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A clear new finance textbook that explains essential models and practices, and how the financial world works now
Contemporary Financial Markets and Institutions: Tools and Techniques to Manage Risk and Uncertainty is an ideal introduction to finance for professionals and students. It covers the basic finance theory required to understand the contemporary financial world and builds on it to present finance in a detailed yet comprehensible way. It explains markets and institutions, and the central bank and government policies that influence how they operate.
The book begins with an overview of basic finance theory, including investments, asset return behavior, derivatives pricing, and credit risk. It discusses topics that have dominated markets in recent decades, such as extreme events, liquidity, currency and debt crises, and radical changes in monetary policy and regulation. The concepts are presented alongside examples, strange market episodes, and data from recent experience. Contemporary Financial Markets and Institutions covers advanced credit topics like securitization in a straightforward, succinct way, without advanced mathematics, but with detailed examples using real market data. It integrates financial and macroeconomic content seamlessly. The book is suitable for use by undergraduate and graduate students, and by practitioners of all backgrounds. Abundant pedagogical resources in the book and online facilitate teaching. This book will help students and practioners:
Ideal as a sole or supplementary textbook for beginning and advanced finance courses, as well as for practitioners in finance-related fields, this book takes a unique, market-focused approach that will serve readers well in our turbulent and puzzling times.
Allan M. Malz has been chief risk officer at several multi-strategy hedge fund management firms. He worked at the Federal Reserve Bank of New York as a researcher and foreign exchange trader, and helped implement the Fed's emergency liquidity programs addressing the global financial crisis. Malz is an investment consultant and adjunct professor at Columbia University, and the author of Financial Risk Management: Models, History, and Institutions. His work on predicting financial crises and on risk measurement for options has been published in industry and academic journals. He holds a Ph.D. from Columbia and a Diplom from Ludwig-Maximilians-Universität München.
List of Figures xiii
List of Tables xvii
Preface xix
About the Author xxi
Part I Finance in the Economic System 1
1 Functions and Structure of the Financial System 3
1.1 Functions of the Financial System 3
1.2 Market Participants, Intermediaries, and Governments 4
1.3 Assets and Markets 6
1.3.1 Money and Money Markets 6
1.3.2 Foreign Exchange 7
1.3.3 Digital Currencies 7
1.3.4 Equity, Loans, and Bonds 7
1.3.5 Spot and Derivative Assets 9
1.3.6 Alternative Investments 11
1.4 Mechanics of Trading 12
1.4.1 Asset Positions and Risk Exposures 12
1.4.2 Market Microstructure 14
1.4.3 Payment Systems 15
1.4.4 Clearing and Settlement 16
Further Reading 17
2 Asset Returns and Risk 19
2.1 Asset Returns and Interest Rates 19
2.1.1 Measuring Asset Returns 19
2.1.2 Interest Rates and Yield Curves 22
2.1.3 Total Returns and Asset Values 25
2.1.4 Inflation and Real Returns 26
2.1.5 Excess Returns 29
2.2 Asset Return Probability Distributions 30
2.3 Financial Risks 32
2.3.1 Market Risk 32
2.3.2 Credit Risk 33
2.3.3 Operational Risks 34
Further Reading 35
3 Information, Preferences, and Asset Prices 37
3.1 Information and the Quantification of Risk 37
