Posted tagged ‘Risk and Markets’

A Fatal Flaw in Reasoning

July 2, 2013

Financial economics has a basic fundamental fatal flaw. That flaw is that:

Financial Economics assumes that no one pays any attention to Financial Economics.

So if we stopped reading and listening and thinking about the insights of financial economics, they are at least somewhat more likely to actually be true.  At least for longer than they are now. 

But in the recent past, say the last 40 years, more and more people are trying to use the insights of financial economics to guide their actions in the financial markets. 

The problem is that once they do that, they are no longer acting like the rational actors that financial economics assumes that they are.  Those rational actors would have used their own insights about the way that markets work to make their decisions.  That is the way that decisions were made during the past time periods that financial economists studied to prove that their theories were reasonable.  Perhaps many people in those historical periods were being informed by earlier, now discredited, financial theories. 

But now, most people who now move money in the financial markets are informed by the exact same financial theories.  That is different from the past because now we have better communications and better education systems so that these best ideas are much more ubiquitous.  So there are large groups of folks who are all using the exact methods of analysis and decision making.  Those methods often are based upon a freeze tag assumption. 

Freeze tag is the children’s game where one person is it and as he or she tags the other palyers, they all freeze. 

The Freeze tag assumption that is built into the models that everyone uses is the assumption that we are all marginal to the market.  We are assuming that while we are doing our analysis and making our choise that the entire market is frozen AND that no one else is doing the analysis or making the decisions that we are making. 

“The technical explanation is that the market-sensitive risk models used by thousands of market participants work on the assumption that each user is the only person using them.”  Avinash Persaud

Financial economics is like magic that gets less and less powerful as more and more people learn it.  Once everyone can pull a coin from behind an ear, no one is very impressed by that trick. 

So the very success and power of financial economics ability to explain and predict financial markets resulted in more and more people adopting it which led to more and more herding of financial behaviors. 

That has led to a secondary issue.  Smart traders know this.  So just as financial economics provided the point of view and formulas and tools to look at how markets should act that applied to the world without financial economics, the smartest traders are looking at the world with financial economics to make their choices of trades to make their profits.  That takes the economic markets not one but two or more steps away from the pre financial economics markets. 

Game theorists have a game that they like where a group of folks are asked to guess the value of 2/3 of the average of their guesses.  If the range of possible guesses is 1 to 100, then all guesses above 66 are impossible, so the “right” answer is 44. But if only numbers below 66 are rational guesses, then you can rationally eliminate guesses above 2/3 of that value and so on until the only logical guess is 0. 

It is the problem that Keynes talked about with beauty contests (and stock markets):

“It is not a case of choosing those [faces] that, to the best of one’s judgment, are really the prettiest, nor even those that average opinion genuinely thinks the prettiest. We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be. And there are some, I believe, who practice the fourth, fifth and higher degrees.” (Keynes, General Theory of Employment Interest and Money, 1936).

Every financial economics theory has a tail like that.  Think about risk free rates.  Once you tell someone that a particluar interest rate is risk free, then those who can borrow at that rate will borrow more and more and more until the borrower is no longer  riskless.  An observation that a praticular rate was a good proxy for a risk free rate can only be correct in retrospect. In any forward sense, it is highly likely to be untrue. 

Businesses are hedging based upon measures of sensitivity of certain instruments to underlying financial information, “the greeks”.  But in October 1987, we found that those sensitivities were, in fact, totally variable based upon the number of people who were relying upon those relationships. 

This is all true because of the flaw in financial economics.  It would never have happened if financial economics papers were not published but were instead only read aloud at economics conferences. 

So what can risk managers learn from this story?  (This blog is for discussing matters of interest to risk managers, so that question is applied to each and every post.)

Risk managers can learn two things:  First, we need to have models that are not  based upon freeze tag type assumptions where “no one but us” knows of the theory.  And second, we need to be careful to try to not ourselves fall into this sort of cycle by getting into a process of trying to guess what everyone else’s risk models will be telling them.

Works if Small, Fails if Large

June 13, 2012

by David Merkel, The Aleph Blog

The Wall Street Journal had an article on risk control that had the attitude of “here are some silver bullets.” Ugh. When will journalists learn that there are no simple solutions to portfolio management?

“Risk-allocation turns 50 years of portfolio theory on its head.”

