Risk Management: Foundations for a Changing Financial World

CHAPTER 33

RISK-MANAGEMENT PROGRAMS^ag

Maarten Nederlof

The panic about derivatives has led to a call for increased regulation, but any regulation should be consistent across different instruments and should not single out derivatives. Changes in domestic and international financial markets have introduced many new risks, and managers need to develop effective strategies to manage them. The five axioms of an effective risk-management program are: (1) do not rely solely on quantitative models; (2) ask “What if I am wrong?” (3) ensure that accountability and authority match; (4) revise strategies and policies constantly; and (5) address the least likely events, which often cause the most damage.

Risk, in and of itself, is not bad. Investment managers have to take some risk to obtain returns in excess of a benchmark. What is bad is risk that is mispriced, mismanaged, or misunderstood. Particularly frightening is the unknown risk—the risk that something might happen that has never happened before—and the potential loss associated with that uncertainty. Recent well-publicized losses have put strong pressure on investment managers to control risk. The pressures have come from customers, boards, shareholders, and senior managers of investment firms.

An interesting side effect of this pressure is the increasing concern for the risks associated with derivatives. Although the visible bulk of the money has been lost by public funds, hedge funds, or broker/dealers, investment management firms ...