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Advanced Financial Risk Management. Tools and Techniques for Integrated Credit Risk and Interest Rate Risk Management. 2nd Edition

  • Book

  • 784 Pages
  • April 2013
  • John Wiley and Sons Ltd
  • ID: 2216166

High Praise for Advanced Financial Risk Management

"Advanced Financial Risk Management is a superb presentation of current risk management methods, including both the HJM interest rate and credit risk models. The writing is crisp and clear. The topic coverage is relevant and comprehensive. There is no doubt that his book should be on every CEO′s, CFO′s, and risk manager′s desk."
—Robert Jarrow, Ronald P. and Susan E. Lynch Professor of Investment Management Johnson Graduate School of Management, Cornell University

"The first edition of Advanced Financial Risk Management was already a valuable resource for anyone responsible for risk–based portfolios, or even just trying to understand risk analysis, in complex modern setting. With the new material that van Deventer, Imai and Mesler have added following the financial crisis, it′s become essential. The sorry history of the crisis and what caused it is replete with the mistakes key decision–makers made, in private risk management and the public policy arena too. With this analysis in hand, there is no excuse for repeating them."
—Benjamin M. Friedman, William Joseph Maier Professor of Political Economy, Harvard University

"Recent events have clearly demonstrated, once again, the importance of sound risk management techniques. Even the largest most sophisticated institutions have stumbled and lost billions of dollars. In this second edition of Advanced Financial Risk Management, the authors include a comprehensive review of events leading to the collapse of the ′bubble.′ I found the chronological list of events leading up to the meltdown of 2008 a most effective way of demonstrating that the early warning signs were all there but ignored by the markets and most market participants.

"The authors draw on lessons from the past as well as their own practical experience in presenting a comprehensive review of risk management techniques. The authors also review and dissect previous models to determine what went wrong and use this as a basis to develop new and better models. This candid discussion was very helpfulthey didn′t make excuses!

"The book is very comprehensive in that it includes an in–depth discussion across a broad cross section of asset classes. The use of case studies as well as drawing on the authors′ own experience greatly enhances the value of the book. Lastly, the book strikes a good balance between quantitative, qualitative and anecdotal examples."
—Edward Emmer, Retired Executive Managing Director, Standard & Poor′s

"The global financial crisis has made it abundantly clear that shortcuts in risk management create the preconditions for catastrophe. This timely volume explains risk management without shortcuts: an integrated understanding of multiple risks from multiple underlying instruments, based on careful empirical analysis rather than convenient simplifications. Despite its rigorous approach, the book is a pleasure to read and should be owned by every risk manager."
—John Y. Campbell, Morton L. and Carole S. Olshan Professor of Economics, Harvard University

Table of Contents

Introduction: Wall Street Lessons from Bubbles xxiii

Key Fallacies in Risk Management xxiii

Selected Events in the Credit Crisis xxviii

PART ONE Risk Management: Definitions and Objectives

CHAPTER 1 A Risk Management Synthesis: Market Risk, Credit Risk, Liquidity Risk, and Asset and Liability Management 3

CHAPTER 2 Risk, Return, Performance Measurement, and Capital Regulation 15

PART TWO Risk Management Techniques for Interest Rate Analytics

CHAPTER 3 Interest Rate Risk Introduction and Overview 45

CHAPTER 4 Fixed Income Mathematics: The Basic Tools 59

CHAPTER 5 Yield Curve Smoothing 73

CHAPTER 6 Introduction to Heath, Jarrow, and Morton Interest Rate Modeling 123

CHAPTER 7 HJM Interest Rate Modeling with Rate and Maturity–Dependent Volatility 142

CHAPTER 8 HJM Interest Rate Modeling with Two Risk Factors 161

CHAPTER 9 HJM Interest Rate Modeling with Three Risk Factors 190

CHAPTER 10 Valuation, Liquidity, and Net Income 230

CHAPTER 11 Interest Rate Mismatching and Hedging 250

CHAPTER 12 Legacy Approaches to Interest Rate Risk Management 257

CHAPTER 13 Special Cases of Heath, Jarrow, and Morton Interest Rate Modeling 283

CHAPTER 14 Estimating the Parameters of Interest Rate Models 316

PART THREE Risk Management Techniques for Credit Risk Analytics

CHAPTER 15 An Introduction to Credit Risk: Using Market Signals in Loan Pricing and Performance Measurement 335

