Macrofinancial Risk Analysis -- Contents -- Foreword -- Preface -- 1 Introduction -- PART I OVERVIEW OF FINANCE, MACROECONOMICS, AND RISK CONCEPTS -- 2 An Overview of Macroeconomics, and Why the Theory of Asset Pricing and Contingent Claims Should Shape its Future -- 2.1 An overview of macroeconomics -- 2.2 How uncertainty is incorporated into macroeconomic models -- 2.3 Missing components in macro models: balance sheets with risk, default, and (nonlinear) risk exposures -- 2.4 Asset-pricing theory, financial derivatives pricing, and contingent claims analysis -- 2.5 Autoregression in economics vs. random walks in finance -- 2.6 Asset price process related to a threshold or barrier -- 2.7 Relating finance models and risk analytics to macroeconomic models -- 2.8 Toward macrofinancial engineering -- 2.9 Summary -- References -- 3 Macroeconomic Models -- 3.1 The Hicks-Hansen IS-LM model of a closed economy -- 3.2 The Mundell-Fleming model of an open economy -- 3.3 A dynamic, stochastic, five-equation, small open economy macro model -- 3.4 Summary -- References -- 4 Stochastic Processes, Asset Pricing, and Option Pricing -- 4.1 Stochastic processes -- 4.2 Itô's lemma -- 4.3 Asset pricing: Arrow-Debreu securities and the replicating portfolio -- 4.4 Put and call option values -- 4.5 Pricing the options using the Black-Scholes-Merton formula -- 4.6 Market price of risk -- 4.7 Implications of incomplete markets for pricing -- 4.8 Summary -- Appendix 4A Primer on relationship of put, call, and exchange options -- Appendix 4B Physics, Feynman, and finance -- References -- 5 Balance Sheets, Implicit Options, and Contingent Claims Analysis -- 5.1 Uncertain assets and probability of distress or default on debt -- 5.2 Probability of distress or default -- 5.3 Debt and equity as contingent claims -- 5.4 Payoff diagrams for contingent claims.

5.5 Understanding why an implicit put option equals expected loss -- 5.6 Using the Merton model and Black-Scholes-Merton formula to value contingent claims -- 5.7 Measuring asset values and volatilities -- 5.8 Estimating implied asset value and asset volatility from equity or junior claims -- 5.9 Risk measures -- 5.10 Summary -- References -- 6 Further Extensions and Applications of Contingent Claims Analysis -- 6.1 Extensions of the Merton model -- 6.2 Applications of CCA with different types of distress barriers and liability structures -- 6.3 Risk-adjusted and actual probabilities using the market price of risk, Sharpe ratios, and recovery rates -- 6.4 Moody's-KMV approach -- 6.5 CCA using skewed asset distributions modeled with a mixture of lognormals -- 6.6 Maximum likelihood methods -- 6.7 Incorporating stochastic interest rates and interest rate term structures into structural CCA balance sheet models -- 6.8 Other structural models with stochastic interest rates -- 6.9 Summary -- Appendix 6A Calculating parameters in the Vasicek model -- References -- PART II THE MACROFINANCE MODELING FRAMEWORK -- 7 The Macrofinance Modeling Framework: Interlinked Sector Balance Sheets -- 7.1 Contingent claim balance sheets for sectors -- 7.2 Measuring asset values and volatilities -- 7.3 Measuring risk exposures -- 7.4 Linkages in a simple four-sector framework -- 7.5 Integrated value and risk transmission between sectors -- 7.6 Policy effectiveness parameters in implicit options -- 7.7 Advantages of an integrated balance sheet risk approach -- 7.8 Summary -- References -- 8 The Macrofinance Modeling Framework: A Closer Look at the Sovereign CCA Balance Sheet -- 8.1 CCA balance sheet for the government and monetary authorities -- 8.2 Sovereign distress.

8.3 Calculating implied sovereign assets and implied sovereign asset volatility using CCA for the public sector balance sheet -- 8.4 Applications of the macrofinancial risk framework to sovereigns -- 8.5 Sovereign risk-neutral and estimated actual default probabilities on foreign-currency-denominated debt -- 8.6 Spreads on sovereign foreign currency and local currency debt -- 8.7 Breaking down sovereign assets into key components -- 8.8 Risk-based scenario and policy analysis using calibrated sovereign CCA related to spreads on foreign currency debt -- 8.9 Short-term and long-term government CCA balance sheets with monetary authority -- 8.10 Summary -- Appendix 8A Value and volatility of local currency liabilities and base money -- References -- 9 The Macrofinance Modeling Framework: Linking Interest Rate Models in Finance and Macroeconomics -- 9.1 Overview of interest rate term structure models in finance -- 9.2 Two early theories: liquidity preference and the market for loanable funds -- 9.3 Monetary policy, Taylor rules, and interest rates -- 9.4 Reconciling different perspectives on interest rate behavior -- 9.5 What to do when the monetary authority is linked closely to the government balance sheet -- 9.6 Summary -- References -- 10 Macrofinance Modeling Framework: Financial Sector Risk and Stability Analysis -- 10.1 Calculating risk indicators for individual banks or financial institutions -- 10.2 Time series of financial system risk indicators -- 10.3 Snapshot of system risk -- 10.4 Expected loss as a portfolio of implicit put options -- 10.5 Using a structural Merton model with stochastic interest rates for capital adequacy estimates -- 10.6 Factor model to assess key drivers of system risk and for scenario analysis -- 10.7 Multifactor risk analysis using copulas -- 10.8 Household balance sheet risk.

