CHAPTER 2

Market Risk Basics

In this chapter, we begin studying how to quantify market risk, the risk of loss from changes in market prices, via statistical models of the behavior of market prices. We introduce a set of tools and concepts to help readers better understand how returns, risk, and volatility are defined, and we review some basic concepts of portfolio allocation theory.

The statistical behavior of asset returns varies widely, across securities and over time:

  • There is enormous variety among assets, as we saw in Chapter 1, ranging from simple cash securities, to fixed-income securities, which have a time dimension, to derivative securities, whose values are functions of other asset prices, to, finally, a bewildering array of indexes, basket products, tradeable fund shares, and structured credit products.
  • The market risks of many, if not most, securities must be decomposed into underlying risk factors, which may or may not be directly observable. In addition to statistical models, therefore, we also need models and algorithms that relate security values to risk factors. We also need to accurately identify the important risk factors.

    We discuss the relationship between asset prices and risk factors further in Chapter 4. For now, we will be a bit loose and use the terms “asset prices” and “risk factors” synonymously.

  • Some risk factors are far from intuitive. It is relatively straightforward to understand fluctuations in, say, equity prices. But options and option-like ...

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