1.

THE NEED FOR RISK MANAGEMENT

1) Business risk
1 daily operations
2 Includes strategic risk, macroecon risk
2) Financial risk
1 Interest rate movements
2 Greater awareness of Fin Risk Mgmt brought about by
o 1971 fixed exchange rate system broke down; shift to floating rate
(exchange rate risk)
o deregulation(inc. interest rate sensitivity)
o globalization(currency risk)
3) Financial institutions
1 Create markets and instruments to share and hedge risks
2 Provide risk advisory services
3 Act as a counterparty, assumes others’ risks
4) Derivative: derives value from underlying security, has a finite definite life, defined reference
rate, defined for a specific notional amount
5) Securities are non-zero-sum games and issued to raise capital (ie stocks and bonds) but
derivatives are zero sum and not raised to raise capital.
6) Leverage allows derivatives to be useful for hedging and speculation (low tranxn costs &
limited initial cash outlay) but also harder to assess downside risk (greater return variance)
7) Financial risk management
1 Detecting, Assessing & Managing financial risks
2 4 types:
o Mkt risk: declining /volatile prices lead to loss
 Absolute( volatility of total returns) vs relative (relative to a
benchmark index or portfolio; measured by tracking error)
 Directional (linear risk exposures)/non-directional
(nonlinear/neutral exposures to changes in economic or fin vars)
 Basis risk: imperfect correlation between price of hedger & hedged
asset
 Volatility risk: risk of loss from changes in actual or implied volatility
of market prices
o Liquidity: cannot liquidate at fair price leading to loss
 Asset-liquidity risk: large position size forcing transxns to influence
price of securities.
 Funding liquidity risk: inability to raise cash needed to rollover
debt/fulfill margin or collateral reqs of counterparties/meet capital
withdrawals
o Credit risk: counterparty default; monetary exposure value is f(n) of
P(default) and( Loss|default)
 Exposure: value of loss that would be realized if credit event
occurred
 o Credit event:change in counterparty’s ability to perform
previously agreed financial obligations
 Recovery rate: % of assets that could be recovered from a
counterparty after a credit event occurs
 Sovereign risk: result from country’s actions; country-specific
 Settlement risk: failure of counterparty to deliver obligation AFTER
party has made its delivery
 Presettlement risk is lower than settlement risk
o Operational risk: inadequate monitoring, management failure, defective
controls, fraud, human error. Particularly relevant to derivative trading.
 Operational failure may increase market and credit risks
 Model risk
 People risk
 Legal risk: risk of loss in value due to legal issues including lawsuits,
fines, penalties and/or damages
8) risk mgmt tools:

Can be aggregated Easy to calc and

across assets? explain?
Stop loss limit: Y Y Ex-post
Eliminate position after cumulative
loss threshold exceeded
Notional limit: limits position N Y
Exposure limits: to risk factors No N
VaR: max loss over a defined Comparable across Not always Ex-ante
period of time at a stated level of different biz units
confidence, given normal mkt with diff asset
conditions characteristics
9) Valuation: discounting expected future value of an asset to determine current price
10) Risk Mgmt with VaR looks at future value of an asset, not the PV, focuses on lower tail, and
uses the dist of returns often assumed equiv to the historical dist.

2. Investors and Risk Mgmt

- Standardized return =(mean ret-target ret)/std(ret)

