Risk Management: Foundations for a Changing Financial World

CHAPTER 3

THE THREE P’S OF TOTAL RISK MANAGEMENT^c

Andrew W. Lo

Current risk-management practices are based on probabilities of extreme dollar losses (e.g., measures like Value at Risk), but these measures capture only part of the story. Any complete risk-management system must address two other important factors—prices and preferences. Together with probabilities, these compose the three P’s of “Total Risk Management.” This article describes how the three P’s interact to determine sensible risk profiles for corporations and for individuals—guidelines for how much risk to bear and how much to hedge. By synthesizing existing research in economics, psychology, and decision sciences and through an ambitious research agenda to extend this synthesis into other disciplines, a complete and systematic approach to rational decision making in an uncertain world is within reach.

Although rational decision making in the face of uncertainty is by no means a new aspect of the human condition,¹ recent events have helped to renew and deepen interest in risk management. Two forces in particular have shaped this trend: advances in financial technology (models for pricing derivative instruments and computationally efficient means for implementing them) and an ever-increasing demand for new and exotic financial engineering products (perhaps because of increased market volatility or simply because of the growing complexity of the global financial system). These forces, coupled with such recent calamities ...