Contents Cover Series Title Page Copyright Dedication Foreword Preface Acknowledgments About the Author Chapter 1: Introduction 1.1 LESSONS FROM A CRISIS 1.2 FINANCIAL RISK AND ACTUARIAL RISK 1.3 SIMULATION AND SUBJECTIVE JUDGMENT Chapter 2: Institutional Background 2.1 MORAL HAZARD—INSIDERS AND OUTSIDERS 2.2 PONZI SCHEMES 2.3 ADVERSE SELECTION 2.4 THE WINNER'S CURSE 2.5 MARKET MAKING VERSUS POSITION TAKING Chapter 3: Operational Risk 3.1 OPERATIONS RISK 3.2 LEGAL RISK 3.3 REPUTATIONAL RISK 3.4 ACCOUNTING RISK 3.5 FUNDING LIQUIDITY RISK 3.6 ENTERPRISE RISK 3.7 IDENTIFICATION OF RISKS 3.8 OPERATIONAL RISK CAPITAL Chapter 4: Financial Disasters 4.1 DISASTERS DUE TO MISLEADING REPORTING 4.2 DISASTERS DUE TO LARGE MARKET MOVES 4.3 DISASTERS DUE TO THE CONDUCT OF CUSTOMER BUSINESS Chapter 5: The Systemic Disaster of 2007–2008 5.1 OVERVIEW 5.2 THE CRISIS IN CDOS OF SUBPRIME MORTGAGES 5.3 THE SPREAD OF THE CRISIS 5.4 LESSONS FROM THE CRISIS FOR RISK MANAGERS 5.5 LESSONS FROM THE CRISIS FOR REGULATORS 5.6 BROADER LESSONS FROM THE CRISIS Chapter 6: Managing Financial Risk 6.1 RISK MEASUREMENT 6.2 RISK CONTROL Chapter 7: VaR and Stress Testing 7.1 VAR METHODOLOGY 7.2 STRESS TESTING 7.3 USES OF OVERALL MEASURES OF FIRM POSITION RISK Chapter 8: Model Risk 8.1 HOW IMPORTANT IS MODEL RISK? 8.2 MODEL RISK EVALUATION AND CONTROL 8.3 LIQUID INSTRUMENTS 8.4 ILLIQUID INSTRUMENTS 8.5 TRADING MODELS Chapter 9: Managing Spot Risk 9.1 OVERVIEW 9.2 FOREIGN EXCHANGE SPOT RISK 9.3 EQUITY SPOT RISK 9.4 PHYSICAL COMMODITIES SPOT RISK Chapter 10: Managing Forward Risk 10.1 INSTRUMENTS 10.2 MATHEMATICAL MODELS OF FORWARD RISKS 10.3 FACTORS IMPACTING BORROWING COSTS 10.4 RISK MANAGEMENT REPORTING AND LIMITS FOR FORWARD RISK Chapter 11: Managing Vanilla Options Risk 11.1 OVERVIEW OF OPTIONS RISK MANAGEMENT 11.2 THE PATH DEPENDENCE OF DYNAMIC HEDGING 11.3 A SIMULATION OF DYNAMIC HEDGING 11.4 RISK REPORTING AND LIMITS 11.5 DELTA HEDGING 11.6 BUILDING A VOLATILITY SURFACE 11.7 SUMMARY Chapter 12: Managing Exotic Options Risk 12.1 SINGLE-PAYOUT OPTIONS 12.2 TIME-DEPENDENT OPTIONS 12.3 PATH-DEPENDENT OPTIONS 12.4 CORRELATION-DEPENDENT OPTIONS 12.5 CORRELATION-DEPENDENT INTEREST RATE OPTIONS Chapter 13: Credit Risk 13.1 SHORT-TERM EXPOSURE TO CHANGES IN MARKET PRICES 13.2 MODELING SINGLE-NAME CREDIT RISK 13.3 PORTFOLIO CREDIT RISK 13.4 RISK MANAGEMENT OF MULTINAME CREDIT DERIVATIVES Chapter 14: Counterparty Credit Risk 14.1 OVERVIEW 14.2 EXCHANGE-TRADED DERIVATIVES 14.3 OVER-THE-COUNTER DERIVATIVES References About the Companion Website Index Founded in 1807, John Wiley & Sons is the oldest independent publishing company in the United States With offices in North America, Europe, Australia, and Asia, Wiley is globally committed to developing and marketing print and electronic products and services for our customers' professional and personal knowledge and understanding The Wiley Finance series contains books written specifically for finance and investment professionals as well as 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practitioner's guide to managing market and credit risk / Steven Allen — 2nd ed online resource Includes bibliographical references and index Description based on print version record and CIP data provided by publisher; resource not viewed ISBN 978-1-118-17545-3 (cloth); 978-1-118-22652-0 (ebk.); ISBN 978-1-118-23164-7 (ebk.); ISBN 978-1-118-26473-7 (ebk.) Financial risk management Finance I Title HD61 658.15'5—dc23 2012029614 To Caroline For all the ways she has helped bring this project to fruition And for much, much more Pindyck, Robert Pin risk (Taleb) Pirrong, Craig Plain-vanilla options See Vanilla option risk management Ponzi, Charles Ponzi schemes broadened meaning hedge slippage and Kidder Peabody case losses from unauthorized positions and original meaning Portfolio credit risk computational alternatives to full simulation estimating default correlations Monte Carlo simulation of risk management and reporting for portfolio credit exposures Portfolio insurance Portfolio Risk Tracker Portfolio theory Position managers, in front office Position taking: defined gambling analogy instruments outside area of