Understanding Risk: The Theory and Practice of Financial Risk Management

Understanding Risk: The Theory and Practice of Financial Risk Management......Page 2
Contents......Page 8
Introduction......Page 16
REFERENCES, QUESTIONS AND DIALOGUES......Page 17
ACKNOWLEDGMENTS......Page 18
Part I: Risk Management and the Behaviour of Products......Page 19
1.1.1 Introducing the Markets......Page 20
1.1.1.2 Market prices......Page 21
1.1.2 Securities......Page 22
1.1.2.3 Ratings agencies......Page 23
1.1.3.1 Foreign exchange......Page 24
1.1.3.3 Physical versus OTC markets......Page 25
1.1.4 Equity Markets......Page 26
1.1.4.3 U.S. stock markets......Page 27
1.1.4.5 Stock market indices......Page 28
1.1.5.1 Debt securities......Page 29
1.1.5.4 Interest conventions......Page 30
1.1.5.5 Deriving curves......Page 31
1.1.5.9 Price and yield......Page 32
1.1.5.10 Bonds on the curve......Page 33
1.1.5.13 Money market instruments......Page 34
1.1.5.15 Treasury notes and bonds......Page 35
1.1.5.17 Corporate bonds......Page 36
1.1.5.20 Asset-backed securities......Page 37
1.1.6.1 Characteristics of the spot FX market......Page 38
1.1.7 Derivatives Markets......Page 39
1.1.7.1 Organised, standardised markets......Page 40
1.1.7.2 Example......Page 41
1.1.8 Principal Investment and Private Equity......Page 42
1.1.8.2 Private equity terminology......Page 43
1.1.9 (A Short Section on) Commodities Markets......Page 44
1.2 TRADING AND MARKET BEHAVIOUR......Page 45
1.2.2 The Anatomy of a Market Crisis......Page 46
1.2.3 Current and Past Markets......Page 49
1.3.1 Types of Risk......Page 56
1.3.2 The Aims of Risk Management......Page 63
1.3.4 Daily Risk Controls: P/L, Limits and P/L Explanation......Page 64
1.3.5 What Do You Own? The Deal Review Process......Page 67
1.3.6 Trader Mandates......Page 68
1.4.1 Risk Management in the Broader Institution......Page 69
1.4.2 Cultural Issues......Page 71
1.4.3 A Taxonomy of Financial Institutions......Page 73
1.4.4 Some Large Losses in the Wholesale Markets......Page 78
1.5 SOME EXTERNAL CONSTRAINTS......Page 80
1.5.1 Regulation......Page 81
1.5.2 Accounting......Page 85
1.5.3 Marking to Fair Value......Page 91
1.5.4 Special Purpose Vehicles and Consolidation......Page 93
2.1.1 Asset Returns and Risk Factors......Page 96
2.1.2 Risk Factor Selection......Page 97
2.1.3 Risk Reporting with a Single Risk Factor......Page 98
2.1.4 Forwards and Arbitrage......Page 101
2.1.5 Models of Market R......Page 105
2.1.6 Risk Reporting in a Return Model......Page 108
2.1.7 Introducing Options......Page 110
2.1.8 The Greeks......Page 112
2.1.9 Options Risk Reporting......Page 114
2.2 PORTFOLIOS AND RISK AGGREGATION......Page 116
2.2.1 The Varieties of Trading Portfolio and Their Management......Page 117
2.2.2 Diversifi cation and Correlation......Page 119
2.2.3 Reporting and Risk in a Return Model: Multiple Factors......Page 122
2.2.4 Scenario Analysis......Page 124
2.2.5 Stress Testing......Page 125
2.3.1 Overview of the Theory of Options Pricing:Black–Scholes and the Replicating Portfolio......Page 129
2.3.2 Implied Volatility and Hedging......Page 133
2.3.3 Retail Equity-Linked Products: Some Simple Structures and Their Problems......Page 138
2.3.4 A Little More about Exotic Options......Page 140
2.3.5 Local and Stochastic Volatility......Page 143
2.4 INTEREST RATE DERIVATIVES AND YIELD CURVE MODELS......Page 146
2.4.1 Futures and Forwards on Interest Rates......Page 147
2.4.2 Interest Rate and Asset Swaps......Page 148
2.4.3 Credit Risk in Swap Structures......Page 152
2.4.4 Other Interest Rate Swap Structures......Page 153
2.4.6 Basis Swaps......Page 154
2.4.7 Caps, Floors and Yield Curve Models......Page 156
2.4.8 Swaptions......Page 159
2.4.9 Exotic Interest Rate Derivatives......Page 160
