Financial Risk Management For Dummies^®

Published by: John Wiley & Sons, Ltd., The Atrium, Southern Gate, Chichester, www.wiley.com

This edition first published 2016

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ISBN 978-1-119-08220-0 (hardback/paperback) ISBN 978-1-119-08218-7 (ebk)

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Financial Risk Management For Dummies®

Visit www.dummies.com/cheatsheet/financialriskmanagment to view this book's cheat sheet.

Table of Contents
1. Cover
2. Introduction
  1. About This Book
  2. Foolish Assumptions
  3. Icons Used In This Book
  4. Beyond the Book
  5. Where to Go From Here
3. Part I: Getting Started with Risk Management
  1. Chapter 1: Living with Risk
    1. Understanding the Scope of Risk
    2. Working with Financial Risk
    3. Communicating Risk
  2. Chapter 2: Understanding Risk Models
    1. Comparing Frequentism and Bayesianism
    2. Playing Roulette
    3. Getting Scientific with Risk
  3. Chapter 3: Taking Charge of Risk
    1. Distinguishing Risk
    2. Choosing Your Goal
    3. Considering Dangers, Opportunities and Risk
  4. Chapter 4: Managing Financial Risk
    1. Looking at Financial Markets
    2. Playing the Game
    3. Maintaining Equilibrium
    4. Surviving
  5. Chapter 5: Functions of a Financial Risk Manager
    1. Developing from Traders and Trading
    2. Running the Middle Office
    3. Reporting Requirements
4. Part II: Measuring Financial Risk
  1. Chapter 6: Valuing Risk
    1. Understanding VaR
    2. Putting VaR to Use
    3. Adding Flavours to VaR
  2. Chapter 7: Stress Testing for Success
    1. Testing for Stress
    2. Imagining Stress Events
    3. Building Your Stress
    4. Telling Sad Stories during a Scenario Analysis
    5. Working Backwards
  3. Chapter 8: Speaking Greek
    1. Parsing Portfolios
    2. Deriving Greeks
    3. Bonding
  4. Chapter 9: Accounting for Extremes
    1. Distinguishing Extremes
    2. Spotting Extreme Fallacies
    3. Adding Dimensions
5. Part III: Managing Financial Risk
  1. Chapter 10: Setting Limits
    1. Describing Basic Limits
    2. Going through the Process
    3. Administering Limits
  2. Chapter 11: Stopping Losses
    1. Understanding Stops
    2. Avoiding Stop Mistakes
    3. Overruling Stops
    4. Monitoring Stop Frequency
  3. Chapter 12: Controlling Drawdowns
    1. Comparing Stopping Loss and Controlling Drawdown
    2. Setting the Baseline Risk Level
    3. Considering Stakeholders
    4. Building a Drawdown Control System
    5. Regrouping after a Drawdown Event
  4. Chapter 13: Hedging Bets
    1. Choosing Goals
    2. Measuring Exposure
    3. Changing Exposure
    4. Monetising Hedges
6. Part IV: Working in Financial Institutions
  1. Chapter 14: Trading Places
    1. Understanding Traders
    2. Helping Traders
  2. Chapter 15: Banking on Risk
    1. Banking Basics
    2. Regulating Capital
    3. Managing Bank Risk
  3. Chapter 16: Managing Assets and Portfolios
    1. Surveying Financial Institutions and Their Risks
    2. Looking at Asset Management Companies and the Funds They Manage
    3. Comparing Portfolio and Risk Management
  4. Chapter 17: Insuring Risk
    1. Understanding Insurance
    2. Reinsuring
    3. Crunching the Numbers with Actuaries
7. Part V: Communicating Risk
  1. Chapter 18: Reporting Risk
    1. Appreciating the Role of Risk Management
    2. Writing Reports
    3. Presenting to Boards of Directors
    4. Incorporating Feedback
  2. Chapter 19: Regulating Finance
    1. Looking at Regulators and What They Do
    2. Forging Relationships with Regulators
    3. Banking on Basel
    4. Stressing Regulation
    5. Dealing with Unintended Consequences
8. Part VI: The Part of Tens
  1. Chapter 20: Ten One-Minute Risk Management Tips
    1. Fear the Market
    2. Plan for Success
    3. Hire Honest People
    4. Listen Another Second
    5. Split the Difference
    6. Don’t Ignore Idiots
    7. Respect the Past
    8. Do the Asymptotics
    9. Check the Data
    10. Encourage Fast Failure
  2. Chapter 21: Ten Days that Shook the (Financial) World
    1. 3 February 1637: Tulipmania
    2. 1 December 1825: South American Bond Crisis
    3. 24 September 1869: Black Friday
    4. 31 July 1905: Le roi du sucre et le roi du marché (The sugar king and the market king)
    5. 27 March 1980: Silver Thursday
    6. 1986–1993: Savings and Loan Crisis
    7. 19 October 1987: Black Monday
    8. 18 April 1994: Rogue Trader Joseph Jett
    9. 6–10 August 2007: Quant Equity Crisis
    10. 12 August 2012: The London Whale
  3. Chapter 22: Ten Great Risk Managers in History
    1. Abraham Wald
    2. Alhazen
    3. Dwight Eisenhower
    4. Epicurus
    5. Gideon
    6. Henry Petroski
    7. John Kelly
    8. Nathan Bedford Forrest
    9. Rituparna
    10. Zu Chongzhi
  4. Chapter 23: Ten Great Risk Books
    1. A Demon of Our Own Design by Richard Bookstaber
    2. Beat the Market by Ed Thorp
    3. Dynamic Hedging by Nassim Taleb
    4. Expert Political Judgment by Philip Tetlock
    5. Finding Alpha by Eric Falkenstein
    6. Fischer Black and the Revolutionary Idea of Finance by Perry Mehrling
    7. Gambling and Speculation by Reuven and Gabrielle Brenner
    8. Iceberg Risk by Kent Osband
    9. Risk Intelligence by Dylan Evans
    10. The Foundations of Statistics by Leonard J Savage
9. About the Author
10. Cheat Sheet
11. Connect with Dummies
12. End User License Agreement

