Categories
Analytics Management
Asset Management
Automated Trading
Current Affairs
Data
Data Management
Database Technology
Derivatives
Events
Financial Markets Industry
Hedge Funds
Investment Banking
Regulation
Risk Management
Software Industry
Spreadsheets
Statistics
TimeScape
Web/Tech
Posts categorized "Hedge Funds"
Active to Passive and Back Again
FT article saying that passive fund management is set for growth giving the disillusionment of investors with the benefits of active fund management. Interesting piece was the bit where the growth in index-based investment may ultimately introduce index-inclusion distortions in constituent pricing, so ultimately swinging round to benefit those active fund managers that are still around to see this. Makes sense as there is always some money to be made (and lost!) when everyone starts to do the same thing, or maybe I am already being taken in by the forward-looking PR departments of the active fund managers?...
Posted by Brian Sentance | 27 June 2010 | 7:33 pm
The Humans Between Risk and Data
Some of my thoughts on risk management, data management and human behaviour, are to be found on page 20 of the Inside Reference Data Special Report "Managing Risk"
Posted by Brian Sentance | 21 June 2010 | 2:22 pm
A Crisis Needs a Utility?
I heard Francis Gross of the ECB speak at one of the panel events at the XTrakter Conference last week, and found that I couldn't avoid asking him whether the aims of the "Data Utility" initiative by the ECB could be better separated from the means by which the ECB proposes to solve them. At the moment, reference data issues for the industry and the data utility seem to be presented as a single "package". I can't say that the response to my question was a clear one to my understanding; however I would say that Francis was helpful after the panel had finished and provided a recent presentation of their ideas, of which you can find a copy here.
Looking through the presentation, the motivations put forward for why the industry needs a data utility seem to include:
- Data processing must be done in an automated manner, since data volumes have moved beyond the capabilities of manual processing.
- can't see anyone arguing with this - Data is a major bottleneck, with multiple providers/sources each with the own "data dialect"
- agreed and to some extent what keeps data/data management vendors in business, but sounds sensible to standardise if possible as there are plenty of other problems to address - These data dialects lead to increased cost, operational risk and reduced responsiveness
- agreed, mainly a cost aspect I would suggest - The recent crisis was not helped by weak data management in the industry
- but nor was it the cause, so not a great premise for a data utility -
- lack of transparency of data
- "transparency" is an over-used word at the moment, but certainly clarity and quality were/are needed - systematic risk could not be assessed due to the availability of data
- using terms like "systematic risk" seems to imply the regulators could calculate something, whereas this discipline is new so I guess we are really talking about simply knowing who is exposed to who and how.
- lack of transparency of data
- fundamentally agreed but also good to qualify with what you propose to be calculated - having a set of "numbers" doesn't seem to have helped much recently...
I started the above bullet point list by saying it contains the motivations for "why the industry needs a data utility" but I guess looking at the above list they really point to the more general aim of "why we need better industry-level data management". In the presentation the above points are then used to state:
"We all need the same good basic reference data. Why build more than one infrastructure?"
Maybe "Why build more than one infrastructure?" should really be changed to say "Why maintain more than one infrastructure?" given that Bloomberg, Thomson Reuters, Six Telekurs, Interactive, Markit and all the other vendors already infrastructure to do this. Not sure if I should read anything into the wording but more logical leaps of faith are to follow.
The presentation then moves on to state that shared reference data standards are a must, to which I cannot see many consumers of data disagreeing with that statement. Not sure I agree though with the overly simplistic statement that "Data will be good for all users or good for none". Trying telling that to the accountancy and risk departments for example but I suppose what we are talking about here is basic reference data not the more subjective price and valuation data. Reference data on instruments and entities is either right or wrong, and the presentation makes the good point that no amount of "data cleaning" can help this i.e. if wrong, the data needs to be re-captured from an accurate source.
