Faculty and Research

International Finance

Kenneth Froot's research spans a variety of topics in international finance. With regard to securitization of insurance risks, particularly those linked to catastrophes such as windstorms and earthquakes, he is exploring the feasibility of securitized reinsurance, the quantitative and qualitative properties of returns on insurance exposures, and the institutional pressures that exist in the marketplace today. Froot is currently organizing research conferences on these topics. A second focus is risk management for corporations and financial institutions. Here, Froot's research seeks to identify appropriate goals and implementation schemes for risk management programs, particularly in financial institutions in which profitability depends critically on the ability to manage risk. Finally, regarding asset allocation for investors, Froot is examining the impact of investor horizons on optimal currency hedge ratios and, in particular, on prudent asset allocation strategies. Other work in progress includes an inquiry into how stock prices are affected by the countries in which stocks are traded.

Distribution of Insurance Risk

Risks that originate with natural disasters such as hurricanes, earthquakes, and floods are substantial enough to exhaust the capital and surplus of insurers and reinsurers many times over. Despite significant advances in the efficiency of risk allocation in the financial system, these catastrophic risks are still largely allocated through brokered insurance and reinsurance agreements. Faculty involved in the Global Financial System project who are pursuing this stream of research, Kenneth A. Froot and Sanjiv R. Das, are studying primarily the institutional arrangements for distributing catastrophic risks. In addition to comparing public and private mechanisms for distributing and analyzing various securities designed to aid in the allocation or hedging of catastrophic risk, they have undertaken an empirical investigation of the pricing of catastrophic exposures. The latter work reveals the historical returns reinsurers have realized from writing catastrophic risks and provides a basis for testing hypotheses about the formulation of catastrophic cover prices.

Risk Capital and Capital Allocation

For the principal financial firms, proper risk control is imperative, and capital allocation exerts an impact on a variety of decisions related to: accounting for the profitability of individual businesses; entering or divesting businesses; determining profit-related employee compensation; choosing from among alternative organizational forms; and managing overall risk. Historically a top-down concern, principally of the CFO/treasurer, with the growing importance of off-balance sheet (derivatives) positions, these issues have also fallen squarely into the domain of the "risk manager," a bottom-up perspective. Of central importance is the need for a unifying framework to reconcile the two perspectives that can be applied on a firmwide basis. The determinants of the costs of risk capital and possible approaches for measuring and allocating these costs to the individual businesses that comprise a firm are receiving particular emphasis in the Global Financial System project. Principal researchers in this area are Andre F. Perold, Kenneth A. Froot, and Robert C. Merton.