Marrison - The Fundamentals of Risk Measurement

THE FUNDAMENTALS OF RISK MEASUREMENT

CHRIS MARRISON, PH.D

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ISBN: 978-0-07-173688-6

MHID: 0-07-173688-3

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Over the last decade, the understanding of risk measurement has become increasingly important as most international banks have adopted Value-at-Risk, economic capital, and risk-adjusted return on capital (RAROC) to control and price their risks. They use these tools to find the loans, trades, and deals that are most profitable, leaving the unprofitable ones for their less sophisticated competitors. The understanding of risk measurement is therefore vital to those who want to manage a bank safely and profitably.

The importance of these risk measurement tools has been greatly magnified by regulators, such as the Federal Reserve and the Bank of England, who plan to start using these concepts to calculate the minimum amount of capital that banks must hold. For competitive and regulatory reasons, it is now necessary for all banks to have a sound risk-measurement framework.

This book was written to address the growing need for easy-to-understand information about how banks can apply effective risk measurement techniques. The goals of this book are the following:

Provide quick access to the whys and hows of risk measurement.

Provide easy-to-understand information, including equations and examples, that can be quickly applied to most risk measurement problems.

Provide information about how risk measurement is used in the management of risk and profitability.

This is a textbook to teach you how to measure risk. The book assumes that you have a general background in science, economics, or finance, and now have a need to quickly understand the field of financial risk analysis. Alternatively you may already have a good understanding of one area of risk but now seek to have an integrated understanding across all types.

The book is deliberately compact so it can be read and understood quickly. It includes background chapters for those unfamiliar with finance and statistics, and includes descriptions of the many techniques that are commonly used in risk measurement. It applies these techniques to the four major risks faced by banks: market risk, credit risk, asset liability mismatch, and operating risk.

The book begins with chapters describing how banks make, and often lose, money. It then describes the two fundamental building blocks of integrated risk measurement: economic capital and RAROC. reviews the statistical relationships that are commonly used in risk measurement and provides reference material for the rest of the book. It is useful for those readers who do not have a recent working knowledge of statistics.

Market risks arise when the perceived value of an investment falls and is most closely associated with trading operations. The measurement of market risks is covered in gives an overview of the main traded instruments and how they can be valued. This chapter is useful for those readers who are new to the finance industry.

the VaR contribution methodology is used to pinpoint the source of a portfolios risk.

Regulators allow banks to use their VaR caculators to set the amount of capital that they hold against market risks. also extends VaR to measure the risk of asset management operations.

Although VaR is the best single metric for market risks, it has several limitations. These limitations, and typical solutions, are discussed in the market risk section concludes by describing how the results of risk measurement are used in risk management, including the procedure for setting VaR limits.

describes how those risks arise and the risk characteristics of different types of deposits and loans.

The measurement of interest rate risk and liquidity risk for ALM is discussed in , including gap reports, rate shift scenarios, simulations, and models of customer behaviour.