Financial Economics

11

RISK AND RISK MANAGEMENT

What do financial economists mean by risk and how is risk to be managed? In this chapter, we explain why risk cannot be described in the abstract, but instead depends on such specifics as the decision maker's preferences, wealth position, and, in many cases, on environmental circumstances as well. For example, a possible monetary loss of $1,000 can mean a great deal to a struggling student, but much less to a wealthy businessperson. Similarly, a possible loss of $1,000 is more serious in a depressed economy than in a buoyant one. Risks can also be characterized according to a number of other features. For example, risks can differ with the decision maker's chosen time horizon. Moreover, those risks can evolve dynamically through time. Decision makers’ preferences can also change, both with respect to differing circumstances and over time. As a result of these many factors characterizing risk, management tasks also take on a large variety of forms that may similarly change through time.

In order to present the complexities of risk-management tasks systematically, this chapter approaches them as management problems. We begin the chapter by outlining different kinds of risks and the attitudes of decision makers facing them. We then examine how different combinations of these elements present a variety of optimization problems. In the present discussion, optimization means doing the best you can, given what you already know and what you can find out.¹ While ...