MACHINE LEARNING METHODS FOR

ESTIMATION OF

FINANCIAL RISKS

Student: Madhan Kondle

Student No: 0817200

Supervisor: Dr. Vitaly Schetinin

May 28, 2010.

 Acknowledgements

It gives me immense satisfaction to convey my sincere thankfulness to my

director Dr. Vitaly schetinin PhD in computer science (computational
intelligence) 1997 for his excellent support throughout the research process
and continuous guidance during the whole process of my dissertation.

Finally, I owe the greatest debt to my Dad, Mom, Brother, Sister for their
wholehearted support and encouragement all the way. They are the great
source of inspiration for me to overcome all the challenges during my course
as well as dissertation process.

Any remaining errors are entirely my responsibility.

Madhan Kondle
 Table of contents

Particulars page
no:
Abstract

Acknowledgments

Table of contents

List of tables

Chapter 1: Introduction

1.1Introduction
1.2Structure of thesis

Chapter 2: Literature Review

2.1 What is risk?

2.2 Risk perception

2.3 Business level risks

2.3.1 Financial risk

2.3.2 Risk management

2.4 Coherent risks

2.5 Bayesian classifiers

2.6 Machine learning

2.7 Artificial intelligence

2.7.1 Artificial neural networks

2.7.2 Artificial neural networks in finance

Chapter 3: credit approval data

3.1 Risk perspective

3.2 Significance of neural networks in credit approval process

Chapter 4: Machine learning techniques

4.1 Artificial neural networks

4.2 Architecture of neural networks

 4.2.1 Interconnections among neurons

4.2.2 Number of hidden neurons

4.2.3 Number of hidden layers

4.2.4 The perceptron

4.3 statistical aspects of ANN

4.3.1 Comparison of ANN to statistical methodologies

4.3.2 Terminology in ANN and statistical methodologies

4.3.3 ANN vs. Statistical methods

4.3.4 Conclusion on ANN and statistical methods

Chapter 5: credit approval data based on ML

5.1 Matlab

5.2 experiments in Matlab

Chapter 6: conclusions

6.1 Conclusions

6.2 Future researches

Chapter 7: References
Abstract:

The current fragmentary credit crunch has highlighted the significance

of financial risk measurement to many financial organisations and financial
institutions. This thesis analysis the most significant portfolio risk measures in
financial mathematics from Bernoulli (1738) to the present CVaR [conditional
value at risk]. Since, estimation of financial risks has a major role to play in
these dynamic financial markets; in this thesis we look at various risk
estimation techniques and methods to calculate the risks and their accuracy
rates. And act accordingly to minimise the effect on the organisations.

Chapter 1:

1.1 Introduction:

There is little hesitation among financial managers and researchers in the field
of finance during the process of decision making due to the level of
uncertainty involved with it, which can be said as the greatest challenge. In
fact, Risk which comes in the form uncertainty is elementary to the
contemporary financial theory and is viewed as an independent restraint, to
which many intellectual resources have been assigned to analyse the risk.
This risk besides making the decision making process complicated also
generates opportunities to those individuals who can handle risk’s in an
efficient manner.

Furthermore, with the development of risk management technology has been

categorized by computer technology trailing the traditional hypothetical
advances. Since, computers are much powerful they are enabled for better
testing and application of financial concepts. Markowitz ideas on portfolio
management have been widely implemented almost for two decades until
enough capacity and computational speed is developed.

In the recent past we have seen increase in the array of computer

technologies that are being applied to the financial applications. One amongst
of them is ARTIFICIAL INTELLIGENCE (AI) which is most exciting in terms of
analysing risk. Artificial Neural Network (ANN), is one of the modern day used
AI methods in permutation with several other methods has began to attain
importance as a potential means in analysing difficult tasks. ANN has been
implemented in wide range of business sectors effectively varying from
medical to space.
http://www.smartquant.com/references/NeuralNetworks/neural28.pdf

Chapter 2:

Literature review:

Prediction always has an illustrious place in the financial markets.

Hence evaluating predictive ability is the main concern for many financial
institutions and organisations. With significant increase in financial risk in the
recent years, risk management is not contemporary anymore. With augment
of the universal markets, risks may instigate with the activities some
thousands of miles away and affect the whole domestic market. Since
information is available instantly, change and subsequent market reactions
can happen quickly.

Investors are being faced off with a constant trade off between
adjusting likely returns at high risks. Financial markets can be affected with in
no time by the varying interest rates, exchange rates and commodity charges
[(Sto00a) and (Mit06)] As a result, at all times it is essential to make sure that
the financial risks are identified and managed appropriately in advance. A
poor risk management system can result in bankruptcies and threaten the
complete collapse of finance division [KH05]

Risk estimation has a vital role to play in multibillion dollar derivative

business [Sto99b] and improper risk analysis can undervalue derivatives
[GF99]. In addition false risk estimation can considerably underestimate the
risks like credit risks, commodity risks, market risk etc.

2.1 What is risk?

Risk is defined as “the net negative impact of application of exposure”

by Feringa et al. (2002). Risk is also defined as “the combination of the
probability of an event and its consequences” (ISO/IEC, 2002, n, p.). The
above mentioned two definitions define risk in their own ways. The major
difference between them is that the latter didn’t state whether the result of
risk is positive / negative and the other considers risk only in negative
perception.

Initially risk was treated as negative impact or treated in downside but in the
recent past it is also accepted that risk has potentially positive impact. Kaplan
and Garrick (1981) stated that risk itself comes with three parts a) what can
go wrong? b) Chances of it going wrong? c) What are the consequences if at
all it goes wrong?
 Answering, the first involves figuring out set of likely scenarios.. The
second requires estimating the likelihood of every scenario and the third
involves evaluating the consequences of each scenario. This explanation
focuses on the improvement of the scenario thus making it part of the
definition.

2.2 Risk perception:

Sjoberg [2000] came out with three underlying concepts in risk

perception. a) Risk attitude or risk effect b) risk sensitivity is a set of
interrelated risks that are mostly interrelated strongly c) fear, which refers to
any losses that may occur.

