Risk modeling

Risk modeling

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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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