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Bubble Value at Risk: A Countercyclical Risk Management Approach, Revised Edition

Book Description

Introduces a powerful new approach to financial risk modeling with proven strategies for its real-world applications

The 2008 credit crisis did much to debunk the much touted powers of Value at Risk (VaR) as a risk metric. Unlike most authors on VaR who focus on what it can do, in this book the author looks at what it cannot. In clear, accessible prose, finance practitioners, Max Wong, describes the VaR measure and what it was meant to do, then explores its various failures in the real world of crisis risk management. More importantly, he lays out a revolutionary new method of measuring risks, Bubble Value at Risk, that is countercyclical and offers a well-tested buffer against market crashes.

  • Describes Bubble VaR, a more macro-prudential risk measure proven to avoid the limitations of VaR and by providing a more accurate risk exposure estimation over market cycles

  • Makes a strong case that analysts and risk managers need to unlearn our existing "science" of risk measurement and discover more robust approaches to calculating risk capital

  • Illustrates every key concept or formula with an abundance of practical, numerical examples, most of them provided in interactive Excel spreadsheets

  • Features numerous real-world applications, throughout, based on the author's firsthand experience as a veteran financial risk analyst

Table of Contents

  1. Cover
  2. Contents
  3. Title
  4. Copyright
  5. Dedication
  6. About the Author
  7. Foreword
  8. Preface
  9. Acknowledgments
  10. Part One: Background
    1. Chapter 1: Introduction
      1. 1.1 The Evolution of Riskometer
      2. 1.2 Taleb’s Extremistan
      3. 1.3 The Turner Procyclicality
      4. 1.4 The Common Sense of Bubble Value-at-Risk (BuVaR)
      5. Notes
    2. Chapter 2: Essential Mathematics
      1. 2.1 Frequentist Statistics
      2. 2.2 Just Assumptions
      3. 2.3 Quantiles, VaR, and Tails
      4. 2.4 Correlation and Autocorrelation
      5. 2.5 Regression Models and Residual Errors
      6. 2.6 Significance Tests
      7. 2.7 Measuring Volatility
      8. 2.8 Markowitz Portfolio Theory
      9. 2.9 Maximum Likelihood Method
      10. 2.10 Cointegration
      11. 2.11 Monte Carlo Method
      12. 2.12 The Classical Decomposition
      13. 2.13 Quantile Regression Model
      14. 2.14 Spreadsheet Exercises
      15. Notes
  11. Part Two: Value at Risk Methodology
    1. Chapter 3: Preprocessing
      1. 3.1 System Architecture
      2. 3.2 Risk Factor Mapping
      3. 3.3 Risk Factor Proxies
      4. 3.4 Scenario Generation
      5. 3.5 Basic VaR Specification
      6. Notes
    2. Chapter 4: Conventional VaR Methods
      1. 4.1 Parametric VaR
      2. 4.2 Monte Carlo VaR
      3. 4.3 Historical Simulation VaR
      4. 4.4 Issue: Convexity, Optionality, and Fat Tails
      5. 4.5 Issue: Hidden Correlation
      6. 4.6 Issue: Missing Basis and Beta Approach
      7. 4.7 Issue: The Real Risk of Premiums
      8. 4.8 Spreadsheet Exercises
      9. Notes
    3. Chapter 5: Advanced VaR Methods
      1. 5.1 Hybrid Historical Simulation VaR
      2. 5.2 Hull-White Volatility Updating VaR
      3. 5.3 Conditional Autoregressive VaR (CAViaR)
      4. 5.4 Extreme Value Theory VaR
      5. 5.5 Spreadsheet Exercises
      6. Notes
    4. Chapter 6: VaR Reporting
      1. 6.1 VaR Aggregation and Limits
