Archive for December 2013

Most Popular Posts of 2013

December 30, 2013

RISKVIEWS made 66 new posts in 2013.  You can visit all 66 using the links at the right of the page for Archives, which link to the new posts for each month.

For total traffic in 2013, posts from 2013, 2012, 2011 and 2010 were the most popular,  led by

  1. Getting Started in a Risk Management Career  from November 2012
  2. Avoiding Risk Management  from February 2012
  3. Five components of resilience – robustness, redundancy, resourcefulness, response and recovery  from January 2013
  4. REDUCING MORAL HAZARD  from July 2010
  5. Frequency vs. Likelihood  from June 2011

And here are ten posts that RISKVIEWS recommends that you may have missed:

Inflationary Expectations
Changing Your Attitude
Skating Away on the Thin Ice of the New Day
Full Spectrum Risk Management
Focusing on the Extreme goes Against the Grain
Maybe it is not as obvious as you think…
The World is not the Same – After
Uncertain Decisions
Murphy was a Risk Manager!

The biggest Risk is that the rules keep changing

December 27, 2013

RISKVIEWS played the board game Risk Legacy with the family yesterday.  We were playing for the 8th time.  This game is a version of the board game Risk where the rules are changed by the players after each time playing the game.  Most often, the winner is the person who most quickly adapts to the new rules.  Once the other players see how the rules can be exploited, they can adapt to defend against that particular strategy, but at the same time, the rules have changed again, presenting a new way to win.

This game provides a brilliant metaphor for the real world and the problems faced by business and risk managers in constantly having to adapt both to avoid losing and to find the path to winning.  The biggest risk is that the rules keep changing.  But unlike the game, where the changes are public and happen only once per game, in the real world, the changes to the rules are often hidden and can happen at any time.

Regulators are forced to follow a path very much like the Risk Legacy game of making public changes on a clear timetable, but  competitors can change their prices or their products or their distribution strategy at any time.  Customers can change their behaviors, sometimes drastically, most often gradually without notice.  Even the weather seems to change, but we are not really sure how much.

Meanwhile, risk managers have been forced into a universe of their own design with the movement towards heavy metal complex risk models.  Those models are most often based upon the premise that when it comes to risk, things will not change.  That the future will be much like the past and in fact, that even inquiring about changes may be difficult and may therefore be discouraged due to limited resources.

But risk can be thought of as the tail of the cat.  The exact path of the cat is unpredictable.  The rules for what a cat is trying to accomplish at any point in time keep changing.  Not constantly changing, but changing nonetheless without warning.  So imagine trying to model the path of the cat.  Now shift to the tail of the cat representing the risk.  The tail has a much wider and more unpredictable path than the body of the cat.

That is not to suggest that the path of the tail (the risk) is wildly unpredictable.  But keeping up with the tail requires much more than simply extrapolating the path of the cat from the recent past.  It requires keeping up with the ever changing path of the cat.  And the tail movement will often represent the possibilities for changes in the future path.

Some risk models and risk management programs are created with recognition of the likelihood that the rules will change, sometimes even between the time that the model assumptions are set and when the model results are presented.  In those programs, the models are valued for their insights into the nature of risk, but of the risk as it was in the recent past.  And with recognition that the risk that will be will be somewhat different because the rules will change.

You actually have to run on the treadmill . . .

December 19, 2013

Yes, that is right. Just buying a treadmill has absolutely no health benefits.


And in the same vein, just creating a risk management system does not provide any benefit. You actually have to activate that system and pay attenion to the signals that it sends. 

And you can count on the risk management system being disruptive.  In fact, if it is not disruptive, then you should shut it down. 

The risk management system is a waste of time and money if it just stays out of the way and you end up doing exactly what you would have done without it.  But, in at least 2/3 of the companies that claim to be running a risk management system, they have trouble coming up with even one story of how they changed what they were planning to do because of the risk management system.

Usually, in a company that is really running a risk management system, the stories of the impact of risk management are of major clashes. 

