Presented by the Morton L. Topfer Chair Lecture Series and the Department of Finance and Risk Engineering.
For conventional finance, the "predictable future is now." This is the underlying theory of fundamental finance and its approach to financial risk management. Current prices reflect future risks and future risks implied in current price. As a result, attention is focused on managing the "predictable" rather than unpredictable, rare, and consequential risks that matter most. The financial dogma has stood on assumptions taken for granted that financial markets are infinitely liquid, balancing those who seek a flight from risk and those seeks it for profit. The financial meltdown of 2008-2009 has increased our awareness that there are lacunae in our financial models to value, price, and hedge. While fundamental theories have served us well when financial markets are predictable, they fail in turbulent, complex, rare and unpredictable times. Rather than just a "static equilibrium," unpredictable financial prices may have "a dynamic equilibrium," beset by unavoidable booms and busts, catastrophe, contagious behaviors, etc. dictated by both short run and long run processes -- both underlying extremely complex processes. The future of financial risk management is fueled by tomorrows' social and financial environment, and by the needs and the ills of a world in turmoil.
The purpose of this presentation is to focus attention on some elements in the future of finance and their implications to financial risk management. My principal assumptions are that such a future is embedded in the following emerging factors:
- A flight from risk at all levels of the financial landscape
- The multi-polarity of global and competing financial markets
- The persistence of complex financial product innovation (in credit, insurance, etc.)
- The complete financial markets dogma threatened with no clear substitute models
- Persistent financial default models or model hypotheses errors
- An IT financial transformation and a new brand of technology risks and Oprisk
- Liquidity and leverage risk management
- Management's risk or its moral hazard
These "future ills" have implications to the future focus of financial risk management in the small (personal and corporate), in the large (by sovereign states regulation and global initiatives) as well as on the basic mix of financial risk management. Traditional tools focused on ex-ante and predictable risks (whether market or credit risks) will have to be amended to counter the effects of strategic risks and (systemic) risk externalities in global and competing financial markets. In this environment, the plethora of conventional financial tools such as VaR and market based hedging models for risk transfer may also be of limited use.