Table Of Content

ManagingUncertainty,MitigatingRisk Managing Uncertainty, Mitigating Risk Tackling the Unknown in Financial Risk Assessment and Decision Making Nick B. Firoozye and Fauziah Ariff ©NickB.FiroozyeandFauziahAriff2016 Softcover reprint of the hardcover 1st edition 2016 978-1-137-33453-4 Allrightsreserved.Noreproduction,copyortransmissionofthis publicationmaybemadewithoutwrittenpermission. Noportionofthispublicationmaybereproduced,copiedortransmitted savewithwrittenpermissionorinaccordancewiththeprovisionsofthe Copyright,DesignsandPatentsAct1988,orunderthetermsofanylicence permittinglimitedcopyingissuedbytheCopyrightLicensingAgency, SaffronHouse,6–10KirbyStreet,LondonEC1N8TS. Anypersonwhodoesanyunauthorizedactinrelationtothispublication maybeliabletocriminalprosecutionandcivilclaimsfordamages. Theauthorshaveassertedtheirrightstobeidentifiedastheauthorsofthiswork inaccordancewiththeCopyright,DesignsandPatentsAct1988. Firstpublished2016by PALGRAVEMACMILLAN PalgraveMacmillanintheUKisanimprintofMacmillanPublishersLimited, registeredinEngland,companynumber785998,ofHoundmills,Basingstoke, HampshireRG216XS. PalgraveMacmillanintheUSisadivisionofStMartin’sPressLLC, 175FifthAvenue,NewYork,NY10010. PalgraveMacmillanistheglobalacademicimprintoftheabovecompanies andhascompaniesandrepresentativesthroughouttheworld. Palgrave®andMacmillan®areregisteredtrademarksintheUnitedStates, theUnitedKingdom,Europeandothercountries. ISBN 978-1-349-56575-7 ISBN 978-1-137-33454-1 (eBook) DOI 10.1057/9781137334541 Thisbookisprintedonpapersuitableforrecyclingandmadefromfully managedandsustainedforestsources.Logging,pulpingandmanufacturing processesareexpectedtoconformtotheenvironmentalregulationsofthe countryoforigin. AcataloguerecordforthisbookisavailablefromtheBritishLibrary. AcatalogrecordforthisbookisavailablefromtheLibraryofCongress. ForRaniaandFaris Contents ListofBoxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . x ListofFigures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . xi ListofTables . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . xiii Preface. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . xiv Acknowledgements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . xix 1 Introduction. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1 Background . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1 Objectives. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4 Scopeofthebook . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4 Outlineofthebook . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6 PartI SettingtheLandscape . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9 2 TheBackdrop . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11 Historicalperspective–riskmanaged,uncertaintysidelined . . . . . . . . . . 12 RiskandUncertaintyinclassicaleconomics. . . . . . . . . . . . . . . . . . . . . . 14 Thebirthofmodernfinanceandeconomicsandthedeathof Uncertainty. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17 RiskandUncertaintyinpractice:probabilityrules . . . . . . . . . . . . . . . . . 20 Post-crisisinnovation–‘UncertaintyLight’ . . . . . . . . . . . . . . . . . . . . . . 28 TherenaissanceofUncertaintyinacademictho.u.g.h.t. . . . . . . . . . . . . . . . 32 3 ManagingUncertainty:AModernNecessity . . . . . . . . . . . . . . . . . . . . . 35 Importanceofmanaginguncertainty . . . . . . . . . . . . . . . . . . . . . . . . . . 35 Uncertaintynot.m. .a.na.g.e.d. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 39 Currenttoolsareinsufficient . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 41 Lessonslearnedoutsidefinancialriskmanage.m.e.n.t. . . . . . . . . . . . . . . . . 47 Apositivenote:signsofuncertaintymanagement inbanking . . . . . . . . . . 53 4 Probability:TheBuildingBlocks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 55 Probabilityinpractice:whataretheodds?. . . . . . . . . . . . . . . . . . . . . . . 56 Approachestoprobability:BayesianvsFrequenti.st. . . . . . . . . . . . . . . . . . 58 Mathematicsofprobability:areview . . . . . . . . . . . . . . . . . . . . . . . . . . 60 Limitationsofprobability:theEllsbergparadox . . . . . . . . . . . . . . . . . . 78 vii viii Contents 5 ProbabilityApplied . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 81 Probabilityandstatisticsinmean-varianceoptimisation . . . . . . . . . . . . . 82 ProbabilityandstatisticsinCAPM . . . . . . . . . . . . . . . . . . . . . . . . . . . . 88 ProbabilityandSDEsinBlack-Scholesandcontinuoustimefinance . . . . . 89 Value-at-risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 95 Pushingtheboundaries–movingtowardsuncertainty . . . . . . . . . . . . . . 101 PartII ManagingUncertainty: TheEssentials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 103 6 ClassificationofUnknownsandRiskScenarios . . . . . . . . . . . . . . . . . . . 105 Risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 107 Uncertaintyandambiguity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 108 Complexityandchaos . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 112 Unknownunknowns,blackswansandignoran.ce. . . . . . . . . . . . . . . . . . . 115 Classificationofriskscenarios . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 116 MappingclassesofUnknowns . