Advanced Financial Risk Management E-Book

Donald R. Van Deventer

• Herausgeber: John Wiley & Sons
• Kategorie: Fachliteratur
• Serie: Wiley Finance Editions
• Sprache: Englisch

Seitenzahl: 1239

Veröffentlichungsjahr: 2013

Beschreibung

Practical tools and advice for managing financial risk, updated for a post-crisis world Advanced Financial Risk Management bridges the gap between the idealized assumptions used for risk valuation and the realities that must be reflected in management actions. It explains, in detailed yet easy-to-understand terms, the analytics of these issues from A to Z, and lays out a comprehensive strategy for risk management measurement, objectives, and hedging techniques that apply to all types of institutions. Written by experienced risk managers, the book covers everything from the basics of present value, forward rates, and interest rate compounding to the wide variety of alternative term structure models. Revised and updated with lessons from the 2007-2010 financial crisis, Advanced Financial Risk Management outlines a framework for fully integrated risk management. Credit risk, market risk, asset and liability management, and performance measurement have historically been thought of as separate disciplines, but recent developments in financial theory and computer science now allow these views of risk to be analyzed on a more integrated basis. The book presents a performance measurement approach that goes far beyond traditional capital allocation techniques to measure risk-adjusted shareholder value creation, and supplements this strategic view of integrated risk with step-by-step tools and techniques for constructing a risk management system that achieves these objectives. * Practical tools for managing risk in the financial world * Updated to include the most recent events that have influenced risk management * Topics covered include the basics of present value, forward rates, and interest rate compounding; American vs. European fixed income options; default probability models; prepayment models; mortality models; and alternatives to the Vasicek model Comprehensive and in-depth, Advanced Financial Risk Management is an essential resource for anyone working in the financial field.

Leseprobe

Contents

Introduction: Wall Street Lessons from Bubbles

Part One: Risk Management: Definitions and Objectives

Chapter 1: A Risk Management Synthesis

Risk Management: Definitions and Objectives

Advances in Integrated Risk Management and Institutional Barriers to Progress

Measuring the Trade-Offs between Risk and Return

When Bad Things Happen to Good People

U.S. Savings and Loan Crisis

Long-Term Capital Management

The 2006–2011 Credit Crisis

A Thousand Cuts

Notes

Chapter 2: Risk, Return, Performance Measurement, and Capital Regulation

Practical Quantification of Risk

Perils and Pitfalls in the Measurement of Risk: The Impact of Selection Bias

Biases in Return vs. a Relative Benchmark

Historical Value at Risk: Selection Bias Again

Monte Carlo–Based Value at Risk

Expected Losses on Tranches of Collateralized Debt Obligations

Measuring Return: Market vs. Accounting Returns

Introduction to Transfer Pricing: Extracting Interest Rate Risk in a Financial Accounting Context

Performance Measurement and Capital Regulation

Perspectives on Measuring Risk: One Source of Risk or Many Sources of Risk?

Interest Rate Risk Management Evolution

Equity Risk Management Evolution

Option Risk Management Evolution

Credit Risk Management Evolution

Managing Risk and Strategy, Business by Business

Risk and Strategy Management in a Complex Financial Institution

What Causes Financial Institutions to Fail?

The Role of Capital in Risk Management and Business Strategy

Capital-Based Risk Management in Banking Today: Pros and Cons

History of Capital-Based Regulations in Commercial Banking

Notes

Part Two: Risk Management Techniques for Interest Rate Analytics

Chapter 3: Interest Rate Risk Introduction and Overview

Background Information on Movements in the U.S. Treasury Yield Curve

A Step-by-Step Approach to Analyzing Interest Rate Risk

The Interest Rate Risk Safety Zone

Notes

Chapter 4: Fixed Income Mathematics

Modern Implications of Present Value

Price, Accrued Interest, and Value

Calculation of Accrued Interest

Present Value

The Basic Present Value Calculation

Calculating the Value of a Fixed Coupon Bond with Principal Paid at Maturity

Calculating the Coupon of a Fixed Coupon Bond with Principal Paid at Maturity When the Value Is Known

The Value of an Amortizing Loan

Calculating the Payment Amount of an Amortizing Bond When the Value Is Known

Calculating the Value of a Floating-Rate Bond or Loan with Principal Paid at Maturity

Compound Interest Conventions and Formulas

Compounding Formulas and Present Value Factors P(t)

