Advanced Financial Risk Management Foundedin1807,JohnWiley&Sonsistheoldestindependentpublishingcompanyin theUnitedStates.WithofficesinNorthAmerica,Europe,Australia,andAsia,Wiley isgloballycommittedtodevelopingandmarketingprintandelectronicproductsand servicesforour customers’ professionalandpersonalknowledgeandunderstanding. 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, riskmanagement,financialengineering,valuation,andfinancialinstrumentanalysis, as well as much more. Foralistofavailabletitles,visitourWebsiteatwww.WileyFinance.com. Advanced Financial Risk Management Second Edition Tools and Techniques for Integrated Credit Risk and Interest Rate Risk Management DONALD R. VAN DEVENTER KENJI IMAI MARK MESLER CoverDesign:Leiva-Sposato. CoverImage:ªhudiemm/iStockphoto. Copyrightª2013byJohnWiley&SonsSingaporePte.Ltd. PublishedbyJohnWiley&SonsSingaporePte.Ltd. 1FusionopolisWalk,#07-01,SolarisSouthTower,Singapore138628 Allrightsreserved. Nopartofthispublicationmaybereproduced,storedinaretrievalsystem,ortransmittedin anyformorbyanymeans,electronic,mechanical,photocopying,recording,scanning,or otherwise,exceptasexpresslypermittedbylaw,withouteitherthepriorwrittenpermissionofthe Publisher,orauthorizationthroughpaymentoftheappropriatephotocopyfeetotheCopyright ClearanceCenter.RequestsforpermissionshouldbeaddressedtothePublisher,JohnWiley &SonsSingaporePte.Ltd.,1FusionopolisWalk,#07-01,SolarisSouthTower,Singapore 138628,tel:65–6643–8000,fax:65–6643–8008,e-mail:[email protected]. LimitofLiability/DisclaimerofWarranty:Whilethepublisherandauthorhaveusedtheirbest effortsinpreparingthisbook,theymakenorepresentationsorwarrantieswithrespecttothe accuracyorcompletenessofthecontentsofthisbookandspecificallydisclaimanyimplied warrantiesofmerchantabilityorfitnessforaparticularpurpose. Nowarrantymaybecreatedor extendedbysalesrepresentativesorwrittensalesmaterials. Theadviceandstrategiescontained hereinmaynotbesuitableforyoursituation. Youshouldconsultwithaprofessionalwhere appropriate. Neitherthepublishernortheauthorshallbeliableforanydamagesarisingherefrom. OtherWileyEditorialOffices JohnWiley&Sons,111RiverStreet,Hoboken,NJ07030,USA JohnWiley&Sons,TheAtrium,SouthernGate,Chichester,WestSussex,P0198SQ,United Kingdom JohnWiley&Sons(Canada)Ltd.,5353DundasStreetWest,Suite400,Toronto,Ontario,M9B 6HB,Canada JohnWiley&SonsAustraliaLtd.,42McDougallStreet,Milton,Queensland4064,Australia Wiley-VCH,Boschstrasse12,D-69469Weinheim,Germany LibraryofCongressCataloging-in-PublicationData ISBN978-1-118-27854-3(Hardcover) ISBN978-1-118-27857-4(ePDF) ISBN978-1-118-27856-7(Mobi) ISBN978-1-118-27855-0(ePub) Typesetin10/12ptSabon-RomanbyMPSLimited,Chennai,India. PrintedinSingaporebyHoPrinting. 10 9 8 7 6 5 4 3 2 1 For Yasuko, Tomoki, and Anna. K. I. To all of our colleagues at Kamakura. M. M. For Ayako, Ella, Ai, and Yuu. D. v. D. Contents Introduction: Wall Street Lessons from Bubbles xxiii Key Fallacies in Risk Management xxiii Selected Events in the Credit Crisis xxviii PART ONE Risk Management: Definitions and Objectives CHAPTER 1 A Risk Management Synthesis: Market Risk, Credit Risk, Liquidity Risk, and Asset and Liability Management 3 Risk Management: Definitions and Objectives 6 Advances in Integrated Risk Management and Institutional Barriers to Progress 8 Measuring the Trade-Offs between Risk and Return 11 When Bad Things Happen to Good People 11 U.S. Savings and Loan Crisis 12 Long-Term Capital Management 13 The 2006(cid:2)2011 Credit Crisis 13 A Thousand Cuts 13 CHAPTER 2 Risk, Return, Performance Measurement, and Capital Regulation 15 Practical Quantification of Risk 15 Perils and Pitfalls in the Measurement of Risk: The Impact of Selection Bias 16 Biases in Return vs. a Relative Benchmark 17 Historical Value at Risk: Selection Bias Again 18 Monte Carlo(cid:2)Based Value at Risk 19 Expected Losses on Tranches of Collateralized Debt Obligations 19 Measuring Return: Market vs. Accounting Returns 20 Introduction to Transfer Pricing: Extracting Interest Rate Risk in a Financial Accounting Context 20 Bank of America, 1973(cid:2)1979 21 First Interstate, 1982(cid:2)1987 24 Performance Measurement and Capital Regulation 26 Perspectives on Measuring Risk: One Source of Risk or Many Sources of Risk? 26 Interest Rate Risk Management Evolution 27 Equity Risk Management Evolution 28 vii viii CONTENTS Option Risk Management Evolution 28 Credit Risk Management Evolution 28 Managing Risk and Strategy, Business by Business 29 Risk and Strategy Management in a Complex Financial Institution 29 What Causes Financial Institutions to Fail? 31 The Role of Capital in Risk Management and Business Strategy 32 Capital-Based Risk Management in Banking Today: Pros and Cons 35 History of Capital-Based Regulations in Commercial Banking 37 PART TWO Risk Management Techniques for Interest Rate Analytics CHAPTER 3 Interest Rate Risk Introduction and Overview 45 Background Information on Movements in the U.S. Treasury Yield Curve 46 A Step-by-Step Approach to Analyzing Interest Rate Risk 55 The Interest Rate Risk Safety Zone 58 CHAPTER 4 Fixed Income Mathematics: The Basic Tools 59 Modern Implications of Present Value 59 Price, Accrued Interest, and Value 60 Calculation of Accrued Interest 60 Present Value 61 The Basic Present Value Calculation 61 Example 62 Calculating the Value of a Fixed Coupon Bond with Principal Paid at Maturity 62 Calculating the Coupon of a Fixed Coupon Bond with Principal Paid at Maturity When the Value Is Known 62 Example 63 The Value of an Amortizing Loan 63 Calculating the Payment Amount of an Amortizing Bond When the Value Is Known 63 Risk Management Implications 64 Calculating the Value of a Floating-Rate Bond or Loan with Principal Paid at Maturity 64 Example 65 Risk Management Implications 65 Compound Interest Conventions and Formulas 66 Future Value of an Invested Amount Earning at a Simple Interest Rate of y Compounded m Times per Year for n Periods 66 Future Value of an Invested Amount Earning at a Simple Interest Rate of y Compounded Continuously for n Years 66 Example 67 Present Value of a Future Amount If Funds Are Invested at a Simple Interest Rate of y Compounded m Times per Year for n Periods 67