Risk Management and The Stock Market - Prof. Pezzuto - Slides Set 1

Risk Management in Banking and Insurance
Ivo Pezzuto
Slide set 1
Investments and Financial Markets

The Big Picture
https://blog.pimco.com/en/2020/12/finding-opportunity-across-sectors
▪ An investment is about sacrificing something of value

now expecting to benefit from the sacrifice in the
future
▪ Investments can be made in real assets (i.e. land,

buildings, machines, technology) or in financial assets
(i.e. stocks, bonds, options, futures, ETFs), or
commodities (oil, silver, gold, rubber, aluminum) and
other valuable objects
▪ Real assets are used to produce goods and services
▪ Financial assets are in general claims to the income

generated by real assets
▪ Whereas real assets generate net income to the

economy, financial assets simply define the
allocation of income or wealth among investors
▪ Individuals can choose between consuming their

wealth today or investing for the future
▪ If they choose to invest in the financial markets, they

may place their in the financial assets by purchasing
various securities like stocks and bonds
▪ When investors buy these securities from companies,

the firm uses the money so raised to pay for real
assets, such as equipment, technology, or inventory
▪ So investors’ returns on securities ultimately come from
the income produced by the real assets that were
financed by the issuance of those securities
▪ Financial markets transfer funds from those who have

excess funds (surplus units) to those who need funds
(deficit units)
▪ Deficit units issue securities which are purchased by

surplus units. These securities can be debt securities or
equity securities. The deficit units consist of households,
firms, governments, foreigners
The role of the Financial Markets

▪ Liquidity – Ensure that investors can trade shares or
bonds frequently and at a fair value prevailing in the
market. A liquid and well-functioning market enables
an ease conversion of securities into cash through the
sale of securities
▪ Price Determination – Financial markets determine the

price of assets thanks to market forces (i.e. Demand
and Supply). The Secondary market, in particular, plays
an important role in determining the prices of issued
assets

▪ Fund Mobilization – Financial markets channel funds
from those who have excess funds (Savers) but lack
attractive investment opportunities to those who need
funds (Entrepreneurs/Firms) and can generate
attractive rates of return from investment projects
▪ Risk Sharing – With the help of the financial markets

the risk is partially transferred (Shared) from the firm or
entrepreneur pursuing the investment opportunity to
those providing the funds

▪ Easy Access – Financial markets provide platforms that
facilitate the matching of supply and demand of funds
(i.e. buying and selling of securities)
▪ Reduction in Transaction Costs – Financial markets

provide a broad range of information to investors and
traders that would normally require time and money to
be collected, this way they reduce the costs of
transactions
THE ROLE OF THE FINANCIAL MARKETS
▪ Capital Formation – Financial markets facilitate the exchange of

financial instruments and financial securities and thus help
playing a crucial role in the economy optimizing capital
allocation to the most promising investment opportunities (i.e.
those with potentially higher expected rates of return) through
the mobilization of funds
Risk and the Financial Markets

There is a trade-off between risk and expected

return. The higher the risk, the greater the expected
return
What is Risk?
▪ Risk, in traditional terms, is viewed as a ‘negative’. Webster’s

dictionary, for instance, defines risk as “exposing to danger or
hazard”. The Chinese symbols for risk, reproduced below,
give a much better description of risk
危机
▪ The first symbol is the symbol for “danger”, while the second
is the symbol for “opportunity”, making risk a mix of danger
and opportunity. You cannot have one, without the other.
▪ Risk is therefore neither good nor bad. It is just a fact of life.
The question that businesses have to address is therefore not
whether to avoid risk but how best to incorporate it into their
decision making.
What is Risk?
▪ To begin with, it is important to distinguish between Risk and
Uncertainty
▪ As explained by the University of Chicago economist Frank
Knight in 1921, risk involves choices we make in a world in which
outcomes are random but their probabilities are known in
advance as in gambling, which involve Risk but there is no
uncertainty (the probabilities can be predicted)
▪ However, according to Knight, markets are not really card decks
▪ In other words, outcomes cannot be modeled with a well-
defined probability distribution which makes them perfectly
known (predictable)
▪ Market models will necessarily contain model risk in varying
degrees, depending on our inability to create a perfect model
What is Risk?
▪ Thus, their predictability is confined within a certain level of

