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									Prof.Dr.Ing. Dimitris N. CHORAFAS




              INTEGRATED RISK MANAGEMENT
          Credit Risk, Market Risk, Derivatives Risk


                            A 4-Day Seminar at
            Ecole Polytechnique Fédérale de Lausanne

                       February 8, 9, 10 and 11, 2010
                               8h30 – 17h30



This four-day program is designed to help participants achieve a comfort
level in evaluating ways and means for an effective credit risk, market risk
and derivatives risk management; also in implementing necessary controls
to make the risk management task effective. The lectures' emphasis is on
"need to know" and on practical applications; they provide:


          A thorough understanding of exposure taken with credit risk,
           market risk, derivatives, and leveraging.


          Methods and tools to be used in implementing risk management
           policies, processes and procedures.


          Ways for strengthening the accountability of bank management,
           and the effectiveness of risk control efforts.
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         Enterprise-wide efficient, focused systems solutions, including
          the use of models supported by high technology.


         Stress testing policies, methods, tools and procedures, as well as
          identification of expected results.


The seminar focuses on concepts, norms and solutions for risk
management; analyzes credit risk models and methods; explains the
shortcomings of value-at-risk (VAR); examines strengths and weaknesses
of other artifacts; outlines a strategy for stress testing and suggests a
policy for control of exposure. Through practical examples, it
demonstrates how to use the best available tools to attain risk control
objectives.


The seminar is based on intensive meetings with 300 senior executives
from 100 organizations including the Federal Reserve Board in
Washington; Federal Reserve Banks of Boston and San Francisco; Office
of the Controller of the Currency (OCC); Federal Deposit Insurance Corp.
(FDIC); Office of Thrift Supervision (OTS); Securities and Exchange
Commission (SEC) in Washington, New York and Boston; Financial
Accounting Standards Board (FASB); International Accounting Standards
Board (IASB); Bank for International Settlements (BIS); Bank of England;
Financial Services Authority (FSA); Banque de France, Commission
Bancaire; Conseil National de Comptabilité; Deutsche Bundesbank;
German Banking Supervision Bureau (BAFIN); Bank of Italy; National
Bank of Austria; Banque Nationale Suisse; and Swiss Federal Banking
Commission.


Other participants to the research have been investments banks like
Merrill Lynch; commercial banks like Citigroup, Barclays Bank,
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Rabobank, Deutsche Bank, Crédit Suisse, UBS, and other selected credit
institutions. Also, all four main independent credit rating agencies:
Standard & Poor's (S&P), Moody's Investors Service, Fitch Ratings, and
A.M. Best.




DAY ONE

Lecture 1
RISK DEFINED
 The Notion of Risk
 Risk, Vagueness and Uncertainty
 A Leptokyrtotic Distribution Of Risk Events
 Normal Distribution; its Tails and Spikes
 Counterparty Risk and Legal Risk
 Classes of Risk Being Assumed
 The Measurement of Risk
 Risk Is A Cost
 Risk Pricing
 Risk Discovery is an Analytical Process
 Lessons from the Columbia Disaster
 Exposure Under Stress Conditions
 Worst-Case Scenarios
 July/August 2007. The Subprimes Crisis
 The Banking Industry’s Self-Inflicted Wounds
 Debt-to-Equity Ratio and Overleveraging
 Critical Ratios with Subprimes
 Strategic Planning Risk Control and Economic Capital

Lecture 2
MONEY, RISK AND REWARD
 What is Money
 Money Comes and Goes: 3 ½ Years of the Banking Industry's
  Capitalization
 Five Major Classes of Financial Instruments
 Financial Markets
 The Interconnection of Financial Instruments
 Gaming the Basel Rules on Capital Reserves
 Regulatory Arbitrage of Capital Adequacy
 Superleveraging of Assets
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   Why Banks Assume a Huge Exposure
   Domains Where Exposure Is Assumed
   Risk Appetite and Its Distributions
   Visualization of Risk Factors
   Deviations in Fair Value Estimates
   Marking to Market
   Marking to Model
   A Radar Chart for OBS Instruments
   Impact of Time Factor on Risk And Return
   Risk and Return is Not Linear
   Three Interactive Frames of Financial Reporting

Lecture 3
CREDIT RISK
 Credit Risk Estimates
 Why Creditworthiness Deteriorates?
 Why Banks Fail. Statistics by Bank of England
 Financial Rating and Management Rating by Moody's
 Decline of Median European Credit Ratings, in the 1990s
 Definition of Default
 Occurrence of Default
 Default Frequency Increases with Leverage
 Spikes in Credit Default Swaps
 Default Resolution
 Difference Between Bank Failure and Bank Default
 Ratings Are Based on Default not on Failure
 Probability of Default Can be Subset of Failure
 Exposure To Counterparty Rating
 Credit Risk Decreases With Higher Quality Assets
 The Practice of Bank Bailouts
 Salvage of Bankrupt Banks by Taxpayer Money

