In Advanced Financial Risk Management Donald R. van Deventer and Kenji Imai, joined by Mark Mesler, extend the concepts outlined in their previous book Credit Risk Models and the Basel Accords and update their 1996 work Financial Risk Analytics. The authors lay out a comprehensive strategy of risk management measures, objectives, and hedging techniques that apply to all types of institutions. They describe a performance measurement approach that goes far beyond traditional capital allocation techniques in measuring risk-adjusted shareholder value creation. Most important, the authors supplement this strategic view of integrated risk with step-by-step tools and techniques for constructing a risk management system that achieves these objectives.
The authors start with an updated review of techniques for constructing the building blocks of risk management, continuous yield curves that are used in everything from equity options to mortgage-backed securities analysis. They show how the creation of smooth credit spreads from bond price data is an extension of traditional yield curve smoothing technology. The authors review the primary credit risk models and discuss the implementation of the most modern form of credit models, the reduced form models of Jarrow, Duffy and Singleton, at great length. Theypresent results from a 1.2 million observation data base on default probabilities in demonstrating how to meet Basel II requirements for credit model testing. They also show how to estimate default probabilities from bond prices and credit derivatives prices even when there is a liquidity "premium" reflected in those prices above and beyond the risk of expected loss due to default or bankruptcy.
The authors then go on to show how three important topics in finance are special cases of the credit risk analysis they introduce: prepayment modeling, valuation of life insurance policies, and the valuation of property and casualty insurance contracts. Van Deventer, Imai and Mesler also revisit the critical issue of the valuation of savings deposits and demand deposits, which hav