2.3 Business level risks:

There are two types of business risks according to Sadgrove [1996]

strategic risks and operational risks. Risks that are associated with loss of
power due to strategy followed are known as strategic risks. Operational risks
are those that are related with the probability of unable to execute the task
that has to be performed.

There are certain standard types of risks:

1) Pure vs. speculative:

A) Pure risk: In this kind of risk there will be no gain and the best possible
outcome is outcome with no loss occurring.
B) Speculative risk: In this type of risk there are chances for both gain and
loss.

2) Diversifiable vs. non- diversifiable:

A) Diversifiable risk the one which can be mitigated during a course of

pooling risks. And non diversifiable risk is vice versa.

http://www.scribd.com/doc/26507765/Financial-Risk-Management

http://www.theshortrun.com/finance/finance.html

2.4 Financial risk:

Any risks associated with any form of financing are known as financial
risks. It is the probability of actual return being less than the expected return.
There is no business without uncertainty in it and that uncertainty is called
risk. The greater the risk the greater the potential benefit you expect.
Thus, taking a risk should mean:

➢ Identifying sources of risk.

➢ Assessing the probability if risk arising.
➢ Assessing their potential impact.
➢ Adopting mitigation techniques.
➢ Identifying a fall back plan.

In financial framework risk can be mitigated in 2 ways

➢ By hedging (prevarication) using various correlation of stocks

➢ Using derivatives.

Generally investors use both although their applications differ.

In an association the requirement for any financial asset lays in relation

between all the other assest in the association. In an association if two assets
are correlated then they are said to be naturally hedged among themselves
each other. Usually financial models are used to calculate the returns. And
among all those models capital asset pricing model (CPAM) is the most
popular model.

Capital asset pricing model is most widely used financial model to facilitate
the portfolio diversification.

http://www.scribd.com/doc/26507765/Financial-Risk-Management

2.6 Risk management:

Risk management is broadly classified into three categories mainly risk

perception, risk analysis and risk attentiveness.

Risks mainly divided into three categories:

➢ Upper hand: risks here are totally unacceptable and must be

wiped off at any cost or at least must be controllable.
➢ Intermediate level: at this level the decisions are made to
reduce the risks by controlling costs and benefits.
➢ Lower hand: in this stage the investors readily accepts the risk
because the benefits are felt to be more than the disadvantages.

Typically, risk management has three major essentials – identification of risk,

risk assessment and the implementation of plans and solutions.
Risk assessment again consists of

➢ Risk identification: in this we determine what are the risks or hazards

that are anticipated and their type, remoteness in time and the likely
effects.
➢ Risk quantification: in this we attach the probability factor to the
occurrence of the negative factor. If it is sure that the risk will not occur
then it is given probability of ‘0’, if the risk occurs then it is given the
probability ‘1’ and the uncertainty risks are assigned values between ‘0’
and ‘1’ .
➢ Risk evaluation: here we try to determine the risk management
priorities by linking between the qualitative and quantitative affiliation
flanked by benefits and risks associated.
➢ Risk acceptance: These states the possible consequences of a
particular risk that we need to accept in the occurrence of the risk.
➢ Risk aversion: risk aversion is nothing but inverse of risk tolerance.
Here the investors may stay away from risks even those risks have high
chances of profits.
➢ Risk control: it is about the processes and methods that are used to
relieve the risk.

http://www.clinicalgovernance.scot.nhs.uk/documents/risk_control.pdf

http://www.businessdictionary.com/definition/risk-identification.html

Risk assessment: “risk assessment can be defined as the overall process of

risk identification, risk quantification, risk evaluation, risk acceptance, risk
aversion and risk management.”

Risk assessment takes determination of risk and evaluation of risk where as

risk management includes risk assessment and risk control.
In financial firms the role of risk management has become more than the
simple insurance of the identified risks, to a level that focuses on the complex
financial models and econometrics uncertainty. The Basel committee defined
the financial risk management as the series of 4 processes

➢ Identification of actions into one or more divisions of the

markets, credit, operational and other risk into certain sub
categories.
➢ Risks can be managed by the risk assessment and the risk
models
➢ By conducting audits on regular basis.
➢ Finally by controlling of these risks by the senior management.

Deregulation has been the main driving force in the financial markets which
has foremost importance on the risk management practices today. Since
1970’s increased globalisation is only due to the deregulation of industries and
also with the deregulation of the financial operations new risks came into
existence where banks started to offer insurance products and insurance
organisations addressing market and credit derivatives.
Understanding and assessing financial risk:

It’s always impossible to avoid risks in any form of business from

occurring but we can manage them. Disclosure to financial risks evolves from
three basic sources mainly

a) Ability to meet up cash flow requirements in timely manner

b) The accessibility and outlay of debt capital
c) Ability to keep the growth equity.

If a plan is developed to meet all the above sources then it can benefit from
long term success. Developing a plan must be from financial statements and
measures of its financial performances. The fact is that without proper
business planning and financial performance analysis, financial managers can
generate a way out of business as easily as a way developing a way out fron
the difficult situations.

All the financial managers must question themselves some questions like

What are the company’s short terms and long term goals or targets?

How do they affect the company’s financial planning?

Which records do we need to file the borrowing demand?

These are the main questions that are to be answered in order to access the
financial risk of any operation.

There are certain minimum requirements to access risk factors and measure
the performance of the organisation these include

a) Balance sheet
b) Income statement
c) Cash flow statement
d) Equity statement of owner.

Balance sheet:

This provides the complete financial snapshot of the business at a point.

This is the summary of all the companies’ assets, liabilities, owner equity and
interrelationships on the data from where the balance sheet is prepared. The
balance sheet clearly reflects the collective effect of previous transactions but
this doesn’t mention the existing financial position.