confidence in a given outcomes’ distribution (i.e. 99%
probability)
▪ Uncertainty, rather, deals with unknown risks such as in a
poker game in which the risk, which can be modeled quite
precisely in a deck of cards (exogenous risk), is elevated
because of the behavior of other players (endogenous risk)
for example, due to bluffing
▪ Risk, therefore is amplified by uncertainty
What is Risk?
▪ Investors who buy an asset expect to make a return over the

time horizon that they will hold the asset
▪ The ACTUAL RETURN that they make over this holding

period may be very different from the EXPECTED RETURN,
and this is where the RISK come in
▪ Some risk are specific to an investment or a few investments

whereas other risks (i.e. market risk) affect a much wider cross
section of investments
What is Risk?
▪ Bearing risk typically must be accompanied by a reward in

the form of a risk premium
▪ The underlying assumption is that most investors are RISK

AVERSE and they seek positive risk premiums
RISK = VARIABILITY OF THE RETURNS IN RELATION TO

THE EXPECTED RATE OF RETURN
▪ THE STANDARD DEVIATION IS A MEASURE OF VOLATILITY AND

PROVIDES A RANGE OF POTENTIAL OUTCOMES (RETURNS).
▪ Normal and Heavy-Tailed Distribution

▪ FOR MOST INVESTORS, THE RISK THEY TAKE WHEN THEY BUY
A STOCK IS THAT THE RETURN WILL BE LOWER THAN
EXPECTED
▪ IN OTHER WORDS, THE RISK IS THE DEVIATION FROM THE

AVERAGE RETURN
▪ EACH STOCK HAS ITS OWN STANDARD DEVIATION FROM THE

MEAN WHICH IS CALLED ‘RISK’
▪ THE RISK OF A PORTFOLIO OF DIVERSE INDIVIDUAL STOCKS

WILL BE LESS THAN THE RISK INHERENT IN HOLDING ANYONE
OF THE INDIVIDUAL STOCKS, AS LONG AS, THEY ARE NOT
CORRELATED (A WELL-DIVERSIFIED PORTFOLIO)
▪ DIVERSIFICATION IS A RISK MANAGEMENT TECHNIQUE THAT

MIXES A WIDE VARIETY INVESTMENTS WITHIN A PORTFOLIO.
▪ THE RATIONALE BEHIND THIS TECHNIQUE IMPLIES THAT A

PORTFOLIO CONSTRUCTED OF DIFFERENT KIND OF
INVESTMENTS WILL, ON AVERAGE, YIELD HIGHER RETURNS
AND POSE A LOWER RISK THAN ANY INDIVIDUAL INVESTMENT
WITHIN THE PORTFOLIO
▪ FURTHERMORE, DIVERSIFICATION BENEFITS CAN BE GAINED BY

INVESTING IN FOREIGN SECURITIES BECAUSE THEY TEND TO BE
LESS CLOSELY CORRELATED WITH DOMESTIC INVESTMENTS
(INTERNATIONAL DIVERSIFICATION OF THE PORTFOLIO)
The benefits of portfolio diversification



Systematic and Nonsystematic Risk

Can be eliminated by diversification
Nonsystematic
Risk
Total Risk
Systematic
Risk
▪ THERE ARE TWO KIND OF RISKS:
➢ THE SYSTEMATIC RISK
➢ THE UNSYSTEMATIC RISK
▪ THE SYSTEMATIC RISK IS REPRESENTED BY THE MARKET RISK
WHICH CANNOT BE COMPLETELY DIVERSIFIED. THESE RISKS
TYPICALLY INCLUDE: CHANGES IN INTEREST RATES ,
RECESSIONS, EXCHANGE RATES, INFLATION, ETC.
▪ THE UNSYSTEMATIC RISK , ALSO KNOWN AS ‘SPECIFIC RISK’,

THAT IS, THE RISK IS SPECIFIC TO INDIVIDUAL STOCKS, AND
CAN BE DIVERSIFIED AWAY AS ONE INCREASES THE NUMBER
OF STOCKS IN THE PORTFOLIO. IT REPRESENTS THE
COMPONENT OF STOCK’S RETURN THAT IS NOT CORRELATED
WITH GENERAL MARKET MOVES
▪ FOR A WELL-DIVERSIFIED PORTFOLIO, THE RISK - OR AVERAGE

