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Author:   Allan M. Malz
Publisher:   John Wiley & Sons Inc
Imprint:   John Wiley & Sons Inc
ISBN:  

9781394179626

ISBN 10:   1394179626
Pages:   432
Publication Date:   22 October 2024
Audience:   General/trade ,  General
Format:   Hardback
Publisher's Status:   Active
Availability:   Available To Order  
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Table of Contents

List of Figures xiii List of Tables xvii Preface xix About the Author xxi Part I Finance in the Economic System 1 1 Functions and Structure of the Financial System 3 1.1 Functions of the Financial System 3 1.2 Market Participants, Intermediaries, and Governments 4 1.3 Assets and Markets 6 1.3.1 Money and Money Markets 6 1.3.2 Foreign Exchange 7 1.3.3 Digital Currencies 7 1.3.4 Equity, Loans, and Bonds 7 1.3.5 Spot and Derivative Assets 9 1.3.6 Alternative Investments 11 1.4 Mechanics of Trading 12 1.4.1 Asset Positions and Risk Exposures 12 1.4.2 Market Microstructure 14 1.4.3 Payment Systems 15 1.4.4 Clearing and Settlement 16 Further Reading 17 2 Asset Returns and Risk 19 2.1 Asset Returns and Interest Rates 19 2.1.1 Measuring Asset Returns 19 2.1.2 Interest Rates and Yield Curves 22 2.1.3 Total Returns and Asset Values 25 2.1.4 Inflation and Real Returns 26 2.1.5 Excess Returns 29 2.2 Asset Return Probability Distributions 30 2.3 Financial Risks 32 2.3.1 Market Risk 32 2.3.2 Credit Risk 33 2.3.3 Operational Risks 34 Further Reading 35 3 Information, Preferences, and Asset Prices 37 3.1 Information and the Quantification of Risk 37 3.1.1 Conceptions of Equilibrium 37 3.1.2 Technical Progress 39 3.1.3 Frictions and Transaction Costs 40 3.1.4 Institutions 41 3.2 Risk Premiums 42 3.2.1 The Convention of the Risk-Free Rate and Reference Rates 42 3.2.2 Expected Returns and Risk Premiums 43 3.2.3 Interest Rate Spreads 46 3.3 An Era of Low Interest Rates and Slowing Growth 48 3.3.1 Safe Assets 52 3.3.2 Rising Debt 54 Further Reading 55 Part II Markets, Uncertainty, and Risk 57 4 The Behavior of Asset Returns over Time 59 4.1 Standard Model of Asset Price Behavior and Reality 59 4.2 Return, Volatility, and Correlation Behavior 61 4.2.1 Return Predictability 61 4.2.2 Time Variation in Return Volatility 62 4.2.3 Time Variation in Return Correlation 62 4.3 Volatility Forecasting 64 4.3.1 Simple Approaches to Volatility Estimation 64 4.3.2 The GARCH Model 66 4.3.3 The Exponentially Weighted Moving Average Model 67 4.4 Tail Risk: the Prevalence of Extremes 70 4.4.1 Extreme Asset Returns 70 4.4.2 Skewness and Kurtosis 72 4.4.3 Clues to Financial Puzzles in the Behavior of Volatility 73 Further Reading 75 5 Capital Markets: How Asset Prices Are Determined 77 5.1 Portfolios, Diversification, and Investor Choice 77 5.1.1 Portfolio Risk 77 5.1.2 Optimal Investor Choice 80 5.2 The Capital Asset Pricing Model 82 5.2.1 The Efficiency of the Market Portfolio 83 5.2.2 Estimating Systematic and Nonsystematic Risk 84 5.2.3 More General Factor Models 86 Further Reading 87 6 Derivatives Values and Risks 89 6.1 Futures, Forwards, and Swaps 89 6.1.1 Forward Foreign Exchange Markets 91 6.1.2 Valuation of Interest Rate Swaps 94 6.1.3 The LIBOR Transition 95 6.1.4 Credit Default Swaps 96 6.2 Options 98 6.2.1 Option Values 98 6.2.2 The Option-Implied