Measurement
Lecture 1:
The Basel II Accord (2004) Basic Concepts of
Risk Management
Romain DEGUEST
In effect practically as of 2008 replacing the Basel I Accord. It is based
Definition of Risk
on three pillars:
Famous Financial
Minimum regulatory requirements – capital charges are set against Disasters
credit risk (CRC), market risk (MRC), and operational risk (ORC). A Fast Market
Evolution
Supervisory review – the role of bank regulators has expanded. Need for Risk
Management
They must ensure the banks have implemented a risk management
Value-at-Risk
process and assess any residual risks.
Creation of
Market discipline – a set of disclosure recommendations are Regulations in Finance
and Insurance
developed encouraging banks to publish information about Activities
exposure, risk profiles, and capital cushion.
The bank’s total capital must exceed the total risk charge (TRC),
Capital > TRC = CRC + MRC + ORC
Several methods are available for each category – standardized or

internal methods.
44/50
Market Risk
Lecture 1:
The Standardized Method (building-block approach), April 1993 Basic Concepts of
Risk Management
Romain DEGUEST
Market risk charges are computed for portfolios exposed to Definition of Risk
interest-rate risk, exchange-rate risk, equity risk, and commodity Famous Financial
Disasters
risk using specific guidelines. A Fast Market
Evolution
The total market-risk charge computed with the standard method
Need for Risk
is as follows: Management
X Value-at-Risk
MRC STD = MRCi , Creation of
i and Insurance
Activities
where MRCi refers to the market risk charges of instrument i.
The main drawback of the standard method is that it ignores
diversification across market risks. Adding up capital charges
assumes that the worst loss will hit all instruments at the same
time.
Apart from the standardized model, financial institutions are
allowed to build internal models.
45/50
Market Risk
Lecture 1:
The Internal Model, April 1995 Basic Concepts of
Risk Management
Romain DEGUEST
The Internal Model was created in response to industry criticism of the Definition of Risk
standard method. Banks have to satisfy qualitative requirements to use Famous Financial
Disasters
it:
A Fast Market
Presence of a risk management system integrated into Evolution
management decisions. Need for Risk

Management
Stress-tests should be conducted. Value-at-Risk
Presence of independent risk-control unit and external audits. Creation of

Full transparency of the results has to be respected. and Insurance
Activities
The market risk charges will be computed from a VaR based on:
A horizon of ∆ = 10 trading days.
A level of 99% confidence for the VaR .
An observation period: at least 1 year of historical data and
updated at least once every quarter.
46/50
Market Risk
Lecture 1:
The Internal Model, continued Basic Concepts of
Risk Management
Romain DEGUEST
The final market risk charge is calculated as the maximum between
Definition of Risk
previous day’s VaR , and the average over the 60 previous business
Famous Financial
day’s VaR (times a multiplicative factor k) plus an additional Disasters
factor: A Fast Market
Evolution
Need for Risk

60
! Management
1 X
MRCtIMA = max k VaR FPt−i+∆ −Pt−i , VaR FPt−1+∆ −Pt−1 Value-at-Risk
60 i=1
Creation of
+SRCt , and Insurance
Activities
where k ≥ 3 and is determined by the local regulator, and SRCt is the

specific risk charge.
The factor k is increased if back-testing reveals that the internal

model incorrectly forecasts risk.
The term SRCt is added because the specific risk of credit-sensitive
debt and equities is not included in the model.
47/50
Market Risk
Lecture 1:
Diversification Reduces Risks Basic Concepts of
Risk Management
Romain DEGUEST
Definition of Risk
Famous Financial
As of 2004, JP Morgan Chase reported a daily 99% VaR of $57 Disasters
million for fixed income trading, $28 million for foreign exchange A Fast Market
Evolution
trading, $20 million for equities trading, and $8 million for Need for Risk
commodities trading. Management
Value-at-Risk
If we add these numbers, we get total 99% VaR = $113 million.
Creation of
The bank reports a total 99% VaR of $72 million. Regulations in Finance
and Insurance
The MRC IMA is routinely much lower than MRC STD which explains Activities
why banks rushed to implement the internal approach.

