Macrofinancial Risk Analysis

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.

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

• Foreword xvPreface xix1 Introduction 1Part I Overview of Finance, Macroeconomics, and Risk Concepts 72 An Overview of Macroeconomics, and Why the Theory of Asset Pricing and Contingent Claims Should Shape its Future 92.1 An overview of macroeconomics 102.2 How uncertainty is incorporated into macroeconomic models 132.3 Missing components in macro models: balance sheets with risk, default, and (nonlinear) risk exposures 152.4 Asset-pricing theory, financial derivatives pricing, and contingent claims analysis 172.5 Autoregression in economics vs. random walks in finance 192.6 Asset price process related to a threshold or barrier 212.7 Relating finance models and risk analytics to macroeconomic models 232.8 Toward macrofinancial engineering 242.9 Summary 25References 263 Macroeconomic Models 293.1 The Hicks–Hansen IS-LM model of a closed economy 293.2 The Mundell–Fleming model of an open economy 333.3 A dynamic, stochastic, five-equation, small open economy macro model 383.4 Summary 42References 424 Stochastic Processes, Asset Pricing, and Option Pricing 434.1 Stochastic processes 434.2 Itô’s lemma 464.3 Asset pricing: Arrow–Debreu securities and the replicating portfolio 474.4 Put and call option values 484.5 Pricing the options using the Black–Scholes–Merton formula 504.6 Market price of risk 524.7 Implications of incomplete markets for pricing 544.8 Summary 55Appendix 4A Primer on relationship of put, call, and exchange options 55Appendix 4B Physics, Feynman, and finance 57References 575 Balance Sheets, Implicit Options, and Contingent Claims Analysis 595.1 Uncertain assets and probability of distress or default on debt 595.2 Probability of distress or default 605.3 Debt and equity as contingent claims 615.4 Payoff diagrams for contingent claims 625.5 Understanding why an implicit put option equals expected loss 635.6 Using the Merton model and Black–Scholes–Merton formula to value contingent claims 645.7 Measuring asset values and volatilities 685.8 Estimating implied asset value and asset volatility from equity or junior claims 685.9 Risk measures 715.10 Summary 72References 726 Further Extensions and Applications of Contingent Claims Analysis 736.1 Extensions of the Merton model 736.2 Applications of CCA with different types of distress barriers and liability structures 746.3 Risk-adjusted and actual probabilities using the market price of risk, Sharpe ratios, and recovery rates 786.4 Moody’s-KMV approach 806.5 CCA using skewed asset distributions modeled with a mixture of lognormals 816.6 Maximum likelihood methods 846.7 Incorporating stochastic interest rates and interest rate term structures into structural CCA balance sheet models 856.8 Other structural models with stochastic interest rates 866.9 Summary 87Appendix 6A Calculating parameters in the Vasicek model 87References 88Part II the Macrofinance Modeling Framework 917 The Macrofinance Modeling Framework: Interlinked Sector Balance Sheets 937.1 Contingent claim balance sheets for sectors 937.2 Measuring asset values and volatilities 987.3 Measuring risk exposures 1007.4 Linkages in a simple four-sector framework 1007.5 Integrated value and risk transmission between sectors 1017.6 Policy effectiveness parameters in implicit options 1057.7 Advantages of an integrated balance sheet risk approach 1067.8 Summary 106References 1078 The Macrofinance Modeling Framework: A Closer Look at the Sovereign CCA Balance Sheet 1098.1 CCA balance sheet for the government and monetary authorities 1098.2 Sovereign distress 1118.3 Calculating implied sovereign assets and implied sovereign asset volatility using CCA for the public sector balance sheet 1118.4 Applications of the macrofinancial risk framework to sovereigns 1158.5 Sovereign risk-neutral and estimated actual default probabilities on foreign-currency-denominated debt 1178.6 Spreads on sovereign foreign currency and local currency debt 1188.7 Breaking down sovereign assets into key components 1228.8 Risk-based scenario and policy analysis using calibrated sovereign CCA related to spreads on foreign currency debt 1238.9 Short-term and long-term government CCA balance sheets with monetary authority 1248.10 Summary 126Appendix 8A Value and volatility of local currency liabilities and base money 126References 1279 The Macrofinance Modeling Framework: Linking Interest Rate Models in Finance and Macroeconomics 1299.1 Overview of interest rate term structure models in finance 1299.2 Two early theories: liquidity preference and the market for loanable funds 1319.3 Monetary policy, Taylor rules, and interest rates 1319.4 Reconciling different perspectives on interest rate behavior 1339.5 What to do when the monetary authority is linked closely to the government balance sheet 1359.6 Summary 136References 13710 Macrofinance Modeling Framework: Financial Sector Risk and Stability Analysis 13910.1 Calculating risk indicators for individual banks or financial institutions 13910.2 Time series of financial system risk indicators 14010.3 Snapshot of system risk 14510.4 Expected loss as a portfolio of implicit put options 14610.5 Using a structural Merton model with stochastic interest