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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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Founded in 1807, John Wiley & Sons is the oldest independent publishing company in the United States. With offices in North America, Europe, Australia and Asia, Wiley is globally committed to developing and marketing print and electronic products and services for our customers’ professional and personal knowledge and understanding.
The Wiley Finance series contains books written specifically for finance and investment professionals as well as sophisticated individual investors and their financial advisors. Book topics range from portfolio management to e-commerce, risk management, financial engineering, valuation and financial instrument analysis, as well as much more.
For a list of available titles, visit our Web site at www.WileyFinance.com.
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.
Limit of Liability/Disclaimer of Warranty: While the publisher and author have used their best efforts in preparing this book, they make no representations or warranties with respect to the accuracy or completeness of the contents of this book and specifically disclaim any implied warranties of merchantability or fitness for a particular purpose. No warranty may be created or extended by sales representatives or written sales materials. The advice and strategies contained herein may not be suitable for your situation. You should consult with a professional where appropriate. Neither the publisher nor author shall be liable for any loss of profit or any other commercial damages, including but not limited to special, incidental, consequential, or other damages.
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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
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
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
Cover
Table of Contents
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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
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.
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.
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.
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.
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.
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:
JOHN HULL Joseph L. Rotman School of ManagementUniversity of Toronto