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Investment Risk and Uncertainty
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Table of Contents

Foreword xiii


Preface xv


Acknowledgments xvii


Introduction Why Risk Management is Mostly Misunderstood 1
Steven P. Greiner, PhD


Quantitative Risk Management Beginnings 3


Quantitative Risk Management Successes 8


Quantitative Risk Management Failures 11


Warren Buffett’s Risk Management Strategy 14


Defining Risk Management 16


Fat Tails, Stationarity, Correlation, and Optimization 18


Managing the Risks of a Risk Management Strategy 23


The Risk Management Opportunity Set 25


Notes 29


Part One


Chapter 1 Exposed versus Experienced Risk Revisited 33
Steven P. Greiner, PhD, and Andrew Geer, CFA, FRM


Exposure Hedge versus Dollar Hedge 37


How the Credit Crisis Moved Risk Management to the Forefront 47


Risks beyond Volatility 49


What Risk Management Should Provide 51


Clarifying Expectations of Risk Management 54


An Example 55


Notes 58


Chapter 2 Definitions of Tractable Risk 59
Steven P. Greiner, PhD, and Andrew Geer, CFA, FRM


The Effect of Uncertainty on Objectives 59


Identifying and Measuring Risks 63


Forecasting and Hedging Risks 71


Portfolio View versus Security-Level View 75


Total Risk View of Multi-Asset-Class (MAC) Portfolios 82


Stability and Accuracy 84


Note 86


Chapter 3 Introduction to Asset Class Specifics 87
Steven P. Greiner, PhD; Andrew Geer, CFA, FRM; and William F. McCoy, CFA, PRM


Equities 87


Fixed Income 96


Conclusion 117


Notes 118


Chapter 4 Commodities and Currencies 121
Steven P. Greiner, PhD, and William F. McCoy, CFA, PRM


Commodities 121


Introduction to Currency Risk 138


Conclusion 143


Notes 144


Chapter 5 Options and Interest Rate Derivatives 145
Steven P. Greiner, PhD; William F. McCoy, CFA, PRM; and Mido Shammaa, CFA, FRM


Short History of Option Pricing 145


Volatility Smile 149


Implied Volatility Model 151


Baroni-Adesi Whaley (BAW) Option Pricing Methodology 161


Other Option Pricing Methods 162


Swaps, Swaptions, Forwards, and Futures 165


Conclusion 181


Notes 182


Chapter 6 Measuring Asset Association and Dependence 183
Steven P. Greiner, PhD; Andrew Geer, CFA, FRM; Christopher Carpentier, CFA, FRM; and Dan diBartolomeo


The Sample Covariance Matrix 183


Estimation Error Maximization 184


Minimizing the Extremes 185


The Copula, the Most Comprehensive Dependent Structure Measure 193


The Model Covariance Matrix 196


Notes 197


Chapter 7 Risk Model Construction 199
Steven P. Greiner, PhD; Andrew Geer, CFA, FRM; Jason MacQueen; Laurence Wormald, PhD


Multifactor Prespecified Risk Models 199


Principal Component (Statistical) Risk Models 205


Customized Hybrid Risk Models 212


Notes 229


Part Two


Chapter 8 Fixed Income Issues 233
David Mieczkowski, PhD, and William F. McCoy, CFA, PRM


Variety. Illiquidity. Size. 235


Empirical Evidence 240


Test Portfolios and Methodology 241


Test Metrics 242


Computational Efficiency 248


Conclusion 249


Notes 250


Chapter 9 Interest Rate Risk 251
David Mieczkowski, PhD, and Mido Shammaa, CFA, FRM


The Term Structure 252


Term Structure Dynamics 258


Factor Models 258


Stochastic Differential Equations 267


Interest Rate Risk Exposures 273


Risk Forecasting 278


Conditional Duration and Expected Tail Duration 281


Conclusion 282


Notes 283


Chapter 10 Spread Risk 285
David Mieczkowski, PhD, and Sameer R. Patel


Spread Basics 286


Reduced Form Approach 290


Structural Approach 292


Spread Exposure 295


Spread Volatility 296


Derived Spread Approach 297


Euro-Sovereign Spreads 308


Factor Model Approach 312


Conclusion 322


Notes 324


Chapter 11 Fixed Income Interest Rate Volatility, Idiosyncratic Risk, and Currency Risk 325
David Mieczkowski, PhD, and Steven P. Greiner, PhD


Fixed Income Interest Rate Risk 325


Fixed Income Idiosyncratic Bond Risk 346


Fixed Income Currency Risk 352


Conclusion 367


Notes 368


Chapter 12 Portfolio Risk Measures 369
William F. McCoy, CFA, PRM, and Steven P. Greiner, PhD


