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.
Written from the combined perspective of a top academic and a
leading practitioner.
Table of Contents
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
224 pages, Hardcover
