Risk factors and the financial crisis

Quantitative Risk Management in Python

Jamsheed Shorish

Computational Economist

Risk factors

Volatility: measure of dispersion of returns around expected value
Time series: expected value = sample average
What drives expectation and dispersion?
Risk factors: variables or events driving portfolio return and volatility

Dispersion plot, deviation of returns from time series mean

Risk exposure

Risk exposure: measure of possible portfolio loss
- Risk factors determine risk exposure
Example: Flood Insurance
- Deductible: out-of-pocket payment regardless of loss
- 100% coverage still leaves deductible to be paid
- So deductible is risk exposure
- Frequent flooding => more volatile flood outcome
- Frequent flooding => higher risk exposure

Systematic risk

Systematic risk: risk factor(s) affecting volatility of all portfolio assets
- Market risk: systematic risk from general financial market movements
Airplane engine failure: systematic risk!
Examples of financial systematic risk factors:
- Price level changes, i.e. inflation
- Interest rate changes
- Economic climate changes

Propeller plane engine

Idiosyncratic risk

Idiosyncratic risk: risk specific to a particular asset/asset class.
Turbulence and the unfastened seatbelt: idiosyncratic risk!
Examples of idiosyncratic risk:
- Bond portfolio: issuer risk of default
- Firm/sector characteristics
  - Firm size (market capitalization)
  - Book-to-market ratio
  - Sector shocks

Airline seat belt

Factor models

Factor model: assessment of risk factors affecting portfolio return
Statistical regression, e.g. Ordinary Least Squares (OLS):
- dependent variable: returns (or volatility)
- independent variable(s): systemic and/or idiosyncratic risk factors
Fama-French factor model: combination of
- market risk and
- idiosyncratic risk (firm size, firm value)

Crisis risk factor: mortgage-backed securities

Investment banks: borrowed heavily just before the crisis
Collateral: mortgage-backed securities (MBS)
MBS: supposed to diversify risk by holding many mortgages of different characteristics
- Flaw: mortgage default risk in fact was highly correlated
- Avalanche of delinquencies/default destroyed collateral value
90-day mortgage delinquency: risk factor for investment bank portfolio during the crisis

90-day mortgage delinquencies 2005-2010

Crisis factor model

Factor model regression: portfolio returns vs. mortgage delinquency
Import statsmodels.api library for regression tools
Fit regression using .OLS() object and its .fit() method
Display results using regression's .summary() method

import statsmodels.api as sm

regression = sm.OLS(returns, delinquencies).fit()

print(regression.summary())

Regression .summary() results

regression summary example

Let's practice!

Quantitative Risk Management in Python

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