Lecture 4
CREDIT RATING
 Credit Decisions and Ratings
 A Brief History Of Rating Agencies
 A Rating Is Not a License
 Mission of Independent Rating Agencies
 Benefits from Greater Granularity in Ratings
 Thresholds in Credit Ratings
 Migration Probabilities in Credit Ratings
 The Value of Ratings Decays with Time
 A 3-Dimensional Rating System
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   Event Risk
   Credit Decisions and Credit Ratings
   Interactive Credit Ratings
   An Interactive Rating Procedure
   Criteria for Credit Risk Rating under Basel II
   Rating Agencies Are Not an Arm of Regulators
   The Contribution of Independent Rating
   Moody's Default Forecasting Model
   The KMV Algorithm
   Values Tracked by KMV
   Effects of Volatility in Equity Prices
   Distance from Default
   Credit Ratings and Globalization


DAY TWO

Lecture 5
DISTANCE TO DEFAULT
 The European Central Bank Algorithm
 Default Frequency, Current Liabilities, Liquid Funds
 Accuracy and Precision in Credit Ratings
 Rating Through Subjective Judgment (Business Analysis)
 Rating Through Financial Analysis
 The Work of a Financial Analyst
 What Is Covered and What Is Not in Financial Analysis
 Rating Criteria by S&P and Moody's
 Default Points and Default Correlations
 Estimating Distance to Default
 Non-Performing Loans by Japanese Banks. A Case Study
 Making Assessment Through Models
 Advantages and Disadvantages with Models
 The Regulators Don't Observe Their Own Rules
 Capital Adequacy Ratio by BEST – a Model
 Mapping the Company’s Probability of Default
 Pattern Analysis of Higher Credit Risk Positions
 Rating and Probability of Default are Relative, not Absolute

Lecture 6
EXPECTED LOSSES AND UNEXPECTED LOSSES
 Expected Losses (EL)
 Probability of Default and Stress Probability of Default (SPD)
 PD and SPD Over 10 Years
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   The Regulator’s Response to Probability Default
   Basel II and Probability of Default
   Models for Calculating a Commercial Bank’s Credit Exposure
   Loss Given Default (LGD)
   LGD Under Basel II
   Stress Loss Given Default (SLGD)
   Stress Exposure at Default (SEAD)
   Comparing Unexpected and Expected Losses
   Mitigating Unexpected Losses
   Unexpected Losses and Extreme Events
   Unexpected Losses and IRB
   Unexpected Losses Based on Stress Tests
   Liquidity Limits
   Limits and Rules Regarding Exposure
   Limits and Testing Procedures
   Downgrading a Big Bank
   Fallout from Bank Bankruptcies

Lecture 7
STRESS TESTING
 Stress Testing and Risk Management
 Disturbances vs Shocks
 Stress Testing for Regulatory Capital
 Stress Testing with IRB
 Leverage and Exposure Correlate
 Scenarios for Liquidity Risk Stress Tests
 Stress Tests of Financial Instruments
 Stress Tests of Forex Exposure
 A 3-D Frame of Reference for Loans
 Stress Testing Through Reverse Engineering
 Stress Testing Interest Rate Volatility
 Stress Testing Default Probability
 Strategic Risk and Business Risk
 Business Risk According to Fitch
 Business Risk According to Moody's
 Stress Testing Business Risk
 Stress Testing at a Major Bank
 S&P on Stress Testing

Lecture 8
THE CONTRIBUTION OF MODELS TO STRESS TESTING
 The Use of Models in Stress Testing
 Normal Testing and Stress Testing
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   Increased Deliverables by Stress Tests
   Stress Testing Non-Performing Loans
   Credit Default Swaps are a Stress Test
   Interest Rate Spread is a Stress Test
   Interbank Rate Spread is a Stress Test
   Standard Deviations of Real Life Events
   Strategies for Analyzing a Non-Normal Distribution
   Reasons Behind Asymmetries
   Estimating Correlation Coefficients
   Correlation Between Dollar Weakness and Price of Oil. An Example
   Confidence Intervals of Correlation Coefficients
   Lack of Sensitivity to Risk by Senior Management
   The Contributions of the Delphi Method
   Use Tests
   Worst-Case Drills
   Worst-Case Drills and Rating Agencies
   Stress Testing a Financial Model


