Risk Practice

McKINSEY WORKING
PAPERS ON RISK

The Risk Revolution

Number 1 Kevin Buehler,

September 2008 Andrew Freeman
and Ron Hulme

Confidential Working Paper. No part may be circulated, quoted, or reproduced for distribution
without prior written approval from McKinsey & Company.

The Risk Revolution

Contents
Introduction

Acknowledgements

The emergence of modern risk management

Table 1: Important theories and their applications

Risk in the financial sector
Goldman Sachs and the culture of risk
Risk for nonfinancial companies
Case study: TXU Corporation
A practical corporate risk-management process
Table 2: Examples of risk across industries
Selected sources

5
8
14
16
19
22
31
35

McKinsey Working Papers on Risk is a new series presenting McKinsey's best current thinking on
risk and risk management. The papers represent a broad range of views, both sector-specific and

cross-cutting,
and are intended to encourage discussion internally and externally. Working papers may
be republished through other internal or external channels. Please address correspondence to the

managing
editor, Andrew Freeman, [email protected]

Introduction
In the past 18 months, we have witnessed a major credit and liquidity crisis in the banking
system as losses from subprime mortgages, structured investment vehicles, and covenantlite leveraged loans generated significant knock-on effects worldwide. Major financial
institutions have taken more than $500 billion in write-offs, and central banks around the globe
have initiated emergency measures to restore liquidity. CEOs have been replaced at such
venerable institutions as Citigroup, Merrill Lynch, and UBS. Bear Stearns, a firm once viewed
as having a conservative approach to risk management, has been the target of a rescue by
JPMorgan that was driven and to some extent sponsored by the Federal Reserve. Lehman
Brothers has filed for bankruptcy. Goldman Sachs and Morgan Stanley have changed status
to become bank holding companies. To the experience of the present crisis we can add our
memories of many others: the savings and loan crisis in the 1980s, Black Monday in 1987, the
Russian debt default and the related collapse of Long-Term Capital Management in 1998, the
dot-com bust of 2000, and the Enron-led merchant-power collapse of 2001.
Interest in risk tends to come to the fore at times of crisis and then recede as conditions revert
to normalcy. This rhythm is the outcome of risk being overwhelmingly discussed in terms of its
downside. But the resounding message of such crises is that risk is always with us, for good
as well as ill. And as recent events have demonstrated, a grave mistake is made, and a
promising opportunity missed, in waiting until everybody else has perceived the problem.
If this tendency is to change, financial and strategic risks must be managed in an integrated
fashion, with ownership vested at the CEO level. The tools and techniques to make this
possible are well established. What has been missing in most organizations is a practical
process that makes such integrated management possible.
The subjects of this working paper are understanding risk and implementing risk tools. The
paper is organized into four sections. The first discusses the historical emergence of risk
management. The second reviews some of the theoretical and market developments that
allowed financial institutions to transfer risk and examines the enormous impact of these
developments on the financial sector. A third section on risk in the corporate sector focuses
on developments in the energy industry to exemplify how risk management can transform the
fortunes of nonfinancial companies. Finally, the paper sets out a comprehensive framework
for how institutions can employ a disciplined, strategic risk-return management process.1
Another article, A Primer on Tools and Techniques of Risk Management (ID# 737072),
complements this paper and provides a more detailed discussion of some of the basic

1 This working paper is a revised and updated version of McKinsey Staff Paper No.68 published in
July 2008. It is not a history of risk, although it covers some important developments. Anyone
interested in the long history of risk should read Peter L. Bernsteins entertaining Against the Gods:
The Remarkable Story of Risk, New York: Wiley, 1996, which remains the most accessible book on
the subject. Those seeking a deeper understanding of some of the financial theory that underpins
modern risk management should read Bernsteins book Capital Ideas: The Improbable Origins of
Modern Wall Street, New York: Free Press, 1992, in which the author explains the emergence of
portfolio theory and the capital asset pricing model, among other important innovations.

concepts, tools, and techniques of risk management. It is recommended both to beginners, as

helpful general background, and to seasoned practitioners in a single area of risk
management, providing context for the more holistic, integrated approach we advocate.
At one level, this paper is a description of risk management as practiced in the financial sector
and the presentation of a process to bring that rigor to nonfinancial companies. But the paper
is also more than that. In the wake of recent events, commercial and investment banks are
themselves asking whether they have made systematic errors in their approach to risk. For
many, the answer is yes. Banks certainly apply sophisticated algorithms and develop
elaborate models in an effort to manage risk effectively. Yet they tend to underestimate the
importance of robust cultural risk processes, including incentives to encourage good behavior
among key business managers and top management.
As such, there is much in the paper, and in the last section in particular, that should be as
useful to financial as to nonfinancial institutions.

Acknowledgements
In an effort to map the evolution of thinking about risk and its practical applications in
companies, we have interviewed leading thinkers and practitioners in the field. How did the
underlying ideas develop? How were they being used in business settings? Thanks are due
to Kenneth Arrow, professor emeritus at Stanford and Nobel laureate; Myron Scholes, Nobel
laureate and co-author of the Black-Scholes option pricing formula; Steve Ross, MIT
professor, author of Neoclassical Finance, and developer of arbitrage pricing theory and
binomial options pricing; Bill Sharpe, Nobel laureate and author of the capital asset pricing
model; Peter Bernstein, author of Against the Gods and Capital Ideas; Anthony Santomero,
senior adviser to McKinsey, professor emeritus at Wharton, and former president of the
Philadelphia Federal Reserve Bank, where he served as a member of the Federal Open
Market Committee; Peter Fisher, a director of BlackRock and former head of markets at the
New York Federal Reserve Bank; Glenn Koller, risk manager at Schlumberger, and author of
Risk Assessment and Decision Making in Business and Industry and Modern Corporate Risk
Management; Tom Skwarek, managing director of Swiss Re and an expert in structured
finance; Mark Lawrence, McKinsey partner and former chief risk officer of ANZ Bank; Lloyd
Blankfein, CEO, Goldman Sachs; and John Wilder, former CEO, TXU. Interested McKinsey
consultants can gain access to a video library through the Know portal that includes interviews
with most of these participants. We would like to acknowledge the many colleagues who have
contributed to the ideas and frameworks described below. We would also particularly like to
thank our colleagues in the Risk Practice and four reviewers for the helpful feedback they
offered. Special thanks to Saul Rosenberg, who edited the original staff paper with insight and
skill and who made a major contribution to its development. Any errors in this paper are, of
course, our own.

The emergence of modern risk management

Before the 1970s, risk management in most corporations was largely defined by the
purchasing of insurance a strategy to manage downside risk, with no attention paid to
upside. Risk management was also rudimentary in the financial sector. Bank regulators
lacked broadly applicable tools for measuring risk in the system, making constructive
intervention difficult. Banks themselves lacked the tools to shape the interest-rate risks in their
loan portfolios, and so could do little to protect themselves from swings in interest rates. They
also lacked tools for quantifying and managing credit risk, and had only the most elementary
understanding of operational risk.
In the university setting, however, some important theoretical foundations had already begun
to be laid. From the 1940s onward, academics started to advance their understanding of riskreturn trade-offs in investment management and to develop tools to apply their findings (some
of which are included in Exhibit 1 and Table 1).
Exhibit 1
NEO-ZZQ845-20080612-JF1

Economics / finance

Foundations of modern risk management

Theory Analytic economics CAPM
(Samuelson)
(Sharpe)
Mean variance
(Markowitz)
State preference
theory (Arrow)
Modigliani-Miller
Business
minicomputer
(PDP-8)

Tools

Decision making / uncertainty

1940s
and 1950s

1960s

Brainstorming
(Osborn)
Delphi method
(RAND)

Underinvestment
problem
(Mayers,
Smith and
Stulz)

Value of
hedging
(Froot,
Scharfstein,
and Stein)

Monte Carlo
in business
VisiCalc

VaR/RAROC
Monte Carlo
spreadsheet
add-ins

Stress testing
RiskMetrics
CreditMetrics

1970s

Theory Game theory

Decision
(Neumann)
analysis
Systems dynamics Nash
(Forrester)
equilibrium
Bounded rationality
(Simon)
Tools

Black-Scholes
Arbitrage pricing
theory (Ross)
Binomial options
(Cox and Ross)

Decision
trees (Hunt)
SWOT
model

1980s

1990s and
beyond

Chaos theory
(Yorke)
Prospect theory /
Cognitive biases
(Kahneman and
Tversky)
Scenario
planning
(Godet)

Genetic
algorithms/AI
Information
markets

Real options
Data mining

Sources: Peter Bernstein, Capital Ideas; Philippe Jorion, Value at Risk; Derivatives Quarterly; McKinsey analysis

Table 1

Important theories and their application

Name
Allocation efficiency, state
preference theory (Kenneth
Arrow, Gerard Debreu)

Mean-variance (Harry
Markowitz)

Capital asset pricing

model, or CAPM (Bill
Sharpe)

Capital structure (Franco

Modigliani, Merton Miller)

Options pricing (Fischer

Black, Myron Scholes, Robert
Merton)
Binomial options pricing
(John Cox, Stephen Ross,
Mark Rubinstein)

Arbitrage pricing theory

(Stephen Ross)

Essence of theory
Demonstrates that an
efficient allocation of
resources and risks requires
a complete set of securities
that permits agents to hedge
all risks, thus laying the
groundwork for general
equilibrium theory
Investors choosing portfolios
should consider the risks as
well as the making
investment choices
Subject to some limitations,
markets compensate firms for
systematic (or market) risk
but do not discount for
idiosyncratic risks, which
investors can diversify
Subject to strong constraints
(e.g., no taxes), a firms
capital structure makes no
difference to its valuation by
the market because the
overall riskiness of the firm is
the same
Volatility is the key to
consistent pricing of options
Models the underlying
instrument over time, as
opposed to at a particular
point, increasing accuracy,
particularly for longer-dated
options
Less restrictive alternative to
CAPM, defines the expected
return of a financial asset as
a linear function of various
macroeconomic factors or
theoretical market indices

Relevance
Underpins derivatives
markets, explains decision
making under uncertainty,
and shows that the ultimate
role of securities markets is
the efficient allocation of risk
across society
Efficient frontier concept for
returns from their choices