Volatility Surface 101 6.2.3 Option Risks 102 6.2.4 Put-Call Parity 104 6.2.5 Interest Rate Implied Volatility 104 6.3 Market-Implied Asset Price Forecasts 105 6.3.1 Risk-Neutral Mean Forecasts 105 6.3.2 Risk-Neutral Volatility and Correlation Forecasts 107 6.3.3 Risk-Neutral Probability Distributions 107 Further Reading 109 7 Capital Market Efficiency 111 7.1 Asset Price Behavior in an Efficient Market 111 7.1.1 Validating the Efficient Markets Hypothesis 112 7.1.2 Market Efficiency, Preferences, and Knowledge 113 7.2 Apparent Violations of Market Efficiency 114 7.2.1 Slow Arbitrage 114 7.2.2 Basis Spreads 115 7.2.3 Foreign Exchange Markets 116 7.3 Efficacy of Active Management 117 7.3.1 Passive and Active Investment Management 117 7.3.2 Empirical Validation of Active Management 118 7.3.3 Alternative Investments 122 Further Reading 126 8 Market Risk 129 8.1 Definition of Value-at-Risk 129 8.1.1 Why Value-at-Risk? 129 8.1.2 Value-at-Risk Is a Quantile 130 8.2 Computing Value-at-Risk for One Risk Factor 130 8.2.1 Modeling Approaches to Value-at-Risk Estimation 130 8.2.2 Parametric Normal Value-at-Risk 133 8.2.3 Computing Value-at-Risk via Monte Carlo Simulation 134 8.2.4 Computing Value-at-Risk via Historical Simulation 134 8.2.5 Value-at-Risk for Short Positions 136 8.2.6 Comparison of Value-at-Risk Computation Approaches 138 8.3 Nonlinear Market Risks 138 8.3.1 Nonlinearity and Risk Measurement 138 8.3.2 Applying Delta-Gamma Value-at-Risk to the Value of an Option 139 8.3.3 Portfolio Value-at-Risk 141 8.4 Incorporating Extreme Events Into Risk Measurement 142 8.4.1 Why Not Value-at-Risk? 142 8.4.2 Stress Testing and Scenario Analysis 143 8.4.3 Expected Shortfall 145 Further Reading 148 9 Credit and Counterparty Risk 149 9.1 Default, Bankruptcy, and Resolution 149 9.1.1 Equity, Debt, and Leverage 149 9.1.2 Information Costs in Credit Intermediation 150 9.1.3 Default and Migration 151 9.1.4 Counterparty Risk, and Collateral 152 9.1.5 Bankruptcy, Capital Structure, and Resolution 153 9.2 Quantifying Credit Risk 155 9.2.1 Credit Risk Metrics 155 9.2.2 Default Modeling 156 9.2.3 Intensity Models and Default Time Analytics 157 9.3 Single-Obligor Credit Risk Models 158 Further Reading 162 Part III Market Institutions and Risk Assessment 163 10 Interest Rate Risk 165 10.1 Sources of Interest Rate Risk 165 10.2 Interest Rate Risk Measurement 167 10.2.1 Measuring Bond Price Sensitivity to Rates 167 10.2.2 Duration and Convexity 169 10.2.3 Convexity and the Mortgage-Backed Securities Markets 171 10.2.4 Measuring Value-at-Risk for a Bond Position 175 Further Reading 176 11 Leverage 177 11.1 Defining and Measuring Leverage 177 11.1.1 Company Financing 177 11.1.2 Corporate Finance Policy 178 11.1.3 Margin and Haircuts 179 11.2 Attractiveness of Leverage and Reaching for Yield 179 11.3 Leveraged Trades 180 11.3.1 Carry Trades 181 11.3.2 Leveraged Investment Funds 184 11.4 Incentive Alignment and Capital Structure 184 11.4.1 Leverage and Incentives to Risk Shifting 184 11.4.2 Debt Overhang 186 Further Reading 187 12 Liquidity 189 12.1 Funding and Market Liquidity Risk 189 12.1.1 Market Liquidity 189 12.1.2 Market Liquidity Stress Events 191 12.1.3 Funding Liquidity 192 12.2 Private Liquidity Creation: Commercial Banking 193 12.2.1 Historical