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Advanced Financial Risk Management: Tools and Techniques for Integrated Credit Risk and Interest Rate Risk Management, 2nd Edition

ISBN: 978-1-118-27854-3
784 pages
April 2013
Advanced Financial Risk Management: Tools and Techniques for Integrated Credit Risk and Interest Rate Risk Management, 2nd Edition (1118278542) cover image
Practical tools and advice for managing financial risk, updated for a post-crisis world

Advanced Financial Risk Management bridges the gap between the idealized assumptions used for risk valuation and the realities that must be reflected in management actions. It explains, in detailed yet easy-to-understand terms, the analytics of these issues from A to Z, and lays out a comprehensive strategy for risk management measurement, objectives, and hedging techniques that apply to all types of institutions. Written by experienced risk managers, the book covers everything from the basics of present value, forward rates, and interest rate compounding to the wide variety of alternative term structure models.

Revised and updated with lessons from the 2007-2010 financial crisis, Advanced Financial Risk Management outlines a framework for fully integrated risk management. Credit risk, market risk, asset and liability management, and performance measurement have historically been thought of as separate disciplines, but recent developments in financial theory and computer science now allow these views of risk to be analyzed on a more integrated basis. The book presents a performance measurement approach that goes far beyond traditional capital allocation techniques to measure risk-adjusted shareholder value creation, and supplements this strategic view of integrated risk with step-by-step tools and techniques for constructing a risk management system that achieves these objectives.

  • Practical tools for managing risk in the financial world
  • Updated to include the most recent events that have influenced risk management
  • Topics covered include the basics of present value, forward rates, and interest rate compounding; American vs. European fixed income options; default probability models; prepayment models; mortality models; and alternatives to the Vasicek model

Comprehensive and in-depth, Advanced Financial Risk Management is an essential resource for anyone working in the financial field.

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Introduction: Wall Street Lessons from Bubbles xxiii

Key Fallacies in Risk Management xxiii

Selected Events in the Credit Crisis xxviii

PART ONE Risk Management: Definitions and Objectives

CHAPTER 1 A Risk Management Synthesis: Market Risk, Credit Risk, Liquidity Risk, and Asset and Liability Management 3

CHAPTER 2 Risk, Return, Performance Measurement, and Capital Regulation 15

PART TWO Risk Management Techniques for Interest Rate Analytics

CHAPTER 3 Interest Rate Risk Introduction and Overview 45

CHAPTER 4 Fixed Income Mathematics: The Basic Tools 59

CHAPTER 5 Yield Curve Smoothing 73

CHAPTER 6 Introduction to Heath, Jarrow, and Morton Interest Rate Modeling 123

CHAPTER 7 HJM Interest Rate Modeling with Rate and Maturity-Dependent Volatility 142

CHAPTER 8 HJM Interest Rate Modeling with Two Risk Factors 161

CHAPTER 9 HJM Interest Rate Modeling with Three Risk Factors 190

CHAPTER 10 Valuation, Liquidity, and Net Income 230

CHAPTER 11 Interest Rate Mismatching and Hedging 250

CHAPTER 12 Legacy Approaches to Interest Rate Risk Management 257

CHAPTER 13 Special Cases of Heath, Jarrow, and Morton Interest Rate Modeling 283

CHAPTER 14 Estimating the Parameters of Interest Rate Models 316

PART THREE Risk Management Techniques for Credit Risk Analytics

CHAPTER 15 An Introduction to Credit Risk: Using Market Signals in Loan Pricing and Performance Measurement 335

CHAPTER 16 Reduced Form Credit Models and Credit Model Testing 359

CHAPTER 17 Credit Spread Fitting and Modeling 396

CHAPTER 18 Legacy Approaches to Credit Risk 421

CHAPTER 19 Valuing Credit Risky Bonds 453

CHAPTER 20 Credit Derivatives and Collateralized Debt Obligations 473

PART FOUR Risk Management Applications: Instrument by Instrument

CHAPTER 21 European Options on Bonds 495

CHAPTER 22 Forward and Futures Contracts 513

CHAPTER 23 European Options on Forward and Futures Contracts 531

CHAPTER 24 Caps and Floors 548

CHAPTER 25 Interest Rate Swaps and Swaptions 567

CHAPTER 26 Exotic Swap and Options Structures 580

CHAPTER 27 American Fixed Income Options 596

CHAPTER 28 Irrational Exercise of Fixed Income Options 622

CHAPTER 29 Mortgage-Backed Securities and Asset-Backed Securities 639

CHAPTER 30 Nonmaturity Deposits 656

CHAPTER 31 Foreign Exchange Markets 675

CHAPTER 32 Impact of Collateral on Valuation Models: The Example of

CHAPTER 33 Pricing and Valuing Revolving Credit and Other Facilities 694

CHAPTER 34 Modeling Common Stock and Convertible Bonds on a Default-Adjusted Basis 700

