TOP | Trade-Off Paradox
One of the curious but broken fixations Risk Management Practitioners have with understanding probability is their lack of insight into how to model and policy drive expected value. Global Risk Management standards have a tendency to depict risk as the likelihood of something happening and its impact.
There is nothing wrong with that; this is all fine, but when Risk Managers fascinate over juvenile ways of demonstrating outcomes from these two realms (probability and impact) by using dice or raw probability without appreciating the transformative relationship between these two distributions, they blind themselves from pricing risk properly.
The Price of Risk or its Expected Value calculation is not dissimilar to reporting exposure potential to stakeholders through the lens of an option premium and over the years, the outcome of this Risk TOP Dilemma has presented itself to me in various settings that have spawned dysfunctional decision-making; here are a few examples.
▨ Your ability to influence or even deflect an exposure becomes more limited the closer its proximity is to you. Additionally, it becomes more expensive to transfer or treat it when a threat is literally upon you. Very few people appreciate this risk velocity dynamic, even fewer people attempt to model it and I often hear business managers demanding things be hedged or controlled when they are already lost.
▨ Models like Value at Risk have their place, but they are also backward-looking much of the time and have a tendency to create stakeholder tunnel vision with respect to risk events that are passing rather than the genuine hazards we face in the moment. Most regulatory standards from the banking domain suffer from this VaR dynamic, and regulators struggle to unravel a solution for it.
▨ Traders who wait for confirmation are paying dearly for this market intelligence by forgoing their potential gain in exchange for certainty. Nothing comes for free and in this case, they are trading off an improvement in probability with their yield.
Nothing comes for free and increasing your certainty is expensive.
Martin Davies | Causal Capital
Understanding EV
In the last TOP Paradox above, it is possible that traders can wait so long for confirmation from the market that the expected value of their opportunity moves into a negative trajectory from basically stalling, procrastinating and observing rather than taking.
To put it another way, it is possible to be so risk adverse that you end up with more risk than less.
Martin Davies | Causal Capital
In the three trade entry point examples shown below, your probability of winning increases as the trade opportunity progresses, but the expected value of the opportunity is also diminishing (risk in the real world is in flux, it's rarely stationary). In the end, when certainty is a near surety, the Expected Value of the opportunity drops into negative space.
The Progression of a Risk Surface | SNB Capital
Lance Breitstein from SNB Capital explains the dilemma well.
Lance Breitstein on Expected Value | SNB Capital
I get it, no one wants risk or downside, but from risk or uncertainty as it is, opportunity is born. So it is with this Risk TOP Dilemma, you can't uncouple opportunity without having risk.
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