Risk management is a control system that focuses on three things:

  • Riskiness of accepted risks
  • Volume of accepted risks
  • Return from accepted risks

The disruptions caused by an actual active risk management system fall into those three categories:

  • Business that would have been accepted prior to risk management system is now deemed to be unacceptable because it is too risky.  Rejection of business or mitigation of the excess risk is now required. 
  • Growth of risky business that may not have been restricted before the risk management system is now seen to be excessive.  Rejection of business or mitigation of the excess risk is now required. 
  • Return from business where the risk was not previously measured is now seen to be inadequate compared to the risk involved.  Business emphasis is now shifted to alternatives with a better return for risk. 

Some firms will find the disruptions less than others, but there will almost always be disruptions. 

The worst case scenario for a new risk management system is that the system is implemented and then when a major potentially disruptive situation arises, an exception to the new risk management system is granted.  That is worst case because those major disruptive situations are actually where the risk management system pays for itself.  If the risk management only applies to minor business decisions, then the company will experience all of the cost of the system but very little of the benefits.

Free Download of Valuation and Common Sense Book

December 19, 2013

RISKVIEWS recently got the material below in an email.  This material seems quite educational and also somewhat amusing.  The authors keep pointing out the extreme variety of actual detailed approach from any single theory in the academic literature.  

For example, the table following shows a plot of Required Equity Premium by publication date of book. 

Equity Premium

You get a strong impression from reading this book that all of the concepts of modern finance are extremely plastic and/or ill defined in practice. 

RISKVIEWS wonders if that is in any way related to the famous Friedman principle that economics models need not be at all realistic.  See post Friedman Model.


Book “Valuation and Common Sense” (3rd edition).  May be downloaded for free

The book has been improved in its 3rd edition. Main changes are:

  1. Tables (with all calculations) and figures are available in excel format in:
  2. We have added questions at the end of each chapter.
  3. 5 new chapters:


Downloadable at:

32 Shareholder Value Creation: A Definition
33 Shareholder value creators in the S&P 500: 1991 – 2010
34 EVA and Cash value added do NOT measure shareholder value creation
35 Several shareholder returns. All-period returns and all-shareholders return
36 339 questions on valuation and finance

The book explains the nuances of different valuation methods and provides the reader with the tools for analyzing and valuing any business, no matter how complex. The book has 326 tables, 190 diagrams and more than 180 examples to help the reader. It also has 480 readers’ comments of previous editions.

The book has 36 chapters. Each chapter may be downloaded for free at the following links:


Downloadable at:

     Table of contents, acknowledgments, glossary
Company Valuation Methods
Cash Flow is a Fact. Net Income is Just an Opinion
Ten Badly Explained Topics in Most Corporate Finance Books
Cash Flow Valuation Methods: Perpetuities, Constant Growth and General Case
5   Valuation Using Multiples: How Do Analysts Reach Their Conclusions?
6   Valuing Companies by Cash Flow Discounting: Ten Methods and Nine Theories
7   Three Residual Income Valuation Methods and Discounted Cash Flow Valuation
8   WACC: Definition, Misconceptions and Errors
Cash Flow Discounting: Fundamental Relationships and Unnecessary Complications
10 How to Value a Seasonal Company Discounting Cash Flows
11 Optimal Capital Structure: Problems with the Harvard and Damodaran Approaches
12 Equity Premium: Historical, Expected, Required and Implied
13 The Equity Premium in 150 Textbooks
14 Market Risk Premium Used in 82 Countries in 2012: A Survey with 7,192 Answers
15 Are Calculated Betas Good for Anything?
16 Beta = 1 Does a Better Job than Calculated Betas
17 Betas Used by Professors: A Survey with 2,500 Answers
18 On the Instability of Betas: The Case of Spain
19 Valuation of the Shares after an Expropriation: The Case of ElectraBul
20 A solution to Valuation of the Shares after an Expropriation: The Case of ElectraBul
21 Valuation of an Expropriated Company: The Case of YPF and Repsol in Argentina
22 1,959 valuations of the YPF shares expropriated to Repsol
23 Internet Valuations: The Case of Terra-Lycos
24 Valuation of Internet-related companies
25 Valuation of Brands and Intellectual Capital
26 Interest rates and company valuation
27 Price to Earnings ratio, Value to Book ratio and Growth
28 Dividends and Share Repurchases
29 How Inflation destroys Value
30 Valuing Real Options: Frequently Made Errors
31 119 Common Errors in Company Valuations
32 Shareholder Value Creation: A Definition
33 Shareholder value creators in the S&P 500: 1991 – 2010
34 EVA and Cash value added do NOT measure shareholder value creation
35 Several shareholder returns. All-period returns and all-shareholders return
36 339 questions on valuation and finance

