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 (Holton 2003) and this outstanding text by Steven Allen.

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. 

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:

addressing moral hazard in the front office;

marking illiquid portfolios to market; and

preparing risk reports that reasonably capture a firm's risk exposures

consume much of a market risk manager's day. This is clearly reflected in Allen's choice of topics.

One of the opening chapters details factors that frequently keep practicing risk managers awake at night:

moral hazard;

trading schemes that mimic Ponzi schemes;

adverse selection; and

the winner's curse.

These discussions are insightful, well written and profoundly important.

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.

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.

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.

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.

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.