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Risk Management

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Dealing with all aspects of risk management that have undergone significant innovation in recent years, this book aims at being a reference work in its field. Different to other books on the topic, it addresses the challenges and opportunities facing the different risk management types in banks, insurance companies, and the corporate sector. Due to the rising volatility in the financial markets as well as political and operational risks affecting the business sector in general, capital adequacy rules are equally important for non-financial companies. For the banking sector, the book emphasizes the modifications implied by the Basel II proposal. The volume has been written for academics as well as practitioners, in particular finance specialists. It is unique in bringing together such a wide array of experts and correspondingly offers a complete coverage of recent developments in risk management.



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A Word of Greeting Preface
Part 1: Bank Risk Management Basel II and the Effects on the Banking Sector Thomas Hartmann-Wendels, Peter Grundke and Wolfgang Spörk Conflicts of Interest and Market Discipline in Financial Services Firms Ingo Walter Risk Management and Value Creation in Banks Gerhard Schröck and Manfred Steiner The New Basel Capital Accord Claudia Holtorf, Matthias Muck, and Markus Rudolf Value at Risk: Regulatory and Other Applications, Methods, and Criticism Alois Paul Knobloch Parsimonious Value at Risk for Fixed Income Portfolios John F. O. Bilson Risk Budgeting with Value at Risk Limits Robert Härtl and Lutz Johanning Value at Risk, Bank Equity and Credit Risk Jack E. Wahl and Udo Broll
Parametric and Nonparametric Estimation of Conditional Return Expectations Wolfgang Drobetz and Daniel Hoechle Credit Risk Portfolio Modeling: An Overview Ludger Overbeck Evaluating Credit Risk Models Hergen Frerichs and Mark Wahrenburg Estimation of Default Probabilities and Default Correlations Stefan Huschens, Konstantin Vogl, and Robert Wania Managing Investment Risks of Institutional Private Equity Investors – The Challenge of Illiquidity Christoph Kaserer, Niklas Wagner and Ann-Kristin Achleitner
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XII Brief Table of Contents
Assessment of Operational Risk Capital Carol Alexander
Operational Risk: The Management Perspective Wilhelm Kross
Part 2: Insurance Risk Management Catastrophic Events as Threats to Society: Private and Public Risk Management Strategies Martin Nell and Andreas Richter New Approaches to Managing Catastrophic Insurance Risk Ulrich Hommel and Mischa Ritter Alternative Risk Transfer Christopher L. Culp The Challenge of Managing Longevity Risk Petra Riemer-Hommel and Thomas Trauth
Asset/Liability Management of German Life Insurance Companies: A Value-at-Risk Approach in the Presence of Interest Rate Guarantees Peter Albrecht and Carsten Weber
Part 3: Corporate Risk Management Risk Management, Corporate Governance and the Public Corporation Fred R. Kaen Integrating Corporate Risk Management Christian Laux Value-Based Motives for Corporate Risk Management Ulrich Hommel Value-based Corporate Risk Management Werner Gleißner Statutory Regulation of the Risk Management Function in Germany: Implementation Issues for the Non-Financial Sector Jürgen Weber and Arnim Liekweg A Comprehensive Approach to the Measurement of Macroeconomic Exposure Lars Oxelheim and Clas Wihlborg Foreign-Exchange-Risk Management in German Non-Financial Corporations: An Empirical Analysis Martin Glaum
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Brief Table of Contents XIII
Estimating the Exchange Rate Exposure of US Multinational Firms: Evidence from an Event Study Methodology Kathryn L. Dewenter, Robert C. Higgins and Timothy T. Simin International Corporate Risk Management: A Comparison of Three Major Airlines Matthias Muck and Markus Rudolf Corporate Risk Management: Real Options and Financial Hedging Alexander J. Triantis The Real Option Value of Operational and Managerial Flexibility in Global Supply Chain Networks Arnd Huchzermeier Managing Acquisition-Related Currency Risk Exposures: The E.ON-Powergen Case Stefan Hloch, Ulrich Hommel, and Karoline Jung-Senssfelder Introducing New Risk Classes to Organized Exchanges: The Case of Electricity Derivatives Christian Geyer and Werner G. Seifert Was Enron’s Business Model Fundamentally Flawed? Ehud I. Ronn “Real” Risk Management: Opportunities and Limits of Consumption-based Strategies Wolfgang Breuer and Olaf Stotz Capacity Options: Convergence of Supply Chain Management and Financial Asset Management Stefan Spinler and Arnd Huchzermeier
