Asset and Liability Management: The Banker’s Guide to Value Creation and Risk Control, Second Edition

The aggregation of risks, Proposal II

Modern portfolio theory was first applied to the stock market by Professors Harry Markowitz and James Tobin, both Nobel Prize winners. Buying one share is risky, as its price can go up or down, but buying many shares is less risky because if one goes down, another one could go up, reducing the total risk of the portfolio. This is just an application of the saying: ‘Do not keep all your eggs in one basket.’ Our ALM problem does not concern the stock market, but interest-rate risk. Although a problem different from the one analysed by modern portfolio theory, it is related mathematically. Instead of looking at two sources of risk coming from the prices of two shares, we are looking at two volatile interest ...