Risk Management in Turbulent Times

Hardcover | August 19, 2011

byGilles Beneplanc, Jean-Charles Rochet

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The subprime crisis has shown that the sophisticated risk management models used by banks and insurance companies had serious flaws. Some people even suggest that these models are completely useless. Others claim that the crisis was just an unpredictable accident that was largely amplified bythe lack of expertise and even naivety of many investors. This book takes the middle view. It shows that these models have been designed for "tranquil times", when financial markets behave smoothly and efficiently. However, we are living in more and more "turbulent times": large risks materialize much more often than predicted by "normal" models, financialmodels periodically go through bubbles and crashes. Moreover, financial risks result from the decisions of economic actors who can have incentives to take excessive risks, especially when their remunerations are ill designed. The book provides a clear account of the fundamental hypotheses underlying the most popular models of risk management and show that these hypotheses are flawed. However it shows that simple models can still be useful, provided they are well understood and used with caution.

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The subprime crisis has shown that the sophisticated risk management models used by banks and insurance companies had serious flaws. Some people even suggest that these models are completely useless. Others claim that the crisis was just an unpredictable accident that was largely amplified bythe lack of expertise and even naivety of ma...

Gilles Beneplanc is the Head of Europe, Middle East, and Africa region for the Mercer consulting firm. Jean-Charles Rochet is a Professor of Mathematics and Economics at the University of Toulouse.
Format:HardcoverDimensions:224 pages, 6.3 × 9.21 × 0.79 inPublished:August 19, 2011Publisher:Oxford University PressLanguage:English

The following ISBNs are associated with this title:

ISBN - 10:0199774080

ISBN - 13:9780199774081

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Table of Contents

IntroductionI Risk Management: What Must Be Changed1. Lessons From recent Financial Crises1.1 The Basic Goals of Risk Management1.2 When Risk Management Fails1.3 What Should Be Done?2. Living in Turbulent Times2.1 New and Larger Risks2.2 Increased Management Accountability2.3 Need for a Global Approach3. The Need for a Proper Methodology3.1 The Necessary Ingredients3.2 Risk Mapping3.3 Loss Control3.4 Risk AllocationII What is Behind Risk Modeling4. The Basic Tools of Risk Modeling4.1 Assessing Probabilities: The Frequentist and Subjective Approaches4.2 Bayesian updating4.3 Estimating Loss Distributions4.4 Combining Event Trees and Monte Carlo Methods4.5 The Dangers of the Stationarity Assumption5. Statistical Risk Measures5.1 The Expectation or Mean5.2 The Variance5.3 Linear Correlation5.4 Copulas5.5 The Value at Risk5.6 Mutualization and Diversification5.7 The Dangers of Using Simple Risk MeasuresAppendix: Extreme Value Theory6. Leverage and Ruin Theory6.1 Leverage and Return on Equity6.2 Economic Capital for a Bank6.3 Economic Capital for an Insurance Company6.4 The Limits of Ruin TheoryIII The Perfect Markets Hypothesis and its Dangers7. Risk Neutral Valuation7.1 The Expected Present Value Criterion7.2 The Magic of Perfect Markets7.3 Complete Markets and Absence of Arbitrage Opportunities7.4 A Binomial Example7.5 The Mirages of the Perfect Markets World8. The Case of Incomplete Markets: Relating Risk Premiums to Economic Fundamentals8.1 Solving the St Petersburg Paradox8.2 Certainty Equivalent8.3 Markets for Exchanging Risks8.4 The Limits of the Equilibrium Approach9. Risk Management in a Normal World9.1 The Mean-Variance Criterion9.2 Portfolio Choice9.3 The Diversification Principle9.4 Efficient Portfolios and the Sharpe Ratio9.5 The Capital Asset Pricing Model (CAPM)9.6 Futures Contracts and Hedging9.7 Capital Allocation and RaRoc9.8 The Dangers of Viewing the World as "Normal"Appendix 1: Portfolio Choice with Several Risky AssetsAppendix 2: Deriving the CAPM FormulaIV Risk Management and Shareholder Value10. Why Market Imperfections Matter for Shareholder Value10.1 Standards Methods for Assessing Shareholder Value10.2 Why is the Shareholder Value Function Likely to Be Non Linear: A Simple Example10.3 Incentive Problems Generate Financial Frictions11. The Shareholder Value Function11.1 A Target Level of Cash11.2 A Model for Optimizing Liquidity Management11.3 Liquidity and Shareholder ValueAppendix 1: Stochastic Differential CalculusAppendix 2: Derivation of the Shareholders Value Function12. 12.1 How Much Risk to Take?12.2 Which Risks to Insure?12.3 How Much Liquidity to Keep in Reserves?12.4 How Much hedging to Perform?V What to do in Practice13. The Different Steps of the Implementation13.1 Estimating the Shareholder Value Function13.2 A Unifying Metric for Risk Mapping: The Risk Value Mapping13.3 The New Instruments of Risk Management14. Learning from an Example14.1 Presentation of Med Corp14.2 Risk Analysis14.3 Shareholder Value and RM for Med Corp14.4 A Risk Transfer Policy for Med Corp15. Conclusion: Some Simple Messages15.1 Message # 1: Quantitative models are needed but they have to be used with precaution15.2 Message # 2: Risk Management creates value for shareholders15.3 Message # 3: Things to do in practice15.4 Message # 4: Key Ingredients for a successful RM approachIndex