Risk Management E-Book

• Herausgeber: John Wiley & Sons
• Kategorie: Fachliteratur
• Serie: CFA Institute Investment Perspectives
• Sprache: Englisch

Seitenzahl: 1621

Veröffentlichungsjahr: 2010

Beschreibung

Key readings in risk management from CFA Institute, the preeminent organization representing financial analysts Risk management may have been the single most important topic in finance over the past two decades. To appreciate its complexity, one must understand the art as well as the science behind it. Risk Management: Foundations for a Changing Financial World provides investment professionals with a solid framework for understanding the theory, philosophy, and development of the practice of risk management by * Outlining the evolution of risk management and how the discipline has adapted to address the future of managing risk * Covering the full range of risk management issues, including firm, portfolio, and credit risk management * Examining the various aspects of measuring risk and the practical aspects of managing risk * Including key writings from leading risk management practitioners and academics, such as Andrew Lo, Robert Merton, John Bogle, and Richard Bookstaber For financial analysts, money managers, and others in the finance industry, this book offers an in-depth understanding of the critical topics and issues in risk management that are most important to today's investment professionals.

Leseprobe

Table of Contents

Title Page

Copyright Page

Foreword

Acknowledgments

Introduction

PART I - OVERVIEW—TWO DECADES OF RISK MANAGEMENT

CHAPTER 1 - A FRAMEWORK FOR UNDERSTANDING MARKET CRISIS

SOURCES OF CRISIS

CASE STUDIES

LESSONS LEARNED

POLICY ISSUES

QUESTION AND ANSWER SESSION

CHAPTER 2 - PRACTICAL ISSUES IN CHOOSING AND APPLYING RISK MANAGEMENT TOOLS

EFFECTIVE RISK MANAGEMENT

DEFINING RISK

RISK MEASURES

BUY OR BUILD?

CONCLUSION

QUESTION AND ANSWER SESSION

NOTES

CHAPTER 3 - THE THREE P’S OF TOTAL RISK MANAGEMENT

THE THREE P’S

PRICES

PROBABILITIES

PREFERENCES

PUTTING THE THREE P’S TOGETHER

THE FUTURE OF RISK MANAGEMENT

ACKNOWLEDGMENTS

NOTES

REFERENCES

CHAPTER 4 - REPORTING AND MONITORING RISK EXPOSURE

THE RISK-MANAGEMENT SYSTEM

INCORPORATING RISK INTO THE INVESTMENT PROCESS

CONCLUSION

ACKNOWLEDGMENTS

QUESTION AND ANSWER SESSION

CHAPTER 5 - RISK MANAGEMENT: A REVIEW

FINANCIAL RISK OR FINANCIAL RISKS?

LESSONS FROM FINANCIAL DISASTERS

POPULAR RISK MEASURES FOR PRACTITIONERS

CREDIT RISK METHODOLOGIES

OPERATIONAL RISK

LIQUIDITY RISK

A NEW CLASSIFICATION OF RISK MEASURES

THE QUEST FOR AN INTEGRATED RISK MEASUREMENT

CONCLUSION

NOTES

REFERENCES

CHAPTER 6 - DEFINING RISK

FRANK KNIGHT

CRITIQUE OF KNIGHT’S DEFINITION

HARRY MARKOWITZ

UNCERTAINTY

EXPOSURE

RISK

OPERATIONAL DEFINITIONS

AN OPERATIONAL PERSPECTIVE ON RISK

CONCLUSION

NOTES

REFERENCES

CHAPTER 7 - VALUE AND RISK: BEYOND BETAS

RISK MANAGEMENT VS. RISK REDUCTION

RISK AND VALUE: CONVENTIONAL VIEW

EXPANDING THE ANALYSIS OF RISK

FINAL ASSESSMENT OF RISK MANAGEMENT

CONCLUSION

NOTE

CHAPTER 8 - A SIMPLE THEORY OF THE FINANCIAL CRISIS; OR, WHY FISCHER BLACK ...

THE FINANCIAL CRISIS: ONE POSSIBLE SCENARIO

HOW WERE ALL THESE SYSTEMATIC ERRORS POSSIBLE?

