Risk Management and Financial Institutions - John C. Hull - ebook

Risk Management and Financial Institutions ebook

John C. Hull

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The most complete, up to date guide to risk management infinance Risk Management and Financial Institutions explains allaspects of financial risk and financial institution regulation,helping readers better understand the financial markets andpotential dangers. This new fourth edition has been updated toreflect the major developments in the industry, including thefinalization of Basel III, the fundamental review of the tradingbook, SEFs, CCPs, and the new rules affecting derivatives markets.There are new chapters on enterprise risk management and scenarioanalysis. Readers learn the different types of risk, how and wherethey appear in different types of institutions, and how theregulatory structure of each institution affects risk managementpractices. Comprehensive ancillary materials include software,practice questions, and all necessary teaching supplements,facilitating more complete understanding and providing an ultimatelearning resource. All financial professionals need a thorough background in riskand the interlacing connections between financial institutions tobetter understand the market, defend against systemic dangers, andperform their jobs. This book provides a complete picture of therisk management industry and practice, with the most up to dateinformation. * Understand how risk affects different types of financialinstitutions * Learn the different types of risk and how they are managed * Study the most current regulatory issues that deal withrisk Risk management is paramount with the dangers inherent in thefinancial system, and a deep understanding is essential for anyoneworking in the finance industry; today, risk management is part ofeveryone's job. For complete information and comprehensivecoverage of the latest industry issues and practices, RiskManagement and Financial Institutions is an informative,authoritative guide.

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Risk Management and Financial Institutions

Fourth Edition

JOHN C. HULL

Cover image: ©iStock.com/Pinkypills Cover design: Wiley

Copyright © 2015 by John C. Hull. All rights reserved.

Published by John Wiley & Sons, Inc., Hoboken, New Jersey.

The Third Edition was published by John Wiley & Sons, Inc. in 2012. The first and second editions of this book was published by Prentice Hall in 2006 and 2009.

Published simultaneously in Canada.

No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as permitted under Section 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, or authorization through payment of the appropriate per-copy fee to the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, (978) 750-8400, fax (978) 646-8600, or on the Web at www.copyright.com. Requests to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030, (201) 748-6011, fax (201) 748-6008, or online at http://www.wiley.com/go/permissions.

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Library of Congress Cataloging-in-Publication Data:

Hull, John, 1946–  Risk management and financial institutions / John C. Hull. — Fourth Edition.    pages cm. — (Wiley finance series)  Includes index.  ISBN 978-1-118-95594-9 (paper); ISBN 978-1-118-95596-3 (ePDF);  ISBN 978-1-118-95595-6 (ePUB)  1. Risk management. 2. Financial institutions—Management. I. Title.  HD61.H83 2015  332.1068′1—dc23

2014037477

To Michelle, Peter, and David

CONTENTS

Business Snapshots

Preface

New Material

Slides

Questions and Problems

Instructor's Manual

Acknowledgments

Chapter 1: Introduction

1.1 Risk vs. Return for Investors

1.2 The Efficient Frontier

1.3 The Capital Asset Pricing Model

1.4 Arbitrage Pricing Theory

1.5 Risk vs. Return for Companies

1.6 Risk Management by Financial Institutions

1.7 Credit Ratings

Summary

Further Reading

Practice Questions and Problems (Answers at End of Book)

Further Questions

Notes

Part One: Financial Institutions and Their Trading

Chapter 2: Banks

2.1 Commercial Banking

2.2 The Capital Requirements of a Small Commercial Bank

2.3 Deposit Insurance

2.4 Investment Banking

2.5 Securities Trading

2.6 Potential Conflicts of Interest in Banking

2.7 Today's Large Banks

2.8 The Risks Facing Banks

Summary

Further Reading

Practice Questions and Problems (Answers at End of Book)

Further Questions

Note

Chapter 3: Insurance Companies and Pension Plans

3.1 Life Insurance

3.2 Annuity Contracts

3.3 Mortality Tables

3.4 Longevity and Mortality Risk

3.5 Property-Casualty Insurance

3.6 Health Insurance

3.7 Moral Hazard and Adverse Selection

3.8 Reinsurance

3.9 Capital Requirements

3.10 The Risks Facing Insurance Companies

3.11 Regulation

3.12 Pension Plans

Summary

Further Reading

Practice Questions and Problems (Answers at End of Book)

