Risk Management and Financial Institutions, 3rd Edition

Instructor Notes

Chapter 1: Introduction
I generally spend about 1 to 1.5 hours on the material in this chapter. The purpose
of most of the chapter is to link concepts in the rest of the book to concepts learned in
courses on corporate finance and investments. If students have not previously been exposed
to these concepts rather more time is likely to be necessary to cover the material in the
chapter.
Sections 1.1 to 1.4 review results on risk-return trade-offs and the distinction between
systematic (nondiversifiable) and non-systematic (diversifiable) risks. In most instances
students will already have been exposed to this material in their first corporate finance
class and classroom time can be used to refresh their memories.
Section 1.5 considers why companies are concerned with more than just systematic
risk and why they hedge. The bankruptcy costs argument (which most students will have
already met in the context of capital structure decisions) is discussed. Business Snapshot
1.1 describes a typical sequence of events that leads to the value of a company being
reduced because it is forced to declare bankruptcy.
Section 1.6 introduces students to the way risks are managed by financial institutions,
distinguishing between “risk decomposition” where risks are managed one by one and risk
aggregation where risks are combined and risk diversification is taken into account.
A new feature of this chapter is the material on credit ratings in Section 1.7. Because
credit ratings are used extensively throughout the book, it makes sense to provide a brief
introduction to them in the first chapter.
The Further Questions can be used either for class discussion or as assignment ques-
tions. Problem 1.17 provides an introduction to capital adequacy concepts.

Chapter 2: Banks
This is the first of three chapters describing the activities of different types of financial
institutions. The chapters provide important background material for the discussion of risk
management and regulation later in the book.
Chapter 2 explains the activities of commercial and investment banks. As students
are likely to be aware, the year 2008 saw the disappearance of large institutions that
were exclusively focused on investment banking. Lehman Brothers went bankrupt; Bear
Stearns was taken over by J. P. Morgan; Merrill Lynch was taken over by Bank of America;
Goldman Sachs and Morgan Stanley became bank holding companies with both commercial
and investment banking interests.
The parts of the chapter that I choose to spend most time on in class are a) Section 2.2
(the capital requirements of a small commercial bank) and b) IPOs and the Dutch auction
approach (in Section 2.4) and c) conflicts of interest in banks (Section 2.6). Section 2.2 is
an introduction to capital adequacy material that comes later in the book. I find it useful
to get students to think about what the balance sheet and income statement for a simple
bank looks like. Students enjoy the discussion of the Dutch auction approach and Google’s

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IPO (see Business Snapshot 2.1). The conflicts of interest section gets students thinking
about important issues that they may not have addressed in other courses.
The Further Questions are straightforward and can be used in a number of differ-
ent ways. For example, Problem 2.15 can be discussed in conjunction with Section 2.2.
Problem 2.17 can be discussed when Dutch auctions are covered.

Chapter 3: Insurance Companies and Pension Funds

This chapter starts by discussing different types of life insurance contracts and annuity
contracts. It explains the investment component of life insurance contracts and the tax
deferral advantages of these contracts. Mortality tables enable students to calculate pre-
miums for simple life insurance contracts. (It can be pointed out that the calculations are
similar to those used to determine the spread for credit default swaps.) The chapter then
moves on to discuss property-casualty insurance, health insurance, moral hazard, adverse
selection, the balance sheets of insurance companies, and pension plans.
Students should understand the types of insurance contracts in the market and the
nature of the risks in life insurance, property-casualty insurance, and health insurance.
They should appreciate the nature of moral hazard and adverse selection. (It is interesting
that individuals who buy life insurance die earlier on average than individuals who buy
annuities.) They should understand why property-casualty companies need more capital.
I consider it important not to cover the pension fund material too quickly. Students
should understand the differences between the two types of pension plans and the risks they
pose for companies. Why are defined benefit pension plans 60% invested in equities when
their liabilities are “bond-like”? The answer appears to be that bonds do not provide a
high enough return for them to be able to meet their obligations. Another way of putting
this is that the only way pension plans can meet their obligations is if equity markets
perform well. To emphasize these points, I go through Problem 3.15 in class (because the
calculations are simple) and assign Problem 3.19.
Problems 3.16, 3.17, and 3.19 can be used for assignments. Problem 3.18 is appropriate
for class discussion.

