Risk Management: a Review
The Research Foundation of CFA Institute Literature Review
Risk Management: A Review
Sébastien Lleo, CFA
Imperial College London
The concept of risk has been central to the theory and practice of finance since Markowitz’s influential work nearly 60 years ago. Yet, risk management has only emerged as a field of independent study in the past 15 years. Advances in the science of risk measurement have been a main contributor to this remarkable development as new risk measures have been proposed and their properties studied. These measures, which in the past have only applied to market risk, are now being applied to credit, operational, and liquidity risk as well as to portfolio optimization. A growing emphasis on risk budgeting has also sparked a quest for an integrated risk measurement framework. But risk management is more than the application of quantitative techniques. A long list of past financial disasters demonstrates that a profound and concrete understanding of the nature of risk is required and that adequate internal controls are crucial.
The modern study of risk can be traced to Markowitz’s seminal work on portfolio selection.1 Markowitz made the observation that one should care about risk as well as return, and he placed the study of risk at center stage in the new field of financial economics. Since then, the science of risk management has grown and become its own field of study. Initially, risk management was manifest in hedging, that is the elimination of unwanted aspects of risk. Hedging is accomplished primarily through the use of derivatives. (An example would be the hedging of foreign currency risk associated with purchasing foreign currency denominated securities.) In the past 15 years, however, risk management has evolved beyond the practice of hedging and into a complex discipline that revolves around two dimensions: risk measurement and the practice of risk management. The two disciplines are different in their connotations for and
Risk Management: A Review
Sébastien Lleo, CFA
Imperial College London
The concept of risk has been central to the theory and practice of finance since Markowitz’s influential work nearly 60 years ago. Yet, risk management has only emerged as a field of independent study in the past 15 years. Advances in the science of risk measurement have been a main contributor to this remarkable development as new risk measures have been proposed and their properties studied. These measures, which in the past have only applied to market risk, are now being applied to credit, operational, and liquidity risk as well as to portfolio optimization. A growing emphasis on risk budgeting has also sparked a quest for an integrated risk measurement framework. But risk management is more than the application of quantitative techniques. A long list of past financial disasters demonstrates that a profound and concrete understanding of the nature of risk is required and that adequate internal controls are crucial.
The modern study of risk can be traced to Markowitz’s seminal work on portfolio selection.1 Markowitz made the observation that one should care about risk as well as return, and he placed the study of risk at center stage in the new field of financial economics. Since then, the science of risk management has grown and become its own field of study. Initially, risk management was manifest in hedging, that is the elimination of unwanted aspects of risk. Hedging is accomplished primarily through the use of derivatives. (An example would be the hedging of foreign currency risk associated with purchasing foreign currency denominated securities.) In the past 15 years, however, risk management has evolved beyond the practice of hedging and into a complex discipline that revolves around two dimensions: risk measurement and the practice of risk management. The two disciplines are different in their connotations for and
References: ———. 2006. The Essentials of Risk Management. New York: McGraw-Hill Professional. Crowder, Martin, Mark Davis, and Giacomo Giampieri. 2005. “Analysis of Default Data Using Hidden Markov Models.” Quantitative Finance, vol. 5, no. 1 (February):27–34. Embrechts, Paul, Rudiger Frey, and Alexander McNeil. 2005. Quantitative Risk Management: Concepts, Techniques and Tools. Princeton, NJ: Princeton University Press. Embrechts, Paul, Claudia Klüppelberg, and Thomas Mikosch. 2008. Modelling Extremal Events for Insurance and Finance. corr. 4th printing. New York: Springer. Embrechts, Paul, Alexander McNeil, and Daniel Straumann. 2002. “Correlation and Dependence in Risk Management: Properties and Pitfalls.” In Risk Management: Value-at-Risk and Beyond. Edited by Michael Dempster. Cambridge, U.K.: Cambridge University Press. Engle, Robert, Robert Ferstenberg, and Jeffrey Russel. 2006. “Measuring and Modeling Execution Cost and Risk.” Working Paper FIN-06-044, New York University Stern (April).