European Journal of Operational Research 150 (2003) 463–465
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Editorial
Financial modelling and extreme events
1. Introduction
Although the tragic attacks of September 11th
gave a new and grim meaning to the phrase ‘‘ex-
treme events’’, its study is not new in financial
economics. The occurrence of extreme events in
financial risk management has become a major
focus of study in recent years as financial instru-
ments have become increasingly complex and
volatile. What is relevant today is not only finan-
cial shocks but also events from other sources such
as political, social and environmental events. Po-
litical leaders warn us of more terrorist attacks
that can affect economic stability. Climatologists
predict more turbulent weather conditions as a
result of global warming that can affect agricul-
tural production. Health experts predict different
forms of diseases that can affect productivity and
industrial output. These events manifest into a
series of shocks that affect the economy continu-
ously. No industry has felt that more than the
insurance industry who have not only witnessed an
increase in frequency of losses but also in magni-
tude. The claim amounts for recent catastrophic
events have been huge and are indeed staggering.
Tentative assessments of the damage from the at-
tacks on September 11th range from $30 billion to
$70 billion, 1 approximately half the record dam-
age claims from the Kobe earthquake in 1995.
Similarly, the shocks to the financial sector
appear to also increase in frequency and size. The
recent scandals of Enron, WorldComm and Ar-
1
Flynn, P., 2002. Financial bailout of September 11: Rapid
response. Challenge 45 (1), 104–116.
0377-2217/03/$ - see front matter Ó 2002 Elsevier B.V. All rights reserved.
doi:10.1016/S0377-2217(02)00771-3
thur Anderson appear to over-shadow some of
the earlier eye-opening events of Orange County,
NatWest, Barings Bank, Sumitomo, LTCM and
ENRON. There is sufficient evidence to indicate
that inadequate risk management tools can be
blamed partially on the high incidence of frauds
and the inability to forecast catastrophic mishaps.
The calls for sophisticated risk management tools
to counter the increasingly complex financial in-
struments appear not to be in place, resulting in
such extreme events.
Several obstacles hamper the proper inclusion
of extreme events in risk management tools. Risk
management tools often involve a trade-off be-
tween the quality of the ÔcentralÕ versus the ÔtailÕ
properties. It is not surprising that in the early
phases, more emphasis was placed on the former
rather than on the latter. Inferences about the tail
of a distribution are usually much harder to make,
since only a few observations enter the tail region.
Moreover, the inferences are very sensitive to the
largest observed losses and the introduction of new
extreme losses to a dataset may have a substantial
impact. Further, since extreme events are rare by
definition, most managers will not be confronted
with them during their time on a specific job. Few
organisations have incentives to stimulate the
performance of future managers at the expense of
the current generation. Finally, for many users the
psychological perception of the risk of an extreme
event is more determined by how vividly they re-
member the last instance than by the statistical
probability of re-occurrence.
These obstacles are, however, being removed
at a rapid rate by the recent developments in
techniques to assess and forecast the risk of
464 Editorial / European Journal of Operational Research 150 (2003) 463–465
extreme events. The Value-at-Risk (VaR) meth-
odology has found its way into textbooks and
practice as a primary tool for financial risk as-
sessment. Specialized methods for VaR prediction,
based on extreme value theory, are now available.
This is a crucial development since VaR is calcu-
lated from the lowest tail part and is therefore
highly dependent on good predictions of extreme
events. As a result, we know more about the na-
ture of extreme events, their relation with volatility
and their time dependence. This enables us, among
other things, to put large stock price movements
into perspective 2 and to assess the extreme cor-
relation between stock markets. 3
In response to the changing nature of the risks
faced by the business community, the regulators of
financial institutions have developed more elabo-
rate frameworks to account for the increasingly
complex securities used by corporations. One re-
sult has been the proposed implementation of the
new minimum capital standards under the Ôthree
pillars approachÕ of the Basel II. In anticipation of
these changes, an enormous, worldwide research
effort is going on to have the necessary risk man-
agement tools in place when the new framework is
implemented. Many of the new insights and re-
search should contribute to enhancing the existing
tools for risk management. Slowly but inexorably
extreme events are becoming an integral part of
risk management systems.