      2. 6.2 Diversification
      3. 6.3 VaR Analytical Tools
      4. 6.4 Scaling and Basel Rules
      5. 6.5 Spreadsheet Exercises
      6. Notes
    5. Chapter 7: The Physics of Risk and Pseudoscience
      1. 7.1 Entropy, Leverage Effect, and Skewness
      2. 7.2 Volatility Clustering and the Folly of i.i.d.
      3. 7.3 “Volatility of Volatility” and Fat Tails
      4. 7.4 Extremistan and the Fourth Quadrant
      5. 7.5 Regime Change, Lagging Riskometer, and Procyclicality
      6. 7.6 Coherence and Expected Shortfall
      7. 7.7 Spreadsheet Exercises
      8. Notes
    6. Chapter 8: Model Testing
      1. 8.1 The Precision Test
      2. 8.2 The Frequency Back Test
      3. 8.3 The Bunching Test
      4. 8.4 The Whole Distribution Test
      5. 8.5 Spreadsheet Exercises
      6. Notes
    7. Chapter 9: Practical Limitations of VaR
      1. 9.1 Depegs and Changes to the Rules of the Game
      2. 9.2 Data Integrity Problems
      3. 9.3 Model Risk
      4. 9.4 Politics and Gaming
      5. Notes
    8. Chapter 10: Other Major Risk Classes
      1. 10.1 Credit Risk (and CreditMetrics)
      2. 10.2 Liquidity Risk
      3. 10.3 Operational Risk
      4. 10.4 The Problem of Aggregation
      5. 10.5 Spreadsheet Exercises
      6. Notes
  12. Part Three: The Great Regulatory Reform
    1. Chapter 11: Regulatory Capital Reform
      1. 11.1 Basel I and Basel II
      2. 11.2 The Turner Review
      3. 11.3 Revisions to Basel II Market Risk Framework (Basel 2.5)
      4. 11.4 New Liquidity Framework
      5. 11.5 The New Basel III
      6. 11.6 The New Framework for the Trading Book
      7. 11.7 The Ideal Capital Regime
      8. Notes
    2. Chapter 12: Systemic Risk Initiatives
      1. 12.1 Soros’ Reflexivity, Endogenous Risks
      2. 12.2 CrashMetrics
      3. 12.3 New York Fed CoVaR
      4. 12.4 The Austrian Model and BOE RAMSI
      5. 12.5 The Global Systemic Risk Regulator
      6. 12.6 Spreadsheet Exercises
      7. Notes
  13. Part Four: Introduction to Bubble Value-at-Risk (BuVaR)
    1. Chapter 13: Market BuVaR
      1. 13.1 Why an Alternative to VaR?
      2. 13.2 Classical Decomposition, New Interpretation
      3. 13.3 Measuring the Bubble
      4. 13.4 Calibration
      5. 13.5 Implementing the Inflator
      6. 13.6 Choosing the Best Tail-Risk Measure
      7. 13.7 Effect on Joint Distribution
      8. 13.8 The Scope of BuVaR
      9. 13.9 How Good Is the BuVaR Buffer?
      10. 13.10 The Brave New World
      11. 13.11 Spreadsheet Exercises
      12. Notes
    2. Chapter 14: Credit BuVaR
      1. 14.1 The Credit Bubble VaR Idea
      2. 14.2 Model Formulation
      3. 14.3 Behavior of Response Function
      4. 14.4 Characteristics of Credit BuVaR
      5. 14.5 Interpretation of Credit BuVaR
      6. 14.6 Spreadsheet Exercises
      7. Notes
    3. Chapter 15: Acceptance Tests
      1. 15.1 BuVaR Visual Checks
      2. 15.2 BuVaR Event Timing Tests
      3. 15.3 BuVaR Cyclicality Tests
      4. 15.4 Credit BuVaR Parameter Tuning
      5. Notes
    4. Chapter 16: Other Topics
      1. 16.1 Diversification and Basis Risks
      2. 16.2 Regulatory Reform and BuVaR
      3. 16.3 BuVaR and the Banking Book: Response Time as Risk
      4. 16.4 Can BuVaR Pick Tops and Bottoms Perfectly?
      5. 16.5 Postmodern Risk Management
      6. 16.6 Spreadsheet Exercises
      7. Note
    5. Chapter 17: Epilogue: Suggestions for Future Research
      1. Note
  14. About the Website
  15. Bibliography
  16. Index