Further Questions

Notes

Chapter 4: Mutual Funds and Hedge Funds

4.1 Mutual Funds

4.2 Hedge Funds

4.3 Hedge Fund Strategies

4.4 Hedge Fund Performance

Summary

Further Reading

Practice Questions and Problems (Answers at End of Book)

Further Questions

Notes

Chapter 5: Trading in Financial Markets

5.1 The Markets

5.2 Clearing Houses

5.3 OTC Market Changes

5.4 Long and Short Positions in Assets

5.5 Derivatives Markets

5.6 Plain Vanilla Derivatives

5.7 Non-Traditional Derivatives

5.8 Exotic Options and Structured Products

5.9 Risk Management Challenges

Summary

Further Reading

Practice Questions and Problems (Answers at End of Book)

Further Questions

Notes

Chapter 6: The Credit Crisis of 2007

6.1 The U.S. Housing Market

6.2 Securitization

6.3 The Crisis

6.4 What Went Wrong?

6.5 Lessons from the Crisis

Summary

Further Reading

Practice Questions and Problems (Answers at End of Book)

Further Questions

Notes

Chapter 7: Valuation and Scenario Analysis: The Risk-Neutral and Real Worlds

7.1 Volatility and Asset Prices

7.2 Risk-Neutral Valuation

7.3 Scenario Analysis

7.4 When Both Worlds Have to be Used

7.5 The Calculations in Practice

7.6 Estimating Real-World Processes

Summary

Further Reading

Practice Questions and Problems (Answers at End of Book)

Further Questions

Notes

Part Two: Market Risk

Chapter 8: How Traders Manage Their Risks

8.1 Delta

8.2 Gamma

8.3 Vega

8.4 Theta

8.5 Rho

8.6 Calculating Greek Letters

8.7 Taylor Series Expansions

8.8 The Realities of Hedging

8.9 Hedging Exotic Options

8.10 Scenario Analysis

Summary

Further Reading

Practice Questions and Problems (Answers at End of Book)

Further Questions

Notes

Chapter 9: Interest Rate Risk

9.1 The Management of Net Interest Income

9.2 Types of Rates

9.3 Duration

9.4 Convexity

9.5 Generalization

9.6 Nonparallel Yield Curve Shifts

9.7 Interest Rate Deltas in Practice

9.8 Principal Components Analysis

9.9 Gamma and Vega

Summary

Further Reading

Practice Questions and Problems (Answers at End of Book)

Further Questions

Notes

Chapter 10: Volatility

10.1 Definition of Volatility

10.2 Implied Volatilities

10.3 Are Daily Percentage Changes in Financial Variables Normal?

10.4 The Power Law

10.5 Monitoring Daily Volatility

10.6 The Exponentially Weighted Moving Average Model

10.7 The GARCH(1,1) Model

10.8 Choosing Between the Models

10.9 Maximum Likelihood Methods

10.10 Using GARCH(1,1) to Forecast Future Volatility

Summary

Further Reading

Practice Questions and Problems (Answers at End of Book)

Further Questions

Notes

Chapter 11: Correlations and Copulas

11.1 Definition of Correlation

11.2 Monitoring Correlation

11.3 Multivariate Normal Distributions

11.4 Copulas

11.5 Application to Loan Portfolios: Vasicek's Model

Summary

Further Reading

Practice Questions and Problems (Answers at End of Book)

Further Questions

Notes

Chapter 12: Value at Risk and Expected Shortfall

12.1 Definition of VaR

12.2 Examples of the Calculation of VaR

12.3 A Drawback of VaR

12.4 Expected Shortfall

12.5 Coherent Risk Measures

12.6 Choice of Parameters for VaR and ES

12.7 Marginal, Incremental, and Component Measures

12.8 Euler's Theorem

12.9 Aggregating VaRs and ESs

12.10 Back-Testing

Summary

Further Reading

Practice Questions and Problems (Answers at End of Book)

