CONTENTS
Acknowledgments = xix
Introduction = xxi
Part Ⅰ : Quantitative Analysis = 1
Ch. 1 Bond Fundamentals = 3
1.1 Discounting, Present, and Future Value = 4
1.2 Price-Yield Relationship = 6
1.2.1 Valuation = 6
1.2.2 Taylor Expansion = 8
1.2.3 Bond Price Derivatives = 9
1.2.4 Interpreting Duration and Convexity = 18
1.2.5 Portfolio Duration and Convexity = 24
1.3 Answers to Chapter Examples = 27
Ch. 2 Fundamentals of Probability = 33
2.1 Characterizing Random Variables = 34
2.1.1 Univariate Distribution Functions = 34
2.1.2 Multivariate Distribution Functions = 35
2.2 Moments = 37
2.3 Functions of Random Variables = 41
2.3.1 Linear Transformation = 41
2.3.2 Sum of Random Variables = 42
2.3.3 Portfolios of Random Variables = 43
2.3.4 Product of Random Variables = 44
2.3.5 Distributions of Transformations of Random Variables = 44
2.4 Important Distribution Functions = 46
2.4.1 Uniform Distribution = 46
2.4.2 Normal Distribution = 47
2.4.3 Lognormal Distribution = 51
2.4.4 Student t Distribution = 53
2.4.5 Binomial Distribution = 55
2.5 Answers to Chapter Examples = 59
Ch. 3 Fundamentals of Statistics = 65
3.1 Real Data = 66
3.1.1 Measuring Returns = 66
3.1.2 Time Aggregation = 68
3.1.3 Portfolio Aggregation = 69
3.2 Parameter Estimation = 71
3.3 Regression Analysis = 75
3.3.1 Bivariate Regression = 75
3.3.2 Autoregression = 78
3.3.3 Multivariate Regression = 79
3.3.4 Example = 79
3.3.5 Pitfalls with Regressions = 81
3.4 Answers to Chapter Examples = 85
Ch. 4 Monte Carlo Methods = 89
4.1 Simulations with One Random Variable = 90
4.1.1 Simulating Markov Processes = 90
4.1.2 The Geometric Brownian Motion = 91
4.1.3 Simulating Yields = 94
4.1.4 Binomial Trees = 96
4.2 Applying Simulations = 100
4.2.1 Simulation for VAR = 100
4.2.2 Simulation for Derivatives = 100
4.2.3 Accuracy = 101
4.3 Multiple Sources of Risk = 104
4.3.1 The Cholesky Factorization = 105
4.4 Answers to Chapter Examples = 107
Part Ⅱ : Capital Markets = 111
Ch. 5 Introduction to Derivatives = 113
5.1 Overview of Derivatives Markets = 114
5.2 Forward Contracts = 116
5.2.1 Definition = 116
5.2.2 Valuing Forward Contracts = 118
5.2.3 Valuing Forward Contracts With Income Payments = 122
5.3 Futures Contracts = 126
5.3.1 Definitions of Futures = 126
5.3.2 Valuing Futures Contracts = 129
5.4 Swap Contracts = 130
5.5 Answers to Chapter Examples = 131
Ch. 6 Options = 133
6.1 Option Payoffs = 134
6.1.1 Basic Options = 134
6.1.2 Put-Call Parity = 137
6.1.3 Combination of Options = 139
6.2 Valuing Options = 143
6.2.1 Option Premiums = 143
6.2.2 Black-Scholes Valuation = 147
6.3 Other Option Contracts = 155
6.4 Valuing Options by Numerical Methods = 158
6.5 Answers to Chapter Examples = 162
Ch. 7 Fixed-Income Securities = 165
7.1 Overview of Bond Markets = 166
7.2 Fixed-Income Securities = 169
7.2.1 Instrument Types = 169
7.2.2 Methods of Quotation = 172
7.3 Analysis of Fixed-Income Securities = 174
7.3.1 The NPV Approach = 174
7.3.2 Duration = 176
7.4 Spot and Forward Rates = 179
7.5 Mortgage Backed Securities = 185