Directly relevant to discussion

about whether a firm should
hedge its idiosyncratic risks
or leave them alone because
the market will not reward it
for mitigating them
When constraints are
removed, the model breaks
down, introducing the idea of
efficient capital structure and
the role of risk mitigation
through hedging
The concept of real options
essentially allows companies
to put a value on waiting
Allows better pricing of
options that contain greater
flexibility

Allows investors to segment

CAPMs systematic risk into
factors or components that
influence correlations

This research began filtering into the business community in the early 1970s via two seminal
developments: the publication of the option pricing model by Fischer Black and Myron Scholes
(along with its independent confirmation and enhancement by Robert Merton), and the
introduction of Bill Sharpes capital asset pricing model (CAPM).2 These contributions marked
the beginning of modern risk management: the moment at which risk could start to be
effectively priced and mitigated. Suddenly, what had existed as latent demand materialized
into a need a need suddenly made more urgent by the end of the Bretton Woods exchangerate regime and the OPEC oil shock.3
The core concept addressed by Black and Scholes was optionality. Embedded in all financial
instruments, capital structures, and business portfolios are options that can expire worthless,
or be exercised or sold. In many cases, an option is both obvious and bounded, such as an
option to buy GE stock at a given price for a given period. In other cases, options are subtler.
In their original publication, Black and Scholes observed that the holders of equity in a firm
with debt in its capital structure have an option to buy back the firm from the debt holders at a
strike price equal to the firms debt. Similarly, the still-emerging field of real options identifies
options implicit in a firms operations for example, the option to cancel or defer a project
based on information from a pilot. The theory of real options puts a value on managerial
flexibility a factor overlooked in straightforward net-present-value (NPV) calculations, which
assume an all-or-nothing attitude to a project.4
Sharpes model, the CAPM, suggests that a companys shares bundle two types of risk. Only
one of these, systematic risk, is compensated by the market. Systematic risk is measured by
the firms beta, which reflects the stocks correlation with the overall market. Sharpe argued
that beta is the sole differentiator of the cost of equity across corporations. The other type of
risk, known as nonsystematic or idiosyncratic risk, is unique to the company. Sharpe
demonstrated that these risks should not affect the companys cost of capital because
investors can hold other shares and investments that diversify away this exposure.
Ironically, given the intellectual achievements Black-Scholes and CAPM represent, the third
important risk-related development in the 1970s was probably the emergence of the handheld
electronic calculator familiar to a particular generation of schoolchildren. Texas Instruments
marketed its new product with the tag line Now you can find the Black-Scholes value using
our . . . calculator. 5 The rapid acceptance of this calculator by options traders cemented the
arrival of derivatives and the broad development of standard pricing models. In 1975, the first
personal computers were launched. In 1979, Dan Bricklin and Bob Frankston released
VisiCalc, the first spreadsheet designed to work on a PC. This gave managers a simple tool
for running what if scenarios. Financial instruments for managing different types of risk were
rapidly developed and trading was begun both on exchanges and in emerging over-thecounter (OTC) derivative markets.

2
3
4
5

Other researchers, notably Jack Treynor, arrived independently at some of Sharpes conclusions,
but Sharpe was the first and his name is associated with CAPM.
It is worth noting that the combined phenomenon of high oil prices, general volatility in the market,
exchange-rate volatility, and inflation is with us again in 2008.
See the companion piece to this paper, A Primer on Tools and Techniques of Risk Management
(ID# 737072), for a fuller exploration of this idea.
Bernstein, Against the Gods, p. 316.

By the 1980s, greater computing power was inexorably adding calculating muscle directly to
trading desks, allowing complex calculations to be run ever faster and pricing to move closer
to real time. Among the most influential machines were the workstations developed by Sun
and DEC and the Bloomberg terminal, which revolutionized price calculation in derivatives and
fixed-income markets respectively. Software developed by companies such as Crystal Ball
allowed traders to run Monte Carlo simulations complex calculating processes that
undertake thousands of iterations to produce distributions of outcomes in a matter of minutes
on laptops, rather than overnight on mainframe computers. The upshot was an
unprecedented growth in liquidity and the integrity of pricing.
As Exhibit 2 suggests, these innovations enabled a revolution in financial services that
included the emergence of stock options, foreign-exchange futures, interest-rate swaps,
commodity futures, index swaps, credit derivatives, and even more sophisticated instruments.
The market for OTC derivatives grew fourfold from 1998 to 2006. All in all, the notion of credit
was essentially reinvented, as entire markets and enormous business opportunities developed
around concepts that had hitherto been inseparable from the underlying assets being traded.
The market has since become so sophisticated that synthetic collateralized debt obligations
Exhibit 2

Risk innovations set off a revolution in the financial services industry

Explosion of risk-transfer markets
1970s Foreign-exchange futures, stock options
1980s

1990s+

Interest-rate swaps
S&P 100 options
NYMEX oil futures
Equity index swaps, catastrophe options,
collateralized debt options (CDOs), credit
derivatives, swaptions, electricity futures,
over-the-counter (OTC) weather futures,
macroeconomic derivatives

Notional OTC derivatives

$ Trillions
596
+728%

72
30
42
Mid 1998

203

Other

393

Interest
rate

56 currency
58 credit
8.5 equity
9 commodity

Reinvention of credit
Disaggregation of origination, credit risk,
and interest-rate risk
Creation of markets e.g., credit default
swaps, CDOs, mortgage-backed
securities
Reduction of costs, credit spreads, and
exposures to interest rates/credit

New business opportunities

Hedge funds (increased by $1 trillion in
the past decade)
Private equity
Commodity traders
Derivatives market makers

End 2007

Sources: U.S. Treasury, BIS

(CDOs), or derivatives of derivatives of derivatives, are now being sold and were in fact the
fastest-growing part of the multitrillion-dollar CDO market until the credit crunch of late 2007.6
Stimulated by these developments, a new generation of academics7 looked at the case for risk
mitigation and confirmed that it could indeed create shareholder value in three main ways: by
reducing the probability and expected costs of financial distress, by enabling a more suitable
level of debt and thereby reducing a firms income taxes and financing costs, and by mitigating
agency costs and preserving managements ability and incentives to carry out profitable
investments. These conclusions gave validity to the growing field of risk management and
provided a counterbalance to the indifference theory, articulated by Modigliani, Miller, and
others, that had schooled generations of MBAs to think that capital structure and hedging had
minimal impact on a companys cost of capital and value. Wall Street and its clients, of course,
had already embraced financial engineering largely relegating the indifference theory debate
to academia.

Risk in the financial sector

Innovations in risk management
Many of the important innovations in risk management originated in the banking and securities
industries, for three reasons. First, financial institutions are effectively risk-intermediation
businesses. Many of the more sophisticated players (generally securities houses and
investment banks) realized that their ability to describe and manage risk was a core
competence, and they were the earliest non-academic institutions to think systematically about
risk.
Second, as Peter Bernstein pointed out, financial industries are rich in data and so were able,
early on, to quantify risk using new technologies. Third, because banks were dealing with
citizens money, they were pushed by regulators to consider the potential impact of failure and
to improve their risk-management capabilities. The fear of financial-institution failure went
back to the Herstatt Bank collapse in 1974. Herstatt, a German bank, failed, and many
international banks were badly hurt because of the time lag related to cross-border settlements
during that period.8
Today, risk management in banking is a core function, and virtually all banks have chief risk
officers. But many of the advances we now take for granted are in fact relatively recent. In the

7
8

It remains to be seen how the recent drying up of liquidity in the markets will unfold. But even a
backlash against the complexity of some structured instruments would be unlikely to cause a retreat
from the underlying technology, i.e., the ability to slice and repackage risks.
Examples include work on the underinvestment problem by David Mayers, Clifford W. Smith, Ren
M. Stulz, and on the value of hedging by Kenneth A. Froot, David S. Sharfstein, Jeremy C. Stein.
Essentially, foreign-exchange transactions executed in Germany before the bank was declared
insolvent had not cleared in New York because the markets there were not yet open, leaving
enormous exposures. This was one of the big wake-up events of modern risk management. It
ultimately took nearly 20 years to solve what became known as Herstatt risk.

early 1990s, the American banking system faced severe difficulties. Citibank was in danger of
collapse and was rescued by a Saudi prince, who came to own the equivalent of 15 percent of
the companys equity.9 Other banks, including Bank of New England, did go under. At root,
poor risk management was to blame. Banks had only a limited understanding of the credit
risks in their loan portfolios, typically had mismatched assets and liabilities, and retained lossmaking exposures on their balance sheets. A typical bank took deposits and originated loans.
But the deposits were of shorter duration than the loans, which meant that a sharp rise in
interest rates could immediately jeopardize a banks financial health.
In the early 1990s, most commercial banks lacked now-commonplace tools such as value at
risk, risk-adjusted return on capital, economic capital, risk-adjusted regulatory capital, creditrisk models, and enterprise risk management.10 By contrast, securities firms and investment
banks had become quite sophisticated in their use of risk management. They realized that
many traditional commercial banking activities could benefit from techniques similar to those
used for trading shares and bonds. Bank loans could be marked to market priced as if they
had to be sold that day, even though they might not mature for years to come turned into
securities, and traded. Portfolios of loans could be packaged into tranches bearing different
levels of risk, interest-rate risk could be separated from credit risk, and so on.
Partly because securities firms and investment banks were skilled in packaging and trading,
and because commercial banks had capital and credit-origination skills, a wave of mergers
began until the distinctions blurred and became less relevant. Over a 20-year period
beginning in the mid-1980s, the financial sector became a gigantic risk clearinghouse. It
remains a work in progress. For instance, the convergence of capital markets and insurance,
essential for the development of new risk-transfer mechanisms and structured riskmanagement solutions, is not yet complete but is well under way as evidenced by the market
for catastrophe bonds.

