On the second day we then critically analyzed the standard equation.

We also learned about

the industrial approach which is Risk Metrics that was developed by JP Morgan in the early 90’s.
Another approach is the academic model approach which is the GARCH model. Lambda value is
taken to be 0.95. This signifies that 0.05 weightage is given to the recent data while 0.95
weightage is given to the historical data. When we’ll take lambda to be 1, we go back to
standard deviation.
We then looked at two portfolios which were: 1. Equity based and 2. Bond based. They both
were giving 8% return. But portfolio 1 had 40% volatility and 0.1% probability of default, while
portfolio 2 had 10% volatility and 1% probability of default.
Portfolio 2 contained CAT bonds (catastrophe bonds). These bonds would pay in case of an
occurrence of a catastrophe. These types of bonds are bought by pension funds.
Volatility can be viewed as the expected risk or risk in normal times while tail risk is the
unexpected risk or risk in abnormal times.
Risk = the probability of an event over a period X Value of portfolio
Value at risk:
Simple: Loss that is unlikely to be exceeded over a period
Complicated: Worst loss over a target horizon that will not be exceeded with a given weight of
confidence