Yields and Yield-to-Maturity Calculations

The Formula for Yield to Maturity

Yield to Maturity for Long or Short First Coupon Payment Periods

Calculating Forward Interest Rates and Bond Prices

Implied Forward Interest Rates on Zero-Coupon Bonds

Implied Forward Zero-Coupon Bond Prices

Present Value of Forward Fixed Coupon Bond

Implied Forward Price on a Fixed Coupon Bond

Implied Forward Coupon on a Fixed Coupon Bond

Other Forward Calculations

Summary

Notes

Chapter 5: Yield Curve Smoothing

Example A: Stepwise Constant Yields and Forwards vs. Nelson-Siegel

Deriving the Form of the Yield Curve Implied by Example A

Fitting the Nelson-Siegel Approach to Sample Data

Example D: Quadratic Yield Splines and Related Forward Rates

Deriving the Form of the Yield Curve Implied by Example D

Example F: Cubic Yield Splines and Related Forwards

Deriving the Form of the Yield Curve Implied by Example F Assumptions

Example H: Maximum Smoothness Forward Rates and Related Yields

Deriving the Parameters of the Quartic Forward Rate Curves Implied by Example H Assumptions

Comparing Yield Curve and Forward Rate Smoothing Techniques

Trading Off Smoothness vs. the Length of the Forward Rate Curve

The Shimko Test for Measuring Accuracy of Smoothing Techniques

Smoothing Yield Curves Using Coupon-Bearing Bond Prices as Inputs

Appendix: Proof of the Maximum Smoothness Forward Rate Theorem

Notes

Chapter 6: Introduction to Heath, Jarrow, and Morton Interest Rate Modeling

Objectives of the Example and Key Input Data

Key Implications and Notation of the HJM Approach

Pseudo-Probabilities

The Formula for Zero-Coupon Bond Price Shifts

Building the Bushy Tree for Zero-Coupon Bonds Maturing at Time T = 2

Building the Bushy Tree for Zero-Coupon Bonds Maturing at Time T = 4

Valuation in the HJM Framework

Valuation of a Zero-Coupon Bond Maturing at Time T = 4

Valuation of a Coupon-Bearing Bond Paying Annual Interest

Valuation of a Digital Option on the One-Year U.S. Treasury Rate

Conclusion

Chapter 7: HJM Interest Rate Modeling with Rate and Maturity-Dependent Volatility

Objectives of the Example and Key Input Data

Key Implications and Notation of the HJM Approach

Pseudo-Probabilities

The Formula for Zero-Coupon Bond Price Shifts

Building the Bushy Tree for Zero-Coupon Bonds Maturing at Time T = 2

Building the Bushy Tree for Zero-Coupon Bonds Maturing at Time T = 4

Valuation in the HJM Framework

Valuation of a Zero-Coupon Bond Maturing at Time T = 4

Valuation of a Coupon-Bearing Bond Paying Annual Interest

Valuation of a Digital Option on the One-Year U.S. Treasury Rate

Conclusion

Chapter 8: HJM Interest Rate Modeling with Two Risk Factors

Probability of Yield Curve Twists in the U.S. Treasury Market

Objectives of the Example and Key Input Data

Introducing a Second Risk Factor Driving Interest Rates

Key Implications and Notation of the HJM Approach

Pseudo-Probabilities

Valuation in the HJM Framework

Valuation of a Zero-Coupon Bond Maturing at Time T = 4

Valuation of a Coupon-Bearing Bond Paying Annual Interest

Valuation of a Digital Option on the One-Year U.S. Treasury Rate

Replication of HJM Example 3 in Common Spreadsheet Software

Conclusion

Chapter 9: HJM Interest Rate Modeling with Three Risk Factors

Probability of Yield Curve Twists in the U.S. Treasury Market

Objectives of the Example and Key Input Data

Risk Factor 1: Annual Changes in the One-Year U.S. Treasury Spot Rate

Alternative Specifications of the Interest Rate Volatility Surface

Key Implications and Notation of the HJM Approach

Pseudo-Probabilities

Valuation in the HJM Framework

Valuation of a Zero-Coupon Bond Maturing at Time T = 4

Valuation of a Coupon-Bearing Bond Paying Annual Interest

Valuation of a Digital Option on the One-Year U.S. Treasury Rate

Conclusion

Note

Chapter 10: Valuation, Liquidity, and Net Income

How Many Risk Factors are Necessary to Accurately Model Movements in the Risk-Free Yield Curve?

