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Financial Risk Management: Models, History, and Institutions


Praise for Financial Risk Management

"The need for sensible and realistic risk management becomes more obvious daily, and achieving it requires familiarity with both quantitative economic models and regulatory policy. Allan Malz's wide experience on Wall Street and at the Fed provides him with the perfect background for writing this important and uniquely comprehensive book."
Emanuel Derman, Professor of Professional Practice, Columbia University's Industrial Engineering and Operations Research Department; author of My Life as a Quant: Reflections on Physics and Finance

"Finance is all about risk and reward. Investors are pretty good at measuring reward—at least after the fact—but many, including more than a few of the most 'sophisticated' are not very good at assessing risk before the fact, which is when of course it matters! There is a better way. Allan Malz provides the road map that investors need to understand the risks they take with the investment decisions they make. Malz has a unique perspective: as an academic, a central banker, and a risk manager—he has been there and done that. His book should be required reading for investors and practitioners alike."
Richard Clarida, C. Lowell Harriss Professor of Economics, Columbia University

"It is almost cliché now to point out that the practice of risk management is as much art as it is science. For those new to the field, however, while there are excellent guides to the science and models of risk, there are none that connect the models to the markets, the economy, the banking system, and the history of all of these. Allan Malz's new book does this, providing a perspective that is critical to managing risk in the post-financial crisis world."
Christopher Finger, Executive Director, MSCI Inc.

"Allan Malz has done a wonderful job of surveying the challenges that face those who labor in the vineyard of financial risk management. He brings a wealth of experience and insight to this work. The first chapter, which tackles the history of financial market innovation and risks, is a tour de force and may well be worth the price of the book itself."
Galen Burghardt, Director of Research, Newedge USA; coauthor of Managed Futures for Institutional Investors: Analysis and Portfolio Construction

"This book provides a wealth of information on the theory and practice of risk management. In clearly written chapters, Malz progresses from simple asset pricing theory to complex derivatives including credit derivatives and CDO tranches. Institutional and historical description is rich and plentiful with a broad discussion of the financial crisis and new regulatory issues."
Robert Engle, 2003 Nobel Laureate in Economics and Michael Armellino Professor of Finance, Stern School of Business, New York University

ALLAN M. MALZ is a Senior Analytical Advisor in the Markets Group at the Federal Reserve Bank of New York, where he has also worked on implementation of the Fed's emergency liquidity programs to address the financial crisis. Before rejoining the Fed, he was chief risk officer at several multi-strategy hedge fund management firms. Previously, Malz was head of research at RiskMetrics Group, which he joined on its spinoff from J.P. Morgan. Malz spent his earlier career at the New York Fed as a researcher and foreign exchange trader. His research, which includes forecasting financial crises, risk measurement for options, and estimation of risk-neutral probability distributions, has been published in a number of industry and academic journals. Malz holds a PhD in economics from Columbia University, where he also teaches a graduate course in financial risk management.
List of Figures xvii

Preface xxi

CHAPTER 1: Financial Risk in a Crisis-Prone World 1

1.1 Some History: Why Is Risk a Separate Discipline Today? 1

1.2 The Scope of Financial Risk 34

CHAPTER 2: Market Risk Basics 43

2.1 Arithmetic, Geometric, and Logarithmic Security Returns 44

2.2 Risk and Securities Prices: The Standard Asset Pricing Model 49

2.3 The Standard Asset Distribution Model 63

2.4 Portfolio Risk in the Standard Model 75

2.5 Benchmark Interest Rates 88

CHAPTER 3: Value-at-Risk 93

3.1 Definition of Value-at-Risk 94

3.2 Volatility Estimation 99

3.3 Modes of Computation 108

3.4 Short Positions 113

3.5 Expected Shortfall 114

CHAPTER 4: Nonlinear Risks and the Treatment of Bonds and Options 119

4.1 Nonlinear Risk Measurement and Options 121

4.2 Yield Curve Risk 136

4.3 VaR for Default-Free Fixed Income Securities Using The Duration and Convexity Mapping 148

CHAPTER 5: Portfolio VaR for Market Risk 159

5.1 The Covariance and Correlation Matrices 160

5.2 Mapping and Treatment of Bonds and Options 162

5.3 Delta-Normal VaR 163

5.4 Portfolio VAR via Monte Carlo simulation 174

5.5 Option Vega Risk 175

CHAPTER 6: Credit and Counterparty Risk 191

6.1 Defining Credit Risk 192

6.2 Credit-Risky Securities 193

6.3 Transaction Cost Problems in Credit Contracts 196

6.4 Default and Recovery: Analytic Concepts 199

6.5 Assessing creditworthiness 204

6.6 Counterparty Risk 207

6.7 The Merton Model 213

6.8 Credit Factor Models 222

6.9 Credit Risk Measures 226

CHAPTER 7: Spread Risk and Default Intensity Models 231

7.1 Credit Spreads 231

7.2 Default Curve Analytics 235

7.3 Risk-Neutral Estimates of Default Probabilities 241

7.4 Spread Risk 261

CHAPTER 8: Portfolio Credit Risk 265

8.1 Default Correlation 266

8.2 Credit Portfolio Risk Measurement 270

8.3 Default Distributions and Credit VaR with the Single-Factor Model 275

8.4 Using Simulation and Copulas to Estimate Portfolio Credit Risk 284

CHAPTER 9: Structured Credit Risk 297

9.1 Structured Credit Basics 297

9.2 Credit Scenario Analysis of a Securitization 309

9.3 Measuring Structured Credit Risk via Simulation 318

9.4 Standard Tranches and Implied Credit Correlation 337

9.5 Issuer and Investor Motivations for Structured Credit 342

CHAPTER 10: Alternatives to the Standard Market Risk Model 349

10.1 Real-World Asset Price Behavior 349

10.2 Alternative Modeling Approaches 363

10.3 The Evidence on Non-Normality in Derivatives Prices 372

CHAPTER 11: Assessing the Quality of Risk Measures 393

11.1 Model Risk 393

11.2 Backtesting of VaR 407

11.3 Coherence of VaR Estimates 414

CHAPTER 12: Liquidity and Leverage 421

12.1 Funding Liquidity Risk 422

12.2 Markets for Collateral 437

12.3 Leverage and Forms of Credit in Contemporary Finance 448

12.4 Transactions Liquidity Risk 461

12.5 Liquidity Risk Measurement 464

12.6 Liquidity and Systemic Risk 469

CHAPTER 13: Risk Control and Mitigation 477

13.1 Defining Risk Capital 478

13.2 Risk Contributions 480

13.3 Stress Testing 499

13.4 Sizing Positions 506

13.5 Risk Reporting 509

13.6 Hedging and Basis Risk 512

CHAPTER 14: Financial Crises 517

14.1 Panics, Runs, and Crashes 519

14.2 Self-Reinforcing Mechanisms 539

14.3 Behavior of Asset Prices During Crises 548

14.4 Causes of Financial Crises 562

14.5 Anticipating Financial Crises 583

CHAPTER 15: Financial Regulation 597

15.1 Scope and Structure of Regulation 598

15.2 Methods of Regulation 605

15.3 Public Policy Toward Financial Crises 621

15.4 Pitfalls in Regulation 635

APPENDIX A: Technical Notes 653

A.1 Binomial Distribution 653

A.2 Quantiles and Quantile Transformations 654

A.3 Normal and Lognormal Distributions 656

A.4 Hypothesis Testing 661

A.5 Monte Carlo Simulation 662

A.6 Homogeneous Functions 664

Further Reading 666

APPENDIX B: Abbreviations 667

APPENDIX C: References 671

Index 701