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Risk management, which is omnipresent nowadays, as Georges Dionne rightly highlights, is nevertheless a relatively young field. Twenty or 30 years ago, the term would have seemed pretentious, and the natural reaction of a company director would have been to associate it with the management of insurance coverage. Not that insurance is no longer the anchor point for risk management—it still is—but the term risk management means a lot more than just insurance coverage. In this respect, three events have changed the content of risk management: the collapse of the Long-Term Capital Management fund in 1998, followed by that of Enron in 2001, and finally that of Lehman Brothers in 2008. These three companies were all among the best in their category, and were considered to have the most sophisticated risk management of the time. Lehman Brothers was thus rated “excellent” in risk management, a real role model. This made these failures all the more resounding. Three main lessons have been drawn from these incidents. First of all, good management of identified risks presupposes good overall governance of all the processes of the organization concerned. Next, sophistication is not enough for good risk management, because it can mask major deficiencies in terms of internal control. Finally, operational risk should not be underestimated and should be subjected to careful and reasoned assessment.

Risk management therefore goes beyond simple knowledge of the risks to which the company is exposed, their possible aggregate cost, and the techniques used to cover them. It covers governance, internal control, and compliance with regulatory requirements. In concrete terms, it covers complex processes that play out in seven logical steps:

1. First of all, a general system of good governance must be in place, which ensures the transparency of management and the rationality of the decisions made by those in charge of the organization.
2. Then the governing bodies need to set objectives for the organization concerned, in sufficient detail (what are the missions, and under what conditions they should be completed?).
3. Also, from these objectives, the governing bodies need to ascertain the organization's preferences in terms of risk or risk appetite (which risks to take or not take, minimise, etc.), bearing in mind that the objective of risk management is not to exclude risk but to control it.
4. After this, the current and emerging risks to which the organization is exposed need to be identified, and their impact on it measured in terms of frequency and severity.
5. The next step consists of deciding which measures are necessary to control these risks, by ruling them out, transferring them to other agents, or containing them within predefined limits.
6. Next, processes, thresholds, and controls must be implemented to ensure that risk control is in place throughout the organization.
7. Finally, there should be internal and external communication on risk management, depending on the legal obligations involved, market practices, and the prudential rules and standards specific to the organization and its reputation.

In this new understanding of “risk management,” which emerged at the end of the twentieth century and the beginning of this one, risk management permeates the entire organization. It is thus an integral part of the company's values and culture, in which all of the company's employees, without exception, are now involved, to the point where judges may refer to it in their rulings. It is a very significant shift. This shift is not fully complete and will not be complete as long as it remains possible to hide from investors the risks to which you are exposed, and against which you are not protected. Decisions on insurance cover have become key variables with which to assess the strength of a company. They can no longer remain hidden within the departments in charge of negotiating the associated contracts. Investors, directors, and officers must be kept informed about them and must be able to assess their relevance to the company's objectives and risk appetite.

Today, good risk management forms part of a company's competitive advantages, particularly in the financial sector, and even more so in the insurance industry where you find risks on both the asset and the liability side of the balance sheet—this situation is particularly conducive to risk accumulation, which is at the root of the most extreme risks. Good risk management forms part of a company's capacity for strategic anticipation.

Georges Dionne's work fits into this renewed approach. It's important to emphasise the fact that although the consideration of risk has shaken the economy, economic analyses and works devoted to risk management and its impact on the behavior of organizations are still few and far between. Some examples are the pioneering work of the Nobel Prize–winners in Economics Lars Peter Hansen and Thomas Sargent, who raise questions in their book Robustness about the impact on capital management of considering risk management, and the works of Jean-Charles Rochet and Gilles Bénéplanc, who propose economic fundamentals consistent with risk management in their book Risk Management in Turbulent Times. It's clear that, for the purposes of optimization, risk management and capital management cannot be separated. The company seeks to maximize its current and future profitability, and therefore its growth, under the constraint of remaining solvent. And in general, the optimal situation is not one in which risk is excluded, but one where taking controlled risk enables the company to maximize its value.

Within the vast field covered by risk management, Georges Dionne's work concentrates on the motivation behind financial risk management and the measurement of its efficiency. It focuses on the management of market, credit, liquidity, and operational risk. This leads it to a detailed analysis of portfolio management and the calculation of optimal and regulatory capital. I recommend reading the entire work carefully, but I particularly appreciated the chapters devoted to analyzing the failures of LTCM and Enron, and to the subprime crisis. I also strongly recommend reading the chapters on capital and value at risk (VaR) and the most sophisticated developments in this regard within the framework of conditional value at risk (CVaR), which lies at the heart of the debate on the measurement of systemic risk. Georges Dionne talks about a textbook for students. In fact, Corporate Risk Management: Theories and Applications is not just a manual, it is also a faithful companion for academics wishing to update their knowledge and for all company directors who want the most appropriate instruments to manage both the risks they have decided to take on and those that are imposed on them.