Revisiting the Phrase “No Arbitrage”

Valuation, Liquidity Risk, and Net Income

Risk-Neutral and Empirical Probabilities of Interest Rate Movements

Monte Carlo Simulation Using HJM Modeling

Common Pitfalls in Interest Rate Risk Management

Summarizing the Problems with Interpolated Monte Carlo Simulation for Risk Analysis

Notes

Chapter 11: Interest Rate Mismatching and Hedging

Political Factions in Interest Rate Risk Management

Making a Decision on Interest Rate Risk and Return: The Safety Zone

Obvious Interest Rate Risk Decisions

Assessing the Risk and Return Trade-Offs from a Change in Interest Rate Risk

Chapter 12: Legacy Approaches to Interest Rate Risk Management

Gap Analysis and Simulation Models

Measuring Interest Rate Risk: A Review

Legacy Rate Risk Tools: Interest Rate Sensitivity Gap Analysis

The Safety Zone

What’s Wrong with Gap Analysis?

Legacy Rate Risk Tools: Multiperiod Simulation

Modeling the Maturity Structure of a Class of Assets

Macaulay’s Duration: The Original Formula

Using Duration for Hedging

Comparing a Duration Hedge with Hedging in the HJM Framework

Duration: The Traditional Market Convention

The Perfect Duration Hedge: The Difference between the Original Macaulay and Conventional Durations

Convexity and Its Uses

Conclusion

Note

Chapter 13: Special Cases of Heath, Jarrow, and Morton Interest Rate Modeling

What is an Academic Term Structure Model and Why Was It Developed?

The Vocabulary of Term Structure Models

Ito’s Lemma

Ito’s Lemma for More Than One Random Variable

Using Ito’s Lemma to Build a Term Structure Model

Duration as a Term Structure Model

Conclusions about the Use of Duration’s Parallel Shift Assumptions

The Vasicek and Extended Vasicek Models

The Merton Term Structure Model: Parallel Yield Curve Shifts

The Extended Merton Model

The Vasicek Model

The Extended Vasicek–Hull and White Model

Alternative Term Structure Models

Reprising the HJM Approach

Appendix A: Deriving Zero-Coupon Bond Prices in the Extended Merton/Ho and Lee Model

Appendix B: Deriving Zero-Coupon Bond Prices in the Vasicek Model

Appendix C: Valuing Zero-Coupon Bonds in the Extended Vasicek Model

Notes

Chapter 14: Estimating the Parameters of Interest Rate Models

Revisiting the Meaning of No Arbitrage

A Framework for Fitting Term Structure Models

Fitting Zero-Coupon Bond Prices and Volatility Parameters Jointly

Steps in Fitting the Interest Rate Volatility Assumptions

Interest Rate Parameter Fitting in Practical Application

Note

Part Three: Risk Management Techniques for Credit Risk Analytics

Chapter 15: An Introduction to Credit Risk

Market Prices for Credit Risk

Critical Sources of Market Data on Credit Risk

Increased Accuracy in Pricing

Increased Clarity in Corporate Strategy

Increased Sophistication in Risk Management

Increased Precision in Measuring the Safety and Soundness of Financial Institutions

Credit Default Swaps: The Dangers of Market Manipulation

Daily Nondealer Trading Volume for 1,090 Reference Names

Credit Default Swap Trading Volume in Municipals and Sub-Sovereigns

Credit Default Swap Trading Volume in Sovereign Credits

Implications of CDS Trading Volume Data

Notes

Chapter 16: Reduced Form Credit Models and Credit Model Testing

The Jarrow-Turnbull Model

The Jarrow Model

Zero-Coupon Bond Prices in the Jarrow Model

Fitting the Jarrow Model to Bond Prices, Credit Derivatives Prices, and Historical Default Databases

Correlations in Default Probabilities

The Jarrow and Jarrow-Turnbull Models: A Summary

Tests of Credit Models Using Historical Data

An Introduction to Credit Model Testing

Misunderstandings about Credit Model Testing

The Two Components of Credit Model Performance

The Predictive Capability of the Jarrow-Chava Reduced Form Model Default Probabilities