I would very much appreciate any of your suggestions for improving the book.

Best regards,
Pablo Fernandez

Collective Approaches to Risk in Business: An Introduction to Plural Rationality Theory

December 18, 2013

New Paper Published by the NAAJ

This article initiates a discussion regarding Plural Rationality Theory, which began to be used as a tool for understanding risk 40 years ago in the field of social anthropology. This theory is now widely applied and can provide a powerful paradigm to understand group behaviors. The theory has only recently been utilized in business and finance, where it provides insights into perceptions of risk and the dynamics of firms and markets. Plural Rationality Theory highlights four competing views of risk with corresponding strategies applied in four distinct risk environments. We explain how these rival perspectives are evident on all levels, from roles within organizations to macro level economics. The theory is introduced and the concepts are applied with business terms and examples such as company strategy, where the theory has a particularly strong impact on risk management patterns. The principles are also shown to have been evident in the run up to—and the reactions after—the 2008 financial crisis. Traditional “risk management” is shown to align with only one of these four views of risk, and the consequences of that singular view are discussed. Additional changes needed to make risk management more comprehensive, widely acceptable, and successful are introduced.

Co-Author is Elijah Bush, author of German Muslim Converts: Exploring Patterns of Islamic Integration.

Ingram Looks into ERM – Eight short articles.

December 17, 2013

The magazine of the Society of Actuaries published eight short essays on a variety of ERM topics.

Making Risk Models Collaborative   With our risk models, we make the contribution of managers to the risk management of the company disappear into the mist of probabilities. And then we wonder why so many managers are opposed to “letting a model run the company.”

We Must Legitimize Uncertainty   In a post to the Harvard Business Review blog, “American CEO’s should Stop Complaining about Uncertainty,” Jonathan Berman points out that while African companies are able to cope with their uncertain environment, American CEOs mostly just complain.  Americans must legitimize the Uncertain environment and study how mest to cope.

Finding a Safe Place New ERM and Old School goals for risk management all seek to keep the company safe.

ERM and the Hierarchy of Corporate Needs  The reason that ERM is not given the degree of priority that its proponents desire is that its proponents want is that it is at best third in the hierarchy of corporate needs.

Help Wanted: Risk Tolerance  It is a rare company that can create a risk appetite statement if they do not already have years of experience with the measure of risk that will be used.

What should you do at a Yellow Light?  Companies need to plan in advance what should be happening when their risk reports indicates that they are entering into risky territory.

Are you Sure about that?  Frequently, we ignore the fact that our risk models do NOT produce infomation about our risks that are all consistently reliable.  Yet we still add those numbers to gether as if they were on the exact same basis. 

Creating a Risk Management Culture – Risk Management needs to be embedded into the corporate culture, just as expense management was embedded thirty years ago. 


Risk Culture doesn’t come from a memo

December 16, 2013

Nor from a policy, nor from a speech, nor from a mission statement nor a value statement.

Like all of corporate culture, Risk Culture comes from experiences.  Risk Culture comes from experiences with risk.  Corporate Culture is fundamentally the embedded, unspoken assumptions that underlie behaviors and decisions of the management and staff of the firm.  Risk Culture is fundamentally the embedded, unspoken assumptions and beliefs about risk that underlie behaviors and decisions of the management and staff of the firm.

Corporate culture is formed initially when a company is first started.  The new company tries an approach to risk, usually based upon the prior experiences of the first leaders of the firm.  If those approaches are successful, then they become the Risk Culture.  If they are unsuccessful, then the new company often just fails.

