Financial risk management: a practitioner's guide to managing market and credit risk + website

**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 + Website__is the definitive source for managing market and credit risk. Financial Risk Management 3 Contents 11 Foreword 19 Preface 21 Acknowledgments 25 About the Author 29 CHAPTER 1 Introduction 31 1.1 Lessons from a Crisis 31 1.2 Financial Risk and Actuarial Risk 32 1.3 Simulation and Subjective Judgment 34 CHAPTER 2 Institutional Background 37 2.1 Moral Hazard—Insiders and Outsiders 37 2.2 Ponzi Schemes 47 2.3 Adverse Selection 49 2.4 The Winner’s Curse 51 2.5 Market Making versus Position Taking 54 CHAPTER 3 Operational Risk 59 3.1 Operations Risk 61 3.1.1 The Risk of Fraud 61 3.1.2 The Risk of Nondeliberate Incorrect Information 65 3.1.3 Disaster Risk 66 3.1.4 Personnel Risk 66 3.2 Legal Risk 67 3.2.1 The Risk of Unenforceable Contracts 67 3.2.2 The Risk of Illegal Actions 70 3.3 Reputational Risk 71 3.4 Accounting Risk 72 3.5 Funding Liquidity Risk 72 3.6 Enterprise Risk 74 3.7 Identification of Risks 74 3.8 Operational Risk Capital 75 CHAPTER 4 Financial Disasters 79 4.1 Disasters Due to Misleading Reporting 79 4.1.1 Chase Manhattan Bank/Drysdale Securities 82 4.1.2 Kidder Peabody 83 4.1.3 Barings Bank 85 4.1.4 Allied Irish Bank (AIB) 87 4.1.5 Union Bank of Switzerland (UBS) 89 4.1.6 Société Générale 91 4.1.7 Other Cases 96 4.2 Disasters Due to Large Market Moves 98 4.2.1 Long-Term Capital Management (LTCM) 98 4.2.2 Metallgesellschaft (MG) 105 4.3 Disasters Due to the Conduct of Customer Business 107 4.3.1 Bankers Trust (BT) 107 4.3.2 JPMorgan, Citigroup, and Enron 109 4.3.3 Other Cases 110 CHAPTER 5 The Systemic Disaster of 2007–2008 113 5.1 Overview 113 5.2 The Crisis in CDOs of Subprime Mortgages 115 5.2.1 Subprime Mortgage Originators 116 5.2.2 CDO Creators 118 5.2.3 Rating Agencies 119 5.2.4 Investors 122 5.2.5 Investment Banks 123 5.2.6 Insurers 136 5.3 The Spread of the Crisis 138 5.3.1 Credit Contagion 138 5.3.2 Market Contagion 139 5.4 Lessons from the Crisis for Risk Managers 141 5.4.1 Subprime Mortgage Originators 141 5.4.2 CDO Creators 141 5.4.3 Rating Agencies 141 5.4.4 Investors 141 5.4.5 Investment Banks 142 5.4.6 Insurers 144 5.4.7 Credit Contagion 145 5.4.8 Market Contagion 145 5.5 Lessons from the Crisis for Regulators 145 5.5.1 Mortgage Originators 146 5.5.2 CDO Creators 146 5.5.3 Rating Agencies 147 5.5.4 Investors 148 5.5.5 Investment Banks 148 5.5.6 Insurers 156 5.5.7 Credit Contagion 156 5.5.8 Market Contagion 159 5.6 Broader Lessons from the Crisis 162 CHAPTER 6 Managing Financial Risk 163 6.1 Risk Measurement 163 6.1.1 General Principles 163 6.1.2 Risk Management of Instruments That Lack Liquidity 174 6.1.3 Market Valuation 177 6.1.4 Valuation Reserves 182 6.1.5 Analysis of Revenue 186 6.1.6 Exposure to Changes in Market Prices 187 6.1.7 Risk Measurement for Position Taking 189 6.2 Risk Control 191 CHAPTER 7 VaR and Stress Testing 199 7.1 VaR Methodology 200 7.1.1 Simulation of the P&L Distribution 203 7.1.2 Measures of the P&L Distribution 217 7.2 Stress Testing 222 7.2.1 Overview 222 7.2.2 Economic Scenario Stress Tests 223 7.2.3 Stress Tests Relying on Historical Data 227 7.3 Uses of Overall Measures of Firm Position Risk 231 CHAPTER 8 Model Risk 239 8.1 How Important Is Model Risk? 240 8.2 Model Risk Evaluation and Control 242 8.2.1 Scope of Model Review and Control 243 8.2.2 Roles and Responsibilities for Model Review and Control 244 8.2.3 Model Verification 249 8.2.4 Model Verification of Deal Representation 252 8.2.5 Model Verification of Approximations 253 8.2.6 Model Validation 256 8.2.7 Continuous Review 262 8.2.8 Periodic Review 264 8.3 Liquid Instruments 267 8.4 Illiquid Instruments 271 8.4.1 Choice of Model Validation Approach 271 8.4.2 Choice of Liquid Proxy 273 8.4.3 Design of Monte Carlo Simulation 275 8.4.4 Implications for Marking to Market 277 8.4.5 Implications for Risk Reporting 279 8.5 Trading Models 280 CHAPTER 9 Managing Spot Risk 283 9.1 