Chapter One

We have mentioned Paul Reichmann in our earlier comments. The Reichmanns are property moguls who bestrode the world until their huge empire collapsed in 1991. They provided rich material for one of the twentieth century's great business stories. Less well known is the fact that, in 1994, they very nearly pulled off a miraculous comeback. A few well-informed readers might recall that they entered a joint venture with George Soros, the famed speculator whose market-moving abilities have caused major controversies from Britain to Malaysia. But only a tiny number of people know that the Reichmanns disastrously blew a second chance to rescue themselves from oblivion, and they destroyed their venture with Soros in the bargain.

Having made and lost a fortune redeveloping vast swaths of cities such as New York, Toronto, and London, the humbled Reichmanns looked further afield in the early 1990s. In search of a new deal that would relaunch their operations, they hopped smartly onto a hot trend--the rise of new economies and so-called "emerging markets." Their dream was a multibillion-dollar development in the capital of one of the fastest-growing economies in the world. Mexico appeared poised on the brink of emergence into an established and accepted economic force. Its trade links with America and Canada were about to be ratified and liberalized via the North American Free Trade Agreement (NAFTA) treaty (signed by President Bill Clinton in 1993). But the city had very few modern office buildings, and rents were high in those that did exist. What could be more appropriate than to revamp a chunk of the sprawling capital city and erect some of the Reichmanns' signature skyscrapers?

The Reichmann-Soros venture almost succeeded. The Reichmanns followed their typical development process. The venture bought two parcels of land, one of which was on a prime site in the heart of the city. The land was bought on favorable terms from the government, on the promise that it would be developed into a top-rate site. By investing a relatively small amount in architects' drawings and marketing, the Reichmanns hoped to lure a local partner into a 50:50 joint development venture. A giant publicity fanfare led to widespread interest among big construction firms. ICA, a large local firm, bought a 50 percent stake in the first parcel of land on the outskirts of the city. In bidding for the second parcel, ICA proposed to be the builder as well as a joint developer.

It seemed like a sure thing. ICA's cash would fund the entire development, leaving the Reichmanns and Soros with no downside exposure but potentially tremendous upside prospects in the event that the project was a success. A further attraction for the Reichmanns was that they had already dealt with ICA and felt that a deal could be closed quickly.

Unfortunately, the Reichmanns, like much of the rest of the world, were overly convinced that Mexico's leaders, trained in American business schools, knew what they were doing. In 1994, the Mexican economy was under increasing pressure. Although inflation had fallen from 180 percent in 1987 to around 8 percent, growth was sluggish. The Mexican currency was the victim of sudden bouts of nerves among traders, which forced the government to intervene heavily in foreign exchange markets. The need to support the currency grew, and Mexico's foreign exchange reserves dwindled from $25 billion in late 1993 to a mere $6 billion a year later. But because the interventions had kept the exchange rate fairly stable, few people watching the market had any idea that big trouble was around the corner. If you were looking at the exchange rate to guide, say, an investment such as the Reichmanns', recent history would have given you little idea of what lay ahead.

The key to the peso's relationship to the dollar was a tight band within which the government insisted that it would stay. On December 20, 1994, the Mexican government announced that it had widened that band. The peso immediately fell by 10 percent, in a move that shocked traders and investors alike. On December 23, the band was removed altogether, and the peso went into free fall against the dollar, losing 50 percent of its value within just a few days. In addition, interest rates quadrupled over the same period. In the months that followed, it became clear that Mexico had suffered a major economic crisis.

How did the Reichmanns and George Soros react? Their deal with ICA was supposed to be signed and sealed on December 20. Mysteriously, in the days before that date, ICA began to stall. Perhaps it sensed that the currency was vulnerable. When the two sides met on December 21, ICA had changed its position. It wanted the 10 percent fall in the peso to be reflected in new terms for the deal. This was not entirely unreasonable; ICA had to use pesos to fund an investment that, in dollars, had suddenly become more expensive.

Ironically, the Reichmanns' partner might have thrown a lifeline, if only its right hand had known what its left hand was doing. George Soros's canny hedge fund traders had long since sold their peso holdings, believing the currency to be risky. But Soros's property arm had no such insight. It carried on as if everything was normal. No warning was sent to the Reichmann-Soros venture, which consequently had little sense of the ugly scenario that was about to unfold.