Part 4: Systemic Issues of Risk Management The Key to Risk Management: Management Adrian E. Tschoegl Economic Risks of EMU Michael Frenkel and Paul McCracken Does Risk Management Make Financial Markets Riskier? Ian R. Harper, Joachim G. Keller, and Christian M. Pfeil Risk Management, Rational Herding and Institutional Investors: A Macro View Torben Lütje and Lukas Menkhoff Revitalization of Japanese Banks – Japan’s Big Bang Reform Mitsuru Misawa
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A Word of Greeting Preface
Part 1: Bank Risk Management Basel II and the Effects on the Banking Sector Thomas Hartmann-Wendels, Peter Grundke and Wolfgang Spörk 1. Overview on the New Basel Capital Accord 1.1 Why Do We Need a More Sophisticated Banking Supervision? 2. The Standardized Approach 3. The Internal Ratings-Based Approach 3.1 The IRB Approach for the Corporate Asset Class 3.1.1 Basic Structure of the IRB Approach for the Corporate Asset  Class 3.1.2 The Risk Components 3.1.3 The Risk Weight Function 3.2 The IRB Approach for the Retail Asset Class 4. Consequences of Basel II 4.1 Consequences on the Lending Margins 4.2 Consequences for the Banking Industry Conflicts of Interest and Market Discipline in Financial Services Firms Ingo Walter 1. A Conflict of Interest Taxonomy 1.1 Conflicts of Interest in Wholesale Financial Markets 1.2 Conflicts of Interest in Retail Financial Services 1.3 Wholesale-Retail Conflicts 2. Conflicts of Interest and Strategic Profiles of Financial Firms 2.1 Potential Conflicts of Interest in Multifunctional Client  Relationships 3. Constraining Exploitation of Conflicts of Interest 3.1 Regulation-Based Constraints 3.2 Market-Discipline Constraints 3.3 Intersection of Regulation and Market-Based Constraints 4. Conclusion Risk Management and Value Creation in Banks Gerhard Schröck and Manfred Steiner 1. Introduction 2. Necessity for a Framework on Risk Management in Banks at the Corporate Level 3. RAROC as Capital Budgeting Rule in Banks 3.1 Evolution of Capital Budgeting Rules in Banks 3.2 Definition of RAROC 3.3 Assumptions and Deficiencies of RAROC 4. Overview of New Approaches
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XVI Table of Contents
5. Implications of the New Approaches on Risk Management and Value Creation in Banks 5.1 Implications for Risk Management Decisions 5.2 Implications on Capital Budgeting Decisions 5.3 Implications on Capital Structure Decisions 6. Foundations for a Normative Theory for Risk Management in Banks 7. Conclusion The New Basel Capital Accord Claudia Holtorf, Matthias Muck, and Markus Rudolf 1. Introduction 2. VaR Calculation 3. Regulatory Reporting, VaR, and Capital Requirement 4. Internal vs. Standard Model 5. Credit Risk 6. Operational Risk 7. Summary and Outlook Value at Risk: Regulatory and Other Applications, Methods, and Criticism Alois Paul Knobloch 1. The Concept of Value at Risk and its Role in Contemporary Risk Management 1.1 Value at Risk: Definition and Risks of Concern 1.2 Applications and Regulatory Background 2. Calculating Value at Risk: Methods and Inherent Sources of Inaccuracy 2.1 Delta-normal and Delta-gamma Approach 2.2 Simulation Methods: Historical and Monte Carlo Simulation 3. Risk Reduction and Capital Allocation Within a Value at Risk Framework 3.1 Minimizing Value at Risk 3.2 Allocating VaR to Business Units 4. Shortcomings of Value at Risk as a Measure of Risk 5. Conclusion
Parsimonious Value at Risk for Fixed Income Portfolios John F. O. Bilson 1. Introduction 1.1 A Simple Example 1.2 The Key Rate Duration Model 1.3 The Level, Slope, and Curvature (LSC) Model 1.4 LSC Risk Analysis 1.5 Conclusion
Risk Budgeting with Value at Risk Limits Robert Härtl and Lutz Johanning 1. Introduction 2. Definition of Value at Risk Limits 3. The Structure of the Simulation Models 4. Adjusting Risk Limits for Time Horizons and Profits and Losses
