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Financial Risk Management
Raman Kannan
rk2153@gmail.com

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Approaches to Risk Management
• Quantitative Risk Management
– Risk Management Models
– Statistical Analysis
– Complex Computation
• Qualitative Risk Management
– Reasoning about Risk
– Understanding Human Cognitive Biases
– Understanding the asset classes

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About this presentation…
• What it is not: Not quantitative
• What it is: A qualitative discourse
– Conceptual
– opinions on the state of Risk Management
Practice
– a prescription for Risk Management
http://riskinstitute.ch/RMGLProcess.htm
“Such stress tests should not be limited to quantitative exercises that
compute potential losses or gains. They should also include
more qualitative analyses”

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Essence of Risk Management
• Capital Preservation
• Avoid volatility drag
– to makeup 80% decline a 400% return is
required
– To makeup 50% decline a 100% return is
required.
• Take care of the downside, the upside
will take care of itself!
• Minimize loss - Smaller the loss easier
the recovery.
Those who survive are not the ones who make the most, but the
ones who lose the least.

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So what is risk?
• Any adverse deviation from expected
return
– downside risk
– actual return is less than expected return
• Returns of different asset classes depend
on different factors
• Price (share price)
• interest rate
• exchange rate and so on

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Types of Risk
Market
Settlement
Operational
Credit
Legal
Liquidity
There are many sources of risk.
Subjective and overlapping scope:
Settlement/credit are related.
Not an exhaustive list.
Ref: http://riskinstitute.ch/00007127.htm

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Types of Risk (II)
Different asset classes are susceptible to different types of risks
Credit -- risk of counterparty failure to make payments as required
Settlement risk – non delivery of cash or the asset – inability to complete
the transaction
Liquidity – cannot be converted into cash at fair market price
Market – investment will decrease in value due to changes in the market
Currency – associated with exchange rate moves that affect the
investment adversely.
Roll – inability to roll into a comparable asset on maturity, at an
equal or at a favorable interest rate – reinvestment or
refinancing risk
Rate – interest rate moves that affect the investment adversely.
Event – exogenous event – shocks that affect the market adversely
Corporate – risk of bankruptcy or other conditions that financial obligations
cannot be met
Country – changes in political and economic conditions that affect the
market adversely
Fraud – ponzi scheme

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Other classifications
• Market Risk: The risk that market prices of securities held in a portfolio may fall
rapidly or unpredictably due to a variety of factors, including changing economic,
political or market conditions.
• Company Risk: The risk that the issuer’s earnings prospects and overall financial
position will deteriorate, causing a decline in the value of the security over short or
extended periods of time.
• Active Management Risk - The risk that poor securities selection by the Fund’s
investment adviser could cause the Fund to underperform its benchmark index or
mutual funds with similar investment objectives.
• Foreign Investment Risk - Foreign markets can be more volatile than the U.S. market
due to increased risks of adverse issuer, political, regulatory, currency, market or
economic developments and can result in greater price volatility and perform
differently from securities of U.S. issuers. This risk may be heightened in emerging or
developing markets.
• Emerging Markets Risk - The risk of foreign investment often increases in countries
with emerging markets. For example, these countries may have more unstable
governments than developed countries, and their economies may be based on only a
few industries. Because their securities markets may be very small, share prices may
be volatile and difficult to determine. In addition, foreign investors are subject to a
variety of special restrictions in many such countries.
• http://www.tiaa-cref.org/public/prospectuses/TCFIE_sumpro.pdf

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Two sides of a coin
• Risk and Reward
– Modern Portfolio Theory
Harry Markowitz
• maximize return given a
risk tolerance
http://upload.wikimedia.org/wikipedia/en/e/e1/Markowitz_frontier.jpg
A PF with lower variance will outperform A PF with higher variance.
Minimizing variability is significant.
Minimize the variance.

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Division of Labor
• Return
– Investment Manager, PF Manager
– Generating revenue, alpha
• Risk
– Risk Manager, Risk Budget/Allocation Office
– Controlling revenue
– Protecting and Preserving the business
Risk Officer and PF Manager: it is a partnership.

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Focus on Market Risk
• Value At Risk (VaR) is a widely used measure
• “standard daily VaR of $1 million at a 1% probability tells you that you have less
than a 1% chance of losing $1 million or more on a given day.”
• The dependence on VaR to estimate is highly criticized.
– VaR current practice ignores what happens in the worst 1%.
• Some criticisms are more fundamental – futility of trying to model risk
– NNT: Risks keep growing where they can be seen the least
• Implication is, VaR is flawed fundamentally and in addition practiced incorrectly.
• Fundamental flaws in the basic principles will now be reviewed starting from MPT.

