Ebook
Risk Management and Financial Institutions, 3rd EditionISBN: 9781118282915
672 pages
April 2012

The dangers inherent in the financial system make understanding risk management essential for anyone working in, or planning to work in, the financial sector. A practical resource for financial professionals and students alike, Risk Management and Financial Institutions, Third Edition explains all aspects of financial risk as well as the way financial institutions are regulated, to help readers better understand financial markets and potential dangers.
Fully revised and updated, this new edition features coverage of Basel 2.5, Basel III and DoddFrank as well as expanded sections on counterparty credit risk, central clearing, and collateralization. In addition, endofchapter practice problems and a website featuring supplemental materials designed to provide a more comprehensive learning experience make this the ultimate learning resource. Written by acclaimed risk management expert, John Hull, Risk Management and Financial Institutions is the only book you need to understand—and respond to—financial risk.
 The new edition of the financial risk management bestseller
 Describes the activities of different types of financial institutions, explains how they are regulated, and covers market risk, credit risk, operational risk, liquidity risk, and model risk
 Features new coverage of Basel III, DoddFrank, counterparty credit risk, central clearing, collateralization, and much more
 Provides readers with access to a supplementary website offering software and unique learning aids
 Author John Hull is one of the most respected authorities on financial risk management
A timely update to the definitive resource on risk in the financial system, Risk Management and Financial Institutions + Web Site, Third Edition is an indispensable resource from internationally renowned expert John Hull.
Business Snapshots xvii
Preface xix
CHAPTER 1 Introduction 1
1.1 Risk vs. Return for Investors 2
1.2 The Efficient Frontier 5
1.3 The Capital Asset Pricing Model 8
1.4 Arbitrage Pricing Theory 13
1.5 Risk vs. Return for Companies 13
1.6 Risk Management by Financial Institutions 16
1.7 Credit Ratings 18
Summary 18
Further Reading 19
Practice Questions and Problems 19
Further Questions 20
CHAPTER 2 Banks 21
2.1 Commercial Banking 22
2.2 The Capital Requirements of a Small Commercial Bank 24
2.3 Deposit Insurance 26
2.4 Investment Banking 27
2.5 Securities Trading 32
2.6 Potential Conflicts of Interest in Banking 33
2.7 Today’s Large Banks 34
2.8 The Risks Facing Banks 37
Summary 38
Further Reading 38
Practice Questions and Problems 38
Further Questions 39
CHAPTER 3 Insurance Companies and Pension Plans 41
3.1 Life Insurance 41
3.2 Annuity Contracts 45
3.3 Mortality Tables 46
3.4 Longevity and Mortality Risk 50
3.5 PropertyCasualty Insurance 51
3.6 Health Insurance 53
3.7 Moral Hazard and Adverse Selection 55
3.8 Reinsurance 56
3.9 Capital Requirements 56
3.10 The Risks Facing Insurance Companies 58
3.11 Regulation 58
3.12 Pension Plans 59
Summary 62
Further Reading 64
Practice Questions and Problems 64
Further Questions 65
CHAPTER 4 Mutual Funds and Hedge Funds 67
4.1 Mutual Funds 67
4.2 Hedge Funds 74
4.3 Hedge Fund Strategies 79
4.4 Hedge Fund Performance 83
Summary 84
Further Reading 85
Practice Questions and Problems 85
Further Questions 86
CHAPTER 5 Trading in Financial Markets 89
5.1 The Markets 89
5.2 Long and Short Positions in Assets 90
5.3 Derivatives Markets 92
5.4 Plain Vanilla Derivatives 93
5.5 Clearing Houses 103
5.6 Margin 104
5.7 NonTraditional Derivatives 107
5.8 Exotic Options and Structured Products 111
5.9 Risk Management Challenges 114
Summary 115
Further Reading 115
Practice Questions and Problems 116
Further Questions 118
CHAPTER 6 The Credit Crisis of 2007 121
6.1 The U.S. Housing Market 121
6.2 Securitization 124
6.3 The Crisis 131
6.4 What Went Wrong? 131
6.5 Lessons from the Crisis 133
Summary 134