- Val of a firm’s equity is PV(Expected FCFs) where discount rate=Expected rate of ret from
CAPM, which depends on systematic risk, or beta of the firm’s cash flows to equity holders.
- Reqd rate of return by shareholders depends only on systematic risk (security risk that arises
due to positive cov of security returns with overall mkt returns) of firm’s equity, not on
diversifiable risk (risk uncorrelated with volatility of mkt portfolio)
o So firm spending to reduce diversifiable risk only reduces future cash flows with no
reduction in discount rate and instead decreases firm value
- In eqm, Financial transactions to reduce a firm’s systematic risk (eg. Shorting market
portfolio/changing portfolio allocation proportion) will not increase firm value.
- To increase firm value, must decreases beta and reqd RoR more than decrease in expected
cash flow (ie cost of strategy)
 - Change in operating strategies eg Reducing fixed costs, can reduce earning volatility and
systematic risk, and increase firm value if it is sufficiently low-cost.
- Security Mkt Line: Expected return on any security or portfolio is determined by its
systematic risk as measured by beta
o Beta=Cov(R_i, R_m)/Var(m)
- Capital Mkt Line: line representing all possible portfolio risk/return combis along line form
the risk free rate through the tangency portfolio.
- Efficient portfolio: has least risk for every level of expected returns.
- HEDGING IRRELEVANCE PROPOSITION: hedging price risk wrt a firm’s output cannot increase
the value of the firm in eqm in the absence of arbitrage opportunities in financial mkts.
o reducing risks tt differ from what is predicted by CAPM will not increase firm value
since investors will still require the same return for bearing such risks
o Absence of arbitrage opportunities( efficient mkts in equilibrium)  value of firm
CANNOT be increased by hedging SYSTEMATIC risk.
o Eg if oil (product of firm) price risk has a positive beta; hedging oil price risk will
decrease the firm’s beta but also decrease expected cash flows. Short forward
position in oil would have a –ve beta. Hedge of mkt risk from a negative beta asset
has a positive value. Entering into a short forward contract for oil must have a
negative expected payoff, so forward price of oil must be lower than expected
future price of oil. Else if dec in E(cash flow)/share from selling oil forward does not
just offset decrease in beta, opportunity for riskless arbitrage exists.

MCQ: In eqm, if the forward contract price of a firm’s output is greater than expected future price:

o A) a short position in the forward contract would produce an arbitrage profit

o B) a long position in the forward would produce arbitrage profit
o C) firm value will be increased by hedging the firm’s output price
o D) a long position in the forward contract has a negative beta.

Ans (D) Since a long forward position has a negative expected return (promises to buy the asset at
F>E(price) ) we conclude that a holder of that position reduces systematic risk in absence of
arbitrage opportunities.

3. Creating value with risk management

 In frictionless mkts, risk mgmt does not add to shareholder value; but it can in mkt with tax,
transxn costs, and agency cost
 Goal of risk mgmt is NOT to minimize risk, but to increase firm value.
o Unlike beta risk and output-price risk, risk of bankruptcy and financial distress (eg.
Costs from debt renegotiation, forgone value creating projects, stricter supplier
terms, lost sales, management time wasted etc) cannot be hedged.
 losses in one period can be used to recover taxes paid in prior periods (tax loss carrybacks)
or to reduce tax liabilities in future periods (tax loss carryforwards)  these make NO
adjustmt to the time val of money.
 Risk mgmt strategies that smooth taxable income reduce total tax and increase firm value.
  In WACC calculation, the contribution of debt is after-tax, hence the tax benefits of adding
debt to a firm’s capital structure.
 For optimal capital structure, add debt to increase firm value by tax savings up to the point
where increase in potential costs of financial distress outweigh savings.
 Risk-reduction strategies can decrease potential costs of financial distress and thereby
increase optimal debt-equity ratio, lowering funding costs (WACC).
 Risk reduction benefiting a large shareholder may increase firm value: Investors are more
willing to hold large positions in firm stock when diversifiable risk is lower.
o Monitoring by large shareholders can decrease agency costs
o Large shareholders may have industry-specific expertise and advice for managers
 Risk management can increase value through
o tax saving
o reduction of potential financial distress costs
o reduction of debt overhang probability.
o Reducing problem of info asymmetry
 Management incentives (improved incentives increases firm value)
o Improved by risk mgmt that decreases nonmanagement-related risk factors in
incentive compensation contracts
o Incentive stock options value increase with increased volatility so cause less desire
to manage risk.
 Other stakeholders can have better incentives to invest in firm-specific capital when firm can
hedge the risks inherent in such investment at lower cost than the stakeholders.
 Firms have decreased value due to debt overhang when amt of debt prevents equity holders
from investing in positive NPV projects cos benefit to debt holders (must be paid first)
reduces the value created for equity holders.
 Information asymmetry leads to higher capital costs (greater WACC)
o Investors must rely on mgmt estimates of quality of growth opportunities for which
funding is sought
o Unclear to investors extent to which firm performance is result of poor management
decisions or nonmanagement factors
o Hedging risks outside management control increases confidence of outside investors
that firm results reflect mgmt quality, reducing funding costs.


