STATISTICAL MODELING IN FINANCIAL

MARKETS

Ngai Hang Chan

Department of Statistics
Chinese University of Hong Kong
Shatin, N.T.
Hong Kong

c N.H. Chan, 2010
Chapter 1

Introduction

1.1 Meaning of Risk Management

• What exactly is risk management?

• What is risk? Broadly speaking, risk is defined as uncertainty. We

relate risk to a bad outcome.

• What is a bad outcome? What is a bad outcome in finance?

Definition 1.1.1 Risk management means taking deliberate actions to shift

the odds in your favor, that is increasing the odds of a good outcome and
reducing the odds of a bad outcome.

In finance, the real problem is how to quantify and price risk appropriately.

1.2 History of Risk Management

• Risk management starts in the banking industry for an obvious reason.

• Before 1999, commercial banks were prohibited from underwriting in-

surance and most kinds of securities according to a law dated back in
1956.

• The reason for this restriction is that after the 1929 economic crisis in
the US, regulators focused on “ystematic risk”, the risk of a collapse
of the banking industry at a regional, national, or international level,
the so-called “domino effect”.

• But since 1999, this restriction was lifted. Banks are engaged in all
kinds of activities today. Brokerage firms, banks, and insurers are
merged (City Group) locally and globally (HSBC).

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 • As a result, banks shift their emphasis from simplistic “profit-oriented”
management to a more sophisticated “risk/return” management. Banks
are also exposed to all kinds of risks in unprecedented scales.

• The classical risk in the banking industry is credit risk. Managing

credit risk has been a key part of the banking business.

• With their increased diversity, the banking industry, however, needs

to manage many other sources of risk: liquidity risk, regulatory risk,
legal risk, human factor risk, . . . etc., collectively known as operational
risk.

• It was estimated that US banks possessed about $1 trillion (109 ) prop-

erty in the derivative market 1986, but $37 trillion in 1996.

1.3 Regulatory Body

• One of the earliest regulations in the US is the Federal Deposit Insur-
ance Corporation (FDIC), which increases the stability of the banking
system by providing insurance for the depositors.

• But the existence of FDIC increases moral hazard and adverse se-
lection. Investors tend to select less credited banks to receive higher
return, ignoring the risk, in light of the guarantee offered by the FDIC.

• Another difficulty in assessing a banks asset is i ts off-balance-sheet ac-

tivities. How does one value a long-term future contract or an option?
Mark to market or discount?

• Even though there are rating agencies such as S&P or Moody s assess
the credit quality of large firms including banks, the ir evaluations are
getting more and more difficult based on pure accounting principles.

• Banks have to develop internal models to assess and compare risks

among different sectors, regions, or industries.

• Bank for International Settlements (BIS)1 based in Basel Switzerland,

issued an Accord in 1988 which requires banks to set aside a flat fixed
percentage of their risk-weighted assets (8% for corporate loans and 4%
for uninsured residential mortgages for example) as regulatory capital
against default.
1
United States, United Kingdom, Canada, Japan, Germany, France, Belgium,
Italy, Netherlands, Sweden (these ten countries are known as G-10), Switzerland, and
Luxembourg

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Table 1.1: Trading Revenues from Cash Instruments and Off-Balance-Sheet
Derivatives, March 31, 1997
Trading Revenues ($ million)
Notional Value Foreign Commodities Total Cash and
of Derivatives Interest Rate Exchange Equity and Other Off-Balance-
Activity Positions Positions Positions Positions Sheet Revenue
Chase Manhattan 6,357,063 168 155 12 41 375
JP Morgan 5,216,959 552 -33 67 3 590
Citibank 2,540,614 219 224 114 0 557
Bankers Trust 1,951,705 149 43 36 25 253
Bank of America 1,672,667 100 48 0 -5 143
NationsBank 1,370,518 37 18 13 13 21
First National Bank 1,091,173 -9 14 6 1 72
of Chicago
Republic Nat. Bank 331,346 15 27 -9 10 43
of New York
Top eight commercial 20,532,045 1,231 495 239 88 2,054
banks with derivatives
Other 496 commercial 1,335,619 118 195 7 9 329
banks with derivatives
Total amounts for all 21,867,664 1,350 690 246 97 2,383
584 banks with derivatives

• In 1995, BIS coordinated a survey of derivative markets among 26

central banks and found that banks have been major players in the
derivative market, as shown in Table 1.1.

• As a result, BIS issued a set of guidelines, known as “96 Amendment”

or “BIS 98”, which became mandatory for all US financial institutions
with major trading activities.

• In essence, these guidelines require banks to treat the off-balance-sheet

items more seriously and thus reduce the risk associated with these
items.

• Since then, both the World Bank and the International Monetary Au-
thority (IMF) have been pushing these guidelines to other countries
beyond the Group of 10 industrial countries.

• For example, the Hong Kong Monetary Authority (HKMA) has been
proposing the adoption of the Accord for the local banking industry
in Hong Kong.

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 Figure 1.1: Typology of Risks

1.4 Typology of Risks

• Market Risk. The risk that changes in financial market prices and rates
will reduce the value of the banks positions. Market risk for a fund
is often measured relative to a benchmark index such as the S&P500
or the HIS, and is often referred to as the “risk of tracking error”.
Market risk also includes the “basis risk”, which describe the chance
of a breakdown in the relationship between the price of a product and
the price of the instrument used to hedge that price exposure.

