Financial Risk Review Test Financial Risk Manager …€¦ · ways to prepare for the Financial Risk Manager (FRM) ... The official reference book for GARP’s FRM ... Quantitative

PHILIPPE JORION

R I S K M A N A G E M E N T L I B R A R Y

FIFTH EDITION

Sample FRM® Review Test CD Included

Financial Riskwileyfinance.com

JORION

$175.00 USA/$210.00 CAN Includes CD-ROM

Includes CD-ROM

Manager HandbookFIFTH EDITION

Finance

The essential reference for fi nancial risk managementRisk professionals looking to earn the Financial Risk Manager (FRM®) certifi cation, as well as corporate training programs,

professors, and graduate students all rely on the Financial Risk Manager Handbook for the most comprehensive and up-to-date

information on fi nancial risk management.

Filled with in-depth insight and practical advice, the Financial Risk Manager Handbook is the core text for risk management

training programs worldwide. Presented in a clear and consistent fashion, this completely updated Fifth Edition—which comes

with an interactive CD-ROM containing hundreds of multiple-choice questions from previous FRM exams—is one of the best

ways to prepare for the Financial Risk Manager (FRM) exam.

Financial Risk Manager Handbook, Fifth Edition supports candidates studying for the Global Association of Risk Professional’s

(GARP) FRM exam, the global benchmark examination for fi nancial risk management professionals, and prepares you to assess

and control risk in today’s rapidly changing fi nancial world. Authored by renowned risk management expert Philippe Jorion—

with the full support of GARP—this defi nitive guide summarizes the core body of knowledge for fi nancial risk managers,

covering such topics as:

• Market, credit, operational, liquidity, and integrated risk management

• Quantitative methods

• Capital markets

• Investment management and hedge fund risk

• Relevant regulatory and legal issues essential to risk professionals

The FRM is recognized as the world’s most prestigious global certifi cation program—created to measure a fi nancial risk

manager’s capabilities. Since the FRM exam is an essential requirement for risk managers around the world, the Financial Risk

Manager Handbook, Fifth Edition focuses on practical fi nancial risk management techniques and solutions that are emphasized

on the test—and are also essential in the real world. Questions from previous exams are explained through tutorials so that

you may prepare yourself or your employees for this comprehensive exam and for the risk management challenges you will

undoubtedly face at some point in your career.

PHILIPPE JORION is Professor of Finance at the Paul Merage School of Business at the University of California at Irvine. He

has also taught at Columbia, Northwestern, the University of Chicago, and the University of British Columbia. He holds an

MBA and a PhD from the University of Chicago and a degree in engineering from the University of Brussels. Dr. Jorion has

authored more than ninety publications—directed towards academics and practitioners—on the topic of risk management and

international fi nance. He is on the editorial board of a number of fi nancial journals and was editor of the Journal of Risk. His

work has received several prizes for research. Dr. Jorion has written the fi rst four editions of Financial Risk Manager Handbook

(Wiley), as well as Financial Risk Management: Domestic and International Dimensions; Big Bets Gone Bad: Derivatives and Bank-

ruptcy in Orange County; and Value at Risk: The New Benchmark for Managing Financial Risk. He is also a managing director at

Pacifi c Alternative Asset Management Company (PAAMCO), a global fund of hedge funds.

HandbookHandbookFinancial Risk Manager

Learn the essentials of managing market, credit, operational, and liquidity risk

Learn the essentials of investment management and hedge fund risk

Learn about structured products, futures, options, and other derivative instruments

Identify regulatory and legal issues

Ideal for self-instruction and in-house training in financial risk management

The official reference book for GARP’s FRM® certification program

www.GARP.org

P1: ABC/ABC P2: c/d QC: e/f T1: g

FM JWBT102-Jorian April 1, 2009 10:21 Printer Name: Courier Westford

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FinancialRisk Manager

HandbookFifth Edition

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Founded in 1807, John Wiley & Sons is the oldest independent publishing com-pany in the United States. With offices in North America, Europe, Australia, andAsia, Wiley is globally committed to developing and marketing print and electronicproducts and services for our customers’ professional and personal knowledge andunderstanding.

The Wiley Finance series contains books written specifically for finance andinvestment professionals as well as sophisticated individual investors and theirfinancial advisors. Book topics range from portfolio management to e-commerce,risk management, financial engineering, valuation, and financial instrument anal-ysis, as well as much more.

For a list of available titles, visit our Web site at www.WileyFinance.com.

