A top risk management practitioner addresses the essential aspects of modern financial risk management In the Second Edition of Financial Risk Management + Website, market risk expert Steve Allen offers an insider's view of this discipline and covers the strategies, principles, and measurement techniques necessary to manage and measure financial risk. Fully revised to reflect today's dynamic environment and the lessons to be learned from the 2008 global financial crisis, this reliable resource provides a comprehensive overview of the entire field of risk management.
Allen explores real-world issues such as proper mark-to-market valuation of trading positions and determination of needed reserves against valuation uncertainty, the structuring of limits to control risk taking, and a review of mathematical models and how they can contribute to risk control. Along the way, he shares valuable lessons that will help to develop an intuitive feel for market risk measurement and reporting.
Presents key insights on how risks can be isolated, quantified, and managed from a top risk management practitioner
Offers up-to-date examples of managing market and credit risk
Provides an overview and comparison of the various derivative instruments and their use in risk hedging
Companion Website contains supplementary materials that allow you to continue to learn in a hands-on fashion long after closing the book
Focusing on the management of those risks that can be successfully quantified, the Second Edition of Financial Risk Management + Websiteis the definitive source for managing market and credit risk.
Foreword xvii
Preface xix
Acknowledgments xxiii
About the Author xxvii
Chapter 1 Introduction 1
1.1 Lessons from a Crisis 1
1.2 Financial Risk and Actuarial Risk 2
1.3 Simulation and Subjective Judgment 4
Chapter 2 Institutional Background 7
2.1 Moral Hazard-Insiders and Outsiders 7
2.2 Ponzi Schemes 17
2.3 Adverse Selection 19
2.4 The Winner's Curse 21
2.5 Market Making versus Position Taking 24
Chapter 3 Operational Risk 29
3.1 Operations Risk 31
3.1.1 The Risk of Fraud 31
3.1.2 The Risk of Nondeliberate Incorrect Information 35
3.1.3 Disaster Risk 36
3.1.4 Personnel Risk 36
3.2 Legal Risk 37
3.2.1 The Risk of Unenforceable Contracts 37
3.2.2 The Risk of Illegal Actions 40
3.3 Reputational Risk 41
3.4 Accounting Risk 42
3.5 Funding Liquidity Risk 42
3.6 Enterprise Risk 44
3.7 Identification of Risks 44
3.8 Operational Risk Capital 45
Chapter 4 Financial Disasters 49
4.1 Disasters Due to Misleading Reporting 49
4.1.1 Chase Manhattan Bank/Drysdale Securities 52
4.1.2 Kidder Peabody 53
4.1.3 Barings Bank 55
4.1.4 Allied Irish Bank (AIB) 57
4.1.5 Union Bank of Switzerland (UBS) 59
4.1.6 Société Générale 61
4.1.7 Other Cases 66
4.2 Disasters Due to Large Market Moves 68
4.2.1 Long-Term Capital Management (LTCM) 68
4.2.2 Metallgesellschaft (MG) 75
4.3 Disasters Due to the Conduct of Customer Business 77
4.3.1 Bankers Trust (BT) 77
4.3.2 JPMorgan, Citigroup, and Enron 79
4.3.3 Other Cases 80
Chapter 5 The Systemic Disaster of 2007-2008 83
5.1 Overview 83
5.2 The Crisis in CDOs of Subprime Mortgages 85
5.2.1 Subprime Mortgage Originators 86
5.2.2 CDO Creators 88
5.2.3 Rating Agencies 89
5.2.4 Investors 92
5.2.5 Investment Banks 93
5.2.6 Insurers 106
5.3 The Spread of the Crisis 108
5.3.1 Credit Contagion 108
5.3.2 Market Contagion 109
5.4 Lessons from the Crisis for Risk Managers 111
5.4.1 Subprime Mortgage Originators 111
5.4.2 CDO Creators 111
5.4.3 Rating Agencies 111
5.4.4 Investors 111
5.4.5 Investment Banks 112
5.4.6 Insurers 114
5.4.7 Credit Contagion 115
5.4.8 Market Contagion 115
5.5 Lessons from the Crisis for Regulators 115
5.5.1 Mortgage Originators 116
5.5.2 CDO Creators 116
5.5.3 Rating Agencies 117
5.5.4 Investors 118
5.5.5 Investment Banks 118
5.5.6 Insurers 126
5.5.7 Credit Contagion 126
5.5.8 Market Contagion 129
5.6 Broader Lessons from the Crisis 132
Chapter 6 Managing Financial Risk 133
6.1 Risk Measurement 133
6.1.1 General Principles 133
6.1.2 Risk Management of Instruments That Lack Liquidity 144
6.1.3 Market Valuation 147
6.1.4 Valuation Reserves 152
6.1.5 Analysis of Revenue 156
6.1.6 Exposure to Changes in Market Prices 157
6.1.7 Risk Measurement for Position Taking 159
6.2 Risk Control 161
Chapter 7 VaR and Stress Testing 169
7.1 VaR Methodology 170
7.1.1 Simulation of the P&L Distribution 173
7.1.2 Measures of the P&L Distribution 187
7.2 Stress Testing 192
7.2.1 Overview 192
7.2.2 Economic Scenario Stress Tests 193
7.2.3 Stress Tests Relying on Historical Data 197
7.3 Uses of Overall Measures of Firm Position Risk 201
Chapter 8 Model Risk 209
8.1 How Important Is Model Risk? 210