rates for capital adequacy estimates 14910.6 Factor model to assess key drivers of system risk and for scenario analysis 15010.7 Multifactor risk analysis using copulas 15210.8 Household balance sheet risk 15210.9 Linking banking sector loans to corporate, household, and other borrowers 15310.10 Foreign-currency-denominated loans and the impact of the presence of foreign banks on banking system risk 15410.11 CCA models, financial stability indicators and links to macro models 15510.12 Summary 159Appendix 10A CCA model for banks and borrowers with foreign-currency-denominated debt and lending spreads based on credit risk 160References 16111 Macrofinancial Modeling Framework: Extensions to Different Exchange Rate Regimes 16311.1 Floating exchange rate regimes, interest rates, and the sovereign balance sheet 16311.2 Fixed exchange rate regimes, interest rates and the sovereign balance sheet 16711.3 The impact of capital flows on the CCA sovereign balance sheet 17211.4 Role of quasi-public entities in exchange rate management 17311.5 Summary 174References 174Part III Linking Macrofinancial and Macroeconomic Frameworks 17512 Sovereign Reserve, Debt, and Wealth Management from a Macrofinancial Risk Perspective 17712.1 Reserves adequacy and asset allocation: moving from simple rules to a national framework 17712.2 CCA for a firm with a subsidiary and its wealth management 17912.3 Constructing contingent claim balance sheets for the national economy 18012.4 Macro risk and wealth management 18112.5 Summary 184References 18513 Macrofinancial Modeling Framework: Relationship to Accounting Balance Sheets and the Flow of Funds 18713.1 Economy-wide macro contingent claim balance sheets and risk exposures 18713.2 Recovering traditional macroeconomic budget constraints and flow identities from CCA valuation equations when volatility is zero 19113.3 Interlinkages between CCA balance sheets, flows, and risk premiums 19513.4 Using the production function to link corporate and household assets 19713.5 Macrofinance, macroeconomic flows, and the business cycle 19813.6 Summary 199Appendix 13A Cross-holding by households and financial sectors of contingent claims in other sectors 200Appendix 13B Contingent claim values and returns of different sectors 201References 20214 Macrofinancial Risk Framework Linked to Macroeconomic Models 20314.1 Adding risk analytics to the spectrum of macroeconomic models 20314.2 The Mundell–Fleming model and default risk 20414.3 Linking macrofinance outputs to DSGE models 20614.4 Linking macrofinance outputs to dynamic, stochastic macroeconomic policy models 20814.5 Linking macrofinance outputs to macroeconometric VAR models 21514.6 An integrated policy framework 21614.7 Summary 217References 217Part IV Crisis and Distress in Economies 21915 Macroeconomic Models vs. Crisis Models: Why Nonlinearity Matters 22115.1 Recent financial crises and crisis models 22215.2 Summary 229References 22916 Sensitivity Analysis, Destabilization Mechanisms, and Financial Crises 23116.1 Sensitivity analysis, the “Greeks”, and the valuation multiplier effect 23216.2 The volatility leverage effect 23616.3 Feedback between the forward rate and domestic interest rates on local currency debt 23716.4 Feedback between local currency debt issuance and local currency spreads in the presence of contingent liability constraints 24116.5 Summary 244References 24517 The Case of Thailand, 1996–1999 24717.1 Background 24717.2 A macrofinance analysis of the Thai crisis 24917.3 Scenario analysis 25317.4 Summary 255Appendix 17A Banking and corporate sector risk analysis with scenarios 257References 25818 The Brazil Crisis of 2002–2003 25918.1 Background 25918.2 A macrofinance analysis of the Brazil crisis 26118.3 Summary 266References 266Part V Macrofinancial Model Applications and Analytical Issues 26719 International Shocks, Risk Transmission, and Crisis Prevention: Backdrop for Understanding the 2007–08 Global Financial Credit Turmoil 26919.1 Changing global environment and global risk 27019.2 Types of global shocks and the interaction with macrofinancial risk models 27719.3 The international financial system and crisis prevention 28119.4 Structuring an effective risk-management hierarchy from the international level down to the country authorities 28219.5 Summary 283References 28320 Macro Risk Management: Ways to Mitigate, Control, and Transfer Risk in the Economy 28520.1 Overview of ways to manage risk 28520.2 Direct change in financial structure 28720.3 Risk transfer 28820.4 Management of guarantees 29020.5 Longer-term risk management via institutional and policy change 29320.6 Summary 294References 29421 Integrated Framework for Corporate and Sovereign Relative Value and Capital Structure Arbitrage 29721.1 Capital structure arbitrage for firms and financial institutions 29721.2 Credit and equity cycles 29921.3 Sovereign capital structure relative value 30021.4 Summary 302References 30222 Conclusions and New Directions for Macrofinance 30322.1 Summary of conceptual issues 30322.2 The roadmap for an integrated contingent claims analysis-macroeconomic Model 306Reference 309Appendix A Mundell–Fleming with a Risk Premium 311A. 1 The model 311A. 2 Equilibrium 315A. 3 Monetary and fiscal policy 317A. 4 Summary 321References 322Index 323