Income statement:

The main purpose of this statement is to compute the profit over

specific time period. An income statement is also called as operating
statement and profit loss statement. This statement raises a question “Did the
company make any profits during the specific time period?” and the result is
the net income or profit. And the time period is called the accounting period
and it is generally for 12 months. This should elucidate the change in owner
equity during that period of time.

http://agecon.uwyo.edu

Cash flow statement:

This statement provides a brief summary of the total cash transactions

like cash payments and cash receipts during the specific time period. This
breaks the cash flow into operating, investments, financing actions. This is
useful to financial managers to identity and control cash flows in the business.
With this statement there are certain questions that can be answered like

a) How and where the company spent the earned cash returns?
b) What did the company do with the cash returned from financing or
from the sale of investments?
c) How did company manage to invest in new investments and clear the
debts?

Owner equity and net worth are the two terms often used interchangeably
by non- accountants and these mean the same. For only business prepared
statements the term owner equity is used and net worth is used in
statements prepared for both business and personal entities. The main
perception of this owner equity statement is to conciliate the value of
business as stated at the staring of the accounting period to the end of the
period. This conciliation authenticates that both statements are in
agreement. Change in owner equity comes from only few sources and the
first is from the sustained earnings and contributed capital. Sustained
earnings are portions from the net income that are reinvested into the
business. Contributed capital is the capital that is invested into the
business from the external sources. The next source of transform is from
the valuation equity. This represents the difference between the present
market value and the book value.

In accessing the financial risk, we need to take into consideration

whether the previous data is used and if used, was it accurate? What are
the changes in key performance measures? The process of changing the
financial statement into the key performance measure will give the result.

Financial performance is nothing but the outcome of the production

and financial decisions made during certain amount of time. Traditionally
financial performances are measured in five categories:

a) Liquidity: This refers to the ability of the business to meet the

financial problems they face without affecting the normal business
activities. It is the firm’s ability to repay the debts by transforming
assets into cash. This liquidity is short run theory since we deal in
current assets and current liabilities here. Generally more the cash
firm able to pay is more the company’s liquidity.
b) Solvency: This is the measure of firm’s risk bearing ability. This
gives an indication of the firm’s capability to clear all the debts by
selling its assets. This also can indicate the ability to continue the
business operations after affected by a risk which leads to much
more debt and reduced equity. This is a long run activity where as
liquidity is a short run activity.
c) Profitability: This evaluates the total profits generated by the firm
by making proper usage of the all the available resources like land,
labour, capital, machinery, management etc. The goal of every
business is to make profits and this can be done with proper usage
available resources. Profitability is the net income of after all the
expenses.
d) Financial efficiency: this is the pace at which the firm uses its
resources to generate gross revenues. This is calculated based on
the net asset turnover ratio. The total compositional gross revenues
can be represented by the operational ratios. These ratios include
interest expense ratio, operating expense ratio, net income from
operations ratio and depreciation expense ratio.
e) Repayment capacity : calculates the ability of a borrower to repay
the debt from the net income. Repayment is a long run process and
must come from long term profitability of the firm or operations.

What does all this mean for finance manager? In times of low returns
received for the operations performed the first affected area will be the
 operational cash flow within the business. If sufficient returns are not
generated from the business activities profitability is the first thing that
is affected. We should remember that the cash flow statement will
examine the operations that will generate the income.

Repayment capacity will be badly affected if profitability goes down and

suppliers will examine this in long run. If reduced profitability continues
over certain period of time then ultimately solvency is the one that will
be affected. Solvency measures the risk bearing capability of all the
activities. Lenders will also watch this when solvency goes down and
with that the borrowing ability of the firm will go down. If the ratio
between debts to asset climbs above 0.5:1 creditors will gain higher
claim on the assets than the operators which means the business is no
longer considered to be solvent.

There are several methods to calculate the financial risks. In this

literature review we look at the various Risk Measure techniques. For
this, we use the ideas of various researchers who have given their
efforts in this field.

One of the best ways to gain knowledge on the concept is to study the
development from its history. By perceiving the issues faced by the
researchers during development will help gain more knowledge on the
concept. It all [risk estimation] started with Pre- Markowitz risk measure.
Markowitz an ambitious student in 1950’s defined risk in a new way. Investors
knew that stocks are risky and many businesses were left over with a great
depression after 1920 financial crash.

The term risk always has an invasive role in literature on economic,

social, political, financial and technological issue. In this review we will have
an axiomatic characterization of various risk measures and discuss the trends
of developments in this field. In this paper we mainly focus on the financial
risks and financial risk measures. This thesis main objective is to improve the
Accuracy of the method that has been used by the organisations. Here we
assume that these financial risks can be quantified on the random variable X.
This variable X may be used as, the expected net position, the small or large
changes to the values in the investment or the total claims during a period for
a collective insurers. In general we consider risk as a random gain or loss of
position. Financial institutions all over the globe are trying to find out a
technique that would enhance the risk measurement process.

There has been immense acceleration in research on the risk measures

in the recent past which is connected with different interconnected aspects
like: a) axiomatic characterisation of risk measures 2) development of
coherent risk measures 3) premium rules in the insurance filed 4) dynamic risk
measures and 6) function of risk measures to financial actions.

In the pre-Markowitz period, financial risks were measured as

correcting aspect for expected returns. These precautionary measures had the
compensation of allowing an instantaneous partisan order of all investments’.
Term variance was first discussed by Markowitz to calculate the risk
associated with the return. Value at Risk (VaR) was bought into picture by the
leading bank in the year 1994 JP Morgan. This is very much popular and also
became part of financial regulations. To overcome the defects in the VaR,
conditional VaR (CVaR) has been proposed and it is not rational risk measure
in common. With the introduction of this coherent risk measure there are
many other risk measures that came into existence.

In practical, risks are basically multi period due to transitional cash

flows for example, accessibility of extraneous cash, possible gains or losses
due to change in the economic market or any adjustments in the portfolio.
Follmer and Leukert [33] and Cvitanic et al [23] have made various studies on
the dynamic risk measures. At the same time Artzner et al. [11], Riedel [56],
and Balbas [12] are also making efforts to define coherent risk measures for
dynamic financial markets.

