Financial Risk Management

<body> <table border="0" cellpadding="5" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" id="table1"> <tr> <td width="48%" valign="top"> <p align="left" class="body_expanded"><strong style="font-weight: 400">We are starting to witness a second generation of risk management books that offer a level of sophistication and practical insights that were unavailable in books published during the mid-to-late 1990s. Among books of this second generation are my own book on value-at-risk (<a target="_blank" href="http://www.value-at-risk.net">Holton 2003</a>) and this outstanding text by Steven Allen.</strong></p> <p align="left" class="body_expanded"><strong style="font-weight: 400">Allen's years of experience with JPMorgan Chase shine through with this practical and insightful text. While the book has brief chapters on credit risk and operational risk, it is primarily a text on market risk management.  </strong></p> <p align="left" class="body_expanded"><strong style="font-weight: 400">Reading many earlier texts, one might surmise that market risk management is mostly about calculating value-at-risk, perhaps with a little stress-testing thrown in. Practicing risk managers know this is not the case. Tasks such as:</strong></p> <p align="left" class="bullet_line_space"><strong style="font-weight: 400"> <img border="0" src="../images/bullet.gif" width="20" height="10">addressing moral hazard in the front office;</strong></p> <p align="left" class="bullet_line_space"><strong style="font-weight: 400"> <img border="0" src="../images/bullet.gif" width="20" height="10">marking illiquid portfolios to market; and </strong></p> <p align="left" class="bullet_line_space"><strong style="font-weight: 400"> <img border="0" src="../images/bullet.gif" width="20" height="10">preparing risk reports that reasonably capture a firm's risk exposures</strong></p> <p align="left" class="body_expanded">consume much of a market risk manager's day. This is clearly reflected in Allen's choice of topics.</p> <p align="left" class="body_expanded">One of the opening chapters details factors that frequently keep practicing risk managers awake at night:</p> <p align="left" class="bullet_line_space"><strong style="font-weight: 400"> <img border="0" src="../images/bullet.gif" width="20" height="10">moral hazard;</strong></p> <p align="left" class="bullet_line_space"><strong style="font-weight: 400"> <img border="0" src="../images/bullet.gif" width="20" height="10">trading schemes that mimic Ponzi schemes;</strong></p> <p align="left" class="bullet_line_space"><strong style="font-weight: 400"> <img border="0" src="../images/bullet.gif" width="20" height="10">adverse selection; and</strong></p> <p align="left" class="bullet_line_space"><strong style="font-weight: 400"> <img border="0" src="../images/bullet.gif" width="20" height="10">the winner's curse.</strong></p> <p align="left" class="body_expanded"><strong style="font-weight: 400">These discussions are insightful, well written and profoundly important. </strong></p> <p align="left" class="body_expanded"><strong style="font-weight: 400">There is a nice chapter detailing many of the large financial losses of recent years—Barings, Kidder-Peabody, Allied Irish, etc. In addition to the chapters on operational risk and credit risk that I have already mentioned, there is a brief chapter on value-at-risk and stress testing. </strong></p> <p align="left" class="body_expanded"><strong style="font-weight: 400">Most of the book focuses on the tactical management of market risk within financial institutions—especially derivatives dealers. This is where the book's practical flair really shines. There is much meat on these bones ... enough to command the attention of even the most experienced risk managers.</strong></p> <p align="left" class="body_expanded"><strong style="font-weight: 400">There is a detailed discussion of valuation reserves. The idea is to not arbitrarily mark-to-model an illiquid position and recognize profits based upon the dubious result. With a valuation reserve, a mark-to-model valuation may reflect a best estimate, but the reserve adds a degree of conservativeness to the result.</strong></p> <p align="left" class="body_expanded">Allen emphasizes the need to aggregate P&Ls according to whether they arise from new or existing business. If a firm fails to do so, a faulty valuation methodology can lead the firm into a trading strategy that will appear profitable from one year to the next, but that actually resembles a Ponzi scheme.