Ain’t true. Modern Portfolio Theory is garbage, but so is this. So volatility is more stable than returns. Volatility can be up or down, and you want to buy volatile asset classes that have gotten trashed. You won’t do it because you are scared, but that is part of why you aren’t a good investor. Good investors make the “pain trades.”

Here’s the question to ask: What would happen if everybody did this? Unlike share-weighted indexing, not all strategies can be applied by everyone at the same time. I have written about risk parity before:

Against Risk Parity
Against Risk Parity, Redux

So long as there are few using the strategy, it may work well, but it will not scale because volatility does not match the proportion of assets available to be purchased. The same is true of “risk control” and “risk budgeting” strategies. They will be “flashes in the pan;” there is no necessary reason why they will work. There is no such thing as risk, but there are risks.

Avoid faddish ideas as described in the WSJ article. Far better to focus on what risks you face in the investment markets, and choose assets that will not be affected by those risks,or, might even benefit from them.

Using volatility as a guide to investing will fail if it gets large enough, and during bull markets, it will be forgotten. Non-scalable strategies work if there is a barrier to entry, and there is no barrier here. Thus I see no long term value in the strategies proposed.


March 14, 2012

Hedge funds were the darlings of the past decade.  The 2 and 20 compensation lure of hedge funds is a major factor in the over compensation of bankers.  The argument was that if the banks did not match the hedge fund money, they would lose all their most talented people.
In 2011, 67% of hedge funds were below their high water marks according to a study by Credit Suisse.

What hedge funds promised was a Free Lunch.  But There’s No Such Thing As A Free Lunch!

The Economist summed it up perfectly in this letter to investors from the Zilch Capital Hedge Fund:

Dear investor,

In line with the rest of our industry we are making some changes to the language we use in our marketing and communications. We are writing this letter so we can explain these changes properly. Most importantly, Zilch Capital used to refer to itself as a “hedge fund” but 2008 made it embarrassingly clear we didn’t know how to hedge. At all. So like many others, we have embraced the title of “alternative asset manager”. It’s clunky but ambiguous enough to shield us from criticism next time around.

We know we used to promise “absolute returns” (ie, that you would make money regardless of market conditions) but this pledge has proved impossible to honour. Instead we’re going to give you “risk-adjusted” returns or, failing that, “relative” returns. In years like 2011, when we delivered much less than the S&P 500, you may find that we don’t talk about returns at all.

It is also time to move on from the concept of delivering “alpha”, the skill you’ve paid us such fat fees for. Upon reflection, we have decided that we’re actually much better at giving you “smart beta”. This term is already being touted at industry conferences and we hope shortly to be able to explain what it means. Like our peers we have also started talking a lot about how we are “multi-strategy” and “capital-structure agnostic”, and boasting about the benefits of our “unconstrained” investment approach. This is better than saying we don’t really understand what’s going on.

Some parts of the lexicon will not see style drift. We are still trying to keep alive “two and twenty”, the industry’s shorthand for 2% management fees and 20% performance fees. It is, we’re sure you’ll agree, important to keep up some traditions. Thank you for your continued partnership.

Zilch Capital LLC

There probably are a handful of money managers who are actually worth the 2 & 20.  But think about it, someone has to be on the other side of all of those trades where the hedge fund managers are winning.  Eventually, everyone who has money that is invested with a manager (or themselves) who loses every time either runs out of money or hires another manager, until more and more of the money is managed by people who are aware of all the ways that the hedge funds have changed the investment markets.

And the hedge fund tricks no longer work.


Do we always underprice tail risk?

April 23, 2011

What in the world might underpricing mean when referring to a true tail risk? Adequacy of pricing assumes that someone actually can know the correct price.

But imagine something that has a true likelihood of 5% in any one period.  Now imagine 100 periods of randomly generated results.

Then for each of three 100 period trials look at 20 year periods. The tables below show the frequency table for the 80 observation periods.

20 Year Observed Frequency Out of 80
0 45
5% 24
10% 12
15% 0
20% 0
20 Year Observed Frequency Out of 80
0 9
5% 28
10% 24
15% 8
20% 7
20 Year Observed Frequency Our of 80
0 50
5% 11
10% 20
15% 0
20% 0

if the “tail risks” are 1/20 events and you do not have any information other than observations of experience, then this is the sort of result you will get. The observed frequency will jump around.

If that is the situation, how would anyone get the price “correct”?