Risk measures relate intimately to the utility function and the asset pricing
theories. Based on the Markowitz portfolio optimization theory (µ =expected
return and σ for standard deviation), and (µ, ρ) is the portfolio optimisation
where ρ is for coherent risk measure. (µ, ρ) can be altered to the maximizing
problem U= µ- λρ, where λ= Lagrangian variable. U can be defined as a utility
function and is used only when ρ is convex. U can also used as an utility
function for specific decision maker in φ(X) = E [U(X)], Dyer and Jia [43]
proved that we can derive an accurate risk measures. ρ(X) = -E
[U(X-E(X))] is for the specific utility purpose. Jaschke and Kuchler [42] have
proved that coherent risk measures are necessarily correspondent to the
comprehensive arbitrage bonds and called “good deal bonds “by the Cerny
and Hodges [21]. Thus coherent bonds link well with both utility maximisation
and economic theory of arbitrage.

Risk measures have been widely used in pricing, capital allocation,

hedging, performance evaluation and portfolio optimisation. We can say that
the application to evaluate performance evaluation and portfolio optimisation
are the main factors to develop risk measure.

2.7 Coherent risk measures:

Subsequent to the Artzner et al system risks are treated as futures net worth.
Ω denotes the set of states on nature and assumed as a finite value; set of
risks is represented by G, explicitly all real valued functions in Ω. For easiness
we consider all the market models without interest rates in this fragment,
anyhow we extend all the definitions and outcomes with interest rates by
discounting approximately.

Definition: a map ρ: X-> ℝ is called COHERENT RISK if it satisfies the following

conditions:

➢ Subadditivity: ρ(X+Y) ≤ ρ(X)+ρ(Y), ∀ X,Y ∈ G;

➢ Positive homogeneity: ρ(λX)=λρ(Y) when λ ≥0;
➢ Monotonicity: if X ≤ Y then λ(X) ≥ λ(Y);
➢ Translation invariance: if m ∈ ℝ, then ρ(X+m) = ρ(X)-m.

In this way if all the above conditions are satisfied then it is said to be a
coherent risk.

Let’s now discuss the economic importance of these axioms.

a) Subadditivity has an easy elucidation if ρ(X+Y) ≥ ρ(X)+ρ(Y),then this does not

hold i.e. in order to decrease the risk firm might be motivated into different integrated
affiliates. From the narrow point of view can reduce the capital requirements.
b) Positive homogeneity can be interpreted as ρ(λX) ≥ λρ(X) and this can be justified by
liquidity considerations i.e. a positive (λX) means less liquidity and therefore more chances
of risk.
c) Monotonicity: it is understandable to expect that if two net worth are such that X≤ Y, then
their risk measures to satisfy the condition ρ(X) ≥ ρ(Y). This Monotonicity rules out the risk
measures defined by ρ(X) = -E(X) +α.σ(X), where α >0.
d) Translation invariance: this defines that the risk can be decreased to m,
by adding a definite return m to apposition X. then we obtain,
Ρ(X +ρ(X)) = ρ(x) – ρ(X) =0. i.e. by adding ρ(X) to the initial
position X we can obtain a neutral position.

These coherent risk measure axioms have been very much influential, and can
be used to regulate capital requirements; risk predicted by the market
associates and insurance underwriters and also it is used to allocate the
capital available. But we should be aware of the fact that these coherent risk
measures are realistic to use under certain practical conditions.

Coherent risk measures were extended by Delbaen [26] and later to convex
risk measures also called as weak coherent risk measures by freeing both
Subadditivity and positive homogeneity conditions and as an alternative
requiring a weaker constraint:
Convexity (e): ρ (XY + (1-λ) Y) ≤ λρ(X) + (1-λ) ρ(Y), ∀λ∈ [0, 1]

Definition convexity: A map X-> ℝ is called convex risk measure if it satisfies

the constraints of convexity, Monotonicity and translation invariance.

Suppose ρ (0) =0 then convexity implies that

ρ (λX) ≤ λ(X), ∀ λ ∈[0,1] , ∀X ∈ G,

ρ (λX) ) ≤ λ(X), ∀ λ ≥ 1, ∀X ∈ G,

The second inequality says that when the value of λ goes large then the whole
position of (λX) will be less liquid than the λ single position for X. the second
inequality says that when λ goes small the first inequality should hold for
certain reasons.

These convex risk measures consider those situations where if risks

increases in nonlinear way with the position.

http://madis1.iss.ac.cn

2.8 Value at Risk (VaR)

The next era in financial risk measurement is introduction of Value at

Risk (VaR). VaR represented a major change in the direction of risk
measurement due to the following reasons:

Firstly, VaR initiated the process of measuring risk in the industry

for the management of risk in industry context. In the year 1994
JP Morgan came up with this VaR concept to measure the risk
across the whole organisation under one holistic risk measure.
[Dow02]. The previous methods did not go for this holistic
method approach to measure risks.
Secondly, previously used methods focused on the returns based
on some theoretical model and risk relation like CAPM. VaR on
the other hand has drifted the focus to measure and to quantify
the risk itself in terms of losses rather than expected returns.
Finally, the Basel committee which standardises international
banking system and practices stipulated a market risk measure
based on the VaR in the year 1995. This made interests grow in
VaR and VaR related measures and also soon this became a
popular risk measure that is used. [DSZ04].

The main question that has to be answered by VaR is “how much can we
expect to lose given cumulative probability ς, and in given time prospect T”?
And therefore VaR can be defined as [Sze05]
 F (Z (T) ≤ VaR = ς

Where

F (ς) is the cumulative probability distribution function,

Z (T) is the loss and is defined as

Z (t) = S (0)-S (t), where S (t) is price of stock at the time t;

Σ represents the cumulative probability related with the threshold value VaR,
to the loss distribution of Z (t).

Implementation of VaR:

The measurement of VaR on a portfolio represents a computational and

hypothetical challenge as is it not an easy job to build an evolution portfolio in
due course containing hundreds and thousands of assets [MR05],[Hul00].
Therefore implementation of VaR is based upon the choice of the industry and
there are four main methods used [Dow02]:

VaR Historical simulation:

In this method we build an empirical probability distribution of losses for

portfolio by using set of historical data sets. And with those we can determine
an appropriate VaR by extracting it from the correlated quantile. This method
is suitable for implementation and can also be enhanced by wide range of
mathematical methods.

