It’s our pleasure to bring you a guest contribution today from Dr. William Shadwick, a highly-regarded mathematician who “crossed the aisle” to the world of finance a decade ago and has since made his mark on the field of investment performance analysis.  Regular readers may remember Bill from his previous guest contribution to AllAboutAlpha.com in 2008 – one of that year’s most-read articles on AAA.  Widely known as the developer of the Omega Function and Omega Metrics®, Shadwick won the 2007 Journalism Award from the Investment Management Consultants Association, jointly with Ana Cascon.   A prominent mathematician, he was responsible for establishing the Fields Institute for Research in Mathematical Sciences before entering the finance industry in 1998.  He is the founder of Omega Analysis Limited, a quantitative research firm in London.

Special to AllAboutAlpha.com by: Dr. William Shadwick, Omega Analysis Limited

The credit crisis and its impact on world markets have prompted a great deal of discussion of risk management (and its absence). Much of the forecasting by financial institutions of the risk inherent in their businesses failed to avoid extreme and, in some cases, catastrophic losses. Institutional investors and other shareholders who failed to manage risk absorbed huge losses as equity markets plummeted.

The goal of statistical analysis in financial risk management is to predict the future with reasonable accuracy over a reasonable period of time. Predictions need not be precisely correct to be of great value in managing risk.

The degree of accuracy that is acceptable varies from investor to investor and across investments of different types. The common feature is the need to estimate both the likelihood and severity of unacceptably large losses. Making such estimates is as essential in building a stock portfolio or a trading position as it is in overseeing regulatory capital requirements for banks. Statistical analysis is an important and, in many cases, essential part of risk management. More…