7.5.1 Description = 185
7.5.2 Prepayment Risk = 190
7.5.3 Financial Engineering and CMOs = 193
7.6 Answers to Chapter Examples = 199
Ch. 8 Fixed-Income Derivatives = 203
8.1 Forward Contracts = 203
8.2 Futures = 205
8.2.1 Eurodollar Futures = 205
8.2.2 T-bond Futures = 207
8.3 Swaps = 210
8.3.1 Definitions = 210
8.3.2 Quotations = 212
8.3.3 Pricing = 212
8.4 Options = 215
8.4.1 Caps and Floors = 216
8.4.2 Swaptions = 218
8.4.3 Exchange-Traded Options = 221
8.5 Answers to Chapter Examples = 222
Ch. 9 Equity Markets = 225
9.1 Equities = 226
9.1.1 Overview = 226
9.1.2 Valuation = 228
9.1.3 Equity Indices = 229
9.2 Convertible Bonds and Warrants = 231
9.2.1 Definitions = 231
9.2.2 Valuation = 232
9.3 Equity Derivatives = 234
9.3.1 Stock Index Futures = 234
9.3.2 Equity Options = 237
9.3.3 Equity Swaps = 238
9.4 Answers to Chapter Examples = 238
Ch. 10 Currencies and Commodities Markets = 241
10.1 Currency Markets = 242
10.2 Currency Swaps = 243
10.2.1 Definitions = 243
10.2.2 Pricing = 245
10.3 Commodities = 248
10.3.1 Products = 248
10.3.2 Pricing of Futures = 250
10.3.3 Futures and Expected Spot Prices = 253
10.4 Answers to Chapter Examples = 257
Part Ⅲ : Market Risk Management = 259
Ch. 11 Introduction to Market Risk Measurement = 261
11.1 Introduction to Financial Market Risks = 262
11.2 VAR as Downside Risk = 264
11.2.1 VAR : Definition = 264
11.2.2 VAR : Caveats = 267
11.2.3 Alternative Measures of Risk = 269
11.2.4 Desirable Properties for Risk Measures = 270
11.3 VAR : Parameters = 273
11.3.1 Confidence Level = 273
11.3.2 Horizon = 274
11.3.3 Application : The Basel Rules = 276
11.4 Elements of VAR Systems = 277
11.4.1 Portfolio Positions = 278
11.4.2 Risk Factors = 279
11.4.3 VAR Methods = 279
11.5 Stress-Testing = 280
11.6 Answers to Chapter Examples = 282
Ch. 12 Identification of Risk Factors = 285
12.1 Market Risks = 286
12.1.1 Absolute and Relative Risk = 286
12.1.2 Directional and Non-directional Risk = 286
12.1.3 Market vs. Credit Risk = 287
12.1.4 Risk Interaction = 288
12.2 Sources of Loss : A Decomposition = 289
12.2.1 Exposure and Uncertainty = 289
12.2.2 Specific Risk = 291
12.3 Discontinuity and Event Risk = 292
12.3.1 Continuous Processes = 292
12.3.2 Discontinuities = 293
12.3.3 Event Risk = 294
12.4 Liquidity Risk = 296
12.5 Answers to Chapter Examples = 299
Ch. 13 Sources of Risk = 301
13.1 Currency Risk = 301
13.1.1 Currency Volatility = 302
13.1.2 Correlations = 303
13.1.3 Devaluation Risk = 305
13.1.4 Cross-Rate Volatility = 306
13.2 Fixed-Income Risk = 307
13.2.1 Factors Affecting Yields = 307
13.2.2 Bond Price and Yield Volatility = 309
13.2.3 Correlations = 313
13.2.4 Global Interest Rate Risk = 315
13.2.5 Real Yield Risk = 317
13.2.6 Credit Spread Risk = 318
13.2.7 Prepayment Risk = 319
13.2.8 Fixed-Income Portfolio Risk = 320
13.3 Equity Risk = 322
13.3.1 Stock Market Volatility = 322
13.3.2 Forwards and Futures = 325
13.3.3 Diagonal Model = 326
13.3.4 Factor Models = 328
13.4 Commodity Risk = 330
13.4.1 Commodity Volatility Risk = 330
