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Week in Risk Week in risk (April 7th)

David Harper CFA FRM

David Harper CFA FRM
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1. Sample statistics versus population parameters: sample variances (when to divide by n -1?) and standard errors are queried every year by new Part 1 candidates. We talk about it here https://trtl.bz/2FXFcnM. The FRM is grounded in econometrics and statistics where a fundamental first step is distinguishing between the one "true" population that is unseen and the many various samples that might be taken from it, each generating effectively random variables like the sample mean. Most realistic situations are samples; e.g., when we observe ten or 500 trading days, those are samples! It's more academic, un-realistic and exam-like to be given a population assumption. For example, to be told that daily returns are normally distributed with volatility of 0.5% is to be given a fully-specified population's distribution. Standard errors do not exist when we've got the benefit of a population; a standard error is a standard deviation, but of sample mean that itself is a random variable.

2. Tricky terminology (Implied volatility versus vega; par yield): Speaking of classic terminology issues, two were asked about this week. First, I like yuwaising's question https://trtl.bz/2FUumis: if the implied volatility smile is flat, what is the implication on option vega? Second, Eric asked about the par yield (which is reviewed in both Hull and Tuckman) https://trtl.bz/2FVYB8P Tuckman actually uses par yields as key rates in the multi-factor key rate shift technique. It's painful to master par yields, especially in key rate shift technique, but it's a fine way to wrap together the key interest rate relationships.

3. Extreme value theory (EVT) derivations : Stuart and I geeked out a bit here https://trtl.bz/2FWv66B when we solved for certain of Dowd's extreme value theory (EVT) formulas. Johnny asked, are the EVT VaR or EVT ES formulas testable? I replied: "The EVT VaR/ES formulas are not very testable (low or no testability). How do I know? Funny you should ask! Years ago the LO read 'Compute VaR and expected shortfall using the POT approach, given various parameter values,' but these were among a set of compute/calculate verbs that we lobbied to soften given their inherently low testability. So today the EVT reading is devoid of calculate/compute action verbs; e.g., Describe the peaks-over-threshold (POT) approach." Yes, that's right, BT played a role over the years advocating to soften certain LO action verbs--from calculate to something qualitative--by providing feedback to GARP that the LOs were unrealistic time-sinks to candidates.


1. Masters of the universe with different ideas about capitalism: Jamie Dimon, CEO of JPMorgan Chase, wrote a 50-page Letter to Shareholders https://reports.jpmorganchase.com/investor-relations/2018/ar-ceo-letters.htm ... and it is a masterpiece, folks. I took so many notes that I could write 10 different articles about this letter, he touched on so many vital topics. (I have a vested interest: I am long BAC for about 2.4 years but I don't own JPM). Let me here just mention of one of his smaller (but technical) issues. Spurred by Crouhy in Topic 1 of the FRM, I was recently asked to illustrate the real-life difference between economic and accounting earnings, see https://trtl.bz/2UnvTrv. Now you have a better, concrete example of the trade-off introduced by Crouhy in the FRM! Writes Dimon, "Accounting rules can be counterintuitive, but you can't make business decisions based on them. While we are rigorous about proper accounting and disclosure, sometimes accounting can distort the actual economics of a business. A few examples will suffice. In credit card accounting, for instance, new card customer costs are expensed over the course of a year and inexplicably as a contra-revenue item (i.e., as a reduction of revenue rather than an expense). In addition, under upcoming accounting rules, losses that are expected over the life of the card balance are accounted for upfront. Meanwhile, the earnings from the card are booked over the life of the card, which averages approximately seven years .... The reason I am making this point is that you need to understand the economics of decisions. Accounting can easily make people do silly things." ... While Jamie Dimon essentially defends capitalism, Ray Dalio published a different view: Why and How Capitalism Needs to Be Reformed (Parts 1 & 2) https://trtl.bz/2FUsuWY

2. Airbnb lessons: What seven years at Airbnb taught me about building a company (medium @ https://trtl.bz/2FVe74O). This isn't about risk, but it's so densely informative that I must share. It's a mini-MBA in 13 minutes. But it's related to one of my favorite topics in risk: governance, and its intangible artifact, culture. Culture is #1 on his list. His point is about culture as competitive advantage, but we also know from the financial disaster case studies that weak (or broken) cultures are often the necessary condition that permits a crisis or debacle. His three ingredients for a strong culture: founders obsessed with culture, a strong sense of self ("Everyone at the company can recount the values verbatim."), and rituals.

3. Central Counterparties (CCP): The study of CCPs shows up three times in the FRM (P1.T2, P2.T6, and P2.T9). It's not academic: according to BIS, almost two-thirds of over-the-counter interest rate derivative contracts are cleared by CCPs, up from only one-fifth a decade ago (https://www.bis.org/publ/qtrpdf/r_qt1812h.htm). Here is a short case study: CCPs and the Risk of Concentration (https://trtl.bz/2G0NM5l). The interviewee, Stephen Cecchetti, writes a blog focused on the topic; e.g., Stress Testing Financial Networks: The Case of CCPs https://www.moneyandbanking.com/com...s-testing-financial-networks-the-case-of-ccps. Also, in January ISDA published: CCP Best Practices http://assets.isda.org/media/b53b5127/55872319-pdf/
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