Corporate Risk Management

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 xiiiIntroduction xviiGeneral Presentation xviiContents of the Book xixAcknowledgments xxGeneral References xxiChapter 1 Risk Management: Definition and Historical Development 11.1 History of Risk Management 21.2 Milestones in Financial Risk Management 31.3 Current Definition of Corporate Risk Management 71.4 Conclusion 8References 9Chapter 2 Theoretical Determinants of Risk Management in Non-Financial Firms 112.1 Value of Risk Management 122.2 Comparative Advantages in Risk Taking 162.3 Risk Management and Capital Structure 172.4 Risk Management and Managerial Incentives 182.5 Conclusion 19References 19Chapter 3 Risk Management and Investment Financing 213.1 Basic Model 213.2 Illustration with the Standard Debt Contract 273.3 Model with Two Random Variables 283.4 Conclusion 31References 31Appendix A: Value of dI*/dw 31Appendix B: Standard Debt Dcontract 32Chapter 4 Significant Determinants of Risk Management of Non-Financial Firms 354.1 Rationale for the Research 354.2 Significant Determinants 364.3 Governance and Endogeneity of Debt 504.4 Conclusion 60References 61Appendix: Construction of the Tax-Save Variable 62Chapter 5 Value at Risk 635.1 Example of VaR 635.2 Numerical Method 655.3 Parametric Method 665.4 Taking Time Periods into Consideration 675.5 Confidence Interval of the VaR 685.6 CVaR 695.7 Conclusion 70References 71Chapter 6 Choice of Portfolio and VaR Constraint 736.1 Optimal Benchmark Portfolio of the Firm 736.2 Optimal Portfolio of a Constrained Manager 756.3 Conclusion 77References 77Chapter 7 VaR in Portfolios of Assets and Options 797.1 VaR as a Risk Measure 797.2 Models without Derivatives 807.3 VaR with Options 857.4 Black and Scholes Model and Risk Management 887.5 Delta-Gamma VaR 907.6 VaR of a General Portfolio 907.7 Application 927.8 Conclusion 97References 97Chapter 8 Conditional VaR 998.1 Motivation for CVaR and Coherence in Risk Measures 998.2 Notation and VaR 1018.3 Definition of CVaR 1048.4 Another Way to Derive CVaR with a Return Distribution 1078.5 Example with Student’s t-Distribution and Other Examples 1088.6 Conclusion: CVaR in Basel Regulation 111References 111Chapter 9 Regulation of Bank Risk and Use of VaR 1139.1 Basel Accords 1149.2 Market Risk Regulation of 1996 1209.3 Specific Risks 1209.4 Total Required Capital 1229.5 Tests 1249.6 Comparison between Standard and Internal Methods with Interest Rate Risk 1249.7 Conclusion 133References 134Chapter 10 Optimal Financial Contracts and Incentives under Moral Hazard 13510.1 Optimal Financial Contracts and Moral Hazard 13610.2 Theoretical Model 14010.3 Empirical Application to Air Accident Risk 14410.4 Conclusion 148References 148Appendix A: Synthesis of Forms of Financial Contracts 149Appendix B: Definitions of Variables 150Chapter 11 Venture Capital Risk with Optimal Financing Structure 15311.1 Some Statistics about Venture Capital 15411.2 Role of Venture Capital Firms 15511.3 Venture Capital Firms and Added Value 15611.4 Role of Convertible Debt 15611.5 Information Asymmetry and Venture Capital 15811.6 Conclusion 163References 164Chapter 12 Bank Credit Risk: Scoring of Individual Risks 16712.1 Theoretical Model 16912.2 Empirical Analysis 17112.3 Credit Line and Loan Default 18012.4 Conclusion 182References 182Chapter 13 Portfolio Management of Credit Risk 18513.1 CreditMetrics 18513.2 Review of Chapters 2 and 3 of CreditMetrics 18613.3 KMV Approach 19313.4 Calculation of Correlations 19613.5 Conclusion 202References 202Chapter 14 Quantification of Banks’ Operational Risk 20514.1 Context and Presentation of Operational Risk 20514.2 Measurement of Regulatory Capital 20814.3 Calculation of Regulatory Capital for Losses of over $1 Million (LDA) 21014.4 Conclusion 227References 228Chapter 15 Liquidity Risk 23115.1 Theoretical Modeling of CDSs 23215.2 Bond Yield Spread’s Default Portion 23315.3 Empirical Measurement of Yield Spreads’ Default Portion 23515.4 Non-Default Portion of Yield Spreads 23715.5 Illiquidity Index 24215.6 Illiquidity Premium 24415.7 Data 24415.8 Principal Component Analysis of Liquidity Risk 24515.9 Empirical Analysis of Credit Cycles 24615.10 Regime Detection Model 24815.11 Detection of Default and Liquidity Regimes 25015.12 Conclusion 251References 252Chapter 16 Long-Term Capital Management 25516.1 Brief History of the Fund 25616.2 Risk Management, VaR, and Required Capital 25816.3 Portfolio Optimization and Leverage Effect 26016.4 Conclusion 261References 262Chapter 17 Structured Finance and the Financial Crisis of 2007–2009 26317.1 Structured Finance 26317.2 Poor Risk Management Linked to the Structured Finance Market 26417.3 Conclusion 266References 268Appendix: How to Create an AAA CDO Tranche from BBB Loans 269Chapter 18 Risk Management and Corporate Governance 27118.1 Enron and Corporate Governance 27118.2 Financial Crisis and Corporate Governance 27318.3 New 2002 Governance Rules 27318.4 Risk Management and Governance 27418.5 Administrative Competence of Board Members 27618.6 New Regulation for Financial Institutions 27618.7 Economic Analysis of Governance Effect 27718.8 Conclusion 288References 288Appendix A: Governance of Canadian Federal Financial Institutions 290Appendix B: Details on the Construction of the Governance Indexes 291Appendix C: Variables 293Chapter 19 Risk Management and Industrial Organization 29519.1 Entry, Production, and Hedging 29519.2 Commitment to Hedging 29719.3 Conclusion 297References 299Chapter 20 Real Implications of Corporate Risk Management 30120.1 Real Implications of Corporate Risk Management: A Review 30220.2 Methodology 30320.3 US Oil Producers 30920.4 Multivariate Results 31620.5 Conclusion 324References 324Appendix: Estimated MTEs 326Chapter 21 Exercises 331Exercise 1 Portfolio Choice and the Notion of Value at Risk (VaR) 331Exercise 2 Backtesting of VaR Models 345Exercise 3 Calculation of VaR with Different Distributions and Accuracy of VaR 351Exercise 4 VaR for an Equity Portfolio with Options 359Exercise 5 CVaR Conditional Value at Risk 369Conclusion 376Reference 376Conclusion 377General References 378Index 379

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