The impact of risk transfer markets

In a risk-transfer market, contracts are exchanged that allow a specified risk or bundle of risks
to change hands. Risk-transfer markets have been major enablers of dramatic growth in four
key segments mortgages, wholesale credit, alternative risk transfer (ART), and hedge
funds/private equity.
1. Mortgages
Clearly, the current crisis was propelled by financial institutions failure to understand certain
mortgage-derived instruments. Yet overall, the market for mortgage-based securities remains
the most readily understood example of how risk instruments can transform the scope and
nature of a business. The mortgage market has grown from a retail-finance backwater, in
which banks originated and held their mortgages as a single portfolio, into one of the largest
and most innovative sectors of the financial industry, particularly in the U.S. (Exhibit 3). Many

9 Interestingly, Prince Alwaleed bin Talal stepped in with a Citigroup equity purchase in 2008.
10 See A Primer on Tools and Techniques of Risk Management (ID#737072) for a fuller description of
VaR, RAROC, and credit-risk models.

10

of the tools of modern risk management have been embraced, from securitization (the pooling
of loans that are then sliced into tranches to create different risk-bearing structures that can be
sold) to the creation of new products that explicitly recognize the optionality built into long-term
products such as the 30-year mortgage (the most obvious option being to repay early).
Exhibit 3

Risk innovations set off a revolution in the financial services industry:

mortgage-backed securities issuance
Mortgage-backed securities issuance 1988-2007*
$ Billions

2,716

2,156
1,883

1,857

2,045
1,865

1,355
929
545

667
422

259 317
165 215
1988 89 1990 91

92

93

318

615

440 487

94 1995 96

97

833

98

99 2000 01

02

03

04 2005 06 2007

* Includes Ginnie Mae, Fannie Mae; Freddie Mac and Non-agency

Source: Inside Mortgage Finance MBS database; Ginnie Mae; Fannie Mae; Freddie Mac

The effects on the banking industry have been profound. Growth coupled with more effective
risk management led to unprecedented profitability. Derivatives and pass-through
mechanisms that transfer elements of risk in a pool of mortgages allowed mortgage originators
to avoid taking interest-rate or credit risk, removing a major hazard from their portfolios and
encouraging further origination, which expanded the market and drove demand for mortgage
products.
As we have now been reminded, the ability to transfer risk does not lead automatically to the
elimination of risk. In some circumstances, it merely moves the risk elsewhere. By mid-2007,
it had become apparent that the underwriting associated with the subprime segment of the
U.S. mortgage market had become far too lax, and a major financial crisis ensued. Rising
default rates and falling house prices quickly had an effect on pricing, first on the lower-rated
tranches of mortgage securitizations and then on more senior tranches. In turn, declining
confidence led to a general withdrawal of liquidity from the banking system and a consequent
reduction of available credit. Many mortgage institutions failed or were sold. Some of the
worlds biggest banks wrote off billions of dollars and fired some of their top managers. Most
famously, in an emergency deal Bear Stearns was sold to JPMorgan for a fraction of its traded

11

value. Lehman Brothers filed for bankruptcy. Fannie Mae and Freddie Mac were nationalized.
The so-called credit crunch changed the policy landscape for central banks, creating
pressure for interest-rate cuts and special lending facilities for liquidity-starved banks and
securities firms.11

2. Wholesale credit markets

A similar transformation has swept the wholesale credit markets, or the markets for large
corporate loans made by commercial banks.
Roughly speaking, the risk profile of a typical commercial bank breaks down into 60 percent
credit risk, 20 percent market risk, and 20 percent operational risk. The past 35 years have
seen a sharp rise in a banks ability to mitigate these risks. The growth in credit derivatives,
greater depth and liquidity in the secondary market for corporate loans, and securitization have
transformed the management of credit risk by hugely expanding the scope for risk transfer.
Increasingly, banks can refine their portfolios to retain only those risks in which they have a
competitive advantage (i.e., those risks of which they are the natural owner). They use credit
portfolio management techniques to decide which combinations of risks to retain. For
example, although they might retain exposure to a corporate customer, they can use credit
default swaps derivative instruments that protect against a given company experiencing
financial distress to mitigate that exposure. They can also use index products to raise or
lower their overall exposure to credit as an asset class, depending on whether they believe
credit to be too cheap or too expensive. Who buys the assets that an individual bank decides
to shed? To some extent, other banks with offsetting risks of their own. The main buyers,
however, are pension and hedge funds, insurers, and other alternative investors seeking
assets not directly correlated with stock and bond markets.
During the past year, it became evident that some instruments, although theoretically sound,
were difficult to manage in practice. In particular, vehicles that pool loans together and then
repackage them, as well as derivatives of the pools themselves, are highly complex. Banks
have discovered the hard way that credit risks thought to be independent often subtly interact.
3. Insurance and alternative risk transfer (ART)
There is a great deal of literature on the evolution of the insurance and reinsurance
industries.12 Insurance concepts have been and remain of enormous influence the
development of risk-transfer products and markets. As with other areas, however, this field is
seen by many as forbiddingly technical and not clearly connected to risk management.

11 The crisis does not invalidate the importance or influence of the ability to slice risks into discrete
elements, although it does reinforce the fact that even the largest markets depend on the quality of
the underlying assets and the continued supply of liquidity.
12 Some of the best summaries can be found in sigma, published by Swiss Re and available on its
Web site. The richest single source is Christopher L. Culp, Structured Finance and Insurance: The
ART of Managing Capital and Risk, New York: Wiley, 2006.

12

ART is simply the creation of a risk-transfer solution that combines capital markets and
insurance such that some of the insurable risks are transferred to non-insurers.13 Consider a
company that is trying to understand its risk capacity. A simple starting point is to ask how
much risk the company wants to insure and how much it wishes to retain as direct exposure
effectively, to self-insure.14
One well-known deal that demonstrates the power of these concepts dates to late 2000, when
Swiss Re and Socit Gnrale developed an innovative facility for Compagnie Financire
Michelin, the Swiss holding company of the French tire maker. At the heart of the transaction
was what is called contingent capital, which gives a company the right to issue new debt,
equity, or some structured securities at a predefined price during a set period of time. In
effect, the company buys the option to issue securities in the future, subject to the trigger (or
triggers) of an unwanted outcome or loss arising from the risks specified in the terms of the
deal. Michelin wanted to lock in the option of raising capital in the event that the worlds largest
economies suffered a slowdown, causing its earnings to fall.
There are many other examples involving financing structures that package options in the form
of insurance contracts. This is an area of ongoing innovation.
4. Financial services industry: hedge funds and private equity
As soon as the kinds of instruments discussed here became available, professional investors
wanted to take advantage of them to separate and transfer many different kinds of risks in
order to optimize their risk exposures. But traditional funds, being open to the general public,
were regulated for the publics protection the public having appropriately been deemed
lacking in the knowledge required to engage in elaborate risk-transfer mechanisms. Enter
hedge funds, investment pools neither subject to the Investment Company Act of 1940 nor
governed as mutual funds, and open only to high-net-worth and institutional investors. Hedge
funds have rapidly evolved to allow investors to be extremely precise about the kinds of
exposure they seek across different asset classes, time horizons, and so on. In addition, they
have become important providers of liquidity to the banking system through their role as
investors in a range of asset-backed securities.
Hedge funds are not without controversy. Do they really control the risks they run, or are they
vulnerable to liquidity shocks and gaming by their competitors concerns that recent events
have sharpened? Does the leverage they use to boost their returns introduce new risks into

13 It is widely accepted that there is an ongoing convergence between insurance and capital markets,
but, as Culp has argued, even the most similar concepts in the two worlds are often not recognized
as being essentially the same thing (Structured Finance and Insurance, p. xv). Culp makes an
important distinction between structured finance the use of nontraditional financing methods to lay
off risk that cannot be dealt with in conventional markets and structured insurance (which includes,
but is not limited to, ART), or the use of nontraditional risk-finance and risk-transfer techniques to
manage risk in a way that also affects the firms capital structure and/or weighted average cost of
capital.
14 Over the past 20 years, many large companies embraced self-insurance, setting up captive
vehicles that essentially took insurance in-house on the basis that meeting any losses would be
cheaper than buying insurance in the market. But the underlying motive was often tax rather than
risk efficiency. Captives have been effective but are also controversial. Critics argue that they
create new risks by removing third-party monitoring (in the form of an insurer).

13

financial markets? These questions surfaced after the high-profile failure of Long-Term
Capital Management in 1998-2000, and again when Amaranth lost billions of dollars on natural
gas futures contracts in 2006, and most recently when the Federal Reserve underwrote
JPMorgans purchase of Bear Stearns. Despite these concerns, however, the sector has been
dynamic and has grown strongly, even through the market fluctuations of late 2007-early 2008
(Exhibit 4).
Exhibit 4

Risk innovations set off a revolution in the financial services industry:

private equity and hedge funds
Private equity and hedge funds global assets under management*
$ Billions
2,786

2,132

918

Private equity

1,868

Hedge funds

667
1,570
1,360
1,207
831
700
579
204

244

340

935

396

1,044

465

387
387

418

375

456

491

539

626

1998

1999

2000

2001

2002

1,465
820

2003

973

2004

1,105

2005

2006

2007

* Hedge fund: all assets under management at the time; Private equity: sum of all buyout AUM raised over previous 5 years
Source: HFR, PE Intelligence
1

Private equity has proved equally dynamic. Private equity firms purchase companies and then
restructure them to focus on the risks the company naturally owns. As with hedge funds, what
was once a marginal activity became a mainstream one. Aggressive, capital-rich private
equity firms stalked the worlds capital markets looking for opportunities to make profits by
taking listed companies into private ownership. By adding leverage through the assumption of
debt and by shaping each companys risk exposure, private-equity buyers increase the odds of
a large payoff. In 2007 we witnessed a string of large deals, culminating in the $45 billion
buyout of TXU (see the case study of this important example of a leading-edge nonfinancial
companys management of risk in the sidebar below).
Although not often described in the language of risk management, as most private equity firms
stress their financial and management skills, private equity can be seen as a cutting-edge
application of risk-management techniques. Many private equity deals utilize complex
structured-finance tools that capitalize on risk markets to provide a lower cost of capital

14

through debt and hedging than would have been available through the traditional use of public
equity.15

Goldman Sachs and the culture of risk

Goldman Sachs, generally recognized as the worlds leading investment banking, securities,
and investment management firm, exploits risk to achieve attractive returns in a prudent
fashion. The results have been formidable. During the financial turmoil of 2007-08, Goldman
notably avoided the large losses that afflicted its main competitors, perhaps the strongest
evidence yet that its risk-based culture creates superior performance. But there was a strong
case before this that the bank had taken risk management to a new level. In 2006, Goldman
set aside a total of $16.5 billion for salaries, bonuses, and benefits, or an average of $622,000
for each of its 26,000 employees. Goldman obtained 68 percent of its net revenues from
trading and principal investments, including a substantial amount from gains earned trading on
its own account. Only 17 percent of net revenues came from the traditional investment
banking and advisory business for which it was once best known.

