Archive for the ‘Hedging’ category

Management by Onside Kick

June 6, 2016

Many American football fans can recall a game when their team drove the ball 80 or more yards in the waning moments of the game to pull within a touchdown of the team that had been dominating them. Then they call for the on side kick – recover the ball and charge to a win within a few more plays.

But according to NFL stats, that onside kick succeeds only 20% of the time in the waning minutes of the game.

Mid game onside kicks – that are surprises – work 60% of the time.

But mostly it is the successful onside kicks that make the highlights reel. RISKVIEWS guesses that on the highlights those kicks are 80% or more successful.

And if you look back on the games of the teams that make it to the Super Bowl, they probably were successful the few times that they called that play.

What does that mean for risk managers?

Be careful where you get your statistics. Big data is now very popular. Winners use Big Data. So many conclude that it will give better indications. But make sure that your data inputs are not from highlight reels or from the records of the best year for a company.

Many firms use default data collected by rating agencies for example to parameterize their credit models. But the rating agencies would point out that the data is from rated companies only. This makes little difference for rated Bonds. There the bonds are rated from issue to maturity or default. But if you want to build a default model of insurers or reinsurers then you need to know that many insurers and some reinsurers will drop their rating if it falls below a level where it hurts their business. So ratings transition statistics for insurers are more like the highlight reels below a certain level.

Some models of dynamic hedging strategies were in effect taking the mid game success rates and assuming that they would apply in bad times. But like the onside kick, things worked very different.

So realize that a business strategy and especially a risk mitigation strategy may work differently when things have gone all a mess.

And an onside kick is nothing more than putting the ball in play and praying that something good will happen.

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The CRO is making a list and checking it twice

February 2, 2015

“You never said that you wanted me to do that”  is an answer that managers often get when they point out a shortfall in performance.  And in many cases it is actually true.  As a rule, some of us tend to avoid too much writing things down.  And that is also true when it comes to risk management

That is where ERM policies come in.  The ERM policy is a written agreement between various managers in a company and the board documenting expectations regarding risk management.

policy

But too many people mistake a detailed procedure manual for a policy statement.  Often a policy statement can be just a page or two.

For Risk Management there are several places where firms tend to “write it down”:

  • ERM Policy – documents that the firm is committed to an enterprise wide risk management system and that there are broad roles for the board and for management.  This policy is usually approved by the board.  The ERM Policy should be reviewed annually, but may not be changed but every three to five years.
  • ERM Framework – this is a working document that lists many of the details of how the company plans to “do” ERM.  When an ERM program is new, this document many list many new things that are being done.  Once a program is well established, it will need no more or no less documentation than other company activities.  RISKVIEWS usually recommends that the ERM Framework would include a short section relating to each of the risk management practices that make up a Risk Management System.
  • Risk Appetite & Tolerance Statement – may be separate from the above to highlight its importance and the fact that it is likely to be more variable than the Policy statement, but not as detailed as the Framework.
  • Separate Risk Policies for major risk categories – almost all insurers have an investment policy.  Most insurers should consider writing policies for insurance risk.  Some firms decide to write operational risk policies as well.  Very few have strategic risk policies.
  • Policies for Hedging, Insurance and/or Reinsurance – the most powerful risk management tools need to have clear uses as well as clear lines of decision-making and authority.
  • Charter for Risk Committees – Some firms have three or more risk committees.  On is a board committee, one is at the executive level and the third is for more operational level people with some risk management responsibilities.  It is common at some firms for board committees to have charters.  Less so for committees of company employees.  These can be included in the ERM Framework, rather than as separate documents.
  • Job Description for the CRO – Without a clear job description many CROs have found that they become the scapegoat for whatever goes wrong, regardless of their actual authority and responsibilities before hand.

With written policies in place, the board can hold management accountable.  The CEO can hold the CRO responsible and the CRO is able to expect that may hands around the company are all sharing the risk management responsibilities.

More on ERM Policies on WillisWire.

http://blog.willis.com/2015/01/erm-in-practice-risk-policies-and-standards/

http://blog.willis.com/2014/02/erm-practices-policies-and-standards/

 

Trimming Risk Positions – 10 ERM Questions from Investors – The Answer Key (6)

July 25, 2011

Riskviews was once asked by an insurance sector equity analyst for 10 questions that they could ask company CEOs and CFOs about ERM.  Riskviews gave them 10 but they were trick questions.  Each one would take an hour to answer properly.  Not really what the analyst wanted.

