Introduction: Wall Street Lessons from Bubbles

The credit crisis that began to unfold in the United States and Europe in 2006 contains a treasure trove of lessons for risk managers that we have tried to incorporate into this book. Since we have each worked in Japan, we felt strongly that the collapse of the Japanese bubble, which peaked in late 1989, contained equally useful lessons for risk managers. As you’ll note in the “key fallacies in risk management” discussed below, many ignored the lessons of the Japanese bubble because of the common fallacy that “if it hasn’t happened to me yet, it won’t happen to me, even if it’s happened to someone else.”

Now that the United States and much of Europe are experiencing the collapse of a bubble much like that which burst in Japan, the lessons from each of these bubbles seem much more relevant to risk managers around the world.

We have worked hard in the second edition of this book to severely de-emphasize the discussion of financial models that are obviously inaccurate, misleading, or clearly inferior to another modeling approach. We make this judgment on the basis of cold hard facts (via model testing) or because of assumptions that are known to be false. The list of models that failed under the duress of the credit crisis is a long one, and we make no apologies for reflecting those failures in this book. We’ve also worked hard to explain which models performed well during the credit crisis. Again, we base that judgment on model testing ...

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