Financial Risk Management - Models, History, and Institutions.pdf
Financial risk has become a focus of financial and nonfinancial firms, individuals, and policy makers. But the study of risk remains a relatively new discipline in finance and continues to be refined. The financial market crisis that began in 2007 has highlighted the challenges of managing financial risk. Now, in Financial Risk Management, author Allan Malz addresses the essential issues surrounding this discipline, sharing his extensive career experiences as a risk researcher, risk manager, and central banker.
The book includes standard risk measurement models as well as alternative models that address options, structured credit risks, and the real-world complexities or risk modeling, and provides the institutional and historical background on financial innovation, liquidity, leverage, and financial crises that is crucial to practitioners and students of finance for understanding the world today.
Financial Risk Management is equally suitable for firm risk managers, economists, and policy makers seeking grounding in the subject. This timely guide skillfully surveys the landscape of financial risk and the financial developments of recent decades that culminated in the crisis. The book provides a comprehensive overview of the different types of financial risk we face, as well as the techniques used to measure and manage them. Topics covered include:
*Market risk, from Value-at-Risk (VaR) to risk models for options
*Credit risk, from portfolio credit risk to structured credit products
*Model risk and validation
*Risk capital and stress testing
*Liquidity risk, leverage, systemic risk, and the forms they take
*Financial crises, historical and current, their causes and characteristics
*Financial regulation and its evolution in the wake of the global crisis
*And much more
Combining the more model-oriented approach of risk management-as it has evolved over the past two decades-with an economist's approach to the same issues, Financial Risk Management is the essential guide to the subject for today's complex world.
List of Figures xvii
Preface xxi
CHAPTER 1
Financial Risk in a Crisis-Prone World 1
1.1 Some History: Why Is Risk a Separate Discipline Today? 1
1.1.1 The Financial Industry Since the 1960s 2
1.1.2 The “Shadow Banking System” 9
1.1.3 Changes in Public Policy Toward the
Financial System 15
1.1.4 The Rise of Large Capital Pools 17
1.1.5 Macroeconomic Developments Since the
1960s: From the Unraveling of Bretton
Woods to the Great Moderation 20
1.2 The Scope of Financial Risk 34
1.2.1 Risk Management in Other Fields 34
Further Reading 41
CHAPTER 2
Market Risk Basics 43
2.1 Arithmetic, Geometric, and Logarithmic Security Returns 44
2.2 Risk and Securities Prices: The Standard Asset
Pricing Model 49
2.2.1 Defining Risk: States, Security Payoffs, and
Preferences 50
2.2.2 Optimal Portfolio Selection 54
2.2.3 Equilibrium Asset Prices and Returns 56
2.2.4 Risk-Neutral Probabilities 61
2.3 The Standard Asset Distribution Model 63
2.3.1 Random Walks and Wiener Processes 64
2.3.2 Geometric Brownian Motion 71
2.3.3 Asset Return Volatility 74
2.4 Portfolio Risk in the Standard Model 75
2.4.1 Beta and Market Risk 76
2.4.2 Diversification 82
2.4.3 Efficiency 85
2.5 Benchmark Interest Rates 88
Further Reading 91
CHAPTER 3
Value-at-Risk 93
3.1 Definition of Value-at-Risk 94
3.1.1 The User-Defined Parameters 97
3.1.2 Steps in Computing VaR 98
3.2 Volatility Estimation 99
