Foreword xv Preface xix 1 Introduction 1 Part I Overview of Finance, Macroeconomics, and Risk Concepts 7 2 An Overview of Macroeconomics, and Why the Theory of Asset Pricing and Contingent Claims Should Shape its Future 9 2.1 An overview of macroeconomics 10 2.2 How uncertainty is incorporated into macroeconomic models 13 2.3 Missing components in macro models: balance sheets with risk, default, and (nonlinear) risk exposures 15 2.4 Asset-pricing theory, financial derivatives pricing, and contingent claims analysis 17 2.5 Autoregression in economics vs. random walks in finance 19 2.6 Asset price process related to a threshold or barrier 21 2.

7 Relating finance models and risk analytics to macroeconomic models 23 2.8 Toward macrofinancial engineering 24 2.9 Summary 25 References 26 3 Macroeconomic Models 29 3.1 The Hicks-Hansen IS-LM model of a closed economy 29 3.2 The Mundell-Fleming model of an open economy 33 3.3 A dynamic, stochastic, five-equation, small open economy macro model 38 3.4 Summary 42 References 42 4 Stochastic Processes, Asset Pricing, and Option Pricing 43 4.1 Stochastic processes 43 4.

2 Itô''s lemma 46 4.3 Asset pricing: Arrow-Debreu securities and the replicating portfolio 47 4.4 Put and call option values 48 4.5 Pricing the options using the Black-Scholes-Merton formula 50 4.6 Market price of risk 52 4.7 Implications of incomplete markets for pricing 54 4.8 Summary 55 Appendix 4A Primer on relationship of put, call, and exchange options 55 Appendix 4B Physics, Feynman, and finance 57 References 57 5 Balance Sheets, Implicit Options, and Contingent Claims Analysis 59 5.1 Uncertain assets and probability of distress or default on debt 59 5.

2 Probability of distress or default 60 5.3 Debt and equity as contingent claims 61 5.4 Payoff diagrams for contingent claims 62 5.5 Understanding why an implicit put option equals expected loss 63 5.6 Using the Merton model and Black-Scholes-Merton formula to value contingent claims 64 5.7 Measuring asset values and volatilities 68 5.8 Estimating implied asset value and asset volatility from equity or junior claims 68 5.9 Risk measures 71 5.

10 Summary 72 References 72 6 Further Extensions and Applications of Contingent Claims Analysis 73 6.1 Extensions of the Merton model 73 6.2 Applications of CCA with different types of distress barriers and liability structures 74 6.3 Risk-adjusted and actual probabilities using the market price of risk, Sharpe ratios, and recovery rates 78 6.4 Moody''s-KMV approach 80 6.5 CCA using skewed asset distributions modeled with a mixture of lognormals 81 6.6 Maximum likelihood methods 84 6.7 Incorporating stochastic interest rates and interest rate term structures into structural CCA balance sheet models 85 6.

8 Other structural models with stochastic interest rates 86 6.9 Summary 87 Appendix 6A Calculating parameters in the Vasicek model 87 References 88 Part II the Macrofinance Modeling Framework 91 7 The Macrofinance Modeling Framework: Interlinked Sector Balance Sheets 93 7.1 Contingent claim balance sheets for sectors 93 7.2 Measuring asset values and volatilities 98 7.3 Measuring risk exposures 100 7.4 Linkages in a simple four-sector framework 100 7.5 Integrated value and risk transmission between sectors 101 7.6 Policy effectiveness parameters in implicit options 105 7.

7 Advantages of an integrated balance sheet risk approach 106 7.8 Summary 106 References 107 8 The Macrofinance Modeling Framework: A Closer Look at the Sovereign CCA Balance Sheet 109 8.1 CCA balance sheet for the government and monetary authorities 109 8.2 Sovereign distress 111 8.3 Calculating implied sovereign assets and implied sovereign asset volatility using CCA for the public sector balance sheet 111 8.4 Applications of the macrofinancial risk framework to sovereigns 115 8.5 Sovereign risk-neutral and estimated actual default probabilities on foreign-currency-denominated debt 117 8.6 Spreads on sovereign foreign currency and local currency debt 118 8.