Goldman Sachs risks money to make money

2002
2003

2004
2005

2006
2007

Negative trading days

52
40
35
40
56
52
11
12
25
29
22
34
8
8
10
18
18
41
20
5
8
7
5
33

People who have left Goldman say that its [risk management] is unmatched at rivals. One
consequence is that Goldman seems confident that it can take more risks than its competitors
do. Its trading revenues are the most volatile among big investment banks and it has the most
days when it loses money. Overall, however, it makes the most money.
Sources: The Economist 2006, Moodys; SNL Financial

21

15 It remains unclear how far the private-equity model will suffer from reduced liquidity. By early 2008,
wider credit spreads and stiffer covenants had essentially halted the momentum of large buyouts.

15

Intriguingly,
these results and 2006, albeit the best, was one of many good years were built

on the back of a firm with trading revenues more volatile than those of all its peers. Goldman
has the most days when it loses money, with a daily trading value at risk (measured at the
95% confidence level) that increased from less than $50 million in 2002 to more than $100
million today. In short, Goldman makes money by being willing to lose it. When securities
markets become more volatile, options rise in value; naturally, the value of experienced risk
management rises also. Goldman ensures that its managers are familiar and comfortable with
risk, can debate it freely without fear of sanctions, and are willing to take decisions quickly
when necessary. The companys aggressive hedging in 2007 in the markets related to
subprime mortgages was a striking example of this. Goldman was both skillful and lucky. It
was skillful in sensing that trouble was brewing and deciding to move quickly to reposition
itself. It was lucky in getting both the decision and the timing correct on that bet.
Creating a culture so contrary to peoples instincts and fears is not easy. In our view
Goldmans success stems from four factors. None is unique to the firm, but Goldman has
deployed them all very effectively:
Partnership heritage. Goldman was funded largely by its own partners from its origins in
1869 to its IPO in 1999. While other private investment banks distributed more than 80 percent
of their earnings annually, Goldman partners traditionally left as much as 80 percent of their
earnings with the firm, withdrawing significant capital only at the end of their careers. Partners
acted as careful stewards of the firms capital because it was their own. This partnership
heritage continues to inform the interactions of the most senior people within the firm, aided by
the substantial portion of equity still owned by employees.
Risk and quantitative professionals. Beginning early in the 1980s, Goldman began to
invest in distinctive risk professionals and quants. Most notable was Fischer Black, of BlackScholes fame, who was brought over from MIT by Robert Rubin in 1984. He led the firms
Quantitative Strategies Group, working on topics ranging from modeling interest-rate
movements to valuing fixed-income options to modern portfolio management. Other quants
and risk professionals at Goldman have included Emanuel Derman, a Ph.D. in physics who
headed the Quantitative Strategies Group after Black, and Bob Litterman, a Ph.D. in
economics and co-developer of the Black-Litterman global asset allocation model. These
people brought an early quantitative and intellectual rigor that gave Goldman the basic risk
skills to manage its complex trading and derivatives businesses.
Risk oversight, organization, and processes. In 1994, when a sudden unexpected rise in
global interest rates caused severe losses on many bond trading desks, the firms large
proprietary positions led to a substantial decline in profitability and a crisis in morale. In
response, Jon Corzine restructured Goldmans risk control systems, establishing a firmwide
risk committee to oversee market and credit risk. The committee meets weekly with the goal
of ensuring that certain risk-return standards are being applied consistently across the firm
worldwide. It follows that risks are carefully reported. Daily reports detail the firms exposures,
with top sheets showing the potential impact of movements in various macroeconomic risk
factors; stress tests showing potential losses under a variety of scenarios (e.g., a stock market
crash on the order of October 1987, a credit spread widening of the kind that occurred in
autumn 1988, a bond market sell-off as seen in 1994); and replicating portfolios (e.g., what
portfolio of a limited number of securities would most closely replicate the firms overall
position?). Some Goldman executives claim they can estimate the firms daily P&L simply

16

based on these risk reports and market movements that day. Other kinds of risk are taken
equally seriously. Operational and reputational risks are addressed by the business practices
committee, loan and underwriting risks are addressed by its firmwide capital and commitments
committees, and liquidity risk is managed by the finance committee.
Values and business principles. Finally, Goldmans values, as embodied in the firms 14
business principles, reinforce many of these risk-management lessons. The firms reputation is
prized most of all. Individuals who join Goldman are quickly taught that, while no one person
will make the firm a success, anyone can do enormous damage to the firms reputation. When
potentially controversial choices arise, individuals are encouraged to escalate, escalate,
escalate, drawing in independent views from risk, compliance, legal, and other powerful
control functions. The fastest way to lose a position at Goldman is not to lose money but to
make a decision that endangers the reputation of the firm without consulting others.
* * *
This is not to say that Goldman is immune from getting things wrong. But were the firm to
stumble, it would not be for lack of a powerful, risk-informed culture that combines intelligence,
discipline, and common sense. In that respect, Goldman is a model for all firms.

Risk for nonfinancial companies

Risk management does not mean always getting things right. It means getting them less
wrong, less often, with less damaging consequences. This is most obvious in a financial
company making buy and sell decisions in liquid markets for traded instruments. It is less
obvious but often more significant in an industrial company wondering whether to invest in a
multibillion-dollar project that will take 5 to 10 years to complete and another 10 to 15 to show
a profit.
Indeed, risk management is only now beginning to emerge as a corporate priority in large
nonfinancial companies. Although more than 80 percent of industrial corporations hedge
using derivatives, most do so only in the context of currency and interest-rate trades made by
their treasury departments (Exhibit 5). While most nonfinancial companies assess risk-andreturn trade-offs qualitatively when making strategic decisions, few have properly developed
risk-adjusted hurdle rates or risk-adjusted performance standards across business units. And
few adequately value their risks based on quantitative models or traded risk markets. As a
result, these companies generally lag far behind the financial players that treat strengthening
risk capabilities as a core strategic priority.

17

Exhibit 5
NEO-ZZQ845-20080612-JF1

Most nonfinancial companies have been slow to embrace modern

risk-management tools
Use only basic risk products
Products used to manage risk
% using products
Insurance

83

Foreign-exchange derivatives

82

Interest-rate derivatives

79
32

Commodity derivatives
Structured products

13

Equity derivatives

12

Credit derivatives

12

Use risk tools only modestly

Tools used by risk group
% using products
Value at risk

45
43

Cash flow at risk

Earnings at risk

36

Tools used in strategic planning

% using product
Scenario analysis
Quantify risks
35
in any way
Simulation analysis
26

46

Source: Deutsche Bank/GARP Corporate CFO survey of 232 CFOs in 39 countries (2005)

Examples abound of poorly understood strategic risks faced by nonfinancial companies. How
might demand for a product change depending on a competitors behavior, or slow if Chinas
economy were to deteriorate? Are there unrecognized reputational risks inherent in a course
of action? What is the probability distribution of a cost or time overrun on a project? What are
the implications of keeping a particular supply chain tighter or looser than it is today? How will
the company be affected by a rise in oil prices, an increase in interest rates, or a dramatic
change in the dollar?
Faced daily with such questions, nonfinancial firms that lack strong risk processes tend to
gravitate toward one of two extremes. At one end of the spectrum, they overspend their risk
capacity, and, if problems occur and credit sources dry up, slash important cash outflows
and in some instances even experience difficulty meeting debt obligations. Far more common,
at the opposite end, corporations hold excess risk capacity often in order to maintain an
arbitrary target credit rating. These companies typically maintain capital structures with little or
no debt and excess cash, a funding strategy that can raise a companys cost of capital and
lower its value by as much as 10 to 15 percent.16 They also often employ risk-averse decision
processes such as inflated investment hurdle rates or conservative price and margin forecasts

16 The 10 to 15 percent value impact reflects a foregone interest tax shield applied to a potential 30 to
40 percent debt level as against a 0 percent debt level (net of cash) and assumes a 35 percent tax
rate.

18

to ration investment capital, choking off value-creating growth opportunities. In some cases,
they go further by hedging interest-rate, currency, or commodity exposures.
The beginning of good risk management is to embrace sophisticated financial firms
fundamental attitude to risk: risk is neither good nor bad; individual risks are good or bad for
your company. Once a management team has made this shift in mindset, it can begin to
position the company to benefit from risk by implementing appropriate controls and protocols.
What should these controls and protocols look like for a typical nonfinancial firm? A good
model is the energy industry, whose players have been in the vanguard among nonfinancial
firms with regard to their active management of risk.

Risk in the energy sector

The energy sector embraced risk-management techniques earlier and more thoroughly than
other corporate sectors, for three principal reasons.
First, energy companies face substantial commodity risk: oil and natural gas producers
experience prices that are typically much more volatile than interest rates, credit spreads, and
exchange rates. Energy processors such as oil refiners face even greater volatility than
producers because they are exposed to fluctuations in prices for refined products as well as
those for crude oil. Deregulated power generators, which produce electricity a commodity
that cannot be stored and so must be sold the moment it is produced face the greatest
volatility of all.
Second, energy companies must make very large investment commitments (a single refinery,
offshore oil platform, or power plant costs several billion dollars) involving time horizons of 30
to 50 years, covering multiple industry cycles and technological discontinuities.
Third, enabled by the creation of spot physical markets for most energy commodities, the
energy industry has undergone a dramatic unbundling, as the vertically integrated market of
30 years ago has given way to a world of independent gas producers, independent refiners,
and merchant power generators.
Given this context, the rapid growth of energy futures markets such as the New York
Mercantile Exchange (NYMEX) and the IntercontinentalExchange (ICE), as well as OTC
derivative markets, is not surprising. In the 1990s, major oil companies (e.g., BP, Shell), large
electric utilities (e.g., Duke Energy, Sempra, RWE, Southern), and leading natural gas
companies (e.g., Dynegy, El Paso, Williams) invested heavily in building commodity trading
and risk intermediation businesses. The most notable player was Enron, which had more than
1,000 energy traders and (even after post-scandal income restatements) more than $2 billion
of annual trading profits. At the time of Enrons collapse, its Enron Online trading platform was
regularly settling commodity transactions in excess of $4 billion per day.
Following Enrons bankruptcy in late 2001, the liquidity of energy commodity markets dried up.
Several trading-oriented companies (Dynegy, El Paso, Reliant, and Mirant) suffered big
losses, and some narrowly avoided bankruptcy. Credit concerns and the absence of liquidity
essentially eliminated trading profits. Wanting to distance themselves from risk and
derivatives, many of the remaining industrial participants shut down their trading floors.

