GEORGES DIONNE is Professor and Canada Research Chair in Risk Management, Department of Finance, HEC Montréal, Quebec, Canada. He was Editor of The Journal of Risk and Insurance from 2007 to 2013, and member of the HEC Montréal Board of Directors from 2009 to 2015. He received the Innis-Gérin Medal in 2011 for his contribution to social sciences in Canada.

Foreword by Denis Kessler xiii

Introduction xvii

General Presentation xvii

Contents of the Book xix

Acknowledgments xx

General References xxi

Chapter 1 Risk Management: Definition and Historical Development 1

1.1 History of Risk Management 2

1.2 Milestones in Financial Risk Management 3

1.3 Current Definition of Corporate Risk Management 7

1.4 Conclusion 8

References 9

Chapter 2 Theoretical Determinants of Risk Management in Non-Financial Firms 11

2.1 Value of Risk Management 12

2.2 Comparative Advantages in Risk Taking 16

2.3 Risk Management and Capital Structure 17

2.4 Risk Management and Managerial Incentives 18

2.5 Conclusion 19

References 19

Chapter 3 Risk Management and Investment Financing 21

3.1 Basic Model 21

3.2 Illustration with the Standard Debt Contract 27

3.3 Model with Two Random Variables 28

3.4 Conclusion 31

References 31

Appendix A: Value of dI*/dw 31

Appendix B: Standard Debt Dcontract 32

Chapter 4 Significant Determinants of Risk Management of Non-Financial Firms 35

4.1 Rationale for the Research 35

4.2 Significant Determinants 36

4.3 Governance and Endogeneity of Debt 50

4.4 Conclusion 60

References 61

Appendix: Construction of the Tax-Save Variable 62

Chapter 5 Value at Risk 63

5.1 Example of VaR 63

5.2 Numerical Method 65

5.3 Parametric Method 66

5.4 Taking Time Periods into Consideration 67

5.5 Confidence Interval of the VaR 68

5.6 CVaR 69

5.7 Conclusion 70

References 71

Chapter 6 Choice of Portfolio and VaR Constraint 73

6.1 Optimal Benchmark Portfolio of the Firm 73

6.2 Optimal Portfolio of a Constrained Manager 75

6.3 Conclusion 77

References 77

Chapter 7 VaR in Portfolios of Assets and Options 79

7.1 VaR as a Risk Measure 79

7.2 Models without Derivatives 80

7.3 VaR with Options 85

7.4 Black and Scholes Model and Risk Management 88

7.5 Delta-Gamma VaR 90

7.6 VaR of a General Portfolio 90

7.7 Application 92

7.8 Conclusion 97

References 97

Chapter 8 Conditional VaR 99

8.1 Motivation for CVaR and Coherence in Risk Measures 99

8.2 Notation and VaR 101

8.3 Definition of CVaR 104

8.4 Another Way to Derive CVaR with a Return Distribution 107

8.5 Example with Student’s t-Distribution and Other Examples 108

8.6 Conclusion: CVaR in Basel Regulation 111

References 111

Chapter 9 Regulation of Bank Risk and Use of VaR 113

9.1 Basel Accords 114

9.2 Market Risk Regulation of 1996 120

9.3 Specific Risks 120

9.4 Total Required Capital 122

9.5 Tests 124

9.6 Comparison between Standard and Internal Methods with Interest Rate Risk 124

9.7 Conclusion 133

References 134

Chapter 10 Optimal Financial Contracts and Incentives under Moral Hazard 135

10.1 Optimal Financial Contracts and Moral Hazard 136

10.2 Theoretical Model 140

10.3 Empirical Application to Air Accident Risk 144

10.4 Conclusion 148

References 148

Appendix A: Synthesis of Forms of Financial Contracts 149

Appendix B: Definitions of Variables 150

Chapter 11 Venture Capital Risk with Optimal Financing Structure 153

11.1 Some Statistics about Venture Capital 154

11.2 Role of Venture Capital Firms 155

11.3 Venture Capital Firms and Added Value 156

11.4 Role of Convertible Debt 156

11.5 Information Asymmetry and Venture Capital 158

11.6 Conclusion 163

References 164

Chapter 12 Bank Credit Risk: Scoring of Individual Risks 167

12.1 Theoretical Model 169

12.2 Empirical Analysis 171

12.3 Credit Line and Loan Default 180

12.4 Conclusion 182

References 182

Chapter 13 Portfolio Management of Credit Risk 185

13.1 CreditMetrics 185

13.2 Review of Chapters 2 and 3 of CreditMetrics 186

13.3 KMV Approach 193

13.4 Calculation of Correlations 196

13.5 Conclusion 202

References 202

Chapter 14 Quantification of Banks’ Operational Risk 205

14.1 Context and Presentation of Operational Risk 205

14.2 Measurement of Regulatory Capital 208

14.3 Calculation of Regulatory Capital for Losses of over $1 Million (LDA) 210

14.4 Conclusion 227

References 228

Chapter 15 Liquidity Risk 231

15.1 Theoretical Modeling of CDSs 232

15.2 Bond Yield Spread’s Default Portion 233

15.3 Empirical Measurement of Yield Spreads’ Default Portion 235

15.4 Non-Default Portion of Yield Spreads 237

15.5 Illiquidity Index 242

15.6 Illiquidity Premium 244

15.7 Data 244

15.8 Principal Component Analysis of Liquidity Risk 245

15.9 Empirical Analysis of Credit Cycles 246

15.10 Regime Detection Model 248

15.11 Detection of Default and Liquidity Regimes 250

15.12 Conclusion 251

References 252

Chapter 16 Long-Term Capital Management 255

16.1 Brief History of the Fund 256

16.2 Risk Management, VaR, and Required Capital 258

16.3 Portfolio Optimization and Leverage Effect 260

16.4 Conclusion 261

References 262

Chapter 17 Structured Finance and the Financial Crisis of 2007–2009 263

17.1 Structured Finance 263

17.2 Poor Risk Management Linked to the Structured Finance Market 264

17.3 Conclusion 266

References 268

Appendix: How to Create an AAA CDO Tranche from BBB Loans 269

Chapter 18 Risk Management and Corporate Governance 271

18.1 Enron and Corporate Governance 271

18.2 Financial Crisis and Corporate Governance 273

18.3 New 2002 Governance Rules 273

18.4 Risk Management and Governance 274

18.5 Administrative Competence of Board Members 276

18.6 New Regulation for Financial Institutions 276

18.7 Economic Analysis of Governance Effect 277

18.8 Conclusion 288

References 288

Appendix A: Governance of Canadian Federal Financial Institutions 290

Appendix B: Details on the Construction of the Governance Indexes 291

Appendix C: Variables 293

Chapter 19 Risk Management and Industrial Organization 295

19.1 Entry, Production, and Hedging 295

19.2 Commitment to Hedging 297

19.3 Conclusion 297

References 299

Chapter 20 Real Implications of Corporate Risk Management 301

20.1 Real Implications of Corporate Risk Management: A Review 302

20.2 Methodology 303

20.3 US Oil Producers 309

20.4 Multivariate Results 316

20.5 Conclusion 324

References 324

Appendix: Estimated MTEs 326

Chapter 21 Exercises 331

Exercise 1 Portfolio Choice and the Notion of Value at Risk (VaR) 331

Exercise 2 Backtesting of VaR Models 345

Exercise 3 Calculation of VaR with Different Distributions and Accuracy of VaR 351

Exercise 4 VaR for an Equity Portfolio with Options 359

Exercise 5 CVaR Conditional Value at Risk 369

Conclusion 376

Reference 376

Conclusion 377

General References 378

Index 379

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