Every industry experiences strategic inflection points which offer promises as well as threats. The crisis of 2007-2009 was one of strategic inflection for the banking industry, and a significant part of the danger came from the fact that risk pricing was found desperately wanting. The flaws in the existing risk pricing system were exposed, but this could also be the starting point of a new, innovative and more accurate risk regime - indeed, if the global economy is to recover with any long-term strength, it must be.
Deconstructing the failures of the past, and introducing some of the best techniques and disciplines for the future, 'Risk Pricing' is an essential guide to how the financial world got risk so badly wrong - and how it might avoid doing so again.
Bringing much needed sunlight on the workings of modern financial risk, and the inadequacies of past attempts to price it, amongst numerous topics the author covers are:
- Why the response of governments to the 2007-2009 crisis was seriously flawed
- How risk complexity makes pricing in the 21st century particularly difficult, and what can be done about it
- The application of Feynman diagrams in risk management
- Why the top methodology of physicists - quantum electrodynamics (QED) - offer a potential solution with the qualities and capacity necessary for this complex task
This is a book about managing risk through the correct pricing of exposure embedded in financial products. A high level risk control plan is necessary because, in many banks and other financial institutions, even CEOs and senior managers have often lacked the timely and detailed information they require to watch over exposures building up in warehoused positions. Regulators, too, have struggled to monitor risk, which means there is no time to lose in implementing a better risk pricing method. Another global economic crisis could take place if changes are not made.
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Acknowledgements
Introduction
Prologue: Physics, Quantum Theory, QED, QCD and Risk
1. Theories in physics
2. The forces of nature
3. Quantum electrodynamics
4. Space-time
5. Entropy
Part One: Risks of the 21st Century
Chapter 1: Risk in Finance
1. Risk defined
2. Effects of volatility
3. The risk's long tail
4. Risk and quantum logic
5. The complexity of modern risks
6. Risk appetite
7. Black swans
Appendix: VIX, the measurement of volatility
Chapter 2: Virtual Economy and Risk Management
1. Real and virtual economy
2. Market liquidity and funding liquidity
3. CDOs, CDSs and systemic risk
4. Structured finance is different to classical banking
5. Advanced statistical methods and tolerances in the
virtual economy 81
6. A bird's-eye view of charts for quality assurance and risk control
7. Know yourself and your institution
Appendix: derivative financial instruments 96
Chapter 3: Product Pricing in the Virtual Economy
1. Why the old pricing theory does not apply
2. Price discovery through credit spreads
3. Discounted cash flow and intrinsic value
4. Price discovery through auctions
5. PPIP: example of an imperfect auction
6. From marking to market, to marking to myth
7. Conflicts of interest in opposing marking to market
Part Two: Using Quantum Electrodynamics for Risk Control
Chapter 4: Not Everything that Counts Gets Counted
1. Basel Committee's proposed revision of the 1996 Market Risk Amendment
2. Underrating risk is bad management
3. Lessons from the credit and banking crisis can help in risk control
4. Incremental risk charge and stress tests
5. The contribution of scenarios to realistic estimates of exposure
6. The scenarios' flexibility
7. The Delphi method
8. Refining judgmental opinions through Delphi
Appendix: why the value at risk model is irrelevant
Chapter 5: Applying Feynman Diagrams in Risk Management
1. The probability of an event
2. Feynman diagrams
3. A broad field of QED implementation
4. Are we planning for failure?
5. Promoting contrarian opinion
6. Quantum electrodynamics and compound events
7. A space-time graph
8. The risk control structure beyond QED
9. Risk fever blues
Appendix: vectors, linear vector spaces and polygons
Part Three: Three Themes for Quantum Chromodynamics
Chapter 6: Legal Risk and Ponzi Risk
1. Using quantum electrodynamics for legal risk
2. Legal risk is a disruptive force
3. Shareholder lawsuits at Bank of America
4. The twilight between legal and illegal practices
5. Transborder legal risk
6. Creative accounting distorts risk pricing
7. Legal risk, political risk and fraudulent conveyance
Chapter 7: Overleveraging Risk
1. Leverage defined
2. The aftermath of gearing is entropy
3. Leveraging with financial instruments
4. The fate of leveraged persons, companies and states
5. Exercising due diligence in leverage
6. Leverage, solvency, liquidity and transparency
7. Cash flow management
8. Deleveraging
Appendix: the basic notion of entropy
Chapter 8: Risk of Poor Supervision
1. The hypotheses regulators have to make
2. Capital inadequacy is condoned by regulators
3. Basel II should undergo a major overhaul
4. Stress tests of default risks
5. The 2009 stress tests mandated by the US Treasury
6. Bad banks, bad assets and the experience of China's AMCs
7. Assessment of toxic after-effects in central banks' vaults
8. Thinking out of the box, when confronted with insolvent banks
Conclusion
Bibliography
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