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Abhijit Biswas

Director and Head of Product Development at Risk Infotech Solutions, one of Indias first company for Portfolio Risk Management Software Products. Founder Director of IIQF. With over twelve years worth of experience in research and development in the field of Financial Engineering, is one of the pioneers of Risk Modelling Technologies in India. He is also an expert in Monte-Carlo Simulation theories and systems and advanced simulation technologies applied to finance and general business risks. As a Quantitative Finance professional, created numerous breakthroughs in Risk Modelling Technology in India. Developed Indias first commercial grade large scale Monte Carlo Simulation system for business analytics using Excel spreadsheet models. Consultant to major global financial institutions in risk management domain. Conducts trainings on Risk Management, Statistics, Econometrics, Simulation and related disciplines at Stock Exchanges and Financial Institutions.

Outline

Introduction to Financial Risk Management

Financial Economics

Log Normal property of Returns, Skewness & Kurtosis: Implications for Risk Management Factor models and Arbitrage Pricing Theory (APT) Implementing an APT Based Risk Model in Excel Employing CAPM for performance evaluation of Portfolios/Funds

Outline

Measures of Risk

Fixed Income Duration, DV01/PV01/PVBP, Standard Deviation and VaR Equities Beta, Standard Deviation / Volatility and VaR

Systematic/Market/Non-Diversifiable Risk Non-Systematic/Residual/Diversifiable Risk

Risk Basics

Market : the risk that declining prices or volatility of prices in the financial markets will result in a loss. Credit : the possibility of default by a counter-party in a financial transaction, and the monetary exposure to credit risk is a function of the Probability of Default and the Loss Given Default. Operational : the risk from various Operational Failures, Frauds etc. Liquidity : the possibility of sustaining significant losses due to the inability to sufficiently liquidate a position at a fair price. Legal, Business, Catastrophe, etc.

Backdrop

Started in 1994 by John Meriwether Former Head of Bond Trading at Salomon Brothers. Included Nobel laureates Myron Scholes and Robert C. Merton (they got the prize in 1997). High net worth investors minimum ticket size of $10mn Started trading in early 1994 with equity base of about $1 billion. Awarded returns in excess of 40% to its investors in its initial years of operations.

Strategies : LTCMs main strategies were:

Fixed-Income Arbitrage Convergence Trades : Buying the cheaper off-the-run bonds and short selling the more expensive, but more liquid, on-the-run bond, it would be possible to make a profit as the difference in the value of the bonds narrowed. Merger Arbitrage Pairs Trading Statistical Arbitrage

Problem :

As differences in Convergence Trades were low so to make significant profit the fund took highly leveraged positions as high as 25:1 debt-to-equity. At the beginning of 1998, the firm had equity of $4.72bn and had borrowed over $124.5bn with assets of around $129 billion. As the capital base grew there were not enough good bondarbitrage opportunities, so they adopted aggressive strategies like merger arbitrage, statistical arbitrage (specially they were short S&P 500 vega),etc.

Problem :

East Asian financial crisis 1997 significant losses in May/June 1998. Losses aggravated by Salomon Brothers exiting arbitrage business in July 1998. Aug/Sept 1998 Russian Govt. defaulted on their bonds.

Problem :

Flight to quality panicked investors sold European and Japanese bonds to buy US treasury bonds resulting in increasing prices of on-the-run bonds and hence divergence instead of convergence Result huge losses to the tune of $1.85bn. Margin pressure and flight-to-safety leading to more liquidations at highly unfavorable prices and suffers further losses in pairs trades.

Lessons :

Model risk

Mathematical models used by LTCM assumed historical relationships would predict future in a reliable manner Correlation between low frequency high severity events understated. Therefore tail risk not captured.

Inadequacy of VaR to capture tail risks. LTCM management believed in risk management and tracked 1-month VaR seriously. However, they failed to look beyond that and did not look at scenario analysis and stress tests. Need of better risk metrics to capture tail risks. Also failed to consider liquidity risk into consideration

Financial Economics

Financial Economics

Stock returns are supposed to be log normal. Implications for risk estimation.

Financial Economics

Skewness and Kurtosis of return distributions Implications for Risk Management Black Swans : Assuming normality in the presence of skewness and/or kurtosis leads to under-estimation of risk.

