1. Toward a Unified Theory of Risk Management
Aaron Brown
AQR Capital Management
Quant Congress USA
July 9, 2008

2. Disclaimer
The opinions expressed in this presentation are those of the presenter. They do not necessarily reflect the views of his employer nor any other entity.

3. History
Prehistoric: Risk takers manage risk and return together—evolve into front office risk managers
Early modern: Analysts compile statistics and produce standardized analyses—evolve into back office risk managers
Mid 1980s: Trading organizations integrate into banks, senior management demands independent, firmwide risk management—middle office risk managers are invented

4. Front Office Risk Risk is good, it creates opportunities
Actual losses are bad because they reduce your capital for taking advantage of future opportunities
Kelly criterion

5. Back Office Risk Risk is bad, it costs money
Potential losses are bad because you need to reserve expensive capital or pay for hedges
Standardized, verifiable metrics

6. Middle Office Risk
Risk is neither good nor bad, it’s a dial you set to the appropriate level to accomplish your goals
Miscalibration is bad, neither actual nor potential losses matter in the long run
Economic capital

7. Comparison Time Focus Quantile Focus Risk is relative to:
Risk management means:
Front Office
Present
Left tail
Wealth
Decisions under uncertainty
Back Office
Backward looking
Worst case
Benchmark
Risk measurement and reporting
Middle Office
Forward looking
Entire distribution
Risk is absolute
Risk management

8. Front Office Unification Model
James Bond makes all the risk decisions
Middle office constraints are generally annoying and counterproductive (M), but sometimes helpful (Q, Felix)
Back office should tell the public whatever is necessary to keep 007 in operation

9. Back Office Unification Model
Police gather some evidence and arrest criminals
Prosecutors direct investigators and handle legal issues
CSI analyzes data gathered by others, integrates it with external data and expert knowledge, and cracks the case

10. Middle Office Unification Model
Lois Lane makes pursues profit (stories) but inevitably incurs excessive risk
Superman comes to the rescue
Clark Kent prepares the story for publication

11. Organizing Principle Front office: Kelly criterion
Back office: Utility theory
Middle office: Option pricing
Differ in everyday experience, but can become identical under extreme conditions
Symmetry breaking

12. Interactions Senior Management Front Office Market Middle Office
Back Office
Stakeholders

13. Baseball Players Owners / Management Reporters / Scorers Front Office
Only important part
Sometimes help, sometimes get in the way
Fantasy baseball players
Back Office
Undisciplined troublemakers
More disciplined troublemakers, but don’t appreciate the game
Great sportswriters, analysts, novelists, only reason it matters
Middle Office
Good when they pay attention to quantitative principles
Moneyball

14. Where does this leave us?
Unification is only possible in the context of a strategy
Economic capital is the only existing concept that spans front, middle and back offices
Unification requires economic capital to become real
Are we in a risk-based economic system?