WHERE DID WE END UP?

REFERENCES

CHAPTER 9 - MANAGING FIRM RISK

ENHANCING RISK INTUITION THROUGH REAL-TIME PORTFOLIO MONITORING

BANK VERSUS FUND RISK MANAGEMENT: NOT THE SAME GAME

RISK REPORTING

RISK JUDGMENTS

CONCLUSION

QUESTION AND ANSWER SESSION

CHAPTER 10 - RISK MEASUREMENT VERSUS RISK MANAGEMENT

FROM DATA TO USEFUL INFORMATION

THE NEW INSTITUTIONAL INVESTOR

TRANSPARENCY AND RISK MEASUREMENT: THE NEW CONSTITUENCY

PROVIDING THE TOOLS

CONCLUSION

NOTE

PART II - MEASURING RISK

CHAPTER 11 - WHAT VOLATILITY TELLS US ABOUT DIVERSIFICATION AND RISK MANAGEMENT

DID DIVERSIFICATION FAIL?

DID RISK MODELS FAIL?

SHOULD THE MAGNITUDE OF RISK HAVE BEEN A SURPRISE?

WERE INVESTORS TOO EXPOSED TO TAIL RISK?

CONCLUSION

QUESTION AND ANSWER SESSION

CHAPTER 12 - RISK: MEASURING THE RISK IN VALUE AT RISK

MEASURING VAR

EVALUATING VAR

CONCLUSIONS

NOTES

REFERENCES

CHAPTER 13 - HOW RISK MANAGEMENT CAN BENEFIT PORTFOLIO MANAGERS

DEFINING RISK

DEFINING RISK MANAGEMENT

VAR BACKGROUND

ADOPTING VAR

CONCLUSION

QUESTION AND ANSWER SESSION

CHAPTER 14 - MERGING THE RISK MANAGEMENT OBJECTIVES OF THE CLIENT AND ...

MANDATES AND GUIDELINES

PARAMETRIC RISK ANALYSIS

PROBABILITY-BASED RISK MEASURES

MARKET RISK STRUCTURE

STRESS TESTING

CONCLUSION

QUESTION AND ANWER SESSION

CHAPTER 15 - THE MISMEASUREMENT OF RISK

WHY INVESTORS CARE ABOUT INTERIM RISK

WITHIN-HORIZON EXPOSURE TO LOSS

APPLICATIONS

CONCLUSIONS

APPENDIX A. WITHIN-HORIZON RISK

NOTES

REFERENCES

CHAPTER 16 - RISKINESS IN RISK MEASUREMENT

ON TOOLS

STATIC RISK

DYNAMIC RISK

REBALANCING REGIMES AND DISTRIBUTIONS

CONCLUSION

QUESTION AND ANSWER SESSION

NOTES

CHAPTER 17 - THE SECOND MOMENT

NOTE

REFERENCES

CHAPTER 18 - THE SENSE AND NONSENSE OF RISK BUDGETING

RISK ALLOCATION MODELS

RISK ALLOCATION VS. ASSET ALLOCATION

OPTIMAL RISK ALLOCATION

SENSITIVITY OF THE OPTIMAL RISK ALLOCATION

RISK ALLOCATIONS AND IMPLIED IRs

OPTIMAL ALLOCATION TO STRATEGIC AND ACTIVE RISK

SETTING THE OVERALL RISK BUDGET

SETTING TARGET IRs

CONCLUSION

ACKNOWLEDGMENTS

APPENDIX A. OPTIMAL RISK ALLOCATION

NOTES

REFERENCES

CHAPTER 19 - UNDERSTANDING AND MONITORING THE LIQUIDITY CRISIS CYCLE

THE CYCLE

MEASURING THE CYCLE

CONCLUSION

NOTE

CHAPTER 20 - WHY COMPANY-SPECIFIC RISK CHANGES OVER TIME

COMPANY-SPECIFIC RISK OVER TIME

WHY DOES COMPANY-SPECIFIC RISK CHANGE OVER TIME?

