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Risk Management Training – The quest for 25 answers to 25 questions. A risk student speaks.

Danish is a recent hire in our risk management practice. Some of you know him as the author of our recent Barclay Libor crisis commentary.

An under training and aspiring actuary he decided to take a leap of faith and switch to risk management from a conventional actuarial valuation career. Over the last three months we have pushed him towards the deeper side of the pool again and again. And to his credit he has managed to come out breathing and in one piece.

Last weekend I asked Danish about his impressions of this field. We started talking about the 25 things that he thought he should understand before he would be really comfortable as a newbie risk manager. The note that follows is Danish’s commentary on the 25 questions he would like to ask and seek answer to when it come to becoming a quant, opening a risk management text book and answering a derivative pricing question from a client. It comes from his heart and is a useful list for us to follow in creating more training options for our customers.

Over to you Danish. Enjoy the journey of self discovery.

Jawwad

Ps. Danish makes a number of references to LNS in his note. LNS is our internal Library of e-learning course, pdf files and video lectures on risk management. Drop us a line or click the Learning Network Subscription Link if you would like to see a free, no obligation demo.

Overview:

I have trained to self study first for my GCE O and A levels and then for my actuarial exams. However studying risk, I came across a number of ideas and topics which I have not been able to cope with. What frustrates me intellectually is my incomplete grasp of these ideas.

My strategy for doing self study is to simply forget topics which I can’t understand. Initially I thought that I had no problems but when I thought about it I gradually discovered lost concepts that I had buried deep in my subconscious.

I don’t study for study sake; the overall assumption I use is that something is useless unless I can APPLY it and this inability is the major source of my intellectual frustration. If anyone thought that this would just be a list of concepts (it does include many concepts though) that I struggle with, they would be disappointed.

The following list indicates the holes in my intellectual understanding and curiosity. The list is NOT numbered in terms of importance; all points mentioned are important and unique in their own respect.

  • 1. Generalized Linear Models (GLMs): Love at first sight because extensive study of regression in actuarial exam CT3 had left me hopeless about ever applying regression in practice. GLMs can be non linear are non- normal and have no fixed volatility; it was like my prayers were finally answered. However there was just theory and more theory and nothing else. This left me wondering why such a good area like GLM is so under used in practice. Finally after much trial and error I discovered that GLMs are used in pricing! GLMs are also taught in CQF Module 5.

    Theory is useless unless applied and that’s where I lack in. I want to see a GLM model for pricing in excel and understand something practical about them after so long.

  • 2. Longevity Risk: Initially I found the term ‘longevity’ appealing and the concept fascinating. Again theory and just more theory. I recently found out that there are actually longevity derivatives. To know the details of Longevity risk is the first step. I would love to know how to price and model longevity derivatives practically using excel.
  • 3. It’s a sad surprise that given we know a lot about Greeks, we end up with just bookish knowledge. Recently I found that traders even use Greeks in making their decisions (let alone Quants). I have unsuccessfully tried to model them in excel but end up with circular references.
  • 4. What is the fuss about capital modeling? On LNS we have perhaps the best packages for ALM modeling including videos and pdfs to precisely document how to do ALM modeling practically. However generally when it comes to capital, there is a lack of information on how to practically perform it.

     

  • 5. GARCH models: so much potential yet so under developed. I even saw a book that was modeling it.

  • 6. Ito’s calculus: Give me anything with the name Ito attached to it be it Ito’s lemma, Ito’s integral or Ito’s calculus I immediately skip this part. This is because far from thinking about it practically, I have not been yet able to even hold the basic concepts of it. The equations look alien to me and the purpose unclear.

  • 7. Partial differential equations and stochastic differential equations: I don’t know how to solve them mathematically! All I see is meaningless equations. This is especially sad given that Black Scholes is defined in terms of partial differential equation. It’s not enough just to show an equation, you must also teach me how to actually solve it.

  • 8. Where is Empirical Bayes Credibility Theorem? It is fantastic in the sense that it requires no assumptions about the distribution of the data and it calculates results using the data it has. But where are the applications and the models for it?

  • 9. Extreme Value Theory: Given that I am a fan of Nicholas Nassim Taleb I have this urge to look at worst case scenarios. While on LNS and beyond there is lots of information about VaR, but what about once the VaR threshold is exceeded? This is a fascinating area of study which I feel is still underdeveloped.

    10. Constructing Brownian motion and Wiener process: Again blank on it theoretically, conceptually and practically.

  • 11. Markov and Kolmogrov equations: I don’t know how to solve them mathematically nor know the theory behind it. Applying them practically is far far away.

  • 12. Martingales: No it doesn’t make sense to me. How can I define mean=0 and praise it for discovering many important financial economics concepts?

  • 13. Delta hedging: Traders use them and I am training to be a quant yet I don’t know how to perform it in excel.

  • 14. Risk neutrality: Difficulty in understanding the concept and its implications. There are even risk neutral valuations. How can risk be neutral? And how come we use it for comparison purposes for actual risk?

  • 15. Volatility smiles: A dark hole trying to break the fundamental assumption of constant volatility in Black Scholes when it was first discovered. What is it and how can we use it practically?
  • 16. Modified Duration: This is a bit embarrassing but if given duration =4.5 years and modified duration= 4.33 years what does this 4.33 years represent?

     

  • 17. Again embarrassing: I understand most things through examples. However I cannot extract a single example of Contango and backwardation. Since I have no example I could not understand the concept as well even when I read about it in basic and user friendly terms.

  • 18. Jarrow-Lando-Turnball model for credit risk: Couldn’t make sense of any of it; neither the theory nor the equations.

  • 19. Asset backed securities: Given that CDOs and other asset backed securities were responsible for the global financial crisis it’s still surprising that we have not yet even made an excel model on how to model and price them. Modeling and pricing will show exactly where we went wrong.

  • 20. Copulas: are they just linking functions? How are they supposed to function practically given that we know that correlations break down under times of stress? How are they used practically?

  • 21. Poisson path construction and Poisson process for modeling jumps: Poisson is clearly the underdog here. Given its flexibility and practical importance yet I can’t model them even in basic spreadsheets like excel.

  • 22. I have worked for 2.5 years in pension consultancy and so I have seen a lot of deterministic modeling. However I am yet to see a stochastic model that is fit to a T to the definition given to it and the requirements for a model to be stochastic. I want to see one.

  • 23. Iterations: Used a lot in quantitative finance yet the theory is unclear and its practical applying ability is nil. Is solver used for producing iterations in excel?

  • 24. The famous 8 steps to replicating a portfolio. This might be my weakest spot. It uses martingales and parity concepts that are still grey shades for me. Conceptually struggling in it.

  • 25. Solvency II: Given that careers are being built on solvency II my ignorance about this important regulation is shocking. There might be good books available that gives a practical hands-off approach while being sufficiently comprehensive like this one.

     

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