In his book, Fooled by Randomness, Nassim Taleb points out that there is a survivor bias involved here.  Some of the companies that survive the early years are managing their risk correctly and some are simply lucky.  Taleb tells the story of mutual fund managers who either beat the market or not each year.  Looking back over 5 years, a fund manager who was one of 30 out of 1000 who beat the market every one of those five years might believe that their performance and therefore their ability was far above average.  However, Taleb points out that if whether a manager beat the market or not each year was determined by a coin toss, statistics tells us to expect 31 to beat the market.

That was for a situation where we assume that the good results were likely 50% of the time.  For risk management, the event that is being managed is often a 1/100 likelihood.  There is a 95% chance of avoiding a 1/100 loss in any five year period, just by showing up with average risk management.  That makes it fairly likely that poor risk management can be easily overcome by just a little bit of luck.

So by the natural process of experience, Risk Culture is formed based upon what worked in the past.

In banks and hedge funds and other financial firms where risk taking is a fundamental part of the business, the Risk Culture often supports those who take risks and win.  Regardless of whether the amount of risk is within limits or tolerances or risk appetite.

You see, all of those ideas (limits, tolerances, appetites) are based upon an opinion about the future.  And the winner just has a different opinion about the future of his/her risk.  The fact that the winner’s opinion proves itself as experience shows that the bad outcome that those worrying risk people said was the future is not the case.  When the winner suddenly makes a bad call (see London Whale), that shows that their ability to see the future better than the risk department’s models may be done.  You see, there are very very few people who can keep the perspective needed to consistently beat the market.  (RISKVIEWS thinks that the fall off might well follow an exponential decay pattern as predicted by statistics!)

The current ideas of a proper Risk Culture (see FSB consultation paper) are doubtless not what most firms set up as their initial response to risk. That paper focuses on four specific aspects of Risk Culture.

  • Tone from the top: The board of directors11 and senior management are the starting point for setting the financial institution’s core values and risk culture, and their behaviour must reflect the values being espoused. As such, the leadership of the institution should systematically develop, monitor, and assess the culture of the financial institution.
  • Accountability: Successful risk management requires employees at all levels to understand the core values of the institutions’ risk culture and its approach to risk, be capable of performing their prescribed roles, and be aware that they are held accountable for their actions in relation to the institution’s risk-taking behaviour. Staff acceptance of risk-related goals and related values is essential.
  • Effective challenge: A sound risk culture promotes an environment of effective challenge in which decision-making processes promote a range of views, allow for testing of current practices, and stimulate a positive, critical attitude among employees and an environment of open and constructive engagement.
  • Incentives: Performance and talent management should encourage and reinforce maintenance of the financial institution’s desired risk management behaviour. Financial and non-financial incentives should support the core values and risk culture at all levels of the financial institution.

(These descriptions are quotes from the paper)

These practices are supported by the Risk Culture for a few very new firms.  As well as a very few other firms (and we will mention why that is in a few paragraphs).  But for at least 80 percent of financial firms, these items, if they are happening, are not at all supported by the Risk Culture.  The true Risk Culture of a successful firm has evolved based upon the original choices of the firm and the decisions and actions taken by the firm that have been successful over the life of the firm.

These aspects of Risk Culture are a part of one of the three layers of culture (see Edgar Schein, The Corporate Culture Survival Guide).  He calls those layers:

  • Artifacts
  • Espoused Values
  • Shared Assumptions

The four aspects of Risk Culture featured by the FSB can all be considered to be “artifacts”.  Those are the outward signs of the culture, but not the whole thing.  Espoused Values are the Memos, policies, speeches, mission and value statements.

Coercion from outside the organization, such as through regulator edict, can force management to change the Espoused Values.  But the real culture will ignore those values.  Those outside edicts can force behaviors, just as prison guards can force prisoners to certain behaviors.  But as soon as the guards are not looking, the existing behavioral standards based upon the shared assumptions will re-emerge.

When the insiders, including top management of an organization, want to change the culture, they are faced with a difficult and arduous task.

That will be the topic of the next post.

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