Protected by the Crowd

A major question for risk managers to ponder is whether it is sufficient to be protected by the crowd.

What I mean is whether they can feel that they are doing their job when they are ignoring the same risks that every one else is ignoring.

An example of that is inflation risk.  Inflation risk does not appear on most firms list of major risks.  But if there is inflation, their expenses will rise, their cost of borrowing will rise, the values of their stock and bond portfolios will fall, their claims costs will rise – all for certain and possibly, just possibly, their prices and their earnings on investments will rise enough to compensate for all of that.

But most firms take the approach that if they do not put inflation on their list of risks, then they do not have to deal with it.

Inflation can be like the rising tide eating away at the child’s sandcastle on the beach.  It does not appear anywhere near as inevitable as it is.  During the low tide, the sand castle appears more than strong enough and plenty far away from the water.  But slowly, slowly the tide works its way up the beach until eventually the castle is completely swept away.

And if everyone does not prepare for inflation, then the price increases that everyone will be able to get will most likely be enough to survive.  Because everyone in the market will need the price increases to survive themselves.

So all it takes to ruin that situation is for one significant competitor to screw it all up and to prepare for the risk of inflation.  Like the one airline that hedged their fuel costs.  They did not need to raise prices when oil prices spiked, so therefore, everyone that competed on routes with them had to eat the cost of their lack of risk management.

The same will be true with inflation.  Some firms will prepare for inflation.  They will not depend on being protected by the crowd.  And they will spoil it by refusing to raise prices as much as the firms that were not prepared need.  The unprepared firms will be stuck with several bad choices – losing business,  doing business at an unsupportable price or cutting costs that may not have any fat in them already.

The U.S. government on Wednesday said it will expand sales of Treasury securities that help investors hedge against inflation risks, a move aimed at improving management of its ballooning debt sales while boosting buying interest at home and abroad. (WSJ)

There has been an excuse, however.  Inflation has been difficult to hedge.  But with the above program of expanding the offerings of TIPS, the cost of hedging inflation may be reduced to something more similar to the hedge costs for other risks (I mean the transaction cost part of the cost of hedging).

The interesting thing about the story behind the TIPS change is that TIPS cannot be said to be a very successful program to date – largely because of the fact that most people and most firms choose to hide in the crowd for this risk.  The TIPS market has been just too thinly traded.  However, the WSJ article says that the TIPS are now seen to be a way to protect foreign investors against rampant dollar inflation.  If the US government must make inflation adjusted payments for a significant fraction of the debt, the WSJ article thought that might be a disincentive to the government excesses that drive inflation.

I wonder if the people who wrote that have heard of the inflation plagued countries where everything is indexed to inflation.  It makes inflation into a more bearable fact of life.  That seems to be a dangerous path to start down.

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Explore posts in the same categories: Hedging, Inflation, Risk Treatment

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