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Risk Management and Financial Institutions, + Web Site, 3rd Edition

Book Description

The essential guide to managing financial institution risk, fully revised and updated

The dangers inherent in the financial system make understanding risk management essential for anyone working in, or planning to work in, the financial sector. A practical resource for financial professionals and students alike, Risk Management and Financial Institutions, Third Edition explains all aspects of financial risk as well as the way financial institutions are regulated, to help readers better understand financial markets and potential dangers.

Fully revised and updated, this new edition features coverage of Basel 2.5, Basel III and Dodd-Frank as well as expanded sections on counterparty credit risk, central clearing, and collateralization. In addition, end-of-chapter practice problems and a website featuring supplemental materials designed to provide a more comprehensive learning experience make this the ultimate learning resource. Written by acclaimed risk management expert, John Hull, Risk Management and Financial Institutions is the only book you need to understand—and respond to—financial risk.

  • The new edition of the financial risk management bestseller

  • Describes the activities of different types of financial institutions, explains how they are regulated, and covers market risk, credit risk, operational risk, liquidity risk, and model risk

  • Features new coverage of Basel III, Dodd-Frank, counterparty credit risk, central clearing, collateralization, and much more

  • Provides readers with access to a supplementary website offering software and unique learning aids

  • Author John Hull is one of the most respected authorities on financial risk management

A timely update to the definitive resource on risk in the financial system, Risk Management and Financial Institutions + Web Site, Third Edition is an indispensable resource from internationally renowned expert John Hull.

Table of Contents

  1. Cover
  2. Series
  3. Title Page
  4. Copyright
  5. Dedication
  6. Business Snapshots
  7. Preface
    1. WHAT’S NEW
    2. SLIDES
    3. QUESTIONS AND PROBLEMS
    4. INSTRUCTOR’S MANUAL
    5. ACKNOWLEDGMENTS
  8. Chapter 1: Introduction
    1. 1.1 RISK VS. RETURN FOR INVESTORS
    2. 1.2 THE EFFICIENT FRONTIER
    3. 1.3 THE CAPITAL ASSET PRICING MODEL
    4. 1.4 ARBITRAGE PRICING THEORY
    5. 1.5 RISK VS. RETURN FOR COMPANIES
    6. 1.6 RISK MANAGEMENT BY FINANCIAL INSTITUTIONS
    7. 1.7 CREDIT RATINGS
    8. SUMMARY
    9. FURTHER READING
    10. PRACTICE QUESTIONS AND PROBLEMS (ANSWERS AT END OF BOOK)
    11. FURTHER QUESTIONS
  9. Chapter 2: Banks
    1. 2.1 COMMERCIAL BANKING
    2. 2.2 THE CAPITAL REQUIREMENTS OF A SMALL COMMERCIAL BANK
    3. 2.3 DEPOSIT INSURANCE
    4. 2.4 INVESTMENT BANKING
    5. 2.5 SECURITIES TRADING
    6. 2.6 POTENTIAL CONFLICTS OF INTEREST IN BANKING
    7. 2.7 TODAY’S LARGE BANKS
    8. 2.8 THE RISKS FACING BANKS
    9. SUMMARY
    10. FURTHER READING
    11. PRACTICE QUESTIONS AND PROBLEMS (ANSWERS AT END OF BOOK)
    12. FURTHER QUESTIONS
  10. Chapter 3: Insurance Companies and Pension Plans
    1. 3.1 LIFE INSURANCE
    2. 3.2 ANNUITY CONTRACTS
    3. 3.3 MORTALITY TABLES
    4. 3.4 LONGEVITY AND MORTALITY RISK
    5. 3.5 PROPERTY-CASUALTY INSURANCE
    6. 3.6 HEALTH INSURANCE
    7. 3.7 MORAL HAZARD AND ADVERSE SELECTION
    8. 3.8 REINSURANCE
    9. 3.9 CAPITAL REQUIREMENTS
    10. 3.10 THE RISKS FACING INSURANCE COMPANIES
    11. 3.11 REGULATION
    12. 3.12 PENSION PLANS
    13. SUMMARY
    14. FURTHER READING
    15. PRACTICE QUESTIONS AND PROBLEMS (ANSWERS AT END OF BOOK)
    16. FURTHER QUESTIONS
  11. Chapter 4: Mutual Funds and Hedge Funds
    1. 4.1 MUTUAL FUNDS
    2. 4.2 HEDGE FUNDS
    3. 4.3 HEDGE FUND STRATEGIES
    4. 4.4 HEDGE FUND PERFORMANCE
    5. SUMMARY
    6. FURTHER READING
    7. PRACTICE QUESTIONS AND PROBLEMS (ANSWERS AT END OF BOOK)
    8. FURTHER QUESTIONS
  12. Chapter 5: Trading in Financial Markets
    1. 5.1 THE MARKETS
    2. 5.2 LONG AND SHORT POSITIONS IN ASSETS
    3. 5.3 DERIVATIVES MARKETS
    4. 5.4 PLAIN VANILLA DERIVATIVES
    5. 5.5 CLEARING HOUSES
    6. 5.6 MARGIN
    7. 5.7 NON-TRADITIONAL DERIVATIVES
    8. 5.8 EXOTIC OPTIONS AND STRUCTURED PRODUCTS
    9. 5.9 RISK MANAGEMENT CHALLENGES
    10. SUMMARY
    11. FURTHER READING
    12. PRACTICE QUESTIONS AND PROBLEMS (ANSWERS AT END OF BOOK)
    13. FURTHER QUESTIONS
  13. Chapter 6: The Credit Crisis of 2007
    1. 6.1 THE U.S. HOUSING MARKET
    2. 6.2 SECURITIZATION
    3. 6.3 THE CRISIS
    4. 6.4 WHAT WENT WRONG?
    5. 6.5 LESSONS FROM THE CRISIS
    6. SUMMARY
    7. FURTHER READING
    8. PRACTICE QUESTIONS AND PROBLEMS (ANSWERS AT END OF BOOK)
    9. FURTHER QUESTIONS
  14. Chapter 7: How Traders Manage Their Risks
    1. 7.1 DELTA
    2. 7.2 GAMMA
    3. 7.3 VEGA
    4. 7.4 THETA
    5. 7.5 RHO
    6. 7.6 CALCULATING GREEK LETTERS
    7. 7.7 TAYLOR SERIES EXPANSIONS
    8. 7.8 THE REALITIES OF HEDGING
