The Known, the Unknown, and the Unknowable in Financial Risk Management

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

Francis X. Diebold
Neil A. Doherty
Richard J. Herring
Copyright Date: 2010
Pages: 390
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  • Book Info
    The Known, the Unknown, and the Unknowable in Financial Risk Management
    Book Description:

    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 calledKuU--theKnown, theunknown, and theUnknowable--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 ofKuUrisks. Along the way, the strengths andlimitationsof "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 paradigmFeatures contributions by leaders in finance and economicsDemonstrates how "killer risks" are often more economic than statistical, and crucially linked to incentivesShows how to invest and design policies amid financial uncertainty

    eISBN: 978-1-4008-3528-7
    Subjects: Business, Finance

Table of Contents

  1. Front Matter
    (pp. i-iv)
  2. Table of Contents
    (pp. v-vi)
    (pp. vii-x)
  4. 1. Introduction
    (pp. 1-30)
    Francis X. Diebold, Neil A. Doherty and Richard J. Herring

    Successful financial risk management requires constant grappling with the known, the unknown and the unknowable (“KuU”). But think ofKuUas more than simply an acronym for “the known, the unknown, and the unknowable”; indeed, we think of it as aconceptual framework.We believe that “KuUthinking” can promote improved decision making—helping us to recognize situations ofKanduandUand their differences, using different tools in different situations, while maintaining awareness that the boundaries are fuzzy and subject to change.

    Perhaps the broadest lesson is recognition of the wide applicability ofKuUthinking, and the...

  5. 2. Risk: A Decision Maker’s Perspective
    (pp. 31-46)
    Sir Clive W.J. Granger

    Risk is a pervasive but subtle concept, widely used and discussed but not well understood.¹ In the initial sections of this chapter I will attempt to discuss some of the sources of agreement between all groups and then mention the forms of disagreement and the implications.

    It is convenient to start with a listing of the major groups in the economy who are concerned with risk:

    a.Uncertainty economists. A group of economists who over a period of roughly half a century produced a powerful theory concerning behavior under uncertainty with many strong results that constrain the behavior of decision...

  6. 3. Mild vs. Wild Randomness: Focusing on Those Risks That Matter
    (pp. 47-58)
    Benoit B. Mandelbrot and Nassim Nicholas Taleb

    Conventional studies of uncertainty, whether in statistics, economics, finance, or social science, have largely stayed close to the so-called bell curve, a symmetrical graph that represents a probability distribution. Used to great effect to describe errors in astronomical measurement by the 19th-century mathematician Carl Friedrich Gauss, the bell curve, or Gaussian model, has since pervaded our business and scientific culture, and terms like sigma, variance, standard deviation, correlation, R-square, and Sharpe ratio are all directly linked to it. Neoclassical finance and portfolio theory are completely grounded in it.

    If you read a mutual fund prospectus, or a hedge fund’s exposure,...

  7. 4. The Term structure of Risk, the Role of Known and Unknown Risks, and nonstationary Distributions
    (pp. 59-73)
    Riccardo Colacito and Robert F. Engle

    Long before the unprecedented collapse of the U.S. banking system that we have witnessed in the recent years, many people believed that there were grave risks facing our financial markets. These included the massive budget deficits, the balance payments deficits, the high cost of energy and many other raw materials, the uncertainty over Federal Reserve (FED) policy, war in Iraq that was going badly, global warming, and the extraordinary amount of U.S. debt that was and still is held by the Chinese government. In addition, there was a concern that the vast global derivatives market, the number of unregulated hedge...

  8. 5. Crisis and noncrisis Risk in Financial Markets: A Unified Approach to Risk Management
    (pp. 74-102)
    Robert H. Litzenberger and David M. Modest

    The litany of financial crises and economic losses caused by failed financial institutions during the last quarter-century has given a major impetus to the design, development, and implementation of robust enterprise-wide risk management systems¹—the Hunt Brothers silver crisis of 1979/80; the U.S. savings and loan crisis in the 1980s; the Mexican Default and the Latin American Debt Crisis starting in 1982; the failure of Continental Illinois in 1984; the Bank of New york systems failure resulting in a $24 billion overnight overdraft at the Federal Reserve Bank of New york in 1985; the stock market crash of 1987; the...

  9. 6. What We Know, Don’t Know, and Can’t Know about Bank Risk: A View from the Trenches
    (pp. 103-144)
    Andrew Kuritzkes and Til Schuermann

    This chapter addresses how the known (K), the unknown (u), and the unknowable (U) vary by risk type within banking.¹ We propose that knowledge of risk differs systematically by risk type—for example, with more being known about market risk than credit risk, and less being known about nonfinancial risks than financial risks. Understanding the nature of the differences across risk types and their relative contribution to total earnings volatility can shed light on the portion of the risk space within banking that is known and knowable—and hence manageable—versus unknown and unmanageable.

    Our primary concern is to describe...

  10. 7. Real estate through the Ages: The Known, the Unknown, and the Unknowable
    (pp. 145-163)
    Ashok Bardhan and Robert H. Edelstein

    Real estate and land are among the oldest asset markets with which humans have had extensive experience.¹ The significance of agricultural, residential, and commercial real estate assets in human history can scarcely be exaggerated. Social structure, marriage institutions, interstate relations, and, more broadly, socio-economic organization have been affected by and simultaneously have influenced the nature and functioning of real estate markets. The complex interaction of real estate markets with social, political, cultural, and economic institutions through the ages, combined with the impact of technological changes, makes the task of assessing what is or was known, unknown, and unknowable in real...

