The Economic Foundations of Risk Management

Theory, Practice, and Applications

Robert Jarrow

• Publisher: WSPC
• Year: 2016
• eBook ISBN: 9789813147539
• Topic: Business
• Subtopic: Financial Risk Management
• Index: Business

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The Economic Foundations of Risk Management presents the theory, the practice, and applies this knowledge to provide a forensic analysis of some well-known risk management failures. By doing so, this book introduces a unified framework for understanding how to manage the risk of an individual's or corporation's or financial institution's assets and liabilities. The book is divided into five parts. The first part studies the markets and the assets and liabilities that trade therein. Markets are differentiated based on whether they are competitive or not, frictionless or not (and the type of friction), and actively traded or not. Assets are divided into two types: primary assets and financial derivatives. The second part studies models for determining the risks of the traded assets. Models provided include the Black-Scholes-Merton, the Heath-Jarrow-Morton, and the reduced form model for credit risk. Liquidity risk, operational risk, and trading constraint models are also contained therein. The third part studies the conceptual solution to an individual's, firm's, and bank's risk management problem. This formulation involves solving a complex dynamic programming problem that cannot be applied in practice. Consequently, Part IV investigates how risk management is actually done in practice via the use of diversification, static hedging, and dynamic hedging. Finally, Part V applies these collective insights to six case studies, which are famous risk management failures. These are Penn Square Bank, Metallgesellschaft, Orange County, Barings Bank, Long Term Capital Management, and Washington Mutual. The credit crisis is also discussed to understand how risk management failed for many institutions and why.

--> --> Contents: Introduction;Traded Assets and Liabilities;Modeling Risks;Optimizing Risk;Managing Risks;Case Studies;
Readership: Graduate students and researchers interested in the topic of risk management.Risk Management, Derivatives, Value-at-Risk, Funding Risk, Financial Engineering

• Presents the theory, the practice, and applies this knowledge to provide a forensic analysis of some well-known risk management failures
• Introduces a unified framework for understanding how to manage the risk of an individual's or corporation's or financial institution's assets and liabilities
• Includes case studies of risk management failures

Part I

Introduction

 

Introduction

This book presents the economic foundations of risk management. It presents the theory, the practice, and applies this knowledge to provide a forensic analysis of some well-known risk management failures. By doing so, this book presents a unified framework for understanding how to manage the risk of an individual’s or corporation’s or financial institution’s assets and liabilities. Providing a framework for analysis, understanding the underlying economics, is essential in practical risk management.

An individual or firm, financial or non-financial, owns a portfolio of assets and liabilities. This portfolio can be represented by a balance sheet that changes across time. Each asset and liability has a present value. For an asset this represents the cash received today if the asset is sold. For a liability this represents the cash paid today to retire the liability. The sum of the assets’ less the liabilities’ present values represents the individual’s or firm’s equity value. This is their net worth.

Assets and liabilities generate future cash flows, both positive and negative. As the future is uncertain, these future cash flows are also uncertain. They are random variables. As time passes, information about these future cash flows changes. This changing information changes the assets’, liabilities’, and equity’s present values. We say that the prices of the assets, liabilities, and equity are a stochastic process. Alternatively stated, the prices of these quantities involve across time in a random fashion.

Since equity is the entity’s net worth, if the value of equity declines then this is a loss. If the value of the equity increases, then this is a gain. Such random changes in value and cash flows across time have a variance, therefore the portfolio’s changing equity value and cash flows entail “risk.”

Individuals and firms utilize the cash flows from the portfolio to consume or to manage the firm’s activities, respectively. They also buy/sell new assets and liabilities across time. The cash flows and changing balance sheet positions so obtained generate benefits or costs for these entities. The entities have preferences (likes/dislikes) over the different patterns of cash flows and balance sheet configurations obtained. It is natural, therefore, that rational entities will seek to maximize these preferences across time by managing the assets and liabilities in their portfolio - by managing the balance sheet. Managing this risk of an individual’s portfolio or a firm’s balance sheet is the topic of this book, called “risk management.”

