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Red-Blooded Risk: The Secret History of Wall Street

ISBN: 978-1-118-04386-8
432 pages
October 2011
US $34.95 Add to Cart

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Business & Finance


October 05, 2011
Hoboken, NJ

Red-Blooded Risk

In emotional terms, thin-blooded people are motivated mainly by fear, hot-blooded people by anger and other passions—or even merely thrills—and cold-blooded people by greed. Red-blooded people feel anger, fear, and greed like anyone else, but understanding successful risk taking is a matter of calculation, not instinct. Red-blooded risk managers utilize specific mathematical techniques to turn any situation into a system with clearly delineated risks, dangers, and opportunities; optimize the risks for the best possible outcome; and arrange things so both dangers and opportunities make the maximum positive contributions.

In RED-BLOODED RISK (Wiley; October 2011; $34.95; 978-1-1180-4386-8; Hardcover; Also Available in Ebook Formats), Aaron Brown, risk manager at AQR Capital Management, offers a treatise on the theory, history, and practice of managing risk, as well as advice for the calculated risk-takers who need precise quantitative guidance that will help separate them from the rest of the pack.

The book follows several themes, which build and interconnect to provide a diverse picture of risk:

The Secret History of Wall Street: In the 1970s, young mathematicians (soon to be known as “quants”) were disillusioned by what they saw as the hypocrisy of many conventional quantitative thinkers in that they were unwilling to bet personally significant stakes on the results of their analysis. They invented a new way of looking at probability and set out to prove it in the ultimate testing ground of odds-making: Las Vegas.

Once there, the quants turned conventional wisdom about gambling on its head. People said you can't beat the house, yet the quants managed to beat blackjack and other casino games. People said you needed a lifetime to learn poker, yet the quants' aggressive mathematical tactics swept the table against the best players in the world. Then they turned to sports betting, overturning the business model and squeezing out local bookies with a global organization that matched bets without taking risk.

Armed with their theories and experience, the quants raised their sights and headed to Wall Street, determined to replicate their success. Finance was a tougher challenge than gambling, but by the mid-1990s, they had remade Wall Street as thoroughly as they had remade Las Vegas. That transformation went unnoticed by the bond salesmen and investment bankers who ran Wall Street, as well as by academics, regulators, journalists, and investors; yet these changes caused both the greatest wealth creation event in the history of the world and the financial disasters witnessed in its wake.

The Theory and Philosophy of Risk: Brown tackles the paradox of the two opposing camps of probability: frequentists, whose fundamental definition of probability rests on repeatable experiments, and Bayesians, whose foundation is subjective degree of belief, and how they have fused together in practice. He also considers the importance of Pascal’s wager and how it relates to risk, the seven principles of risk management, efficient markets, exponentials and how risk-avoiding people often use them recklessly, and the work of Harry Markowitz and John Kelly in the 1950s.  

The Story of Money: Since money is essential to managing risk, Brown examines it in depth, starting with a discussion of the idea of property and how it has led to exchange. Until someone owned something, nothing could be exchanged. He then looks how money has transformed, from the development of gambling and equal-value exchange in the Upper Paleolithic Era to the creation of paper money by the Romans to how the American colonists created low-quality money to pay for the Revolutionary War and the creation of futures contracts around 1850, when boards of trade appeared in the major cities. He then argues that derivatives are the new money in the modern economy and addresses this in the context of the fall of Lehman Brothers. Brown asks “If paper money will fade to insignificant economic importance to be replaced by derivative-like arrangements, how will this affect the nature of risk taking?”

What a Risk Manager Does: Incorporating his own experience, Brown addresses how risk management is organized within a finance-related company, from a front-office risk manager, including sales and trading, asset management, retail financial services, institutional financial services, lending and investment banking, to back office, which involves compiling what has become a huge volume of risk reports for decision makers, regulators, and investors, and the middle office, which is designed to create two information loops in the bank, focusing on information that is vital to companywide risk.

The book assesses the tools of the trade, including Value at Risk (VaR), which almost all financial risk managers use as a primary component of their processes; stress testing and scenario analysis, which concentrate on dramatic external events that could harm the firm; and the employment of mathematical techniques to identify losses that occur from unexpected combinations of events that are not individually unlikely. He also explores why risk manager failed to prevent the financial crisis and provides his list of risk “unspeakable truths,” including risk managers should make sure firms fail; there’s good stuff beyond the VaR limit; and risk managers create risk.

The Illustrated Side of Risk: Brown has teamed up with renowned manga artist Eric Kim, who has provided multiple comics, from depicting the story of money and applying VaR to surviving in the jungle to the ongoing saga of red blood (the heroine who understands risk) and the other bloods (blue, cold, hot, thin and risk manager blood sucker, among others) who fall prey to taking too much risk out of greed or arrogance or not enough out of fear.

Risk taking is not just a quantitative discipline; it is a philosophy of life. RED-BLOODED RISK demonstrates how embracing risk taking opportunities that offer a positive edge in the long run will result in expected outcomes.