    9. 7.9 HEDGING EXOTIC OPTIONS
    10. 7.10 SCENARIO ANALYSIS
    11. SUMMARY
    12. FURTHER READING
    13. PRACTICE QUESTIONS AND PROBLEMS (ANSWERS AT END OF BOOK)
    14. FURTHER QUESTIONS
  15. Chapter 8: Interest Rate Risk
    1. 8.1 THE MANAGEMENT OF NET INTEREST INCOME
    2. 8.2 LIBOR AND SWAP RATES
    3. 8.3 DURATION
    4. 8.4 CONVEXITY
    5. 8.5 GENERALIZATION
    6. 8.6 NONPARALLEL YIELD CURVE SHIFTS
    7. 8.7 INTEREST RATE DELTAS IN PRACTICE
    8. 8.8 PRINCIPAL COMPONENTS ANALYSIS
    9. 8.9 GAMMA AND VEGA
    10. SUMMARY
    11. FURTHER READING
    12. PRACTICE QUESTIONS AND PROBLEMS (ANSWERS AT END OF BOOK)
    13. FURTHER QUESTIONS
  16. Chapter 9: Value at Risk
    1. 9.1 DEFINITION OF VaR
    2. 9.2 EXAMPLES OF THE CALCULATION OF VaR
    3. 9.3 VaR vs. EXPECTED SHORTFALL
    4. 9.4 VaR AND CAPITAL
    5. 9.5 COHERENT RISK MEASURES
    6. 9.6 CHOICE OF PARAMETERS FOR VAR
    7. 9.7 MARGINAL VAR, INCREMENTAL VAR, AND COMPONENT VAR
    8. 9.8 EULER’S THEOREM
    9. 9.9 AGGREGATING VaRS
    10. 9.10 BACK-TESTING
    11. SUMMARY
    12. FURTHER READING
    13. PRACTICE QUESTIONS AND PROBLEMS (ANSWERS AT END OF BOOK)
    14. FURTHER QUESTIONS
  17. Chapter 10: Volatility
    1. 10.1 DEFINITION OF VOLATILITY
    2. 10.2 IMPLIED VOLATILITIES
    3. 10.3 ARE DAILY PERCENTAGE CHANGES IN FINANCIAL VARIABLES NORMAL?
    4. 10.4 THE POWER LAW
    5. 10.5 MONITORING DAILY VOLATILITY
    6. 10.6 THE EXPONENTIALLY WEIGHTED MOVING AVERAGE MODEL
    7. 10.7 THE GARCH(1,1) MODEL
    8. 10.8 CHOOSING BETWEEN THE MODELS
    9. 10.9 MAXIMUM LIKELIHOOD METHODS
    10. 10.10 USING GARCH(1,1) TO FORECAST FUTURE VOLATILITY
    11. SUMMARY
    12. FURTHER READING
    13. PRACTICE QUESTIONS AND PROBLEMS (ANSWERS AT END OF BOOK)
    14. FURTHER QUESTIONS
  18. Chapter 11: Correlations and Copulas
    1. 11.1 DEFINITION OF CORRELATION
    2. 11.2 MONITORING CORRELATION
    3. 11.3 MULTIVARIATE NORMAL DISTRIBUTIONS
    4. 11.4 COPULAS
    5. 11.5 APPLICATION TO LOAN PORTFOLIOS: VASICEK’S MODEL
    6. SUMMARY
    7. FURTHER READING
    8. PRACTICE QUESTIONS AND PROBLEMS (ANSWERS AT END OF BOOK)
    9. FURTHER QUESTIONS
  19. Chapter 12: Basel I, Basel II, and Solvency II
    1. 12.1 THE REASONS FOR REGULATING BANKS
    2. 12.2 BANK REGULATION PRE-1988
    3. 12.3 THE 1988 BIS ACCORD
    4. 12.4 THE G-30 POLICY RECOMMENDATIONS
    5. 12.5 NETTING
    6. 12.6 THE 1996 AMENDMENT
    7. 12.7 BASEL II
    8. 12.8 CREDIT RISK CAPITAL UNDER BASEL II
    9. 12.9 OPERATIONAL RISK CAPITAL UNDER BASEL II
    10. 12.10 PILLAR 2: SUPERVISORY REVIEW
    11. 12.11 PILLAR 3: MARKET DISCIPLINE
    12. 12.12 SOLVENCY II
    13. SUMMARY
    14. FURTHER READING
    15. PRACTICE QUESTIONS AND PROBLEMS (ANSWERS AT END OF BOOK)
    16. FURTHER QUESTIONS
  20. Chapter 13: Basel 2.5, Basel III, and Dodd–Frank
    1. 13.1 BASEL 2.5
    2. 13.2 BASEL III
    3. 13.3 CONTINGENT CONVERTIBLE BONDS
    4. 13.4 DODD–FRANK ACT
    5. 13.5 LEGISLATION IN OTHER COUNTRIES
    6. SUMMARY
    7. FURTHER READING
