Handbook in Monte Carlo Simulation: Applications in Financial Engineering, Risk Management, and Economics

Chapter Thirteen

Risk Measurement and Management

In this chapter we deal with a fundamental key issue in finance, i.e., risk. Actually, risk is a multidimensional concept, and there is a long list of risk factors that are relevant in finance. Risk factors directly related to financial markets are the first that come to mind, such as volatility in stock prices, interest rates, and foreign exchange rates, but they do not exhaust the list at all. For instance, after the subprime mortgage crisis, everyone is well aware of the role of credit risk, and the increasing interplay between financial markets and energy/commodity markets contributes to complicate the overall picture. In fact, the impact of derivative markets on oil and commodity (most notably, food) prices is controversial. The growth of derivative markets casts some doubts on seemingly obvious causal links: If one thinks about interest rate derivatives, it may seem natural assume that the value of those derivatives depends on prevailing conditions on money and capital markets. However, if one realizes the sheer volume of derivatives traded on regulated exchanges and over the counter, some doubts may arise about tails wagging dogs.

The above risk factors are often addressed by Monte Carlo methods, but we should mention that there are other risk factors that are less amenable to statistical approaches. The increasing role of information/communication technologies and globalization has introduced other forms of risk, such as ...