Law of Risk & Light
Risk management is all about making conscious decisions about risk taking. Fully recognizing the potential losses that could result from a risky undertaking. But in many camps, risk management is being simplified and simplified to a point where it may well mislead CEOs and Boards about the potential effectiveness of an oversimplified risk management regime.
These simplified risk management regimes are often in violation of the Law. The Law of Risk and Light…
Risks in the light shrink, Risks in the dark grow
Return for Risks in the light shrinks faster than risk
Return for Risks in the dark does not grow as fast as risk
What this means is that risks that are visible to the market (in the light) will be managed by the market. The degree of uncertainty around the risk will shrink. With decreased uncertainty, the risk premium will shrink. With broad comfort, demand will rise; with increased demand, risk premium will shrink further.
Risks in the dark are risks that are not visible or known to the market. If the market charges little or nothing for a risk, then those who are aware of the risk will bring more and more of that risk to market. And if the market continues to be unaware of a risk, then more and more extreme versions of the risk will be brought to market, the risk will grow.
As the risks grow and grow, that growth might be noticed faintly by the market as a shadow of a risk. Some market participants are canny enough to know that if someone really wants to do a transaction, then a higher price for that transaction is probably in order, even if they do not fully understand the underlying reasons.
This law is as fundamental to risk management as supply and demand is fundamental to micro economics. Any risk management actions that are taken or planned without recognition of the risks that may be in the dark initially could end up to be as flawed as management without consideration of risk.
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