Teachers, researchers, students, and decision makers will find in Georges Dionne's work a presentation of these instruments, their economic consistency, and their intrinsic limits that is at once pedagogical and comprehensive. Anyone who is allergic to quantitative techniques need not worry about the mathematical developments contained in the text: the author has stylized and simplified them so well that they are accessible to any enthusiastic reader, while retaining the flavor of mathematic discipline. This is therefore a work to read, to engage with, and to keep at hand.

DENIS KESSLER
Chairman and chief executive officer of the SCOR Group
April 12, 2018

GENERAL PRESENTATION

The study of financial risk management began after World War II. This rather young discipline aims to reduce the costs associated with risk. It covers all risk categories.

Risks cause various types of costs: physical, economic, financial, and even psychological. Some are insurable and others are not. This book concentrates on economic and financial risks that businesses and individuals face, especially those that are not anticipated, although some anticipated risks are also discussed. The costs of risk are generated not only by passive exposure to hazards, but also by risk taking in hazardous environments linked notably to the competition, technology, debt, economic conditions, climatic conditions, market imperfections, and regulations, although regulations may also mitigate the social costs of some risks.

Risk management does not imply risk aversion. It may concern risk-averse decision makers, but risk aversion is not a necessary condition for its use. It is well known that an increase in risk (mean preserving spread) decreases the welfare of risk-averse decision makers, but it also reduces the value of firms that have a concave objective function. This concavity may be obtained by a moderate risk appetite along with an exposure to nonlinear financial products, and by market imperfections such as the convexity of tax functions, or information asymmetry in financial markets.

Under the regulations governing banks and insurance companies, the risk appetite of a financial institution must be stipulated and adopted by its board of directors. This should apply as well to all businesses, for the benefit of shareholders and various stakeholders. This exercise is important because its result determines the optimal risk management actions to take. An important corollary is that firms should not cover all risks automatically; they must take only the risk management actions that maximize firms' value.

Risk is ubiquitous. Individuals, businesses, communities, and governments all face it. Risk affects welfare and includes several dimensions. In finance, it combines hazards and opportunities. It is commonly measured by modeling different possible states of nature according to their probability of occurrence and the associated consequence. This combination is linked to a probability distribution of occurrences of states of nature that have different moments. Depending on the needs and preferences of decision-making agents, these moments may yield different costs and benefits. For losses related to pure risks, mathematical expectation or mean plays a determining role. Weighting of mean and volatility prevails in the estimation of opportunities related to financial assets. Higher moments may become important when all information is not contained in the first two moments. In the study of catastrophe risks, modeling extreme losses with very low probabilities is crucial. It often involves using higher moments of the probability distribution. When statistical information is lacking, these risk measures may become inapplicable. Other approaches of risk management must be used. Precaution is a form of risk management when agents lack information on the probabilities and consequences of the states of nature.

Information asymmetry and its consequences on risk management receive particular attention in this book. Banks cannot perfectly evaluate the risks posed by the individuals and businesses to which they make loans. This lack of information affects the risk premiums imposed by the banks, along with the forms of bank contracts and the default probabilities. Further, financial contracts affect borrowers' behavior. Choosing optimal forms of contracts is part of the risk management of financial institutions. The rating of clients' risks by banks is another form of credit risk management. In the years preceding the last financial crisis, banks put loans on the market using nonoptimal forms of securitization (without retention) in the presence of moral hazard. These choices affected their credit risk management behavior and greatly increased the probabilities of default on mortgage loans.

Information asymmetry also pertains to the governance of risk management. Do managers always choose the forms of risk management that maximize firm value? The answer may be partly linked to the different types of managerial compensation. Managers paid by stock options may not always be motivated to reduce the volatility of their firm value, compared with managers paid by shares or salary.

Information asymmetry can even justify risk management. For example, it may explain the hedging of internal financing of investment projects to avoid paying overly high interest rate premiums on external loans, arising from the difficulty that banks face when evaluating the risks associated with projects.

Information asymmetry affects risk prevention and reduces risk management when financing contracts are not written so as to give borrowers appropriate incentives. In some situations, risk becomes endogenous, which makes it more difficult to manage. Chapters 10 and 11 address this form of moral hazard.

