Investment Risk Management FINANCIAL MARKETS AND INVESTMENTS SERIES H Kent Baker and Greg Filbeck, Series Editors Portfolio Theory and Management H Kent Baker and Greg Filbeck (Editors) Public Real Estate Markets and Investments H Kent Baker and Peter Chinloy (Editors) Private Real Estate Markets and Investments H Kent Baker and Peter Chinloy (Editors) Investment Risk Management H Kent Baker and Greg Filbeck (Editors) Investment Risk Management EDITED BY H KENT BAKER and GREG FILBECK 3 Oxford University Press is a department of the University of Oxford It furthers the University’s objective of excellence in research, scholarship, and education by publishing worldwide Oxford New York Auckland Cape Town Dar es Salaam Hong Kong Karachi Kuala Lumpur Madrid Melbourne Mexico City Nairobi New Delhi Shanghai Taipei Toronto With offices in Argentina Austria Brazil Chile Czech Republic France Greece Guatemala Hungary Italy Japan Poland Portugal Singapore South Korea Switzerland Thailand Turkey Ukraine Vietnam Oxford is a registered trade mark of Oxford University Press in the UK and certain other countries Published in the United States of America by Oxford University Press 198 Madison Avenue, New York, NY 10016 © Oxford University Press 2015 All rights reserved No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, without the prior permission in writing of Oxford University Press, or as expressly permitted by law, by license, or under terms agreed with the appropriate reproduction rights organization Inquiries concerning reproduction outside the scope of the above should be sent to the Rights Department, Oxford University Press, at the address above You must not circulate this work in any other form and you must impose this same condition on any acquirer Library of Congress Cataloging-in-Publication Data Investment risk management / edited by H Kent Baker and Greg Filbeck p cm — (Financial markets and investments series) Includes bibliographical references and index ISBN 978–0–19–933196–3 (alk paper) Investments Risk Financial risk Portfolio management I Baker, H Kent (Harold Kent), 1944– II Filbeck, Greg HG4521.I4229 2015 332.6—dc23 2014024764 Printed in the United States of America on acid-free paper Contents List of Figures viii List of Tables xi Acknowledgments xiii About the Editors xv About the Contributors Abbreviations xxviii Part One xvii FOUNDATIONS OF RISK MANAGEMENT Investment Risk Management: An Overview H KENT BAKER AND GREG FILBECK Measuring and Managing Risk 17 R A I M U N D M K O VA C E V I C, G E O R G C H P F L U G, A N D A L O I S P I C H L E R How Risk Management Adds Value 42 M MARTIN BOYER AND MONICA MARIN Accounting and Risk Management 60 M A R K B R A D S H AW A N D B J O R N J O R G E N S E N Part Two TYPES OF RISK Market Risk 81 R A M O N P D E G E N N A R O A N D C H A N A K A P E D I R I S I N G H E Credit Risk 96 NORBERT J JOBST v vi CONTENTS Operational Risk 119 PAV E L V S H E V C H E N K O Liquidity Risk 141 K O S E J O H N, S A M I R S A A D I, A N D H U I Z H U Country Risk 155 A S WAT H D A M O D A R A N 10 Systemic Risk 179 ANDREAS KRAUSE 11 Behavioral Risk 197 M M A R T I N B O Y E R, F R A N C A G L E N Z E R, A N D S A M U E L O U Z A N 12 Governance Risk 213 DIDIER COSSIN 13 Inflation Risk 237 C L A U S H U B E R, F E L I X G A S S E R, A N D N I C O L A S BÜR K L E R 14 Risk Aggregation and Capital Management 261 S U M I T M AT H U R Part Three QUANTITATIVE ASSESSMENT OF RISK 15 Value-at-Risk and Other Risk Measures 283 MARKUS LEIPPOLD 16 Stress Testing 304 ˇ HÁK M A R T I N CI 17 Risk Management and Regulation 324 D AV I D E A L L E N, R O B E R T J P O W E L L, A N D A B H AY K S I N G H 18 Risk Budgeting 346 G R E G G F I S H E R, T I M N G U Y E N, A N D C R I S T I A N I T I U 19 Risk-Adjusted Performance Measurement PILAR GRAU CARLES 20 Risk Attribution Analysis PHILIPPE BERTRAND 387 365 CONTENTS Part Four RISK MANAGEMENT AND ASSET CLASSES 21 Risk and Mortgage-Backed Securities in a Time of Transition HAROLD C BARNETT 22 Credit Value Adjustment 426 J A M E S T M O S E R 23 Risk Management and Hedge Funds 442 R A Z VA N PA S C A L A U Part Five 24 Options HEDGING RISK 463 K I T P O N G W O N G, G R E G F I L B E C K, A N D H K E N T B A K E R 25 Futures 482 L U D W I G B C H I N C A R I N I , C F A 26 Swaps 508 DIMITRIS TSOUKNIDIS AND ELIAS BOUKRAMI 27 Credit Derivatives 523 U D O B R O L L, S I M O N E R A A B, A N D P E T E R W E L Z E L 28 Foreign Exchange Derivatives in Frontier Markets OT H M A N E B O U K R A M I A N D B E R T VA N L I E R Part Six GOING FORWARD 29 Risk Management and Financial Disasters G A B R I E L E S A B ATO 30 The Future of Risk Management HUNTER M HOLZHAUER Discussion Questions