Overview 283 9.2 Foreign Exchange Spot Risk 287 9.3 Equity Spot Risk 288 9.4 Physical Commodities Spot Risk 289 CHAPTER 10 Managing Forward Risk 293 10.1 Instruments 300 10.1.1 Direct Borrowing and Lending 300 10.1.2 Repurchase Agreements 301 10.1.3 Forwards 302 10.1.4 Futures Contracts 302 10.1.5 Forward Rate Agreements 304 10.1.6 Interest Rate Swaps 305 10.1.7 Total Return Swaps 306 10.1.8 Asset-Backed Securities 308 10.2 Mathematical Models of Forward Risks 312 10.2.1 Pricing Illiquid Flows by Interpolation 314 10.2.2 Pricing Long-Dated Illiquid Flows by Stack and Roll 321 10.2.3 Flows Representing Promised Deliveries 323 10.2.4 Indexed Flows 325 10.3 Factors Impacting Borrowing Costs 329 10.3.1 The Nature of Borrowing Demand 329 10.3.2 The Possibility of Cash-and-Carry Arbitrage 330 10.3.3 The Variability of Storage Costs 331 10.3.4 The Seasonality of Borrowing Costs 332 10.3.5 Borrowing Costs and Forward Prices 333 10.4 Risk Management Reporting and Limits for Forward Risk 334 CHAPTER 11 Managing Vanilla Options Risk 341 11.1 Overview of Options Risk Management 343 11.2 The Path Dependence of Dynamic Hedging 348 11.3 A Simulation of Dynamic Hedging 351 11.4 Risk Reporting and Limits 359 11.5 Delta Hedging 374 11.6 Building a Volatility Surface 376 11.6.1 Interpolating between Time Periods 376 11.6.2 Interpolating between Strikes—Smile and Skew 377 11.6.3 Extrapolating Based on Time Period 382 11.7 Summary 385 CHAPTER 12 Managing Exotic Options Risk 389 12.1 Single-Payout Options 394 12.1.1 Log Contracts and Variance Swaps 397 12.1.2 Single-Asset Quanto Options 399 12.1.3 Convexity 400 12.1.4 Binary Options 401 12.1.5 Contingent Premium Options 407 12.1.6 Accrual Swaps 408 12.2 Time-Dependent Options 408 12.2.1 Forward-Starting and Cliquet Options 408 12.2.2 Compound Options 409 12.3 Path-Dependent Options 411 12.3.1 Standard Analytic Models for Barriers 413 12.3.2 Dynamic Hedging Models for Barriers 415 12.3.3 Static Hedging Models for Barriers 417 12.3.4 Barrier Options with Rebates, Lookback, and Ladder Options 432 12.3.5 Broader Classes of Path-Dependent Exotics 433 12.4 Correlation-Dependent Options 434 12.4.1 Linear Combinations of Asset Prices 435 12.4.2 Risk Management of Options on Linear Combinations 439 12.4.3 Index Options 443 12.4.4 Options to Exchange One Asset for Another 445 12.4.5 Nonlinear Combinations of Asset Prices 447 12.4.6 Correlation between Price and Exercise 452 12.5 Correlation-Dependent Interest Rate Options 455 12.5.1 Models in Which the Relationship between Forwards Is Treated as Constant 456 12.5.2 Term Structure Models 460 12.5.3 Relationship between Swaption and Cap Prices 467 CHAPTER 13 Credit Risk 475 13.1 Short-Term Exposure to Changes in Market Prices 476 13.1.1 Credit Instruments 477 13.1.2 Models of Short-Term Credit Exposure 481 13.1.3 Risk Reporting for Market Credit Exposures 486 13.2 Modeling Single-Name Credit Risk 487 13.2.1 Estimating Probability of Default 488 13.2.2 Estimating Loss Given Default 495 13.2.3 Estimating the Amount Owed at Default 498 13.2.4 The Option-Theoretic Approach 501 13.3 Portfolio Credit Risk 509 13.3.1 Estimating Default Correlations 509 13.3.2 Monte Carlo Simulation of Portfolio Credit Risk 512 13.3.3 Computational Alternatives to Full Simulation 516 13.3.4 Risk Management and Reporting for Portfolio Credit Exposures 520 13.4 Risk Management of Multiname Credit Derivatives 523 13.4.1 Multiname Credit Derivatives 523 13.4.2 Modeling of Multiname Credit Derivatives 525 13.4.3 Risk Management and Reporting for Multiname Credit Derivatives 528 13.4.4 CDO Tranches and Systematic Risk 530 CHAPTER 14 Counterparty Credit Risk 535 14.1 Overview 535 14.2 Exchange-Traded Derivatives 536 14.3 Over-the-Counter Derivatives 542 14.3.1 Overview 542 14.3.2 The Loan-Equivalent Approach 543 14.3.3 The Collateralization Approach 545 14.3.4 The Collateralization Approach—Wrong-Way Risk 551 14.3.5 The Active Management Approach 556 References 563 About the Companion Website 577 Index 583

