Historical Background

There is evidence of risk management activity going back to the dawn of time.† There are indications of forward dealing taking place in India as early as 2000 BC; a forward market in grain is said to have existed in Ancient Rome; and certainly by the Middle Ages risk sharing was widely used. Merchants spread their risks through collective ventures by pooling capital to finance trading expeditions, thus allowing them to diversify their investments. Agreements allowing parties with opposite risks to exchange positions were also becoming common practice. For instance, a forward market in currencies was well established in Antwerp by the close of the fifteenth century. The Antwerp exchange was the original model for Thomas Gresham’s Bourse, which was set up in 1571 in London, later to be known as the Royal Exchange. By the eighteenth century in England thriving risk exchange activity was taking place, with buyers and sellers willing to contract forward to eliminate price and delivery risk on basic commodities. Since much of the uncertainty arose in relation to imported products, these markets were located at terminal points such as dockyards. It was at this time that life assurance was first introduced as a product and that insurance companies were established. The above evidence is testimony to the ongoing nature of the problem presented by risk in human affairs and the willingness of individuals to create arrangements to mitigate its worst effects. In the nineteenth century, the development of modern risk management techniques took a step forward with the formation of organised terminal or futures exchanges to allow participants to exchange risks on a wide range of agricultural commodities. The United States, because of the economic importance of its large agricultural base, led the way with the establishment of commodity exchanges in New York and Chicago. Soon after, similar terminal exchanges were established in other major trading centres, such as London and Paris.

Financial risk management has always been implicit in the management of the firm. Its recent development as a major management responsibility, however, is the result of two major post-war developments. The first was the collapse of the Bretton Woods Agreement following the decision by the US on 15 August 1971 to stop exchanging dollars for gold at the fixed price of $35 per oz. From that moment on, foreign exchange markets became more volatile, a factor that directly affected interest rates and, indirectly, other assets such as commodities, many of which are priced and traded in dollars.* The collapse of the fixed exchange rate system was shortly followed by the first oil shock, when the price of oil quadrupled in the winter of 1973–4. These two events led directly to a demand for instruments to manage these risks.

The increased price uncertainty or volatility that has been seen since the early 1970s has been one of the main driving forces behind changes in financial risk management tools and techniques and the increased choice available to practitioners. Another development encompassed the fundamental changes that took place in the behaviour of economic variables from the mid-1960s. With the collapse of the Bretton Woods Agreement, individual countries were able to pursue divergent economic policies, the impact of which was now transmitted through the freefloating exchange rate. To combat inflation and to prevent excessive currency depreciation, countries needed to have a more aggressive approach to managing interest rates, which in some cases were raised to unprecedented levels.