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Risk Management: Foundations for a Changing Financial World

Book Description

Key readings in risk management from CFA Institute, the preeminent organization representing financial analysts

Risk management may have been the single most important topic in finance over the past two decades. To appreciate its complexity, one must understand the art as well as the science behind it. Risk Management: Foundations for a Changing Financial World provides investment professionals with a solid framework for understanding the theory, philosophy, and development of the practice of risk management by

  • Outlining the evolution of risk management and how the discipline has adapted to address the future of managing risk

  • Covering the full range of risk management issues, including firm, portfolio, and credit risk management

  • Examining the various aspects of measuring risk and the practical aspects of managing risk

  • Including key writings from leading risk management practitioners and academics, such as Andrew Lo, Robert Merton, John Bogle, and Richard Bookstaber

For financial analysts, money managers, and others in the finance industry, this book offers an in-depth understanding of the critical topics and issues in risk management that are most important to today's investment professionals.

Table of Contents

  1. Title Page
  2. Copyright Page
  3. Foreword
  4. Acknowledgments
  5. Introduction
  6. PART I - OVERVIEW—TWO DECADES OF RISK MANAGEMENT
    1. CHAPTER 1 - A FRAMEWORK FOR UNDERSTANDING MARKET CRISIS
      1. SOURCES OF CRISIS
      2. CASE STUDIES
      3. LESSONS LEARNED
      4. POLICY ISSUES
      5. QUESTION AND ANSWER SESSION
    2. CHAPTER 2 - PRACTICAL ISSUES IN CHOOSING AND APPLYING RISK MANAGEMENT TOOLS
      1. EFFECTIVE RISK MANAGEMENT
      2. DEFINING RISK
      3. RISK MEASURES
      4. BUY OR BUILD?
      5. CONCLUSION
      6. QUESTION AND ANSWER SESSION
      7. NOTES
    3. CHAPTER 3 - THE THREE P’S OF TOTAL RISK MANAGEMENT
      1. THE THREE P’S
      2. PRICES
      3. PROBABILITIES
      4. PREFERENCES
      5. PUTTING THE THREE P’S TOGETHER
      6. THE FUTURE OF RISK MANAGEMENT
      7. ACKNOWLEDGMENTS
      8. NOTES
      9. REFERENCES
    4. CHAPTER 4 - REPORTING AND MONITORING RISK EXPOSURE
      1. THE RISK-MANAGEMENT SYSTEM
      2. INCORPORATING RISK INTO THE INVESTMENT PROCESS
      3. CONCLUSION
      4. ACKNOWLEDGMENTS
      5. QUESTION AND ANSWER SESSION
    5. CHAPTER 5 - RISK MANAGEMENT: A REVIEW
      1. FINANCIAL RISK OR FINANCIAL RISKS?
      2. LESSONS FROM FINANCIAL DISASTERS
      3. POPULAR RISK MEASURES FOR PRACTITIONERS
      4. CREDIT RISK METHODOLOGIES
      5. OPERATIONAL RISK
      6. LIQUIDITY RISK
