Mathematical Finance Seminar

April 19, 2001 , 5:30 PM to 7:00 PM

David Heath, Carnegie Mellon University

Risk Management Using Coherent Measures of Risk

This talk provides a framework for measuring and managing financial risk in a firm with multiple decision makers (desks) in a coherent fashion. The proposed method employs an internal market for risk limits in which desks can purchase or sell the ability to take risks in firm-specified (generalized) scenarios. We show the consistency of such risk limits with utility theory, and prove that the firm-wide optimal solution (for the problem of maximizing expected return subject to coherent firm-wide risk limits) results from an equilibrium in the internal risk limit market. The resulting transfer payments (for purchase and sale of risk limits) provide a natural way to compute risk-adjusted trading profits.