3.1.1 Conceptions of Equilibrium 37
3.1.2 Technical Progress 39
3.1.3 Frictions and Transaction Costs 40
3.1.4 Institutions 41
3.2 Risk Premiums 42
3.2.1 The Convention of the Risk-Free Rate and Reference Rates 42
3.2.2 Expected Returns and Risk Premiums 43
3.2.3 Interest Rate Spreads 46
3.3 An Era of Low Interest Rates and Slowing Growth 48
3.3.1 Safe Assets 52
3.3.2 Rising Debt 54
Further Reading 55
Part II Markets, Uncertainty, and Risk 57
4 The Behavior of Asset Returns over Time 59
4.1 Standard Model of Asset Price Behavior and Reality 59
4.2 Return, Volatility, and Correlation Behavior 61
4.2.1 Return Predictability 61
4.2.2 Time Variation in Return Volatility 62
4.2.3 Time Variation in Return Correlation 62
4.3 Volatility Forecasting 64
4.3.1 Simple Approaches to Volatility Estimation 64
4.3.2 The GARCH Model 66
4.3.3 The Exponentially Weighted Moving Average Model 67
4.4 Tail Risk: the Prevalence of Extremes 70
4.4.1 Extreme Asset Returns 70
4.4.2 Skewness and Kurtosis 72
4.4.3 Clues to Financial Puzzles in the Behavior of Volatility 73
Further Reading 75
5 Capital Markets: How Asset Prices Are Determined 77
5.1 Portfolios, Diversification, and Investor Choice 77
5.1.1 Portfolio Risk 77
5.1.2 Optimal Investor Choice 80
5.2 The Capital Asset Pricing Model 82
5.2.1 The Efficiency of the Market Portfolio 83
5.2.2 Estimating Systematic and Nonsystematic Risk 84
5.2.3 More General Factor Models 86
Further Reading 87
6 Derivatives Values and Risks 89
6.1 Futures, Forwards, and Swaps 89
6.1.1 Forward Foreign Exchange Markets 91
6.1.2 Valuation of Interest Rate Swaps 94
6.1.3 The LIBOR Transition 95
6.1.4 Credit Default Swaps 96
6.2 Options 98
6.2.1 Option Values 98
6.2.2 The Option-Implied Volatility Surface 101
6.2.3 Option Risks 102
6.2.4 Put-Call Parity 104
6.2.5 Interest Rate Implied Volatility 104
6.3 Market-Implied Asset Price Forecasts 105
6.3.1 Risk-Neutral Mean Forecasts 105
6.3.2 Risk-Neutral Volatility and Correlation Forecasts 107
6.3.3 Risk-Neutral Probability Distributions 107
Further Reading 109
7 Capital Market Efficiency 111
7.1 Asset Price Behavior in an Efficient Market 111
7.1.1 Validating the Efficient Markets Hypothesis 112
7.1.2 Market Efficiency, Preferences, and Knowledge 113
7.2 Apparent Violations of Market Efficiency 114
7.2.1 Slow Arbitrage 114
7.2.2 Basis Spreads 115
7.2.3 Foreign Exchange Markets 116
7.3 Efficacy of Active Management 117
7.3.1 Passive and Active Investment Management 117
7.3.2 Empirical Validation of Active Management 118
7.3.3 Alternative Investments 122
Further Reading 126
8 Market Risk 129
8.1 Definition of Value-at-Risk 129
8.1.1 Why Value-at-Risk? 129
8.1.2 Value-at-Risk Is a Quantile 130
8.2 Computing Value-at-Risk for One Risk Factor 130
8.2.1 Modeling Approaches to Value-at-Risk Estimation 130
8.2.2 Parametric Normal Value-at-Risk 133
8.2.3 Computing Value-at-Risk via Monte Carlo Simulation 134
8.2.4 Computing Value-at-Risk via Historical Simulation 134
8.2.5 Value-at-Risk for Short Positions 136
8.2.6 Comparison of Value-at-Risk Computation Approaches 138
8.3 Nonlinear Market Risks 138
8.3.1 Nonlinearity and Risk Measurement 138
8.3.2 Applying Delta-Gamma Value-at-Risk to the Value of an Option 139
8.3.3 Portfolio Value-at-Risk 141
8.4 Incorporating Extreme Events Into Risk Measurement 142
8.4.1 Why Not Value-at-Risk? 142
8.4.2 Stress Testing and Scenario Analysis 143
8.4.3 Expected Shortfall 145
Further Reading 148
9 Credit and Counterparty Risk 149
9.1 Default, Bankruptcy, and Resolution 149
9.1.1 Equity, Debt, and Leverage 149
9.1.2 Information Costs in Credit Intermediation 150
9.1.3 Default and Migration 151