Introduction

Risk management is about preparing for anything that might happen. People who try to predict the future are the enemies of risk management. They’re the ones who say, ‘Let’s build a wall on the north side of town because that’s where we predict the attack will come.’ Risk managers know that leaving any gap in the wall means the attackers will exploit the gap.

Preventing disaster is easy – you just don’t take any risk. Risk management is about surviving disaster, not preventing it. If there weren’t disasters, you wouldn’t call it risk. You need risk – and its attendant disasters – to learn, to grow, to excel.

If you want to be a risk manager, this book gives you a good start. You need practice at risk taking, plus some maths and financial theory, plus some practice at finance. If you already have all of those things, you should be writing this book, not reading it.

About This Book

People have been concerned about risk as long as there have been people. Financial Risk Management For Dummies explains the background and some theory about risk, quantitative analysis of risk and modern financial risk management and shows you how to apply them in practice, without jargon or mathematics. Okay, I throw in a few examples that require addition and multiplication, but they’re clearly labelled and can be skipped, and I also give you lots of simple, specific illustrations.

This book tells you what financial risk managers do and why they do it.

Foolish Assumptions

I make three different guesses about who you are and why you’re reading this book:

You’re currently, or hope to be, a financial manager, and you want to delve into the risk management aspect of your job. By itself, this book cannot teach you that, but if you already know the basic financial theory and mathematics or go elsewhere to discover them, this book can show you how to apply them properly to become a good financial risk manager.
You work with financial risk managers and want to understand how they see things. This book can show you the world from their perspective, and help you form constructive partnerships.
You have no professional connection to finance, but want to understand both the good risks in finance, the ones that help the economy grow and people realise their dreams, and the bad risks in finance, the ones that damage the economy and blight lives. This book can help you navigate the modern financial system to achieve financial security.

Icons Used In This Book

These little pieces of margin art bring your attention to exceptionally interesting or useful information. That is, except for text next to the Technical Stuff icon, which is information – usually maths – you may find helpful if you’re interested.

Simple, standalone advice that you can take to improve your risk management.