2.5.1 Products......Page 163
2.5.2 Credit Events and Documentation......Page 164
2.5.3 Credit Derivatives Valuation......Page 168
2.5.4 Risk Reporting for Credit Derivatives......Page 169
2.6.1 Mark-to-Market and Mark-to-Model......Page 170
2.6.2 Marking and Model Risk......Page 171
2.6.3 Hedging, P/L and Mark Adjustments......Page 174
Part II: Economic and Regulatory Capital Models......Page 178
3.1.1 What Is Capital for?......Page 179
3.1.2 Earnings Volatility and Capital......Page 180
3.1.3 The Optimisation Problem......Page 181
3.2 CAPITAL INSTRUMENT FEATURES......Page 183
3.2.1 Seniority and Subordination......Page 184
3.2.4 Convertibility and Write-Down......Page 185
3.2.5 Example Capital Securities......Page 186
3.3.1 The Tiers of Basel Capital......Page 187
3.3.3 Consolidated Capital......Page 189
3.3.4 Capital Management: Issues and Strategies......Page 190
4.1.1 Value at Risk Techniques I: Variance/Covariance......Page 193
4.1.2 Value at Risk Techniques II: Revaluation and Historical Simulation......Page 198
4.1.3 Value at Risk Techniques III: Monte Carlo Approaches......Page 200
4.1.5 Backtesting, VAR Exceptions and the VAR Hypothesis......Page 202
4.2.1 Specifi c Risk......Page 204
4.2.2 Volatility and Correlation Instabilities......Page 205
4.2.3 The Holding Period Assumption......Page 206
4.2.4 What Is the VAR Good for?......Page 208
4.3.1 Effective Risk Reporting......Page 209
4.3.2 Market Data......Page 212
5.1.1 Retail Banking......Page 217
5.1.2 Commercial Banking......Page 219
5.2 CREDIT RISK FOR SMALL NUMBERS OF OBLIGATORS......Page 221
5.2.1 Single Transaction Exposure......Page 222
5.2.2 Potential Future Credit Exposure......Page 225
5.2.3 What Is a Credit Spread Compensation for?......Page 227
5.2.4 Partial Credit Mitigation......Page 228
5.2.5 Introducing Basket Credit Derivatives......Page 229
5.3.1 Funding and Loss Absorption......Page 232
5.3.2 Securitisation and Tranching......Page 233
5.3.3 Collateralised Debt Obligations......Page 236
5.3.4 Structuring and the Waterfall......Page 238
5.3.5 Index Credit Products......Page 239
5.3.6 (The Problem with) Credit Event Correlation......Page 240
5.3.7 Practical Credit-Adjusted Pricing......Page 242
5.4.1 The Portfolio Credit Risk Loss Distribution......Page 243
5.4.2 Some Models of Portfolio Credit Risk......Page 245
5.4.3 Stress Testing Credit Portfolios......Page 249
5.4.4 Active Credit Portfolio Management......Page 250
5.4.5 Credit Scoring and Internal Rating......Page 253
5.5 POLITICAL AND COUNTRY RISK......Page 256
5.5.1 Examples of Country Risk......Page 257
5.5.2 The Effect of Country Risk......Page 258
5.5.3 Measuring Country Risk......Page 259
5.5.4 Country Risk Management......Page 261
6.1 AN INTRODUCTION TO OPERATIONAL RISK......Page 263
6.1.1 Operational Risk Classes and Losses......Page 264
6.1.2 Scorecard Approaches to Operational Risk......Page 268
6.1.3 Some Issues in Operational Risk Management......Page 269
6.2 THE TAILS AND OPERATIONAL RISK MODELLING......Page 273
6.2.1 The Tails and Extreme Value Theory......Page 274
6.2.2 The Case of Long Term Capital Management......Page 275
6.2.4 Operational Risk Modelling......Page 279
6.3 ALLOCATING CAPITAL AND OTHER RISKS......Page 280
6.3.1 Capital Allocation and Portfolio Contributions......Page 281
6.3.2 Reputational and Other Risks......Page 284
6.3.3 Hedging versus Capital......Page 289
HOW DETAILED AND RISK SENSITIVE SHOULDCAPITAL REQUIREMENTS BE?......Page 291
7.1.1 Before Basel II: Basel I and the Market Risk Amendment......Page 292
7.1.2 An Overview of Basel II......Page 301
7.1.3 Basel II: Credit Risk without Mitigation......Page 303
7.1.4 Basel II: Credit Risk Mitigation in the IRB Approaches......Page 311