</p> <p align="left" class="body_expanded" style="margin-bottom: 12">Much of the book focuses on the disaggregation of market risk into components that can be uniformly represented in risk reports. The discussion culminates with a detailed chapter that describes how to represent exotic derivatives with equivalent positions in underliers and vanilla options. This facilitates a uniform method of treatment for most derivatives in risk reports. <table border="0" cellpadding="5" cellspacing="0" style="border-collapse: collapse" width="100%" bgcolor="#CCCCFF" height="24" id="table2"> <tr> <td width="100%" align="left" bgcolor="#FFFFFF"> <span style="font-size: 2pt"> </span></td> </tr> <tr> <td width="100%" align="left"> <script type="text/javascript"></script> <script type="text/javascript" src="http://pagead2.googlesyndication.com/pagead/show_ads.js"> </script> </td></tr> </table> </td> <td width="52%" valign="top" class="body"> <table border="0" cellpadding="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" id="table3"> <tr> <td width="100%" bgcolor="#333366"> <p class="header_yellow" align="center">Contents</td> </tr> <tr> <td width="100%" class="explanatory_text"> <table border="1" cellpadding="0" cellspacing="5" style="border-collapse: collapse" bordercolor="#CCCCFF" bgcolor="#CCCCFF" width="100%" id="table4"> <tr> <td class="contents_expanded"> <p class="contents"><b>1. Introduction</b><br> The Contents of This Book<br> The Use of Mathematics in This Book<br> Overview</p> <p class="contents"><b>2. Institutional Background</b><br> Moral Hazard—Insiders and Outsiders<br> Ponzi Schemes<br> Adverse Selection<br> The Winner’s Curse<br> Market Making versus Position Taking</p> <p class="contents"><b>3. Operational Risk</b><br> Operations Risk<br> Legal Risk<br> Reputational Risk<br> Accounting Risk<br> Funding Liquidity Risk<br> Enterprise Risk<br> The Identification of Risks<br> Operational Risk Capital</p> <p class="contents"><b>4. Financial Disasters</b><br> Disasters Due to Misleading Reporting<br> Disasters Due to Large Market Moves<br> Disasters Due to Conduct of Customer Business</p> <p class="contents"><b>5. Managing Market Risk</b><br> Risk Measurement<br> Risk Control</p> <p class="contents"><b>6. Model Risk</b><br> The Role of Models in Managing Risk<br> Model Control<br> Mark to Market vs Mark to Model</p> <p class="contents"><b>7. Managing Spot Risk</b></p> <p class="contents"><b>8. Managing Forward Risk</b><br> Instruments<br> Mathematical Models of Forward Risk<br> Factors Impacting Borrowing and Lending Costs<br> Risk Management Reporting and Limits for Forward Risk</p> <p class="contents"><b>9. Managing Vanilla Options Risk</b><br> Overview of Options Risk Management<br> The Path Dependency of Dynamic Hedging<br> A Simulation of Dynamic Hedging<br> Risk Reporting and Limits<br> Delta Hedging<br> Building a Volatility Surface<br> Summary</p> <p class="contents"><b>10. Managing Exotic Options Risk</b><br> Single-Payout Options<br> Time-Dependent Options<br> Path-Dependent Options<br> Correlation-Dependent Options<br> Correlation-Dependent Interest Rate Options</p> <p class="contents"><b>11. Value-at-Risk and Stress Testing</b><br> VaR Methodology<br> Stress Testing<br> Uses of Overall Measures of Firm Position Risk</p> <p class="contents"><b>12. Credit Risk</b><br> Short-Term Exposures to Changes in Market Prices<br> Long-Term Risk of Default<br> Lines of Credit<br> Counterparty Credit Risk </td> </tr> </table> </td> </tr> </table> <p align="left" class="body_expanded">Taleb (<a href="../titles/taleb_n_(1996).htm">1996</a>) is cited a number of times, and that book seems to be an influence for this one. Like Taleb, Allen is intent on communicating practical knowledge to a sophisticated audience. Taleb targets traders working for derivatives dealers, but is also of interest to market risk managers. Allen targets risk managers working at derivatives dealers, but is of interest to traders. Allen is less mathematical than Taleb, but he alludes to and cites a fair amount of technical material. Allen is also more modern, discussing financial engineering results that have appeared since Taleb was published. </p> <p align="left" class="body_expanded">Who is this book for? I highly recommend it for market risk managers, especially those who work for derivatives dealers. The focus is on the capital markets, but there is much of value for practitioners working in the energy or commodity markets. The book has plenty to offer sophisticated derivatives traders and financial engineers who are interested in risk assessment.</p> <p align="center" class="body"> </p> </td> </tr> </table> </body>