The internal models are much more precise and can evolve as risk
measurement techniques evolve. Of course, close scrutiny is
required by regulators.
48/50
Market Risk
Lecture 1:
The Solvency II Accord (2009) Basic Concepts of
Risk Management
Romain DEGUEST
Often called “Basel for insurers”, Solvency II is somewhat similar to the Definition of Risk
banking regulations of Basel II, but it applies to insurance or Famous Financial

Disasters
reinsurance companies. It exhibits the same three pillars:
A Fast Market
Evolution
1 quantitative requirements (for example, the amount of capital an
Need for Risk
insurer should hold); Management
2 sets out requirements for the governance and risk management of Value-at-Risk
insurers, as well as for the effective supervision of insurers; Creation of

and Insurance
3 disclosure and transparency requirements. Activities
Solvency Capital Requirement (SCR) can be computed either with a

standard formula given by the regulators or an internal model developed
by the (re)insurance company, based on a VaR computation with:
A horizon of 1 year (i.e. ∆ = 260 business days).
A level of 99.5% confidence for the VaR .
49/50
Market Risk
Lecture 1:
Conclusion Basic Concepts of
Risk Management
Romain DEGUEST
Definition of Risk
Famous Financial
The idea that diversification reduces risks is ignored by the Disasters
standard formula, but can be taken into account in internal risk A Fast Market
Evolution
management models.
Need for Risk
Therefore, internal models lead to less constraints in terms of Management
capital requirement and allow for more flexibility. Value-at-Risk
Creation of
Unfortunately, internal models are often complicated to build and Regulations in Finance
require some R&D investments (small companies cannot develop and Insurance
Activities
such risk management procedures and have to use the standard
method).
Nowadays, a lot of hiring positions are in risk management units,
since regulation requirements are increasing and force companies to
react quickly and smartly.
50/50

Market Risk Measurement: MSC in Financial Markets

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Market Risk

Market Risk Measurement

2 Famous Financial Disasters

3 A Fast Market Evolution

4 Need for Risk Management

6 Creation of Regulations in Finance and Insurance Activities

little change of apparent meaning would result.” Value-at-Risk

Risk can be man-made: wars, attempt, fraud.

Generally, companies are exposed to 2 types of risk: Romain DEGUEST

business decisions: investment decisions, product development A Fast Market

Need for Risk

Need for Risk

Definition Definition of Risk

Need for Risk

processing, settlement systems or more generally in back-office Value-at-Risk

operations, e.g. Creation of

Different aspects of operational risks include:

Need for Risk

Credit risk can concern anyone:

Definition Romain DEGUEST

be bought or sold quickly enough. Famous Financial

Need for Risk

suggested by one of the chosen model.

Recipe for disaster: A Fast Market

leading to a rolling-over of short-term future contracts.

Recipe for disaster: A Fast Market

On Sep 11, 2001 financial markets froze for 6 days.

Need for Risk

Need for Risk

Need for Risk

Need for Risk

deals, and increasing sizes of deals. Value-at-Risk

Need for Risk

Need for Risk

Immunizes against an increase of the underlying security price if

Need for Risk

Immunizes against a decrease of the underlying security price if one

Need for Risk

Immunizes against an increase of the underlying security price if

Need for Risk

Immunizes against low volatility regimes.

Need for Risk

Immunizes against an increase or a decrease of the stock (against

In mid-1980s, the futures industry was concentrated in Chicago. Romain DEGUEST

The total dollar value of outstanding positions on Famous Financial

Need for Risk

For risk management purposes these numbers are misleading

risks(X1 ) + risks(X2 ) ≥ risks(X1 + X2 )

This intuitive property of risks is called subadditivity, and is

A derivative instrument should be seen as a transfer of market risks

Pros: Romain DEGUEST

in an efficient way. Famous Financial

Need for Risk

Need for Risk

VIX is a popular measure of the implied volatility of S&P 500 index

Need for Risk

The Fairfield Sentry fund compared to S&P 500.

Pros: Romain DEGUEST

Need for Risk

Such a quantity does not give information on how to manage

1992 Stress testing Definition of Risk

1993 Value-at-Risk (VaR ) Famous Financial

q (FL ) = FL−1 ()

VaR (FσL+µ ) = σVaR (FL ) − µ

face in the near future with a (1 − ) confidence. (typically