Managing Downside Risk

Abstract

Managing Downside Risk, edited by Frank Sortino and Stephen Satchell, 2001, Oxford, UK: Butterworth-Heinemann, Quantitative Finance Series, 267 pages main topic of this volume, covering both theoretical and practical profiles, is of great interest: downside, asymmetric risk in financial markets. This is because of the implications that these predominant new modeling paradigms have in terms of financial risk identification, measurement, and management. book is divided into two separate sections: part 1 (Applications of Downside Risk) and part 2 (Underlying Theory). comprehensive (although heterogeneous) series of contributions-from professionals, practitioners, and academics-on the concept of downside risk offers a survey of the ways that such risk can be defined and dealt with, based on a half century of theoretical developments. Frank Sortino, one of the editors of the book, authors the first chapter (From Alpha to Omega), which is mostly devoted to providing a historical excursus of the debate leading to the schism between the mean-variance framework-whose definitive importance is firmly acknowledged-and competing approaches. Asymmetry of uncertainty is emphasized and minimum acceptable return (MAR) is treated in the chapter, together with the importance of the stochastic dominance rules. This is in order to reveal some of the faults coming from basing decisions only on the first and second moments of the probability distributions, as in the modern portfolio theory (MFT). Sortino's contribution serves as a useful introduction to the book, for it anticipates some of the matters treated by the following authors, and some of their conclusions. We first mention Hal Forsey (chapter 4, The Mathematician View: Modelling Uncertainty with the Three Parameter Lognormal), who is the author, with Sortino, of the software that comes with the book (the Forsey-Sortino model). Forsey describes the Pension Research Institute model designed to estimate downside risk by providing some measurements based on the MAR. Joseph Messina should be mentioned as well (chapter 6, An Evaluation of Value at Risk and the Information Ratio (for Investors Concerned with Downside Risk)), for his discussion of the adequacy and usefulness of VAR and IR measures, when investor goals are defined in terms of MAR. Other contributions included in the second part of the book are closely linked to Sortino's paper, e.g., the one by Leslie Balzer (chapter 8, Investment Risk: A Unified Approach to Upside and Downside Returns), a magnificent synopsis of criticalities concerned with traditional (commonly used) and innovative risk measures, or the one by Auke Plantinga and Sebastian de Groot (chapter 10, Preference Functions and Risk Adjusted Performance Measures), evaluating R-adjusted performance measures and preference functions, as alternative approaches to rank investment opportunities for individuals. …