Chapter 1

Setting the Scene

“If history repeats itself, and the unexpected always happens, how incapable must Man be of learning from experience.”

George Bernard Shaw (1856–1950)

1.1 FINANCIAL RISK MANAGEMENT

Financial risk management has experienced a revolution over the last two decades. This has been driven by infamous financial disasters due to the collapse of large financial institutions such as Barings (1995), Long Term Capital Management (1998), Enron (2001), Worldcom (2002), Parmalat (2003) and Lehman Brothers (2008). Such disasters have proved that huge losses can arise from insufficient management of financial risk and cause negative waves throughout the global financial markets.

Corporations need to manage risk carefully. This may be achieved rather passively by simply attempting to avoid exposure to risk factors that could be potentially damaging. More commonly, a firm may see the ability to understand risks and take exposure to particular areas as offering a strong competitive advantage. Quantitative approaches to risk management have been widely adopted in recent times, in particular with the popularity of the value-at-risk concept. Whilst strong quantitative risk management and reliance on financial models can be a useful part of the risk management armoury, overreliance on mathematics can be counterproductive.

Financial risk is broken down into many areas, of which counterparty risk is one. Counterparty risk is arguably one of the more complex areas to deal with ...

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