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What are Black Swans in Risk Management?

Hey there! So good to have you back again. Are you wondering what the term “Black Swans” in risk management indicates and why the name, black swan?

Way back in the year 2007, Nassim Nicholas Taleb, who was a finance professor, a writer, and a former wall street trader, coined this term and mentioned this idea in a book before the 2008 financial crisis. In simple words, black swan events are impossible to predict because of their extreme rarity that may cause major setbacks and consequences. Hence, people need to consider any possibility of a black swan event, whenever it may be, and accordingly, a plan must be created.

One of the most relatable and recent examples is Covid-19 which started earlier in the year 2020 and then became a global pandemic, disrupting various markets and global economies around the world. The name black swan event is because black swans are very rare as many swans are white. Earlier black swans were considered not to exist at all until one was discovered, and hence the main lesson for all is that what we consider to be rare events can be more of a common occurrence than we think.

Black swans are completely random and are very hard to predict both in terms of timing and the magnitude of the event. A few of the examples have been stated below:

The Wall Street crash of 1929:

  • The Wall Street crash, also known as the great crash, was the first black swan event in recorded history.
  • The consequence of this event pushed the US into a prolonged recession that lasted over ten years, spreading to other countries as well.
  • The event of hyperinflation in Germany, the rise of Hitler, and eventually World War II are all the outcomes of the US recession.

Did you know that as Covid-19 spread its wings, the Indian stock markets started witnessing a steep fall too? However, this is not something new as there have been prior such events in the past that made the Sensex decline. One such incident we all are aware of is the Harshad Mehta scam that had a shattering impact on the economy. For those who aren’t aware, it involved a huge manipulation of stocks worth around Rs.4500 crores and led to the securities scam of 1992.

One thing to be noted here is black swans may not always be negative. One such example is India’s decision to open the economy in the year 1991. Economists and analysts back then would have never given it much chance for a large-scale liberalization. The impact was a game-changer and created immense value for the Indian economy and the Indian markets.

Let us now understand how to avoid black swans:

  • Traditional risk management usually relies on identifying risks, generally based on the expertise and experience of the teams involved in the enterprise.
  • If the risk falls out of the expertise of the team, then it is unlikely to be considered on priority. Risk management, however, is not designed to identify back swan events.
  • Risk management focuses more on managing risks that have a high probability of occurrence. Time and resources are allocated to prioritize all the potential bad events.
  • To conclude, by applying traditional risk management techniques, most of the black swan risks may not be considered as they have a very low probability.
  • Strategic assumptions must be made for the business operations.
  • This strategy then needs to be broken into smaller assumptions. To ensure that the strategy is achieved, both internal and external factors must be kept in mind.

This set of assumptions needs to be tested against various risk drivers that would impact the business strategy to a massive extent.

For example:

  1. Market changes like currency fluctuations, oil prices
  2. Socio-political changes like change of government
  3. Health crises like a pandemic, flu, etc

Minor events like oil price fluctuations of 10% per annum would have a comparatively less impact than oil price fluctuations that triple in 12 months. These drivers challenge sensitivity and stability so that they can be changed with immediate effect.

To conclude:

  • Black swans can be both good as well as bad for the business.
  • Some of the businesses seemed highly impossible at the beginning but are very successful now.
  • Examples include Google and eBay, both have now become massive global businesses.
  • One tip here that can be very useful would be to not consider black swan’s events as risks but should be considered as investment opportunities.

If you are interested to know more about the topic of risk or risk management, then you should consider doing the FRM course. The FRM course eligibility is very simple. There are no minimum eligibility criteria for appearing for the FRM course exam. The FRM course full form stands is Financial Risk Manager and is regulated by GARP (Global Association of Risk Professionals), USA.

What is the FRM Course (Financial Risk Manager)?

What is the FRM course? Here’s a summary:

  • The FRM course prepares candidates to make informed risk decisions. 
  • Financial Risk Managers acquire expertise and are committed to better risk management practices. 
  • The FRM course is valid across 195 countries, and GARP has over 263,000 active members. 
  • The core topics covered are foundations of risk management, quantitative analysis, financial markets and products, and lastly, valuation and risk models.

To know more, please feel free to contact our counsellors, who would be more than happy to assist you. All the best and happy learning.