The New Arsenal of Risk Management.docx
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The New Arsenal of Risk Management.docx
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TheNewArsenalofRiskManagement
TheNewArsenalofRiskManagement
HarvardBusinessReview;Sep2008,Vol.86Issue9,p92-100
ByKevinBuehler;AndrewFreemanandRonHulme
Abstract:
Theglobalbankingsystemisfacingasevereliquiditycrisis:
Inthefirsthalfof2008,majorfinancialinstitutionswroteoffnearly$400billion,causingbanksaroundtheworldtoinitiateemergencymeasures.Similarcriseshaveoccurredwithinrecentmemory:
ThinkofS&Ls,thedot-combust,andEnron.Riskis,quitesimply,afactofcorporatelife--butbecauserisk-managementresearchhasincreasinglyemphasizedmathematicalmodeling,managersmayfinditincomprehensibleandthusshyawayfrompowerfultoolsandmarketsforcreatingvalue.Buehler,Freeman,andHulme,allwithMcKinsey,describetheevolutionofriskmanagementsincethe1970s,showhownewmarketshavechangedthelandscapeinbothfinancialservicesandtheenergysector,andexplainwhatittakestocompeteinthecurrentenvironment.Todemonstratehowsignificantafactorriskcanbewhenincorporatedintostrategyandorganization,theytakethecaseofGoldmanSachs--which,despiteitsrelianceonhighlyvolatiletradingrevenues,hassofaravoidedthebigwrite-offsthathaveafflicteditsleadingcompetitors.TheauthorsbelievethatthisisbecauseGoldmantakestheantithesisofthetypicalcorporateapproach--itscultureembracesratherthanavoidsrisk.And,theysay,Goldmanveryefficientlyemploysallfourofthefollowingfactors:
quantitativeprofessionals,strongoversight,partnershipinvestment,andaclearstatementofbusinessprinciples,withemphasisonpreservingthecompany'sreputation.Stayingonthesidelinesofriskmanagementmayhaveshieldedsomecompaniesfromcrisis,butithasalsopreventedthemfromgrowingasquicklyastheymighthave.Intheircompanionarticle,"OwningtheRightRisks,"theauthorsoutlineaprocessthatwillenableexecutivesinanycompanytoincorporateriskintotheirstrategicdecisionmaking.[ABSTRACTFROMAUTHOR]
Section:
TheRiskRevolution
THETOOLS
DISCUSSIONSOFRISKusuallycometotheforefrontintimesofcrisisbutthenrecedeasnormalcyreturns.Aswewrite,theglobalbankingsystemisfacingamajorcreditandliquiditycrisis.Lossesfromsubprimemortgages,structuredinvestmentvehicles,and"covenantlite"loansarecreatingacreditcrunchthatmayinturntriggeraglobalslowdown.Inthepastyearmajorfinancialinstitutionshavewrittenoffnearly$400billion,andcentralbanksaroundtheworldhaveinitiatedemergencymeasurestorestoreliquidity.Severalothercriseshaveoccurredwithinmemory:
theU.S.savings-and-loancollapseinthe1980sand1990s,BlackMondayin1987,theRussiandebtdefaultandtherelateddiveofLong-TermCapitalManagementin1998,thedot-combustof2000,andtheEnron-ledmerchant-powercollapseof2001.
Theresoundingmessageisthatriskisalwayswithus.Executivesneedtowakeuptothatfact.Unfortunately,agrowingemphasisonmathematicalmodelinghasrenderedmuchoftherisk-managementdebateandresearchincomprehensibletothoseoutsidethefinancefunctionandthefinancialservicesindustry.Asaresult,manycorporatemanagershaveshiedawayfromthepowerfulrisk-managementtoolsandmarketscreatedoverthepastthreedecades-andthushaveforgoneconsiderableopportunitiestocreatevalue.
Ouraimhereistohelpmanagersunderstandboththeadvantagesandthelimitationsofthemarketsandtoolsthatareimplicatedinthecreditandliquiditycrisis.Wewilldescribetheevolutionofriskmanagementinrecentdecades,showhownewmarketshavechangedthelandscapeinbothfinancialservicesandtheenergysector,andexplainwhatittakestocompeteinthecurrentenvironment.Theseanalyseswillhelpreadersmakesenseofthecrisisandwillillustratejusthowpowerfulalensriskcanbewhenappliedtocorporatestrategyandorganization.Inthecompanionarticlepublishedinthisissue,wedescribeaprocesswherebyexecutivesinallcompaniescanincorporateriskintotheirstrategicdecisionmaking.
TheIdeaThatChangedtheWorld
Forthefirst70yearsofthetwentiethcentury,corporateriskmanagementwaslargelyaboutbuyinginsurance.Riskmanagementinthefinancialsectorwasalsorudimentary:
Bankregulatorslackedtoolsformeasuringriskinthesystem,soconstructiveinterventionwasdifficult.Banksthemselveshadnowaytocontroltheinterest-rateriskintheirloanportfoliosortoquantifyandmanagecreditrisk-inpartbecausefewalternativestoinsuranceexisted.Tobesure,somefuturesandoptionscontractswerewrittenandsold,butreliabletoolsforpricingthemwererare,andthemarketsforthesesecuritieswerethinandcharacterizedbywidebid-askspreads.
