Dictionary of Financial Risk Management
by Gary L. Gastineau & Mark P. Kritzman

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 The Essentials of Financial Risk Management
   - Shifting Price or Rate Risk
   - The Risk Management Process
   - Liquidity Risks
   - Market Price Discontinuities
   - Credit or Counterparty Risk
   - Legal or Regulatory Risk
   - Suitability Risk
   - Tax Risk
   - Accounting Risk
   - Improving Settlements
   - Conclusion


Financial risk management is the measurement and the attempt to control trade-offs between risks and rewards in both profit-motivated enterprises and non-profit organizations. The vocabulary of financial risk management is the heart of the language of finance. Financial activities have grown more complex in recent years, and the terminology used by financial managers reflects that complexity.

This dictionary is designed for professional financial analysts and managers. It does not attempt to compete with such general reference works as the Barron's Dictionary of Finance and Investment Terms or The Encyclopedia of Banking and Finance. The present volume defines and describes many financial terms and concepts that these reference works do not attempt to cover, but it does not list or define at length many of the basic terms and concepts a financial analyst learns in introductory courses in finance or in daily experience in financial markets. The principal criterion for inclusion in this volume is that a word or phrase be something that a working finance professional might want to look up.

We list the vocabulary a sophisticated reader might encounter for the first time in an article in an academic finance journal. We include terms an analyst might encounter when reading the work of a fellow analyst who uses a different set of quantitative tools. We include extensive listings and profit/loss diagrams of new (or newly named) financial instruments. Common acronyms are enclosed in parentheses and printed in a bold font with each definition. To conserve space, acronyms are listed separately only if they would not otherwise be listed in the alphabetical listing by the first letter of the full term. We do not include the specialized terminology a securities analyst will encounter in covering companies in a specific industry. We have not attempted to duplicate all definitions used in legal or regulatory documents. While we have tried to capture common usage, definitions used in documentation prepared to International Swaps and Derivatives Association (ISDA) or British Bankers Association standards or by a regulator may not be consistent with our interpretation of common usage.

There is heavy coverage of derivatives, new products, and quantitative techniques that a finance professional might not have come across in his or her formal education, or in a CFA or CPA review course. The listing cannot be complete even within these boundaries; for, as Samuel Johnson said in the preface to his own dictionary, "...no dictionary of a living tongue ever can be perfect, since while it is hastening to publication, some words are budding, and some falling away."

Our purpose was not to produce the world's most comprehensive dictionary, but one that will be particularly useful to the working financial analyst and financial manager. Like Dr. Johnson, we have no illusions: "Every author may aspire to praise; the lexicographer can only hope to escape reproach, and even this negative recompense has been granted to very few."

We encourage users of this dictionary to reproach us freely if they feel a definition is inadequate, inaccurate, or absent. We want to make any future versions more useful.

Gary L. Gastineau
Mark P. Kritzman


In the spring of 1992 - shortly after I joined Swiss Bank Corporation to prepare financial risk management research material for customers - the great Chicago flood shut down Swiss Bank's offices in the Board of Trade building, forcing me to work at a trading desk in New York.

While there are advantages to an active trading environment, maintaining a high degree of concentration on analysis and writing is not one of them. I had planned to assemble a dictionary of financial risk management terminology eventually, but my limited attention span on the trading floor was more compatible with writing definitions one paragraph at a time than with more complex research projects.

Once the first draft of the dictionary was completed, my colleagues at Swiss Bank were helpful and supportive in checking definitions for accuracy, suggesting additional terms and, in some cases, mentioning new topics that should be examined. I received extensive help and support from Perry Beaumont, Prescott Beighley, David Dubendorfer, Arash Farmanfarmaian, Gerald Herman, Phillip Nehro, David Purcell, Glenn Satty, Sebastian Steib, Joseph Troccolo, and Eric Weinstein.

