Risk Management in Turbulent Times

By Gilles Bénéplanc; Jean-Charles Rochet | Go to book overview

PART TWO
What is Behind Risk Modeling

“All models are wrong, but some are useful.” (old saying in Statistics)

Risk management cannot be envisaged without some form of risk modeling. However, one of the main lessons that can be drawn from recent financial crises is that models cannot always be trusted. The traders who have lost billions of dollars on financial markets were often confusing their models with the real world. At best, a model is a good approximation of the real world with a limited validity both in time and scope. All industries, and especially financial markets, are subject to regime changes: a model that has worked well for a long period suddenly ceases to be a good approximation of reality. Risk managers have to be ready to such regime changes. The second part of this book (“What is Behind Risk Modeling”) is dedicated to a lucid presentation of the main tools of risk modeling. These tools have been elaborated by statisticians, actuaries, financiers, and economists. Each of these tools can potentially be useful but also has its limits. The purpose of the following chapters is to specify the assumptions that are behind each of these tools, so as to clarify under which circumstances they can be useful and, by contrast, when they can be misleading. A parallel with physics can be useful. One of the most important discoveries in the history of sciences is the Newtonian modeling of the freefall of a body subject to a constant acceleration under gravity. A crucial assumption behind this model is that air resistance can be neglected. Is this assumption acceptable by a scientist who wants to study the movement of a falling body? Well, it depends. If the body in question is a lead ball, then the model is excellent. If, by contrast, the body in question is a feather, then the model is appalling. Our objective in the following chapters is to show how decision makers can select among different risk models, depending on the question addressed.

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