Szylar - Handbook of Market Risk

Table of Contents

Copyright 2014 by John Wiley & Sons, Inc. All rights reserved

Published by John Wiley & Sons, Inc., Hoboken, New Jersey

Published simultaneously in Canada

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Library of Congress Cataloging-in-Publication Data:

Szylar, Christian.

Handbook of market risk / Christian Szylar, Marshall Wace LLP.

pages cm

Includes bibliographical references and index.

ISBN 978-1-118-12718-6 (cloth) ISBN 978-1-118-51494-8 ISBN 978-1-118-51492-4 (ePDF) ISBN 978-1-118-51493-1 (ePub) ISBN 978-1-118-51490-0

1. Risk management. 2. Financial risk management. 3. Capital market. I. Title.

HD61.S99 2013

332.64'5dc23

2013018808

To my wife and my two beloved sons

Foreword

Market risk is a field of great importance both to firms managing risk and supervisors alike. It embraces a huge field, made more complex as innovations lead to an ever-expanding variety of financial instruments, and which needs to cover many fields of activity from banking to asset management.

Christian Szylar has written an excellent expos of the field, which manages to retain an inherent readability for the nontechnical reader, with a rigorous technical approach for those wishing to go into more depth.

The book helps to reduce inherent complexities into a field better understood and makes a valuable contribution for all those interested in the area of managing risks. At a time when we are living with the aftermath of financial crisis, it deserves to be widely read.

S ir A ndrew L arge

Former Deputy Governor, Bank of England

Acknowledgments

My first acknowledgment is of course to Ruey S. Tsay and Steve. Quigley for giving me this opportunity to work on this handbook. It was a great honor for me that both of them thought about me for this project. I owe a very special debt of gratitude to both of them.

My thanks go to Paul Marshall and Ian Wace from Marshall Wace LLP. I hope they appreciate the merits of this work. I thank them for creating an environment where their risk team can freely challenge and discuss with the investment teams all matters of market risk.

My sincere thanks to Sebastian Ceria and Alessandro Michelini from Axioma; they gave me access to some of their internal documents and in particular their Axioma Robust Risk Model Handbook. Their extracts were crucial for this handbook, especially on building the fundamental multifactor model.

Sincere thanks to John Carter at Marshall Wace LLP for his support and review of my mathematical formulations, which have been extremely valuable especially for the volatility estimates. His constructive remarks helped to improve the content of this book.

Sincere thanks to Alessandro Orsaria at Marshall Wace LLP for his valuable research on correlation estimates; I hope this work will help him in furthering his studies.

Finally, my biggest debt is to my friend Clement Menace, whose support was essential for this book and especially regarding Basel II/III. His inputs have been invaluable.

C.S.

About the Author

Christian Szylar is currently Global Head of Risk and Performance Measurement in a global leading asset management company Marshall Wace LLP. Christian worked at Kinetic Partners LLP as a Partner, where he headed a risk and valuation solution to asset management firms and banks. Prior to this, he was Managing Director of RBS Portfolio Risk Services, where he developed a portfolio of risk management services tailored to worldwide asset managers, and was also a conducting officer at RBS Luxembourg offering independent management company services. He was also Vice President at Mizuho Financial Group.

Christian holds a Ph.D. in Management Science from University of Law, Economics and Management at Nancy. He furthered his studies at MIT/Sloan School of Management and participated in a number of Harvard Economics programs. He teaches in various Masters degree programs in Finance, and for some time he headed the MBA program in Luxembourg.

Christian also acted as a senior official expert for the ATTF, and as such he advised many financial institutions and Central Banks. He was Vice President of the IAS Luxembourg, an organization aiming to promote corporate social responsibility in Europe.

Christian has published many articles on risk, finance, macroeconomics, and economic intelligence in reviews and several books. He recently published Risk Management under UCITS III/IVNew Challenges for the Fund Industry (ISTE/Wiley) and also edited the UCITS Handbook (ISTE/Wiley).

Introduction

The last five years have been driven by the credit crisis that started in the United States in 2008 before spreading all around the globe and affecting all of major economies. The severity of this crisis can be compared to the 1929 crisis. Charles Kindelberger, a professor at the Massachusetts Institute of Technology (MIT), analyzed all financial and economic crises since the seventeenth century, and it seems that all crises seem to follow the same steps: (1) a boom (often driven by new product(s); (2) keen interest/enthusiasm/frenzy and transaction speed and volume until its maximum, and then the crisis starts; (3) fear and mess/chaos, and behavior/reference marks are lost; (4) a consolidation phase where we decrease what has increased in an overly excessive way and has contaminated the entire economyrecession starts; and finally (5) the recovery with usually public and state support. The 2007 crisis is not different from this pattern formalized by Charles Kindelberger. The amplitude and severity of this recent crisis has nevertheless something that is different from the other ones. The big difference is that all of the models, assumptions, and practices we knew from the past about investing and managing market risk will not be working again. This crisis led to a new investment paradigm, hence modifying our market risk perception and management. This is a major change for the investment community, and today's investors and those who manage money try to identify how best to manage this new paradigm. The pre-2008 era is profoundly different from the post-2008 years.