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Hedging Market Exposures: Identifying and Managing Market Risks

ISBN: 978-0-470-53506-6
295 pages
August 2011
Hedging Market Exposures: Identifying and Managing Market Risks (0470535067) cover image
Identify and understand the risks facing your portfolio, how to quantify them, and the best tools to hedge them

This book scrutinizes the various risks confronting a portfolio, equips the reader with the tools necessary to identify and understand these risks, and discusses the best ways to hedge them.

The book does not require a specialized mathematical foundation, and so will appeal to both the generalist and specialist alike. For the generalist, who may not have a deep knowledge of mathematics, the book illustrates, through the copious use of examples, how to identify risks that can sometimes be hidden, and provides practical examples of quantifying and hedging exposures. For the specialist, the authors provide a detailed discussion of the mathematical foundations of risk management, and draw on their experience of hedging complex multi-asset class portfolios, providing practical advice and insights.

  • Provides a clear description of the risks faced by managers with equity, fixed income, commodity, credit and foreign exchange exposures
  • Elaborates methods of quantifying these risks
  • Discusses the various tools available for hedging, and how to choose optimal hedging instruments
  • Illuminates hidden risks such as counterparty, operational, human behavior and model risks, and expounds the importance and instability of model assumptions, such as market correlations, and their attendant dangers
  • Explains in clear yet effective terms the language of quantitative finance and enables a non-quantitative investment professional to communicate effectively with professional risk managers, "quants", clients and others

Providing thorough coverage of asset modeling, hedging principles, hedging instruments, and practical portfolio management, Hedging Market Exposures helps portfolio managers, bankers, transactors and finance and accounting executives understand the risks their business faces and the ways to quantify and control them.

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Preface ix

Introduction xi

About the Authors xvii

CHAPTER 1
The Economic Environment 1

1.1 Introduction 1

1.2 Inflation and Unemployment 5

1.3 Central Banks and the Money Supply 6

1.4 The Business Cycle 9

1.5 Predicting the Future? 11

1.6 Economic Indicators 11

CHAPTER 2
Risk: An Introduction 17

2.1 What Is Risk? 17

2.2 Risks of Financial Instruments 19

2.3 Operational Risk 43

2.4 What Risks Are in Your Portfolio? Hidden Hazards 44

2.5 Hedging Market Risks 47

CHAPTER 3
Asset Modeling 51

3.1 Asset Value 51

3.2 Financial Models 55

3.3 Valuation Principles 70

3.4 Discount Rates Selection 74

3.5 Cash Flow Projection and Asset Valuation 80

3.6 Stochastic Asset Valuation 82

3.7 The Monte Carlo Method 88

3.8 Stochastic Extrapolation 100

CHAPTER 4
Market Exposures and Factor Sensitivities 103

4.1 From Valuation to Responses and Sensitivities 103

4.2 Response Matrix and Scenario Grid 105

4.3 Stress-Testing 109

4.4 Sensitivities 110

4.5 Interest Rate Sensitivities: Duration, PV01, Convexity, Key Rate Measures 126

4.6 Numerical Evaluation of Sensitivities 137

4.7 Performance Attribution and Completeness Test 139

CHAPTER 5
Quantifying Portfolio Risks 145

5.1 The Nature of Risk 145

5.2 Standard Risk Measures 149

5.3 Optimal Hedge Sizing 160

5.4 Tail-Risk Measures 162

CHAPTER 6
The Decision to Hedge 171

6.1 To Hedge or Not to Hedge? 171

6.2 The Hedging Process 178

CHAPTER 7
Constructing a Hedge 193

7.1 An Ideal Hedge 193

7.2 A Sample Hedge 194

7.3 Static and Dynamic Hedging 200

7.4 Proxy Hedging 205

7.5 Protection versus Upside 208

7.6 Basis Risk 211

7.7 Unintended Consequences 213

7.8 Hedging Credit Risk 214

7.9 Hedging Prepayment, Redemption, and Other Human Behavior Risks 221

7.10 Execution 223

APPENDIX A

Basics of Probability Theory 227

APPENDIX B

Elements of Statistics and Time Series Analysis 247

References 255

Glossary 259

Index 281

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OLEG V. BYCHUK has eleven years of capital markets experience. This includes roles as head of Risk Management at Julius Baer Investment Management and head of Risk Management and Quantitative Research at Alternative Asset Managers. He has also held various positions at Citigroup Global Markets, OppenheimerFunds, and Deutsche Bank. Dr. Bychuk holds degrees from Columbia University (PhD) and Lomonosov Moscow State University and has published numerous articles.

BRIAN J. HAUGHEY is an Assistant Professor of Finance and Director of the Investment Center at Marist College. Previously, he headed the Mutual Fund Fee business in the Global Special Situations Group at Citigroup Global Markets. Prior to joining Citigroup, he was with Fitch Ratings.

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