DEVIATION FROM THE MEAN – OF EACH STOCK CONTRIBUTES
LITTLE TO PORTFOLIO RISK
▪ INSTEAD, IT IS THE DIFFERENCE BETWEEN INDIVIDUAL STOCK’S

LEVELS OF RISK (COVARIANCE) THAT DETERMINES OVERALL
PORTFOLIO RISK
▪ AS A RESULT, INVESTORS BENEFIT FROM HOLDING WELL-

DIVERSIFIED PORTFOLIOS INSTEAD OF INDIVIDUAL STOCKS
▪ CALCULATION OF SYSTEMATIC RISK (β)
▪ SYSTEMATIC RISK IS THAT PART OF THE TOTAL RISK THAT IS

CAUSED BY FACTORS BEYOND THE CONTROL OF A SPECIFIC
COMPANY, SUCH AS ECONOMIC, POLITICAL, AND SOCIAL
FACTORS.
▪ IT CAN BE CAPTURED BY THE SENSITIVITY OF A SECURITY’S

RETURN WITH RESPECT TO THE OVERALL MARKET RETURN
▪ THIS SENSITIVITY CAN BE CALCULATED BY USING THE β (BETA)

COEFFICIENT.
The Beta (β) is represented by the slope of the regression line.
Beta (slope) is an important measure in the Security Market Line

equation
Beta is a measure of volatility or systematic risk or a security or a

portfolio as compared to the market as a whole
The Security Market Line is therefore the visual representation of

the Capital Asset Pricing Model. The Security Market Line is
upward-sloping because securities with higher systematic risk (a
higher beta) have a higher expected return.
THE CAPITAL ASSET PRICING MODEL (CAPM)
• IT IS A MODEL THAT DESCRIBES THE RELATIONSHIP

BETWEEN THE EXPECTED RETURN AND THE RISK OF
INVESTING IN A SECURITY
• IT SHOWS THAT THE EXPECTED RETURN ON A SECURITY IS

EQUAL TO THE RISK-FREE RETURN PLUS A RISK PREMIUM
BASED ON THE (β) OF THE SECURITY
THE CAPITAL ASSET PRICING MODEL (CAPM)

where:
BETA s = the return on an individual
stock
m =the return on the overall
market
Covariance =how changes in
a stock’s returns are related
changes in the market’s
returns
Variance = how far the
market’s data points spreads
out from their average value
Types of Beta Values:
Beta Value Equal to 1.0

If a stock has a beta of 1.0, it indicates that its price activity is
strongly correlated with the market.
Beta Value Less Than One

A beta value that is less than 1.0 means that the security is
theoretically less volatile than the market. Including this stock in a
portfolio makes it less risky than the same portfolio without the
stock. For example, utility stocks often have low betas because they
tend to move more slowly than market averages.
https://finance.yahoo.com/quote/VWAGY?p=VWAGY
Types of Beta Values:
Beta Value Greater Than One

A beta that is greater than 1.0 indicates that the security's price is
theoretically more volatile than the market. For example, if a stock's
beta is 1.2, it is assumed to be 20% more volatile than the market.
This indicates that adding the stock to a portfolio will increase the
portfolio’s risk, but may also increase its expected return.
Negative Beta Value

Some stocks have negative betas. A beta of -1.0 means that the
stock is inversely correlated to the market benchmark. Put options
and inverse ETFs are designed to have negative betas. There are
also a few industry groups, like gold miners, where a negative beta
is also common.
Beta effectively describes the how securities’ returns responds to

swings in the market.
This portfolio is therefore sensitive to systematic risk, but the risk

can be reduced by hedging.
This can be achieved by adding other stocks in the portfolio that

have negative or low betas, or by using derivatives to limit
downside losses.
Derivatives such as options, swaps, futures, and forward contracts

can be effective hedges against their underlying assets, since the
relationship between the two is more or less clearly defined.
It’s possible to use derivatives to set up a trading strategy in

which a loss for one investment is mitigated or offset by a gain in
a comparable derivative.
• INVESTORS PREFER HIGH RETURNS AND LOW STANDARD

DEVIATIONS
• PORTFOLIOS ARE CHOSEN BY THEIR EFFICIENCY
• THE RELEVANT MEASURE OF AN INDIVIDUAL SECURITY FOR

BUILDING EFFICIENT PORTFOLIOS IS NOT ITS OWN RISK BUT
ITS CONTRIBUTIONS TO THE RISK OF A PORTFOLIO.
• THIS CONTRIBUTION DEPENDS ON THE STOCK’S SENSITIVITY