10.9 Linking banking sector loans to corporate, household, and other borrowers -- 10.10 Foreign-currency-denominated loans and the impact of the presence of foreign banks on banking system risk -- 10.11 CCA models, financial stability indicators and links to macro models -- 10.12 Summary -- Appendix 10A CCA model for banks and borrowers with foreign-currency-denominated debt and lending spreads based on credit risk -- References -- 11 Macrofinancial Modeling Framework: Extensions to Different Exchange Rate Regimes -- 11.1 Floating exchange rate regimes, interest rates, and the sovereign balance sheet -- 11.2 Fixed exchange rate regimes, interest rates and the sovereign balance sheet -- 11.3 The impact of capital flows on the CCA sovereign balance sheet -- 11.4 Role of quasi-public entities in exchange rate management -- 11.5 Summary -- References -- PART III LINKING MACROFINANCIAL AND MACROECONOMIC FRAMEWORKS -- 12 Sovereign Reserve, Debt, and Wealth Management from a Macrofinancial Risk Perspective -- 12.1 Reserves adequacy and asset allocation: moving from simple rules to a national framework -- 12.2 CCA for a firm with a subsidiary and its wealth management -- 12.3 Constructing contingent claim balance sheets for the national economy -- 12.4 Macro risk and wealth management -- 12.5 Summary -- References -- 13 Macrofinancial Modeling Framework: Relationship to Accounting Balance Sheets and the Flow of Funds -- 13.1 Economy-wide macro contingent claim balance sheets and risk exposures -- 13.2 Recovering traditional macroeconomic budget constraints and flow identities from CCA valuation equations when volatility is zero -- 13.3 Interlinkages between CCA balance sheets, flows, and risk premiums -- 13.4 Using the production function to link corporate and household assets -- 13.5 Macrofinance, macroeconomic flows, and the business cycle -- 13.6 Summary.

Appendix 13A Cross-holding by households and financial sectors of contingent claims in other sectors -- Appendix 13B Contingent claim values and returns of different sectors -- References -- 14 Macrofinancial Risk Framework Linked to Macroeconomic Models -- 14.1 Adding risk analytics to the spectrum of macroeconomic models -- 14.2 The Mundell-Fleming model and default risk -- 14.3 Linking macrofinance outputs to DSGE models -- 14.4 Linking macrofinance outputs to dynamic, stochastic macroeconomic policy models -- 14.5 Linking macrofinance outputs to macroeconometric VAR models -- 14.6 An integrated policy framework -- 14.7 Summary -- References -- PART IV CRISIS AND DISTRESS IN ECONOMIES -- 15 Macroeconomic Models vs. Crisis Models: Why Nonlinearity Matters -- 15.1 Recent financial crises and crisis models -- 15.2 Summary -- References -- 16 Sensitivity Analysis, Destabilization Mechanisms, and Financial Crises -- 16.1 Sensitivity analysis, the "Greeks", and the valuation multiplier effect -- 16.2 The volatility leverage effect -- 16.3 Feedback between the forward rate and domestic interest rates on local currency debt -- 16.4 Feedback between local currency debt issuance and local currency spreads in the presence of contingent liability constraints -- 16.5 Summary -- References -- 17 The Case of Thailand, 1996-1999 -- 17.1 Background -- 17.2 A macrofinance analysis of the Thai crisis -- 17.3 Scenario analysis -- 17.4 Summary -- Appendix 17A Banking and corporate sector risk analysis with scenarios -- References -- 18 The Brazil Crisis of 2002-2003 -- 18.1 Background -- 18.2 A macrofinance analysis of the Brazil crisis -- 18.3 Summary -- References -- PART V MACROFINANCIAL MODEL APPLICATIONS AND ANALYTICAL ISSUES.

19 International Shocks, Risk Transmission, and Crisis Prevention: Backdrop for Understanding the 2007-08 Global Financial Credit Turmoil.