19

But the retrenchment was short-lived because the fundamental need to reduce volatility and
secure financing had not disappeared. Major investment banks quickly stepped in, and after
them hedge funds, hiring former employees of Enron and other energy players. By the end of
2005, liquidity levels once again approached those of 2001. Many big investment banks
acquired trading desks from industry players. Two such banks together reported more than $3
billion in profits from energy commodity trading and risk management over just the 2 years
2005 and 2006.
Several innovative players took advantage of liquid commodity markets and turned
aggressively to strategic risk management.17 Among them, the most dramatic example is
TXU Corporation.

Case study: TXU Corporation

TXU was the incumbent electric utility in North Texas when the state fully deregulated
wholesale and retail electricity markets in 2002. Competition, capacity overinvestment, and
commodity price exposures triggered by deregulation put TXU under severe pressure,
reducing its market capitalization by more than half between late 2002 and late 2003 and
burdening the company with debt above 70 percent of its market capitalization.
When John Wilder became CEO in February 2004, he realized that even a small decline in
wholesale power prices would put the company at risk of bankruptcy. Wilder responded by
initiating TXUs highly successful risk-and-return restructuring program, which was built on two
core principles: embracing risks of which TXU was the natural owner while actively mitigating
all others, and dynamically managing TXUs risk capacity to ensure continued solvency and
liquidity.
Wilders primary Texas competitor abandoned its integrated retail and generation business in
response to deregulation and experienced lackluster equity returns. Other deregulated
generators moved to hedge their risks by entering highly discounted power purchase
agreements (PPAs). But Wilder, against example and advice, determined that TXU was in
fact the natural owner of its generation business, despite the apparent risks of a downturn in
the wholesale market. Wilder recognized that wholesale power price levels were heavily
influenced by TXUs own investment and pricing decisions. He also realized that TXUs
vertically integrated retail business provided the company with a natural hedge: Should the
wholesale market turn down, TXU could compensate by keeping its retail prices
proportionately high so long as it could maintain a large portion of its market share through

17 Flores & Rucks (later Ocean Energy and now merged into Devon Energy) grew from a start-up to
become one of the most successful independent producers using structured financing vehicles such
as loans secured on underlying oil and gas assets. Chesapeake Energy has grown into an industry
leader in exploration and production on a business model built around fully hedging its natural gas
exposure. Refiners such as Valero, Tosco, and Premcor have used hedging and risk strategies to
fund dramatic acquisition- and merger-based growth. Suncor, a pioneer in extracting oil from
Canadian oil sands, has in the past used hedging to maintain its capital-intensive program through
industry down cycles. Anadarko used creative bridge financing and hedging to enable two largely
debt-funded simultaneous acquisitions whose total cost exceeded Anadarkos own market
capitalization.

20

strong marketing and customer service. (In this sense, TXUs exposure was a natural call
option on higher prices, rather than a simple long position.) Taken together, he determined
that generation and wholesale power, including the related risks, were worth more to TXU than
to any other owner or hedge counterparty that is, any other player would charge more to
take on the risk than the value of any loss TXU might expect to incur by retaining it.

Gain transparency into true economic exposures:

TXU example

Equivalent
North
American gas
reserves
TCF

ERCOT dispatch curve

$/MWh

TXU

11

AEP

Exelon

Exxon

Nuclear

Coal
Demand

TWh

10

14

Anadarko

38
16

15

BP
Gas

Impact of a
$1/MMBtu change
in gas price on
equity value
%

2
2

18

Chevron

Conoco

Shell

15

Sources: Team analysis; public data

But in committing to the generation business, TXU faced a formidable risk-capacity problem: it
would need to fund the capital investment required to maintain its generation business while
keeping an adequate cushion against a material chance of bankruptcy should power prices
decline. Wilders response was to create additional risk capacity through a program of
divestitures, capital-structure changes, outsourcing, and operational improvements. In his first
60 days, he divested four businesses and used the $7 billion in proceeds to repurchase debt
and convertible securities. He outsourced TXUs call centers and billing operations, and he
launched a major lean-operations improvement initiative in the companys plants and mines.
Wilder used some of this newly created risk capacity to restore TXUs exposure to wholesale
prices, unwinding expensive commodity hedges entered into by TXUs prior management
team. His market foresight paid off. Wholesale power prices more than doubled from early
2004 to the end of 2005, yielding profits unmitigated by unnecessary hedging. Wilder used the
remainder of his excess risk capacity to repurchase stock. Over the next year, he bought back
almost 40 percent of TXUs outstanding shares at an average price of $25 per share. When
financial models indicated that the company was carrying excess risk capacity in late 2004,

21

TXU entered the bond market to borrow $4 billion for the express purpose of buying back even
more shares.
Over the following 2 years, TXU continued to optimize its risk capacity dynamically, actively
managing commodity hedging, corporate debt, project finance, outsourcing, and share
buybacks. For example, in late 2006, when TXU embarked on a major capital-expenditure
program to build new coal-fired generation plants, it locked in favorable market terms by
hedging the resulting increase in its exposure to natural gas and by making large-scale, fixedprice equipment purchase commitments so that it could project its costs with confidence.
Even though plans for several of its new plants were cancelled following TXUs 2007 LBO, the
company still profited from these commitments (e.g., it recorded almost $1 billion in hedging
gains). The exhibit below shows how TXU dramatically reduced its risk exposure in 2004,
before Wilders aggressive strategy allowed it to increase its risk-taking from a much sounder
financial base. The distributions in the small charts show Monte Carlo simulations of TXUs
interest-coverage ratio, a key financial measure for industrial companies (note that this ratio
shifted from minimal coverage to a much stronger position as TXUs strategy developed).

TXU example: dynamic management of risk capacity

Return
Description

Step
6

Project finance, new plants

Gas price increases, growth program

Debt issuance/share repurchase

4
($4bn recap)
Operational improvement, share
buybacks, hedge removal 3
Operational improvements

2
1

Divestitures ($7 bn) &

security retirements

New CEO arrives

Share price
($)

Date

Early 2007

65

Mid-2005

52

Early 2005

38

Aug-Sept 2004

24

May 2004
April 2004
February 2004

19
17
12
Risk

% of trials
60
03A

% of trials

40

40

20

20

0
0
2
4
EBIT/gross interest

Steps 3, 4: Late 2004/early 2005

Steps 1, 2: April to August 2004

Step 0: February to April 2004

Improvement: 2.8x

60

% of trials
60

05E

Coverage ratio
decrease: 0.8x

40

05E

20
0
0
2
4
EBIT/gross interest

0
2
4
EBIT/gross interest

18

Wilders use of risk mechanisms and markets allowed TXU to focus its portfolio on risks of
which it was the natural owner, and its financial returns grew rapidly. In 2006, TXU generated
EBITDA of $5.3 billion (up by more than $2.5 billion from 2003, despite a 40 percent reduction
in the companys asset base) and earnings per share of $5.55 (up more than fourfold from
2003). Its share price increased from $12 in early 2004 to $69 when it was taken private via
leveraged buyout (LBO), creating more than $32 billion in value, and placing it fourth among

22

S&P 500 companies in terms of stock performance. TXU estimates that its risk-return
restructuring program contributed some 75 percent of this value.
In October 2007, TXU was taken private in the largest-ever LBO, a $45 billion deal led by
KKR, TPG, and Goldman Sachs. Interestingly, the transaction economics hinged in part on the
buyers ability to continue to manage TXUs exposure to commodity price risk. After hedging
virtually all the companys commodity risk for the next few years, the private-equity owners
tripled debt levels (from $12 billion to $37 billion). The largely annuitized operating cash flows
(achieved by hedging the commodity risk) are expected to ensure debt coverage and allow the
new owners to recover most of their $8 billion equity investment. The use of hedges and nonamortizing debt have effectively provided the new owners with a low-cost call option on
wholesale power prices. In effect, via this clever structure, they own the upside while the debt
holders bear most of the risk of a decline in value although the latter, too, are protected in
part by the commodity hedges. The buyers took aggressive advantage of an extremely LBOfriendly market, in which the combination of hedging and debt was thought to create a lower
cost of capital than public equity. Time will tell how TXUs new owners and their creditors
adapt to the new risk environment.

A practical corporate risk-management process

Just as many risks faced by financial institutions have been well understood in the academic
context for decades, so too has academia long possessed the management and decisiontheory insights that nonfinancial companies must master.18 But if the individual tools are well
understood in academia, the challenge is applying them effectively to a companys situation.
The fullest approach to corporate risk management is known as enterprise risk management
(ERM). Rather than seeing and tackling risks one by one, ERM aspires to view all risks
together within a coordinated and strategic framework.19 While sound in concept, many
companies have found that their ERM processes have failed to deliver on their promise. As a
result, many have become skeptical of the concept, and there is now a widespread sense that
today, ERM largely exists in name only.20
We believe that ERMs shortfalls stem from the lack of a practical approach that can be
integrated with a corporations other core managerial processes. As such, our best service to
our clients is to provide them with the background offered here, along with a straightforward
five-step program that will allow them not merely to anticipate and respond to risk events but to

18 Five of the most influential strands of this theory scenario planning, game theory, decision trees,
real option value, and behavioral heuristics are described in A Primer on Tools and Techniques of
Risk Management (ID# 737072).
19 This definition comes from Brian W. Nocco and Ren M. Stulz, Enterprise Risk Management:
Theory and Practice, Journal of Applied Corporate Finance, vol. 18, no. 4, pp. 8-20.
20 Quoted from Michael Crouhy, Dan Galai, and Robert Mark, The Essentials of Risk Management,
New York: McGraw-Hill, 2006, p. 387.

