Quantitative Methods in Finance

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Financial risk management is a new quantitative discipline. Its development began during the 1970s, spurred on by the first Basel Accord, between the G10 countries, which covered the regulation of banking risk. Over the past 30 years banks have begun to understand the risks they take, and substantial progress has been made, particularly in the area of market risks.

Here the availability of market data and the incentive to reduce regulatory capital charges through proper assessment of risks has provided a catalyst to the development of market risk management software. Nowadays this software is used not only by banks, but also by asset managers, hedge funds, insurance firms and corporate treasurers. Understanding market risk is the first step towards managing market risk.

Yet, despite the progress that has been made over the last 30 years, there is still a long way to go before even the major banks and other large financial institutions will really know their risks. At the time of writing there is a substantial barrier to progress in the profession, which is the refusal by many to acknowledge just how mathematical a subject risk management really is.

Asset management is an older discipline than financial risk management, yet it remains at a less advanced stage of quantitative development. Unfortunately the terms ‘equity analyst’, ‘bond analyst’ and more generally ‘financial analyst’ are something of a misnomer, since little analysis in the mathematical sense is required for these roles.

I discovered this to my cost when I took a position as a ‘bond analyst’ after completing a postdoctoral fellowship in algebraic number theory. One reason for the lack of rigorous quantitative analysis amongst asset managers is that, traditionally, managers were restricted to investing in cash equities or bonds, which are relatively simple to analyse compared with swaps, options and other derivatives. Also regulators have set few barriers to entry.

Almost anyone can set up an asset management company or hedge fund, irrespective of their quantitative background, and risk-based capital requirements are not imposed. Instead the risks are borne by the investors, not the asset manager or hedge fund. The duty of the fund manager is to be able to describe the risks to their investors accurately.

Fund managers have been sued for not doing this properly. But a legal threat has less impact on good practice than the global regulatory rules that are imposed on banks, and this is why risk management in banking has developed faster than it has in asset management. Still, there is a very long way to go in both professions before a firm could claim that it has achieved ‘best practice’ in market risk assessment, despite the claims that are currently made.

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