In his preface, Riccardo Rebonato states, “financial risk management is in a state of confusion.” He expands this assertion by noting that managers spend too much time measuring risk and developing risk metrics and not enough time making actual decisions based on the results of the risk models.
In response to this situation, Rebonato has developed what he considers a radical critique of risk management methodology. In Plight of the Fortune Tellers: Why We Need to Manage Financial Risk Differently, Rebonato analyzes and offers solutions to problems related to quantitative risk management strategies and the value-at-risk (VAR) methodology currently used by financial managers. Through stories, examples, theory, and practical methods, he first provides a critical review of the current state of affairs in investment risk management. Then, he proposes how we should “revisit our ideas about probability in financial risk management” and “put decision making back at center stage.”
Plight of the Fortune Tellers is logically organized by themes into three main segments: the history of quantitative decision making and risk measurement, a critique of current VAR methods and the decision-making process, and suggestions for investment managers and market regulators about how to improve the risk management process.
To begin, Rebonato provides a brief history of the development of risk measurement techniques that is reminiscent of Peter Bernstein’s book Against the Gods: The Remarkable Story of Risk (1996, reviewed in the March/April 1997 FAJ). He reminds readers of the work of Daniel Bernoulli and Thomas Bayes and the success of such researchers as Harry Markowitz in developing decision-making techniques in a world of uncertainty. He points out, however, that much of the research developed in the last half-century or so seems to have been lost on practitioners in the present quantitative world of risk management.
With this problem acknowledged and using his risk management proposals, Rebonato presents theoretical and practical suggestions to improve the decision-making process in risk management on the basis of the simple, but sometimes overlooked, concept of expected return as measured by a combination of risk, return, and probability.
In his critique of current VAR methods, Rebonato develops what he refers to as the “four corners” of risk management that will help managers determine where on the probability spectrum the relevant data and subsequent analysis fall. The spectrum runs from the purely “frequentist” (objective) view of probability to the Bayesian (subjective) approach to probability. Rebonato argues that the adjustment of the VAR model, and the decisions based on the model, should be determined by the following characteristics: “the frequency of the data collection, time homogeneity of the phenomenon, the rarity of the event . . . [percentile level], and the time horizon of [the] prediction.”
These adjustment factors should be familiar to most quantitative researchers working within the VAR framework. But by introducing the concept of trend into the risk management discussion, Rebonato treads on radical thinking and returns to a Bayesian approach to risk management. He points out that as the time horizon of the portfolio is extended from the short-term horizon of “trading books” to the longer-term horizon of credit risk and asset and liability management, the problems and complexities of determining the trend should take precedence over attempts to estimate portfolio volatility. By making this adjustment, Rebonato argues, the risk manager can develop more robust VAR models and estimates of portfolio risk levels than those in use today.
In the last segment of the book, Rebonato provides remedies for the current problems in the risk management arena and argues that risk managers should use risk management tools that are different from the ones that market regulators use because the two groups are driven by different motives. For the private-firm risk manager, Rebonato recommends separating the analysis of risk from the analysis of future returns. He also recommends using a frequentist approach to measure and estimate the dispersion of the distribution and a Bayesian approach to make decisions related to the return estimation process and to estimate the future mean of the return distribution. For market regulators, Rebonato suggests moving beyond the crude methods of VAR toward a more Bayesian risk management approach by applying a risk safety factor based on the adverse-event estimates generated by private-firm banks.
Plight of the Fortune Tellers contains valuable insights into the development of VAR methodology and problems associated with its use in the present financial management arena. Rebonato seems to approve of most of the current methods but recommends a number of adjustments. His suggestions may be new to some portfolio managers, but managers dealing with derivative securities have already fixed some of the problems that Rebonato points out. For example, trend-following, nonlinear trading strategies have been in use for quite some time in the real-asset markets, even though these strategies have generally been shunned by managers of debt and equity portfolios.
Plight of the Fortune Tellers is a book recommended for practitioners currently involved in quantitative methods and for students of investments and risk management at the graduate school level. The author’s critique of the current use of VAR methods is consistent with recent articles in the Economist magazine (see Buttonwood 2007; “Spooking Investors” 2007) and Risk Intelligence by David Apgar (2006), which discuss the limitations of VAR methodology.
Rebonato’s critique is especially timely in light of current concerns in the global markets about securitized real estate loans and market liquidity. Because of these upheavals, the quantitative methods and risk management techniques of global fund managers are being called into question. Furthermore, questions have arisen about the role of central bank regulators and whether their responses to financial market problems are timely, adequate, and prudent. Plight of the Fortune Tellers easily lends itself to the discussion of these important current issues and provides a possible framework for remedying the situation.
—J.J.