Rethinking Valuation and Pricing Models - 1st Edition - ISBN: 9780124158757, 9780124158887

Rethinking Valuation and Pricing Models

1st Edition

Lessons Learned from the Crisis and Future Challenges

Editors: Carsten Wehn Christian Hoppe Greg Gregoriou
Hardcover ISBN: 9780124158757
eBook ISBN: 9780124158887
Imprint: Academic Press
Published Date: 8th November 2012
Page Count: 652
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It is widely acknowledged that many financial modelling techniques failed during the financial crisis, and in our post-crisis environment many techniques are being reconsidered.  This single volume provides a guide to lessons learned for practitioners and a reference for academics.  Including reviews of traditional approaches, real examples, and case studies, contributors consider portfolio theory; methods for valuing equities and equity derivatives, interest rate derivatives, and hybrid products; and techniques for calculating risks and implementing investment strategies.  Describing new approaches without losing sight of their classical antecedents, this collection of original articles presents a timely perspective on our post-crisis paradigm.

Key Features

  • Highlights pre-crisis best classical practices, identifies post-crisis key issues, and examines emerging approaches to solving those issues
  • Singles out key factors one must consider when valuing or calculating risks in the post-crisis environment
  • Presents material in a homogenous, practical, clear, and not overly technical manner


Addresses issues relevant for upper-division undergraduates, graduate students, and professionals worldwide working in asset management / trading / risk control of banks and insurance companies / consultancy firms  / auditing / regulation / applied mathematics and finance

Table of Contents

Editor’s Disclaimers




1. The Effectiveness of Option Pricing Models During Financial Crises

1.1 Introduction

1.2 Methodology

1.3 Data

1.4 Results

1.5 Concluding Remarks


2. Taking Collateral into Account

2.1 Introduction

2.2 Notations and Problem

2.3 Black–Scholes Partial Differential Equation in the Presence of Collateral

2.4 Collateral Discount Curve Bootstrapping

2.5 Pricing and Bootstrapping of the IR Vanilla Swap Term Structure

2.6 European Swaption Pricing Framework

2.7 Collateral Effect and Term-Structure Models

2.8 Conclusion


3. Scenario Analysis in Charge of Model Selection

3.1 Introduction to Model Risk

3.2 Classical Calibration Procedure

3.3 Processes, Dynamics and Model Definition

3.4 Importance of Risk Premia

3.5 Equity Volatility Modeling

3.6 Foreign Exchange Volatility Modeling

3.7 Conclusions



4. An “Economical” Pricing Model for Hybrid Products

4.1 Introduction

4.2 Pricing Convertible Bonds

4.3 Two-Factor Numerical Procedure

4.4 Default Risk

4.5 Pricing Convertible Bonds Subject to Interest Rate Risk and Default Risk

4.6 Conclusion



5. Credit Valuation Adjustments– Mathematical Foundations, Practical Implementation and Wrong Way Risks

5.1 Introduction

5.2 Mathematical Foundations of CVA

5.3 Practical Implementation: Issues and (Wrong Way) Risks

5.4 Model Risks in CVA Calculation

5.5 Summary and Prospects



6. Counterparty Credit Risk and Credit Valuation Adjustments (CVAs) for Interest Rate Derivatives–Current Challenges for CVA Desks