      7. A NEW CLASSIFICATION OF RISK MEASURES
      8. THE QUEST FOR AN INTEGRATED RISK MEASUREMENT
      9. CONCLUSION
      10. NOTES
      11. REFERENCES
    6. CHAPTER 6 - DEFINING RISK
      1. FRANK KNIGHT
      2. CRITIQUE OF KNIGHT’S DEFINITION
      3. HARRY MARKOWITZ
      4. UNCERTAINTY
      5. EXPOSURE
      6. RISK
      7. OPERATIONAL DEFINITIONS
      8. AN OPERATIONAL PERSPECTIVE ON RISK
      9. CONCLUSION
      10. NOTES
      11. REFERENCES
    7. CHAPTER 7 - VALUE AND RISK: BEYOND BETAS
      1. RISK MANAGEMENT VS. RISK REDUCTION
      2. RISK AND VALUE: CONVENTIONAL VIEW
      3. EXPANDING THE ANALYSIS OF RISK
      4. FINAL ASSESSMENT OF RISK MANAGEMENT
      5. CONCLUSION
      6. NOTE
    8. CHAPTER 8 - A SIMPLE THEORY OF THE FINANCIAL CRISIS; OR, WHY FISCHER BLACK STILL MATTERS
      1. THE FINANCIAL CRISIS: ONE POSSIBLE SCENARIO
      2. HOW WERE ALL THESE SYSTEMATIC ERRORS POSSIBLE?
      3. WHERE DID WE END UP?
      4. REFERENCES
    9. CHAPTER 9 - MANAGING FIRM RISK
      1. ENHANCING RISK INTUITION THROUGH REAL-TIME PORTFOLIO MONITORING
      2. BANK VERSUS FUND RISK MANAGEMENT: NOT THE SAME GAME
      3. RISK REPORTING
      4. RISK JUDGMENTS
      5. CONCLUSION
      6. QUESTION AND ANSWER SESSION
    10. CHAPTER 10 - RISK MEASUREMENT VERSUS RISK MANAGEMENT
      1. FROM DATA TO USEFUL INFORMATION
      2. THE NEW INSTITUTIONAL INVESTOR
      3. TRANSPARENCY AND RISK MEASUREMENT: THE NEW CONSTITUENCY
      4. PROVIDING THE TOOLS
      5. CONCLUSION
      6. NOTE
  7. PART II - MEASURING RISK
    1. CHAPTER 11 - WHAT VOLATILITY TELLS US ABOUT DIVERSIFICATION AND RISK MANAGEMENT
      1. DID DIVERSIFICATION FAIL?
      2. DID RISK MODELS FAIL?
      3. SHOULD THE MAGNITUDE OF RISK HAVE BEEN A SURPRISE?
      4. WERE INVESTORS TOO EXPOSED TO TAIL RISK?
      5. CONCLUSION
      6. QUESTION AND ANSWER SESSION
    2. CHAPTER 12 - RISK: MEASURING THE RISK IN VALUE AT RISK
      1. MEASURING VAR
      2. EVALUATING VAR
      3. CONCLUSIONS
      4. NOTES
      5. REFERENCES
    3. CHAPTER 13 - HOW RISK MANAGEMENT CAN BENEFIT PORTFOLIO MANAGERS
      1. DEFINING RISK
      2. DEFINING RISK MANAGEMENT
      3. VAR BACKGROUND
      4. ADOPTING VAR
      5. CONCLUSION
      6. QUESTION AND ANSWER SESSION
    4. CHAPTER 14 - MERGING THE RISK MANAGEMENT OBJECTIVES OF THE CLIENT AND INVESTMENT MANAGER
      1. MANDATES AND GUIDELINES
      2. PARAMETRIC RISK ANALYSIS
      3. PROBABILITY-BASED RISK MEASURES
      4. MARKET RISK STRUCTURE
      5. STRESS TESTING
      6. CONCLUSION
      7. QUESTION AND ANWER SESSION
    5. CHAPTER 15 - THE MISMEASUREMENT OF RISK
      1. WHY INVESTORS CARE ABOUT INTERIM RISK
      2. WITHIN-HORIZON EXPOSURE TO LOSS
      3. APPLICATIONS
      4. CONCLUSIONS
