Problem 13.13 works well as an assignment question. Problem 13.12 can also be used
as a short assignment question. Problem 13.17 is similar to Problem 13.13, but a little
more difficult as it is not quite so easy for students to use the worksheets that have been
created for students. If the worksheets for the four-index example are displayed in class,
Problems 13.14, 13.15, and 13.16 can be used to illustrate how they are manipulated.
Chapter 14: Model-Building Approach
This chapter is similar to Chapter 15 of the third edition. Like chapters 12 and 13, it
has more emphasis on expected shortfall. This chapter covers the model-building approach
for calculating market-risk VaR, which is the main alternative to historical simulation. It
explains the relationship of VaR to the Markowitz results and also shows how covariance
matrices can be used. The chapter uses the same four-index example as Chapter 13 and
worksheets for the use of the model building approach for the example are on the author’s
website. The example shows that volatilities and correlations increased during the stressed
market conditions of September 2008.
The chapter first explains how the model building approach can be used for the situ-
ation where the value of the portfolio is linearly dependent on the values of the underlying
market variables. (This includes a discussion of how interest rates can be handled with
cash flow mapping.) After that it moves on to consider what can be done in the situation
where the portfolio is not linearly dependent on the underlying variables. The alternatives
here are a) use a linear approximation (delta), b) use a quadratic approximation (delta +
gamma), and c) use Monte Carlo simulation.
This chapter requires a good understanding of the Greek letters and Taylor Series
expansions (covered in Chapter 8 and Appendix G). I generally spend about two hours
on the material. It should be noted that most banks now use the historical simulation
approach because of the problems mentioned in the text at the end of Section 14.10.
Any of Problems 14.16 to 14.23 can be used as assignment questions. 14.21 is a more
challenging than the others. 14.23 is based on the Excel spreadsheets for the four-index
example that is in the chapter and can be covered in class if the spreadsheets for the
example are displayed in class.
Chapter 15: Basel I, Basel II, and Solvency II
This is similar to Chapter 12 in the third edition. In order to understand the way
in which banks are currently regulated it is essential to have an understanding of the
history of regulation since 1988. For example, the concepts underlying many of the current
regulations (e.g., risk weighted assets) have their origins in Basel I. This chapter explains
how banks were regulated prior to the crisis. It also covers the Solvency I and Solvency II
regulations for insurance companies in Europe.
I usually start by asking students why banks are regulated and other companies en-
gaged in manufacturing and retailing are not. The answer is that banks are allowed to
take deposits from consumers and a stable banking system is an essential part of a healthy
economy. Many governments have deposit insurance systems and to avoid large payouts
they need to ensure that a bank’s capital is sufficient for the risks it is taking.
9