International Law

The Risks of Risk management

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Paul Wilmott has an instructive piece on why risk can mean much more than statistical risk.

"We have learned the hard way how important it is to measure and manage risk.

Despite the thousands of mathematics and science PhDs working in risk management nowadays we seem to be at greater financial and economic risk than ever before. To show you one important side of banking I would like you to follow me in an exercise with parallels in risk management.

You are in the audience at a small, intimate theatre, watching a magic show. The magician hands a pack of cards to a random member of the audience, asks him to check that it is an ordinary pack, and to give it a shuffle.

The magician turns to another member of the audience and asks her to name a card at random. "Ace of Hearts," she says. Pick a card, any card The magician covers his eyes, reaches out to the pack of cards, and after some fumbling around he pulls out a card.

The question to you is what is the probability of the card being the Ace of Hearts?"

Wilmott has some good answers, but I cannot tell whether he is making the claim that most of the risk underlying say a particular derivative are non mathematical, and that we cannot even hope for an actuarial science of risk. In his particular example, Bayesians could always come up with the right answer based upon what they picked as the underlying probability distribution.

For example, one answer to the Wilmott question is that the answer is zero, because the fumbling of the magician reveals that he is pretending not to be very good, and he is setting up the audience for finding the Ace of Hearts somewhere else.

If you have seen this trick before, this is a perfectly good answer. But if you haven't seen this trick before, the answer of zero will strike you as off-base or somehow deeply wrong.

I think that the overall point Wilmott is making is the exercise of risk taking involves making bets about things that you may not have seen before - events that cannot be treated as if they were the result of many sided dice.

Full post as published by Misleading Advertising Law on December 11, 2008 (boomark / email).