Dealing with Financial Risk

The essence of financial risk management is imagining what things might go wrong and then guarding against them. In the past thirty years, a whole industry has grown up around the idea that the behavior of financial markets can be analyzed and outsmarted by mathematical models. But markets are always changing. Modern risk management can only narrow down future outcomes into bands of probabilities. It can never predict; it can only infer what might happen.

Ultimately, financial firms have learned that mathematics has limited power to calculate the likelihood of the less frequent more extreme events. As regulators and forward-thinking firms come to grips with this problem, they have ventured into the more uncertain territory of designing stress tests, imagining scenarios, and occasionally playing out entire fictions of the future. Risk management at these extremes challenges the wildest imagination and the frontiers of creativity. Like mountain climbing, it is about minimizing danger and taking calculated risks.

Dealing With Financial Risk is a clear and colorful guide to the peaks and crevasses of financial risk management, leading through the theory and practice of risk taking from swaps and futures to credit derivatives and the implications of Basel II, dynamic hedging, Monte Carlo simulations, chaos theory, neural networks, Raroc (risk-adjusted return on capital), stress tests, worst-case scenarios, and all kinds of games that are played in the cause of managing risk. In addition, it looks at some spectacular failures of risk management and the lessons that can be learned from them.

David Shirreff is the Frankfurt correspondent for The Economist, covering business and finance. Before that, he was the capital markets editor of The Economist in London. He has also written about banking and risk management for EuroMoney and he cofounded Risk magazine in 1987.