CONTROLLING FOR THE THREE FACTORS

CONCLUSION

ACKNOWLEDGMENTS

NOTES

REFERENCES

CHAPTER 21 - BLACK MONDAY AND BLACK SWANS

THE LIGHT SHINED BY KNIGHT

MANDELBROT ON RISK, RUIN, AND REWARD

THE WISDOM OF KEYNES

QUANTIFYING KEYNES’ DISTINCTION

MINSKY ADDS A CRUCIAL INGREDIENT

RISK AND RUIN—A REPRISE

HIGH RISKS, LOW RISK PREMIUMS?

OTHER RISKS

AFTERWORD

NOTES

REFERENCES

CHAPTER 22 - THE UNCORRELATED RETURN MYTH

THEORY

EVIDENCE

NOTES

PART III - MANAGING RISK

CHAPTER 23 - RISK MANAGEMENT FOR HEDGE FUNDS: INTRODUCTION AND OVERVIEW

WHY RISK MANAGEMENT?

WHY NOT VAR?

SURVIVORSHIP BIAS

DYNAMIC RISK ANALYTICS

NONLINEARITIES

LIQUIDITY AND CREDIT

OTHER CONSIDERATIONS

CONCLUSION

ACKNOWLEDGMENTS

NOTES

REFERENCES

CHAPTER 24 - RISK MANAGEMENT FOR ALTERNATIVE INVESTMENT STRATEGIES

RISK MANAGEMENT FRAMEWORK

MANAGING RISK AND RETURN

DUE DILIGENCE

TYPES OF RISKS

HOLISTIC APPROACH

CONCLUSION

QUESTION AND ANSWER SESSION

NOTES

CHAPTER 25 - SOURCES OF CHANGE AND RISK FOR HEDGE FUNDS

BENCHMARKING

TRANSPARENCY

ARTICULATION OF INVESTMENT STRATEGY

FEE RATIONALIZATION

RISK CONTROL

QUESTION AND ANSWER SESSION

NOTE

CHAPTER 26 - RISK MANAGEMENT IN A FUND OF FUNDS

DEFINING RISK

MANAGING TAIL RISK

FUTURE RISKS

QUESTION AND ANSWER SESSION

NOTE

CHAPTER 27 - HEDGE FUNDS: RISK AND RETURN

THE TASS DATABASE

NONNORMALITY OF RETURNS

BIASES IN REPORTED HEDGE FUND RETURNS

PERSISTENCE IN HEDGE FUND RETURNS

PROBIT ANALYSIS OF PROBABILITY OF FUND DEMISE

CONCLUSION

ACKNOWLEDGMENTS

NOTES

REFERENCES

CHAPTER 28 - CREDIT RISK

WHAT ARE CREDIT DERIVATIVES?

PREDICTING DEFAULT

STRUCTURAL PRICING MODELS

REDUCED-FORM PRICING MODELS

CDS

TIME-VARYING DEFAULT INTENSITIES

SIMULATING DEFAULT TIMES

EXAMPLE OF SIMULATING DEFAULT TIMES

CDOs

THE IMPACT OF CORRELATION ON CDO PRICES

CREDIT INDICES

BASKET DEFAULT SWAPS

MODELS OF CORRELATED DEFAULT

PRICING A CDO BY MONTE CARLO ANALYSIS

SUMMARY

ACKNOWLEDGMENTS

NOTES

REFERENCES - Acharya, Viral V., Sreedhar T. Bharath, and Anand Srinivasan. ...

CHAPTER 29 - TUMBLING TOWER OF BABEL: SUBPRIME SECURITIZATION AND THE CREDIT CRISIS

RISK-SHIFTING BUILDING BLOCKS

WHAT GOES UP . . .

. . . MUST COME DOWN

CONCLUSION: BUILDING FROM THE RUINS

ACKNOWLEDGMENTS

NOTES

REFERENCES

CHAPTER 30 - APPLYING MODERN RISK MANAGEMENT TO EQUITY AND CREDIT ANALYSIS

PAST DISTORTIONS IN VALUATION AND RISK ANALYSIS

PRESENT FAILURES IN RECOGNIZING VALUE AND RISK

FUTURE DISTORTIONS: DERIVATIVES IN STRATEGIC RISK MANAGEMENT

CONCLUSION

QUESTION AND ANSWER SESSION

NOTE

REFERENCES

CHAPTER 31 - THE USES AND RISKS OF DERIVATIVES

DERIVATIVES

HISTORY OF DERIVATIVE PRODUCTS

USING DERIVATIVES IN GLOBAL PORTFOLIOS

RISK MANAGEMENT AND DERIVATIVES

CONCLUSION

NOTES

CHAPTER 32 - EFFECTIVE RISK MANAGEMENT IN THE INVESTMENT FIRM

WHY RISK MANAGEMENT NOW?

