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transparency and more precise calculation of the capital needed to support risks. None of the previously mentioned approaches would achieve these objectives on their own. Thus, the new capital adequacy approach integrates the different risk categories and the different supervisory tools in the form of capital adequacy calculation, disclosure requirements, crossborder cooperation among supervisors, and the like.
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Risk management is not a new function or gadget in the financial industry. However, based on recent events, regulators and the media have increasingly scrutinized risk management practices and techniques. A closer look at some of the accidents makes it apparent that managers, regulators, and investors have partially lost control of risk management, overestimated their own capabilities and capacities, and brought companies and entire markets to the edge of the abyss. For well over 100 years, farmers, for example, have engaged in risk management as they have sought to hedge their crops against price fluctuations in commodity markets. Their preferred strategy has been to sell short some or all of their anticipated crops before harvest time to another party on what are called futures markets. The Chicago Board of Trade (CBOT) was the first exchange to offer futures contracts. This strategy guarantees the farmer a known price for a crop, regardless of what the commodity s future price turns out to be when the crop is harvested. Risk management along these lines makes sense for farmers for at least two reasons. First, agricultural prices are exposed to volatility. Many of these farmers are not diversified and must also borrow in order to finance their crops. Therefore, setting the future sale price now migrates the risk of price fluctuations. For another example that demonstrates the same approach, consider a large aluminum extraction company, owned by numerous shareholders, facing similar commodity price risk. For concreteness, consider a firm primarily engaged in the extraction and sale of raw aluminum on a global basis. Given that aluminum prices are relatively volatile and are exposed to global economic cycles, the first rationale for risk management might seem similar to the farmer s. However, unlike the farmer s circumstance, this firm is owned by a large number of shareholders, who can, if they wish, greatly reduce or eliminate their risk from low aluminum prices simply by holding a diversified portfolio that includes only a small fraction of assets invested in the aluminum extraction company. More generally, if investors can freely trade securities in many firms, they can choose their exposure to volatility in aluminum prices. Indeed, in two studies, Modigliani and Miller21 showed that, in a world with no transactions costs
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or taxes and with equal information, managers could not benefit their shareholders by altering the risk profile of the firm s cash flow. Essentially, in this situation, shareholders can already do whatever they choose at no cost; actions by managers are redundant. Although the Modigliani and Miller studies considered the options of changing the firm s risk profile only through the use of debt financing (1958),22 or the distribution (or lack thereof) of dividends (1961),23 and not through the use of financial derivative securities, the powerful implication here is the same as that outlined earlier. However, the practical world is not without transaction costs and not as transparent as academic assumptions would have it. Several times over the past decades, investors and the market have been surprised by the announcement that a company has incurred substantial losses through speculation, fraud, or money laundering, leaving investors with dramatically devalued investments or even in bankruptcy. No risk management strategy as proposed by Miller and Modigliani could have prevented such a disaster, as shareholders were unable to take any action to offset or mitigate the risks. Regulators have become more active over the past decades and have launched several initiatives regarding credit, market, and operational risks, forcing financial organizations to invest in their infrastructure, processes, and knowledge bases. The objective of both management and the regulators is to build and enforce an integrated risk management framework. However, although the objective might be the same, the strategy is completely different from the regulatory and management viewpoints, which is why risk management has become a hot issue. Management seeks to protect clients assets at the lowest possible cost by avoiding losses and by increasing the value of the shareholders investment through business decisions that optimize the risk premium. Regulators seek to protect the clients assets without regard to cost, maintaining market stability and protecting the financial market by excluding systemic risk. Risk management has to serve both purposes and thus has to be structured, built, and managed in such a way that it can answer these different needs simultaneously. The models and approaches used in the different risk categories must give statements about the risk exposures and allow aggregation of risk information across different risk categories. It is the purpose of this book to look into the different models and analyze the compatibility, assumptions, and conditions between the different models and risk categories.
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