13.4.2 Forwards and Futures = 332
13.4.3 Delivery and Liquidity Risk = 334
13.5 VAR and Correlations = 334
13.6 Answers to Chapter Examples = 336
Ch. 14 Hedging Linear Risk = 339
14.1 Introduction to Futures Hedging = 340
14.1.1 Unit Hedging with Currencies = 340
14.1.2 Basis Risk = 342
14.2 Optimal Hedging = 343
14.2.1 The Optimal Hedge Ratio = 345
14.2.2 The Hedge Ratio as Regression Coefficient = 347
14.2.3 Example = 348
14.2.4 Liquidity Issues = 350
14.3 Applications of Optimal Hedging = 351
14.3.1 Duration Hedging = 351
14.3.2 Beta Hedging = 355
14.4 Answers to Chapter Examples = 357
Ch. 15 Non-Linear Risk : Options = 361
15.1 Evaluating Options = 362
15.1.1 Definitions = 362
15.1.2 Taylor Expansion = 363
15.1.3 Option Pricing = 365
15.2 Option "Greeks" = 366
15.2.1 Option Sensitivities : Delta and Gamma = 366
15.2.2 Option Sensitivities : Vega = 370
15.2.3 Option Sensitivities : Rho = 372
15.2.4 Option Sensitivities : Theta = 373
15.2.5 Option Pricing and the "Greeks" = 374
15.2.6 Option Sensitivities : Summary = 376
15.3 Dynamic Hedging = 381
15.3.1 Delta and Dynamic Hedging = 381
15.3.2 Implications = 383
15.3.3 Distribution of Option Payoffs = 383
15.4 Answers to Chapter Examples = 386
Ch. 16 Modeling Risk Factors = 391
16.1 The Normal Distribution = 392
16.1.1 Why the Normal? = 392
16.1.2 Computing Returns = 392
16.1.3 Time Aggregation = 394
16.2 Fat Tails = 398
16.3 Time-Variation in Risk = 400
16.3.1 GARCH = 400
16.3.2 EWMA = 403
16.3.3 Option Data = 406
16.3.4 Implied Distributions = 407
16.4 Answers to Chapter Examples = 410
Ch. 17 VAR Methods = 411
17.1 VAR : Local vs. Full Valuation = 412
17.1.1 Local Valuation = 412
17.1.2 Full Valuation = 413
17.1.3 Delta-Gamma Method = 414
17.2 VAR Methods : Overview = 416
17.2.1 Mapping = 416
17.2.2 Delta-Normal Method = 417
17.2.3 Historical Simulation Method = 418
17.2.4 Monte Carlo Simulation Method = 419
17.2.5 Comparison of Methods = 420
17.3 Example = 422
17.3.1 Mark to Market = 422
17.3.2 Risk Factors = 424
17.3.3 VAR : Historical Simulation = 424
17.3.4 VAR : Delta-Normal Method = 428
17.4 Answers to Chapter Examples = 430
Part Ⅳ : Credit Risk Management = 431
Ch. 18 Introduction to Credit Risk = 433
18.1 Settlement Risk = 434
18.1.1 Presettlement vs Settlement Risk = 434
18.1.2 Handling Settlement Risk = 435
18.2 Overview of Credit Risk = 437
18.2.1 Drivers of Credit Risk = 437
18.2.2 Measurement of Credit Risk = 438
18.2.3 Credit Risk vs. Market Risk = 440
18.3 Measuring Credit Risk = 441
18.3.1 Credit Losses = 441
18.3.2 Joint Events = 441
18.3.3 An Example = 443
18.4 Credit Risk Diversification = 447
18.5 Answers to Chapter Examples = 453
Ch. 19 Measuring Actuarial Default Risk = 455
19.1 Credit Event = 456
19.2 Default Rates = 459
19.2.1 Credit Ratings = 459
19.2.2 Historical Default Rates = 462
19.2.3 Cumulative and Marginal Default Rates = 465
19.2.4 Transition Probabilities = 471
19.2.5 Predicting Default Probabilities = 473
19.3 Recovery Rates = 474
19.3.1 The Bankruptcy Process = 474