THE GROUP OF THIRTY REPORT

THE 1994 FOLLOW-UP STUDY

MARKET RISK

CONCLUSION

QUESTION AND ANSWER SESSION

CHAPTER 33 - RISK-MANAGEMENT PROGRAMS

RISK-MANAGEMENT PREMISES

TODAY’S RISKS

A RISK-MANAGEMENT PROGRAM

CONCLUSION

QUESTION AND ANSWER SESSION

NOTE

CHAPTER 34 - DOES RISK MANAGEMENT ADD VALUE?

COMPANY USES OF RISK MANAGEMENT

MARKET REACTION

CONCLUSION

QUESTION AND ANSWER SESSION

NOTES

CHAPTER 35 - EMENT AND FIDUCIARY DUTIES

FIDUCIARY RELATIONSHIPS

FIDUCIARY LAW

FIDUCIARY LAW VERSUS CONTRACT LAW

TRUST LAW VERSUS CORPORATE LAW

FIDUCIARY DUTIES

LESSONS FROM CASE LAW

CONCLUSION

QUESTION AND ANSWER SESSION

NOTES

CHAPTER 36 - FINANCIAL RISK MANAGEMENT IN GLOBAL PORTFOLIOS

THE FUNDAMENTALS

DEALING WITH RISK

DEALING WITH MISCONCEPTIONS

CONCLUSION

NOTES

CHAPTER 37 - HEDGING: OPTIMIZING CURRENCY RISK AND REWARD IN INTERNATIONAL ...

WHY HEDGE AT ALL?