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5. Incorporating Asset Correlations Into Risk Budgets 6. Conclusion and Practical Implications
Value at Risk, Bank Equity and Credit Risk Jack E. Wahl and Udo Broll 1. Introduction 2. A Banking Firm 2.1 The Economic Setting 2.2 The Stochastic Setting 2.3 Value at Risk and the Bank’s Profit 3. Optimal Capital Requirement 4. Value Maximization and Bank Equity 5. Conclusion
Table of Contents XVII
Parametric and Nonparametric Estimation of Conditional Return Expectations Wolfgang Drobetz and Daniel Hoechle 1. Introduction 2. Parametric versus Nonparametric Regression – A Simple Derivation 2.1 Conditional Mean, Econometric Loss, and Weighted Least Squares 2.2 The Parametric Approach: An Unusual Representation of OLS 2.3 Nonparametric Regression Analysis 2.4 The Multivariate Case 2.5 Bandwidth Selection for Nonparametric Regression Estimators 3. Data Description 4. Empirical Results 4.1 In-sample Results 4.2 Out-of-sample Results 5. Conclusion 6. Acknowledgement
Credit Risk Portfolio Modeling: An Overview Ludger Overbeck 1. Purpose of Credit Risk Modeling 1.1 Enterprise Risk Management 1.1.1 Economic Capital 1.1.2 Capital Allocation 1.2 Integration of Risk Types 1.3 Loss Distribution 1.4 Risk Measure 1.5 Portfolio Transactions 2. Basic Components of Credit Risk Modeling 2.1 Inputs 2.1.1 Exposure at Default 2.1.2 Loss Given Default 2.1.3 Default Probability 2.1.4 Dependency Concept 2.1.5 Event Versus Time Series Correlation 2.2 Output 2.2.1 Economic Capital
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XVIII Table of Contents
2.2.2 Value-at-Risk 2.2.3 Expected Shortfall 2.2.4 Coherent Risk Measures 2.2.5 Capital Allocation 2.2.6 Contribution to Volatility and Contribution to VaR,  Capital Multiplier 2.2.7 Contribution to Expected Shortfall 3. Portfolio Models 3.1 Actuarial Approach 3.1.1 Specification of Severity and Frequency Distributions 3.1.2 Dependence 3.1.3 Extensions 3.2 Structural Approach 3.2.1 Default Event 3.2.2 Dependencies 3.2.3 Loss Distribution 3.2.4 Extensions 4. Summary
Evaluating Credit Risk Models Hergen Frerichs and Mark Wahrenburg 1. Introduction 2. Backtests Based on the Frequency of Tail Losses 3. Backtests Based on Loss Density Forecasts 4. Forecast Evaluation Approaches to Backtesting 5. Conclusion
Estimation of Default Probabilities and Default Correlations Stefan Huschens, Konstantin Vogl, and Robert Wania 1. Introduction 2. Estimation of Default Probabilities 2.1 Single-Period Case 2.2 Multi-Period Case 2.3 Multi-Group Case 3. Estimation of Default Correlation 3.1 Concepts of Dependent Defaults 3.2 Estimation in a General Bernoulli Mixture Model 3.3 Estimation in a Single-Factor Model 4. Simultaneous Estimation 4.1 General Bernoulli Mixture Model 4.2 Single-Factor Model 5. Conclusion
Managing Investment Risks of Institutional Private Equity Investors – The Challenge of Illiquidity Christoph Kaserer, Niklas Wagner and Ann-Kristin Achleitner 1. Introduction 2. Measuring Private Equity Returns and Risk 2.1 Asset Value Based Returns 2.2 Smoothed Proxy Observations 2.3 Noisy Smoothed Proxy Observations
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2.4 Cash Flow Based Returns 3. Risk Management and Asset Allocation 3.1 Specific Issues in Risk Management 3.2 Specific Issues in Asset Allocation 4. Conclusion
Table of Contents XIX
Assessment of Operational Risk Capital Carol Alexander 1. The Operational Risk Capital Model 1.1 Frequency, Severity and the Loss Distribution 1.2 Operational Risk Capital Calculation 2. Dealing with Operational Risk Data 2.1 Choosing the Functional Form of the Loss Model 2.2 Data Filtering and Scaling 2.3 Risk Self-Assessment 2.4 Data-Oriented AMA 3. Aggregation of Operational Risks 3.1 Identification of Dependencies 3.2 The Effect of Dependencies on the Aggregate ORC 3.3 Aggregating Operational Risks with Other Risks 4. Summary and Conclusions
Operational Risk: The Management Perspective Wilhelm Kross 1. Introduction 1.1 Commonly Practiced Approaches to OpRisk 1.2 Pitfalls on the Road to AMA Compliance 1.3 Inefficiencies in AMA Compliance Management 1.4 Desirable Side-Effects in OpRisk Management 1.5 Priorities and Maximized Value in OpRisk Management 1.6 Generic Roadmap towards Effective OpRisk Management 1.7 Conclusions and Recommendations
