A very brief history of risk management

Risk management is not exactly a new idea. One of the earliest examples of risk management appears in the Old Testament of the Bible. An Egyptian Pharaoh had a dream. His adviser, Joseph interpreted this dream as seven years of plenty to be followed by seven years of famine. To deal with this risk, the Pharaoh purchased and stored large quantities of corn during the good times. As a result, Egypt prospered during the famine. Similarly, in Matsya Avatar, Lord Vishnu asked Sage King Satyavratha to put one pair of each species safely on board the ship that would help them escape the deluge the Lord was planning to unleash. This ensured the perpetuation of different flora and fauna.

The modern era of risk management probably goes back to the Hindu Arabic numbering system, which reached the West about 800 years back. The Indians developed the system while the Arabs played a key role in spreading the knowledge to the west. Without numbers, it would have been impossible to quantify uncertainty. But mathematics alone was not sufficient. What was needed was a change in mindset. This happened during the Renaissance, when long-held beliefs were challenged and scientific enquiry was encouraged. The Renaissance was a period of discovery, investigation, experimentation and demonstration of knowledge. As theories of probability, sampling and statistical inference evolved, the risk management process became more scientific. Many risk management tools used by traders today originated during the 1654-1760 period. The pioneers of the Renaissance age included Luca Paccioli, Girolamo Cardano, Galileo, Blaise Pascal, Pierre de Fermat, Chevalier de Mere and Christian Huygens.

Strangely enough, gamblers played a major role in the advancement of probability theory. A landmark problem they tried to solve was how to estimate the probability of a win for each team after an unfinished game of cards. These ideas were later supplemented by advances such as the regression to the mean by Francis Galton in 1885 and the concept of portfolio diversification by Harry Markowitz in 1952.

More sophisticated risk management tools have been developed in recent decades. These include models for estimating value-at-risk, volatility, probability of default, exposure at default and loss given default. A landmark event in the history of risk management was the development of the Black Scholes Merton Option Pricing Model in 1973. Thanks to better understanding of various domains, quantitative models and the availability of computing power, it has become possible to quantify risk to a large extent. Yet, as the recent sub prime crisis has demonstrated, these numbers are of little use if mature human judgment is not exercised, by the people involved.