6.1 Introduction

6.2 Traditional Counterparty Risk Management Approaches

6.3 Modeling Credit Exposure and Pricing CCR

6.4 New Challenges and Reactions

6.5 Practical Problems

6.6 Conclusions and Lessons Learned


7. Designing a Counterparty Risk Management Infrastructure for Derivatives

7.1 Need for an Integrated Counterparty Risk Management

7.2 Building Blocks for an Adequate Infrastructure

7.3 General Computing Approach

7.4 Trade Assessment



8. A Jump–Diffusion Nominal Short Rate Model

8.1 Introduction

8.2 The Economy

8.3 Equilibrium Interest Rates and Monetary Policy

8.4 A Nominal Interest Rate Model

8.5 Conclusion

Appendix: Proof of Proposition 2



9. The Widening of the Basis: New Market Formulas for Swaps, Caps and Swaptions

9.1 Introduction

9.2 Assumptions on the Discount Curve

9.3 Fra Rates: Definition and Pricing

9.4 IRS Valuation

9.5 Pricing of Caplets and Swaptions

9.6 Conclusions


10. The Financial Crisis and the Credit Derivatives Pricing Models

10.1 Introduction

10.2 Brief Description of Credit Derivatives

10.3 CDO Pricing Models and the Financial Crisis

10.4 Conclusion: Risk Premia and Asset Pricing Models


11. Industry Valuation-Driven Earnings Management

11.1 Introduction

11.2 Literature Review and Hypotheses Development

11.3 Data and Variables

11.4 Empirical Tests and Results

11.5 Conclusion


12. Valuation of Young Growth Firms and Firms in Emerging Economies

12.1 Introduction

12.2 The Basic Problem

12.3 Data and Numerical Procedure

12.4 Results

12.5 Conclusion


13. Towards a Replicating Market Model for the US Oil and Gas Sector

13.1 Introduction

13.2 Model

13.3 Data

13.4 Preliminary Analysis and Results

13.5 Main Results

13.6 Conclusion


14. Measuring Systemic Risk from Country Fundamentals: A Data Mining Approach

14.1 Introduction

14.2 Financial Crises and Leading Indicators

14.3 Financial Crises and Risk Signals

14.4 Analysis and Results

14.5 Conclusions


15. Computing Reliable Default Probabilities in Turbulent Times

15.1 Introduction

15.2 Brief Review of the KMV-Merton Model

15.3 Brief Review of the ZPP Model

15.4 Empirical Analysis

15.5 Conclusion


16. Discount Rates, Default Risk and Asset Pricing in a Regime Change Model

16.1 Introduction

16.2 Proxy for Discount Rates from a Regime Change Model

16.3 Leveraging, Risk Premia and Asset Prices using Brownian Motions

16.4 Discount Rates, Risk Premia and Asset Prices in a Dynamic Model

16.5 Results of the Numerical Study

16.6 Conclusions


17. A Review of Market Risk Measures and Computation Techniques

17.1 Introduction

17.2 Market Risk, Portfolio Value and Returns

17.3 Market Risk Factors and Portfolio Value

17.4 Major Market Risk Measures and Their Computation Methods

17.5 Backtesting of Market Risk Computation Methods

17.6 Conclusion

Appendix: Stochastic Processes Used in Finance


18. High-Frequency Performance of Value at Risk and Expected Shortfall: Evidence from ISE30 Index Futures

18.1 Introduction

18.2 Literature

18.3 Market and Data

18.4 Methodology

18.5 Empirical Results

18.6 Conclusion



19. A Copula Approach to Dependence Structure in Petroleum Markets

19.1 Introduction

19.2 Empirical Methodology

19.3 Data and Results

19.4 Conclusion


20. Mistakes in the Market Approach to Correlation: A Lesson For Future Stress-Testing

20.1 Introduction

20.2 From Flat Correlation towards a Realistic Approach

20.3 Payoff Stress and the Liquidity Mistake

20.4 Testing with Historical Scenarios and the Concentration Mistake

20.5 Lessons for Future Stress-Testing



21. On Correlations between a Contract and Portfolio and Internal Capital Alliocation

21.1 Introduction

21.2 Adding a Deal to a Company Portfolio

21.3 Example: Correlated Power-Law Distributions

21.4 Formula for the Quantile Shift

21.5 Quantile Shift Under Secondary Uncertainty

21.6 Capital Allocation by Average Shortfall

21.7 Evolution of Quantiles in Portfolio Aggregation