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FinancialRisk Manager

HandbookFifth Edition

PHILIPPE JORIONGARP

John Wiley & Sons, Inc.

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Copyright c© 2009 by Philippe Jorion, except for FRM sample questions, which are copyright 1997–2009 byGARP. The FRM designation is a GARP trademark. All rights reserved.Published by John Wiley & Sons, Inc., Hoboken, New Jersey.Published simultaneously in Canada.

Designations used by companies to distinguish their products are often claimed as trademarks. In all instanceswhere John Wiley & Sons, Inc. is aware of a claim, the product names appear in initial capital or all capitalletters. Readers, however, should contact the appropriate companies for more complete information regardingtrademarks and registration.

No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or byany means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as permitted underSection 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of thePublisher, or authorization through payment of the appropriate per-copy fee to the Copyright ClearanceCenter, Inc., 222 Rosewood Drive, Danvers, MA 01923, (978) 750-8400, fax (978) 646-8600, or on the webat www.copyright.com. Requests to the Publisher for permission should be addressed to the PermissionsDepartment, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030, (201) 748-6011, fax (201)748-6008, or online at http://www.wiley.com/go/permissions.

Limit of Liability/Disclaimer of Warranty: While the publisher and author have used their best efforts inpreparing this book, they make no representations or warranties with respect to the accuracy or completenessof the contents of this book and specifically disclaim any implied warranties of merchantability or fitness for aparticular purpose. No warranty may be created or extended by sales representatives or written sales materials.The advice and strategies contained herein may not be suitable for your situation. You should consult with aprofessional where appropriate. Neither the publisher nor author shall be liable for any loss of profit or anyother commercial damages, including but not limited to special, incidental, consequential, or other damages.

For general information on our other products and services or for technical support, please contact ourCustomer Care Department within the United States at (800) 762-2974, outside the United States at (317)572-3993 or fax (317) 572-4002.

Wiley also publishes its books in a variety of electronic formats. Some content that appears in print may not beavailable in electronic books. For more information about Wiley products, visit our web site at www.wiley.com.

Library of Congress Cataloging-in-Publication Data:

Jorion, Philippe, 1955–Financial risk manager handbook / Philippe Jorion – 5th ed.

p. cm. – (Wiley finance series)Includes index.ISBN 978-0-470-47961-2 (paper/CD-ROM)

1. Financial risk management. 2. Risk management. 3. Corporate–Finance. I. Title.HD61.J67 2009332.64’5–dc22

2009008330

Printed in the United States of America

10 9 8 7 6 5 4 3 2 1

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Contents

Preface ix

About the Author xi

About GARP xiii

Introduction xv

PART ONEQuantitative Analysis

CHAPTER 1Bond Fundamentals 3

CHAPTER 2Fundamentals of Probability 31

CHAPTER 3Fundamentals of Statistics 67

CHAPTER 4Monte Carlo Methods 89

PART TWOCapital Markets

CHAPTER 5Introduction to Derivatives 111

CHAPTER 6Options 127

CHAPTER 7Fixed-Income Securities 161

CHAPTER 8Fixed-Income Derivatives 195

CHAPTER 9Equity, Currency, and Commodity Markets 217

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vi CONTENTS

PART THREEMarket Risk Management

CHAPTER 10Introduction to Market Risk 247

CHAPTER 11Sources of Market Risk 273

CHAPTER 12Hedging Linear Risk 297

CHAPTER 13Nonlinear Risk: Options 315

CHAPTER 14Modeling Risk Factors 341

CHAPTER 15VAR Methods 359

PART FOURInvestment Risk Management

CHAPTER 16Portfolio Management 383

CHAPTER 17Hedge Fund Risk Management 401

PART FIVECredit Risk Management

CHAPTER 18Introduction to Credit Risk 431

CHAPTER 19Measuring Actuarial Default Risk 451

CHAPTER 20Measuring Default Risk from Market Prices 479

CHAPTER 21Credit Exposure 499

CHAPTER 22Credit Derivatives and Structured Products 531

CHAPTER 23Managing Credit Risk 561



Contents vii

PART SIXLegal, Operational, and Integrated Risk Management

CHAPTER 24Operational Risk 587

CHAPTER 25Liquidity Risk 607

CHAPTER 26Firm-Wide Risk Management 623

CHAPTER 27Legal Issues 643

PART SEVENRegulation and Compliance

CHAPTER 28Regulation of Financial Institutions 657

CHAPTER 29The Basel Accord 667

CHAPTER 30The Basel Market Risk Charge 699

About the CD-ROM 715

Index 717



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Preface

The Financial Risk Manager Handbook provides the core body of knowledgefor financial risk managers. Risk management has evolved rapidly over the past

decade and has become an indispensable function in many institutions.This Handbook was originally written to provide support for candidates tak-

ing the FRM examination administered by GARP. As such, it reviews a widevariety of practical topics in a consistent and systematic fashion. It covers quan-titative methods and capital markets, as well as market, credit, operational, andintegrated risk management. It also discusses regulatory and legal issues essentialto risk professionals.