Reduced Form Model vs. Merton Model Performance

Consistency of Estimated and Actual Defaults

Recent Results from North America

The Falkenstein and Boral Test

Performance of Credit Models vs. Naïve Models of Risk

Testing Credit Models: The Analogy with Interest Rates

Appendix: Converting Default Intensities to Discrete Default Probabilities

Notes

Chapter 17: Credit Spread Fitting and Modeling

Introduction to Credit Spread Smoothing

The Market Convention for Credit Spreads

A Better Convention for Credit Model–Independent Credit Spreads

Credit Spread Smoothing Using Yield Curve–Smoothing Techniques

Fitting Credit Spreads with Cubic Splines

Maximum Smoothness Forward Credit Spreads

Comparing Results

Data Problems with Risky Issuers

Determinants of Credit Spread Levels

The Credit Risk Premium: The Supply and Demand for Credit

Conclusion

Notes

Chapter 18: Legacy Approaches to Credit Risk

The Rise and Fall of Legacy Ratings

Ratings: What They Do and Don’t Do

Through the Cycle vs. Point in Time, a Distinction without a Difference

Stress Testing, Legacy Ratings, and Transition Matrices

Transition Matrices: Analyzing the Random Changes in Ratings from One Level to Another

Moral Hazard in “Self-Assessment” of Ratings Accuracy by Legacy Rating Agencies

Comparing the Accuracy of Ratings and Reduced Form Default Probabilities

Problems with Legacy Ratings in the 2006 to 2011 Credit Crisis

The Jarrow-Merton Put Option and Legacy Ratings

The Merton Model of Risky Debt

The Intuition of the Merton Model

The Basic Merton Model

Valuing Multipayment Bonds with the Merton Model of Risky Debt

Estimating the Probability of Default in the Merton Model

Implying the Value of Company Assets and Their Return Volatility σ

Mapping the Theoretical Merton Default Probabilities to Actual Defaults

The Merton Model When Interest Rates are Random

The Merton Model with Early Default

Loss Given Default in the Merton Model

Copulas and Correlation between the Events of Default of Two Companies

Problems with the Merton Model: Summing Up

Appendix

Notes

Chapter 19: Valuing Credit Risky Bonds

The Present Value Formula

Valuing Bonds with No Credit Risk

Simulating the Future Values of Bonds with No Credit Risk

Current and Future Values of Fixed Income Instruments: HJM Background and a Straight Bond Example

Valuation of a Straight Bond with a Bullet Principal Payment at Maturity

Valuing an Amortizing Loan

Valuing Risk-Free, Floating-Rate Loans

Valuing Bonds with Credit Risk

Simulating the Future Values of Bonds with Credit Risk

Valuing the Jarrow-Merton Put Option

Chapter 20: Credit Derivatives and Collateralized Debt Obligations

Credit Default Swaps: Theory

Credit Default Swaps: Practice

Collateralized Debt Obligations: Theory

Collateralized Debt Obligations: A Worked Example of Reduced Form Simulation

Collateralized Debt Obligations: Practice

The Copula Method of CDO Valuation: A Postmortem

Valuing the Jarrow–Merton Put Option

Notes

Part Four: Risk Management Applications: Instrument by Instrument

Chapter 21: European Options on Bonds

Example: European Call Option on Coupon-Bearing Bond

Example: Coupon-Bearing Bond with Embedded European Call Option

European Options on Defaultable Bonds

HJM Special Case: European Options in the One-Factor Vasicek Model

Options on Coupon-Bearing Bonds

The Jarrow-Merton Put Option

Chapter 22: Forward and Futures Contracts

Forward Contracts on Zero-Coupon Bonds

Eurodollar Futures-Type Forward Contracts

Futures on Zero-Coupon Bonds: The Sydney Futures Exchange Bank Bill Contract

Futures on Coupon-Bearing Bonds: Dealing with the Cheapest to Deliver Option

Eurodollar and Euroyen Futures Contracts

Defaultable Forward and Futures Contracts

Note

Chapter 23: European Options on Forward and Futures Contracts

Valuing Options on Forwards and Futures: Notations and Useful Formulas

European Options on Forward Contracts on Zero-Coupon Bonds

European Options on Forward Rate Agreements

European Options on a Eurodollar Futures-Type Forward Contract

Defaultable Options on Forward and Futures Contracts

Note

Chapter 24: Caps and Floors

Caps as European Options on Forward Rate Agreements

Forming Other Cap-Related Securities

Value of a Loan with a Cap and a Floor

Measuring the Credit Risk of Counterparties on Caps and Floors

Note

Chapter 25: Interest Rate Swaps and Swaptions

Interest Rate Swap Basics

Valuing the Interest Rate Swaps

The Observable Fixed Rate in the Swap Market

An Introduction to Swaptions

Notes

Chapter 26: Exotic Swap and Options Structures

Arrears Swaps

Digital Option

Digital Range Notes

Range Floater

Other Derivative Securities

Credit Risk and Exotic Derivatives Structures

Chapter 27: American Fixed Income Options

An Overview of Numerical Techniques for Fixed Income Option Valuation

An Example of Valuation of a Callable Bond with a Three-Factor HJM Bushy Tree

What is the Par Coupon on a Callable Bond?