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MPT
• MPT models an asset's return as a normally distributed
• defines risk as the standard deviation of return
• models a portfolio as a weighted combination of assets
• Thus, the return of a portfolio is the weighted
combination of the assets' returns.
• MPT seeks to reduce the total variance of the portfolio
return, by combining different assets whose returns are
not perfectly positively correlated,
• MPT also assumes that investors are rational and
markets are efficient.
• criticized and debated for assumptions: STD as risk,
normality, rationality, efficient market hypothesis.

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MPT Criticism 01
• Assumption: Market participants are rational
• In actuality they are not rational
– Bubbles are regular and frequent
• 1987 Crash
• Internet bubble
• real estate bubble
• Credit crisis
– Each bubble is characterized by
• Irrational exuberance
– Driven by greed
• Eventual collapse
– Driven by fear
Fear and greed drive the market.
Herding best characterizes market not rationality.

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MPT Criticism 02
• Assumption: Efficient Market Hypothesis
• At best, EMH is valid over long horizon
– 3 or more years
• In the short term EMH does not appear to
be valid
– Market Open/Close
– Event driven {earnings report, M&A activity}
– News driven
– Triple witching days

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MPT Criticism 03
• Assumption: Normality
• Returns are not normal
– Downside is limited, upside is unlimited
– Approximation:Returns are log-normal
• Extreme events are frequent
– Fat tail
• Emerging MLE and ETL ideas are gaining
acceptance

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MPT Criticism 04
• volatility is a measure of risk
• Standard deviation taken to be volatility is a
questionable measure of risk
– Semivariance
• http://www.answers.com/topic/semivariance
• Markets exhibit both uncertainty and
unpredictability exhibiting feedback
– Crowd behavior markets include irrational actors
– Feedback/reflexivity
• market data ticks triggers HFT, Trading triggers more ticks
• Risk is abstract and easily misinterpreted and
misunderstood

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Other limitations
• Operational Issues
– Most risk computations assume correlations
are static
• Volatility and correlations are both time dependent
– Data is limited
• Once in hundred year events cannot be predicted
with 25 year data
– Assumptions may not be valid
• Constant default rate resulted in real estate bubble
• Spread assumptions resulted in LTCM collapse

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Free Markets?
• There is no such thing!
– Markets are not random but managed
– At the extreme govs and regulators control the market
• Too big to fail response
• There are circuit breakers in equity
– Regulatory skews (bias against short)
– Markets can only go up.
• Notice:not individual securities.
• Bond Markets are the domain of FOMC
– Interest rates, inflation and money supply
• FX are the domain of Central Banks
• Commodities are the domain of OPEC and other entities

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Human Cognitive Biases
• Loss Aversion
– Asymmetric weighting
– Markets exhibit long bias
• Shorts are disadvantaged
• Overconfidence/Confirmation bias
– Many fraudsters believe they can make it right
• Human Mind seeks to be precisely wrong
– Not suitable for interval logic
• Faulty Memory – survivor bias

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Evolving trends
• Extreme Tail Loss ETL
– Correcting for fat tail
• Maximum Likelihood Estimators
– Correcting for parametric statistics
• Risk Parity and Risk Budgeting
– Diversifying by risk as well as return
• Emphasis on scenario testing
– Correcting for insufficient data

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Asset Return
Returns tend to have
– fat-tails
• Not gaussian ( not a normal distribution )
– volatility clustering
• periods of high volatility and periods of low
volatility
– asymmetry
• loss is limited to 100%
• profit is unlimited
– tail dependence
– volatility is not a constant
– correlation is not a constant
Market Risk
http://meketagroup.com/documents/RiskParityWP_000.pdf
Occasional outsized losses can wipe out years of
normal profits, in addition to the volatility drag.

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Recommendations
• Risk under normal conditions
– VaR could be used
• Risk where VaR is not useful
– Maximum Likelihood Estimators (MLE)
– Scenarios with outlandish shocks (SOS)
• in correlation
• in outsized changes
• find what conventional wisdom rejects and subject the
system to those conditions
• review the assumptions and relax every one of them
• modify as per current sentiment macro and micro
• incorporate adversity induced by other risk (liquidity for ex)
• Total Risk = f(VaR, MLE, SOS)

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References & Disclosures
• Fooled By Randomness by NNT Nassim Nicholas Taleb
• Black Swan also by NNT
• http://www.wired.com/techbiz/it/magazine/17-03/wp_quant
• http://www.fooledbyrandomness.com/Technicalpapers.pdf
• http://www.tiaa-cref.org/public/prospectuses/TCFIE_sumpro.pdf
• http://www.top1000funds.com/wp-content/uploads/2010/10/qian_risk_party_portfolios.pdf
• http://www.sharpeinvesting.com/2007/08/george-soros-theory-of-reflexivity-mit-
speech.html
• http://riskinstitute.ch/00007127.htm
• http://www.garpdigitallibrary.org/download/GRR/2012.pdf
Insight and ideas are not mine.
Mistakes are mine. Please send me a note.
rk2153@gmail dot com
raman@assetcorporation dot net