This edition has been thoroughly updated to reflect recent developments infinancial markets. The unprecedented losses incurred by many institutions haveraised questions about risk management practices. These issues are now addressedin various parts of the book, which also include lessons from recent regulatoryreports. The securitization process and structured credit products are criticallyexamined. A new chapter on liquidity risk has been added, given the importanceof this risk during the recent crisis. Finally, this Handbook incorporates the latestquestions from the FRM examinations.

Modern risk management systems cut across the entire organization. Thisbreadth is reflected in the subjects covered in this Handbook. The book was de-signed to be self-contained, but only for readers who already have some exposureto financial markets. To reap maximum benefit from this book, readers shouldhave taken the equivalent of an MBA-level class on investments.

Finally, I want to acknowledge the help received in writing this Handbook.In particular, I thank the numerous readers who shared comments on previouseditions. Any comment or suggestion for improvement will be welcome. Thisfeedback will help us to maintain the high quality of the FRM designation.

Philippe JorionFebruary 2009

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About the Author

Philippe Jorion is a Professor of Finance at the Paul Merage School of Business atthe University of California at Irvine. He has also taught at Columbia University,Northwestern University, the University of Chicago, and the University of BritishColumbia. He holds an M.B.A. and a Ph.D. from the University of Chicago anda degree in engineering from the University of Brussels. He is also a managingdirector at Pacific Alternative Asset Management Company (PAAMCO), a globalfund of hedge funds.

Dr. Jorion is the author of more than 90 publications directed to academicsand practitioners on the topics of risk management and international finance. Hehas also written a number of books, including Big Bets Gone Bad: Derivatives andBankruptcy in Orange County, the first account of the largest municipal failurein U.S. history, and Value at Risk: The New Benchmark for Managing FinancialRisk, which is aimed at finance practitioners and has become an industry standard.

Philippe Jorion is a frequent speaker at academic and professional conferences.He is on the editorial board of a number of finance journals and was editor inchief of the Journal of Risk.

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About GARP

Founded in 1996, the Global Association of Risk Professionals (GARP) is theleading not-for-profit association for world-class financial risk certification,

education, and training with close to 100,000 members representing 167 countries.With deep expertise and a strong reputation, GARP sets global standards andcreates risk management programs valued worldwide. All GARP programs aredeveloped with input from experts around the world to ensure that concepts andcontent reflect globally accepted practices.

GARP is dedicated to advancing the risk profession. For more informationabout GARP, please visit www.garp.com.

FINANCIAL RISK MANAGER (FRM R©) CERTIFICATION

The benchmark FRM designation is the globally accepted risk management certifi-cation for financial risk professionals. The FRM objectively measures competencyin the risk management profession based on globally accepted standards. With acompound annual growth rate of 25 percent over the past seven years, the FRMprogram has experienced significant growth in every financial center around theworld. Now 16,000+ individuals hold the FRM designation in over 90 coun-tries. In addition, organizations with five or more FRM registrants grew from105 in 2003 to 424 in 2008, further demonstrating the FRM program’s globalacceptance.

The FRM Continuing Professional Education (CPE) program, to be offeredstarting in 2009 exclusively for certified FRM holders, provides the perspectiveand framework needed to further develop competencies in the ever-evolving fieldof risk management.

For more information about the FRM program, please visit www.garp.com/frmexam.

OTHER GARP CERTIFICATIONS

International Certificate in Banking Riskand Regulation (ICBRR)

The ICBRR allows individuals to expand their knowledge and understanding ofthe various risks, regulations, and supervisory requirements banks must face intoday’s economy, with emphasis on the Basel II Accord. This certificate is idealfor employees who are not professional risk managers but who have a strong needto understand risk concepts. The ICBRR program is designed for employees in

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Financial Risk Review Test Financial Risk Manager …€¦ · ways to prepare for the Financial Risk Manager (FRM) ... The official reference book for GARP’s FRM ... Quantitative