4. The CAPM and application to performance measurement

 Capital Mkt Line shows linear relationship btw E(R) of a portfolio and its std dev when that
portfolio consists of a combination of mkt portfolio and risk-free asset.
 The mkt portfolio is one of a continuum of portfolios along the efficient frontier tt is
composed only of risky assets
 Efficient frontier is a convex curve drawing locus of all portfolios tt have the min std dev of
return given an expected return.
o If risk-free asset exists, CML is new efficient frontier.
 CAPM assumes
 o Investors are rational, risk-averse, end-of-period expected utility maximizers and all
have the same investment horizon
o Investors only consider mean and std dev of asset returns (ie quadratic utility
function; or normally-distributed returns)
o Investors can borrow/lend unlimited amts at same risk-free rate
o Investors have same expectations concerning returns. Information same.
o No taxes nor transaction costs and assets are infinitely divisible. (PERFECT mkts)
markets are (strong-form) efficient.
o CAPM claims that in eqm all investors hold a portfolio of risky assets that has the
same weights as mkt portfolio.
Co v M , i
o SML: E ( Ri ) =Rf + [ E ( R m )−R f ]
[ σM
2
]
o Market behavior is determined by beta (‘qty of risk’) and mkt risk premium ie
E(R_m)-R_f (‘price of risk’)

 Treynor measure=
[ E ( R p )−R F ] is appropriate for comparing well-diversified portfolios
βp
 Jensen' salpha=E ( R p )− RF + β P ( E ( R M )−R F ) is for comparing portfolios with same
[ ]
beta.
 Treynor is more forward-looking than Sharpe; sharpe is considered better for measuring
historical performance
 Portfolio that has higher Treynor but lower Sharpe measure than market is likely not well
diversified.
 Sharpe can apply to all portfolios since it uses total risk.
σp
 For well diversified portfolio, β P ≈
σM
 Information ratio assesses if manager’s deviation from benchmark reaps an appropriate
E ( R p )−E ( R B )
return.e p=R P−R B ; σ e =tracking error ; info ratio=
p
[ σep
] =α P /σ e p

E ( R p )−R min❑ 1
 Sortino Ratio = , MS D min❑= ¿
√ MS Dmin❑ N

5. Expected Returns and the APT

 Limitations of CAPM
o Mkt portfolio shd be portfolio with highest sharpe ratio of all, and must include all
investible assets. This assumption may hold for a globally constructed portfolio but
cannot hold when restricted to a single equity market.
o Expected excess returns for mkt are assumed to be known, based on assumptions
that (1) investors have access to same info and have homog expectations (2)
distribution probability beliefs of investors match true returns distr.
  APT: multifactor regression model; “mkt” portfolio will have lowest risk of all possible
portfolios given identical factor exposures
 A qualified model utilizes a mkt portfolio that is fully diversified so tt the model explains a
majority of the variation in excess returns
 Finding a qualified model is easy part of implementing APT< but Factor Forecasting is hard.
 Fundamental law of active mgmt: investor’s info ratio is a f(n) of dept of knowledge about
individual securities (information coefficient) and the no. of investment decisions (investor’s
breadth)
 If an analyst could independently forecast 1000 stocks or 10 factors, he would need to be
10x as good at forecasting factors to produce the same Info Ratio.
 Backcasting- using historical average factor returns as a forecast
 Structural Model---assume an underlying factor-return relationship possible to forecast
factors using statistical methods of forecasting and verify that these forecasts are
reasonable. Not possible to do so in statistical model.
o Structural Model –3 types: Factor exposures known and factor returns forecasted,
factor returns known and exposures forecasted, both forecasted
o Statistical Model – PCA/MLE factor analysis/ Asymptotic Principal Components.
(asmpy. PC Reduces size of covariance matrix (TxT) )
o Practitioners mainly use structural models. Academics are primary users of stat
models cos they don’t want to introduce bias.