VaR parametric model:

This parametric model requires a systematic /logical solution to

determine the VaR for any cumulative portfolio. Unfortunately not all the
distributions will have solutions anyhow we can make use of Extreme Value
Theory to compute VaR [CT04].

VaR Monte Carlo Simulation:

This Monte Carlo Simulation theory is general approach of simulating

some random processes representing the assets or the whole portfolio itself.
Accordingly after ample simulations we can attain loss distribution and thus
extract VaR for random probabilities is done for historical simulation. We can
improve this Monte Carlo Simulation through various computational methods
[gla04] like antithetic sampling, sampling and stratified sampling.
VaR variance- Covariance method:

This method is also called as Delta Normal Method. In this model we

design the portfolio’s loss distribution on two assumptions:

➢ We assume that the portfolio is linear and the change in its

price V (t) is linearly dependent on the integral asset price.

ΔV(t)=

If a portfolio has no derivatives then it will be linear. In

addition some researchers have assumed non linear
portfolio’s to be linear for analytical tractability. This
assumption is from [RU00].
➢ Constituent assets include mutual normal return distribution,
which means the portfolios returns are normally distributed. It
is important to note that the sum of normally distributions
functions is not normal all the times and the definite property
of joint normality however ensures the portfolios return is
normal. Therefore the linear portfolio assumption on own
cannot promise the portfolios return is normal.

Future directions of risk measurement:

Risk measurement is a booming field of research. At the current

level the focus is to find the suitable methods of modelling dependencies
between stocks other than correlations and copulas. On the other hand there
is much interest in finding copulas which is meaningfully can detain
dependency behaviours.

Other area of risk management is dynamic risk management which involves

measuring risk in continuous time rather than static distribution. Dynamic risk
measurement examples include [Rie04],[G0o8],[DS05].

The final area of risk management is in devising risk specific risk measures
like liquidity risk measures, credit risk measures etc. Any how these should be
noted in such manner that such risk exists already in those areas example
Merton’s structural credit default model [Mer74] and the KMV model [Kea03].

2.9 Decision Trees:

There is no proper technique to eliminate the risks

involved in decision making, though managers can manage themselves if they
stick to a logical approach for decision making. And the best method which
considers all the available options and the chances of them occurring is
decision trees. “A decision tree is a graphical model depicting the sequence of
event-action combinations “.

This is a diagram which represents three key features of a decision:

➢ The chances of these outcomes happening

➢ All the possible options available for an manager to make a
decision
➢ Different outcomes from those different options.

Simply, a decision tree can be defined as a diagram that sets out the various
options connections related with a decision and the possible outcomes that
may come from those options.

How to construct a decision tree?

The steps involved in constructing a decision tree are

➢ Decision trees are constructed from left to right.

➢ Every branch of the tree represents an option along with the outcomes
and possibility of them occurring.
➢ Decision points in the trees are denoted by square and are called
decision nodes.
➢ And a circle represents range of possible outcomes that may occur and
is called a chance node.
➢ Possibilities/ probabilities are shown along with each of these possible
outcomes. These possibilities are shown in numerical values of an event
occurring and they calculate the chance of an outcome happening.
➢ The pay-offs are the expected gains or losses for a particular outcome
and by analysing every single option the manager can make up a
decision to minimise the financial risks involved.

The typical method that is used in constructing decision tree is as follows:

1. Make out all the possible courses of actions.

2. Record all the possible outcomes i.e. list the state of nature of all
course of actions as specified in step 1.
3. Compute the pay off of every possible combination of courses of
actions and outcomes. Pay-offs is generally in financial terms.
4. Assign probabilities to various possible outcomes for each given
course of action. Probability is defines as the chance of occurrence
of a particular event.
 5. Calculate the expected value and expected outcome if does not
occur is multiplied by the probability of an event occurring.
6. Lastly, choose the action with maximum pay- off and minimum risk
involved.

Advantages of using decision trees in financial risk management:

1. This approach builds the decision making process thus helps in

making decisions in an organized manner.
2. This method necessitates that the decision maker will consider
all the possible outcomes despite of whether they are pleasing or
adverse. Thus, no probable outcome is left unconsidered in
decision making process.
3. This approach is really helpful in communicating decision making
process with others in clear and succinct way, evidently showing
the assumptions made.
4. Focus can be made on financial figure, probability, as also the
core assumption, one at a time.
5. These can be used with computers which mean various sets of
assumptions can be used to discover their effect on the final
outcome.
6. This is the dynamic response to risk, by connecting actions and
outcomes of uncertain events, decision trees encourage
organisations how they should respond under different
circumstances. As a result firms will be prepared for whatever
outcomes and will be ready with an action plan in place.
7. Decision trees come up with useful viewpoint on the value of
information in decision making process.
8. Since these provide a graphical representation of how cash flow
they are helpful in deciding what risks should be avoided against
doing so.

On the whole decision trees provide a flexible and influential approach when
dealing with risks mainly those involved in phases where decisions in each
phase reflect the outcomes in previous one. Besides providing us with the
measures of risk exposure they also make us think during the course how we
will think in both adverse and positive outcomes after each phase. On the
other side there are also some limitations in using decision trees

1. Decision trees call for more time and money to complete. So,
they are not suitable for making minor decisions where the cost
involved may exceed the benefit derived from those trees.
 2. As the information is accessible in quantitative form there is a
risk that it might be taken as it is and it is essential to make sure
that the information used in these trees are reliable.
3. Non- quantifiable factors like market changes, government
policies and peoples decision etc may play a vital role but these
cannot be used in decision trees.

2.9 Bayesian analysis:

In some cases if the analysis made from decision trees is

not helpful for the management in making decision then we use this more
sophisticated method known as BAYESIAN ANALYSIS. At times management
figures that the prior probabilities concerning some issues are no longer
appropriate. For example, a cell phone manufacturing company figures out
that certain models are not selling in the market due to its shape. Therefore,
the firm now has to make some changes in the shape of the models in the
mean time firm has to improve its prior probabilities it may be noted that the
prior probabilities are changed after transformed after attaining some more
information as the probabilities can be altered on the account of the
accessibility of new information, probability theory has an considerable
significance in decision making.