7 Breaking down sovereign assets into key components 122 8.8 Risk-based scenario and policy analysis using calibrated sovereign CCA related to spreads on foreign currency debt 123 8.9 Short-term and long-term government CCA balance sheets with monetary authority 124 8.10 Summary 126 Appendix 8A Value and volatility of local currency liabilities and base money 126 References 127 9 The Macrofinance Modeling Framework: Linking Interest Rate Models in Finance and Macroeconomics 129 9.1 Overview of interest rate term structure models in finance 129 9.2 Two early theories: liquidity preference and the market for loanable funds 131 9.3 Monetary policy, Taylor rules, and interest rates 131 9.4 Reconciling different perspectives on interest rate behavior 133 9.

5 What to do when the monetary authority is linked closely to the government balance sheet 135 9.6 Summary 136 References 137 10 Macrofinance Modeling Framework: Financial Sector Risk and Stability Analysis 139 10.1 Calculating risk indicators for individual banks or financial institutions 139 10.2 Time series of financial system risk indicators 140 10.3 Snapshot of system risk 145 10.4 Expected loss as a portfolio of implicit put options 146 10.5 Using a structural Merton model with stochastic interest rates for capital adequacy estimates 149 10.6 Factor model to assess key drivers of system risk and for scenario analysis 150 10.

7 Multifactor risk analysis using copulas 152 10.8 Household balance sheet risk 152 10.9 Linking banking sector loans to corporate, household, and other borrowers 153 10.10 Foreign-currency-denominated loans and the impact of the presence of foreign banks on banking system risk 154 10.11 CCA models, financial stability indicators and links to macro models 155 10.12 Summary 159 Appendix 10A CCA model for banks and borrowers with foreign-currency-denominated debt and lending spreads based on credit risk 160 References 161 11 Macrofinancial Modeling Framework: Extensions to Different Exchange Rate Regimes 163 11.1 Floating exchange rate regimes, interest rates, and the sovereign balance sheet 163 11.2 Fixed exchange rate regimes, interest rates and the sovereign balance sheet 167 11.

3 The impact of capital flows on the CCA sovereign balance sheet 172 11.4 Role of quasi-public entities in exchange rate management 173 11.5 Summary 174 References 174 Part III Linking Macrofinancial and Macroeconomic Frameworks 175 12 Sovereign Reserve, Debt, and Wealth Management from a Macrofinancial Risk Perspective 177 12.1 Reserves adequacy and asset allocation: moving from simple rules to a national framework 177 12.2 CCA for a firm with a subsidiary and its wealth management 179 12.3 Constructing contingent claim balance sheets for the national economy 180 12.4 Macro risk and wealth management 181 12.5 Summary 184 References 185 13 Macrofinancial Modeling Framework: Relationship to Accounting Balance Sheets and the Flow of Funds 187 13.

1 Economy-wide macro contingent claim balance sheets and risk exposures 187 13.2 Recovering traditional macroeconomic budget constraints and flow identities from CCA valuation equations when volatility is zero 191 13.3 Interlinkages between CCA balance sheets, flows, and risk premiums 195 13.4 Using the production function to link corporate and household assets 197 13.5 Macrofinance, macroeconomic flows, and the business cycle 198 13.6 Summary 199 Appendix 13A Cross-holding by households and financial sectors of contingent claims in other sectors 200 Appendix 13B Contingent claim values and returns of different sectors 201 References 202 14 Macrofinancial Risk Framework Linked to Macroeconomic Models 203 14.1 Adding risk analytics to the spectrum of macroeconomic models 203 14.2 The Mundell-Fleming model and default risk 204 14.

3 Linking macrofinance outputs to DSGE models 206 14.4 Linking macrofinance outputs to dynamic, stochastic macroeconomic policy models 208 14.5 Linking macrofinance outputs to macroeconometric VAR models 215 14.6 An integrated policy framework 216 14.7 Summary 217 References 217 Part IV Crisis and Distress in Economies 219 15 Macroeconomic Models vs. Crisis Models: Why Nonlinearity Matters 221 15.1 Recent financial crises and crisis models 222 15.2 Summary 229 References 229 16 Sensitivity Analysis, Destabilization Mechanisms, and Financial Crises 231 16.

1 Sensitivity analysis, the "Greeks", and the valuation multiplier effect 232 16.2 The volatility leverage effect 236 16.3 Feedback between the forward rate and domestic interest rates on local currency debt 237 16.4 Feedback between local currency debt issuance and local currency spreads in the presence of contingent liability constraints 241 16.5 Summary 244 References 245 17 The Case of Thailand, 1996-1999 247 17.1 Background 247 17.2 A macro.