Chapter 2

Risk, Return, Performance Measurement, and Capital Regulation

In Chapter 1, we defined risk management as a discipline designed to help management understand the relative risks and returns from different strategies, both at the portfolio level (i.e., the perspective of the CEO or chief executive officer) and at the transaction level (i.e., the perspective of the trader, portfolio strategist, or lending officer). In this chapter, we focus on the nature of risk and return in a practical sense, not a philosophical sense. The practical definition of risk and return reflects the differences in perception of different parts of the financial world. The definitions also introduce a number of biases into perceived risk and return that can be very dangerous. We point out these dangers in this chapter and then spend the rest of the book talking about how to “avoid these pitfalls” in the conventional wisdom.

There is an ongoing debate in the financial services industry as to how risk and return should be measured. Fund managers and the asset side of pension funds are almost always on a mark-to-market basis. Insurance companies and commercial banks use a mix of mark-to-market risk/return management and a variation on financial accounting called transfer pricing, which separates the interest rate risk portion of net income from the non-rate-related components. We introduce the common practice of transfer pricing and its history in the last half of this chapter. We discuss the best ...

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