Financial Risk Management For Dummies

Chapter 9

Accounting for Extremes

In This Chapter

Understanding the two types of extreme events

Avoiding common errors

Accounting for multiple dimensions

Understanding extreme events is an essential part of financial risk management, and you don’t need maths for it. As risk manager, you need to be sure your company has the resources in place to survive dramatic changes such as stock market crashes or bank failures. But maintaining these resources is costly. If you insist on too high a level of protection, you can strangle the business. You need clear insight into which extreme events are plausible enough to affect your contingency planning.

When a civil engineer designs a bridge, he must think about the maximum stresses it will face: the heaviest loads, the biggest earthquakes, the highest floods and so on. Risk managers face the same issue when approving products and businesses and when setting limits and making contingency plans. Of course, financial risk managers are more concerned with political and market events than with physical risks (although physical risks pop up from time to time).

You must maintain focus when considering stresses and extremes. Don’t be foolish and ask, ...