The Risk Management Wager

Many people will look at Risk Management actions as “bets” that they either win or lose.  To those people, Risk Management is a good bet if there is an actual net increase to profits from the risk management activities.

That is a backwards looking approach to Risk Management.  Under that approach, many risk management actions will “lose” money for the firm.  That is because if the risk management action involves a transaction that creates a risk offset, the counterparty will expect to be paid a margin over the expected cost of the risk, which will mean that on the average, people who transfer risks will lose money to at least the amount of that margin.

But that backwards look is not the whole story about Risk Management’s value.  The rest of the story is about how Risk Management changes the forward looking prospects of the firm.

Think about it this way, if your business is to run lit sticks of explosives into a building to be demolished, how would you feel about a longer fuse?

For as long as you have been in this business, the fuse has been long enough.  So without the longer fuse, you have always been ok.  And so far, you have never, ever tripped and fallen on the way in or out of a building.

And more fuse is expensive.  Probably a dollar per inch.  If you had added a few extra inches in the past for the hundreds of times you had run the dynamite into the buildings, all of that extra money would have been wasted.

All that extra fuse adds is a chance to get up and run out of the range of the blast if you should stumble.  And if you never stumble that is a waste of money.

So what do you bet?

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