Risk Management: Foundations for a Changing Financial World

CHAPTER 1

A FRAMEWORK FOR UNDERSTANDING MARKET CRISIS^a

Richard M. Bookstaber

The key to truly effective risk management lies in the behavior of markets during times of crisis, when investment value is most at risk. Observing markets under stress teaches important lessons about the role and dynamics of markets and the implications for risk management.

No area of economics has the wealth of data that we enjoy in the field of finance. The normal procedure we apply when using these data is to throw away the outliers and focus on the bulk of the data that we assume will have the key information and relationships that we want to analyze. That is, if we have 10 years of daily data—2,500 data points—we might throw out 10 or 20 data points that are totally out of line (e.g., the crash of 1987, the problems in mid-January 1991 during the Gulf War) and use the rest to test our hypotheses about the markets.

If the objective is to understand the typical day-to-day workings of the market, this approach may be reasonable. But if the objective is to understand the risks, we would be making a grave mistake. Although we would get some good risk management information from the 2,490 data points, unfortunately, that information would result in a risk management approach that works almost all the time but does not work when it matters most. This situation has happened many times in the past: Correlations that looked good on a daily basis suddenly went wrong at exactly the time the market was in turmoil; ...