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 Prices446
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