This issue marks the twentieth anniversary of the founding of The Journal of Risk. It gives us an opportunity to reflect on the topics the journal has addressed since its inception, which occurred in a rapidly evolving financial landscape. Since the mid-1990s, we have witnessed major regulation overhauls and significant crises following pricing bubbles as well as the systemic effects of large portfolio losses. Within this context, risk management has taken on added importance and, in some cases, urgency. Given the focus on mathematical modeling that The Journal of Risk has adopted, it is imperative to look back and assess both successes and failures in managing financial risk in this formal manner. Mathematical models for risk management have had a major impact on financial institutions and their regulators. It is now clear that they will continue to do so as new paradigms – be they in the form of financial products or regulations – emerge.
In this issue, we are very fortunate to have papers written by prominent and active contributors to the varied facets of financial risk management. In our first paper, “A Darwinian view on internal models”, Paul Embrechts provides some personal perspectives on the environment surrounding the birth of The Journal of Risk and developments in formal quantitative risk management (QRM). He singles out internal models for the critical role they play in an ecosystem involving major institutions, regulators, politicians and the general public. Embrechts highlights significant issues surrounding internal models, including calibration, validation and systemic impact, as well as moral hazard, incentives and communication, among many other things.
In the issue’s second paper, “Risk management and regulation”, Tobias Adrian proceeds with a more systematic review of the chronological evolution of risk management, in tandem with financial innovation and methodological advances in derivatives pricing. In these developments he points out the emergence of the now pervasive interaction between QRM and regulations. He notes the failures of both market mechanisms and regulations to adequately contain the major financial crises of the past two decades. The former, as captured by risk concentration and spiraling liquidity evaporation, and the latter, through inconsistent regulatory capital requirements, both took place in strongly interconnected financial markets. Adrian then highlights the necessity of a system-wide perspective on regulations, as developed along recent initiatives, such as building countercyclical buffers and developing related stress tests with risk measures that capture systemic impact.
The financial crisis of 2007–8, like many before it, was immediately preceded by a (housing) price bubble. The frequencies and magnitudes of bubbles vary, whether they occur at the individual asset level or more broadly. In the third paper of this issue, “Asset price bubbles and risk management”, Robert A. Jarrow addresses the generally neglected yet important effect of bubbles on financial risk management. He highlights their impact on portfolio formation and related regulatory capital as well as on asset pricing and hedging. He shows through a martingale pricing model that the expected risk-adjusted return on a risky asset is smaller in an economy with pricing bubbles. Jarrow also shows how this model captures the fact that the risk-adjusted probability of insolvency increases in the presence of bubbles. The model also points to the impact of bubbles on put–call parity and derivatives hedging.
The last major financial crisis also elevated the issue of credit risk and its effect on derivatives pricing. In “Derivatives pricing under bilateral counterparty risk”, the last paper in this issue, Peter Carr and Samim Ghamami introduce dynamic models for the short interest rate and stochastic intensities of a counterparty’s default times to obtain pricing expressions that are either in closed form or easily amenable to computational schemes. Their approach is particularly appealing due to the fact that it is a path-independent probabilistic formulation and incorporates wrong-way risk, addressing credit value adjustment in a direct and less ad hoc manner than current practice.
Warrington College of Business, University of Florida
In this paper, Paul Embrechts reviews discussions on regulation within banking (Basel III and IV) and insurance (Solvency II and Swiss Solvency Test (SST)) from a historical, personal and academic point of view.
The author presents a systematic review of the chronological evolution of risk management, in tandem with financial innovation and methodological advances in derivatives pricing.
The purpose of this paper is to review the literature on asset price bubbles to study the impact that the existence of bubbles has on standard risk management methodologies.
The authors consider risk-neutral valuation of a contingent claim under bilateral counterparty risk using the well-known reduced-form approach.