Bad Label leads to Bad Thinking

How many times have you heard the term “Risk Transfer” to refer to a risk mitigation action such as hedging or (re)insurance? It is used in text books and articles about risk management. But, be careful, that labeling is bad and it could just lead to bad decisions.

That is because risks are rarely actually “transferred” to another party. If they were actually transferred, then the consequences would be theirs and theirs alone. However, in most hedging and (re)insurance situations, the risk is usually just “offset”. There are two common terms that are used to refer to the real differences between risk transfer and risk offset.

Those terms are counterparty risk and basis risk. If the risk had been transferred, then there would be no counterparty risk, the risk would BELONG to the other party. In fact, the risk does not belong to them, it still belongs to you. You have paired the risk with an offsetting obligation from the counterparty and you are as safe from loss due to the risk as the counterparty is secure. If the counterparty fails to pay their obligation to you, then you still have the risk and experience the entire loss.

And also, because you have not really transferred the risk, there is a possibility that their payment to you will not be a perfect match to the loss in timing or amount or both. The risk offset might be triggered by a different event than your obligation. For example, the trigger for CDS to actually pay-off are not exactly tied to missed bondholder obligations so the spreads on CDS for a distressed bond may move slightly differently than the actual bond spreads, even though they moved very similarly when the bond was not distressed. A hedging strategy based upon market sensitivities (greeks) is only as good of a fit with the hedged risk as the models used to calculate the greeks.

But this bad terminology is not harmless. If you execute a risk offset and tell others that it is a risk transfer, then they might be quite happy to treat the gains as fully realized. They will not inquire about the offsetting positions, because the bad terminology implies that there are none. When in fact, in any case of risk offset, it should be import to monitor and communicate the risk offsets, highlighting the counterparty risk and tracking the potential emergence of basis risk.

Advertisements
Explore posts in the same categories: ERM, Hedging, Reinsurance, Risk Management, risk transfer

Tags:

You can comment below, or link to this permanent URL from your own site.

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s


%d bloggers like this: