Risk as Strategy: Defending against Catastrophic Turns of Fortune
10 Pages Posted: 24 Apr 2020
Date Written: April 22, 2020
As I write this, markets across the globe are in turmoil and economies are slowing due to the Covid-19 pandemic. Throughout the early phases of the turmoil, we heard explanatory narratives beginning to form such as, “This came out of nowhere! No-one saw this coming.” The irony is that statements like this are both true and irrelevant: executives don’t have to see disruptions coming to strategically prepare for one. In fact, if they can see one coming it is likely too late to economically mitigate its risk.
Many executives feel their corporate risk management functions, including enterprise risk management (ERM) functions, address potentially disruptive Black Swans. These functions often prepare risk inventories and other risk-related analyses that list events that could impact a firm, and then they catalogue ways such events are being monitored and controlled. However, processes like these generate a dangerous illusion of control because, as one executive recently explained to me, “No one believes something is going to happen, until it happens and of course, by then it’s too late.”
It is important to understand how prevalent the problem of underestimating Black Swans or tail risk is. For example, how many firms, mutual funds, pension funds, etc., exposed to the stock market entered the year 2020 with an equity tail risk hedge? If our experience is any indication, the answer is not very many even though it was well-known that: (1) the then equity bull market was very mature, (2) equity returns at the time were well above historical norms, and (3) the cost of equity risk was very low.
We believe executives will increasingly become accountable for the performance of their firms during periods of extreme volatility following a crisis, catastrophe or recession. Given the frequency with which such events are occurring this seems inevitable, especially given the amount of debt that continues to be added to the national balance sheet.
This paper presents a strategy-based approach for managing corporate tail risk, which is illustrated by way of a contemporary example using the volatility index (VIX) before the recent (February-March, 2020) volatility expansion.
Keywords: Black Swan, Corporate Strategy, Economical Hedging, Tail Risk Management
JEL Classification: L21, L22, L25, M21
Suggested Citation: Suggested Citation