TO CHANGES IN THE VALUE OF THE PORTFOLIO
• THE SENSITIVITY IS MEASURED BY BETA AND IS EQUAL TO

THE MARGINAL CONTRIBUTION OF A STOCK TO THE
PORTFOLIO RISK
CAPM EXAMPLE:
• A STOCK IS TRADED ON THE NYSE
• YIELD (RISK-FREE RATE) ON THE U.S. 10-YEAR TREASURY IS

2.5%
• THE AVERAGE EXCESS HISTORIAL ANNUAL RETURN FOR

THE US STOCKS IS 7.5%
• THE BETA OF THE STOCK IS 1.25 (ITS AVERAGE RETURN IS

1.25x AS VOLATILE AS THE S&P500 OVER THE LAST 2 YEARS)
• WHAT IS THE EXPECTED RETURN OF THE SECURITY USING

THE CAPM FORMULA?
CAPM EXAMPLE:
• LET’S BREAK DOWN THE ANSWER USING THE FORMULA

FROM THE CAPM:
• EXPECTED RETURN = RISK FREE RATE + [BETA x MARKET

RETURN PREMIUM]
• MARKET RETURN PREMIUM = MARKET RETUN – RISK FREE

RATE = [10% - 2.5%] = 7.5%
• EXPECTED RETURN = 2.5% + [1.25 x 7.5%]
• EXPECTED RETURN = 11.9%

▪ CALCULATION OF SYSTEMATIC RISK (β)
▪ SYSTEMATIC RISK IS THAT PART OF THE TOTAL RISK THAT IS

CAUSED BY FACTORS BEYOND THE CONTROL OF A SPECIFIC
COMPANY, SUCH AS ECONOMIC, POLITICAL, AND SOCIAL
FACTORS.
▪ IT CAN BE CAPTURED BY THE SENSITIVITY OF A SECURITY’S

RETURN WITH RESPECT TO THE OVERALL MARKET RETURN
▪ THIS SENSITIVITY CAN BE CALCULATED BY USING THE β (BETA)

COEFFICIENT.
▪ DIVERSIFICATION STRIVES TO SMOOTH OUT UNSYSTEMATIC
RISK EVENTS IN A PORTFOLIO SO THE POSITIVE PERFORMANCE
OF SOME INVESTMENTS NEUTRALIZES THE NEGATIVE
PERFORMANCE OF OTHERS
▪ THEREFORE, THE BENEFITS OF DIVERSIFICATION HOLD ONLY IF

THE SECURITIES IN THE PORTFOLIO ARE NOT PERFECTLY
CORRELATED
▪ SOME STUDIES HAVE SHOWN THAT MAINTANING A WELL-

DIVERSIFIED PORTFOLIO OF 25 – 30 STOCKS YIELDS THE MOST
COST-EFFECTIVE LEVEL OF RISK REDUCTION. INVESTING IN
MORE YIELDS FURTHER DIVERSIFICATION BENEFITS BUT AT A
LOWER RATE
▪ MOST NON-PROFESSIONAL INVESTORS OFTEN HAVE A LIMITED
INVESTMENT BUDGET AND MAY FIND IT DIFFICULT TO CREATE
AN ADEQUATELY DIVERSIFIED PORTFOLIO.
▪ THE FACT CAN EXPLAIN WHY MUTUAL FUNDS, INDEX FUNDS,

AND ETFs HAVE BEEN INCREASING IN POPULARITY
▪ BUYING SHARES IN A MUTUAL FUND CAN PROVIDE INVESTORS

WITH AN INEXPENSIVE SOURCE OF DIVERSIFICATION
▪ IN GENERAL, INVESTORS USE ALSO ETFs (i.e. iShares MSCI, etc.)

