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

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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 Known, the unknown, and the Unknowable—that enables one to conceptualize the different kinds of financial risks and...

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More About This Book

Overview

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 Known, the unknown, and the Unknowable—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
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Editorial Reviews

Reading the Markets blog
It is a bold book, tackling both theory and practice and spanning the worlds of (among others) banking, insurance, real estate, and investment. It is also utterly engrossing. . . . Although this book is most obviously addressed to risk managers and regulators, I think it should be read by every intellectually curious person with skin in the financial game. If the investor or trader doesn't come away with at least one or two ideas of practical importance to his financial life, he is a 'sleepreader.'
— Brenda Jubin
Financial Markets and Portfolio Management
Peppered with anecdotes and prominent examples, the book never abandons the practical side of its topic. It will be helpful for readers interested in only specific subtopics that each article is a stand-alone piece. I recommend this book to a wide audience: academics and practitioners, of course, but even people who are not directly involved in the financial sector, but are interested in it, will find it definitely worth their time.
— Tobias Nigbur
Reading the Markets blog - Brenda Jubin
It is a bold book, tackling both theory and practice and spanning the worlds of (among others) banking, insurance, real estate, and investment. It is also utterly engrossing. . . . Although this book is most obviously addressed to risk managers and regulators, I think it should be read by every intellectually curious person with skin in the financial game. If the investor or trader doesn't come away with at least one or two ideas of practical importance to his financial life, he is a 'sleepreader.'
Financial Markets and Portfolio Management - Tobias Nigbur
Peppered with anecdotes and prominent examples, the book never abandons the practical side of its topic. It will be helpful for readers interested in only specific subtopics that each article is a stand-alone piece. I recommend this book to a wide audience: academics and practitioners, of course, but even people who are not directly involved in the financial sector, but are interested in it, will find it definitely worth their time.
Financial Markets and Portfolio Management

Peppered with anecdotes and prominent examples, the book never abandons the practical side of its topic. It will be helpful for readers interested in only specific subtopics that each article is a stand-alone piece. I recommend this book to a wide audience: academics and practitioners, of course, but even people who are not directly involved in the financial sector, but are interested in it, will find it definitely worth their time.
— Tobias Nigbur
Reading the Markets blog

It is a bold book, tackling both theory and practice and spanning the worlds of (among others) banking, insurance, real estate, and investment. It is also utterly engrossing. . . . Although this book is most obviously addressed to risk managers and regulators, I think it should be read by every intellectually curious person with skin in the financial game. If the investor or trader doesn't come away with at least one or two ideas of practical importance to his financial life, he is a 'sleepreader.'
— Brenda Jubin
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Product Details

  • ISBN-13: 9780691128832
  • Publisher: Princeton University Press
  • Publication date: 5/9/2010
  • Pages: 390
  • Product dimensions: 6.30 (w) x 9.30 (h) x 1.20 (d)

Meet the Author

Francis X. Diebold is the Paul F. and E. Warren Shafer Miller Professor of Economics at the University of Pennsylvania and professor of finance and statistics at the university's Wharton School. Neil A. Doherty is the Frederick H. Ecker Professor of Insurance and Risk Management at the Wharton School. Richard J. Herring is the Jacob Safra Professor of International Banking and professor of finance at the Wharton School.

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Table of Contents

Preface vii

Chapter 1: Introduction by Francis X. Diebold, Neil A. Doherty, and Richard J. Herring 1

Chapter 2: Risk: A Decision Maker's Perspective by Sir Clive W. J. Granger 31

Chapter 3: Mild vs. Wild Randomness: Focusing on Those Risks That Matter by Benoit B. Mandelbrot and Nassim Nicholas Taleb 47

Chapter 4: The Term Structure of Risk, the Role of Known and Unknown Risks, and Nonstationary Distributions by Riccardo Colacito and Robert F. Engle 59

Chapter 5: Crisis and Noncrisis Risk in Financial Markets: A Unified Approach to Risk Management by Robert H. Litzenberger and David M. Modest 74

Chapter 6: What We Know, Don't Know, and Can't Know about Bank Risk: A View from the Trenches by Andrew Kuritzkes and Til Schuermann 103

Chapter 7: Real Estate through the Ages: The Known, the Unknown, and the Unknowable by Ashok Bardhan and Robert H. Edelstein 145

Chapter 8: Reflections on Decision-making under Uncertainty by Paul R. Kleindorfer 164

Chapter 9: O n the Role of Insurance Brokers in Resolving the Known, the Unknown, and the Unknowable by Neil A. Doherty and Alexander Muermann 194

Chapter 10: Insuring against Catastrophes by Howard Kunreuther and Mark V. Pauly 210

Chapter 11: Managing Increased Capital Markets Intensity: The Chief Financial Officer's Role in Navigating the Known, the Unknown, and the Unknowable by Charles N. Bralver and Daniel Borge 239

Chapter 12: The Role of Corporate Governance in Coping with Risk and Unknowns by Kenneth E. Scott 277

Chapter 13: Domestic Banking Problems by Charles A. E. Goodhart 286

Chapter 14: Crisis Management: The Known, The Unknown, and the Unknowable by Donald L. Kohn 296

Chapter 15: Investing in the Unknown and Unknowable by Richard J. Zeckhauser 304

List of Contributors 347

Index 359

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