China Business Knowledge @ CUHK Luncheon Series: Managing Invisible Risks

By China Business Knowledge @ CUHK

It is interesting how human beings are always trying to predict the future while we know very well that the efforts are often in vain. Especially in the business world, researchers and practitioners have come up with numerous complex models to predict the market movements or upcoming trends to eliminate future risks. However, some risks are simply unforeseeable. What should investors and business leaders do then? In the 12^th talk of the China Business Knowledge @ CUHK Luncheon Series: Risk Management of Invisible Risks, Prof. Michael Zhang and Mr. Patrick Ip shared their insights on this relevant yet difficult topic.

“The traditional method of calculating risks assumes some distribution of events. For example, when it comes to stock market performance, we often use historical data to make claims such as tomorrow there is a 70% chance that the stock price will go up with 30% chance it will go down. However, we are just pretending we know, when we don’t really know for sure,” said. Prof. Zhang, Associate Dean (Innovation and Impact) and Professor of Decision Sciences and Managerial Economics at CUHK Business School. “For anything that is more complex than dice rolling and coin flipping, it is not possible to know the distribution of probabilities and there is no guarantee that the distribution will not change.”

 

In probability and statistics, the distribution of a data set tells us the possible values or intervals of the data and how often they occur. In reality, however, many life events, such as political elections and outcome of certain research and development projects, are impossible for us to map out the distribution. Without the distribution, one cannot calculate the probability and assign confidence.

And, what is equally worse is that when we pretend to know the distribution and calculate the probability based on our assumptions. This also explains why most traditional models on risk assessment using historical data are still inadequate when used to predict the future. As Prof. Zhang explained, when ambiguity (or distribution uncertainty) was added to the equation, it would greatly affect how well we predicted the unforeseeable risk.

“Ambiguity means we know that tomorrow the stock market will go up or down but we don’t know the distribution, which means we don’t know the probability. That’s probably the most realistic depiction of the stock market or anything we observe,” Prof. Zhang said. “You always have higher uncertainty when you have ambiguity, on top of traditional risks.”

In financial markets, even if one uses hedging to remove risks in the best possible way, whenever there is ambiguity, one is still faced with many uncertainties. In his paper, Prof. Zhang calculated that whenever there is one unit of ambiguity and one unit of risk, the uncertainty level would increase four times than what the traditional risk would measure.

“You cannot ignore ambiguity and just use traditional risk models to make predictions. You have to introduce ambiguity into your model to obtain better measure of uncertainty and then place your caution on the newly calculated risks,” said Prof. Zhang.

How can we measure ambiguity? Prof. Zhang said there are two ways: subjectively and objectively.

“Subjectively, if you feel something is not right, you can actually manually give a big number to ambiguity and avoid trading,” Prof. Zhang said, adding that the objective way of measuring ambiguity can be achieved using an AI algorithm.

While it may seem normal for people to run away from risks, there is also the saying that where there is risk, there is opportunity. Veteran banking expert Mr. Patrick Ip shared with the audience how risk managers balance risks and opportunities. Mr. Ip is currently the Managing Director for Jiufu Group and a CUHK alumnus.

“In order to take precaution, we always try to find out what we should know. However, sometimes we don’t know what we should know and that’s the biggest issue in risk management. Risks will happen when we do not know what we should know,” said Mr. Ip. “In the traditional banking world, we cannot predict what will happen in the financial market but we try to manage the uncertainties.”

Given today’s fast-changing world, unpredictable events are expected to happen more frequently in the financial markets. According to Mr. Ip, even though we can’t really predict what will happen, there is no harm in trying to prepare for the rainy days. For example, risk managers can study closely about the supply chain and sources of risks in a company, perform scenario analysis and stress tests and create contingency plans and drills, etc.

“If you’re fully prepared in advance, it doesn’t mean you can always solve a crisis situation in reality. But at least you’re prepared for the worst scenario” said Mr. Ip, adding that sometimes good crisis management is going back to basics and relying on our common sense.

“Banking is a risk-taking industry. Actually, we earn profits by taking credit risk and market risk. The return compensates the risks we take. Whether we can manage the risk well is very important. If we can, we can earn more,” he said. “We need to articulate the risk very well and try to find out what is the right way to take it. We need to accept and embrace risks; we don’t just avoid risks because playing safe cannot help a company make any profit.”

Good leadership is also invaluable to a company facing a crisis. “This is the time for senior management to take the lead and help the company out of the crisis. If a leader can do that well, he or she can move the company forward on the profit-making track,” said Mr. Ip.

The luncheon talk generated a vibrant discussion between the speakers and the audience. Stay tuned for our future events.

China Business Knowledge @ CUHK is the knowledge platform of CUHK Business School. It showcases top-notch research by the faculty at CUHK Business School and offers thought leadership and insights into the ongoing developments and modern business environment of China and the world.

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