23

use risk as a strategic and operational organizing principle. The five steps, also illustrated in
Exhibit 6, are as follows:
1. Develop risk transparency. What are the corporations major risks, and what is the
magnitude of those risks?
2. Determine whether you are the natural owner of the risks you are running. Which
risks should the corporation hold, and which should it mitigate or transfer?
3. Determine your capacity and appetite for risk. Is the corporation maintaining the
proper amount of risk capital, or is it overinsured or underinsured? How much risk would it
like to own?
4. Embed risk awareness in all decisions and processes. Are risk-return trade-offs fully
embedded in the companys strategic, operational, commercial, and financial decisionmaking processes?
5. Establish a risk-appropriate culture, organization, and governance model. Is there
proper risk oversight at all levels of the organization?
Exhibit 6
NEO-ZZQ845-20080612-JF1

An integrated approach to managing risk and return

5. Risk organization and

governance
Are the structures, systems,
controls and infrastructure in
place for you to manage risk
and comply with regulatory
requirements? Is your
governance model robust?

1. Insight and risk transparency

Do you have transparency across the
range of risks that will affect your
companys future performance, and deep
insight into the risks that matter the most?

Risk governance and

organization realignment
4. Risk-related decisions and
managerial processes
Are critical business decisions taken
with a clear view of how they change
your companys risk profile ?
Core service lines in investment/
project risk, financial risk, operational
risk, regulatory risk,
and commercial risk (including
hedging/trading, credit contract
negotiation, pricing, and sourcing)

Corporate
risk diagnostic (CRD)

Integrated
risk-return
management
(IRRM)

2. Natural ownership and

risk strategy
Do you understand which risks
your company is competitively
advantaged to own and which you
should seek to transfer or mitigate
in order to meet your strategic
corporate objectives?
Natural
ownership of risk review

Risk culture
3. Risk capacity and appetite
Is your overall risk capacity aligned
with your strategy? Do you have
processes to ensure that you avoid
being overextended or overinsured?
CFaR, VaR, capital
structure review

These steps make most sense at the enterprise level, although they can be applied to
business units within a company. Sound implementation of the full program will strengthen a
companys risk-return situation. And each step can form the basis for a conversation with the
CEO.

24

1. Developing risk transparency

It is easy to grasp that an uncertain future is better expressed by a probability distribution than
by a single-point forecast. In practice, however, single-point forecasting is still the norm. Bestpractice risk assessment requires adopting a probabilistic view of a companys key risks. In
some cases, the probabilities can be ascertained from traded markets (e.g., by deriving
implied volatility from options traded on commodity futures markets). In other cases, they can
be extrapolated from an analysis of historical data. For example, companies can compile data
from past projects and model the statistical likelihood of the success of future projects. Of
course, in many situations, risk probabilities are more difficult to quantify and require more
subjective assessments. Fortunately, an array of decision tools can help, including scenarios,
agent-based modeling, and Delphi surveys.21
In our experience, just a few types of risk typically drive the exposure of a given company.
Contrary to the exhaustive list that many ERM processes churn out, we advocate a strategic
conversation on the several types that matter typically, demand, commodity, country,
operational, and foreign-exchange risk. The list will vary slightly by company, industry, and
geography. In one example, we advised a diversified metals company which had identified
sixty risks across its business units. We found that six of these risks contributed more than 90
percent of the overall cash-flow volatility.
Once individual risk assessments have been made, companies can use a number of
approaches developed by leading financial institutions, including Monte Carlo simulations,
which aggregate risk at the enterprise level, or value-at-risk measures, which enable the
company to estimate the maximum downside it is likely to face and to value the impact of
various risk-mitigation actions.
A dynamic perspective is crucial. If the industry evolves unfavorably, will it be possible to pass
risks on? In the 1990s, U.S. airlines faced relatively limited fuel-cost risk since fuel-price
changes could be passed on in fares. But beginning around 2002, low-cost carriers such as
Southwest Airlines began to hedge their fuel purchases and offer fares that no longer floated
with the oil markets. Major carriers could no longer raise their fares when oil prices increased
and suffered billions of dollars in losses from their new exposures. Similarly, in the aluminum
industry, the arrival of Chinese producers meant that rising labor costs in developed
economies could no longer be passed on to customers.
A second aspect of risk assessment identifies portfolio effects within the company: risks that
are effectively diversified away within the company itself. Common examples are foreign-

21 One other tool that is becoming increasingly popular is offered by so-called information or prediction
markets. Essentially, these have been adapted from futures markets originally designed to predict
the outcome of elections. Voters can use an organized exchange to place bets on which
candidates they think are most likely to win. These have proved to be far more accurate than
opinion polls. In corporate settings, such markets have already found some interesting applications.
One leading U.S. retailer found that the accuracy of its sales forecasts was substantially greater
using a prediction market that tapped the direct knowledge of its regional sales teams rather than
relying on a centrally generated forecast. Google has been a pioneer in this area, creating markets
on dozens of occasions to test ideas and monitor project performance. For more on this, see Bo
Cowgill, Justin Wolfers, and Eric Zitzewitz, Using Prediction Markets to Track Information Flows:
Evidence from Google, at http://bocowgill.com/Google PredictionMarketPaper.pdf.

25

exchange netting across a multinational or vertical integration across markets for inefficient
factor costs.
Finally, a diagnosis must address the big what ifs facing the company. As Myron Scholes
pointed out, it is helpful to divide risks into three categories: those that are known, those that
are unknown, and those that are unknowable (the KUU framework). This ensures that
outlying risks that could have a meaningful impact on future performance are identified.
There are challenges to a risk diagnosis that go beyond its technical aspects. Internal
dynamics can interfere: business unit heads may push to secure funding for certain projects,
whether or not the company has better options elsewhere, or problems of definition could arise
(e.g., the legal and financial departments might have different views of risk and no shared
language or measures with which to discuss them). So implementation is not straightforward.
Nevertheless, the process itself is an essential and eye-opening foundation for riskmanagement decisions.

2. Are you the natural owner? Holding, acquiring,

mitigating, and divesting risk
In the 1970s, a revolution occurred in the field of corporate strategy. A boom in mergers and
acquisitions launched new professions in M&A banking, M&A law, and strategy consulting.
Given an active and efficient market for corporate control, companies shifted their corporate
strategy focus from owning the most attractive businesses to owning those businesses for
which they were competitively advantaged of which, that is, they were the natural owners. If
an owner were not advantaged, then even its fastest-growing or most profitable businesses
could be divested at prices above the companys hold case. Conversely, if the company
were a competitively advantaged owner, it was typically sensible to keep even its least exciting
businesses.
A similar revolution is now occurring in the field of strategic risk management. Once again, the
catalysts are emerging marketplaces: risk-transfer markets such as those for financial
derivatives, commodity derivatives, business process outsourcing, reinsurance and contingent
capital, and so on. Companies can now seek out not only businesses for which they are the
natural owner (which represent a bundle of risks), but also those risks for which they would be
the natural owner. Such risks should be kept and, if possible, acquired. All others should be
hedged or transferred.
How does a management team assess natural ownership? We have found three questions
helpful. First, does the corporations business portfolio contain natural offsets? Second, does
the company have differentiated capabilities to manage the risk (e.g., information advantages
in traded commodities, project-management skills for large investments)? Third, are the
accessible risk-transfer markets reasonably efficient (e.g., the market for interest-rate
derivatives is so efficient that even the most sophisticated banks derive no benefit from natural
ownership)?

26

Exhibit 7

Which risks are you competitively advantaged to hold?

Airlines and jet fuel risk example

Advantaged
Disadvantaged
Neutral

Assessment of advantage
Consideration
Industry
knowledge and
insight

pass through cost

increases
Airlines only pass
through 30%
Refiners change run
rate & product slates
Traders focus on
building logistic and
commercial flexibility
Most refiners backed
by oil major AAA
balance sheet or
National Oil Co

Investors in refiner

Oil price level

Refining economics
Local basis &
logistics in jet fuel

Natural offsets
in portfolio
A natural owner
has superior
insight into a risk
or an advantage in
holding/mitigating
the risk

Physical
flexibility (real
option)

Cost advantage
in holding the
risk
Alignment with
investors
appetite

Refiner Trader Airline

Refiners regularly

and trader want

price exposure

The natural-ownership assessment yields a clear risk strategy for the company (Exhibit 7
above illustrates this assessment using the airline industry as an example). Advantaged risks
create superior returns and (subject to the risk-capacity issues addressed below) should not
be hedged or transferred. In fact, the company should seek to acquire such risks, whether in
risk-transfer markets or embedded with assets or commodities in physical markets.
Disadvantaged risks should be mitigated wherever there are efficient risk-transfer markets.
Even when such markets are not available, it may be possible for companies to develop risktransfer opportunities (e.g., long-term contracts or tolling arrangements with customers or
suppliers, joint ventures with partners that have offsetting risk positions).
In a well-known case that illustrates the concept of natural ownership, Southwest Airlines
persevered through the industry-wide downturn in the airline business following September 11,
2001, maintaining three decades of profitable performance. A contributing factor was a
sophisticated fuel hedging strategy begun in the 1990s, which allowed Southwest to reduce its
fuel costs by as much as 50 percent compared with competitors. The strategy has generated
gains in excess of $4 billion. In 2005 alone, hedging gains represented $1 billion (105
percent) of Southwests operating income. Less well known, however, is the reasoning behind
Southwests hedging decision. For its executives, thinking about fuel-cost risk was only part of
a larger strategy centered on the principle of stability of costs, service levels, and fares. They
knew that rising fuel prices were the biggest threat to the companys business model as a lowcost carrier. The decision to lock in those prices was not a decision to place a bet on oil
markets. Rather, the executives reasoned that whatever happened, Southwest needed to

27

remain a low-cost provider. If fuel prices rose, the hedge meant they would win in the market
because existing labor and productivity advantages would be further strengthened by an edge
in fuel prices. If prices fell or stayed flat, Southwest would still be the low-cost leader, because
its cost advantage in nonfuel areas was greater than any reasonable expectation of a fall in
fuel prices.

