Risk Management: Foundations for a Changing Financial World

CHAPTER 5

RISK MANAGEMENT: A REVIEW^e

Sébastien Lleo, CFA

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. ...