Hi,
It has been a while since we last posted at Links. Life became very busy in the second half of 2009 for us and posting news items became a luxury we struggled to afford. However, as work calms down ahead of the holiday season and as thoughts turn to the new year, we just wanted to say thanks very much to all the clients who supported us in 2009. We look forward to working with you in 2010 and we also look forward to welcoming a number of potential new clients into our portfolio.
The story for 2009 was one of unusual volatililty and extreme market moves both up and down. It has been a challenging environment to say the least. 2010 no doubt will also throw up its fair share of googlies / curve balls (delete as applicable depending on Nationality) to test both businesses and investors to the limit. However, one thing remains certain, sound risk management will continue to be critical to safely negotiating an uncertain market place and will continue to drive strategy at many firms.
Enjoy the holiday season and all the best for the new year,
Andy Shaw and Mark Tomsett
Monday, December 21, 2009
Monday, July 6, 2009
Green shoots but doesn't score.....
Hi,
Originally credited to Norman Lamont in a 1991 recession era speech at the Conservative Party conference, the phrase "green shoots" has been popping up everywhere recently. It even has it's own entry in the Cambridge Online Dictionary:
"Green Shoots - plural noun. (Used especially in newspapers) the firstsigns of an improvement in an economy that is performing badly."
From Baroness Vadera (who probably wishes she hadn't) to Ben Bernanke, from bank research articles to every newspaper whether pink or red topped (although the latter may have been referring to England's latest goalkeeper). However, as the burning sun torches the greenery in my garden so the "green shoots" appear to be withering. But rather than ask whether there ever were any green shoots, the more interesting question is how does the use of language and data affect our behaviour?
Social psychologists such as Kahneman, Slovic and Tversky (1) have studied how we make judgements under conditions of uncertainty. If you ask someone how likely it is that an elephant will fall out of the sky and land on their head they will tell you that the probability is (virtually) zero. Ask them again just after a five tonne African bull elephant has given them a fine centre parting (assuming they survive) and the their answer will be very different. Lotteries don't emphasise the fact that the odds of winning are tiny - they highlight the size of the payouts of recent winners.
These are just two examples of the so called "availability error" - the process of determining probability by the first thing that comes to mind. The "anchoring heuristic" describes how we determine the frequency, probability, or value of items by comparing the item to an anchor point. It appears to be relatively easy to influence the actions of individuals simply by generating numbers regardless of whether they have any relation to reality. Make the number dramatic enough and people will sit up and take notice. By the time people realise how baseless the original assertion was it's too late - it now has momentum. Ask someone (who doesn't actually know) to estimate the population of the Maldives and preface the question by asking whether it is more or less than one million. The actual number is much less but the average guess will be around this figure - the anchor point. Financial numbers can be manipulated in the same way. Unrealistic price targets, growth forecasts, etc, can easily become anchors. If the true figure turns out to be very different the market reaction can be severe even thoughthe original forecast should simply have been discounted more heavily.The problems caused by the "anchoring heuristic" can be exacerbated by the "confirmation bias". This is a tendency to find data that supports an hypothesis and ignore data that rejects it.
If you believe that a particular stock rises on a certain phase of the moon you'll make note of the rises when this phase occurs and ignore rises at other times. Doing this frequently reinforces the belief in this relationship.
These heuristics exist because they save us time. Why bother doing the research when a simple rule-of-thumb will suffice? However, failing to acknowledge their clear weaknesses can easily lead to irrational investment decisions. When someone starts talking of "green shoots" or any other phrase du jour look before you leap. Question their motivation and check to see if the supporting data stacks up. As the old saying goes, invest in haste and repent at leisure.
(1) Kahneman, D. Slovic, P and Tverskty, A. eds. (1982) "Judgement Under Uncertainty, Huristics and Biases", CUP.
Dr Mark Tomsett
Originally credited to Norman Lamont in a 1991 recession era speech at the Conservative Party conference, the phrase "green shoots" has been popping up everywhere recently. It even has it's own entry in the Cambridge Online Dictionary:
"Green Shoots - plural noun. (Used especially in newspapers) the firstsigns of an improvement in an economy that is performing badly."
