Review of The Essentials of Risk Management (Hardcover)

This book provides an introduction to the field of risk management for readers who do not yet want to get deeply involved in the mathematical formalism that is typically used. The authors wrote the book so that it is "accessible to everyone", and they have done a fine job. Those readers who need a more quantitative treatment will have to consult another book or the vast research literature on the subject. Risk management, as they see it, is an attempt to estimate both the `expected' losses and the `unexpected' losses, and being able to differentiate between these two concepts goes to the core of the subject. Thus the book emphasizes the "intuition" behind risk management, and not the formalism. However, one must not conclude from this that "intuition" and "formalism" are distinct, and the belief that they are has resulted in a lot of confusion (and financial losses) in recent years. The authors clearly do not believe that they are, but have merely emphasized "intuition" from a pedagogical point of view.

The authors classify risk into eight categories, namely market, credit, liquidity, operational, legal and regulatory, business, strategic, and reputation risk. Financial risk, as they see it, is composed of two of these, namely market and credit risk. Their discussion of corporate risk management is very interesting, in that it begins with the observation first made almost forty years ago that the value of a firm is not altered solely by financial transactions. This is due to their assumption of the perfect market hypothesis, which effectively suppresses the ability of the firm to gain significant advantages over an individual investor. Therefore with this assumption a firm should not concern itself with risks outside of the ones that all other firms face. This is an interesting conclusion, particularly in the context of using hedging via derivatives, as it implies that it cannot compete with ordinary self-insurance, due to the presence of transaction costs. The authors discuss in fair detail why the perfect market assumption is faulty, and therefore why managing risk with hedging is a viable strategy.

The regulatory environment, particularly in the banking industry, has enormous ramifications for risk management, as the authors discuss in the book. This is due in part to the Basel Accords of 1988 and 1996, and Basel II which is due to be in place at the end of 2007. The Basel accords are essentially a standardization for capital reserves, defining a `assets-to-capital' multiple and a `risk-based capital' ratio. The authors review the 1988 Accord and discuss the elementary relationships involved, including the `Cooke ratio' and how to obtain the credit equivalent for the off-balance-sheet exposures. They also discuss the reasons for the 1996 amendment, which essentially were the result of the new trading activities that banks were indulging themselves in. It would have been interesting if the authors had included a (historical) discussion on the efficacy of the Basel Accords in suppressing banking failures. They do mention the fiasco with Barings Bank, claiming that its demise would have been adverted if it were prohibited from racking up huge exchange-traded futures positions. This is certainly true, but any regulation needs to be validated by historical data, to the extent that this is possible, and this requires of course tracking of the financial institutions that are under the umbrella of the regulation. In this regard though, the authors do view bank regulation as a `research lab' for risk management, implying that they are aware of the need for validation of any regulations that are actually put in place. It will be fascinating therefore to see the impact of the new Basel II accords when they become active, and indeed observe, if possible, any `regulatory arbitrage' that occurs. This also brings up the question of how to assess the quality of the risk management strategies of a particular financial institution. The authors spend a little time discussing this, with one of them referring to a method analogous to credit scoring.

No book on risk management could be complete without discussion of academic research on the topic, for the reason that much of this research has found practical application and has greatly influenced portfolio management and risk valuation. The authors review four theoretical models, namely modern portfolio theory, the capital asset pricing model, the Black-Scholes option-pricing model, and the Modigliani-Miller theory of corporate finance. Even though the discussions are very short, one has to admire the authors' ability to avoid complicated mathematics in discussing all of these theories without sacrificing clarity. The more mathematically-mature reader may perhaps be annoyed with the omission of mathematical formalism, but a natural question that might arise for such a reader is whether or not risk can indeed be put in a general axiomatic framework that will encompass all of its different manifestations, such as credit risk, operational risk, etc. Such a framework would allow a complete mathematical characterization of risk, and would allow various general and quantitative statements to be made about it.

Due to the extent of mortgage portfolios in the United States at the present time, and due to the sensitive dependence of their values on interest rates, the authors spend a fair amount of time discussing interest-rate risk and how to hedge it with derivatives. Thus they speak of the `sensitivity' of financial instruments to certain risk factors, and study the case of fixed-income products via the `DV01' risk measure, which is the change in value of a security after a change in interest rate of 1 basis point. This measure gives a `first-order' approximation to the change in yield, but the authors show how to obtain a `second-order' approximation using the `convexity' adjustment.

For complex portfolios, the most popular method for risk management has been the value-at-risk or VAR, and so it is not surprising that the authors devote an entire chapter to it in the book. The authors view it as a more sophisticated method because of its ability to deal with volatilities and correlations. However, they point out that its efficacy is restricted to relatively short time scales and under `normal' market conditions. The fiasco at LTCM (Long Term Capital Management) is discussed as an example of the failure of VAR to measure risk over long time scales and under abnormal market conditions. They do not however give any detailed evidence for this claim, but a perusal of the research literature (surprisingly rather slim) reveals that LTCM made "major" errors in terms of their risk management, if viewed from the standpoint of VAR. This still leaves open the question as to whether it made "major" errors from the standpoint of some other method for measuring and evaluating risk that is possibly radically different from VAR.



Click Here to see more reviews about: The Essentials of Risk Management (Hardcover)