TO ENSURE A TRUE DIVERSIFICATION WITH DIVERGENT
CORRELATIONS AMONG SECURITIES
▪ THE CORRELATION MATRIX IS SIMPLY A TABLE WHICH DISPLAYS

THE CORRELATION COEFFICIENTS FOR DIFFERENT VARIABLES
▪ THE CORRELATION COEFFICIENT IS MEASURED ON A SCALE OF

-1 to +1
▪ IF THE COEFFICIENT IS +1 IT MEANS THAT THE VARIABLES HAVE

A PERFECT POSITIVE CORRELATION – SECURITIES MOVE IN THE
SAME DIRECTION.
▪ IF THE COEFFICIENT IS -1 IT MEANS THAT THE VARIABLES HAVE

A PERFECT NEGATIVE CORRELATION- SECURITIES MOVE IN
OPPOSITE DIRECTIONS.
▪ IF THE COEFFICIENT IS EQUALS TO 0, SECURITIES HAVE A EQUAL

CHANCE OF MOVING TOGETHER OR IN THE OPPOSITE
DIRCETION.
▪ IN THE CORRELATION MATRIX ARE REPORTED THE

CORRELATIONS OF THE RETURNS BETWEEN SECURITIES, FUNDS,
OR INDICES
▪ THE CORRELATION MATRIX CAN HELP INVESTORS DIVERSIFY

OR DE-RISK THEIR PORTFOLIO
▪ A HIGHLY CORRELATED PORTFOLIO IS A RISKIER PORTFOLIO

THAN AN UNCORRELATED PORTFOLIO
▪ ALTHOUGH IT IS NOT POSSIBLE TO ELIMINATE RISK

COMPLETELY (i.e. NO RISK = VERY LOW RETURNS), INVESTORS
CAN BUILD A PORTFOLIO WITH A MIX OF SECURITIES THAT ARE
LESS CORRELATED, UNCORRELATED, OR NEGATIVELY
CORRELATED TO REDUCE THE PORTFOLIO’S OVERALL
VOLATILITY
▪ AN OPTIMAL LEVEL OF CORRELATION IN THE PORTFOLIO

DEPENDS ON THE INVESTOR’S RISK TOLERANCE.
▪ RISK-AVERSE INVESTORS CHOSE PORTFOLIOS WITH LIMITED

CORRELATION
▪ TO REDUCE PORTFOLIO RISK, INVESTORS SHOULD CHOOSE

SECURITIES THAT ARE WEAKLY CORRELATED, THAT IS FOR
EXAMPLES SECURITIES WITH CORRELATIONS COEFFICIENTS
BELOW 0.70.
▪ HEDGING STRATEGIES ARE THOSE IN WHICH INVESTORS

CHOOSE SECURITIES THAT HAVE A NEGATIVE CORRELATION TO
THE MARKET
▪ THE DIAGONAL SET OF 1’s ARE THE IDENTIY CELLS
▪ THEY REPRESENT THE INTERSECTION OF A SECURITY WITH

ITSELF IN THE GRID
▪ THE IDENTITY CELL WILL ALWAYS CONTAIN A 1 BECAUSE A

SECURITY IS PERFECTLY CORRELATED WITH ITSELF.
▪ BUT THERE IS MORE INFORMATION HIDDEN IN THIS CELL –

WHEN ONE MOUSE OVER IT, IT REPORTS WHICH SECURITIES IN
THE GRID ARE MOST AND LEAST CORRELATED WITH THE
IDENTITY SECURITY
▪ A so-called “Heat Map” (Correlation Matrix) provides

different colors of shades for higher and lower
correlation coefficients
▪ Thus, an investor may add on their “potential buy”

watchlist securities and sectors that have a relatively low
correlation to the portfolio, then the investor can
proceed with a deeper assessment of the value that the
security may add to the portfolio risk-return trade-off
▪ It is important to invest in uncorrelated asset classes

and industries
▪ Perfect diversification in the portfolio might not be the

true goal to maximize risk/return targets
▪ It is also important to diversify among different asset

classes and investment strategies (Value investing,
Growth investing, Income investing, Smart beta
investing, Etc.)
Typical Risk Mitigation Techniques in Investments
• Portfolio Diversification (low security correlation; asset and
geographical diversification)
• Multiple Investment Strategies
• Sector rotation
• Portfolio Rebalancing (70/30; 60/40; etc.) and Position Sizing
• Hedging Strategies with Derivatives (options, swaptions, swaps,
Futures, etc.)
• Stress Testing and Scenario Analysis
• Stop Loss Orders
• Inflation-Linked Products and Index Products (ETFs)
• Insurance-Linked Securities (ILS);
• Securitizations and Collateralized Securities
Risk in Investments is measured by:
• Credit Risk (the issuer defaults on the payment of the Bond)