19.3.2 Estimates of Recovery Rates = 476
19.4 Application to Portfolio Rating = 478
19.5 Assessing Corporate and Sovereign Rating = 479
19.5.1 Corporate Default = 479
19.5.2 Sovereign Default = 481
19.6 Answers to Chapter Examples = 485
Ch. 20 Measuring Default Risk from Market Prices = 489
20.1 Corporate Bond Prices = 490
20.1.1 Spreads and Default Risk = 490
20.1.2 Risk Premium = 492
20.1.3 The Cross-Section of Yield Spreads = 495
20.1.4 The Time-Series of Yield Spreads = 497
20.2 Equity Prices = 498
20.2.1 The Merton Model = 499
20.2.2 Pricing Equity and Debt = 501
20.2.3 Applying the Merton Model = 504
20.2.4 Example = 506
20.3 Answers to Chapter Examples = 508
Ch. 21 Credit Exposure = 511
21.1 Credit Exposure by Instrument = 512
21.2 Distribution of Credit Exposure = 516
21.2.1 Expected and Worst Exposure = 516
21.2.2 Time Profile = 517
21.2.3 Exposure Profile for Interest Rate Swaps = 518
21.2.4 Exposure Profile for Currency Swaps = 530
21.2.5 Exposure Profile for Different Coupons = 531
21.3 Exposure Modifiers = 536
21.3.1 Marking to Market = 536
21.3.2 Exposure Limits = 538
21.3.3 Recouponing = 539
21.3.4 Netting Arrangements = 540
21.4 Credit Risk Modifiers = 545
21.4.1 Credit Triggers = 546
21.4.2 Time Puts = 546
21.5 Answers to Chapter Examples = 547
Ch. 22 Credit Derivatives = 551
22.1 Introduction = 551
22.2 Types of Credit Derivatives = 552
22.2.1 Credit Default Swaps = 553
22.2.2 Total Return Swaps = 556
22.2.3 Credit Spread Forward and Options = 558
22.2.4 Credit-Linked Notes = 559
22.3 Pricing and Hedging Credit Derivatives = 564
22.3.1 Methods = 564
22.3.2 Example : Credit Default Swap = 565
22.4 Pros and Cons of Credit Derivatives = 568
22.5 Answers to Chapter Examples = 570
Ch. 23 Managing Credit Risk = 573
23.1 Measuring the Distribution of Credit Losses = 574
23.2 Measuring Expected Credit Loss = 578
23.2.1 Expected Loss over a Target Horizon = 578
23.2.2 The Time Profile of Expected Loss = 579
23.3 Measuring Credit VAR = 582
23.4 Portfolio Credit Risk Models = 583
23.4.1 Approaches to Portfolio Credit Risk Models = 583
23.4.2 CreditMetrics = 585
23.4.3 CrditRisk＋ = 588
23.4.4 KMV = 589
23.4.5 Credit Portfolio View = 590
23.4.6 Comparison = 591
23.5 Answers to Chapter Examples = 594
Part Ⅴ : Operational and Integrated Risk Management = 597
Ch. 24 Operational Risk = 599
24.1 The Importance of Operational Risk = 600
24.1.1 Case Histories = 600
24.1.2 Business Lines = 601
24.2 Defining Operational Risk = 603
24.2.1 Definitions = 604
24.2.2 Why Definitions are Important = 606
24.2.3 Conceptual Problems = 607
24.3 Approaches to Operational Risk = 609
24.4 Causal Networks = 611
24.5 Actuarial Models = 612
24.6 Managing Operational Risk = 617
24.6.1 Capital Allocation = 617
24.6.2 Regulatory Requirements = 618
24.6.3 Preventing Operational Risk = 620
24.7 Answers to Chapter Examples = 623
Ch. 25 Risk Capital and RAROC = 627
25.1 RAROC = 628
25.1.1 Risk Capital = 628
25.1.2 RAROC Methodology = 630
25.1.3 Application to Compensation = 631
25.2 Performance Evaluation and Pricing = 633