There are mainly three different types of analysis that can be made using
Bayesian analysis- prior analysis, pro posterior analysis and posterior analysis.

Prior analysis:

In this analysis during the decision process of which action should

chosen, the decision maker or the management uses prior probabilities and
only these probabilities are prior to the acknowledgment of any new
information.

Pre- posterior analysis:

This analysis deals with the question of whether new information

should be obtained or not if obtained how much prior to deciding the course of
action.

Posterior analysis:

This analysis makes use of posterior probabilities whilst deciding on

the course of action prior probabilities are revised by the management on
taking the new information based on the states of nature.
If the decision maker or the management is definitely enthusiastic to make
some probability assessments then pre-posterior analysis would definitely
ensure them to determine the value of the alternative studies before
undertaking the research and this value is known as the expected monetary
value of imperfect information (EMVII) from this is the cost if information (CI) is
subtracted, and this expected monetary value of imperfect information can be
obtained from

EMGII= EMVII-CI

Steps involved in pre-posterior analysis:

1. The first step is to identify all the possible outcomes and analyse the
marginal/ unconditional probabilities.
2. Suppose that each research result has been obtained. Now for every
research outcome
a) Calculate posterior probabilities b) determine the expected
monetary value of each course of action under consideration c)
select that course of action that yield highest value of expected
monetary value and d) multiply the highest expected value to the
marginal probability of research outcome.
1. Add the products of step 2 to get the expected monetary value of the
plan that includes commissioning of research before coming to the final
decision.
2. Calculate EMVII
3. Calculate EMGII
4. Decide the strategy that gives highest EMGII provided at least there is
at least 1 strategy that produces a positive EMGII. In case if there is no
strategy or plan with a positive EMGII then select the strategy that
yields highest EMV.

2.10 Artificial intelligence in finance:

Expert system:

Financial analysis are categorised in the proficient task field of Artificial

intelligence by Rich and Knight [1991]. Therefore, it’s not astonishing that
most used AI techniques in financial ground are categorised under expert
systems. The program developer for expert system is called as knowledge
engineer who might lack realm understanding of the job at the hand with help
of domain “expert” who even may lack in programming knowledge. Expert
system is build by means of capturing the human expert’s cognizance into a
set of encoding convention that aid in decision making process. These
systems are widely used in applications like fraud recognition, financial
applications, examining and mineral discovery etc.

Artificial Neural Networks in Finance

From the group of AI, Artificial Neural Networks is the one that deals
best with uncertainty levels. Dealing with financial uncertainty mainly
concerns with identification of patterns in previous data and predict future
events using that information. Accurate estimation of financial tasks like
foreign exchange rates, currency movements etc is highly complicated
practices in business, it also lines most important factor for business survival.
This issue is better dealt by ANN’S than any other technique and the reason is
they deal well with large noisy data sets. Unlike expert systems ANNs are not
transparent this makes hard to interpret.

According to Zahedi [1993], these expert systems and artificial neural

networks offer qualitative methods for business and financial systems that
conventional quantitative methods in statistics and econometrics couldn’t
compute due to the level of complexity involved in translating the systems
into accurate statistical functions.

Medsker et al. [1993] mentioned the following financial analysis task of which
sample neural network model have been build:

➢ Default and bankruptcy prediction

➢ Financial forecasting/ risk estimation
➢ Credit approval programme
➢ Project management and bidding scheme
➢ Prioritising risk rating in fixed income investments’ and foreign
exchange trading
➢ Exposure of regularities in price movements

Hsieh [1993] has stated that the following business financial applications can
be drastically improved with ANN technology.

➢ Economical simulation
➢ Predicting investors actions
➢ Estimation
➢ Credit endorsement
➢ Security and portfolio management
➢ Determining optimal investment structure
Trippi and Turban [1996] stated that financial organisations are in the second
place for the US defence academy for sponsorship on research in artificial
neural networks applications.

Artificial neural networks:

These ANNs models were encouraged by the biological sciences which learn
how Neuroanatomy of living animals has developed in solving problems.
Nelson and Illingworth [1990] also called these ANNs as the following:

➢ Neuro computing
➢ Neuromorphic systems
➢ Parallel distributed processing models
➢ Self organizing systems
➢ ANNs consist of various interconnected processors called as neurons
which execute the summing function. Information here is stored on the
connections weights.

An ANN resembles the human brain neural network. Living organism’s nervous
system functions with the biological neural network through which complex
tasks can be processed instinctively. Neurons are the central processing units
of the human nervous system. Human brain has around 10 to 100 billion
neurons each linked to many other by ‘synapses’. There are around 100
trillion synapses in human brain. Simply, they imitate the learning process of
human brain. The first ANN theory was illustrated by researchers to examine
the human brain and the thinking process.

The four different fields of research in ANN are:

➢ These ANNS are used to model the biological networks which enable to
gain knowledge on the human brain and its working. This area of
interest to researchers in neuroanatomy and psychologists.
➢ These ANNs can be used as an educational tool to solve complex
problems that the conventional AI methodologies and computer
algorithms cannot solve. Researchers in this include the computer
engineers, scientists etc. who are mainly concerned to construct better
algorithms by studying the problem solving process of ANN.
➢ ANNs are also used to solve real world problems in various commercial
and financial applications. Many researchers in this are from different
backgrounds than those that are related to ANN and the main reason
for this is its simplicity in using the tool and the reported success in the
fields that’s already in use. There are many ANN software tools in the
 market which enables users to get used to it very quickly without any
hassles and also without in depth knowledge about the ANN algorithms.
This is unlike the traditional computer algorithms where user must go
through and understand the whole algorithm before working on it. In
case of ANN all user need to know is to how to present the problem at
hand in form that ANN can understand.
➢ Improving ANN algorithms. Researchers in this area are interested in
designing better ANN algorithms that can work more effectively i.e.
more accurate results.

