Portfolio Risk Analysis »

Gregory Connor is professor of finance at the National University of Ireland, Maynooth, and senior research associate at the London School of Economics and Political Science. Lisa R. Goldberg is executive director of analytic initiatives at MSCI Barra and adjunct professor of statistics at the University of California, Berkeley. Robert A. Korajczyk is professor of finance at Northwestern University.

"Thorough and well-cited, this is a comprehensive treatment of techniques for portfolio risk management. It provides a unique perspective, from the fundamentals to practical applications. There are few books that cover this material in this particular way."--Christopher L. Culp, author of Structured Finance and Insurance

"The range of topics is wide and the coverage is deep. An impressive book."--Peter Christoffersen, McGill University

"The conceptual framework of this book is presented in a lucid and clear manner. The treatment is mathematically rigorous where it matters, without ever becoming pedantic and without cutting corners."--Riccardo Rebonato, Royal Bank of Scotland

"This book takes major steps forward in the crucially important area of portfolio risk measurement, making significant strides toward incorporating industry and country risk, as well as macroeconomic, FX, credit, transactions cost, and liquidity risks. It will be an essential reference text for academics, central bankers, and others in the financial services industry."--Francis X. Diebold, University of Pennsylvania

Acknowledgments xi Introduction xiii Key Notation xix

Chapter 1: Measures of Risk and Return 1
1.1 Measuring Return 1
1.2 The Key Portfolio Risk Measures 6
1.3 Risk-Return Preferences and Portfolio Optimization 12
1.4 The Capital Asset Pricing Model and Its Applications to Risk Analysis 23
1.5 The Objectives and Limitations of Portfolio Risk Analysis 31

Chapter 2: Unstructured Covariance Matrices 36
2.1 Estimating Return Covariance Matrices 36
2.2 The Error-Maximization Problem 47
2.3 Portfolio Choice as Decision Making under Uncertainty 54

Chapter 3: Industry and Country Risk 61
3.1 Industry-Country Component Models 61
3.2 Empirical Evidence on the Relative Magnitudes of Country and Industry Risks 73
3.3 Sector-Currency Models of Corporate Bond Returns 77

Chapter 4: Statistical Factor Analysis 79
4.1 Types of Factor Models 79
4.2 Approximate Factor Models 82
4.3 The Arbitrage Pricing Theory 86
4.4 Small-n Estimation Methods 88
4.5 Large-n Estimation Methods 93
4.6 Number of Factors 98

Chapter 5: The Macroeconomy and Portfolio Risk 101
5.1 Estimating Macroeconomic Factor Models 101
5.2 Event Studies of Macroeconomic Announcements 110
5.3 Macroeconomic Policy Endogeneity 112
5.4 Business Cycle Betas 115
5.5 Empirical Fit and the Relative Value of Macroeconomic Factor Models 116

Chapter 6: Security Characteristics and Pervasive Risk Factors 117
6.1 Equity and Fixed-Income Characteristics 117
6.2 Characteristic-Based Factor Models of Equities 122
6.3 The Fama-French Model and Extensions 130
6.4 The Semiparametric Approach to Characteristic-Based Factor Models 132

Chapter 7: Measuring and Hedging Foreign Exchange Risk 134
7.1 Definitions of Foreign Exchange Risk 134
7.2 Optimal Currency Hedging 142
7.3 Currency Covariances with Stock and Bond Returns 149
7.4 Macroeconomic Influences on Currency Returns 151

Chapter 8: Integrated Risk Models 155
8.1 Global and Regional Integration Trends 155
8.2 Risk Integration across Asset Classes 158
8.3 Segmented Asset Allocation and Security Selection 159
8.4 Integrated Risk Models 162

Chapter 9: Dynamic Volatilities and Correlations 167
9.1 GARCH Models 167
9.2 Stochastic Volatility Models 178
9.3 Time Aggregation 180
9.4 Downside Correlation 181
9.5 Option-Implied Volatility 184
9.6 The Volatility Term Structure at Long Horizons 187
9.7 Time-Varying Cross-Sectional Dispersion 188

Chapter 10: Portfolio Return Distributions 191
10.1 Characterizing Return Distributions 191
10.2 Estimating Return Distributions 196
10.3 Tail Risk 203
10.4 Nonlinear Dependence between Asset Returns 207

Chapter 11: Credit Risk 212
11.1 Agency Ratings and Factor Models of Spread Risk 213
11.2 Rating Transitions and Default 217
11.3 Credit Instruments 218
11.4 Conceptual Approaches to Credit Risk 220
11.5 Recovery at Default 232
11.6 Portfolio Credit Models 232
11.7 The 2007-8 Credit-Liquidity Crisis 238

Chapter 12: Transaction Costs and Liquidity Risk 241
12.1 Some Basic Terminology 241
12.2 Measuring Transactions Cost 246
12.3 Statistical Properties of Liquidity 261
12.4 Optimal Trading Strategies and Transaction Costs 266

Chapter 13: Alternative Asset Classes 271
13.1 Nonsynchronous Pricing and Smoothed Returns 271
13.2 Time-Varying Risk, Nonlinear Payoff, and Style Drift 284
13.3 Selection and Survivorship Biases 291
13.4 Collectibles: Measuring Return and Risk with Infrequent and Error-Prone Observations 295
13.5 Summary 298

Chapter 14: Performance Measurement 299
14.1 Return-Based Performance Measurement 299
14.2 Holdings-Based Performance Measurement and Attribution 303
14.3 Volatility Forecast Evaluation 309
14.4 Value-at-Risk Hit Rates 316
14.5 Forecast and Realized Return Densities 317

Chapter 15: Conclusion 319
15.1 Some Key Messages 319
15.2 Questions for Future Research 320

References 323
Index 345