3.2.1 Short-Term Conditional Volatility Estimation 99
3.2.2 The EWMA Model 104
3.2.3 The GARCH Model 106
3.3 Modes of Computation 108
3.3.1 Parametric 108
3.3.2 Monte Carlo Simulation 109
3.3.3 Historical Simulation 111
3.4 Short Positions 113
3.5 Expected Shortfall 114
Further Reading 116
CHAPTER 4
Nonlinear Risks and the Treatment of Bonds and Options 119
4.1 Nonlinear Risk Measurement and Options 121
4.1.1 Nonlinearity and VaR 123
4.1.2 Simulation for Nonlinear Exposures 126
4.1.3 Delta-Gamma for Options 127
4.1.4 The Delta-Gamma Approach for General
Exposures 134
4.2 Yield Curve Risk 136
4.2.1 The Term Structure of Interest Rates 138
4.2.2 Estimating Yield Curves 141
4.2.3 Coupon Bonds 144
4.3 VaR for Default-Free Fixed Income Securities Using
The Duration and Convexity Mapping 148
4.3.1 Duration 149
4.3.2 Interest-Rate Volatility and Bond Price Volatility 150
4.3.3 Duration-Only VaR 152
4.3.4 Convexity 154
4.3.5 VaR Using Duration and Convexity 155
Further Reading 156
CHAPTER 5
Portfolio VaR for Market Risk 159
5.1 The Covariance and Correlation Matrices 160
5.2 Mapping and Treatment of Bonds and Options 162
5.3 Delta-Normal VaR 163
5.3.1 The Delta-Normal Approach for a Single
Position Exposed to a Single Risk Factor 164
5.3.2 The Delta-Normal Approach for a Single
Position Exposed to Several Risk Factors 166
5.3.3 The Delta-Normal Approach for a Portfolio
of Securities 168
5.4 Portfolio VAR via Monte Carlo simulation 174
5.5 Option Vega Risk 175
5.5.1 Vega Risk and the Black-Scholes Anomalies 176
5.5.2 The Option Implied Volatility Surface 180
5.5.3 Measuring Vega Risk 183
Further Reading 190
CHAPTER 6
Credit and Counterparty Risk 191
6.1 Defining Credit Risk 192
6.2 Credit-Risky Securities 193
6.2.1 The Economic Balance Sheet of the Firm 193
6.2.2 Capital Structure 194
6.2.3 Security, Collateral, and Priority 195
6.2.4 Credit Derivatives 196
6.3 Transaction Cost Problems in Credit Contracts 196
6.4 Default and Recovery: Analytic Concepts 199
6.4.1 Default 199
6.4.2 Probability of Default 200
6.4.3 Credit Exposure 201
6.4.4 Loss Given Default 201
6.4.5 Expected Loss 202
6.4.6 Credit Risk and Market Risk 204
6.5 Assessing creditworthiness 204
6.5.1 Credit Ratings and Rating Migration 204
6.5.2 Internal Ratings 207
6.5.3 Credit Risk Models 207
6.6 Counterparty Risk 207
6.6.1 Netting and Clearinghouses 209
6.6.2 Measuring Counterparty Risk for Derivatives
Positions 209
6.6.3 Double Default Risk 211
6.6.4 Custodial Risk 211
6.6.5 Mitigation of Counterparty Risk 212
6.7 The Merton model 213
6.8 Credit Factor Models 222
6.9 Credit Risk Measures 226
6.9.1 Expected and Unexpected Loss 228
6.9.2 Jump-to-Default Risk 229
Further Reading 229
CHAPTER 7
Spread Risk and Default Intensity Models 231
7.1 Credit Spreads 231
7.1.1 Spread Mark-to-Market 233
7.2 Default Curve Analytics 235
7.2.1 The Hazard Rate 237
7.2.2 Default Time Distribution Function 239
7.2.3 Default Time Density Function 239
7.2.4 Conditional Default Probability 240
7.3 Risk-Neutral Estimates of Default Probabilities 241
7.3.1 Basic Analytics of Risk-Neutral Default Rates 242
7.3.2 Time Scaling of Default Probabilities 245
7.3.3 Credit Default Swaps 246
7.3.4 Building Default Probability Curves 250
7.3.5 The Slope of Default Probability Curves 259
7.4 Spread Risk 261
7.4.1 Mark-to-Market of a CDS 261
7.4.2 Spread Volatility 262
Further Reading 264
Financial Risk Management - Models History and Institutions.rar
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