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Monday, July 16, 2018

How to Straddle Risk

When we hear risk managers say there are five ways to treat risk (accept it, transfer it, reduce it, increase it, avoid it), we have to accept they aren't being especially creative with their solutions when potentially there is an unlimited number of risk treatment strategies available to them. All they have to do is just broaden their minds.

The Straddle Strategy
To demonstrate the point further, a client recently asked me to show how it is possible for a stakeholder to benefit from something when its price goes up or down but in a way that the risk is contained. 
"Is it possible to avoid the risk but take an opportunity when two specific future scenarios contradict each other?"
The short answer to it is yes! If the risk manager is able to develop a Structured Response to the risk the stakeholder is facing, they can be taking on risk (buying it) or letting it go (selling it) at different netted levels or times throughout the forward risk horizon. The effect of this netted position can be very beneficial for stakeholders and it usually helps them directly meet their specific risk appetites to different scenarios across a risky situation. 

The risk treatment strategy we need to employ to satisfy our client's request is known as 'The Straddle', and I have developed a straightforward presentation on this profitable treatment approach with a real-life example on Donald Trump's Oil dilemma that you can view at the following LINK.

Structured Response to Risk and Payoffs | Presentation Link

At the moment there is a big push in the Enterprise Risk Management domain for risk managers to apply their work directly to the decision-making space of stakeholders rather than churn out stale backward looking heatmap reports. As a risk management community, we should welcome this refreshing and sweeping change, but if risk managers are going to be useful to their stakeholder's decisiveness, they are going to need to equip themselves with more than five risk treatment strategies.

Accept the risk, transfer the risk, reduce the risk, increase the risk, avoid the risk, is that all ERM has to offer in its risk treatment tool set?

Why not start with the tactic of converting a risk into an opportunity ~ that is surely much more favorable than the first five suggestions on offer :-)

Risk Payoffs
So where does a risk manager begin if they want to learn the science and practice needed to develop a Structured Control Response to the risks they face?

Risk Payoff Diagrams are an incredibly useful technique to explore, and these charts are often employed by traders and market risk managers to explain what happens to their trades under different price conditions. Enterprise Risk Managers can also borrow from this method and apply it to a whole range of risks they have to manage and in the process of developing a solution, they will at the very least become more proficient at pricing or measuring risk.

Building Payoffs by Mat Brigida

Anyway, that's it for the time being, and we hope you find the presentation LINK easy reading and informative. Causal Capital is developing a lot of Risk 2 solutions at the moment and over the coming months ahead, we are going to explore these payoffs structures and the underlying risk measurement models in far more detail.

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