Financial Risk Analytics A Term Structure Model Approach for Banking, Insurance & Investment Management

About the Book
The book Financial Risk Analytics is the first book written by experienced risk managers that is designed to explain, in comprehensive yet understandable terminology, the analytics of interest rate risk, credit rate risk, foreign exchange risk and capital allocation from A to Z. Risk management experts Donald R. van Deventer and Kenji Imai show in a very practical, concrete way how the term structure models used to price interest rate derivatives can be used to hedge all common products in banking, insurance and investment management, allowing the same risk management approach for an entire institution that is normally taken for a derivatives portfolio alone.

Financial Risk Analytics allows you to develop a comprehensive understanding of this complex subject, including: The basics of present value, forward rates and interest rate compounding. American fixed income option vs. European options. The wide variety of alternative term structure models to the basic Vasicek model. Bridging the gap between the idealized assumptions used for valuation and the realities that must be reflected in management actions.   Financial institution risk management is a complex, highly technical pursuit that is often difficult to grasp. The result can be choosing ineffective risk management techniques over superior counterparts, or completely missing the mark on meaningful risk management altogether. Financial Risk Analytics introduces and expands upon prevalent market theories. It is indispensable in its common-sense approach to risk management in today's environment.

"Financial Risk Analytics fills the gaps left by dry, fixed-income valuation formulas in finance textbooks with the best market-tested and up-to-date complex bond valuation and risk measurement practices available today .... a valued high-level and accessible reference."- David Shimko, J. P. Morgan

"This book is a detailed, well-organized, practitioner-oriented compendium of models and computational procedures for valuation of fixed income securities and derivatives, and the assessment of their risk characteristics." - Olderich A. Vasicek, KMV Corporation

