Читать книгу The Trade Lifecycle - Baker Robert P. - Страница 21

Risk is a major part of trading. Not only do most traders need to actively manage risks that arise from their trading (market risk) but the actual processes in the trade lifecycle carry various types of risk. Here we present an introduction to the concept of risk in general.

2.1 The concept of risk

The German sociologist, Niklas Luhmann, defined risk as ‘the threat or probability that an action or event will adversely or beneficially affect an organisation's ability to achieve its objectives’.

In the financial services industry, the term risk often denotes the market risk of holding trading positions. Risk management is then the action taken by traders to control this risk. This is an important type of risk and one to which we will devote a chapter of this book (Chapter 10), but it is by no means the only source of risk to an organisation engaged in trading. Whenever we use the unqualified term risk, we mean the wider connotation of risk as in Luhmann's definition.

2.2 Risk is inevitable

Imagine you own £10,000 in cash and decide to store it in the proverbial shoebox under the bed. You are now certain that you have protected your money – there are no risks attached. Correct? Unfortunately, things are not quite as safe as you think. Firstly, it could get stolen or there could be fire or flood. Secondly, if you leave the cash there long enough, the denomination of bank notes could cease to be legal tender and banks and shops refuse to accept them. Thirdly, inflation of prices might reduce the real value. In addition to these risks of losing all or part of your money, you are also foregoing the ability to invest your money for profit.

In reality there is no such thing as being of free of risk. All activities incur some sort of risk. Trading and its associated processes have many risks; the important thing is to be aware of risks and choose how to deal with them.

2.3 Quantifying risk

In order to quantify and manage risk, one must define:

■ the event upon which the risk is to be measured

■ the probability of the event occurring

■ the loss entailed if it occurs

■ the means by which some or all of the risk can be mitigated

■ the cost of mitigating risk.

Both probability and loss calculations are very important in order to have an appreciation of the risk. A catastrophic event that occurs with a remote probability may require greater protective action than an everyday event that causes a small loss.

In practice, it may be difficult to quantify either the probability or the amount of loss entailed or both. With finite resources, an organisation will need to spread the amount it spends on protection against risk according to priorities. However, even an estimation of risk should aid the process of assigning priority. Also, in deciding a future course of action, the organisation should weigh the benefits against the risks in order to arrive at a fair decision as to how to proceed.

In Table 2.1, we give three examples of risk events, a rough estimate of the probability of occurrence, the amount of loss should the event happen, the selected remedial action and the estimated cost of such action.

Table 2.1 Examples of risk events

2.4 Methods of dealing with risk

There are four main ways to deal with risk:

■ Ignore

An event carrying risk may be considered of negligible impact and so can be totally ignored. Alternatively, it may be more expensive to protect against the risk than to let the event occur – sometimes an organisation just has to take the hit.

For example, the loss to a hedge fund of being without electricity is negligible compared to the cost of installing its own generator.

■ Minimise

If it is impossible or too costly to remove the risk altogether, steps can be taken to either lessen its impact or reduce the probability of it occurring.

The skydiver may carry two parachutes in case one malfunctions. (He would rather not think about the probability of both not working!)

■ Avoid

Again, if it is too difficult to protect against a risky event or the benefits are not sufficient to justify the possible damage entailed, the risk can be totally avoided.

For example, the market risk department might rule that a trade is so risky it cannot be transacted despite the potential profit.

■ Remove

Removal of risk is certainly desirable, but often difficult to achieve.

An example of risk removal is house insurance. One transfers the risks associated with owning a house to an insurance company. (Obviously there is still a residual risk that the insurance company will default on its obligations, but legislation and regulation generally make this probability negligible.)

2.5 Managing risk

A successful organisation relies on good management. One key feature of management is assessing weaknesses and taking steps to tackle them. In order to do this, a good understanding of risk is essential. Many business functions within a financial entity are partly or fully concerned with the management of risk. All trading activities entail risk. As different parts of the trade lifecycle give rise to different risks, the success of the trade is dependent on the knowledge of its risks and the management of them. Since risk in all its manifestations is part of the business of financial trading, the company that can manage its risk best will be at a distinct advantage.

It should be said that managing risk is distinct from being risk-averse. There are many reasons why a trading desk might take on market risk and manage it successfully. Similarly an institution may decide on a more risky course of action because the likely benefits outweigh the possible losses. As long as the potential risks are understood and estimated, it can be said that risk is being managed.

2.6 Problems of unforeseen risk

No stakeholders in a business – investors, managers, employees and customers – want unforeseen risk. Due to its sudden effect, the organisation is ill-equipped to deal with it and its consequences are unknown. One of the major causes of the recent credit crunch was the failure of many organisations to take into account a particular risk: that so many American sub prime mortgage borrowers would be unable to repay their debt. Unforeseen risk points to poor management and supervision and reduces confidence in the financial entity. If risk is present, it should be identified and then sensible decisions can be taken about how to manage it.

2.7 Summary

A financial entity must accept that risks are an unavoidable part of the trading process. When an adverse scenario arises, it will fare better and be able to keep costs down if it is proactive in uncovering them, estimating their probability and effect and deciding best how to deal with them. Controlling risks does not necessarily mean being cautious in business – aggressive trading can reap big rewards. But recognising risk in all its manifestations is a fundamental part of managing the trading process.