Standalone stuff it pays to keep in mind.

Stuff I love and the For Dummies editors don’t has this icon. You can skip it if you want, I promise all the important ideas are explained clearly in non-technical language elsewhere. But come on, this stuff is really fun and a little maths won’t hurt you.

This icon marks stuff not to do. In risk management, if you do something you’re not supposed to, it isn’t usually actually dangerous. This icon marks situations that may seem attractive in the short run but that defeat the long-term goals of risk management.

Real-world scenarios, and sometimes real-life maths, get this icon.

Beyond the Book

Risk is a big topic, too big to fit entirely into the book or e-book you’re holding at the moment. I put some additional material on the web. I created cheat sheets (www.dummies.com/cheatsheet/financialriskmanagment) with the key ideas for managing seven specific kinds of risk:

Market risk: Uncertainty due to changes in market prices.
Credit risk: Uncertainty due to a failure of an external entity to keep a promise.
Operational risk: Institutional uncertainties other than market or credit risk.
Liquidity risk: Uncertainty about terms and the ability to make a transaction when necessary or desired.
Funding risk: Uncertainty about whether investors will provide sufficient funds.
Reputational risk: Uncertainty about how your entity will be perceived.
Political risk: Uncertainty about government actions.

I also stick in some concentrated summaries of four sections of this book: Measuring Risk, Communicating Risk, Managing Risk and Working as a Risk Manager. You can also access bonus material at www.dummies.com/extras/financialriskmanagement, including ten great links that illustrate ten financial risk management lessons is amusing and dramatic fashion, from killer molasses to an Olympic David versus Goliath tale.

Where to Go From Here

If you know nothing about finance or risk and want to be a financial risk manager, I recommend reading this book in order. But, you can jump around to whatever chapters and sections seem interesting. Switching back and forth between theory and practice, between high-level views of the forest and detailed descriptions of individual trees may be the best way to understand what modern financial risk management is all about.

If you know nothing about finance, risk or financial risk management and are walking into work for your first day as a financial risk manager of a major global bank, turn straight to Chapter 10 and follow the directions step-by-step through to the end of Chapter 13.

If you’re really in a hurry, turn right to Chapter 20 and get all the really important stuff in ten minutes. Not ten minutes to read, ten minutes to read and do!

Wherever you start, I trust you’ll find information you can put to use.

Part I

Getting Started with Risk Management

For Dummies can help you get started with lots of subjects. Visit www.dummies.com to discover more and do more with For Dummies.

In this part …

Recognize risk and distinguish it from danger and opportunity.

Choose the right framework to make risk decisions.

Take charge of risk: identify the goal, consider the options, and make the decision.

Manage risk in the front office of a financial institution: set limits, approve trades, approve portfolio strategies, and deal directly with risk takers.

Manage risk in the middle office of a financial institution: determine risk appetite, set risk policy, deal with the board and senior management, and work with regulators.

Manage risk in the back office of a financial institution: create control frameworks, compile reports, monitor constraints, and identify issues.

Chapter 1

Living with Risk

In This Chapter

Exploring the idea of risk

Managing financial risk

Informing people about risk

Life is risk, and risk is life. Nobody knows what tomorrow may bring. As the poet Robert Burns famously put it, ‘The best-laid schemes o’ mice an’ men, gang aft agley, an’ lea’e us nought but grief an’ pain, for promis’d joy!’ (Roughly translated, Burns warns that careful plans can come to nothing.)

While most of us instinctively first think about bad risk, good surprises happen as well. ‘Fortune favours the bold,’ we are told, and, ‘Sometimes things just go your way.’ In fact, risk is more than just sometimes good, it is essential. As another saying goes, ‘The only place with people and no risk is a graveyard.’ Religions, philosophies and especially superstitions are deeply rooted in ideas about risk.

My topic is managing risk, not risk itself, which means that I don’t cover all the risks you can’t control – the sun going supernova tomorrow or being diagnosed with a genetic heart condition, for examples. Also, my topic is financial risk, so I don’t talk about risks that aren’t priced in the financial markets. That still leaves me with a large topic, but one I can cover in enough detail to be useful.