23-RiskManagement Page 737 Wednesday, February 4, 2004 1:13 PM
CHAPTER
23
Risk Management
R
isk means uncertainty. There is risk whenever there is uncertainty
about future events. There are many different notions of risk. In busi-
ness, as well as in daily life, an endeavor is considered risky if it is diffi-
cult or if depends on many things that might go wrong. The notion of
risk espoused by financial theory is that of pure probabilistic uncertainty,
without any possibility of controlling the outcome. For example, an
investor does not control market fluctuations.
Though risk cannot be individually influenced it can be managed by
diversification and risk transfer. The idea of transferring and reducing
risk is not new. As observed in Chapter 1, the practice of insurance and
of risk reduction through diversification was already well established in
the Middle Ages. Diversification is an intuitive idea, easily conveyed by
the saying, “Do not put all your eggs in the same basket.”
However, the modern idea of measuring risk and of selectively
transferring carefully calibrated portions of risk had to wait the devel-
opment of modern probability theory. As seen in Chapter 3, the founda-
tion of probability theory as a sound mathematical discipline was
achieved only around 1930.
The development of the mathematical theory of risk, initiated by
Lundberg (see Chapter 3), led to the practice of modern insurance and
to the development of the insurance business. Insurance is deeply rooted
in the notion of diversification: Individuals protect themselves by pool-
ing risks together. If the number of uncorrelated risks is large, individual
risk becomes negligible.
In recent years, financial firms and insurance companies have taken
the concept of risk management further in three different directions: (1)
by recognizing that the shape of risk is an important determinant of the
risk-return trade-off; (2) by engineering contracts able to transfer737