A ONE-STOP GUIDE FOR THE THEORIES, APPLICATIONS, AND STATISTICAL METHODOLOGIES OF MARKET RISK Understanding and investigating the impacts of market risk on the financial landscape is crucial in preventing crises. Written by a hedge fund specialist, the Handbook of Market Risk is the comprehensive guide to the subject of market risk. Featuring a format that is accessible and convenient, the handbook employs numerous examples to underscore the application of the material in a real-world setting. The book starts by introducing the various methods to measure market risk while continuing to emphasize stress testing, liquidity, and interest rate implications. Covering topics intrinsic to understanding and applying market risk, the handbook features: An introduction to financial markets The historical perspective from market events and diverse mathematics to the value-at-risk Return and volatility estimates Diversification, portfolio risk, and efficient frontier The Capital Asset Pricing Model and the Arbitrage Pricing Theory The use of a fundamental multi-factors model Financial derivatives instruments Fixed income and interest rate risk Liquidity risk Alternative investments Stress testing and back testing Banks and Basel II/III The Handbook of Market Risk is a must-have resource for financial engineers, quantitative analysts, regulators, risk managers in investments banks, and large-scale consultancy groups advising banks on internal systems. The handbook is also an excellent text for academics teaching postgraduate courses on financial methodology.
Foreword xv Acknowledgments xvii About the Author xix Introduction xxi 1 Introduction to Financial Markets 1 1.1 The Money Market 4 1.2 The Capital Market 5 1.3 The Futures and Options Market 19 1.4 The Foreign Exchange Market 22 1.5 The Commodity Market 22 Further Reading 26 2 The Efficient Markets Theory 27 2.1 Assumptions behind a Perfectly Competitive Market 28 2.2 The Efficient Market Hypothesis 30 2.3 Critics of Efficient Markets Theory 33 2.4 Development of Behavioral Finance 35 2.5 Beating the Market: Fundamental versus Technical 35 Further Reading 42 3 Return and Volatility Estimates 44 3.1 Standard Deviation 47 3.2 Standard Deviation with a Moving Observation Window 48 3.3 Exponentially Weighted Moving Average (EWMA) 50 3.4 Double (Holt) Exponential Smoothing Model (DES) 53 3.5 Principal Component Analysis (PCA) Models 53 3.6 The VIX 54 3.7 Geometric Brownian Motion Process 55 3.8 GARCH 56 3.9 Estimator Using the Highest and Lowest 56 Further Reading 58 4 Diversification, Portfolios of Risky Assets, and the Efficient Frontier 59 4.1 Variance and Covariance 61 4.2 Two-Asset Portfolio: Expected Return and Risk 61 4.3 Correlation Coeffi cient 63 4.4 The Effi cient Frontier 69 4.5 Correlation Regime Shifts and Correlation Estimates 80 4.6 Correlation Estimates 88 Further Reading 100 5 The Capital Asset Pricing Model and the Arbitrage Pricing Theory 101 5.1 Implications of the CAPM Assumptions 102 5.2 The Separation Theorem 105 5.3 Relationships Defi ned by the CAPM 107 5.4 Interpretation of Beta 110 5.5 Determining the Level of Diversification of a Portfolio 112 5.6 Investment Implications of the CAPM 112 5.7 Introduction to the Arbitrage Pricing Theory (APT) 115 Further Reading 119 6 Market Risk and Fundamental Multifactors Model 120 6.1 Why a Multifactors Model? 122 6.2 The Returns Model 124 6.3 Estimation Universe 134 6.4 Model Factors 135 6.5 The Risk Model 143 Further Reading 147 7 Market Risk: A Historical Perspective from Market Events and Diverse Mathematics to the Value-at-Risk 148 7.1 A Brief History of Market Events 149 7.2 Toward the Development of the Value-at-Risk 158 7.3 Definition of the Value-at-Risk 169 7.4 VaR Calculation Models 171 Further Reading 193 8 Financial Derivative Instruments 195 8.1 Introducing Financial Derivatives Instruments 195 8.2 Market Risk and Global Exposure 208 8.3 Options 218 Further Reading 233 9 Fixed Income and Interest Rate Risk 235 9.1 Bond Valuation 236 9.2 The Yield Curve 236 9.3 Risk of Holding a Bond 240 Further Reading 246 10 Liquidity Risk 247 10.1 Traditional Methods and Techniques to Measure Liquidity Risk 249 10.2 Liquidity at Risk 253 10.3 Other Liquidity Risk Metrics 263 10.4 Methods to Measure Liquidity Risk on the Liability Side 264 Further Reading 267 11 Alternatives Investment: Targeting Alpha, Idiosyncratic Risk 269 11.1 Passive Investing 269 11.2 Active Management 271 11.3 Main Alternative Strategies 272 11.4 Specifi c Hedge Fund Metrics 273 Further Reading 288 12 Stress Testing and Back Testing 289 12.1 Defi nition and Introduction to Stress Testing 290 12.2 Stress Test Approaches 294 12.3 Historical Stress Testing 300 12.4 Reverse Stress Test 303 12.5 Stress Testing Correlation and Volatility 303 12.6 Multivariate Stress Testing 304 12.7 What Is Back Testing? 306 12.8 Back Testing: A Rigorous Approach Is Required 310 Further Reading 314 13 Banks and Basel II/III 315 13.1 A Brief History of Banking Regulations 316 13.2 The 1988 Basel Accord 317 13.3 Basel II 325 13.4 Example of the Calculation of the Capital Ratio 364 13.5 Basel III and the New Definition of Capital; The Introduction of Liquidity Ratios 365 Further Reading 371 14 Conclusion 373 Index 378
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