CO3085 Risk Management

Course Structure

Lesson 1 - Introduction to Financial Risk Management

Lesson 2 - Introduction to Market Risk Measurement

Lesson 3 - Sources of Market Risk

Lesson 4 - Fixed-Income Market Risk

Lesson 5 - Fixed-Income Market Risk II

Objectives

In this course of advanced level in finance, the student will be able to analyse and apply different methodologies used in the financial markets to asses the risk of the financial instruments and portfolios. It is a prerequisite that the student has knowledge and good level of understanding of statistics, economic and financial databases, and programming skills to elaborate risk management financial models. We assume the student has knowledge of basic derivatives instruments (definitions, use and pricing). We are going to develop models using MATLAB and we will interface our algorithms with C++ and Excel VBA.

Course Program

1. INTRODUCTION TO MARKET RISK MEASUREMENT (5 weeks) (a) Introduction to Financial Market Risks i. Types of Financial Risks

ii. Risk Management Tools (b) VAR as a Downside Risk Measure i. VAR: Definition ii. VAR: Caveats iii. Alternative Measures of Risk iv. Cash Flow at Risk (c) VAR Parameters i. Confidence Level ii. Horizon iii. Application: The Basel Rules (d) Elements of VAR Systems i. Portfolio Positions ii. Risk Factors iii. VAR Methods (e) Stress-Testing (f) Liquidity Risk

2. SOURCES OF MARKET RISK (2 weeks) (a) Sources of Loss: A Decomposition (b) Currency Risk i. Currency Volatility ii. Correlations iii. Cross-Rate Volatility (c) Fixed-Income Risk i. Factors Affecting Yields ii. Bond Price and Yield Volatility iii. Correlations iv. Global Interest Rate Risk v. Real Yield Risk vi. Credit Spread Risk vii. Prepayment Risk (d) Equity Risk i. Stock Market Volatility (e) Commodity Risk i. Commodity Volatility ii. Futures Risk (f) Risk Simplification i. Diagonal Model ii. Fixed-Income Portfolio Risk

3. FIXED-INCOME MARKET RISK AND HEDGING LINEAR RISK (4 weeks)

(a) Introduction to Futures Hedging i. Unitary Hedging ii. Basis Risk (b) Optimal Hedging i. The Optimal Hedge Ratio ii. Example iii. Liquidity Issues (c) Applications of Optimal Hedging i. Duration Hedging ii. Beta Hedging

4. INTRODUCTION TO CREDIT RISK (2 weeks) (a) Settlement Risk i. Pre-settlement Versus Settlement Risk ii. Handling Settlement Risk (b) Overview of Credit Risk i. Drivers of Credit Risk ii. Measurement of Credit Risk iii. Credit Risk versus Market Risk (c) Measuring Credit Risk i. Credit Losses ii. Joint Events (d) Credit Risk Diversification

5. MEASURING DEFAULT RISK FORM MARKET PRICES (2 weeks) (a) Corporate Bond Prices i. Spreads and Default Risk ii. Risk Premium iii. The Cross-Section of Yield Spreads iv. Time Variation in Credit Spreads (b) Equity Prices i. The Merton Model ii. Pricing Equity and Debt iii. Applying the Merton Model

6. THE BASEL ACCORD (1 week) (a) Steps in the Basel Accord i. The Basel I Accord ii. The 1996 Amendment iii. The Basel II Accord (b) The 1988 Basel Accord

i. Risk Capital ii. On-Balance Sheet Risk Charges iii. O-Balance Sheet Risk Charges iv. Total Risk Charge (c) Illustration (d) The New Basel Accord i. Issues with the 1988 Basel Accord ii. Definition of Capital iii. The Credit Risk Charge iv. The Operational Risk Charge v. Evaluation (e) Conclusions

Evaluation

Course evaluation will be done as following:

1. One case study (Goldman UDEM Investment Banking - Risk Management Department) presented and evaluated by 3 risk management written reports in English, that occur during the partial and final exam dates, and three presentations, that occur during the partial and final exam dates. There will be 3 (three) evaluations during the semester. The final grade will be a weighted average of the three exams:

1. Partial Exam 1 - 22/02/2017 - 30% (Risk Management Report). 2. Partial Exam 2 - 29/03/2017 - 30% (Risk Management Report). 3. Final Exam - 17/05/2017 - 40% (Risk Management Report).

On the final exam, the groups will present jointly the reports (10 mins presentations in English), and this will have a weight of 30% of the reports for that exam, with the other 70% corresponding to the evaluation of written work. There will be four grades during the presentation: the upper grade will be the presentation grade +2 points for the best presenter, +1 point for the second best, -1 point for the third best, and -2 points for the worst presenter. A report that is not presented on time will have zero grade.

It will be considered approved the student with minimum assistance that obtains a total grade superior to 70 from the three evaluations. Will be considered failed the student with less than 70 points (69.5, for example). The student with more than 3 weeks of nonattendance will not be able to participate in the final exam.

References

[1] JORION, Phillipe. Financial Risk Manager Handbook. Fourth Edition. New Jersey, John Wiley & Sons, 2007. [2] JORION, Phillipe. Value at Risk: The New Benchmark for Managing Financial Risk. Second Edition. New York, McGraw{Hill, 2001. [3] CHOUDHRY, Moorad. An Introduction to Value-at-Risk. Fourth Edition. New Jersey, John Wiley & Sons, 2006. [4] ALEXANDER, C. Market Risk Analysis, Volume I: Quantitative Methods in Finance. West Sussex, John Wiley & Sons, 2008. [5] ALEXANDER, C. Market Risk Analysis, Volume II: Practical Financial Econometrics. West Sussex, John Wiley & Sons, 2008. [6] ALEXANDER, C. Market Risk Analysis, Volume III: Pricing, Hedging and Trading. West Sussex, John Wiley & Sons, 2008. [7] ALEXANDER, C. Market Risk Analysis, Volume IV: Value at Risk Models. West Sussex, John Wiley & Sons, 2008.