The Finance Professionals' Post

A Tale of Two Overhangs: The Nexus of Financial Sector and Sovereign Credit Risks

ABSTRACT

There has emerged in the Western economies a strong nexus between the credit risks of financial sectors and their sovereigns. We argue that this phenomenon can be understood in the context of two debt overhang problems: one affecting the financial sector due to its under-capitalization following the crisis of 2007–08; the second, affecting the non-financial sector, whose incentives are crowded out by high sovereign debt and anticipated future taxes. While the desire to resolve the financial sector overhang may make bailouts tempting, they raise the risk of exacerbating the overhang related to sovereign debt. Conversely, reduction of growth prospects due to sovereign debt overhang can make the financial sector riskier as it is highly exposed to sovereign debt both through direct holdings and indirectly through implicit government guarantees. We provide evidence on this important nexus, based on our ongoing research that exploits data on European bank and sovereign credit risks.

Recent Research: Highlights from February 2012

"Measuring and Modeling Execution Cost and Risk"
The Journal of Portfolio Management (Winter 2012)
Robert Engle, Robert Ferstenberg, and Jeffrey Russell

Financial markets are considered to be liquid if a large quantity can be traded quickly and with minimal price impact. Although the idea of a liquid market involves both a cost as well as a time component, most measures of execution costs tend to focus on only a single number that reflects average costs and do not explicitly account for the temporal dimension of liquidity. In practice, trading takes time because larger orders are often broken up into smaller transactions or because of price limits. Recent work shows that the time taken to transact introduces a risk component in execution costs. In this setting, the decision can be viewed as a risk–reward trade-off faced by the investor who can solve for a mean-variance utility-maximizing trading strategy. Engle, Ferstenberg, and Russell introduce an econometric method to jointly model the expected cost and risk of the trade, thereby characterizing the mean-variance tradeoffs associated with different trading approaches, given market and order characteristics. They apply their methodology to a novel dataset and show that the risk component is a nontrivial part of the transaction decision.

With the Financial Markets Growing Riskier Why Aren’t Risk Managers More in Demand?

 

Risk management is a lot like anger management. It’s one of those disciplines you don’t really notice until it’s no longer there and things suddenly go awry. To put it simply, risk management is tasked with assessing, mitigating, and monitoring the potential for a bad outcome. When it’s working, everything runs smoothly. When it doesn’t … well, just turn on your television to any business channel.

Mathematical Role Models

Whether you are an aspiring risk manager, quantitative analyst, or a trader, your first order of business is to manage risk. Fundamental analysis can tell you what a company is worth or whether a sector is undervalued theoretically, but market prices and volatility have their say also. You come to find that entries and exits are important, but ultimately risk management comes down to position sizing.

From there you can purchase expensive backtesting/simulation software and a subscription to the data that you need to run through it, but unless you have been trained in what all the boxes you've checked before you click "Run" mean, you will likely have data mined and over optimized your way to hypothetical success.

At various times of my career I have used such simulation software. Admittedly, it is very helpful and still is in some ways. It is very fast in its calculations and can also run Monte Carlo simulations for you, for example. However, nothing will replace the knowledge you will get from having to learn to do it from the ground up. I have done that too. My first model was created by hand on spreadsheets: first Lotus 123 cum Excel.

Constructing a portfolio that will provide you and your clients with the best risk-adjusted returns, while suitably diversifying your holdings, is done by teams these days. Teams that have a great deal of resources and intellectual capital. You need to learn how to construct such a model in order to compete in the global marketplace that is seeming to become more and more uncertain each day, perhaps by yourself at the beginning. It may appear to be easy in theory, but it is much harder in practice. One of the best things you can do to get started in an affordable manner is to become very proficient in Excel.

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Quantitative hedge funds (Quant funds), such as AQR and Renaissance, spend enormous amounts of time, money, and effort to make sure they sift through oceans of data to find the most profitable opportunities. They also invest in the best personnel...many of whom have PhD's in Quantitative Finance or hold designations such as the CQF (Certification in Quantitative Finance). The competition is brutal, and this is before you have to fight off the high frequency traders...

Successful risk managers know the limitations of VaR, the Kelly formula, and CAPM. As Aaron Brown, Risk Manager of AQR wrote in his new book, Red Blooded Risk, "Successful risk taking is not about winning a big bet or even a long series of bets. Success comes from winning a sufficient fraction of a series of bets, where your gains and losses are multiplicative.

