Thursday, May 17, 2012

Known vs. Unknown Risks

[T]here are known knowns; there are things we know we know.
We also know there are known unknowns; that is to say we know there are some things we do not know.
But there are also unknown unknowns – there are things we do not know we don't know.

As "Business is War", the above philosophy absolutely applies to financial trading, fund management. 

An options trader may look at a far Out-Of-The-Money put option, and conclude that it's well overpriced using Black-Scholes valuation; the next question should then be, "is it really?" 

From my experience, there're plenty of seemingly high reward, exploitable with low risk, lucrative market inefficiencies off empirical analysis; yet unobserved risks always exist. And as soon as money's committed, Murphy's law kicks in immediately, that 'Anything that can go wrong, will go wrong'; of course...

Practical Risk Management 

So realistic risk management for any business must take into account both known and unknown risks. In the case of market neutral fund management, this could be valuation model inaccuracy, liquidity shortage, actual transaction costs, asset structural change, term structure moves, short squeeze events, fat finger mistakes and etc.

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