Chapter 4: Mutual Funds and Hedge Funds

This chapter explains the differences between open-end mutual funds, closed-end mu-
tual funds, and ETFs. It reviews the evidence on the performance of mutual funds and
discusses the increasing popularity of index funds. It explains how hedge funds differ from
mutual funds. It considers the incentives of hedge fund managers, describes different hedge
fund strategies, and reviews their performance.
Some students are usually unwilling to accept that a) actively traded mutual funds
do not outperform stock indices and b) that the past performance of a mutual fund is
not a good guide to its future performance. I spend some time explaining Jensen’s classic
results and point out that many other studies conducted since Jensen have reached similar
conclusions. I discuss the growth of index funds. I also explain carefully how ETFs work
and why they have been voted the most innovative investment vehicle of the last two
decades. A discussion of late trading reinforces the fact that mutual funds trade only at
4pm each day. This distinguishes them from closed-end funds and ETFs.

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 Students usually enjoy learning about the strategies followed by hedge funds and the
fees earned by hedge fund managers. I explain that the hedge fund manager has a call
option on the assets being managed and therefore has an incentive to take high risks.
Amaranth is a classic example of a hedge fund where a trader took advantage of the
value of its call option. (In previous editions, there was some ambiguity about whether
incentive fees are calculated before or after management fees. This edition makes it clear
that incentive fees are usually on returns net of management fees.)
The Further Questions are all fairly short and can be assigned to illustrate points
made in class.

Chapter 5: Trading in Financial Markets

The amount of time spent in class on this chapter will depend on the background of
students. If they have taken an introductory course on investments or derivatives, they
should be familiar with most of the material in the chapter and a 30 minute review is likely
to be all that is necessary. In other situations instructors may wish to spend two or three
hours making sure that students understand what derivative products are and how they
are used.
After explaining the difference between exchange-traded and over-the-counter mar-
kets, the chapter describes how short positions are created and moves on to discuss plain
vanilla derivatives. It then explains how margin accounts are used in different situations.
(There is new material on clearing houses and central clearing in the third edition.) It
concludes by discussing nontraditional derivatives, exotic options and structured products.
It can be fun to discuss any or all of the five business snapshots in class.
Any of the problems can be used as hand-in assignment questions. I sometimes use
5.33, 5.35, and 5.36 for class discussion.

Chapter 6: The Credit Crisis of 2007

This material has been moved to a much earlier point in the book in the third edition.
I find that it is appropriate to have a discussion of the crisis relatively early in the course.
I have taught variations on the material in this chapter to many different groups of exec-
utives and students. It always goes down well. Participants always feel a great sense of
achievement when they understand the products that were created from mortgages. No
doubt many instructors will wish to change some of the slides to incorporate their own
views on the credit crisis.
The first part of the chapter explains the bubble in U.S. house prices. The chapter
then moves on explain the products that were created from mortgages in securitizations.
ABSs were formed at the first level of securitization. ABS CDOs were created at the second
level of securitization. Further securitizations sometimes produced a CDO of CDO. I spend
some time on Table 6.1 to make sure students understand the way the tranches work and
the risk.
The BBB tranche of the ABS in Figure 16.5 is much thinner than the tranches in the
earlier examples. But it is worth noting that in practice the BBB tranche in Figure 16.5
were often be split into three sub-tranches so that the tranches constituting the Mezz ABS
CDO were often only 1% wide. As the BBB tranches used to make ABS CDOs become

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thinner, the tranches of ABS CDOs begin to look more and more similar to each other.
(See the two Business Snapshots in this chapter.) I like to get students to work this out
for themselves by asking leading questions.
The corresponding chapter in the second edition included material on synthetic CDOs.
This material has been moved to Appendix L.
It is worth going through the material in Section 6.5 carefully. Many of the points
will be returned to later in the course.
Problem 6.15 can be set as a (fairly straightforward) assignment question. Problem
6.15 can be discussed in class to illustrate the thin tranches point mentioned above.