25.3 Answers to Chapter Examples = 635
Ch. 26 Best Practices Reports = 637
26.1 The G-30 Report = 638
26.2 The Bank of England Report on Barings = 643
26.3 The CRMPG Report on LTCM = 645
26.4 Answers to Chapter Examples = 648
Ch. 27 Firmwide Risk Management = 649
27.1 Types of Risk = 650
27.2 Three-Pillar Framework = 652
27.2.1 Best-Practice Policies = 652
27.2.2 Best-Practice Methodologies = 652
27.2.3 Best-Practice Infrastructure = 653
27.3 Organizational Structure = 653
27.4 Controlling Traders = 659
27.4.1 Trader Compensation = 659
27.4.2 Trader Limits = 660
27.5 Answers to Chapter Examples = 664
Part Ⅵ : Legal, Accounting, and Tax Risk Management = 667
Ch. 28 Legal Issues = 669
28.1 Legal Risks with Derivatives = 670
28.2 Netting = 674
28.3 ISDA Master Netting Agreement = 678
28.4 Glossary = 683
28.4.1 General Legal Terms = 683
28.4.2 Bankruptcy Terms = 683
28.4.3 Contract Terms = 684
28.5 Answers to Chapter Examples = 686
Ch. 29 Accounting and Tax Issues = 689
29.1 Internal Reporting = 690
29.1.1 Purpose of Internal Reporting = 690
29.1.2 Comparison of Methods = 691
29.1.3 Historical Cost versus Marking-to-Market = 695
29.2 External Reporting = 698
29.2.1 Financial Accounting Standards Board(FASB) = 698
29.2.2 International Accounting Standards Committee(IASC) = 702
29.3 Tax Considerations = 705
29.4 Conclusions = 707
29.5 Answers to Chapter Examples = 708
Part Ⅶ : Regulation and Compliance = 711
Ch. 30 Regulation of Financial Institutions = 713
30.1 Definition of Financial Institutions = 714
30.2 Systemic Risk = 715
30.3 Regulation of Commercial Banks = 717
30.4 Regulation of Securities Houses = 720
30.5 Tools and Objectives of Regulation = 723
30.6 Answers to Chapter Examples = 726
Ch. 31 The Basel Accord = 727
31.1 Steps in The Basel Accord = 728
31.1.1 The 1988 Accord = 728
31.1.2 The 1996 Amendment = 728
31.1.3 The New Basel Accord = 729
31.2 The 1988 Basel Accord = 732
31.2.1 Risk Capital = 732
31.2.2 On-Balance Sheet Risk Charges = 735
31.2.3 Off-Balance Sheet Risk Charges = 736
31.2.4 Total Risk Charge = 740
31.3 Illustration = 743
31.4 The New Basel Accord = 747
31.4.1 Issues with the 1988 Basel Accord = 748
31.4.2 The New Basel Accord : Credit Risk Charges = 750
31.4.3 Securitization and Credit Risk Mitigation = 752
31.4.4 The Basel Operational Risk Charge = 754
31.5 Answers to Chapter Examples = 756
31.6 Further Information = 758
Ch. 32 The Basel Market Risk Charges = 763
32.1 The Standardized Method = 764
32.1.1 Interest Rate Risk = 764
32.1.2 Equity Risk = 768
32.1.3 Currency Risk = 769
32.1.4 Commodity Risk = 769
32.1.5 Option Risk = 771
32.1.6 The Market Risk Charge = 773
32.2 The Internal Models Approach = 774
32.2.1 Qualitative Requirements = 775
32.2.2 The Market Risk Charge = 776
32.2.3 Combination of Approaches = 778
32.3 Stress Testing = 782
32.4 Backtesting = 784
32.4.1 Measuring Exceptions = 784
32.4.2 Statistical Decision Rules = 785
32.4.3 The Penalty Zones = 786
32.5 Answers to Chapter Examples = 790
Index = 793
