Risk Management: Foundations for a Changing Financial World

CHAPTER 6

DEFINING RISK^f

Glyn A. Holton

 

 

Financial markets are becoming increasingly sophisticated in pricing, isolating, repackaging, and transferring risks. Tools such as derivatives and securitization contribute to this process, but they pose their own risks. The failure of accounting and regulation to keep abreast of developments introduces yet more risks, with occasionally spectacular consequences.

Practical applications—including risk limits, trader performance-based compensation, portfolio optimization, and capital calculations—all depend on the measurement of risk. In the absence of a definition of risk, it is unclear what, exactly, such measurements reflect. With financial decisions hanging in the balance, debates flare on trading floors and in industry magazines.

A search of the financial literature yields many discussions of risk but few definitions. To understand risk, we must explore two streams flowing through the 20th century. One is subjective probability. The other is operationalism. Where they meet, we can understand risk. Interestingly, both streams have origins in the same source—the empiricism of David Hume.

FRANK KNIGHT

The most famous definition of risk is that provided by Frank Knight (1921), who wrote during a period of active research into the foundations of probability. Contemporaneous research includes John Maynard Keynes (1921), Richard von Mises (1928), and Andrey Kolmogorov (1933). One debate from this period relates to subjective versus objective ...