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Investment Risk and Uncertainty: Advanced Risk Awareness Techniques for the Intelligent Investor



Investment Risk and Uncertainty: Advanced Risk Awareness Techniques for the Intelligent Investor

Steven P. Greiner

ISBN: 978-1-118-42141-3 March 2013 608 Pages

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Valuable insights on the major methods used in today's asset and risk management arena

Risk management has moved to the forefront of asset management since the credit crisis. However, most coverage of this subject is overly complicated, misunderstood, and extremely hard to apply. That's why Steven Greiner—a financial professional with over twenty years of quantitative and modeling experience—has written Investment Risk and Uncertainty. With this book, he skillfully reduces the complexity of risk management methodologies applied across many asset classes through practical examples of when to use what.

Along the way, Greiner explores how particular methods can lower risk and mitigate losses. He also discusses how to stress test your portfolio and remove the exposure to regular risks and those from "Black Swan" events. More than just an explanation of specific risk issues, this reliable resource provides practical "off-the-shelf" applications that will allow the intelligent investor to understand their risks, their sources, and how to hedge those risks.

  • Covers modern methods applied in risk management for many different asset classes
  • Details the risk measurements of truly multi-asset class portfolios, while bridging the gap for managers in various disciplines—from equity and fixed income investors to currency and commodity investors
  • Examines risk management algorithms for multi-asset class managers as well as risk managers, addressing new compliance issues and how to meet them

The theory of risk management is hardly ever spelled out in practical applications that portfolio managers, pension fund advisors, and consultants can make use of. This book fills that void and will put you in a better position to confidently face the investment risks and uncertainties found in today's dynamic markets.

Foreword xiii

Preface xv

Acknowledgments xvii


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