Welcome!

Q U A N T I TAT I V E R I S K M A N A G E M E N T I N P Y T H O N

Dr. Jamsheed Shorish

Computational Economist
About Me
Computational Economist

Specializing in:
asset pricing

nancial technologies ("FinTech")

computer applications to economics and nance

Co-instructor, "Economic Analysis of the Digital Economy" at the ANU

Shorish Research (Belgium): computational business applications

QUANTITATIVE RISK MANAGEMENT IN PYTHON

What is Quantitative Risk Management?
Quantitative Risk Management: Study of quanti able uncertainty

Uncertainty:
Future outcomes are unknown

Outcomes impact planning decisions

Risk management: mitigate (reduce e ects of) adverse outcomes

Quanti able uncertainty: identify factors to measure risk

Example: Fire insurance. What factors make re more likely?

This course: focus upon risk associated with a nancial portfolio

QUANTITATIVE RISK MANAGEMENT IN PYTHON

Risk management and the Global Financial Crisis
Great Recession (2007 - 2010)
Global growth loss more than $2 trillion

United States: nearly $10 trillion lost in household wealth

U.S. stock markets lost c. $8 trillion in value

Global Financial Crisis (2007-2009)

Large-scale changes in fundamental asset values

Massive uncertainty about future returns

High asset returns volatility

Risk management critical to success or failure

QUANTITATIVE RISK MANAGEMENT IN PYTHON

Quick recap: financial portfolios
Financial portfolio
Collection of assets with uncertain future returns

Stocks

Bonds

Foreign exchange holdings ('forex')

Stock options

Challenge: quantify risk to manage uncertainty

Make optimal investment decisions

Maximize portfolio return, conditional on risk appetite

QUANTITATIVE RISK MANAGEMENT IN PYTHON

Quantifying return
Portfolio return: weighted sum of individual asset returns
Pandas data analysis library

DataFrame prices

.pct_change() method

.dot() method of returns

prices = pandas.read_csv("portfolio.csv")
returns = prices.pct_change()
weights = (weight_1, weight_2, ...)
portfolio_returns = returns.dot(weights)

QUANTITATIVE RISK MANAGEMENT IN PYTHON

Quantifying risk
Portfolio return volatility = risk

Calculate volatility via covariance matrix

Use .cov() DataFrame method of

returns and annualize

covariance = returns.cov()*252
print(covariance)

QUANTITATIVE RISK MANAGEMENT IN PYTHON

Quantifying risk
Portfolio return volatility = risk

Calculate volatility via covariance matrix

Use .cov() DataFrame method of

returns and annualize

Diagonal of covariance is individual asset

variances

covariance = returns.cov()*252
print(covariance)

QUANTITATIVE RISK MANAGEMENT IN PYTHON

Quantifying risk
Portfolio return volatility = risk

Calculate volatility via covariance matrix

Use .cov() DataFrame method of

returns and annualize

Diagonal of covariance is individual asset

variances

O -diagonals of covariance are

covariances between assets

covariance = returns.cov()*252
print(covariance)

QUANTITATIVE RISK MANAGEMENT IN PYTHON

Portfolio risk
Depends upon asset weights in portfolio

Portfolio variance σp2 is

σp2 := wT ⋅ Covp ⋅ w

Matrix multiplication can be computed using @ operator in Python

Standard deviation is usually used instead of variance

weights = [0.25, 0.25, 0.25, 0.25] # Assumes four assets in portfolio

portfolio_variance = np.transpose(weights) @ covariance @ weights
portfolio_volatility = np.sqrt(portfolio_variance)

QUANTITATIVE RISK MANAGEMENT IN PYTHON

Volatility time series
Can also calculate portfolio volatility over
time

Use a 'window' to compute volatility over a

xed time period (e.g. week, 30-day
'month')

Series.rolling() creates a window

Observe volatility trend and possible

extreme events

windowed = portfolio_returns.rolling(30)
volatility = windowed.std()*np.sqrt(252)
volatility.plot()
.set ylabel("Standard Deviation...")

QUANTITATIVE RISK MANAGEMENT IN PYTHON

 Let's practice!
Q U A N T I TAT I V E R I S K M A N A G E M E N T I N P Y T H O N
 Risk factors and the
financial crisis
Q U A N T I TAT I V E R I S K M A N A G E M E N T I N P Y T H O N

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

QUANTITATIVE RISK MANAGEMENT IN PYTHON

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 ooding => more volatile ood outcome

Frequent ooding => higher risk exposure

QUANTITATIVE RISK MANAGEMENT IN PYTHON

Systematic risk
Systematic risk: risk factor(s) a ecting
volatility of all portfolio assets
Market risk: systematic risk from general
nancial market movements

Airplane engine failure: systematic risk!

