Advanced Financial Risk Management: Tools & Techniques for Integrated Credit Risk and Interest Rate Risk Managements (Hardcover)

by Donald R. Van Deventer (Author), Kenji Imai (Author), Mark Mesler (Author)
Key Phrases: loss distribution model, capital regulation, percentile range, Advanced Financial Risk Management, Bank of America, Extended Vasicek (more...)

Editorial Reviews

Product Description
This book is written by experienced risk managers, integrating interest rate risk, credit risk, FX risk and capital allocation using a consistent risk management approach. It explains, in detailed yet understandable terms, the analytics of interest rate risk, credit risk, foreign exchange risk and capital allocation from A to Z. This book bridges the gap between the idealized assumptions used for valuation and the realities that must be reflected in management actions, and includes:

• The basics of present value, forward rates and interest rate compounding
• American fixed income options vs. European options
• The wide variety of alternatives term structure models to the basic Vasicek model.

From the Inside Flap
Advanced Financial Risk Management outlines an integrated framework for fully integrated risk management. Credit risk, market risk, asset and liability management, and performance measurement have historically been thought of as separate disciplines, but recent developments in financial theory and computer science now allow these views of risk to be analyzed on a fully integrated basis.

In Advanced Financial Risk Management Donald R. van Deventer and Kenji Imai, joined by Mark Mesler, extend the concepts outlined in their previous book Credit Risk Models and the Basel Accords and update their 1996 work Financial Risk Analytics. The authors lay out a comprehensive strategy of risk management measures, objectives, and hedging techniques that apply to all types of institutions. They describe a performance measurement approach that goes far beyond traditional capital allocation techniques in measuring risk-adjusted shareholder value creation. Most important, the authors supplement this strategic view of integrated risk with step-by-step tools and techniques for constructing a risk management system that achieves these objectives.

The authors start with an updated review of techniques for constructing the building blocks of risk management, continuous yield curves that are used in everything from equity options to mortgage-backed securities analysis. They show how the creation of smooth credit spreads from bond price data is an extension of traditional yield curve smoothing technology. The authors review the primary credit risk models and discuss the implementation of the most modern form of credit models, the reduced form models of Jarrow, Duffy and Singleton, at great length. They present results from a 1.2 million observation data base on default probabilities in demonstrating how to meet Basel II requirements for credit model testing. They also show how to estimate default probabilities from bond prices and credit derivatives prices even when there is a liquidity premium reflected in those prices above and beyond the risk of expected loss due to default or bankruptcy.

The authors then go on to show how three important topics in finance are special cases of the credit risk analysis they introduce: prepayment modeling, valuation of life insurance policies, and the valuation of property and casualty insurance contracts. Van Deventer, Imai and Mesler also revisit the critical issue of the valuation of savings deposits and demand deposits, which have no explicit maturity and a random principal balance.

Finally, the authors present a comprehensive framework for performance measurement at both the transaction level and the portfolio level that is consistent with best practice valuation techniques. Performance measurement has a history of many decades but it is rapidly evolving beyond simple concepts of plus alpha or interest rate margin to true measures of value generation.

Advanced Financial Risk Management also contains a rich array of formulas for basic and advanced risk management calculations which will be of enormous use to practitioners in fund management, pension fund management, banking, insurance and the securities industry.

See all Editorial Reviews

Product Details

• Hardcover: 650 pages
• Publisher: Wiley (November 10, 2004)
• Language: English
• ISBN-10: 0470821264
• ISBN-13: 978-0470821268
• Product Dimensions: 8.9 x 6.4 x 1.8 inches
• Shipping Weight: 2.4 pounds (View shipping rates and policies)
• Average Customer Review: 5.0 out of 5 stars See all reviews (3 customer reviews)
• Amazon.com Sales Rank: #722,226 in Books (See Bestsellers in Books)

Customer Reviews

Most Helpful Customer Reviews

5 of 6 people found the following review helpful:

5.0 out of 5 stars Introduction to the KRM, November 18, 2006

By	Dr. Lee D. Carlson (Baltimore, Maryland USA) - See all my reviews (TOP 100 REVIEWER)    (REAL NAME)