From Baroness Vadera (who probably wishes she hadn't) to Ben Bernanke, from bank research articles to every newspaper whether pink or red topped (although the latter may have been referring to England's latest goalkeeper). However, as the burning sun torches the greenery in my garden so the "green shoots" appear to be withering. But rather than ask whether there ever were any green shoots, the more interesting question is how does the use of language and data affect our behaviour?
Social psychologists such as Kahneman, Slovic and Tversky (1) have studied how we make judgements under conditions of uncertainty. If you ask someone how likely it is that an elephant will fall out of the sky and land on their head they will tell you that the probability is (virtually) zero. Ask them again just after a five tonne African bull elephant has given them a fine centre parting (assuming they survive) and the their answer will be very different. Lotteries don't emphasise the fact that the odds of winning are tiny - they highlight the size of the payouts of recent winners.
These are just two examples of the so called "availability error" - the process of determining probability by the first thing that comes to mind. The "anchoring heuristic" describes how we determine the frequency, probability, or value of items by comparing the item to an anchor point. It appears to be relatively easy to influence the actions of individuals simply by generating numbers regardless of whether they have any relation to reality. Make the number dramatic enough and people will sit up and take notice. By the time people realise how baseless the original assertion was it's too late - it now has momentum. Ask someone (who doesn't actually know) to estimate the population of the Maldives and preface the question by asking whether it is more or less than one million. The actual number is much less but the average guess will be around this figure - the anchor point. Financial numbers can be manipulated in the same way. Unrealistic price targets, growth forecasts, etc, can easily become anchors. If the true figure turns out to be very different the market reaction can be severe even thoughthe original forecast should simply have been discounted more heavily.The problems caused by the "anchoring heuristic" can be exacerbated by the "confirmation bias". This is a tendency to find data that supports an hypothesis and ignore data that rejects it.
If you believe that a particular stock rises on a certain phase of the moon you'll make note of the rises when this phase occurs and ignore rises at other times. Doing this frequently reinforces the belief in this relationship.
These heuristics exist because they save us time. Why bother doing the research when a simple rule-of-thumb will suffice? However, failing to acknowledge their clear weaknesses can easily lead to irrational investment decisions. When someone starts talking of "green shoots" or any other phrase du jour look before you leap. Question their motivation and check to see if the supporting data stacks up. As the old saying goes, invest in haste and repent at leisure.
(1) Kahneman, D. Slovic, P and Tverskty, A. eds. (1982) "Judgement Under Uncertainty, Huristics and Biases", CUP.
Dr Mark Tomsett
Sunday, June 28, 2009
Inflating a golden balloon??
Hi,
A topic LINKS has seen in the press on and off in recent months has been the issue of whether Gold makes a good hedge against inflation. This issue clearly isn't the only one turning the grey matter of investors who have inflation issues.
Where are interest rates going? Can markets absorb the large supply and what will happen to inflation outright? Will governments use inflation to reduce the real impact of the huge wave of public expenditure of the last few months? At this stage it's unclear what will happen and it is this uncertainty that continues to drive markets.
It is unlikely that we will see inflation rear its head for some time while there is spare capacity in the global economy. However, those with a longer -term view or those looking at the tail risk should now be considering suitable hedges.
The obvious hedge for inflation is gold. Or is it? It's a position that has reached almost mythical status but supporting evidence is thin on the ground. In fact, the seminal work by Roy W. Jastram (1977) presented in "The Golden Constant" suggests something very different. He analyses the purchasing power of gold in England and the US from 1560 to 1976. The key conclusions are that:
- Gold is an ineffective hedge against inflation
- Gold appreciates in operational wealth in major deflations
- Gold is an ineffective hedge against yearly commodity price increases
- Gold maintains its purchasing power over long periods of time. This is not because gold eventually moves towards commodity prices but because commodity prices move towards gold.
