Saturday, January 31, 2009

The Nature of Risk - Alpha

Risk seems to encompass:
i) volatility (how much the price of an asset fluctuates);
ii) holding power (whether an investor can hold on to an asset for a certain period of time);
iii) the probability of the permanent loss of capital (what happens at the end, the final payout).

If an investor is patient, smart, and attentive, volatility works in her favor. She understands value, so can quickly buy when prices are depressed and sell when prices are elevated. Yet this depends on holding power, which can be contractual or psychological. Since no one can time the exact bottom, an investor needs to buy and hold on, either till the price swings back up temporarily (volatility) or till the end when the price converges to the final value. If an investor takes outside debt or equity and these providers pull out before the upswing or value convergence, she does not have contractual holding power. If she can't stomach the risk mentally, she does not have psychological/emotional holding power. All three are linked: vol, duration/holding power, and final payout probabilities all matter in defining risk. I'm not sure if there is a single equation or metric that can capture it all (VAR, cVAR, drawdowns, etc.).

As Vega notes, models and risk managers failed horribly, for many reasons. The most honest explanation I've seen of this failure came from an anonymous article by a risk manager at a big investment bank, here: Confessions of a Risk Manager. As the risk manager notes, multiple assumptions about risk were wrong. Flawed models failed. And incentives were skewed, allowing traders to take on much risk and get the upside, but neither trader nor risk manager bore a share of the downside (heads I win $10 million, tails the bank loses $10 billion).

The saddest part of this are the reports of the major bank heads, who had no clue about the risk being taken in their firms. This happened even at the best firms, and continues today. For example, the CFO of Goldman Sachs, Jeff Viniar, commented in late 2007 regarding one fund that: “We were seeing things that were 25-standard deviation moves, several days in a row. There have been issues in some of the other quantitative spaces. But nothing like what we saw last week.” This statement shows that at least one bank head doesn't understand risk, since a 25-standard deviation event is only supposed to occur once a few million years (i.e. never). I talked to one banker today, who mentioned that the largest investment banks in the US and Europe (including his own - one of the world's largest) are fully insolvent. They haven't taken anywhere near the amount of losses on their assets to reflect reality. They can't, because that would show their insolvency. So if they can't acknowledge reality, how can they acknowledge risk and uncertainty?

To end, Frank Knight's distinction in Risk, Uncertainty, and Profits is important:
Uncertainty must be taken in a sense radically distinct from the familiar notion of Risk, from which it has never been properly separated. . . The essential fact is that "risk" means in some cases a quantity susceptible of measurement, while at other times it is something distinctly not of this character; and there are far-reaching and crucial differences in the bearings of the phenomenon depending on which of the two is really present and operating. There are other ambiguities in the term "risk" as well, which will be pointed out; but this is the most important. It will appear that a measurable uncertainty, or "risk" proper, as we shall use the term, is so far different from an unmeasurable one that it is not in effect an uncertainty at all. We shall accordingly restrict the term "uncertainty" to cases of the non-quantitative type. (emphasis added, I.I.26)

Basically, the difference between risk and uncertainty is:
i) risk = a measurable, finite set of outcomes, with probability and magnitude known;
ii) uncertainty = an unmeasurable set of outcomes, where either one or both, probability and magnitude are not known, or the set isn't finite; hence anything not "risk."
Unfortunately, the line between the two isn't often clear.

2 comments:

  1. "I've seen of this failure came from an anonymous article by a risk manager at a big investment bank, here: Confessions of a Risk Manager. As the risk manager notes, multiple assumptions about risk were wrong. Flawed models failed. And incentives were skewed, allowing traders to take on much risk and get the upside, but neither trader nor risk manager bore a share of the downside (heads I win $10 million, tails the bank loses $10 billion).".


    I am not sure, if these are the competent risk managers who earn $$$$$$$/yr, they are greedy a$$es, who think having an ivy netorking is enough. Reason for saying this is not my arrogance, may be my ignorance of the subject. Here is my take. If the guy woke up in 2007, i have no respect for him. If he woke up in 2005/6, okay atleast he is worth his pay scale. If woke in 2003/4 he is well worth the pay. yes there are many folks who saw this comming, including me(By not buying a house, may not be a good play...) and couple of bloggers..i can reference.

    The main issue behind the whole credit crunch/housing bubble, was Banks & their greed with others money. Banks were just raising the money from Investors/Fed and loaning the money with minimal supervision (reason being, not their money), building a stupid RMBS( or similiar fancy named stuff) and getting a rating for that RMBS from a rating agency, and selling back the securities to Investors. Nice 1-2pt profit for this whole life cycle. So why did banks get skewed ??. Obviously the musical chairs stopped. Bunch of banks were holding the RMBS. Also, some banks were dumb enough to guarantee the RMBS they sold for a default %. Some banks are being sued by investors for selling the securities with wrong mortgage applications...

    So what is the solution in my opinion: Even if the home ownership growth is limited ( not really from 62 to 65%, but say 62 to 63%), we should have laws to loan only money which belongs to an organization/person ( He has maximum interest to get the principal back safely). Or may be we should allow the lended money to be also, loaned but should keep the margin money very very high ( 25/30%). This is the exactly the same solution we use for giving a person a home loan. Pay 20%, we beleive you have vexed interest to pay the mortogage...

    Anyways, back to the risk manager of the bank story:
    He/She should have identified that , there will be a time when the music will stop and everyone is going to rush thru. the doors.Risk manager seems to have applied the traditional risk model ( 2-8% defaults loans) for the modern finance ( 0% down, so home owner has no vexed interest, if property goes down. Come on, we are not british, where they can come agnaist our personal money..).Hence i beleive the risk managers should have applied the new risk model ( say 15-20% defaults on loans..)

    ==
    Now on innovative stuff..Predictions for 2009..
    Fed and govt. are printing and throwing money for any issue, any dip or any shit..so whats the result for future ...Something called inflation...Let have some subjects on the results of the feds actions of throwing money at every issue and taking the bad securities as guarantee..

    PS: I know my english is pretty basic.:)

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  2. Sitara,

    Alpha and I agree that inflation is in our future, but its complicated. A lot of smart hedge fund managers got burned betting on inflation 6 months ago only to see commodities and treasury yields plummet. The fed is printing money, but the velocity of money (the rate at which a dollar gets multiplied as it moves through the banking system) has slowed even more. The result is that the money supply has actually shrunk. Will velocity pick up next month or in 2 years? That depends in part on the depth and length of the recession.

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