21.8 Static and Dynamic Capital Allocation

21.9 Conclusion


22. A Maximum Entropy Approach to the Measurement of Event Risk

22.1 Introduction

22.2 Theory and Methods

22.3 Empirical Analysis

22.4 Conclusions


23. Quantifying the Unquantifiable: Risks Not in Value at Risk

23.1 Introduction and Motivation

23.2 Regulatory Developments and Requirements

23.3 Examples of Different Products and Risk Factors

23.4 Approaches to Quantifying Risks not in VaR

23.5 Treatment within the Internal Capital Adequacy Process

23.6 Conclusion and Outlook



24. Active Portfolio Construction When Risk and Alpha Factors are Misaligned

24.1 Introduction

24.2 Framework for Active Portfolio Construction

24.3 Misalignment of Risk and Alpha Models

24.4 Portfolio Optimization with Alpha Decomposition

24.5 Mitigation for Alpha and Risk Factor Misalignment

24.6 Case Studies

24.7 Conclusion


25. Market Volatility, Optimal Portfolios and Naive Asset Allocations

25.1 Introduction

25.2 Mean and Variance Forecasts

25.3 Investment Sets

25.4 Performance Evaluation

25.5 Results from the Full Sample-Analysis

25.6 Rolling Performance Evaluation and Market Volatility

25.7 Conclusions


26. Hedging Strategies with Variable Purchase Options

26.1 Introduction

26.2 Description of the Product

26.3 Pricing and Hedging Bounded VPOs

26.4 Conclusions



27. Asset Selection Using a Factor Model and Data Envelopment Analysis– A Quantile Regression Approach

27.1 Introduction

27.3 Data and Methodology

27.4 Discussion of Results

27.5 Conclusion


28. Tail Risk Reduction Strategies

28.1 Introduction

28.2 Data and Methodology

28.3 Empirical Results

28.4 Conclusion


29. Identification and Valuation Implications of Financial Market Spirals

29.1 Introduction

29.2 Literature Review

29.3 Data and Descriptive Statistics

29.4 Results

29.5 Conclusion


30. A Rating-Based Approach to Pricing Sovereign Credit Risk

30.1 Introduction

30.2 Literature Review and Methodology

30.3 Dataset

30.4 Transition Matrices Estimation

30.5 Asset Pricing

30.6 Conclusions



31. Optimal Portfolio Choice, Derivatives and Event Risk

31.1 Introduction

31.2 Model

31.3 Parameter Estimation

31.4 Optimal Portfolios

31.5 Conclusion


32. Valuation and Pricing Concepts in Accounting and Banking Regulation

32.1 Introduction

32.2 Accounting

32.3 Banking Regulation

32.4 Critical Assessment

32.5 Conclusion


33. Regulation, Regulatory Uncertainty and the Stock Market: The Case of Short Sale Bans

33.1 Introduction

33.2 Classical Models: Theoretical Models of Constraining Short Sales

33.3 Empirical Evidence Prior to the 2008 Financial Crisis

33.4 Empirical Evidence from and Since the Financial Crisis of 2008

33.5 Future Challenges


34. Quantitative Easing, Financial Risk and Portfolio Diversification

34.1 Introduction

34.2 Financial Markets and Macro-Finance Indicators Before and After 2006

34.3 Risk Aversion, Risk Premia and the Discounting Process

34.4 Concluding Remarks


35. Revisiting Interest Rate Pricing Models from an Indian Perspective: Lessons and Challenges

35.1 Introduction

35.2 Success and Lessons

35.3 Challenges

35.4 Conclusion


36. Investment Opportunities in Australia’s Healthcare Stock Markets After the Recent Global Financial Crisis

36.1 Introduction

36.2 Patterned Vecm Modeling and Causality Measurement

36.3 Data and Empirical Vecm Findings

36.4 Conclusion


37. Predicting ASX Health Care Stock Index Movements After the Recent Financial Crisis Using Patterned Neural Networks

37.1 Introduction

37.2 Construction of a Polynomial Neural Networks Using a Patterned VAR

37.3 Data and Empirical Sparse-Patterned VAR Findings

37.4 Conclusion




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About the Editor

Carsten Wehn

Head of the risk modelling team at DekaBank, Frankfurt, Germany. He is responsible for development and validation of internal portfolio models for measuring and managing credit risk.