7.1.5 Basel II: Capital Rules for Positions That Have Been Securitised......Page 314
7.1.6 Implications of the Basel Credit Risk Framework......Page 315
7.1.7 Operational Risk in Basel II......Page 316
7.2.1 Pillar 2 in Basel II......Page 319
7.2.2 Pillar 3 and Banks’ Disclosures......Page 321
7.2.3 The Impact of Basel II......Page 322
Part III: Treasury and Liquidity Risks......Page 324
8.1 AN INTRODUCTION TO ASSET/LIABILITY MANAGEMENT......Page 325
8.1.1 The Trading Book, the Banking Book and the Treasury......Page 326
8.1.2 Accounting for an Old-Fashioned Bank......Page 328
8.1.3 Assets and Liabilities through Time......Page 330
8.1.4 What Is ALM?......Page 332
8.2.1 Transfer Pricing......Page 333
8.2.2 Interest Rate Risk in the Banking Book......Page 337
8.2.3 Non-Interest Income and Operating Expenses......Page 339
8.3.1 Risk in the Transfer Pricing Book......Page 340
8.3.2 The Market Value of Portfolio Equity......Page 342
8.3.3 Strategic Risk and Real Options......Page 344
8.3.4 ALM Risk Reporting......Page 345
8.3.5 P/L Translation and Hedging......Page 346
8.3.6 The Role of the ALCO......Page 347
8.4.1 Repo and Other Forms of Secured Funding......Page 348
8.4.2 Practical Issues in the Funding of Trading Books......Page 349
9.1 LIQUIDITY OF SECURITIES AND DEPOSITS......Page 351
9.1.1 What Is Liquidity Risk?......Page 352
9.1.2 Liability Liquidity......Page 354
9.1.3 Asset Liquidity under Ordinary Conditions......Page 355
9.2.1 Measures of Liquidity Risk and the Firm’s Liquidity Profi le......Page 359
9.2.2 Policies, Procedures and the Regulatory Perspective......Page 361
9.2.4 The Implications of Illiquidity for Pricing and Risk Measurement......Page 362
9.3.1 Positive Contingent Liquidity......Page 364
9.3.2 Conduits......Page 365
9.4 STRESSES OF LIQUIDITY......Page 367
9.4.1 Liquidity in a Crisis......Page 368
9.4.2 Liquidity Stress Testing......Page 370
9.4.3 The Liquidity Plan......Page 371
Part IV: Some Trading Businesses and Th eir Challenges......Page 373
10.1 CONTRACTUAL RELATIONS......Page 374
10.1.1 The Documentation of Derivatives and Credit Risk Mitigation......Page 375
10.1.2 Credit Derivatives in the Form of Insurance......Page 378
10.1.3 Enforceability and the Pros and Cons of Enforcement......Page 380
10.2.1 Mortgage-Backed Securities......Page 381
10.2.2 Other ABS and Pool Modelling......Page 388
10.2.3 ABS Tranche Analysis......Page 391
10.3.1 CDO, CLO and Related Structures......Page 392
10.3.2 Banking Using Securitisation......Page 395
10.3.3 ABS in Principal Finance and Whole Business Securitisation......Page 396
10.3.4 Some Revolving and Blind Securitisations......Page 400
11.1 INFLATION-LINKED PRODUCTS......Page 404
11.1.1 Infl ation Indices......Page 405
11.1.2 Infl ation-Linked Bond Design......Page 407
11.1.3 Retail Infl ation-Linked Products......Page 409
11.1.4 Lags and the Infl ation-Linked Curve......Page 410
11.1.5 Infl ation Swaps......Page 412
11.1.6 Pension Fund Risk Management......Page 414
11.2.1 Basket Options and Rainbow Products......Page 418
11.2.2 Copulas and the Problem with Gaussian Correlation......Page 420
11.3 CONVERTIBLE BONDS......Page 424
11.3.1 Convertible Bond Structures......Page 425
11.3.2 The Behaviour of Convertible Bonds......Page 426
11.3.3 Modelling Convertibles......Page 427
11.4.1 The Merton Model of Capital Structure......Page 432
11.4.2 More Sophisticated Capital Structure Models......Page 437
11.4.3 Equity/Credit Optionality and Hybrid Security Modelling......Page 438
11.4.4 Credit Copulas and Credit Event Association......Page 440
11.5.1 The New Product Approval Process......Page 442
11.5.2 Managing Product Complexity......Page 445
11.5.3 Hedge Fund Risk Management......Page 446
Concluding Remarks......Page 450
Figures......Page 453