Financial Risk Management -- Contents -- 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 -- 3.1.1 The Risk of Fraud -- 3.1.2 The Risk of Nondeliberate Incorrect Information -- 3.1.3 Disaster Risk -- 3.1.4 Personnel Risk -- 3.2 Legal Risk -- 3.2.1 The Risk of Unenforceable Contracts -- 3.2.2 The Risk of Illegal Actions -- 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 -- 4.1.1 Chase Manhattan Bank/Drysdale Securities -- 4.1.2 Kidder Peabody -- 4.1.3 Barings Bank -- 4.1.4 Allied Irish Bank (AIB) -- 4.1.5 Union Bank of Switzerland (UBS) -- 4.1.6 Société Générale -- 4.1.7 Other Cases -- 4.2 Disasters Due to Large Market Moves -- 4.2.1 Long-Term Capital Management (LTCM) -- 4.2.2 Metallgesellschaft (MG) -- 4.3 Disasters Due to the Conduct of Customer Business -- 4.3.1 Bankers Trust (BT) -- 4.3.2 JPMorgan, Citigroup, and Enron -- 4.3.3 Other Cases -- CHAPTER 5 The Systemic Disaster of 2007-2008 -- 5.1 Overview -- 5.2 The Crisis in CDOs of Subprime Mortgages -- 5.2.1 Subprime Mortgage Originators -- 5.2.2 CDO Creators -- 5.2.3 Rating Agencies -- 5.2.4 Investors -- 5.2.5 Investment Banks -- 5.2.6 Insurers -- 5.3 The Spread of the Crisis -- 5.3.1 Credit Contagion -- 5.3.2 Market Contagion -- 5.4 Lessons from the Crisis for Risk Managers -- 5.4.1 Subprime Mortgage Originators.

5.4.2 CDO Creators -- 5.4.3 Rating Agencies -- 5.4.4 Investors -- 5.4.5 Investment Banks -- 5.4.6 Insurers -- 5.4.7 Credit Contagion -- 5.4.8 Market Contagion -- 5.5 Lessons from the Crisis for Regulators -- 5.5.1 Mortgage Originators -- 5.5.2 CDO Creators -- 5.5.3 Rating Agencies -- 5.5.4 Investors -- 5.5.5 Investment Banks -- 5.5.6 Insurers -- 5.5.7 Credit Contagion -- 5.5.8 Market Contagion -- 5.6 Broader Lessons from the Crisis -- CHAPTER 6 Managing Financial Risk -- 6.1 Risk Measurement -- 6.1.1 General Principles -- 6.1.2 Risk Management of Instruments That Lack Liquidity -- 6.1.3 Market Valuation -- 6.1.4 Valuation Reserves -- 6.1.5 Analysis of Revenue -- 6.1.6 Exposure to Changes in Market Prices -- 6.1.7 Risk Measurement for Position Taking -- 6.2 Risk Control -- CHAPTER 7 VaR and Stress Testing -- 7.1 VaR Methodology -- 7.1.1 Simulation of the P&L Distribution -- 7.1.2 Measures of the P&L Distribution -- 7.2 Stress Testing -- 7.2.1 Overview -- 7.2.2 Economic Scenario Stress Tests -- 7.2.3 Stress Tests Relying on Historical Data -- 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 -- 8.2.1 Scope of Model Review and Control -- 8.2.2 Roles and Responsibilities for Model Review and Control -- 8.2.3 Model Verification -- 8.2.4 Model Verification of Deal Representation -- 8.2.5 Model Verification of Approximations -- 8.2.6 Model Validation -- 8.2.7 Continuous Review -- 8.2.8 Periodic Review -- 8.3 Liquid Instruments -- 8.4 Illiquid Instruments -- 8.4.1 Choice of Model Validation Approach -- 8.4.2 Choice of Liquid Proxy -- 8.4.3 Design of Monte Carlo Simulation -- 8.4.4 Implications for Marking to Market -- 8.4.5 Implications for Risk Reporting -- 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 -- 10.1.1 Direct Borrowing and Lending -- 10.1.2 Repurchase Agreements -- 10.1.3 Forwards -- 10.1.4 Futures Contracts -- 10.1.5 Forward Rate Agreements -- 10.1.6 Interest Rate Swaps -- 10.1.7 Total Return Swaps -- 10.1.8 Asset-Backed Securities -- 10.2 Mathematical Models of Forward Risks -- 10.2.1 Pricing Illiquid Flows by Interpolation -- 10.2.2 Pricing Long-Dated Illiquid Flows by Stack and Roll -- 10.2.3 Flows Representing Promised Deliveries -- 10.2.4 Indexed Flows -- 10.3 Factors Impacting Borrowing Costs -- 10.3.1 The Nature of Borrowing Demand -- 10.3.2 The Possibility of Cash-and-Carry Arbitrage -- 10.3.3 The Variability of Storage Costs -- 10.3.4 The Seasonality of Borrowing Costs -- 10.3.5 Borrowing Costs and Forward Prices -- 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 -- 11.6.1 Interpolating between Time Periods -- 11.6.2 Interpolating between Strikes-Smile and Skew -- 11.6.3 Extrapolating Based on Time Period -- 11.7 Summary -- CHAPTER 12 Managing Exotic Options Risk -- 12.1 Single-Payout Options -- 12.1.1 Log Contracts and Variance Swaps -- 12.1.2 Single-Asset Quanto Options -- 12.1.3 Convexity -- 12.1.4 Binary Options -- 12.1.5 Contingent Premium Options -- 12.1.6 Accrual Swaps -- 12.2 Time-Dependent Options -- 12.2.1 Forward-Starting and Cliquet Options -- 12.2.2 Compound Options -- 12.3 Path-Dependent Options -- 12.3.1 Standard Analytic Models for Barriers -- 12.3.2 Dynamic Hedging Models for Barriers.

