Quantitative Risk Management. Concepts, Techniques and Tools. Alexander J. McNeil. R üdiger Frey. Paul Embrechts. Princeton University Press. Princeton. Quantitative Risk Management. Concepts, Techniques and Tools. A.J. McNeil, R. Frey and P. Embrechts. Princeton University Press, Paul Embrechts. PDF | The implementation of sound quantitative risk models is a vital concern for all financial institutions, Alexander J. McNeil R¨udiger Frey Paul Embrechts.

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Quantitative Risk Management. Concepts, Techniques and Tools Revised Edition by Alexander J. McNeil, Rüdiger Frey & Paul Embrechts. This book provides. Mini-Conference on Risk Management in Finance and Insurance Abstract: Together with Alexander McNeil and Rüdiger Frey we just finished. Alexander J. McNeil, Rüdiger Frey & Paul Embrechts Describing the latest advances in the field, Quantitative Risk Management Table of Contents [PDF].

Risk in Perspective There were other important cases which led to a widespread discussion of the need for increased regulation: the Herstatt Bank case in , Metallgesellschaft in or Orange County in See Notes and Comments below for further reading on the above.

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Derivatives have without doubt played a role in some spectacular cases and as a consequence are looked upon with a much more careful regulatory eye. Thus it is imperative that mathematicians take a serious interest in derivatives and the risks they generate.

Moreover, many life insurance products now have options embedded. In those days one would rely to a large extent on self-regulation or local regulation, but rules were there. However, key developments leading to the present regulatory risk-management framework are very much a twentieth century story.

Much of the regulatory drive originated from the Basel Committee of Banking Supervision. The Basel Committee does not possess any formal supranational supervising authority, and hence its conclusions do not have legal force.

Rather, it formulates broad supervisory standards and guidelines and recommends statements of best practice in the expectation that individual authorities will take steps to implement them through detailed arrangements—statutory or otherwise—which are best suited to their own national system.

The summary below is brief.

Interested readers can consult, for example, Crouhy, Galai and Mark for further details, and should also see Notes and Comments below. Its main emphasis was on credit risk, by then clearly the most important source of risk in the banking industry. Also the treatment of derivatives was considered unsatisfactory.

The birth of VaR. Around the same time, the banking industry clearly saw the need for a proper risk management of these new products. At JPMorgan, for instance, the famous Weatherstone 4. In a highly dynamic world with round-the-clock market activity, the need for instant market valuation of trading positions known as marking-to-market became a necessity.

Moreover, in markets where so many positions both long and short were written on the same underlyings, managing risks based on simple aggregation of nominal positions became unsatisfactory. Banks pushed to be allowed to consider netting effects, i. In the important Amendment to Basel I prescribed a so-called standardized model for market risk, but at the same time allowed the bigger more sophisticated banks to opt for an internal, VaR-based model i.

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Legal implementation was to be achieved by the year The coarseness problem for credit risk remained unresolved and banks continued to claim that they were not given enough incentives to diversify credit portfolios and that the regulatory capital rules currently in place were far too risk insensitive. The second Basel Accord. By a consultative process for a new Basel Accord Basel II had been initiated; this process is being concluded as this book goes to press.

The second important theme of Basel II is the consideration of operational risk as a new risk class. Industry is participating in several Quantitative Impact Studies in order to gauge the risk-capital consequences of the new accord. Parallel developments in insurance regulation. It should be stressed that most of the above regulatory changes concern the banking world.

We are also witnessing increasing regulatory pressure on the insurance side, coupled with a drive to combine the two regulatory frameworks, either institutionally or methodologically.

The Joint Forum is comprised of an equal number of senior bank, insurance and securities supervisors representing each supervisory constituency. The process is underway in many countries. The following statement is taken from this release. The Basel II Framework sets out the details for adopting more risksensitive minimum capital requirements [Pillar 1] for banking organizations.

The new framework reinforces these risk-sensitive requirements by laying out principles for banks to assess the adequacy of their capital and for supervisors to review such assessments to ensure banks have adequate capital to support their risks [Pillar 2].

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The three-pillar concept. As is apparent from the above quote, a key conceptual change within the Basel II framework is the introduction of the three-pillar concept. The New Regulatory Framework 11 time, operational risk. Whereas the treatment of market risk is unchanged relative to the Amendment of the Basel I Capital Accord, the capital charge for credit risk has been revised substantially. In computing the capital charge for credit risk and operational risk banks may choose between three approaches of increasing risk sensitivity and complexity; some details are discussed below.

