Risk management and financial institutions

Includes index.

Previous edition: 2012.
First and second editions published by Prentice Hall in 2006 and 2009.

Business Snapshots xxiiiPreface xxvChapter 1 Introduction 11.1 Risk vs. Return for Investors 21.2 The Efficient Frontier 61.3 The Capital Asset Pricing Model 81.4 Arbitrage Pricing Theory 141.5 Risk vs. Return for Companies 141.6 Risk Management by Financial Institutions 181.7 Credit Ratings 19Summary 20Further Reading 20Practice Questions and Problems (Answers at End of Book) 21Further Questions 22Part 1: Financial Institutions and Their Trading 23Chapter 2 Banks 252.1 Commercial Banking 262.2 The Capital Requirements of a Small Commercial Bank 282.3 Deposit Insurance 302.4 Investment Banking 312.5 Securities Trading 362.6 Potential Conflicts of Interest in Banking 382.7 Today's Large Banks 392.8 The Risks Facing Banks 42Summary 43Further Reading 43Practice Questions and Problems (Answers at End of Book) 44Further Questions 44Chapter 3 Insurance Companies and Pension Plans 473.1 Life Insurance 483.2 Annuity Contracts 513.3 Mortality Tables 523.4 Longevity and Mortality Risk 563.5 Property-Casualty Insurance 573.6 Health Insurance 603.7 Moral Hazard and Adverse Selection 613.8 Reinsurance 623.9 Capital Requirements 633.10 The Risks Facing Insurance Companies 643.11 Regulation 643.12 Pension Plans 66Summary 70Further Reading 71Practice Questions and Problems (Answers at End of Book) 71Further Questions 72Chapter 4 Mutual Funds, ETFs, and Hedge Funds 754.1 Mutual Funds 754.2 Exchange-Traded Funds 794.3 Active vs. Passive Management 804.4 Regulation 824.5 Hedge Funds 834.6 Hedge Fund Strategies 884.7 Hedge Fund Performance 93Summary 94Further Reading 95Practice Questions and Problems (Answers at End of Book) 95Further Questions 96Chapter 5 Trading in Financial Markets 975.1 The Markets 975.2 Clearing Houses 985.3 Long and Short Positions in Assets 995.4 Derivatives Markets 1015.5 Plain Vanilla Derivatives 1025.6 Non-Traditional Derivatives 1145.7 Exotic Options and Structured Products 1175.8 Risk Management Challenges 118Summary 120Further Reading 122Practice Questions and Problems (Answers at End of Book) 122Further Questions 125Chapter 6 The Credit Crisis of 2007-2008 1276.1 The U.S. Housing Market 1286.2 Securitization 1316.3 The Losses 1376.4 What Went Wrong? 1386.5 Lessons from the Crisis 140Summary 141Further Reading 142Practice Questions and Problems (Answers at End of Book) 142Further Questions 143Chapter 7 Valuation and Scenario Analysis: The Risk-Neutral and Real Worlds 1457.1 Volatility and Asset Prices 1467.2 Risk-Neutral Valuation 1477.3 Scenario Analysis 1527.4 When Both Worlds Have to Be Used 1537.5 The Calculations in Practice 1547.6 Estimating Real-World Processes 155Summary 156Further Reading 157Practice Questions and Problems (Answers at End of Book) 157Further Questions 158Part 2: Market Risk 159Chapter 8 How Traders Manage Their Risks 1618.1 Delta 1618.2 Gamma 1698.3 Vega 1718.4 Theta 1738.5 Rho 1748.6 Calculating Greek Letters 1748.7 Taylor Series Expansions 1758.8 The Realities of Hedging 1778.9 Hedging Exotic Options 1788.10 Scenario Analysis 180Summary 181Further Reading 181Practice Questions and Problems (Answers at End of Book) 181Further Questions 182Chapter 9 Interest Rate Risk 1859.1 The Management of Net Interest Income 1869.2 Types of Rates 1889.3 Duration 1939.4 Convexity 1969.5 Generalization 1989.6 Nonparallel Yield Curve Shifts 2009.7 Principal Components Analysis 2049.8 Gamma and Vega 207Summary 208Further Reading 209Practice Questions and Problems (Answers at End of Book) 209Further Questions 210Chapter 10 Volatility 21310.1 Definition of Volatility 21310.2 Implied Volatilities 21510.3 Are Daily Percentage Changes in FinancialVariables Normal? 