THE UNIVERSAL HEDGING FORMULA

APPLYING THE FORMULA TO OTHER TYPES OF PORTFOLIOS

CONCLUSION

NOTES

CHAPTER 38 - STRATEGIES FOR HEDGING

MOTIVATION FOR CURRENCY-RISK MANAGEMENT

CURRENCY EXPOSURE AND DIVERSIFICATION

LINEAR CURRENCY-HEDGING STRATEGIES

NONLINEAR CURRENCY-HEDGING STRATEGIES

CASH FLOW MANAGEMENT FOR CURRENCY-HEDGING STRATEGIES

CONCLUSION

QUESTION AND ANSWER SESSION

CHAPTER 39 - CURRENCY RISK MANAGEMENT IN EMERGING MARKETS

MANAGING CURRENCY RISK

CONCLUSION

CHAPTER 40 - MANAGING GEOPOLITICAL RISKS

PROCESSES DRIVING RISK

UNITED STATES

CHINA

RUSSIA

EMERGING MARKETS

GEOPOLITICAL RISK AND THE ENERGY PROBLEM

CONCLUSION

QUESTION AND ANSWER SESSION

NOTES

CHAPTER 41 - COUNTRY RISK IN GLOBAL FINANCIAL MANAGEMENT

FOREWORD

PREFACE

EXECUTIVE SUMMARY

INTRODUCTION

COUNTRY RISK

DETERMINING COUNTRY RISK IN PRACTICE

APPLICATIONS OF COUNTRY RISK ANALYSIS

IMPLICATIONS FOR PORTFOLIO MANAGEMENT

Other Portfolio Management Applications

CONCLUSION

APPENDIX: COUNTRY RISK RATINGS USED IN THE MONOGRAPH

NOTES

REFERENCES

CHAPTER 42 - POLITICAL RISK IN THE WORLD ECONOMIES

POLITICAL RISK ANALYSIS

POLITICAL RISK MODEL

COUNTRY RANKINGS

CONCLUSION

NOTE

CHAPTER 43 - A BEHAVIORAL PERSPECTIVE ON RISK MANAGEMENT

LOSS AVERSION

RISK VERSUS UNCERTAINTY

INTERPRETING PROBABILITIES

CONCLUSION

QUESTION AND ANSWER SESSION

NOTES

CHAPTER 44 - BEHAVIORAL RISK: ANECDOTES AND DISTURBING EVIDENCE

FLAW ONE: OVERCONFIDENCE

FLAW TWO: DECISION FRAMING

FLAW THREE: AGENCY FRICTION

CONCLUSION

NOTE

READING LIST

CHAPTER 45 - THE TEN COMMANDMENTS OF OPERATIONAL DUE DILIGENCE

ONE: DEFINE THE ROLE

TWO: DEFINE THE GOAL—SAFEGUARD THE ASSETS

THREE: DEFINE THE OBJECTIVE—INTEGRATE CONTROLS CONSISTENTLY AND EFFECTIVELY

FOUR: SEGREGATE THE FUNCTION

FIVE: DO THE WORK

SIX: DOCUMENT AND COMMUNICATE

SEVEN: WORK EFFICIENTLY WITH INVESTMENT RESEARCH

EIGHT: REMEMBER THE FUNDAMENTALS

NINE: NOTE THE TONE AT THE TOP

TEN: BE VIGILANT ABOUT RED FLAGS

QUESTION AND ANSWER SESSION

NOTE

CHAPTER 46 - MODELS

MODEL AIRPLANES

MODELS IN PHYSICS

MODELS IN FINANCE

THE FOUNDATIONS OF FINANCIAL ENGINEERING

MODEL RISK

CONCLUSION

NOTE

REFERENCE

CHAPTER 47 - THE USE AND MISUSE OF MODELS IN INVESTMENT MANAGEMENT

WHERE FINANCIAL MODELS ARE USEFUL

IMPLICATIONS FOR HEDGING

MISUSES OF MODELS

MODELS FOR NONLINEARITIES IN CORPORATE BOND AND BANKING RISKS

REAL ESTATE RISKS NEVER SEEN BEFORE

CONCLUSION

QUESTION AND ANSWER SESSION

REFERENCES

CHAPTER 48 - REGULATING FINANCIAL MARKETS: PROTECTING US FROM OURSELVES AND OTHERS

MARGIN (LEVERAGE) REGULATIONS

SUITABILITY REGULATIONS

BLUE SKY AND MANDATORY DISCLOSURE

WHAT SHOULD WE DO?

CONCLUSION

REFERENCES

CHAPTER 49 - BUDGETING AND MONITORING PENSION FUND RISK

PENSION FUND CHARACTERISTICS

ESTIMATING RISK

PENSION FUND APPLICATIONS

IMPLEMENTATION ISSUES

CONCLUSION

NOTES

REFERENCES

CHAPTER 50 - THE PLAN SPONSOR’S PERSPECTIVE ON RISK MANAGEMENT PROGRAMS

BACKGROUND

PHILOSOPHY, OBJECTIVES, AND MISSION

RISK MANAGEMENT APPROACH

BUILDING BLOCKS OF RISK MANAGEMENT

KEY CRITERIA

CONCLUSION

QUESTION AND ANSWER SESSION

CHAPTER 51 - EVALUATING A RISK-MANAGEMENT PROGRAM

A VIEW OF RISK

POTENTIAL OBJECTIVES FOR A RISK-MANAGEMENT PROGRAM

HOW A PLAN SPONSOR MIGHT IMPLEMENT AND EVALUATE RISK MANAGEMENT

CONCLUSION

QUESTION AND ANSWER SESSION

NOTES

CHAPTER 52 - DEVELOPING AND IMPLEMENTING A RISK-BUDGETING SYSTEM

ROLE OF THE SPONSOR

THE PENSION FUNDING CRISIS

PENSION RISK

CHANGES IN OTPP POLICIES

PASSIVE AND ACTIVE RISK

ALTERNATIVE INVESTMENTS

ASSET MIX AND TOTAL RISK

CONCLUSION

QUESTION AND ANSWER SESSION

NOTES

CHAPTER 53 - LIABILITY-DRIVEN INVESTMENT STRATEGIES FOR PENSION FUNDS

SWISS PENSION SYSTEM

LIABILITY-DRIVEN INVESTING

UNDERSTANDING LIABILITIES

IMMUNIZATION AND CASH FLOW MATCHING

CONCLUSION

QUESTION AND ANSWER SESSION

ABOUT THE CONTRIBUTORS

INDEX

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ISBN 978-0-470-90339-1 (cloth); ISBN 978-0-470-93409-8 (ebk); ISBN 978-0-470-93410-4 (ebk); ISBN 978-0-470-93411-1 (ebk)

