Macrofinancial Risk Analysis

Macrofinancial risk analysis Dale Gray and Samuel Malone Macrofinancial Risk Analysis provides a new and powerful framework with which policymakers and investors can analyze risk and vulnerability in economies, both emerging market and industrial. Using modern risk management and financial engineering techniques applied to the macroeconomy, an economic value can be placed on the risks posed by inter-linkages between sectors, the risk of default of different sectors on their outstanding debt obligations quantified, and the value ex-ante of guarantees to private sector entities by the government calculated. This book guides the reader through the basic macroeconomic and financial models necessary to understand the framework, the core analytical tools, and more advanced contributions that will be of interest to researchers. This unique synthesis of ideas from finance and macroeconomics offers several original contributions to the theory of financial crises, as well as a range of new policy options for governments interested in achieving a better tradeoff between economic growth and macro risk.

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"...compelling" (Risk, November 2008)

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Dr. DALE GRAY is the Senior Risk Expert in the Monetary and Capital Markets Department of the International Monetary Fund (IMF). He is founder and President of Macro Financial Risk, Inc. (Mf Risk) a pioneer in the application of risk management tools to economies (board members include Robert Merton and Zvi Bodie). He has worked for investment banks, hedge funds, Moody's Investors Service, IMF, World Bank, IFC as well as advising governments on macro risk analysis, management of sovereign wealth funds, and the design of risk mitigation strategies. He has worked on over thirty countries, is a frequent lecturer with numerous publications. He has a Ph.D. from MIT, MS from Stanford and is a certified Financial Risk Manager. Dr. SAMUEL W. MALONE is a professor of finance at the IESA, a business school in Caracas, and director of ProAlea, Inc., a risk and strategy consultancy based in Latin America. He holds a doctorate in economics from the University of Oxford, UK, and undergraduate degrees in mathematics and economics from Duke University, where he graduated Phi Beta Kappa with summa cum laude Latin honors. Elected to attend Oxford as a Rhodes Scholar representing the United States, Malone is also a four-time winner of the international Mathematical Contest in Modeling, an intensive problem-solving competition in which participants devise and write up solutions to real-world problems chosen by experts in government and industry. Author of several articles in applied mathematics and economics, he has consulted for the International Monetary Fund and the Inter-American Development Bank in Washington, DC.

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Foreword Preface 1 Introduction PART I OVERVIEW OF FINANCE, MACROECONOMICS, AND RISK CONCEPTS 2 A Brief History of Macroeconomics, and Why the Theory of Asset Pricing and Contingent Claims Should Shape its Future 2.1 A brief history of macroeconomics 2.2 How uncertainty is incorporated into macroeconomic models 2.3 Missing components in macro models: balance sheets with risk, default and (nonlinear) risk exposures 2.4 Asset pricing theory, financial derivatives pricing and contingent claims analysis 2.5 Autoregression in economics vs. random walks in finance. 2.6 Asset price process related to a threshold or barrier 2.7 Relating finance models and risk analytics to macroeconomic models 2.8 Toward macrofinancial engineering 2.9 Summary References 3 Macroeconomic Models 3.1 The Hicks-Hansen IS-LM model of a closed economy 3.2 The Mundell-Fleming model of an open economy 3.3 A dynamic, stochastic, five-equation small open economy macro model 3.4 Summary References 4 Stochastic Processes, Asset Pricing, and Option Pricing 4.1 Stochastic processes 4.2 Ito's lemma 4.3 Asset pricing: Arrow-Debreu securities and the replicating portfolio 4.4 Put and call option values 4.5 Pricing the options using the Black-Scholes-Merton formula 4.6 Market price of risk 4.7 Implications of incomplete markets for pricing 4.8 Summary Appendix 4A Primer on relationship of put, call, and exchange options Appendix 4B Physics, Feynman, and finance References 5 Balance Sheets, Implicit Options, and Contingent Claims Analysis 5.1 Uncertain assets and probability of distress or default on debt 5.2 Probability of distress or default 5.3 Debt and equity as contingent claims 5.4 Payoff diagrams for contingent claims 5.5 Understanding why an implicit put option equals expected loss 5.6 Using the Merton model and Black-Scholes-Merton formula to value contingent claims 5.7 Measuring asset values and volatilities 5.8 Estimating implied asset value and asset volatility from equity or junior claims 5.9 Risk measures 5.10 Summary References 6 Further Extensions and Applications of Contingent Claims Analysis 6.1 Extensions of the Merton model 6.2 Applications of CCA with different types of distress barriers and liability structures 6.3 Risk adjusted and actual probabilities using the market price of risk, Sharpe ratios, and recovery rates 6.4 Moody's-KMV's approach 6.5 CCA using skewed asset distributions modeled with a mixture of lognormals 6.6 Maximum likelihood methods 6.7 Incorporating stochastic interest rates and interest rate term structures into structural CCA balance sheet models 6.8 Other structural models with stochastic interest rates 6.9 Summary Appendix 6A Calculating parameters in the Vasicek model References PART II THE MACROFINANCE MODELING FRAMEWORK 7 The Macrofinance Modeling Framework: Interlinked Sector Balance Sheets 7.1 Contingent claim balance sheets for sectors 7.2 Measuring asset values and volatilities 7.3 Measuring risk exposures 7.4 Linkages in a simple four-sector framework 7.5 Integrated value and risk transmission between sectors 7.6 Policy effectiveness parameters in implicit options 7.7 Advantages of an integrated balance sheet eiskapproach 7.8 Summary References 8 The Macrofinance Modeling Framework: A Closer Look at the Sovereign CCA Balance Sheet 8.1 CCA balance sheet for the government and monetary authorities 8.2 Sovereign distress 8.3 Calculating implied sovereign assets and implied sovereign asset volatility using CCA for the public sector balance sheet 8.4 Applications of the macrofinancial risk framework to sovereigns 8.5 Sovereign risk-neutral and estimated actual default probabilities on foreign-currency-denominated debt 8.6 Spreads on sovereign foreign currency and local currency debt 8.7 Breaking down sovereign assets into key components 8.8 Risk-based scenario and policy analysis using calibrated sovereign CCA related to spreads on foreign currency debt 8.9 Short-term and long-term government CCA balance sheets with mone

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