Coherent Risk Measures 370


Commonly Used Risk Measures 370


Marginal Contribution 375


Stress-Testing 377


Notes 399


Chapter 13 Risk for the Fundamental Investor 401
Richard Barrett, CFA, FRM; Roberto Isch, CFA, FRM; and Steven P. Greiner, PhD


Fundamental Investing versus Other Approaches 401


Typical Risk Controls for Fundamental Investors 403


Implementing Risk Management Strategies into a Fundamental Process 405


Optimization 421


Conclusion 428


Chapter 14 Portfolio Optimization 429
Sebastian Ceria, PhD, and Kartik Sivaramakrishnan, PhD


The Enhanced MVO Model 432


Constraints and Objectives in EMVO 434


Further Improvements to the Enhanced MVO Model 441


Factor Alignment Problems 443


Constraint Attribution 445


Specially Structured MVO Models 448


Extreme Tail Loss Optimization 450


Incorporating Nonlinear Instruments in the EMVO Model 452


Algorithms for Solving MVO Models 453


How to Choose an Optimizer 456


Notes 459


Part Three


Chapter 15 The SunGard APT Risk Management System 465
Laurence Wormald, PhD


Introduction to Statistical Factor Models 465


APT Factor Model Estimation—Equities Models 468


Selection of the Core Universe for Factor Modeling 469


Choosing the Number of APT Factors 470


Estimating the Risk Profiles in an APT Factor Model 471


APT Multi-Asset-Class Factor Model Estimation 474


Modeling Derivatives and Other Nonunderlying Securities 477


User-Defined Assets within APT Models 479


Conclusion 480


Notes 481


Chapter 16 Axioma Risk Models 483
Bill Wynne; Melissa Brown, CFA; and Sebastian Ceria, PhD


Background 483


Risk Model–Based Reporting 484


Role of Risk Models in Investment Decisions 485


Axioma Value at a High Level 486


Daily Risk Models, Delivered Daily 487


Multiple Risk Models 488


Empirical Results 489


Details of Axioma Innovations 492


Conclusion 506


Notes 506


Chapter 17 Distinguishing Risk Models 507
Steven P. Greiner, PhD, and Richard Barrett, CFA, FRM


History 507


Risk Model Details 508


Risk Model–Based Reporting 510


Conclusion 520


Notes 521


Chapter 18 Northfield’s Integration of Risk Assessments across Multiple Asset Classes 523
Dan diBartolomeo, PRM, and Joseph J. Importico, CFA, FRM


A Unified Framework 524


Interest Rate Risk 526


Credit Risk 527


Equity Factor Representation of Corporate Credit Risk 528


Default Correlation 529


Complex Instruments and Derivatives 531


Private Equity 532


Direct Real Estate and Geographically Localized Assets 536


Concluding Example 540


Conclusion 543


References 544


Chapter 19 R-Squared 547
Jason MacQueen


Why Build Stock Risk Models? 547


Generic Risk Modeling 548


Practical Risk Modeling 551


Statistical Factor Models 552


Defined Factor Models 554


Estimate Factors or Estimate Betas? 555


Practical Consequences at the Stock Level 557


Practical Consequences at the Portfolio Level 557


A Short Digression 558


Hybrid Risk Models 559


The R-Squared Short-Term Hybrid Risk Model for Global Equities 560


Summary 565


Note 565


Chapter 20 The Future of Risk Management and Analytics 567
Steven P. Greiner, PhD; David Mieczkowski, PhD; William F. McCoy, CFA, PRM; Andrew Geer, CFA, FRM; Daniel S. Mathon, PhD, CFA; Viviana Vieli; Christopher Carpentier, CFA, FRM; Mido Shammaa, CFA, FRM; and Sameer R. Patel


The Increasing Regulatory Environment 569


The Impact of Regulations with Technology 571


The Future View 572


New Types of Risk Models 573


Stress-Testing Your Way to Event Risk Preparedness 577


Index 579

About the Author

STEVEN GREINER is currently the head of Risk Research for FactSet Research Systems. He has served as the senior quantitative strategist and portfolio manager for Allegiant Asset Management (now wholly owned by PNC Capital Advisors) and was a member of its investment committee. Prior to this, Greiner was a senior quantitative strategist for large capitalization investments at Harris Investment Management. He has more than twenty years of quantitative and modeling experience. Greiner received his BS in mathematics and chemistry from the University at Buffalo, his MS and PhD in physical chemistry from the University of Rochester, and attained postdoctoral experience from the Free University Berlin, Department of Physics. Greiner has published numerous papers and is the author of the Wiley book Ben Graham Was a Quant.

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