Five Paradigms of Market Risk Management

Market risk is a term of the financial sector. Wikipedia: market risk is the risk of losses in positions arising from movements in market prices. Risk factors are equity risk, interest rate risk, exchange rate risk, commodity risk, inflation risk…Other risk categories are credit risk, liquidity risk, operational risk, volatility risk, reputation risk, counter party risk…

For better financial risk management I recommend Aaron Brown's great book: Red-Blooded Risk.

Any business that transforms knowledge, products, services…into margins face (market) risks. The big difference to finance: most of the instruments used to manage it are usually not tradable.

Does everyone know what risk is?

Everyone talks about risk, but only a few give serious thought to what it is. It is two-sided - with opportunities and danger. Although, danger and opportunities are often not quantifiable, optimizing risk means arranging things that make opportunities and danger a positive contribution.

Optimal risk of cross country skiing

I love skating on diverse tracks through a beautiful winter land.

In seeking the optimal risk I select duration and speed to have fun but avoid hazardous actions. The preferred tracks are not the most difficult ones, but their profile look like a smoothed trajectory of a, say, stock price time series. Ups and downs follow quite frequently and arhythmic.

I need to decide: how fast do I go down to get enough momentum saving energy when skating up the following uphill section without falling. And how fast do I skate uphill to reserve enough power to make the final step powerful enough to get the right speed for the following downhill part.

Running the same tracks more often I become more experienced and find the optimum easier. But it becomes boring...

In business you know your abilities quite well and they are even quantifiable, but what about the market? Innovation usually means riding the waves of a market behavior you don't know well. And this is where the headache begins.

Five paradigms of market risk management

Duality - in your analysis, be aware that you have two parts: the known and the unexpected
Boundaries - try to find boundaries that distinguish situations where markets behave "normal" from the rest. Boundaries based on cost of risk should work.
Optimization - Risk optimization only works inside the boundaries.
Evolution - business is often co-evolution. Not surprisingly genetic programming is a general way to optimize
Game Theory - a mathematical study of uncertainty caused by actions of others

IMO, important is Duality, Boundaries and Optimization.

Market risk optimization is the key: it's an instrument of enterprise development and control. Real options are one tool…Indispensable for Innovators.