Here they are:

  1. What is the firm’s risk profile?
  2. How much time does the board spend discussing risk with management each quarter?
  3. Who is responsible for risk management for the risk that has shown the largest percentage rise over the past year?
  4. What outside the box risks are of concern to management?
  5. What is driving the results that you are getting in the area with the highest risk adjusted returns?
  6. Describe a recent action taken to trim a risk position?
  7. How does management know that old risk management programs are still being followed?
  8. What were the largest positions held by company in excess of risk the limits in the last year?
  9. Where have your risk experts disagreed with your risk models in the past year?
  10. What are the areas where you see the firm being able to achieve better risk adjusted returns over the near term and long term?

They never come back and asked for the answer key.  Here it is:

There are a number of issues relating to this question.  First of all, does the insurer ever trim a risk position?  Some insurers are pure buy and hold.  They never think to trim a position, on either side of their balance sheet.  But it is quite possible that the CEO might know that terminology, but the CFO should.  And if the insurer actually has an ERM program then they should have considered trimming positions at some point in time.  If not, then they may just have so much excess capital that they never have felt that they had too much risk.

Another issue is whether the CEO and CFO are aware of risk position trimming.  If they are not, that might indicate that their system works well and there are never situations that need to get brought to their attention about excess risks.  Again, that is not such a good sign.  It either means that their staff never takes and significant risks that might need trimming or else there is not a good communication system as a part of their ERM system.

Risks might need trimming if either by accident or on purpose, someone directly entered into a transaction, on either side of the balance sheet, that moved the company past a risk limit.  That would never happen if there were no limits, if there is no system to check on limits or if the limits are so far above the actual expected level of activity that they are not operationally effective limits.

In addition, risk positions might need trimming for several other reasons.  A risk position that was within the limit might have changed because of a changing environment or a recalibration of a risk model.  Firms that operate hedging or ALM programs could be taking trimming actions at any time.  Firms that use cat models to assess their risk might find their positions in excess of limits when the cat models get re-calibrated as they were in the first half of 2011.

And risk positions may need to be trimmed if new opportunities come along that have better returns than existing positions on the same risk.  A firm that is expecting to operate near its limits might want to trim existing positions so that the new opportunity can be fit within the limits.

SO a firm with a good ERM program might be telling any of those stories in answer to the question.

Skating Away on the Thin Ice of the New Day

April 23, 2010

The title of an old Jethro Tull song.  It sounds like the theme song for the economy today!

Now we all know.  The correlations that we used for our risk models were not reliable in the one instance where we really wanted an answer.

In times of stress, correlations go to one.

That is finally, after only four or five examples with the exact same result, become accepted wisdom.

But does that mean that Diversification is dead as a strategy?

I would argue that it certainly puts a hurt to diversification as a strategy for finding risk free returns.  Which is how it was being (mis) used in the Sub Prime markets.

But Diversification should still reign as the king of risk management strategies.  But it needs to be real diversification.  Not tiny diversification that is observable only under a mathematical microscope.  Real Diversification is where risks have completely different drivers.  Not slightly different statistical histories.

So in Uncertain Times, and these days must be labeled Uncertain Times (or the thin ice age), diversification is the best risk management strategy.  Along with its mirror image twin, avoidance of concentrations.

The banks had given up on diversification as a risk strategy.  Instead they believed that they were making risk free returns by taking lots and lots of concentrated risk that they were either fully hedging or moving the risk off their balance sheets very quickly.

Both ideas failed.  Hedging failed when the counter party was Lehman Brothers.  It succeeded when the counter party was any of the other institutions that were bailed out, but there was an extended period of severe uncertainty about that before the bailouts were finally put into place.  Moving the risks off the balance sheet failed in two ways.  First it failed because they were really playing hot potato without admitting it.  When the music stopped, someone was holding the potato.  And some banks were holding many potatoes.  It also failed because some banks had been offloading the risks to hedge funds and other investors who they were lending funds to finance the purchase.  When the CDOs soured, the loans secured by the CDOs were underwated and the CDOs came back onto the bank balance sheets.

The banks that were hurt the least were the banks who were not so very concentrated in just one major risk.

The cost of the simple diversification strategy is that those banks with real diversification showed lower returns during the build up of the bubble.

So that is the risk reward trade off of real diversification – it will often produce lower returns than the mathematical diversification but it will also show lower losses in proportion to total revenue than a strategy that concentrates in the most profitable risk choices according to a model that is tuned to the accounting or performance bonus system.

Diversification is the risk management strategy for the Thin Ice Age.