9.1.4 Counterparty Risk, and Collateral 152
9.1.5 Bankruptcy, Capital Structure, and Resolution 153
9.2 Quantifying Credit Risk 155
9.2.1 Credit Risk Metrics 155
9.2.2 Default Modeling 156
9.2.3 Intensity Models and Default Time Analytics 157
9.3 Single-Obligor Credit Risk Models 158
Further Reading 162
Part III Market Institutions and Risk Assessment 163
10 Interest Rate Risk 165
10.1 Sources of Interest Rate Risk 165
10.2 Interest Rate Risk Measurement 167
10.2.1 Measuring Bond Price Sensitivity to Rates 167
10.2.2 Duration and Convexity 169
10.2.3 Convexity and the Mortgage-Backed Securities Markets 171
10.2.4 Measuring Value-at-Risk for a Bond Position 175
Further Reading 176
11 Leverage 177
11.1 Defining and Measuring Leverage 177
11.1.1 Company Financing 177
11.1.2 Corporate Finance Policy 178
11.1.3 Margin and Haircuts 179
11.2 Attractiveness of Leverage and Reaching for Yield 179
11.3 Leveraged Trades 180
11.3.1 Carry Trades 181
11.3.2 Leveraged Investment Funds 184
11.4 Incentive Alignment and Capital Structure 184
11.4.1 Leverage and Incentives to Risk Shifting 184
11.4.2 Debt Overhang 186
Further Reading 187
12 Liquidity 189
12.1 Funding and Market Liquidity Risk 189
12.1.1 Market Liquidity 189
12.1.2 Market Liquidity Stress Events 191
12.1.3 Funding Liquidity 192
12.2 Private Liquidity Creation: Commercial Banking 193
12.2.1 Historical Emergence of Banks 193
12.2.2 Commercial Bank Liquidity Creation 194
12.2.3 Commercial Bank Risks 195
12.3 Private Liquidity Creation: Short-Term Funding 198
12.3.1 Structure of Collateralized Securities Lending Markets 199
12.3.2 Repo Markets 201
12.3.3 Money Market Mutual Funds 204
Further Reading 206
13 Portfolio Credit Risk 207
13.1 Credit Portfolios and Default Correlation 207
13.1.1 Challenges in Portfolio Credit Risk Modeling 207
13.1.2 Default Correlation 209
13.1.3 Granularity and Uncorrelated Portfolios 210
13.1.4 Granularity, Subadditivity, and Credit Value-at-Risk 212
13.2 Measuring Portfolio Credit Risk 213
13.2.1 Single Factor Credit Risk Model 213
13.2.2 Single Factor Model for Portfolios 216
13.2.3 Portfolio Credit Value-at-Risk 219
Further Reading 223
14 Securitization and Structured Product Risk 225
14.1 Introduction to Securitization 225
14.1.1 Function and Design of Securitization 225
14.1.2 Securitization in the United States 226
14.2 Securitization Structure 228
14.3 Credit Risk Measurement of Securitizations 231
14.3.1 Securitization Loss Scenarios 231
14.3.2 Securitization Risk Modeling 233
14.3.3 Credit Value-at-Risk of Securitizations 237
14.3.4 Risk Analysis and Structuring of Securitizations 238
14.4 Credit Correlation Trading 240
14.4.1 CDS Indexes and Standard Tranches 240
14.4.2 The 2005 Auto Industry Credit Crisis and the "London Whale" 241
Further Reading 244
15 Financial Instability and Financial Crises 245
15.1 Defining Financial Crises 245
15.2 Runs and Liquidity in Financial Crises 246
15.3 Causes of Financial Crises 251
15.3.1 Interest Rates, Volatility, and Financial Imbalances 251
15.3.2 Long-Term Liabilities and Interest Rates 253
15.3.3 Reaching for Yield 254
15.4 International Financial Imbalances 258
15.4.1 Rising International Trade and Global Debt 258
15.4.2 The Role of the US Dollar 260
15.4.3 The Cross-Currency Basis 263
15.4.4 International Financial Imbalances and Stability 264
Further Reading 268
Part IV Monetary and Regulatory Policy 269
16 Overview of Financial Regulation 271
16.1 Structure of Financial Regulation 271
16.1.1 Financial Regulatory Authorities 271
16.1.2 Law and Regulation 272
16.2 Methods of Regulation 273
16.2.1 Bank Supervision 274