21710.4 The Power Law 22010.5 Monitoring Daily Volatility 22210.6 The Exponentially Weighted Moving Average Model 22510.7 The GARCH(1,1) Model 22710.8 Choosing Between the Models 22910.9 Maximum Likelihood Methods 22910.10 Using GARCH(1,1) to Forecast Future Volatility 235Summary 239Further Reading 239Practice Questions and Problems (Answers at End of Book) 240Further Questions 241Chapter 11 Correlations and Copulas 24311.1 Definition of Correlation 24311.2 Monitoring Correlation 24511.3 Correlation and Covariance Matrices 24811.4 Multivariate Normal Distributions 25011.5 Copulas 25211.6 Application to Loan Portfolios: Vasicek's Model 258Summary 264Further Reading 264Practice Questions and Problems (Answers at End of Book) 265Further Questions 266Chapter 12 Value at Risk and Expected Shortfall 26912.1 Definition of VaR 27112.2 Examples of the Calculation of VaR 27212.3 A Drawback of VaR 27312.4 Expected Shortfall 27412.5 Coherent Risk Measures 27412.6 Choice of Parameters for VaR and ES 27812.7 Marginal, Incremental, and Component Measures 28312.8 Euler's Theorem 28412.9 Aggregating VaRs and ESs 28512.10 Back-Testing 285Summary 289Further Reading 289Practice Questions and Problems (Answers at End of Book) 290Further Questions 291Chapter 13 Historical Simulation and Extreme Value Theory 29313.1 The Methodology 29313.2 Accuracy of VaR 29913.3 Extensions 30113.4 Computational Issues 30613.5 Extreme Value Theory 30713.6 Applications of EVT 310Summary 313Further Reading 313Practice Questions and Problems (Answers at End of Book) 314Further Questions 314Chapter 14 Model-Building Approach 31714.1 The Basic Methodology 31814.2 Generalization 32114.3 The Four-Index Example Revisited 32314.4 Handling Term Structures 32614.5 Extensions of the Basic Procedure 33114.6 Risk Weights and Weighted Sensitivities 33214.7 Handling Non-Linearity 33314.8 Model-Building vs.Historical Simulation 339Summary 340Further Reading 340Practice Questions and Problems (Answers at End of Book) 341Further Questions 342Part 3: Regulation 345Chapter 15 Basel I, Basel II, and Solvency II 34715.1 The Reasons for Regulating Banks 34715.2 Bank Regulation Pre-1988 34815.3 The 1988 BIS Accord 35015.4 The G-30 Policy Recommendations 35315.5 Netting 35415.6 The 1996 Amendment 35615.7 Basel II 35915.8 Credit Risk Capital Under Basel II 36015.9 Operational Risk Capital Under Basel II 36915.10 Pillar 2: Supervisory Review 37015.11 Pillar 3: Market Discipline 37015.12 Solvency II 371Summary 372Further Reading 373Practice Questions and Problems (Answers at End of Book) 373Further Questions 375Chapter 16 Basel II.5, Basel III, and Other Post-Crisis Changes 37716.1 Basel II.5 37816.2 Basel III 38116.3 Contingent Convertible Bonds 39016.4 Use of Standardized Approaches and SA-CCR 39016.5 Dodd-Frank Act 39216.6 Legislation in Other Countries 394Summary 396Further Reading 397Practice Questions and Problems (Answers at End of Book) 397Further Questions 398Chapter 17 Regulation of the OTC Derivatives Market 39917.1 Clearing in OTC Markets 40017.2 Post-Crisis Regulatory Changes 40417.3 Impact of the Changes 40817.4 CCPs and Bankruptcy 412Summary 412Further Reading 413Practice Questions and Problems (Answers at End of Book) 413Further Questions 414Chapter 18 Fundamental Review of the Trading Book 41518.1 Background 41618.2 Standardized Approach 41718.3 Internal Models Approach 42118.4 Trading Book vs. Banking Book 425Summary 426Further Reading 426Practice Questions and Problems (Answers at End of Book) 426Further Question 427Part 4: Credit Risk 429Chapter 19 Estimating Default Probabilities 43119.1 Credit Ratings 43119.2 Historical Default Probabilities 43419.3 Recovery Rates 43619.4 Credit Default Swaps 43719.5 Credit Spreads 44219.6 Estimating Default Probabilities from Credit Spreads 44419.7 Comparison of Default Probability Estimates 44719.8 Using Equity Prices to Estimate Default Probabilities 452Summary 454Further Reading 455Practice Questions and Problems (Answers at End of Book) 455Further Questions 457Chapter 20 CVA and DVA 45920.1 Credit Exposure on Derivatives 46020.2 CVA 46120.3 The Impact of a New Transaction 46520.4 CVA