You can never take the risk out of risk
One of the factors that set the human race apart from other creatures is our ability to
recognise and consider the uncertainty of the future. Some analyses of the future have
significant economic effects on large numbers of people – the Bank of England’s Monetary
Policy Committee’s takes its decisions on the level of interest rates after considering
predictions about the future state of the UK economy. Other analyses may only affect small
numbers – the punter at Kempton who puts money on a runner in the 2.30. More generally,
any business that wants to plan for the future needs to incorporate at least some predictions
about the future.
New technology is being used to help those who need to look into the future. Increasing
quantities of data can be recorded and processed by sophisticated processors to provide
predictions of future developments. This use of technology allows currency and equity
traders to view modelled graphs on their computer screens predicting the future movements
of the particular price they are tracking. The advent of the Internet enables this technology
to be used by non-professionals in their own homes.
Whilst currency and equity traders have always had to try to ‘predict the future’, increasingly
company directors are required to as well. Corporate governance rules make a company’s
board not only responsible for the maintenance of shareholder value but also for the setting
of company policy for identifying and managing the risks that their companies face.
Just as technology has been harnessed to help currency and equity traders, so it has been
developed to help the risk manager. Ever more sophisticated risk management techniques
can be used within a corporate treasury responsible for measuring and managing risk. But
the use of technology and advanced calculations in these techniques may give the
impression that a predictive risk management program is scientific, and thus reliable. This
impression of reliability can be illusory.
All of the methods of prediction to which we have referred here rely on past events and
relationships. For example, the predictions of value at risk or the likely level of the future
value of a currency are determined by patterns and reactions observed under similar market
conditions in the past.
The success of this style of prediction relies on the program being able to recognise which
previous market conditions are currently being repeated. But, however much like a past
pattern a current reaction is, the prevailing market conditions are always slightly different.
This, in turn, ignores the effect of the technology itself. As technology advances, more
traders and risk managers use it to help make their decisions. Reactions to market changes
become quicker, making the markets more volatile, and the current event less like previous
events. Because technology changes what is possible for the traders, so it changes the
ways that these traders react, changing events in the markets too. Risk managers who
measure the company’s value at risk are also affected.
All this might suggest that we think that risk management is a pointless exercise. Nothing
could be further from the truth. Our point is that as risk management policies become ever
more sophisticated, it becomes easier for the risk manager to become complacent and rely
on the program. It is important that the risk manager understands the principles behind the
program as well. Moreover, because predictive technology is based on past events and
experiences, it cannot by definition account for the effect of the truly unexpected event. And
the truly unexpected event often gives rise to an exposure that cannot be hedged until some
‘rocket scientist’ turns his mind to it.
Whilst technology has allowed the risk manager to measure and manage risk more
accurately, it should always be remembered that any assessment of any risk is only reliable
within certain limits. It cannot be a substitute or a replacement for common sense and an
understanding of the principles of your business. The prudent risk manager, and the prudent
board, should always recognise what the limitations are. One of those limits is that we
cannot look so clearly into the future as to completely eliminate risk.
That is the fun of business!