University of California at Irvine
The Journal of Risk is now well into its second year. Over time, the mix of papers has witnessed an interesting evolution, reflecting the fast-changing pace of research in financial risk management.
The first paper in this issue, by Berkowitz, deals with stress testing, a topic that is receiving increased emphasis nowadays. While regulators and institutions recognize the need for a regular stress-testing program, the industry seems to lack a consensus definition of stress testing. Often, stress scenarios are defined as situations that could create extreme losses. But in theory, extreme losses could also be identified by increasing the confidence level of VaR. So, it is not clear why stress testing should be performed outside the usual VaR models. Berkowitz contributes to the current thinking by giving a rigorous definition of stress testing. The paper also proposes a unified framework in which stress-test scenarios are incorporated into the basic risk model used by the firm.
The second paper, by Rebonato and Jäckel, deals with the construction of the correlation matrix for risk management purposes. When the number of assets is large, the correlation matrix is often inconsistent, sometimes leading to zero or even negative values. This inconsistency can be traced to lack of data or faulty estimation procedures. If this is the case, the correlation matrix needs to be altered to ensure consistency. Other applications include stress testing, where it is useful to examine the effect of changing correlations on the portfolio risk. Previous adjustments, however, were ad hoc and could not always ensure consistency of the modified matrix. Instead, the paper presents a reliable procedure for adjusting the correlation matrix.
The third paper, by Tompkins, deals with power options. These have payoffs that are linked to a power, typically the square, of the underlying asset price. Power options are viewed as difficult to model and were recently the subject of a dispute between Merrill Lynch and the Kingdom of Belgium. Tompkins shows how to price and hedge these options. In addition, the paper discusses interesting applications, including using power options to hedge levels of implied volatility or to hedge nonlinear risk, such as total revenue risk.
Finally, the fourth paper, by Muralidhar and van der Wouden, presents an application of asset-liability management for a pension fund. Here, risk is much more complex than the usual downside risk: it is related to the possibility that the surplus, i.e., the difference between assets and liabilities, could turn negative. Because the institution is an ongoing concern, the average contribution rate to the pension fund and its variability also matter. Risk should not be assessed only in terms of current positions, but it should also account for the possibility of corrective action later. The authors compare various investment strategies and find some counter-intuitive results.
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.
The most general methodology for creating a valid correlation matrix for risk management and option pricing purposes