FOREWORD

Although risk management has always been an integral part of the investment management process, it has certainly become more prominent in recent years. By properly measuring and managing risk, the needs of clients and firms can be more effectively addressed. As the ever-evolving financial markets become more sophisticated and challenging, the application of risk management techniques must also evolve. This book traces that evolution from the perspective of some of the greatest minds in the investment management business.

The 53 individual chapters included in this book highlight two decades of risk management thought. They are taken from the Research Foundation of CFA Institute, Financial Analysts Journal, and CFA Institute conference proceedings series. The pieces represent works by Nobel Prize winners, industry legends, and a host of insightful academics and practitioners. The reader will be struck by the timelessness of the principles: An article written in the throes of the 1997 Asian currency crisis could easily be mistaken for one written after the most recent global financial meltdown.

The chapters are organized into three main sections. The first section provides an introduction and overview of risk management thought. The second section, which investigates the measurement of risk, focuses on risk modeling; it addresses such topics as value at risk, risk budgeting, and liquidity risk. The third section concentrates on risk management and issues related to asset classes, such as alternative investments. In addition, derivatives are explored, as well as the topical areas of credit, global, nonfinancial, and pension risk.

Risk Management: Foundations for a Changing Financial World represents the third in our CFA Institute Investment Perspectives Series and joins our previous works on private wealth management and investment performance management. We hope you will find it a useful guide and resource in addressing current issues as well as the many risk management challenges you may face in the future.

ROBERT R. JOHNSON, PhD, CFA Senior Managing Director CFA Institute

ACKNOWLEDGMENTS

It has been one of the greatest honors of my professional career to review and select the risk management works included in this book. My sincerest appreciation goes out to CFA Institute for entrusting me with this great responsibility. In particular, I would like to thank Heather Packard; Stephen Horan, PhD, CFA; and Rodney Sullivan, CFA, for all of their help along the way, and Tom Robinson, PhD, CFA, and John Rogers, CFA, whose division and organization, respectively, green-lighted the project. In addition, many thanks to Bob Johnson, PhD, CFA, who wrote the Foreword to this book; and Peter Went, PhD, CFA, who co-wrote the Introduction.

Special acknowledgment goes out to the contributors who provided the valuable insights that we are so very proud to share with you and to everyone involved with the Financial Analysts Journal, Conference Proceedings Quarterly, and Research Foundation of CFA Institute for making the publication of this information possible. John Wiley & Sons’ excellent contribution to the actual publication of this book must also be recognized.

I would also like to thank everyone who has contributed knowledge to the field of risk management and to the Global Association of Risk Professionals (GARP) and the Professional Risk Managers International Association (PRMIA) for their excellent work. Risk management affects all of us in the investment business, and it is through global cooperation that we can all benefit from what has been learned in this field and what will be learned in the future.

WALTER V. “BUD” HASLETT JR., CFA

INTRODUCTION

Risk is an integral part of virtually every decision we make. In a modern portfolio theory framework, risk and return are two required inputs as we seek to maximize returns at a given level of risk. This task is further simplified by the assumption that an asset providing a higher rate of return is riskier than an asset providing a lower rate of return. In this process, risk is assumed to be known and quantified. Standard deviation, variance, and volatility offer simple and tangible metrics to quantify the amount of risk at play.

Because risk is quantifiable, it should be easily predictable and readily manageable. Using various statistical and nonstatistical approaches, risk measures can be calculated and used to predict the impact risks may have on the performance of the portfolio. These methods allow for managing the risks that we know that we know, such as small price and yield changes. For this task, we can use the various financial tools that have developed over the years to manage the effects of these types of risks.