In order to get to the place where you can affect such trades, you need to test the data. I believe that this is best accomplished these days in an affordable manner using Excel. Thankfully, Excel has dozens of built-in mathematical functions that which can utilize advanced techniques that can give you the answers you need with the statistical significance to boot.

Without these answers, you will not have the emotional nor statistical confidence to manage the risk, nor will you have the answers to the questions that are frequently being asked in today's environment: "What happens if....?"

 

–Michael Martin

Michael Martin has been a successful trader for over 20 years. He is the creator of "Martin Kronicle," author of The Inner Voice of Trading, and instructor of the NYSSA Certificate in Commodity Trading & Trend Following.

European Safe Bonds (ESBies)

The euro-nomics group^i,*

Markus Brunnermeier, Luis Garicano, Philip R. Lane, Marco Pagano, Ricardo Reis, Tano Santos, Stijn Van Nieuwerburgh, and Dimitri Vayanos

26th of September 2011

INTRODUCTION

The European Union today faces one of the greatest challenges in its existence. The euro-zone, which just at the start of this century was lauded as Europe's great unifying achievement, has given way to states on the verge of default, financial systems that seem as solid as a deck of cards, and a great deal of disappointment with the European institutions. There are many reasons for this state of affairs, most of which fall within the realm of economics. One factor, that is crucial but under-appreciated is that Europe's problems are a consequence of a much wider, world, problem: the lack of safe assets. As a long-term trend, the impressive growth in the developing world during the last two decades has increased the demand for safe assets, as those countries' economic development outpaces their financial development yet they already need to build up reserves to smooth future shocks. As a short-term phenomenon, but one that is here to stay, the financial crisis of 2007–08 showed that financial markets can go through periods of tremendous volatility that have investors plunging towards an asset that is deemed safe.ⁱⁱ.

Modern financial systems rely heavily on safe assets. At the foundation of even the most complex financial securities there is usually a requirement to post as collateral some asset that is deemed safe by the parties involved. Prudent bank regulation, following Basel in its many rounds, requires banks to manage the risk in their assets in proportion to their capital. As a result, a substantial part of any bank's balance sheet must be in safe assets, as defined by the financial regulators. Pension funds are another example of a large class of investors that must hold a significant amount of safe assets, and even the least risk-averse of investors needs, even if only temporarily, to park investments in a safe vehicle. Finally, in conducting conventional monetary policy, the central bank should exchange money for safe bonds.

A safe asset for all of these purposes is one tha is liquid, that has minimal risk of default, and that is denominated in a currency with a stable purchasing power. To meet the large demand we just described, there is very little supply of assets satisfying these three characteristics. As a result, the most used of them, the U.S. Treasury bills and bonds, earn a large "safe haven" premium of as much as 0.7% per year.ⁱⁱⁱ Europe, in spite of the size of its economy and its developed financial markets, and in spite of being home to one of the worlds' reserve currencies, does not supply a safe asset that rivals U.S. Treasuries. This has been noted before. What is less appreciated is that this deficiency is at the heart of the current European crisis.

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In the absence of a European safe asset, bank regulators, policymakers, and investors have treated the bonds of all of the sovereign states in the euro-area as safe for the last 12 years. Bank regulators following the Basel criteria give sovereign bonds held by national banks a riskless assessment in calculating capital requirements, even as insuring against the default of some sovereign bonds using credit default swaps costs more than 5% today. The stress tests of European banks rule out, by assumption, the likely default in some of the sovereign assets held by the banks, making it difficult for investors to trust them. European policymakers have treated Greek and Dutch bonds as identically safe, even though they have traded at widely different prices in the market. The ECB accepts sovereign bonds of all its member states in its discounting operations, and while it applies different haircuts to them, they have been generous towards the riskier sovereigns. In turn, national policymakers have persuaded national banks to hold larger amounts of local national debt than prudent diversification would suggest. Finally, investors have been fervently speculating on whether sovereign states will be bailed out or not by their European partners, alternating between seeing the bonds as all equally safe, or seeing some of them as hopelessly doomed.

This situation led to two severe problems. First it created a diabolic loop, illustrated in Figure 1. Encouraged by the absence of any regulatory discrimination among bonds, European banks hold too much of their national debts, which, far from being safe, instead feeds never-ending speculation on the solvency of the banks. Sovereigns, in turn, face a constant risk of having to rescue their banks, which, combined with the uncertainty on what fiscal support they will receive from their European partners, increases the riskiness of their bonds. Finally, European policymakers lack the institutions and own resources to intervene in all of the troubled sovereign debt markets. The ECB ends up holding the riskiest of the sovereign bonds as the ECB becomes the sole source of financing for the troubled banks.

Figure 1: Diabolic Loop between Sovereign Debt Risk and Banking Debt Risk.

 

Breaking this loop, and giving the euro-zone a chance to survive in the long run, requires creating a European safe asset that banks can hold without being exposed to sovereign risk. However, contrary to what is widely believed, this does not require creating Eurobonds, backed in solidarity by all the European states and their taxing power. Many Europeans are not willing to accept the fiscal integration required by Eurobonds. Moreover, without essential control mechanisms on national public accounts, hastily introduced Eurobonds may lead to a much larger debt crisis in a few years, from which there is no way back. We offer an alternative that creates a safe asset, while eliminating these problems with Eurobonds.

The second severe problem is that, in the absence of a European safe bond, the bonds of some sovereigns at Europe’s center have satisfied the demand for safe assets. In times of crisis, capital flows from the periphery to the center; in boom phases, capital flows from the center to the periphery. These alternating capital flows between searching for “yield” and searching for “safe haven”, generate large capital account imbalances in the Euro area, with associated changes in relative prices and potential disruptions in asset markets.^iv

Our proposal is to create European Safe Bonds (ESB), which we will refer to as ESBies for short.^v They are European, issued by a European Debt Agency in accord with existing European Treaties, and do not require more fiscal integration than the one we already have. They are Safe, by virtue of being designed to minimize the risk of default, being issued in euros and benefitting from the ECB's anti-inflation commitment, and being liquid as they are issued in large volumes and serve as safe haven for investors seeking a negative correlation with other yields. They are Bonds, freely traded in markets, and held by banks, investors and central banks to satisfy the demand that we described.

Combined with appropriate regulation that gives the correct risk weights to sovereign bonds, ESBies could solve the two problems that we just described. Banks would have an alternative to sovereign bonds, allowing them to become better diversified and less dependent on their country’ public finances. Moreover, the flight of capital to a “safe haven” would no longer be across borders, but across different financial instruments issued at the European level.

This document lays down the details of how ESBies work. The next section explains the proposal. Section 3 lists the main benefits that ESBies would bring. Section 4 to 6 go deeper into the nuts and bolts of ESBies explaining, in turn, how their composition is determined, how their safety is ensured, and how they would be issued. Section 7 compares our proposal with alternatives, the leading one being Eurobonds. Section 8 briefly concludes.

ESBies: THEIR STRUCTURE AND USE

In one sentence, ESBies are securities issued by a European Debt Agency (EDA) composed of the senior tranche on a portfolio of sovereign bonds issued by European states, held by that agency and potentially further guaranteed through a credit enhancement.

In more detail, our proposal is for the EDA to buy the sovereign bonds of member nations according to some fixed weights. The weights would be set by a strict rule, to represent the relative size of the different member States. There would be no room to change the weights by discretion to respond to any crises, perceived or real. Therefore, the EDA cannot bail out a nation having difficulties placing its sovereign debt. It would typically run a boring business that does not make the headlines: It would simply passively hold sovereign bonds as assets in its balance sheet, and use them as collateral to issue two securities.

The first security, ESBies, would grant the right to a senior claim to the payments from the bonds held in the portfolio. If the tranching cut-off is X%, then the first X% lost in the pool of bonds because of potential European sovereign defaults would have no effect on the payment of the ESBies. The remaining 1-X% of revenues from holding the bonds would go to the holders of the ESBies. The number X% is relatively large, so that even in a worst-case scenario (e.g. a partial default by Greece, Portugal and Ireland and a haircut on Italian and Spanish debt), the payment on the ESBies would not be jeopardized. On top of it, the EDA, using some initial capital paid in by the member states, would offer a further guarantee on the payment of Y% of the ESBies, so that it would take losses of more than Y+X% before the ESBies did not offer a perfectly safe payment in euros to its holders. As long as this sum was picked adequately, the ESBies would be effectively safe. European banks, pension funds and the ECB would be a natural starting clientele for the ESBies, but as their reputation grows, they could be as widely used as US Treasuries are used today all over the world. They could also be used as reserve currency assets by countries such as China, Brazil, the OPEC, etc.