Research efforts on ANN are going on global basis. Nelson and Illingworth
[1991] stated that jasper Lupo, director of the tactical technology office of the
Defence Advanced Research Projects Agency (DARPA) called the neural
technology as “more powerful than atomic bomb” [Johnson and Schwartz
1998]. Japan’s primary ANN research is sponsored by its govt. Under its post
fifth generation computer program called “THE HUMAN FRONTIERS”. Anyhow,
Japanese corporations are already in the process of developing ANN based
products.

Europe’s ANNs research attempt is called ESPIRIT II and is in a five year

project with eight different countries and several hundreds of worker- years of
effort [Mehta 1988]. Germany has a US$ 250 million 5 year program [Johnson
1989b], France, is the most active participant with almost six neural based
microchip projects in Paris alone [Johnson 1988], United Kingdom gas US$470
million project. The UK advisory council for science and technology stated that
it would invest 5.7 million pounds over the coming years to bring awareness of
the benefits of neural networks to 6,000 UK companies [Milton 1993].

Chapter 3: Credit Approval Data

In general an organisation or an individual will go through

some point of time and after that they plan of taking extra money from third
party to repay in extended time period.

a) Assess credit worthiness:

In general, whenever an individual tries

to apply for some loan or to borrow some amount, the lender will
perform credit check of the individual and based on the outcome if
lender feels he/she is capable of clearing the debt within specified time
he will approve it. The optimism that the lender has in borrower accepts
credit. In this structure, lender has to use several financial tools to
calculate his risk in approving the credit. And if that is for a business
then lender has to go through the company’s cash flow analysis, income
statements, balance statements, liquidity, assets etc before sanctioning
so this takes larger time span than that for an individual.
 For example, lets us consider an
individual applying for a loan in bank. For this bank will perform the
credit check of the individual and take into account all the qualitative
credit check process where relations with previous banks will be
checked, repayment times ( if there are any previous loans) bank
statements , transactions and over drafts will be checked before
sanctioning loan. This credit check process also varies based on the
type of loan that an individual is applying suppose if the individual is
applying for any mortgages then along with his credit performance they
need to have a look at his legal position also to check the security
provided is legally correct to take over if in case anything goes wrong.
So, for this legal clearance is also required sometimes so based on type
of loans they apply the process changes so for all these processes
credit approval process is very much important.

Risk analysis plays a significant role in

this credit approval process. The distinction of credit approval from a
risk perspective is in determining all the possible credit risk possibilities.

3.1 Role of Neural Networks in Credit Approval Process

These neural networks perform well even when

the input data is noisy and incomplete. The mechanized information has
acquired by the capability of these neural networks by analysis performed.
With this training process neural networks obtain knowledge and this
knowledge is encoded and is sent all over the network structure. Neural
network knowledge is also numerically distributed and this has to modified
into symbolic form so that this is useful with respect to the production
process.

The human expert’s knowledge is also very much important for the progress
the computerised or programmed expert system. In view of the fact that, this
is a time taking process and also there are more chances of producing
erroneous results the decisions made by the human expert systems are
inferred or secondary besides considering the decisions.

Chapter 4: Artificial Neural Networks

Artificial neural network models:

Nelson and Illingworth [1990] stated that there are many

(infinite) ways to keep a neural network organised and out of
them only 12 of them are most commonly used. Neurodynamics
and its architecture defines organisation of neural network where
Neurodynamics refers to the characteristics of single artificial
neuron which consist of the following:

a) Combination of inputs(s);
b) Combination of outputs (s);
c) Weighting procedures i.e. initialization of weights and the
weighting algorithms
d) Types of Activation or transfer functions

All these properties can also be applied to the entire network on system basis.
Network architecture which is also called as network topology defines the
network structure and also includes the following characteristics:

a) Total number of layers

b) Total number of neurons
c) Types of interconnections among artificial neurons

4.1 Neurodynamics:

This Neurodynamics refers to four important

characteristics of artificial neuron

a) Inputs: This input layer of an artificial neuron usually works as a buffer

for inputs, processing information to subsequent layers. Pre-processing
these inputs layers may necessitate ANN’s as they only deal with the
numeric information. This involves scaling the information and encoding
or converting the input information to numerical data that ANN can use
with ease. ANN used binary information for representation for example
it represents “1” for ‘yes’ and “0” for ‘No’. lets us see how character “T”
is represented in ANN
1111111
0001000
0001000
0001000
The above is the binary representation of character “T”.
b) Outputs: This output layer of ANN functions same as input function
apart from that it transferring the data from network to the real world.
This output layer post processes the data which is essential to convert
data into understandable and functional format in the real world. This
post processing is effortless as just scaling of the output ranging to
more detail giving out in hybrid systems.
c) Transfer or activation function: This function generates the output by
summing all the weighted neuron inputs. The transfer layer for the
neurons in the hidden layer are non linear and therefore they provide
nonlinearities in the network.
The below equation represents the output of neuron j which is obtained
after summation of the inputs from neuron 1 to i that has been mapped
by the transfer function f :

 
Oj = fj
 ∑wij xi 
 i 
Equation 4.1

Transfer function relates any real number into domain which is

generally bordered by 0 -1 or -1 to 1. These kind of bounded activations
are called as squashing functions [sarle 1994]. In the beginning ANN
models like perceptron made use of a simple threshold function which is
also called as Heaviside function or step- function.

Threshold: f (x)  0 if x  0, 1 otherwise.

 The most commonly used transfer functions in ANN are the sigmoid or
(S- shaped) functions. Masters [1993] limply stated sigmoid function as
a ‘continuous real valued function’ whose domain value is real,
derivative is at all times positive and range is bordered. Some of the
examples of sigmoid functions are:

1
logistic: f ( x) =
1 + e- x
x - x
hyperbolic tangent: f ( e - e
x)= ex + e - x

Due to its ease of computing, logistic function remains the most frequently
used in ANN

f’ ( x) = f ( x)(1 − f ( x))

d) Weighing schemes and learning algorithms: The preliminary weights of

ANN are arbitrarily chosen or by an algorithm. This learning algorithm
analyzes how weights are changed, usually based on the extent of the
error in the network output to the anticipated output. The main purpose
of this learning algorithm is to minimize the error to an acceptable
range. The back propagation algorithm is the widely used learning
algorithm used in multilayer networks.

