Chapter 1

Risk Management*

Financial risk management is the process by which financial risks are identified, assessed, measured, and managed in order to create economic value.

Some risks can be measured reasonably well. For those, risk can be quantified using statistical tools to generate a probability distribution of profits and losses. Other risks are not amenable to formal measurement but are nonetheless important. The function of the risk manager is to evaluate financial risks using both quantitative tools and judgment.

As financial markets have expanded over recent decades, the risk management function has become more important. Risk can never be entirely avoided. More generally, the goal is not to minimize risk; it is to take smart risks.

Risk that can be measured can be managed better. Investors assume risk only because they expect to be compensated for it in the form of higher returns. To decide how to balance risk against return, however, requires risk measurement.

Centralized risk management tools such as value at risk (VAR) were developed in the early 1990s. They combine two main ideas. The first is that risk should be measured at the top level of the institution or the portfolio. This idea is not new. It was developed by Harry Markowitz (1952), who emphasized the importance of measuring risk in a total portfolio context.1 A centralized risk measure properly accounts for hedging and diversification effects. It also reflects the fact that equity is a common capital buffer ...

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