The book is intended for graduate students in finance, financial economics, and financial engineering. It aims to provide a detailed presentation of the advanced literature on risk management. It does not use complex mathematics, but readers should have basic knowledge of statistical analysis, probability theory, applied econometrics, and finance, including portfolio management and the use of derivatives. This book does not discuss the risk management processes of risk identification, evaluation, prioritization, and control in detail, nor the execution of action plans to reduce risks under optimal scenarios. It does not address financial-product pricing or other activities related to financial engineering. Rather, it examines the motivation for risk management and the measurement of its efficiency. As the title indicates, the book is mainly dedicated to the corporate finance dimension of risk management by presenting different theoretical models that justify risk management, and by performing empirical verification of different theoretical propositions. It also proposes statistical modeling to identify the importance of different risks and of their variations according to economic cycles. Default, liquidity, and operational risks during the financial crisis that began in 2007 are analyzed in detail.

Obviously, this book cannot cover all financial risks. It focuses on market, credit, liquidity, and operational risk. It does not cover insurable risks. More specifically, it addresses portfolio market risk management and portfolio credit risk management, the use of derivatives and structured financial products, the calculation of optimal regulatory capital, prevention, conditional value at risk, regulation, and governance of risk management. It presents extreme examples that have cast doubt on the efficiency of risk management, like the financial crisis of 2007–2009, the Enron bankruptcy in 2001, and the failure of the fund Long-Term Capital Management (LTCM) in 1998.

CONTENTS OF THE BOOK

The book contains 21 chapters. The first chapter reviews the history of risk management and of derivatives and structured financial products. A definition of risk management for nonfinancial firms is proposed. It highlights the maximization of firm value by integrating internal activities of self-protection and self-insurance with external activities like the use of market insurance, derivatives, and structured financial products.

A large part of the book contains a detailed investigation of the motivations for risk management of nonfinancial firms. By taking into account managers' risk attitude and behavior, risk management generally aims to reduce the costs associated with various risks such as those of financial distress, premiums to different partners, taxes, and investment financing. Risk management also covers dividend payments, liquidity requirements, mergers and acquisitions and firm governance. These determinants are analyzed from a theoretical standpoint (Chapters 2 and 3), and their effects are estimated using empirical studies (Chapter 4).

The concepts of value at risk (VaR) and conditional value at risk (CVaR) are explored in Chapters 5 and 8. We also present the calculation of the VaR of a financial portfolio containing equity and derivatives (Chapter 7), and the optimal choices of a portfolio under the constraint of VaR (Chapter 6). Value at risk (VaR) and conditional value at risk (CVaR) are estimated and tested using exercises. The use of VaR is also documented in Chapter 9, dedicated to the regulation of banks' market risk under the Basel Accord. We examine whether financial institutions' should use internal models rather than the standard models proposed by the Basel regulation, depending on the diversification opportunities.

Chapters 10 and 11 analyze the effects of different forms of financial contracts on managers' risk prevention activities. Empirical applications to risks of air accidents and default by venture capital corporations are presented. Chapter 10 links air accidents to the financing contracts of airlines' investment projects, and Chapter 11 analyzes how financing of venture capital affects the default probabilities of new innovative or technological businesses that need financing. A test for the presence of residual asymmetric information in the portfolio of a venture capital firm is presented, using methodologies developed during the recent years.

Next, we analyze various risks. Chapters 12 and 13 cover credit risk. Chapter 12 proposes a theoretical and empirical model of scoring of bank borrowers' default risk, and Chapter 13 presents the CreditMetrics model of risk management of default of a bond portfolio. This type of model lets banks calculate the capital required to satisfy the regulatory requirements linked to the credit risk of their financial asset portfolio or loan portfolio. This model is distinguished by its consideration of correlations between different assets in the portfolio.

Chapters 14 and 15 present empirical analyses of operational and liquidity risk. In these chapters we propose regime models that we test on data collected during the financial crisis of 2007–2009. Data on operational risk come from American banks that hold assets of $1 billion or more. We show that consideration of Markov regimes reduces regulatory capital. Data on liquidity risk are taken from a private bond portfolio. We use CDS premiums to measure the default risk of bonds, and we apply principal component analysis to create an illiquidity index, based on different illiquidity measures. We show that liquidity risk was a key element in bonds' credit spreads during the most recent financial crisis.

Chapter 16 proposes an analysis of the LTCM fund debacle, caused by the exaggerated use of leverage and poor risk management. The managers exposed the aggregate portfolio to credit and liquidity risks by considering only very short-term market risk. Chapter 17 describes the mismanagement of different structured products, including CDOs (collateral debt obligations), during the years leading up to the financial crisis of 2007–2009.

Chapter 18 analyzes the governance of risk management at financial institutions in relation to the Enron bankruptcy and the last financial crisis. Chapter 19 reviews recent contributions on the industrial organization of risk management and Chapter 20 covers the effect of risk management on firm value. Lastly, five detailed exercises are presented in Chapter 21. The Excel files containing the solutions to these exercises are available at: https://chairegestiondesrisques.hec.ca/en/seminars-and-publications/book-Wiley.

