Financial Risk Management: A Practitioners Guide to Managing Market and Credit Risk

Advance Praise for Financial Risk Management, Second Edition

"Steve Allen′s revised book is an excellent read for both seasoned risk professionals and students. He has done a wonderful job of making a complex topic understandable. His chapters on financial crises should be a must–read for everyone in the profession as ′those who don′t learn from history are forced to repeat it.′"
Leslie Rahl, CEO and Managing Partner, Capital Market Risk Advisors

Praise for the First Edition

"A very practical and deep approach to the problems of financial risk management."
Nassim Nicholas Taleb, Distinguished Professor of Risk Engineering, New York University′s Polytechnic Institute, and??author of The Black Swan and Antifragile

"Key material on how risks can be isolated, quantified, and managed from a top risk management practitioner."
John Hull, Maple Financial Chair in Derivatives and Risk Management, and Director, Bonham Centre for Finance, University of Toronto

"Allen′s book is a treasure–trove of material and an invaluable resource for any professional seeking to understand modern risk management. It begins with basic concepts and builds carefully to the practical and theoretical ideas necessary for dealing with the complexities of the most sophisticated and relevant financial instruments today."
Neil Chriss, Managing Principal, Hutchin Hill Capital, and author of Black–Scholes and Beyond

The Second Edition of Financial Risk Management + Website puts an emphasis on practical application. To that end, this book provides readers with exclusive access to a companion website filled with supplementary materials,??allowing you to continue to learn in a hands–on fashion long after closing the book.

Foreword xvii

Preface xix

Acknowledgments xxiii

About the Author xxvii

CHAPTER 1 Introduction 1

1.1 Lessons from a Crisis 1

1.2 Financial Risk and Actuarial Risk 2

1.3 Simulation and Subjective Judgment 4

CHAPTER 2 Institutional Background 7

2.1 Moral Hazard Insiders and Outsiders 7

2.2 Ponzi Schemes 17

2.3 Adverse Selection 19

2.4 The Winner s Curse 21

2.5 Market Making versus Position Taking 24

CHAPTER 3 Operational Risk 29

3.1 Operations Risk 31

3.2 Legal Risk 37

3.3 Reputational Risk 41

3.4 Accounting Risk 42

3.5 Funding Liquidity Risk 42

3.6 Enterprise Risk 44

3.7 Identification of Risks 44

3.8 Operational Risk Capital 45

CHAPTER 4 Financial Disasters 49

4.1 Disasters Due to Misleading Reporting 49

4.2 Disasters Due to Large Market Moves 68

4.3 Disasters Due to the Conduct of Customer Business 77

CHAPTER 5 The Systemic Disaster of 2007 2008 83

5.1 Overview 83

5.2 The Crisis in CDOs of Subprime Mortgages 85

5.3 The Spread of the Crisis 108

5.4 Lessons from the Crisis for Risk Managers 111

5.5 Lessons from the Crisis for Regulators 115

5.6 Broader Lessons from the Crisis 132

CHAPTER 6 Managing Financial Risk 133

6.1 Risk Measurement 133

6.2 Risk Control 161

CHAPTER 7 VaR and Stress Testing 169

7.1 VaR Methodology 170

7.2 Stress Testing 192

7.3 Uses of Overall Measures of Firm Position Risk 201

CHAPTER 8 Model Risk 209

8.1 How Important Is Model Risk? 210

8.2 Model Risk Evaluation and Control 212

8.3 Liquid Instruments 237

8.4 Illiquid Instruments 241

8.5 Trading Models 250

CHAPTER 9 Managing Spot Risk 253

9.1 Overview 253

9.2 Foreign Exchange Spot Risk 257

9.3 Equity Spot Risk 258

9.4 Physical Commodities Spot Risk 259

CHAPTER 10 Managing Forward Risk 263

10.1 Instruments 270

10.2 Mathematical Models of Forward Risks 282

10.3 Factors Impacting Borrowing Costs 299

10.4 Risk Management Reporting and Limits for

Forward Risk 304

CHAPTER 11 Managing Vanilla Options Risk 311

11.1 Overview of Options Risk Management 313

11.2 The Path Dependence of Dynamic Hedging 318

11.3 A Simulation of Dynamic Hedging 321

11.4 Risk Reporting and Limits 329

11.5 Delta Hedging 344

11.6 Building a Volatility Surface 346

11.7 Summary 355

CHAPTER 12 Managing Exotic Options Risk 359

12.1 Single Payout Options 364

12.2 Time Dependent Options 378

12.3 Path Dependent Options 381

12.4 Correlation Dependent Options 404

12.5 Correlation Dependent Interest Rate Options 425

CHAPTER 13 Credit Risk 445

13.1 Short Term Exposure to Changes in Market Prices 446

13.2 Modeling Single Name Credit Risk 457

13.3 Portfolio Credit Risk 479

13.4 Risk Management of Multiname Credit Derivatives 493

CHAPTER 14 Counterparty Credit Risk 505

14.1 Overview 505

14.2 Exchange Traded Derivatives 506

14.3 Over the Counter Derivatives 512

References 533

About the Companion Website 547

Index 553

STEVEN ALLEN is a risk management consultant, specializing in risk measurement and valuation with a particular emphasis on illiquid and hard–to–value assets. Until his retirement in 2004, he was Managing Director in charge of risk methodology at JPMorgan Chase, where he was responsible for model validation, risk capital allocation, and the development of new measures of valuation, reserves, and risk for both market and credit risk. Previously, he was in charge of market risk for derivative products at Chase. He has been a key architect of Chase′s value–at–risk and stress testing systems. Prior to his work in risk management, Allen was the head of analysis and model building for all Chase trading activities for over ten years. Since 1998, Allen has been associated with the Mathematics in Finance Master′s Program at New York University′s Courant Institute of Mathematical Sciences. In this program, he has served as Clinical Associate Professor and Deputy Director and has created and taught courses in risk management, derivatives mathematics, and interest rate and credit models. He was a member of the board of directors of the International Association of Financial Engineers and continues to serve as co–chair of their Education Committee.