Financial Risk Management: Models, History, and Institutions

CHAPTER 1

Financial Risk in a Crisis-Prone World

Risk has become a focal point for anyone thinking about, or acting in, financial markets. The financial market crisis that began in 2007 confirmed the centrality of risk analysis in finance and in public policy vis-à-vis the financial markets. The crisis, which we'll refer to going forward as the “subprime crisis,” will be the reference point for thinking about risk for decades to come.

The name itself is a bit of a misnomer for a crisis that now extends far beyond the subprime residential mortgage sector in the United States to the entire world and most sectors of the economy and financial system. It has highlighted grave shortcomings in public policy toward the economy, business and financial practices, and in previous analyses and prescriptions. It will be a recurrent and inescapable theme in this book.

In order to adequately analyze, or even describe, the subprime crisis, we need an analytical toolkit, which this textbook will provide. In this chapter, we survey the landscape of financial risk historically, sketch the financial world of our time, and provide an overview of different types of financial risk. We have two main objectives: to get a basic sense of the subject matter of financial risk analysis, and of the financial world in which we live and which market participants try to understand and influence. But a fuller description of the crisis itself will have to wait until later chapters.

1.1 SOME HISTORY: WHY IS RISK ...