Risk management - measures, models and factors

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Risk management - measures, models and factors

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Risk management consists of quantifying and analyzing the potential losses and gains for any investment, and then deciding to invest or not, and taking some appropriate actions according to the risks to be taken, the investor's objectives and the risk tolerance. Basically, there are two steps in risk management: First, determine what the existing risks of a given investment are, and then handling these risks in a manner that best fits to the objectives of the potential investment. Risk management is omnipresent worldwide, and it is important to understand what are the different tools that can be used to help investors make their decisions. There are three main aspects in risk management: Measurement of the risk, depending on the interests, maturity etc, Monitoring, that is to say, be careful of all information and details for trading, Management, which basically involves having good strategies and trains the risk takers in order to avoid losses. 'Value at Risk' is a technique used to measure the worst expected losses under normal market conditions for a certain period of time and at a given confidence level. It's also based on the statistical analysis of historical price trends and volatilities. Generally speaking, 'value at risk' is more used by banks and security firms to measure the market risk of their potential investment. This method allows also companies to measure risks when it happens and gives useful information when companies trade or make decisions. Basically, 'value at risk' answers the question 'how much can I loose with X% of probability over a given period of time?'

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Describe the advantages and disadvantages for each of the following risk measures
1. DV01
2. Stress testing
3. Scenario testing
4. Value at Risk (VaR)
In implementing a VaR model, what considerations would you give to each of the following
You have been asked to do a risk management review of a medium sized hedge fund. What are the factors you would consider in evaluating the effectiveness of their risk management capabilities? Why are these factors important in effecting risk management?
Consider a portfolio that consists of Treasuries, corporate bonds, interest rate swaps and options
1. Describe in the limit structure you would put in place to manage this trading book
2. Describe the risk measures you would use to manage the risks in the book

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Extraits

[...] - Good explanation of the different methodologies. - Use different measurement risk tools, as each one of them has advantages and differentiate from each other in risk measurement. - Risk measurement is based on assumptions, which is quite risky because there is though a higher level of uncertainty (unexpected factors and events ) - Detail the different options in methodology at all levels of the companies and organizations in order to be sure that people make the right choice. The company has to choose its tools depending on the product and the portfolio, and risks have to be limited to a certain extent. [...]

[...] Anyway there are still some risks : - Unexpected events - Liquidity risk. - Credit risk - Changes in interest rates - Risks during the transactions Options: Options are a financial derivative that gives the holder the right to engage in a future transaction on some underlying security or in a future contract. Indeed, the holder can buy (call) or sell (put) a security or another financial asset at an agreed upon price (strike price) during a given period of time (also called exercise date). [...]

[...] Risk measures like duration and basis point value, (DV01), do not provide a statistical measure of the likelihood of loss. They just give you an absolute risk figure rather than a probability of such a loss arising. Therefore VAR is an improvement on these techniques. - It can be calculated for all types of assets. This means you can calculate VAR for interest rate risk, foreign exchange risk, credit risk and commodity price risk. Some firms add these individual VARs together to arrive at an overall VAR. You cannot do this with other risk measures. [...]

[...] Describe in the limit structure you would put in place to manage this trading book Let's first define the different elements: - Treasuries - Corporate bonds - Interest rates Swaps - Options An investor can hold a portfolio with different kinds of investments possible: Treasuries: Treasury bonds are negotiable US government debt obligations, issued most of the time to pay and finance the different projects put in place by the government. It's basically a loan to the US government. The principal is repaid to the bond holder, as well as interests (depending on the interest rate). Treasury bonds are low risk investments as they are guaranteed the full faith and credit”. So basically, the holder is sure to get his money back, as the government can decide to pay the money back just by printing money. Moreover, the interests on the treasury bonds are not subject to taxes. [...]

[...] To complete the VaR tool, I would use the BPV model, which has also several advantages and completes the VaR disadvantages in my opinion (see answers to question 1). Indeed, BPV allows the investor to forecast what would happen when there is an extreme market trend change, which would give more information to the investor. Sources http://www.barbicanconsulting.co.uk/quickguides/bpv http://pluto.mscc.huji.ac.il/~mswiener/research/Benninga74.pdf www.wikipedia.org www.investopedia.com http://www.family-business-experts.com/risk-monitoring.html http://www.investorwords.com/5057/Treasuries.html Speed of implementation Cost (e.g. [...]

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