Further Reading 135
Practice Questions and Problems 136
Further Questions 136
CHAPTER 7 How Traders Manage Their Risks 137
7.1 Delta 137
7.2 Gamma 144
7.3 Vega 146
7.4 Theta 148
7.5 Rho 149
7.6 Calculating Greek Letters 150
7.7 Taylor Series Expansions 151
7.8 The Realities of Hedging 152
7.9 Hedging Exotic Options 153
7.10 Scenario Analysis 154
Summary 156
Further Reading 156
Practice Questions and Problems 156
Further Questions 157
CHAPTER 8 Interest Rate Risk 159
8.1 The Management of Net Interest Income 159
8.2 LIBOR and Swap Rates 162
8.3 Duration 164
8.4 Convexity 168
8.5 Generalization 169
8.6 Nonparallel Yield Curve Shifts 172
8.7 Interest Rate Deltas in Practice 174
8.8 Principal Components Analysis 176
8.9 Gamma and Vega 179
Summary 179
Further Reading 180
Practice Questions and Problems 181
Further Questions 181
CHAPTER 9 Value at Risk 183
9.1 Definition of VaR 183
9.2 Examples of the Calculation of VaR 185
9.3 VaR vs. Expected Shortfall 186
9.4 VaR and Capital 188
9.5 Coherent Risk Measures 190
9.6 Choice of Parameters for VaR 191
9.7 Marginal VaR, Incremental VaR, and Component VaR 195
9.8 Euler’s Theorem 196
9.9 Aggregating VaRs 197
9.10 BackTesting 197
Summary 200
Further Reading 201
Practice Questions and Problems 201
Further Questions 202
CHAPTER 10 Volatility 205
10.1 Definition of Volatility 205
10.2 Implied Volatilities 208
10.3 Are Daily Percentage Changes in Financial
Variables Normal? 209
10.4 The Power Law 211
10.5 Monitoring Daily Volatility 213
10.6 The Exponentially Weighted Moving Average Model 216
10.7 The GARCH(1,1) Model 218
10.8 Choosing Between the Models 220
10.9 Maximum Likelihood Methods 220
10.10 Using GARCH(1,1) to Forecast Future Volatility 225
Summary 229
Further Reading 229
Practice Questions and Problems 230
Further Questions 231
CHAPTER 11 Correlations and Copulas 233
11.1 Definition of Correlation 233
11.2 Monitoring Correlation 235
11.3 Multivariate Normal Distributions 238
11.4 Copulas 240
11.5 Application to Loan Portfolios: Vasicek’s Model 246
Summary 252
Further Reading 253
Practice Questions and Problems 253
Further Questions 254
CHAPTER 12 Basel I, Basel II, and Solvency II 257
12.1 The Reasons for Regulating Banks 257
12.2 Bank Regulation Pre1988 258
12.3 The 1988 BIS Accord 259
12.4 The G30 Policy Recommendations 262
12.5 Netting 263
12.6 The 1996 Amendment 265
12.7 Basel II 268
12.8 Credit Risk Capital Under Basel II 269
12.9 Operational Risk Capital Under Basel II 277
12.10 Pillar 2: Supervisory Review 278
12.11 Pillar 3: Market Discipline 278
12.12 Solvency II 279
Summary 280
Further Reading 281
Practice Questions and Problems 281
Further Questions 283
CHAPTER 13 Basel 2.5, Basel III, and Dodd–Frank 285
13.1 Basel 2.5 285
13.2 Basel III 289
13.3 Contingent Convertible Bonds 295
13.4 Dodd–Frank Act 296
13.5 Legislation in Other Countries 298
Summary 299
Further Reading 300
Practice Questions and Problems 300
Further Questions 301
CHAPTER 14 Market Risk VaR: The Historical Simulation Approach 303
14.1 The Methodology 303
14.2 Accuracy 308
14.3 Extensions 309
14.4 Computational Issues 313
14.5 Extreme Value Theory 314
14.6 Applications of EVT 317
Summary 319
Further Reading 320
Practice Questions and Problems 320
Further Questions 321
CHAPTER 15 Market Risk VaR: The ModelBuilding Approach 323
15.1 The Basic Methodology 323
15.2 Generalization 326
15.3 Correlation and Covariance Matrices 327
15.4 Handling Interest Rates 330
15.5 Applications of the Linear Model 334
15.6 Linear Model and Options 335
15.7 Quadratic Model 338
15.8 Monte Carlo Simulation 340
15.9 NonNormal Assumptions 341
15.10 ModelBuilding vs. Historical Simulation 342
Summary 343
Further Reading 343
Practice Questions and Problems 343
Further Questions 345
CHAPTER 16 Credit Risk: Estimating Default Probabilities 347
16.1 Credit Ratings 347
16.2 Historical Default Probabilities 349
16.3 Recovery Rates 351
16.4 Credit Default Swaps 352
16.5 Credit Spreads 357