Examples of nancial systematic risk

factors:
Price level changes, i.e. in ation

Interest rate changes

Economic climate changes

QUANTITATIVE RISK MANAGEMENT IN PYTHON

Idiosyncratic risk
Idiosyncratic risk: risk speci c 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

QUANTITATIVE RISK MANAGEMENT IN PYTHON

Factor models
Factor model: assessment of risk factors a ecting 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 ( rm size, rm value)

QUANTITATIVE RISK MANAGEMENT IN PYTHON

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 di erent 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

QUANTITATIVE RISK MANAGEMENT IN PYTHON

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())

QUANTITATIVE RISK MANAGEMENT IN PYTHON

Regression .summary() results

QUANTITATIVE RISK MANAGEMENT IN PYTHON

 Let's practice!
Q U A N T I TAT I V E R I S K M A N A G E M E N T I N P Y T H O N
 Modern portfolio
theory
Q U A N T I TAT I V E R I S K M A N A G E M E N T I N P Y T H O N

Jamsheed Shorish
Computational Economist
The risk-return trade-off
Risk factors: sources of uncertainty a ecting return

Intuitively: greater uncertainty (more risk) compensated by greater return

Cannot guarantee return: need some measure of expected return

average (mean) historical return: proxy for expected future return

QUANTITATIVE RISK MANAGEMENT IN PYTHON

Investor risk appetite
Investor survey: minimum return required for given level of risk?

Survey response creates (risk, return) risk pro le "data point"

Vary risk level => set of (risk, return) points

Investor risk appetite: de nes one quanti ed relationship between risk and return

QUANTITATIVE RISK MANAGEMENT IN PYTHON

Choosing portfolio weights
Vary portfolio weights of given portfolio => creates set of (risk, return) pairs

Changing weights = beginning risk management!

Goal: change weights to maximize expected return, given risk level

Equivalently: minimize risk, given expected return level

Changing weights = adjusting investor's risk exposure

QUANTITATIVE RISK MANAGEMENT IN PYTHON

Modern portfolio theory
E cient portfolio: portfolio with weights generating highest expected return for given level
of risk

Modern Portfolio Theory (MPT), 1952

H. M. Markowitz (Nobel Laureate 1990)

E cient portfolio weight vector w⋆ solves:

QUANTITATIVE RISK MANAGEMENT IN PYTHON

The efficient frontier
Compute many e cient portfolios for di erent levels of risk

E cient frontier: locus of (risk, return) pairs created by e cient portfolios

PyPortfolioOpt library: optimized tools for MPT

EfficientFrontier class: generates one optimal portfolio at a time

Constrained Line Algorithm ( CLA ) class: generates the entire e cient frontier
Requires covariance matrix of returns

Requires proxy for expected future returns: mean historical returns

QUANTITATIVE RISK MANAGEMENT IN PYTHON

Investment bank portfolio 2005 - 2010
Expected returns: historical data

Covariance matrix: Covariance Shrinkage improves e ciency of estimate

Constrained Line Algorithm object CLA

Minimum variance portfolio: cla.min_volatility()

E cient frontier: cla.efficient_frontier()

expected_returns = mean_historical_return(prices)
efficient_cov = CovarianceShrinkage(prices).ledoit_wolf()
cla = CLA(expected_returns, efficient_cov)
minimum_variance = cla.min_volatility()
(ret, vol, weights) = cla.efficient_frontier()

QUANTITATIVE RISK MANAGEMENT IN PYTHON

Visualizing the efficient frontier
Sca er plot of (vol, ret) pairs

QUANTITATIVE RISK MANAGEMENT IN PYTHON

Visualizing the efficient frontier
Sca er plot of (vol, ret) pairs

Minimum variance portfolio: smallest

volatility of all possible e cient portfolios

QUANTITATIVE RISK MANAGEMENT IN PYTHON

Visualizing the efficient frontier
Sca er plot of (vol, ret) pairs

Minimum variance portfolio: smallest

volatility of all possible e cient portfolios

Increasing risk appetite: move along the

frontier

QUANTITATIVE RISK MANAGEMENT IN PYTHON

 Let's practice!
Q U A N T I TAT I V E R I S K M A N A G E M E N T I N P Y T H O N