Heads or Tails? Hedging extreme risks

What are extreme risks?

Risk managers refer to extreme risks as "tail risks"; they are at the outer tails of the normal distribution curve. Several factors influence the definition of an "extreme" risk. 

1. severity of consequences: The higher the potential loss, the more extreme the risk (e.g., bankruptcy vs. decline in sales). 
2. probability of occurrence: events that are very unlikely to occur but have severe, negative consequences are considered extreme risks (e.g. asteroid hits the earth)
3. systemic impact: an extreme risk event affects multiple sectors, industries, or regions (e.g., COVID-19 pandemic).

Which extreme risks are typical for the CEE region? 

The CEE region, with its unique geopolitical and economic situation, is exposed to certain extreme risks that can have a significant impact on businesses and economies in the region.

1. Proximity to conflict areas and historical geopolitical tensions can pose extreme risks in the CEE region (example: Russia-Ukraine conflict spills over to neighboring countries).
2. Many CEE countries are heavily dependent on energy imports and vulnerable to supply disruptions (example: lack of natural gas supplies from Russia)
3. Economies in the CEE region can be sensitive to global economic conditions, foreign investment, and fluctuations in export demand (example: Economic downturn in 2008 led to decline in foreign investment and falling export demand)
   
4. Regulatory changes in both the CEE region and the European Union can bring extreme risks (example: EU regulations on data protection required significant adjustments in the CEE region). 
5. Cybersecurity threats are evolving in parallel with digital transformation in the CEE region (increased cyberattacks on financial institutions and government infrastructures).
6. Extreme weather events and environmental disasters are risks with widespread impact on multiple sectors (example: damage from floods)
7. Migration and demographic changes can pose long-term risks to economic stability and social cohesion in CEE countries (example: Aging population and migration of skilled labor to Western Europe).

Conclusion: These risks, which are often intertwined and exacerbated by global trends, require comprehensive and forward-looking risk management strategies to mitigate their impact. By understanding the unique risks facing the CEE region, businesses and policymakers can better prepare for and respond to extreme risk events, strengthening the region's resilience and long-term stability. 

Internal or external risk management?

Especially in high-risk industries (such as insurance, pharmaceuticals, mining, …), companies have specialized risk management departments. Despite these internal resources, there are good reasons to involve external partners in risk management.

External partners...

... offer an unbiased perspective on the risk profile and provide new insights (example: external company helps financial institution to review and improve risk management processes)

... have specialized expertise in particular risk types or industries to develop robust risk management strategies (example: RBI advises on expansion into CEE region)

... provide additional resources to manage complex or emerging risks (example: external team of experts provides support when a crisis occurs)

... can improve a company's risk management with benchmarking and best practices (example: external company prepares benchmarking study for manufacturing company)

... assist in training and development of internal risk management team (example: external expert trains employees of energy company on latest regulatory requirements)

... enable compliance with regulatory requirements, such as regulatory or contractual obligations for independent assessments or audits (example: external auditor meets regulatory requirements for pharmaceutical companies on drug safety)

... have access to advanced risk management technologies and tools (example: technology company implements advanced analytics tools at retail companies to manage supply chain risks)

Bottom line: Involving external partners in risk management improves a company's ability to identify, assess and mitigate extreme risks, especially in a rapidly changing and increasingly complex business environment. 

When does hedging make sense? 

Hedging is intended to mitigate a risk. This risk management strategy is used to limit or offset the likelihood of losses due to price fluctuations in commodities, currencies, or securities. But hedging a risk is not always feasible or practical.  

The ability to hedge a particular risk depends largely on the availability of suitable financial instruments. For example, commodity futures allow farmers to hedge against the risk of price fluctuations in agricultural products and thus achieve a certain degree of financial stability.

The costs of hedging may exceed the benefits, especially if the prices of hedging instruments are inefficient. For example, the cost of hedging against currency fluctuations could be prohibitive if the premiums for the required option contracts are excessive.

Some risks are unhedgeable due to their nature. Geopolitical risks, for example, are almost impossible to hedge because they are highly unpredictable and there is no direct financial instrument to offset them.

Hedging strategies should be in line with overall business objectives. Over-hedging or hedging the wrong risks can lead to missed opportunities or unexpected losses. For example, a company that focuses too much on hedging against fuel price volatility may miss the opportunity to hedge against currency fluctuations.

Effective hedging requires a deep understanding of the risks involved and the financial instruments at hand. The complexity of hedging strategies requires specialized expertise.