The World Of Risk

Risk is a four letter word and is an abstract concept. The subject of risk has again come to the fore after the recent subprime and credit crises not to mention the Societe Generale reporting biggest fraud ever.

The Concept

Risk in plain terms is the probability of occurance of an unfavourable event. Both subjective and objective definitions have been given to the concept of risk. According to objective interpretation, probabilities are real, we may discover them by logic or estimate estimate them through statistical analysis. According to subjective interpretations, probabilities are human beliefs. they are not intrinsic to nature. Individuals tend to charecterize to their own uncertainity.
This brings us to the word uncertainity which by many confuse with risk. Uncertainity refers to lack of knowledge about the outcome for an event. However statistical probabilities reflect "measurable uncertainity" and opinion reflect "unmeasurable Uncertainity". We may use the term "Risk" to distinguish the former and the term "uncertainity" for the latter. Risk relates to objective probabilities and uncertainity relates to subjective probabilities.

Measurement and Interpretation.

Risk measurement is not just about calculating the likelihood of an event but also the magnitude of the event. Risk in a financial sense means the variablity of cash flows or earnings. Most commonly employed tool to measure the divergences is Standard Deviation (S.D) in other words the magnitude of difference of an event from the mean. S.D is based on an assumption that returns fit into Normal Distribution.
Another tool used is VAR - Value At Risk. VAR is used to know the likely financlial exposure with a given level of probability. There is also DEAR. Its not endearment but stands for Daily Earnings At Risk. The major criticism is that VAR limit of $10 million at 99% confidence level is, well meaningless. It can be satisfied by a portfolio where there is a 99% chance that the losses will be below $10 million but a 1% chance that the loss is $1,000 million !!
Some recommend the use of stress testing and Extreme Value Theorey (EVT). Stress testing analyses the effect of extreme price movements. EVT measures the financial impact of low probability but a very high magnitude event. One of the most fundamental problem in many of the todays risk models is the fact that they are based on past data and future might hold little relevance to past events.

Mark Twain once remarked "It aint wat U dont know that gets u into trouble. Its what u know for sure that just aint so"
Take the case of LTCM, the infamous hedge fund which collapsed in 1998 and the one that required Fed intervention to minimise systematic risk(to be covered in next article) . The firms risk model predicted loss of $34million per day. But on 21 Aug 1998, the firm lost $550million. The models had judged that kind of a loss to be a 14 S.D event.

Risk Management

Risk is a four letter word. It is polite in company to use - "Risk Management". Risk management is a beautiful lie . Beautiful lies are lies that we know are not true but desperately want to believe in. Risk management is also a true lie.
Satyajit Das.

Risk management is a process of containing risk through hedging, avoidance, sharing and by many other ways. Risk management is a structured approach to managing uncertainity related to athreat, through a sequence of human activities including: risk assesment,strategies development to manage it, and mitigation of risk using managerial resources.
The strategies include transferring the risk to another party, avoiding the risk, reducing the negative effect of the risk, and accepting some or all of the consequences of a particular risk.

Taleb, a risk consultant in his latest bokk "The Black Swan: The impact of the highly improbable" says that we're all blind to rare events and routinely fool ourselves into believeing we can predict risks and rewards.

Creation of new financial instruments by innovative banks for seemingle sophesticated investors have created risks in world financial markets which are hard to measure, let alone manage in a perfect manner.