      5. APPENDIX A. WITHIN-HORIZON RISK
      6. NOTES
      7. REFERENCES
    6. CHAPTER 16 - RISKINESS IN RISK MEASUREMENT
      1. ON TOOLS
      2. STATIC RISK
      3. DYNAMIC RISK
      4. REBALANCING REGIMES AND DISTRIBUTIONS
      5. CONCLUSION
      6. QUESTION AND ANSWER SESSION
      7. NOTES
    7. CHAPTER 17 - THE SECOND MOMENT
      1. NOTE
      2. REFERENCES
    8. CHAPTER 18 - THE SENSE AND NONSENSE OF RISK BUDGETING
      1. RISK ALLOCATION MODELS
      2. RISK ALLOCATION VS. ASSET ALLOCATION
      3. OPTIMAL RISK ALLOCATION
      4. SENSITIVITY OF THE OPTIMAL RISK ALLOCATION
      5. RISK ALLOCATIONS AND IMPLIED IRs
      6. OPTIMAL ALLOCATION TO STRATEGIC AND ACTIVE RISK
      7. SETTING THE OVERALL RISK BUDGET
      8. SETTING TARGET IRs
      9. CONCLUSION
      10. ACKNOWLEDGMENTS
      11. APPENDIX A. OPTIMAL RISK ALLOCATION
      12. NOTES
      13. REFERENCES
    9. CHAPTER 19 - UNDERSTANDING AND MONITORING THE LIQUIDITY CRISIS CYCLE
      1. THE CYCLE
      2. MEASURING THE CYCLE
      3. CONCLUSION
      4. NOTE
    10. CHAPTER 20 - WHY COMPANY-SPECIFIC RISK CHANGES OVER TIME
      1. COMPANY-SPECIFIC RISK OVER TIME
      2. WHY DOES COMPANY-SPECIFIC RISK CHANGE OVER TIME?
      3. CONTROLLING FOR THE THREE FACTORS
      4. CONCLUSION
      5. ACKNOWLEDGMENTS
      6. NOTES
      7. REFERENCES
    11. CHAPTER 21 - BLACK MONDAY AND BLACK SWANS
      1. THE LIGHT SHINED BY KNIGHT
      2. MANDELBROT ON RISK, RUIN, AND REWARD
      3. THE WISDOM OF KEYNES
      4. QUANTIFYING KEYNES’ DISTINCTION
      5. MINSKY ADDS A CRUCIAL INGREDIENT
      6. RISK AND RUIN—A REPRISE
      7. HIGH RISKS, LOW RISK PREMIUMS?
      8. OTHER RISKS
      9. AFTERWORD
      10. NOTES
      11. REFERENCES
    12. CHAPTER 22 - THE UNCORRELATED RETURN MYTH
      1. THEORY
      2. EVIDENCE
      3. NOTES
  8. PART III - MANAGING RISK
    1. CHAPTER 23 - RISK MANAGEMENT FOR HEDGE FUNDS: INTRODUCTION AND OVERVIEW
      1. WHY RISK MANAGEMENT?
      2. WHY NOT VAR?
      3. SURVIVORSHIP BIAS
      4. DYNAMIC RISK ANALYTICS
      5. NONLINEARITIES
      6. LIQUIDITY AND CREDIT
      7. OTHER CONSIDERATIONS
      8. CONCLUSION
      9. ACKNOWLEDGMENTS
      10. NOTES
      11. REFERENCES
    2. CHAPTER 24 - RISK MANAGEMENT FOR ALTERNATIVE INVESTMENT STRATEGIES
      1. RISK MANAGEMENT FRAMEWORK
      2. MANAGING RISK AND RETURN
      3. DUE DILIGENCE
      4. TYPES OF RISKS
      5. HOLISTIC APPROACH
      6. CONCLUSION
      7. QUESTION AND ANSWER SESSION
      8. NOTES
    3. CHAPTER 25 - SOURCES OF CHANGE AND RISK FOR HEDGE FUNDS
      1. BENCHMARKING
      2. TRANSPARENCY
      3. ARTICULATION OF INVESTMENT STRATEGY
      4. FEE RATIONALIZATION
      5. RISK CONTROL
      6. QUESTION AND ANSWER SESSION
      7. NOTE