The use of gold as an inflation hedge seems to have its roots in the collapse of the Bretton Woods agreement in 1971. Since gold was no longer regarded as money it would act like any other commodity. However, during Jastram's period of study gold flips between being "money" and a "commodity" on numerous occasions: it isn't this distinction that drives the relationship. Gold may not be money but it certainly acts like it. Gold is produced for accumulation, whereas all other commodities are produced for consumption.
The other reason for the strength of the hedgers' convictions is simply poor inductive reasoning. Because gold has preserved its value in periods of big upheaval does not mean that it is useful as a strategy against cyclical behaviour. It is a crisis hedge rather than an inflation hedge.
Those wishing to hedge inflation will need to be a little more creative, particularly given uncertainty over what will cause it and the point of its emergence. Something we will return to in a later blog.
Regards,
Dr Mark Tomsett
A topic LINKS has seen in the press on and off in recent months has been the issue of whether Gold makes a good hedge against inflation. This issue clearly isn't the only one turning the grey matter of investors who have inflation issues.
Where are interest rates going? Can markets absorb the large supply and what will happen to inflation outright? Will governments use inflation to reduce the real impact of the huge wave of public expenditure of the last few months? At this stage it's unclear what will happen and it is this uncertainty that continues to drive markets.
It is unlikely that we will see inflation rear its head for some time while there is spare capacity in the global economy. However, those with a longer -term view or those looking at the tail risk should now be considering suitable hedges.
The obvious hedge for inflation is gold. Or is it? It's a position that has reached almost mythical status but supporting evidence is thin on the ground. In fact, the seminal work by Roy W. Jastram (1977) presented in "The Golden Constant" suggests something very different. He analyses the purchasing power of gold in England and the US from 1560 to 1976. The key conclusions are that:
- Gold is an ineffective hedge against inflation
- Gold appreciates in operational wealth in major deflations
- Gold is an ineffective hedge against yearly commodity price increases
- Gold maintains its purchasing power over long periods of time. This is not because gold eventually moves towards commodity prices but because commodity prices move towards gold.
The use of gold as an inflation hedge seems to have its roots in the collapse of the Bretton Woods agreement in 1971. Since gold was no longer regarded as money it would act like any other commodity. However, during Jastram's period of study gold flips between being "money" and a "commodity" on numerous occasions: it isn't this distinction that drives the relationship. Gold may not be money but it certainly acts like it. Gold is produced for accumulation, whereas all other commodities are produced for consumption.
The other reason for the strength of the hedgers' convictions is simply poor inductive reasoning. Because gold has preserved its value in periods of big upheaval does not mean that it is useful as a strategy against cyclical behaviour. It is a crisis hedge rather than an inflation hedge.
Those wishing to hedge inflation will need to be a little more creative, particularly given uncertainty over what will cause it and the point of its emergence. Something we will return to in a later blog.
Regards,
Dr Mark Tomsett
Friday, June 12, 2009
Rolex quantitative strategies - beware of expensive imitations
Hi,
http://www.battleofthequants.com/agenda.html
I've just returned from the Battle of the Quants having survived a close scrape with a cyborg hedge fund investor sent from the future to melt the markets. Think Gordon Gekko crossed with the Terminator - not a pleasant experience. Now, in all seriousness, some of the claims from the quant strategists to be able to read the future didn't seem much more far fetched than my fictional market cyborg, yet they were adamant at the value they could guarantee to add.
Autoregressive models do have some merit, particularly some of the smarter times series analysis out there, but you're only ever as good as your data, and keeping these models current is tough in chaotic illiquid markets, especially when the markets have just gone through what a chaos mathematician would call a 'phase' change.
Despite this, I don't want to put investors off. If you do your homework and if your quant strategist is willing to pull the curtain back on their methodology, savvy investors will find some good returns in the quant strategy field. However, in this environment you must keep one eye on your exit. When quant strategies get too crowded, exiting with your returns intact can be a precarious business - the Goldman funds debacle of Aug 2007 is well documented and could easily happen again. Furthermore, whenever a strategy meets some degree of success, beware of what the biologists would call 'mimicry'.
