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Dealing With Financial Risk by David Shirreff

By David Shirreff

Facing monetary possibility is a transparent and colourful consultant to the peaks and crevasses of economic hazard administration, best during the concept and perform of possibility taking from swaps and futures to credits derivatives and the consequences of Basel II, dynamic hedging, Monte Carlo simulations, chaos thought, neural networks, Raroc (risk-adjusted go back on capital), pressure exams, worst-case eventualities, and every kind of video games which are performed within the reason for handling hazard. furthermore, it appears to be like at a few miraculous mess ups of threat administration and the teachings that may be realized from them.

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Each one provided a lesson for the future. The weakest link in modern risk management was “model risk”, the tendency for a simplified view of the market to apparently work well for a while and then go horribly wrong. False impressions A good principle to bear in mind is that every model, whether it is an aspect of the financial market or anything else – a model steam engine or a hydroelectric dam – will behave differently from the real thing, especially in extreme conditions. A model that appears to replicate market behaviour perfectly in certain circumstances is likely to go off course if circumstances change too much.

This is not a huge amount of capital for contracts that can quickly build up in one side’s favour, leaving a considerable credit exposure. The more a counterparty sees a swap move in its favour, the more cautious it should be about the other side’s creditworthiness, just as a gambler, the more he wins, is more anxious about the loser’s ability to pay up. In most cases, these days, a counterparty will ask for collateral, such as cash or bonds, to cover the amount that the other party owes (or is likely to owe at the next payment date) on the swap.

Morgan developed a database known as RiskMetrics, which offered users a common basis for calculations of the volatility and correlation of various financial markets and financial instruments around the world. In 1994 it made RiskMetrics freely available on the internet. P. Morgan. RiskMetrics was based on the concept of value-at-risk (var). The volatility and correlation matrix showed you what your biggest expected loss (var) would be over a given period. But only up to a point: the var calculation did not take into account extreme market conditions, when correlation and volatility go off the scale.

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