Risk magazine/Technical paper
Unsystematic credit risk
Although Basel has shifted its treatment of unsystematic credit risk from the first, capital rules pillar (where it was called the ‘granularity adjustment’) to the second, supervisory pillar of the forthcoming Accord, this issue is of great practical…
Minimising extremes
Portfolio diversification often breaks down in stressed market environments, but the co-movement of asset prices in a tail risk regime may be modelled using a coefficient of tail dependence. Here, Yannick Malevergne and Didier Sornette show how such…
A bootstrap back-test
Back-testing
Copula vulnerability
Counterparty credit risk
Reconstructing volatility
Options on stock baskets have become a mainstay of the equity derivatives business, but pricing and hedging of such products is highly sensitive to implied volatility and correlation assumptions. Here, Marco Avellaneda, Dash Boyer-Olson, Jérôme Busca and…
Reconstructing volatility
Equity derivatives
Component proponents
Principal component analysis is a widely used technique in finance but can be problematic when different data sets are grouped together. Christophe Pérignon and Christophe Villa show how to resolve this problem using a technique from biology called…
Finessing fixed dividends
Equity options
Assets with jumps
Option pricing
VAR you can rely on
Analytical and simulation-based methods often appear as rivals, but many real world problems are best served by judicious combinations of both approaches. In a first of a pair of computationally themed papers, Rabi De and Tanya Tamarchenko present a…
Trees from history
Option pricing
Calculating portfolio loss
For credit portfolios, analytical methods work best for tail risk, while Monte Carlo is used to model expected loss. However, products such as CDOs require a model for the entire distribution. Sandro Merino and Mark Nyfeler meet the challenge by…
Risk and probability measures
Although its drawbacks are well known, VAR has become institutionalised as the market risk measure of choice among trading firms and regulators. Now there is a growing feeling that a reappraisal is overdue, exemplified here by Phelim Boyle, Tak Kuen Siu…
On the log-log linearity of the size distribution of growth stocks
Mauboussin & Schay (2000)1 discovered an almost linear relationship between the logarithm of the market capitalisation and the logarithm of the rank for growth stocks. Kou & Kou (2001)2 proposed an explanation for this observation based on the theory of…
A two-factor mean-reverting model
Commodity markets exhibit multi-factor behaviour as well as mean reversion. Building upon their previous paper, David Beaglehole and Alain Chebanier conclude the current Masterclass series by developing a two-factor mean-reverting model for crude oil…
The maturity effect on credit risk capital
In a mark-to-market approach to credit risk capital, ratings or spread volatility has the effect of making longer-maturity loans more capital-intensive. This is incorporated in the current Basel II proposals via a maturity adjustment factor. Arguing that…
Long or short in CDOs
Masterclass with Deutsche Bank
Extreme events and default baskets
Credit derivatives
Unified Asian pricing
Options
Testing assumptions
In calculating value-at-risk forecasts for trading portfolios, distributional assumptions are asimportant as the choice of risk factors, but it is not easy to determine the source of errorwhen rejected forecasts occur. Here, Jeremy Berkowitz develops a…
Substitute hedging
Derivatives on assets that are difficult to trade are of growing importance. Pricing suchderivatives requires the use of utility theory and proxy assets for hedging. Here, VickyHenderson and David Hobson review the theory and discuss several topical…
Universal Barriers
As our survey in this issue shows, there is an increasing volume of barrier products traded in the forex options market. Here, Alexander Lipton and William McGhee discuss the pricing of barriers under various model frameworks, with particular focus on…
Honour your contribution
What is the best method for determining the risk contribution of a component in a portfolio? An exploration of the pros and cons of three important methods, showing that none dominates the others.
Mean-reverting smiles
Commodity markets such as crude oil exhibit mean reversion as well as option smiles. The authors construct a model suitable for pricing exotic options in these markets