Financial risk has become a focus of financial and nonfinancial firms, individuals, and policy makers. But the study of risk remains a relatively new discipline in finance and continues to be refined. The financial market crisis that began in 2007 has highlighted the challenges of managing financial risk. Now, in Financial Risk Management, author Allan Malz addresses the essential issues surrounding this discipline, sharing his extensive career experiences as a risk researcher, risk manager, and central banker. The book includes standard risk measurement models as well as alternative models that address options, structured credit risks, and the real-world complexities or risk modeling, and provides the institutional and historical background on financial innovation, liquidity, leverage, and financial crises that is crucial to practitioners and students of finance for understanding the world today. Financial Risk Management is equally suitable for firm risk managers, economists, and policy makers seeking grounding in the subject. This timely guide skillfully surveys the landscape of financial risk and the financial developments of recent decades that culminated in the crisis. The book provides a comprehensive overview of the different types of financial risk we face, as well as the techniques used to measure and manage them. Topics covered include:* Market risk, from Value-at-Risk (VaR) to risk models for options* Credit risk, from portfolio credit risk to structured credit products* Model risk and validation* Risk capital and stress testing* Liquidity risk, leverage, systemic risk, and the forms they take* Financial crises, historical and current, their causes and characteristics* Financial regulation and its evolution in the wake of the global crisis* And much more Combining the more model-oriented approach of risk management-as it has evolved over the past two decades-with an economist's approach to the same issues, Financial Risk Management is the essential guide to the subject for today's complex world.
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
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