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Risk Management and Financial Institutions, 4th Edition

Book Description

The most complete, up to date guide to risk management in finance

Risk Management and Financial Institutions explains all aspects of financial risk and financial institution regulation, helping readers better understand the financial markets and potential dangers. This new fourth edition has been updated to reflect the major developments in the industry, including the finalization of Basel III, the fundamental review of the trading book, SEFs, CCPs, and the new rules affecting derivatives markets. There are new chapters on enterprise risk management and scenario analysis. Readers learn the different types of risk, how and where they appear in different types of institutions, and how the regulatory structure of each institution affects risk management practices. Comprehensive ancillary materials include software, practice questions, and all necessary teaching supplements, facilitating more complete understanding and providing an ultimate learning resource.

All financial professionals need a thorough background in risk and the interlacing connections between financial institutions to better understand the market, defend against systemic dangers, and perform their jobs. This book provides a complete picture of the risk management industry and practice, with the most up to date information.

  • Understand how risk affects different types of financial institutions

  • Learn the different types of risk and how they are managed

  • Study the most current regulatory issues that deal with risk

  • Risk management is paramount with the dangers inherent in the financial system, and a deep understanding is essential for anyone working in the finance industry; today, risk management is part of everyone's job. For complete information and comprehensive coverage of the latest industry issues and practices, Risk Management and Financial Institutions is an informative, authoritative guide.