3. Determining risk capacity and appetite

Once a company has identified the risks it should own and sought to mitigate all others, it
should reexamine its risk capacity and potentially acquire more advantaged risks.
To understand whether it has the optimal level of risk capacity, a company must first quantify
its operating-cash-flow risk. A Monte Carlo simulation to develop probability distributions of
cash inflows over the next few years can be mapped against the companys projected cashflow needs to determine the probability of shortages or surpluses over time.
Exhibit 8 illustrates how to apply this cash flow at risk concept. It maps a distribution of
future operating cash flows against the companys cash needs. If the distribution falls too far
to the right, there is a negligible chance of an outcome that does not easily meet anticipated
needs, and the company is being unduly conservative. Too far to the left (as in Exhibit 8), and
the company would be underinsured against events that could limit its ability to meet even
Exhibit 8
NEO-ZZQ845-20080612-JF1

Assessing risk capacity using cash flow at risk

Unit of measure

Probability

Value of $1

Text

Operating cashflow distribution

$3
$2
$1

Cash Interest and Divineeds principal

dends
$

Avoid distress

Sustaining
capex

Reliability

Ongoing
project
capex

R&D and Expectamarketing tions

investment

Protect
Keep strategic
investments/ flexibility and
growth
investor
credibility

15

28

basic cash needs. This explains the second element of the chart: the idea that a dollar of cash
flow does not always have the same value. Used to pay interest and principal, a cash-flow
dollar is worth far more to shareholders than a dollar used for more discretionary purposes. In
effect, the chart illustrates what is only a relatively recent ability to use quantitative methods to
help a company think strategically about its risk-bearing capacity.
Exhibit 9 extends this idea by showing examples of two companies, both of which need to
adjust their risk capacity so that the cash-flow distribution appropriately aligns with their
strategic goals.
In addition to optimizing risk capacity against annual cash-flow requirements, many companies
should manage their risk capacity against other dimensions of enterprise risk. A company in a
cyclical industry might want to manage its overall equity value at risk, seeking to keep its
expected stock-price volatility below an absolute level or below the expected level of a peer
group. Alternatively, a company might place a high premium on meeting earnings-per-share
guidance and thus want to assess and manage earnings at risk.

Exhibit 9

Risk capacity can be optimized to avoid inefficient risk-return management

Overextended company

Ways to reshape
Hedging
Contracting
Portfolio changes
Capital structure

Probability

Cash
needs
$

Interest & Divi- Sustain- Ongoing R&D &

principal dends ing capex capex marketing
investment

Overinsured company

Cash
needs
$
Interest & Divi- Sustain- Ongoing R&D &
principal dends ing capex capex

EBITDA
cash reserve
Ways to reshape
Increase debt
Share
repurchases

Probability

marketing
investment

When it typically
applies
Recent distress
Substantial
growth/capital
program

When it typically
applies
High free cash
flow (pecking
order theory)

EBITDA
cash reserve
1

Exhibit 10 on the following page provides a simplified comparison of debt and risk levels in
different industries and suggests that there is a huge scope for companies to rebalance their
capital structures in light of their risk capacity.

29

Exhibit 10

Many companies are overinsured relative to their risk

Potentially underlevered
Balanced debt structure
Distressed

Volatility in earnings per share 1992-2005

50%

Is there an opportunity
to recapitalize overinsured companies?
Ability to quantify
required risk capacity
Cash flow at risk
Equity value at risk
Benefits of capitalization
Debt tax shields
Signaling
Upside concentration
Of course there are
other considerations:
Strategic growth and
flexibility
Contingent liabilities

Airlines

40

Chemicals

30

Metals & mining

High tech

Auto
manufacturers

Petroleum
Telecom

Pharma

20

Retail

Consumer Utilities
products

0%
0%

20

40

60

80

100

120

140%

Net debt to equity ratio 2008

Source: Bloomberg; Datastream; McKinsey analysis

24

Of course, none of these tools can absolutely ensure that a company wont suffer a shortfall.
Extreme and unanticipated outcomes do occur. A sophisticated risk-management system,
however, can often identify and rectify a strategic course that is taking a company toward the
overextended or overinsured extremes that we find to be all too common.

4. Embedding risk awareness in decision-making and

managerial processes
Risk management is not an exercise to be undertaken once, or once a year. It is an attitude to
problems and decisions. Psychology and behavioral economics have established that we have
difficulty correctly incorporating risk into our thinking. So companies must put in place formal
processes for risk-informed decision making.
In some respects, this is more challenging than the earlier elements of the risk-management
process this paper has outlined. It requires commitment, discipline, and senior leadership
willing and able to communicate why risk is a critical metric for decisions. It also inevitably
requires a willingness to apply risk thinking in new areas.
For this to happen, there must be a broad understanding of the range of decisions to which
risk management is relevant. Four kinds of managerial decisions can benefit substantially
from risk-enabled approaches:

30

Investment decisions. By adopting a probabilistic approach to investments, companies

can avoid many of the pitfalls inherent in more traditional evaluations. Instead of a single
NPV point estimate, companies can determine the probability of a whole range of
outcomes, including the probability of a negative NPV. The range of probabilities can then
be compared with those under alternative project structures e.g., turnkey engineering,
procurement, and construction (EPC) contracts or hedged product prices. Companies can
also quantify the value associated with real options the ability to defer or accelerate an
investment program based on unfolding events.

Commercial decisions. Most industrial purchasing and pricing decisions, whether shortterm spot or long-term contracts, can benefit from risk-book concepts common to
financial asset management and trading firms. Risk books break complex risks into
component parts, enabling more effective matching and measurement of exposures. For
example, a chemical company that produces plastics for packaging could better
understand its true exposure to oil prices, and whether higher costs for its feedstock will be
more than offset by the higher prices resulting from higher costs for competing materials
such as aluminum or paper.

Financial decisions. Most financial policy decisions involve risk trade-offs that should be
viewed in the context of enterprise cash flow and value trade-offs. Should the company
employ greater hedging to increase its debt capacity? Should the capital budget be cut to
provide a cushion? Should the company issue equity instead of debt to fund an
acquisition? Too often, these decisions are based on arbitrary debt/equity guidelines or
target credit ratings instead of cash-flow-at-risk and value-at-risk principles.

Operational decisions. Decisions on a companys manufacturing footprint, supply chain

design, outsourcing, and inventory policy involve significant risk-return trade-offs that can
also benefit from an enterprise risk perspective.

Generally, these decisions are neither coordinated across a company nor evaluated using risk
decision tools. Investment and operational decisions are made by business unit managers;
procurement decisions by purchasing; pricing decisions by sales-force management; and
financial policy decisions by the CFO. Yet each decision consumes or creates risk capacity.
Each involves uncertainty and risk exposure.
We cannot overstate the importance of this. Ask clients whether they struggle with big
decisions such as whether to enter a new market, increase R&D spending, or whether to lower
prices by squeezing their procurement processes. The typical approach is to take a base
case, or perhaps a high and low case, and forecast accordingly. But these are to a large
extent risk-management questions. Working off one case or even three ignores most of the
probability distribution ignores, that is, most of reality.
Exhibit 11 illustrates how the tools we have discussed might help across different types of risk.
Table 2 lays out the impact this approach can have in a range of industries.

31

Exhibit 11
NEO-ZZQ845-20080612-JF1

Strengthening decision making using all available tools

Complexity of
problem

High

Monte Carlo

Number of
risks
Number of
interdependent
players
Availability of
market data

VaR

Real
options
Range of NPV

Core
tools in
financial
services

Black
Scholes Derivative
and other
riskGame
transfer
theory
markets

NPV
spreadsheet

Agent-based
modeling/genetic
algorithms
Information
markets

Stress testing
Decision
tree

Scenario
planning

Delphi

Low
Low

Clear enough
(expected
outcomes with
sensitivities)

Discrete
futures/
choices

Continuous
range of
futures

True
ambiguity

High

Inherent degree of uncertainty*

Known
knowns

Known
unknowns

Unknown
unknowns

* Degrees of uncertainty (x-axis) from Courtney, Kirkland, and Viguerie, Strategy Under Uncertainty, Harvard
Business Review, November 1997 Source: McKinsey analysis

Table 2

Examples of risk across industries

Industry

Where risk management can lead to better decisions

Pharmaceuticals

How robust is our R&D pipeline? Which drugs should we license?

Consumer goods

Should we lock in volatile materials and packaging costs? Will we be

able to pass through commodity price increases?

Electric utilities

How should we invest in view of the controversy over greenhouse gas

emissions or with regard to regulations on renewable power?

Telecom

How and where should we invest to compete in VoIP?

Software

Do our global sales justify multilocal manufacturing? Can we manage

currency risks more effectively with derivatives?

Automotive

Should we continue to grow our call center in India or look for a lowercost site that will take longer to become operational?

Railroads

Should we hedge our fuel costs? Are we helped or hurt by higher oil
prices given their competitive impact on truckers?

32

5. Establishing a risk-appropriate culture, organization,

and governance model
In an ideal world, all business managers or decision makers would analyze the impact of a
proposed project or investment on the overall level of the companys risk and make precise
trade-offs that would help the company maintain optimal risk exposure. In the real world, this is
true only in companies that have a strong risk culture that informs how managers at all levels
make decisions. This includes incentive systems that encourage individuals to value the
whole enterprise rather than personal fiefdoms and to make decisions with an eye to long-term
economic outcomes rather than short-term performance.
It is not easy to get managers thinking about risk in the way we have described. A highly
motivated CEO who understands the power of managing both risk and returns can inspire an
entire management team and shape corporate culture. But this requires a lot of education on
the part of the CEO and the application of consistent discipline. It does not happen overnight,
but rather takes years. Yet when it does occur, in our experience, it tends to have a lasting
positive impact on how a company performs. One highly successful company that has very
publicly put risk at the center of its culture is BHP Billiton, which has combined the
sophisticated use of analytics to support its strategic decisions with unprecedented
transparency about risk taking for stakeholders.
No discussion of risk would be complete without acknowledging that the oversight of a riskreturn management effort requires constant vigilance from a companys executives and board.
Companies with the best risk-management processes describe a culture of questioning and
openness: information is simultaneously challenged and filtered in an organized fashion to
minimize surprises. By contrast, in many companies there is no clear governance structure
and the effort becomes segmented, just as risk is siloed and therefore not understood at the
firm level. Exhibit 12 on the following page suggests some typical shortcomings reminding
us at the same time of the complexity of the organizational challenges that must be overcome
to embed a risk-return-based culture.
Because a strategy must be formulated in the context of the organization that will execute it,
systematic or strategic risk management can happen only if the organization is aligned from
top to bottom so that everybody has a common understanding of the companys key risks and
a clear line of sight into the overall level of exposure to those risks. Few companies achieve
this. Most may try to identify the different aspects of risk, and perhaps take some mitigating
steps, but lack genuine insight into the risks they are running. Although companies may
employ a chief risk officer, they are unlikely to imbue the role with much power and tend to
have only limited understanding of how risks interact. Many of these companies will be using
capital sub-optimally and will also be running strategic risks of which they are unaware.22

22 Nocco and Stulz suggest two essential organizational components. First, all business managers (or
decision makers) should be required to evaluate project returns in relation to the marginal increases
in firmwide risk to achieve the optimal amount of risk at the corporate level. Second, performance
evaluations of business units should take into account their contributions to the total risk of the firm
so that managers at every level have the incentive to refuse risks that are economically unattractive
(Enterprise Risk Management: Theory and Practice, pp. 4-7, see note 19).