For every sound quant strategy out there, you'll also find a manager or two with a poor idea yet the marketing machine to raise capital. This manager effectively gains an advantage by mimicking the successful credible quant players, despite having weak models and a poor idea. With 'black box' strategies still doing the rounds, and with complex lingo coming thick and fast in a world with cash rich investors chasing credible hedge fund managers, dud horses will inevitably be backed.
I can't stress enough for investors to ensure they have some explanation of the strategy employed, in what markets the manager believes it will work (there's no magic bullet for quant strategies, despite what the most bullish of quants may say), and, should returns prove negative, a rapid exit strategy.
You'd never buy a Rolex out of a suitcase on Times Sq, why do the same with your hedge fund investments?
Happy hunting,
Andy
http://www.battleofthequants.com/agenda.html
I've just returned from the Battle of the Quants having survived a close scrape with a cyborg hedge fund investor sent from the future to melt the markets. Think Gordon Gekko crossed with the Terminator - not a pleasant experience. Now, in all seriousness, some of the claims from the quant strategists to be able to read the future didn't seem much more far fetched than my fictional market cyborg, yet they were adamant at the value they could guarantee to add.
Autoregressive models do have some merit, particularly some of the smarter times series analysis out there, but you're only ever as good as your data, and keeping these models current is tough in chaotic illiquid markets, especially when the markets have just gone through what a chaos mathematician would call a 'phase' change.
Despite this, I don't want to put investors off. If you do your homework and if your quant strategist is willing to pull the curtain back on their methodology, savvy investors will find some good returns in the quant strategy field. However, in this environment you must keep one eye on your exit. When quant strategies get too crowded, exiting with your returns intact can be a precarious business - the Goldman funds debacle of Aug 2007 is well documented and could easily happen again. Furthermore, whenever a strategy meets some degree of success, beware of what the biologists would call 'mimicry'.
For every sound quant strategy out there, you'll also find a manager or two with a poor idea yet the marketing machine to raise capital. This manager effectively gains an advantage by mimicking the successful credible quant players, despite having weak models and a poor idea. With 'black box' strategies still doing the rounds, and with complex lingo coming thick and fast in a world with cash rich investors chasing credible hedge fund managers, dud horses will inevitably be backed.
I can't stress enough for investors to ensure they have some explanation of the strategy employed, in what markets the manager believes it will work (there's no magic bullet for quant strategies, despite what the most bullish of quants may say), and, should returns prove negative, a rapid exit strategy.
You'd never buy a Rolex out of a suitcase on Times Sq, why do the same with your hedge fund investments?
Happy hunting,
Andy
Wednesday, May 27, 2009
Business as usual.....
Hi,
Firstly, lots of people have commended us on the speed and pragmatism of our swine flu piece, see it below on this page if you haven't already.
Secondly, it has been a busy month for Links and one overwhelming sense I have seen this month is of 'business as usual' in the financial industry. Banks are starting to recruit in certain areas, hedge funds are raising money again, investors are starting to commit capital; the paralysis that had gripped many parts of the financial markets seems to have eased to the point that the machine as a whole is starting to function again.
I wouldn't say we are out of the woods yet as we remain particularly vulnerable to an unexpected downside event, and the economy and the financial industry as it recovers will look very different to the one that went into this crisis in 2007, however, people are now mentally gearing up for the future and are looking to take some risk.
One point I'd like to make is that there is still much needed flesh to add to the bones of the suggested reforms in the financial industry. It's possible that, as the economy recovers, politicians will lose the drive for change under the misapprehension that it will stifle the recovery. What economies need is genuine 'value add' in a whole range of business rather than an economy feeding off what was arguably a bubbling financial services industry. Failure to get the financial reforms right could see a repeat of the issues which have caused the current crisis from which we are only now escaping.
Happy hunting,
Andy
Firstly, lots of people have commended us on the speed and pragmatism of our swine flu piece, see it below on this page if you haven't already.
Secondly, it has been a busy month for Links and one overwhelming sense I have seen this month is of 'business as usual' in the financial industry. Banks are starting to recruit in certain areas, hedge funds are raising money again, investors are starting to commit capital; the paralysis that had gripped many parts of the financial markets seems to have eased to the point that the machine as a whole is starting to function again.