    8. PRACTICE QUESTIONS AND PROBLEMS (ANSWERS AT END OF BOOK)
    9. FURTHER QUESTIONS
  21. Chapter 14: Market Risk VaR: The Historical Simulation Approach
    1. 14.1 THE METHODOLOGY
    2. 14.2 ACCURACY
    3. 14.3 EXTENSIONS
    4. 14.4 COMPUTATIONAL ISSUES
    5. 14.5 EXTREME VALUE THEORY
    6. 14.6 APPLICATIONS OF EVT
    7. SUMMARY
    8. FURTHER READING
    9. PRACTICE QUESTIONS AND PROBLEMS (ANSWERS AT END OF BOOK)
    10. FURTHER QUESTIONS
  22. Chapter 15: Market Risk VaR: The Model-Building Approach
    1. 15.1 THE BASIC METHODOLOGY
    2. 15.2 GENERALIZATION
    3. 15.3 CORRELATION AND COVARIANCE MATRICES
    4. 15.4 HANDLING INTEREST RATES
    5. 15.5 APPLICATIONS OF THE LINEAR MODEL
    6. 15.6 LINEAR MODEL AND OPTIONS
    7. 15.7 QUADRATIC MODEL
    8. 15.8 MONTE CARLO SIMULATION
    9. 15.9 NON-NORMAL ASSUMPTIONS
    10. 15.10 MODEL-BUILDING vs. HISTORICAL SIMULATION
    11. SUMMARY
    12. FURTHER READING
    13. PRACTICE QUESTIONS AND PROBLEMS (ANSWERS AT END OF BOOK)
    14. FURTHER QUESTIONS
  23. Chapter 16: Credit Risk: Estimating Default Probabilities
    1. 16.1 CREDIT RATINGS
    2. 16.2 HISTORICAL DEFAULT PROBABILITIES
    3. 16.3 RECOVERY RATES
    4. 16.4 CREDIT DEFAULT SWAPS
    5. 16.5 CREDIT SPREADS
    6. 16.6 ESTIMATING DEFAULT PROBABILITIES FROM CREDIT SPREADS
    7. 16.7 COMPARISON OF DEFAULT PROBABILITY ESTIMATES
    8. 16.8 USING EQUITY PRICES TO ESTIMATE DEFAULT PROBABILITIES
    9. SUMMARY
    10. FURTHER READING
    11. PRACTICE QUESTIONS AND PROBLEMS (ANSWERS AT END OF BOOK)
    12. FURTHER QUESTIONS
  24. Chapter 17: Counterparty Credit Risk in Derivatives
    1. 17.1 CREDIT EXPOSURE ON DERIVATIVES
    2. 17.2 BILATERAL CLEARING
    3. 17.3 CENTRAL CLEARING
    4. 17.4 CVA
    5. 17.5 THE IMPACT OF A NEW TRANSACTION
    6. 17.6 CVA RISK
    7. 17.7 WRONG WAY RISK
    8. 17.8 DVA
    9. 17.9 SOME SIMPLE EXAMPLES
    10. SUMMARY
    11. FURTHER READING
    12. PRACTICE QUESTIONS AND PROBLEMS (ANSWERS AT END OF BOOK)
    13. FURTHER QUESTIONS
  25. Chapter 18: Credit Value at Risk
    1. 18.1 RATINGS TRANSITION MATRICES
    2. 18.2 VASICEK’S MODEL
    3. 18.3 CREDIT RISK PLUS
    4. 18.4 CREDITMETRICS
    5. 18.5 CREDIT VAR IN THE TRADING BOOK
    6. SUMMARY
    7. FURTHER READING
    8. PRACTICE QUESTIONS AND PROBLEMS (ANSWERS AT END OF BOOK)
    9. FURTHER QUESTIONS
  26. Chapter 19: Scenario Analysis and Stress Testing
    1. 19.1 GENERATING THE SCENARIOS
    2. 19.2 REGULATION
    3. 19.3 WHAT TO DO WITH THE RESULTS
    4. SUMMARY
    5. FURTHER READING
    6. PRACTICE QUESTIONS AND PROBLEMS (ANSWERS AT END OF BOOK)
    7. FURTHER QUESTIONS
  27. Chapter 20: Operational Risk
    1. 20.1 WHAT IS OPERATIONAL RISK?
    2. 20.2 DETERMINATION OF REGULATORY CAPITAL
    3. 20.3 CATEGORIZATION OF OPERATIONAL RISKS
    4. 20.4 LOSS SEVERITY AND LOSS FREQUENCY
    5. 20.5 IMPLEMENTATION OF AMA
    6. 20.6 PROACTIVE APPROACHES
    7. 20.7 ALLOCATION OF OPERATIONAL RISK CAPITAL
    8. 20.8 USE OF POWER LAW
    9. 20.9 INSURANCE