16.6 Estimating Default Probabilities from Credit Spreads 360
16.7 Comparison of Default Probability Estimates 362
16.8 Using Equity Prices to Estimate Default Probabilities 367
Summary 370
Further Reading 371
Practice Questions and Problems 371
Further Questions 373
CHAPTER 17 Counterparty Credit Risk in Derivatives 375
17.1 Credit Exposure on Derivatives 375
17.2 Bilateral Clearing 376
17.3 Central Clearing 380
17.4 CVA 382
17.5 The Impact of a New Transaction 385
17.6 CVA Risk 387
17.7 Wrong Way Risk 388
17.8 DVA 389
17.9 Some Simple Examples 389
Summary 394
Further Reading 395
Practice Questions and Problems 395
Further Questions 396
CHAPTER 18 Credit Value at Risk 399
18.1 Ratings Transition Matrices 400
18.2 Vasicek’s Model 402
18.3 Credit Risk Plus 403
18.4 CreditMetrics 405
18.5 Credit VaR in the Trading Book 406
Summary 410
Further Reading 410
Practice Questions and Problems 411
Further Questions 411
CHAPTER 19 Scenario Analysis and Stress Testing 413
19.1 Generating the Scenarios 413
19.2 Regulation 419
19.3 What to Do with the Results 423
Summary 426
Further Reading 426
Practice Questions and Problems 427
Further Questions 428
CHAPTER 20 Operational Risk 429
20.1 What is Operational Risk? 430
20.2 Determination of Regulatory Capital 431
20.3 Categorization of Operational Risks 433
20.4 Loss Severity and Loss Frequency 434
20.5 Implementation of AMA 435
20.6 Proactive Approaches 439
20.7 Allocation of Operational Risk Capital 440
20.8 Use of Power Law 441
20.9 Insurance 442
20.10 SarbanesOxley 443
Summary 444
Further Reading 445
Practice Questions and Problems 445
Further Questions 446
CHAPTER 21 Liquidity Risk 447
21.1 Liquidity Trading Risk 447
21.2 Liquidity Funding Risk 454
21.3 Liquidity Black Holes 462
Summary 468
Further Reading 469
Practice Questions and Problems 470
Further Questions 470
CHAPTER 22 Model Risk 473
22.1 Marking to Market 473
22.2 Models for Linear Products 475
22.3 Physics vs. Finance 476
22.4 How Models are Used for Pricing Standard Products 478
22.5 Hedging 484
22.6 Models for Nonstandard Products 485
22.7 Dangers in Model Building 486
22.8 Detecting Model Problems 487
Summary 488
Further Reading 488
Practice Questions and Problems 489
Further Questions 489
CHAPTER 23 Economic Capital and RAROC 491
23.1 Definition of Economic Capital 491
23.2 Components of Economic Capital 493
23.3 Shapes of the Loss Distributions 495
23.4 Relative Importance of Risks 497
23.5 Aggregating Economic Capital 498
23.6 Allocation of Economic Capital 501
23.7 Deutsche Bank’s Economic Capital 503
23.8 RAROC 503
Summary 505
Further Reading 506
Practice Questions and Problems 506
Further Questions 507
CHAPTER 24 Risk Management Mistakes to Avoid 509
24.1 Risk Limits 509
24.2 Managing the Trading Room 512
24.3 Liquidity Risk 514
24.4 Lessons for Nonfinancial Corporations 517
24.5 A Final Point 518
Further Reading 519
Appendix A Compounding Frequencies for Interest Rates 521
Appendix B Zero Rates, Forward Rates, and ZeroCoupon Yield Curves 525
Appendix C Valuing Forward and Futures Contracts 529
Appendix D Valuing Swaps 531
Appendix E Valuing European Options 533
Appendix F Valuing American Options 535
Appendix G Taylor Series Expansions 539
Appendix H Eigenvectors and Eigenvalues 543
Appendix I Principal Components Analysis 547
Appendix J Manipulation of Credit Transition Matrices 549
Appendix K Valuation of Credit Default Swaps 551
Appendix L Synthetic CDOs and Their Valuation 555
Answers to Questions and Problems 559
Glossary 595
DerivaGem Software 615
Table for N(x) when x ≤ 0 621
Table for N(x) when x ≥ 0 623
Index 625
John C. Hull is the Maple Financial Group Chair in Derivatives and Risk Management at the Joseph L. Rotman School of Management, University of Toronto, and codirector of Rotman's Master of Finance program. He has acted as consultant to many North American, Japanese, and European financial institutions, and is the author of three books and an associate editor of eight academic journals.