expertise market making versus models as forecasting tools risk measurement for Power options Predescu, Mirela Price taking See Position taking Price-vol matrix: advantage of for being a short a call option for a calendar spread for a call spread interpolation results based on for a reduced risk portfolio in vanilla option risk management PriceVolMatrixCycle spreadsheet PriceVolMatrix spreadsheet Pricewaterhouse Coopers Prince, Chuck Private equity funds, need for broader regulatory oversight Procter & Gamble (P&G) Program trading Proprietary trading Prudential-Bache Securities Pull to par Pyramid schemes See also Ponzi schemes Quanto: nonlinear combinations of asset prices single-asset quanto options Quanto worksheet Rafael, Andrea Raiffa, Howard Rainbow contracts Rajan, Raghuram Ramberg, John Random matrix theory/shrinkage estimation RateData spreadsheet Rates spreadsheet Ratios worksheet Rawnsley, Judith Real options Rebates, barrier options with Rebonato, Riccardo Rebooking trades Reduced risk portfolio Rehedging Reiner, Eric Remargin period Remolona, Eli Renault, Olivier Rennie, Andrew Repurchase agreements (RPs) Reputational risk accounting risk as form of Bankers Trust (BT) case defined large money moves and nature of Researchers, in front office Reserves See Valuation reserves Resti, Andrea Revealing positions, problems of Richardson, Matthew Right-way risk Risk-adjusted return on capital (RAROC) Risk aggregation Risk arbitrage See Merger arbitrage Risk control detailed limits on size of exposure incentive-based approach to internal hedging in risk decomposition and Risk decomposition: defined models to perform reporting in risk control and Risk Identification for Large Exposures (RIFLE) Risk magazine Risk management See Financial risk management Risk Management Association Risk managers, in front office Risk measurement analysis of revenue exposure to changes in market prices general principles instruments that lack liquidity liquidation time and market valuation for position taking principles of risk management in rules for stop-loss limit valuation reserves and RiskMetrics Group Risk of fraud pressures Risk of nondeliberate incorrect information Risk reversals Roe, John Roseman, Alan Rosen, Dan Ross, Stephen Roubini, Nouriel Royal Bank of Scotland Rubinstein, Mark Rullière, Didier Runyon, Damon Rusnak, John Russian debt default of 1998 Salespeople, in front office Salmon, Felix Salomon Brothers Sanders, Anthony Sarkar, Asani Saunders, Anthony Scenario analysis Schachter, Barry Scheinkman, Jose Scheuermann, Til Schonbucher, Philipp Schorderet, Yann Schuermann, Til Schutz, Dirk Seasonality, of borrowing costs Securities and Exchange Commission (SEC) Securities Industry Association Seinfeld (TV program) Sell side See Market makers/market making Semi-American options Semi-European options Senior Supervisors Group report Senior tranches September 11, 2001 attacks, disaster risk and Serrat, Angel Shakespeare, William Shareholders: information asymmetry and outside monitors for Shareholder value added (SVA) Sharma, Pawan Sharpe, William Sharpe ratio Shaw, Julian Shiller, Robert Shin, Hyun Song Shirreff, David Shkolnik, Alexander Short, meanings of Shortfall/expected shortfall VaR Shorting a call option Short squeeze Short-term credit exposure CDS-bond basis risk convexity of credit instruments impact of bankruptcy law risk reporting for market credit exposures Sidenius, Jakob Sifakis, Carl Simulation See also Monte Carlo simulation advantages of computational alternatives to full simulation historical data in illiquid positions in Monte Carlo (see Monte Carlo simulation) nature of of P&L distribution Simulation for risk measurement subjective judgment and Single-asset quanto options Single-name credit risk estimating amount owed at default estimating loss given default estimating probability of default option-theoretic approach Single-payout options accrual swaps binary options contingent premium options convexity described intensity of use log contract swaps single-asset quanto options variance swaps Singleton, Kenneth Sironi, Andrea Skew Smiles Smith, Adam Smith, Roy Smithson, Charles Société Générale