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!