CAPM deficiency

One of the limitations of CAPM is the determination of market portfolio as a stock market index. Its use is largely restricted to the equity markets and index taken as market portfolio does not contain any other asset classes CAPM also assumes complete knowledge of risk premium

It is a multiple factor model of excess returns It assumes that excess return of a portfolio can be expressed as an impact of k factors and is given by E(Rp) = Xp,k * mk + up where Xp,k = exposure/loading of stock p to factor k mk = factor return for factor k un = stocks return that cannot be explained by other factors APT says excess return of a stock/portfolio can be determined by its factor exposure and factor returns, although it does not specify a clear method to find it APT calls for regressing with certain identified factors

APT with k=1, factor loading as beta of the stock and factor exposure as market risk premium, reduces to CAPM model Alternatively, APT betas can be treated as components to the overall Beta used in CAPM CAPM requires knowledge of expected market returns. APT requires no such data. It simply uses risky assets expected return in relation to certain economic and company factors CAPM is generally suited for a more stable market, where beta remains relatively constant. APT is more suited for out-of-sample forecasting

APT Model

Any APT model that is capable of explaining the risk of a well-diversified portfolio is a qualified model Thus, if our APT model can explain the variations in returns of a broad index, say S&P 500, they qualify to be an effective APT model Once we have a qualified APT model, the next step is concerned with identifying the factor betas or factor loadings Once we have a model with factor exposures, we need to consider factor returns. This is generally done by a cross-sectional regression.

Choosing factors for APT models: Factors that are quantifiable Factors that are common to several stocks, but have differential effects on each of them or we can say that the companies have different exposures to each of the factors Factors whose effect persists over time Factors that have intuitive or theoretical significance

APT Model

In general, we should only consider factors for which a reasonable forecast can be made APT models can be structural or statistical models Under the structural model, we consider factors as specific variables which have an underlying relationship with stocks and thus carry a definite explanation. For example, a stocks industry group, earnings yield, size and so on With structural model, factor forecasts are easier and the relationship turns intuitive There are a host of statistical techniques available to estimate the relationship between a stock and various indices. However, explanation is not intuitive.

APT model is less restrictive compared to CAPM. It requires only three of its assumptions:

Investors are risk-averse and utility maximisers Investors can borrow and lend at risk-free rate There are no taxes or transaction costs

There is no arbitrage opportunity Investor agree on number and identity of factors that are necessary for pricing of assets

Multifactor Model

Specify a factor model Measure a-priori factor exposures for each return period Carry out cross-sectional regression for each period to get the factor returns Estimate the variance-covariance matrix of factor returns

Multifactor Model

Where V = Stock variance-covariance matrix E = Stock factor exposure matrix F = Factor variance-covariance matrix H = Portfolio holdings vector S = Portfolio Variance

Multifactor Model

Excel Workshop

Performance Analysis

It is the process of assessing the amount of risk being taken while investing in a particular asset or portfolio vis-a-vis the amount of return being generated by it. It further involves analyzing the returns generated and attributing it to various sources. The typical structure of a risk-adjusted performance measure is: risk-adjusted performance = Performance / Risk

The goal of performance analysis is to distinguish skilled and unskilled investment managers.

It helps us to know whether the manager is earning alpha returns above the risk adjusted benchmark returns. It helps us to know whether the returns are because of skill or luck.

Performance Analysis

Measuring Returns

Arithmetic Return R = (P1 P0) / P0 Logarithmic Return R = ln(P1 / P0)

Performance Analysis

Average Returns

Arithmetic Average Return

Performance Analysis

Excess Return = Portfolio Return Risk-free Rate Active Return = Portfolio Return Benchmark Return

Performance Analysis

Portfolio Returns SD Portfolio Excess Returns SD Portfolio Active Returns SD Beta

Performance Analysis

Benchmark Selection

Benchmarks for index funds Benchmarks for stylized funds Benchmarks for sector funds

Treynor Ratio

Measures the systematic risk-adjusted return performance of the portfolio. Risk is measured as the Beta of the Portfolio. Treynor Ratio = Mean Excess Return Beta

Treynor Ratio

A high positive value indicates that the manager has achieved superior beta-adjusted returns. It compares the returns with the systematic risk of the portfolio. It is more suitable for well diversified portfolios.

Sharpe Ratio

Measures the risk-adjusted return performance of the portfolio. Risk is measured as the total Standard Deviation of Realized Portfolio Excess Returns. Sharpe Ratio = Mean Excess Return SD of Excess Return

Sharpe Ratio

A value greater than 1 indicates that the manager has achieved good risk-adjusted returns. A value higher than the benchmarks SR indicates superior performance. It compares the returns with the total risk of the portfolio. It is more suitable for non diversified portfolios.

Sharpe Ratio

The statistical significance of the Sharpe Ratio is measured with the t-statistic. A t-stat of 2 or more is indicative of skill at 95% confidence level.

t = (SRp SRb) / Sqrt(2/N) Where : SRp = Sharpe Ratio of portfolio SRb = Sharpe Ratio of benchmark N = Number of time periods

Sortino Ratio

Measures the portfolio return performance against the realized downside risk i.e. the standard deviation of the negative returns. Sortino Ratio = Mean Excess Return SD of Negative Excess Returns

Sortino Ratio

It compares the portfolio return performance against the downside risk assumed by it. It is more appropriate for hedge fund performance analysis.

Information Ratio

Measures the return performance of the portfolio vis--vis its benchmark. Measures the Active Return generated per unit of Active Risk taken by the manager.

Information Ratio

IR is a measure of the value-added by the manager. The bigger the value of IR the higher is the value added and better is the performance. The statistical significance of the IR is measured by the t-test:

Jensens Alpha

It uses the CAPM predicted return to assess the performance of the portfolio. Rp Rf = E + F * (Rm Rf)

where Rp = Portfolio Return Rf = Risk-free Rate Rm = Market Return E = Jensens alpha F = CAPM Beta

Jensens Alpha

Statistically significant positive Alpha indicates that the manager has earned better risk adjusted returns. Statistically significant positive Alphas over a period of time would indicate that the manager has skills rather than being lucky. t = (E 0) / Standard Error of E

The portfolio return in excess of the benchmark return is broken into three components Allocation, Selection and Interaction. Rp Rb = A + S + I A S I = 7 [np [nb) Rbn = 7 [nb (Rpn Rbn) = 7 [np [nb) (Rpn Rbn)

Additive Attribution

Rp Rb A S I [np [nb Rpn Rbn = Portfolio return = Benchmark return = Allocation Effect = Selection Effect = Interaction Effect = Weight of sector n in portfolio = Weight of sector n in benchmark = Return of sector n in portfolio = Return of sector n in benchmark

Excel Workshop

Measures of Risk

Any measure of risk, say R, is called a Coherent Measure of risk, if it satisfies the following properties:

Monotonicity: If X <= Y for each outcome, then R(X) >= R(Y)

That is, if we have two portfolios X and Y such that portfolio Y always has better values than portfolio X under all scenarios then the risk of Y should be less than the risk of X

Positive Homogeneity : For b >= 0, R(bX) = b R(X)

Means that if a portfolio is multiplied by a constant b then the risk is also multiplied by b.

Translation Invariance For constant c, R(X + c) = R(X) c

The value c is just like adding cash to your portfolio X, the risk of X + c is less than the risk of X, and the difference is exactly the added cash c.

Sub-additivity : R(X + Y) <= R(X) + R(Y)

Means that the risk of a portfolio as a whole is less than or equal to the sum of the risks of two/more subsets of the portfolio. It may also be stated as: a merger does not create extra risk

Why is Sub-additivity so important? If an exchange's risk measure were to fail to satisfy this property, then, for example, an individual wishing to take the risk X + Y may open two accounts, one for the risk X and the other for the risk Y, incurring the smaller margin requirement of R(X) + R(Y), a matter of concern for the exchange. If a firm was forced to meet a requirement of extra capital which did not satisfy this property, the firm might be motivated to break up into two separately incorporated affiliates, a matter of concern for the regulator.

Why is Sub-additivity so important? Suppose that two desks in a firm compute in a decentralized way, the measures R(X) and R(Y) of the risks they have taken. If the risk measure R is sub-additive, the supervisor of the two desks can count on the fact that R(X) + R(Y) is a feasible guarantee relative to the global risk X + Y. If indeed he has an amount m of cash available for their joint business, he knows that imposing limits m1 and m2 with m = m1 + m2, allows him to decentralise his cash constraint into two cash constraints, one per desk. Similarly, the firm can allocate its capital among managers.

Equities

Beta Standard Deviation Value-at-Risk

Fixed Income

Duration Modified Duration Convexity, etc. Value-at-Risk Standard Deviation

Delta Gamma Vega Theta Rho Value-at-Risk

Other Metrics

Tail VaR / CVaR / Expected Shortfall/Mean Excess Loss LPM / Downside Semi-variance EaR, DEaR, etc.

Duration

It represents the average maturity period of a portfolio It measures the sensitivity of bond prices to a unit change in yield

The negative sign is used to denote the negative price yield relationship Duration however assumes a relationship between price and yield linear

Durations

Dollar Duration

It represents the absolute change in bond price w.r.t. an absolute change in yield It is however not used directly.