Additional suggestions and criticisms from Charles Baubonis, Rolf Böni, Edward Chambliss, Thomas Curran, Steven Depp, Jeffrey Diehl, Keith Fishe, Michael Gorham, Thomas Hickey, Gordon Holterman, Claire Leaman, Suzanne Martin-Reay, Satish Nandapurkar, Michael Reveley, Barry Seeman, Sam Serisier, Jim Singh, Christophe Trefalt, and David Weiner are also gratefully acknowledged.

On the production side, Albert Gerra and Masatsugu Takahashi were helpful in establishing the basis for the first edition's graphics. Elizabeth Thompson prepared and edited the text and the graphs for the first edition with extraordinary skill and patience.

As holder of the copyright on the first edition, Swiss Bank has granted permission to incorporate the original definitions in new hard copy and electronic editions - in recognition of the fact that the vocabulary of financial risk management continues to grow.

There are three major new contributors to this edition. Coauthor Mark Kritzman's definitions of terms used on the quantitative side of finance help round out the lexicon. Many readers will find his additions to the breadth of coverage extremely useful. Don Rich contributed an unusually large number of new terms and helped Mark and me define them. His insights into the mathematical tools of finance have been invaluable. My associate, Margaret Shergalis, has taken on the production and graphics responsibilities with skill and enthusiasm. She has taken full advantage of the advances in desktop graphics technology and has helped knit together the numerous cross references. Others who have checked part or all of the revised manuscript for accuracy, contributed new terminology, or provided other assistance include James Angel, Michael Bickford, Nenette Carter, Don Chance, George Chow, David DeRosa, Ognian Enchev, Frank Fabozzi, Stephen Figlewski, Jack Clark Francis, David Helson, Andrew Kalotay, Ira Kawaller, Robert Kopprasch, Sandra Lee Kurecki, Robert Loffredo, Chip Lowry, Richard Mikaliunas, Paul O'Connell, Marguerite Oneto-Tatum, Phil Rivett, Charles Smithson, and Joseph Stefanelli.

I would also like to acknowledge the kind and useful comments of many reviewers and readers who have called to suggest additional terms for inclusion and to point out the inevitable errors that creep into any work of this nature. Particular thanks are due to John F. Marshall, Executive Director, International Association of Financial Engineers and Professor of Financial Engineering, St. John's University for his support and encouragement.

Gary L. Gastineau

The Essentials of Financial Risk Management

"New financial instruments are not created simply because someone on Wall Street believes that it would be "fun" to introduce an instrument with more "bells and whistles" than existing instruments. The demand for new instruments is driven by the needs of borrowers and investors based on their asset/liability management situation, regulatory constraints (if any), financial accounting considerations, and tax considerations."
- Frank J. Fabozzi and Franco Modigliani

Many of the derivatives disaster news stories of 1994 and 1995 seem to take issue with Fabozzi and Modigliani's comments. Some financial instruments may have been bought and sold for "fun" (or profit) and with limited regard for the sensible reasons advanced in the quotation.

Criticisms of financial markets and instruments may include complaints about sales practices, accusations of speculation by managers whose mandate is to reduce risk, predictions of systemic meltdown of markets, and laments over the complexity of many new instruments and techniques. Some of these criticisms are justified, but correctable. Others, specifically the forecasts of market meltdown and complaints over complexity, are generally off the mark.

We leave the sales practice and speculation issues to others. The facts of each case of inappropriate use or inappropriate instruments will be decided by negotiation between the parties, by regulators, or by the courts. While we avoid comment on the highly specific problems encountered by a handful of financial market participants, we can provide plenty of comfort in these introductory comments that the financial system is not at risk. Furthermore, one of the primary purposes of this volume is to take some of the mystery and complexity out of financial markets and instruments. On both these points, much confusion clears when an observer remembers that the principal applications of most financial instruments are the funding and risk management of an enterprise.

We attempt to distinguish among various kinds of risk and discuss how they affect the soundness of the financial system. We also explain how financial intermediaries provide financial risk management products and services to a variety of institutional investors, corporations, and governments around the world - without necessarily taking on risk themselves.

