Market Risk in Turbulent Markets

Abstract

In this thesis we study market risk in turbulent markets over different risk horizons. We construct portfolios which represent possible investments for a life assurance fund. The portfolios consist of equities, fixed income instruments, cash positions and interest rate derivatives. Today, the most commonly used metrics for market risk are Value-at-Risk (VaR) and Expected Shortfall (ES), and they will be central. We introduce necessary theory from quantitative finance related to asset price dynamics and security pricing. Further, interest rate related instruments are handled by the LIBOR Market Model (LMM), while equity prices are modeled as geometric Brownian motions. We use implied volatilities for instruments where they are available, and historical for the rest. We implement a risk model and make daily and quarterly market risk estimates between 2000-2008 for the portfolios. We choose some central events from the last quarter of 2008, a critical phase of the ongoing financial crisis, and analyze how the portfolios and the corresponding risk estimates are affected. Comparison of the portfolio losses against risk estimates allows us to evaluate the reliability of the broadly adopted model.