Foreword

How many children dream of one day becoming risk managers? I very much doubt little Carol Jenkins, as she was called then, did. She dreamt about being a wild white horse, or a mermaid swimming with dolphins, as any normal little girl does. As I start crunching into two kilos of Toblerone that Carol Alexander-Pézier gave me for Valentine's day (perhaps to coax me into writing this foreword), I see the distinctive silhouette of the Matterhorn on the yellow package and I am reminded of my own dreams of climbing mountains and travelling to distant planets. Yes, adventure and danger! That is the stuff of happiness, especially when you daydream as a child with a warm cup of cocoa in your hands.

As we grow up, dreams lose their naivety but not necessarily their power. Knowledge makes us discover new possibilities and raises new questions. We grow to understand better the consequences of our actions, yet the world remains full of surprises. We taste the sweetness of success and the bitterness of failure. We grow to be responsible members of society and to care for the welfare of others. We discover purpose, confidence and a role to fulfil; but we also find that we continuously have to deal with risks.

Leafing through the hundreds of pages of this four-volume series you will discover one of the goals that Carol gave herself in life: to set the standards for a new profession, that of market risk manager, and to provide the means of achieving those standards. Why is market risk management so important? Because in our modern economies, market prices balance the supply and demand of most goods and services that fulfil our needs and desires. We can hardly take a decision, such as buying a house or saving for a later day, without taking some market risks. Financial firms, be they in banking, insurance or asset management, manage these risks on a grand scale. Capital markets and derivative products offer endless ways to transfer these risks among economic agents.

But should market risk management be regarded as a professional activity? Sampling the material in these four volumes will convince you, if need be, of the vast amount of knowledge and skills required. A good market risk manager should master the basics of calculus, linear algebra, probability – including stochastic calculus – statistics and econometrics. He should be an astute student of the markets, familiar with the vast array of modern financial instruments and market mechanisms, and of the econometric properties of prices and returns in these markets. If he works in the financial industry, he should also be well versed in regulations and understand how they affect his firm. That sets the academic syllabus for the profession.

Carol takes the reader step by step through all these topics, from basic definitions and principles to advanced problems and solution methods. She uses a clear language, realistic illustrations with recent market data, consistent notation throughout all chapters, and provides a huge range of worked-out exercises on Excel spreadsheets, some of which demonstrate analytical tools only available in the best commercial software packages. Many chapters on advanced subjects such as GARCH models, copulas, quantile regressions, portfolio theory, options and volatility surfaces are as informative as and easier to understand than entire books devoted to these subjects. Indeed, this is the first series of books entirely dedicated to the discipline of market risk analysis written by one person, and a very good teacher at that.

A profession, however, is more than an academic discipline; it is an activity that fulfils some societal needs, that provides solutions in the face of evolving challenges, that calls for a special code of conduct; it is something one can aspire to. Does market risk management face such challenges? Can it achieve significant economic benefits?

As market economies grow, more ordinary people of all ages with different needs and risk appetites have financial assets to manage and borrowings to control. What kind of mortgages should they take? What provisions should they make for their pensions? The range of investment products offered to them has widened far beyond the traditional cash, bond and equity classes to include actively managed funds (traditional or hedge funds), private equity, real estate investment trusts, structured products and derivative products facilitating the trading of more exotic risks – commodities, credit risks, volatilities and correlations, weather, carbon emissions, etc. – and offering markedly different return characteristics from those of traditional asset classes. Managing personal finances is largely about managing market risks. How well educated are we to do that?

Corporates have also become more exposed to market risks. Beyond the traditional exposure to interest rate fluctuations, most corporates are now exposed to foreign exchange risks and commodity risks because of globalization. A company may produce and sell exclusively in its domestic market and yet be exposed to currency fluctuations because of foreign competition. Risks that can be hedged effectively by shareholders, if they wish, do not have to be hedged in-house. But hedging some risks in-house may bring benefits (e.g. reduction of tax burden, smoothing of returns, easier planning) that are not directly attainable by the shareholder.

Financial firms, of course, should be the experts at managing market risks; it is their métier. Indeed, over the last generation, there has been a marked increase in the size of market risks handled by banks in comparison to a reduction in the size of their credit risks. Since the 1980s, banks have provided products (e.g. interest rate swaps, currency protection, index linked loans, capital guaranteed investments) to facilitate the risk management of their customers. They have also built up arbitrage and proprietary trading books to profit from perceived market anomalies and take advantage of their market views. More recently, banks have started to manage credit risks actively by transferring them to the capital markets instead of warehousing them. Bonds are replacing loans, mortgages and other loans are securitized, and many of the remaining credit risks can now be covered with credit default swaps. Thus credit risks are being converted into market risks.