Chapter 7: How Traders Manage Their Risks

If students are required to take a course on derivatives prior to the course based on
this book relatively little time needs to be spent on this chapter. But in other situations
instructors may want to spend two to three hours of classroom on the chapter.
The focus in the chapter is on a trader working for a financial institution. The trader
might have a position such as that shown in Table 7.1 and is faced with the problem of
hedging his or her exposures to changes in the price of the underlying asset, changes in its
volatility, and changes in interest rates. The Greek letters are measures of these exposures.
The chapter distinguishes between linear and non-linear products as far as delta is
concerned. A “hedge-and-forget” strategy can be used for linear products. Non-linear
products require the hedge position to be continually rebalanced. The way the rebalancing
works is illustrated in Table 7.2 and 7.3.
When discussing gamma I spend some time on Figure 7.4 to show the problem created
by non-linearity. I emphasize that changing the gamma or vega of a position requires a
trade in an option or similar derivative. Trading the underlying asset has no effect on these
Greek letters.
When teaching students about Greek letters I find it useful to show students some
output from DerivaGem. The mechanics of the calculation of the Greek letters is discussed
in Appendices E and F at the end of the book.
Section 7.7 is an important way of thinking about the Greek letters. It has implications
for some of the material that comes later in the book on short cuts to measuring VaR
for a portfolio. It also explains the relationship between theta and gamma for a delta-
neutral portfolio (see equation 7.2). Section 7.9 deals with static options replication. An
understanding of this is not necessary for subsequent material. As a result the material in
this section can be covered or skipped depending on the tastes of the instructor.
Any of Problems 7.15 to 7.19 can be used as hand-in assignments. 7.15 also works
well for class discussion.

Chapter 8: Interest Rate Risk

The chapter starts with a discussion of the management of net interest income. It
then moves on the explain the importance of LIBOR rates, swap rates, and OIS rates. The
rest of the chapter is then spent on duration, convexity and related issues.
I like to spend some time on the risk-free rate issue. (See Section 7.2.) Traders have
traditionally used the LIBOR/swap zero curve as a proxy for the risk-free yield curve.

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Students should understand the difference between the five-year AA-borrowing rate and
the five-year swap rate. The former is the fixed rate at which a AA-rated company can
borrow for five years. The latter is the rate earned when a series of short-term loans are
made to AA-rated companies. Increasingly the OIS rate is being used as a proxy for the
risk-free rate and this is covered in this edition.
Duration and convexity provide simple ways of hedging exposures to interest rate
movements. By matching the duration of assets and liabilities a bank is hedged against
small parallel shifts in the yield curve. By matching both duration and convexity it is
hedged against small and relatively large parallel shifts in the yield curve. The duration
measure can be extended to consider non-parallel yield curve shifts. One approach is to
define the duration with respect to the ith point, yi , on the yield curve as
1 ∂P
−
P ∂yi
where P is the value of the portfolio. This is sometimes referred to as the partial duration
approach. (See Figure 8.4.) Another approach is to consider the effect on the portfolio
value of commonly occurring non-parallel shifts in the yield curve. (Figure 8.5 shows a
rotation.) The convexity measure can be extended similarly.
Section 8.7 discusses four ways interest rate deltas can be calculated. One of these is
the DV01 approach that assumes parallel shifts and fits in with the traditional definition
of duration. Another is the partial duration approach mentioned earlier. A third involves
bucketing the zero curve. This is illustrated in Figure 8.6 and is commonly used in asset-
liability management. The fourth involves calculating partial derivatives with respect to
the instruments that will be used for hedging (which tend to be the same as those used
for constructing the zero curve) and is commonly used by traders.
Section 8.8 covers principal components analysis and an be regarded as an extension of
the duration approach where commonly occurring non-parallel shifts are considered. The
principal components analysis example is for a new set of data on swap rates. Software
for carrying out a principal components analysis is now on the author’s web site.
Any of Problems 8.15 to 8.19 can be used as hand-in assignment questions. 8.16 and
8.17 can be used as part of the classroom discussion of duration and convexity. Problem
8.18 can be used to illustrate the partial duration approach in class.

Chapter 9: Value at Risk

This chapter requires 2 to 3 hours of classroom time. It starts by explaining value
at risk (VaR). It compares VaR to expected shortfall and shows that the latter has better
theoretical properties. (To use the technical term, it is more “coherent.”) It discusses
the choice of parameters for VaR, and the impact of autocorrelation on VaR estimates.
It covers the calculation of marginal VaR, incremental VaR, and component VaR. It also
deals with back-testing issues. The third edition covers the aggregation of VaR estimates
in this chapter as it is relevant to some of the material in later chapters.
One thing I found after I wrote the first edition of the book is that many students have
difficulty calculating VaR and expected shortfall when the probability distribution of losses
is discrete. Consequently, I included several extra examples illustrating the calculations.