How to manage the risks that we know that we do not know remains a challenge, even though reoccurring financial crises generously generate ample data to analyze, observe, and extrapolate.

But the real challenge in managing risks in investment management is managing and measuring the impact of risks that we do not know that we do not know. These risks, such as extreme tail risks or black swan events, are risks that we cannot fully comprehend, imagine, or possibly conceive in advance. These types of risks are made even more challenging by the fact that they fail to occur independently and often experience significant and rapidly shifting correlation between various risk events. Although a skilled risk manager could compute, with relative ease, the separate impact of each of these risks in advance, the collective effect of these events would be almost impossible to quantify and predict.

Because risk management is about learning from experience, the difference between good and bad risk management is how to best consider risk in the context of the investment decision-making process. Even if all possible risks are known in advance, are quantifiable, and are considered, some remaining challenges can affect the outcome. Equity prices, interest rates, and foreign exchange rates are innately volatile, and this continuous, unpredictable, and unexpected volatility is a fact of life. As long as these changes are small and not significant, the existing risk metrics and risk management tools available to manage these everyday risk events should be adequate. But oftentimes these changes are not insignificant. It appears that, in managing risks, the only certainty is that risks are uncertain.

The chapters in this book summarize much of our current knowledge and understanding of risks and risk management. The permanence of risk shines through in each of them. This enduring nature is particularly evident when comparing the risk events in the 1990s with those of the events of the latter half of the first decade of the 2000s. The lessons were there for all to see and learn, and they remind us that there are more lessons to learn.

In the Overview (Part I) of the book, we first address lessons learned from the 1990s with articles and conference proceedings from Richard Bookstaber, Jacques Longerstaey, Andrew Lo, and Robert Kopprasch, CFA. The 1990s was a decade dominated by Barings Bank, Long-Term Capital Management, and the Asian contagion, and many of these works reflect lessons learned directly from those incidents. From discussions on liquidity to the organizational structure needed to effectively manage risk, these chapters provide timeless insights for all investment professionals.

The second portion of the Overview (2000 to the present) begins with a comprehensive Research Foundation piece by Sébastien Lleo, CFA, and is followed by works from Glyn Holton, Aswath Damodaran, Tyler Cowen, Bluford Putnam, and Sykes Wilford. Besides being affected by the decade’s events, such as the bursting of the tech bubble and the housing crisis, these chapters include a healthy discussion of the qualitative nature of risk management, which is an important theme running throughout the book. To be successful, risk management needs to contain a strong quantitative component, but if viewed in isolation, these measures alone will be inadequate. It is when the quantitative measures are combined with well-informed qualitative insights that risk management can become truly effective.

Works from Max Darnell; Philippe Jorion; Michelle McCarthy; Bennett Golub; Mark Kritzman, CFA, and Don Rich; Roland Lochoff; Don Ezra; Arjan Berkelaar, CFA, Adam Kobor, CFA, and Masaki Tsumagari, CFA; Richard Bookstaber; James Bennett, CFA, and Richard Sias; John Bogle; and Richard Ennis, CFA, in Part II: Measuring Risk address many quantitative aspects of risk management, including limitations of popular measures and the dangers of extreme events (such as the previously mentioned tail risk and black swan events). Correlated and uncorrelated returns as well as analysis of volatility are also discussed in this section.

In Part III: Managing Risk, a broad grouping of chapters is organized into several different subsections. Because of the increasing importance and complexity of alternative investment strategies, Andrew Lo, Leslie Rahl, Clifford Asness, Luke Ellis, and Burton Malkiel and Atanu Saha discuss the unique risk issues in this area. Nonnormal distributions, distinct characteristics of hedge funds and fund-of-funds investments, and the question of return persistency are all discussed in these timely works.

Jeremy Graveline and Michael Kokalari, Bruce Jacobs, and Robert Merton discuss credit risk in a grouping of chapters covering such topics as collateralized debt obligations (CDOs), credit default swaps (CDSs), and the pricing of credit risk. These more recent chapters precede and follow the credit crisis and provide an eye-opening analysis of developments before, during, and after this most challenging period of time.

