#04-21
Practical Volatility and Correlation Modeling for Financial Market Risk Management
Torben G. Andersen, Tim Bollerslev, Peter F. Christoffersen, and Francis X. Diebold
Abstract: 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.
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