Risk Management, PRMIA

amgodbole

I discussed this in 1994 with the systems world and as late as 2006 as I am do a PhD in Complexity Economics & System Theory, it doesn't work.

For one this you invoke the 1st and 2nd Laws of Thermodynamics which have been proven not to work and are doubtful in general. Secondly value can be destroyed because you are not dealing with absolutes here but someones idea of value with imperfect coupling between parties.

There's a lot more, see W Brian Arthur's site and the Complexity Theory page on Wikipedia.

Just my thoughts..

Stefan

Aniruddha
Good thought, many 'treatments' for risk do in fact merely change one risk type for another.

However there is one case where risk can be created and destroyed, i.e. writing options
Writing an OTC option, for example, creates market risk for the writer, and credit risks for the purchaser. On option expiry, the risk evaporates, the only movement being the premium or settlement amount, or nothing if the writer is liquidated. On exchanges, the credit risk is absorbed by the clearing house, with both sides having market risk which evaporates again on settlement or margin call.
Pat

Good thinking theoretically. If there was a law of conservation of risk, then risks would be transferred from one entity to another. As long as there is no law of conservation of returns, there can not be a law of conservation of risks.

A result of looking for such a law would lead to better risk management as instruments developed with this in view are likely to be more suitable.

Keep it up Aniruddha.

To Mr. Pat Mc Connell:

I am not sure whether the risk is being destroyed. Consider, I have a EUR 100 export which I expect to realize 12 months later, and which I hedge by buying a 3 month ATMF strike put on EUR (call on US$). The market risk is clearly transformed into a credit risk (on the writer of the option) But, what after 3 months and 1 day? My underlying exposure (i.e. the export)is still alive while the option has expired. In the example you gave the risk got elimanated due to the exposure getting extinguished---and that would also be the case if there were no hedge at all!

To Mr. D N Prahlad:

It is very interesting that you point out that a complementary "law of conservation of financial returns" would also have to exist IF a "law of conservation of financial risk" exists. Its interesting and I need to think more about this!

My problem was, and is always, in the way people describe the problem. Your title was financial but in reality the correlated risk is invariable not so. Thus when I replied it was to address the superficial statement and I note from one of you respondent something about Credit. This is a popular misconception about 'risk' in general because the issuer of the 'risk' invariably addresses an underlying concern that has a proxy to 'credit' and so buys such but when the correlation doesn't manifest and they have a loss the 'problem'. Your respondent is technically right but functionally wrong because all layers of the client's risk thought process should be considered in the question you posed not just a single aspect of 'product'.
There is a whole science of organisational management that has been overlooked because it is inconvenient to traders yet articulates the issues involved and explains why feedback (and feed forward) structures appear everywhere in Nature and therefore the Economy (because we a re a social system derived therefrom).
I would implore some who are interested to review Stafford Beer and Frederic Vester as two names capable of explaining many of the issues.
Hope this assists.
Stefan

Aniruddha
You have used a specific example of hedging an export to illustrate a risk that remains after option expiry. Of course the export risk itself will be 'destroyed' (an emotive word I admit) when the export contract is executed, e.g. when the export becomes useless (e.g. rots in the warehouse) or is sold at a profit or loss to an importer. Either way the risk is extinguished. Of course you might argue what you do with the money received is in some way a conservatiion of risk. It is not if the choice is to give the money away.

Life is full of risks but that does mean that there is somewhere a fixed quantum of risk that is somehow distributed around the world and conserved through multiple transactions.

My original example was not hedging but speculation. For whatever reason, assume whimsy, I choose to write an option, which creates risk. When the option expires it is extinguished, with a loss or a gain.
Think of it in betting. I bet on the third horse in the sixth race. It loses I lose the stake I have risked, it wins I am up a few dollars. Either way risk created, risk destroyed.

But keep it up, a great discussion point
Pat

I agree with Aniruddha. I don't think a law of conservation of risk could exist. As Aniruddha points out, the mere perception of demand or supply can influence the measure of risk. To decide whether risk is conserved or not, we will first require an absolute way to quantify risk. And there is no absolute way to quantify risk. All the known measures of risk are highly subjective. Be it the simple s.d. or the not so simple ARCH, GARCH or something more fancy. They are all subjective upon the underlying model of price moves assumed.



I may also point out that energy need not necessarily be conserved. The law of conservation of energy comes from the fact that we have a time translational symmetry in the known laws of physics (refer to Noether's theorem). It is just that we do not know of any physical laws or phenomena where this might not hold true. In which case, the law of conservation of energy breaks down. Just like what happened with parity.



-- Krishna