Assume the deal with ICA had been successfully renegotiated. What would have been the Reichmanns' position? Arguably, because the original deal had been a rich one, the new terms were simply slightly less rich. The Reichmanns still stood to make an extremely favorable deal with great upside. By signing a contract with ICA, they would have ensured that the project went ahead. They would then have recovered their sunk costs and been largely insulated from further falls in the peso. In effect, most of the future financial risk in the development would have been shouldered by ICA. The best scenario for the Reichmanns was a return of the peso to its former value, which could have added 10 percent to their upside. The worst scenario was that the peso would continue to fall and the deal could be lost altogether--a large downside.

Paul Reichmann, the family's most influential member, refused to deal. He would not allow any alteration to ICA's terms. Then things happened very fast. As the peso went into free fall after December 23, ICA saw that its timing for the development was lousy--the returns in dollars were insufficient to make the project worthwhile. Not surprisingly, it abruptly lost its appetite. The Reichmanns' comeback was off.

Imagine the scene in Mexico City on December 21. The Reichmanns had to ask themselves whether the initial peso devaluation would be the end of the matter, or whether there was more trouble to come. They might have done a simple analysis: What were financial markets telling them about the likelihood of further devaluations of the peso? A quick look at the currency options markets would have shown that traders indeed expected more bad news. Locking in terms at a 10 percent lower rate for the peso might turn out to be a bargain if it fell an additional 40 percent. However, a naive look at the past eighteen months of stable U.S./Mexican exchange rates would lull one into thinking that the current drop in rates was an aberration.

Instead, the Reichmanns chose a more subjective analysis, perhaps because they were committed to the idea of making a comeback. They concluded that the peso's troubles were temporary and that they should not make any concessions to ICA.

The point is that the Reichmanns bet everything on a single outcome. In effect, they were gambling that a single outlook for the peso would turn out to be correct. In fact, anything could have happened to the peso, so it really made sense to consider several possible outcomes. This is a key point about proper risk management that is often overlooked. When we plan around a single view of the future, we are actually gambling. Sensible planning requires us to consider a multitude of possible events and explore how each one might cause us to react.

Sources close to Paul Reichmann report that he carried on, trying to revive the deal and hoping that things could be ironed out. When it because clear that it would take many months to solve the problems in Mexico, Reichmann because more reclusive than ever and showed signs of rapid mood swings. He was clearly suffering from serious Regret that he had so badly misjudged the situation.

Even though we may not always be conscious of it, we are all risk managers. As we navigate daily life, we must make a host of decisions that more or less explicitly reveal our attitude toward risk. Shall I travel by plane or train? Which detergent has fewer noxious chemicals? Which over-the-counter drug is less harmful? Should I buy a lottery ticket instead of a sandwich? Should I invest in mutual funds, stocks, or bonds? Which securities should I buy, and how long should I plan to own them? Should I give up smoking? Our views of risk are surprisingly idiosyncratic--one person's pleasure is another's poison. Hence the diversity of economic and business life.

There is a rich contemporary debate about the fine line between an acceptable and an unacceptable risk. From nuclear safely to food additives, we are bombarded with often contradictory and confusing information about risks. Is the tiny risk from using the chemical Alar on apples a price worth paying for its otherwise beneficial effects? If consumers had known more about ValuJet's safety record, would the airline have folded before the crash in the Everglades that killed so many persons? If the American money market funds that invested disastrously in complicated but supposedly yield-boosting derivatives in 1994 had been frank about the risks they were running in order to deliver slightly higher returns, would an investor boycott have forced the fund management firms to change the funds' approach before an expensive bailout became necessary? Would people have signed up to be "Names" at the Lloyd's insurance market in London if they had known how much downside risk was involved? Would so many banks have lent money (which they subsequently lost in large amounts) to Robert Maxwell if they had known more about the British tycoon's shaky finances? Why did many of the same banks then take a further bath when they lent another fortune to the Eurotunnel, the project to build a tunnel under the English Channel that was as successful in engineering terms as it was hopeless in financial ones? The list of such questions is endless.

The list is also daunting, for these broad inquiries point to a central confusion about risk management. At a societal level, we rely on governments to maintain or introduce regulations that are designed to protect us from many excessive or unwarranted risks. The ban, in some countries, on smoking in public is an obvious example, as are rules about handling nuclear waste or processing uranium. Alternatively, institutions such as mutual societies and credit unions have arisen to extend access to risk management to large numbers of people. (Mutual funds achieve the same purpose by virtue of their transactional efficiency.) In developed economies, these forms of "insurance" have helped to spread financial security and well-being far more widely than was previously the case.

