That 2.5% Probability Event Will Never Happen!

This is a line we often hear from clients. Why do I need to measure my risk at 2.5% if that is very unlikely to happen? Our answer is; because it happens more often than you expect…

When managing risk, and we mean the risk that comes embedded in your business model, you must look to treat it as managing the business for the next 100 years and not the next 3 months; as wise men say  “If central bankers are paid to worry, risk managers and traders are paid to look out for the events that can kill and guard against them”.

2020 has obviously been a challenging year which no one at the end of 2019 would or could clearly have predicted. The depth of the collapse in demand, the demand for liquidity that pushed asset prices to levels not expected are all elements that would completely obliterate any budget. However, even if it could not be forecast; one could have planned for it and have it as a possible outcome, even as a low probability event.

The chart above shows the USDCOP exchange rate. The first parabola starts on the 1st of January 2020 using the volatility of the market and a 2.5% probability. One would have expected the exchange rate to remain within the parabola for 2020 with 95% probability. In reality, what happened is that the exchange rate always remained above the upper end of the parabola… a sustained 2.5% probability event.

Some businesses were able to take advantage of the move in the exchange rate but others were affected. If these businesses had done their risk management properly even though no one could predict the effect of the virus, it is probable that an outcome as the one we have seen would have been considered, and a plan could have been crafted to deal with it. Take this point further to the extreme. How do you stress test your business model? Most often our work starts by taking the clients away from a bad normal and good scenario planning framework to the effect of probable outcomes on the business financial results.

What remains is still an uncertain future, but if you were the beneficiary of the fx move how are you preparing for the possible readjustment?

Risk Management is about creating robustness and making sure the business is around for the next 100 years so it can take advantage of those 2.5% positive outcomes that will hopefully come.

For a comprehensive review of your risk management capability (FX, Commodities, Credit, Interest Rates) and turn key technological solutions get in touch: [email protected]