The rapid development of capital markets and, in particular, of derivative products bears witness to these changes. At the time of writing this foreword, the total notional size of all derivative products exceeds $500 trillion whereas, in rough figures, the bond and money markets stand at about $80 trillion, the equity markets half that and loans half that again. Credit derivatives by themselves are climbing through the $30 trillion mark. These derivative markets are zero-sum games; they are all about market risk management – hedging, arbitrage and speculation.

This does not mean, however, that all market risk management problems have been resolved. We may have developed the means and the techniques, but we do not necessarily understand how to address the problems. Regulators and other experts setting standards and policies are particularly concerned with several fundamental issues. To name a few:

1. How do we decide what market risks should be assessed and over what time horizons? For example, should the loan books of banks or long-term liabilities of pension funds be marked to market, or should we not be concerned with pricing things that will not be traded in the near future? We think there is no general answer to this question about the most appropriate description of risks. The descriptions must be adapted to specific management problems.
2. In what contexts should market risks be assessed? Thus, what is more risky, fixed or floating rate financing? Answers to such questions are often dictated by accounting standards or other conventions that must be followed and therefore take on economic significance. But the adequacy of standards must be regularly reassessed. To wit, the development of International Accounting Standards favouring mark-to-market and hedge accounting where possible (whereby offsetting risks can be reported together).
3. To what extent should risk assessments be ‘objective’? Modern regulations of financial firms (Basel II Amendment, 1996) have been a major driver in the development of risk assessment methods. Regulators naturally want a ‘level playing field’ and objective rules. This reinforces a natural tendency to assess risks purely on the basis of statistical evidence and to neglect personal, forward-looking views. Thus one speaks too often about risk ‘measurements’ as if risks were physical objects instead of risk ‘assessments’ indicating that risks are potentialities that can only be guessed by making a number of assumptions (i.e. by using models). Regulators try to compensate for this tendency by asking risk managers to draw scenarios and to stress-test their models.

There are many other fundamental issues to be debated, such as the natural tendency to focus on micro risk management – because it is easy – rather than to integrate all significant risks and to consider their global effect – because that is more difficult. In particular, the assessment and control of systemic risks by supervisory authorities is still in its infancy. But I would like to conclude by calling attention to a particular danger faced by a nascent market risk management profession, that of separating risks from returns and focusing on downside-risk limits.

It is central to the ethics of risk managers to be independent and to act with integrity. Thus risk managers should not be under the direct control of line managers of profit centres and they should be well remunerated independently of company results. But in some firms this is also understood as denying risk managers access to profit information. I remember a risk commission that had to approve or reject projects but, for internal political reasons, could not have any information about their expected profitability. For decades, credit officers in most banks operated under such constraints: they were supposed to accept or reject deals a priori, without knowledge of their pricing. Times have changed. We understand now, at least in principle, that the essence of risk management is not simply to reduce or control risks but to achieve an optimal balance between risks and returns.

Yet, whether for organizational reasons or out of ignorance, risk management is often confined to setting and enforcing risk limits. Most firms, especially financial firms, claim to have well-thought-out risk management policies, but few actually state trade-offs between risks and returns. Attention to risk limits may be unwittingly reinforced by regulators. Of course it is not the role of the supervisory authorities to suggest risk–return trade-offs; so supervisors impose risk limits, such as value at risk relative to capital, to ensure safety and fair competition in the financial industry. But a regulatory limit implies severe penalties if breached, and thus a probabilistic constraint acquires an economic value. Banks must therefore pay attention to the uncertainty in their value-at-risk estimates. The effect would be rather perverse if banks ended up paying more attention to the probability of a probability than to their entire return distribution.

With Market Risk Analysis readers will learn to understand these long-term problems in a realistic context. Carol is an academic with a strong applied interest. She has helped to design the curriculum for the Professional Risk Managers’ International Association (PRMIA) qualifications, to set the standards for their professional qualifications, and she maintains numerous contacts with the financial industry through consulting and seminars. In Market Risk Analysis theoretical developments may be more rigorous and reach a more advanced level than in many other books, but they always lead to practical applications with numerous examples in interactive Excel spreadsheets. For example, unlike 90% of the finance literature on hedging that is of no use to practitioners, if not misleading at times, her concise expositions on this subject give solutions to real problems.

In summary, if there is any good reason for not treating market risk management as a separate discipline, it is that market risk management should be the business of all decision makers involved in finance, with primary responsibilities on the shoulders of the most senior managers and board members. However, there is so much to be learnt and so much to be further researched on this subject that it is proper for professional people to specialize in it. These four volumes will fulfil most of their needs. They only have to remember that, to be effective, they have to be good communicators and ensure that their assessments are properly integrated in their firm's decision-making process.

Jacques Pézier