Financial Risk Management (eBook)

Francisco Javier Población García is a Principal Financial Stability Expert at the European Central Bank. He holds a master's degree in economics and finance and a PhD in banking and finance. He has previously worked at Oliver Wyman and Repsol YPF, and was a Bank Inspector at Banco de España, before joining the European Central Bank. He has also had significant experience in teaching university level courses in risk management.

Preface 7
Contents 9
List of Figures 18
List of Tables 22
Part I: Introduction and Perspectives 24
1: Introduction 25
1.1 General Principles 25
1.1.1 Risk 26
1.1.2 The Purpose of Corporate Risk Management: The Natural Risk Profile 26
1.1.3 Cost-Benefit Analysis 29
1.1.4 Hedging Versus Trading 30
1.1.5 Accounting Recognition 31
1.1.6 Corporate Strategies: Systemic Risk Versus Idiosyncratic Risk 33
1.2 Individual and Savings Bank Risk Management 34
1.2.1 Individual Risk Management 34
1.2.2 Risk Management in Savings Banks 36
2: Risk Quantification 38
2.1 Basic Concepts 38
2.1.1 Long Positions and Short Positions 39
2.1.2 Derivative Assets 40
2.1.2.1 Greek Letters 46
2.1.3 Linear Exposure 47
2.1.4 Option Type Exposure 49
2.2 Types of Risk 51
2.2.1 Market Risk 51
2.2.1.1 Equity 51
2.2.1.2 Interest Rate 52
2.2.1.3 Exchange Rate 53
2.2.1.4 Commodities 54
2.2.2 Credit Risk 55
2.2.2.1 Counterparty Risk 56
2.2.3 Other Risks 57
2.2.3.1 Operational Risk 57
2.2.3.2 Liquidity Risk 58
2.3 The Accounting Impact of Hedging 58
Part II: Market Risk 60
3: One-Dimensional Market Risk Equity Risk
3.1 Basic Concepts 61
3.1.1 Terminology 62
3.2 Probabilistic Model 64
3.3 Value at Risk (VaR) 69
3.3.1 Concept 69
3.3.2 Theoretical Calculation and Examples 73
3.3.3 Empirical VaR Calculation 76
3.3.3.1 Numerical Simulation (Monte Carlo Experiment) 76
3.3.3.2 Historical Simulation 80
3.3.3.3 Concrete Simulation Scenarios 82
3.4 Incremental and Marginal Measures 85
3.4.1 General Ideas 85
3.4.2 Formal Definition 87
3.5 VaR Applications 89
3.5.1 Relationship to Risk-Return Approach 89
3.5.2 Diversification and Hedging 90
4: Multidimensional Market Risk 94
4.1 Basic Concepts 94
4.1.1 Cash Flow and Net Present Value 94
4.1.2 Multi-Period Measures Concept and Classification 95
4.2 Probabilistic Models 96
4.2.1 Time Series (Stochastic Processes) 96
4.2.2 Intertemporal Volatility and Correlation 101
4.2.3 Temporal Aggregation and Considerations on Interest Rates 103
4.3 Risk Measures 103
4.3.1 Measures Without Discount: The CFaR 103
4.3.2 Measures with Discount: The NPVaR 105
4.4 Calculation Methodology 106
4.4.1 Analytical Estimation 106
4.4.1.1 Example of Analytical Calculation of the CFaR 107
4.4.1.2 The Analytical Estimation of NPVaR 109
4.4.2 Numerical Estimation (Simulation) 110
4.4.3 Calculation Without an Explicit Model 116
4.5 Diversification and Hedging Considerations 117
5: Interest Rate Risk 119
5.1 Basic Concepts 119
5.1.1 Different Fixed-Income Instruments 120
5.1.2 Different Ways of Characterising the Interest Rate 121
5.1.3 The Risk Premium 122
5.1.4 Interest Rate Risk and Inflation 124
5.2 The Term Structure of Interest Rates 126
5.2.1 Term Structure Theories of Interest Rates 128
5.2.2 The Implicit Interest Rate, the Forward Interest Rate and IRR 133
5.3 Duration 134
5.3.1 Simple or Macaulay Duration and Modified Duration 134
5.3.2 Convexity 137
5.3.3 Portfolio Immunisation 140
5.4 The VaR for Fixed Income 143
5.5 Interest Rate Derivatives 146
5.5.1 Interest Rate Futures 146
5.5.2 Forward Rate Agreement (FRA) and Interest Rate Swap (IRS) 147
5.5.3 Cap, Floor and Collar 148
5.6 Structured Bonds 151
6: Exchange Rate Risk 153
6.1 Basic Concepts 153
6.1.1 Exchange Rate Markets 154
6.1.2 Types of Exposure with Exchange Rate Risk 157
6.2 Denomination Currency Versus Exposure Currency 159
6.2.1 Estimation of Exposure Currency 162
6.3 VaR in the Exchange Rate 166
6.4 Exchange Rate Derivatives 167
6.5 Exchange Rate Hedging under Uncertainty in Cash Flows 168
6.6 Relationship between Interest Rate and Exchange Rate 169
7: Price Risk in Commodities 172
7.1 Basic Concepts 172
7.1.1 Storage Costs 173
7.1.2 Convenience Yield 174
7.1.3 The Forward Curve 175
7.1.4 Seasonality 177
7.2 Commodity Price Dynamics 179
7.2.1 Mean Reversion 179
7.2.2 Factorial Models 180
7.3 VaR Calculation for Commodities 184