The second security, composed of the junior tranche on the portfolio of bonds, would be sold to willing investors in the market. In contrast with the ESBies, this is a risky security, akin to an equity claim on the EDA (but obviously without control rights). Any risk that a sovereign state may fail to honor in full its debts would be reflected in the expected return on this security. Any realized losses would be absorbed by the holders of this junior security, and not by the EDA nor the European Union nor its member States. Investors that want to hedge (or even speculate) on the ability of European member states to repay their debt would be willing to hold and trade this security.

Beyond being correctly designed and issued, the success of the ESBies depends on two regulatory changes. First, the ECB would grant strict preferential treatment to ESBies, accepting them as its main form of collateral in repo and discounting operations. In effect, the ECB would still be holding sovereign bonds as assets, but now indirectly via the ESBies; and, importantly, it would only hold the safest component of these sovereign bonds. Because of the fixed weights in the ESBies, this would be consistent with conventional monetary policy, where open market operations trade money for safe ESBies without creating credit risk for the ECB and ensuring it has a safe balance sheet. Second, banking regulators, including Basel, would give a zero risk weight to ESBies, but not automatically to other sovereign bonds. The new risk weights for European sovereign bonds will reflect their default risk just as risk weights reflect the risk on banks’ holdings of other assets such as corporate bonds or corporate loans.

Figure 2 summarizes the details in this description. There are three parts of the proposal that require further explanation: how to set the weights in the portfolio of sovereign bonds? How to choose the size of the ESBies relative to the junior tranche and the credit enhancement? And how would the EDA operate day-to-day? These are explained in more detail in sections 4 to 6. But, before discussing the details in more depth, we summarize the virtues of the proposal.

Figure 2: Graphical Representation of Tranching with Possible Credit Enhancement.

 

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NOTES

*Euro-nomics is a group of concerned European economists, unaffiliated with any of their respective national governments. Their objective is to provide concrete, carefully considered, and politically feasible ideas to address the serious problems currently faced by the Eurozone. Their affiliations can be found at the end of the present document and on www.euro-nomics.com

^i. This is an extract from a chapter of a book being produced as a larger project, Project Europe, by the euro-nomics group: www.euro-nomics.com. That project proposes a new institutional framework for the European financial system to overcome the current crisis. European Safe Bonds are one of the legs of that proposal, and are explained in this document. We are not sponsored by any organization or institution and are independent from any country or policy institution.

^ii. Farhi, Gourinchas and Rey (2011) go in detail over the many reasons why the demand for safe assets far outstrips supply today.

^iii. Krishnamurthy and Vissing-Jorgensen (2010) estimate this premium.

^iv.Some empirical evidence for the “flight to safety premium” for German bunds is that their yield sank to an almost record low in August and September, while at the same time the CDS spread for German bunds increased, indicating that even Germany’s default risk was increasing.

^v.ESBies has the merit of capturing the sound of two possible initials for the securities, ESB for European Safe Bonds, and ESBBS for European Sovereign Bond-backed Securities.

Recent Research: Highlights from November 2011

"Breadth, Skill, and Time"
The Journal of Portfolio Management (Fall 2011)
Richard C. Grinold and Ronald N. Kahn

The information ratio determines the potential of an investment process to add value, and according to the fundamental law of active management, adding value depends on a combination of skill and breadth. Grinold and Kahn use an equilibrium dynamic model to provide insight into the concept of breadth, as well as a refined notion of skill. In equilibrium, the arrival rate of new information exactly balances the decay rate of old information. Grinold and Kahn denote the information turnover rate g. It is relatively easy to measure for any investment process. If the investment process forecasts returns on N assets, the breadth of the strategy i is g · N. Skill—the correlation of forecasts and returns—increases with the return horizon for small horizons, but then asymptotically decays to zero for very long horizons. The authors’ main result is that the ex ante information ratio is  , where κ is a measure of skill.

Investors Step Up Pressure for Integrated Reporting

We live in a world of rapid human population growth and consumption,  heightened resource scarcity, and the attendant stresses placed by all these factors, not to mention our "business as usual" economy on the earth's ecosystem.   Corporations must acknowledge this and can no longer afford to operate without closely monitoring, managing, and disclosing their environmental, social, and [corporate] governance (ESG) risks—any one of which can explode into a crisis with very material financial consequences. Asset managers who fail to require the companies in which they invest to step up to the plate and take on this responsibility are rightfully being viewed as shirking their own fiduciary duty. 

Portfolio Heat: When Corn Starts Popping

When your portfolio heat increases too fast, too soon, you need to cut your position size(s) down to lower the overall risk to your portfolio. Else you have a Jiffy Pop portfolio.

Recent Research: Highlights from August 2011

Risk-Based Asset Allocation: A New Answer to an Old Question? The Journal of Portfolio Management (Summer 2011). Wai Lee.

In recent years, we have witnessed an alarmingly large and growing amount of literature on portfolio construction approaches focused on risks and diversification rather than on estimating expected returns. Numerous simulations applied to different universes have been documented in support of these approaches based on their apparent outperformance versus passive market capitalization–weighted or static fixed-weight portfolios. Many studies attribute the better performance of these risk-based asset allocation approaches to superior diversification. Given the absence of clearly defined investment objective functions behind these approaches as well as the metrics used by these studies to evaluate ex post performance, Lee puts these approaches into the same context of mean-variance efficiency in an attempt to understand their theoretical underpinnings. In doing so, he hopes to shed some light on what these approaches attempt to achieve and on the characteristics of the investment universe, if indeed these approaches are meant to approximate mean-variance efficiency. Rather than adding to the already large collection of simulation results, Lee uses some simple examples to compare and contrast the portfolio and risk characteristics of these approaches. He also reiterates that any portfolio which deviates from the market capitalization–weighted portfolio is an active portfolio. He concludes that there is no theory to predict, ex ante, that any of these risk-based approaches should outperform.

Fully Flexible Extreme Views

The combination of subjective views within a broadly accepted risk model is one of the main challenges in quantitative portfolio management. Indeed, any risk model, be it based on historical scenarios, parametric fits, or Monte Carlo scenarios generated according to a given distribution, is subject to estimation risk and thus it is inherently flawed. Therefore, it is important to provide a framework that allows practitioners to overlay their judgement to any risk model in a statistically sound way.

Recent Research: Highlights from July 2011

“The Role of Speculators During Times of Financial Distress.” The Journal of Alternative Investments (Summer 2011). Naomi E. Boyd, Jeffrey H. Harris, and Arkadiusz Nowak.

One of the best-known and largest hedge fund failures was the 2006 failure of Amaranth Advisors, LLC. The authors use detailed, trader-level data to examine the role of speculators during times of financial distress—in this case, the failure of Amaranth. They find that speculators served as a stabilizing force during the period by maintaining or increasing long positions, even while prices fell. The authors develop two testable propositions regarding liquidation versus transfer of positions and conclude that the probability of transfer was more likely for distant contract expirations and for contracts more dominantly held by the distressed trader. The article also examines the role of speculators in providing liquidity and mitigating the effects of liquidity risk by evaluating the change in the number of traders, the size and time between trades, and a Herfindahl measure of speculative trader concentration during the crisis period.

Fully Flexible Views: Theory and Practice

Scenario analysis allows the practitioner to explore the implications on a given portfolio of a set of subjective views on possible market realizations, see e.g. Mina and Xiao (2001). The pathbreaking approach pioneered by Black and Litterman (1990) (BL in the sequel) generalizes scenario analysis, by adding uncertainty on the views and on the reference risk model. Further generalizations have been proposed in recent years. Qian and Gorman (2001) provide a framework to stress-test volatilities and correlations in addition to expectations. Pezier (2007) processes partial views on expectations and covariances based on least discrimination. Meucci (2009) extends the above models to act on risk factors instead of returns, and thus covers highly non-linear derivative markets and views on external factors that influence the p&l only statistically.

Robert Litterman: Who Should Hedge Tail Risk?

In a somewhat ironic turn of events, many investment banks began selling insurance against equity tail risk to institutional investors following the financial crisis. Ironic because one might expect that investment banks, with high leverage and quarterly earnings reports to worry about, would be the natural buyers of such insurance and long-horizon investors the natural sellers.

Surely, those with deep pockets and long horizons, who would be little affected by the crisis, should be selling insurance to those with short horizons and leveraged positions, who would be most highly affected.

Of course, there will always be a price low enough that a given investor would be willing to buy insurance, and there will always be a price high enough that the same investor would be willing to sell insurance. But investors who have long horizons, sufficient liquidity, and low leverage should consider carefully whether, in practice, the price at any given time is low enough that buying tail-risk insurance makes sense for them. That scenario is unlikely because long-horizon investors are not natural buyers of tail-risk insurance.

Continue reading "Who Should Hedge Tail Risk?" »

Sustainable Mining—An Oxymoron or a Challenge to be Met?

It can be argued that the mining industry is at a decided disadvantage as it attempts to establish its creds as a sector of the economy committed to making a contribution to a more sustainable economy. As Stephen D’Esposito, former executive director of Earthworks, suggests in an article published in  Corporate Ethics Monitor, “Is Mining Sustainable?” the very fact that mining is in the business of depleting finite natural resources argues that the term sustainable mining will forever be oxymoronic. However, mine we must, and the industry has much headway to make in reducing the tremendous amounts of energy it consumes, water it pollutes, toxins it emits, solid waste it produces, landscapes it scars, and habitats it disturbs in the process of extracting minerals and metals from the earth. The challenge on all these fronts becomes greater as the process of extraction becomes technically more difficult and more environmentally damaging as the richest mineral deposits are increasingly depleted, requiring that ever-larger volumes of rock and soil be disturbed to extract a given amount of mineral or metal.

Suggestions for Modern Security Analysts

Economics is the social science that most identifies itself with the natural sciences. There is much that can be written about this statement in light of the events that unfolded in the 2007–2008 credit crisis, but this article focuses on the consequences pertaining to the field of Security Analysis, which is an economics-based discipline.

Security Analysis seeks to value firms based on the goods and services sold to customers via the assets (tangible and intangible) and obligations (liabilities) generated to support those sales. Despite the simplicity of this exposition, and the related simplicity of cash flow-based valuation, assessing value can be extremely difficult. The difficulty stems from the well-known fact that value is subjective, and from the equally well-known fact that the future is uncertain. Subjectivity and uncertainty means that Security Analysis requires many working assumptions, which is important because modern economics is currently grounded in mathematics that accommodates only a limited number of assumptions. As a purely theoretical, science-like endeavor this may (or may not) work, but Security Analysis is a profession, and professions are concerned with decision-making in contrast to science, which is concerned with prediction.

BP’s Failure to Debias: Underscoring the Importance of Behavioral Corporate Finance

“BP has a systemic problem with its culture that runs deep.”

–Ending the Management Illusion, Shefrin (2008), p. 95.

“In the view of the Commission, these findings highlight the importance of organizational culture and a consistent commitment to safety by industry, from the highest management levels on down.”

–Report to the President, National Commission on the BP Deepwater Horizon Oil Spill and Offshore Drilling, (2011), p. ix.

1. INTRODUCTION

In this paper, we apply key concepts from behavioral finance to document how psychological biases and framing effects impacted corporate culture and management decisions at energy firm BP. On April 20, 2010, an accident drilling BP’s Macondo well in the Gulf of Mexico produced the worst environmental disaster in US history, an event which dominated the daily news during the spring and summer of 2010. In itself, this event makes for the study of BP’s decision making of interest, prompting the question of whether the April 20 accident was simply an unfavorable chance event or instead the result of biased decision making.

Positions in Operational Risk On the Rise

Operational risk remains a focus for trading operations and for good reason. Banks and investment firms say they’re worried about repeating the errors of the past. But just where do the operational risk managers and the quants meet, for instance? That’s been a serious point of contention.

Continue reading "Positions in Operational Risk On the Rise" »

Liquidity Level or Liquidity Risk? Evidence from the Financial Crisis

Although generally considered safe assets, liquid stocks underperformed illiquid stocks during the financial crisis of 2008–2009. The performance of stocks during the crisis can be better explained by their historical liquidity betas (risk) than by their historical liquidity levels. Stocks with different historical liquidity levels did not experience different returns after controlling for liquidity risk. The authors’ findings highlight the importance of accounting for both liquidity level and liquidity risk in risk management applications.

Continue reading "Liquidity Level or Liquidity Risk?" »

Sliced & Diced: A Taste of Structured Investments

A May 2009 report from Research and Markets of Dublin notes that “structured products are among the fastest growing investment classes in world financial markets.” Although not really an asset class, structured investment products represent an array of investment tools for retail and institutional investors. They can enhance the returns of traditional asset classes, provide exposure to hard-to-reach sectors and markets, and often mitigate investors’ risk of losing some or all of their principal.

The Threat of Losing the AAA is Self-Fulfilling

On Monday, April 18, Standard and Poor’s (S&P) put the US’s sovereign rating on negative outlook. The action was prompted by the continued deterioration of the US’s fiscal imbalances and the lack of urgency with which US political leaders have approached the country’s fiscal problems. By citing that Canada, the UK, France, and Germany all have better fiscal profiles including both better financial leverage ratios and stronger political discipline to manage their countries’ finances the rating agency has signaled that the US has lost its global financial pre-eminence. Such pre-eminence has allowed it to issue bonds at a premium to comparables and have a fiat money that has served as the world’s reserve currency. The US’s reign of global financial dominance has now officially ended.

How Your Family Office Can Practice Philanthropy Through Its Investment Practice

While “giving back through philanthropy” will be a key topic for discussion at NYSSA’s 3rd Annual Family Office Conference on May 10, it may be well worth noting that a number of family offices are now discovering that they can express their philanthropic goals not just by “giving back” in the traditional sense but also through their investment practices.

Stephen Viederman has first-hand experience with this innovative approach to philanthropy as the former president of the Jessie Smith Noyes Foundation, a family foundation that was one of the earliest to put its investment assets behind its mission. The practical guidance he has offered to family foundations like Noyes is equally applicable to family offices that are not explicitly “purpose-driven” but whose family members desire to deploy a significant portion of their assets for the social and/or environmental benefits of their community or for the world at large.

Recent Research: Highlights from April 2011

“The Impact of Illiquidity and Higher Moments of Hedge Fund Returns on Their Risk-Adjusted Performance and Diversification Potential.” The Journal of Alternative Investment (Spring 2011). Laurent Cavenaile, Alain Coën, and Georges Hübner.

This article studies the joint impact of smoothing and fat tails on the risk–return properties of hedge fund strategies. First, the authors adjust risk and performance measures for illiquidity and the non-Gaussian distribution of hedge funds returns. They use two risk metrics: the Modified Value-at-Risk and a preference-based measure retrieved from the linear exponential utility function. Second, they revisit the hedge fund diversification effect with these adjustments for illiquidity. Their results report similar fund performance rankings and optimal hedge fund strategy allocations for both adjusted metrics. They also show that the benefits of hedge funds in portfolio diversification persist but tend to weaken after adjustments for illiquidity are made.

A New Approach to Calculating Risk-Adjusted Returns

"People don’t perceive that they are going to be the one in a crash,” laments Russ Rader, media director at the IIHS (Insurance Institute for Highway Safety). “They believe that they are in control when they’re behind the wheel. They don’t sense how high the risk actually is.” The IIHS, a Virginia-based, national nonprofit that has helped significantly increase seat belt usage in the last twenty years, has a simple objective: lessen the risk taken in everyday driving behavior. The risk-measurement approach it employs has the potential to revolutionize how the investment community evaluates manager performance.

Reputational Risk

The global financial crisis of 2007–2009 was associated with an unprecedented degree of financial and economic damage. For investors and financial intermediaries, the estimates seem to have risen to over $4 trillion or so worldwide by the time things began to stabilize, according to the International Monetary Fund (2009). Along with the financial damage has come substantial reputational damage for the financial services industry, for financial intermediaries and asset managers, and for individuals.

Mental Aspects of Day Trading

Throughout my years in the futures industry, I have come to a conclusion in regards to the difference between winning and losing as a trader. In my opinion, the primary characteristic of successful traders is the ability to stay calm through thick and thin. This means avoiding the panic feeling that overcomes logic when trades are going against the speculation, and resisting the over-confidence that can come with a few winning endeavors. Each of these symptoms can have a severely negative impact on future trading decisions and profitability.

Just One Question: Did You Calculate the Risk?

The movie Stalag 17 opens with an escape attempt from an Austrian POW camp during World War II. Two POWs, Manfredi and Johnson, are preparing to escape through a tunnel that has been secretly constructed beneath one of the camp’s latrines. As the two would-be escapees go through a last minute review of their plans with Hoffy, the barrack chief, and Price, the barrack security officer, a skeptical POW asks a key question.

