Financial Risk Management: Models, History, and Institutions

Preface xxi

CHAPTER 1: Financial Risk in a Crisis-Prone World 1

1.1 Some History: Why Is Risk a Separate Discipline Today? 1

1.2 The Scope of Financial Risk 34

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

2.3 The Standard Asset Distribution Model 63

2.4 Portfolio Risk in the Standard Model 75

2.5 Benchmark Interest Rates 88

CHAPTER 3: Value-at-Risk 93

3.1 Definition of Value-at-Risk 94

3.2 Volatility Estimation 99

3.3 Modes of Computation 108

3.4 Short Positions 113

3.5 Expected Shortfall 114

CHAPTER 4: Nonlinear Risks and the Treatment of Bonds and Options 119

4.1 Nonlinear Risk Measurement and Options 121

4.2 Yield Curve Risk 136

4.3 VaR for Default-Free Fixed Income Securities Using The Duration and Convexity Mapping 148

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

5.4 Portfolio VAR via Monte Carlo simulation 174

5.5 Option Vega Risk 175

CHAPTER 6: Credit and Counterparty Risk 191

6.1 Defining Credit Risk 192

6.2 Credit-Risky Securities 193

6.3 Transaction Cost Problems in Credit Contracts 196

6.4 Default and Recovery: Analytic Concepts 199

6.5 Assessing creditworthiness 204

6.6 Counterparty Risk 207

6.7 The Merton Model 213

6.8 Credit Factor Models 222

6.9 Credit Risk Measures 226

CHAPTER 7: Spread Risk and Default Intensity Models 231

7.1 Credit Spreads 231

7.2 Default Curve Analytics 235

7.3 Risk-Neutral Estimates of Default Probabilities 241

7.4 Spread Risk 261

CHAPTER 8: Portfolio Credit Risk 265

8.1 Default Correlation 266

8.2 Credit Portfolio Risk Measurement 270

8.3 Default Distributions and Credit VaR with the Single-Factor Model 275

8.4 Using Simulation and Copulas to Estimate Portfolio Credit Risk 284

CHAPTER 9: Structured Credit Risk 297

9.1 Structured Credit Basics 297

9.2 Credit Scenario Analysis of a Securitization 309

9.3 Measuring Structured Credit Risk via Simulation 318

9.4 Standard Tranches and Implied Credit Correlation 337

9.5 Issuer and Investor Motivations for Structured Credit 342

CHAPTER 10: Alternatives to the Standard Market Risk Model 349

10.1 Real-World Asset Price Behavior 349

10.2 Alternative Modeling Approaches 363

10.3 The Evidence on Non-Normality in Derivatives Prices 372

CHAPTER 11: Assessing the Quality of Risk Measures 393

11.1 Model Risk 393

11.2 Backtesting of VaR 407

11.3 Coherence of VaR Estimates 414

CHAPTER 12: Liquidity and Leverage 421

12.1 Funding Liquidity Risk 422

12.2 Markets for Collateral 437

12.3 Leverage and Forms of Credit in Contemporary Finance 448

12.4 Transactions Liquidity Risk 461

12.5 Liquidity Risk Measurement 464

12.6 Liquidity and Systemic Risk 469

CHAPTER 13: Risk Control and Mitigation 477

13.1 Defining Risk Capital 478

13.2 Risk Contributions 480

13.3 Stress Testing 499

13.4 Sizing Positions 506

13.5 Risk Reporting 509

13.6 Hedging and Basis Risk 512

CHAPTER 14: Financial Crises 517

14.1 Panics, Runs, and Crashes 519

14.2 Self-Reinforcing Mechanisms 539

14.3 Behavior of Asset Prices During Crises 548

14.4 Causes of Financial Crises 562

14.5 Anticipating Financial Crises 583

CHAPTER 15: Financial Regulation 597

15.1 Scope and Structure of Regulation 598

15.2 Methods of Regulation 605

15.3 Public Policy Toward Financial Crises 621

15.4 Pitfalls in Regulation 635

APPENDIX A: Technical Notes 653

A.1 Binomial Distribution 653

A.2 Quantiles and Quantile Transformations 654

A.3 Normal and Lognormal Distributions 656

A.4 Hypothesis Testing 661

A.5 Monte Carlo Simulation 662

A.6 Homogeneous Functions 664

Further Reading 666

APPENDIX B: Abbreviations 667

APPENDIX C: References 671

Index 701