But they have also helped to obscure a central and fundamental aspect of risk: each individual's attitude toward risk can often be at odds with the attitudes of other people. In the blunt language of investing and finance, how we feel about a particular risk depends greatly on our unique circumstances, not the least of which is how rich or poor we are, and whether (or when) we will need to get our hands on hard cash as opposed to paper assets that represent real money in the future. Our circumstances are unlikely to be precisely the same as everyone else's. Even if two people end up making the same investment decision--for example, to buy $1,000 worth of Citicorp stock--they will probably have quite different reasons and motives for doing so. Further, there is a common misperception that risk is purely an active concept, that it only involves assuming danger in the hope of reward. In fact, risk comes in other guises. If we have $1 million but choose to leave it under the mattress, then we are avoiding many risks. But we are just as certainly assuming others. There is risk in doing nothing, just as there is risk in taking action. Indeed, perhaps striking a balance between action and inaction is the essence of risk management.

From just this preliminary exploration, it should already be clear that risk is a remarkably subtle notion. Its meanings and boundaries shift constantly, making it difficult to pin down. An acceptable risk on one day might appear a foolish gamble on the next day. As we shall see, a way of thinking about risk that encompasses this subtlety has eluded generations of thinkers and researchers. Even in this age of high-tech computing, the basic architecture of risk management remains primitive. It is as if all that fancy technology is stored in the intellectual equivalent of a wooden shack.

Much has been written about risk in recent years. Indeed, an unprecedented amount of intellectual firepower has been directed at the subject, particularly in the field of finance. We only have to look at the recipients of Nobel prizes for economics during the past decade to see that great store is now set on the challenge of unmasking risk and explaining its finer points. Why does risk remain so elusive? One answer is that, for all of our sophistication, we sometimes shy away from asking simple questions, as if this avoidance makes it easier to grapple with difficult ones. Because great minds have battled with the meaning of risk, it seems presumptuous to suggest that we might need to start from first principles. Another answer is more humdrum. Rather than seek a comprehensive approach to risk, people have chosen "fit for purpose" solutions--the risk management equivalent of "quick and dirty" computer codes. For many business problems, that approach is sensible enough. But when investment and financial risks are involved, it borders on the cavalier. Why embrace an approach to risk that may be flawed, when the outcome could be disastrous? No professional gamblers would adopt such an approach; they know too much about ruin!

In Against the Gods (New York: John Wiley & Sons, 1996), Peter Bernstein describes how our understanding of risk and risk management has developed over the centuries. Until some central problems in mathematics and probability theory were solved, our ability to define and manage risk was necessarily limited. Moreover, developments in risk theory have been uneven. For generations, little would happen; then a burst of innovation and activity would bring thinking to a new plateau.

Bernstein asks rhetorically: What distinguishes thousands of years of history from what we think of as modern times? Human history has been chock full of brilliant individuals whose technological and mathematical achievements were astonishing; think of the early astronomers or the builders of the pyramids. The answer, suggests Bernstein, is our acceptance of risk: "... the notion that the future is more than a whim of the gods and that men and women are not passive before nature. Until human beings discovered a way across that boundary, the future was either a mirror of the past or the murky domain of oracles and soothsayers who held a monopoly over knowledge of anticipated events."

With helpful skepticism, Bernstein asks whether the fancy mathematics and computer wizardry of today are dangerously analogous to the graven images and idols before which earlier generations made their genuflections. If we rely too heavily on clever models and "black boxes," might we not be succumbing to an updated version of the faith that ancestors placed in deities and shamans? Indeed, might the false "science" of risk management be a dangerous illusion that itself hides potentially catastrophic risks?

Recent history tends to support this view. Until the dangers of risk management began to emerge during the 1980s, few ordinary people had heard of financial derivatives, for example--those infamous futures and options that supposedly caused a series of corporate blowups and disasters in the early 1990s. Few television-watching households have escaped at least a passing familiarity with derivatives. In Britain, for instance, the collapse in 1995 of Barings, an august and snobbish bank, led to the equivalent of a countrywide education program in modern finance.

Similarly, voters in Orange County, California, had an unexpected crash-course in finance in 1994, when their investment pool was so severely damaged that the county chose to declare itself bankrupt. How did this disaster happen? Robert Citron, the county's elected treasurer, had recklessly used "leverage," hoping to boost returns. In effect, this means taking on risks that are orders of magnitude larger than the underlying stake. He was found out by a big reversal in financial markets.