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I find it useful to go through most of these examples in class. Examples 9.6 and 9.8
which deal with continuous distributions are more difficult than the others. (Some readers
found the set up for the examples ambiguous. Hopefully this has been clarified in the
third edition.) I point out that the “VaR vs expected shortfall” arguments are not just
pure academic arguments. Risk managers are sometimes surprised to find that, when they
combine VaR for two portfolios, the VaR for the total portfolio is greater than the sum of
the VaRs for two component portfolios. Many financial institutions like the properties of
expected shortfall and use it internally as one of their risk measures.
However, VaR seems to be here to stay! Regulators seem to prefer to base capital
requirements on VaR rather than expected shortfall, perhaps because it can be calculated
more accurately and is easier to backtest. The calculation of VaR is therefore an impor-
tant activity for banks and other financial institutions. Also, increasingly non-financial
corporations are using VaR as a risk measure and setting risk limits based on VaR.
Section 9.7 to 9.9 explain marginal VaR, incremental VaR, and component VaR. They
explain the role of Euler’s theorem in the allocation of VaR and give a way of aggregating
VaRs. The material on back-testing in Section 9.10 gives some standard tests of statistical
significance and includes a relatively powerful two-tailed test proposed by Kupiec.
Any of Further Questions can be used as hand-in assignments. I usually use 9.12.

Chapter 10: Volatility

This chapter requires two to three hours of classroom time. It provides a formal
definition of volatility and then moves on to discuss how the volatility of a variable can
be monitored by risk managers. One issue is whether volatility should be considered to be
a trading-day or calendar-day phenomenon. This is discussed in Business Snapshot 10.1.
Whatever the reason, volatility is much greater when markets are open than when they
are closed. It therefore makes sense to measure volatility using trading days rather than
calendar days. This is what traders and risk managers do.
Implied volatilities are explained in Section 10.2. Section 10.3 explores whether returns
are approximately normally distributed for exchange rates. It finds that they are not. This
leads on to a discussion of the power law that has been found to hold for a wide range
of financial variables. (The purpose of the material in this chapter is to introduce the
power law; extreme value theory and the theoretical underpinnings of the power law are in
Chapter 14.) A “quick and dirty” analysis shows that the α = 5.5 fits the exchange rate
data in Table 9.2 quite well.
The rest of the chapter covers exponentially weighted moving average (EWMA) and
GARCH (1,1) procedures for estimating the current level of a volatility. It explains max-
imum likelihood methods. Material is included on the implications of GARCH (1,1) for
forecasting option volatility and calculating vega. (See Section 10.10.) At the outset, it is
important to make sure students understand the notation. The variable σn is the volatility
estimated for day n at the end of day n − 1; un is the realized return during day n. The
EWMA approach, although not as sophisticated as GARCH(1,1), is widely used and is a
useful lead-in to GARCH(1,1).
Although it is not difficult to find “black box” software for implementing GARCH
(1,1) I like students to develop their own Excel applications. By doing this they develop

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a much better understanding of how maximum likelihood methods work. As indicated on
page 224, the Solver routine in Excel works reasonably well if used in such a way that all
the parameters being searched for are the same order of magnitude.
Any of Problems 10.18 to 10.23 can be used as hand-in assignment questions. Problems
10.20 and 10.22 are more challenging than the others.

Chapter 11: Correlations and Copulas

This chapter requires about two hours of classroom time. It starts by defining cor-
relation and explaining the difference between correlation and dependence. It explains
that correlation is designed to measure one particular type of dependence, namely linear
dependence. The chapter explains that correlation can be monitored in the same way as
volatility. Either the exponentially weighted moving average or GARCH (1,1) procedure
can be used. It also explains the positive-semidefinite condition for a consistent variance-
covariance matrix.
Copulas are explained in this chapter because the Gaussian copula model of defaults is
necessary for an understanding of Basel II in Chapter 12. As preparation for the material
on copulas, the chapter discusses the properties of multivariate normal distributions and
explains factor models. The latter provide a convenient way of defining the correlation
matrix for a large number of variables. The capital asset pricing model which is likely to
be somewhat familiar to a lot of students provides an example of a one-factor model.
The notation used by mathematicians for copulas is too abstract for many students
of risk management. As will be evident from Chapter 11 and the slides that go with it, I
prefer to use a minimal amount of algebra. I go through the copula material fairly slowly.
(I find the copula material, once understood, is considered to be so straightforward that
students cannot understand why they had any difficulty with it in the first place!)
I start by asking students to suppose they know the marginal (unconditional) probabil-
ity distributions of two variables and want to define a correlation structure. If the variables
are normally distributed it is natural to assume that they are bivariate normal (although
this is by no means the only possibility). In other cases we can map the distributions
on a “quantile-to-quantile” basis to standard normal distributions and assume that these
are bivariate normal. Thus the correlation structure between the original distributions is
defined indirectly using other easier-to-deal-with distributions.
This procedure is illustrated in the text for two variables that have triangular dis-
tributions. (I choose triangular distributions because it is easy to calculate cumulative
probabilities for them.) The marginal distributions of the variables are shown in Figure
11.2. The transformation of the first variable to a standard normal distribution is shown in
Table 11.1 and that for the second variable is shown in Table 11.2. The joint distribution
of the variables when the correlation between the normal distributions is 0.5 is shown in
Table 11.3. The overall methodology is shown diagrammatically in Figure 11.3.
Figures 11.2 and 11.3 together with Tables 11.1, 11.2, and 11.3 provide an example of
the Gaussian copula model. Other copula models can be understood similarly. For example
we can transform two variables to Student t-distributions on a quantile-to-quantile basis
and assume the transformed variables have a bivariate Student t-distribution. As shown
in Figures 11.4 and 11.5 the Student t-copula has more tail dependence than the Gaussian

