Financial Risk Management

Foreword xvii Preface xix Acknowledgments xxiii About the Author xxvii CHAPTER 1 Introduction 1 1.1 Lessons from a Crisis 1 1.2 Financial Risk and Actuarial Risk 2 1.3 Simulation and Subjective Judgment 4 CHAPTER 2 Institutional Background 7 2.1 Moral Hazard--Insiders and Outsiders 7 2.2 Ponzi Schemes 17 2.3 Adverse Selection 19 2.4 The Winner's Curse 21 2.5 Market Making versus Position Taking 24 CHAPTER 3 Operational Risk 29 3.1 Operations Risk 31 3.2 Legal Risk 37 3.3 Reputational Risk 41 3.4 Accounting Risk 42 3.5 Funding Liquidity Risk 42 3.6 Enterprise Risk 44 3.7 Identification of Risks 44 3.8 Operational Risk Capital 45 CHAPTER 4 Financial Disasters 49 4.1 Disasters Due to Misleading Reporting 49 4.2 Disasters Due to Large Market Moves 68 4.3 Disasters Due to the Conduct of Customer Business 77 CHAPTER 5 The Systemic Disaster of 2007-2008 83 5.1 Overview 83 5.2 The Crisis in CDOs of Subprime Mortgages 85 5.3 The Spread of the Crisis 108 5.4 Lessons from the Crisis for Risk Managers 111 5.5 Lessons from the Crisis for Regulators 115 5.6 Broader Lessons from the Crisis 132 CHAPTER 6 Managing Financial Risk 133 6.1 Risk Measurement 133 6.2 Risk Control 161 CHAPTER 7 VaR and Stress Testing 169 7.1 VaR Methodology 170 7.2 Stress Testing 192 7.3 Uses of Overall Measures of Firm Position Risk 201 CHAPTER 8 Model Risk 209 8.1 How Important Is Model Risk? 210 8.2 Model Risk Evaluation and Control 212 8.3 Liquid Instruments 237 8.4 Illiquid Instruments 241 8.5 Trading Models 250 CHAPTER 9 Managing Spot Risk 253 9.1 Overview 253 9.2 Foreign Exchange Spot Risk 257 9.3 Equity Spot Risk 258 9.4 Physical Commodities Spot Risk 259 CHAPTER 10 Managing Forward Risk 263 10.1 Instruments 270 10.2 Mathematical Models of Forward Risks 282 10.3 Factors Impacting Borrowing Costs 299 10.4 Risk Management Reporting and Limits for Forward Risk 304 CHAPTER 11 Managing Vanilla Options Risk 311 11.1 Overview of Options Risk Management 313 11.2 The Path Dependence of Dynamic Hedging 318 11.3 A Simulation of Dynamic Hedging 321 11.4 Risk Reporting and Limits 329 11.5 Delta Hedging 344 11.6 Building a Volatility Surface 346 11.7 Summary 355 CHAPTER 12 Managing Exotic Options Risk 359 12.1 Single-Payout Options 364 12.2 Time-Dependent Options 378 12.3 Path-Dependent Options 381 12.4 Correlation-Dependent Options 404 12.5 Correlation-Dependent Interest Rate Options 425 CHAPTER 13 Credit Risk 445 13.1 Short-Term Exposure to Changes in Market Prices 446 13.2 Modeling Single-Name Credit Risk 457 13.3 Portfolio Credit Risk 479 13.4 Risk Management of Multiname Credit Derivatives 493 CHAPTER 14 Counterparty Credit Risk 505 14.1 Overview 505 14.2 Exchange-Traded Derivatives 506 14.3 Over-the-Counter Derivatives 512 References 533 About the Companion Website 547 Index 553