125.

811 Advanced Risk Analytics

Week 1: Basics of Risk Management – A Review

 Lecturer

❖ Assoc. Prof. Hung Do

❖ Phone: (09) 4140800 Ext 43160
❖ Email: [email protected]
❖ Room: QB2.34A
❖ Zoom link: https://massey.zoom.us/j/2188823606
Sessions: 9am – 12pm Sundays (Vietnam local time)
(See more details in the course guide)

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 Materials
Required textbook:
Risk Management and Financial Institutions
Author: John C. Hull
Edition: 5th
Publisher: Wiley Finance
ISBN-13: 978-1-119-44811-2

Information about other recommended books is presented

in the Course Guide. Other materials will be posted on
STREAM.

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 Topics
Week 1 (20 Jun) Basics of risk management: a review Chapter 1

Week 2 (27 Jun) Learnings from the financial disasters Chapter 6

Week 3 (04 Jul) How traders manage their risks Chapter 8. A1 announced.

Week 4 (11 Jul) Market risk analytics I – Volatility and GARCH Chapter 10

Week 5 (18 Jul) Market risk analytics II – Correlations and Copulas Chapter 11

Week 6 (25 Jul) Credit risk analytics I – PD, LGD and EAD Chapter 19
MID-SEMESTER BREAK (26 July – 07 August)
Week 7 (08 Aug) Credit risk analytics II – Credit Value at Risk Chapter 21

Week 8 (15 Aug) Case study assessment and discussion A1 dues. A2 announced.

Week 9 (22 Aug) Country risk: Determinants, measures, and implications Reading materials (on Stream)

Week 10 (29 Aug) Operational risk and measuring operational risk Chapter 23

Week 11 (05 Sep) Liquidity risk Chapter 24

Week 12 (12 Sep) Model risk management and Review Chapter 22, 25. A2 dues.

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 Learning outcomes

1. Appraise current risk management practices.

2. Analyse the evolving process of risk management from
historical shocks and appraise their financial
implications.
3. Analyse financial data to formulate risk modelling and
monitoring frameworks.
4. Critique the accepted practices of ethical conduct and
professional integrity of financial risk practitioners.

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 Assessments

Learning Percentage
Assessment Due Dates
Outcomes Weighting
Case study 1,2,4 20% Week 8
Individual project 3,4 20% Week 12
Final Exam 1,2,3,4 60% TBC

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 Assessment 1: Case study (group work)
Announced Week 3

Due date Week 8

Structure Case studies about financial disasters/crises will be given. You will
be required to describe the historical background, identify factors
which played an important role in the disasters/crises, identify
different types of risks and appraise their financial implications. You
will also be required to identify any possible violation of the ethical
conducts in the case studies and its consequences.

Submission 125.811 Advanced Risk Analytics Stream site. Under Assessment

section, click on the dropbox labelled “125811 Case study” to
upload your work.

Resources Lecture notes, textbook, reading materials and other internet

source.

Worth Maximum of 20% of final mark

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 Assessment 2: Individual project
Announced Week 8

Due date Week 12

Structure You will be required to collect and analyse financial data. Based on
the real data, you will also be required to build, validate and
stress-test the risk modelling and monitoring framework.
Statistical software can be used to generate results for this project.

Submission 125.811 Advanced Risk Analytics Stream site. Under Assessment

section, click on the dropbox labelled “125811 Individual project”
to upload your work.

Resources Lecture notes, textbook, reading materials and other internet

source.

Worth Maximum of 20% of final mark

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 Risk and Risk Management: A review

Chapter 1

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 Risk vs Return for Investors

• There is a trade off between risk and expected return

• The higher the risk, the higher the expected return
• A convenient measure of risk often used is the
standard deviation of the returns: an uncertainty in
return of an investment.