Advance Praise for Financial Risk Management, Second Edition

Steve Allen's revised book is an excellent read for both seasoned risk professionals and students. He has done a wonderful job of making a complex topic understandable. His chapters on financial crises should be a must-read for everyone in the profession as 'those who don't learn from history are forced to repeat it.'
-Leslie Rahl, CEO and Managing Partner, Capital Market Risk Advisors

Praise for the First Edition

A very practical and deep approach to the problems of financial risk management.
-Nassim Nicholas Taleb, Distinguished Professor of Risk Engineering, New York University's Polytechnic Institute, and-uthor of The Black Swan and Antifragile

Key material on how risks can be isolated, quantified, and managed from a top risk management practitioner.
-John Hull, Maple Financial Chair in Derivatives and Risk Management, and Director, Bonham Centre for Finance, University of Toronto

Allen's book is a treasure-trove of material and an invaluable resource for any professional seeking to understand modern risk management. It begins with basic concepts and builds carefully to the practical and theoretical ideas necessary for dealing with the complexities of the most sophisticated and relevant financial instruments today.
-Neil Chriss, Managing Principal, Hutchin Hill Capital, and author of Black-Scholes and Beyond

The Second Edition of Financial Risk Management + Website puts an emphasis on practical application. To that end, this book provides readers with exclusive access to a companion website filled with supplementary materials,-llowing you to continue to learn in a hands-on fashion long after closing the book.

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 + Website is the definitive source for managing market and credit risk. Foreword Preface Acknowledgments Introduction Institutional background Operational risk Financial disasters The systemic disaster of 2007-2008 Managing financial risk Var and stress testing Model risk Managing spot risk Managing forward risk Managing vanilla options risk Managing exotic options risk Credit risk Counterparty credit risk Bibliography About the companion website Index.