• Operational Risk (internal and external frauds, process mgt.)
• Market Risk (interest rates, inflation, policy/political
instability)
• Volatility Risk (high volatility of some securities)
• Margin Risk (borrowing funds on margin)
• Liquidity Risk (investing in illiquid assets)
• Funding Risk (short-term funding/overnight)
• Model Risk (inadequate model valuation)
Credit Risk Framework
▪ Any organization that’s lending money or extending

credit needs a credit risk management framework to
protect itself, as well as assess credit risk.
▪ Without a framework, it’s easy to become

overextended on financial obligations and put your
organization at a greater chance of finding itself in the
hole.
▪ A credit risk management framework helps identify,

monitor, measure, and control risks when you’re
extending credit.
▪ By understanding the full financial picture of borrowers

and the associated risks, banks, credit unions, leasing
companies, and others can better protect themselves
against defaults and improve their financial health — all
while avoiding potential financial crisis.
▪ Today, risk management frameworks are dynamic and

assess a variety of evaluating components. It is not just
about looking at borrower’s credit score or a small
handful of other factors in making risk assessments
▪ The best frameworks will analyze hundreds of data

sources to help organizations make better credit
decisions and mitigate risk.
▪ Credit risk is no longer a subjective judgment made by

lenders based solely on character, capacity, capital,
and collateral.
▪ It is an objective measure that can be quantified based

on a real-time credit assessment in relation to a
company’s entire portfolio. This change in the ability to
more accurately analyze credit risk has given many
banks and other institutions the opportunity to increase
cash flows while lowering default probability.
▪ There are five traditional components to a credit risk
management framework:
1. Risk identification (delinquency rates and default rates,
through the use of risk models, under different scenarios)
2. Risk measurement and analysis (key risk indicators - KRIs)
3. Risk mitigation (Credit risk policies, underwriting and
purchase criteria, loan administration, investment portfolio
management, credit concentration, diversification)
4. Risk reporting and measurement (maintain robust reporting
on aggregate risk to ensure risk levels are within your
organizational tolerance/risk appetite).
5. Risk governance (rules on how loans are assessed, what
scores/metrics must be achieved for lending, authority and
approvals, risk limits, & general oversight).
▪ Assessment, design and implementation of credit risk
strategies
frameworks
frameworks for the purpose of regulatory capital
management; e.g. Basel 3
▪ Assessment, design and implementation of Credit Risk
Appetite Statements
▪ Basel II and III Credit Risk: Model Development
▪ Economic capital modelling in relation to credit risk
▪ Assessment, design and implementation of monitoring and
reporting processes.
▪ Risk Weighted Asset (RWA) optimization

▪ Credit portfolio Analytics
▪ Credit Risk stress testing
▪ Collection and recovery performance effectiveness
enhancement
▪ Credit risk system implementation: user requirement,
system/vendor selection, implementation, user
acceptance tracking
▪ Variance analysis and implementation of remedial
actions
What is LGD (Loss Given Default)?
▪ LGD (Loss Given Default) is a lender’s (creditor) ‘s

projected loss in the event that a borrower triggers an
event of default.
▪ LGD is a measure used by financial institutions and

other private, non-bank lenders to help calculate the
projected profitability of a loan (often referred to as a
credit facility – which may include operating credit,
term loans, commercial mortgages, capital leases, etc.).
▪ LGD is most commonly expressed as a percentage;

however, it can also be expressed as an absolute dollar
figure.
▪ It is tied very closely to any collateral security

underpinning the credit exposure. In fact, in its most
literal sense, LGD is the inverse (1 minus) of an asset’s
recovery rate.
▪ Recovery rates are a function of the underlying

collateral, as well as the loan-to-value against those
assets.
▪ Lender’s returns are calculated as income less expenses

and less expected (credit) losses.
▪ Expected loss is calculated as the credit exposure (at

default), multiplied by the borrower’s probability of
default, multiplied by the loss given default (LGD).
What is EAD (Exposure at Default)?
▪ Exposure at Default (EAD) is the predicted amount of

loss a bank may face in the event of, and at the time of,
the borrower’s default.
▪ While under the foundation internal ratings-based

approach (F-IRB), calculation of EAD is guided by the
regulators, under the advanced approach (A-IRB),
banks enjoy greater flexibility on how they calculate
EAD.
▪ Banks often calculate an EAD value for each loan and

then use the figures to determine their overall default
risk. It is a dynamic number that changes as a borrower
repays a lender.
▪ Banks can help reduce their capital charge by using an

advanced IRB approach (A-IRB).
▪ A bank may calculate its expected loss by taking the

product of EAD, PD, and LGD
EL (Expected Loss)
▪ EL = PD (in%) x LGD (in%) x EAD (in $)
▪ EL = PD × LGD × EAD = PD × (1 − RR) × EAD
▪ RR = Recovery Rate (RR = 1 − LGD).