7.4 Risk Management in Commodities 184
8: Market Risk Hedging 187
8.1 Basic Concepts 187
8.1.1 Hedging Costs and Profits 187
8.1.2 The Residual Risk 189
8.2 Types of Hedging 190
8.3 Hedging Instruments 194
8.3.1 Derivative Assets 194
8.3.1.1 Payment System Design 195
8.3.1.2 Derivative Asset Valuation 198
8.3.1.3 Risk Management in Derivatives 202
8.3.2 Embedded Derivatives 203
8.4 Hedge Accounting 206
8.4.1 General Issues 206
8.4.1.1 Held-to-Maturity Investment Accounting 206
8.4.1.2 Derivative Accounting 207
8.4.2 Types of Hedge Accounting 211
8.4.3 Embedded Derivatives Accounting 213
Part III: Credit Risk 215
9: Credit Risk: Measurement 216
9.1 Basic Concepts 216
9.1.1 Credit Risk Versus Market Risk 217
9.1.2 The Credit Event 218
9.1.2.1 Default Definition in Banking Regulation 220
9.2 Measuring Credit Risk 221
9.2.1 Probability of Default (PD) 222
9.2.1.1 Estimates from Historical Data (Credit Scoring/Rating) 222
Banks´ Regulatory Requirements for PD Calculation 229
9.2.1.2 Estimates from Bond Prices 234
9.2.1.3 Estimates from Share Prices and Volatility 238
9.2.2 Loss Given Default (LGD) 240
9.2.2.1 Banks´ Regulatory Requirements for LGD Calculation 243
9.2.3 Exposure at Default (EAD) 246
9.2.3.1 Banks´ Regulatory Requirements for EAD Calculation 247
9.3 Expected Loss Versus Unexpected Loss 248
10: Credit Risk: Validation 250
10.1 Basic Concepts 250
10.2 Qualitative Validation 251
10.3 Quantitative Validation 251
10.3.1 Discriminatory Power 251
10.3.1.1 Rating/Scoring Systems: Probability of Default (PD) 251
ROC Curve 254
CAP Curve 257
10.3.1.2 LGD and EAD 258
10.3.2 Parameters 259
10.3.2.1 Predictive Power: Back-Testing 259
PD 259
LGD and EAD 261
10.3.2.2 Benchmarking 262
11: Credit Risk Management 264
11.1 Basic Concepts 264
11.2 Traditional Management 265
11.2.1 Retail and Corporate Portfolios 266
11.2.1.1 The Retail Portfolio 266
11.2.1.2 The Corporate Portfolio 267
11.2.2 Capital Requirements 268
11.2.2.1 Non-defaulted Assets 268
11.3 Hedging with Derivatives 272
11.4 Stress Test 275
12: Derivative Credit Risk (Counterparty Risk) 279
12.1 Basic Concepts 279
12.2 OTC Markets Versus Organised Markets 280
12.2.1 OTC Markets 280
12.2.1.1 International Swaps and Derivatives Association: Framework 282
12.2.2 Organised Markets 283
12.2.2.1 The Clearing House 284
Part IV: Other Risks 288
13: Operational Risk 289
13.1 Basic Concepts 289
13.1.1 Definition of Operational Risk 289
13.2 Operational Risk Measurement 293
13.2.1 Loss Function 293
13.2.2 Databases 295
13.2.3 Approaches to Operational Risk Measurement 296
13.3 Operational Risk Mitigation Systems 297
13.3.1 Insurance 299
13.3.2 Financial Hedges 301
13.4 Approach to Operational Risk in Basel II: Determination of Regulatory Capital 302
14: Liquidity Risk 305
14.1 Basic Concepts 305
14.1.1 Types of Liquidity Risk and Its Relationships with Other Risks 306
14.2 Liquidity Risk Measurement 307
14.2.1 Static Measurement 308
14.2.2 Dynamic Measurement 309
14.2.3 Pricing Liquidity Risk 310
14.2.4 Methods to Assess Liquidity Risk: Liquidity Stress Test 311
14.3 Liquidity Risk Management 312
14.3.1 Liquidity Crisis 314
15: Country Risk 316
15.1 Basic Concepts 316
15.1.1 Country Risk in a Strict Sense 317
15.1.2 Country Risk in a Broad Sense 318
15.2 Variables Influencing Country Risk 320
15.3 Adjustments to the Cost of Capital: The Country Risk Premium 323
15.4 Regulatory Risk/Legal Risk 326
15.4.1 Regulatory Risk in OECD Countries 327
15.4.2 The Examples of Bolivia and Argentina 328
15.4.3 Risks in Accounting 329
15.5 Country Risk Management 330
Part V: Financial Implications of Risk 331
16: The CAPM 332
16.1 Basic Concepts 332
16.2 Portfolio Theory 333
16.2.1 Graphical Representation of Portfolios in the Mean: Standard Deviation Plan 335
16.2.2 Efficient Portfolios 339
16.2.2.1 Analytic Derivation of the Efficient Portfolio Frontier 339
16.2.2.2 Analytic Derivation of the Minimum Variance Portfolio 345
16.2.2.3 The Introduction of the Risk-Free Asset: The Capital Market Line (CML) 346
16.3 The CAPM 349
16.3.1 The Securities Market Line (SML) 349
16.3.2 The Market Model 351
17: The WACC 354
17.1 Basic Concepts 354
17.2 WACC Calculation 356
17.2.1 The Risk Premium 358
17.3 The WACC of an Investment Project 359
17.3.1 Risk-Adjusted Cash Flows 360
18: Conclusions 361
Glossary of Terms 367
Bibliography 392
Index 397