Stress Testing Mortgages. Part 2
The team of Scott L. Smith, Jesse Weiher, and Debra Fuller at the Federal Housing Finance Agency (FHFA) use specialized financial models to estimate potential losses. They carried out empirical tests of countercyclical shocks using four different models of mortgage credit risk. This posting continues a February 4, 2015, presentation by Scott L. Smith to an audience of financial risk managers at Global Association of Risk Professionals (GARP). Two models were devised at FHFA, and two are commercially available credit models: one, called Black Knight (formerly LPS-AA), and the other called ADCO Loan Dynamics. The estimated losses were converted to a capital […]
Stress Testing Mortgages. Part 1
“One needs to be careful and not over-reliant on any one model,” said Scott L. Smith, Associate Director for Capital Policy at the Federal Housing Finance Agency (FHFA). He was referring to the financial models used by major financial institutions to estimate potential losses. On February 4, 2015, he was presenting a GARP-sponsored webinar on countercyclical stress tests to set capital requirements. Smith explained how credit risk is measured for mortgages, and described a way to embed stress testing that uses countercyclical concepts. He and colleague Jesse Weiher, Senior Economist at FHFA, performed dynamic stress testing that was adjusted to […]
When Data Is Sparse. Part 2
It’s difficult to model sovereign credit risk for emerging markets using structural models such as the Merton model because “calibration is always an issue,” said Rob Stamicar, Senior Director of Research in Multi-Asset Class Risk Management at Axioma, continuing a theme during the second half of his webinar on December 2, 2014. During the first half, he showed how the probability of default can be used as a common link among the asset classes of interest (bonds, swaps, and equities). In the second half, he focused more on sovereign credit risk. Calculation of sovereign risk could be done directly, “but […]
When Data Is Sparse. Part 1
When modelling risk in emerging markets, are you hampered by sparse data? “Relationships between different asset classes can help measure the sovereign risk in emerging markets,” said Rob Stamicar, Senior Director of Research in Multi-Asset Class Risk Management at Axioma. He was sole presenter at a webinar on December 2, 2014, sponsored by the Global Association of Risk Professionals. When modelling global multi-asset class portfolios, “aggregation can be challenging,” said Stamicar, because the FX rates must also be taken into consideration—the subject for another day. His talk focussed on three asset classes: equity, fixed income, and credit portfolios. Infrequent data, […]
Stressed Interest Rates: ‘Simple’ Not Good Enough
“It’s difficult to apply historical down-shocks to the current low interest rate environment,” said Will Doerner, “and models have problems in the low interest rate environments of today.” Doerner is Senior Economist at the Federal Housing Finance Agency (“Agency”), and was the first presenter at a GARP webinar on how to generate historically-based interest rate shocks, which was held October 28, 2014. An accurate estimation of market risk helps financial institutions determine the amount of capital needed to withstand adverse market events. Interest rate changes represent a key factor for institutions with large fixed income portfolios. As such, when stress […]
Correlation Risk
“Before we argue about correlation, we must first agree on which interpretation we are talking about,” said Gunter Meissner, President of Derivatives Software, Founder and CEO of Cassandra Capital Management, and Adjunct Professor of Mathematical Finance at NYU-Courant. He was sole presenter at a webinar on October 21, 2014, sponsored by GARP. Meissner cited three different interpretations commonly used for correlation risk. “In trading practice, it can mean similar movement in time. Or it can be narrowly defined,” he said, “to only refer to the linear Pearson definition.” Third, it can be used in the broader sense of any type […]
Clickable Calculus
When finding a definite integral, do you spend an inordinate amount of time in the step-by-step algebra? Let’s say you are integrating over a probability of default function that has been fitted to real-life data (a non-normal curve) and you want to understand step-size dependence. Or perhaps you are a beginning student of mathematical finance, reviewing the fundamentals of integration, and you just wish there was a faster way to change functions and spit out a graph. “Integration is a summative process, and the applications that show this can become a time-sink,” said Robert Lopez, Emeritus Professor of Mathematics at […]
Risk Ratings 2. “Hundreds of Spreadsheets”
“There were hundreds of different spreadsheet templates floating around,” said Christopher Hansert, Product Manager at Bosch Software Innovations, and the second of two presenters at a GARP webinar on the impact of new capital rules on risk ratings, held June 24, 2014. He presented a case study of an unnamed US commercial bank. Due to an acquisition during the period of regulatory change, he said that the bank had a “heterogeneous set of platforms, models, and inconsistent ratings. They wanted one robust and centralized” risk rating system. Inconsistencies in the risk rating process increased the likelihood of error, Hansert pointed […]
Risk Ratings 1. The Big Choke Points
“The inter-connectedness of the regulatory landscape has increased dramatically,” said Balachander Lakshmanan, Director at Deloitte & Touche LLP. He was the first of two presenters at the June 24, 2014, webinar sponsored by the Global Association of Risk Professionals to discuss the impact of capital rules on risk rating systems. In the wake of the financial crisis, new regulations—Basel, Volcker rule, Comprehensive Capital Analysis and Review (CCAR)—have proliferated. Due to changes in capital rules, new operating models are starting to emerge at banks, said Lakshmanan. There are requests for “spot calculations” or snapshots of a bank at any given time. […]
Fama-French 2. Three is Now Five?
Fama and French, originators of the three-factor model for asset pricing, are working to understand the fourth factor –and a fifth factor, too, said Marlena Lee, PhD, VP of Dimensional Fund Advisors. She should know; she has worked closely with Nobel laureate Gene Fama and was his former teaching assistant at the University of Chicago Booth School of Business. Lee spoke at the CFA Society Toronto on June 19, 2014, about the evolution of asset pricing. Part 1 summarizes her comments on the dimension of profitability. Could there be another component? As early as 1993 Jegadeesh and Titman had proposed […]