Dollar Duration

Dollar Duration

Modified Duration

It represents the relative change in bond price w.r.t. an absolute change in yield It is however, an approximate measure that does not allow for consideration of option in bonds and changes in CFs to yield curve changes

Modified Duration

Macaulays Duration

Macaulay duration

The simplest and the most direct form of duration understood conventionally The interpretation is that of average maturity of a bond. It is quoted in years. It is obtained as a weighted average of maturity of CFs of the bond Weight here represents the fraction of total PV of cash flow contributed by a particular bond

Macaulays Duration

Macaulays Duration

Effective Duration

Effective duration has the same interpretation as that of Modified duration However, it explicitly allows for considering various factors that might decide the value of a bond, as yield changes This is the standard interpretation and type of Duration D = (V- - V+)/(2*V0*change in yield)

Duration

Higher the duration greater the interest rate risk Duration increases as: (easy to understand from Modified duration point of view)

Coupon rate decreases YTM decreases Maturity/tenor increases Lower credit spreads / credit upgrade

Duration

Duration of a portfolio can be simply obtained as a weighted average of individual bonds in the portfolio Portfolio duration = w1D1+w2D2++wnDn Limitation of this approach is that it assumes a parallel shift in yield curve In actual fact, yields of various bonds in the portfolio could move differently, driven by maturity, credit profile, embedded options

The absolute change (dollar value change) in price of a bond given a 1 basis point change in yield. PV01 = Dmod * P * 0.0001

Relative change = DV01 / bond value DV01 calculation includes only duration and not convexity adjustment DV01 increases with declining yield, increasing maturity (same as duration) but increases with higher coupon rates (unlike duration, due to price impact)

Convexity

relationship

This works for small changes in yield For a large change in yield, this under or over states the actual price change Therefore, an adjustment factor is used to adjust the duration impact. This factor is called convexity

Convexity

It is the second order partial derivative w.r.t. the yield, while duration is the first order partial derivative Convexity has a positive value.

Dollar Convexity

Modified Convexity

Effective Convexity

Using duration to estimate the price change implies that the change in price is the same size regardless of whether the price increased or decreased. The price yield relationship shows that this is not true.

Estimating change in price using Duration Estimating change in price using Duration and Convexity Using the Taylor Series Expansion of a function

Duration impact = - (duration)* (change in y) Convexity impact = 0.5*(convexity)*(change in y)^2

Negative Convexity

Convexity is positive for a straight bond However, bonds with embedded options could exhibit negative convexity Negative convexity implies price not rising as much or decreasing as much with a fall or rise in yield as observed with straight bond This is primarily due to presence of embedded options in the bond

Negative Convexity

If a bond has an embedded call option, it would have a cap on price upside beyond a certain level of decline in yield Similarly, with a put option, the bond would have a floor on price movement beyond a certain level of rise in yield

Excel Workshop

Multifactor model of fixed income portfolio Historical Simulation (Next day) Monte Carlo Simulation (Next day)

Value-at-Risk

Definition

Value-at-Risk (VaR) is defined as the predicted maximum loss at a specific confidence level (e.g. 99%) over a certain period of time.

VaR

1 0.8 0.6 0.4 VaR1% 0.2

1%

Profit/Loss

-3 -2 -1 1 2 3

Meaning of VaR

A portfolio manager has a daily VaR equal $1M at 99% confidence level. This means that there is only one chance in 100 that a daily loss bigger than $1M occurs, under normal market conditions.

VaR 1%

89 Indian Institute of Quantitative Finance

VaR

VaR

VaR

VaR Advantages

It captures an important aspect of risk in a single number It is easy to understand Regulators base the capital they require banks to keep on VaR

VaR Limitations

It is generally not Sub-Additive. It is sub-additive only for assets with elliptical return distributions (e.g. Normal distribution) It is uninformative about extreme tail losses It is percentile based it only considers the probability of loss not magnitude of extreme losses doubling the largest loss may not impact the VaR at all!

VaR Methods

Delta-Normal Delta-Gamma Normal

Monte Carlo Simulation Historical Simulation Hybrid

Systematic / Market / Non-diversifiable risk : Risk of the portfolio attributable to the market fluctuations. Sqrt( B^2 * Wb^2) Where B = Portfolio Beta Wb = Benchmark risk

Non-systematic / Residual / Diversifiable Risk : Risk of the portfolio arising out of stock specific or industry specific fluctuations and is uncorrelated with the market fluctuations. Sqrt(Wp^2 - Wb^2) Where Wp = Portfolio risk Wb = Benchmark risk

Conditional VaR

CVaR

Also known as Tail VaR or Mean Excess Loss or Conditional Tail Expectation Coherent measure of risk hence superior measure of risk than VaR Probability weighted average loss if VaR is breached. Takes into account the probability as well as magnitude of extreme tail losses. Ignores losses below the VaR

Downside Semi-variance

Downside Semi-variance

The problem with variance or standard deviation as a measure of risk is that it penalizes profits as well as losses. DSV takes into account only the losses. It is the variance of only the losses during the specified period. Mostly used in context of hedge fund performance analysis.

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