Emergence of Banks 193 12.2.2 Commercial Bank Liquidity Creation 194 12.2.3 Commercial Bank Risks 195 12.3 Private Liquidity Creation: Short-Term Funding 198 12.3.1 Structure of Collateralized Securities Lending Markets 199 12.3.2 Repo Markets 201 12.3.3 Money Market Mutual Funds 204 Further Reading 206 13 Portfolio Credit Risk 207 13.1 Credit Portfolios and Default Correlation 207 13.1.1 Challenges in Portfolio Credit Risk Modeling 207 13.1.2 Default Correlation 209 13.1.3 Granularity and Uncorrelated Portfolios 210 13.1.4 Granularity, Subadditivity, and Credit Value-at-Risk 212 13.2 Measuring Portfolio Credit Risk 213 13.2.1 Single Factor Credit Risk Model 213 13.2.2 Single Factor Model for Portfolios 216 13.2.3 Portfolio Credit Value-at-Risk 219 Further Reading 223 14 Securitization and Structured Product Risk 225 14.1 Introduction to Securitization 225 14.1.1 Function and Design of Securitization 225 14.1.2 Securitization in the United States 226 14.2 Securitization Structure 228 14.3 Credit Risk Measurement of Securitizations 231 14.3.1 Securitization Loss Scenarios 231 14.3.2 Securitization Risk Modeling 233 14.3.3 Credit Value-at-Risk of Securitizations 237 14.3.4 Risk Analysis and Structuring of Securitizations 238 14.4 Credit Correlation Trading 240 14.4.1 CDS Indexes and Standard Tranches 240 14.4.2 The 2005 Auto Industry Credit Crisis and the “London Whale” 241 Further Reading 244 15 Financial Instability and Financial Crises 245 15.1 Defining Financial Crises 245 15.2 Runs and Liquidity in Financial Crises 246 15.3 Causes of Financial Crises 251 15.3.1 Interest Rates, Volatility, and Financial Imbalances 251 15.3.2 Long-Term Liabilities and Interest Rates 253 15.3.3 Reaching for Yield 254 15.4 International Financial Imbalances 258 15.4.1 Rising International Trade and Global Debt 258 15.4.2 The Role of the US Dollar 260 15.4.3 The Cross-Currency Basis 263 15.4.4 International Financial Imbalances and Stability 264 Further Reading 268 Part IV Monetary and Regulatory Policy 269 16 Overview of Financial Regulation 271 16.1 Structure of Financial Regulation 271 16.1.1 Financial Regulatory Authorities 271 16.1.2 Law and Regulation 272 16.2 Methods of Regulation 273 16.2.1 Bank Supervision 274 16.2.2 Regulatory Developments of Recent Decades 275 16.3 Purposes and Efficacy of Financial Regulation 276 16.3.1 Rationale of Financial Regulation 276 16.3.2 Information Problems in Regulation 277 16.3.3 Incentives and the Efficacy of Regulation 279 Further Reading 281 17 Monetary Policy 283 17.1 The Emergence of Monetary Policy 283 17.2 The Framework of Monetary Policy 284 17.2.1 Policy Targets and Instruments 285 17.2.2 Credibility of Monetary Policy 286 17.2.3 Money Supply Control 287 17.2.4 Interest Rate Control 289 17.2.5 The New Keynesian Framework 289 17.2.6 Alternative Approaches to Monetary Policy 291 17.3 Monetary Operations in Normal Times 292 Further Reading 296 18 Regulation for Financial Stability 297 18.1 The Lender of Last Resort Function 297 18.1.1 Bagehot’s Rule 297 18.1.2 Market Maker of Last Resort 298 18.1.3 Credit Support and Liquidity Support 299 18.2 The Onset of the Global Financial Crisis 300 18.3 Financial Stability Policy 302 18.3.1 Financial Stability and Monetary Policy 302 18.3.2 Financial Stability Monitoring 304 