The Uses and Abuses of Risk Management: How Men Learnt to Bet Against the Gods

Abstract:     
This 1997 review in the Times Literary Supplement (London) conjoins two books - the first, by investment banker turned finance historian Peter L. Berstein, is a history of the idea of risk, as it developed from Renaissance times through contemporary finance. The second, by the former editor of the derivatives journal Risk, Lillian Chew, is an account of contemporary financial derivatives and their uses and abuses. The point of linking these two books in a single review is to point out that the basic ideas behind today's financial derivatives - forms of forwards, options, swaps, and so on - are very old. The analysis of risk dates back to the Renaissance, and in particular to a debate between Pascal and Fermat over the issue of how to divide the stakes in an incomplete game. It is noteworthy that although the two mathematicians framed the issue as game theory, for Pascal, at least, the issue was very much theological as well - it had bearing on the formulation of his famous Pascal's Wager. Bernstein notes, however, that the systematic analysis of risk, while old, is not ancient - classical philosophy, science, and mathematics had no concept of risk analysis, which had its origins in medieval Arab algebra, and indeed, the very idea was seen as a challenge to God, divine will, and fate - it was, in Berstein's view, a key cultural component in the growth of the secular West. Chew picks up the story in the 1990s, with the development of sophisticated financial instruments which, no matter how sophisticated, still play off the basic concept of leverage with borrowed money - hence, for all the complexity, they either hedge against risks or magnify them. She offers several telling accounts of disasters with derivatives from the 1990s, such as the Orange County default. Her account of derivatives is lucid and remarkably accessible to the nonspecialist and much recommended even a decade later.

Keywords: Risk, finance, finance history, derivatives, swaps, forwards, futures, options, financial instruments, leverage, Pascal, Fermat

JEL Classifications: B10, B11, B15, B30, B31, G00, G10, G19, Z10

Accepted Paper Series