7.

 Risk management includes (and will fail in the lack of)

o Assessing risks faced by firm
o Communicating risks to risk-taking decision makers
o Monitor and manage risk in order to max. firm value. (main objective is NOT to
prevent losses, but to ensure the firm only takes the necc amt of risk for the max
return)
 Large loss does not mean risk mgmt has failed. Losses are result of risk-taking, which is
required for value creation.
 Returns correlation increase during times of stress (eg credit risk corr with mkt risk)
 Unknown risks are not a severe problem when they are
o Ultra-extreme eg asteroid crashing earth
o Their consequences are known (though their nature is not known)

 Monitoring and managing risk may
o Change the nature of risk (Heisenberg)
o Stifle trading department’s innovation
 Firms may fail to monitor and manage risk on an ongoing basis by not having an adequate
incentive structure and/or culture that promotes effective risk mgmt.
 Risk metrics provide managers a target to achieve, but may be too narrow in scope.
 One misuse of VaR is choosing a time period(eg daily/weekly) that does not correspond to
the liquidity of the assets in the portfolio. Financial institutions generally focus on firm-wide
 risk mgmt on one-year horizon. But need to look ahead multiple periods to factor in
potential crisis.
 VaR also assumes losses are uncorrelated over time.
 Risk metrics generally fail to capture effect of firm’s actions on the overall market, and
behavior patterns such as Predatory trading (other firms in a mkt see tt a large player is in
trouble, and attempt to push price down further to hurt the large player.)

Time Value of Money

 Interest rate=opportunity cost of current consumption=req rate of return for an investment

(equilibrium interest rate)
 Real risk-free rate: theoretical rate on a single period loan with no expectation of inflation in it.
 Real rate of return: investor’s increase in purchasing power after adjusting for inflation
 Rates observed on Tbills are risk-free but not Real. Tbill rates are nominal risk-free rates;
nominal riskfree rate =real riskfree rate+ expected inflation rate
 Securities have some types of risk:
o Default risk: risk tt borrower will not make promised payments in timely manner
o Liquidity risk: risk of receiving less than fair value for an investment if it must be sold for
cash quickly.
o Maturity risk: longer-term bonds have greater price volatility than ST bonds.
 Required interest rate on a security=nominal R_f + default risk premium + liquidity
premium+maturity risk premium

Topic 9: Nature and Scope of Econometrics

 Methodology
1. Formulate hypothesis
2. Collect data
3. Specify model/math representation of theory
4. Specify econometric model (Not “deterministic” , there is an error term)
5. Estimate params
6. Test model specification (i.e. choice of input vars)
7. Test hypothesis
8. Use model for forecasting
 Pooled data set contains a set of cross-sxnal observations over several time periods.
 Panel data: type of pooled data where researcher looks at a unit of observations such as a fmily
and records changes for each member of the family over time.
 Dummy vars=categorical variables

Topic 10: Stats Review I

 2 defining pptys of probability

o P(E_i) \in [0,1]
o If set of E_i are mutually exclusive and exhaustive, Sum(P(E_i))=1
  Constructing a freq distr
1. Define the intervals (must be mutually exclusive)
2. Tally ; then count observations
 Empirical definition of probability=relative frequency definition of probability (no of
occurrences of event/total no. of observations)
P ( O|I )
 Bayes formula: P ( I |O ) = ∗P ( I )
P (O)
 Probability distribtns: prob. fn/prob.mass fn is for discrete; prob. density fn for continuous
 For CRVs, a multivariate normal distribution may be used to desc them if all the
indiv.variables follow normal distrbutn

