tABlE 1: Strengths and Weaknesses of Various Risk Views
RiSk ViEW StREngtH
Eyes Shut Low cost; high reward
Quick look Reliable, proven
one-Eyed
two-Eyed
multidimensional
Can readily develop and explain risk-reward trade-
offs
Two views of risk just might take care of most of the
risk
Never having to say you’re sorry
WEAknESS
Low predictability; high failure rate
Declining/fluctuating returns due to forces outside of
field of view; may miss non-traditional risks
Expensive; choices will eventually tend toward
aspects of risk that aren’t covered by the single view
Which two views will be the most important?
very expensive; can tend toward finding a reason not
to do everything
gresham’s law of Risk
Those who don’t see a risk will drive ■ ■
those who do see the risk out of the
market.
Gresham’s law is, of course, the same
as the adage, “Bad money will drive out
good.” The varying risk views affect the
types of transactions that are likely between counterparties with different risk
views. Since five risk views were defined,
there are 20 counterparty pairs that can
be formed in a two-way transaction. I’ll
examine a few examples of the counterparty effects using three risk views:
one-eyed (volatility), one-eyed (ruin)
and two-eyed.
(volatility) risk view favors risks that are
in areas B, C and D. The one-eyed (ruin)
risk view favors risks in areas A, B and
C. The two-eyed risk view favors risks
in areas F, A, and B.
Since the ruin and volatility risk
views overlap in areas B and C, then that
is where they are likely to find agreements as counterparties. The two-eyed
risk manager finds agreement with the
one-eyed (ruin) risk manager for risks in
areas A and B, but only in area B with the
one-eyed (volatility) player. In this case,
agreement can only be found in areas A,
B and C.
the influence of Competition
As mentioned earlier, financial market
theories often assume that the market
is completely immune to any influence
of the participants. In some situations,
that’s just not the case for risk transactions. The participants often do seem to
affect the market, and diverse risk views
may play a major role. Again using the
graph, the evolution of the market and
the working of Gresham’s law can be
seen to operate in much the same way
as a natural progression of types of trees
in a forest.
For example, consider a market where
market Effects
Think of Figure 1 as representing the
space of all risk and reward choices
that are possible to these three market
participants. The vertical axis shows
the expected reward as a percentage
of the ruin estimate. The horizontal
axis represents the expected reward as
a percentage of volatility. The vertical
line at the 100 percent mark represents
a hypothetical minimum target for the
one-eyed (volatility) risk manager and
the horizontal line slightly above the 25
percent mark is a hypothetical minimum
target for a one-eyed (ruin) risk manager. The diagonal line represents a very
hypothetical target for the two-eyed risk
view—different weights on volatility vs.
ruin would affect the slope and position
of the line.
With these three lines, the risk universe is divided up into six regions,
labeled A through F. The one-eyed
FiguRE 1: Viability of Transaction Depends on Risk View
Risk & Reward 40%
35%
B
A
C
30%
25%
F
D
20%
RoE
15%
E
10%
5%
0%
0%
50%
100%
150%