CHAPTER 35 Valuing Insurance Policies and Pension Obligations 708

PART FIVE Portfolio Strategy and Risk Management

CHAPTER 36 Value-at-Risk and Risk Management Objectives Revisited at the Portfolio and Company Level 719

CHAPTER 37 Liquidity Analysis and Management: Examples from the Credit Crisis 735

CHAPTER 38 Performance Measurement: Plus Alpha vs. Transfer Pricing 765

CHAPTER 39 Managing Institutional Default Risk and Safety and Soundness 783

CHAPTER 40 Information Technology Considerations 793

CHAPTER 41 Shareholder Value Creation and Destruction 800

Postscript 808

Bibliography 809

Index 819

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DONALD R. VAN DEVENTER founded the Kamakura Corporation in April 1990 and is currently Chairman and CEO. In 2003, he was voted into the Risk Hall of Fame for having made a profound contribution to the field of risk management. He has been involved in financial advisory assignments involving both risk management and mergers and acquisitions. Prior to founding Kamakura Corporation, he was senior vice president of the investment banking department of Lehman Brothers. From 1982 to 1987, he was the treasurer for First Interstate Bancorp in Los Angeles. He holds a PhD in business economics, a joint degree of the Harvard University Department of Economics and the Harvard Graduate School of Business Administration.

Kenji Imai has headed Software Development for Kamakura for sixteen years. Mr. Imai is member of the Managing Committee of Kamakura. Prior to Kamakura, Mr. Imai worked in the derivatives structuring/trading and risk management groups at the Sanwa Bank and S.G. Warburg. He graduated from the University of Tokyo with a BS in civil engineering and from the Sloan School of the Massachusetts Institute of Technology with a MS in management, concentrating on finance.

Mark Mesler is Managing Director and heads Kamakura Risk Information Services, Kamakura's innovative Basel II and III compliant default probability service. Mr. Mesler is in charge of the daily production of the KRIS Merton model, Jarrow reduced form model, and hybrid model default probabilities. Mr. Mesler has twenty-seven years' experience in the financial services information and systems field and is a veteran of State Street Bank, KPMG, Oracle, and the Bank of America. Prior to joining Kamakura Corporation, Mr. Mesler was vice president at Askari Risk Management Solutions, at that time a subsidiary of State Street Bank in Boston.

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May 20, 2013
Advanced Financial Risk Management: Tools and Techniques for Integrated Credit Risk and Interest Rate Risk Management, 2nd Edition

If the global credit crisis has taught us anything about financial risk management, it's that the traditional "silo" approach falls fatally short of the mark when it comes to understanding and circumventing the array of institutional risks inherent in virtually all financial and business activities. While the limitations of pre-digital technologies may once have made it seem natural to treat credit risk, market risk, asset and liability management, and performance measurement as separate disciplines, developments in financial theory and computer science not only make it possible for those risks to be analyzed on a fully integrated basis, they mandate it.

Written by a team of internationally recognized experts in the field, Advanced Financial Risk Management, Second Edition schools you in proven tools and techniques for fulfilling that mandate.

The authors lay out a comprehensive strategy for integrating risk management measures, objectives, and hedging techniques that apply to all types of financial institutions. Just as importantly, they develop a framework for creating a dynamic, fully integrated, multi-model risk management system tailored to your specific institutional needs and goals.

Thoroughly updated and revised to reflect the many changes wrought by the 2008 credit crisis, this new edition of the acclaimed guide bridges the gap between idealized assumptions about valuation and the realities of day-to-day risk management actions with:

  • Detailed explanations of which models performed well during the credit crisis, as well as the reasons why other models failed to measure up
  • Proven tools and techniques for constructing a risk management system that protects institutional assets while measuring risk-adjusted shareholder value
  • Guidance on how to construct continuous yield curves for everything from equity options to mortgage-backed securities
  • Performance measurement techniques that go far beyond traditional methods of capital allocation and measuring risk-adjusted shareholder value creation
  • Clear, accessible expositions of fixed income mathematics, duration, convexity, term structure models, risk-neutral instruments, derivatives, advanced hedging, and more
  • Detailed discussions of the analytics of interest rate risk, credit risk, foreign exchange risk, and capital allocation
  • In-depth discussions of the false assumptions behind many accepted risk management models and how to avoid falling prey to them
  • A strong case for why a realistic computer simulation that has no "closed form" mathematical solution is, in most cases, the best, most accurate way to describe risk.

Describing a strategic integrated multi-model approach to risk management designed to insulate institutions from catastrophic events such as those that unfolded during the credit crisis, Advanced Financial Risk Management, Second Edition is an indispensable working resource for commercial bank lenders, insurance company lenders, credit derivatives dealers, securities firms and bankers.

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