Topic 11> Characteristics of Prob. Distributns

 Chebyshev’s inequality: for any set of sample/population data, regardless of shape of distrbutn,
percentage of observations that lie within k std devs of the mean is > (1-1/k^2) for all k>1
σ x std dev ofX
 Relative dispersion: measured with coefficient of variation= = In an investment
X́ av . val of X
setting.CV is used to measure risk perunit of expected return
 A distr that has a greater % of small deviations from the mean and a greater % of extremely large
deviations from the mean will be leptokurtic (+ve kurtosis)
3
( X i− X́ )
∗1
 Skewness: n
s3
Sk =∑ ; s is sample standard deviation
i=1 n

Positive (right) skew Mean>Median>modeNegative(left) skew Mean<Median<mode

4
( X i− X́ )
∗1
 n
s4
Kurtosis=∑ ; s is sample standard deviation
i=1 n
 Excess kurtosis=Kurtosis-3; positive excess kurt=leptokurtic (fat tails and more peaked) ; negative
(platykurtic) (thin tails, less peaked); Excess kurtosis>1 is large

Topic 12 Some Impt Prob Distri

 Sampling error is the difference between a sample statistic and its corresponding popn
param.
 Std error of the sample mean is the stdev of the distribution of the sample means and is
calculated as
σ s
σ X́ = ; σ ,the popn stdev is known;∨s X́ = ; s is sample stdev∧the popn stdev is unknown
√n √n
 t-dist (shorter and fatter tails than normal; as n ∞, gets taller with thinner tails and
approaches normal) ; defined by a single parameter, the degrees of freedom = n-1
 t dist is appropriate for constructing confidence intervals based on
1. small samples from popns with unknown variance and approximately normal distrib.
2. Unknown popn variance, large enuf n tt CLT assures sampling distrib approx normal
 (similar categorization for hypothesis testing; But if n is very large, z-stat can
also be used even if popn variance is unknown)
 Z 0.05=1.645 ; z 0.025=1.96 ; z 0.005=2.575 ; P ( within one std dev ¿mean )=0.68
( n−1 ) s2
 χ 2n−1= 2
where s2 is sample var ; σ 20 ishypothesized value for popn varianc e is
σ0
asymmetrical and approaches normal as dof increases; used for hypothesis tests concerning
variance of a normally distributed popn.

σ 21
F(n −1 ,n −1)= 2 ; by convention σ 21> σ 22 ; generally ∈testing σ 2 is represented by estimate s 2 ; n1∧n2 are respecti
1 2
σ2
tests equality of variances of 2 popns.
 F dist is right-skewed and truncated at zero on the left side. Shape determined by 2 separate
dofs. Rejection region is the right-side tail of distribution (becos of F stat computation
convention) .
 F approaches normal as n increases
 Square of t-stat with (n-1) dfs is F-distributed with (n-1) numerator and denominator df (?? I
think it is F_(n-1,1)