Further Questions

Notes

Chapter 13: Historical Simulation and Extreme Value Theory

13.1 The Methodology

13.2 Accuracy of VaR

13.3 Extensions

13.4 Computational Issues

13.5 Extreme Value Theory

13.6 Applications of EVT

Summary

Further Reading

Practice Questions and Problems (Answers at End of Book)

Further Questions

Notes

Chapter 14: Model-Building Approach

14.1 The Basic Methodology

14.2 Generalization

14.3 Correlation and Covariance Matrices

14.4 Handling Interest Rates

14.5 Applications of the Linear Model

14.6 Linear Model and Options

14.7 Quadratic Model

14.8 Monte Carlo Simulation

14.9 Non-Normal Assumptions

14.10 Model-Building vs. Historical Simulation

Summary

Further Reading

Practice Questions and Problems (Answers at End of Book)

Further Questions

Notes

Part Three: Regulation

Chapter 15: Basel I, Basel II, and Solvency II

15.1 The Reasons for Regulating Banks

15.2 Bank Regulation Pre-1988

15.3 The 1988 BIS Accord

15.4 The G-30 Policy Recommendations

15.5 Netting

15.6 1996 Amendment

15.7 Basel II

15.8 Credit Risk Capital Under Basel II

15.9 Operational Risk Capital Under Basel II

15.10 Pillar 2: Supervisory Review

15.11 Pillar 3: Market Discipline

15.12 Solvency II

Summary

Further Reading

Practice Questions and Problems (Answers at End of Book)

Further Questions

Notes

Chapter 16: Basel II.5, Basel III, and Other Post-Crisis Changes

16.1 Basel II.5

16.2 Basel III

16.3 Contingent Convertible Bonds

16.4 Dodd–Frank Act

16.5 Legislation in other Countries

Summary

Further Reading

Practice Questions and Problems (Answers at End of Book)

Further Questions

Notes

Chapter 17: Fundamental Review of the Trading Book

17.1 New Market Risk Measures

17.2 Trading Book vs. Banking Book

17.3 Credit Trades

Summary

Further Reading

Practice Questions and Problems (Answers at End of Book)

Further Question

Notes

Part Four: Credit Risk

Chapter 18: Managing Credit Risk: Margin, OTC Markets, and CCPs

18.1 Margin and Exchanges

18.2 OTC Markets

18.3 Consequences of New OTC Regulations

18.4 The Risk of a CCP Failure

Summary

Further Reading

Practice Questions and Problems (Answers at End of Book)

Further Questions

Notes

Chapter 19: Estimating Default Probabilities

19.1 Credit Ratings

19.2 Historical Default Probabilities

19.3 Recovery Rates

19.4 Credit Default Swaps

19.5 Credit Spreads

19.6 Estimating Default Probabilities from Credit Spreads

19.7 Comparison of Default Probability Estimates

19.8 Using Equity Prices to Estimate Default Probabilities

19.9 Summary

Further Reading

Practice Questions and Problems (Answers at End of Book)

Further Questions

Notes

Chapter 20: CVA and DVA

20.1 Credit Exposure on Derivatives

20.2 CVA

20.3 The Impact of a New Transaction

20.4 CVA Risk

20.5 Wrong-Way Risk

20.6 DVA

20.7 Some Simple Examples

Summary

Further Reading

Practice Questions and Problems (Answers at End of Book)

Further Questions

Notes

Chapter 21: Credit Value at Risk

21.1 Ratings Transition Matrices

21.2 Vasicek's Model

21.3 Credit Risk Plus

21.4 Creditmetrics

21.5 Credit-Sensitive Instruments in the Trading Book

Summary

Further Reading

Practice Questions and Problems (Answers at End of Book)

Further Questions

Notes

Part Five: Other Topics

Chapter 22: Scenario Analysis and Stress Testing

22.1 Generating the Scenarios

22.2 Regulation

22.3 What to Do with the Results

Summary

Further Reading

Practice Questions and Problems (Answers at End of Book)

