Chapter 1

A Risk Management Synthesis

Market Risk, Credit Risk, Liquidity Risk, and Asset and Liability Management

The field of risk management has undergone an enormous change in the past 40 years and the pace of change is accelerating, thanks in part to the lessons learned during the credit crisis that began in late 2006.

It hasn’t always been this way in the risk management field, as Frederick Macaulay must have realized nearly 40 years after introducing the concept of duration in 1938. The oldest of the three authors entered the banking industry in the aftermath of what seemed at the time to be a major interest rate crisis taking place in the United States in the years 1974 and 1975. Financial institutions were stunned at the heights to which interests rates could rise, and they began looking for ways to manage the risk. Savings and loan associations, whose primary asset class was the 30-year fixed rate mortgage, hurriedly began to offer floating-rate mortgages for the first time. In the midst of this panic, where did risk managers turn? To the concept of mark to market and hedging using Macaulay duration? (We discuss these in Chapters 3 to 13.) Unfortunately, for many of the institutions involved, the answer was no.

During this era in the United States, a mark-to-market approach came naturally to members of the management team who rose through the ranks on the trading floor. In this era, however, and even today, chief executive officers who passed through the trading floor ...

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