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copula.
When many variables are involved and the Gaussian copula model is used, each vari-
able can be transformed into a normal distribution on a quantile-to-quantile basis. A factor
model can then be used to define the correlations between the normal distributions.
Section 11.5 has been extended in the third edition. It now covers Gordy’s result for
a large non-homogeneous portfolio, the estimation of PD and ρ using maximum likelihood
methods, and some alternatives to the Gaussian copula model. I do not usually go through
the math in Section 11.5 in class. Instead, I summarize the results and encourage students
to work through the math for themselves. The slides indicate the approach I use.
Problems 11.15 to 11.18 all make good hand-in assignment questions.

Chapter 12: Basel I, Basel II, and Solvency II

In order to understand the way in which banks are currently regulated it is essential to
have an understanding of the history of regulation since 1988. For example, the concepts
underlying many of the current regulations (eg, risk weighted assets) have their origins in
Basel I. This chapter explains how banks were regulated prior to the crisis. It also covers
the Solvency I and Solvency II regulations for insurance companies in Europe.
I usually start by asking students why banks are regulated and other companies en-
gaged in manufacturing and retailing are not. The answer is that banks are allowed to
take deposits from consumers and a stable banking system is an essential part of a healthy
economy. Many governments have deposit insurance systems and to avoid large payouts
they need to ensure that a bank’s capital is sufficient for the risks it is taking.
Before getting into the details of bank regulations, I like to explain the “big picture”
model used by bank regulators. This is shown in Figure 12.1. Capital is required to
cover the difference between the expected loss and a “worst case” loss over sometime time
horizon. For example, the time horizon could be one year and the worst case loss could be
the loss that has only a 0.1% chance of being exceeded.
The key developments in bank regulation that need to be explained are a) the 1988
Basel Accord (Basel I); b) the modification to reflect netting in 1995; c) the 1996 amend-
ment that charged capital for market risk, and d) Basel II. In the material presented in the
book, I have tried to give enough details to give students a good feel for the regulations
without giving so many details that the chapter becomes unreadable. There are a number
of numerical examples to illustrate the workings of Basel I and Basel II. I find it useful to
go through these in class. The material in the second edition on ”Revisions to Basel II”
has been eliminated as that material is now in Chapter 13 under Basel 2.5.
The presentation of Basel II focuses on the underlying credit risk model, which is the
factor-based Gaussian copula model covered in Chapter 11. A Harvard Business School
case study that can be used in connection with Basel II is “Basel II: Assessing the Default
and Loss Characteristics of Project Finance Loans (A)” (9-203-035).
Problem 12.19 can be used for class discussion. Problems 12.20 to 12.22 can be used
as hand-in assignments.

Chapter 13: Basel 2.5, Basel III, and Dodd–Frank

This chapter is new to the third edition and summarizes some of the important de-
velopments in regulation of banks since the 2007 crisis.

