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Samenvatting  Risk management and financial institutions

1.1 LECTURE SHEETS SUMMARY LESSON 1&2

What is Risk Management?
RM is a hybrid discipline combining tools of statistics, probability, economics, fincance, decision theory and management.

What's the aim of RM?
 to identify, asess and prioritize risks;
 to minimize, monitor, and control the probability of unfortunate events;
 to maximize business oportunities

Name some of the benefits of RM to society
 it helps in lowering systemic risk;
 it aims at dispersing risks, so that economic shocks are more easily absorbed and do not cause cascading failures;
 it increases the general stability of the system.

Name some of the benefits of RM to shareholders and companies.
 it may reduce tax costs, by reduing the variability of cash flow;
 it increases the credit scoring and the value of a company, by making bankruptcy less likely;
 it reduces the costs of external financing, since it helps in achieving optimal investment.

What is risk? (definition restricted to economics and finance)
the probability that an actual return (or loss) on an investment/financial decision will be lower (or higher) than the expected return (or loss).

Can we always quantify financial risks?
No, because of Knightian uncertainty (from Frank Knight). This is uncertainty that we cannot measure, calculate or estimate.

Name three types of financial risk often discussed in the book.
Market Risk, Credit Risk and Operational Risk

What is meant by the expected return?
The expected return is the expected value of the returns (or roughly: the weighted average of returns).

Denote the formula for the standard deviation (STD(R)=...)
STD(R) = sqrt(E[R^2]  (E[R])^2)

What's the practical use of a risk measure?
A risk measure is meant to determine the amount of an asset (or set of assets) to be kept in reserve. The aim of a reserve is to guarantee that the presence of capital that can be used as a (partial) cover if the risky event manifests itself, generating a loss.

Denote the formula for the SD of a combined portfolio consisting of 2 investments.
sigma(portfolio) = sqrt ( w1^2*sig1^2 + w2^2*sig2^2 + 2*rho1,2*w1*w2*sig1*sig2 )

What does the efficient frontier represent?
The EF represents all portfolios that maximize the E[R] and minimize sigma[R], thus dominating all other portfolios. The portfolios on the EF are convex linear combinations of all the portfolios of the economy.

Give an example of a risk free invesment and explain why we call it 'risk free' and the difference between a risky investment.
An example of a risk free investment is a German federal bond (the bund). It's risk free because it guarantees a constant return (the risk free rate). The difference between the bund and a risky investment is that a risky investment has a higher expected return, but there's a chance it will generate a loss. The lower risk free return is 'sure'.

How do we get from the efficient frontier to the new efficient frontier and what is represented by the touch point?
We add the Riskfree rate to the graph and then we draw a tangent line from this point to the EF. The point where the two meet represents the market portfolio.

Which is a straight line: The new efficient frontier or the efficient frontier and why?
The NEF is a straight line. This is because we draw a tangent line from the riskfree rate to the EF and beyond, because now investors can choose the most rewarding portfolio combination in terms of the SD and return.

What is the capital asset pricing model and give the formula's with and without alpha.
It's a model used to determine the theoretically appropriate required rate of return of an asset, if the asset is to be added to an already welldiversified portfolio, given that asset's nondiversifiable risk.
E[R] = alpha + beta*R(M) + epsilon
E[R] = (1beta)*R(F) + beta*E[R(M)]
where beta*R(M) is known as systematic risk (SR) and epsilon is called the nonsystematic/idyosincratic risk (IR).

Explain the difference between systematic risk and nonsystematic/idyosincratic risk.
IR can be controlled with diversification, but SR depends on the economy as a whole and can therefore not be diversified. E.g. a riskaverse investor will require extra returns to compensate for SR.

Does the CAPM work in reality?
It is an estimation calculated with strong assumptions which don't apply to the real world (e.g. the world is guassian and linearity). It's used because it's simple and easy to understand by nonexperts.
Laatst toegevoegde flashcards
The weight (gamma) given to the longrun average variance rate is 1alphabeta, and the longrun average variance rate is omega/(1  alpha  beta).
 Increasing omega increases the longrun average variance rate.
 Increasing alpha increases the weight given to the most recent data item, reduces the weight given to the longrun average variance rate, and increases the level of the longrun average variance rate.
 Increasing beta increases the weight given to the previous variance estimate, reduces the weight given to the longrun average variance rate, and increases the level of the longrun average variance rate.
GARCH(1,1) adapts the EWMA model by giving some weight to a longrun average variance rate. Whereas the EWMA has no mean reversion, GARCH(1,1) is consistent with a meanreverting variancerate model.
Implied volatility is the volatility that leads to the option price equaling the market price when BlackScholes assumptions are used. It is found by 'trial and error'. Since different options have different implied volatilities, traders are not using the same assumptions as BS.
Traders assume 252 (business) days because the volatility on the market is much higher when the market is open.
Marginal VaR is the rate of change of VaR with the amount invested in the ith asset. Incremental VR is the incremental effect of the ith asset on VaR (i.e., the difference between VaR with and without the asset). Component VaR is the part of VaR that can be attributed the ith asset (the sum of component VaRs equals the total VaR.
A spectral risk measure is a risk measure that assigns weights to the quantiles of the loss distribution. For the subadditicity condition to be satisfied, the weight assigned to the qth quenatile must be a nondecreasing function of q.
Companies may be linked by systemic risk, commercial relations or other forms of dependence. This may cause the distribution of defaults to ' spread' and we see a larger number of defaults with a higher probability. The more defaults are dependent, the more the loss distributions shifts to the left and shows a fatter right tail.
The world is not Gaussian. Loss distributions are often highly skewed and possess relatively heavy upper tails. There's need for EVT in determining risk capital.
Te management of a firm has more information about the firm itself than every other bank or fin. institution, which creates mistrust and volatility on the market.
Scarce inormation about the credit quality of corporations and, often, individuals. There's few data for calibration.