CHAPTER 16 Reduced Form Credit Models and Credit Model Testing 359

CHAPTER 17 Credit Spread Fitting and Modeling 396

CHAPTER 18 Legacy Approaches to Credit Risk 421

CHAPTER 19 Valuing Credit Risky Bonds 453

CHAPTER 20 Credit Derivatives and Collateralized Debt Obligations 473

PART FOUR Risk Management Applications: Instrument by Instrument

CHAPTER 21 European Options on Bonds 495

CHAPTER 22 Forward and Futures Contracts 513

CHAPTER 23 European Options on Forward and Futures Contracts 531

CHAPTER 24 Caps and Floors 548

CHAPTER 25 Interest Rate Swaps and Swaptions 567

CHAPTER 26 Exotic Swap and Options Structures 580

CHAPTER 27 American Fixed Income Options 596

CHAPTER 28 Irrational Exercise of Fixed Income Options 622

CHAPTER 29 Mortgage–Backed Securities and Asset–Backed Securities 639

CHAPTER 30 Nonmaturity Deposits 656

CHAPTER 31 Foreign Exchange Markets 675

CHAPTER 32 Impact of Collateral on Valuation Models: The Example of

CHAPTER 33 Pricing and Valuing Revolving Credit and Other Facilities 694

CHAPTER 34 Modeling Common Stock and Convertible Bonds on a Default–Adjusted Basis 700

CHAPTER 35 Valuing Insurance Policies and Pension Obligations 708

PART FIVE Portfolio Strategy and Risk Management

CHAPTER 36 Value–at–Risk and Risk Management Objectives Revisited at the Portfolio and Company Level 719

CHAPTER 37 Liquidity Analysis and Management: Examples from the Credit Crisis 735

CHAPTER 38 Performance Measurement: Plus Alpha vs. Transfer Pricing 765

CHAPTER 39 Managing Institutional Default Risk and Safety and Soundness 783

CHAPTER 40 Information Technology Considerations 793

CHAPTER 41 Shareholder Value Creation and Destruction 800

Postscript 808

Bibliography 809

Index 819


DONALD R. VAN DEVENTER founded the Kamakura Corporation in April 1990 and is currently Chairman and CEO. In 2003, he was voted into the Risk Hall of Fame for having made a profound contribution to the field of risk management. He has been involved in financial advisory assignments involving both risk management and mergers and acquisitions. Prior to founding Kamakura Corporation, he was senior vice president of the investment banking department of Lehman Brothers. From 1982 to 1987, he was the treasurer for First Interstate Bancorp in Los Angeles. He holds a PhD in business economics, a joint degree of the Harvard University Department of Economics and the Harvard Graduate School of Business Administration.

Kenji Imai has headed Software Development for Kamakura for sixteen years. Mr. Imai is member of the Managing Committee of Kamakura. Prior to Kamakura, Mr. Imai worked in the derivatives structuring/trading and risk management groups at the Sanwa Bank and S.G. Warburg. He graduated from the University of Tokyo with a BS in civil engineering and from the Sloan School of the Massachusetts Institute of Technology with a MS in management, concentrating on finance.

Mark Mesler is Managing Director and heads Kamakura Risk Information Services, Kamakura′s innovative Basel II and III compliant default probability service. Mr. Mesler is in charge of the daily production of the KRIS Merton model, Jarrow reduced form model, and hybrid model default probabilities. Mr. Mesler has twenty–seven years′ experience in the financial services information and systems field and is a veteran of State Street Bank, KPMG, Oracle, and the Bank of America. Prior to joining Kamakura Corporation, Mr. Mesler was vice president at Askari Risk Management Solutions, at that time a subsidiary of State Street Bank in Boston.