I wouldn't say we are out of the woods yet as we remain particularly vulnerable to an unexpected downside event, and the economy and the financial industry as it recovers will look very different to the one that went into this crisis in 2007, however, people are now mentally gearing up for the future and are looking to take some risk.
One point I'd like to make is that there is still much needed flesh to add to the bones of the suggested reforms in the financial industry. It's possible that, as the economy recovers, politicians will lose the drive for change under the misapprehension that it will stifle the recovery. What economies need is genuine 'value add' in a whole range of business rather than an economy feeding off what was arguably a bubbling financial services industry. Failure to get the financial reforms right could see a repeat of the issues which have caused the current crisis from which we are only now escaping.
Happy hunting,
Andy
Wednesday, April 29, 2009
Risk managing swine flu when you aren't a virologist.......
Hi,
Swine flu is the big topic of the day and I thought I'd post a few pointers for those of you who are scratching your heads wondering what on earth to do. The path of least resistance is just to watch and see how this plays out, and I'm sure that's what the majority of people are doing. Unless of course you managed to pile into the pharmaceutical shares at the start of the week to jump on that predictable capital inflow bandwagon.
It isn't clear yet how deadly this virus is but given it has probably been around for a couple of months already and hasn't yet registered its first death in Europe, leads me to instinctively say that it won't be any where near as virulent as some of the more theatric media reports are suggesting. The media makes money from getting your attention, what better way to get your attention than the possibility of death by pig inspired influenza. Deaths will certainly come from this virus, and no doubt flu deaths are likely to spike above normal (for the UK normal is roughly 10,000 per year, ish, but these deaths never receive any media attention and are an accepted fact of daily life), but how far above normal is not an easy question to answer.
With markets flat lining, current popular opinion is that the flu will be largely a damp squib, not meriting the attention it is currently getting. Could we be surprised on the downside? It isn't impossible but I don't think so. Media attention is way overplaying the risk and unnecessarily alarming the public.
A few facts to keep in mind when considering what to do:
Firstly, the Spanish flu pandemic of 1918 killed between 2 and 20% of all those infected, one of the symptoms being hemorrhaging from the ears and mouth. So far, the reports of the symptoms don't come anywhere close to those of the severity of the Spanish flu outbreak of 1918. Of course the virus could mutate into something more sinister but it certainly hasn't yet and there's no guarantee that it will. The first reason to be cheerful !
Secondly, the majority of those who died in 1918 did so of secondary bacterial infections brought on by the initial influenza outbreak. For those people living in countries with well funded health care systems, the majority of those bacterial infections are likely be avoided through antiviral drugs and antibiotics. The second reason to be cheerful. In 1918 all you had was the whiskey bottle and your own constitution.
Thirdly,with international travel over the last 20years through plane, train and automobile available to the masses on a scale never before seen in humanity's history, human beings are more interconnected than they have ever been before. As a result, flu viruses spread through society much more quickly than ever before. While this is a risk in the sense that, if a killer flu does come along, it will spread very quickly, it is also a defence; due to human interconnectivity we all get a whiff of every virulent flu strain every year and our immune systems are that much more efficient at fighting them off, even if they are a particularly nasty strain.
In summary, ignore the media hype. Flu is here to stay, occasionally flu deaths will spike but the threat of a flu pandemic is an unavoidable fact of human life and something we are better prepared for than ever before. I would suggest carrying on as normal, have bacon with your breakfast if that is your habit and, if you must, buy OTM equity puts in emerging market indices, especially if it looks like the virus has mutated into something more formidable. Look for reports from key medical agencies that list more severe symptoms to give you a head start on whether a malignant mutation has occurred or not.
Happy hunting,
Andy Shaw
Swine flu is the big topic of the day and I thought I'd post a few pointers for those of you who are scratching your heads wondering what on earth to do. The path of least resistance is just to watch and see how this plays out, and I'm sure that's what the majority of people are doing. Unless of course you managed to pile into the pharmaceutical shares at the start of the week to jump on that predictable capital inflow bandwagon.