It is further recognized that any quantitative approach to risk management should be embedded in a well-functioning corporate governance structure.

Thus bestpractice risk management imposes clear constraints on the organization of the institution, i. This is where Pillar 2 enters. Through this important pillar, also referred to as the supervisory review process, local regulators review the various checks and balances put into place.

Pillar 3 seeks to establish market discipline through a better public disclosure of risk measures and other information relevant to risk management. In particular, banks will have to offer greater insight into the adequacy of their capitalization. The capital charge for market risk. As discussed in Section 1.

This was addressed in detail in the Amendment to Basel I, which prescribed standardized market risk models but also allowed more sophisticated banks to opt for internal VaR models.

In Chapter 2 we shall give a detailed discussion of the calculation of VaR. Credit risk from Basel I to II. In a banking context, by far the oldest risk type to be regulated is credit risk.

As mentioned in Section 1. In Basel I, creditworthiness is split into three crude categories: governments, 12 1. Risk in Perspective regulated banks and others. Also, the risk weight for all corporate borrowers is identical, independent of their credit-rating category. Due to its coarseness, the implementation of Basel I is extremely simple. This is the main content of the new Basel II proposals, where banks will be allowed to choose between standardized approaches or more advanced internal-ratingsbased IRB approaches for handling credit risk.

Already the banks opting for the standardized approach can differentiate better among the various credit risks in their portfolio, since under the Basel II framework the risk sensitivity of the available risk weights has been increased substantially.

This issue is currently being debated in the risk community, and it is widely expected that in the longer term a revised version of the Basel II Capital Accord allowing for the use of fully internal models will come into effect.

In Chapter 8, certain aspects of the regulatory treatment of credit risk will be discussed in more detail. Opening the door to operational risk. A basic premise for Basel II was that, whereas the new regulatory framework would enable banks to reduce their credit risk capital charge through internal credit risk models, the overall size of regulatory capital throughout the industry should stay unchanged under the new rules.

This opened the door for the new risk category of operational risk, which we discuss in more depth in Section The introduction of this new risk class has led to heated discussions among the various stakeholders. Whereas everyone agrees that risks like human risk e. For more detail see, for example, Crouhy, Galai and Mark Some criticism. Customer-protection acts, basic corporate governance, clear guidelines on fair and comparable accounting rules, the ongoing pressure for transparent customer and shareholder information on solvency, capital- and riskmanagement issues are all positive developments.

This herding phenomenon has been suggested in connection with the crash and the events surrounding the LTCM crisis.

Several critical discussions have taken place questioning to what extent the crocodile of regulatory risk management is eating its own tail. The reader should be aware that there are several aspects to the overall regulatory side of risk management which warrant further discussion.

The Basel process has the very laudable aspect that constructive criticism is taken seriously. We concentrate on the current solvency discussion, also referred to as Solvency 2.

The following statement, made by the EU Insurance 14 1. The difference between the two prudential regimes goes further in that their actual objectives differ. The prudential objective of the Basel Accord is to reinforce the soundness and stability of the international banking system.

To that end, the initial Basel Accord and the draft New Accord are directed primarily at banks that are internationally active. The draft New Accord attaches particular importance to the self-regulating mechanisms of a market where practitioners are dependent on one another. In the insurance sector, the purpose of prudential supervision is to protect policyholders against the risk of isolated bankruptcy facing every insurance company.

The various solvency committees in EU member countries and beyond are trying to come up with some global principles which would be binding on a larger geographical scale. We discuss some of the more recent developments below. From Solvency 1 to 2.

This led to a single, robust system which is easy to understand and inexpensive to monitor. However, on the negative side, it is mainly volume based and not explicitly risk based; issues like guarantees, embedded options and proper matching of assets and liabilities were largely neglected in many countries.

These and further shortcomings will be addressed in Solvency 2. At the heart of Solvency 2 lies a risk-oriented assessment of overall solvency, honouring the three-pillar concept from Basel II see the previous section.

Insurers are encouraged to measure and manage their risks based on internal models. Why Manage Financial Risk? In principle, all risks are to be analysed including underwriting, credit, market, operational corresponding to internal operational risk under Basel II , liquidity and event risk corresponding to external operational risk under Basel II. Strong emphasis is put on the modelling of interdependencies and a detailed analysis of stress tests.

