xx

PREFACE

section, to allow easy cutandpaste linking to referenced material on

the web. Updates will also include discussion of new developments. For
example, at the time this book went to press, there is not yet enough public
information about the causes of the large trading losses at JPMorgans London investment office to allow a discussion of risk management lessons; as
more information becomes available, I will place an analysis of risk management lessons from these losses on the website.
This book is divided into three parts: general background to financial
risk management, the principles of financial risk management, and the details of financial risk management.

The general background part (Chapters 1 through 5) gives an institutional framework for understanding how risk arises in financial firms
and how it is managed. Without understanding the different roles and
motivations of traders, marketers, senior firm managers, corporate risk
managers, bondholders, stockholders, and regulators, it is impossible
to obtain a full grasp of the reasoning behind much of the machinery
of risk management or even why it is necessary to manage risk. In this
part, you will encounter key concepts risk managers have borrowed
from the theory of insurance (such as moral hazard and adverse selection), decision analysis (such as the winners curse), finance theory
(such as the arbitrage principle), and in one instance even the criminal
courts (the Ponzi scheme). Chapter 4 provides discussion of some of the
most prominent financial disasters of the past 30 years, and Chapter 5
focuses on the crisis of 20072008. These serve as case studies of failures in risk management and will be referenced throughout the book.
This part also contains a chapter on operational risk, which is necessary
background for many issues that arise in preventing financial disasters
and which will be referred to throughout the rest of the book.
The part on principles of financial risk management (Chapters 6
through 8) first lays out an integrated framework in Chapter 6, and
then looks at VaR and stress testing in Chapter 7 and the control of
model risk in Chapter 8.
The part on details of financial risk management (Chapters 9 through 14)
applies the principles of the second part to each specific type of financial risk: spot risk in Chapter 9, forward risk in Chapter 10, vanilla
options risk in Chapter 11, exotic options risk in Chapter 12, credit
risk in Chapter 13, and counterparty credit risk in Chapter 14. As each
risk type is discussed, specific references are made to the principles elucidated in Chapters 6 through 8, and a detailed analysis of the models
used to price these risks and how these models can be used to measure
and control risk is presented.