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Chapter 2
Overview of Financial Risk Management
RISK MANAGEMENT DEFINED
Risk management describes a collection of activities to identify, measure and ultimately manage a set of risks. Human enterprise in its various forms confront risks every day; the individual deciding whether to leave a relatively secure job for another with better opportunity and compensation across country; the government facing the threat of terrorist attacks on public transportation; or the bank having to determine which financial products it should offer to customers. While some risks are fairly mundane and others a matter of life or death at times, the fundamental process for assessing risk entails evaluation of tradeoffs of outcomes depending on the course of action taken. The complexity of the risk assessment is a function of the potential impact from a particular set of outcomes; the individual deciding to take a different job is likely to engage in a simpler risk assessment; perhaps drawing up a pros and cons template while a government facing terrorist threats might establish a rigorous set of quantitative and surveillance tools to gather intelligence and assign likelihoods and impacts to a range of outcomes.
Regardless of the application or circumstance, each of the assessments above has a common thread; namely the assessment of risk. But what exactly is risk and is it the same across all of these situations? Risk is fundamentally about quantifying the unknown. Uncertainty by its very nature tends to complicate our thinking about risk since we cannot touch or see it although it is all around us. As human beings have advanced in their application of technology and science to problem solving, a natural evolution to assessing risk using such capabilities has taken place over time. Quantifying uncertainty has taken the discipline of institutional risk management to a new level over the last few decades with the acceleration in computing hardware and software and
Overview of Financial Risk Management
RISK MANAGEMENT DEFINED
Risk management describes a collection of activities to identify, measure and ultimately manage a set of risks. Human enterprise in its various forms confront risks every day; the individual deciding whether to leave a relatively secure job for another with better opportunity and compensation across country; the government facing the threat of terrorist attacks on public transportation; or the bank having to determine which financial products it should offer to customers. While some risks are fairly mundane and others a matter of life or death at times, the fundamental process for assessing risk entails evaluation of tradeoffs of outcomes depending on the course of action taken. The complexity of the risk assessment is a function of the potential impact from a particular set of outcomes; the individual deciding to take a different job is likely to engage in a simpler risk assessment; perhaps drawing up a pros and cons template while a government facing terrorist threats might establish a rigorous set of quantitative and surveillance tools to gather intelligence and assign likelihoods and impacts to a range of outcomes.
Regardless of the application or circumstance, each of the assessments above has a common thread; namely the assessment of risk. But what exactly is risk and is it the same across all of these situations? Risk is fundamentally about quantifying the unknown. Uncertainty by its very nature tends to complicate our thinking about risk since we cannot touch or see it although it is all around us. As human beings have advanced in their application of technology and science to problem solving, a natural evolution to assessing risk using such capabilities has taken place over time. Quantifying uncertainty has taken the discipline of institutional risk management to a new level over the last few decades with the acceleration in computing hardware and software and