Forecasting risky business

Repeating the mistakes of the past has no excuse in Philippe Jorion’s book. The renowned authority on risky ventures says that we now have the tools for averting financial catastrophes like Orange County’s record-breaking municipal bankruptcy. The largest in US history, the collapse of the county’s investment pool in 1994 led to a staggering $1.7 billion loss. And, according to the cutting-edge researcher and UCI’s Graduate School of Management vice dean, with what we now know, it doesn’t take a crystal ball to predict trouble.

The “new knowledge” resulting from his unraveling of the nasty web of derivatives, hybrid financial securities and Big Bets Gone Bad, (the title of Jorion’s first book on the subject) served to ignite a revolution in how risk is calculated and monitored in the financial industry. The book also set in motion more extensive research in the area, with Jorion emerging as one of the top international financial advisors in the field of Risk Management.

“During the era of derivative disasters in the ‘90s, of which Orange County’s debacle ranks infamous, the financial industry was beginning to recognize the need for a better techniques to help identify imbalanced exposures before a collapse,” he explained. What was needed according to Jorion, was a simple measure of “downside risk.”

Value At Risk, his acclaimed second book aimed at financial practitioners, advances a downside risk measure, VAR, that has emerged as the new benchmark for controlling market risk. The method is also gaining wide acceptance in the banking industry for its application in measuring and assessing credit risk.

Simply speaking, he says downside risk is a calculation of an investment portfolio’s worst-case, “bad day” scenario. “The method forecasts in dollars the most amount of money a portfolio could possibly lose, based on a specified target ‘horizon’ (day, month, year etc.), at some level of confidence. The history of the portfolio’s returns is plotted and a probability of future losses generated. One of the great advantages of VAR as a measure of risk, is that it can summarize leverage, diversification effects, and probabilities of adverse price movements in a single dollar amount that is easy to communicate. Before 1994, shareholders and investors really had no way to get a good sense of the extent of the trading risks assumed by financial institutions.”

Most major financial institutions in the United States, Canada and Europe are now publishing VAR numbers on an annual, or even quarterly basis.

“It’s not foolproof,” he says, “but the method is reliable with a high degree of confidence as long as the historical performance data is available. Attention also should be taken to insure that banks and investment funds are playing by the rules and not ‘gaming the system’ if the method is to be a good predictor of risk.”

Jorion brings a wealth of knowledge to his position at UCI, receiving his engineering degree from the Universitee Libre de Bruxelles, Belgium. He also attended the University of Chicago, receiving his MBA in 1980 and Ph.D. in International Finance in 1983. He served as an Associate Professor at Columbia University for five years before joining the faculty of UCI’s Graduate School of Management in 1993.

“His research in this area has advanced the science of Risk Management, as well as served to establish a universal standard for training risk managers,” says David H. Blake, dean of the Graduate School of Management. “The VAR method has gained wide acceptance in the world of international finance as the result of Jorion’s work.”

Editor-In-Chief of the Journal of Risk, Jorion keeps apprised of the latest developments in his field. His training manual, Financial Risk Manager, is used as the foundation for topics covered in the certification exam for risk managers which is administered by the Global Association of Risk Professionals, and given in many countries around the world.

“As an illustration of the global interest in this topic, we have instituted a very successful exchange program with a Korean University which allows students to take courses here at GSM in Risk Management in preparation for the certification exam. This program is also helping to spread the ‘risk management mentality’ in Asia and in the world of finance internationally,” Jorion noted.

Jorion’s intensive analysis of the bankruptcy of one of the nation’s wealthiest municipalities is now helping insure that risk measures are in place, alerting fund managers to potential problems before the become front page news. And when financial institutions navigate into the turbulent seas of financial markets, these new protections should help in shoring up the system. But, one thing is for certain; with great minds like Philippe Jorion hard at work tracking down new solutions from devastating past mistakes, a forecast for smoother sailing would seem to be just ahead on the “horizon.”