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Monday, December 10, 2012

Can risk practices be shared?

There is a common belief among many enterprise risk managers that practices in operational risk can be applied to market or credit risk with ease. However, such thinking might be a little bit misplaced.

Let's take a look at this.
  
The world of operational risk
The world of operational risk is dominated with a modus operandi that goes along the following lines. We go out and identify a particular hazard, discover its causal factors, conceptualize the side effects and then insert controls between the causal factors and the outcome to reduce our exposure from the side effects.

These things are best explained with a diagram.


What you are seeing here is various stages of risk acceptance; If the risk manager doesn't have an appetite for the inherent risk, then policy is set. If the residual risk state at stage 1 is still too high, controls are then inserted and this risk aversion process carries on until the desired level of risk is met. The additional cost of inserting each control along the way becomes the restrictive factor on whether a risk analyst accepts the risk of pays for it to be transferred or negated away.

Risk in this case, is being thought of in a linear like scale of high risk to low risk and the difference between one place and the other comes at the expense of inserting controls.

In effect and in the world of operational risk, we are trading the outcome of risk against control cost. One point to note of course is that we have to accept that no control is likely to be 100% effective all the time and it is improbable that any control will capture all risk drivers perpetually.

If an analyst carries on with this type of conceptualization in risk management, they may be lead to believe that some of the following are always going to be logically correct:
[] Value is found in low risk, high control and high efficiency operations.
[] That uncertainty is a bad thing which we must try and remove, sometimes at any cost.
[] That our risk appetite is a direct outcome of how much we are willing to pay to remove a potential hazard.
These concepts are real and they are also true but when risk is traded, they need to be put to one side.

Does this thinking apply in markets?
In the world of market risk when a trader is long one thing and short another, uncertainty can add value in some cases, rather than remove it.

How is that so?


Imagine two companies have issued a one year bond on the market for a hundred bucks and these bonds are both paying 10% yield to maturity. If the ratings are the same, you could buy either bond and your profit at the end of the year would be $10, its the same either way.

What happens one day after both bonds are issued if company B reports bad news? Let's say it suffered a major problem with one of its operating centres and repayment of its current liabilities are now likely to become impaired.  

The market is probably going to perceive this realisation of uncertainty negatively and many bond holders investing in company B will want to dispose of their investment just to move away from the new credit risk. Unfortunately for these investors, they may need to discount their investment to offload it onto the market.

Forget the mathematics here because it is far more complex than what I have indicated above but the overall concept is simple and gives rise to the idea of credit spreads. That is, paper of the same maturity, even the same yield to maturity, will trade at different prices due to the prevailing idiosyncratic risk or uncertainty or quality of that unique investment.

In effect the higher the risk, the higher the yield and a normal market concept that goes against our operational risk ideal of "Value is found in low risk, high control and high efficiency operations."

Let's look at historical credit spreads in sovereign bonds, just to emphasize how the market discounts to price in risk.


Where is the value here? You will make more profit buying Greek paper over Italian but the big question you have to ask yourself is, do you have the appetite for this investment decision?

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