Some of the biggest and most respectable names in finance and business have fallen afoul of risk management in recent years. And there is no local or geographical monopoly on such disasters. Think of Britain's National Westminster Bank; Germany's Metallgesellschaft; America's Gibson Greetings, Merrill Lynch, and Bankers Trust; Japan's Daiwa Bank, Sumitomo, and IBJ--to name a few. Plenty of other firms have had problems, but they have chosen to cover them up rather than lose face and public confidence. Many banks, for example, have lost a few million dollars here and there as they have acquired trading and operating skills in the notoriously difficult options business.

One big bank was even the silent victim of an audacious robbery. Clever but criminal staff got inside an options pricing model and used tiny changes to skim off a few million dollars of profits for themselves. They were eventually caught, but the bank elected not to prosecute them. It feared (probably correctly, in light of other banks' experiences) that the revelation of the swindle could wipe out hundreds of millions of dollars of its overall value as nervous investors decided to place their money elsewhere.

It is impossible to calculate the real cost of risk management failures among businesses, but it certainly runs to many billions. In 1995 and 1996, documented losses were some $12 billion. Moreover, there are few signs that firms' reliance on mathematics and machines is diminishing. In the trading rooms that are the temples of modern finance, some of the world's brightest brains are competing to attain, however briefly, the strongest grip on risk. Therein lies competitive advantage--to put it crudely, the ability to wring huge profits from less-equipped rivals. These are the "model wars," a kind of intellectual and financial arms race that promises fat rewards to the victors.

Is there a danger of relying too much on models and not enough on common sense? We do not think there is too much reliance on models, for two main reasons. First, the past few decades have witnessed such rapid developments in finance theory and such growth in the world economy that the fact that many firms have occasionally fumbled is not surprising. The banks that have lost big money in options trades, for instance, have undoubtedly learned painful lessons. The best ones have adjusted their practices and grafted new rules and precautions onto older and sloppier systems so that they will not be similarly embarrassed in the future. For example, in 1987, Merrill Lynch, arguably the world's biggest investment bank, was embarrassed when it lost $377 million trading mortgage-backed securities. Since then, having installed new risk systems and maintained a careful watch over its trading, there has been no significant mishap.

Firms like Merrill Lynch probably have also absorbed the lesson that a risk might pop up somewhere else, quite unexpectedly. They can never relax; occasional losses, sometimes even big ones, are in the nature of life and business. That is why firms have money set aside as a cushion. It is known as equity, and it is there to fall back on in bad times. That is also why regulators require financial firms to set aside capital. Arguments about how much capital is the right amount are the main reason for the continued flourishing of risk management. Those who need the least capital to run the same risks can enjoy a profound competitive advantage. What we have seen to date in financial risk management at this level is perhaps best characterized as a series of related lessons about the dangers of innovation. But it is not a sign that there is some fatal flaw in modern efforts to improve our approach to risk. Indeed, it seems almost self-evident that if the costs of risk management really outweighed the massive benefits brought by a variety of new risk-sharing techniques, then the techniques would quickly have been rejected.

Our second reason for thinking that, in machines and mathematics, we have not reached a dangerous dead end is that thinking about risk has never been more widespread and has never been conducted at a higher level. The inadequacies of many existing approaches to risk have triggered a flourishing and fundamental debate, to which this book is a contribution.

Arguably, for the first time, risk is undergoing a comprehensive dissection, a process that simultaneously informs us in new detail and allows us to adopt and invent new techniques for risk sharing. Both in our ability to map and understand risk, and in our ability to build mechanisms that allow us to manipulate risk, far from being at a dead end, we are in an era of rich, astonishing, and (thanks to technology) possibly unprecedented progress.

Sharing the Risk

The idea of risk sharing is important but often neglected. As the voters in Orange County found out, a big loss, when spread among thousands or millions of people, causes only moderate or inconsequential pain for individuals. But where risks are concentrated, the results can be disastrous. Citibank nearly blew itself apart as recently as 1991 because it had made far too many loans to the real estate industry. It now carefully monitors its lending to avoid concentrations that could inflict similar damage. And it can use new financial instruments--credit derivatives, for example--that allow it to transfer to other banks, and to investors, risks that make it uncomfortable.

