Financial Risk Analysis is the first book written by experience 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.
'This is the book I wish I had written.'
Robert D. Selvaggio, Ph.D., Director, Fixed Income and Mortgage Research, The Chase Manhattan Bank, N.A.
'Financial Risk Analytics provides an excellent introduction to arbitrage-free term structure models and their uses in the management of financial institutions. The text is clearly-written, well-organized and comprehensive in its coverage of various derivative securities.'
Robert A. Jarrow, Ronald P. And Susan E. Lynch Professor of Investment Management, Johnson Graduate School of Management, Cornell University
'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.'
Oldrich A. Vasicek, KMV Corporation
'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. Bond analysts, derivative specialists, risk assessors and their managers will regard this book as a valued high-level and accessible reference.'
David Shimko, J.P. Morgan
1. 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
2. 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
3. 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
4. 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
5. 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
6. 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
7. 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
8. European Options on Forward and Futures Contracts
Valuing Options on Forwards and Futures
European Options on Forward Contacts 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
9. Caps and Floors
Introduction to Caps and Floors
Caps as European Options on Forward Rate Agreements
Forming Other Cap-Related Securities
10. 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
11. 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
12. 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
13. 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
14. 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
15. 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)
16. 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
17. 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
18. 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
19. 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
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