Elements of Financial Risk Management

Peter Christoffersen

• Publisher: Academic Press
• Year: 2011
• ISBN:
  9780080922430
• Edition: 2
• Topic: Commerce
• Subtopic: Investissements et valeurs mobilières

The Second Edition of this best-selling book expands its advanced approach to financial risk models by covering market, credit, and integrated risk. With new data that cover the recent financial crisis, it combines Excel-based empirical exercises at the end of each chapter with online exercises so readers can use their own data. Its unified GARCH modeling approach, empirically sophisticated and relevant yet easy to implement, sets this book apart from others. Five new chapters and updated end-of-chapter questions and exercises, as well as Excel-solutions manual, support its step-by-step approach to choosing tools and solving problems.

• Examines market risk, credit risk, and operational risk
• Provides exceptional coverage of GARCH models
• Features online Excel-based empirical exercises

1. Risk Management and Financial Returns

This chapter begins by listing the learning objectives of the book. We then discuss theoretical reasons for why firms should spend resources on risk management and discuss the empirical evidence of the effectiveness and impact of current risk management practices in the corporate and financial sectors. Next, we list the types of risks faced by a corporation, and we briefly discuss the costs and benefits of exposure to each type of risk. The chapter also develops a list of stylized facts of asset returns, which a proper risk model needs to capture. Finally, we introduce the Value-at-Risk concept for risk measurement.

Keywords: Types of risk, asset returns, stylized facts of returns, Value-at-Risk.

1. Chapter Outline

This chapter begins by listing the learning objectives of the book. We then ask why firms should be occupied with risk management in the first place. In answering this question, we discuss the apparent contradiction between standard investment theory and the emergence of risk management as a field, and we list theoretical reasons why managers should give attention to risk management. We also discuss the empirical evidence of the effectiveness and impact of current risk management practices in the corporate as well as financial sectors. Next, we list a taxonomy of the potential risks faced by a corporation, and we briefly discuss the desirability of exposure to each type of risk. After the risk taxonomy discussion, we define asset returns and then list the stylized facts of returns, which are illustrated by the S&P 500 equity index. We then introduce the Value-at-Risk concept. Finally, we present an overview of the remainder of the book.

2. Learning Objectives

The book is intended as a practical handbook for risk managers as well as a textbook for students. It suggests a relatively sophisticated approach to risk measurement and risk modeling. The idea behind the book is to document key features of risky asset returns and then construct tractable statistical models that capture these features. More specifically, the book is structured to help the reader

• Become familiar with the range of risks facing corporations and learn how to measure and manage these risks. The discussion will focus on various aspects of market risk.

• Become familiar with the salient features of speculative asset returns.

• Apply state-of-the-art risk measurement and risk management techniques, which are nevertheless tractable in realistic situations.

• Critically appraise commercially available risk management systems and contribute to the construction of tailor-made systems.

• Use derivatives in risk management.

• Understand the current academic and practitioner literature on risk management techniques.

3. Risk Management and the Firm

Before diving into the discussion of the range of risks facing a corporation and before analyzing the state-of-the art techniques available for measuring and managing these risks it is appropriate to start by asking the basic question about financial risk management.

3.1. Why Should Firms Manage Risk?

From a purely academic perspective, corporate interest in risk management seems curious. Classic portfolio theory tells us that investors can eliminate asset-specific risk by diversifying their holdings to include many different assets. As asset-specific risk can be avoided in this fashion, having exposure to it will not be rewarded in the market. Instead, investors should hold a combination of the risk-free asset and the market portfolio, where the exact combination will depend on the investor's appetite for risk. In this basic setup, firms should not waste resources on risk management, since investors do not care about the firm-specific risk.

From the celebrated Modigliani-Miller theorem, we similarly know that the value of a firm is independent of its risk structure; firms should simply maximize expected profits, regardless of the risk entailed; holders of securities can achieve risk transfers via appropriate portfolio allocations. It is clear, however, that the strict conditions required for the Modigliani-Miller theorem are routinely violated in practice. In particular, capital market imperfections, such as taxes and costs of financial distress, cause the theorem to fail and create a role for risk management. Thus, more realistic descriptions of the corporate setting give some justifications for why firms should devote careful attention to the risks facing them:

• Bankruptcy costs. The direct and indirect costs of bankruptcy are large and well known. If investors see future bankruptcy as a nontrivial possibility, then the real costs of a company reorganization or shutdown will reduce the current valuation of the firm. Thus, risk management can increase the value of a firm by reducing the probability of default.

• Taxes. Risk management can help reduce taxes by reducing the volatility of earnings. Many tax systems have built-in progressions and limits on the ability to carry forward in time the tax benefit of past losses. Thus, everything else being equal, lowering the volatility of future pretax income will lower the net present value of future tax payments and thus increase the value of the firm.

• Capital struc...