Figure 1.2: Market Risks

• Credit Risk. The risk that a change in the credit quality (default or

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 downgrade) of a counterparty will affect the value of a banks posi-
tion. Default means the counterparty is unwilling of unable to fulfill
its obligations.

• Liquidity Risk. This risk involves the funding liquidity risk and the
trading liquidity risk. The funding liquidity risk relates to a financial
institutions ability to raise the necessary cash to roll over its deb t, to
meet the cash margin, and collateral requirements or to satisfy cash
withdrawals.

• Trading liquidity risk, often referred as liquidity risk, is the risk that
an institution will not be able to execute a transaction at a prevailing
market price because there is no appetite for the deal on the other side
of the market. If the transaction cannot be postponed, its execution
may lead to a substantial loss in the position. Negative equity in
property prices is a typical example of trading liquidity risk.

Figure 1.3: Liquidity Risks

• Operational Risk refers to potential losses resulting from inadequate

systems, management failure, faulty controls, fraud, and human errors.
This risk is very difficult to quantify.

• Legal Risk arises from a variety of situations. It becomes apparent

when a counterparty losses money on a transaction and decide to sue
the bank to avoid meeting its obligations. A famous example is Proctor
& Gamble lost $157 million on two interest swaps that it had entered
into with Bankers Trust, and then sued Bankers Trust for misrepre-
sentation of the risks involved in the transactions.

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 • Model Risk. The valuation of complex derivatives creates considerable
risk, known as model risk.

• Human factor risk is a special form of operational risk. It relates to

losses that may result from human errors such as pushing the wrong
button on a computer. This happens quite often in light of the popu-
larity of electronic tradings on the web.

• We can further slice and dice each risk type down to more detailed
level, see Figure 1.4.

Figure 1.4: Further Categorizations of Risks

1.5 Recent Financial Pitfalls

1.5.1 Orange County
The county treasurer, Bob Citron was entrusted with a $7.5 billion portfolio
belonging to county schools, cities, special districts and Orange county itself.
Bob Citron, invested a large portion of his holdings in high yield (low grade)
bonds. This amounts to taking a huge bet on interest rates staying low.
At the beginning, he was so successful that nearby counties also asked him
to manage their holdings. When interest rates started rising in 94, he lost
about $1.8 billion in total and the county went bankrupt.

1.5.2 Barings Bank

Barings, a 233 year old bank. Nick Lesson lost about $1.3 billion from
derivative trading, mainly Nikkei stock index futures, in 1995 which basically
wiped out the firms entire equity capital. Lession spent 43 months in prison

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and was released in 1999. The main problem is too much risk bear by one
single individual.

1.5.3 Peregrine Securities

Andrea Lee, a front-desk credit derivative trader invested in questionable
instruments. He purchased bonds for companies with questionable credit
ratings and put the security firm in jeopardy. For example, he invested in
an Indonesian taxi company which was owned by the son-in-law of the former
Indonesian president. When the Asian crisis hit in 98, the loan cannot be
repaid and there goes Peregrine.

1.5.4 Japanese Yen Crsis

• Volatility in exchange rates between the Yen and US dollars in 95 led to
huge losses of many Japanese firms. When a firm earns US$, it needs
to convert it back to Yen in order to fulfill the financial obligations
back home, paying taxes and bonuses for example. As a result, these
companies need to hedge away the risk in the FX market. They can
achieve by purchasing some put options. For example, if the company
is worried about the the dollar may get weaker in the near future, they
can buy a put option with a strike price they are comfortable with,
90, say. In this case, if the dollar does get weaker in 3 months, the
company is protected by getting an exchange rate of at least 90 Yens.
However, such options are usually expensive. To get around the prob-
lem, they enter into the down-put-out option. This means that one can
get protection only up to a pre-agreed lower limit, 85 Yen for example.
When the dollar goes further down, the option is voided. Otherwise,
the option holder can still exercise with a strike of 90 Yens. The at-
tractive feature of this type of option is that it only costs a fraction
of the regular option. Many companies entered into such agreements
with investment banks in 94. At the end of 94, everyone thought 85
Yen was the magic bound. Starting in 95, the US$ began sliding, 120,
100, 95, 90, 86, . . .
• There are two sides to this situation. When the dollar was dropping
towards the boundary of 85 Yen, everyone was panic and started dump-
ing dollars for Yens, which made the dollar weaker.
• For the investment banker, when the boundary was about to be breached,
they have more intention to drive down the dollars to release their obli-
gations. BIG investment houses can move the market. Both sides were
driving the dollar down, although for different reasons. The bound-
ary was breached in no time in 95, resulting in huge losses. This is

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 like buying an insurance which offers protection if your house is only
partially burnt, but offers nothing when completely burnt!

1.5.5 Long Term Capital Management

Long Term Capital Management (LTCM), a hedging fund which traded for
profit on the discrepancies in the fixed income and FX domains in the global
market. When the global condition felt in 98, the mathematical models
used by LTCM suggested taking a even bigger position in these risk seeking
strategy which eventually led to its bailing out by major US banks at the
end of 98.