ACKNOWLEDGMENTS

I would like to thank the late professor Jean-Claude Cosset, who strongly encouraged me to write this book during his tenure as Research Director at HEC Montréal. His outstanding intellectual rigor and tremendous kindness will forever be remembered.

Several sections of this book were developed jointly with coauthors in the field of risk management, to whom I am very grateful: Manuel Artis, Anne-Sophie Bergerès, Oussama Chakroun, Héla Dahen, Philippe d'Astous, Pascal François, Robert Gagné, François Gagnon, Martin Garand, Geneviève Gauthier, Montserrat Guillen, Khemais Hammami, Sadok Laajimi, Olfa Maalaoui-Chun, Sara Malekan, Mohamed Mnasri, Abdelhakim Nouira, Karima Ouederni, Nadia Ouertani, Maria Pacurar, Samir Saissi Hassani, Marc Santugini, Jean-Guy Simonato, Nabil Tahani, Thouraya Triki, Charles Vanasse, and Xiaozhou Zhou.

The contents of this book are drawn from the topics of the graduate-level risk management courses I have taught since 1996. Several students have read and reread different chapters in the past few years. I would like to thank in particular Julie Beaudoin, Anne-Sophie Clarisse, Katherine D'Onofrio, Marie-Ève Drolet-Mailhot, Geneviève Dussault, Alain-Philippe Fortin, David Gutkovsky, Jeanne Mutshioko, and Hassane Saddiki for their contribution to the book. Sabrina Mc Carthy was a very diligent reader of the latest versions of all chapters. Five research assistants were heavily involved in preparing and presenting the exercises: Alain-Philippe Fortin, Tom Imbernon, Martin Lebeau, Samir Saissi Hassani, and Faouzi Tharkani.

I am deeply indebted to Claire Boisvert for her invaluable help in formatting all of the versions of the book. She has produced a remarkable manuscript. Her extreme skill and congeniality facilitated the preparation of different versions over several years. Karen Sherman translated the manuscript in a highly professional manner. Their contribution was exemplary in many respects. The production of this book was partly financed by HEC Montréal, the Canada Research Chair in Risk Management, and the Social Sciences and Humanities Research Council of Canada (SSHRC).

My family has always encouraged me with great love and understanding. Thanks to my spouse Danielle and our two sons Jean-François and André-Pierre, together with Anne-Pier, Noah, Mila, and Zoë.

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1. Bolton, P., and Dewatripont, M., 2005. Contract Theory. Cambridge, MA: MIT Press.
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3. Christoffersen, P.F., 2012. Elements of Financial Risk Management, 2nd ed. Oxford, UK: Academic Press.
4. Courbage, C., Rey, B., and Treich, N., 2013. “Prevention and Precaution.” In G. Dionne (Ed.), Handbook of Insurance, 2nd ed. New York: Springer, 185–204.
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6. Cruz, M.G., 2002. Modeling, Measuring and Hedging Operational Risk. New York: John Wiley & Sons.
7. Dionne, G., 2013. “The Empirical Measure of Information Problems with Emphasis on Insurance Fraud and Dynamic Data.” In G. Dionne (Ed.), Handbook of Insurance, 2nd. ed. New York: Springer, 423–448.
8. Dionne, G., 2013. Handbook of Insurance, 2nd ed. New York: Springer.
9. Dionne, G., and Harrington, S.E., 2014. “Insurance and Insurance Markets.” In W.K. Viscusi and M. Machina (Eds.), Handbook of the Economics of Risk and Uncertainty. Amsterdam: North Holland, 203–261.
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16. Laffont, J.J., 1989. The Economics of Uncertainty and Information. Cambridge, MA: MIT Press, MA.
17. Lando, D., 2004. Credit Risk Modeling: Theory and Applications. Princeton, NJ: Princeton University Press.
18. McNeil, A.J., Frey, R., and Embrechts, P., 2015. Quantitative Risk Management: Concepts, Techniques and Tools. Princeton, NJ: Princeton University Press.
19. Ritchken, P., 1996. Derivative Markets: Theory, Strategy, and Applications. New York: Harper Collins College Publishers.
20. Salanié, B., 2005. The Economics of Contracts, 2nd ed. Cambridge, MA: MIT Press.
21. Saunders, A., and Allen, L., 2010. Credit Risk Measurement In and Out the Financial Crisis: New Approaches to Value at Risk and Other Paradigms, 2nd ed. Hoboken, NJ: John Wiley & Sons.
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