DAY THREE

Lecture 9
MARKET RISK
 Market Risk Defined
 Market Risks Taken by a Money Center Bank
 Volatility and Liquidity
 A Pattern of Market Volatility
 Why Volatility and Liquidity Correlate
 What Is Meant by "Volatility Is Rising"?
 Liquid Assets
 Implied Stock Market Volatility
 Upside and Downside Movements in the Equity Market
 Implied Bond Market Volatility
 Types of Bonds Issued by Credit Institutions
 Debt is Traded in Both Money Market and Capital Market
 Real Bond Spreads and the Corporates
 Anomalies in Equity Market. Amazon.com
 Liquidity Crises Associated to Liabilities
 The Family of Interest Rate Risks
 Interest Rate Risk and Country Risk Correlate
 Spillover from Yield Volatility
 Warning Signals of a Currency Collapse
 Currency Exchange Risk. The Brazilian Real
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Lecture 10
DERIVATIVE FINANCIAL INSTRUMENTS
 Derivatives Defined
 The Underlying
 Underlying of CDOs Used in 2006 and Up to September 2007
 Notional Principal Amount
 Global Distribution of Derivatives Trades
 Interest Rate and Currency Underlyings
 OTC and Exchange Traded Derivatives
 Time Spread of Derivatives
 Why Derivative Instruments are Complex
 Derivatives are Unstuck from the Real Economy
 Advice on Controlling Derivatives Risk by the Fed
 Demodulating the Notional Principal Amount
 Growth in Derivatives and Bank Failures
 Bank-To-Bank Exposure in Derivatives
 What Senior Bankers Think About Derivatives Risk
 Alan Greenspan's Warning on Derivatives
 Warren Buffett's Warning on Derivatives
 Warren Buffett on the Derivatives Daisy Chain
 Bankers Comments on Buffett’s Position

Lecture 11
MATHEMATICAL MODELS
 Models for Explanation and Experimentation
 Accept/Reject; a Basic Principle of Science
 The Sense of Mathematical Models
 Financial Models
 Models for Risk Management
 Factors Working Against Models
 Making a Mathematical Model
 Challenges with Analysis
 Assumptions Used in Models
 Induction
 Deduction
 Bias. An Example With Volatility Smile
 Model Limits: Missing Tail Events
 Different Models Give Different Results
 Statistical Quality Control Charts
 Trend Analysis in a c-Chart
 Model Risk
 Model Limits
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Chapter 12
VALUE AT RISK
 VAR Defined
 Is VAR Sufficient?
 VAR’s Shortcomings
 Confidence Intervals with VAR
 Operating Characteristics Curve
 Failure Due to Types of Risk Distributions
 Comparing VAR Estimates and Trading Losses
 A VAR Mosaic by 10 Banks. A Case Study
 VAR Results are Not Comparable Among Banks
 Unreliability of VAR’s Input/Output
 Pitfalls with Black Boxes
 VAR99.97 and CAR99.97
 Zooming VAR. What's the Reason?
 VAR Exposure at Global Banks
 Warren Buffett on Marking to Model
 Hitting the Model’s Limits
 Critique of VAR and Use of GARCH
 Ten Major Failures of VAR
 Backtesting and Benchmarking
 The Supervision of Eigenmodels

DAY FOUR

Lecture 13
RISK MANAGEMENT
 Major Risks of Early 21st Century
 High Volatility Means Risk and Opportunity
 On Financial Markets and Fortune
 Market Risk Morphing Into Credit Risk
 Credit Risk Uncertainties
 Market Risk Uncertainties
 Derivatives, Credit Risk, Market Risk
 Risk Appetite and Risk Control
 The Basel Committee on Leverage
 Allocating Leveraged Capital Among Investment Channels
 The Management of Liabilities
 Two Interactive Frames of Reference for Risk Management
 Using Manhattan Project Methodology
 The Risk of Failure Is Unevenly Distributed
 Greenspan Suggests to Use Visualization
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   Tableau de Bord for Outstanding Factors
   3-D Presentation Is the Better Alternative

Lecture 14
ECONOMIC CAPITAL
 Economic Capital Is Risk Capital
 Derivatives Exposure of top US Banks
 Critical Ratios and Derivatives
 Financial Cost of Outliers
 Economic Capital Allocation
 Importance of Time Horizon
 The Overriding Need for Risk Management
 Risk Management Is Like Pre-Trial Preparation
 Rubin's Opinion on Pre-trial Preparation
 Borodovsky's Opinion on Pre-trial Preparations
 Rules of a Risk Manager
 Uncertainty and the Risk Manager
 Derivatives Turn from Assets to Liabilities in a Split Second
 The Two Heisenberg Principles Which Apply in Finance
 What Can Go Wrong With a Diversification Project
 Feynman's Advice on Personal Accountability
 The Lawn Sprinkler's Surprise

Lecture 15
THE FUNCTIONS OF MANAGEMENT
 The Six Functions of Management
 Buddha
 Every Phenomenon Has a Characteristic Curve
 The Risk of Misjudging Our Opponents
 The Risk of Misjudging Our Clients
 Planning for the Next Milestones. The Jean Monnet Principle
 All Men and Self-Made
 The Challenging Road of Risk and Return
 Taking Calculated Risks
 Six Principles of Talent Management
 Talent Management in Modern Society
 The Distorted 2-D View
 A 3-D View is Better
 Radar Chart
 The Risk of Being Locked-up in a Box
 Efficiency and Effectiveness
 Lifelong Learning
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Last Section of Fourth Day
ORAL EXAM

								
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