Dodd-Frank and similar post-crisis legislation in other countries are discussed. Dodd
Frank is a particularly complicated piece of legislation. The material in the book attempts
to summarize the main provisions. The main objective of the legislation is to prevent
future bailouts of financial institutions and protect the consumer. No doubt there will be
crises in the financial sector in the future. They will probably not be similar to the crisis
that started in 2007. Whether Dodd-Frank and the Basel regulations will be successful
in reducing their severity and preventing future bailouts remains to be seen. Students
typically have mixed view on this.
Problem 16.14 can be used as an assignment question on liquidity ratios.
Chapter 17: Fundamental Review of the Trading Book
This chapter is new to the fourth edition. It deals with an important new proposal on
market risk coming out of the Basel committee. There will be many important changes in
the calculation of capital for market risk when the proposal is implemented. Capital will
be calculated from a stressed expected shortfall measure. Liquidity risk will be taken into
account by letting the time horizon used for determining the shocks that are applied to
a market variable depend on the nature of the market variable. The distinction between
the banking book and the trading book will be made more clear cut. The calculation of
capital for trades involving credit risk is changed.
Problem 17.7 is a possible assignment question.
Chapter 18: Margin, Collateral and CCPs
This chapter is new to the fourth edition. The material on the different ways in which
margin accounts are used has been moved from Chapter 5 of the third edition to the
beginning of this chapter. The chapter then moves on to discuss the ways the trading and
clearing of OTC derivatives is handled and the changes that have taken place since the
2007-9 crisis. The chapter also explains how defaults are handled under central clearing
and bilateral clearing.
Problems 18.16 to 18.18 can be used as short assignment questions or discussed in
class.
Chapter 19: Estimating Default Probabilities
This chapter is an update to Chapter 16 of the third edition. I find that at least
three hours of classroom time is necessary for the material. A number of approaches for
estimating default probabilities are considered: a) using historical data, b) using credit
spreads (from bonds, CDSs, or asset swaps), and c) using equity prices (Merton’s model).
One of the most important messages in this chapter is the difference between real world
(physical) and risk-neutral (implied) default probabilities. Real world default probabilities
are generally less than risk neutral default probabilities—but the difference between the
two varies through time. I spend quite a bit of classroom time going through Tables 19.4 to
19.6 and the arguments and the subsequent arguments on why there is a risk premium in
Table 19.6. The risk-neutral default rate for 1996 to 2007 is compared with the real-world
default rate for 1970 to 2013. The time periods do not match because a) the Merrill Lynch
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