Active Risk Management: A Credit Investor’s Perspective

Vineer Bhansali

Contents

Introduction to 'Lessons from the Financial Crisis'

1.

The Credit Crunch of 2007: What Went Wrong? Why? What Lessons Can be Learned?

2.

Underwriting versus Economy: A New Approach to Decomposing Mortgage Losses

3.

The Shadow Banking System and Hyman Minsky’s Economic Journey

4.

The Collapse of the Icelandic Banking System

5.

The Quant Crunch Experience and the Future of Quantitative Investing

6.

No Margin for Error: The Impact of the Credit Crisis on Derivatives Markets

7.

The Re-Emergence of Distressed Exchanges in Corporate Restructurings

8.

Modelling Systemic and Sovereign Risks

9.

Measuring and Managing Risk in Innovative Financial Instruments

10.

Forecasting Extreme Risk of Equity Portfolios with Fundamental Factors

11.

Limits of Implied Credit Correlation Metrics Before and During the Crisis

12.

Another view on the pricing of MBSs, CMOs and CDOs of ABS

13.

Pricing of Credit Derivatives with and without Counterparty and Collateral Adjustments

14.

A Practical Guide to Monte Carlo CVA

15.

The Endogenous Dynamics of Markets: Price Impact, Feedback Loops and Instabilities

16.

Market Panics: Correlation Dynamics, Dispersion and Tails

17.

Financial Complexity and Systemic Stability in Trading Markets

18.

The Martingale Theory of Bubbles: Implications for the Valuation of Derivatives and Detecting Bubbles

19.

Managing through a Crisis: Practical Insights and Lessons Learned for Quantitatively Managed Equity Portfolios

20.

Active Risk Management: A Credit Investor’s Perspective

21.

Investment Strategy Returns: Volatility, Asymmetry, Fat Tails and the Nature of Alpha

The credit crisis which began in 2007 taught us many lessons about the importance of the “robustness of process” of risk management. As the crisis metamorphosed from a relatively isolated area of mortgages to the financial sector to corporates and ultimately to sovereign credit, we learnt some important principles that will impact on portfolio construction in fundamental ways. This chapter will provide a credit investor’s perspective on tail-risk management of credit portfolios.

The most important lesson learnt is that, though the details of this crisis were different, in many ways the recent episode also had striking similarities to past crisis events. Among these similarities is the central role played by de-leveraging, illiquidity and flight to quality. Once again, the central importance of equity and funding markets to other markets was revealed. Asset prices became increasingly correlated, and the ability to anticipate even short-term portfolio returns for risky securities became impossible. The response from aware investors required a delicate balancing act: one that is conscious of the elements that persist through these recurrent crises yet is flexible in its response to

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