Presentation on theme: "Toward a Unified Theory of Risk Management"— Presentation transcript:
1 Toward a Unified Theory of Risk Management Aaron BrownAQR Capital ManagementQuant Congress USAJuly 9, 2008
2 DisclaimerThe 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 HistoryPrehistoric: Risk takers manage risk and return together—evolve into front office risk managersEarly modern: Analysts compile statistics and produce standardized analyses—evolve into back office risk managersMid 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 opportunitiesKelly 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 hedgesStandardized, verifiable metrics
6 Middle Office RiskRisk is neither good nor bad, it’s a dial you set to the appropriate level to accomplish your goalsMiscalibration is bad, neither actual nor potential losses matter in the long runEconomic capital
7 Comparison Time Focus Quantile Focus Risk is relative to: Risk management means:Front OfficePresentLeft tailWealthDecisions under uncertaintyBack OfficeBackward lookingWorst caseBenchmarkRisk measurement and reportingMiddle OfficeForward lookingEntire distributionRisk is absoluteRisk management
8 Front Office Unification Model James Bond makes all the risk decisionsMiddle 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 criminalsProsecutors direct investigators and handle legal issuesCSI 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 riskSuperman comes to the rescueClark Kent prepares the story for publication
11 Organizing Principle Front office: Kelly criterion Back office: Utility theoryMiddle office: Option pricingDiffer in everyday experience, but can become identical under extreme conditionsSymmetry breaking
12 Interactions Senior Management Front Office Market Middle Office Back OfficeStakeholders
13 Baseball Players Owners / Management Reporters / Scorers Front Office Only important partSometimes help, sometimes get in the wayFantasy baseball playersBack OfficeUndisciplined troublemakersMore disciplined troublemakers, but don’t appreciate the gameGreat sportswriters, analysts, novelists, only reason it mattersMiddle OfficeGood when they pay attention to quantitative principlesMoneyball
14 Where does this leave us? Unification is only possible in the context of a strategyEconomic capital is the only existing concept that spans front, middle and back officesUnification requires economic capital to become realAre we in a risk-based economic system?