33

Exhibit 12

Common failings in risk culture

Insists on a more
strategic dialogue
around risk, but must
rely on intuition

Board

Sees extensive mapping of risks,

but typically has little influence
on decision making

Uses sophisticated
Risk-management
tools for short - term
risk

Has narrow and

siloed view of risk;
often focused on
compliance

CEO

CRO

Trading

Lacks knowledge and

common language to
engage in dialogue with
management team on risk

CFO

BU

BU

BU

Must assess strategic

risks, but lack
capabilities and
standard methodologies

20

Even companies that have an appreciation of the risks they are taking, and some
sophistication about managing them, usually fall short of what is required. The most common
mistake is to adopt a decentralized approach, in which business units own risks with oversight
from the corporate center, which has some degree of power over portfolio choices that
aggregate risks in positive ways. This is typical of large, project-based companies with
complex risks of long duration. Such companies tend to have only limited understanding of the
real risk-reward trade-offs at the aggregate level and usually combine large equity cushions
with heavy insurance to protect downside exposure. There is often tension between the center
and the business units the latter tends to perceive the risk function as internal police,
determined to call a halt to independent activity.
In our experience with clients, we have found that the most effective model by far is a
centralized one, with a powerful chief risk officer who reports to the chief executive and
presents regularly at the board level. Companies with this structure tend to manage volatile
risks that require vigilance and discipline. Risk is embraced for its upside potential because
the corporate culture understands it and is in command of the trade-offs being made. As we
have noted, successful risk-return managers such as Goldman Sachs ensure that the
organizational functions responsible for risk are widespread. They also make sure that
successful managers who rise through the organization spend some time working in the formal
risk-return function, so that this experience will shape how they interact with the function from

34

subsequent positions as senior decision makers either in the corporate center or in business
units. A risk-return philosophy becomes an integral part of the cultural norms of the
organization.

***
The message is clear: companies must consider both the risks and returns of their strategies.
The considerations are best done systematically. Those companies with good risk-return
management systems and a culture of careful decision making will outperform less disciplined
competitors. Top management, including the CEO and the board, should take the lead in
introducing a dynamic risk-return management process. Strategically, this means
understanding the risks being taken, determining which risks the company should own, and
assessing whether the companys risk capacity is properly aligned with its strategy.
Operationally, this means avoiding any tendency to rely on gut feeling and introducing and
championing analytics and decision-support tools. For us as consultants, bringing the
surgeons tools offered by financial risk management, even at a time when many financial
institutions appear to have lost some of their own discipline, together with the blunter but very
practical tools of corporate leadership, can allow us to achieve a significant positive impact in
helping companies through the evolution or the revolution required to improve their
performance over the long term.

Kevin Buehler is a Director in the New York office. Andrew Freeman is a Risk Practice
senior knowledge expert based in the London office, and Ron Hulme is a Director in the
Houston office.

35

Selected sources
There is an enormous breadth of literature, both popular and academic, on risk and risk
management. This source list is intended as a guide to some of the most useful texts and is
not meant to be comprehensive. It complements, rather than reproduces, the texts mentioned
in the footnotes.

General works
Bernstein, Peter L. Against the Gods: The Remarkable Story of Risk. New York: Wiley, 1996.
Bookstaber, Richard. A Demon of Our Own Design: Markets, Hedge Funds, and the Perils of
Financial Innovation. Hoboken, N.J.: Wiley, 2007.
Borge, Dan. The Book of Risk. New York: Wiley, 2001.
Courtney, Hugh. 20/20 Foresight: Crafting Strategy in an Uncertain World. Boston: Harvard
Business School Publishing, 2001.
Chew, Donald H., ed. Corporate Risk Management. New York: Columbia Business School
Publishing, 2008.
Dembo, Ron S., and Andrew Freeman. Seeing Tomorrow: Rewriting the Rules of Risk. New
York: Wiley, 1998.
Gladwell, Malcolm. Blink: The Power of Thinking Without Thinking. New York: Little, Brown,
2005.
Shiller, Robert J. The New Financial Order: Risk in the 21st Century. Princeton, N.J.:
Princeton University Press, 2003.
Taleb, Nassim Nicholas. Fooled by Randomness: The Hidden Role of Chance in the Markets
and in Life. New York: Texere, 2001.
. The Black Swan: The Impact of the Highly Improbable. New York: Random House,
2007.

More specialized works

Adams, John. Risk. London: UCL Press, 1995.
Beaver, William H., and George Parker, eds. Risk Management: Challenges and Solutions.
McGraw-Hill, 1995.
Culp, Christopher L. Risk Transfer: Derivatives in Theory and Practice. Hoboken, N.J.: Wiley,
2004.
. Structured Finance and Insurance: The ART of Managing Capital and Risk. Hoboken,
N.J.: Wiley, 2006.

36

Derman, Emanuel. My Life as a Quant: Reflections on Physics and Finance. Hoboken, N.J.:
Wiley, 2004.
de Servigny, Arnaud, and Olivier Renault. The Standard & Poors Guide to Measuring and
Managing Credit Risk. New York: McGraw-Hill, 2004.
Field, Peter, ed. Modern Risk Management: A History. London: Risk Books, 2003.
Gigerenzer, Gerd. Calculated Risks: How to Know When the Numbers Deceive You. New
York: Simon & Schuster, 2002.
Gigerenzer, Gerd, Peter M. Todd, and ABC Research Group. Simple Heuristics That Make Us
Smart. New York: Oxford University Press, 1999.
Hubbard, Douglas W. How to Measure Anything: Finding the Value of Intangibles in Business.
Hoboken, N.J.: Wiley, 2007.
Hutter, Bridget, and Michael Power, eds. Organizational Encounters with Risk. New York:
Cambridge University Press, 2005.
Jorion, Philippe. Value at Risk: The New Benchmark for Managing Financial Risk. 3rd ed.
New York: McGraw-Hill, 2007.
Kahneman, Daniel, Paul Slovic, and Amos Tversky, eds. Judgment Under Uncertainty:
Heuristics and Biases. New York: Cambridge University Press, 1982.
Koller, Glenn. Risk Assessment in Decision Making in Business and Industry: A Practical
Guide. 2nd ed. Boca Raton, Fla.: Chapman & Hall, 2005.
. Modern Corporate Risk Management: A Blueprint for Positive Change and
Effectiveness. Fort Lauderdale, Fla.: J. Ross Publishing, 2007.
Lupton, Deborah. Risk. New York: Routledge, 1999.
Marrison, Chris. The Fundamentals of Risk Measurement. New York: McGraw-Hill, 2002.
Ong, Michael K., ed. The Basel Handbook: A Guide for Financial Practitioners. London: Risk
Books, 2004.
Rebonato, Riccardo. Plight of the Fortune Tellers: Why We Need to Manage Financial Risk
Differently. Princeton, N.J.: Princeton University Press, 2007.
Sharpe, William F. Investors and Markets: Portfolio Choices, Asset Prices, and Investment
Advice. Princeton, N.J.: Princeton University Press, 2006.
Welch, David A. Decisions, Decisions: The Art of Effective Decision Making. Amherst, New
York: Prometheus Books, 2002.

Handbooks
Global Association of Risk Professionals. 2008 FRM Core Readings Course Pack v2.0,
www.garpdigitallibrary.org/display/frm.asp.

37

Jorion, Philippe. Financial Risk Manager Handbook. 4th ed. Hoboken, N.J.: Wiley, 2007.
Professional Risk Managers International Association. The PRM Handbook, 2008,
http://prmia.org/index.php?page=training&option=trainingLectures.

38

McKINSEY WORKING PAPERS ON RISK

EDITORIAL BOARD

1. The Risk Revolution

Kevin Buehler, Andrew Freeman and Ron Hulme
2. Making Risk Management a Value-Added
Function in the Boardroom
Gunnar Pritsch and Andr Brodeur
3. Incorporating Risk and Flexibility in
Manufacturing Footprint Decisions
Martin Pergler, Eric Lamarre and Gregory
Vainberg
4. Liquidity: Managing an Undervalued Resource
in Banking after the Crisis of 2007-08
Alberto Alvarez, Claudio Fabiani, Andrew
Freeman, Matthias Hauser, Thomas Poppensieker
and Anthony Santomero
5. Turning Risk Management into a True
Competitive Advantage: Lessons from the
Recent Crisis
Gunnar Pritsch, Andrew Freeman and
Uwe Stegemann
6. Probabilistic Modeling as an Exploratory
Decision-Making Tool
Martin Pergler and Andrew Freeman

Andrew Freeman
Managing Editor
Senior Knowledge Expert
McKinsey & Company,
London
[email protected]
Peter de Wit
Director
McKinsey & Company,
Amsterdam
[email protected]
Leo Grepin
Principal
McKinsey & Company,
Boston
[email protected]
Ron Hulme
Director
McKinsey & Company,
Houston
[email protected]
Cindy Levy
Director
McKinsey & Company,
London
[email protected]
Martin Pergler
Senior Expert,
McKinsey & Company,
Montral
[email protected]
Anthony Santomero
Senior Advisor
McKinsey & Company,
New York
[email protected]