Affiliations and Expertise

DeKaBank, Frankfurt, Germany

Christian Hoppe

Christian Hoppe is the Head of Credit Solutions at Commerzbank, Frankfurt, Germany, and the founder of Anleihen Finder GmbH.

Affiliations and Expertise

Commerzbank, Frankfurt, Germany

Greg Gregoriou

A native of Montreal, Professor Greg N. Gregoriou obtained his joint Ph.D. in finance at the University of Quebec at Montreal which merges the resources of Montreal's four major universities McGill, Concordia, UQAM and HEC. Professor Gregoriou is Professor of Finance at State University of New York (Plattsburgh) and has taught a variety of finance courses such as Alternative Investments, International Finance, Money and Capital Markets, Portfolio Management, and Corporate Finance. He has also lectured at the University of Vermont, Universidad de Navarra and at the University of Quebec at Montreal. Professor Gregoriou has published 50 books, 65 refereed publications in peer-reviewed journals and 24 book chapters since his arrival at SUNY Plattsburgh in August 2003. Professor Gregoriou's books have been published by McGraw-Hill, John Wiley & Sons, Elsevier-Butterworth/Heinemann, Taylor and Francis/CRC Press, Palgrave-MacMillan and Risk Books. Four of his books have been translated into Chinese and Russian. His academic articles have appeared in well-known peer-reviewed journals such as the Review of Asset Pricing Studies, Journal of Portfolio Management, Journal of Futures Markets, European Journal of Operational Research, Annals of Operations Research, Computers and Operations Research, etc. Professor Gregoriou is the derivatives editor and editorial board member for the Journal of Asset Management as well as editorial board member for the Journal of Wealth Management, the Journal of Risk Management in Financial Institutions, Market Integrity, IEB International Journal of Finance, and the Brazilian Business Review. Professor Gregoriou's interests focus on hedge funds, funds of funds, commodity trading advisors, managed futures, venture capital and private equity. He has also been quoted several times in the New York Times, Barron's, the Financial Times of London, Le Temps (Geneva), Les Echos (Paris) and L'Observateur de Monaco. He has done consulting work for numerous clients and investment firms in Montreal. He is a part-time lecturer in finance at McGill University, an advisory member of the Markets and Services Research Centre at Edith Cowan University in Joondalup (Australia), a senior advisor to the Ferrell Asset Management Group in Singapore and a research associate with the University of Quebec at Montreal's CDP Capital Chair in Portfolio Management. He is on the advisory board of the Research Center for Operations and Productivity Management at the University of Science and Technology (Management School) in Hefei, Anhui, China.

Affiliations and Expertise

School of Business and Economics, State University of New York, Plattsburgh, NY, USA


"This reference is for financial professionals and advanced students and scholars working in asset management trading and risk control of banks and insurance companies. It looks at tensions revealed by the financial crisis between classical, well-established models and emerging issues in valuation models, derivatives pricing, risk calculation, and managing portfolios."--Reference & Research Book News, December 2013
"This book shows in a comprehensive way the influences and impacts of past crises. After guiding the reader through several investment styles and asset classes, the editors can present a deep comparison of governmental regulation on the one side and markets' tendencies toward self-regulation on the other. Their analytics identify leading indicators of future crises. A must-read for every financial market participant."--Christoph D. Kauter, Trigon Equity Partners
"In both our personal and professional lives, crises stimulate serious soul searching. The Global Financial Crisis was bound to have this effect on financial risk management. Rethinking Valuation and Pricing Models: Lessons Learned from the Crisis represents a major contribution to the collective soul searching currently under way in the world of quantitative finance. Particular attention is paid to the need for improved treatment of "higher order risks" such as basis risk, counterparty default risk, the instability of implied correlations and the shifting credit quality inherent in many interest rate indices. Also addressed is the realization that some risks are different in kind from those reflected in daily fluctuations of prices and rates (essentially the difference between risk and uncertainty in the Frank Knight sense). While not a volume for the quantitatively faint of heart, this book represents a significant contribution to the continuing reassessment of what we know about risk and how to quantify it."--David M. Rowe, David M. Rowe Risk Advisory