case detection of unauthorized positions development of unauthorized positions failure to detect unauthorized positions further reading incident lessons to be learned result Sony Corporation Sorkin, Andrew Ross Soros, George South Korea SpecComm Speculation See Position taking Spence, Michael Split-fee options Spot risk management equity firm-level risk management foreign exchange overview physical commodities spot trades, defined Spreadsheets: AmericanOption spreadsheet BasketHedge spreadsheet BasketOption spreadsheet BinaryMC spreadsheet Bootstrap spreadsheet calculating default rates from bond rates CapFit spreadsheet CarrBarrierMC spreadsheet CarrBarrier spreadsheet CDO spreadsheet comparing the jump process credit model to the Merton model CreditPricer spreadsheet CrossHedge spreadsheet DataMetricsRatesData spreadsheet DermanErgenerKani20 spreadsheet DermanErgenerKaniDoubleBarrier spreadsheet DermanErgenerKaniPartialBarrier spreadsheet DermanErgenerKani spreadsheet EVT spreadsheet ForwardStartOption spreadsheet ForwardStart spreadsheet generating fat tails in Monte Carlo simulations interpolation JumpProcessCredit spreadsheet maximizing diversification measuring fat tails in historical data MertonModel spreadsheet MixtureofNormals spreadsheet Monte Carlo simulation of options hedging NastyPath spreadsheet OptBarrier spreadsheet OptionMC1000 spreadsheet OptionMCHedged1000 spreadsheet OptionMCHedged spreadsheet OptionMC spreadsheet OptionRoll spreadsheet options portfolio risk measures PriceVolMatrixCycle spreadsheet PriceVolMatrix spreadsheet RateData spreadsheet Rates spreadsheet simulation of the impact of trading rules on expected return and risk stack and roll Swaptions spreadsheet TermStructure spreadsheet using Vasicek model for risk measurement of CDO tranches value-at-risk computations VaR spreadsheet (example) VolCurve spreadsheet VolSurfaceStrike spreadsheet WinnersCurse spreadsheet Squam Lake Group Stack-and-roll hedge advantages of described Stafford, Erik Standard & Poor's (S&P) 500 stock index Standard & Poor's (S&P) ratings Static hedging strategies: for barrier options for exotic options flows representing promised deliveries indexed flows nature of pricing illiquid flows by interpolation quasistatic representations stack-and-roll hedge Static overhedge Statistical hedging, inadequate analysis in financial crisis of 2007–2008 Stay period Stein, Roger Sticky delta Sticky strike Stiglitz, Joseph Stigum, Marcia Stochastic volatility models Stop-loss limits Storage costs Stress tests in assessing credit risk in capital requirements reform recommendations of counterparty credit exposure economic scenario stress tests for exchange-traded derivatives factor-push historical data stress tests impact of large money moves and inadequate large money moves and Monte Carlo simulation versus Monte Carlo simulation with overall measures of firm position risk overview performance measurement and for positions that achieve liquidity Strickland, Chris Stroughair, John Structured Finance Litigation blog Structured investment vehicles (SIVs) Structurers, in front office Subjective judgment See also Stress tests historical information versus in Li's Gaussian copula formula simulation and Subprime mortgage originators See also Financial crisis of 2007–2008 in financial crisis of 2007–2008 Sullivan, Arthur Sumitomo Corporation of Japan Suo, Wulin Super-senior tranches Swaps: accrual basis binary credit default credit default (see Credit default swaps [CDS]) cross-currency interest rate log contract total return variance volatility Swaptions Bermudan European relationships between cap prices and Swaptions spreadsheet Swensen, David Swiss Bank Corporation (SBC) Synthetic tranches Systematic/nondiversifiable risk Tadikamalla, Pandu Taleb, Nassim Tanega, Joseph Technologists, in front office Technology stock bubble (2001) Telecom Term structure models TermStructure spreadsheet Tett, Gillian Thaler, Richard Theta: defined price-vol-matrix and Tickets in the drawer Time-dependent options cliquet options compound options described forward-start options intensity of use “Too big to fail” mentality Total return