Understanding Financial Risk Management

Halftitle Page
Title Page
Copyright Page
Contents
List of Tables
List of Figures
Preface to the Second Edition
Addendum to the Preface
Chapter 1: Risk: An Overview
	1.1. Introduction
		1.1.1. Randomness and Uncertainty
		1.1.2. Rationality and Risk Aversion
		1.1.3. Types of Risk
	Snapshot 1.1
		Common Forms of Utility Functions
	1.2. The Process of Risk Management
		1.2.1. Risk in Corporations and Financial Institutions
		1.2.2. Identification, Measurement and Mitigation
		1.2.3. Risk Response Strategies
	1.3. Theory of Markets
		1.3.1. Arbitrage
		1.3.2. The EMH
		1.3.3. Brownian Motion
	Snapshot 1.2
		Sampling of Brownian Motion Paths in Excel
	Summary
	Bibliography
	Exercises
		Questions
		Problems
	Appendix: Types of Market Failure
Chapter 2: Financial Markets and Volatility
	2.1. Modern Portfolio Theory
		2.1.1. The Risk/Return Trade Off
		2.1.2. Optimal Portfolios of Risky Assets 
		2.1.3. Optimal Portfolios with Risk-free Asset
	Snapshot 2.1 
		Portfolio Optimization in Excel
	2.2. The CAPM
		2.2.1. Model Assumptions 
		2.2.2. The SML
		2.2.3. Beyond CAPM
	2.3. Volatility and Correlation
		2.3.1. Types of Volatility
		2.3.2. Correlation Versus Covariance
		2.3.3. Maximum Likelihood Methods
	Snapshot 2.2
		The Covariance Matrix of Financial Returns
	Summary
	Bibliography
	Exercises
		Questions
		Problems
	Appendix: The Table of the Standard Normal Distribution
Chapter 3: Conditional Dependence and Time Series
	3.1. Modeling Financial Comovements
		3.1.1. Conditional Covariance
		3.1.2. Conditional Correlation
	3.2. Time Series Analysis
		3.2.1. ARCH/GARCH Models
		3.2.2. Autocorrelation of Financial Returns
		3.2.3. Other Stylized Facts
	Summary
	Bibliography
Chapter 4: Statistical Analysis
	4.1. Relevant Distributions
		4.1.1. Pareto Distribution
		4.1.2. Binomial Distribution
		4.1.3. Poisson Distribution
	Snapshot 4.1
		Excel Statistical Functions
	4.2. Probabilistic Approaches
		4.2.1. Scenario Analysis
		4.2.2. Decision Trees
		4.2.3. Simulations
	Summary
	Bibliography
	Exercises
		Questions
		Problems
	Appendix: Ito’s Lemma
Chapter 5: Financial Derivatives
	5.1. Options and Futures
		5.1.1. Types of Traders in the Market
		5.1.2. Option Structure and Payout
		5.1.3. Forward and Futures
	Snapshot 5.1
		Volatility Strategy with Strangles
	5.2. Interest Rate Derivatives
		5.2.1. Interest Rate Swaps
		5.2.2. Caps and Floors
		5.2.3. Swaptions
	Summary
	Bibliography
	Exercises
	Appendix: The Market Price of Risk
Chapter 6: Option Pricing and Risk Modeling
	6.1. Option Pricing Models
		6.1.1. Binomial Trees
		6.1.2. BSM Model
	6.2. Portfolio Hedging
		6.2.1. Delta Hedging
		6.2.2. Gamma and Vega Hedging
		6.2.3. The Cost of Hedging
	Summary
	Bibliography
	Exercises
Chapter 7: Market Risk
	7.1. Market Risk Metrics
		7.1.1. Overview of Market Risk
		7.1.2. Quantile Metrics and VaR
		7.1.3. VaR Rationale and Definition
	Snapshot 7.1
		The Choice of Parameters for VaR
	7.2. VaR Calculation Methods
		7.2.1. Historical Simulation Approach
		7.2.2. Parametric Method
		7.2.3. Monte Carlo Simulation
	Snapshot 7.2
		Euler’s Theorem on Homogeneous Functions
