Financial Risk Management: Applications in Market, Credit, Asset and Liability Management and Firmwide Risk

"The Skoglund and Chen book, Financial Risk Management: Applications in Market, Credit, Asset and Liability Management, and Firmwide Risk, provides the practitioner with a comprehensive and integrated set of quantitative models along with numerous examples that add significant value to the tactical and strategic management of financial risk. The book provides invaluable insight to the economics underlying the models and guides practitioners on a path towards making informed risk–adjusted return decisions that fit their appetite for risk. The book is highly recommended for practitioners, researchers, and students who want to gain a deep appreciation of the real–world uses of financial risk management models."

Dr. Bob Mark, Managing Partner, Black Diamond Risk Enterprises

A practitioner′s guide to banking risk management worldwide

Financial Risk Management gives practitioners everything they need to anticipate, mitigate, and manage risk in the modern banking industry. Written by the leaders of global banking risk products and management at SAS, this everyday guidebook provides the most up–to–date information and expert insight into practical risk management, including comprehensive examinations of the stress tests performed by the U.S. Federal Reserve and the European Banking Authority. Practice–oriented discussions provide the essential strategies, skills, and tools you need to implement the covered methods immediately to begin developing a robust risk management system. Through the collective experience of the authors as well as the banking and risk–technology experts they work with, you gain a competitive edge with world–class exposure to:

Techniques for computing and managing market, credit, and asset and liability risk The latest information on regulatory practices and the requirements to risk models The insight to apply firmwide risk management and stress testing techniques The ins and outs of risk adjusted profitability, capital allocation, optimal decision, and more

Instead of providing a broad overview of approaches for you to assess yourself through trial and error, this time–saving guide only gives you the risk models and applications the authors found most useful in their own research and actual implementation at a variety of banks. You can′t prepare for what you′re not looking at, and Financial Risk Management shows you how to keep an eye on risk throughout an organization so you always know your precise position.

Preface i

Acknowledgements vii

1 Introduction 1

1.1 Banks and Risk Management 1

1.2 Evolution of Bank Capital Regulation 4

1.3 Creating Value from Risk Management 9

1.4 Financial Risk Systems 11

1.5 Model Risk Management 18

I Market Risk 23

2 Market Risk with the Normal Distribution 25

2.1 Linear Portfolios 26

2.2 Quadratic Portfolios 47

2.3 Simulation Based Valuation 58

3 Advanced Market Risk Analysis 81

3.1 Risk Measures, Risk Contributions and Risk Information 82

3.2 Modeling the Stylized Facts of Financial Time Series 104

3.3 Scaling VaR and VaR with Trading 143

3.4 Market Liquidity Risk 146

3.5 Scenario Analysis and Stress Testing 152

3.6 Portfolio Optimization 166

3.7 Developments in the Market Risk Internal Models Capital Regulation 175

II Credit Risk 179

4 Portfolio Credit Risk 181

4.1 Issuer Credit Risk in Wholesale Exposures and Trading Book 184

4.2 Credit Models for the Banking Book 247

4.3 Firmwide Portfolio Credit Risk and Credit Risk Dependence 307

4.4 Credit Risk Stress Testing 310

4.5 Features of New Generation Portfolio Credit Risk Models 320

4.6 Hedging Credit Risk 326

4.7 Regulatory Capital for Credit Risk 336

5 Counterparty Credit Risk 345

5.1 Counterparty Pricing and Exposure 347

5.2 CVA Risks 397

5.3 Portfolios of Derivatives 398

5.4 A Note on Recent Counterparty Credit Risk Developments 409

5.5 Counterparty Credit Risk Regulation 411

III Asset and Liability Management 417

6 Liquidity Risk Management 419

6.2 Liquidity Exposure 431

6.3 Hedging the Liquidity Exposure 446

6.4 Structural Liquidity Planning 460

6.5 Components of the Liquidity Hedging Program 468

6.6 Cash Liquidity Risk and Liquidity Risk Measures 468

6.6.3 Allocating Cash Liquidity Risk 471

6.7 Regulation for Liquidity Risk 474

7 Funds Transfer Pricing and Profitability of Cash Flows 481

7.1 Basic Funds Transfer Pricing Concept 484

7.2 Risk Based Funds Transfer Pricing 485

7.3 Funds Transfer Rate and Risk Adjusted Returns 500

7.4 Profitability Measures and Decompositions 501

7.5 Banking Book Fair Value with Funds Transfer Rates 504

7.6 A Note on the Scope of Funds Transfer Pricing 505

7.7 Regulation and Profitability Analysis 506

IV Firmwide Risk 509

8 Firmwide Risk Aggregation 511

8.1 Correlated Aggregation and Firmwide Risk Levels 512

8.2 Capital Allocation in Risk Aggregation 519

8.3 Risk Aggregation and Regulation 521

9 Firmwide Scenario Analysis and Stress Testing 525

9.1 Firmwide Scenario Model Approaches 527

9.2 Firmwide Risk Capital Measures 530

9.3 Regulatory Stress Scenario Approach 535

9.4 The Future of Firmwide Stress Testing 542

References 545

Jimmy Skoglund is principal product manager of global risk products at SAS. He has more than fifteen years of market experience developing and implementing risk methodologies, and his articles have appeared in such publications as the Journal of Risk, Journal of Banking and Finance, and Journal of Risk Management in Financial Institutions. Jimmy holds a PhD from the Stockholm School of Economics.

Wei Chen is director of stress testing solutions at SAS. He has more than fifteen years′ experience in risk analytics and technology in banking and insurance, and he is an associate editor of the Journal of Risk Model Validation. His publications have appeared in several journals including Journal of Risk and Journal of Risk Model Validation. Wei holds a PhD from the University of Iowa.