4.2 Neural Networks Architecture

4.2.1 Types of interconnections among neurons

Any neural network is said to be fully connected if

output from one neuron is connected with every neuron in succeeding
layer. Networks which pass their connections only in single direction i.e.
only to next layer is called as ‘feedforward’ network. Nelson and Illingworth
[1990] stated that ‘feedback’ network i s the one that passes its output to
the previous layer. They also defined that the networks which operate in
closed loops are called as ‘recurrent’ networks. They also stated that those
networks which passes inputs to other nodes in same layer as’ feedlateral
‘networks. Of all the networks a feedforward network works faster this is
because they only require a single pass to get a solution. They also stated
that recurrent networks are widely used in applications like energy
normalisation, automatic gain control and selecting maximum in complex
functions.

Although, many ANN books categorize networks into two categories

only feedforward and recurrent. Feedforward networks are most widely
used networks in ANN’s and fully connected feedforward networks are
often called as multi layer perceptron.

The number of hidden neurons:

These hidden neurons are required to compute and evaluate

complex tasks like
Non- separable functions. The total number of inputs and outputs are
defined by the request at hand. Nevertheless, there are no standard rules
in determining total number of neurons in hidden layers there are several
standards suggested by the researches:
a) Shih [1994] suggested that a network topology must have a pyramidal
shape; this is because with this kind of pyramidal shape we have more
number of neurons in the initial layers and less neurons in the bottom
layers. He also suggested that number of neurons in every layer must
be a number from the mid- way to the preceding and subsequent layers
to twice the number of previous layers.
b) Azoff [1994], recommended that the number of training data should be
at least 1o times the number of its weights. He also quoted a theorem
due to kolmogorov [Hecht 1990 and Lippmann 1987] which suggests
that a network with single hidden layer and 2N+1 hidden neurons can
have N input values.
c) Lawrence[1994, p.237] stated that for calculating the total number of
hidden neurons required in a network :
Number of hidden neurons= training facts * error
tolerance
d) Baum and Haussler [1988] recommended that the total number of
neurons in hidden layers can be calculated as follows

j= me/n+z;
Where, j= neurons in hidden layer
m= number of data points in the training sets
e= error tolerance
n= inputs
z=outputs

The final two standards are almost similar and might not be useful when
the error tolerance values are much smaller than the training facts. For
example if the total number of training facts are 1000 and the error
tolerance is 0.0001 which means that the number of hidden neurons
would be 0.001 which is meaningless in Lawrence’s suggestion, on the
other hand Baum and Haussler’s suggestions would result in much
smaller value for the hidden neurons. Most researchers still don’t
believe that the hidden neurons cannot be determined by input and
output values.

4.2.2 Number of hidden layers:

According to Neural Network FAQ[1996]

hidden layers doesn’t play any role in determining input and output
values and this is based on Mc Cullagh and Nelder’s[1989] paper. It is
found that both generalised and linear models has role to play in many
applications. They imply that even if the function is slightly nonlinear, a
simple linear model is enough to get better result than using non-linear
complicated model if there is not enough information or large noise
data to estimate the nonlinearities precisely.

MLP’s which make use of

step/threshold/Heaviside transfer functions require 2 hidden layers
designed for complete generality [ Sontag 1992], whilst an MLP which
makes use of any continuous nonlinear hidden layer transfer functions
need only single hidden layer with ‘randomly large number of hidden
neurons’ to attain ‘global approximation’ and this property is described
by Homik et al [1989] and Homik [1993].
 4.2.3 Perceptron
This perceptron model was developed by
Frank Rosenblatt in mid 1960’s. Carling [1992] stated that this model
was stimulated by the invention of Hubel and Wiesel [1962]. Rosenblatt
developed this perceptron model which defines that if a perceptron
learns a set of pattern then it is definite to calculate the weight set by
the perceptron.
This Rosenblatt perceptron model consists only
an input and output layer but no hidden layers. And these input and
output layers can contain more than one neuron. This model makes use
of threshold function as a transfer function even though it can use any
of the transfer functions. Hence if sum of the input values is more than
the threshold function then output neuron will presume the value as 1 if
not 0. Fu [1994] states that with respect to classification an object will
be classified by the neuron into class A if

∑w ij
xi > θ

Equation 4-2

where w
ij = weight of neuron from i to neuron j
x
i= neuron i input
θ = threshold on neuron j

If not the object will be classified as class B.

This is an iterative process until convergence is obtained. Convergence is the

procedure where the errors are minimised to a tolerable range.

Ripley [1993] believes that the error rate will be finite for a random pattern
with N perceptron inputs, given that the patterns are linearly separable. And
this is irrespective to the learning pattern algorithm.

Figure

A Simple Perceptron Model

Output, Oj=f(hj,θ j)

hj

j w2
w1j j
 x1 Inputs x2

4.2.4 Multilayer perceptron model

Multilayer perceptron model (MLP) is also called as multilayer

feedforward network which is an extension to the normal perceptron model
this MLP includes hidden layers (s) and hidden neurons with nonlinear transfer
functions. MLP with one hidden layer is known as universal approximator, this
is able to learn any function defined on an compact domain and is continuous
and also functions that comprise of definite collection points.
Machine Learning Techniques For Estimation Of Financial Risks Page 33
Mat lab:

Matlab is developed by Mathworks and is a fourth generation

language. Matlab provides a numerical computing environment. Matlab enables
users to create their own mathematical functions like scheming of data and
functions, creating user own interfaces, implementing the data etc. Matlab is
widely in use across the world and almost all the firms

Machine Learning Techniques For Estimation Of Financial Risks Page 34

 References:

http://www.theshortrun.com/finance/finance.html

http://www.clinicalgovernance.scot.nhs.uk/documents/risk_control.pdf

http://www.businessdictionary.com/definition/risk-identification.html

Machine Learning Techniques For Estimation Of Financial Risks Page 35