Overview

Making money is easy; keeping it is hard. Risk management is the art of not blowing up. It involves identifying, measuring, and mitigating risks.

Core Idea

Value at Risk (VaR): A statistical measure. “We are 99% confident that we won’t lose more than $10 million in a single day.” (But that 1% can kill you).

Formal Definition (if applicable)

Stress Testing: Simulating extreme scenarios (e.g., “What if the stock market drops 50% and interest rates double?”) to see if the bank survives.

Intuition

  • Market Risk: Prices move against you.
  • Credit Risk: Borrowers don’t pay you back.
  • Operational Risk: Computers crash, fraud, or a pandemic hits.
  • Liquidity Risk: You can’t sell your assets when you need cash.

Examples

  • Hedging: Buying insurance against a crash (Put options).
  • Diversification: Spreading bets.
  • Collateral: Asking for a house as security for a mortgage.

Common Misconceptions

  • “Risk management eliminates risk.” (No, it manages it. You need to take risk to make profit.)
  • “Models are perfect.” (The map is not the territory. “Black Swans” break models.)
  • Basel Accords: International rules on how much capital banks must hold.
  • Moral Hazard: If you are insured (or bailed out), you take more risks.
  • Tail Risk: The risk of extreme events (the tails of the bell curve).

Applications

  • Banks: Required by law to have robust risk management.
  • Insurance: Their entire business is pricing risk.

Criticism / Limitations

VaR can give a false sense of security. It failed spectacularly in 2008.

Further Reading

  • Taleb, The Black Swan
  • Jorion, Value at Risk