An Example of Valuation of a Rationally Prepaid Amortizing Loan

Finite Difference Methods

Binomial Lattices

Trinomial Lattices

HJM Valuation of American Fixed Income Options When Default Risk is Present

Notes

Chapter 28: Irrational Exercise of Fixed Income Options

Analysis of Irrationality: Criteria for a Powerful Explanation

The Transactions Cost Approach

Irrational Exercise of European Options

The Irrational Exercise of American Options

Implied Irrationality and Hedging

Credit Risk and Irrational Prepayment Behavior

Chapter 29: Mortgage-Backed Securities and Asset-Backed Securities

Transactions Costs, Prepayments, Default, and Multinomial Logit

Legacy Prepayment Analysis of Mortgage-Backed Securities

Legacy Approaches: Option-Adjusted Spread

Implications for OAV Spread, CMOs, and ARMs

Logistic Regression, Credit Risk, and Prepayment

Mortgage-Servicing Rights: The Ultimate Structured Product

An Introduction to the Valuation of Mortgage-Servicing Rights

Comparing Best Practice and Common Practice in Valuing and Hedging Mortgage-Servicing Rights

Conclusion

Notes

Chapter 30: Nonmaturity Deposits

The Value of the Deposit Franchise

Total Cash Flow of Nonmaturity Deposits

Specifying the Rate and Balance Movement Formulas

The Impact of Bank Credit Risk on Deposit Rates and Balances

Case Study: German Three-Month Notice Savings Deposits

The Regulators’ View

Conclusion

Notes

Chapter 31: Foreign Exchange Markets

Setting the Stage: Assumptions for the Domestic and Foreign Economies

Foreign Exchange Forwards

Numerical Methods for Valuation of Foreign Currency Derivatives

Legacy Approaches to Foreign Exchange Options Valuation

Implications of a Term Structure Model-Based FX Options Formula

The Impact of Credit Risk on Foreign Exchange Risk Formulas

Notes

Chapter 32: Impact of Collateral on Valuation Models

The Impact of Changing Home Prices on Collateral Values in the Credit Crisis

Modeling Variations in Collateral Values

The Impact of Collateral Values on a Rationally Prepaid Mortgage

Conclusions about the Impact of Collateral Values

Chapter 33: Pricing and Valuing Revolving Credit and Other Facilities

Analyzing Revolving Credit and Other Facilities

Fluctuating Credit Risk and Revolving Credit Drawdowns

Incorporating Links between Credit Quality and Line Usage

Is a Line of Credit a Put Option on the Debt of the Issuer?

Chapter 34: Modeling Common Stock and Convertible Bonds on a Default-Adjusted Basis

Modeling Equities: The Traditional Fund Management Approach

Modeling Equities: The Derivatives Approach

Modeling Equities: A Credit Risk–Adjusted Approach

Options on the Common Stock of a Company That Can Go Bankrupt

Convertible Bonds of a Company That Can Go Bankrupt

Note

Chapter 35: Valuing Insurance Policies and Pension Obligations

Life Insurance: Mortality Rates vs. Default Probabilities

Pension Obligations

Property and Casualty Insurance

The Jarrow-Merton Put Option

Notes

Part Five: Portfolio Strategy and Risk Management

Chapter 36: Value-at-Risk and Risk Management Objectives Revisited at the Portfolio and Company Level

The Jarrow-Merton Put Option as a Measure of Total Risk: An Example

A Four-Question Pass–Fail Test for Financial Institutions’ CEOs and Boards of Directors

Is Your Value-at-Risk from Value-at-Risk?

VaR vs. the Put Option for Capital Allocation

Why Are the VaR and Put Approaches So Different: Self-Insurance vs. Third-Party Insurance

Calculating the Jarrow-Merton Put Option Value and Answering the Key 4 + 26 Questions

Valuing and Simulating the Jarrow-Merton Put Option

What’s the Hedge?