The Seat Belt Problem: A New Approach to Calculating Risk-Adjusted Returns

“People don’t perceive that they are going to be the one in a crash,” laments Russ Rader, media director at the IIHS (Insurance Institute for Highway Safety). “They believe that they are in control when they’re behind the wheel. They don’t sense how high the risk actually is.” The IIHS, a Virginia-based, national nonprofit that has helped significantly increase seat belt usage in the last twenty years, has a simple objective: lessen the risk taken in everyday driving behavior. The risk-measurement approach it employs has the potential to revolutionize how the investment community evaluates manager performance.

In our industry any credible performance comparison is risk adjusted. It makes no sense to equate the returns of two funds that take different amounts of risk. The challenge has always been how to measure the risk taken by managers—mathematically speaking, what to stick in the denominator.

Proceed with Caution: The Pitfalls of Value at Risk

Value at Risk, or VaR, continues to garner a great deal of attention from the investment community, the media, and academia. While it is commonly used at banks, in trading depart-ments, and by many asset managers, we must ask how reliable it is. In Lecturing Birds on Flying (2009), Pablo Triana criticizes it amply; however, there may be more objective ways to grasp its shortcomings.

In Defense of a Quant (Part II): The Ups and Downs of the Normal Distribution

In my previous column, I mentioned that particular attacks on the deficiency of mathematical finance are centered on the alleged misuse of “simplistic” normal distribution by the quants. Nassim Taleb never fails to contrast the disdainful and primitive “Brownian” paradigm with the supposedly more sophisticated “fractal” point of view, which he attributes to Benoît Mandelbrot. I quote only two passages from the Black Swan: “I find it ludicrous to present the uncertainty principle as having anything to do with uncertainty. Why? First, this uncertainty is Gaussian.” Or another pick: “So selecting the Gaussian while invoking some general law appears to be convenient. The Gaussian is used as a default distribution for that very reason.”

Commentary: From Risk to Uncertainty

Stress-test complacency will be a cause of the next financial meltdown.

Economic commentators have been increasingly using the word “uncertainty” as of late. The context has included the business climate, the stimulate vs. austerity debate, and forecasting the investment outlook across capital markets. 

The Greater Fool Theory: Managing and Modeling Risk

The most dramatic financial meltdown since the Great Depression occurred despite recent advances in risk management techniques. Because of a fervent but unfounded belief in some quarters that VaR (value at risk) measures worst-case scenarios, financial institutions were exposed to crippling losses when VaR models failed to anticipate the extent of potential price movements, in some cases by whole orders of magnitude. 

Crisis Mode: Modern Portfolio Theory Under Pressure

During financial crises correlations among security returns approach one.

Therefore, diversification fails just when you need it.

Therefore, MPT (modern portfolio theory) is of no use.

The first of the statements above is correct; the second is partially true; the last statement is false. In order to understand the assertions of the last sentence, we need to review what MPT is and is not, what it offers and what it does not promise.

The Hierarchy of Risk: A New Approach to Risk Management

Risk culture is comprised of those values and behaviors, on the parts of both management and employees, which define an organization’s awareness of and approach to risk. As the financial crisis continues, the most successful firms have been those possessing risk cultures with high awareness, quick escalation, and strategic flexibility. There are echoes of behavioral finance in the way an organization’s view of risk may be skewed by its current investment appetite, its compensation and incentives, and its degree of knowledge of historical risk. Complicating this risk culture is quantitative modeling of limited historical data, decreasing transparency due to financial product innovation, and overreliance on credit ratings.

A Primer on Value at Risk

Value at risk, or VaR, is viewed by some as a massively important measure. It is unique in how it characterizes risk. Most measures show risk either as a percentage (as standard deviation and tracking error do) or in units (as the Sharpe and Treynor risk-adjusted measures do). VaR shows risk in terms of money—that is, the money that might be lost.

Calculating the Risks of Impending Water Shortages

Water is taking center stage alongside the emission of carbon as the preeminent environmental risk facing the planet in the twenty-first century. And, in a manner similar to its early response to carbon risk, the private sector has begun to prepare for an era of stricter regulation and rationing of what is perhaps the earth’s most precious finite resource.

The media has recently focused on water scarcity primarily from a climate-change perspective. Glacial melting—which Achim Steiner, executive director of the UNEP (United Nations Environment Programme), has called “the canary in the coal mine”—is reportedly depleting the freshwater supply of vast regions of Asia and South America.