The system should be as much as possible principle based rather than rules based and should lead to prudent regulation which focuses on the total balance sheet, handling assets and liabilities in a single common framework. Each of these stakeholders may have a different answer, and, at the end of the day, an equilibrium between the various interests will have to be found. In this section, we will focus on some of the players involved and give a selective account of some of the issues.

It is not our aim, nor do we have the competence, to give a full treatment of this important subject. The regulatory process culminating in Basel II has been strongly motivated by the fear of systemic risk, i. Risk in Perspective past year.

The development of our paradigms for containing risk has emphasized dispersion of risk to those willing, and presumably able, to bear it. In the face of such spillover scenarios, society views risk management positively and entrusts regulators with the task of forging the framework that will safeguard its interests.

Consider the debate surrounding the use and misuse of derivatives. Perhaps contrary to the popular view, derivatives should be seen as instruments that serve to enhance stability of the system rather than undermine it, as argued by Greenspan in the same address.

Moreover, the counterparty credit risk associated with the use of derivative instruments has been mitigated by legally enforceable netting and through the growing use of collateral agreements.

Quantitative Risk Management - Concepts, Techniques and Tools

Questions to be answered include the following. In this way we hope to alert the reader to the fact that there is more to RM than 1. The potential irrelevance of corporate RM for the value of a corporation is an immediate consequence of the famous Modigliani—Miller Theorem Modigliani and Miller This leads to the following rationales for RM.

The last two points merit a more detailed discussion. Bankruptcy costs consist of direct bankruptcy costs, such as the cost of lawsuits, and the more important indirect bankruptcy costs. Moreover, increased likelihood of bankruptcy often has a negative effect on key employees, management and customer relations, in particular in areas where a client wants a long-term business relationship.

For instance, few customers 18 1. Risk in Perspective would want to enter into a life insurance contract with an insurance company which is known to be close to bankruptcy. On a related note, banks which are close to bankruptcy might be faced with the unpalatable prospect of a bank run, where depositors try to withdraw their money simultaneously. A further discussion of these issues is given in Altman For references to the literature see Notes and Comments.

This is directly linked to the notion of economic capital. Quantitative Risk Management 19 Given such a value distribution, the next step involves the determination of the probability of default solvency standard that is acceptable to the institution.

The mapping from risk solvency standard to capital often uses standard external benchmarks for credit risk.

The choice of horizon must relate to natural capital planning or business cycles, which might mean one year for a bank but typically longer for an insurance company. In the ideal RM set-up, it is economic capital that is used for setting risk limits.

Or, as stated in Drzik, Nakada and Schuermann , economic capital can serve as a common currency for risk limits. We hope that our brief discussion of the economic issues surrounding modern RM has convinced the reader that there is more to RM than the mere statistical computation of risk measures, important though the latter may be.

The Notes and Comments provide some references for readers who want to learn more about the economic foundations of RM. In the remainder of the book we adopt a somewhat narrower view and treat QRM as a quantitative science using the language of mathematics in general, and probability and statistics in particular.

In this section we describe the challenge that we have attempted to meet in this book and discuss where QRM may lead in the future. In doing this we have been guided by the consideration of what topics should form the core of a course on QRM for a wide audience of students interested in RM issues; nonetheless, the list is far from complete and will continue to evolve as the discipline matures.

In the following paragraphs we elaborate on some of these issues. Risk in Perspective Extremes matter. Improving the characterization of the distribution of extreme values is of paramount importance. The interdependence and concentration of risks. A further important challenge is presented by the multivariate nature of risk. Volume 37 , Issue 3. Please check your email for instructions on resetting your password. If you do not receive an email within 10 minutes, your email address may not be registered, and you may need to create a new Wiley Online Library account.

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Volume 37 , Issue 3 May Pages This was addressed in detail in the Amendment to Basel I, which prescribed standardized market risk models but also allowed more sophisticated banks to opt for internal VaR models. At the heart of Solvency 2 lies a risk-oriented assessment of overall solvency, honouring the three-pillar concept from Basel II see the previous section.

For GBP online orders, e-mail: A further risk category that has received a lot of recent attention is operational risk, the risk of losses resulting from inadequate or failed internal processes, people and systems, or from external events. Perhaps contrary to the popular view, derivatives should be seen as instruments that serve to enhance stability of the system rather than undermine it, as argued by Greenspan in the same address.

For the insurance company, the policy sold may or may not be triggered by the underlying event covered. Describing the latest advances in the field, Quantitative Risk Management covers the methods for market, credit and operational risk modelling.