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 Example
• Consider two alternative investments:
• Buy Treasury bills which yield 5% (risk free)
• Buy stocks with returns for an equity investment are:

Probability Return
0.05 +50%
0.25 +30%
0.40 +10%
0.25 –10%
0.05 –30%

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 Example
• We can characterize investments by their expected
return and standard deviation of return
• For treasuries:
• Expected return = 5%
• Risk (standard deviation of returns) = 0%
• For the equity investment:
• Expected return =10%
• Standard deviation of return =18.97%
• Increasing the expected return from 5% to 10%
requires an additional risk of 18.97% in terms of SD.
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 Combining Two Risky Investments

 P = w11 + w22 P = w1212 + w2222 + 2w1w212

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Expected
Return (%)
1 = 10%
14

12

 2 = 15% 10

1 = 16% 8

 2 = 24%
6

 = 0 .2 2 Standard Deviation
of Return (%)

0
0 5 10 15 20 25 30

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 Combining all possible risky investments:
Efficient Frontier
NW
Efficient
• Curve moves to the
Expected Frontier
North-West (NW)
Return direction if more risky
assets added to the
risky portfolio

Investments • Efficient frontier

represents the limit
that the curve can
move to the NW
S.D. of direction
Return

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 Efficient Frontier of All Investments
(Risky + Risk-Free investment)

Expected J Invest 𝛽𝐼 of funds (𝛽𝐼 < 1) in risky

Return portfolio, M, and 1 − 𝛽𝐼 in risk-
M free investment F to form I:
E(RM)
𝐸 𝑅𝐼 = 1 − 𝛽𝐼 𝑅𝐹 + 𝛽𝐼 𝐸(𝑅𝑀 )
I 𝜎𝐼 = 𝛽𝐼 𝜎𝑀
Previous
Efficient Frontier
RF F Borrow (𝛽𝐽 − 1) of funds (𝛽𝐽 >
New Efficient 1) at 𝑅𝐹 , and invest all in M to
Frontier form J:
S.D. of Return 𝐸 𝑅𝐽 = − 𝛽𝐽 − 1 𝑅𝐹 + 𝛽𝐽 𝐸 𝑅𝑀
M or, 𝐸 𝑅𝐽 = 1 − 𝛽𝐽 𝑅𝐹 + 𝛽𝐽 𝐸 𝑅𝑀
𝜎𝐽 = 𝛽𝐽 𝜎𝑀

• Risky Portfolio M referred as the market portfolio

• An optimal portfolio is a combination of M and F
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 Systematic vs Non-Systematic Risk
We can calculate the best fit linear relationship
between return from an investment (R) and return from
market portfolio

𝑅 − 𝑅𝐹 = 𝛼 + 𝛽 𝑅𝑀 − 𝑅𝐹 + 𝜀

Systematic Risk Non-systematic risk

(non-diversifiable) (diversifiable)

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 The Capital Asset Pricing Model

Expected
Return
E(R)
E(RM)

E ( R) − RF =  [ E ( RM ) − RF ]
RF

Beta
1.0

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 Assumptions
• Investors care only about expected return and SD of return
• The e’s of different investments are independent
• Investors focus on returns over one period
• All investors can borrow or lend at the same risk-free rate
• Tax does not influence investment decisions
• All investors make the same estimates of ’s, ’s and ’s.

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 Alpha
• Alpha measure the extra return on a portfolio in
excess of that predicted by CAPM

so that

E ( RP ) = RF + ( RM − RF )

 = RP − RF − ( RM − RF )

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 Extensions of CAPM
• Arbitrage Pricing Theory Model (Ross, 1976), Fama-
French three-factor model (1992), Carhart four-factor
model (1997), Fama-French five-factor model (2015)
• Returns depend on several factors other than excess
market returns
• We can form portfolios to eliminate the dependence
on the factors
• This leads to result that expected return is linearly
dependent on the realization of the factors

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 Risk vs Return for Companies
• If shareholders care only about systematic risk, should the
same be true of company managers?
• In practice companies are concerned about total risk
• Earnings stability and company survival are important
managerial objectives
• The regulators of financial institutions are primarily interested
in total risk
• “Bankruptcy costs” arguments show that that managers may
be acting in the best interests of shareholders when they
consider total risk

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 What Are Bankruptcy Costs?
• In a perfect world, bankruptcy would be a fast affair where
company assets can be sold at their fair market prices. In
reality, it is not the case:
• Lost sales (There is a reluctance to buy from a bankrupt company):
assets’ value (both tangible and intangible) decreases
• Large legal and accounting costs
• Project with a high total risk leads to a higher probability of
bankruptcy → it is rejected if bankruptcy cost is considered
• Bankruptcy cost is even more crucial for financial institutions:
• FIs maintain their probability of bankruptcy very low
• If this risk is other than “very low”, sources of funding will dry up