It isn't clear yet how deadly this virus is but given it has probably been around for a couple of months already and hasn't yet registered its first death in Europe, leads me to instinctively say that it won't be any where near as virulent as some of the more theatric media reports are suggesting. The media makes money from getting your attention, what better way to get your attention than the possibility of death by pig inspired influenza. Deaths will certainly come from this virus, and no doubt flu deaths are likely to spike above normal (for the UK normal is roughly 10,000 per year, ish, but these deaths never receive any media attention and are an accepted fact of daily life), but how far above normal is not an easy question to answer.
With markets flat lining, current popular opinion is that the flu will be largely a damp squib, not meriting the attention it is currently getting. Could we be surprised on the downside? It isn't impossible but I don't think so. Media attention is way overplaying the risk and unnecessarily alarming the public.
A few facts to keep in mind when considering what to do:
Firstly, the Spanish flu pandemic of 1918 killed between 2 and 20% of all those infected, one of the symptoms being hemorrhaging from the ears and mouth. So far, the reports of the symptoms don't come anywhere close to those of the severity of the Spanish flu outbreak of 1918. Of course the virus could mutate into something more sinister but it certainly hasn't yet and there's no guarantee that it will. The first reason to be cheerful !
Secondly, the majority of those who died in 1918 did so of secondary bacterial infections brought on by the initial influenza outbreak. For those people living in countries with well funded health care systems, the majority of those bacterial infections are likely be avoided through antiviral drugs and antibiotics. The second reason to be cheerful. In 1918 all you had was the whiskey bottle and your own constitution.
Thirdly,with international travel over the last 20years through plane, train and automobile available to the masses on a scale never before seen in humanity's history, human beings are more interconnected than they have ever been before. As a result, flu viruses spread through society much more quickly than ever before. While this is a risk in the sense that, if a killer flu does come along, it will spread very quickly, it is also a defence; due to human interconnectivity we all get a whiff of every virulent flu strain every year and our immune systems are that much more efficient at fighting them off, even if they are a particularly nasty strain.
In summary, ignore the media hype. Flu is here to stay, occasionally flu deaths will spike but the threat of a flu pandemic is an unavoidable fact of human life and something we are better prepared for than ever before. I would suggest carrying on as normal, have bacon with your breakfast if that is your habit and, if you must, buy OTM equity puts in emerging market indices, especially if it looks like the virus has mutated into something more formidable. Look for reports from key medical agencies that list more severe symptoms to give you a head start on whether a malignant mutation has occurred or not.
Happy hunting,
Andy Shaw
Monday, April 20, 2009
Stress testing and VaR models - finding the wood from the trees
Hi,
http://www.ft.com/reports/risk-management-april2009
Business is hotting up for us and I wasn't going to post anything until next week but the risk management report in the FT and the recent fretting about the Wall St stress tests has left me with some opinions I thought you'd find interesting.
VaR models come in for much criticism in the FT report but the pundits who are commenting on this are missing some basic issues and are still unable to see the wood from the trees. I've mentioned a number of times in recent blogs about the importance of understanding your risk models and their weaknesses. VaR continues to come in for much flak, especially the monte-carlo based models, however, the answer here isn't to throw them out and start building again, it is to adapt your models to the new environment, and make them 'future market proof'.
The scope of how to do this is too large for these pages but I stress, building again from scratch isn't needed if you have operational capacity to produce monte-carlo based VaR numbers. If you understand your model, you can easily adapt it to give you a much better guide on potential losses in future market scenarios. Now isn't the time to invest large sums of money in the alleged latest way to model financial risk. Now is the time for sound 'what if' analysis from your risk management department coupled with a smart hedging strategy.
This leads me neatly in to the Wall St stress tests which is the mother of all 'what if' projects. These numbers will undoubtedly influence share prices, but I suspect they will merely confirm what the market has decided in the past year. I don't think there will be a huge divergence in perceived health beyond that which has been implied already in the last two years of share price moves.