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 120 7 KnowledgeandInformation:AnUnrestrictedView. . . . . . . . . . . . . . . . 123 Knowledge:aquicklook . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 124 ApplicationsinFinance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 127 Sourcesofmodellinginformation:Bayesianm.e.th.o.d.s. . . . . . . . . . . . . . . . 134 ScientificevidenceandBayesianpriors . . . . . . . . . . . . . . . . . . . . . . . . . 137 Acaseforbroadeningandenrichinghistorica.ld.a.t.a. . . . . . . . . . . . . . . . . 140 FinalRemarks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 144 8 BuildingonProbability:UncertaintyandUVaR . . . . . . . . . . . . . . . . . . 146 Mathematicsofuncertainty:impreciseprobab.i.lit.y. . . . . . . . . . . . . . . . . . 147 Second-orderprobability . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 156 Credalnets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 157 TacklingUncertainty–UVaR. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 163 ThecaseforUVaR . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 167 PartIII Framework,Methodology andCaseStudies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 173 9 FrameworkforAddressingUncertainty . . . . . . . . . . . . . . . . . . . . . . . . 175 ManagingUncertainty:anewapproach . . . . . . . . . . . . . . . . . . . . . . . . 176 Theframework . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 177 10 MethodologyandApplicationsofUVaR. . . . . . . . . . . . . . . . . . . . . . . . 187 CategorisingtheUnknown . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 187 Determinationofkeyriskscenarios,drivers,eventsandeventtrees. . . . . . 190 DefiningUVaR . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 193 Contents ix Scenariodevelopmentandscripting . . . . . . . . . . . . . . . . . . . . . . . . . . . 199 Finalthoughts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 203 11 CaseStudy:EuropeanSovereignDebtCrisis . . . . . . . . . . . . . . . . . . . . 204 UVaRapplication:Greekexit. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 204 Additionalcasematerial . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 215 LessonsLearned . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 225 12 FinalThoughts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 226 Appendix:ModelUncertainty . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 229 Notes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 234 Index. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 261

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ManagingUncertainty,MitigatingRisk Managing Uncertainty, Mitigating Risk Tackling the Unknown in Financial Risk Assessment and Decision Making Nick B. Firoozye and Fauziah Ariff ©NickB.FiroozyeandFauziahAriff2016 Softcover reprint of the hardcover 1st edition 2016 978-1-137-33453-4 Allrightsreserved.Noreproduction,copyortransmissionofthis publicationmaybemadewithoutwrittenpermission. Noportionofthispublicationmaybereproduced,copiedortransmitted savewithwrittenpermissionorinaccordancewiththeprovisionsofthe Copyright,DesignsandPatentsAct1988,orunderthetermsofanylicence permittinglimitedcopyingissuedbytheCopyrightLicensingAgency, SaffronHouse,6–10KirbyStreet,LondonEC1N8TS. Anypersonwhodoesanyunauthorizedactinrelationtothispublication maybeliabletocriminalprosecutionandcivilclaimsfordamages. Theauthorshaveassertedtheirrightstobeidentifiedastheauthorsofthiswork inaccordancewiththeCopyright,DesignsandPatentsAct1988. Firstpublished2016by PALGRAVEMACMILLAN PalgraveMacmillanintheUKisanimprintofMacmillanPublishersLimited, registeredinEngland,companynumber785998,ofHoundmills,Basingstoke, HampshireRG216XS. PalgraveMacmillanintheUSisadivisionofStMartin’sPressLLC, 175FifthAvenue,NewYork,NY10010. PalgraveMacmillanistheglobalacademicimprintoftheabovecompanies andhascompaniesandrepresentativesthroughouttheworld. Palgrave®andMacmillan®areregisteredtrademarksintheUnitedStates, theUnitedKingdom,Europeandothercountries. ISBN 978-1-349-56575-7 ISBN 978-1-137-33454-1 (eBook) DOI 10.1057/9781137334541 Thisbookisprintedonpapersuitableforrecyclingandmadefromfully managedandsustainedforestsources.Logging,pulpingandmanufacturing processesareexpectedtoconformtotheenvironmentalregulationsofthe countryoforigin. AcataloguerecordforthisbookisavailablefromtheBritishLibrary. AcatalogrecordforthisbookisavailablefromtheLibraryofCongress. ForRaniaandFaris Contents ListofBoxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . x ListofFigures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . xi ListofTables . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . xiii Preface. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . xiv Acknowledgements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . xix 1 Introduction. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1 Background . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1 Objectives. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4 Scopeofthebook . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4 Outlineofthebook . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6 PartI SettingtheLandscape . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9 2 TheBackdrop . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11 Historicalperspective–riskmanaged,uncertaintysidelined . . . . . . . . . . 12 RiskandUncertaintyinclassicaleconomics. . . . . . . . . . . . . . . . . . . . . . 14 Thebirthofmodernfinanceandeconomicsandthedeathof Uncertainty. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17 RiskandUncertaintyinpractice:probabilityrules . . . . . . . . . . . . . . . . . 20 Post-crisisinnovation–‘UncertaintyLight’ . . . . . . . . . . . . . . . . . . . . . . 28 TherenaissanceofUncertaintyinacademictho.u.g.h.t. . . . . . . . . . . . . . . . 32 3 ManagingUncertainty:AModernNecessity . . . . . . . . . . . . . . . . . . . . . 35 Importanceofmanaginguncertainty . . . . . . . . . . . . . . . . . . . . . . . . . . 35 Uncertaintynot.m. .a.na.g.e.d. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 39 Currenttoolsareinsufficient . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 41 Lessonslearnedoutsidefinancialriskmanage.m.e.n.t. . . . . . . . . . . . . . . . . 47 Apositivenote:signsofuncertaintymanagement inbanking . . . . . . . . . . 53 4 Probability:TheBuildingBlocks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 55 Probabilityinpractice:whataretheodds?. . . . . . . . . . . . . . . . . . . . . . . 56 Approachestoprobability:BayesianvsFrequenti.st. . . . . . . . . . . . . . . . . . 58 Mathematicsofprobability:areview . . . . . . . . . . . . . . . . . . . . . . . . . . 60 Limitationsofprobability:theEllsbergparadox . . . . . . . . . . . . . . . . . . 78 vii viii Contents 5 ProbabilityApplied . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 81 Probabilityandstatisticsinmean-varianceoptimisation . . . . . . . . . . . . . 82 ProbabilityandstatisticsinCAPM . . . . . . . . . . . . . . . . . . . . . . . . . . . . 88 ProbabilityandSDEsinBlack-Scholesandcontinuoustimefinance . . . . . 89 Value-at-risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 95 Pushingtheboundaries–movingtowardsuncertainty . . . . . . . . . . . . . . 101 PartII ManagingUncertainty: TheEssentials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 103 6 ClassificationofUnknownsandRiskScenarios . . . . . . . . . . . . . . . . . . . 105 Risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 107 Uncertaintyandambiguity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 108 Complexityandchaos . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 112 Unknownunknowns,blackswansandignoran.ce. . . . . . . . . . . . . . . . . . . 115 Classificationofriskscenarios . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 116 MappingclassesofUnknowns . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 120 7 KnowledgeandInformation:AnUnrestrictedView. . . . . . . . . . . . . . . . 123 Knowledge:aquicklook . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 124 ApplicationsinFinance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 127 Sourcesofmodellinginformation:Bayesianm.e.th.o.d.s. . . . . . . . . . . . . . . . 134 ScientificevidenceandBayesianpriors . . . . . . . . . . . . . . . . . . . . . . . . . 137 Acaseforbroadeningandenrichinghistorica.ld.a.t.a. . . . . . . . . . . . . . . . . 140 FinalRemarks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 144 8 BuildingonProbability:UncertaintyandUVaR . . . . . . . . . . . . . . . . . . 146 Mathematicsofuncertainty:impreciseprobab.i.lit.y. . . . . . . . . . . . . . . . . . 147 Second-orderprobability . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 156 Credalnets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 157 TacklingUncertainty–UVaR. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 163 ThecaseforUVaR . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 167 PartIII Framework,Methodology andCaseStudies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 173 9 FrameworkforAddressingUncertainty . . . . . . . . . . . . . . . . . . . . . . . . 175 ManagingUncertainty:anewapproach . . . . . . . . . . . . . . . . . . . . . . . . 176 Theframework . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 177 10 MethodologyandApplicationsofUVaR. . . . . . . . . . . . . . . . . . . . . . . . 187 CategorisingtheUnknown . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 187 Determinationofkeyriskscenarios,drivers,eventsandeventtrees. . . . . . 190 DefiningUVaR . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 193 Contents ix Scenariodevelopmentandscripting . . . . . . . . . . . . . . . . . . . . . . . . . . . 199 Finalthoughts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 203 11 CaseStudy:EuropeanSovereignDebtCrisis . . . . . . . . . . . . . . . . . . . . 204 UVaRapplication:Greekexit. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 204 Additionalcasematerial . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 215 LessonsLearned . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 225 12 FinalThoughts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 226 Appendix:ModelUncertainty . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 229 Notes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 234 Index. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 261

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