2a. Quantifying particular risks

2a. Quantifying particular risks

1. 1. Market and Economic r

   • a. Characteristics of financial times series, char. of multivariate return series
   • b. Modeling; bootstrapping, factor-based approaches, data-based multivariate distr, PCA,
   • c. Other: gvt bonds, corp bonds, Historical risk prm, CAPM, benchmaks,B-S models
   • ways to manage/minimize: 1. Policies, Procedures and Limits, 2. diversification 3. investment strategy 4. hedging
     • Hedging: fwd vs futures, their counterparty risk, types of margin, pricing, basis risk (formula), determine exposure nb or amt of hedge position
       • other hedging solutions: put option, CDS, out-performance option
         • Hedging exposure to options: option delta, stock delta, delta neutral, gamma, theta and vega
       • No basis if (4): same settlement/sale date, early sale, cross hedge - same settl./sale date, cross hedge - early sale,

2. 2. Interest Rate Risk

   • Spot rates + bootstrapping approach, forward rates
   • Multi-Factor Interest Model: Brennan-Schwartz, PCA-based, deriving price changes, Black model
   • SIngle-factor interest rate models, pros + cons
   • Investment management
     • 4 faces of interest model
       • when to use each
         • Categories of mitigation
           • direct exposure: FRAs, interest rate caps & floors
           • indirect exposure: IR swaps & swaptions
             • cf matching, duration matching, hedging using model pts
               • see KRD in 4

3. 3. Foreign Exchange risk

   • Interest rate parity
     • Mitigations: fwd, futures, options, swaps and others, return/risk, hedge net level vs gross level

4. 4. Credit Risk

   • Sources, components (4), purposes
   • Qualitative credit models : factors, time horizon, characteristics
   • Quantitative credit models
     • 3 types
       • Credit scoring
         • Probit/Logit models, Discriminant Analysis, The k-Nearest Neighbor Approach, Support Vector Machines (SVMs), Time-until default (survival) models
       • Structural form
         • The Merton Model, the KMV model,
       • Reduced form
         • Credit Migration Models, CreditMetrics,
   • Credit pf models: Multivariate structural models, common shock models, Multivariate credit migration models
   • Common Shock Models, Extent of loss: measures, factors, modeling
   • 4a. Counterparty risk
     • characteristics, 2 broad classes (OTC + securities financing trx), counter. risk vs lending risk, mitigation (netting, collateralization, CCDS)
       • Mitigation
         • 4 forms: Diversification, Netting Collateralization, Hedging
           • Methods: Trading w/ high-quality counterparties, cross-product netting, close-out, collateralization (margiing), walk-away, monolines, Diversification of counterparty risk, Exchanges and Centralized Clearing Houses
     • Credit exposure, default prob, credit migration, impt aspects when considering: time horizon, future default prob,
       • default prob: mean reversion, calibration method: real measure vs risk-neutral measure
       • other terminology: recovery, LGD, MtM, Replacement cost, Exposure, PFE
         • Metrics: Exp MtM, EE, PFE
           • EE and PFE for normal distr, EPE, eff EE, eff EPE, Max PFE
     • Quantification: trade, counterparty and pf. credit line
       • pricing (CVA), Hedging (CDS, CCDSs), concerns, capital requirements
   • Mitigation: 1. Change capital structure 2. Reduce the volume and mix of business 3. Increase underwriting standards 4. Conduct due diligence 5. Buy credit insurance or CDS 6. Securitize assets, CDO: attachment vs detachment pts

5. 5. Liquidity risk

   • reason for difficulty, stress testing, scenarios (7), considerations
     • See 1 for assessment
   • Mitigation: 1. Allow for the transfer of liquidity within and across legal entities 2. Ensure that employees have an incentive to allow for liquidity risk 3. Use investment strategy to manage market liquidity risk 4. Allow for liquidity risk in the product design 5. Ensure diversification in the term and source of funding 6. Gauge the firm's ability to raise capital from each source 7. Have a contingency funding plan to provide liquidity in times of stress

6. 6. Systemic risks (feedback + contagion)

   • ways to reduce systemic...: counterparty risk, feedback risk, liquidity risk, strategic risk

7. 7. Demographic risk

   • Level (experience rating/risk rating), volatility, catastrophe and trend, other demo
     • Mitigation: Non Life/Life: premium rating, risk transfer, diversification

8. 8. Non-Life Insurance risk

   • aspects, grps of ins classes, ways + stat issues, rsv methods ( total loss ratio, chain ladder, Bornhuetter-Ferguson)

9. 9. Operational Risks

   • Nature, ways to asses
   • New approach to manage OR
     • a. goals, agg loss distr, data requirement
     • c. frequency + severity distr., (PDF, CDF. LEC),
       • challenges in severity distr., 4 ways to model severity
       • Frequency distr: poisson, neg bin, bin
     • b. Combining internal + external data
     • d. Assessment, scenario analysis & stress testing
     • e. VaR: simulation steps, shortcomings
     • f. OR component of other risks
   • ways to control: OR, business continuity, regulatory, technology, crime, people [employment-related, adverse selection, moral hazard, agency risk], bias, legal, process, model , data, reputational, project, strategic
   • See 6