Financial Risk Management (2^nd Ed.)
A Practitioner's Guide to Managing Market and Credit Risk
Wiley Finance Series

In the Second Edition of Financial Risk Management + Website, market risk expert Steve Allen offers an insider's view of this discipline and covers the strategies, principles, and measurement techniques necessary to manage and measure financial risk. Fully revised to reflect today's dynamic environment and the lessons to be learned from the 2008 global financial crisis, this reliable resource provides a comprehensive overview of the entire field of risk management.

Allen explores real-world issues such as proper mark-to-market valuation of trading positions and determination of needed reserves against valuation uncertainty, the structuring of limits to control risk taking, and a review of mathematical models and how they can contribute to risk control. Along the way, he shares valuable lessons that will help to develop an intuitive feel for market risk measurement and reporting.

• Presents key insights on how risks can be isolated, quantified, and managed from a top risk management practitioner
• Offers up-to-date examples of managing market and credit risk
• Provides an overview and comparison of the various derivative instruments and their use in risk hedging
• Companion Website contains supplementary materials that allow you to continue to learn in a hands-on fashion long after closing the book

Focusing on the management of those risks that can be successfully quantified, the Second Edition of Financial Risk Management + Websiteis the definitive source for managing market and credit risk.

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

3.1.1 The Risk of Fraud 31

3.1.2 The Risk of Nondeliberate Incorrect Information 35

3.1.3 Disaster Risk 36

3.1.4 Personnel Risk 36

3.2 Legal Risk 37

3.2.1 The Risk of Unenforceable Contracts 37

3.2.2 The Risk of Illegal Actions 40

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

4.1.1 Chase Manhattan Bank/Drysdale Securities 52

4.1.2 Kidder Peabody 53

4.1.3 Barings Bank 55

4.1.4 Allied Irish Bank (AIB) 57

4.1.5 Union Bank of Switzerland (UBS) 59

4.1.6 Société Générale 61

4.1.7 Other Cases 66

4.2 Disasters Due to Large Market Moves 68

4.2.1 Long‐Term Capital Management (LTCM) 68

4.2.2 Metallgesellschaft (MG) 75

4.3 Disasters Due to the Conduct of Customer Business 77

4.3.1 Bankers Trust (BT) 77

4.3.2 JPMorgan, Citigroup, and Enron 79

4.3.3 Other Cases 80

Chapter 5 The Systemic Disaster of 2007–2008 83

5.1 Overview 83

5.2 The Crisis in CDOs of Subprime Mortgages 85

5.2.1 Subprime Mortgage Originators 86

5.2.2 CDO Creators 88

5.2.3 Rating Agencies 89

5.2.4 Investors 92

5.2.5 Investment Banks 93

5.2.6 Insurers 106

5.3 The Spread of the Crisis 108

5.3.1 Credit Contagion 108

5.3.2 Market Contagion 109

5.4 Lessons from the Crisis for Risk Managers 111

5.4.1 Subprime Mortgage Originators 111

5.4.2 CDO Creators 111

5.4.3 Rating Agencies 111

5.4.4 Investors 111

5.4.5 Investment Banks 112

5.4.6 Insurers 114

5.4.7 Credit Contagion 115

5.4.8 Market Contagion 115

5.5 Lessons from the Crisis for Regulators 115

5.5.1 Mortgage Originators 116

5.5.2 CDO Creators 116

5.5.3 Rating Agencies 117

5.5.4 Investors 118

5.5.5 Investment Banks 118

5.5.6 Insurers 126

5.5.7 Credit Contagion 126

5.5.8 Market Contagion 129

5.6 Broader Lessons from the Crisis 132

Chapter 6 Managing Financial Risk 133

6.1 Risk Measurement 133

6.1.1 General Principles 133

6.1.2 Risk Management of Instruments That Lack Liquidity 144

6.1.3 Market Valuation 147

6.1.4 Valuation Reserves 152

6.1.5 Analysis of Revenue 156

6.1.6 Exposure to Changes in Market Prices 157

6.1.7 Risk Measurement for Position Taking 159

6.2 Risk Control 161

Chapter 7 VaR and Stress Testing 169

7.1 VaR Methodology 170

7.1.1 Simulation of the P&L Distribution 173

7.1.2 Measures of the P&L Distribution 187

7.2 Stress Testing 192

7.2.1 Overview 192

7.2.2 Economic Scenario Stress Tests 193

7.2.3 Stress Tests Relying on Historical Data 197

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

8.2.1 Scope of Model Review and Control 213

8.2.2 Roles and Responsibilities for Model Review and Control 214

8.2.3 Model Verification 219

8.2.4 Model Verification of Deal Representation 222

8.2.5 Model Verification of Approximations 223

8.2.6 Model Validation 226

8.2.7 Continuous Review 232

8.2.8 Periodic Review 234

8.3 Liquid Instruments 237

8.4 Illiquid Instruments 241

8.4.1 Choice of Model Validation Approach 241

8.4.2 Choice of Liquid Proxy 243

8.4.3 Design of Monte Carlo Simulation 245

8.4.4 Implications for Marking to Market 247

8.4.5 Implications for Risk Reporting 249

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

10.1.1 Direct Borrowing and Lending 270

10.1.2 Repurchase Agreements 271