The risk transfer process is far simpler than much recent commentary suggests. The market risks that financial intermediaries exchange can be broken into basic components, which are readily understandable and manageable. Some non-market risks are more difficult to manage. The latter are an appropriate topic for public policy debate and political or regulatory resolution. The policy issues are clear, and, given appropriate political will, can be resolved - with an attendant improvement in public confidence in financial markets and institutions.

Shifting Price or Rate Risk

The market risks that financial intermediaries reallocate are price, interest rate, and currency exchange rate risks. Price and rate risks come in a variety of flavors, but all markets share two features:

1. Any movement in a price or rate will be undesirable to some market participants. The popular name for exposure to an undesirable market movement is market risk.

2. One person's risk is usually someone else's potential reward. By exchanging packages of risks and rewards, both parties to a risk management transaction can be better off. To draw an illustration from a prototypical price risk environment, consider a new issue of common stock from the viewpoints of three key market participants:

-the corporate issuer that sells the new stock into the marketplace,

-the asset manager or investor who buys the stock on the initial offering or in the secondary market, and

-the market maker who trades the stock in the secondary market as the needs of asset managers and investors change over time.

The figure illustrates each market participant's notion of risk. Each is exposed to financial loss - accounting loss or opportunity loss - but each views the possibility of loss from a different perspective.

Starting our examination of risk with the market maker, we find a classic risk position. He is exposed to any large price change. Nothing could make him happier than a regular alternation of buyers who take his offer and sellers who hit his bid. However, by posting a continuous bid and offer, the market maker exposes himself to potential loss if the stock price moves very far in either direction. If the market falls, the market maker will be called upon to buy more stock, and his inventory will decline in value. If the price of the stock rises, the market maker will be called upon to deplete his inventory of stock. With a reduced inventory, the market maker's participation in the rally will be limited. He might even sell stock short to meet market demand. As a short-seller, the market maker will face out-of-pocket losses in a market advance. The market maker's position is disadvantageous - risky - if prices fall or rise sharply.

The stock's issuer and the investors who hold the stock in portfolios view risk from very different perspectives. Each views risk from only one side of the market. The issuing corporation views risk as exposure to a rising market. If the corporation had waited to issue the stock until after the market rise, it could have obtained the same amount of cash for fewer shares. For the issuer, risk is a stock price that rises after it sells stock. If the stock price falls tomorrow, the issuer's sale of the stock today will appear fortuitous.

The asset manager or investor who buys stock as a portfolio investment sees risk as the possibility of a stock price decline. If prices drop tomorrow, the investor will wish she had waited to buy. Of course, a stock price that rises after purchase is a favorable development for the investor.

In this simplified picture of the stock market, participants have no obvious way to trade some return potential for a reduction in risk. In the real world, risk management products and services provided by options and futures exchanges and by financial intermediaries can help to reduce risks.

Many market participants are willing to trade some of their opportunity to profit from favorable price behavior for protection against an adverse price move. The essential role of options and futures markets and financial intermediaries is to help asset and liability managers - investors and issuers - modify risks and rewards so that some or all of the effects of price movements are transferred to others. Actual or opportunity losses often cause more pain than an equivalent profit causes pleasure. Consequently, many market participants are willing to give up sizable profit opportunities in exchange for protection from risk. This normal, human aversion to risk creates the market for financial risk management products and services.

In the stock market or in virtually any other price or rate risk situation, combinations of swaps, options, forward or futures contracts, and traditional financial instruments can reallocate participation in price or rate movements in a variety of ways. When a single market or market sector is integrated with financial instruments and markets around the world, the opportunities for risk and return reallocation become extremely complex. However, the basic principle behind all financial risk management is the exchange of one set of risks and rewards for another set that fits a market participant's utility preferences more closely.

The essential characteristic of all financial management is the modification of the natural risk/reward position of an issuer, an investor, a market maker, a bank, a public treasury, or a non-financial corporation. The manager evaluates instruments and measures their ability to neutralize unwanted risks or enhance returns. The outcome of this process should be a financial structure that reflects the preferences of the organization's constituents.

