Handbook of Market Risk

CHRISTIAN SZYLAR, PhD, is Global Head of Risk at Marshall Wace, LLP. Dr. Szylar has over eighteen years of working experience with international financial organizations and has advised numerous financial institutions on how best to implement efficient risk management in banking as well as in both UCITS and hedge fund markets. Dr. Szylar has taught multiple master's-level courses on market risk and speaks regularly at international conferences.

A ONE-STOP GUIDE FOR THE THEORIES, APPLICATIONS, AND STATISTICAL METHODOLOGIES OF MARKET RISK
 

Understanding and investigating the impacts of market risk on the financial landscape is crucial in preventing crises. Written by a hedge fund specialist, the Handbook of Market Risk is the comprehensive guide to the subject of market risk.
 
Featuring a format that is accessible and convenient, the handbook employs numerous examples to underscore the application of the material in a real-world setting. The book starts by introducing the various methods to measure market risk while continuing to emphasize stress testing, liquidity, and interest rate implications. Covering topics intrinsic to understanding and applying market risk, the handbook features:
* An introduction to financial markets
* The historical perspective from market
* events and diverse mathematics to the
* value-at-risk
* Return and volatility estimates
* Diversification, portfolio risk, and
* efficient frontier
* The Capital Asset Pricing Model
* and the Arbitrage Pricing Theory
* The use of a fundamental
* multi-factors model
* Financial derivatives instruments
* Fixed income and interest rate risk
* Liquidity risk
* Alternative investments
* Stress testing and back testing
* Banks and Basel II/III
 

The Handbook of Market Risk is a must-have resource for financial engineers, quantitative analysts, regulators, risk managers in investments banks, and large-scale consultancy groups advising banks on internal systems. The handbook is also an excellent text for academics teaching postgraduate courses on financial methodology.

Authored by an acknowledged expert in the quantification of market risk, this one-stop guide conveniently and systematically displays all of the financial engineering topics, theories, applications, and current statistical methodologies that are intrinsic to the subject matter.

Foreword xv
 
Acknowledgments xvii
 
About the Author xix
 
Introduction xxi
 
1 Introduction to Financial Markets 1
 
1.1 The Money Market 4
 
1.2 The Capital Market 5
 
1.2.1 The Bond Market 6
 
1.2.2 The Stock Market 16
 
1.3 The Futures and Options Market 19
 
1.4 The Foreign Exchange Market 22
 
1.5 The Commodity Market 22
 
Further Reading 26
 
2 The Efficient Markets Theory 27
 
2.1 Assumptions behind a Perfectly Competitive Market 28
 
2.2 The Efficient Market Hypothesis 30
 
2.2.1 Strong EMH 31
 
2.2.2 Semi-Strong EMH 32
 
2.2.3 Weak-Form EMH 32
 
2.3 Critics of Effi cient Markets Theory 33
 
2.4 Development of Behavioral Finance 35
 
2.5 Beating the Market: Fundamental versus Technical 35
 
2.5.1 Fundamental Methods 36
 
2.5.2 Technical Analysis 39
 
Further Reading 42
 
3 Return and Volatility Estimates 44
 
3.1 Standard Deviation 47
 
3.2 Standard Deviation with a Moving Observation Window 48
 
3.3 Exponentially Weighted Moving Average (EWMA) 50
 
3.4 Double (Holt) Exponential Smoothing Model (DES) 53
 
3.5 Principal Component Analysis (PCA) Models 53
 
3.6 The VIX 54
 
3.7 Geometric Brownian Motion Process 55
 
3.8 GARCH 56
 
3.9 Estimator Using the Highest and Lowest 56
 
3.9.1 Parkinson Estimator 56
 
3.9.2 Rogers Satchell Estimator 57
 
3.9.3 Garman-Klass Estimator 57
 
Further Reading 58
 
4 Diversification, Portfolios of Risky Assets, and the Efficient Frontier 59
 
4.1 Variance and Covariance 61
 
4.2 Two-Asset Portfolio: Expected Return and Risk 61
 
4.3 Correlation Coefficient 63
 
4.3.1 Correlation Coefficient and Its Impact on Portfolio Risk 63
 
4.3.2 The Number of Assets in a Portfolio and Its Impact on Portfolio Risk 66
 
4.3.3 The Effect of Diversification on Risk 68
 
4.4 The Efficient Frontier 69
 
4.5 Correlation Regime Shifts and Correlation Estimates 80
 
4.5.1 Increased Correlation 80
 
4.5.2 Severity of Correlation Changes 84
 
4.6 Correlation Estimates 88
 
4.6.1 Copulas 90
 
4.6.2 Moving Average 91
 

4.6.3 Correlation Estimators in Matrix Notation 92
 
4.6.4 Bollerslev's Constant Conditional Correlation Model 93
 
4.6.5 Engle's Dynamic Conditional Correlation Model 94
 
4.6.6 Estimating the Parameters of the DCC Model 95
 
4.6.7 Implementing the DCC Model 97
 
Further Reading 100
 
5 The Capital Asset Pricing Model and the Arbitrage Pricing Theory 101
 
5.1 Implications of the CAPM Assumptions 102
 
5.1.1 The Same Linear Efficient Frontier for All Investors 102
 
5.1.2 Everyone Holds the Market Portfolio 102
 
5.2 The Separation Theorem 105
 
5.3 Relationships Defined by the CAPM 107
 
5.3.1 The Capital Market Line 107
 
5.3.2 The Security Market Line 109
 
5.4 Interpretation of Beta 110
 
5.5 Determining the Level of Diversifi cation of a Portfolio 112
 
5.6 Investment Implications of the CAPM 112
 
5.7 Introduction to the Arbitrage Pricing Theory (APT) 115
 
Further Reading 119
 
6 Market Risk and Fundamental Multifactors Model 120
 
6.1 Why a Multifactors Model? 122
 
6.2 The Returns Model 124
 
6.2.1 The Least-Squares Regression Solution 124
 
6.2.2 Statistical Approaches 131
 
6.2.3 Hybrid Solutions 134
 
6.3 Estimation Universe 134