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Quantitative Financial Risk Management: Theory and Practice


A Comprehensive Guide to Quantitative Financial Risk Management

Written by an international team of experts in the field, Quantitative Financial Risk Management: Theory and Practice provides an invaluable guide to the most recent and innovative research on the topics of financial risk management, portfolio management, credit risk modeling, and worldwide financial markets.

This comprehensive text reviews the tools and concepts of financial management that draw on the practices of economics, accounting, statistics, econometrics, mathematics, stochastic processes, and computer science and technology. Using the information found in Quantitative Financial Risk Management can help professionals to better manage, monitor, and measure risk, especially in today's uncertain world of globalization, market volatility, and geo-political crisis.

Quantitative Financial Risk Management delivers the information, tools, techniques, and most current research in the critical field of risk management. This text offers an essential guide for quantitative analysts, financial professionals, and academic scholars.

CONSTANTIN ZOPOUNIDIS, PHD, is professor of Financial Engineering and Operations Research at Technical University of Crete in Greece and distinguished research professor at Audencia Nantes School of Management in France.

EMILIOS GALARIOTIS, PHD (Dunelm), HDR, is professor of Finance at Audencia Nantes School of Management in France. He is the founder and director of the Centre for Financial and Risk Management and head of research in the area of finance, risk, and accounting performance at Audencia. He is also joint-Head of the Accounting and Finance Department.

Preface xvii

About the Editors xix

SECTION ONE Supervisory Risk Management

CHAPTER 1 Measuring Systemic Risk: Structural Approaches 3
Raimund M. Kovacevic and Georg Ch. Pflug

Systemic Risk: Definitions 4

From Structural Models to Systemic Risk 6

Measuring Systemic Risk 10

Systemic Risk and Copula Models 15

Conclusions 20

References 20

CHAPTER 2 Supervisory Requirements and Expectations for Portfolio-Level Counterparty Credit Risk Measurement and Management 22
Michael Jacobs Jr., PhD, CFA

Introduction 22

Review of the Literature 25

Supervisory Requirements for CCR 26

Conceptual Issues in CCR: Risk versus Uncertainty 41

Conclusions 44

References 44

CHAPTER 3 Nonperforming Loans in the Bank Production Technology 46
Hirofumi Fukuyama and William L. Weber

Introduction 46

Selective Literature Review 47

Method 51

Empirical Application 57

Summary and Conclusion 65

Appendix 3.1 Bank Names and Type 66

References 67

SECTION TWO Risk Models and Measures

CHAPTER 4 A Practical Guide to Regime Switching in Financial Economics 73
Iain Clacher, Mark Freeman, David Hillier, Malcolm Kemp and Qi Zhang

A Brief Look at Markov Regime Switching in Academic Economics and Finance 74

Regime Switching and Interest Rate Processes 75

Regime Switching and Exchange Rates 76

Regime Switching, Stock Returns, and Asset Allocation 77

Single-Asset Markov Models 79

Two-State Estimation 82

Three-State Estimation 84

Markov Models for Multiple Assets 85

Practical Application of Regime Switching Models for Investment Purposes 87

Intuitive Appeal of Such Models 87

Implementation Challenges 89

Selecting the “Right" Model Structure 89

Calibrating the Selected Model Type to Suitable Data 90

Drawing the Right Conclusions from the Model 93

References 95

CHAPTER 5 Output Analysis and Stress Testing for Risk Constrained Portfolios 98
Jitka Dupa¡cová and Miloš Kopa

Introduction 98

Worst-Case Analysis 107

Stress Testing via Contamination 110

Conclusions and New Problems 122

References 122

CHAPTER 6 Risk Measures and Management in the Energy Sector 126
Marida Bertocchi, Rosella Giacometti and Maria Teresa Vespucci

Introduction 126

Uncertainty Characterization via Scenarios 128

Measures of Risks 132

Case Studies 137

Summary 147

References 147

SECTION THREE Portfolio Management

CHAPTER 7 Portfolio Optimization: Theory and Practice 155
William T. Ziemba

Static Portfolio Theory 155

Importance of Means 163

Stochastic Programming Approach to Asset Liability Management 167

Siemens InnoALM Pension Fund Model 182

Dynamic Portfolio Theory and Practice: The Kelly Capital Growth Approach 194

Transactions Costs 199

Some Great Investors 201

Appendix 7.1: Estimating Utility Functions and Risk Aversion 206

References 208

CHAPTER 8 Portfolio Optimization and Transaction Costs 212
Renata Mansini, Wlodzimierz Ogryczak and M. Grazia Speranza

Introduction 212

Literature Review on Transaction Costs 215

An LP Computable Risk Measure: The Semi-MAD 221

Modeling Transaction Costs 223

Non-Unique Minimum Risk Portfolio 232

Experimental Analysis 234

Conclusions 237

Appendix 238

References 239

CHAPTER 9 Statistical Properties and Tests of Efficient Frontier Portfolios 242
C J Adcock

Introduction 242

Notation and Setup 245

Distribution of Portfolio Weights 247

Empirical Study 255

Discussion and Concluding Remarks 267

References 268

SECTION FOUR Credit Risk Modelling

CHAPTER 10 Stress Testing for Portfolio Credit Risk: Supervisory Expectations and Practices 273
Michael Jacobs Jr.

Introduction and Motivation 273

Conceptual Issues in Stress Testing: Risk versus Uncertainty 276

The Function of Stress Testing 277

Supervisory Requirements and Expectations 280

Empirical Methodology: A Simple ST Example 281

Conclusion and Future Directions 291

References 293

CHAPTER 11 A Critique of Credit Risk Models with Evidence from Mid-Cap Firms 296
David E. Allen, Robert J. Powell and Abhay K. Singh

Introduction 296

Summary of Credit Model Methodologies 297

Our Empirical Methodology 302

Critique 303

Conclusions 310

References 310

CHAPTER 12 Predicting Credit Ratings Using a Robust Multicriteria Approach 312
Constantin Zopounidis

Introduction 312

Credit Scoring and Rating 315

Multicriteria Methodology 319

Empirical Analysis 325

Conclusions and Future Perspectives 330

References 331

SECTION FIVE Financial Markets

CHAPTER 13 Parameter Analysis of the VPIN (Volume-Synchronized Probability of Informed Trading) Metric 337
Jung Heon Song, Kesheng Wu and Horst D. Simon

Introduction 337

Definition of VPIN 341

Computational Cost 346

Optimization of FPR 348

Uncertainty Quantification (UQ) 353

Conclusion 360

References 362

CHAPTER 14 Covariance Specification Tests for Multivariate GARCH Models 364
Gregory Koutmos

Introduction 364

Covariance Specification Tests 365

Application of Covariance Specification Tests 367

Empirical Findings and Discussion 368

Conclusion 370

References 370

CHAPTER 15 Accounting Information in the Prediction of Securities Class Actions 372
Vassiliki Balla

Introduction 372

Literature Review 375

Methodology 376

Data 378

Results 387

Conclusions 394

References 395

About the Contributors 399

Glossary 413

Index 421