Risk Management and Financial Institutions - Fifth Edition

Risk Management and

Financial Institutions

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Risk Management and

Financial Institutions

Fifth Edition

John C. Hull

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Copyright © 2018 by John C. Hull. All rights reserved.

Published by John Wiley & Sons, Inc., Hoboken, New Jersey.

The Third Edition was published by John Wiley & Sons, Inc., in 2012. The first and second editions of this

book were published by Prentice Hall in 2006 and 2009, respectively.

Published simultaneously in Canada.

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Library of Congress Cataloging-in-Publication Data:

Hull, John, 1946–

Risk management and financial institutions / John C. Hull. — Fifth Edition.

pages cm. — (Wiley finance series)

Includes index.

ISBN 978-1-119-44811-2 (cloth); ISBN 978-1-119-44816-7 (ePDF);

ISBN 978-1-119-44809-9 (ePUB)

1. Risk management. 2. Financial institutions—Management. I. Title.

HD61.H83 2015

332.1068′

1—dc23

2014037477

Printed in the United States of America

10 9 8 7 6 5 4 3 2 1

To Michelle, Peter, and David

Contents in Brief

Business Snapshots xxiii

Preface xxv

Chapter 1 Introduction 1

Part 1: Financial Institutions and Their Trading 23

Chapter 2 Banks 25

Chapter 3 Insurance Companies and Pension Plans 47

Chapter 4 Mutual Funds, ETFs, and Hedge Funds 75

Chapter 5 Trading in Financial Markets 97

Chapter 6 The Credit Crisis of 2007–2008 127

Chapter 7 Valuation and Scenario Analysis: The Risk-Neutral and Real

Worlds 145

Part 2: Market Risk 159

Chapter 8 How Traders Manage Their Risks 161

Chapter 9 Interest Rate Risk 185

vii

viii CONTENTS IN BRIEF

Chapter 10 Volatility 213

Chapter 11 Correlations and Copulas 243

Chapter 12 Value at Risk and Expected Shortfall 269

Chapter 13 Historical Simulation and Extreme Value Theory 293

Chapter 14 Model-Building Approach 317

Part 3: Regulation 345

Chapter 15 Basel I, Basel II, and Solvency II 347

Chapter 16 Basel II.5, Basel III, and Other Post-Crisis Changes 377

Chapter 17 Regulation of the OTC Derivatives Market 399

Chapter 18 Fundamental Review of the Trading Book 415

Part 4: Credit Risk 429

Chapter 19 Estimating Default Probabilities 431

Chapter 20 CVA and DVA 459

Chapter 21 Credit Value at Risk 479

Part 5: Other Topics 495

Chapter 22 Scenario Analysis and Stress Testing 497

Chapter 23 Operational Risk 515

Chapter 24 Liquidity Risk 537

Chapter 25 Model Risk Management 565

Chapter 26 Economic Capital and RAROC 585

Chapter 27 Enterprise Risk Management 603

Chapter 28 Financial Innovation 621

Chapter 29 Risk Management Mistakes to Avoid 643

Contents in Brief ix

Part 6: Appendices 655

Appendix A Compounding Frequencies for Interest Rates 657

Appendix B Zero Rates, Forward Rates, and Zero-Coupon Yield Curves 661

Appendix C Valuing Forward and Futures Contracts 667

Appendix D Valuing Swaps 669

Appendix E Valuing European Options 673

Appendix F Valuing American Options 677

Appendix G Taylor Series Expansions 681

Appendix H Eigenvectors and Eigenvalues 685

Appendix I Principal Components Analysis 689

Appendix J Manipulation of Credit Transition Matrices 691

Appendix K Valuation of Credit Default Swaps 693

Appendix L Synthetic CDOs and Their Valuation 697

Answers to Questions and Problems 701

Glossary 745

RMFI Software 773

Table for N(x) When x ≥ 0 777

Table for N(x) When x ≤ 0 779

Index 781

Contents

Business Snapshots xxiii

Preface xxv

Chapter 1 Introduction 1

1.1 Risk vs. Return for Investors 2

1.2 The Efficient Frontier 6

1.3 The Capital Asset Pricing Model 8

1.4 Arbitrage Pricing Theory 14

1.5 Risk vs. Return for Companies 14

1.6 Risk Management by Financial Institutions 18

1.7 Credit Ratings 19

Summary 20

Further Reading 20

Practice Questions and Problems (Answers at End

of Book) 21

Further Questions 22

Part 1: Financial Institutions and Their Trading 23

Chapter 2 Banks 25

2.1 Commercial Banking 26

2.2 The Capital Requirements of a Small Commercial Bank 28

2.3 Deposit Insurance 30

2.4 Investment Banking 31

2.5 Securities Trading 36

2.6 Potential Conflicts of Interest in Banking 38

xi

xii CONTENTS

2.7 Today’s Large Banks 39

2.8 The Risks Facing Banks 42

Summary 43

Further Reading 43

Practice Questions and Problems (Answers at End

of Book) 44

Further Questions 44

Chapter 3 Insurance Companies and Pension Plans 47

3.1 Life Insurance 48

3.2 Annuity Contracts 51

3.3 Mortality Tables 52

3.4 Longevity and Mortality Risk 56

3.5 Property-Casualty Insurance 57

3.6 Health Insurance 60

3.7 Moral Hazard and Adverse Selection 61

3.8 Reinsurance 62

3.9 Capital Requirements 63

3.10 The Risks Facing Insurance Companies 64

3.11 Regulation 64

3.12 Pension Plans 66

Summary 70

Further Reading 71

Practice Questions and Problems (Answers at End

of Book) 71

Further Questions 72

Chapter 4 Mutual Funds, ETFs, and Hedge Funds 75

4.1 Mutual Funds 75

4.2 Exchange-Traded Funds 79

4.3 Active vs. Passive Management 80

4.4 Regulation 82

4.5 Hedge Funds 83

4.6 Hedge Fund Strategies 88

4.7 Hedge Fund Performance 93

Summary 94

Further Reading 95

Practice Questions and Problems (Answers at End

of Book) 95

Further Questions 96

Chapter 5 Trading in Financial Markets 97

5.1 The Markets 97

5.2 Clearing Houses 98

Contents xiii

5.3 Long and Short Positions in Assets 99

5.4 Derivatives Markets 101

5.5 Plain Vanilla Derivatives 102

5.6 Non-Traditional Derivatives 114

5.7 Exotic Options and Structured Products 117

5.8 Risk Management Challenges 118

Summary 120

Further Reading 122

Practice Questions and Problems (Answers at End

of Book) 122

Further Questions 125

Chapter 6 The Credit Crisis of 2007–2008 127

6.1 The U.S. Housing Market 128

6.2 Securitization 131

6.3 The Losses 137

6.4 What Went Wrong? 138

6.5 Lessons from the Crisis 140

Summary 141

Further Reading 142

Practice Questions and Problems (Answers at End

of Book) 142

Further Questions 143

Chapter 7 Valuation and Scenario Analysis: The Risk-Neutral

and Real Worlds 145

7.1 Volatility and Asset Prices 146

7.2 Risk-Neutral Valuation 147

7.3 Scenario Analysis 152

7.4 When Both Worlds Have to Be Used 153

7.5 The Calculations in Practice 154

7.6 Estimating Real-World Processes 155

Summary 156

Further Reading 157

Practice Questions and Problems (Answers at End

of Book) 157

Further Questions 158

Part 2: Market Risk 159

Chapter 8 How Traders Manage Their Risks 161

8.1 Delta 161

8.2 Gamma 169

8.3 Vega 171

8.4 Theta 173