INTRODUCTION xv
PART ONE Risk Management and the Behaviour of Products
CHAPTER 1 ■ Markets, Risks and Risk Management in Context 3
1.1 FINANCIAL MARKETS OVERVIEW 3
1.1.1 Introducing the Markets 3
1.1.2 Securities 5
1.1.3 Other Instruments 7
1.1.4 Equity Markets 9
1.1.5 Interest Rate Instruments 12
1.1.6 Foreign Exchange Markets 21
1.1.7 Derivatives Markets 22
1.1.8 Principal Investment and Private Equity 25
1.1.9 (A Short Section on) Commodities Markets 27
1.2 TRADING AND MARKET BEHAVIOUR 28
1.2.1 Th e Diffi culty of Forecasting
Market Levels 29
1.2.2 Th e Anatomy of a Market Crisis 29
1.2.3 Current and Past Markets 32
1.3 BASIC IDEAS IN RISK MANAGEMENT 39
1.3.1 Types of Risk 39
1.3.2 Th e Aims of Risk Management 46
1.3.3 Sensitivities 47
1.3.4 Daily Risk Controls: P/L, Limits and P/L Explanation 47
1.3.5 What Do You Own? Th e Deal Review Process 50
1.3.6 Trader Mandates 51
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1.4 CULTURE AND ORGANISATION 52
1.4.1 Risk Management in the Broader Institution 52
1.4.2 Cultural Issues 54
1.4.3 A Taxonomy of Financial Institutions 56
1.4.4 Some Large Losses in the Wholesale Markets 61
1.5 SOME EXTERNAL CONSTRAINTS 63
1.5.1 Regulation 64
1.5.2 Accounting 68
1.5.3 Marking to Fair Value 74
1.5.4 Special Purpose Vehicles and Consolidation 76
CHAPTER 2 ■ Derivatives and Quantitative Market Risk Management 79
2.1 RETURNS, OPTIONS AND SENSITIVITIES 79
2.1.1 Asset Returns and Risk Factors 79
2.1.2 Risk Factor Selection 80
2.1.3 Risk Reporting with a Single Risk Factor 81
2.1.4 Forwards and Arbitrage 84
2.1.5 Models of Market Returns 88
2.1.6 Risk Reporting in a Return Model 91
2.1.7 Introducing Options 93
2.1.8 Th e Greeks 95
2.1.9 Options Risk Reporting 97
2.1.10 P/L Explanation for Options 99
2.2 PORTFOLIOS AND RISK AGGREGATION 99
2.2.1 Th e Varieties of Trading Portfolio and Th eir Management 100
2.2.2 Diversifi cation and Correlation 102
2.2.3 Reporting and Risk in a Return Model:
Multiple Factors 105
2.2.4 Scenario Analysis 107
2.2.5 Stress Testing 108
2.3 UNDERSTANDING THE BEHAVIOUR OF DERIVATIVES 112
2.3.1 Overview of the Th eory of Options Pricing:
Black–Scholes and the Replicating Portfolio 112
2.3.2 Implied Volatility and Hedging 116
2.3.3 Retail Equity-Linked Products: Some Simple
Structures and Th eir Problems 121
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2.3.4 A Little More about Exotic Options 123
2.3.5 Local and Stochastic Volatility 126
2.4 INTEREST RATE DERIVATIVES AND YIELD CURVE MODELS 129
2.4.1 Futures and Forwards on Interest Rates 130
2.4.2 Interest Rate and Asset Swaps 131
2.4.3 Credit Risk in Swap Structures 135
2.4.4 Other Interest Rate Swap Structures 136
2.4.5 Cross-Currency Swaps 137
2.4.6 Basis Swaps 137
2.4.7 Caps, Floors and Yield Curve Models 139
2.4.8 Swaptions 142
2.4.9 Exotic Interest Rate Derivatives 143
2.5 SINGLE-NAME CREDIT DERIVATIVES 146
2.5.1 Products 146
2.5.2 Credit Events and Documentation 147
2.5.3 Credit Derivatives Valuation 151
2.5.4 Risk Reporting for Credit Derivatives 152
2.6 VALUATION, HEDGING AND MODEL RISK 153
2.6.1 Mark-to-Market and Mark-to-Model 153
2.6.2 Marking and Model Risk 154
2.6.3 Hedging, P/L and Mark Adjustments 157
PART TWO Economic and Regulatory Capital Models
CHAPTER 3 ■ Capital: Motivation and Provision 163
3.1 MOTIVATIONS FOR CAPITAL 163
3.1.1 What Is Capital for? 163
3.1.2 Earnings Volatility and Capital 164
3.1.3 Th e Optimisation Problem 165
3.1.4 Capital, More or Less 167
3.2 CAPITAL INSTRUMENT FEATURES 167
3.2.1 Seniority and Subordination 168
3.2.2 Deferral and Dividends 169
3.2.3 Maturity and Replacement 169
3.2.4 Convertibility and Write-Down 169
3.2.5 Example Capital Securities 170
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3.3 REGULATORY CAPITAL PROVISION 171
3.3.1 Th e Tiers of Basel Capital 171
3.3.2 Insurance Capital 173
3.3.3 Consolidated Capital 173
3.3.4 Capital Management: Issues and Strategies 174
CHAPTER 4 ■ Market Risk Capital Models 177
4.1 GENERAL MARKET RISK CAPITAL MODELS 177
4.1.1 Value at Risk Techniques I: Variance/Covariance 177
4.1.2 Value at Risk Techniques II: Revaluation
and Historical Simulation 182
