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Financial Risk Management: Applications in Market, Credit, Asset and Liability Management and Firmwide Risk


A global banking risk management guide geared toward the practitioner

Financial Risk Management presents an in-depth look at banking risk on a global scale, including comprehensive examination of the U.S. Comprehensive Capital Analysis and Review, and the European Banking Authority stress tests. Written by the leaders of global banking risk products and management at SAS, this book provides the most up-to-date information and expert insight into real risk management. The discussion begins with an overview of methods for computing and managing a variety of risk, then moves into a review of the economic foundation of modern risk management and the growing importance of model risk management. Market risk, portfolio credit risk, counterparty credit risk, liquidity risk, profitability analysis, stress testing, and others are dissected and examined, arming you with the strategies you need to construct a robust risk management system. The book takes readers through a journey from basic market risk analysis to major recent advances in all financial risk disciplines seen in the banking industry. The quantitative methodologies are developed with ample business case discussions and examples illustrating how they are used in practice. Chapters devoted to firmwide risk and stress testing cross reference the different methodologies developed for the specific risk areas and explain how they work together at firmwide level. Since risk regulations have driven a lot of the recent practices, the book also relates to the current global regulations in the financial risk areas.

Risk management is one of the fastest growing segments of the banking industry, fueled by banks' fundamental intermediary role in the global economy and the industry's profit-driven increase in risk-seeking behavior. This book is the product of the authors' experience in developing and implementing risk analytics in banks around the globe, giving you a comprehensive, quantitative-oriented risk management guide specifically for the practitioner.

  • Compute and manage market, credit, asset, and liability risk
  • Perform macroeconomic stress testing and act on the results
  • Get up to date on regulatory practices and model risk management
  • Examine the structure and construction of financial risk systems
  • Delve into funds transfer pricing, profitability analysis, and more

Quantitative capability is increasing with lightning speed, both methodologically and technologically. Risk professionals must keep pace with the changes, and exploit every tool at their disposal. Financial Risk Management is the practitioner's guide to anticipating, mitigating, and preventing risk in the modern banking industry.

Preface i

Acknowledgements vii

1 Introduction 1

1.1 Banks and Risk Management 1

1.2 Evolution of Bank Capital Regulation 4

1.3 Creating Value from Risk Management 9

1.4 Financial Risk Systems 11

1.5 Model Risk Management 18

I Market Risk 23

2 Market Risk with the Normal Distribution 25

2.1 Linear Portfolios 26

2.2 Quadratic Portfolios 47

2.3 Simulation Based Valuation 58

3 Advanced Market Risk Analysis 81

3.1 Risk Measures, Risk Contributions and Risk Information 82

3.2 Modeling the Stylized Facts of Financial Time Series 104

3.3 Scaling VaR and VaR with Trading 143

3.4 Market Liquidity Risk 146

3.5 Scenario Analysis and Stress Testing 152

3.6 Portfolio Optimization 166

3.7 Developments in the Market Risk Internal Models Capital Regulation 175

II Credit Risk 179

4 Portfolio Credit Risk 181

4.1 Issuer Credit Risk in Wholesale Exposures and Trading Book 184

4.2 Credit Models for the Banking Book 247

4.3 Firmwide Portfolio Credit Risk and Credit Risk Dependence 307

4.4 Credit Risk Stress Testing 310

4.5 Features of New Generation Portfolio Credit Risk Models 320

4.6 Hedging Credit Risk 326

4.7 Regulatory Capital for Credit Risk 336

5 Counterparty Credit Risk 345

5.1 Counterparty Pricing and Exposure 347

5.2 CVA Risks 397

5.3 Portfolios of Derivatives 398

5.4 A Note on Recent Counterparty Credit Risk Developments 409

5.5 Counterparty Credit Risk Regulation 411

III Asset and Liability Management 417

6 Liquidity Risk Management 419

6.2 Liquidity Exposure 431

6.3 Hedging the Liquidity Exposure 446

6.4 Structural Liquidity Planning 460

6.5 Components of the Liquidity Hedging Program 468

6.6 Cash Liquidity Risk and Liquidity Risk Measures 468

6.6.3 Allocating Cash Liquidity Risk 471

6.7 Regulation for Liquidity Risk 474

7 Funds Transfer Pricing and Profitability of Cash Flows 481

7.1 Basic Funds Transfer Pricing Concept 484

7.2 Risk Based Funds Transfer Pricing 485

7.3 Funds Transfer Rate and Risk Adjusted Returns 500

7.4 Profitability Measures and Decompositions 501

7.5 Banking Book Fair Value with Funds Transfer Rates 504

7.6 A Note on the Scope of Funds Transfer Pricing 505

7.7 Regulation and Profitability Analysis 506

IV Firmwide Risk 509

8 Firmwide Risk Aggregation 511

8.1 Correlated Aggregation and Firmwide Risk Levels 512

8.2 Capital Allocation in Risk Aggregation 519

8.3 Risk Aggregation and Regulation 521

9 Firmwide Scenario Analysis and Stress Testing 525

9.1 Firmwide Scenario Model Approaches 527

9.2 Firmwide Risk Capital Measures 530

9.3 Regulatory Stress Scenario Approach 535

9.4 The Future of Firmwide Stress Testing 542

References 545