	Summary
	Bibliography
	Exercises
		Questions
		Problems
	Appendix: Factor Mapping for VaR
Chapter 8: Inside Value at Risk
	8.1. VaR Features
		8.1.1. Decomposition
		8.1.2. Limitations
		8.1.3. Analytic Approximations
	8.2. VaR Testing
		8.2.1. Model Backtesting
		8.2.2. Stress Testing
	Summary
	Bibliography
Chapter 9: Interest Rate Risk
	9.1. The Dynamics of Interest Rates
		9.1.1. Bond Prices and Yields
		9.1.2. Fixed Income Futures
		9.1.3. Yield Shifts and Immunization
	Snapshot 9.1
		Compounding Frequencies for Interest Rates
	9.2. Short Rate Models
		9.2.1. The Term Structure of Interest Rates
		9.2.2. Single-factor Models
		9.2.3. Multi-factor Models
	9.3. IRR Management
		9.3.1. Sources and Identification
		9.3.2. Measurement Techniques
		9.3.3. Duration and Convexity Hedging
	Summary
	Bibliography
	Exercises
		Questions
		Problems
	Appendix: Principal Component Analysis of the Term Structure
Chapter 10: Credit Risk
	10.1. Basic Concepts
		10.1.1. Default Probabilities
		10.1.2. Loss Given Default
		10.1.3. Credit Ratings
	10.2. Structural Models
		10.2.1. The KMV-Merton Approach
		10.2.2. First Passage Models
		10.2.3. CreditMetrics™
	10.3. Reduced-form Models
		10.3.1. Jarrow–Turnbull Model
		10.3.2. The Duffie–Singleton Model
		10.3.3. CreditRisk+™
	Summary
	Bibliography
	Exercises
		Questions
		Problems
	Appendix: Markov Process for Transition Matrices
Chapter 11: Commodity Risk
	11.1. Commodity Markets
		11.1.1. Commodity Types and Classification
		11.1.2. The Risk for Traders and Investors
	11.2. Commodity Risk Hedging
		11.2.1. Commodity Futures and Forward Contracts
		11.2.2. Commodity Options and Swaps
	Summary
	Exercises
	Bibliography
Chapter 12: Liquidity Risk
	12.1. Market Prices
		12.1.1. Market Microstructure
		12.1.2. Price Formation
		12.1.3. Funding Versus Market Liquidity
	Snapshot 12.1
		Liquidity Black Holes
	12.2. Liquidity Models
		12.1.1. Theoretical Models
		12.2.2. Traceable Models
		12.2.3. The Diamond–Dybvig Model
	12.3. Liquidity Risk and Regulation
		12.3.1. Liquidity Coverage Ratio
		12.3.2. Net Stable Funding Ratio
		12.3.3. Monitoring Tools
	Summary
	Bibliography
	Exercises
		Questions
		Problems
	Appendix: Liquidity Capital Asset Pricing Model (CAPM)
Chapter 13: Enterprise Risk
	13.1. The Fundamentals
		13.1.1. Identification and Assessment
		13.1.2. The ERM Framework
		13.1.3. The COSO ERM
	13.2. Building and Enhancing Capabilities
		13.2.1. Improving the Process View
		13.2.2. Technological Capabilities
	13.3. Practical Implementation
		13.3.1. The Role of the Management
		13.3.2. Implementation and Models
	Summary
	Bibliography
Chapter 14: Other Risks
	14.1. Operational Risk
		14.1.1. Identification and Assessment
		14.1.2. Treatment and Control
		14.1.3. Basel II Approach
	14.2. Currency Risk
		14.2.1. Types of Currency Risk
		14.2.2. Foreign Exchange Derivatives
		14.2.3. Risk Hedging in FX Markets
	14.3. Volatility Risk
		14.3.1. Implied Volatility
		14.3.2. Callable Bonds
		14.3.3. Variance Swaps
	Snapshot 14.1
		Gamma Swaps
	Summary
	Bibliography
Chapter 15: Beyond Normality and Correlation
	15.1. Copula Functions
		15.1.1. Basic Properties
