This will be a real challenge, but it should be an interesting challenge. Much o

Question

This will be a real challenge, but it should be an interesting challenge. Much of the way we measure risk relies on probability distribution (the bell curve as shown on page 425). For many things in life, and business, this is perfectly valid, but for others it is not. Can you come up with some illustrations of business risk measurement where bell curve type analysis is inappropriate? This will take a little research on the Internet. Why may the bell curve be an inappropriate tool for looking at market risk? Find out what Mandelbrot (The Mis Behvior of Markets) and Taleb (The Black Swan) have to say.

Explanation / Answer

Question:

Can you come up with some illustrations of business risk measurement where bell curve type analysis is inappropriate?

Solution:

Bell curve has lot of applications in business processes which follow normal probability distribution. But it is not appropriate to use bell curve everywhere in business risk measurement. All business risk processes are of different shape and might not follow normal distribution. Some of the defects or equipment failures follow Poisson distribution. Some business processes are better defined using exponential or Gaussian distribution. All business processes are also not symmetric and have different shapes. Also to measure business risk by bell curve one should be have good cognizance regarding calculus to define business risk. Revenue, income and margin distributions dont follow bell curve. Also the business process risk in which there are multiple modes (say depending on the condition), bell curve is not able to characterize all risks properly.

Question:

Why may the bell curve be an inappropriate tool for looking at market risk?
Find out what Mandelbrot (The Mis Behavior of Markets) and Taleb (The Black Swan) have to say regarding market risk.

Solution:

Bell curve can be considered appropriate to look at market risk if investor has long period view. Reason is that stock market returns follow normal distribution pattern only at long period intervals. But bell curve will be an inappropriate tool for market risk if investor has shorter view of horizon as in shorter intervals, stock market returns might deviate from following normal probability distribution. Also there can be a problem of fat tail distribution while considering stock prices

Mandelbrot view regarding market risks is that stock markets do deviate(misbehave) and problem of fat tails or black swans is quite common as discussed in financial academic theories. This results in problems of valuation of VAR(Value at Risk).He also believes that future prices have long term dependence regarding which way to move on past prices .If we know the source of data or how it is evaluated we can then decide in a better way to tell whether bell curve will be an appropriate tool or not in measuring the business process risk.

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