Details
- Written from the combined perspective of a top academic and a leading practitioner.
The subprime crisis has shown that the sophisticated risk management models used by banks and insurance companies had serious flaws. Some people even suggest that these models are completely useless. Others claim that the crisis was just an unpredictable accident that was largely amplified by the lack of expertise and even naivety of many investors. This book takes the middle view. It shows that these models have been designed for "tranquil times", when financial markets behave smoothly and efficiently. However, we are living in more and more "turbulent times": large risks materialize much more often than predicted by "normal" models, financial models periodically go through bubbles and crashes. Moreover, financial risks result from the decisions of economic actors who can have incentives to take excessive risks, especially when their remunerations are ill designed. The book provides a clear account of the fundamental hypotheses underlying the most popular models of risk management and show that these hypotheses are flawed. However it shows that simple models can still be useful, provided they are well understood and used with caution.
Readership: The targeted audience ranges from risk professionals, academic researchers and finance students.
INTRODUCTION
I RISK MANAGEMENT: WHAT MUST BE CHANGED
1 Lessons From recent Financial Crises
1.1 The Basic Goals of Risk Management
1.2 When Risk Management Fails
1.3 What Should Be Done?
2 Living in Turbulent Times
2.1 New and Larger Risks
2.2 Increased Management Accountability
2.3 Need for a Global Approach
3 The Need for a Proper Methodology
3.1 The Necessary Ingredients
3.2 Risk Mapping
3.3 Loss Control
3.4 Risk Allocation
II WHAT IS BEHIND RISK MODELING
4 The Basic Tools of Risk Modeling
4.1 Assessing Probabilities: The Frequentist and Subjective Approaches
4.2 Bayesian updating
4.3 Estimating Loss Distributions
4.4 Combining Event Trees and Monte Carlo Methods
4.5 The Dangers of the Stationarity Assumption
5 Statistical Risk Measures
5.1 The Expectation or Mean
5.2 The Variance
5.3 Linear Correlation
5.4 Copulas
5.5 The Value at Risk
5.6 Mutualization and Diversification
5.7 The Dangers of Using Simple Risk Measures
Appendix: Extreme Value Theory
6 Leverage and Ruin Theory
6.1 Leverage and Return on Equity
6.2 Economic Capital for a Bank
6.3 Economic Capital for an Insurance Company
6.4 The Limits of Ruin Theory
III THE PERFECT MARKETS HYPOTHESIS AND ITS DANGERS
7 Risk Neutral Valuation
7.1 The Expected Present Value Criterion
7.2 The Magic of Perfect Markets
7.3 Complete Markets and Absence of Arbitrage Opportunities
7.4 A Binomial Example
7.5 The Mirages of the Perfect Markets World
8 The Case of Incomplete Markets: Relating Risk Premiums to Economic
Fundamentals
8.1 Solving the St Petersburg Paradox
8.2 Certainty Equivalent
8.3 Markets for Exchanging Risks
8.4 The Limits of the Equilibrium Approach
9 Risk Management in a Normal World
9.1 The Mean-Variance Criterion
9.2 Portfolio Choice
9.3 The Diversification Principle
9.4 Efficient Portfolios and the Sharpe Ratio
9.5 The Capital Asset Pricing Model (CAPM)
9.6 Futures Contracts and Hedging
9.7 Capital Allocation and RaRoc
9.8 The Dangers of Viewing the World as <"Normal>"
Appendix 1: Portfolio Choice with Several Risky Assets
Appendix 2: Deriving the CAPM Formula
IV RISK MANAGEMENT AND SHAREHOLDER VALUE
10 Why Market Imperfections Matter for Shareholder Value
10.1 Standards Methods for Assessing Shareholder Value
10.2 Why is the Shareholder Value Function Likely to Be Non Linear: A Simple Example
10.3 Incentive Problems Generate Financial Frictions
11 The Shareholder Value Function
11.1 A Target Level of Cash
11.2 A Model for Optimizing Liquidity Management
11.3 Liquidity and Shareholder Value
Appendix 1: Stochastic Differential Calculus
Appendix 2: Derivation of the Shareholders Value Function
12 Risk Management and the Shareholder Value Function
12.1 How Much Risk to Take?
12.2 Which Risks to Insure?
12.3 How Much Liquidity to Keep in Reserves?
12.4 How Much hedging to Perform?
V WHAT TO DO IN PRACTICE?
13 The Different Steps of the Implementation
13.1 Estimating the Shareholder Value Function
13.2 A Unifying Metric for Risk Mapping: The Risk Value Mapping
13.3 The New Instruments of Risk Management
14 Learning from an Example
14.1 Presentation of Med Corp
14.2 Risk Analysis
14.3 Shareholder Value and RM for Med Corp
14.4 A Risk Transfer Policy for Med Corp
15 Conclusion: Some Simple Messages
15.1 Message # 1: Quantitative models are needed but they have to be used
with precaution
15.2 Message # 2: Risk Management creates value for shareholders
15.3 Message # 3: Things to do in practice
15.4 Message # 4: Key Ingredients for a successful RM approach
Index
Gilles Beneplanc, Region leader, Europe, Middle East, and Africa, Mercer LLC, and Jean-Charles Rochet, Professor of Mathematics and Economics, University of Toulouse
Gilles Beneplanc is the Head of Europe, Middle East, and Africa region for the Mercer consulting firm. Jean-Charles Rochet is Professor of Mathematics and Economics at the University of Toulouse.
"This book is a breath of fresh air in the field of risk management. By bringing together one of the best research economists in the world with a top risk management practitioner, the book offers the reader deep insights into the theory and practice of risk management and its effect on firm value and financial stability. The final chapter on 'What To Do' is a must read. This book will become required reading for students of finance and economics, for private sector practitioners and for policy makers and economists concerned with financial stability."--Hyun Song Shin, Hughes-Rogers Professor of Economics, Princeton University
"After a financial crisis of the magnitude of the 2008-2009 crisis, it is normal to see a lot of soul searching going on in financial markets. This book is an important contribution to this movement. Gilles Bénéplanc and Jean-Charles Rochet give a remarkable analysis of the difficulties of risk management in times of crisis. But contrary to many, they do not stop at the criticisms but propose interesting ways to move ahead. They introduce a healthy skepticism towards the approach to let models decide what the risks are, and at the same time they show how one can greatly improve them by introducing common sense and sophisticated mathematics in their construction, like extreme value theory. This book will be invaluable reading for both practitioners and academics that deal with risk management and risk-modeling."--Michel Dacorogna, Group Deputy Chief Risk Officer, SCOR SE
"Coming out of the financial crisis, teaching as well as practice of risk management have shown numerous weaknesses. This book puts the record straight! The authors present a wonderful balance between theory-practice, banking-insurance, quantitative-qualitative. Their findings are summarized through the novel notion of Shareholder Value Function. The result is a true gem, a book that will appeal to many and needs to be read by all with an interest in (corporate) risk management."--Paul Embrechts, RiskLab, ETH Zurich