  11. 8. Reflections on Decision-making under Uncertainty
    (pp. 164-193)
    Paul R. Kleindorfer

    Frank Knight (1885–1972) completed his doctoral thesis at Cornell in 1916, at a time when great geopolitical uncertainties were unfolding in horrific ways in World War I.¹ A minor revision of his thesis later became the essence of his celebrated book (Knight 1921), which remained the centerpiece of his economic contributions at the University of Chicago, where Knight joined other great economists in creating the intellectual fabric of risk, uncertainty, and profit that has become the foundation of modern finance and business strategy.

    The essence of Knight’s contribution was arguably his recognition that the modern firm was not just...

  12. 9. On the Role of Insurance Brokers in Resolving the Known, the Unknown, and the Unknowable
    (pp. 194-209)
    Neil A. Doherty and Alexander Muermann

    Insurance transfers risk, and knowledge of the level of risk is important to the parties in deciding whether to engage in this activity. Without knowledge of the underlying loss distribution, the insurer will find it difficult to set a price and the policyholder is unable to tell whether he is getting a good price from the insurer. It is also difficult for both parties to see what impact the policy will have on the insurer’s overall book of business and its ability to keep its promised payment. Here we show that brokers play an important role in completing markets that...

  13. 10. Insuring against Catastrophes
    (pp. 210-238)
    Howard Kunreuther and Mark V. Pauly

    The terrorist attacks of 9/11 and the hurricanes in the Gulf Coast have raised a number of questions regarding the role that insurance can or should play in providing protection against catastrophic risks.¹ This chapter focuses on the role that information about potential adverse events plays in both the supply and demand for insurance where there is considerable uncertainty regarding the likelihood of the event occurring and the resulting consequences. Our focus will be on how insurers and those at risk react to events that can cause catastrophic losses to them.

    Natural hazards are an example of a known risk...

  14. 11. Managing Increased Capital Markets Intensity: The Chief Financial Officer’s Role in Navigating the Known, the Unknown, and the Unknowable
    (pp. 239-276)
    Charles N. Bralver and Daniel Borge

    KuU—the known, the unknown and the unknowable—reminds us that decision makers usually face situations where hard facts and analytic models are, by themselves, insufficient descriptions of reality and that different people have different perceptions of present reality and future possibilities. The role of the chief financial officer of a modern corporation is an example ofKuUs having substantive consequences in the practical world of finance. Differences in perceivedKuUcan lead to conflict between management and investors over how a company should be run, who runs it, and who owns it. In our view, the chief financial officer...

  15. 12. The Role of Corporate Governance in Coping with Risk and Unknowns
    (pp. 277-285)
    Kenneth E. Scott

    The concern of this book is with financial risk management: the known, the unknown and the unknowable. There may not be complete agreement on what that encompasses. For my purpose, I would defineriskas the possible occurrence of a future event (state of nature) that has a significant financial consequence for a decision maker. Depending on your particular position, your primary focus might be on the management of risk by financial institutions, or on the oversight of that management by government agencies regulating financial institutions, or on businesses in their operations or dealings with financial institutions and transacting partners....

  16. 13. Domestic Banking Problems
    (pp. 286-295)
    Charles A. E. Goodhart

    Problems in the banking sector are primarily caused by losses. A profitable bank is, by and large, one without problems. So in table 13.1 there is a matrix of the conditions under which losses are incurred and the resulting nature of the loss, and then a (brief) record of the reaction by three segments of private sector agents: accountants, the individual bank, and the capital market. The final row indicates how the public sector might respond.

    The first point to make is that the three-way split (i.e.,KuU) proposed by the organizers of this book is insufficient. The distribution has...

  17. 14. Crisis Management: The Known, the Unknown, and the Unknowable
    (pp. 296-303)
    Donald L. Kohn

    In pursuing its policy objectives, a central bank must make decisions in the face of uncertainty related to incomplete knowledge about the evolving condition of the economy and the financial system as well as about the potential effects of its actions. This uncertainty implies that the central bank must incorporate into its decisions the risks and consequences of several alternative outcomes. That is, it needs to assess not only the most likely outcome for a particular course of action but also the probability of the unusual—the tail event. And it needs to weigh the welfare costs of the possible...

  18. 15. Investing in the Unknown and Unknowable
    (pp. 304-346)
    Richard J. Zeckhauser

    David Ricardo made a fortune buying bonds from the British government four days in advance of the Battle of Waterloo.¹ He was not a military analyst, and even if he were, he had no basis to compute the odds of Napoleon’s defeat or victory, or hard-to-identify ambiguous outcomes. Thus, he was investing in the unknown and the unknowable. Still, he knew that competition was thin, that the seller was eager, and that his windfall pounds should Napoleon lose would be worth much more than the pounds he’d lose should Napoleon win. Ricardo knew a good bet when he saw it....

    (pp. 347-358)
  20. INDEX
    (pp. 359-380)