Further Questions

Notes

Chapter 23: Operational Risk

23.1 Defining Operational Risk

23.2 Determination of Regulatory Capital

23.3 Categorization of Operational Risks

23.4 Loss Severity and Loss Frequency

23.5 Implementation of AMA

23.6 Proactive Approaches

23.7 Allocation of Operational Risk Capital

23.8 Use of Power Law

23.9 Insurance

23.10 Sarbanes-Oxley

Summary

Further Reading

Practice Questions and Problems (Answers at End of Book)

Further Questions

Notes

Chapter 24: Liquidity Risk

24.1 Liquidity Trading Risk

24.2 Liquidity Funding Risk

24.3 Liquidity Black Holes

Summary

Further Reading

Practice Questions and Problems (Answers at End of Book)

Further Questions

Notes

Chapter 25: Model Risk

25.1 Marking to Market

25.2 Models for Linear Products

25.3 Physics vs. Finance

25.4 How Models are Used for Pricing Standard Products

25.5 Hedging

25.6 Models for Nonstandard Products

25.7 Dangers in Model Building

25.8 Detecting Model Problems

Summary

Further Reading

Practice Questions and Problems (Answers at End of Book)

Further Questions

Notes

Chapter 26: Economic Capital and RAROC

26.1 Definition of Economic Capital

26.2 Components of Economic Capital

26.3 Shapes of the Loss Distributions

26.4 Relative Importance of Risks

26.5 Aggregating Economic Capital

26.6 Allocation of Economic Capital

26.7 Deutsche Bank's Economic Capital

26.8 RAROC

Summary

Further Reading

Practice Questions and Problems (Answers at End of Book)

Further Questions

Notes

Chapter 27: Enterprise Risk Management

27.1 Risk Appetite

27.2 Risk Culture

27.3 Identifying Major Risks

27.4 Strategic Risk Management

Summary

Further Reading

Practice Questions and Problems (Answers at End of Book)

