Risk Budgeting: Portfolio Problem Solving with Value–at–Risk

Praise for Risk budgeting

"Professor Pearson has raised the bar for books on market risk. Moving beyond descriptions of VaR calculation and stress testing, he provides careful discussions of both the refinements and the limits of the VaR technique. Even more importantly, this book provides structure to the heretofore vague idea of ′risk budgeting.′ "
–Charles Smithson, Managing Partner, Rutter Associates

"Pearson has written an excellent resource for risk management practitioners who actually need to compute and use VaR. Numerous concrete examples make a broad range of VaR techniques accessible to the people who actually need to use them. The book also provides tangible applications of risk budgeting, a term often used but rarely made relevant. Pearson has put meat on the bones for plan sponsors who want to actually employ risk budgeting techniques."
–Bennett Golub, Co–head of Risk Management and Analytics,
Founding Partner, BlackRock

"An excellent book. This text provides a bridge from the theoretical to the practical, and clears the fog between the buzzwords of risk budgeting and the realities of a useful new portfolio management tool. Pearson′s writing is well balanced between needed academic foundation and the practicalities of managing portfolios."
–Rob Roy, Director, Cash and Investments, Adventist Health System

"I just wish I could summarize this book as ably as Professor Pearson summarizes the voluminous literature on Value–at–Risk. Unfortunately, I suspect no further compression is possible. To reduce the risk of reading rubbish, your best bet is to read this book."
–Dr. Peter Carr, Senior Consultant, Risk Capital Management

PART ONE: INTRODUCTION.

What are Value–at–Risk and Risk Budgeting?

Value–at–Risk of a Simple Equity Portfolio.

PART TWO: TECHNIQUES OF VALUE–AT–RISK AND STRESS TESTING.

The Delta–Normal Method.

Historical Simulation.

The Delta–Normal Method for a Fixed Income Portfolio.

Monte Carlo Simulation.

Using Factor Models to Compute the VaR of Equity Portfolios.

Using Principal Components to Compute the VaR of Fixed–Income Portfolios.

Stress Testing.

PART THREE: RISK DECOMPOSITION AND RISK BUDGETING.

Decomposing Risk.

A "Long–Short" Hedge Fund Manager.

Aggregating and Decomposing the Risks of Large Portfolios.

Risk Budgeting and the Choice of Active Managers.

PART FOUR: REFINEMENTS OF THE BASIC METHODS.

Delta–Gamma Approaches.

Variants of the Monte Carlo Approach.

Extreme Value Theory and VaR.

PAART FIVE: LIMITATIONS OF VALUE–AT–RISK.

VaR Is Only an Estimate.

Gaming the VaR.

Coherent Risk Measures.

PART SIX: CONCLUSION.

A Few Issues in Risk Budgeting.

References.

Index.

NEIL D. PEARSON, PhD, is an Associate Professor of Finance at the University of Illinois at Urbana–Champaign. His research includes work on the development, estimation, and evaluation of models for pricing and hedging various derivatives and other financial instruments. Dr. Pearson has published papers in a number of academic journals, and is an Associate Editor of both the Journal of Financial Economics and the Journal of Financial and Quantitative Analysis. He has consulted for a number of U.S. and international banks, working on term structure models, the evaluation of derivatives pricing models, and issues that arise in the computation of Value–at–Risk measures. He received his PhD from the Massachusetts Institute of Technology.