The nature of the financial crisis and the regulatory debates of 2008 and 2009 cry out for special attention to derivatives, which are discussed by Joanne Hill, Mark Brickell, Maarten Nederlof, Charles Smithson, and Robert McLaughlin. Again, the reader will note the vintage of some of these works and the power of their insights. It is truly remarkable how many of the derivatives issues of the past (such as rising correlations in a time of crisis, impact of outlier events, and fiduciary responsibilities) are still derivatives issues of the present, despite the passing of more than a decade.

The timelessness of risk management principles is also apparent in the Global Risk subsection, which features articles from Charles Tschampion, CFA; Fischer Black; Mark Kritzman, CFA; Gifford Fong; Marvin Zonis; and Claude Erb, CFA, Campbell Harvey, and Tadas Viskanta. Global investing has expanded dramatically over the past 20 years, yet these articles are still providing a wealth of information for dealing with the challenges of increasing currency volatility, sovereign risk, and the many other intricacies we face in our increasingly global economies and investment universe.

Works in the Nonfinancial Risk subsection of Managing Risk are from such notable experts as Andrew Lo, Arnold Wood, Robert Swan, Emanuel Derman, Douglas Breeden, and Meir Statman and address many operational, behavioral, and model risk issues not covered in other sections. The challenges during the credit crisis highlighted many of these issues, and particular attention to the concepts will assist with developing a framework to minimize such negative impacts in the future.

Rounding out the Managing Risk section is the subsection Pension Risk, with works from William Sharpe; Desmond Mac Intyre; Christopher Campisano, CFA; Leo de Bever; and Roman von Ah. From manager and marginal risk to liability-driven investing, as an increasingly large group of the global population enters and approaches retirement age, these issues are sure to provide valuable insights into this critically important area.

The risk involved with using timeless articles is that, although the concepts are fundamentally sound, the data are dated. This is particularly true of the “Country Risk in Global Financial Management” and Fischer Black chapters. Nonetheless, the data serve as a trip down memory lane for those who experienced the information firsthand, or provide a valuable reference point for those who were not involved in the investment business at that time.

Any emphasis implied by either the number of articles or the number of pages in any particular section is unintentional because all topics addressed are important to risk management. Risk, like water, tends to seek out and find weaknesses in structure, and so strength in all areas is the best defense against the unintended ravages that poor risk management can bring.

Because risk management affects so many areas of investment management, the information in this book will provide value to a broad cross section of investment professionals. We are delighted to present this timeless wealth of information for all to use and enjoy, and we hope the insights learned will lead to much success for you, your clients, and your firm.

WALTER V. “BUD” HASLETT JR., CFA PETER WENT, PhD, CFA

PART I

OVERVIEW—TWO DECADES OF RISK MANAGEMENT

CHAPTER 1

A FRAMEWORK FOR UNDERSTANDING MARKET CRISISa

Richard M. Bookstaber

The key to truly effective risk management lies in the behavior of markets during times of crisis, when investment value is most at risk. Observing markets under stress teaches important lessons about the role and dynamics of markets and the implications for risk management.

No area of economics has the wealth of data that we enjoy in the field of finance. The normal procedure we apply when using these data is to throw away the outliers and focus on the bulk of the data that we assume will have the key information and relationships that we want to analyze. That is, if we have 10 years of daily data—2,500 data points—we might throw out 10 or 20 data points that are totally out of line (e.g., the crash of 1987, the problems in mid-January 1991 during the Gulf War) and use the rest to test our hypotheses about the markets.

If the objective is to understand the typical day-to-day workings of the market, this approach may be reasonable. But if the objective is to understand the risks, we would be making a grave mistake. Although we would get some good risk management information from the 2,490 data points, unfortunately, that information would result in a risk management approach that works almost all the time but does not work when it matters most. This situation has happened many times in the past: Correlations that looked good on a daily basis suddenly went wrong at exactly the time the market was in turmoil; value at risk (VAR) numbers that tracked fairly well day by day suddenly had no relationship to what was going on in the market. In the context of effective risk management, what we really should do is throw out the 2,490 data points and focus on the remaining 10 because they hold the key to the behavior of markets when investments are most at risk.