    Table of Contents

    1. Business Snapshots
    2. Preface
      1. New Material
      2. Slides
      3. Questions and Problems
      4. Instructor's Manual
      5. Acknowledgments
    3. 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
      12. Notes
    4. Part One: Financial Institutions and Their Trading
      1. 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
        13. Note
      2. 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
        17. Notes
      3. 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
        9. Notes
      4. Chapter 5: Trading in Financial Markets
        1. 5.1 The Markets
        2. 5.2 Clearing Houses
        3. 5.3 OTC Market Changes
        4. 5.4 Long and Short Positions in Assets
        5. 5.5 Derivatives Markets
        6. 5.6 Plain Vanilla Derivatives
        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
        14. Notes
      5. 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
        10. Notes
      6. Chapter 7: Valuation and Scenario Analysis: The Risk-Neutral and Real Worlds
        1. 7.1 Volatility and Asset Prices
        2. 7.2 Risk-Neutral Valuation
        3. 7.3 Scenario Analysis
        4. 7.4 When Both Worlds Have to be Used
        5. 7.5 The Calculations in Practice
        6. 7.6 Estimating Real-World Processes
        7. Summary
        8. Further Reading
        9. Practice Questions and Problems (Answers at End of Book)
        10. Further Questions
        11. Notes
    5. Part Two: Market Risk
      1. Chapter 8: How Traders Manage Their Risks
        1. 8.1 Delta
        2. 8.2 Gamma
        3. 8.3 Vega
        4. 8.4 Theta
        5. 8.5 Rho
        6. 8.6 Calculating Greek Letters
        7. 8.7 Taylor Series Expansions
        8. 8.8 The Realities of Hedging
        9. 8.9 Hedging Exotic Options
        10. 8.10 Scenario Analysis
        11. Summary
        12. Further Reading
        13. Practice Questions and Problems (Answers at End of Book)
        14. Further Questions
        15. Notes
      2. Chapter 9: Interest Rate Risk
        1. 9.1 The Management of Net Interest Income
        2. 9.2 Types of Rates
        3. 9.3 Duration
        4. 9.4 Convexity
        5. 9.5 Generalization
        6. 9.6 Nonparallel Yield Curve Shifts
        7. 9.7 Interest Rate Deltas in Practice
        8. 9.8 Principal Components Analysis
        9. 9.9 Gamma and Vega
        10. Summary
        11. Further Reading
        12. Practice Questions and Problems (Answers at End of Book)
        13. Further Questions
        14. Notes
      3. 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
        15. Notes
      4. 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
        10. Notes
      5. Chapter 12: Value at Risk and Expected Shortfall
        1. 12.1 Definition of VaR
        2. 12.2 Examples of the Calculation of VaR
        3. 12.3 A Drawback of VaR
        4. 12.4 Expected Shortfall
        5. 12.5 Coherent Risk Measures
        6. 12.6 Choice of Parameters for VaR and ES
        7. 12.7 Marginal, Incremental, and Component Measures
        8. 12.8 Euler's Theorem
        9. 12.9 Aggregating VaRs and ESs
        10. 12.10 Back-Testing
        11. Summary
        12. Further Reading
        13. Practice Questions and Problems (Answers at End of Book)
        14. Further Questions
        15. Notes
      6. Chapter 13: Historical Simulation and Extreme Value Theory
        1. 13.1 The Methodology
        2. 13.2 Accuracy of VaR
        3. 13.3 Extensions
        4. 13.4 Computational Issues
        5. 13.5 Extreme Value Theory
        6. 13.6 Applications of EVT
        7. Summary
        8. Further Reading
        9. Practice Questions and Problems (Answers at End of Book)
        10. Further Questions
        11. Notes
      7. Chapter 14: Model-Building Approach
        1. 14.1 The Basic Methodology
        2. 14.2 Generalization
        3. 14.3 Correlation and Covariance Matrices
        4. 14.4 Handling Interest Rates
        5. 14.5 Applications of the Linear Model
        6. 14.6 Linear Model and Options
        7. 14.7 Quadratic Model
        8. 14.8 Monte Carlo Simulation
        9. 14.9 Non-Normal Assumptions
        10. 14.10 Model-Building vs. Historical Simulation
        11. Summary
        12. Further Reading
        13. Practice Questions and Problems (Answers at End of Book)
        14. Further Questions
        15. Notes
    6. Part Three: Regulation
      1. Chapter 15: Basel I, Basel II, and Solvency II
        1. 15.1 The Reasons for Regulating Banks
        2. 15.2 Bank Regulation Pre-1988
        3. 15.3 The 1988 BIS Accord
        4. 15.4 The G-30 Policy Recommendations
        5. 15.5 Netting
        6. 15.6 1996 Amendment
        7. 15.7 Basel II
        8. 15.8 Credit Risk Capital Under Basel II
        9. 15.9 Operational Risk Capital Under Basel II
        10. 15.10 Pillar 2: Supervisory Review
        11. 15.11 Pillar 3: Market Discipline
        12. 15.12 Solvency II
        13. Summary
        14. Further Reading
        15. Practice Questions and Problems (Answers at End of Book)
        16. Further Questions
        17. Notes
      2. Chapter 16: Basel II.5, Basel III, and Other Post-Crisis Changes
        1. 16.1 Basel II.5
        2. 16.2 Basel III
        3. 16.3 Contingent Convertible Bonds
        4. 16.4 Dodd–Frank Act
        5. 16.5 Legislation in other Countries
        6. Summary
        7. Further Reading
        8. Practice Questions and Problems (Answers at End of Book)
        9. Further Questions
        10. Notes
      3. Chapter 17: Fundamental Review of the Trading Book
        1. 17.1 New Market Risk Measures
        2. 17.2 Trading Book vs. Banking Book
        3. 17.3 Credit Trades
        4. Summary
        5. Further Reading
        6. Practice Questions and Problems (Answers at End of Book)
        7. Further Question
        8. Notes
    7. Part Four: Credit Risk
      1. Chapter 18: Managing Credit Risk: Margin, OTC Markets, and CCPs
        1. 18.1 Margin and Exchanges
        2. 18.2 OTC Markets
        3. 18.3 Consequences of New OTC Regulations
        4. 18.4 The Risk of a CCP Failure
        5. Summary
        6. Further Reading
