Financial risk modeling is the use of formal
mathematical and
econometric techniques to measure, monitor and control the
market risk,
credit risk, and
operational risk on a firm's
balance sheet
In financial accounting, a balance sheet (also known as statement of financial position or statement of financial condition) is a summary of the financial balances of an individual or organization, whether it be a sole proprietorship, a business ...
, on a bank's
trading book, or re a
fund manager's portfolio value; see
Financial risk management
Financial risk management is the practice of protecting economic value in a firm by using financial instruments to manage exposure to financial risk - principally operational risk, credit risk and market risk, with more specific variants as l ...
.
Risk modeling is one of many subtasks within the broader area of
financial modeling.
Application
Risk modeling uses a variety of techniques including
market risk,
value at risk (VaR),
historical simulation (HS), or
extreme value theory (EVT) in order to analyze a portfolio and make forecasts of the likely losses that would be incurred for a variety of risks. As above, such risks are typically grouped into
credit risk,
market risk,
model risk
In finance, model risk is the risk of loss resulting from using insufficiently accurate models to make decisions, originally and frequently in the context of valuing financial securities. However, model risk is more and more prevalent in activities ...
,
liquidity risk
Liquidity risk is a financial risk that for a certain period of time a given financial asset, security or commodity cannot be traded quickly enough in the market without impacting the market price.
Types
Market liquidity – An asset cannot be s ...
, and
operational risk categories.
Many large financial intermediary firms use risk modeling to help portfolio managers assess the amount of
capital reserves to maintain, and to help guide their purchases and sales of various classes of
financial assets.
Formal risk modeling is required under the
Basel II
Basel II is the second of the Basel Accords, which are recommendations on banking laws and regulations issued by the Basel Committee on Banking Supervision. It is now extended and partially superseded by Basel III.
The Basel II Accord was publi ...
proposal for all the major international banking institutions by the various national depository institution regulators. In the past, risk analysis was done qualitatively but now with the advent of powerful computing software, quantitative risk analysis can be done quickly and effortlessly.
Criticism
Modeling the changes by distributions with finite variance is now known to be inappropriate.
Benoît Mandelbrot found in the 1960s that changes in prices in financial markets do not follow a
Gaussian distribution
In statistics, a normal distribution or Gaussian distribution is a type of continuous probability distribution for a real-valued random variable. The general form of its probability density function is
:
f(x) = \frac e^
The parameter \mu ...
, but are rather modeled better by
Lévy stable distributions. The scale of change, or volatility, depends on the length of the time interval to a
power a bit more than 1/2. Large changes up or down, also called ''
fat tails
A fat-tailed distribution is a probability distribution that exhibits a large skewness or kurtosis, relative to that of either a normal distribution or an exponential distribution. In common usage, the terms fat-tailed and heavy-tailed are somet ...
'', are more likely than what one would calculate using a Gaussian distribution with an estimated
standard deviation
In statistics, the standard deviation is a measure of the amount of variation or dispersion of a set of values. A low standard deviation indicates that the values tend to be close to the mean (also called the expected value) of the set, whil ...
.
corporate scandals
A corporate collapse typically involves the insolvency or bankruptcy of a major business enterprise. A corporate scandal involves alleged or actual unethical behavior by people acting within or on behalf of a corporation. Many recent corporate co ...
in the past few years (most notably, Enron
Enron Corporation was an American energy, commodities, and services company based in Houston, Texas. It was founded by Kenneth Lay in 1985 as a merger between Lay's Houston Natural Gas and InterNorth, both relatively small regional compani ...
), Basel II
Basel II is the second of the Basel Accords, which are recommendations on banking laws and regulations issued by the Basel Committee on Banking Supervision. It is now extended and partially superseded by Basel III.
The Basel II Accord was publi ...
, the revised FAS 123R and the Sarbanes–Oxley Act
The Sarbanes–Oxley Act of 2002 is a United States federal law that mandates certain practices in financial record keeping and reporting for corporations.
The act, (), also known as the "Public Company Accounting Reform and Investor Protect ...
, and for their failure to predict the financial crash of 2008.[ From The Economist print edition.]
Rapid development of financial innovations lead to sophisticated models that are based on a set of assumptions. These models are usually prone to model risk
In finance, model risk is the risk of loss resulting from using insufficiently accurate models to make decisions, originally and frequently in the context of valuing financial securities. However, model risk is more and more prevalent in activities ...
. There are several approaches to deal with model uncertainty. Jokhadze and Schmidt (2018) propose practical model risk measurement framework based on Bayesian calculation.
See also
* Black–Scholes model
* Financial risk management
Financial risk management is the practice of protecting economic value in a firm by using financial instruments to manage exposure to financial risk - principally operational risk, credit risk and market risk, with more specific variants as l ...
* Knightian uncertainty
In economics, Knightian uncertainty is a lack of any quantifiable knowledge about some possible occurrence, as opposed to the presence of quantifiable risk (e.g., that in statistical noise or a parameter's confidence interval). The concept acknow ...
* Financial modeling
* Value-at-Risk
Bibliography
*
* Machina, Mark J., and Michael Rothschild (1987). "Risk," '' The New Palgrave: A Dictionary of Economics'', v. 4, pp. 201–206.
*
References
External links
Risk World
is a web site devoted to risk, with a collection of books.
A Stochastic Processes toolkit for Risk Management
at SSNR.com is a tutorial paper by Damiano Brigo, Antonio Dalessandro, Matthias Neugebauer and Fares Triki, explaining how to use different stochastic processes for risk measurement.
{{Financial risk
Actuarial science