This chapter is an update to Chapter 21 of the third edition. Liquidity risk has
become increasingly important since the crisis. The chapter considers liquidity trading
risk and liquidity funding risk. The liquidity trading risk material includes a discussion
of proportional bid-offer spreads, the costs of liquidation, liquidity-adjusted VaR, and a
procedure for optimally unwinding a portfolio that was suggested by Almgren and Chriss.
The liquidity funding risk material discusses different sources of liquidity and emphasizes
the importance of liquidity planning. The chapter discusses the phenomenon of liquidity
black holes and some of the reasons why they occur.
The Basel III liquidity ratios can be discussed here or at the time Chapter 16 is
covered.
Problem 24.13 can be used for class discussion. Problems 24.14 and 24.15 can be used
as assignment questions.
Chapter 25: Model Risk
This chapter is an update to Chapter 22 of the third edition. After an initial coverage
of marking to market and accounting, the discussion of model risk is divided into three
parts. The first part is concerned with models for linear products. There is generally very
little uncertainty about the correct model to use for linear products—but the examples
given in the text (Business Snapshots 25.1 and 25.2) show that it is still necessary to
be vigilant. The second part is concerned with models for actively traded (nonlinear)
products. Here there is a discussion of volatility smiles/skews and an explanation that
the model is used as an interpolation tool for pricing (but has a more important role to
play in hedging). The third part discusses the role of models in the pricing and hedging
of nonstandard products.
Problem 25.13 and 25.15 can be used for classroom discussion. Problems 25.14 and
25.16 can be used as assignments
Chapter 26: Economic Capital and RAROC
This chapter is an updated version of Chapter 23 in the third edition. It explains
how banks estimate economic capital. This is the capital that they themselves think they
need for the business they transact. I spend about two hours on the chapter. Many of the
methods used to assess economic capital are similar to those used for regulatory capital.
The basic model is the same (see Figure 26.1.) A common time horizon and a common
confidence level should be used for all the risks considered. Often a AA-rated bank will
choose a time horizon of one year and a high confidence level such as 99.95%. (This is
because the statistics produced by rating agencies indicate that an AA-rated company
should have a probability of about 0.05% of defaulting in one year.) In the case of credit
risk, banks often choose a correlation model that is different from that used in Basel II.
Creditmetrics is a popular choice.
Typical loss distributions for market risk, credit risk, and operational risk are shown in
Figures 26.3, 26.4, and 26.5. Banks typically calculate economic capital for different types
of risk and different business units. They are then faced with an aggregation problem. A
popular and robust approach, introduced in Chapter 12, is known as the hybrid approach
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