What is PD (Probability of Default)?
▪ PD (Probability of Default) analysis is a method

generally used by larger institutions to calculate their
expected loss. A PD is assigned to a specific risk
measure and represents the likelihood of default as a
percentage.
▪ It is usually measured by assessing past-due loans and

is calculated by running a migration analysis of similarly
rated loans. The calculation pertains to a specific time
horizon and measures the percentage of loans that
default.
Lender’s returns, income, expenses, expected credit losses
▪ Let’s assign some numbers to illustrate. Assume:

▪ $1,000,000 loan exposure (at the time of default).
▪ A 2.00% (0.02) probability of default for the borrower.
And,
▪ An assigned LGD of 25.00% (0.25).
▪ The expected loss in this example (expressed in dollars)
would be $5,000. That’s:
▪ EL = $1,000,000 x 0.02 x 0.25 = $5,000

▪ LGD is calculated as 1 minus the anticipated recovery

rate of an asset (or assets). The recovery rate
(expressed as a percentage) is the proportion of an
asset’s value that a lender can realistically expect to get
back if a client were to trigger an event of default that
eventually leads the creditor to a liquidation scenario.
▪ If the expected recovery rate for an asset (or an asset

class) is 75% (0.75), then the LGD would be (1 – 0.75),
which equals 25%.
▪ A higher anticipated recovery rate equals a lower LGD.
Capital adequacy and risk calculation
▪ Capital adequacy - general idea:

▪ CAR = capital / RWA
▪ CAR (capital adequacy ratio)
▪ RWA (risk weighted assets)
▪ Two approaches to risk calculations:

▪ Standardized Approach (F-IRB)
▪ Internal Model Approach (advanced IRB approach).
Capital adequacy and risk calculation
▪ To be eligibe to adopt the IRB approach, bank must

pass the use test of its national regulator.
▪ Under IRB approach, banks must divide their banking
book exposures into six broad classes of assets:
corporate, sovereign, bank retail, equity and other
exposures.
Capital requirements and bank supervision
Expected Loss (EL), Unexpected Loss (UL) and Capital
Expected Loss (EL), Unexpected Loss (UL) and Capital
Enterprise-Wide Risk Framework
The Greeks
• Commonly referred to as the “Greeks”, These metrics
are appropriate for measuring the risk associated with
derivatives positions
Delta
Theta
Gamma
Vega
Rho
Asset Allocation and Portfolio Construction

▪ Investors can construct a portfolio to optimize the

risk-return trade-off
▪ A top-down process for the portfolio construct entails

the following steps:
➢Capital allocation strategy

➢Asset allocation strategy
➢Security selection strategy
109
• Active investment strategy – it uses a variety of

approaches for selecting securities that will outperform
the benchmark
• The active strategies focus on selecting individual

securities in an asset class or in various classes
• Active managers may also try to time a market (i.e.

buying when they believe the market is undervalued
and selling when they believe the market is
overvalued).
• Active investment strategies require an active role of the

portfolio manager
• The role of active management is to beat the stock

market’s average returns and take full advantage of
short-term fluctuations
• It involves a much deeper analysis and expertise to

know when to pivot into or out of a particular sector,
bond, stock, or any asset
• Active investment management implies for the investor

a potential higher risk
• Active investment managers can adopt hedging

strategies such as short-selling or put options
• Active investment management is more expensive and

it may significantly reduce investors’ returns
• Passive investment strategies implies a more limited buying and

selling of securities in the portfolio
• This strategy consists in low-cost transaction fees or no-fee

trading
• Typical examples include buying index funds or ETF that follow

one of the major indices like the S&P 500, Nasdaq, Dow Jones,
or MSCI
• Transparency is high with passive investing since it is always clear

which assets are in the index fund
Passive ESG funds
Global Leveraged and Inverse ETPs
Some Underweight EMs
Global ETF/ETP Issuance levels
The Rise of Asia
China’s Local Currency Government Bond Market
EM Local Currency Government Bond Market
Actively Managed EM Equity Funds
Investment Strategies
Investment strategies
Investment Strategies (Examples)
• Value investing
• Growth investing
• Momentum investing
• Contrarian investing
• Income investing
• Buy and hold investing
• Small and cap investing
• Socially responsible investing
• Factor investing
• Smart beta investing