10.1.3 Forwards 272

10.1.4 Futures Contracts 272

10.1.5 Forward Rate Agreements 274

10.1.6 Interest Rate Swaps 275

10.1.7 Total Return Swaps 276

10.1.8 Asset‐Backed Securities 278

10.2 Mathematical Models of Forward Risks 282

10.2.1 Pricing Illiquid Flows by Interpolation 284

10.2.2 Pricing Long‐Dated Illiquid Flows by Stack and Roll 291

10.2.3 Flows Representing Promised Deliveries 293

10.2.4 Indexed Flows 295

10.3 Factors Impacting Borrowing Costs 299

10.3.1 The Nature of Borrowing Demand 299

10.3.2 The Possibility of Cash‐and‐Carry Arbitrage 300

10.3.3 The Variability of Storage Costs 301

10.3.4 The Seasonality of Borrowing Costs 302

10.3.5 Borrowing Costs and Forward Prices 303

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

11.6.1 Interpolating between Time Periods 346

11.6.2 Interpolating between Strikes—Smile and Skew 347

11.6.3 Extrapolating Based on Time Period 352

11.7 Summary 355

Chapter 12 Managing Exotic Options Risk 359

12.1 Single‐Payout Options 364

12.1.1 Log Contracts and Variance Swaps 367

12.1.2 Single‐Asset Quanto Options 369

12.1.3 Convexity 370

12.1.4 Binary Options 371

12.1.5 Contingent Premium Options 377

12.1.6 Accrual Swaps 378

12.2 Time‐Dependent Options 378

12.2.1 Forward‐Starting and Cliquet Options 378

12.2.2 Compound Options 379

12.3 Path‐Dependent Options 381

12.3.1 Standard Analytic Models for Barriers 383

12.3.2 Dynamic Hedging Models for Barriers 385

12.3.3 Static Hedging Models for Barriers 387

12.3.4 Barrier Options with Rebates, Lookback, and Ladder Options 402

12.3.5 Broader Classes of Path‐Dependent Exotics 403

12.4 Correlation‐Dependent Options 404

12.4.1 Linear Combinations of Asset Prices 405

12.4.2 Risk Management of Options on Linear Combinations 409

12.4.3 Index Options 413

12.4.4 Options to Exchange One Asset for Another 415

12.4.5 Nonlinear Combinations of Asset Prices 417

12.4.6 Correlation between Price and Exercise 422

12.5 Correlation‐Dependent Interest Rate Options 425

12.5.1 Models in Which the Relationship between Forwards is Treated as Constant 426

12.5.2 Term Structure Models 430

12.5.3 Relationship between Swaption and Cap Prices 437

Chapter 13 Credit Risk 445

13.1 Short‐Term Exposure to Changes in Market Prices 446

13.1.1 Credit Instruments 447

13.1.2 Models of Short‐Term Credit Exposure 451

13.1.3 Risk Reporting for Market Credit Exposures 456

13.2 Modeling Single‐Name Credit Risk 457

13.2.1 Estimating Probability of Default 458

13.2.2 Estimating Loss Given Default 465

13.2.3 Estimating the Amount Owed at Default 468

13.2.4 The Option‐Theoretic Approach 471

13.3 Portfolio Credit Risk 479

13.3.1 Estimating Default Correlations 479

13.3.2 Monte Carlo Simulation of Portfolio Credit Risk 482

13.3.3 Computational Alternatives to Full Simulation 486

13.3.4 Risk Management and Reporting for Portfolio Credit Exposures 490

13.4 Risk Management of Multiname Credit Derivatives 493

13.4.1 Multiname Credit Derivatives 493

13.4.2 Modeling of Multiname Credit Derivatives 495

13.4.3 Risk Management and Reporting for Multiname Credit Derivatives 498

13.4.4 CDO Tranches and Systematic Risk 500

Chapter 14 Counterparty Credit Risk 505

14.1 Overview 505

14.2 Exchange‐Traded Derivatives 506

14.3 Over‐the‐Counter Derivatives 512

14.3.1 Overview 512

14.3.2 The Loan‐Equivalent Approach 513

14.3.3 The Collateralization Approach 515

14.3.4 The Collateralization Approach—Wrong‐Way Risk 521

14.3.5 The Active Management Approach 526

References 533

About the Companion Website 547

Index 553

STEVEN ALLEN is a risk management consultant, specializing in risk measurement and valuation with a particular emphasis on illiquid and hard-to-value assets. Until his retirement in 2004, he was Managing Director in charge of risk methodology at JPMorgan Chase, where he was responsible for model validation, risk capital allocation, and the development of new measures of valuation, reserves, and risk for both market and credit risk. Previously, he was in charge of market risk for derivative products at Chase. He has been a key architect of Chase's value-at-risk and stress testing systems. Prior to his work in risk management, Allen was the head of analysis and model building for all Chase trading activities for over ten years. Since 1998, Allen has been associated with the Mathematics in Finance Master's Program at New York University's Courant Institute of Mathematical Sciences. In this program, he has served as Clinical Associate Professor and Deputy Director and has created and taught courses in risk management, derivatives mathematics, and interest rate and credit models. He was a member of the board of directors of the International Association of Financial Engineers and continues to serve as co-chair of their Education Committee.