		15.1.2. Measures of Dependence
		15.1.3. Application to Risk Management
	Snapshot 15.1
		Monte Carlo Simulation of Copulas
	15.2. Extreme Value Theory
		15.2.1. Theoretical Background
		15.2.2. Data Application
		15.2.3. Extreme VaR
	15.3. Beyond VaR
		15.3.1. Model Backtesting
		15.3.2. Expected Shortfall
		15.3.3. Conditional VaR
	Summary
	Bibliography
	Exercises
		Questions
	Appendix: VaR for Portfolios of Derivatives
Chapter 16: Conditional Risk Analysis
	16.1. Beyond VaR
		16.1.1. Expected Shortfall
		16.1.2. Conditional VaR
	16.2. Multivariate Return Distributions
		16.2.1. GARCH (p,q) Modeling
	Summary
	Bibliography
Chapter 17: High-frequency Data
	17.1. High-frequency Trading
		17.1.1. Data Filtering
		17.1.2. Basic Stylized Facts
	17.2. Intraday Risk Analysis
		17.2.1. Heterogeneous Volatility
	Summary
	Bibliography
	Exercises
		Questions
	Appendix: Power Laws for Intraday Data
Chapter 18: Financial Crisis and Securitization
	18.1. Crisis and Regulation
		18.1.1. The Lack of Regulatory Framework
		18.1.2. The Crisis in Europe
		18.1.3. The Impact on the Financial Industry
	18.2. Credit Derivatives
		18.2.1. Asset Swaps
		18.2.2. Credit Default Swaps
		18.2.3. CDS Spreads with Counterparty Credit Risk
	Snapshot 18.1 
		The Newton‒Raphson Method
	18.3. Securitization
		18.3.1. Structure and Participants
		18.3.2. Collateralized Debt Obligations
		18.3.3. Advantages and Disadvantages
	Summary
	Bibliography
	Exercises
		Questions
	Appendix: A Model of SPVs
Chapter 19: Hedging Techniques
	19.1. Market Risk Hedging
		19.1.1. Delta Hedging
		19.1.2. Gamma and Vega Hedging
		19.1.3. The Cost of Hedging
	19.2. Credit Risk Hedging
		19.2.1. Modeling Exposure
		19.2.2. Credit Value Adjustment
		19.2.3. Monte Carlo Methods
	19.3 Advanced IRR Hedging
		19.3.1. M-Absolute and M-squared Models
		19.3.2. Duration Vectors
		19.3.3. Hedging with Fixed Income Derivatives
	Snapshot 19.1
		Convexity Adjustment for Interest Rate Derivatives
	Summary
	Bibliography
	Exercises
		Questions
		Problems
Chapter 20: Advanced Topics
	20.1. VaR Advances
		20.1.1. Modified Delta-VaR
		20.1.2. Historical Simulation Revisited
		20.1.3. Modified MC and Scenario Analysis
	20.2. Alternative Risk Transfer
		20.2.1. The ART Market
		20.2.2. Primary Contracts
		20.2.3. Insurance Derivatives
	Summary
	Bibliography
	Exercises
		Questions
Chapter 21: Digital Finance and Risk
	21.1. The Fintech Revolution
		21.1.1. Introduction
		21.1.2. The Role of Big Data
		21.1.3. Fintech and Risk Management
	21.2. Derivatives on Bitcoin
		21.2.1. Hedging Techniques
		21.2.2. The Impact on Markets and Investments
	Summary
	Bibliography
Chapter 22: The Future of Financial Risk Management
	22.1. The Role of Corporate Governance
		22.1.1. Management Failures
		22.1.2. Remuneration and Incentive Systems
		22.1.3. Postcrisis Perspectives
	22.2. The Banking Sector
		22.2.1. Bank Risk and Business Models
		22.2.2. Risk Management Systems
		22.2.3. Areas of Future Improvements
	22.3. Challenges for Research
		22.3.1. Interbank Risk
		22.3.2. Energy Derivatives
		22.3.3. Sovereign Risk Dynamics
	Summary
	Bibliography
	Exercises
		Questions
Index