Risk 46720.5 Wrong-Way Risk 46820.6 DVA 46920.7 Some Simple Examples 470Summary 474Further Reading 475Practice Questions and Problems (Answers at End of Book) 475Further Questions 476Chapter 21 Credit Value at Risk 47921.1 Ratings Transition Matrices 48021.2 Vasicek's Model 48221.3 Credit Risk Plus 48321.4 Creditmetrics 48621.5 Credit Spread Risk 488Summary 492Further Reading 492Practice Questions and Problems (Answers at End of Book) 492Further Questions 493Part 5: Other Topics 495Chapter 22 Scenario Analysis and Stress Testing 49722.1 Generating the Scenarios 49722.2 Regulation 50422.3 What to Do with the Results 507Summary 511Further Reading 511Practice Questions and Problems (Answers at End of Book) 512Further Questions 513Chapter 23 Operational Risk 51523.1 Defining Operational Risk 51723.2 Categorization of Operational Risks 51823.3 Regulatory Capital Under Basel II 51923.4 The Standardized Measurement Approach 52523.5 Preventing Operational Risk Losses 52723.6 Allocation of Operational Risk Capital 53023.7 Use of Power Law 53023.8 Insurance 53123.9 Sarbanes-Oxley 533Summary 533Further Reading 534Practice Questions and Problems (Answers at End of Book) 535Further Questions 536Chapter 24 Liquidity Risk 53724.1 Liquidity Trading Risk 53824.2 Liquidity Funding Risk 54524.3 Liquidity Black Holes 554Summary 561Further Reading 562Practice Questions and Problems (Answers at End of Book) 562Further Questions 563Chapter 25 Model Risk Management 56525.1 Regulatory Requirements 56625.2 Models in Physics and Finance 57225.3 Simple Models: Expensive Mistakes 57225.4 Models for Pricing Actively Traded Products 57525.5 Models for Less Actively Traded Products 57825.6 Accounting 58025.7 What Makes a Successful Pricing Model? 58025.8 Model Building Missteps 581Summary 582Further Reading 583Practice Questions and Problems (Answers at End of Book) 583Further Questions 584Chapter 26 Economic Capital and RAROC 58526.1 Definition of Economic Capital 58626.2 Components of Economic Capital 58826.3 Shapes of the Loss Distributions 59026.4 Relative Importance of Risks 59126.5 Aggregating Economic Capital 59226.6 Allocation of Economic Capital 59626.7 Deutsche Bank's Economic Capital 59726.8 RAROC 598Summary 600Further Reading 600Practice Questions and Problems (Answers at End of Book) 600Further Questions 601Chapter 27 Enterprise Risk Management 60327.1 Risk Appetite 60427.2 Risk Culture 61027.3 Identifying Major Risks 61427.4 Strategic Risk Management 616Summary 617Further Reading 618Practice Questions and Problems (Answers at End of Book) 618Further Questions 619Chapter 28 Financial Innovation 62128.1 Technological Advances 62228.2 Payment Systems 62528.3 Lending 62928.4 Wealth Management 63228.5 Insurance 63328.6 Regulation and Compliance 63528.7 How Should Financial Institutions Respond? 638Summary 640Further Reading 641Practice Questions and Problems (Answers at End of Book) 641Further Questions 642Chapter 29 Risk Management Mistakes to Avoid 64329.1 Risk Limits 64329.2 Managing the Trading Room 64729.3 Liquidity Risk 64929.4 Lessons for Nonfinancial Corporations 65229.5 A Final Point 653Further Reading 654Part 6: Appendices 655Appendix A Compounding Frequencies for Interest Rates 657Appendix B Zero Rates, Forward Rates, and Zero-Coupon Yield Curves 661Appendix C Valuing Forward and Futures Contracts 667Appendix D Valuing Swaps 669Appendix E Valuing European Options 673Appendix F Valuing American Options 677Appendix G Taylor Series Expansions 681Appendix H Eigenvectors and Eigenvalues 685Appendix I Principal Components Analysis 689Appendix J Manipulation of Credit Transition Matrices 691Appendix K Valuation of Credit Default Swaps 693Appendix L Synthetic CDOs and Their Valuation 697Answers to Questions and Problems 701Glossary 745RMFI Software 773Table for N(x) When x 0 777Table for N(x) When x 0 779Index 781

Risk Management and Financial Institutions, Fifth Edition 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