No Risk Management is Betting

March 22, 2010

So many times, the financial press gets it exactly backwards. (See Bloomberg) Firms who manage their risks by hedging or insurance are reported to be betting and firms who do not are simply subject to the normal fluctuations of uncontrollable events.

But Risk Management offers a real alternative to either betting or being tossed around by the frothy seas of misfortune.  Risk management offers the possibility of identifying and mitigating the most extreme negative events and trends of the world.

Imagine your business owns a building worth $100,000,000.  There is a 1 in 250 chance that a storm will hit your building and destroy the building leaving you with a $10 million piece of empty property and a $10 million clean up bill.  (ignore the business interruption for now).

So the expected cost of that loss is $400,000.  You get an insurance quote for $600,000.  There are two ways you can tell the story of purchasing insurance:

  1. The firm can place a bet that its building will be destroyed by a storm.  If there is no storm, then they lose their bet.
  2. The firm can manage its risk from a severe storm by buying an insurance policy.

Now if the storm does not happen, the story can be:

  1. The firm lost its bet that its building would be destroyed.
  2. The firm incurred a fixed cost of managing its storm risk and avoided the volatility of an uninsured situation.

And if the storm does one day hit, the story is:

  1. The firm won its bet that a storm would destroy its building and was rewarded by a $100 million gain from insurance.
  2. The losses from the storm were covered by the firms insurance.

Risk Management just is not a good story for the reporters, if told right.  For the firm, that may just be one more reason to consider risk management.

Now if the firm chooses not to buy the insurance, the coverage is twisted.  Again read two ways that it might be reported if there is no storm:

  1. No story.  Nothing happened.
  2. The firm got lucky and did not take a loss on its uninsured building.  They took a bet that had a huge downside for their shareholders for a very small payoff.

ANd if the storm hits, the story is reported as:

  1. Tragedy strikes.  Unfortunate event causes $100 M loss.  CEO say “We are just not able to control the weather.”
  2. The bet that management took went bad.  That bet was just not necessary.  Now shareholders have experienced large losses because the management was trying to save a little on insurance.  The CEO should be fired.

Unless the firm’s was in the business of long term weather forecasting they had no business making the bet when they did NOT buy the insurance.  THey had no expertise to tell them that they shouldn’t buy the insurance.

They were just gambling.

Protected by the Crowd

February 3, 2010

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.

Moral Hazard

January 13, 2010

Kevin Dowd has written a fine article titled “Moral Hazard and the Financial Crisis” for the Cato Journal.  Some of his very well articulated points include:

  • Moral Hazard comes from the ability for individuals to benefit from gains without having an equal share in losses.  (I would add that that has almost nothing to do with government bailouts.  It exists fully in the compensation of most executives of most firms in most economies. )
  • Bad risk model (Gaussian).  That ignore abnormal market conditions. 
  • Ignoring the fact that others in the market all have the same risk management strategy and that that strategy does not work for the entire market at once. 
  • Mark to Model where model is extremely sensitive to assumptions. 
  • Using models that were not designed for that purpose. 
  • Assumption of continuously liquid markets. 
  • Risk management system too rigid, resulting in easy gaming by traders. 
  • “the more sophisticated the [risk management] system, the more unreliable it might be.”
  • Senior management was out of control.  (and all CEOs are paid as if they were above average!)
  • Fundamental flaw in Limited Liability system.  No one has incentive to put a stop to this.  Moral Hazard is baked into the system.

Unfortunately, there are two flaws that I see in his paper. 

First, he misses the elephant in the room.  The actual exposure of the financial system to mortage loan losses in the end was over 400% of the amount of mortgages.  So without the multiplication of risk that happened under the guise of risk spreading had not happened, the global financial crisis would have simply been a large loss for the banking sector and other investors.  However, with the secret amplification of risk that happened with the CDO/CDS over the counter trades, the mortgage crisis became a depression sized loss, exceeding the capital of many large banks. 

So putting all of the transactions out in the open may have gone a long way towards allowing the someone to react intelligently to the situation.  Figuring out a way to limit the amount of the synthetic securities would probably be a good idea as well.  Moral Hazard is a term from insurance that is important to this situation.  Insurable interest in one as well. 

The second flaw of the paper is the standard Cato line that regulation should be eliminated.  In this case, it is totally outrageous to suggest that the market would have applied any discipline.  The market created the situation, operating largely outside of regulations. 

So while I liked most of the movie, I hated the ending. 

We really do need a Systemic Risk Regulator.  And somehow, we need to create a system so that 50 years from now when that person is sitting on a 50 year track record of no market meltdowns, they will still have enough credibility to act against the mega bubble of those days.


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