This feature issue presents some examples of
the kind of research discussed above, as well as
examples from other areas in the broad field of
financial modelling.
2. Contents of this issue
In the first paper, Berger, highlights the effi-
ciency effects of a single market for financial ser-
2
See Jansen, D.W., de Vries, C.G., 1991. On the frequency
of large stock returns: Putting booms and busts into perspec-
tive. The Review of Economics and Statistics 73 (1), 18–24.
3
Longin, F., Solnik, B., 2001. Extreme correlation of
international equity markets. The Journal of Finance LVI (2),
649–676.
vices in Europe. In an exhaustive survey of the
literature, he finds that mergers and acquisitions
produce efficiency gains only when they occur
within a country and not across borders. Although
formal regulatory barriers may have been removed,
cultural and other differences appear to have still
prevented efficiency gains from being fully ex-
ploited. More research is recommended in the area
of cross-border mergers and acquisitions.
In the second paper, Spronk and Vermeulen
propose a multidimensional framework for com-
parative performance evaluation. The framework
corrects for risks beyond the control of the deci-
sion maker and takes account of differences in
operational characteristics between firms. Thus, it
combines the advantages of extended comparison
techniques and the multifactor method.
Steuer and Na provide a categorized bibliogra-
phy on the application of multiple criteria decision
making in the area of finance. This extensive study
shows the world wide origins of contributions to
this important area and underlines the position of
the European Journal of Operational Research at
the very front of scientific developments.
A new method to estimate VaR is put forward
by Cabedo, Semper and Clemente. Combining
ARCH models with factor analysis techniques,
this method overcomes the drawback of the ex-
cessive number of parameters required in ARCH
models.
Castellacci and Siclari examine this issue from
the software implementation of VaR methodo-
logies. They examine five different methodologies
for quadratic portfolios, Delta-Normal, Delta-
Gamma-Normal, Cornish-Fisher, Delta-Gamma
Monte Carlo and Full Monte Carlo models, in-
cluding computational efficiency. One interesting
result among the many they find is that taking into
account non-linearity by using higher moments
may be more beneficial than the full Monte Carlo
evaluation.
Crama and Schyns describe the application of a
simulated annealing approach to a complex port-
folio selection model, and report promising results
for this class of problems.
Benati examines the portfolio selection problem
by modifying the standard Markowitz mean–
variance model, replacing variance with the worst
 Editorial / European Journal of Operational Research 150 (2003) 463–465
conditional expectation variable. He shows that
using a linear programming approach with an
exponential number of constraints and appropri-
ate separation sub-routines can solve for optimal
portfolio values.
3. The next feature issues on financial modelling
Over the past fifteen years, the EURO Working
Group on financial modelling has been a successful
platform to establish and maintain contact with
the work and ideas of other financial modellers
from both academia and practice. Many of the
papers in this feature issue have their roots in the
Working Group. The Meetings of this Working
Group, organised twice per year, 4 have become an
important place for presenting papers, exchanging
ideas and starting joint research projects. EJORÕs
feature issues on financial modelling intend to
follow up on these meetings with a feature issue
after every meeting or combination of meetings.
4
The previous two meetings were in Haarlem (Holland) and
Capri, the next will be on Cyprus.
465
This mutually enforcing cycle of publications and
presentations can be a powerful instrument to
keep abreast with developments in a rapidly chang-
ing area of research like financial modelling. The
purpose is by no means to exclude papers from
outside the EURO Working Group Meetings. On
the contrary, all papers that fit the editorial pol-
icy 5 will remain welcome as before.
Anoop Rai
Department of Finance
Hofstra University
221 Weller Hall
Hempstead
NY 1155, USA
Fax: +1-516-463-4834
E-mail address: anoop.rai@hofstra.edu
Nico van der Wijst
Department of Industrial
Economics and Technology Management
Norwegian University of Science and Technology
N-7491 Trondheim, Norway
5
Papers on financial modelling are solicited that help to
solve financial-economic decision problems in practice. They
may relate to new insights, both theoretical and empirical, into
the decision makerÕs environment, new tools and the integration
of these tools within frameworks for decision making.