Hedging Market Exposures: Identifying and Managing Market Risks

Praise for Hedging Market Exposures:Identifying and Managing Market Risks

"This timely book draws on the lessons of the recent financial crisis to provide a comprehensive survey of the vast array of overt and, most importantly, hidden hazards that face investors and managers. The authors, who combine extensive industry experience with academic thoroughness, offer a practical guide on how to prepare for market turbulence by following the often challenging steps of identifying, quantifying, and, most crucially, managing risks. An indispensable read for all market participants." Frank J. Fabozzi, Professor in the Practice of Finance, Yale School of Management, and Editor, Journal of Portfolio Management

"An essential addition to every asset manager′s library, this book is an apt reminder that investment management means, above all, managing risks. The authors make this task easier by introducing a number of innovative techniques that extend and complement existing methods." Jolanta Wysocka, CEO, Mountain Pacific Group, LLC

"This is a valuable resource for seasoned professionals and beginners alike. Methodical yet accessible, it is written by authors with broad experience in hedging various financial exposures, offering a refreshingly original perspective on handling risk and the role and use of hedging techniques. They guide the reader from identifying the major sources of risks in capital markets to a detailed explanation of the quantitative tools necessary to measure those risks, to demonstrating the practical trade–offs of actual hands–on market exposure management." Rudi Schadt, PhD, Senior Portfolio Risk Analyst, Invesco Ltd.

"This book, by two veterans of the financial crisis, puts the reader on a fast track to understanding risk management and hedging in modern financial markets. It presents a comprehensive catalog of investment risks and a practitioner′s perspective on the whys and hows of hedging those risks. The authors elucidate how the interplay of markets, regulation, financial practice, and human behavior impact the hedging decision, and enliven the discussion with examples from past risk management debacles. This is an enjoyable book and can be effective either as an introduction or as an overview." Colm O′Cinneide, Head of Portfolio Construction, QS Investors, LLC, New York

Preface ix

Introduction xi

About the Authors xvii

CHAPTER 1
The Economic Environment 1

1.1 Introduction 1

1.2 Inflation and Unemployment 5

1.3 Central Banks and the Money Supply 6

1.4 The Business Cycle 9

1.5 Predicting the Future? 11

1.6 Economic Indicators 11

CHAPTER 2
Risk: An Introduction 17

2.1 What Is Risk? 17

2.2 Risks of Financial Instruments 19

2.3 Operational Risk 43

2.4 What Risks Are in Your Portfolio? Hidden Hazards 44

2.5 Hedging Market Risks 47

CHAPTER 3
Asset Modeling 51

3.1 Asset Value 51

3.2 Financial Models 55

3.3 Valuation Principles 70

3.4 Discount Rates Selection 74

3.5 Cash Flow Projection and Asset Valuation 80

3.6 Stochastic Asset Valuation 82

3.7 The Monte Carlo Method 88

3.8 Stochastic Extrapolation 100

CHAPTER 4
Market Exposures and Factor Sensitivities 103

4.1 From Valuation to Responses and Sensitivities 103

4.2 Response Matrix and Scenario Grid 105

4.3 Stress–Testing 109

4.4 Sensitivities 110

4.5 Interest Rate Sensitivities: Duration, PV01, Convexity, Key Rate Measures 126

4.6 Numerical Evaluation of Sensitivities 137

4.7 Performance Attribution and Completeness Test 139

CHAPTER 5
Quantifying Portfolio Risks 145

5.1 The Nature of Risk 145

5.2 Standard Risk Measures 149

5.3 Optimal Hedge Sizing 160

5.4 Tail–Risk Measures 162

CHAPTER 6
The Decision to Hedge 171

6.1 To Hedge or Not to Hedge? 171

6.2 The Hedging Process 178

CHAPTER 7
Constructing a Hedge 193

7.1 An Ideal Hedge 193

7.2 A Sample Hedge 194

7.3 Static and Dynamic Hedging 200

7.4 Proxy Hedging 205

7.5 Protection versus Upside 208

7.6 Basis Risk 211

7.7 Unintended Consequences 213

7.8 Hedging Credit Risk 214

7.9 Hedging Prepayment, Redemption, and Other Human Behavior Risks 221

7.10 Execution 223

APPENDIX A

Basics of Probability Theory 227

APPENDIX B

Elements of Statistics and Time Series Analysis 247

References 255

Glossary 259

Index 281

OLEG V. BYCHUK has eleven years of capital markets experience. This includes roles as head of Risk Management at Julius Baer Investment Management and head of Risk Management and Quantitative Research at Alternative Asset Managers. He has also held various positions at Citigroup Global Markets, OppenheimerFunds, and Deutsche Bank. Dr. Bychuk holds degrees from Columbia University (PhD) and Lomonosov Moscow State University and has published numerous articles.

BRIAN J. HAUGHEY is an Assistant Professor of Finance and Director of the Investment Center at Marist College. Previously, he headed the Mutual Fund Fee business in the Global Special Situations Group at Citigroup Global Markets. Prior to joining Citigroup, he was with Fitch Ratings.