Pre-crisis, stress testing had been too lax with risk managers not able to make the conceptual leap from nonvolatile markets into possible future volatile ones. This is a classic human context mistake. If you are in a benign environment, it is very difficult for you to make the jump into a potential crisis enironment and come up with scenarios based off what a major increase in volatility would look like. Now that volatility has come, I'm sure that some of the possible future scenarios being suggested are the other way - much too conservative and apocalyptic. Despite the fact you may solve the context problem, assessing worst case scenario loss in chaotic markets and coming up with anything like meaningful numbers is an impossible job to do accurately. Stress scenarios are typically driven by liquidity issues and forced unwinds of a defaulted firms positions than assets jumping to certain fundamental levels which banks were able to anticipate in their stress analysis.
As a result, financial firms need to subtly change how they use this information to help to protect themselves in a downturn. They should consider dampening losses through a clever hedging strategy as any possible scenario, however comprehensively thought out, is exactly that - only a possible scenario. Of course then the challenge becomes how much to spend on your hedging strategy and how to apply it. Well, good risk managers are going to more than earn their money in the coming years, and the best of them will be the ones who can get the most bang for their company's buck in terms of hedging their business strategy. If you can get this right, it will have the potential to catapult your company's brand beyond your competition when the next wave of volatility hits the market as you will sail through it as opposed to being sunk.
Happy hunting,
Andy Shaw
http://www.ft.com/reports/risk-management-april2009
Business is hotting up for us and I wasn't going to post anything until next week but the risk management report in the FT and the recent fretting about the Wall St stress tests has left me with some opinions I thought you'd find interesting.
VaR models come in for much criticism in the FT report but the pundits who are commenting on this are missing some basic issues and are still unable to see the wood from the trees. I've mentioned a number of times in recent blogs about the importance of understanding your risk models and their weaknesses. VaR continues to come in for much flak, especially the monte-carlo based models, however, the answer here isn't to throw them out and start building again, it is to adapt your models to the new environment, and make them 'future market proof'.
The scope of how to do this is too large for these pages but I stress, building again from scratch isn't needed if you have operational capacity to produce monte-carlo based VaR numbers. If you understand your model, you can easily adapt it to give you a much better guide on potential losses in future market scenarios. Now isn't the time to invest large sums of money in the alleged latest way to model financial risk. Now is the time for sound 'what if' analysis from your risk management department coupled with a smart hedging strategy.
This leads me neatly in to the Wall St stress tests which is the mother of all 'what if' projects. These numbers will undoubtedly influence share prices, but I suspect they will merely confirm what the market has decided in the past year. I don't think there will be a huge divergence in perceived health beyond that which has been implied already in the last two years of share price moves.
Pre-crisis, stress testing had been too lax with risk managers not able to make the conceptual leap from nonvolatile markets into possible future volatile ones. This is a classic human context mistake. If you are in a benign environment, it is very difficult for you to make the jump into a potential crisis enironment and come up with scenarios based off what a major increase in volatility would look like. Now that volatility has come, I'm sure that some of the possible future scenarios being suggested are the other way - much too conservative and apocalyptic. Despite the fact you may solve the context problem, assessing worst case scenario loss in chaotic markets and coming up with anything like meaningful numbers is an impossible job to do accurately. Stress scenarios are typically driven by liquidity issues and forced unwinds of a defaulted firms positions than assets jumping to certain fundamental levels which banks were able to anticipate in their stress analysis.
As a result, financial firms need to subtly change how they use this information to help to protect themselves in a downturn. They should consider dampening losses through a clever hedging strategy as any possible scenario, however comprehensively thought out, is exactly that - only a possible scenario. Of course then the challenge becomes how much to spend on your hedging strategy and how to apply it. Well, good risk managers are going to more than earn their money in the coming years, and the best of them will be the ones who can get the most bang for their company's buck in terms of hedging their business strategy. If you can get this right, it will have the potential to catapult your company's brand beyond your competition when the next wave of volatility hits the market as you will sail through it as opposed to being sunk.
Happy hunting,
Andy Shaw
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