Everything You Ever Wanted to Know About Risk…

The recent credit crisis offers an opportunity to reflect upon the success and failure of existing risk management tools, putting the spotlight on two in particular: traded derivatives to hedge credit risk and risk management models to quantify credit risk. Did these risk management tools fail?

The financial press has blamed these new fangled derivatives—especially those on subprime mortgages— and the risk management models as the cause of the crisis. Warren Buffett admonished models and quantitative researchers in a Wall Street Journal report, warning, “All I can say is, beware of geeks… bearing formulas.” (WSJ November 3, 2008.) And in testimony to Congress days before, Alan Greenspan stated, “Had instead the models been fitted more appropriately to historic periods of stress, capital requirements would have been much higher and the financial world would be in far better shape today, in my judgment.” Perhaps. But before we can form a judgment, we need to dispel three myths that appear repeatedly in the financial press, claimingthat:(1)derivativesarenew;(2)derivativesare bad, and (3) using risk models is bad. Contrary to common belief, the first myth is false.