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READING 31: RISK MANAGEMENT (31.1: RISK MANAGEMENT (Effective ERM…

- - - - based on normal distribution + concept 1-tail distribution
      - VaR calculation - Analytical method
        VAR = [ E(r) - (z) SD] Value of portfolio
        5% VaR = 1.65 SD below the mean
        1% VaR = 2.33 SD below the mean
        [https://bit.ly/2TIHAFK]
      - Advantages
        
        Easy to calculate
        
        Allow modeling the correlation of risks
        
        Applicable to shorter / longer time period as relevant
      - Disadvanatges
        
        Assume returns are normally distributed
        but in fact, securities sometimes have skewed returns and / or exhibit many extreme returns ( fat-tail).
      - To deal with skewed return: use delta normal method or gamma hedging.
        
        In options trading, delta refers to a change in the price of an option contract (i.e. premium) per change in the price of the underlying asset. Gamma refers to the rate of change of delta
        
        Delta hedging aims to reduce the risk associated with price movements in the underlying asset by offsetting long and short positions. (i,e, a long call position with delta of 0.6 may be delta-hedged by shorting (1 contract x 100 shares x0.6= 60 the underlying stocks)
        
        Gamma hedging attempts to reduce, or eliminate, the risk created by changes in an option's delta, with respect to the change in price of the underlying asset (i.e. gamma=0.2 for 1$ change in underlying price => delta will +/- 0.2 => buy/ sell 20 stocks more to gamma hedge the position)
        
        Read more: https://www.investopedia.com/terms/d/deltagamma-hedging.asp
      - :question:WHY T-score vs. z-score
        https://bit.ly/38GwGGk
    - - HOW
        
        rank the returns from highest to lowest, identify the lowest 5% return
        
        The highest in the group of 5% lowest is the 1-day 5% VaR (for exp)
        
        1.accumulate a number of past daily returns
      - Advantages
        
        Easy to calculate
        
        Not assume returns of normal distribution
        
        Applicable to different time period per industry norm
      - Disadvantage
        
        past returns does not guarantee future performance
        
        Become troublesome with more tradings :-1:
        
        Securities characteristics might change with passage of time. :warning:
    - - HOW
        
        The user might specify normal distributions for some assets, skewed for others, leptokurtic for others, and complex shifting correlations over time.
        
        uses computer software to generate hundreds or
        thousands of possible outcomes from the distributions of inputs specified by the user. :computer:
      - Advantage:
        
        It can incorporate any assumptions regarding return patterns,
        correlations, and other factors the analyst believes are relevant. For some portfolios it may be the only reasonable approach to use.
      - Disadvantage
        
        the output is only as good as the input assumptions.
        
        lead to a false sense of overconfidence in the output among the less informed
  - - - continually Back-test
      - Incremental VaR (IVAR)
        
        it is the effect of an individual item on the overall risk of the portfolio. IVAR is calculated by measuring the different between the porf. Var before and after the addition of the asset / asset class.
      - Cashflow at risk (CFAR)
        
        measures the risk of the company's cash
        flows, when some companies cannot be valued directly.
      - Earnings at risk (EAR)
        
        analogous to CFAR, only from an accounting
        earnings standpoint
      - Tail value at risk (TVAR)
        
        It is VaR plus the average of the
        outcomes in the tail.
      - stress testing
        
        may reveal outcomes not reflected in the typical VaR calculation as it is just an extreme scenario
      - Scenario analysis
        
        only as good as the accuracy of the assumptions
        
        Sequence of events can result in different outcomes.
        
        Stylized scenario
        
        The analyst changes to risk factors & analyze the effect
        
        Follow industry norm (for exp. "Framework for Voluntary Oversight"
        
        (https://bit.ly/3cQdHfN)
        
        Actual extreme event : back test with the past major events
        
        Hypothetical events: test with extreme events that might occur , not previously occurred.
      - Stressing models
        
        Factor push modes: push factors to the most disadvantageous combinations of possible circumstances and measures the impact on porfolio
        
        Max loss optimization : use computer modelling to find the worst combination of factors
        
        Worst case scenario: the worst case the analyst thinks is likely to occur.
- - - - the market value is determined by
        
        The remaining cashflows to be exchanged ( and at risk_
        
        the degree to which market conditions have changed to create gain / loss in value.
- - - - Return on VAR
        => to compare manager performance
    - - Position limits
      - Liquidity limits ( x % of typical trading volumes)
      - Performance stop out ( absolute dollar limit for losses)
      - Risks factor limits
      - Scenario analysis limits
      - Leverage limits
  - - - holder will receive a payment when the rate on an asset exceeds a reference yield by more than a specified spread.
        
        i.e the spread of bond yield vs. LIBOR is set at x % When (bond yield vs. LIBOR)> x%
        => bond value declines => holder receives payment , compensates for the decline in bond value.
    - - total return swap
        
        Asset value up: owner pays $ to dealer
        
        Asset value down: owner receive $ from dealer
  - - - Principal drawbacks
        The excess returns are assume to be normally distributed
    - - RAROC= Expected return / Var
        Expected return => means already risk- adjusted
    - - A drawdown refers to how much an investment or trading account is down from the peak before it recovers back to the peak.
    - - Sortino ratio = [ R(p) - minimum acceptable return (MAR) ] / downside deviation
  - - - Nominal, notional, or monetary position limits
      - Max loss limit
      - Internal and regulatory capital requirements
      - Behavioral conflicts