Liquidity, Performance, Capital Allocation, and Own Default Risk

Note

Chapter 37: Liquidity Analysis and Management

Liquidity Risk Case Studies from the Credit Crisis

Case Studies in Liquidity Risk

Implications of the Credit Crisis History for Liquidity Risk Management and Analysis

Determining the Optimal Liquidity Strategy

Summing Up

Notes

Chapter 38: Performance Measurement

Transaction-Level Performance Measurement vs. Portfolio-Level Performance Measurement

Plus Alpha Benchmark Performance vs. Transfer Pricing

Why Default Risk Is Critical in Performance Measurement of Equity Portfolios

“Plus Alpha” Performance Measurement in Insurance and Banking

Decomposing the Reasons for Plus or Minus Alpha in a Fixed Income Portfolio

A Worked Example of Modern Fixed Income Performance Attribution

The Jarrow-Merton Put Option and Capital

Using the Jarrow-Merton Put Option for Capital Allocation

Summing Up

Notes

Chapter 39: Managing Institutional Default Risk and Safety and Soundness

Step 1: Admitting the Possibility of Failure

Managing the Probability of Failure

Controlling the Probability of Failure through the Credit Cycle

Hedging Total Risk to Maximize Shareholder Value

Implications for Basel II, Basel III, and Solvency II

Simulating Your Own Probability of Default

Note

Chapter 40: Information Technology Considerations

Common Practice in Risk Management Systems: Dealing with Legacy Systems

Upgrading the Risk Infrastructure: The Request for Proposal Process

Paid Pilots as Final Proof of Concept

Keys to Success in Software Installation

Vendor Size: Larger Vendor or Small Vendor?

Being a Best Practice User

Chapter 41: Shareholder Value Creation and Destruction

Do No Harm

Measure the Need to Change

Rating Your Primary Risk System

Master the Politics and Exposition of Risk Management: Shareholder Value Creation

Daily Management Reporting of Total Risk

Moving from Common Practice to Best Practice

The Senior Management Perspective

The Middle Management Perspective

The Working-Level Perspective

Getting Help to Create Shareholder Value

Postscript

Notes

Bibliography

Index

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D. v. D.

Introduction: Wall Street Lessons from Bubbles

The credit crisis that began to unfold in the United States and Europe in 2006 contains a treasure trove of lessons for risk managers that we have tried to incorporate into this book. Since we have each worked in Japan, we felt strongly that the collapse of the Japanese bubble, which peaked in late 1989, contained equally useful lessons for risk managers. As you’ll note in the “key fallacies in risk management” discussed below, many ignored the lessons of the Japanese bubble because of the common fallacy that “if it hasn’t happened to me yet, it won’t happen to me, even if it’s happened to someone else.”

Now that the United States and much of Europe are experiencing the collapse of a bubble much like that which burst in Japan, the lessons from each of these bubbles seem much more relevant to risk managers around the world.

We have worked hard in the second edition of this book to severely de-emphasize the discussion of financial models that are obviously inaccurate, misleading, or clearly inferior to another modeling approach. We make this judgment on the basis of cold hard facts (via model testing) or because of assumptions that are known to be false. The list of models that failed under the duress of the credit crisis is a long one, and we make no apologies for reflecting those failures in this book. We’ve also worked hard to explain which models performed well during the credit crisis. Again, we base that judgment on model testing and the logical consistency and accuracy of the assumptions behind those models.

We believe in a “multiple models approach” to risk management. That doesn’t mean, however, that all models used are equally accurate. Nothing could be further from the truth. The use of a multiple models approach, however, makes it clear when a better model has been brought to the risk management discipline and when it’s time for an older model to be removed from the toolkit. One of our British friends provided the elegant observation that “I don’t think it’s gentlemanly to compare the accuracy of two models.” The authors, by contrast, believe that such comparisons are a mandatory part of corporate governance and best practice risk management.

With that brief introduction, we turn to a short summary of common fallacies in risk management that have been exposed as fallacies very starkly in the wake of the recent credit crisis.

KEY FALLACIES IN RISK MANAGEMENT

Summarizing the dangerous elements of conventional wisdom in risk management isn’t easy. We’ve restricted ourselves to the seven most dangerous ways of thinking about risk. Each of them has much in common with this famous quote of John Maynard Keynes from “The Consequences to the Banks of the Collapse of Money Values” in 1931: “A sound banker, alas, is not one who foresees danger and avoids it, but one who, when he is ruined, is ruined in a conventional way along with his fellows, so that no one can really blame him.” We summarize them here and discuss each briefly in turn: