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Correlation Risk Modeling and Management: An Applied Guide including the Basel III Correlation Framework - With Interactive Models in Excel / VBA, + Website

Book Description

A thorough guide to correlation risk and its growing importance in global financial markets

Ideal for anyone studying for CFA, PRMIA, CAIA, or other certifications, Correlation Risk Modeling and Management is the first rigorous guide to the topic of correlation risk. A relatively overlooked type of risk until it caused major unexpected losses during the financial crisis of 2007 through 2009, correlation risk has become a major focus of the risk management departments in major financial institutions, particularly since Basel III specifically addressed correlation risk with new regulations. This offers a rigorous explanation of the topic, revealing new and updated approaches to modelling and risk managing correlation risk.

  • Offers comprehensive coverage of a topic of increasing importance in the financial world

  • Includes the Basel III correlation framework

  • Features interactive models in Excel/VBA, an accompanying website with further materials, and problems and questions at the end of each chapter

  • Table of Contents

    1. Cover
    2. Series Page
    3. Title Page
    4. Copyright
    5. Preface
    6. Acknowledgments
    7. About the Author
    8. Chapter 1: Some Correlation Basics: Properties, Motivation, Terminology
      1. 1.1 What are Financial Correlations?
      2. 1.2 What is Financial Correlation Risk?
      3. 1.3 Motivation: Correlations and Correlation Risk are Everywhere in Finance
      4. 1.4 How Does Correlation Risk Fit Into the Broader Picture of Risks in Finance?
      5. 1.5 A Word on Terminology
      6. 1.6 Summary
      7. Appendix 1A: Dependence and Correlation
      8. Appendix 1B: On Percentage and Logarithmic Changes
      9. Practice Questions and Problems
      10. References and Suggested Readings
    9. Chapter 2: Empirical Properties of Correlation: How Do Correlations Behave in the Real World?
      1. 2.1 How Do Equity Correlations Behave in a Recession, Normal Economic Period, or Strong Expansion?
      2. 2.2 Do Equity Correlations Exhibit Mean Reversion?
      3. 2.3 Do Equity Correlations Exhibit Autocorrelation?
      4. 2.4 How are Equity Correlations Distributed?
      5. 2.5 Is Equity Correlation Volatility an Indicator for Future Recessions?
      6. 2.6 Properties of Bond Correlations and Default Probability Correlations
      7. 2.7 Summary
      8. Practice Questions and Problems
      9. References and Suggested Readings
    10. Chapter 3: Statistical Correlation Models—Can We Apply Them to Finance?
      1. 3.1 A Word on Financial Models
      2. 3.2 Statistical Correlation Measures
      3. 3.3 Should We Apply Spearman's Rank Correlation and Kendall's τ in Finance?
      4. 3.4 Summary
      5. Practice Questions and Problems
      6. References and Suggested Readings
    11. Chapter 4: Financial Correlation Modeling—Bottom-Up Approaches
      1. 4.1 Correlating Brownian Motions (Heston 1993)
      2. 4.2 The Binomial Correlation Measure
      3. 4.3 Copula Correlations
      4. 4.4 Contagion Correlation Models
      5. 4.5 Summary
      6. Appendix 4A: Cholesky Decomposition
      7. Appendix 4B: A Short Proof of the Gaussian Default Time Copula
      8. Practice Questions and Problems
      9. References and Suggested Readings
    12. Chapter 5: Valuing CDOs with the Gaussian Copula—What Went Wrong?
      1. 5.1 CDO Basics—What is a CDO? Why CDOs? Types of CDOs
      2. 5.2 Valuing CDOs
      3. 5.3 Conclusion: The Gaussian Copula and CDOs—What Went Wrong?
      4. 5.4 Summary
      5. Practice Questions and Problems
      6. References and Suggested Readings
    13. Chapter 6: The One-Factor Gaussian Copula (OFGC) Model—Too Simplistic?
      1. 6.1 The Original One-Factor Gaussian Copula (OFGC) Model
      2. 6.2 Valuing Tranches of A CDO with the OFGC
      3. 6.3 The Correlation Concept in the OFGC Model
      4. 6.4 The Relationship Between the OFGC and the Standard Copula
      5. 6.5 Extensions of the OFGC
      6. 6.6 Conclusion—Is the OFGC Too Simplistic to Evaluate Credit Risk in Portfolios?
      7. 6.7 Summary
      8. Practice Questions and Problems
      9. References and Suggested Readings
    14. Chapter 7: Financial Correlation Models—Top-Down Approaches
      1. 7.1 Vasicek's 1987 One-Factor Gaussian Copula (OFGC) Model Revisited
      2. 7.2 Markov Chain Models
      3. 7.3 Contagion Default Modeling in Top-Down Models
      4. 7.4 Summary
      5. Practice Questions and Problems
      6. References and Suggested Readings
    15. Chapter 8: Stochastic Correlation Models
      1. 8.1 What is a Stochastic Process?
      2. 8.2 Sampling Correlation from a Distribution (Hull and White 2010)
      3. 8.3 Dynamic Conditional Correlations (DCCs) (Engle 2002)
      4. 8.4 Stochastic Correlation—Standard Models
      5. 8.5 Extending the Heston Model with Stochastic Correlation (Buraschi et al. 2010; DA Fonseca et al. 2008)
      6. 8.6 Stochastic Correlation, Stochastic Volatility, and Asset Modeling (LU and Meissner 2012)
      7. 8.7 Conclusion: Should We Model Financial Correlations with a Stochastic Process?
      8. 8.8 Summary
      9. Practice Questions and Problems
      10. References and Suggested Readings
    16. Chapter 9: Quantifying Market Correlation Risk
      1. 9.1 The Correlation Risk Parameters Cora and Gora
      2. 9.2 Examples of Cora in Financial Practice
      3. 9.3 Cora and Gora in Investments
      4. 9.4 Cora in Market Risk Management
      5. 9.5 Gora in Market Risk Management
      6. 9.6 Summary
      7. Practice Questions and Problems
      8. References and Suggested Readings
    17. Chapter 10: Quantifying Credit Correlation Risk
      1. 10.1 Credit Correlation Risk in a CDS
      2. 10.2 Pricing CDSs, Including Reference Entity–Counterparty Credit Correlation
      3. 10.3 Pricing CDSs, Including the Credit Correlation of All Three Entities
      4. 10.4 Correlation Risk in a Collateralized Debt Obligation (CDO)
      5. 10.5 Summary
      6. Practice Questions and Problems
      7. References and Suggested Readings
    18. Chapter 11: Hedging Correlation Risk
      1. 11.1 What is Hedging?
      2. 11.2 Why is Hedging Financial Correlations Challenging?
      3. 11.3 Two Examples to Hedge Correlation Risk
      4. 11.4 When to Use Options and When to Use Futures to Hedge
      5. 11.5 Summary
      6. Practice Questions and Problems
      7. References and Suggested Readings
    19. Chapter 12: Correlation and Basel II and III
      1. 12.1 What are the Basel I, II, and III Accords? Why Do Most Sovereigns Implement the Accords?
      2. 12.2 Basel II and III's Credit Value at Risk (CVaR) Approach
      3. 12.3 Basel II's Required Capital (RC) for Credit Risk
      4. 12.4 Credit Value Adjustment (CVA) Approach Without Wrong-Way Risk (WWR) in the Basel Accord
      5. 12.5 Credit Value Adjustment (CVA) with Wrong-Way Risk in the Basel Accord
      6. 12.6 How do the Basel Accords Treat Double Defaults?
      7. 12.7 Debt Value Adjustment (DVA): IF Something Sounds too Good to be True…
      8. 12.8 Funding Value Adjustment (FVA)
      9. 12.9 Summary
      10. Practice Questions and Problems
      11. References and Suggested Readings
    20. Chapter 13: The Future of Correlation Modeling
      1. 13.1 Numerical Finance: Solving Financial Problems Numerically with the Help of Graphical Processing Units (GPUs)
      2. 13.2 New Developments in Artificial Intelligence and Financial Modeling
      3. 13.3 Summary
      4. Practice Questions and Problems
      5. References and Suggested Readings
    21. Glossary
    22. Index