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.

Preface.

1 Financial risk in a crisis-prone world.

1.1 Some history: why is risk a separate discipline today?

1.2 The scope of financial risk.

2 Market risk basics.

2.1 Arithmetic, geometric, and logarithmic security returns.

2.2 Risk and securities prices: the standard asset pricing model.

2.3 The standard asset distribution model.

2.4 Portfolio risk in the standard model.

2.5 Benchmark interest rates.

3 Value-at-Risk.

3.1 Definition of value-at-risk.

3.2 Volatility estimation.

3.3 Modes of computation.

3.4 Short positions.

3.5 Expected shortfall.

4 Nonlinear risks and the treatment of bonds and options.

4.1 Nonlinear risk measurement and options.

4.2 Yield curve risk.

4.3 Fixed-income VaR using duration and convexity.

5 Portfolio VaR for market risk.

5.1 The covariance and correlation matrices.

5.2 Mapping and treatment of bonds and options.

5.3 Delta-normal VaR.

5.4 Portfolio VaR viaMonte Carlo simulation.

5.5 Option vega risk.

6 Credit and counterparty risk.

6.1 Defining credit risk.

6.2 Credit risky securities.

6.3 Transaction cost problems in credit contracts.

6.4 Default and recovery: analytic concepts.

6.5 Assessing creditworthiness.

6.6 Counterparty risk.

6.7 TheMerton model.

6.8 Credit factor models.

6.9 Credit risk measures.

7 Spread risk and default intensity models.

7.1 Credit spreads.

7.2 Default curve analytics.

7.3 Risk-neutral estimates of default probabilities.

7.4 Spread risk.

8 Portfolio credit risk.

8.1 Default correlation.

8.2 Credit portfolio risk measurement.

8.3 Credit VaR with the single-factor model.

8.4 Using simulation and copulas to estimate portfolio credit risk.

9 Structured credit risk.

9.1 Structured credit basics.

9.2 Credit scenario analysis of a securitization.

9.3 Measuring structured credit risk via simulation.

9.4 Standard tranches and implied correlation.

9.5 Issuer and investor motivations for structured credit.

10 Alternatives to the standard market risk model.

10.1 Real-world asset price behavior.

10.2 Alternative modeling approaches.

10.3 The evidence on non-normality in derivatives prices.

11 Assessing the quality of risk measures.

11.1 Model risk.

11.2 Backtesting of VaR.

11.3 Coherence of VaR estimates.

12 Liquidity and leverage.

12.1 Funding liquidity risk.

12.2 Markets for collateral.

12.3 Leverage and forms of credit in contemporary finance.

12.4 Transactions liquidity risk.

12.5 Liquidity risk measurement.

12.6 Liquidity and systemic risk.

13 Risk control and mitigation.

13.1 Defining risk capital.

13.2 Risk contributions.

13.3 Stress testing.

13.4 Sizing positions.

13.5 Risk reporting.

13.6 Hedging and basis risk.

14 Financial crises.

14.1 Panics, runs, and crashes.

14.2 Self-reinforcing mechanisms.

14.3 Behavior of asset prices during crises.

14.4 Causes of financial crises.

14.5 Anticipating financial crises.

15 Financial regulation.

15.1 Scope and structure of regulation.

15.2 Methods of regulation.

15.3 Public policy toward financial crises.

15.4 Pitfalls in regulation.

A Technical notes.

A.1 Binomial distribution.

A.2 Quantiles and quantile transformations.

A.3 Normal and lognormal distributions.

A.4 Hypothesis testing.

A.5 Monte Carlo simulation.

A.6 Homogeneous functions.

B Notation.

C Abbreviations.

D References.

Praise for Financial Risk Management

"The need for sensible and realistic risk management becomes
more obvious daily, and achieving it requires familiarity with both
quantitative economic models and regulatory policy. Allan Malz's
wide experience on Wall Street and at the Fed provides him with the
perfect background for writing this important and uniquely
comprehensive book."

--Emanuel Derman, Professor of Professional Practice,
Columbia University's Industrial Engineering and Operations
Research Department; author of My Life as a Quant: Reflections
on Physics and Finance

"Finance is all about risk and reward. Investors are pretty good
at measuring reward--at least after the fact--but many,
including more than a few of the most 'sophisticated' are not very
good at assessing risk before the fact, which is when of course it
matters! There is a better way. Allan Malz provides the road map
that investors need to understand the risks they take with the
investment decisions they make. Malz has a unique perspective: as
an academic, a central banker, and a risk manager--he has been
there and done that. His book should be required reading for
investors and practitioners alike."

--Richard Clarida, C. Lowell Harriss Professor of
Economics, Columbia University

"It is almost cliché now to point out that the practice of
risk management is as much art as it is science. For those new to
the field, however, while there are excellent guides to the science
and models of risk, there are none that connect the models to the
markets, the economy, the banking system, and the history of all of
these. Allan Malz's new book does this, providing a perspective
that is critical to managing risk in the post-financial crisis
world."

--Christopher Finger, Executive Director, MSCI Inc.

"Allan Malz has done a wonderful job of surveying the challenges
that face those who labor in the vineyard of financial risk
management. He brings a wealth of experience and insight to this
work. The first chapter, which tackles the history of financial
market innovation and risks, is a tour de force and may well be
worth the price of the book itself."

--Galen Burghardt, Director of Research, Newedge USA;
coauthor of Managed Futures for Institutional Investors:
Analysis and Portfolio Construction

"This book provides a wealth of information on the theory and
practice of risk management. In clearly written chapters, Malz
progresses from simple asset pricing theory to complex derivatives
including credit derivatives and CDO tranches. Institutional and
historical description is rich and plentiful with a broad
discussion of the financial crisis and new regulatory
issues."

--Robert Engle, 2003 Nobel Laureate in Economics and
Michael Armellino Professor of Finance, Stern School of Business,
New York University