But suppose that you then set a price for this tail risk. Let’s just say you picked 15% because that is what your competitor is doing.

And you have a very patient set of investors. They will judge you by 5 year results. So then we plot the 5 year results.

And you see that my profits are quite a wild ride.

Now in the insurance sector, what seems to happen is that when there are runs of good results people tend to cut rates to pick up market share. And when the profits run to losses, people tend to raise rates to make up for losses.

So again we are stymied from knowing what is the correct rate since the market goes up and down with a lag to experience.

Is the result a tendency to underprice?  You be the judge.

Rents vs. Risk and Reward

April 16, 2011

Many people talk and write as if risk and reward were the true trade-offs in a capitalist system.  It certainly makes risk management important if that were true.

But unfortunately for us risk managers, and fortunately for business managers, choosing among risky alternatives is not the best choice for business success.

In fact, the natural tendency of capitalism is directly away from risk and towards Competitive Advantage.  If a business can find a competitive advantage, their first choice forever after is to strengthen that advantage and to reduce their risk.

A business with a total competitive advantage, also called a monopoly, is crazy to then take any risk.  Economists call their income a rent.  The income from risk taking is called a risk premium.  All businesses prefer rents to risk premiums under that definition.

So the risk managers who talk all of the time about the risk and reward continuum and about the efficient frontier of risk taking are talking nonsense to any business person who knows the story of any of the most successful businesses.  The most successful businesses all made fortunes for their founders by collecting rents.

What we should be talking about is the Rent / Risk continuum.  If you want to be really successful, you need to find a way to collect rents.  If you want to get mediocre returns, then you can go out and take risks.

Many years ago, Riskviews was producing risk reports for return on risk capital for an insurer.  The insurer had some fee for service business.  This business did not fit into the risk reward framework.

Investment Banks had at one time been mostly fee for services businesses.  Then for a time, they decided that they could make more money taking risks.  It turns out that they were largely wrong.  The “profits” that they were recording on their risk taking were risk premiums for taking very large risks that were “in the dark“.  According to Taleb, they were being massively underpaid for those large but infrequent risks.

Some reinsurers that make their business taking on large amounts of catastrophe risks can be shown to be taking a significant amount of their value from the “default put” that is created because they collect premiums for all expected claims under their reinsurance contracts, but they do not intend to pay off on the largest catastrophes because they will have defaulted.

Risk taking is a questionable way to make profits.

So risk managers need to work to identify rents and properly reflect the superior place that rents should have in business goals.  Risk managers should be slow to claim that any risk taking behavior will make a profit and not just mistaken accounting of risks that are waiting in the dark and growing stronger to take back all of the so called profits from risk taking.

When is a Risk Premium Earned?

April 7, 2011

This is a difficult question.  One that challenges our accounting systems.

Think of two insurance contracts.  One lasts for one minute, the other for an hour.  They are both sold for residents of Antartica.  They cover the risk of being hit with a snowball.  On the average, residents of Antarctica are hit with a snowball 3 times per day.  The contracts pay out $10 every time the insured is hit with a snowball.  Premiums are $5 for the one hour policy and $0.10 for the one minute policy. The policies are renewable.

On Antarctica it is the custom of insurers to publish quarterly financials, that is every quarter hour.

Right now, there are 4 people on Antarctica and two of them have policies.  One bought the one minute policy and the other bought the one hour policy.

After the first quarter hour, there have been no claims.  What are the profits from the two policies?

The answers are completely different depending upon whether you decide to look at earning risk premium over the maximum holding period for the policies or the minimum holding period.

Our accounting systems tend to take the minimum holding period approach.  However, the maximum holding period approach might give a more useful answer.

The maximum holding period approach would be to think of the risk over the effectively infinite maximum holding period.  To determine profits, look forward and consider the amount needed for future losses.  You expect to have lumpy losses that average to a certain level.  The maximum holding period approach would then tend to reflect the excess over the expected losses as the profits in a period as profits and allow a build up of reserves to take care of the lumpy losses.

The minimum holding period approach suggests that at the end of the minimum holding period, you are done and reflect any revenue not needed to pay losses as profits.

So if no snowballs were thrown that quarter hour, all premiums (less expenses, which are very high for insurers operating in Antarctica) as profits.  If during any quarter hour there are snowballs, then there will be losses.  Very lumpy results.

This is not just an insurance consideration, it applied to any risks, such as credit or any far out of the money derivatives where losses are not expected in every period.

