Problems 20.13 to 20.16 are possible assignment questions of varying difficulty.
Chapter 21: Credit Value at Risk
This chapter is a update to Chapter 18 of the third edition. The chapter starts by
explaining what rating transitions matrices are and how they can be manipulated. (The
manipulation of credit transition matrices is explained in Appendix J and software for doing
it is provided on my web site.) It then discusses three different approaches for calculating
VaR for the banking book. Vasicek’s model is the one used by regulators. Credit Risk
Plus corresponds to an approach widely used by the insurance industry . Creditmetrics
is most commonly used by banks when they calculate economic capital. More details on
both credit risk plus and creditmetrics are given in the fourth edition.
The chapter then moves on to calculate credit VaR for items in the trading book. In
particular it discusses how the specific risk charge and the incremental risk charge can be
computed.
Any of the three further questions can be used as assignments.
Chapter 22: Scenario Analysis and Stress Testing
This chapter is an update to Chapter 19 of the third edition. More material has been
included on regulatory stress testing. Stress testing has clearly become a more important
topic as a result of the credit crisis. The chapter discusses a) how the scenarios are
generated, b) how the scenarios are evaluated, and c) how the results should be used. It
emphasizes the importance of senior management involvement in the generation of the
scenarios. It also makes the point that the evaluation of the scenarios is not a mechanistic
exercise because the market’s reaction to the scenario and the consequences of that reaction
need to be considered. The technique of reverse stress testing is explained and Berkowitz’s
procedure for integrating VaR with stress testing is outlined.
Problems 22.10 and 22.11 can be used as assignment questions. 22.10 requires an
understanding of the DerivaGem Applications Builder.
Chapter 23: Operational Risk
This chapter is an update to Chapter 20 of the third edition. With the advent of
Basel II, there has been a big increase in the resources devoted to measuring operational
risk at banks and other financial institutions. The estimation of operational risk is less
quantitative than the estimation of other risks. The different approaches are outlined in
the chapter. I generally spend about 1.5 hours on the chapter.
By the end of a class based on the chapter students should understand a) the dis-
tinction between loss frequency and loss severity and how they are combined to calculate
a loss distribution, b) the ways in which internal and external data are used, c) the role
of scenario analysis, d) the importance of BEICFs, e) self assessment and f) the moral
hazard/adverse selection issues in insurance.
Problem 23.13 can be used for class discussion. Problems 23.12 and 23.14 are potential
hand-in assignments.
Chapter 24: Liquidity Risk
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