Financial Risk Management: Models, History, and Institutions
Financial Risk Management started as onething and has ended as another. I took up this project with the primary aim of making risk measurement and management techniques accessible, by working through simple examples, and explaining some of the real life detail of ﬁnancing positions. I had gotten fairly far along with it when the subprime crisis began and the world changed. I had already begun to appreciate the importance of liquidity and leverage risks, which are even harder to measure quantitatively than market and credi trisks, and therefore all the more important inpractice. In the subprime crisis, liquidity and leverage risks were dominant. Had the subprime crisis never occurred, they would have had an honorable place in this text. After the crisis erupted, it became hard to think about anything else. To understand why liquidity and leverage are so important, one needs to understand the basic market and credit risk models. But one also needs to understand the institutional structure of the ﬁnancial system.
One airm of Financial Risk Management is therefore to bring together the modeloriented approach ofther isk management discipline ,asit has evolved over the past two decades, with economists’ approaches to the same issues. There is much that quants and economists can learn from one another. One needs to understand how ﬁnancial markets work to apply risk management techniques effectively. A basic aim of the book is to provide some institutional and historical context for riskmanagement issues.Wherever possible,I’ve provided readers with data from a variety of public- and private-sector sources, for the most part readily accessible by practitioners and students. One of the blessings of technology is the abundance of easily obtainable economic and ﬁnancial data. The particular phenomena illustrated by the data in the ﬁgures are important, but even more so familiarity with data sources and the habit of checking impressions of how the world works against data.
Some themes are developed across several chapters, but can be read in sequence for a course or for individual study: Recent ﬁnancial history, including postwar institutional changes in the ﬁnancial system, developments in macroeconomic and regulatory policy, recent episodes of ﬁnancial instability, and the global ﬁnancial crisis are the focus of all or part of Chapters 1, 9, 11, 12, 14, and 15. Market riskis studied in Chapters 2 through 5 on basic riskmodels and applications. Chapter 7 discusses spread risk, which connects market and credit risks, Chapter 11 discusses model validation, and Chapters 12 through 15 discuss liquidity risk, risk capital, the behavior of asset returns during crises, and regulatory approaches to market risk. Credit risk is studied in Chapters 6 through 9, which present basic concepts and models of the credit risk of single exposures and credit portfolios, and in Chapters 11, 12, and 15, which study credit risk in the context of leverage, liquidity, systemic risk and ﬁnancial crises. Structured credit products and their construction, risks, and valuation, are the focus of Chapter 9. Chapter 11 continues the discussion of structured credit risk, while Chapters, 12, 14, and 15 discuss the role of structured products in collateral markets and in ﬁnancial system leverage. Risk management of options is developed in Chapters 4 and 5 in the context of nonlinear exposures and portfolio risk. Chapter 14 discusses the role of option risk management in periods of ﬁnancial stress. Extraction of riskmeasures based on market prices,suchasrisk-neutral return and default probabilities and equity and credit implied correlations, is studied in Chapters 7, 9 and 10, and applied in Chapters 1, 11, and 14.
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