Consider an entrepreneur who has a 60 percent stake in her successful and fast-growing company but is overexposed to its fortunes and would be ruined if the firm failed. She would like to reduce that concentration by investing some of her paper wealth in other assets, and modern finance has come up with several ways to help her do just that. By giving up to other investors some of the upside potential of her stake, she can shelter her finances from an extreme negative outcome, such as her firm's going bust.

Risk sharing has a long history. Early financiers used the idea as the basis of today's insurance industry. Merchants and traders quickly learned that while they could be ruined individually by the loss of a single ship, they could quickly get rich if they joined together and formed fleets of ships that would not suffer unduly because of occasional wrecks. More than a century ago, mutually owned life insurance firms in America and Europe were able to extend the benefits of risk sharing to the masses, changing millions of people's lives.

A desire to manage risk and to profit from superior insight was just as prevalent among our ancestors as it is today. A random, simple, and intriguing example should suffice. In the fall of 1807, a group of middle-class women who lived in Arbois, a small town near Besancon, regional capital of the Jura, a rugged and little-known area of France that borders Alsace and Switzerland, undertook an amazing risk management transaction. The women ran a charitable concern, distributing food and material aid to poor people in the town and its surrounding villages. They laced their charity with a not-so-subtle dose of religion in the form of moral education. But theirs was a lay organization that functioned largely beyond the formal reach of the Catholic Church. The women displayed an acute sense of financial management in the conduct of their affairs. They sought out the best interest rates for any funds they collected, and they negotiated fiercely with local contractors to ensure that they were getting full value for their money when they purchased food.

In the course of their work, they traveled extensively in the town's environs. And they observed in 1807 that a rash of bad weather, following what had hitherto been a good growing season, had left much of that year's crop rotting in the fields. Instead of wringing their hands, they did something remarkable. They bought a futures contract that would lock in the price of grain that they would pay over the coming winter months. They paid 4 francs per measure for some 200 measures, rather than the 3 francs, 12 centimes that was the current market price. In that way, they knew that their charitable activities could continue in the harsh months when they contributed most in terms of welfare to the community. The fact that, had they been speculating, they would also have locked in a fat profit, probably did not occur to them. Today, the women can be imagined running their own investment club and, on the back of their successful trade, starring in their own public television investment show!

Better risk-sharing mechanisms could help many people to mute the effects of similar risks on their lives. For instance, if there were a market in housing derivatives (contracts that allowed us to bet on movements in house prices), someone worried about missing out on a big rise in prices could purchase options that would, in effect, pay out compensation to the nonowner. Similarly, owners could buy options that would give them downside protection in the event that the value of their house fell below the carrying cost of their mortgage.

Why don't such markets exist already? There are still plenty of practical barriers standing in their way. For instance, although the real estate market is far better understood these days, it remains relatively opaque, and prices are set rather arbitrarily. There is not yet sufficient reliable and regular price information to allow a meaningful derivatives market, particularly one that would be suitable for individuals. Also, there is no easily defined "standard house" that might be the basis for pro forma financial contracts. A home that one person thinks is a palace is an ugly pile to someone else. Similarly, before there could be a smoothly functioning market in "country risk," there would have to be a common definition of economic performance and some means of standardizing how each country measured its output.

It is likely, or perhaps inevitable, that such markets will be developed in the future, to satisfy the compelling power of risk sharing. Indeed, the idea of risk sharing--insurance--is central to our new framework for risk. We are not suggesting that insurance is the same thing as risk, or that, of itself, insurance is all that is needed for effective risk management. Our framework is more flexible than that. Rather, we want to suggest that if a risk can be understood, then, using modern financial techniques, it should be possible to devise ways of hedging/distributing that risk. And once that can be done, risks can be managed in two directions. Some people will be keen to take on more risk, and others will be glad to pay a premium to shed some or all of it. These responses to risk form the basis of a market in which a natural competition between buyers and sellers creates real and transparent prices. Where plenty of risks are traded with transparent prices, it is even possible for individuals and firms to "optimize" their risk exposures--that is, they can select those exposures that, for an equivalent level of risk, are likely to produce the highest returns, and they can sell their less efficient assets.

This is not pie in the sky or wishful thinking. In June 1997, for instance, a novel transaction launched in America attracted huge interest from investors around the world. Ask most investors if they would like to share the hurricane damage risk of a big insurer and they would probably balk--all that talk of "El Nino" might have been a tad unnerving. But consider the following bet that was offered by a leading insurer: you buy a one-year security that yields 11 percent (well above yields on bonds that carry similar credit ratings); in return, you buy into an 80 percent share of the risk that a single hurricane season will cause the insurer losses of more than $1 billion but only up to $1.5 billion. In other words, if the worst happens during a single hurricane season, you will lose all of your principal. Once the insurer has lost more than $1 billion, you will be on the hook for your share of the $400 million maximum exposure. Would you take this bet?