    4. CHAPTER 26 - RISK MANAGEMENT IN A FUND OF FUNDS
      1. DEFINING RISK
      2. MANAGING TAIL RISK
      3. FUTURE RISKS
      4. QUESTION AND ANSWER SESSION
      5. NOTE
    5. CHAPTER 27 - HEDGE FUNDS: RISK AND RETURN
      1. THE TASS DATABASE
      2. NONNORMALITY OF RETURNS
      3. BIASES IN REPORTED HEDGE FUND RETURNS
      4. PERSISTENCE IN HEDGE FUND RETURNS
      5. PROBIT ANALYSIS OF PROBABILITY OF FUND DEMISE
      6. CONCLUSION
      7. ACKNOWLEDGMENTS
      8. NOTES
      9. REFERENCES
    6. CHAPTER 28 - CREDIT RISK
      1. WHAT ARE CREDIT DERIVATIVES?
      2. PREDICTING DEFAULT
      3. STRUCTURAL PRICING MODELS
      4. REDUCED-FORM PRICING MODELS
      5. CDS
      6. TIME-VARYING DEFAULT INTENSITIES
      7. SIMULATING DEFAULT TIMES
      8. EXAMPLE OF SIMULATING DEFAULT TIMES
      9. CDOs
      10. THE IMPACT OF CORRELATION ON CDO PRICES
      11. CREDIT INDICES
      12. BASKET DEFAULT SWAPS
      13. MODELS OF CORRELATED DEFAULT
      14. PRICING A CDO BY MONTE CARLO ANALYSIS
      15. SUMMARY
      16. ACKNOWLEDGMENTS
      17. NOTES
      18. REFERENCES
    7. CHAPTER 29 - TUMBLING TOWER OF BABEL: SUBPRIME SECURITIZATION AND THE CREDIT CRISIS
      1. RISK-SHIFTING BUILDING BLOCKS
      2. WHAT GOES UP . . .
      3. . . . MUST COME DOWN
      4. CONCLUSION: BUILDING FROM THE RUINS
      5. ACKNOWLEDGMENTS
      6. NOTES
      7. REFERENCES
    8. CHAPTER 30 - APPLYING MODERN RISK MANAGEMENT TO EQUITY AND CREDIT ANALYSIS
      1. PAST DISTORTIONS IN VALUATION AND RISK ANALYSIS
      2. PRESENT FAILURES IN RECOGNIZING VALUE AND RISK
      3. FUTURE DISTORTIONS: DERIVATIVES IN STRATEGIC RISK MANAGEMENT
      4. CONCLUSION
      5. QUESTION AND ANSWER SESSION
      6. NOTE
      7. REFERENCES
    9. CHAPTER 31 - THE USES AND RISKS OF DERIVATIVES
      1. DERIVATIVES
      2. HISTORY OF DERIVATIVE PRODUCTS
      3. USING DERIVATIVES IN GLOBAL PORTFOLIOS
      4. RISK MANAGEMENT AND DERIVATIVES
      5. CONCLUSION
      6. NOTES
    10. CHAPTER 32 - EFFECTIVE RISK MANAGEMENT IN THE INVESTMENT FIRM
      1. WHY RISK MANAGEMENT NOW?
      2. THE GROUP OF THIRTY REPORT
      3. THE 1994 FOLLOW-UP STUDY
      4. MARKET RISK
      5. CONCLUSION
      6. QUESTION AND ANSWER SESSION
    11. CHAPTER 33 - RISK-MANAGEMENT PROGRAMS
      1. RISK-MANAGEMENT PREMISES
      2. TODAY’S RISKS
      3. A RISK-MANAGEMENT PROGRAM
      4. CONCLUSION
      5. QUESTION AND ANSWER SESSION
      6. NOTE
    12. CHAPTER 34 - DOES RISK MANAGEMENT ADD VALUE?
      1. COMPANY USES OF RISK MANAGEMENT
      2. MARKET REACTION
      3. CONCLUSION
      4. QUESTION AND ANSWER SESSION
      5. NOTES
    13. CHAPTER 35 - RISK MANAGEMENT AND FIDUCIARY DUTIES
      1. FIDUCIARY RELATIONSHIPS
      2. FIDUCIARY LAW
