Are You Sure About That?

Most risk models consist of a series of best guesses for the size of each risk. Some of the risks are very well known. The risk models here have relatively little uncertainty. They are mostly models of volatility, where there is a long history of past volatility and good reason to expect future volatility to be similar. Others of the risks have little or no track record. The volatility assumptions in these models are based on extensions of information from other situations. There may be very high degrees of uncertainty in the parameters for these models. However, many of the folks who build the models believe for various reasons that reflecting parameter uncertainty is too cautious an approach to the risk model and adds so much to the risk evaluation that it makes the risk model unusable. The numbers from both types of risk are usually just added together or presented on the same page with no distinction between their credibility. So it seems that the users of risk models are faced with two choices – to have risk models that reflect high potential risk for new and untested risks and therefore stifle participation in new business opportunities and risk models that sometimes drastically understate the risks.

The alternate is to keep track of many different aspects of risk and pay attention to all of them.  See Multidimensional risk.

Then everyone can know that the economic capital or any other comprehensive risk measurement does NOT reflect the degree of uncertainty, but that another report gives information about uncertainty.

The report on uncertainty might look at each of the risks and give an indication of the level of uncertainty of each of the values in the economic capital.  So it might say that 75% of economic capital comes from risks with low uncertainty, 20% moderate and 5% high uncertainty.

Even more revealing, profits could be analyzed in the same manner.  That might help to show how much of profits are coming from activities with higher uncertainty – a dangerous situation that should trigger a high degree of concern among management.

Explore posts in the same categories: Assumptions, Enterprise Risk Management, ERM, Modeling, Risk, Risk Management, Uncertainty, Volatility


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One Comment on “Are You Sure About That?”

  1. riskviews Says:

    To have numbers seems to be more important than whether the numbers are reliable. George Cooper in The Origin of the Financial Crisis

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