On the face of it, the answer is unclear. So before you decide, you might ask a few questions. How much have past hurricanes cost the insurer--in this case, United Services Automobile Association (USAA), a firm that specializes in insuring members and veterans of America's military and their families? Hurricane Andrew, the worst storm to hit Florida and the southern coastal states in recent history, cost USAA $555 million of losses in 1992. Fine; but how much would, say, the horrendous storm of 1926 cost USAA if it happened again today? Using a computer simulation to model that storm's impact, the answer is $800 million. There would be no loss on your stake. So the bet is beginning to look reasonably attractive. Indeed, do some fancier computer modeling to generate possible storms that could occur in the future, and let the virtual weather rage for 10,000 years, and you find that the likelihood of USAA's experiencing a loss greater than $1 billion is less than 1 percent. The chance of a loss of more than $1.5 billion is less than four-tenths of 1 percent. By now, you might be reaching for your checkbook.

That is just what some sixty institutional investors, including banks and mutual funds, did. From mid-June 1997 until the end of that year's hurricane season, they were avid watchers of the Weather Channel; for as long as the hurricane season lasted, they were exposed to a unique form of risk. Were USAA required to pay damages, some $313 million of investors' money was at risk; an additional $164 million was tied up in a second set of securities that carried a lower return but guaranteed the principal amount for less-risk-seeking folk. For a deal that started out trying to raise $150 million, that represented a huge success.

One reason for its success was that the attraction of the securities for investors went far beyond the probabilities of the single bet they were offered. Until such deals began to appear--the first widely syndicated offering was launched in December 1996 for a broad portfolio of risks underwritten by St. Paul Re, subsidiary of a big insurer based in Minnesota--investors could only gain exposure to the reinsurance (that is, the insurance of the existing insurance risk) market by buying the shares of reinsurers. However, that is an inefficient and unreliable way of capturing reinsurance risk.

Because they are uncorrelated to the returns from financial markets, the returns from pure reinsurance risks such as those offered in the USAA deal are highly desirable for investors who are otherwise limited to financial assets. When share and bond prices might be tumbling, chances are that reinsurance returns will hold up fine. Adding reinsurance risk to a portfolio should therefore significantly lower its overall volatility--which, after all, is one of the basic tenets of modern portfolio theory.

For this important reason, investment bankers have high hopes for the nascent market in so-called catastrophe insurance bonds, and the rest of us should take note. The technique expands the overall ability of insurers and reinsurers to spread risk around. At present, they play a sophisticated game of "passing the parcel" among professionals. But if they can offer pure insurance risks to investors, they can tap vast new demand while avoiding the unnecessary expense of buying cover from their competitors. In time, that should make insurance cheaper (because less volatile) and hence more ubiquitous. Insurance risk will, in effect, become a new asset class alongside shares, bonds, and commodities.

Another impact of catastrophe reinsurance has perhaps the greatest potential to change financial markets. At present, large industrial firms have a constant insurance dilemma. It would be too costly to insure every bus, truck, and piece of equipment they own. Consequently, many companies choose to "self-insure." An oil refiner, for example, will assume all of the risk that one of its plants might be destroyed by a disastrous fire, betting that, over time, the returns from its other assets will cover the loss more cheaply than if it were to buy continuous cover. Insurance bonds can change that. A refiner might choose instead to package some of its business risk and offer it, in the form of securities, to investors. It would, in effect, strip away that risk from its underlying operations, which would, in turn, affect the risk profile of its other issued securities. (By implication, the price of its shares should rise.) In essence, the financial technology creates reinsurance bonds can be used to develop a class of risk that was previously undiversifiable. Provided the risks are carefully defined and can be priced to attract investors, there should be no lack of demand for such bonds.

Anyone who can understand these related ideas is well on the way to grasping the essences of modern finance, even if the arcane language of derivatives and portfolio theory still seems foreign. In the chapters that follow, we will explore these ideas in more detail. But our next step moves backward. Before we explain a new framework for managing risk, we need to lay out the basic building blocks of risk and risk management--the pieces that we need if we are to understand and control risk.