Book Contents 

  • Fixed-Income Mathematics Price, Accrued Interest, and Value Present Value Compound Interest Conventions and Formulas Yields and Yield-to-Maturity Calculations Calculating Forward Interest Rates and Bond Prices Summary
  • Yield Curve Smoothing Cubic Spline Yield Smoothing Cubic Spline Price Smoothing Maximum Smoothness Forward Rates Smoothing Coupon-Bearing Bond Data or Other Data Conclusion Appendix: Proof of the Theorem
  • Duration and Convexity: The Traditional Risk Management Tools Macaulay's Duration: The Original Formula Using Duration for Hedging Duration: The Market Convention The Perfect Hedge: The Difference between the Original Macaulay and Conventional Durations Convexity and its Uses Conclusion
  • Duration as a Term Structure Model What Is a Term Structure Model and Why Do We Need One? The Vocabulary of Term Structure Models Ito's Lemma Ito's Lemma for More than One Random Variable Using Ito's Lemma to Build a Term Structure Model Duration as a Term Structure Model Conclusions about the Use of Duration's Parallel Shift Assumptions
  • The Vasicek and Extended Vasicek Models The Merton Model The Extended Merton Model The Vasicek Model The Extended Vasicek/Hull and White Model An Example of the Hedging Implications of Tier Structure Models Compared to the Duration Approach Conclusion
  • Risk-Neutral Interest Rates and European Options on Bonds An Introduction to Risk-Neutral Interest Rates and the No-Arbitrage Assumption Relationship between the Expected Short Rate, Expected Risk-Neutral Short Rate, and Forward Rates A General Valuation Formula for Valuation of Interest-Rate-Related Securities in the Vasicek Model Derivation of the Closed-Form Valuation Formula The Value of European Options on a Zero Coupon Bond European Puts on Zero Coupon Bonds Options on Coupon-Bearing Bonds An Example
  • Forward and Futures Contracts Forward Contracts on Zero Coupon Bonds Forward Rate Agreements Eurodollar Futures-type Forward Contracts Futures on Zero Coupon Bonds: The Sydney Futures Exchange Bank Bill Contract Futures on Coupon-Bearing Bonds: Example Using the SIMEX Japanese Government Bond Future Eurodollar, Euroyen, and Euromark Futures Contracts
  • European Options on Forward and Futures Contracts Valuing Options on Forwards and Futures European Options on Forward Contracts on Zero Coupon Bonds European Options on Forward Rate Agreements European Options on a Eurodollar Futures-type Forward Contract European Options on Futures on Zero Coupon Bonds European Options on Futures on Coupon-Bearing Bonds Options on Eurodollar, Euroyen, and Euromark Futures Contracts
  • Caps and Floors Introduction to Caps and Floors Caps as European Options on Forward Rate Agreements Forming Other Cap-Related Securities
  • Interest Rate Swaps and Swaptions Introduction to Interest Rate Swaps Valuing the Floated-Rate Payment on a Swap The Observable Fixed Rate in the Swap Market An Introduction to Swaptions Valuation of European Swaptions Valuation of American Swaptions
  • Exotic Swap and Option Structures Introduction to Exotic Swaps and Options Arrears Swaps Digital Options Digital Range Notes Range Floaters Min-Max Floaters Other Derivative Securities
  • American Fixed-Income Options Introduction to American Options An Overview of Numerical Techniques for Fixed-Income Option Valuation Monte Carlo Simulation Finite Difference Methods Binomial Lattices Bushy Trees Trinomial Lattices Valuing Securities on the Lattice: European and American Calls
  • Irrational Exercise of Fixed-Income Options Irrationality Analysis of Irrationality Criteria for a Powerful Explanation The Transactions Cost Approach Irrational Exercise of European Options Valuing a Zero Coupon Bond with an Irrationality Exercised Embedded Call Option The Irrational Exercise of American Options Implied Irrationality and Hedging
  • Mortgage-Backed Securities Introduction to the Analysis of Mortgage-Backed Securities Prepayment Speeds and the Valuation of Mortgages Constant Prepayment Speeds as a Principal Amortization Assumption Fitting Actual GNMA Data with a Single Prepayment Speed Model Can We Forecast Prepayment Rates? Option-Adjusted Spread The Transactions Cost Approach to Prepayments Implications for OAV Spread, CMOs, and ARMs
  • Nonmaturity Deposits An Introduction to Nonmaturity Deposits The Value of the Deposit Franchise Total Cash Flow of Nonmaturity Deposits Deposit Valuation with Constant Balances or Known Variation in Balances Random Deposit Balances with Constant Interest Rates The Valuation of Deposits Whose Rates and Balances Vary with Open-Market rates Using the Jarrow-van Deventer Formula in Practice Appendix: Derivation of Valuation Formulas in Section 15.5 (Random Deposits Balances with Constant Interest Rates)
  • The Valuation of Risky Debt Introduction to the Value of Risky Debt The Merton Model of Risky Debt Risky Debt with Stochastic Interest Rates Implications of the Valuation of Risky Debt Other Approaches to the Valuation of Risky Debt
  • Foreign Exchange Markets: A Term Structure Model Approach Introduction to Foreign Exchange Forwards and Options Foreign Exchange Forwards Foreign Exchange Options Implications of a Term Structure Model-Based FX Options Formula Improved Accuracy of the Stochastic Interest Rate FX Model Extensions of the Stochastic Interest Rate Approach to Foreign Currency-Related Securities Pricing
  • Alternative Term Structure Models Introduction to Alternative Term Structure Models Alternative One-Factor Interest Rate Models Two-Factor Interest Rate Models The Heath, Jarrow, and Morton Approach Term Structure Model Selection
  • Estimating the Parameters of Term Structure Models Introduction to the Estimation of Term Structure Model Parameters Traditional Academic Approach Volatility Curve Approach Advanced Volatility Curve Approach Implied Parameters from an Observable Yield Curve The Best Approach Hedging and Risk Measurement Introduction to Hedging and Risk Measurement Portfolio Selection: What Assets Should We Sell and What Assets Should We Buy? What Level of Risk Maximizes Shareholder Value? How Should the Aggregate Level of Risk Be Measured? The Best Hedge Performance Evaluation: Which Managers Did Well? Risk-Adjusted Return on Capital Summing Up