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 Basel 2.5 consists of three changes to the rules for calculating market risk capital. The
rules are a) banks are required to calculate a stressed VaR and use it in the determination
of market risk capital b) banks are subject to an incremental risk charge to ensure that
capital requirements are not reduced when exposures are switched from the banking book
to the trading book, and c) banks are required to use a new method for calculating capital
for exposures that depend on credit correlation.
Basel III consists of new rules for calculating capital for credit risk and two liquidity
ratios that must be adhered to. (The rule concerning CVA can be mentioned for complete-
ness but is probably best handled when Chapter 17 is covered.)
The chapter covers contingent convertible bonds. These work quite differently from
regular convertible bonds. Regular convertible bonds are exercised when the stock price of
the company issuing the bonds is doing well and the bondholders decide that they would
rather hold equity than debt. Contingent convertible bonds are exercised automatically
when a bank’s equity capital is reaches a low trigger relative to regulatory requirements.
Dodd-Frank is a complicated piece of legislation. The material in the book attempts
to summarize the main provisions. The main objective of the legislation is to prevent
future bailouts of financial institutions and protect the consumer. No doubt there will be
crises in the financial sector in the future. They will probably not be similar to the crisis
that started in 2007. Whether Dodd-Frank and the Basel regulations will be successful
in reducing their severity and preventing future bailouts remains to be seen. Students
typically have mixed views on this.
Equation 13.14 can be used as an assignment question on liquidity ratios.

Chapter 14: Market Risk VaR: The Historical Simulation Approach

This chapter requires about 1.5 hours of classroom time. The advantage of the histor-
ical simulation approach is that it requires no assumptions about probability distributions
and correlations. It assumes that percentage changes in all market variables over the next
day are a random sample from the last N days. In the third edition, the four-index exam-
ple has been changed so that the data is adjusted for exchange rates. Also, material has
been added on the use of delta/gamma approximations.
Section 14.1 explains the basic historical simulation approach while Section 14.2 ex-
plains how to calculate a standard error for VaR. (The standard error is quite large and
would be even larger if the assumption that the joint distribution of daily changes in market
variables is stationary through time could be relaxed.) Section 14.3 describes some exten-
sions of the historical simulation approach. These involve alternative weighting schemes,
procedures involving the volatility updating procedures of Chapter 10, and the use of
the bootstrap method to determine a confidence interval for VaR. Section 14.4 covers the
delta/gamma approximation. Section 14.5 and 14.6 present material on extreme value
theory which extends the material on the power law in Chapter 10. It provides a scientific
way of “smoothing the tails” of an empirically observed distribution.
Excel worksheets that go with the four-index example that is covered in the chapter
can be downloaded from my web site.
Problem 14.13 works well as an assignment question. Problem 14.12 can also be used
as a short assignment question. Problems 14.17 is similar to Problem 14.13, but a little

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more difficult as it is not quite so easy for students to use the worksheets that have been
created for students. If the worksheets for the four-index example are displayed in class,
Problems 14.14, 14.15, and 14.16 can be used to illustrate how they are manipulated.

Chapter 15: Market Risk VaR: The Model-Building Approach

This chapter covers the model-building approach for calculating market-risk VaR,
which is the main alternative to historical simulation. It explains the relationship of VaR
to the Markowitz results and also shows how covariance matrices can be used. The chapter
uses the same four-index example as Chapter 14 (now adjusted for exchange rates) and
worksheets for the use of the model building approach for the example are on the author’s
website. The example shows that volatilities and correlations increased during the stressed
market conditions of September 2008.
The chapter first explains how the model building approach can be used for the situ-
ation where the value of the portfolio is linearly dependent on the values of the underlying
market variables. (This includes a discussion of how interest rates can be handled with
cash flow mapping.) After that it moves on to consider what can be done in the situation
where the portfolio is not linearly dependent on the underlying variables. The alternatives
here are a) use a linear approximation (delta), b) use a quadratic approximation (delta +
gamma), and c) use Monte Carlo simulation.
This chapter requires a good understanding of the Greek letters and Taylor Series
expansions (covered in Chapter 7 and Appendix G). I generally spend about two hours
on the material. It should be noted that most banks now use the historical simulation
approach because of the problems mentioned in the text at the end of Section 15.10.
Any of Problems 15.16 to 15.23 can be used as assignment questions. 15.21 is a more
challenging than the others. 15.23 is based on the Excel spreadsheets for the four-index
example that is in the chapter and can be covered in class if the spreadsheets for the
example are displayed in class.

