Class 1: Financial Risk and Modeling

Question 1

What is Financial Risk?

Answer 1

Risk is the potential for divergence between the actual outcome and what is expected.

In finance, risk is usually related to whether expected cash flows will materialize, and returns will be as expected or whether security prices will fluctuate unexpectedly.

• Expected Value of Cashflows
• Volatility of asset price

Question 2

Measuring Performance

Answer 2

Dollar return (over one period):
= Dividends + End of Period Price – Beginning of Period Price

Percentage return (over one period):
=Dollar return/Beginning of Period Price
=(Dividends + End of Period Price)/Beginning of Period Price -1

Examples: calculate both $ and % returns
P0=$50, Div1=$2, P1=$55.50
P0=$20, Div1=$0.25, P1=$12.75
P0 = $30, Div1=$1, Capital Gain=$5
P0 = $130, Div1=$0, Capital Loss=$128

Question 3

Holding Period Return

Answer 3

Question 4

What is the Mean Return?

Answer 4

Question 5

What is expected Value [EV]

Answer 5

Question 6

What is a Risk Premium?

Answer 6

• Definition: the risk premium is the return on a risky security minus the return on a risk-free security (often T-bills are used as the risk-free security)
• Another name for a security’s risk premium is the excess return of the risky security.
  The market risk premium is the return on the market (as a whole) minus the risk-free rate of return.
• We may talk about the past observed risk premium, the average risk premium, or the expected risk premium.

Question 7

What are the risk measures of stock (distribution)?

Answer 7

Studies of stock returns indicate they are approximately normally distributed. Two statistics describe a normal distribution, the mean and the standard deviation .

For stock returns, a more spread out distribution means there is a higher probability of returns being farther away from the mean.

For our estimate of the expected return, we can use the mean of returns from a sample of stock returns.

For our estimate of the risk, we can use the standard deviation or variance calculated from a sample of stock returns.

Question 8

What is some Risk Modeling background?

Answer 8

Risk modeling has existed in certain industries in which taking calculated risk is an integral part of the business, e.g., financial services.

For the last decade, public and private firms have begun to adopt an array of risk models to address strategic, operational, compliance, geopolitical, and other types of risk.

Wider availability of data and sophisticated analysis capabilities is making modeling more practical; at the same time, the need to cope with an increasingly risky environment is making it more valued.

Question 9

What is Big Data? And what are the results of the use of Big Data?

Answer 9

The rise of Big Data and the introduction of dynamic data visualization tools have spurred an increased appetite for using data analytics to address risk.

However, data analytics has its limitations, and one of them is that the historical data used is inherently backward looking.

So, you’re seeing how a system has behaved in the past, and you can look for correlations, which can give you some indication of causation.

But if you want to be predictive, you can’t extrapolate those results into the future assuming that the system will behave in the future as it has in the past.

That’s where modeling comes in—as an adjunct to data analytics and other statistical techniques and a powerful decision-making tool in its own right.

Question 10

What is a risk model? What are the two greatest challenges of risk modeling?

Answer 10

A risk model is a mathematical representation of a system, commonly incorporating probability distributions.

Models use relevant historical data as well as “expert judgement” from people versed in the topic at hand to understand the probability of a risk event occurring and its potential severity.

Gathering the right data is one of the two greatest challenges of risk modeling; the second is getting decision makers comfortable enough with the models and their underlying assumption to use them when making meaningful decisions.

Question 11

What is involved in the Risk Model Lifecycle?

Answer 11

Model and Development Acquisition

Model Implementation

Model Validation

Model Approval

Model Ongoing Monitoring

Model Change Management

Model Retirement

Question 12

What is Credit Risk?

Answer 12

Question 13

What is Value at Risk (VaR)?

Answer 13

Question 14

What does Expected Shortfall mean?

Answer 14

Question 15

What is Prepayment Risk?

Answer 15

Question 16

What types of calculus for modeling will be used?

Answer 16

Question 17

What are non linear models?

Answer 17

Question 18

What is Model Risk?

Answer 18

Model risk is a type of risk that occurs when a financial model is used to measure quantitative information, and the model performs inadequately and leads to adverse outcomes.

In finance, models are used to identify potential future stock values & trading opportunities, and help managers make business decisions.
Model risk is present whenever an insufficiently accurate model is used to make decisions.

Model risk can stem from using a model with bad specifications, programming or technical errors, or data or calibration errors.

Model risk can be reduced with model management such as backtesting, benchmarking, governance policies, internal audit and independent review.