Further Questions

Notes

Chapter 28: Risk Management Mistakes to Avoid

28.1 Risk Limits

28.2 Managing the Trading Room

28.3 Liquidity Risk

28.4 Lessons for Nonfinancial Corporations

28.5 A Final Point

Further Reading

Notes

Part Six: Appendices

Appendix A: Compounding Frequencies for Interest Rates

Note

Appendix B: Zero Rates, Forward Rates, and Zero-Coupon Yield Curves

Appendix C: Valuing Forward and Futures Contracts

Appendix D: Valuing Swaps

Note

Appendix E: Valuing European Options

Note

Appendix F: Valuing American Options

Note

Appendix G: Taylor Series Expansions

Appendix H: Eigenvectors and Eigenvalues

Note

Appendix I: Principal Components Analysis

Appendix J: Manipulation of Credit Transition Matrices

Note

Appendix K: Valuation of Credit Default Swaps

Appendix L: Synthetic CDOs and Their Valuation

Note

Answers to Questions and Problems

Chapter 1

Chapter 2

Chapter 3

Chapter 4

Chapter 5

Chapter 6

Chapter 7

Chapter 8

Chapter 9

Chapter 10

Chapter 11

Chapter 12

Chapter 13

Chapter 14

Chapter 15

Chapter 16

Chapter 17

Chapter 18

Chapter 19

Chapter 20

Chapter 21

Chapter 22

Chapter 23

Chapter 24

Chapter 25

Chapter 26

Chapter 27

Glossary

DerivaGem Software

Getting Started

Next Steps

Bond Options

Caps and Swaptions

CDSs

CDOs

How Greek Letters Are Defined

The Applications Builder

Table for

N

(

x

) When

x

≤ 0

Table for

N

(

x

) When

x

≥ 0

Index

EULA

List of Tables

Chapter 1

Table 1.1

Table 1.2

Chapter 2

Table 2.1

Table 2.2

Table 2.3

Table 2.4

Chapter 3

Table 3.1

Table 3.2

Table 3.3

Table 3.4

Chapter 4

Table 4.1

Table 4.2

Table 4.3

Table 4.4

Table 4.5

Chapter 5

Table 5.1

Table 5.2

Table 5.3

Table 5.4

Table 5.5

Table 5.6

Chapter 6

Table 6.1

Chapter 8

Table 8.1

Table 8.2

Table 8.3

Table 8.4

Table 8.5

Chapter 9

Table 9.1

Table 9.2

Table 9.3

Table 9.4

Table 9.5

Table 9.6

Table 9.7

Table 9.8

Table 9.9

Chapter 10

Table 10.1

Table 10.2

Table 10.3

Table 10.4

Table 10.5

Table 10.6

Table 10.7

Chapter 11

Table 11.1

Table 11.2

Table 11.3

Table 11.4

Chapter 12

Table 12.1

Chapter 13

Table 13.1

Table 13.2

Table 13.3

Table 13.4

Table 13.5

Table 13.6

Table 13.7

Table 13.8

Table 13.9

Table 13.10

Chapter 14

Table 14.1

Table 14.2

Table 14.3

Table 14.4

Table 14.5

Table 14.6

Table 14.7

Table 14.8

Table 14.9

Table 14.10

Chapter 15

Table 15.1

Table 15.2

Table 15.3

Table 15.4

Table 15.5

Table 15.6

Table 15.7

Chapter 16

Table 16.1

Table 16.2

Table 16.3

Table 16.4

Table 16.5

Chapter 17

Table 17.1

Chapter 19

Table 19.1

Table 19.2

Table 19.3

Table 19.4

Table 19.5

Table 19.6

Chapter 21

Table 21.1

Table 21.2

Table 21.3

Table 21.4

Table 21.5

Chapter 22

Table 22.1

Chapter 23

Table 23.1

Chapter 25

Table 25.1

Chapter 26

Table 26.1

Table 26.2

Table 26.3

Table 26.4

Chapter 27

Table 27.1

Table 27.2

Guide

Cover

Table of Contents

Preface

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Business Snapshots

 1.1

The Hidden Costs of Bankruptcy

 2.1

Google's IPO

 2.2

PeopleSoft's Poison Pill

 2.3

How to Keep Loans Performing

 3.1

Equitable Life

 3.2

A Perfect Storm

 4.1

Mutual Fund Returns Can Be Misleading

 5.1

The Unanticipated Delivery of a Futures Contract

 5.2

A Software Error?

 5.3

Microsoft's Hedging

 5.4

Procter and Gamble's Bizarre Deal

 5.5

SocGen's Big Loss in 2008

 6.1

All BBBs Are Not the Same

 6.2

A Trading Opportunity?

 8.1

Hedging by Gold Mining Companies

 8.2

Dynamic Hedging in Practice

 8.3

Is Delta Hedging Easier or More Difficult for Exotics?

10.1

What Causes Volatility?

10.2

Making Money from Foreign Currency Options

12.1

Historical Perspectives on VaR

15.1

Systemic Risk

16.1

Credit Suisse's CoCo Bond Issues

18.1

Rehypothecation

19.1

The CDS Market

19.2

Is the CDS Market a Fair Game?

19.3

Contagion

22.1

Long-Term Capital Management's Big Loss

22.2

Traffic Light Options

23.1

The Hammersmith and Fulham Story

23.2

Rogue Trader Insurance

24.1

Northern Rock

24.2

Ashanti Goldfields

24.3

Metallgesellschaft

24.4

The Crash of 1987

25.1

Kidder Peabody's Embarrassing Mistake

25.2

Exploiting the Weaknesses of a Competitor's Model

25.3

Crashophobia

25.4

The London Whale

26.1

The EGT Fund

27.1

The Santander Rail Deal

27.2

Abacus

28.1

Big Losses

Preface

Risk management practices and the regulation of financial institutions have continued to evolve in the past three years. Risk Management and Financial Institutions has been expanded and updated to reflect this. Like my other popular text Options, Futures, and Other Derivatives, the book is designed to be useful to practicing managers as well as college students. Those studying for GARP and PRMIA qualifications will find the book particularly helpful.