Chapter 16: Credit Risk: Estimating Default Probabilities

I find that at least three hours of classroom time is necessary for the material. A
number of approaches for estimating default probabilities are considered: a) using historical
data b) using accounting data (Altman’s Z-score), b) using credit default swaps, c) using
bond prices (or asset swap spreads), and e) using equity prices (Merton’s model).
One of the most important messages to get across when this chapter is covered is the
difference between real world (physical) and risk-neutral (implied) default probabilities.
Real world default probabilities are generally less than risk neutral default probabilities—
but the difference between the two varies through time. I spend quite a bit of classroom
time going through Tables 16.4 and 16.5 and the arguments on page 364 to 367. I also
use Business Snapshot 16.3 to explain to (or remind) students about how risk-neutral
valuation is used in the valuation of derivatives. The risk-neutral default rate for 1996 to
2007 is compared with the real-world default rate for 1970 to 2010. This time periods do
not match because a) the Merrill Lynch data does not start until 1996 and b) I wanted to
relate the real world default rates to Table 16.1. If the crisis period had been included for

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the risk-neutral default rate estimates the difference between real world and risk-neutral
default probabilities would have been much greater.
This chapter incorporates material on credit default swaps. It also explains asset
swap spreads which are used by the market to calculate credit spreads relative to the
LIBOR/swap curve. The typical asset swap is a deal where the coupon on a bond is
exchanged for LIBOR plus a spread and the coupon is paid regardless of whether the bond
defaults. The present value of the asset swap spread provides a convenient quick estimate
of the present value of losses on the underlying bond. (See Problem 16.16 for a proof of
this.) Equation (16.3) is a widely used way of converting a credit spread to an average
hazard rate. Some instructors will also wish to go through the more exact calculation on
pages 361 to 362.
Any of the Problems 16.22, 16.23 and 16.24 can be used as assignment questions.

Chapter 17: Counterparty Credit Risk in Derivatives

This chapter is new to the third edition (although part of the material was covered
in a different way in Chapter 15 of the second edition). The chapter covers the difference
between central clearing and bilateral clearing, but the main focus of the chapter is on how
credit value adjustment (CVA) should be calculated when there is bilateral clearing.
The chapter first explains how the exposure on a derivatives portfolio with a particular
counterparty is calculated. If V is the value of the portfolio with the counterparty and
no collateral is posted the exposure at any given time (i.e., the maximum amount that
can be lost is max(V, 0). When collateral is posted, the calculation of the exposure at a
time is more complicated because it depends on the collateral available at the time. The
calculations must take account of the fact that the counterparty is likely to have stopped
posting collateral a number of days before defaulting.
Calculating CVA involves a) dividing the life of the derivatives portfolio into a number
of time steps b) carrying out a Monte Carlo simulation to calculate the expected exposure
at the mid point of each time step and c) using credit spreads to calculate the probability
of default during each time step. The CVA is
X
(1 − R)qi vi
i

where R is the recovery rate, qi is the probability of default during the ith time and vi is
the present value of the expected exposure at the mid point of the ith time step.
The chapter concludes with some simple examples where it is not necessary to use
Monte Carlo simulation to get results.
Problems 17.21 and 17.22 are fairly short easy assignment questions. Problem 17.19
is more difficult and Problem 17.20 is more difficult again.

Chapter 18: Credit Value at Risk

This chapter is new to the third edition (although part of the material was covered
in Chapter 15 of the second edition). The chapter starts by explaining what rating tran-
sitions matrices are and how they can be manipulated. (Software for manipulating credit

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transition is provided with the third edition.) It then discusses three different approaches
for calculating VaR for the banking book. Vasicek’s model is the one used by regula-
tors. Credit Risk Plus corresponds to a approach widely used by the insurance industry.
Creditmetrics is most commonly used by banks when they calculate economic capital.
The chapter then moves on to calculate credit VaR for items in the trading book. In
particular it discusses how the specific risk charge and the incremental risk charge can be
computed.
Any of the three further questions can be used as assignments.

Chapter 19: Scenario Analysis and Stress Testing

Stress testing has clearly become a more important topic as a result of the credit
crisis. The chapter discusses a) how the scenarios are generated, b) how the scenarios are
evaluated, and c) how the results should be used. It emphasizes the importance of senior
management involvement in the generation of the scenarios. It also makes the point that
the evaluation of the scenarios is not a mechanistic exercise because the market’s reaction
to the scenario and the consequences of that reaction need to be considered. The technique
of reverse stress testing is explained and Berkowitz’s procedure for integrating VaR with
stress testing is outlined.
Problems 19.10 and 19.11 can be used as assignment questions. 19.10 requires an
understanding of the DerivaGem Applications Builder.

