Introduction

Many of the approaches described above are used directly to quantify particular types of risk. These applications are described in this chapter, together with some specific extensions that can also be used to determine levels of risk. Since different risks can affect different types of institutions in different ways, several approaches are sometimes needed to deal with a single risk. The links between various risks and the implications for quantification are also discussed.

When quantifying particular risks, it is important that these risks are modelled consistently with each other. In particular, it is important that assets and liabilities are modelled together, so that their evolution can be mapped. This is the basic principle of asset-liability modelling.

As part of this process, it is also important to consider the level of assets and liabilities throughout the projection period, not just at the ultimate time horizon. If the modelling suggests that action should be taken at points within the projection time horizon, then the projection should be re-run taking these actions into account. This is known as dynamic solvency testing or dynamic financial analysis.

Market and economic risk

Characteristics of financial time series

Before discussing the way in which market and economic risks can be modelled, it is worth considering some important characteristics of financial time series, particularly in relation to equity investments.