18.4 The Problem of Public-Sector Guarantees 304 18.4.1 Deposit Insurance 305 18.4.2 Regulation of Money Market Mutual Funds 305 18.4.3 Too Big to Fail 307 18.4.4 Emergence of a Too Big To Fail Policy 307 18.4.5 The Too Big to Fail Subsidy and its Cost 308 18.4.6 Too Big to Fail and the Regulatory System 309 Further Reading 309 19 Regulation of Capital Funding, Liquidity, and Large Banks 311 19.1 Historical Background of the Capital Standards 311 19.2 Bank Accounting Standards and Regulation 312 19.2.1 Treatment of Losses 312 19.2.2 The Banking and Trading Books 314 19.3 Measuring Risk-Weighted and Adjusted Assets 315 19.3.1 Risk-Weighted Assets 315 19.3.2 Leverage Exposure 317 19.4 Quality and Quantity of Capital 317 19.4.1 Quality of Capital 318 19.4.2 Quantity of Capital 318 19.4.3 Effectiveness and Market Impact of Capital Regulation 319 19.5 Regulation of Large Banks 321 19.5.1 Regulatory Capital Ratios for Large Banks 321 19.5.2 Bail-in-able Liabilities 322 19.5.3 Regulatory Stress Tests 323 19.5.4 Resolution of Large Banks 325 19.5.5 Regulatory Liquidity Standards for Banks 328 Further Reading 331 20 Monetary Policies Since the Global Financial Crisis 333 20.1 The Monetary Policy Response to the Global Financial Crisis 333 20.1.1 Interest on Reserves 333 20.1.2 Quantitative Easing 334 20.1.3 Forward Guidance 335 20.2 Monetary Operations with a Large Balance Sheet 337 20.2.1 Quantitative Easing and the Soggy Money Market 338 20.2.2 The Ample Reserves Operating Framework 340 20.2.3 The Impact of Exit on Funding and Market Liquidity 343 20.2.4 Money Markets in September 2019 344 20.3 The Liquidity Paradox and the Banking Turmoil 346 20.3.1 The Public-Sector Response to the Covid Pandemic 346 20.3.2 The Rise in Interest Rates and the Financial System 349 20.3.3 The 2023 US Bank Panic 351 Further Reading 354 Appendix 357 A Much of the Probability and Statistics You Need 359 A1 Probability Distributions and Their Properties 359 A.1.1 Moments of a Distribution 359 A.1.2 Quantiles of a Distribution 360 A.2 Important Distributions 360 A.2.1 Binomial Distribution 361 A.2.2 Poisson Distribution 361 A.2.3 Normal Distribution 361 A.2.4 Multivariate Distributions 362 A.3 Stochastic Processes 363 A.4 Statistical Tests 365 A.4.1 Samples 365 A.4.2 Sample Moments 365 A.4.3 Quantiles of Samples 366 A.4.4 Central Limit Theorem 367 A.4.5 Hypotheses 367 A.4.6 Test Statistics 368 A.5 Linear Regression Analysis 368 Further Reading 370 B Notation 371 C Abbreviations 373 References 377 Index 395

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Allan M. Malz has been chief risk officer at several multi-strategy hedge fund management firms. He worked at the Federal Reserve Bank of New York as a researcher and foreign exchange trader, and helped implement the Fed's emergency liquidity programs addressing the global financial crisis. Malz is an investment consultant and adjunct professor at Columbia University, and the author of Financial Risk Management: Models, History, and Institutions. His work on predicting financial crises and on risk measurement for options has been published in industry and academic journals. He holds a Ph.D. from Columbia and a Diplom from Ludwig-Maximilians-Universität München.

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