      3. FIDUCIARY LAW VERSUS CONTRACT LAW
      4. TRUST LAW VERSUS CORPORATE LAW
      5. FIDUCIARY DUTIES
      6. LESSONS FROM CASE LAW
      7. CONCLUSION
      8. QUESTION AND ANSWER SESSION
      9. NOTES
    14. CHAPTER 36 - FINANCIAL RISK MANAGEMENT IN GLOBAL PORTFOLIOS
      1. THE FUNDAMENTALS
      2. DEALING WITH RISK
      3. DEALING WITH MISCONCEPTIONS
      4. CONCLUSION
      5. NOTES
    15. CHAPTER 37 - UNIVERSAL HEDGING: OPTIMIZING CURRENCY RISK AND REWARD IN INTERNATIONAL EQUITY PORTFOLIOS
      1. WHY HEDGE AT ALL?
      2. THE UNIVERSAL HEDGING FORMULA
      3. APPLYING THE FORMULA TO OTHER TYPES OF PORTFOLIOS
      4. CONCLUSION
      5. NOTES
    16. CHAPTER 38 - STRATEGIES FOR HEDGING
      1. MOTIVATION FOR CURRENCY-RISK MANAGEMENT
      2. CURRENCY EXPOSURE AND DIVERSIFICATION
      3. LINEAR CURRENCY-HEDGING STRATEGIES
      4. NONLINEAR CURRENCY-HEDGING STRATEGIES
      5. CASH FLOW MANAGEMENT FOR CURRENCY-HEDGING STRATEGIES
      6. CONCLUSION
      7. QUESTION AND ANSWER SESSION
    17. CHAPTER 39 - CURRENCY RISK MANAGEMENT IN EMERGING MARKETS
      1. MANAGING CURRENCY RISK
      2. CONCLUSION
    18. CHAPTER 40 - MANAGING GEOPOLITICAL RISKS
      1. PROCESSES DRIVING RISK
      2. UNITED STATES
      3. CHINA
      4. RUSSIA
      5. EMERGING MARKETS
      6. GEOPOLITICAL RISK AND THE ENERGY PROBLEM
      7. CONCLUSION
      8. QUESTION AND ANSWER SESSION
      9. NOTES
    19. CHAPTER 41 - COUNTRY RISK IN GLOBAL FINANCIAL MANAGEMENT
      1. FOREWORD
      2. PREFACE
      3. EXECUTIVE SUMMARY
      4. INTRODUCTION
      5. COUNTRY RISK
      6. DETERMINING COUNTRY RISK IN PRACTICE
      7. APPLICATIONS OF COUNTRY RISK ANALYSIS
      8. IMPLICATIONS FOR PORTFOLIO MANAGEMENT
      9. Other Portfolio Management Applications
      10. CONCLUSION
      11. APPENDIX: COUNTRY RISK RATINGS USED IN THE MONOGRAPH
      12. NOTES
      13. REFERENCES
    20. CHAPTER 42 - POLITICAL RISK IN THE WORLD ECONOMIES
      1. POLITICAL RISK ANALYSIS
      2. POLITICAL RISK MODEL
      3. COUNTRY RANKINGS
      4. CONCLUSION
      5. NOTE
    21. CHAPTER 43 - A BEHAVIORAL PERSPECTIVE ON RISK MANAGEMENT
      1. LOSS AVERSION
      2. RISK VERSUS UNCERTAINTY
      3. INTERPRETING PROBABILITIES
      4. CONCLUSION
      5. QUESTION AND ANSWER SESSION
      6. NOTES
    22. CHAPTER 44 - BEHAVIORAL RISK: ANECDOTES AND DISTURBING EVIDENCE
      1. FLAW ONE: OVERCONFIDENCE
      2. FLAW TWO: DECISION FRAMING
      3. FLAW THREE: AGENCY FRICTION
      4. CONCLUSION
      5. NOTE
      6. READING LIST
    23. CHAPTER 45 - THE TEN COMMANDMENTS OF OPERATIONAL DUE DILIGENCE
      1. ONE: DEFINE THE ROLE
      2. TWO: DEFINE THE GOAL—SAFEGUARD THE ASSETS
      3. THREE: DEFINE THE OBJECTIVE—INTEGRATE CONTROLS CONSISTENTLY AND EFFECTIVELY
