Archive for November 2010


November 29, 2010

My favorite book of the Bible is Job.  That could have been called the book of WHY.  Everyone throughout the book assumes that there must be an answer and they try out those answers but none seems to fit.

Finally, they get an answer, but it is not the sort of answer that they were looking for.  The answer that they get is something like”you would never understand”.

But the risk manager is always being asked why?  Asked to explain the unexplainable.

David Hackett Fisher advised historians to avoid WHY.  To stick with who, what, when, where  and how.

A why question tends to become a metaphysical question. It is also an imprecise question, for the adverb ‘why’ is slippery and difficult to define. Sometimes it seeks a cause, sometimes a motive, sometimes a reason, sometimes a description, sometimes a process, sometimes a purpose, sometimes a justification.

This list of definitions for the word why is useful to the risk manager however, because often there is no “why” under some definitions, but the other definitions can help to provide a path to an answer that is probably less than satisfactory but better than nothing.

Nothing being the same as the answer “it is still a 1 in 100 event, we were just unlucky”.

If you want the company’s executives to really embrace ERM, then the risk manager needs to have all of these definitions and as many of the answers as humanly possible on hand.  The executive will need the risk manager to provide the words that they can use and feel comfortable lording it over their peers who do not have such a smart risk management department.  They need the words than answer WHY.

The famous quote about risk..


David Vinar, CFO Goldman Sachs
August 2007

Vinar obviously had someone who did not have the above list of definitions of WHY on hand, he got the S— Happens answer from a math geek.

Executives need to be brought into the Baysian recalibration process.  Each year, the  experience of the year needs to be placed on the scale from the model (as Vinar did above) and the scale then either accepted or rejected.  (Which step Vinar obviously did after making that statement.)

That exercize ought to be a part of every year end wrap up from the risk department.  Their recount of the who, what, when, where, how and WHY of the events of the year.


Risk Language

November 27, 2010












Intrinsic Risk

November 26, 2010

If you were told that someone had flipped a coin 60 times and had found that heads were the results 2/3 of the time, you might have several reactions.

  • You might doubt whether the coin was a real coin or whether it was altered.
  • You might suspect that the person who got that result was doing something other than a fair flip.
  • You might doubt whether they are able to count or whether they actually counted.
  • You doubt whether they are telling the truth.
  • You start to calculate the likelihood of that result with a fair coin.

Once you take that last step, you find that the story is highly unlikely, but definitely not impossible.  In fact, my computer tells me that if I lined up 225 people and had them all flip a coin 60 times, there is a fifty-fifty chance  that at least one person will get that many heads.

So how should you evaluate the risk of getting 40 heads out of 60 flips?  Should you do calculations based upon the expected likelihood of heads based upon an examination of the coin?  You look at it and see that there are two sides and a thin edge.  You assess whether it seems to be uniformly balanced.  Then you conclude that you are fairly certain of the inherent risk of the coin flipping process.

Your other choice to assess the risk is to base your evaluation on the observed outcomes of coin flips.  This will mean that the central limit theorem should help us to eventually get the right number.  But if your first observation is that person described above, then it will be quite a few additional observations before you find out what the Central Limit Theorem has to tell you.

The point being that a purely observation based approach will not always give you the best answer.   Good to make sure that you understand something about the intrinsic risk.

If you are still not convinced of this, ask the turkey.  Taleb uses that turkey story to explain a Black Swan.  But if you think about it, many Black Swans are nothing more than ignorance of intrinsic risk.

Measuring Risks

November 25, 2010

What gets measured gets managed.

Measuring risks is the second of the eight ERM Fundamental Practices.

There are many, many ways to measure risks.  For the most part, they give information about different aspects of the risks.  Some basic types of measures include:

  • Transaction Flows, measuring counts or dollar flows of risk transactions
  • mean Expected Loss
  • Standard deviation of loss
  • Expected loss at a particular confidence interval (also known as VaR or Value at Risk)
  • Average expected loss beyond a certain confidence interval (also known as TVaR, Expected Shortfall, and other names)

So you needs to think about what you want from a risk measure.  Here are some criteria of a GOOD RISK MEASURE:

1. Timely – if you do not get the information about risk in time, the information is potentially entertaining or educational, but not useful.

2. Accurately distinguishes broad degrees of riskiness within the broad risk class – allowing you to discern whether one choice is riskier than another.

3. Not too expensive or time intensive to produce – the information needs to be more valuable than the cost of the process that produces it, either in dollars or opportunity cost based on the time it uses up.

4. Understood by all who must use – some will spend lots of time making sure that they have a risk measure that is the theoretical BEST.  But the improvements from intellectual purity may come with a large trade-off in the ability of a broad audience to understand.  And if people in power do not understand something, there are few who will really rely on it when their career’s are at stake in an extreme risk situation.

5. Actionable – the risk measure must be able to point to a possible action.   Otherwise, it just presents management with a difficult and unpleasant puzzle that needs to be solved.  And risk is often not a presenting problem, but a possible problem, so it is easier always to defer actions that are unclearly indicated.

If you can set up your risk measurement systems so that you can satisfy all five of those criteria, then you can feel pretty good. Your risk management system is well served.

But some do not stop there.  They look for EXCELLENT RISK MEASURES.  Those are measures that in addition to satisfying the five criteria above:

6. Can help to identify changes to risk quality – this is the Achilles heel of the risk measurement process.  The deterioration of the key riskiness of the individual risks.  Without this ability, it is possible for a tightly managed risk portfolio to fail unexpectedly because the measures gradually drifted away from the actual underlying riskiness of the portfolio of risks.

7. Provides information that is consistent across different Broad Classes of Risk – this would allow a firm to actually do Risk Steering.  And to more quantitatively assess their Diversification.  So this quality is needed to support two of the four key ERM Strategies and is also needed to  apply an enterprise view to Risk Trading and Loss Controlling.

8. For most sensitive risks will pinpoint variations in risk levels – this is the characteristic that brings a risk measure to the ultimate level of actionability.  This is the information that risk managers who are seeking to drive their risk measurement down to the transaction level should be seeking to achieve.  However, it is very important to know the actual accuracy of the risk measure in these situations.  When the standard error is much larger than the differences in risk between similar transaction then process has gone ahead of substance.



Turkey Risk

November 25, 2010




Happy Thanksgiving.

What is Too Big to Fail?

November 20, 2010







Risk Regimes

November 18, 2010



So these regimes would be:

  • Boom – high drift, low vol
  • Bust – negative drift, low vol
  • Normal – moderate drift, moderate vol





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