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Saturday, June 9, 2012

Time in risk

A recent debate on the G31000 Linked in forum about time and risk poses the following question "Is delaying a risk considered a separate treatment method or is it just a sub-type of changing the likelihood?"
This is a very interesting statement and it leads this blog posting into looking at some of the aspects of risk through time. 
Time or the lack of it would intuitively have anyone believe that impact is likely to increase overtime just like a pressure cooker building up. I suppose that is one manner in which to conceptualize these time effects more practically. Alternatively, the "spreading out" of risk events makes for easier management, rather than having a lot of events occurring in a short period of time, it can go both ways. Perhaps then, time features more in risk management than we would like to first acknowledge?

In this blog posting we take a look at eight situations where time intertwines with risk. There are many more examples of risk in time or time in risk as it is, but we have chosen to talk about eight unique relationships of risk and time.

[1] Volatility Overtime
Perhaps one of the most obvious places where time features in the world risk management is in the context of finance. The Black-Scholes calculation which is used for pricing an option is very much determined by the time horizon.
Black-Scholes Calculation | [Reference Here]

In effect, the option price or premium is based around how much uncertainty a trade is receiving and how much longer it has to endure this uncertainty. One of the magical aspects of the option calculation is that each contract will have a different experience to the volatility surface through time and the Black-Scholes equation is able to convert the two functions of risk and time directly into a price.

In the end we finish up pricing risk by looking at volatility or uncertainty but inline with time.

[2] Pricing Return - Time in Money
The world of finance and its affair with time is nothing new and has been around a lot longer than the option calculation that is explained above. Time Value Money is perhaps the most customary application of time in finance and is used to price a huge array of contract types.
Time Value Of Money | [Reference Here]

In short, the calculation is used to "count" the amount of interest earned or paid overtime and the entire world of economics is driven by it or precisely the discounted cash flows through time. Risk is an extension of opportunity cost for investing in one asset or another compared to the "risk free rate" but all framed in time. Enough said here and entire books are written on the subject of Time Value Money.
[3] Burn In and Burn Out 
Away from finance specifically, burn in and burn out is a risk concept that extends on the idea that new "things" or specifically; processes, controls and products have a higher tendency of failing when they are first introduced into a system and old things suffer wear and tare before they burn out.
Bath Tub Curve | [Reference Here]

The Bath Tub Curve shown above can be used to measure the expected time for a process to stabilise overtime, how long until the Mean Time Between Failure and the Mean Time To Repair normalize, how long we have before materials need replacing and the useful life of a system as a whole.

[4] Propagation of Explosions
Explosions have a tendency to propagate through space and time. In fact the most serious damage from percussive shocks often doesn't happen closest to the blast but a coupled seismic distance away.

Shock Wave Propagation overtime | [Mysterious Explosions]

Understanding the dynamics of this time / space dimension is especially important for blast management and a critical aspect for designing effective controls, shelters or escape routes from such threats. What we do know from studying wave propagation is that wavelength, energy reflection, refraction are all substantially impacted by changing the environmental background of time.

[5] Statistical Events in time
Random events through time often have a central tendency effect with time. Quantifying this relationship is important as it helps many different types of statisticians understand when the next big single impacting event is due.
Predicting the event zone | Frequency of Events

Meteorologists through to volcanists are tangled up in stratified event frequency analysis and as it stands today, be warned: [1] The San Andreas Fault is overdue for the big impact day and [2] The global community is overdue for a pandemic. Certainly the conditions are ripe for propagation of infection and the time is statistically overdue, all that is missing is the contagion.

[6] Calendar Spreads
Businesses are often not only threatened by impending uncertainty from commodity price volatility but also that single risk coupled through time and connected to a point in time.

Understanding the calendar spread | Calendar Spreads in crude

The calendar spread attempts to show the difference of implied volatilities between two calendar periods and can be used to highlight where risk through time is the highest.

[7] Propagation of market fed crashes
Asset bubbles have a tendency to build slowly and collapse rapidly. This relationship of volatility overtime creates a very disproportionate window for planning and risk managers often don't have enough time to unwind their positions when prices are diving.
Asset Bubbles Feeding and Busting Cycles | US Shiller Home Prices

As the market climbs, investors become comfortable and complacent enough that they can go deeper into the market without exposing themselves to additional risk. This feeding phase is generally long winded and investors don't appreciate that adding to the portfolio transacts in a very different way to the sell-off event, it isn't simply another trade of buy or sell.

[8] Concentration Overtime
Don't ever underestimate the cumulative effects of the growth of any factor through time and small amounts do add up overtime. A common method for understanding how long it takes for anything to double is the doubling time and more information can be found here at this [link].
Tipping Points and Boiled Frog Syndrome | Concentration in Time

The big problem is that concentration builds up overtime until a tipping point is eventually reached, at which time a regime shift occurs and a new system takes over. Today we are moving into a lot of doubling time regime shift potentials, let's take a look at a few.

[1Do you honestly believe that the Euro crisis is going to be resolved in a matter of months when it has taken several years for jurisdictional politicians to have accomplish very little. In reality nothing substantial has been put in place to resolve the breakup of the Euro or the impacts from such an event occurring except hope that such an event won't happen. The Euro is only designed to be the Euro not to be untangled, it has to work because the alternatives are untenable.

[2The US debt clock is a "ticking time bomb" without a solution. Take a look at this [link] and take a deep breath.

[3] The peak oil problem is not going to fix itself either. The growth of petroleum consumption, population and the scarcity of crude as an energy resource is an impending disaster without a viable commercial alternative. Oh there are plenty of energy options away from crude but they all generally lack a suitable supply chain to cope with a large regime shift in the price of crude.

These are just some of the potential issues that can occur from the relationship between time and risk, there are of course plenty of others and I would be more than happy to discuss them with risk analysts.

1 comment:

  1. Martin, very nice examples. For the last (8th) Concentration Overtime I would like to add few things
    1- As we all know risk depends on objectives. I believe that ( and wrote in several topics and articles) Germany has different objective then other nations in EU. Germany sees this crisis as an opportunity to form a more integrated Europe fiscally and politically. So waits till every nation in debt to agree on her rules and get bailed out later. Just wait them to come down to their knees. They think this is the current best way to achieve this. It will probably take at least 4 years to stabilize and it will be very painful for some countries. But when I saw Germany's latest commentary, I have become pretty confident that Germany will lead and unite the EU. We can see situations similar to East and West Germany union. We will probably see demographic changes in Europe as well, like from East Europe countries to ones by the Mediterranean. Of course these are all my own predictions about future but I am quite positive on the long run.
    2- The world has no other option currently else then US dollar BUT it may be a real problem when more countries start to trade on their currencies. This mutuality in trade conditions would really hurt Dollar.
    3-Absolutely agree on that plus new incoming (emerging) is water problem.