ABSTRACT
In this chapter we discuss risk management, beginning with a survey of the different types of risks institutions face, ranging from market risk to operational or model risk. Additional context is provided on the difference between defined risk, that we know and can observe, and undefined risk which is latent and has yet to present itself. We then discuss common measures of risk, from volatility to value-at-risk to conditional value-at-risk. Next, we discuss two approaches to computing the VaR or CVaR of a portfolio, historical simulation and via Monte Carlo. A critical example of an out-of-sample VaR test is presented where validate that the VaR model we built is consistent with subsequent realizations. Finally, we consider how risk management changes in the presence of non-linear instruments, such as options, and in rates and credit markets where we must contend with a yield curve or a potential jump into default.
