Dealing With Financial Risk

The essence of financial risk management is imagining what things might go wrong and then guarding against them. In the past thirty years, a whole industry has grown up around the idea that the behavior of financial markets can be analyzed and outsmarted by mathematical models. But markets are always changing. Modern risk management can only narrow down future outcomes into bands of probabilities. It can never predict; it can only infer what might happen. Ultimately, financial firms have learned that mathematics has limited power to calculate the likelihood of the less frequent more extreme events. As regulators and forward-thinking firms come to grips with this problem, they have ventured into the more uncertain territory of designing stress tests, imagining scenarios, and occasionally playing out entire fictions of the future. Risk management at these extremes challenges the wildest imagination and the frontiers of creativity. Like mountain climbing, it is about minimizing danger and taking calculated risks