Bubble Value at Risk A Countercyclical Risk Management Approach

Max C.Y. Wong is a specialist in the area of risk modeling and Basel III. He started his career as a derivatives consultant at Credit Suisse First Boston in 1996. During the Asian crisis in 1998 he traded index futures at the open-outcry floor of SIMEX (now SGX). From 2003 to 2011, he worked for Standard Chartered Bank as a risk manager and senior quant. He is currently head of VaR model testing at the Royal Bank of Scotland. He has published papers on VaR models and Basel capital, recently looking at innovative ways to model risk more effectively during crises and to deal with the issues of procyclicality and Black Swan event in our financial system. He has spoken on the subject at various conferences and seminars. He holds a B.Sc. Physics from University of Malaya (1994) and a M.Sc. financial engineering from National University of Singapore (2004). He is an adjunct at Singapore Management University, a member of the editorial board of the Journal of Risk Management in Financial Institutions, and a member of the steering committee of PRMIA Singapore chapter.

About the Author
Foreword
Preface
Acknowledgments

Part One
Background
Chapter 1
Introduction
1.1 The Evolution of Riskometer
1.2 Taleb’s Extremistan
1.3 The Turner Procyclicality
1.4 The Commonsense of Bubble Value-at-Risk (buVaR)
Endnotes

Chapter 2
Essential Mathematics
2.1 Frequentist Statistics
2.2 Just Assumptions
2.3 Quantiles, VaR and Tails
2.4 Correlation and Autocorrelation
2.5 Regression Models and Residual Errors
2.6 Significance Tests
2.7 Measuring Volatility
2.8 Markowitz Portfolio Theory
2.9 Maximum Likelihood Method
2.10 Cointegration
2.11 Monte Carlo Method
2.12 The Classical Decomposition
2.13 Quantile Regression Model
2.14 Spreadsheet Exercises
Endnotes

Part Two
Value at Risk Methodology
Chapter 3
Preprocessing
3.1 System Architecture
3.2 Risk Factor Mapping
3.3 Risk Factor Proxies
3.4 Scenario Generation
3.5 Basic VaR Specification
Endnotes

Chapter 4
Conventional VaR Methods
4.1 Parametric VaR
4.2 Monte Carlo VaR
4.3 Historical Simulation VaR
4.4 Issue: Convexity, Optionality and Fat tails
4.5 Issue: Hidden Correlation
4.6 Issue: Missing Basis and Beta Approach
4.7 Issue: The Real Risk of Premiums
4.8 Spreadsheet Exercises
Endnotes

Chapter 5
Advanced VaR Methods
5.1 Hybrid Historical Simulation VaR
5.2 Hull-White Volatility Updating VaR
5.3 Conditional Autoregressive VaR (CAViaR)
5.4 Extreme Value Theory VaR
5.5 Spreadsheet Exercises
Endnotes

Chapter 6
VaR Reporting
6.1 VaR Aggregation and Limits
6.2 Diversification
6.3 VaR Analytical Tools
6.4 Scaling and Basel Rules
6.5 Spreadsheet Exercises
Endnotes

Chapter 7
The Physics of Risk and Pseudoscience
7.1 Entropy, Leverage effect and Skewness
7.2 Volatility Clustering and the folly of i.i.d.
7.3 “Volatility of volatility” and Fat-tails
7.4 Extremistan and the Fourth quadrant
7.5 Regime change, Lagging riskometer and Procyclicality
7.6 Coherence and Expected shortfall
7.7 Spreadsheet Exercises
Endnotes

Chapter 8
Model Testing
8.1 Precision Test
8.2 Frequency Back Test
8.3 Bunching Test
8.4 Whole distribution test
8.5 Spreadsheet Exercises
Endnotes

Chapter 9
Practical Limitations of VaR
9.1 Depegs and Changes to “Rules of the game”
9.2 Data Integrity Problems
9.3 Model Risk
Endnotes

Chapter 10
Other Major Risk Classes
10.1 Credit Risk (and Creditmetrics)
10.2 Liquidity Risk
10.3 Operational risk
10.4 The Problem of Aggregation
10.5 Spreadsheet Exercises
Endnotes

Part Three
The Great Regulatory Reform
Chapter 11
Regulatory Capital Reform
11.1 Basel I and Basel II
11.2 The Turner Review
11.3 Revisions to Basel II Market Risk Framework (Basel 2.5)
11.4 New Liquidity Framework
11.5 The New Basel III
11.6 New framework for Trading Book
11.7 The Ideal Capital Regime
Endnotes

Chapter 12
Systemic Risk Initiatives
12.1 Soros’ Reflexivity, Endogenous Risks
12.2 Crashmetrics
12.3 New York Fed CoVaR
12.4 The Austrian Model and BOE RAMSI
12.5 The Global Systemic Risk Regulator
12.6 Spreadsheet Exercises
Endnotes

Part Four
Introduction to Bubble Value-at-Risk (BuVaR)
Chapter 13
Market BuVaR
13.1 Why an Alternative to VaR
13.2 Classical Decomposition, New Interpretation
13.3 Measuring the Bubble
13.4 Calibration
13.5 Implementing the Inflator
13.6 Choosing the Best Tail Risk Measure
13.7 Effect on Joint Distribution
13.8 The Scope of BuVaR
13.9 How Good is the BuVaR Buffer?
13.10 The Brave New World
13.11 Spreadsheet Exercises
Endnotes

Chapter 14
Credit BuVaR
14.1 The Credit Bubble VaR Idea
14.2 Model Formulation
14.3 Behavior of Response Function
14.4 Characteristics of Credit BuVaR
14.5 Interpretation of Credit BuVaR
14.6 Spreadsheet Exercises
Endnotes

Chapter 15
Acceptance Tests
15.1 BuVaR Visual Checks
15.2 BuVaR Event Timing Tests
15.3 BuVaR Cyclicality Tests
15.4 Credit BuVaR Parameter Tuning
Endnotes

Chapter 16
Other Topics
16.1 Diversification and Basis Risks
16.2 Regulatory Reform and BuVaR
16.3 BuVaR and the Banking Book. Response time as Risk.
16.4 Can buVaR pick tops and bottoms perfectly?
16.5 Post-modern Risk Management
16.6 Spreadsheet Exercises
Endnote

Chapter 17
Epilogue: Suggestions for Future Research
Endnote

Bibliography
Index
  

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