Risk management and financial institutions

TABLE OF CONTENTS
Business Snapshots xxiii

Preface xxv

Chapter 1 Introduction 1

1.1 Risk vs. Return for Investors 2

1.2 The Efficient Frontier 6

1.3 The Capital Asset Pricing Model 8

1.4 Arbitrage Pricing Theory 14

1.5 Risk vs. Return for Companies 14

1.6 Risk Management by Financial Institutions 18

1.7 Credit Ratings 19

Summary 20

Further Reading 20

Practice Questions and Problems (Answers at End of Book) 21

Further Questions 22

Part 1: Financial Institutions and Their Trading 23

Chapter 2 Banks 25

2.1 Commercial Banking 26

2.2 The Capital Requirements of a Small Commercial Bank 28

2.3 Deposit Insurance 30

2.4 Investment Banking 31

2.5 Securities Trading 36

2.6 Potential Conflicts of Interest in Banking 38

2.7 Today’s Large Banks 39

2.8 The Risks Facing Banks 42

Summary 43

Further Reading 43

Practice Questions and Problems (Answers at End of Book) 44

Further Questions 44

Chapter 3 Insurance Companies and Pension Plans 47

3.1 Life Insurance 48

3.2 Annuity Contracts 51

3.3 Mortality Tables 52

3.4 Longevity and Mortality Risk 56

3.5 Property-Casualty Insurance 57

3.6 Health Insurance 60

3.7 Moral Hazard and Adverse Selection 61

3.8 Reinsurance 62

3.9 Capital Requirements 63

3.10 The Risks Facing Insurance Companies 64

3.11 Regulation 64

3.12 Pension Plans 66

Summary 70

Further Reading 71

Practice Questions and Problems (Answers at End of Book) 71

Further Questions 72

Chapter 4 Mutual Funds, ETFs, and Hedge Funds 75

4.1 Mutual Funds 75

4.2 Exchange-Traded Funds 79

4.3 Active vs. Passive Management 80

4.4 Regulation 82

4.5 Hedge Funds 83

4.6 Hedge Fund Strategies 88

4.7 Hedge Fund Performance 93

Summary 94

Further Reading 95

Practice Questions and Problems (Answers at End of Book) 95

Further Questions 96

Chapter 5 Trading in Financial Markets 97

5.1 The Markets 97

5.2 Clearing Houses 98

5.3 Long and Short Positions in Assets 99

5.4 Derivatives Markets 101

5.5 Plain Vanilla Derivatives 102

5.6 Non-Traditional Derivatives 114

5.7 Exotic Options and Structured Products 117

5.8 Risk Management Challenges 118

Summary 120

Further Reading 122

Practice Questions and Problems (Answers at End of Book) 122

Further Questions 125

Chapter 6 The Credit Crisis of 2007–2008 127

6.1 The U.S. Housing Market 128

6.2 Securitization 131

6.3 The Losses 137

6.4 What Went Wrong? 138

6.5 Lessons from the Crisis 140

Summary 141

Further Reading 142

Practice Questions and Problems (Answers at End of Book) 142

Further Questions 143

Chapter 7 Valuation and Scenario Analysis: The Risk-Neutral and Real Worlds 145

7.1 Volatility and Asset Prices 146

7.2 Risk-Neutral Valuation 147

7.3 Scenario Analysis 152

7.4 When Both Worlds Have to Be Used 153

7.5 The Calculations in Practice 154

7.6 Estimating Real-World Processes 155

Summary 156

Further Reading 157

Practice Questions and Problems (Answers at End of Book) 157

Further Questions 158

Part 2: Market Risk 159

Chapter 8 How Traders Manage Their Risks 161

8.1 Delta 161

8.2 Gamma 169

8.3 Vega 171

8.4 Theta 173

8.5 Rho 174

8.6 Calculating Greek Letters 174

8.7 Taylor Series Expansions 175

8.8 The Realities of Hedging 177

8.9 Hedging Exotic Options 178

8.10 Scenario Analysis 180

Summary 181

Further Reading 181

Practice Questions and Problems (Answers at End of Book) 181

Further Questions 182

Chapter 9 Interest Rate Risk 185

9.1 The Management of Net Interest Income 186

9.2 Types of Rates 188

9.3 Duration 193

9.4 Convexity 196

9.5 Generalization 198

9.6 Nonparallel Yield Curve Shifts 200

9.7 Principal Components Analysis 204

9.8 Gamma and Vega 207

Summary 208

Further Reading 209

Practice Questions and Problems (Answers at End of Book) 209

Further Questions 210

Chapter 10 Volatility 213

10.1 Definition of Volatility 213

10.2 Implied Volatilities 215

10.3 Are Daily Percentage Changes in Financial

Variables Normal? 217

10.4 The Power Law 220

10.5 Monitoring Daily Volatility 222

