Risk Management - VarModel and Portfolio analysis

Résumé du document

The risk management process is definitely marked by several steps that have to be respected in order to avoid financial risk exposure. It actually starts with the establishment of the context for strategic, organizational as well as risk management criterion according to each evaluated risk. The identification of the risks is primordial in the prevention of achieving an organization's business and strategic objectives. After a deep analysis of risks that has to be considered to assess the potential results, the probability that those effects could occur. Evaluating the risks is then strategic in order to compare risks against the firm's criterion and there is a need to balance between potential advantages and drawbacks. The next step is to treat risks through the implementation of plans, so that potential benefits can increase and costs linked to those risks can be treated. As a result, the establishment of those measures permits the risks monitor and review. Nowadays, there are no doubts that trading exposures and risks have rapidly evolved and increased in response to market changes such as financial engineering and innovation, development of the international markets, increased financial innovation, and growth of lower credit quality debt. Undeniably, risk management has consistently had trouble keeping up with the complexity and speed of the products. That is why the evolution of risk measures has led to better quantification of potential losses.

Extraits

[...] To sum up, this method gives a framework to assess risks in all kinds of markets. Disadvantages There is no doubt that past experiences and historical statistics are not accurate all the time. Indeed, variances and correlations can change radically according to extreme market changes. Besides, this technique is very sensitive and gives more complicated estimations that can lead to biased results. Finally, VaR is based on previous volatility and correlation but we cannot deny that volatility is unstable and that correlation between instruments measures are imperfect. [...]

[...] First of all, treasuries are negotiable U.S. Government debt obligation, backed by its full faith and credit[8]. They are actually issued by the American State in order to finance government projects. These Treasury Bonds are low risk investments due to a State guarantee for refunding the principal and an interest, both not subjected to taxes. As the risk is low, the return on investment is also low. Then, a corporate bond is defined as a debt security issued by a corporation and sold to investors[9]. [...]

[...] Besides, this method demonstrates the change in a bond's price compared to a decrease in the bond's yield[1]. This is basically done to assess investments' risks. Advantages The DV01 method is quite easy to establish through a basic calculation. Its intrinsic analysis and interpretation are very understandable by most of dealers. In addition, this method can be used for other financial tools that already know cash flows or to calculate hedge ratios. Disadvantages The main drawback of this method is the impossibility to evaluate the yield curve on a day-to-day basis. [...]

[...] Therefore, Value at Risk is a unique number, which represents how much you can anticipate of a portfolio to lose over a given time period. Moreover, to manage positions, specific sensitivities need to be assessed for individual and overall positions. Only quantifying the likely impact of each risk factor regarding risks that should be reduced or hedged can make decisions. Stress tests will respond to how much money will I lose if things go terribly wrong? As a result, we will be able to see what would happen to our portfolio according to a variety of different scenarios, such as a spectacular increase in interest rates for example. [...]

[...] The panel of possible trading technologies within the VaR method can influence risk levels. That is why, choosing the best technology with less possible risks could be judicious. As every technology, the quick improvement of this VaR technology never gives a total certainty to avoid risks. In addition, all systems have their own weaknesses due to the decompartmentalization of processes within an institution. Thus, assessing the importance of the various systems, databases, and applications is definitely strategic. You have been asked to do a risk management review of a medium sized hedge fund. [...]