Financial Risk Management: A Practitioner's Guide to Managing Market and Credit Risk, 2nd Edition

Foreword

Risk was a lot easier to think about when I was a doctoral student in finance 25 years ago. Back then, risk was measured by the variance of your wealth. Lowering risk meant lowering this variance, which usually had the unfortunate consequence of lowering the average return on your wealth as well.

In those halcyon days, we had only two types of risk, systemic and unsystematic. The latter one could be lowered for free via diversification, while the former one could only be lowered by taking a hit to average return. In that idyllic world, financial risk management meant choosing the variance that maximized expected utility. One merely had to solve an optimization problem. What could be easier?

I started to appreciate that financial risk management might not be so easy when I moved from the West Coast to the East Coast. The New York–based banks started creating whole departments to manage financial risk. Why do you need dozens of people to solve a simple optimization problem? As I talked with the denizens of those departments, I noticed they kept introducing types of risk that were not in my financial lexicon. First there was credit risk, a term that was to be differentiated from market risk, because you can lose money lending whether a market exists or not. Fine, I got that, but then came liquidity risk on top of market and credit risk. Just as I was struggling to integrate these three types of risk, people started worrying about operational risk, basis risk, mortality risk, ...