The book is appropriate for university courses in either risk management or financial institutions. It is not necessary for students to take a course on options and futures markets prior to taking a course based on this book. But if they have taken such a course, some of the material in the first nine chapters does not need to be covered.

The level of mathematical sophistication and the way material is presented have been managed carefully so that the book is accessible to as wide an audience as possible. For example, when covering copulas in Chapter 11, I present the intuition followed by a detailed numerical example; when covering maximum likelihood methods in Chapter 10 and extreme value theory in Chapter 13, I provide numerical examples and enough details for readers to develop their own Excel spreadsheets. I have also provided my own Excel spreadsheets for many applications on my website:

www-2.rotman.utoronto.ca/~hull

This is a book about risk management, so there is very little material on the valuation of derivatives. (This is the main focus of my other two books, Options, Futures, and Other Derivatives and Fundamentals of Futures and Options Markets.) The appendices at the end of the book include material that summarizes some of the valuation key results that are important in risk management, and the DerivaGem software can be downloaded from my website.

NEW MATERIAL

The fourth edition has been fully updated and contains much new material. In particular:

There is a new chapter comparing scenario analysis to valuation (Chapter 7). The chapter introduces the reader to the statistical processes often assumed for market variables (without any stochastic calculus), explains Monte Carlo simulation, and distinguishes between the real and risk-neutral worlds.

There is a new chapter on the Fundamental Review of the Trading Book (Chapter 17). This is an important new proposal from the Basel Committee.

There is a new chapter on margin, OTC markets, and central counterparties (CCPs) (Chapter 18). This covers recent developments in the trading of over-the-counter derivatives and introduces the reader to a number of credit risk issues.

There is a new chapter on enterprise risk management (Chapter 27). This discusses risk appetite, risk culture, and the importance of taking a holistic approach to risk management.

The sequencing of the material in the book has been improved. For example, the calculation of value at risk and expected shortfall is now covered immediately after these risk measures are introduced. The book is now divided into six parts: financial institutions and their trading, market risk, regulation, credit risk, other topics, and appendices.

There is more emphasis throughout the book on the use of expected shortfall. This is consistent with the Basel Committee’s plans for changing the way market risk capital is calculated (see Chapter 17).

The material on credit value adjustment (CVA) and debit value adjustment (DVA) has been restructured and improved (see Chapter 20).

A new simpler method for taking volatility changes into account in the historical simulation method is presented (Chapter 13).

There are many new end-of-chapter problems.

A great deal of software on the author's website accompanies the book.

SLIDES

Several hundred PowerPoint slides can be downloaded from my website or from the Wiley Higher Education website. Adopting instructors are welcome to adapt the slides to meet their own needs.

QUESTIONS AND PROBLEMS

End-of-chapter problems are divided into two groups: “Practice Questions and Problems” and “Further Questions.” Solutions to the former are at the end of the book. Solutions to the latter and accompanying software are available to adopting instructors from the Wiley Higher Education website.

INSTRUCTOR'S MANUAL

The instructor’s manual is made available to adopting instructors on the Wiley Higher Education website. It contains solutions to “Further Questions” (with Excel spreadsheets), notes on the teaching of each chapter, and some suggestions on course organization.

ACKNOWLEDGMENTS

Many people have played a part in the production of this book. I have benefited from interactions with many academics and practicing risk managers. I would like to thank the students in my MBA and Master of Finance risk management courses at University of Toronto, many of whom have made suggestions as to how the material could be improved.

Alan White, a colleague at the University of Toronto, deserves a special acknowledgment. Alan and I have been carrying out joint research and consulting in the area of derivatives and risk management for about 30 years. During that time we have spent countless hours discussing key issues. Many of the new ideas in this book, and many of the new ways used to explain old ideas, are as much Alan’s as mine. Alan has done most of the development work on the DerivaGem software.

Special thanks are due to many people at Wiley, particularly Evan Burton, Vincent Nordhaus, Judy Howarth, and Helen Cho for their enthusiasm, advice, and encouragement.

I welcome comments on the book from readers. My e-mail address is:

[email protected]

JOHN HULL Joseph L. Rotman School of ManagementUniversity of Toronto