The Risk Management Process

The most complicated risk management structure can be broken down into components that any high school graduate should be able to understand thoroughly. Ph.D.s with various specialties - the "rocket scientists" described in the press - play an important role in financial risk management. Nonetheless, a Ph.D. is not necessary to understand any single aspect of financial risk or to evaluate the overall effectiveness of risk control.

In our simplified stock market example, options can help the issuer trade some of the possible opportunity gain from a falling stock price for protection from the opportunity loss associated with a rising stock price. Correspondingly, the investor can use options to exchange some of her upside potential for downside protection. Convertible bonds and some equity offerings like preference equity redemption cumulative stock (PERCS) have risk-reallocating option provisions embedded in the security itself. The market maker can buy options for protection from large price movements in either direction.

If price or rate risk were the only kind of risk, there would be no controversy over the market in risk management agreements of any kind. After all, consenting adults are simply exchanging cash flows, and they expect these exchanges to improve or protect their financial well-being.

When customized risk management contracts transfer financial risks from one party to another, the process often leads to the mistaken view that these instruments are used exclusively to reduce some specific risk element, and that the financial intermediary who creates the product or facilitates the risk exchange is acting as a reservoir for risk absorption. Actually, the creator of the product is primarily a provider of liquidity. The financial intermediary typically disaggregates, repackages, and redistributes risks and their corresponding rewards to other market participants.

For example, one contract may insulate a pension or profit-sharing plan from a downside stock market move. Another contract may transfer equivalent stock market exposure to an investor who expects substantial cash inflows in the near future, and who wants immediate participation in stock prices. The intermediary who handles the transfer is not taking any increased stock price risk.

The financial intermediary who sells risk management products is the ultimate risk manager, but not the ultimate risk-taker. In addition to managing risk balanced 60;books61; in one or a variety of markets, the financial intermediary is sharply attuned to the credit of counterparties (in cases where credit is a significant issue). Cash securities markets and exchange-traded option and futures contracts are used extensively by the providers of liquidity to manage the risks of their customer positions. The financial intermediary - by linking specific customer needs through cash markets and exchange-traded and OTC derivatives - provides liquidity to international capital markets.

Liquidity Risks

Our stock market example assumes that the market maker was prepared to make a market, and our discussion of risk management has implicitly assumed that appropriate financial instruments can be traded. In reality, not all packages of risks and rewards are freely or actively traded. Many financial markets are characterized by extreme illiquidity. Examples of illiquid markets include real estate, small-capitalization stocks, and a variety of debt contracts between financial institutions and consumers (including accounts receivable, credit card debt, and auto loans).

Financial market innovations have sharply reduced many liquidity risks in recent years. Real estate investment trusts, publicly traded limited partnerships, and several other vehicles have made modest steps toward improving liquidity in real estate markets. Small-capitalization stocks have some way to go before acceptable liquidity is achieved, but exchange-traded contracts like the S&P midcap SPDRs, options, and futures are a small step in the right direction.

Probably the greatest achievement in improving the liquidity of financial instruments has come in the area of securitization. Credit card debt, automobile paper, and consumer loans have joined mortgages as prime candidates for securitization. A bank or other loan originator is no longer committed to holding these instruments for the life of the loan. They can be traded in securitized form as easily as any traditional security. Government affiliates such as Ginnie Mae, Fannie Mae, and Freddie Mac have played essential roles in mortgage securitization, but most of the steps taken to improve liquidity have occurred at the initiation of private market practitioners searching for liquidity or trying to earn a profit by providing it. Fortunately, most market structures and regulations have been sufficiently flexible to permit the introduction of new securitized instruments.

The phenomenon of securitization illustrates what market forces can accomplish in an environment that permits innovation. However, innovation has not yet eliminated market price discontinuities, a particularly severe liquidity problem.

Market Price Discontinuities

The classic market of economic theory is a call auction market where all market participants meet in one place at one time to arrive at a market clearing price through open outcry of bids and offers. In agricultural societies, these markets were often held annually, at harvest time, but the development of futures contracts has spread commodities trading over the year. Financial markets have traditionally been open each business day. As volume in many markets has grown, efficient continuous markets - some operating on a twenty-four-hour basis - have become the norm in currencies and in a few widely held securities.