      4. FOUR: SEGREGATE THE FUNCTION
      5. FIVE: DO THE WORK
      6. SIX: DOCUMENT AND COMMUNICATE
      7. SEVEN: WORK EFFICIENTLY WITH INVESTMENT RESEARCH
      8. EIGHT: REMEMBER THE FUNDAMENTALS
      9. NINE: NOTE THE TONE AT THE TOP
      10. TEN: BE VIGILANT ABOUT RED FLAGS
      11. QUESTION AND ANSWER SESSION
      12. NOTE
    24. CHAPTER 46 - MODELS
      1. MODEL AIRPLANES
      2. MODELS IN PHYSICS
      3. MODELS IN FINANCE
      4. THE FOUNDATIONS OF FINANCIAL ENGINEERING
      5. MODEL RISK
      6. CONCLUSION
      7. NOTE
      8. REFERENCE
    25. CHAPTER 47 - THE USE AND MISUSE OF MODELS IN INVESTMENT MANAGEMENT
      1. WHERE FINANCIAL MODELS ARE USEFUL
      2. IMPLICATIONS FOR HEDGING
      3. MISUSES OF MODELS
      4. MODELS FOR NONLINEARITIES IN CORPORATE BOND AND BANKING RISKS
      5. REAL ESTATE RISKS NEVER SEEN BEFORE
      6. CONCLUSION
      7. QUESTION AND ANSWER SESSION
      8. REFERENCES
    26. CHAPTER 48 - REGULATING FINANCIAL MARKETS: PROTECTING US FROM OURSELVES AND OTHERS
      1. MARGIN (LEVERAGE) REGULATIONS
      2. SUITABILITY REGULATIONS
      3. BLUE SKY AND MANDATORY DISCLOSURE
      4. WHAT SHOULD WE DO?
      5. CONCLUSION
      6. REFERENCES
    27. CHAPTER 49 - BUDGETING AND MONITORING PENSION FUND RISK
      1. PENSION FUND CHARACTERISTICS
      2. ESTIMATING RISK
      3. PENSION FUND APPLICATIONS
      4. IMPLEMENTATION ISSUES
      5. CONCLUSION
      6. NOTES
      7. REFERENCES
    28. CHAPTER 50 - THE PLAN SPONSOR’S PERSPECTIVE ON RISK MANAGEMENT PROGRAMS
      1. BACKGROUND
      2. PHILOSOPHY, OBJECTIVES, AND MISSION
      3. RISK MANAGEMENT APPROACH
      4. BUILDING BLOCKS OF RISK MANAGEMENT
      5. KEY CRITERIA
      6. CONCLUSION
      7. QUESTION AND ANSWER SESSION
    29. CHAPTER 51 - EVALUATING A RISK-MANAGEMENT PROGRAM
      1. A VIEW OF RISK
      2. POTENTIAL OBJECTIVES FOR A RISK-MANAGEMENT PROGRAM
      3. HOW A PLAN SPONSOR MIGHT IMPLEMENT AND EVALUATE RISK MANAGEMENT
      4. CONCLUSION
      5. QUESTION AND ANSWER SESSION
      6. NOTES
    30. CHAPTER 52 - DEVELOPING AND IMPLEMENTING A RISK-BUDGETING SYSTEM
      1. ROLE OF THE SPONSOR
      2. THE PENSION FUNDING CRISIS
      3. PENSION RISK
      4. CHANGES IN OTPP POLICIES
      5. PASSIVE AND ACTIVE RISK
      6. ALTERNATIVE INVESTMENTS
      7. ASSET MIX AND TOTAL RISK
      8. CONCLUSION
      9. QUESTION AND ANSWER SESSION
      10. NOTES
    31. CHAPTER 53 - LIABILITY-DRIVEN INVESTMENT STRATEGIES FOR PENSION FUNDS
      1. SWISS PENSION SYSTEM
      2. LIABILITY-DRIVEN INVESTING
      3. UNDERSTANDING LIABILITIES
      4. IMMUNIZATION AND CASH FLOW MATCHING
      5. CONCLUSION
      6. QUESTION AND ANSWER SESSION
  9. ABOUT THE CONTRIBUTORS
  10. INDEX