Part 2: Insurance Risk Management Catastrophic Events as Threats to Society: Private and Public Risk Management Strategies Martin Nell and Andreas Richter 1. Introduction 2. Insurance-linked Securities 3. State Guarantees for Catastrophic Risk? 4. Problems with Catastrophe Insurance Demand 5. Conclusion New Approaches to Managing Catastrophic Insurance Risk Ulrich Hommel and Mischa Ritter 1. Introduction 2. CAT-Linked Securities – A New Asset Class 3. Traditional and ART-Based CAT Reinsurance 4. Optimizing the Issuer’s Risk Portfolio 5. Risk Management Strategies Using CAT-Linked Securities
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XX Table of Contents
5.1 Ex-Post Capital Provision and Funding Cost Reduction with  CAT-linked Bonds 6. Valuation Issues 7. Concluding Remarks
Alternative Risk Transfer Christopher L. Culp 1. Introduction 2. Self-Insurance, Captives, and the Emergence of ART 2.1 Single-Parent Captives 2.2 Other Captive-Like Structures 2.2.1 Mutualized Structures 2.2.2 Rent-A-Captives and Protected Cell Companies 3. Finite Risk 3.1 Typical Finite Risk Structures 3.2 Potential Benefits to Corporates 3.3 The AIG/Brightpoint SEC Settlement 4. Multi-Line Programs and Risk Bundling 4.1 Overcoming Silo-by-Silo Inefficiency 4.2 A Mixed Record 5. Multi-Trigger Programs 6. Structured Finance Solutions 6.1 Asset Securitization 6.2 Risk Securitization 6.3 Future Flow Securitization 6.4 Structured Liabilities 7. Contingent Capital 8. Conclusion
The Challenge of Managing Longevity Risk Petra Riemer-Hommel and Thomas Trauth 1. Introduction 2. Establishing the Relevance of Longevity Risk to the Insurance Industry 3. Economic Reasons for the (Re)Insurance Gap 3.1 Difficulties in Forecasting Longevity Trends 3.2 Adverse Selection 3.3 Moral Hazard 3.4 Absence of Diversification and Hedging Opportunities 4. Possible Solutions for Longevity Risk (Re)Insurance 4.1 Pricing to Risk 4.2 Finite Reinsurance Solutions 4.3 Capital Market Solutions 5. Conclusion
Asset/Liability Management of German Life Insurance Companies: A Value-at-Risk Approach in the Presence of Interest Rate Guarantees Peter Albrecht and Carsten Weber 1. Introduction 2. The Model and its Calibration 3. The Case of German Life Insurance Companies 4. Pure Market Values of Assets
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Table of Contents XXI
5. Book Values of Assets 6. The Riskless Asset 7. Summary 8. Appendix A: Probable Minimum Return 9. Appendix B: Worst Case-Average Return 10. Appendix C: Conversion of Market Values into Book Values
Part 3: Corporate Risk Management
Risk Management, Corporate Governance and the Public Corporation Fred R. Kaen 1. Introduction 2. “Scientific” Theoretical Perspective on Risk Management 3. From Theory to Practice: Why Firms Should Manage Risk 3.1 Using Risk Management to Lower Taxes 3.2 Reducing Financial Distress and Bankruptcy Costs 3.3 Using Risk Management to Encourage and Protect  Firm Specific Investments 3.4 Using Risk Management to Monitor and Control Managers 3.5 Using Risk Management to Improve Decision Making  and Capital Budgeting 3.6 Risk Management and Dividends 4. Back to Berle and Means 5. Summary and Conclusions
Integrating Corporate Risk Management Christian Laux 1. Introduction 2. How Does Risk Management Add Value? 3. Measuring the Value of Risk Management 4. Identifying a Firm’s Collective Risks 5. Interactions Between Risk Management, Financial Structure, and Operating Decisions 6. Integrated Products 7. Risk Management and Managerial Incentive Problems
Value-Based Motives for Corporate Risk Management Ulrich Hommel 1. Introduction 2. The Irrelevance Theorem of Modigliani-Miller (MM) 3. Value Based Motives for Corporate Risk Management 3.1 Raising the Efficiency of Financial Contracting 3.1.1 Shareholders vs. Management 3.1.2 Creditors vs. Shareholders 3.2 Reducing the Corporate Tax Burden 3.3 Reducing Transaction Costs 3.3.1 Transaction Cost of Financial Distress 3.3.2 Transaction Cost of Hedging 3.4 Selecting the Optimal Risk Portfolio 3.5 Coordinating Financial and Investment Policies 4. Conclusion
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