        7. Practice Questions and Problems (Answers at End of Book)
        8. Further Questions
        9. Notes
      2. Chapter 19: Estimating Default Probabilities
        1. 19.1 Credit Ratings
        2. 19.2 Historical Default Probabilities
        3. 19.3 Recovery Rates
        4. 19.4 Credit Default Swaps
        5. 19.5 Credit Spreads
        6. 19.6 Estimating Default Probabilities from Credit Spreads
        7. 19.7 Comparison of Default Probability Estimates
        8. 19.8 Using Equity Prices to Estimate Default Probabilities
        9. 19.9 Summary
        10. Further Reading
        11. Practice Questions and Problems (Answers at End of Book)
        12. Further Questions
        13. Notes
      3. Chapter 20: CVA and DVA
        1. 20.1 Credit Exposure on Derivatives
        2. 20.2 CVA
        3. 20.3 The Impact of a New Transaction
        4. 20.4 CVA Risk
        5. 20.5 Wrong-Way Risk
        6. 20.6 DVA
        7. 20.7 Some Simple Examples
        8. Summary
        9. Further Reading
        10. Practice Questions and Problems (Answers at End of Book)
        11. Further Questions
        12. Notes
      4. Chapter 21: Credit Value at Risk
        1. 21.1 Ratings Transition Matrices
        2. 21.2 Vasicek's Model
        3. 21.3 Credit Risk Plus
        4. 21.4 Creditmetrics
        5. 21.5 Credit-Sensitive Instruments in the Trading Book
        6. Summary
        7. Further Reading
        8. Practice Questions and Problems (Answers at End of Book)
        9. Further Questions
        10. Notes
    8. Part Five: Other Topics
      1. Chapter 22: Scenario Analysis and Stress Testing
        1. 22.1 Generating the Scenarios
        2. 22.2 Regulation
        3. 22.3 What to Do with the Results
        4. Summary
        5. Further Reading
        6. Practice Questions and Problems (Answers at End of Book)
        7. Further Questions
        8. Notes
      2. Chapter 23: Operational Risk
        1. 23.1 Defining Operational Risk
        2. 23.2 Determination of Regulatory Capital
        3. 23.3 Categorization of Operational Risks
        4. 23.4 Loss Severity and Loss Frequency
        5. 23.5 Implementation of AMA
        6. 23.6 Proactive Approaches
        7. 23.7 Allocation of Operational Risk Capital
        8. 23.8 Use of Power Law
        9. 23.9 Insurance
        10. 23.10 Sarbanes-Oxley
        11. Summary
        12. Further Reading
        13. Practice Questions and Problems (Answers at End of Book)
        14. Further Questions
        15. Notes
      3. Chapter 24: Liquidity Risk
        1. 24.1 Liquidity Trading Risk
        2. 24.2 Liquidity Funding Risk
        3. 24.3 Liquidity Black Holes
        4. Summary
        5. Further Reading
        6. Practice Questions and Problems (Answers at End of Book)
        7. Further Questions
        8. Notes
      4. Chapter 25: Model Risk
        1. 25.1 Marking to Market
        2. 25.2 Models for Linear Products
        3. 25.3 Physics vs. Finance
        4. 25.4 How Models are Used for Pricing Standard Products
        5. 25.5 Hedging
        6. 25.6 Models for Nonstandard Products
        7. 25.7 Dangers in Model Building
        8. 25.8 Detecting Model Problems
        9. Summary
        10. Further Reading
        11. Practice Questions and Problems (Answers at End of Book)
        12. Further Questions
        13. Notes
      5. Chapter 26: Economic Capital and RAROC
        1. 26.1 Definition of Economic Capital
        2. 26.2 Components of Economic Capital
        3. 26.3 Shapes of the Loss Distributions
        4. 26.4 Relative Importance of Risks
        5. 26.5 Aggregating Economic Capital
        6. 26.6 Allocation of Economic Capital
        7. 26.7 Deutsche Bank's Economic Capital
        8. 26.8 RAROC
        9. Summary
        10. Further Reading
        11. Practice Questions and Problems (Answers at End of Book)
        12. Further Questions
        13. Notes
      6. Chapter 27: Enterprise Risk Management
        1. 27.1 Risk Appetite
        2. 27.2 Risk Culture
        3. 27.3 Identifying Major Risks
        4. 27.4 Strategic Risk Management
        5. Summary
        6. Further Reading
        7. Practice Questions and Problems (Answers at End of Book)
        8. Further Questions
        9. Notes
      7. Chapter 28: Risk Management Mistakes to Avoid
        1. 28.1 Risk Limits
        2. 28.2 Managing the Trading Room
        3. 28.3 Liquidity Risk
        4. 28.4 Lessons for Nonfinancial Corporations
        5. 28.5 A Final Point
        6. Further Reading
        7. Notes
    9. Part Six: Appendices
      1. Appendix A: Compounding Frequencies for Interest Rates
        1. Note
      2. Appendix B: Zero Rates, Forward Rates, and Zero-Coupon Yield Curves
      3. Appendix C: Valuing Forward and Futures Contracts
      4. Appendix D: Valuing Swaps
        1. Note
      5. Appendix E: Valuing European Options
        1. Note
      6. Appendix F: Valuing American Options
        1. Note
      7. Appendix G: Taylor Series Expansions
      8. Appendix H: Eigenvectors and Eigenvalues
        1. Note
      9. Appendix I: Principal Components Analysis
      10. Appendix J: Manipulation of Credit Transition Matrices
        1. Note
      11. Appendix K: Valuation of Credit Default Swaps
      12. Appendix L: Synthetic CDOs and Their Valuation
        1. Note
    10. 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
      24. Chapter 24
      25. Chapter 25
      26. Chapter 26
      27. Chapter 27
    11. Glossary
    12. 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
    13. Table for <i xmlns="http://www.w3.org/1999/xhtml" xmlns:epub="http://www.idpf.org/2007/ops" xmlns:m="http://www.w3.org/1998/Math/MathML" xmlns:svg="http://www.w3.org/2000/svg">N</i>((<i xmlns="http://www.w3.org/1999/xhtml" xmlns:epub="http://www.idpf.org/2007/ops" xmlns:m="http://www.w3.org/1998/Math/MathML" xmlns:svg="http://www.w3.org/2000/svg">x</i>) When ) When <i xmlns="http://www.w3.org/1999/xhtml" xmlns:epub="http://www.idpf.org/2007/ops" xmlns:m="http://www.w3.org/1998/Math/MathML" xmlns:svg="http://www.w3.org/2000/svg">x</i> &#8804; 0 ≤ 0
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    15. Index
    16. EULA