    10. 20.10 SARBANES-OXLEY
    11. SUMMARY
    12. FURTHER READING
    13. PRACTICE QUESTIONS AND PROBLEMS (ANSWERS AT END OF BOOK)
    14. FURTHER QUESTIONS
  28. Chapter 21: Liquidity Risk
    1. 21.1 LIQUIDITY TRADING RISK
    2. 21.2 LIQUIDITY FUNDING RISK
    3. 21.3 LIQUIDITY BLACK HOLES
    4. SUMMARY
    5. FURTHER READING
    6. PRACTICE QUESTIONS AND PROBLEMS (ANSWERS AT END OF BOOK)
    7. FURTHER QUESTIONS
  29. Chapter 22: Model Risk
    1. 22.1 MARKING TO MARKET
    2. 22.2 MODELS FOR LINEAR PRODUCTS
    3. 22.3 PHYSICS vs. FINANCE
    4. 22.4 HOW MODELS ARE USED FOR PRICING STANDARD PRODUCTS
    5. 22.5 HEDGING
    6. 22.6 MODELS FOR NONSTANDARD PRODUCTS
    7. 22.7 DANGERS IN MODEL BUILDING
    8. 22.8 DETECTING MODEL PROBLEMS
    9. SUMMARY
    10. FURTHER READING
    11. PRACTICE QUESTIONS AND PROBLEMS (ANSWERS AT END OF BOOK)
    12. FURTHER QUESTIONS
  30. Chapter 23: Economic Capital and RAROC
    1. 23.1 DEFINITION OF ECONOMIC CAPITAL
    2. 23.2 COMPONENTS OF ECONOMIC CAPITAL
    3. 23.3 SHAPES OF THE LOSS DISTRIBUTIONS
    4. 23.4 RELATIVE IMPORTANCE OF RISKS
    5. 23.5 AGGREGATING ECONOMIC CAPITAL
    6. 23.6 ALLOCATION OF ECONOMIC CAPITAL
    7. 23.7 DEUTSCHE BANK’S ECONOMIC CAPITAL
    8. 23.8 RAROC
    9. SUMMARY
    10. FURTHER READING
    11. PRACTICE QUESTIONS AND PROBLEMS (ANSWERS AT END OF BOOK)
    12. FURTHER QUESTIONS
  31. Chapter 24: Risk Management Mistakes to Avoid
    1. 24.1 RISK LIMITS
    2. 24.2 MANAGING THE TRADING ROOM
    3. 24.3 LIQUIDITY RISK
    4. 24.4 LESSONS FOR NONFINANCIAL CORPORATIONS
    5. 24.5 A FINAL POINT
    6. FURTHER READING
  32. Appendix A: Compounding Frequencies for Interest Rates
  33. Appendix B: Zero Rates, Forward Rates, and Zero-Coupon Yield Curves
  34. Appendix C: Valuing Forward and Futures Contracts
  35. Appendix D: Valuing Swaps
  36. Appendix E: Valuing European Options
  37. Appendix F: Valuing American Options
  38. Appendix G: Taylor Series Expansions
  39. Appendix H: Eigenvectors and Eigenvalues
  40. Appendix I: Principal Components Analysis
  41. Appendix J: Manipulation of Credit Transition Matrices
  42. Appendix K: Valuation of Credit Default Swaps
    1. Marking to Market a CDS
  43. Appendix L: Synthetic CDOs and Their Valuation
  44. Answers to Questions and Problems
    1. CHAPTER 1
    2. CHAPTER 2
    3. CHAPTER 3
    4. CHAPTER 4
    5. CHAPTER 5
    6. CHAPTER 6
    7. CHAPTER 7
    8. CHAPTER 8
    9. CHAPTER 9
    10. CHAPTER 10
    11. CHAPTER 11
    12. CHAPTER 12
    13. CHAPTER 13
    14. CHAPTER 14
    15. CHAPTER 15
    16. CHAPTER 16
    17. CHAPTER 17
    18. CHAPTER 18
    19. CHAPTER 19
    20. CHAPTER 20
    21. CHAPTER 21
    22. CHAPTER 22
    23. CHAPTER 23
  45. Glossary
  46. DerivaGem Software
    1. GETTING STARTED
    2. NEXT STEPS
    3. BOND OPTIONS
    4. CAPS AND SWAPTIONS
    5. CDSs
    6. CDOs
    7. HOW GREEK LETTERS ARE DEFINED
    8. THE APPLICATIONS BUILDER
  47. Table for N(x) when x ≤ 0
  48. Table for N(x) when x ≥ 0
  49. Index