Risk Management

Human beings have been taking and managing risks for centuries. Peter Bernstein argues that the mastery of risk is what separates ancient from modern times. He attributes the calculation of probabilities, beginning in 16th-century Italy, with our ability to quantify risk and to make informed decisions on the basis of scientific forecasts.

Although risk management has been practiced for thousands of years, it was not until the 1950s that it was articulated and formally developed, by academics working in the field of insurance. Their initial focus was on “pure risk,” or “hazard risk,” where there is either a loss or no loss. For example, owning a house gives rise to the risk of loss from it burning down or being destroyed by a hurricane or other force of nature. These are risks that have traditionally been covered by insurers. Robert Mehr and Bob Hedges, widely credited as the fathers of risk management, argued that risks should be managed in a comprehensive manner and not simply insured.

Risk can also be classified as “speculative risk” if the source ofrisk gives rise to the possibility of gain as well as loss. For example, investing in the stock market generates the possibility of a gain if share prices rise or a loss if they fall. Such “financial risks” were of little consequence when interest rates were stable, foreign exchange rates were fixed, and inflation was low. This changed in the 1970s with the abolition of the Bret-ton Woods system of fixed exchange rates and the oil price increases that arose from cuts in production by the Organization of Petroleum Exporting Countries (OPEC). The oil price shocks led the U.S. Federal Reserve to focus on fighting inflation rather than stabilizing interest rates, with the result that U.S. interest rates became more volatile, leading to a spillover effect on other nations. Thus, financial risks became an important concern for companies and financial institutions, which required products to hedge them.

Most financial risks are hedged using derivative products—forwards, futures, options, and swaps. With the exception of swaps, which are a recent innovation (the first swap transaction, involving currencies, took place in 1981), derivative products based on nonfinancial assets had been in use long before they were adapted to deal with financial risks. However, it did not take long for a wide array of financial derivatives to be developed. An important catalyst was the publication of the Black-Scholes-Merton formula for pricing options. This coincided with the opening of the Chicago Board Options Exchange in 1973, the first exchange devoted solely to options trading, and laid the foundations for a rapid growth in the volume of contracts traded in this new market.

Financial risks can be classified broadly into three categories: market risk, credit risk, and operational risk. Market risk is the risk of a change in the value of a financial position arising from changes in the value of the underlying components on which that position depends, such as stock prices, bond prices, or exchange rates. All entities that own financial assets face market risk. For example, the value of currencies owned by banks depends on exchange rates. The most popular method to measure market risk is value at risk (VaR) which refers to the maximum possible loss from an unfavorable event, within a given level of confidence, for a defined holding period. It was popularized by the investment bank JP Morgan in 1994 when it published a technical document, RisIcMetrics, to promote the use of VaR among the firm's institutional clients. Before this, VaR was largely unheard of among corporate treasuries and commodity trading firms, but after the publication of RisIcMetrics, its adoption spread rapidly among both financial and nonfinancial firms.

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