Implicit in many naive risk management calculations is the doubtful assumption that most markets are continuous from one trade to the next, with only gradual price changes. The October 1987 stock market break was a dramatic challenge to the assumption of market continuity.

In general, market forces have dealt effectively with the reallocation of price and rate risk and have provided liquidity through securitization and the allocation of capital to market making. Market forces have not yet dealt adequately with the risk of market discontinuities. Ironically, the mechanism for dealing with this problem is in place52;the option market.

Anyone willing to accept downside discontinuity risk can sell a put option. Unfortunately, regulation of securities option position limits often restricts the number of exchange-traded option contracts any market participant can buy or sell. As a result, large investors who want to buy or sell protection against market discontinuities are denied meaningful access to the exchange-traded option markets. Listed option markets, in turn, often lack depth because of the virtual absence of large investors. The thinness of the option market denies all investors opportunities to use options to build automatic risk adjustments into their portfolios at a reasonable cost. Recent liberalization of position limits in the United States and several European countries should improve option market liquidity over time.

Financial intermediaries have provided some help in bringing the providers of this specialized form of liquidity to buyers who value it highly, but an intermediary57;s role is limited if both sides of the discontinuity risk exchange are not accessible. Financial intermediaries are not in the business of betting their companies on the proposition that October '87 will never happen again. So-called dynamic hedging, or replication of option risk and return patterns with futures and cash market trades, may occur on the margin, but major financial intermediaries serve by redistributing financial risk, not by absorbing it. Until position limits and other restrictions on the widespread use of option markets are eliminated, market discontinuities will be an unnecessarily large short-term risk to the stability of the financial system.

Credit or Counterparty Risk

Some of the concern regulators and the financial press have expressed over the state of the market in risk management instruments has centered on the issue of credit or counterparty risk. Credit evaluation will never be an exact science. However, appropriate price or rate discounts and premiums that reflect differences in credit quality can adjust for reasonable differences in credit risk exposure.

Financial intermediaries closely scrutinize the credit risk element in a risk management agreement, because most intermediaries have experienced sizable credit losses in recent years. The credit exposure of a risk management agreement depends on the type of contract and on the underlying markets, as well as on the credit status of the counterparty. In most instances, credit issues are manageable if both parties are imaginative and the incentive for undertaking the risk management agreement is strong enough.

To encourage financial and non-financial parties to enter into risk transfer agreements that improve market liquidity, public policy often helps counterparties to reduce unnecessary credit risks. Netting arrangements and collateralization agreements made in good faith are often protected in the event of a counterparty's subsequent financial distress. One justification for this policy is that an appropriate risk transfer agreement can alleviate or even prevent distress. The growth of netting and collateralization have combined to reduce concern over credit issues to a manageable level.

Some regulations applied to hybrid derivatives contracts and some bankruptcy policies create credit and counterparty problems where none need exist. Clearing up confusion and eliminating inappropriate regulation will require an internationally coordinated effort. As an example of movement in the right direction, U.S. bankruptcy law reform has sharply reduced many credit and counterparty risks when U.S. law applies. The U.S. example and competition from the U.S. has pushed the U.K. government in a similar direction.

Legal and Regulatory Risk

Legal and regulatory risk is one of the greatest obstacles to effective functioning of the market in risk management instruments. In the notorious case of Hazell v. The Council of the London Borough of Hammersmith and Fulham and Others, the House of Lords held that, as a matter of public law, entering into swap transactions was beyond the legal capacity of the local government counterparty. This case is the kind of financial land mine that reduces the efficiency of the market in risk management products, and endangers the financial structure. The solution is to clarify the legal and regulatory framework so that parties to risk management agreements need not fear similar events in the future.

Such events impose a "tax" on the financial system, which is reflected in wider trading spreads and in a reluctance to trade with some parties that need to transfer risks. Financial intermediaries can manage market risks, but they cannot protect themselves from legal and regulatory risks except by declining to trade.