Risk Management and The Stock Market - Prof. Pezzuto - Slides Set 1

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Risk Management and The Stock Market - Prof. Pezzuto - Slides Set 1

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Risk Management in Banking and Insurance

Investments and Financial Markets

▪ An investment is about sacrificing something of value

▪ Investments can be made in real assets (i.e. land,

▪ Real assets are used to produce goods and services

▪ Financial assets are in general claims to the income

▪ Whereas real assets generate net income to the

▪ Individuals can choose between consuming their

▪ If they choose to invest in the financial markets, they

▪ When investors buy these securities from companies,

▪ Financial markets transfer funds from those who have

▪ Deficit units issue securities which are purchased by

The role of the Financial Markets

▪ Price Determination – Financial markets determine the

The role of the Financial Markets

▪ Risk Sharing – With the help of the financial markets

The role of the Financial Markets

▪ Reduction in Transaction Costs – Financial markets

THE ROLE OF THE FINANCIAL MARKETS

▪ Capital Formation – Financial markets facilitate the exchange of

Risk and the Financial Markets

There is a trade-off between risk and expected

▪ Risk, in traditional terms, is viewed as a ‘negative’. Webster’s

▪ Thus, their predictability is confined within a certain level of

▪ Investors who buy an asset expect to make a return over the

▪ The ACTUAL RETURN that they make over this holding

▪ Some risk are specific to an investment or a few investments

▪ Bearing risk typically must be accompanied by a reward in

▪ The underlying assumption is that most investors are RISK

RISK = VARIABILITY OF THE RETURNS IN RELATION TO

▪ THE STANDARD DEVIATION IS A MEASURE OF VOLATILITY AND

▪ Normal and Heavy-Tailed Distribution

▪ IN OTHER WORDS, THE RISK IS THE DEVIATION FROM THE

▪ EACH STOCK HAS ITS OWN STANDARD DEVIATION FROM THE

▪ THE RISK OF A PORTFOLIO OF DIVERSE INDIVIDUAL STOCKS

▪ DIVERSIFICATION IS A RISK MANAGEMENT TECHNIQUE THAT

▪ THE RATIONALE BEHIND THIS TECHNIQUE IMPLIES THAT A

▪ FURTHERMORE, DIVERSIFICATION BENEFITS CAN BE GAINED BY

The benefits of portfolio diversification

The benefits of portfolio diversification

The benefits of portfolio diversification

Systematic and Nonsystematic Risk

▪ THE UNSYSTEMATIC RISK , ALSO KNOWN AS ‘SPECIFIC RISK’,

▪ FOR A WELL-DIVERSIFIED PORTFOLIO, THE RISK - OR AVERAGE

▪ INSTEAD, IT IS THE DIFFERENCE BETWEEN INDIVIDUAL STOCK’S

▪ AS A RESULT, INVESTORS BENEFIT FROM HOLDING WELL-

▪ CALCULATION OF SYSTEMATIC RISK (β)

▪ SYSTEMATIC RISK IS THAT PART OF THE TOTAL RISK THAT IS

▪ IT CAN BE CAPTURED BY THE SENSITIVITY OF A SECURITY’S

▪ THIS SENSITIVITY CAN BE CALCULATED BY USING THE β (BETA)

The Beta (β) is represented by the slope of the regression line.

Beta (slope) is an important measure in the Security Market Line

Beta is a measure of volatility or systematic risk or a security or a

The Security Market Line is therefore the visual representation of

THE CAPITAL ASSET PRICING MODEL (CAPM)

• IT IS A MODEL THAT DESCRIBES THE RELATIONSHIP

• IT SHOWS THAT THE EXPECTED RETURN ON A SECURITY IS

THE CAPITAL ASSET PRICING MODEL (CAPM)

Types of Beta Values:

Beta Value Equal to 1.0

Beta Value Less Than One

Types of Beta Values: