Multi-Asset Risk Modeling

Techniques for a Global Economy in an Electronic and Algorithmic Trading Era

Morton Glantz, Robert Kissell

• Publisher: Academic Press
• Year: 2013
• ISBN:
  9780124016941
• Topic: Business
• Subtopic: Investments & Securities
• Index: Business

Multi-Asset Risk Modeling describes, in a single volume, the latest and most advanced risk modeling techniques for equities, debt, fixed income, futures and derivatives, commodities, and foreign exchange, as well as advanced algorithmic and electronic risk management. Beginning with the fundamentals of risk mathematics and quantitative risk analysis, the book moves on to discuss the laws in standard models that contributed to the 2008 financial crisis and talks about current and future banking regulation. Importantly, it also explores algorithmic trading, which currently receives sparse attention in the literature. By giving coherent recommendations about which statistical models to use for which asset class, this book makes a real contribution to the sciences of portfolio management and risk management.

• Covers all asset classes
• Provides mathematical theoretical explanations of risk as well as practical examples with empirical data
• Includes sections on equity risk modeling, futures and derivatives, credit markets, foreign exchange, and commodities

Chapter 1

Introduction to Multi-Asset Risk Modeling—Lessons from the Debt Crisis

This introductory chapter reviews how statistical pricing and risk-forecasting models contributed to the debt crisis. For example, they gave incorrect results, underestimated risk, and mispriced collateralized debt obligations, mortgage-backed securities, and credit derivatives. Some reasons these models gave incorrect results was due to how quickly risk regimes could change due to global macroeconomic events, investor sentiment, and how ill-prepared traditional risk modeling systems (which rely on historical data) are to properly account for potential change in asset value.

We show how risk managers incorporate views and information sets across different asset classes to improve risk forecasts in rapidly changing markets. We present an overview of different types of risk and risk management products. In particular, we discuss details inherent in credit and equity risk: price risk (volatility), operational risk, country risk, default risk, company-specific risk, liquidity risk, interest rate risk, operational risk, macroeconomic factor risk. We also discuss how money managers, investors, and risk managers expand their understanding of risk and infer real-time information from derivatives and options, FX rates, debt markets, and macroeconomic changes. Finally, we discuss components of algorithmic trading, the industry’s lifeblood.

Keywords

Faulted Risk Models; Debt Crisis; Covariance Models; Volatility; Credit Risk; Liquidity Risk; Type II Statistical Error; Correlation Modeling; VIX Index; Flash Crash; Simplistic Investment Models; Static Forecasting

Financial services firms suffered significant losses brought on by one of the deepest crises ever to hit the financial services industry. As a result, risk modeling and management, loan valuation methods, capital allocation, and governance structures are shaken top to bottom. Fallout from the debt crisis continues to afflict most banks. Credit is still tight at the time of this writing. Banks, particularly those with significant levels of illiquid and difficult to sell assets, were finding it difficult to raise funds from traditional capital suppliers. In response, many institutions exited capital intensive, structured deals in an effort to deleverage and, notably, move away from international operations to concentrate on domestic business.

The debt crisis began when loan incentives, coupled with the acceleration in housing prices, encouraged borrowers to assume mortgages in the belief that they could refinance at favorable terms. Once prices started to drop, refinancing became difficult. Defaults and foreclosures increased dramatically as easy terms expired, home prices failed to go up, and interest rates reset higher. Foreclosures accelerated in late 2006, triggering a global financial crisis. Loan activities at banks froze while the ability of corporations to obtain funds through commercial paper dropped sharply. The expression a perfect storm, a “once in a hundred years” event, found its marker. The same could be said for Hurricane Sandy, Black Monday, and the October 1987 crash.

The CEO of Lehman Brothers said the firm was also the victim of “the perfect storm”—yet Lehman did not resist the lure of profits, leveraged balance sheets, and cheap credit. At Goldman Sachs, credit swaps created four billion dollars in profits. The financial modeling that helped produce results at these two investment banks were cutting edge, yet it appears that Lehman, AIG, and other profit takers amassed scant few algorithms to preserve capital protection against unexpected macroeconomic collapse.

Two government-sponsored enterprises, Fannie Mae and Freddie Mac, encouraged home sales by convincing investors that home values would rise over the long term, and that housing investments were safe. Fannie Mae and Freddie Mac created and sold Mortgage-Backed Securities (MBS), an investment considered reliable since the two firms guaranteed interest and principal payments on these loans. Originally, the two firms had strict rules governing their securities. However, during the 1990s, looser standards resulted in loan approvals to borrowers who had neither collateral nor financial strength to satisfy their obligations. Subprime loans encouraged the housing market initially, but later led to an uncontrollable housing expansion that ended up as the baseline of the financial crisis. Loan oversupply combined with the willingness of the borrowers to lend freely created an untenable outcome for lenders and borrowers.

On the government side, the debt crisis started with the notion that home ownership was a right. Fannie Mae was founded as part of Roosevelt’s New Deal to both purchase and securitize mortgages so that cash would be available to lend to home buyers. In 1970, a Republican congress created Freddie Mac to purchase mortgages on the secondary market, and pool and sell the mortgage-backed securities. Social and political pressure expanded the pool of home owners, mostly adding low- and middle-income families. The Equal Credit Opportunity Act prohibited institutional discrimination against minorities, while the Community Investment Act addressed discrimination in lending and encouraged financial institutions to lend to all income brackets in their communities.

In the early 80s, the passage of the Alternative Mortgage Transaction Parity Act preempted state laws by prohibiting adjustable rate mortgages, balloon payments, and negative amortization while allowing lenders to make loans with terms that obscured the loan’s cost. The Tax Reform Act prohibited taxpayers from deducting interest payments on consumer loans such as auto loans and credit cards, permitting them to deduct interest on mortgages, which sent homeowners in the millions to refinance mortgages and apply for home equity loans. As a result, household debt increased to 134% from 60% of disposable income. The elimination of Regulation Q was partially responsible for the Savings and Loan Crisis, resulting in a 40 billion dollar taxpayer loss. Despite the closing of hundreds of thrifts, lawmakers continued to deregulate the industry.

The Federal Housing Enterprises Financial Safety and Soundness Act of 1992 required Freddie Mac and Fannie Mae to devote a higher percentage of loans to support affordable housing. Banks were encouraged to do business across state lines, creating the mega banks we have today. Community banks, which had traditionally kept loans in neighborhoods, dwindled along with local loans. Behind the scenes, the banking lobby worked to repeal the Glass-Steagall Act of 1932 that separated commercial and investment banking. Gramm-Leach-Bliley, known also as the Financial Services Modernization Act of 1999, allowed financial institutions to operate as commercial and investment banks and insurance companies.

Many financial institutions ignored sustainability strategies¹ and credit guidelines originating at the Federal Reserve, Comptroller of the Currency, the Basel Committee, and other regulators years prior to the financial crisis. As an example, the office of the Comptroller of the Currency, Administrator of National Banks defined nine categories of risk for bank supervision purposes ten years before the crisis. Risks identified by the OCC included credit, interest rate, liquidity, price, foreign exchange, transaction, compliance, strategic, and reputation.²

Types of Risk

Credit Risk

Loans are the largest source of credit risk. There are other credit risk products, undertakings, and services included here such as the investment portfolio, overdrafts, letters of credit, and derivatives, foreign exchange, and cash management services. A financial institution’s credit policies and procedures define its risk profile. For example, sound credit policies and procedures deal with the following: (1) establish an appropriate credit risk environment; (2) operate under a sound credit granting process; (3) maintain an appropriate credit administration, measurement and monitoring process; and (4) ensure adequate controls over credit risk. Although specific credit risk management practices may differ among banks depending upon the nature and complexity of their credit activities, a comprehensive credit risk management program focuses on these four areas. These practices should also be applied in conjunction with sound practices related to the assessment of asset quality, the adequacy of provisions and reserves, and the disclosure of credit risk, all of which have been addressed in other recent Basel Committee documents.³ While the exact approach chosen by individual supervisors depends on a host of factors, doctrines set out in Principals for the Management of Credit Risk should have formed the basis of all bank audits. Yet, profits took rank over sustainability.

Effective management of multi-asset, particularly loan portfolio, credit risk requires that the board and (loan) administration understand and control an institution’s risk profile, and preserve credit culture and portfolio integrity. To accomplish this, bankers must have a thorough knowledge of the portfolio’s composition and its inherent risks. They must understand the portfolio’s product mix, industry and geographic concentrations, average risk ratings, and other aggregate characteristics. They must be sure that the policies, processes, and practices implemented to control risks of individual loans and portfolio segments are sound and that lending personnel adhere to them.⁴

Interest Rate and Market Risk

Market risks arise from adverse movements in market price or rates, for instance, interest, foreign exchange rates, or equity prices. Traditionally, management and regulators concentrated strictly on credit risk. In recent years, another group of assets have come under scrutiny: assets typically traded in financial markets. The level of interest rate risk attributed to the bank’s lending activities depends on the composition of its loan portfolio and the degree to which the terms of its loans expose the bank’s revenue stream to changes in rates. As part of the risk management process, banks typically identify exposures with heightened sensitivity to interest rate changes, and develop strategies to mitigate the risk: interest rate swaps, for example.

Liquidity Risk

Liquidity risk embodies the likelihood that an institution will be unable to meet obligations when due because assets cannot be liquidated, required funding is unavailable, or specific exposures cannot be unwound without significantly lowering market prices because of market disruptions brought on by a macroeconomic shock. Despite rigorous models and risk management controls, financial institution exposure from tail risk can accumulate. For highly leveraged financial institutions, cumulative exposure from tail risk can threaten survival in a stressed environment, as many banks learned too late. Capital position has a direct bearing on an institution’s ability to access liquidity and survive a debt crisis. Weak liquidity might cause a bank to liquefy assets or acquire liabilities to refinance maturing claims. As part of liquidity planning, a bank’s overall liquidity strategy should form an important measure of sustainable management.⁵

Price Risk

Exposures originated for sale as part of a securitization or for direct placement in the secondary market carry price risk while awaiting packaging and sale. During that period, the assets should be placed in a “held-for-sale” account, where they must be repriced at the lower of cost or market.⁶

Foreign Exchange Risk

Foreign exchange risk is present when a loan or portfolio of loans is denominated in a foreign currency or funded by borrowings in another currency. In some cases, banks enter into multi-currency credit commitments that permit borrowers to select the currency they prefer to use in each rollover period. Foreign exchange risk increases if bankers do not hedge political, social, or economic developments. In addition, results can be unfavorable if one currency becomes snarled in stringent exchange controls or experiences wide exchange-rate fluctuations.

Transaction Risk

The level of transaction risk depends on the capability of information systems and controls, the quality of operating procedures, and the capability and integrity of employees. Significant losses in loan and lease portfolios have resulted when information systems failed to provide adequate statistics to identify concentrations, failed to document auditing failures, expired facilities, or when stale financial statements led to model breakdowns. Banks have incurred losses because they failed to perfect or renew collateral liens; to obtain proper signatures on loan documents; or to disburse loan proceeds as required by the loan documents.⁷

Compliance Risk

“Lending activities encompass a broad range of compliance responsibilities and risks. By law, a bank must observ...