8.2 Model Risk Evaluation and Control 212
8.2.1 Scope of Model Review and Control 213
8.2.2 Roles and Responsibilities for Model Review and Control 214
8.2.3 Model Verification 219
8.2.4 Model Verification of Deal Representation 222
8.2.5 Model Verification of Approximations 223
8.2.6 Model Validation 226
8.2.7 Continuous Review 232
8.2.8 Periodic Review 234
8.3 Liquid Instruments 237
8.4 Illiquid Instruments 241
8.4.1 Choice of Model Validation Approach 241
8.4.2 Choice of Liquid Proxy 243
8.4.3 Design of Monte Carlo Simulation 245
8.4.4 Implications for Marking to Market 247
8.4.5 Implications for Risk Reporting 249
8.5 Trading Models 250
Chapter 9 Managing Spot Risk 253
9.1 Overview 253
9.2 Foreign Exchange Spot Risk 257
9.3 Equity Spot Risk 258
9.4 Physical Commodities Spot Risk 259
Chapter 10 Managing Forward Risk 263
10.1 Instruments 270
10.1.1 Direct Borrowing and Lending 270
10.1.2 Repurchase Agreements 271
10.1.3 Forwards 272
10.1.4 Futures Contracts 272
10.1.5 Forward Rate Agreements 274
10.1.6 Interest Rate Swaps 275
10.1.7 Total Return Swaps 276
10.1.8 Asset-Backed Securities 278
10.2 Mathematical Models of Forward Risks 282
10.2.1 Pricing Illiquid Flows by Interpolation 284
10.2.2 Pricing Long-Dated Illiquid Flows by Stack and Roll 291
10.2.3 Flows Representing Promised Deliveries 293
10.2.4 Indexed Flows 295
10.3 Factors Impacting Borrowing Costs 299
10.3.1 The Nature of Borrowing Demand 299
10.3.2 The Possibility of Cash-and-Carry Arbitrage 300
10.3.3 The Variability of Storage Costs 301
10.3.4 The Seasonality of Borrowing Costs 302
10.3.5 Borrowing Costs and Forward Prices 303
10.4 Risk Management Reporting and Limits for Forward Risk 304
Chapter 11 Managing Vanilla Options Risk 311
11.1 Overview of Options Risk Management 313
11.2 The Path Dependence of Dynamic Hedging 318
11.3 A Simulation of Dynamic Hedging 321
11.4 Risk Reporting and Limits 329
11.5 Delta Hedging 344
11.6 Building a Volatility Surface 346
11.6.1 Interpolating between Time Periods 346
11.6.2 Interpolating between Strikes-Smile and Skew 347
11.6.3 Extrapolating Based on Time Period 352
11.7 Summary 355
Chapter 12 Managing Exotic Options Risk 359
12.1 Single-Payout Options 364
12.1.1 Log Contracts and Variance Swaps 367
12.1.2 Single-Asset Quanto Options 369
12.1.3 Convexity 370
12.1.4 Binary Options 371
12.1.5 Contingent Premium Options 377
12.1.6 Accrual Swaps 378
12.2 Time-Dependent Options 378
12.2.1 Forward-Starting and Cliquet Options 378
12.2.2 Compound Options 379
12.3 Path-Dependent Options 381
12.3.1 Standard Analytic Models for Barriers 383
12.3.2 Dynamic Hedging Models for Barriers 385
12.3.3 Static Hedging Models for Barriers 387
12.3.4 Barrier Options with Rebates, Lookback, and Ladder Options 402
12.3.5 Broader Classes of Path-Dependent Exotics 403
12.4 Correlation-Dependent Options 404
12.4.1 Linear Combinations of Asset Prices 405
12.4.2 Risk Management of Options on Linear Combinations 409
12.4.3 Index Options 413
12.4.4 Options to Exchange One Asset for Another 415
12.4.5 Nonlinear Combinations of Asset Prices 417
12.4.6 Correlation between Price and Exercise 422
12.5 Correlation-Dependent Interest Rate Options 425
12.5.1 Models in Which the Relationship between Forwards is Treated as Constant 426
12.5.2 Term Structure Models 430
12.5.3 Relationship between Swaption and Cap Prices 437
Chapter 13 Credit Risk 445
13.1 Short-Term Exposure to Changes in Market Prices 446
13.1.1 Credit Instruments 447
13.1.2 Models of Short-Term Credit Exposure 451
13.1.3 Risk Reporting for Market Credit Exposures 456
13.2 Modeling Single-Name Credit Risk 457
13.2.1 Estimating Probability of Default 458
13.2.2 Estimating Loss Given Default 465
13.2.3 Estimating the Amount Owed at Default 468
13.2.4 The Option-Theoretic Approach 471
13.3 Portfolio Credit Risk 479
13.3.1 Estimating Default Correlations 479
13.3.2 Monte Carlo Simulation of Portfolio Credit Risk 482
13.3.3 Computational Alternatives to Full Simulation 486
13.3.4 Risk Management and Reporting for Portfolio Credit Exposures 490
13.4 Risk Management of Multiname Credit Derivatives 493
13.4.1 Multiname Credit Derivatives 493
13.4.2 Modeling of Multiname Credit Derivatives 495
13.4.3 Risk Management and Reporting for Multiname Credit Derivatives 498
13.4.4 CDO Tranches and Systematic Risk 500
Chapter 14 Counterparty Credit Risk 505
14.1 Overview 505
14.2 Exchange-Traded Derivatives 506
14.3 Over-the-Counter Derivatives 512
14.3.1 Overview 512
14.3.2 The Loan-Equivalent Approach 513
14.3.3 The Collateralization Approach 515
14.3.4 The Collateralization Approach-Wrong-Way Risk 521
14.3.5 The Active Management Approach 526
References 533
About the Companion Website 547
Index 553