4.1.3 Value at Risk Techniques III: Monte Carlo Approaches 184
4.1.4 Relative VAR 186
4.1.5 Backtesting, VAR Exceptions and the VAR Hypothesis 186
4.2 SOME LIMITATIONS OF VALUE AT RISK MODELS 188
4.2.1 Specifi c Risk 188
4.2.2 Volatility and Correlation Instabilities 189
4.2.3 Th e Holding Period Assumption 190
4.2.4 What Is the VAR Good for? 192
4.3 RISK SYSTEMS AND RISK DATA 193
4.3.1 Eff ective Risk Reporting 193
4.3.2 Market Data 196
CHAPTER 5 ■ Credit Risk and Credit Risk Capital Models 201
5.1 THE BANKING BOOK: INTRODUCING THE PRODUCTS
AND THE RISKS 201
5.1.1 Retail Banking 201
5.1.2 Commercial Banking 203
5.1.3 Forces for Change 205
5.2 CREDIT RISK FOR SMALL NUMBERS OF OBLIGATORS 205
5.2.1 Single Transaction Exposure 206
5.2.2 Potential Future Credit Exposure 209
5.2.3 What Is a Credit Spread Compensation for? 211
5.2.4 Partial Credit Mitigation 212
5.2.5 Introducing Basket Credit Derivatives 213
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5.3 AN INTRODUCTION TO TRANCHING AND PORTFOLIO
CREDIT DERIVATIVES 216
5.3.1 Funding and Loss Absorption 216
5.3.2 Securitisation and Tranching 217
5.3.3 Collateralised Debt Obligations 220
5.3.4 Structuring and the Waterfall 222
5.3.5 Index Credit Products 223
5.3.6 (Th e Problem with) Credit Event Correlation 224
5.3.7 Practical Credit-Adjusted Pricing 226
5.4 CREDIT PORTFOLIO RISK MANAGEMENT 227
5.4.1 Th e Portfolio Credit Risk Loss Distribution 227
5.4.2 Some Models of Portfolio Credit Risk 229
5.4.3 Stress Testing Credit Portfolios 233
5.4.4 Active Credit Portfolio Management 234
5.4.5 Credit Scoring and Internal Rating 237
5.5 POLITICAL AND COUNTRY RISK 240
5.5.1 Examples of Country Risk 241
5.5.2 Th e Eff ect of Country Risk 242
5.5.3 Measuring Country Risk 243
5.5.4 Country Risk Management 245
CHAPTER 6 ■ Operational Risk and Further Topics in Capital Estimation 247
6.1 AN INTRODUCTION TO OPERATIONAL RISK 247
6.1.1 Operational Risk Classes and Losses 248
6.1.2 Scorecard Approaches to Operational Risk 252
6.1.3 Some Issues in Operational Risk Management 253
6.2 THE TAILS AND OPERATIONAL RISK MODELLING 257
6.2.1 Th e Tails and Extreme Value Th eory 258
6.2.2 Th e Case of Long Term Capital Management 259
6.2.3 Th e Stable Process Assumption 263
6.2.4 Operational Risk Modelling 263
6.3 ALLOCATING CAPITAL AND OTHER RISKS 264
6.3.1 Capital Allocation and Portfolio Contributions 265
6.3.2 Reputational and Other Risks 268
6.3.3 Hedging versus Capital 273
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CHAPTER 7 ■ Bank Regulation and Capital Requirements 275
7.1 REGULATORY CAPITAL AND THE BASEL ACCORDS 276
7.1.1 Before Basel II: Basel I and the Market Risk Amendment 276
7.1.2 An Overview of Basel II 285
7.1.3 Basel II: Credit Risk without Mitigation 287
7.1.4 Basel II: Credit Risk Mitigation in the IRB Approaches 295
7.1.5 Basel II: Capital Rules for Positions
Th at Have Been Securitised 298
7.1.6 Implications of the Basel Credit Risk Framework 299
7.1.7 Operational Risk in Basel II 300
7.1.8 Floors and Transitional Arrangements 303
7.2 BASEL II: BEYOND THE CAPITAL RULES 303
7.2.1 Pillar 2 in Basel II 303
7.2.2 Pillar 3 and Banks’ Disclosures 305
7.2.3 Th e Impact of Basel II 306
PART THREE Treasury and Liquidity Risks
CHAPTER 8 ■ The Treasury and Asset/Liability Management 311
8.1 AN INTRODUCTION TO ASSET/LIABILITY MANAGEMENT 311
8.1.1 Th e Trading Book, the Banking Book and the Treasury 312
8.1.2 Accounting for an Old-Fashioned Bank 314
8.1.3 Assets and Liabilities through Time 316
8.1.4 What Is ALM? 318
8.2 BANKING BOOK INCOME AND FUNDING THE BANK 319
8.2.1 Transfer Pricing 319
8.2.2 Interest Rate Risk in the Banking Book 323
8.2.3 Non-Interest Income and Operating Expenses 325
8.3 ALM IN PRACTICE 326
8.3.1 Risk in the Transfer Pricing Book 326
8.3.2 Th e Market Value of Portfolio Equity 328
8.3.3 Strategic Risk and Real Options 330
8.3.4 ALM Risk Reporting 331
8.3.5 P/L Translation and Hedging 332
8.3.6 Th e Role of the ALCO 333
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8.4 TRADING BOOK ALM 334
8.4.1 Repo and Other Forms of Secured Funding 334
8.4.2 Practical Issues in the Funding of Trading Books 335