Financial Risk Management

STEVEN ALLEN is a risk management consultant, specializing in risk measurement and valuation with a particular emphasis on illiquid and hard-to-value assets. Until his retirement in 2004, he was Managing Director in charge of risk methodology at JPMorgan Chase, where he was responsible for model validation, risk capital allocation, and the development of new measures of valuation, reserves, and risk for both market and credit risk. Previously, he was in charge of market risk for derivative products at Chase. He has been a key architect of Chase's value-at-risk and stress testing systems. Prior to his work in risk management, Allen was the head of analysis and model building for all Chase trading activities for over ten years. Since 1998, Allen has been associated with the Mathematics in Finance Master's Program at New York University's Courant Institute of Mathematical Sciences. In this program, he has served as Clinical Associate Professor and Deputy Director and has created and taught courses in risk management, derivatives mathematics, and interest rate and credit models. He was a member of the board of directors of the International Association of Financial Engineers and continues to serve as co-chair of their Education Committee.

Foreword xvii Preface xix Acknowledgments xxiii About the Author xxvii Chapter 1 Introduction 1 1.1 Lessons from a Crisis 1 1.2 Financial Risk and Actuarial Risk 2 1.3 Simulation and Subjective Judgment 4 Chapter 2 Institutional Background 7 2.1 Moral HazardInsiders and Outsiders 7 2.2 Ponzi Schemes 17 2.3 Adverse Selection 19 2.4 The Winners Curse 21 2.5 Market Making versus Position Taking 24 Chapter 3 Operational Risk 29 3.1 Operations Risk 31 3.1.1 The Risk of Fraud 31 3.1.2 The Risk of Nondeliberate Incorrect Information 35 3.1.3 Disaster Risk 36 3.1.4 Personnel Risk 36 3.2 Legal Risk 37 3.2.1 The Risk of Unenforceable Contracts 37 3.2.2 The Risk of Illegal Actions 40 3.3 Reputational Risk 41 3.4 Accounting Risk 42 3.5 Funding Liquidity Risk 42 3.6 Enterprise Risk 44 3.7 Identification of Risks 44 3.8 Operational Risk Capital 45 Chapter 4 Financial Disasters 49 4.1 Disasters Due to Misleading Reporting 49 4.1.1 Chase Manhattan Bank/Drysdale Securities 52 4.1.2 Kidder Peabody 53 4.1.3 Barings Bank 55 4.1.4 Allied Irish Bank (AIB) 57 4.1.5 Union Bank of Switzerland (UBS) 59 4.1.6 Socit Gnrale 61 4.1.7 Other Cases 66 4.2 Disasters Due to Large Market Moves 68 4.2.1 LongTerm Capital Management (LTCM) 68 4.2.2 Metallgesellschaft (MG) 75 4.3 Disasters Due to the Conduct of Customer Business 77 4.3.1 Bankers Trust (BT) 77 4.3.2 JPMorgan, Citigroup, and Enron 79 4.3.3 Other Cases 80 Chapter 5 The Systemic Disaster of 20072008 83 5.1 Overview 83 5.2 The Crisis in CDOs of Subprime Mortgages 85 5.2.1 Subprime Mortgage Originators 86 5.2.2 CDO Creators 88 5.2.3 Rating Agencies 89 5.2.4 Investors 92 5.2.5 Investment Banks 93 5.2.6 Insurers 106 5.3 The Spread of the Crisis 108 5.3.1 Credit Contagion 108 5.3.2 Market Contagion 109 5.4 Lessons from the Crisis for Risk Managers 111 5.4.1 Subprime Mortgage Originators 111 5.4.2 CDO Creators 111 5.4.3 Rating Agencies 111 5.4.4 Investors 111 5.4.5 Investment Banks 112 5.4.6 Insurers 114 5.4.7 Credit Contagion 115 5.4.8 Market Contagion 115 5.5 Lessons from the Crisis for Regulators 115 5.5.1 Mortgage Originators 116 5.5.2 CDO Creators 116 5.5.3 Rating Agencies 117 5.5.4 Investors 118 5.5.5 Investment Banks 118 5.5.6 Insurers 126 5.5.7 Credit Contagion 126 5.5.8 Market Contagion 129 5.6 Broader Lessons from the Crisis 132 Chapter 6 Managing Financial Risk 133 6.1 Risk Measurement 133 6.1.1 General Principles 133 6.1.2 Risk Management of Instruments That Lack Liquidity 144 6.1.3 Market Valuation 147 6.1.4 Valuation Reserves 152 6.1.5 Analysis of Revenue 156 6.1.6 Exposure to Changes in Market Prices 157 6.1.7 Risk Measurement for Position Taking 159 6.2 Risk Control 161 Chapter 7 VaR and Stress Testing 169 7.1 VaR Methodology 170 7.1.1 Simulation of the P&L Distribution 173 7.1.2 Measures of the P&L Distribution 187 7.2 Stress Testing 192 7.2.1 Overview 192 7.2.2 Economic Scenario Stress Tests 193 7.2.3 Stress Tests Relying on Historical Data 197 7.3 Uses of Overall Measures of Firm Position Risk 201 Chapter 8 Model Risk 209 8.1 How Important Is Model Risk? 210 8.2 Model Risk Evaluation and Control 212 8.2.1 Scope of Model Review and Control 213 8.2.2 Roles and Responsibilities for Model Review and Control 214 8.2.3 Model Verification 219 8.2.4 Model Verification of Deal Representation 222 8.2.5 Model Verification of Approximations 223 8.2.6 Model Validation 226 8.2.7 Continuous Review 232 8.2.8 Periodic Review 234 8.3 Liquid Instruments 237 8.4 Illiquid Instruments 241 8.4.1 Choice of Model Validation Approach 241 8.4.2 Choice of Liquid Proxy 243 8.4.3 Design of Monte Carlo Simulation 245 8.4.4 Implications for Marking to Market 247 8.4.5 Implications for Risk Reporting 249 8.5 Trading Models 250 Chapter 9 Managing Spot Risk 253 9.1 Overvi