Practical Volatility and Correlation Modeling for Financial Market Risk Management

What do academics have to offer market risk management practitioners in financial institutions? Current industry practice largely follows one of two extremely restrictive approaches: historical simulation or RiskMetrics. In contrast, we favor flexible methods based on recent developments in financial econometrics, which are likely to produce more accurate assessments of market risk. Clearly, the demands of real-world risk management in financial institutions – in particular, real-time risk tracking in very high-dimensional situations – impose strict limits on model complexity. Hence we stress parsimonious models that are easily estimated, and we discuss a variety of practical approaches for high-dimensional covariance matrix modeling, along with what we see as some of the pitfalls and problems in current practice. In so doing we hope to encourage further dialog between the academic and practitioner communities, hopefully stimulating the development of improved market risk management technologies that draw on the best of both worlds. _________________ * This paper is prepared for Mark Carey and René Stulz (eds.), Risks of Financial Institutions, University of Chicago Press for NBER. For helpful comments we would like to thank Ken Abbott, Casper de Vries, Philipp Hartmann, Patricia Jackson, Jim O'Brien, Hashem Pesaran, and Pedro Santa-Clara. For research support, Andersen, Bollerslev and Diebold thank the U.S. National Science Foundation, and Christoffersen thanks FQRSC, SSHRC and IFM2. a Department of Finance, Kellogg School of Management, Northwestern University, Evanston, IL 60208, and NBER phone: 847-467-1285, e-mail: [email protected] b Department of Economics, Duke University, Durham, NC 27708, and NBER phone: 919-660-1846, e-mail: [email protected] c Faculty of Management, McGill University, Montreal, Quebec, H3A 1G5, and CIRANO phone: 514-398-2869, e-mail: [email protected] d Department of Economics, University of Pennsylvania, Philadelphia, PA 19104, and NBER phone: 215-898-1507, e-mail: [email protected]