Topic 13: Stat Inference: Estimation and Hypothesis Testing

 Statistical inference has 2 areas: estimation and hypothesis testing
 Point estimates are single values used to est. popn params
 Formula used to compute the point estimate is an estimator.
 Conf. Intervals = point estimate ±(reliability factor x std error)
 Desirable Pptys of point estimates: Unbiasedness (E(estimator)=true value), efficiency,
consistency (accuracy of parameter estimate increases as sample size increases)
 Also, linearity.
 If we are sampling from nonnormal distribution, cannot create confidence interval if n small
(<30)
 A hypothesis is a statement about the value of a population param, developed to test a
theory or belief.
 Procedure: state hypothesis; select appropriate test stat; specify lvl of sig, state decision rule
(ie rejection rule) regarding hypothesis, collect sample and calc sample stats, make decision
regarding hypothesis (either Reject or Fail to Reject; we don’t consider ”Accept” a correct
term), make decision based on test results
 The null hypothesis is what the researcher wants to reject, always uses = sign. (or ≤,≥)
o Eg. Suspect that group 1’s earnings are more divergent than group 2’s earnings; then
H 0 :σ 21 ≤σ 22 ; H 1 : σ 21 >σ 22
 Type I error: reject null when true; significance level is probability of Type I error.
  Type II error: fail to reject null when it is false; depends on sample size and choise of
significance level (ie P(Type I))
 Power: probability of correctly rejecting null hypothesis when false. i.e. 1-P(type II error)
 For a given sample size, we can increase the power fo a test only with the cost that
P(rejecting a true null) ie type I error, increases.
 For a given sig lvl we can increase power of test only by increasing sample size.
 P-value is the probability of obtaining a critical value that would lead to a rejection of the
null hypothesis, assuming the null hypothesis is true. It is the smallest lvl of significance for
which the null hypothesis can be rejected.
σ
 use z=(x́−μ0 )/( ) in stat analysis when population variance is known, and
√n
s
t=( x́−μ0) /( )when unknown
√n
 T-stat gives larger Conf Ints than Z-stats.

Example Problem:

A random sample of analyst earnings estimates has a mean of 2.84 and a std dev of 0.40. What can
we say about the 90% CI for earnings next period if (1) sample size, n =20? (2) n=40?

What probabilistic statement could we make at the 9)% Conf Lvl if (3) n=15, (4) n=60?

(1)& (2) : no statement cos we have NO DIRECT INFO about distribution of POSSIBLE EARNINGS of
the next period, only have estimates’ data.

(3) Cannot assume normal distribution, so no inferences.

(4)t-stat for a 90% CI with 59 dofs is approximately 1.671 (t_60). 90% CI is 2.84+-
1.671(0.4/sqrt(60)) . and we are 90% confident that the true mean of the population of ANALYST
ESTIMATES is within this range.

Topic 14 Discrete Probability Distri

 Poisson P ( X=x )=( λ ¿ ¿ x e− λ )/x ! ¿ E(X)=Var(X) =\lambda ; X : no. of successes/unit

 Bin(n,p) Po(np) when p v small and n large; Po normal as n  infinity
 Bin. Distribution uses combination formula I computing probabilities

Topic 15 Continuous Probability Distributions

 Normal distribution has location parameter μ and scale parameter σ

 Other pptys of Normal curve:
o location-scale invariance: RVs derived from other normal distri RVs will also be
normal
o summation stability: summing means from normal RVs will produce a normally distri
value. Also, the sum of the variances from these independent normal RVs will
produce a normally distributed variance.
o domain of attraction: this ppty results in CLT which states that a large sample size
will prloduce a distribution that closely resembles a normal distr.
 Lognormal: X follows a distr st log X is normal
o Useful for modelling asset prices cos bounded below by 0.
o A price relative =S_1/S_0 and is min. zero
 Exponential distribution, used to model waiting times
o
1 1 1
f ( x )= λ e−λx , x ≥ 0 , E ( X )= ; Var ( X ) = 2 , scale param β= ; rate par ameter λknown as hazard rate
λ λ λ
o Poisson distri will give no. of defaults up to a certain time period. Exponential assess
time taken for default.
 Weibull distribution (generalized exponential distribution)
o models severity of operational loss event
α
x
o α x α −1 −( β )
f ( x )= ∗e , x ≥ 0; α ( shape param ) >0 , β (scale)>0
βα
o Alpha of about 3.5 will produce a distribution that resembles normal
o Hazard rate largely determined by alpha; alpha >1  hazard rate increases over
time; alpha <1  hazard rate decrease over time
 Gamma distribution: often used to model waiting times (generalized exponential and chi-
squard distributions)
 Beta distribution models default probabilities and recovery rates
o Used in CreditMetrics credit risk model
o Mass located between zero and one
o Distribution can be symmetric or skewed depending on values of shape params
alpha and beta
 Logistic distribution is similar to normal but with higher kurtosis (heavier tails) ; cumulative
logistic function fits logit models
 Extreme Value Theory (impt role in modelling operational risk losses)
o Block Maxima
 Starts with a large, high density (eg daily), iid data set.
 Observations subdivided into equal-sized mutually exclusive and exhaustive
blocks
 Local maxim (or minima) of each block identified
 Local maxima normalized, and, after appealing to CLT, follow a generalized
extreme value (GEV) distribution.
 This distributn introduces a tail index (shape parameter ξ) which captures
the fatness of the tails and how fast the tails approach zero asymptotically.
 The generalized nature of this process allows for modelling of all sources of
risk.
 For a given ξ, 3 distribution functions can result from this GEV distribution
a. Gumbel distribution ξ=0
b. Weibull ξ<0
c. Frechet ξ>0