12.3.3 Static Hedging Models for Barriers -- 12.3.4 Barrier Options with Rebates, Lookback, and Ladder Options -- 12.3.5 Broader Classes of Path-Dependent Exotics -- 12.4 Correlation-Dependent Options -- 12.4.1 Linear Combinations of Asset Prices -- 12.4.2 Risk Management of Options on Linear Combinations -- 12.4.3 Index Options -- 12.4.4 Options to Exchange One Asset for Another -- 12.4.5 Nonlinear Combinations of Asset Prices -- 12.4.6 Correlation between Price and Exercise -- 12.5 Correlation-Dependent Interest Rate Options -- 12.5.1 Models in Which the Relationship between Forwards Is Treated as Constant -- 12.5.2 Term Structure Models -- 12.5.3 Relationship between Swaption and Cap Prices -- CHAPTER 13 Credit Risk -- 13.1 Short-Term Exposure to Changes in Market Prices -- 13.1.1 Credit Instruments -- 13.1.2 Models of Short-Term Credit Exposure -- 13.1.3 Risk Reporting for Market Credit Exposures -- 13.2 Modeling Single-Name Credit Risk -- 13.2.1 Estimating Probability of Default -- 13.2.2 Estimating Loss Given Default -- 13.2.3 Estimating the Amount Owed at Default -- 13.2.4 The Option-Theoretic Approach -- 13.3 Portfolio Credit Risk -- 13.3.1 Estimating Default Correlations -- 13.3.2 Monte Carlo Simulation of Portfolio Credit Risk -- 13.3.3 Computational Alternatives to Full Simulation -- 13.3.4 Risk Management and Reporting for Portfolio Credit Exposures -- 13.4 Risk Management of Multiname Credit Derivatives -- 13.4.1 Multiname Credit Derivatives -- 13.4.2 Modeling of Multiname Credit Derivatives -- 13.4.3 Risk Management and Reporting for Multiname Credit Derivatives -- 13.4.4 CDO Tranches and Systematic Risk -- CHAPTER 14 Counterparty Credit Risk -- 14.1 Overview -- 14.2 Exchange-Traded Derivatives -- 14.3 Over-the-Counter Derivatives -- 14.3.1 Overview -- 14.3.2 The Loan-Equivalent Approach -- 14.3.3 The Collateralization Approach.

14.3.4 The Collateralization Approach-Wrong-Way Risk -- 14.3.5 The Active Management Approach -- References -- About the Companion Website -- Index.