Another extremely important legal and regulatory "tax" is the cost of keeping the financial system afloat. Major financial firms rarely create public distress when they fail. Their problem positions are transferred to a stronger competitor or divided among several firms. The cost of their breakup and absorption is spread among former competitors and major creditors. Often, customers outside the financial industry are protected at the expense of the financial industry's survivors.

The demise of much of the savings and loan industry in the U.S. is an example of a problem too large to be absorbed by the remaining companies in the financial industry. The S&L crisis was essentially caused by a regulatory and incentive structure that created a moral hazard: The system rewarded management handsomely if it took huge risks that paid off, and protected depositors from loss if management's high-risk business strategies failed. Depositors had no incentive to limit management's risk-taking. Some simple changes in the regulatory structure could have prevented a large part of this fiasco. Unfortunately, the legal and regulatory framework changes slowly.

Partly in response to the S&L example and partly in response to widely expressed concerns, risk management transactions have become a popular subject for study. A sound financial intermediary should not be reluctant to meet with groups studying markets or to face any other open-minded inquiry. Broad and deep knowledge of these markets is the world financial structure's best protection from groups that articulate their conclusions before they ask questions.

Suitability Risk In the aftermath of the derivatives disaster stories of 1994 and 1995, a corollary to legal and regulatory risk - suitability risk - has been an item of some concern. The key issue is what responsibility, if any, a dealer in financial instruments has for the decision of a customer to take positions that expose the customer to inappropriate risks. Brokers and dealers have long had responsibility in many markets for the suitability of what they sell to individual investors, but there have been few special rules other than obvious (but important) prohibitions against fraud to protect institutional investors. Any rule that goes beyond a reiteration of the law on fraud will probably increase a dealer's costs and reduce market efficiency. The customer will ultimately pay for any suitability protection imposed from outside the market itself.

Tax Risk

The S&L situation is not the only case where risk reduction and effective risk management have been discouraged by government policy. In the Arkansas Best case, the U.S. Supreme Court affirmed an Internal Revenue Service position that certain losses on risk-reducing (hedging) positions were capital losses, and hence could not be offset against ordinary income. This ruling generated very little incremental tax revenue, but it encouraged corporations to retain risks they would lay off in a tax-neutral environment. A Fannie Mae tax court decision eliminated some of the tax problems caused by Arkansas Best, but other tax issues remain in the U.S. and elsewhere.

Accounting Risk

The Securities and Exchange Commission's opposition to matching unrealized or partially realized risk management gains and losses for accounting purposes creates uncertainty about the financial reporting impact of risk management solutions that make economic sense. In the U.S., and to a lesser extent in other countries, sensible risk management policies often conflict with results reported on a corporation's tax return, income statement, or balance sheet. No comprehensive solution to this problem is imminent. The Financial Accounting Standards Board (FASB) has issued a new derivatives accounting standard (Statement of Financial Accounting Standards No. 133) that increases disclosure of derivatives positions including those used in risk management and requires marking most of these positions to market for U.S.-based companies. International accounting standards-setters are moving toward a more comprehensive mark-to-market standard. Directionally, these changes are appropriate, but the specific implementations are not always adequate.

A variant of accounting risk is disclosure risk. While disclosure is generally desirable, U.S. companies are under pressure to disclose many details of their risk positions and risk management activities. Too much disclosure of specific risk management positions that must be rolled forward can encourage other market participants to trade against a company's disclosed position. SEC derivatives disclosure requirements place too much emphasis on the structure of a position and too little emphasis on its function. SEC disclosure requirements may or may not lead to useful revelations. The reporting corporation retains the ability to obfuscate if it chooses to do so. In their search for workable solutions, the FASB and the SEC need to revisit the thorny issue of marking liabilities as well as assets to market. Some of the most important developments in risk management in the late 1990s have come in accounting and disclosure and more changes are necessary.

Improving Settlements

The most important improvements in systemic risk reduction since the 1992 edition of this book have been enhanced credit risk management through improved collateralization and netting and the reduction of settlement risk. Securities and futures clearing houses and central banks have been the leading proponents of shorter settlement periods and new systems to reduce settlement exposure, particularly in stock and currency markets.