o Peaks-over-threshold (POT)
 More modern EVT model than block maxima
  Utilizes a distribution of extreme realizations above a high (or below a low)
threshold
 Distribution of these extreme values follows the generalized Pareto
distribution (GPD)
 To calculate GPD, one must establish a threshold u and calculate the
conditional probability of loss above u.
 Shape parameter ξ indicates fatness of tail, along with beta, a scaling
parameter
 Values of ξ>0 indicates fat tail and is assumed for GPD:
−1
ξx
 (
F ( x )=1− 1+
β ) ξ

 GPD exhibits a curve that dips below the normal distribution prior to the tail.
It then moves above the normal distribution until it reaches the extreme tail.
The GPD then provides a linear approximation of the tail, which more closely
matches empirical data than normal distrib.
 With knowledge of distributional pptys of the tail, VaR can be computed at
high CIs regardless of distribution describing the data.

Topic 16 Simple Linear Regression

 If sample of X and Y variables is a random sample, difference between the sample coefficients
and the population coefficients of regression will be random too.
 Linear regression model is linear in both variables and parameters
 b 1=¿

Topic 17: 2-variable model, hypothesis testing

 MLR assumptions:

 Homoskedasticity: Var(\epsilon_i|X_i) = \sigma^2 =constant across all X_i

 Conditional heteroscedasticity: varaicne is function of indep variables.
 Standard error of estimate is square root of σ^ 2=¿

 Standard error of a regression coefficient indicates the accuracy of the estimated OLS coeff wrt
population param
 Gauss-Markov theorem:
 o If linear reg assumptions are true, then OLS estimators have following pptys
 OLS estimated coeffcieints have min var compared to other estimation methods
 OLS coefficients are based on linear functions
 OLS estimated coeffs are unbiased.
 OLS estimate of variance of errors is unbiased.
o Gauss-Markov+CLT allow us to test estimated coeff as normal RVs (z-test for known
popn var or t-test if unknown variance)
ESS ( explained ∑ of squares )
 Coeff of determination = R2= =¿ ESS also called SSR (sum of
TSS
squares regression); RSS(residual sum of squares) also known as SSE(sum of squared errors) ie
TSS (or SST) = ESS+RSS = SSR+SSE
 R^2 implies a causation or explanatory power while Corr coefficient does not.
 In simple regression, sqrt(R^2) = corr(X,Y)
 Testing normality
o Normal probability plot computes expected values of variable assuming normal distri
and plots expected values over observed values. Plot will be a straight line if residuals
are normal.
n ( K −3 )2
o Jarque bera test: reject normal if statistic is too large. JB= ∗[S 2+ ]
6 4
o JB is chi-square with 2 dofs if n is large.(JBstat can only use for large n)
 Forecast standard error se ( Y^ X )=σ √ ¿ ¿
i

 Lin regression does NOT assume tt Y is uncorrelated with the residuals.

