Financial risk has become a focus of financial and nonfinancial
firms, individuals, and policy makers. But the study of risk
remains a relatively new discipline in finance and continues to be
refined. The financial market crisis that began in 2007 has
highlighted the challenges of managing financial risk. Now, in
Financial Risk Management, author Allan Malz addresses the
essential issues surrounding this discipline, sharing his extensive
career experiences as a risk researcher, risk manager, and central
banker. The book includes standard risk measurement models as well
as alternative models that address options, structured credit
risks, and the real-world complexities or risk modeling, and
provides the institutional and historical background on financial
innovation, liquidity, leverage, and financial crises that is
crucial to practitioners and students of finance for understanding
the world today.

Financial Risk Management is equally suitable for firm
risk managers, economists, and policy makers seeking grounding in
the subject. This timely guide skillfully surveys the landscape of
financial risk and the financial developments of recent decades
that culminated in the crisis. The book provides a comprehensive
overview of the different types of financial risk we face, as well
as the techniques used to measure and manage them. Topics covered
include:

* Market risk, from Value-at-Risk (VaR) to risk models for
options

* Credit risk, from portfolio credit risk to structured credit
products

* Model risk and validation

* Risk capital and stress testing

* Liquidity risk, leverage, systemic risk, and the forms they
take

* Financial crises, historical and current, their causes and
characteristics

* Financial regulation and its evolution in the wake of the
global crisis

* And much more

Combining the more model-oriented approach of risk management-as
it has evolved over the past two decades-with an economist's
approach to the same issues, Financial Risk Management is
the essential guide to the subject for today's complex world.

ALLAN M. MALZ is a Senior Analytical Advisor in the Markets Group at the Federal Reserve Bank of New York, where he has also worked on implementation of the Fed's emergency liquidity programs to address the financial crisis. Before rejoining the Fed, he was chief risk officer at several multi-strategy hedge fund management firms. Previously, Malz was head of research at RiskMetrics Group, which he joined on its spinoff from J.P. Morgan. Malz spent his earlier career at the New York Fed as a researcher and foreign exchange trader. His research, which includes forecasting financial crises, risk measurement for options, and estimation of risk-neutral probability distributions, has been published in a number of industry and academic journals. Malz holds a PhD in economics from Columbia University, where he also teaches a graduate course in financial risk management.

Zusammenfassung
Financial risk has become a focus of financial and nonfinancial firms, individuals, and policy makers. But the study of risk remains a relatively new discipline in finance and continues to be refined. The financial market crisis that began in 2007 has highlighted the challenges of managing financial risk. Now, in Financial Risk Management, author Allan Malz addresses the essential issues surrounding this discipline, sharing his extensive career experiences as a risk researcher, risk manager, and central banker. The book includes standard risk measurement models as well as alternative models that address options, structured credit risks, and the real-world complexities or risk modeling, and provides the institutional and historical background on financial innovation, liquidity, leverage, and financial crises that is crucial to practitioners and students of finance for understanding the world today.

Financial Risk Management is equally suitable for firm risk managers, economists, and policy makers seeking grounding in the subject. This timely guide skillfully surveys the landscape of financial risk and the financial developments of recent decades that culminated in the crisis. The book provides a comprehensive overview of the different types of financial risk we face, as well as the techniques used to measure and manage them. Topics covered include:

• Market risk, from Value-at-Risk (VaR) to risk models for options
• Credit risk, from portfolio credit risk to structured credit products
• Model risk and validation
• Risk capital and stress testing
• Liquidity risk, leverage, systemic risk, and the forms they take
• Financial crises, historical and current, their causes and characteristics
• Financial regulation and its evolution in the wake of the global crisis
• And much more

Combining the more model-oriented approach of risk management-as it has evolved over the past two decades-with an economist's approach to the same issues, Financial Risk Management is the essential guide to the subject for today's complex world.

List of Figures xvii

Preface xxi

Chapter 1 Financial Risk in a Crisis-Prone World 1

1.1 Some History: Why Is Risk a Separate Discipline Today? 1

1.1.1 The Financial Industry Since the 1960s 2

1.1.2 The Shadow Banking System 9

1.1.3 Changes in Public Policy Toward the Financial System 15

1.1.4 The Rise of Large Capital Pools 17

1.1.5 Macroeconomic Developments Since the 1960s: From the Unraveling of Bretton Woods to the Great Moderation 20

1.2 The Scope of Financial Risk 34

1.2.1 Risk Management in Other Fields 34

Further Reading 41

Chapter 2 Market Risk Basics 43

2.1 Arithmetic, Geometric, and Logarithmic Security Returns 44

2.2 Risk and Securities Prices: The Standard Asset Pricing Model 49

2.2.1 Defining Risk: States, Security Payoffs, and Preferences 50

2.2.2 Optimal Portfolio Selection 54

2.2.3 Equilibrium Asset Prices and Returns 56

2.2.4 Risk-Neutral Probabilities 61

2.3 The Standard Asset Distribution Model 63

2.3.1 Random Walks and Wiener Processes 64

2.3.2 Geometric Brownian Motion 71

2.3.3 Asset Return Volatility 74

2.4 Portfolio Risk in the Standard Model 75

2.4.1 Beta and Market Risk 76

2.4.2 Diversification 82

2.4.3 Efficiency 85

2.5 Benchmark Interest Rates 88

Further Reading 91

Chapter 3 Value-at-Risk 93

3.1 Definition of Value-at-Risk 94

3.1.1 The User-Defined Parameters 97

3.1.2 Steps in Computing VaR 98

3.2 Volatility Estimation 99

3.2.1 Short-Term Conditional Volatility Estimation 99

3.2.2 The EWMA Model 104

3.2.3 The GARCH Model 106

3.3 Modes of Computation 108

3.3.1 Parametric 108

3.3.2 Monte Carlo Simulation 109

3.3.3 Historical Simulation 111

3.4 Short Positions 113

3.5 Expected Shortfall 114

Further Reading 116

Chapter 4 Nonlinear Risks and the Treatment of Bonds and Options 119

4.1 Nonlinear Risk Measurement and Options 121

4.1.1 Nonlinearity and VaR 123

4.1.2 Simulation for Nonlinear Exposures 126

4.1.3 Delta-Gamma for Options 127

4.1.4 The Delta-Gamma Approach for General Exposures 134

4.2 Yield Curve Risk 136

4.2.1 The Term Structure of Interest Rates 138

4.2.2 Estimating Yield Curves 141

4.2.3 Coupon Bonds 144

4.3 VaR for Default-Free Fixed Income Securities Using the Dura…