Financial Risk Management

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1 r r Financial Risk Management A Practitioner's Guide to Managing Market and Credit Risk Second Edition STEVEN ALLEN WILEY John Wiley & Sons, Inc.

2 Contents Foreword Preface Acknowledgments About the Author CHAPTER 1 Introduction 1.1 Lessons from a Crisis 1.2 Financial Risk and Actuarial Risk 1.3 Simulation and Subjective Judgment CHAPTER Z Institutional Background 2.1 Moral Hazard Insiders and Outsiders 2.2 Ponzi Schemes 2.3 Adverse Selection 2.4 The Winner's Curse 2.5 Market Making versus Position Taking CHAPTER 8 Operational Risk 3.1 Operations Risk The Risk of Fraud The Risk of Nondeliberate Incorrect Information Disaster Risk Personnel Risk 3.2 Legal Risk The Risk of Unenforceable Contracts The Risk of Illegal Actions 3.3 Reputational Risk 3.4 Accounting Risk xvii xlx xxiii xxvii IX

3 X CONTENTS Funding Liquidity Risk Enterprise Risk Identification of Risks Operational Risk Capital CHAPTER 4 Financial Disasters 4.1 Disasters Due to Misleading Reporting Chase Manhattan Bank/Drysdale Securities Kidder Peabody Barings Bank Allied Irish Bank (AIB) Union Bank of Switzerland (UBS) Societe Generate ' Other Cases 4.2 Disasters Due to Large Market Moves Long-Term Capital Management (LTCM) Metallgesellschaft (MG) 4.3 Disasters Due to the Conduct of Customer Business Bankers Trust (BT) JPMorgan, Citigroup, and Enron Other Cases CHAPTERS The Systemic Disaster of Overview 5.2 The Crisis in CDOs of Subprime Mortgages Subprime Mortgage Originators CDO Creators Rating Agencies Investors Investment Banks Insurers 5.3 The Spread of the Crisis Credit Contagion Market Contagion 5.4 Lessons from the Crisis for Risk Managers Subprime Mortgage Originators CDO Creators Rating Agencies x Investors Investment Banks

4 Contents Xl f Insurers Credit Contagion Market Contagion Lessons from the Crisis for Regulators Mortgage Originators CDO Creators Rating Agencies Investors Investment Banks Insurers Credit Contagion Market Contagion v Broader Lessons from the Crisis 132 CHAPTER 8 Managing Financial Risk Risk Measurement General Principles Risk Management of Instruments That Lack Liquidity Market Valuation Valuation Reserves Analysis of Revenue Exposure to Changes in Market Prices Risk Measurement for Position Taking Risk Control 161 CHAPTER 7 VaR and Stress Testing VaR Methodology Simulation of the P&L Distribution Measures of the P&L Distribution Stress Testing Overview Economic Scenario Stress Tests Stress Tests Relying on Historical Data Uses of Overall Measures of Firm Position Risk 201 CHAPTER 8 Model Risk How Important Is Model Risk? Model Risk Evaluation and Control 212

5 XII CONTENTS Scope of Model Review and Control Roles and Responsibilities for Model Review f and Control Model Verification Model Verification of Deal Representation Model Verification of Approximations Model Validation Continuous Review Periodic Review Liquid Instruments Illiquid Instruments Choice of Model Validation Approach, Choice of Liquid Proxy Design of Monte Ca'rlo Simulation Implications for Marking to Market Implications for Risk Reporting Trading Models 250 CHAPTERS Managing Spot Risk Overview Foreign Exchange Spot Risk Equity Spot Risk Physical Commodities Spot Risk 259 CHAPTER 10 Managing Forward Risk Instruments Direct Borrowing and Lending Repurchase Agreements Forwards Futures Contracts Forward Rate Agreements Interest Rate Swaps Total Return Swaps Asset-Backed Securities Mathematical Models of Forward Risks Pricing Illiquid Flows by Interpolation Pricing Long-Dated Illiquid Flows by Stack and Roll * Flows Representing Promised Deliveries Indexed Flows 295

6 Contents Kill 10.3 Factors Impacting Borrowing Costs The Nature of Borrowing Demand The Possibility of Cash-and-Carry Arbitrage The Variability of Storage Costs The Seasonality of Borrowing Costs Borrowing Costs and Forward Prices Risk Management Reporting and Limits for * Forward Risk ' 304 CHAPTER 11 Managing Vanilla Options Risk Overview of Options Risk Management The Path Dependence of Dynamic Hedging A Simulation of Dynamic Hedging Risk Reporting and Limits Delta Hedging v Building a Volatility Surface Interpolating between Time Periods Interpolating between Strikes Smile and Skew Extrapolating Based on Time Period Summary 355 CHAPTER 12 Managing Exotic Options Risk Single-Payout Options Log Contracts and Variance Swaps Single-Asset Quanto Options Convexity, Binary Options Contingent Premium Options Accrual Swaps Time-Dependent Options Forward-Starting and Cliquet Options Compound Options Path-Dependent Options Standard Analytic Models for Barriers Dynamic Hedging Models for Barriers Static Hedging Models for Barriers Barrier Options with Rebates, Lookback, and Ladder Options Broader Classes of Path-Dependent Exotics Correlation-Dependent Options 404

7 XlV CONTENTS Linear Combinations of Asset Prices Risk Management of Options on Linear *, Combinations Index Options, Options to Exchange One Asset for Another Nonlinear Combinations of Asset Prices Correlation between Price and Exercise Correlation-Dependent Interest Rate Options Models in Which the Relationship between Forwards Is Treated as Constant Term Structure Models Relationship between Swaption and Cap.Prices 437 CHAPTER IS Credit Risk Short-Term Exposure to Changes in Market Prices Credit Instruments Models of Short-Term Credit Exposure Risk Reporting for Market Credit Exposures Modeling Single-Name Credit Risk Estimating Probability of Default Estimating Loss Given Default Estimating the Amount Owed at Default The Option-Theoretic Approach Portfolio Credit Risk Estimating Default Correlations Monte Carlo Simulation of Portfolio Credit Risk, Computational Alternatives to Full Simulation Risk Management and Reporting for Portfolio Credit Exposures Risk Management of Multiname Credit Derivatives Multiname Credit Derivatives Modeling of Multiname Credit Derivatives Risk Management and Reporting for Multiname Credit Derivatives CDO Tranches and Systematic Risk 500 CHAPTER 14 Counterparty Credit Risk» Overview Exchange-Traded Derivatives 506

8 Contents XV 14.3 Over-the-Counter Derivatives Overview The Loan-Equivalent Approach The Collateralization Approach The Collateralization Approach Wrong-Way Risk The Active Management Approach 526 References About the Companion Website 547 Index 553

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