Risk Modeling

Risk modeling refers to the use of formal econometric
techniques to determine the aggregate risk in a financial portfolio.
Risk modeling is one of many subtasks within the broader area of
financial modeling.

Risk modeling uses a variety of techniques including market risk, Value-at-Risk (VaR), Historical Simulation
(HS), or Extreme Value Theory (EVT) in order to analyze a portfolio and
make forecasts of the likely losses that would be incurred for a
variety of risks. Such risks are typically grouped into credit risk,
liquidity risk, interest rate risk, and operational risk categories.

Many
large financial intermediary firms use risk modeling to help portfolio
managers assess the amount of capital reserves to maintain, and to help
guide their purchases and sales of various classes of financial assets.

Formal risk modeling is required under the Basel II proposal for all the major international banking institutions by the various national depository institution regulators.

Quantitative
risk analysis and modeling have become important in the light of
corporate scandals in the past few years (most notably, Enron), Basel
II, the revised FAS 123R and the Sarbanes-Oxley Act. In the past, risk
analysis was done qualitatively but now with the advent of powerful
computing software, quantitative risk analysis can be done quickly and
effortlessly.

See also

• Financial risk management


• Knightian uncertainty


• Financial modeling

References

• Crockford, Neil (1986). An Introduction to Risk Management (2nd ed.). Woodhead-Faulkner. ISBN 0-859-41332-2.


• Machina, Mark J., and Michael Rothschild (1987). "risk," The New Palgrave: A Dictionary of Economics, v. 4, pp. 201-206.

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