21 Aug 2020
Taming the swan: black swan events & risk management post Covid-19
Covid-19 and the impact of confinement on the world economy makes it a classic black swan event: it’s been utterly devastating in both its impact and its unpredictability. What learnings have we had so far, and what strategies can we potentially employ to cope with similar events in future?
In his book The Black Swan: The Impact of the Highly Improbable, former Wall Street trader and finance professor Nassim Nicholas Taleb defines the “black swan” event as a high impact, low probability event with certain pre-conditions: it’s unpredictable and rare beyond what is normally expected of a situation, and it has potentially severe consequences.
The black swan event and the South African rand
The South African Rand is typically considered to be a good proxy for the emerging market basket of currencies. As the full effects of the pandemic have become clearer, the Rand, trading against the US Dollar and other hard currencies, has been absolutely savaged by the flight to safe haven assets and currencies by global investors and traders alike. To illustrate this, the Rand depreciated by nearly R5 in a relatively short period of time after the pandemic hit, as panic selling quickly turned into widespread risk aversion.
Conventional market risk models are typically used by applying historical data to a regression model based in a “normal” market environment. A model simulation is then run over thousands of times by changing model factors slightly, resulting in a distribution of various possible outcomes. But even the most sophisticated models often cannot accurately predict the severity or duration of a black swan event on financial markets.
More specifically, they cannot predict the effect of the black swan event on the currencies of the beleaguered countries that are affected – after all, it’s not possible to predict something by mapping history that has never happened before.
But this paralysis in short-term liquidity markets and wider capital market dislocation had a profound impact on treasuries all across the world, not just in South Africa.
Coping with the consequences of black swan events
If conventional financial models can’t accurately predict these low probability black swan events, and our emotional biases make us seemingly blind to them, are there strategies that risk managers can use to cope with the event’s actual or potential consequences?
Nassim Taleb identifies five human constructs that muddy our ability to forecast and predict when black swan events will arrive:
- Humans are better with information that confirms or supports they own beliefs and values, known as confirmation bias.
- We love stories, they can cloud the facts and our ability to make rational decisions. This means that we may be drawn towards a less desirable outcome simply because it’s a better story.
- Human nature is not programmed to imagine black swan events.
- Humans tend to prefer to exist at the more extreme edges of the success/failure pendulum, ignoring seemingly boring “middle” data when formulating simple decisions.
- Humans overestimate their own intelligence or knowledge and focus too narrowly on their own field of expertise (tunnel vision).
Moving from risk management to planning strategies
So how should treasuries and risk managers prepare for Taleb’s black swan event as an outlier, when our own psychology is designed to blind us to them?
The answer may lie in shifting the emphasis from classic risk management to dealing with the consequences of such unforeseen events. This new kind of risk management approach should consider the following elements:
● Liquidity management
Does your business have immediate and sufficient access to cash flow in a time of need?
● Risk based approach to market volatility
Just because a strategy has worked for the last 10 years doesn’t mean it’s future proof. Diversification allows treasurers to structure their portfolios with alternative hedging products that act as counterweights to different economic or financial circumstances.
● Prepare and plan
It’s crucial to have a hedging policy that clearly articulates the appropriateness of different hedging instruments to use, given a specific set of market scenarios and given a company’s ability and willingness to tolerate risk.
It’s also important to ensure awareness of the black swan event concept through the decision making structure, from management up to and including the Board. Counter-complacency can be put in place by regularly seeking an independent view via external experts, reviewing market research or analysing third party data.
● Stress test your risk assessment
Instead of scenario analysis, see what levels of market risk your business will capitulate under and work backwards to ensure you’re protecting your treasury functions accordingly.
● Work from home
Robust IT networks, uninterrupted power supply and treasury platforms are critical to ensuring that companies continue to function when normal office conditions are disrupted from lockdown restrictions, social distancing and/or load shedding.
For many businesses, it takes a sudden and unforeseen event for its treasury to get its “black swan fire drill” in place. However, it is much more preferable for risk managers to prepare for the unexpected and think the unthinkable before it has actually happened, rather than to get wise only after the event has happened. The good news, though, is that companies that make it through unprecedented crises such as the Covid-19 pandemic will emerge stronger, and many of the drivers of precaution and risk management will drive value creation over the long term too.
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