Steve L. Allen 
Financial Risk Management 
A Practitioner’s Guide to Managing Market and Credit Risk

A top risk management practitioner addresses the essential
aspects of modern financial risk management

In the Second Edition of Financial Risk Management +
Website, market risk expert Steve Allen offers an insider’s
view of this discipline and covers the strategies, principles, and
measurement techniques necessary to manage and measure financial
risk. Fully revised to reflect today’s dynamic environment and the
lessons to be learned from the 2008 global financial crisis, this
reliable resource provides a comprehensive overview of the entire
field of risk management.

Allen explores real-world issues such as proper mark-to-market
valuation of trading positions and determination of needed reserves
against valuation uncertainty, the structuring of limits to control
risk taking, and a review of mathematical models and how they can
contribute to risk control. Along the way, he shares valuable
lessons that will help to develop an intuitive feel for market risk
measurement and reporting.

* Presents key insights on how risks can be isolated, quantified,
and managed from a top risk management practitioner

* Offers up-to-date examples of managing market and credit
risk

* Provides an overview and comparison of the various derivative
instruments and their use in risk hedging

* Companion Website contains supplementary materials that allow
you to continue to learn in a hands-on fashion long after closing
the book

Focusing on the management of those risks that can be
successfully quantified, the Second Edition of Financial
Risk Management + Websiteis the definitive source for managing
market and credit risk.

Table of Content

Foreword xvii

Preface xix

Acknowledgments xxiii

About the Author xxvii

CHAPTER 1 Introduction 1

1.1 Lessons from a Crisis 1

1.2 Financial Risk and Actuarial Risk 2

1.3 Simulation and Subjective Judgment 4

CHAPTER 2 Institutional Background 7

2.1 Moral Hazard–Insiders and Outsiders 7

2.2 Ponzi Schemes 17

2.3 Adverse Selection 19

2.4 The Winner’s Curse 21

2.5 Market Making versus Position Taking 24

CHAPTER 3 Operational Risk 29

3.1 Operations Risk 31

3.2 Legal Risk 37

3.3 Reputational Risk 41

3.4 Accounting Risk 42

3.5 Funding Liquidity Risk 42

3.6 Enterprise Risk 44

3.7 Identification of Risks 44

3.8 Operational Risk Capital 45

CHAPTER 4 Financial Disasters 49

4.1 Disasters Due to Misleading Reporting 49

4.2 Disasters Due to Large Market Moves 68

4.3 Disasters Due to the Conduct of Customer Business 77

CHAPTER 5 The Systemic Disaster of 2007-2008 83

5.1 Overview 83

5.2 The Crisis in CDOs of Subprime Mortgages 85

5.3 The Spread of the Crisis 108

5.4 Lessons from the Crisis for Risk Managers 111

5.5 Lessons from the Crisis for Regulators 115

5.6 Broader Lessons from the Crisis 132

CHAPTER 6 Managing Financial Risk 133

6.1 Risk Measurement 133

6.2 Risk Control 161

CHAPTER 7 Va R and Stress Testing 169

7.1 Va R Methodology 170

7.2 Stress Testing 192

7.3 Uses of Overall Measures of Firm Position Risk 201

CHAPTER 8 Model Risk 209

8.1 How Important Is Model Risk? 210

8.2 Model Risk Evaluation and Control 212

8.3 Liquid Instruments 237

8.4 Illiquid Instruments 241

8.5 Trading Models 250

CHAPTER 9 Managing Spot Risk 253

9.1 Overview 253

9.2 Foreign Exchange Spot Risk 257

9.3 Equity Spot Risk 258

9.4 Physical Commodities Spot Risk 259

CHAPTER 10 Managing Forward Risk 263

10.1 Instruments 270

10.2 Mathematical Models of Forward Risks 282

10.3 Factors Impacting Borrowing Costs 299

10.4 Risk Management Reporting and Limits for

Forward Risk 304

CHAPTER 11 Managing Vanilla Options Risk 311

11.1 Overview of Options Risk Management 313

11.2 The Path Dependence of Dynamic Hedging 318

11.3 A Simulation of Dynamic Hedging 321

11.4 Risk Reporting and Limits 329

11.5 Delta Hedging 344

11.6 Building a Volatility Surface 346

11.7 Summary 355

CHAPTER 12 Managing Exotic Options Risk 359

12.1 Single-Payout Options 364

12.2 Time-Dependent Options 378

12.3 Path-Dependent Options 381

12.4 Correlation-Dependent Options 404

12.5 Correlation-Dependent Interest Rate Options 425

CHAPTER 13 Credit Risk 445

13.1 Short-Term Exposure to Changes in Market Prices
446

13.2 Modeling Single-Name Credit Risk 457

13.3 Portfolio Credit Risk 479

13.4 Risk Management of Multiname Credit Derivatives 493

CHAPTER 14 Counterparty Credit Risk 505

14.1 Overview 505

14.2 Exchange-Traded Derivatives 506

14.3 Over-the-Counter Derivatives 512

References 533

About the Companion Website 547

Index 553

About the author

STEVEN ALLEN is a risk management consultant, specializing in risk measurement and valuation with a particular emphasis on illiquid and hard-to-value assets. Until his retirement in 2004, he was Managing Director in charge of risk methodology at JPMorgan Chase, where he was responsible for model validation, risk capital allocation, and the development of new measures of valuation, reserves, and risk for both market and credit risk. Previously, he was in charge of market risk for derivative products at Chase. He has been a key architect of Chase’s value-at-risk and stress testing systems. Prior to his work in risk management, Allen was the head of analysis and model building for all Chase trading activities for over ten years. Since 1998, Allen has been associated with the Mathematics in Finance Master’s Program at New York University’s Courant Institute of Mathematical Sciences. In this program, he has served as Clinical Associate Professor and Deputy Director and has created and taught courses in risk management, derivatives mathematics, and interest rate and credit models. He was a member of the board of directors of the International Association of Financial Engineers and continues to serve as co-chair of their Education Committee.