Uncertainty About Financial Risk

The Economist has an interesting article (Feb 1, 2007) on uncertainty regarding financial risk. The article briefly explores whether financial risk is being properly mitigated or whether people are simply paying lip service to risk management and that, in reality, hidden risks are poised to send shock waves throughout the markets.

As The Economist points out the 'great-and-good' at Davos and elsewhere seem to be mindful of risk, yet:

[A]s the Bible says, “by their fruits ye shall know them”. Banks are still financing leveraged buy-outs, junk bonds are offering their lowest spreads since March 2005, and the cost of insuring against a share-price fall, as measured by the Chicago Board Options Exchange Volatility Index (Vix), is low (see chart below). Financiers may be worrying about risk, but they do not seem to be doing much about it.

Perhaps the most succinctly wise way of thinking about financial risk is what Warren Buffet had to say about it: “It's only when the tide goes out that you learn who's been swimming naked.” In other words, we won't know whether the optimists or the pessimists are right about risk until the proverbial "tide goes out."