Plight of the Fortune Tellers

Plight of the Fortune Tellers: Why We Need to Manage Financial Risk Differently

Riccardo Rebonato
Copyright Date: 2007
Pages: 304
https://www.jstor.org/stable/j.ctt7rzf3
  • Cite this Item
  • Book Info
    Plight of the Fortune Tellers
    Book Description:

    Today's top financial professionals have come to rely on ever-more sophisticated mathematics in their attempts to come to grips with financial risk. But this excessive reliance on quantitative precision is misleading--and puts everyone at risk. InPlight of the Fortune Tellers, Riccardo Rebonato forcefully argues that we must restore genuine decision making to our financial planning. Presenting a financial model that uses probability, experimental psychology, and decision theory, Rebonato challenges us to rethink the standard wisdom about risk management. He offers a radical yet surprisingly commonsense solution: managing risk comes down to real people making decisions under uncertainty.

    Plight of the Fortune Tellersis a must-read for anyone concerned about how today's financial markets are run. In a new preface, Rebonato explains how the ideas presented in this book fit into the context of the global financial crisis that followed its original publication. He argues that risk managers are still stuck in a probabilistic rut, and need to engage with the structural causes of real events.

    eISBN: 978-1-4008-3639-0
    Subjects: Economics, Business, Finance

Table of Contents

  1. Front Matter
    (pp. i-vi)
  2. Table of Contents
    (pp. vii-viii)
  3. PREFACE TO THE PAPERBACK EDITION
    (pp. ix-xxx)
  4. PREFACE
    (pp. xxxi-xlviii)
  5. ACKNOWLEDGMENTS
    (pp. xlix-lii)
  6. CHAPTER 1 WHY THIS BOOK MATTERS
    (pp. 1-21)

    This book is about the quantitative use of statistical data to manage financial risk. It is about the strengths and limitations of this approach. Since we forget the past at our own peril, we could do worse than remind ourselves that the application of statistics to economic, political, and social matters is hardly a new idea. The very word ʺstatisticsʺ shares its root with the word ʺstate,ʺ a concept that, under one guise or another, has been with us for at least a few centuries. The closeness of this link, between compilations of numbers, tables of data, and actuarial information...

  7. CHAPTER 2 THINKING ABOUT RISK
    (pp. 22-39)

    In this chapter I take a look at how human beingsactuallyreact to risk. I intend to show that we can be both surprisingly good and spectacularly bad at dealing with uncertain events. Very often, the same individuals can display a very keen and subtle intuition of risk, but then, faced with a different situation (or perhaps even with the same situation ʺframedʺ in different terms) can fail miserably at producing an acceptable risk assessment.

    Risk blunders are not the prerogative of the man in the street. Experts and extremely intelligent people have fared just as badly, and at times...

  8. CHAPTER 3 THINKING ABOUT PROBABILITIES
    (pp. 40-66)

    What is the probability of obtaining heads when tossing a given coin? What is the probability of the next president of the United States being a Democrat? What is the probability thatThe IliadandThe Odysseywere written by the same person?

    In posing these three questions, I have used the same word: ʺprobability.ʺ Yet a momentʹs thought clearly shows that it has a very different meaning in the three contexts. The first has to do with an event (the tossing of the coin) that can, in principle, be repeated many times under virtually identical conditions. We can ideally...

  9. CHAPTER 4 MAKING CHOICES
    (pp. 67-106)

    Risk management is about decision making under uncertainty. There are well-established disciplines, going under the collective name ʺdecision theory,ʺ that tackle this topic. Both utility and prospect theory, for instance, claim to offertheunique correct solution toallproblems of choice under uncertainty. I do not believe that either fulfills this promise fully, but I cannot ignore their claims. To argue the case as to why they fall short of their promise, I must first give an intuitive explanation of what influences our risky choices and then explain, as sympathetically as I can, what utility and prospect theory offer....

  10. CHAPTER 5 WHAT IS RISK MANAGEMENT FOR?
    (pp. 107-116)

    After the discussion in chapter 1, it is pretty clear why regulators should care about the financial good health of a bank: just recall what we said about systemic risk, about the inherent ʺfragile robustnessʺ of a bank, about the stake a state acquires in private banks via deposit insurance, etc. But what about the banks themselves? What dotheycare? Why would private firms, unfettered by regulatory constraints, engage in risk management at all? What is risk management for?

    The questions may sound bizarre: isnʹt all risk ʺbadʺ? Is it not a motherhood-and-apple-pie statement that reducing risk is a...

  11. CHAPTER 6 VAR & CO: HOW IT ALL STARTED
    (pp. 117-138)

    In the introductory chapter I pointed out that the roots of the current debate about the use of quantitative techniques in risk management can be traced all the way back to the eighteenth-century Franco-Prussian debate about statistics and the state. I then discussed the types of probability (subjective/Bayesian versus frequentist) relevant for risk management; the difficulties one encounters in the search for a single indicator (a ʺmagic formulaʺ) to help us decide; and, finally, the raison dʹêtre for risk management itself. Having started from the 30,000-feet view, I intend to focus on a less sweeping vista of current quantitative risk...

  12. CHAPTER 7 LOOKING BENEATH THE SURFACE: HIDDEN PROBLEMS
    (pp. 139-181)

    Despite the fact that the tone of this book has been kept as discursive and breezy as possible, in order to appreciate some of the weaknesses of a naive statistical approach to risk management it is necessary to take at least a peak under the bonnet. As we have seen, the basic idea behind VaR is very simple and appealing. ʺJustʺ assign a probability, it says, to each possible monetary outcome from your portfolio and examine some important features (often some rather high percentile) of the resulting distribution curve. This seems to make a lot of sense: since looking at...

  13. CHAPTER 8 WHICH TYPE OF PROBABILITY MATTERS IN RISK MANAGEMENT?
    (pp. 182-198)

    This is a short but important chapter, because we are beginning to look at what practical insight the general ideas we have developed in the previous chapters can provide.

    We have seen in chapter 2 that there is more than one type of probability. Or, to be more precise, I have tried to explain that the ʺtraditionalʺ (frequentist) probability, the one we learn about in Statistics 101 (and the only one that regulators and practitioners seem to talk about when they deal with financial risk management), is actually a special case of a wider class of probability, the Bayesian or...

  14. CHAPTER 9 THE PROMISE OF ECONOMIC CAPITAL
    (pp. 199-222)

    What is economic capital?¹ No single definition has found universal acceptance, but a reasonable, brief definition would probably sound something like, ʺEconomic capital is the amount of capital a bank wouldvoluntarilyset aside to support its business independent of any regulatory requirement to do so.ʺ You may feel rather underwhelmed by this definition. Yet economic capital has been hailed by some as a major breakthrough in the management of the risk and of the strategic decisions of a bank. Surely, there must be more to this dry definition than meets the eye. Are we missing something?

    Indeed, as we...

  15. CHAPTER 10 WHAT CAN WE DO INSTEAD?
    (pp. 223-258)

    Criticizing something is always considerably easier than proposing a constructive alternative. Indeed, it is so much easier that it would be unfair of me not to try and offer some proposals as to what one could do instead, thus laying myself open to someone elseʹs criticism.

    My starting point is somewhat different from the currently received wisdom, i.e., the motherhood-and-apple-pie statement that great advantages will be reaped by aligning prudential regulation with the ʺbest risk-management practiceʺ actually implemented by financial institutions. Regulators, according to this view, should take inspiration for theirrulesfrom the industryʹs risk-managementpractices. This approach may...

  16. ENDNOTES
    (pp. 259-266)
  17. INDEX
    (pp. 267-272)