10.6 The Exponentially Weighted Moving Average Model 225

10.7 The GARCH(1,1) Model 227

10.8 Choosing Between the Models 229

10.9 Maximum Likelihood Methods 229

10.10 Using GARCH(1,1) to Forecast Future Volatility 235

Summary 239

Further Reading 239

Practice Questions and Problems (Answers at End of Book) 240

Further Questions 241

Chapter 11 Correlations and Copulas 243

11.1 Definition of Correlation 243

11.2 Monitoring Correlation 245

11.3 Correlation and Covariance Matrices 248

11.4 Multivariate Normal Distributions 250

11.5 Copulas 252

11.6 Application to Loan Portfolios: Vasicek’s Model 258

Summary 264

Further Reading 264

Practice Questions and Problems (Answers at End of Book) 265

Further Questions 266

Chapter 12 Value at Risk and Expected Shortfall 269

12.1 Definition of VaR 271

12.2 Examples of the Calculation of VaR 272

12.3 A Drawback of VaR 273

12.4 Expected Shortfall 274

12.5 Coherent Risk Measures 274

12.6 Choice of Parameters for VaR and ES 278

12.7 Marginal, Incremental, and Component Measures 283

12.8 Euler’s Theorem 284

12.9 Aggregating VaRs and ESs 285

12.10 Back-Testing 285

Summary 289

Further Reading 289

Practice Questions and Problems (Answers at End of Book) 290

Further Questions 291

Chapter 13 Historical Simulation and Extreme Value Theory 293

13.1 The Methodology 293

13.2 Accuracy of VaR 299

13.3 Extensions 301

13.4 Computational Issues 306

13.5 Extreme Value Theory 307

13.6 Applications of EVT 310

Summary 313

Further Reading 313

Practice Questions and Problems (Answers at End of Book) 314

Further Questions 314

Chapter 14 Model-Building Approach 317

14.1 The Basic Methodology 318

14.2 Generalization 321

14.3 The Four-Index Example Revisited 323

14.4 Handling Term Structures 326

14.5 Extensions of the Basic Procedure 331

14.6 Risk Weights and Weighted Sensitivities 332

14.7 Handling Non-Linearity 333

14.8 Model-Building vs.Historical Simulation 339

Summary 340

Further Reading 340

Practice Questions and Problems (Answers at End of Book) 341

Further Questions 342

Part 3: Regulation 345

Chapter 15 Basel I, Basel II, and Solvency II 347

15.1 The Reasons for Regulating Banks 347

15.2 Bank Regulation Pre-1988 348

15.3 The 1988 BIS Accord 350

15.4 The G-30 Policy Recommendations 353

15.5 Netting 354

15.6 The 1996 Amendment 356

15.7 Basel II 359

15.8 Credit Risk Capital Under Basel II 360

15.9 Operational Risk Capital Under Basel II 369

15.10 Pillar 2: Supervisory Review 370

15.11 Pillar 3: Market Discipline 370

15.12 Solvency II 371

Summary 372

Further Reading 373

Practice Questions and Problems (Answers at End of Book) 373

Further Questions 375

Chapter 16 Basel II.5, Basel III, and Other Post-Crisis Changes 377

16.1 Basel II.5 378

16.2 Basel III 381

16.3 Contingent Convertible Bonds 390

16.4 Use of Standardized Approaches and SA-CCR 390

16.5 Dodd–Frank Act 392

16.6 Legislation in Other Countries 394

Summary 396

Further Reading 397

Practice Questions and Problems (Answers at End of Book) 397

Further Questions 398

Chapter 17 Regulation of the OTC Derivatives Market 399

17.1 Clearing in OTC Markets 400

17.2 Post-Crisis Regulatory Changes 404

17.3 Impact of the Changes 408

17.4 CCPs and Bankruptcy 412

Summary 412

Further Reading 413

Risk Management and Financial Institutions, explains all aspects of financial risk and financial institution regulation, helping you better understand the financial markets—and their potential dangers. Inside, you’ll 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 to understand and quantify the risks associated with their decisions. This book provides a complete guide to risk management 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

• Get the help you need, whether you’re a student or a professional

Risk management has become increasingly important in recent years 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, Fifth Edition is an informative, authoritative guide.