The greatest systemic risk in the 1987 market crash in the U.S. was not the direct impact of market losses, it was the risk that trades made before and during the decline would not settle five business days later and that funds transfers (which took an additional day) would not occur. In 1995, following the recommendation of a G-30 study that predated the crash, the settlement interval for stock transactions was reduced to three business days. The adoption of same day funds settlement (SDFS) in early 1996 eliminated the extra day for funds transfers. SEC Chairman Arthur Levitt now advocates same day settlement for stock transactions by the end of the century. A year or two of slippage in this goal seems likely, given the system demands of year 2000 compliance, but locked-in trades and settlements are inevitable.

Cross-border fund transfers (currency settlements) have been the object of many efforts to streamline procedures and reduce credit exposures. Two major multilateral currency payment netting and settlement systems are in early stages. The level of attention given to currency settlement risks suggests that the remaining problems will be solved. Within a few years, settlement risk should cease to be an issue in mature financial markets.


The central bankers' and clearing houses' efforts on settlements - and progress on payment netting and collateralization - must extend to securities regulation, accounting rules, and tax policy. The SEC, the CFTC, the IRS, and their counterparts in other countries often send conflicting signals. The SEC has played a major role in shortening the stock settlement period from a week to three business days, but its accounting, disclosure, and option policies have been slow to adapt to the financial system's requirements. The IRS ruling that excluded swaps and other notional principal contracts used by tax-exempt institutions from the unrelated business income tax removed an important obstacle to effective financial risk management by pension funds and endowments. At the same time, the Fannie Mae decision does not eliminate all tax obstacles to effective risk management by taxable entities. The IRS has been slow to issue regulations under the 1997 tax law revision.

It is unfair and unnecessary to assign blame for weaknesses in the global financial structure to the regulatory agencies, the legislature, or the executive branch of any government. It is both fair and reasonable to expect their help in making improvements. The world's central bankers are moving toward system risk reduction with settlement procedure improvements that risk managers and financial intermediaries cannot achieve on their own initiative. The central bankers' example is a model for others.

It is common to address concerns for the stability of the financial system by emphasizing strict capital requirements and increased capital charges for certain banking and securities transactions. Capital adequacy is certainly important, but no amount of capital can substitute for intelligent management of a firm's business risks in a legal and regulatory framework free of unnecessary hazards. Even the best capital rules create inappropriate behavioral incentives as they oversimplify risk analysis to standardize capital charges. Capital rules are no substitute for a thorough understanding - by both managements and regulators - of the risk characteristics of diverse transactions.

The only viable legal and regulatory framework for financial markets is a system that rewards intelligent decisions with profit, encourages constructive innovation, and discourages risk-taking for its own sake. Capital requirements play a role in ensuring the integrity of the market, but rigid proscriptions stifle innovation. Improving the clarity and rationality of commercial, bankruptcy, and tax codes to give the parties to financial contracts a clear picture of their non-market risks will do more than stricter capital rules to remove unnecessary risks from the global financial structure.

© Copyright 1996, 1999 Gary L.Gastineau. First Edition. © 1992 Swiss Bank Corporation.

The American Stock Exchange (“Amex”) has been granted by Frank J. Fabozzi Associates (“Fabozzi”), the publisher of the “Dictionary of Financial Risk Management” (the “Dictionary”) and by Gary L. Gastineau and Mark P. Kritzman, the authors of the Dictionary, the exclusive right to publish current and future editions of the Dictionary on the Internet subject to the terms of an agreement between the parties. The information contained in the Dictionary is provided "as is" without warranty of any kind. Because of the possibility of human and mechanical errors as well as other factors, neither the Amex nor the Publisher or Authors are responsible for any errors or omissions in the information. Neither the Amex nor the Publisher or Authors make any representations and disclaim all express, implied and statutory warranties of any kind to any users and/or any third party, including any warranties of accuracy, timeliness, completeness, merchantability and fitness for a particular purpose.