16.2.2 Regulatory Developments of Recent Decades 275
16.3 Purposes and Efficacy of Financial Regulation 276
16.3.1 Rationale of Financial Regulation 276
16.3.2 Information Problems in Regulation 277
16.3.3 Incentives and the Efficacy of Regulation 279
Further Reading 281
17 Monetary Policy 283
17.1 The Emergence of Monetary Policy 283
17.2 The Framework of Monetary Policy 284
17.2.1 Policy Targets and Instruments 285
17.2.2 Credibility of Monetary Policy 286
17.2.3 Money Supply Control 287
17.2.4 Interest Rate Control 289
17.2.5 The New Keynesian Framework 289
17.2.6 Alternative Approaches to Monetary Policy 291
17.3 Monetary Operations in Normal Times 292
Further Reading 296
18 Regulation for Financial Stability 297
18.1 The Lender of Last Resort Function 297
18.1.1 Bagehot's Rule 297
18.1.2 Market Maker of Last Resort 298
18.1.3 Credit Support and Liquidity Support 299
18.2 The Onset of the Global Financial Crisis 300
18.3 Financial Stability Policy 302
18.3.1 Financial Stability and Monetary Policy 302
18.3.2 Financial Stability Monitoring 304
18.4 The Problem of Public-Sector Guarantees 304
18.4.1 Deposit Insurance 305
18.4.2 Regulation of Money Market Mutual Funds 305
18.4.3 Too Big to Fail 307
18.4.4 Emergence of a Too Big To Fail Policy 307
18.4.5 The Too Big to Fail Subsidy and its Cost 308
18.4.6 Too Big to Fail and the Regulatory System 309
Further Reading 309
19 Regulation of Capital Funding, Liquidity, and Large Banks 311
19.1 Historical Background of the Capital Standards 311
19.2 Bank Accounting Standards and Regulation 312
19.2.1 Treatment of Losses 312
19.2.2 The Banking and Trading Books 314
19.3 Measuring Risk-Weighted and Adjusted Assets 315
19.3.1 Risk-Weighted Assets 315
19.3.2 Leverage Exposure 317
19.4 Quality and Quantity of Capital 317
19.4.1 Quality of Capital 318
19.4.2 Quantity of Capital 318
19.4.3 Effectiveness and Market Impact of Capital Regulation 319
19.5 Regulation of Large Banks 321
19.5.1 Regulatory Capital Ratios for Large Banks 321
19.5.2 Bail-in-able Liabilities 322
19.5.3 Regulatory Stress Tests 323
19.5.4 Resolution of Large Banks 325
19.5.5 Regulatory Liquidity Standards for Banks 328
Further Reading 331
20 Monetary Policies Since the Global Financial Crisis 333
20.1 The Monetary Policy Response to the Global Financial Crisis 333
20.1.1 Interest on Reserves 333
20.1.2 Quantitative Easing 334
20.1.3 Forward Guidance 335
20.2 Monetary Operations with a Large Balance Sheet 337
20.2.1 Quantitative Easing and the Soggy Money Market 338
20.2.2 The Ample Reserves Operating Framework 340
20.2.3 The Impact of Exit on Funding and Market Liquidity 343
20.2.4 Money Markets in September 2019 344
20.3 The Liquidity Paradox and the Banking Turmoil 346
20.3.1 The Public-Sector Response to the Covid Pandemic 346
20.3.2 The Rise in Interest Rates and the Financial System 349
20.3.3 The 2023 US Bank Panic 351
Further Reading 354
Appendix 357
A Much of the Probability and Statistics You Need 359
A1 Probability Distributions and Their Properties 359
A.1.1 Moments of a Distribution 359
A.1.2 Quantiles of a Distribution 360
A.2 Important Distributions 360
A.2.1 Binomial Distribution 361
A.2.2 Poisson Distribution 361
A.2.3 Normal Distribution 361
A.2.4 Multivariate Distributions 362
A.3 Stochastic Processes 363
A.4 Statistical Tests 365
A.4.1 Samples 365
A.4.2 Sample Moments 365
A.4.3 Quantiles of Samples 366
A.4.4 Central Limit Theorem 367
A.4.5 Hypotheses 367
A.4.6 Test Statistics 368
A.5 Linear Regression Analysis 368
Further Reading 370
B Notation 371
C Abbreviations 373
References 377
Index 395
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