The Known, the Unknown, and the Unknowable in Financial Risk Management: Measurement and Theory Advancing Practice

The Known, the Unknown, and the Unknowable in Financial Risk Management: Measurement and Theory Advancing Practice

The Known, the Unknown, and the Unknowable in Financial Risk Management: Measurement and Theory Advancing Practice

The Known, the Unknown, and the Unknowable in Financial Risk Management: Measurement and Theory Advancing Practice

Synopsis

A clear understanding of what we know, don't know, and can't know should guide any reasonable approach to managing financial risk, yet the most widely used measure in finance today--Value at Risk, or VaR--reduces these risks to a single number, creating a false sense of security among risk managers, executives, and regulators. This book introduces a more realistic and holistic framework called
KuU
--the
K
nown, the
u
nknown, and the
U
nknowable--that enables one to conceptualize the different kinds of financial risks and design effective strategies for managing them. Bringing together contributions by leaders in finance and economics, this book pushes toward robustifying policies, portfolios, contracts, and organizations to a wide variety of
KuU
risks. Along the way, the strengths and limitations of "quantitative" risk management are revealed.


In addition to the editors, the contributors are Ashok Bardhan, Dan Borge, Charles N. Bralver, Riccardo Colacito, Robert H. Edelstein, Robert F. Engle, Charles A. E. Goodhart, Clive W. J. Granger, Paul R. Kleindorfer, Donald L. Kohn, Howard Kunreuther, Andrew Kuritzkes, Robert H. Litzenberger, Benoit B. Mandelbrot, David M. Modest, Alex Muermann, Mark V. Pauly, Til Schuermann, Kenneth E. Scott, Nassim Nicholas Taleb, and Richard J. Zeckhauser.


  • Introduces a new risk-management paradigm
  • Features contributions by leaders in finance and economics
  • Demonstrates how "killer risks" are often more economic than statistical, and crucially linked to incentives
  • Shows how to invest and design policies amid financial uncertainty

Excerpt

This book provides a variety of glimpses into the successes and failures of various parts of modern financial risk management. However, it is not our intent — indeed it is not logically possible—to provide a survey of the known, the unknown, and the unknowable (KuU). Instead, we aim to provide illustrations of a KuU-based perspective for conceptualizing financial risks and designing effective risk management strategies. Sometimes we focus on K, and sometimes on U, but most often our concerns blend aspects of K and u and U. Indeed, K and U are extremes of a smooth spectrum, with many of the most interesting and relevant situations interior.

The contributions gathered here emphasize a tripartite reality. First, financial risk measurement and theory, depending on context, range from highly developed to woefully inadequate. Second, financial risk measurement and theory, in any particular context, are typically not equally well developed. Finally, financial risk measurement and/or theory, in many important contexts, may never be well developed: although some financial phenomena are amenable to statistical or mathematical quantifcation, many are not. Our focus, then, is on quantitative risk measurement and its limits, including risk mitigation and management in murky real-world environments (contractual, organizational, policy-making, etc.) characterized by large doses of the unknown and the unknowable.

A generous Sloan Foundation grant to the Wharton Financial Institutions Center fueled the research program distilled in this volume. Both Wharton and Sloan are well aware that just as measurement beneficially disciplines theory, so too do practitioners beneficially discipline academics. Hence, we aspired to blend the two, and a series of two conferences proved a stimulating and effective vehicle. The first meeting took place in Philadelphia, with additional generous support from the Oliver Wyman Institute, and featured a series of panel discussions by top practitioners in financial policy-making, banking, venture capital, insurance, and asset management. Top academics attended and used the perspectives and issues raised to inform their chapters-in-progress commissioned for this volume. We turned the tables at a second meeting in Boston a year later, at which the academics presented their chapters-in-progress and practitioners offered lively commentary.

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