Topic 18 Multiple Regression

 Multicollinearity causes greater probability that we will incorrectly conclude that a variable is
not statistically significant (ie Type II error)
 Sample population variance , σ^2=¿
 Coefficient of multiple correlation=sqrt(R^2)
 F=(ESS/df)/(RSS/df) ; the first df=k,denominator df=n-k-1, where k is no. of indep vars
 Adjusted R^2 = 1-(1-R^2) x (n-1)/(n-k-1); is always smaller than R^2
 Adjusted R^2 can be negative; and adding a new indep variable may either increase or decrease
adjusted R2 though it Always increases R2

Intro to VaR

 1933 Glass Steagall Act

 1990s JP Morgan developed RiskMetrics, publically available, which advanced the appeal of VaR
as a risk measurement method.
 Generally, time period selected for VaR is one day
 Var(5%)_J days=Var(5%)_1 day * sqrt(J); Var(5%) = E(R)-1.65*stdev(R)

VaR methods
Linear methods: replace portfolio positions with linear exposures on the appropriate risk factor

1) Delta-normal (also called variance-cov/analytical) approach:

o If portfolio valued wrt risk factor S;

o dV=b_S * dS
o VaR = |b_S| * z*\sigma_S * S_0 ??  is S_0 original portfolio value?
o Nonlinear exposures such as convexity are not adequately captured; and can be accounted
for by using delta-gamma method
o More accurate over shorter horizons than longer.

Delta-normal method is appropriate for large portfolios without significant option-like exposures.
This method is fast and efficient.

o Problems: When a distribution has fat tails (equity returns frequently exhibit leptokurtosis) ,
var will tend to underestimate the loss and its assoc. probability. Also, Historical calculation
 if portfolio composition changes/unusual events in estimate period/changed econ.
Conditions  inaccurate
o Results in a higher proportion of distributions with fat tails, cos of either unidentified time
variation in risk or unidentified risk factors and/or correlations
o Nonlinear relationships of option-like positions are not adequately described. Instability of
option deltas is not captured so VaR is misstated.

o If true expected return is used, VaR for diff lengths periods must be calculated independently
o Usually, calculate VaR over a short time period (Basel Accord recommends 2 week ie 10 days)
and then multiplied by sqrt(multiplying factor) to get VaR over longer time period

Full valuation methods: fully reprice the portfolio for each scenario encountered over a historical
period, or over great no of hypothetical situations developed thru historical simulation or Monte
Carlo simulation

1) Monte Carlo simulation revalues a portfolio for a large no. of risk factor values randomly selected
from a NORMAL distribution.

Advantages: most powerful model; can account for both linear and nonlinear risks, can include time
variation in risk and correlations by aging positions over chosen horizons, can incorporate additional
risk factors, nearly unlimited nos of scenarios can produce well-described distributions

Disadvantages: computationally expensive; subject to model risk of selected stochastic process,

subject to sampling variation at lower no. of simulations.

2) Historical simulation revalues a portfolio using actual values for risk factors taken from historical
data.

Can use percentile method, or some form of averaging; the percentile method gives a more
conservative estimate.
 Advantages are that horizon can be selected, not exposed to model risk, based on actual
price data, includes all correlation sas embedded in mkt price changes

Disadvantages are: only one event path is used which includes changes in correlation sand
volatilities that may only have occurred in that historical period; time variation of risk in past may
not reflect future; model may not recognize changes in volatility and correlations from structural
changes; slow to adapt to new events though EWMA can help mitigate; small no. of actual
observation smay lead to insufficient defined distribution tails

These full valuation approaches provide the most accurate measurements because they include all
nonlinear relationships and other potential correlations that may not be included in the linear
valuation models.

Full valuation methods may be the only appropriate methods for large portfolios with 1) substantial
option-like exposure (ie nonlinear) 2) a wider range of risk factors, or a 3) longer-term horizon.

Topic 19 Estimating Volatilities and Correlations