Wednesday, July 25, 2012

Hull, Risk Management and Financial Institutions, 3d ed.

Most people in the world of finance know John C. Hull of the Joseph L. Rotman School of Management, University of Toronto from his classic Options, Futures, and Other Derivatives, now in its eighth edition. Risk Management and Financial Institutions, 3d ed. (Wiley, 2012) overlaps the material covered in the book on derivatives but includes much that is new. It is a paperback of over 650 pages intended to be used as a textbook—I trust by very gentle page turners. It has practice questions and problems, with answers at the end of the book, and further questions, where the reader is on his own.

Although Hull’s book has its fair share of math, much of it surprisingly elementary, the focus of the book is not on the math but on the context in which it is used. Readers seeking a quant-heavy book should turn elsewhere.

After some preliminary chapters that cover banks, insurance companies and pension plans, mutual funds and hedge funds, trading (primarily derivatives), the credit crisis of 2007, how traders manage their risks using the Greeks, and interest rate risk, Hull moves on to key concepts in risk management: VaR, volatility, and correlations and copulas. He then deals with bank regulation (Basel in its several iterations and Dodd-Frank). The following nine chapters are devoted to various kinds of risk and risk measurement: market risk VaR (historical simulation approach and model-building approach), credit risk, counterparty credit risk in derivatives, credit VaR, scenario analysis and stress testing, operational risk, liquidity risk, and model risk.

Hull includes business snapshots that show real-life examples of the principles he discusses—including instances in which financial institutions managed to get things very wrong. I want to share one snapshot here because, although I read about the Joseph Jett story in 1994, I had no idea exactly what went wrong. And no wonder. The New York Times reported what I remember: that “There were virtually no genuine profitable trades. Joseph Jett, Kidder, Peabody’s former bond-trading star, simply made up trades and marked them down as having made money. In the meantime, his few real trades consistently lost money.”

Hull sets the record straight. “Investment banks have developed a way of creating a zero-coupon bond, called a strip, from a coupon-bearing Treasury bond by selling each of the cash flows underlying the coupon-bearing bond as a separate security. Joseph Jett … had a relatively simple trading strategy. He would buy strips and sell them in the forward market. The forward price of the strip was always greater than the spot price, and so it appeared that he had found a money-making machine! In fact, the difference between the forward price and the spot price represents nothing more than the cost of funding the purchase of the strip. … Kidder Peabody’s computer system reported a profit on each of Jett’s trades equal to the excess of the forward price over the spot price…. By rolling his contracts forward, Jett was able to prevent the funding cost from accruing to him. The result was that the system reported a profit of $100 million on Jett’s trading (and Jett received a big bonus) when in fact there was a loss in the region of $350 million. This shows that even large financial institutions can get relatively simple things wrong!” (p. 476) Indeed!

Risk Management and Financial Institutions is a good text for those who, as Thomas S. Coleman draws the distinction, aspire to manage risk but who will most likely leave risk measurement to others. In brief, it’s a business school textbook.

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