and Answers Index 639 599 580 563 543 409 vii List of Figures 2.1 2.2 2.3 2.4 2.5 2.6 2.7 2.8 2.9 3.1 3.2 3.3 4.1 4.2 5.1 5.2 6.1 6.2 6.3 6.4 6.5 6.6 7.1 7.2 12.1 12.2 12.3 viii The Density of a Profit-and-Loss Distribution and Coverage of Losses 21 The VaR at a Confidence Level of 90 Percent 27 Standard Deviation, Efficient Frontier, and Portfolio Composition 30 Lower Standard Deviation, Efficient Frontier, and Portfolio Composition 31 Mean Absolute Deviation, Efficient Frontier, and Portfolio Composition 32 Value-at-Risk, Efficient Frontier, and Portfolio Composition 32 Average Value-at-Risk Deviation, Efficient Frontier, and Portfolio Composition 33 Entropic Deviation, Efficient Frontier, and Portfolio Composition 33 Linear-quadratic Error Measure, Efficient Frontier, and Portfolio Composition 34 Transformation Possibility Frontier and Optimal Firm Value 52 The Role of Financial Risk Management in Creating Room for Value Creation 53 The Impact of the Concavity of the Firm’s Transformation Possibility Frontier after a Change in the Market Price of Risk 54 The Relationship between Earnings and Stock Prices 62 Option Smirk Curve 71 Relative Firm Strengths for Firms in Each Sector for 2011Q1 89 R2 of Factor Regressions of Stock Returns 90 US GDP Growth and Aggregate Default Rates 104 The Asset Return Set-up 105 The Link between Loss Distribution and Capital 110 Sector Overlay to Regulatory Capital Derived from Economic Capital Modeling 113 Synthetic Securitization Structure and Loss Mechanics 115 Hypothetical CDO Portfolio Loss Distribution and Tranche (4 to Percent) Overlay 116 Operational Risk Capital Requirements 126 Extreme Value Theory to Fit Severity Distribution 133 An Interdisciplinary View of Governance 215 The Drivers of Governance Performance 221 A Board Psychological Pattern: The NEO Survey 223 LIST OF FIGURES 12.4 12.5 12.6 12.7 13.1 13.2 13.3 13.4 13.5 13.6 13.7 13.8 14.1 15.1 15.2 15.3 15.4 16.1 16.2 16.3 16.4 16.5 17.1 17.2 18.1 19.1 19.2 19.3 19.4 20.1 20.2 20.3 21.1 21.2 22.1 23.1 23.2 23.3 23.4 23.5 23.6 25.1 ix Working Roles of the Board 225 An Example of Board Tasks 225 An Example of Process: On-Boarding 228 ICBC’s Governance System 233 Total and Required U.S Bank Reserves: January 2007 to April 2013 240 Realized Inflation for Germany, Switzerland, the United Kingdom, and the United States: 1971 to 1985 and 1998 to 2012 242 Public Debt as a Percent of GDP 245 Real P/E Ratios and Annual CPI Changes for the United States: 1872 to 2012, Sorted by Annual CPI Changes 247 Causality between Market Price Trendiness and CTA Performance 253 CTA Returns during Crises Scenarios 254 Dow Jones versus Gold: 1976–1981 255 Historical Returns of CTA Pioneers 256 Roll-up Risks at Various Levels 273 Value-at-Risk and Expected Shortfall 290 Risk Spectra for Value-at-Risk and Expected Shortfall 295 Risk Spectra for Spectral Risk Measures 296 Impact of Standard Deviation-Based Risk Measures on Portfolio Allocation 298 Stress Testing Process 305 Example of a “Step Function” 307 An Example of Calibrating a Supervisory Early Warning System 308 “Macro” Interbank Contagion 316 Worst-Case Approach vs Threshold Approach 318 The Process of Securitization 333 S&P/Case-Shiller 20-City Composite Home Price Index 337 The Value of $1 Invested in the GTM Strategy 358 The Capital Market Line and the Sharpe Ratio 368 Graphic Representation of M 370 A Graphic Representation of VaR0.5 372 The Security Market Line 375 Linear Regression of RP on RM without Market Timing (β P = cste) 390 Linear Regression of RP on RM with Successful Market Timing (Variable β P ) 390 Mean/Variance and Tracking-Error Variance (TEV) Efficient Frontiers 396 Homeownership Rates: 1965–2013 411 GSAMP Trusts Projected Loss and Credit Ratings 413 Vanilla Interest-Rate Swap 427 The Worst Drawdown across Hedge Fund Styles 451 The Sharpe Ratio across Hedge Fund Styles 452 The Sterling Ratio across Hedge Fund Styles 452 The Sortino Ratio across Hedge Fund Styles 453 The Efficiency Ratio across Hedge Fund Styles 453 The Average Beta across Hedge Fund Styles 454 The Term Structure of Soybean Prices on September 30, 2011 495 ... Markets and Investments H Kent Baker and Peter Chinloy (Editors) Private Real Estate Markets and Investments H Kent Baker and Peter Chinloy (Editors) Investment Risk Management H Kent Baker and... methodologies Before that, he conducted research funded by Fidelity Investments Dr Jobst has taught at Brunel University, Imperial College, and the European School of Management He has published... Physical Problems and a PhD in theoretical physics from the University of New South Wales Abhay K Singh is a Postdoctoral Research Fellow at the School of Business, Edith Cowan University He has