The minimum holding period approach will tend to encourage risk taking.  The maximum holding period approach would tend to make risk takers realize that they do expect losses sometimes.

Then if someone wants to recognize all of their profits from exposure to an infrequent risk during no loss periods, they would need to totally exit that position.




The following chart is referenced in the comment from Robert Arvanitis…

Risk/Reward NOT Linked

May 18, 2010

At least they are not automatically linked.

Here is a description of the “Law of Risk and Reward” from somewhere on the web. . .

The risk versus reward curve is a fundamental principle in business. The simple explanation is that, as risk in a given transaction increases so does the reward.

This is the fallacy that most of us have heard many, many times.  We hear it so often, it actually seems to be true. 

But it definitely is not now, nor was it ever true that increasing risk increases reward.  

Alfred Marshal is the originator of the supply and demand curves that we were all taught in microeconomics. 

“in all undertakings in which there are risks of great losses, there must also be hopes of great gains.”
Alfred Marshall 1890 Principles of Economics

Somehow, as his idea above about “hopes” for gains was repeated over the years, the word “hopes” was left off. 

And in fact, it takes much more than “hopes” to get great gains out of great risks.  In fact, there are two paths to great gains…

  • Great Luck
  • Great Risk Management

The “Law of Risk and Reward” above seems to follow a fairness sort of reasoning.  It would only be fair if increased risk resulted in increased reward.  But the world is not fair. 

It is quite possible to:

  1. Get a large gain after taking a small risk
  2. Get a large loss after taking a small risk
  3. Get a small gain after taking a large risk
  4. Get a small gain after taking a small risk
  5. Get a large gain after taking a large risk
  6. Get a large loss after taking a large risk

There are several reasons for this.  First of all, the size of the risk is always an estimate made in advance with incomplete information.  Clearly the situations like number 2 above are cases where the risk may have been underestimated.  Also, the economists will emphasize that situations like 1 do not usually last for long.  (See the old joke about the economist and the $20 bill.)  A second reason is that the risk management performed by the risk taker can be effective both in terms of risk selection and in terms of loss severity mitigation.  However, the risk management tasks that result in good risk selection and effective loss severity mitigation require skill and execution. 

Risk takers who believe in the “Law of Risk and Reward” will tend to think that the time, effort and expense of doing good risk management is wasted effort since more risk results in more reward by law.

Another Fine Mess

May 9, 2010

High speed trading ran amok on Thursday, May 6.  It sounds like exactly the same thing that lead to the 1987 market crash.  There never was an explanation in 1987 and there most likely will not be one now.

Why not?  Because it is not in the interest of the people who are in a position to know the answer to tell anyone.

Look, the news says that this high speed trading is 75% of the volume of trading on the exchanges. That means that it is probably close to 75% of the exchanges revenue.

Most likely, the answer is that this sort of crash has always been possible at any time of any day with computers sending in orders by the thousands per minute. The people who programmed the computers just do not have enough imagination to anticipate the possibility that no one would want to take the other side of their trade.

Of course this is much less likely if someone actually looked at what was going on, but that would eliminate 90% of that volume.  Back before we handed all of the work to computers, the floor brokers who were the market makers would take care of these situations.

The exchange, that is benefiting from all of this volume, should perhaps be responsible to take some responsibility to maintain an orderly market.  Or else someone else should.  The problem is that there needs to be someone with deep pockets and the ability to discern the difference between a temporary lack of buyers or sellers and a real market route.

Oh, that was the definition of the old market makers – perhaps we eliminated that job too soon.  But people resented paying anything to those folks during the vast majority of the time when their services were not needed.

The problem most likely is that there is not a solution that will maintain the revenue to the exchanges.   Because if you brought back the market makers and then they got paid enough to make the very high risk that they were taking worth their while, that would cut into the margins of both the exchanges and the high speed traders.

Just one more practice that is beneficial to the financial sector but destructive to the economy.  After the 1929 crash, many regular people stayed out of the markets for almost 50 years.  It seems that every year, we are learning one more way that the deck is stacked against the common man.

In poker, when you sit down at the table, it is said that you should look around and determine who is the chump at the table.  If you cannot tell, then you are the chump.

As we learn about more and more of these practices that are employed in the financial markets to extract extra returns for someone, it seems more and more likely that those of us who are not involved in those activities are the chumps.

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