Financial Risk Measurement for Financial Risk Management∗

Current practice largely follows restrictive approaches to market risk measurement, such as historical simulation or RiskMetrics. In contrast, we propose flexible methods that exploit recent developments in financial econometrics and are likely to produce more accurate risk assessments, treating both portfoliolevel and asset-level analysis. Asset-level analysis is particularly challenging because 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 powerful yet parsimonious models that are easily estimated. In addition, we emphasize the need for deeper understanding of the links between market risk and macroeconomic fundamentals, focusing primarily on links among equity return volatilities, real growth, and real growth volatilities. Throughout, we strive not only to deepen our scientific understanding of market risk, but also cross-fertilize the academic and practitioner communities, promoting improved market risk measurement technologies that draw on the best of both. ∗This paper is prepared for G. Constantinedes, M. Harris and René Stulz (eds.), Handbook of the Economics of Finance, Elsevier. For helpful comments we thank Hal Cole and Dongho Song. For research support, Andersen, Bollerslev and Diebold thank the National Science Foundation (U.S.), and Christoffersen thanks the Social Sciences and Humanities Research Council (Canada). †Torben G. Andersen is Nathan and Mary Sharp Distinguished Professor of Finance at the Kellogg School of Management, Northwestern University, Research Associate at the NBER, and International Fellow of CREATES, University of Aarhus, Denmark. [email protected]. ‡Tim Bollerslev is Juanita and Clifton Kreps Professor of Economics, Duke University, Professor of Finance at its Fuqua School of Business, Research Associate at the NBER, and an International Fellow of CREATES, University of Aarhus, Denmark. [email protected]. §Peter F. Christoffersen is Professor of Finance at the Rotman School of Management, University of Toronto and affiliated with Copenhagen Business School and CREATES, University of Aarhus, Denmark. [email protected]. ¶Francis X. Diebold is Paul F. and Warren S. Miller Professor of Economics at the University of Pennsylvania, Professor of Finance and Statistics and Co-Director of the Financial Institutions Center at its Wharton School, and Research Associate at the NBER. [email protected].