As alluded to in this description, there are four topics that need to be mastered in risk management. The first is to understand the assets and liabilities that trade. The second is to understand how to model the risks from holding the assets and liabilities. The third is to characterize an individual or firm’s preferences. And, the fourth is to understand how to manage the risks of the traded assets and liabilities to maximize their preferences. These four topics compose the four parts of this book.

Part II

Traded Assets and Liabilities

Overview

To understand how to risk manage an entity’s portfolio or balance sheet, we first need to understand what assets and liabilities are available for trading, and what are the characteristics of the markets within which they trade. Since one person’s liability is another person’s (the counter party’s) asset, we really only need to understand the traded assets in an economy.

There are two basic types of assets: primary assets and derivatives. Derivatives are financial securities whose payoffs depend on the primary asset’s payoffs and/or values. We discuss each of these in turn. The subsequent discussion is conceptual focusing on the economic considerations in trading assets. Institutional details are presented, but only in an abstract form so that the relevant economics of the institutional structures are understood.

Chapter 1

Primary Assets

This chapter discusses the primary assets. To understand the traded primary assets, the markets in which they trade need to be understood first.

1.1Market Types

There are two types of markets in which assets trade: spot markets and forward markets.

By definition, a spot market is a market in which an asset is exchanged immediately for cash. An example of a spot market is a grocery store where one can buy oranges for cash.

By definition, a forward market is a market in which one agrees today, to buy an asset at a future (forward) date. Cash will be exchanged at the future date when the asset is delivered. An example of a forward market is an auto dealer who agrees to sell you a car which will be made in 2 months time at the auto factory. Delivery will take place immediately after production in 2 months. To trade in a forward market, a financial contract must be created and “signed” by both parties. This financial contract is an example of a derivative security. As such, we will discuss forward markets in the next Chapter. This chapter just concentrates on spot markets.

The structure of a spot market in which an asset trades can be different for different assets. From an economic point of view, the most important aspects of spot markets are the following three characteristics:

1.Competitive or not. Competitive means that the traders have no quantity impact from trading on the price of the asset purchased or sold. Hence, when trading they act as price takers. Any other market situation is defined to be non-competitive. An example of a non-competitive market is one where buyers bargain with sellers over the price, and different buyers get different prices.

2.Frictionless or not, and the type of frictions. A frictionless market is a market without transaction costs and trading constraints. Transaction costs are fees paid to trade. Trading constraints include indivisibilities in the quantity of an asset traded, short sale restrictions, collateral/margin requirements, borrowing constraints, and bounds on quantities transacted. A frictionless market is the proverbial “ideal” market.

3.Actively traded (large volume) or not. This characteristic of a market often corresponds to liquid or illiquid markets. A liquid market is defined to be a competitive market where there is no quantity impact from trading on the price.

1.2Asset Types

This section discusses the different types of assets that trade in spot markets. Notation for asset prices will be introduced. For the notation, we assume that the time horizon is given by t ∈ [0, T]. This is called a finite horizon model. Because the terminal date T can be quite large, say 10,000 years, finite horizon models are really without loss of generality. We impose the finite horizon assumption to simplify the mathematics.

There are two types of assets that trade in spot markets: physical commodities and financial securities.

1.2.1Physical Commodities

Physical commodities that trade include currencies (U.S. dollars, Euros, etc.), precious metals (gold, silver, etc.), agricultural commodities (corn, wheat, etc.), energy related commodities (oil, gas, etc.), and so forth. Physical commodities also include residential housing and commercial pro...

Table of contents

• Cover
• Halftitle
• Title
• Copyright
• Dedication
• Preface
• About the Author
• Contents
• Part I Introduction
• Part II Traded Assets and Liabilities
• Part III Modeling Risks
• Part IV Optimizing Risk
• Part V Managing Risks
• Part VI Case Studies
• Bibliography
• Index