Chapter 20: Operational Risk

With the advent of Basel II, there has been a big increase in the resources devoted
to measuring operational risk at banks and other financial institutions. The estimation
of operational risk is less quantitative than the estimation of other risks. The different
approaches are outlined in the chapter. I generally spend about 1.5 hours on the chapter.
By the end of a class based on the chapter students should understand a) the distinc-
tion between loss frequency and loss severity and how they are combined to calculate a
loss distribution, b) the ways in which internal and external data are used, c) the role of
scenario analysis, d) self assessment and d) the moral hazard/adverse selection issues in
insurance.
Problem 20.13 can be used for class discussion. Problems 20.12 and 20.14 are appro-
priate for hand-in assignments.

Chapter 21: Liquidity Risk

Liquidity risk has become increasingly important since the crisis. The chapter con-
siders liquidity trading risk and liquidity funding risk. The liquidity trading risk material
includes a discussion of proportional bid-offer spreads, the costs of liquidation, liquidity-
adjusted VaR, and a procedure for optimally unwinding a portfolio that was suggested
by Almgren and Chriss. The liquidity funding risk material discusses different sources of
liquidity and emphasizes the importance of liquidity planning. The chapter discusses the
phenomenon of liquidity black holes and some of the reasons why they occur.
The Basel III liquidity ratios can be discussed here or at the time Chapter 13 is
covered.

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 Problem 21.13 can be used for class discussion. Problems 21.14 and 21.15 can be used
as assignment questions.

Chapter 22: Model Risk

After an initial coverage of marking to market and accounting, the discussion of model
risk is divided into three parts. The first part is concerned with models for linear prod-
ucts. There is generally very little uncertainty about the correct model to use for linear
products—but the examples given in the text (Business Snapshots 22.1 and 22.2) show
that it is still necessary to be vigilant. The second part is concerned with models for
actively traded (nonlinear) products. Here there is a discussion of volatility smiles/skews
and an explanation that the model is used as an interpolation tool for pricing (but has a
more important role to play in hedging). The third part discusses the role of models in
the pricing and hedging of nonstandard products.
Problem 22.13 and 22.15 can be used for classroom discussion. Problems 22.14 and
22.16 can be used as assignments

Chapter 23: Economic Capital and RAROC

This chapter explains how banks estimate economic capital. This is the capital that
they themselves think they need for the business they transact. I spend about two hours
on the chapter. Many of the methods used to assess economic capital are similar to those
used for regulatory capital. The basic model is the same (see Figure 23.1.) A common
time horizon and a common confidence level should be used for all the risks considered.
Often a AA-rated bank will choose a time horizon of one year and a high confidence level
such as 99.95%. (This is because the statistics produced by rating agencies indicate that
an AA-rated company should have a probability of about 0.05% of defaulting in one year.)
In the case of credit risk, banks often choose a correlation model that is different from that
used in Basel II. Creditmetrics is a popular choice.
Typical loss distributions for market risk, credit risk, and operational risk are shown in
Figures 23.3, 23.4, and 23.5. Banks typically calculate economic capital for different types
of risk and different business units. They are then faced with an aggregation problem. A
popular and robust approach, introduced in Chapter 9, is known as the hybrid approach
(see equation 23.3.) This is based on research by Rosenberg and Schuermann that is
referenced in the text.
The total economic capital for the whole bank is less than the sum of the individual
economic capital amounts. Section 23.6 discusses how the total economic capital for the
bank should be allocated to business units. The problem here is analogous to the problem of
allocating VaR that is considered in Chapter 9. Arguably the theoretically best allocation
scheme is to allocate an amount
∂E
xi
∂xi
to business unit i where xi is a measure of the size of business unit i and E is the total
economic capital. Euler’s theorem shows that the sums of the allocated economic capital
amounts equals the total economic capital, E. Example 23.4 illustrates this.

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 The final section of the chapter is on RAROC, risk-adjusted return on capital. Once
economic capital has been allocated to business units RAROC can be calculated. It is
important to distinguish between the use of RAROC to measure past performance and
the use of RAROC to decide whether particular business units should be expanded or
contracted.
Any of Problems 23.10, 23.11, and 23.12 can be used as assignment questions.

Chapter 24: Risk Management Mistakes to Avoid

This chapter describes some well-publicized losses of the last 20 years and discusses
the lessons that can be learned from them.
Chapter 24 is a great chapter for the final class of a course. Students love talking
about disasters such as SocGen and LTCM. I use the chapter to review key points covered
during the course.

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