Financial Risk Management: Models, History, And Institutions

Financial risk has become a focus of financial and nonfinancial firms, individuals, and policy makers. But the study of risk remains a relatively new discipline in finance and continues to be refined. The financial market crisis that began in 2007 has highlighted the challenges of managing financial risk. Now, in Financial Risk Management, author Allan Malz addresses the essential issues surrounding this discipline, sharing his extensive career experiences as a risk researcher, risk manager, and central banker. The book includes standard risk measurement models as well as alternative models that address options, structured credit risks, and the real-world complexities of risk modeling, and provides the institutional and historical background on financial innovation, liquidity, leverage, and financial crises that is crucial to practitioners and students of finance for understanding the world today.

Financial Risk Management is equally suitable for firm risk managers, economists, and policy makers seeking grounding in the subject. This timely guide skillfully surveys the landscape of financial risk and the financial developments of recent decades that culminated in the crisis. The book provides a comprehensive overview of the different types of financial risk, as well as the techniques used to measure and manage them. Topics covered include:

Market risk, from Value-at-Risk (VaR) to risk models for options

Credit risk, from portfolio credit risk to structured credit products

Model risk and validation

Risk capital and stress testing

Liquidity risk, leverage, systemic risk, and the forms they take

Financial crises, historical and current, and their causes and characteristics

Financial regulation and its evolution in the wake of the global crisis

Allan M. Malz is a Senior Analytical Advisor in the Markets Group at the Federal Reserve Bank of New York, where he has also worked on implementation of the Fed's emergency liquidity programs to address the financial crisis. Before rejoining the Fed, he was chief risk officer at several multi-strategy hedge fund management firms. Previously, Malz was head of research at RiskMetrics Group, which he joined on its spinoff from J.P. Morgan. Malz spent his earlier career at the New York Fed as a researcher and foreign exchange trader. His research, which includes forecasting financial crises, risk measurement for options, and estimation of risk-neutral probability distributions, has been published in a number of industry and academic journals. Malz holds a PhD in economics from Columbia University, where he also teaches a graduate course in financial risk management.

Preface.

1 Financial risk in a crisis-prone world.

1.1 Some history: why is risk a separate discipline today?

1.2 The scope of financial risk.

2 Market risk basics.

2.1 Arithmetic, geometric, and logarithmic security returns.

2.2 Risk and securities prices: the standard asset pricing model.

2.3 The standard asset distribution model.

2.4 Portfolio risk in the standard model.

2.5 Benchmark interest rates.

3 Value-at-Risk.

3.1 Definition of value-at-risk.

3.2 Volatility estimation.

3.3 Modes of computation.

3.4 Short positions.

3.5 Expected shortfall.

4 Nonlinear risks and the treatment of bonds and options.

4.1 Nonlinear risk measurement and options.

4.2 Yield curve risk.

4.3 Fixed-income VaR using duration and convexity.

5 Portfolio VaR for market risk.

5.1 The covariance and correlation matrices.

5.2 Mapping and treatment of bonds and options.

5.3 Delta-normal VaR.

5.4 Portfolio VaR viaMonte Carlo simulation.

5.5 Option vega risk.

6 Credit and counterparty risk.

6.1 Defining credit risk.

6.2 Credit risky securities.

6.3 Transaction cost problems in credit contracts.

6.4 Default and recovery: analytic concepts.

6.5 Assessing creditworthiness.

6.6 Counterparty risk.

6.7 TheMerton model.

6.8 Credit factor models.

6.9 Credit risk measures.

7 Spread risk and default intensity models.

7.1 Credit spreads.

7.2 Default curve analytics.

7.3 Risk-neutral estimates of default probabilities.

7.4 Spread risk.

8 Portfolio credit risk.

8.1 Default correlation.

8.2 Credit portfolio risk measurement.

8.3 Credit VaR with the single-factor model.

8.4 Using simulation and copulas to estimate portfolio credit risk.

9 Structured credit risk.

9.1 Structured credit basics.

9.2 Credit scenario analysis of a securitization.

9.3 Measuring structured credit risk via simulation.

9.4 Standard tranches and implied correlation.

9.5 Issuer and investor motivations for structured credit.

10 Alternatives to the standard market risk model.

10.1 Real-world asset price behavior.

10.2 Alternative modeling approaches.

10.3 The evidence on non-normality in derivatives prices.

11 Assessing the quality of risk measures.

11.1 Model risk.

11.2 Backtesting of VaR.

11.3 Coherence of VaR estimates.

12 Liquidity and leverage.

12.1 Funding liquidity risk.

12.2 Markets for collateral.

12.3 Leverage and forms of credit in contemporary finance.

12.4 Transactions liquidity risk.

12.5 Liquidity risk measurement.

12.6 Liquidity and systemic risk.

13 Risk control and mitigation.

13.1 Defining risk capital.

13.2 Risk contributions.

13.3 Stress testing.

13.4 Sizing positions.

13.5 Risk reporting.

13.6 Hedging and basis risk.

14 Financial crises.

14.1 Panics, runs, and crashes.

14.2 Self-reinforcing mechanisms.

14.3 Behavior of asset prices during crises.

14.4 Causes of financial crises.

14.5 Anticipating financial crises.

15 Financial regulation.

15.1 Scope and structure of regulation.

15.2 Methods of regulation.

15.3 Public policy toward financial crises.

15.4 Pitfalls in regulation.

A Technical notes.

A.1 Binomial distribution.

A.2 Quantiles and quantile transformations.

A.3 Normal and lognormal distributions.

A.4 Hypothesis testing.

A.5 Monte Carlo simulation.

A.6 Homogeneous functions.

B Notation.

C Abbreviations.

D References.