Risk management, as the authors define it, delineates for the management of a firm the risks and returns of every strategic decision at the institutional and transactional levels. It indicates how the management must change a particular strategy with the goal of aligning the trade-off between risk and return with the optimal long and short-term goals of the firm. If one desires an in-depth quantitative understanding of risk management as it is practiced at the present time, this book offers a comprehensive and useful overview. Although the authors are clearly showing bias towards a particular tool used for risk management, namely the Kamakura Risk Manager @ product which they helped to develop and market, the reader still gains insight into the relevant factors that go into successful risk management and will understand just how challenging this field is. The book is geared towards the student, for there are usually exercises at the end of each chapter. The goal of the book is very ambitious, in that the authors attempt to integrate credit, market, and operational risk, along with asset and liability management, performance measurement, and transfer pricing into a single framework. The justification for this integration is given as the book unfolds, and because of this the reader may frequently feel impatient, and thus tempted to skip ahead. However, readers who do this will miss out on the interesting argumentation and historical analysis the authors give, with each chapter setting up next. There is therefore a heavy dependence between chapters, and this makes a "skim read" more difficult, at least from the standpoint of in-depth comprehension of the subject matter. Those readers who are not experts in risk management, such as this reviewer, but who have a sound background in probability theory, stochastic processes, and financial engineering (at the level of the Black-Scholes model) will find this book ideal. Options theory plays a central role in the book, as the authors propose that the Jarrow-Merton put option is the best comprehensive measure of integrated credit, interest rate, and foreign exchange risk. The authors believe that risk management should make no distinction between credit risk, market risk, operational risk, asset and liability management, performance measurement, and transfer pricing.

The authors begin the book by discussing the difference between risk management from the standpoint of net income and from the standpoint of mark-to-market, and how a failure by some financial institutions to adopt the latter caused them great pain. Their historical commentary on this topic is enlightening for it gives insight into some of the biases concerning risk that exist even at the present time. For this reviewer, one of the most interesting discussions in the book concerned the transaction cost approach to prepayment modeling in asset-backed securities. In this approach, the authors divide the borrowers into three classes, with the first being those who make prepayments even when they should not. The second class are borrowers who prepay at a time when the advantages of prepayment exceeds the transaction costs of doing so. The third class are those borrowers who make prepayments when advantageous to do so, even though in the past they have refrained from doing so. Following the book's paradigm, the authors formulate the prepayment model in terms of options, with the value of the option to prepay being calculated from observable market data. The authors claim that this approach fits the movements in loan prices better than the approaches based on prepayment speeds and prepayment tables, but they do not offer explicit evidence for this claim. In fact throughout the book there are many instances where the authors do not offer any real case studies that would illustrate the superiority of their approach and the use of the Kamakura Risk Manager@. Risk analysts and managers will insist on the availability of these studies before committing themselves and institutional resources to this product or any others that make such claims.

The book should not be viewed therefore as purely a "theoretical" overview of risk management techniques. The authors give examples illustrating the main principles. For example, in their discussion of one-period models they assert that a collection of homogeneous risks are not sufficient, since the likelihood, magnitude, and timing of risks are closely linked. As examples, they quote the debacles in the U.S. Savings and Loan and Long Term Capital Management, and the takeover of Security Pacific Corporation by Bank of America. They also give examples of 'selection bias' in measuring risk.

Many interesting questions are addressed in the book, such as: 1. Why are 'fat-tailed' events important in risk analysis? 2. What is 'transfer pricing' and why is it useful? 3. Should risk be measured in terms of the volatility of the mark-to-market value of the relevant portfolio or in terms of the volatility of the net income? 4. How large should risk limits be for each part of a financial institution? 5. How is the mark-to-market value of a portfolio measured? 6. How is tracking error measured? 7. How is a hedging strategy to be priced? 8. What advantages, if any, are there in using Monte Carlo simulations of returns over a chosen time horizon? 9. What are the implications to credit risk of the new Basel II accords? 10.Why are stress tests important in a hedging strategy? 11.What area of the financial organization should be responsible for credit risk?

The authors also give a thorough discussion of yield curve smoothing, and how to derive the zero-coupon bond prices from observable data. The method of splines seems to be their preferred method of choice as a smoothing technique, which they advertise as being one that allows the calculation of zero-coupon bond prices for a large number of payment dates. They show, interestingly, that a cubic spline of zero-coupon bond yields is the smoothest yield curve.

1 of 1 people found the following review helpful:

5.0 out of 5 stars Great Book for serious reader, June 29, 2007

By	Lijun Shi "Crazy Quant" (Cleveland, OH USA) - See all my reviews

This book is written by professionals for professionals. Period.

Unless you are serious about risk management, you will not care about some of the little details covered by this book. When you do, you will really appreciate this book.

Formulas are well places, examples are real life relevent, well written. I fell in love with this book when I first read this book.

2 of 3 people found the following review helpful:

5.0 out of 5 stars Great book on the subject. A must have., May 11, 2006

By	Jose A. Montero Sanchez "Jose Montero" (Mexico DF) - See all my reviews (REAL NAME)

I think this book is a must have for everyone involved in managing or supervising interest rate risk. The authors are clear in their explanations and light to read, but they also get in-depth in several technical aspects.

I am a banking supervisor and I had been lookin for a book on this subject for a while, specially one with an emphasis on managing interest rate risk since the Basel committee has very few pointers on this.

The book tackles the most common problems, including the managerial aspects, as well as the techniques frequently used for modelling things like deposits (DDAs), revolving credit and a product by product guide to financial instruments, and much, much more. Definitely a must have, if you can browse through a few sections or the index and you will quickly see what I mean.