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 Approaches to Bank Risk
Management

• Risk aggregation: aims to get rid of non-systematic

risks with diversification
• Risk decomposition: tackles risks one by one
• In practice banks use both approaches

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 Types of Risk
• Two broad categories of risk: Systematic and non-
systematic risk
• Specific types of risks:
• Credit risk
• Country risk
• Liquidity risk
• Foreign-exchange risk
• Interest rate risk
• Political risk
• …
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 Risk Management Process
Identify
Risk

Oversee,
Measure
Audit, and
Risk
Realign

Control Monitor
Risks Risk

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 Global Association of Risk Professionals (GARP)
Code of Conduct
• Reference reading and video:
https://analystprep.com/study-notes/frm/part-
1/foundations-of-risk-management/garp-code-of-
conduct/
• Principles to manage the AI-driven algorithmic risk
models and ensure their alignment with code of
conduct:
https://www.garp.org/risk-
intelligence/technology/all/a1Z1W000005kXh0UAE

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 Practice Questions and Problems
1.4. What is the difference between systematic and
nonsystematic risk? Which is more important to an
equity investor? Which can lead to the bankruptcy of a
corporation?
• Systematic risk refers to the uncertainty in the movement of
the asset price corresponds to the movement of the market.
It is not diversifiable
• Non-systematic risk is idiosyncratic risk of a particular asset. It
can be diversified
• Systematic risk is more important to the equity investor
• Either risk can lead to bankruptcy of a corporation
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 Practice Questions and Problems
1.9. What is meant by risk aggregation and risk
decomposition? Which requires an in-depth
understanding of individual risks? Which requires a
detailed knowledge of the correlations between risks?
• Risk aggregation (RA) is a procedure where a portfolio of risks
is considered and diversified
• Risk decomposition (RD) refers to a procedure where risks are
handled one by one
• RD requires an in-depth understanding of individual risks
• RA requires a detailed knowledge of the correlations between
risks
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 Practice Questions and Problems
1.10. A bank’s operational risk includes the risk of very
large losses because of employee fraud, natural
disasters, litigation, and so on. Do you think
operational risk is best handled by risk decomposition
or risk aggregation?
If the potential losses are very large, it is not appropriate to
aggregate them and assume they will be diversified away. It is
more appropriate to consider them one by one and handle
them with insurance contracts, tighter internal controls, and
similar.

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 Practice Questions and Problems
1.12. Why do you think that banks are regulated to
ensure that they do not take too much risk but most
other companies (e.g., those in manufacturing and
retailing) are not?
Normally banks would need to maintain a “very low” probability
of bankruptcy. Any risk level other than “very low” may cause
panic to depositors, which can lead to dry the funding source
very quickly due to the domino effects. This in turn can increase
the likelihood of the collapse of banks and would heavily and
adversely affect the stability of the whole financial system.

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 Practice Questions and Problems
1.11. A bank’s profit next year will be normally
distributed with a mean of 0.6% of assets and a
standard deviation of 1.5% of assets. The bank’s equity
is 4% of assets. What is the probability that the bank
will have a positive equity at the end of the year?
Ignore taxes.
𝑃𝑟𝑜𝑏 𝑥 > −4% ? 𝑥 ~ 𝑁(0.6%, 1.5%)
−4% − 0.6%
𝑃𝑟𝑜𝑏 𝑥 > −4% = 𝑃𝑟𝑜𝑏 𝑧 >
1.5%
= 𝑃𝑟𝑜𝑏 𝑧 > −3.067 = 𝑃𝑟𝑜𝑏(𝑧 < 3.067) = 99.89%

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 Practice Questions and Problems
1.14. The return from the market last year was 10%
and the risk-free rate was 5%. A hedge fund manager
with a beta of 0.6 has an alpha of 4%. What return did
the hedge fund manager earn?
E(Rp) = 4% + 5% + 0.6 x (10% - 5%) = 12%

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 Practice with EViews
See Workshop document

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