Thelowlevelofinterestinriskmanagementwasalsotosomeextentaproductofprevailingthoughtinfinance,originatingwithFrancoModiglianiandMertonMiller's"indifferencetheory,"whicharguedthatacompany'svaluewasnot(inmostcases)affectedbycapitalstructureorhedging,andthecapitalassetpricingmodel(CAPM),developedbyWilliamSharpeandothers,whicharguedthatriskshouldbemanagedprimarilythroughportfoliodiversificationbyinvestors.(Forasummaryofthemaintheoriesrelatingtothefield,seetheexhibit"TheEvolutionofRiskManagement.")
Allthisbegantochangein1973,withthepublicationoftheoptions-pricingmodeldevelopedbyFischerBlackandMyronScholesandexpandedonbyRobertC.Merton.Thenewmodelenabledmore-effectivepricingandmitigationofrisk.Itcouldcalculatethevalueofanoptiontobuyasecurityaslongastheusercouldsupplyfivepiecesofdata:
therisk-freerateofreturn(usuallydefinedasthereturnonathree-monthU.S.Treasurybill),thepriceatwhichthesecuritywouldbepurchased(usuallygiven),thecurrentpriceatwhichthesecuritywastraded(tobeobservedinthemarket),theremainingtimeduringwhichtheoptioncouldbeexercised(given),andthesecurity'spricevolatility(whichcouldbeestimatedfromhistoricaldataandisnowmorecommonlyinferredfromthepricesofoptionsthemselvesiftheyaretraded).Theequationsinthemodelassumethattheunderlyingsecurity'spricemimicstherandomwayinwhichairmoleculesmoveinspace,familiartoengineersasBrownianmotion.
ThecoreideaaddressedbyBlack-Scholeswasoptionality:
Embeddedinallinstruments,capitalstructures,andbusinessportfoliosareoptionsthatcanexpire,beexercised,orbesold.Inmanycasesanoptionisbothobviousandbounded-asis,forexample,anoptiontobuyGeneralElectricstockatagivenpriceforagivenperiod.Otheroptionsaresubtler.Intheir1973paperBlackandScholespointedoutthattheholdersofequityinacompanywithdebtinitscapitalstructurehaveanoptiontobuybackthefirmfromthedebtholdersatastrikepriceequaltothecompany'sdebt.Similarly,theemergingfieldofrealoptionsidentifiedthoseimplicitinacompany'soperations-forexample,theoptiontocancelordeferaprojectbasedoninformationfromapilot.Thetheoryofrealoptionsputavalueonmanagerialflexibility-somethingoverlookedinstraightforwardNPVcalculations,whichassumeanall-or-nothingattitudetowardprojects.
Thenewmodelcouldhardlyhavecomeatamorepropitioustime,coincidingasitdidwiththespreadofthehandheldelectroniccalculator.TexasInstrumentsmarketedanearlyversiontofinancialprofessionalswiththetagline"NowyoucanfindtheBlack-Scholesvalueusingourcalculator."Thecalculator'srapidacceptancebyoptionstradersfueledthegrowthinderivativesmarketsandthebroaddevelopmentofstandardpricingmodels.Othertechnologicaladvancesquicklyfollowed:
In1975thefirstpersonalcomputerswerelaunched.In1979DanBricklinandBobFrankstonreleasedVisiCalc,thefirstspreadsheetdesignedtoworkonapersonalcomputer,givingmanagersasimpletoolwithwhichtorunwhat-ifscenarios.Thefinancialsectorrapidlydevelopednewinstrumentsformanagingdifferenttypesofriskandbegantradingthemonexchanges-notablytheChicagoBoardOptionsExchange-andinover-the-counterderivativesmarkets.
Bythe1980s,withcalculatingmuscleinexorablyincreasingonthetradingdesk,ithadbecomefareasiertoidentify,price,andtradedifferentkindsofoptions.AmongthemostinfluentialmachineswereworkstationsdevelopedbySunMicrosystemsandDigitalEquipmentandtheBloombergTerminal,whichrevolutionizedpricecalculationinderivativesandfixed-incomemarketsrespectively.CrystalBallandotherfirmsdevelopedsoftwarethatallowedtraderstorunMonteCarlosimulationsinamatterofminutesonlaptops,ratherthanovernightonmainframecomputers.Bythebeginningofthe1990sitwaspossibletobuycontractsthatcoveredawidevarietyofrisksusingderivativesofvariouskinds-options,futures,andswaps,oftenincombination.Derivativesmarketsbeganwithcurrencies,equities,andinterestratesandquicklyexpandedtoincludeenergy,metals,andothercommodities.Inasecondwaveofinnovation,instrumentsemergedthatallowedthehedgingortransferofcreditrisk,atthattimethemajorremainingcategoryoffinancialriskandasubjectofconcernamongbankregulators.Bytheendofthedecadederivativesmarketswereexploding;thenotionalvalueofthesecuritiesinvolvedrosefrom$72trillionin1998to$370trillionin2006.Bytheendof2007thetotalhadreachedalmost$600trillion.Themarketwassosophisticatedthat"syntheticCDOs"-derivativesofderivativesofderivatives-soonappearedandinfactwerethefastest-growingsectorofthemulti-trillion-dollarmarketforcollateralizeddebtobligationsun
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