Read the summary and the most important questions on Elements of Financial Risk Management | 9780080472614 | Peter Christoffersen

• 1.3 Risk management and the Firm

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• Why should firms mange risk, give two reasons out classical theory why not?

  (1)Diversifiable risk not priced, every investor hold the market portfolio and risk free assets. (2)Modigliani-Miller, firm value independent of risk structure --> firms only care about expected profit.

• Why should firms manage risk, give four reasons out practice why they should.

  1. Bankruptcy costs
  2. REduce volatility of earnings --> reduce taxes.
  3. Captial structure does affect risk and cost of capital. --> higher debt-equity ratio requires RM
  4. Compensation packages.

• Give one empirical evidence why RM should.

  Empirical evidence indicates that RM reduces cash flow and share price volatil-ity⇒lower cost of capital⇒more investment, outperformance.Empirical evidence indicates that 

• Why should banks and financial institutions manage risk?  give 2 reasons.

  1. Highly leveraged, probbilty of default should be minimal.
  2. A default of a major bank is shocking and affect stability of financial system
  3. For this reason Basel 1,2 ,3 are there.

• 1.5 Asset retruns Definations

• What are the pros and cons for log and not log returns?

  1. Pro not log   Log returns can't sum up(the sum of log is not the same as the log of sums so.
  2. Pro log there is a lowerbound at zoro since the expectation of a log can't go lower as zero. 
  3. Pro log you can easily caluclulate the compounded return distribution.  
  

• 1.6 Stylized facts of Asset returns

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• The stylized facts about previous retruns

  Little autorcorrelation: Corr(Rt, Rt-t) = 0 for all t>1;

• The stylized facts 2. Does daily returns follow a normal distribution?

  Non-normal. Daily rturns have higher kurtosis, (more peaked longer tails) than normal distribution. Higher prob of more extreme's losses of gains. More small positive and less small negative returns.

• The stylized fact 3 about the relation of volatility

  Volatitlity Clustering: Corr(r^2, r^2t-1)>0, you can't say anything about the sign. But times of high volatility follow, times of high volatility. It's slowly decreasing in terms of lags.

• What is Time varying correlations?

  Different correlations for different times. When the market are decreasing than corrolation appears to increase (crisis) all assets go down.

• 1.7 A generic model of assets Returns

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• Explain the generic model of assets returns

  Radnom variable zt+1 is (i.i.d) (D(0,1). The mean is mostly 0 and the variance is the exectation of the return - the mean squared.