This issue of the Journal of Risk deals with a wide variety of topics, covering operational risk, credit risk, and market risk. While market risk is firmly established, the journal is now receiving more high-quality research in the developing areas of credit risk and operational risk.
In “Operational Risk: A Practitioner’s View”, S. Ebnöther et al. describe a practical approach for modelling operational risk losses. This starts with describing processes by a system of arrays and nodes. These processes can be affected by six risk factors (system failure, loss of staff, theft, fraud, error, and external catastrophe). Self-assessment produces frequency loss distributions and severity distributions, which are combined into a loss distribution. The authors describe the results of a case study and find that, for the bank analyzed, the largest losses can be traced to a small fraction of processes, primarily fraud.
The second article, by C. H. Hui, C. F. Lo and S. W. Tsang, “Pricing Corporate Bonds with Dynamic Default Barriers”, presents an interesting extension of the Merton model approach to corporate debt. The Merton model values a corporate bond as a risk-free bond with a short position in a put on the company’s assets. Default occurs when the value of the firm falls below liabilities at a fixed horizon. In practice, this assumption of a fixed horizon is unrealistic. In addition, it leads to credit spreads that are lower than observed spreads. Later models have assumed a deterministic barrier, either constant, or increasing at the risk-free rate. This article goes one step further and assumes that default can occur whenever the firm value falls below a dynamic barrier. The authors provide closed-form solutions, which they show fit the observed credit spreads better than previous models.
The next article, “Discrete Hedging Under Piecewise Linear Risk Minimization”, by T. F. Coleman, Y. Li and M.-C. Patron, addresses the issue of dynamic hedging of options when rebalancing can only be made at discrete intervals. In practice, some slippage inevitably occurs and the strategy must be designed to minimize some measure of risk during the hedging period. Previous literature has examined quadratic cost functions, which lend themselves to closed-form solutions. The present paper examines linear cost functions, which are more realistic. Using simulations, the paper demonstrates the superiority of the proposed rebalancing strategies.
Finally, the article by D. M. Chance, “Swaptions and Options”, shows that many common types of equity, currency, and commodity swaptions are similar to standard options on the underlying asset. This aids in developing intuition for how these products can be used and in terms of developing pricing formulae. The mission of The Journal of Risk is to further our understanding of risk management.
Contributions to the journal are welcome from academics, practitioners, and regulators in the field. With this in mind, authors are encouraged to submit full-length papers.