swaps Totem Market Valuations service Trade cancellation Trade compression Traders: adverse selection and collusion and conservatism versus independence and control personnel versus delta rehedging and detailed limits on size of exposure fraud risk and in front office G-30 recommendations on trading risk incentive-based approaches in risk control information asymmetry and monopoly rents and moral hazard and positions in instruments outside area of expertise pressure to book immediate profits trading models and valuation reserves and Trading and Capital-Markets Activities Manual (Federal Reserve System) Trading models Transportation costs, in physical commodities spot risk Treasury function, funding liquidity risk control and Trinomial tree model Tsiveriotis, Kostas Tuckman, Bruce Turner Review Twelfth Night (Shakespeare) UniCredit Group Union Bank of Switzerland (UBS): Amplified Mortgage Portfolio (AMPS) analysis of financial crisis of 2007–2008 VaR methodologies Union Bank of Switzerland (UBS) case development of authorized positions further reading incident lessons learned result Up and in (knock-in) Up and out (knock-out) Utopia, Limited (Gilbert & Sullivan) Vacation policy Valuation reserves aging reserve policy impact of exiting large positions model verification and objective standards for reserves to shield earnings from fluctuation Value at risk (VaR) analysis back-testing based on credit rating agencies based on historical variance/covariance Value at risk (VaR) analysis in capital requirements reform recommendations counterparty credit exposure detail recorded on positions and market prices determining all market variables direct measurement of profit and loss earnings volatility and for exchange-traded derivatives exotic derivative prices and extreme value theory (EVT) in in financial crisis of 2007–2008 for forward positions illiquid positions in importance sampling in liquidity considerations in measures of profit and loss distribution nonstatistical measures versus for option positions overall measures of firm position risk overreliance on performance measurement and for positions that are born illiquid in risk control shortfall/expected shortfall simulations of P&L for spot positions Vanilla option risk management building a volatility surface conventions delta hedging dynamic hedging strategies overview risk reporting and limits tools in vanilla call spread vanilla options, defined van Nieuwerburgh, Stijn VaR analysis See Value at risk (VaR) analysis Varian, Hal Variance gamma model Variance swaps VaR spreadsheet Vasicek model Vause, Nicholas Vega: defined price-vol-matrix and Vigorish Volatility surface extrapolating based on time period interpolating between strikes interpolation between time periods for pricing vanilla options Volatility swaps Volcker, Paul Volcker rule VolCurve spreadsheet VolSurfaceStrike spreadsheet Vosey Inheritance, The (Granville-Barker) Wagner, Christoph Wall Street Journal Walter, Ingo Wang, Jin Wang, Yuan Washington Mutual Wealth of Nations, The (Smith) Weather derivative options Weinberger, Alfred Weiss, Gary Whaley, Elizabeth White, Alan White, Lawrence Williams, Jeffrey Williams, Meredith Wilmott, Paul Wilson, Charles Wilson, Harry Wilson, Thomas Winner's curse application to trading defined mechanism leading to WinnersCurse spreadsheet Winters, Bill Wired magazine Wolfe, Eric Wolfe, Lan-Ling World Bank Wrong-way risk Y2K crisis Yield curve, nonstatistical limits on yield curve shape Youngblood, Michael Zandi, Mark Ziehmann, Christine Zou, Joseph Z-score model ... proper practice of financial risk management The first core principle is that financial risk management is not just risk management as practiced in financial institutions; it is risk management that... divided into three parts: general background to financial risk management, the principles of financial risk management, and the details of financial risk management The general background part (Chapters... Operational Risk 3.1 OPERATIONS RISK 3.2 LEGAL RISK 3.3 REPUTATIONAL RISK 3.4 ACCOUNTING RISK 3.5 FUNDING LIQUIDITY RISK 3.6 ENTERPRISE RISK 3.7 IDENTIFICATION OF RISKS 3.8 OPERATIONAL RISK CAPITAL