The call for the establishment and use of reference data standards in the presentation then seems to be used to "slide "into a call for a standard reference data infrastructure. Unless I am very much mistaken, these two things are not necessarily the same thing and so it seems a logical leap has been taken here. The presentation talks about the possible necessity of "top down" legal compulsion for the industry, again something that I could agree and see the need for, but both the issues and legal compulsion do not automatically drive us to a "data utility" as the only option? Why couldn't legal compulsion be applied to the existing data vendors to standardise on common IDs for instance? ISIN is proposed as a standard in the presentation, but I can only assume that this is due to the ECB being mainly focussed on the bond world where to a large degree ISIN's work (i.e. are unique), whereas in the world of equities ISIN needs a lot of qualification (currency, exchange, share class...) before it uniquely identifies a quoted equity.
In summary, the presentation starts with showing how great the ECB's Centralised Security DataBase is (7 million securities, 3 million record updates/day etc...) and it does look good. The data issues for the industry seem clear, although I think the "crisis" is a bit of a red herring to the aim of data cost reduction, however the logical jump from industry need to effectively "we must have a data utility" is an interesting one, one where I would prefer that more options were discussed. It seems ironic that in these days of "transparency" it is not at all that transparent to me why more alternative solutions are not being discussed and a choice justified. Talking of choice and as a final thought, I am also not sure why the data vendors are not up in arms about this initiative - are they frantically lobbying behind the scenes? - do they simply think the utility won't go ahead? - or are they afraid of upsetting the EU? Any insight is very welcome, and maybe more of update from me when I get chance to speak with Francis in more detail.
Posted by Brian Sentance | 4 June 2010 | 8:00 am
Accountants, Prices and Upsidedown Elastic...
I am sure I am not the only one who has had to suffer the boredom of a economics lecture on price elasticity, but my interest in this old topic was sparked by an article by Tony Jackson in the FT on Monday, providing a very simple and clear explanation of how mark-to-market accounting (see earlier post) can conspire with leverage to turn price elasticity on its head, so the more something goes up in price, the more in demand it becomes...perhaps I should have paid more (or less?) attention to what the dusty prof was saying...
Posted by Brian Sentance | 31 March 2010 | 12:35 pm
Data models are not what they used to be...
AIM have released the results from their 2009 survey on reference data management which is worth a look, particularly given the 2008 results are also shown for comparison. Seems like Mike Atkin and the EDM Council have their work cut out in getting the Semantics Repository adopted if the survey is anything to go by, with the number of institutions using standards-based data models having dropped significantly when comparing 2009 to 2008. What is going on there in these heady days of the finance industry sorting out its data problem through adopting standards? - In cash starved times, maybe it costs more to conform to a standard? - Is the survey data not broad enough? Any ideas appreciated!
Posted by Brian Sentance | 18 March 2010 | 8:09 pm
One man's speculation is another man's insurance...
The current finanical crisis in Greece has prompted an outburst of entertaining discussion at the FT about CDS contracts, initiated by a feature article by Wolfgang Munchau who advocates that naked CDS contracts should be banned. The main argument used is that you should not be able to insure against a risk that you do not face e.g. buying insurance on somebody else's house then arranging to have the house burnt down. In support of Mr Munchau, one reader letter points out that insurance without interest in the insured item has been illegal since 1746, which on the face of it seems a long enough time to be a credible point in the discussion.
However, in using this argument then Mr Munchau seems be to attacking the whole of the derivatives industry not just CDS, for example the same argument could be used to ban the use of naked index puts to hedge equity market risk. I guess he is also helping some of the politicians in the EU direct attention away from Greece's financial mismanagement more towards the "evils" of the derivatives markets and hedge funds.
Some good letters in response, for instance this one with a good illustration of what hedging would be like without intermediaries to buy and sell risks that they do not own, plus another more direct one from the Association of Corporate Treasurers.
Whilst talking of Greece and credit, the FT Alphaville team also poked some fun at Anatole Kaletsky, the economist of the London Times Newspaper, who has recently done some interesting articles in the paper concerning his predictions about the stresses being suffered by Greece and the Euro. From their post, it would seem that Mr Kaletsky also runs a credit related fund, so it is implied that some of his newspaper views need to "calibrated" against his own vested interests...
Posted by Brian Sentance | 9 March 2010 | 2:40 pm
"Cut and Paste" Valuation Services
You can talk about more robust modelling, more stringent scenario testing and even moving everything onto an exchange, but unless we move the principles of good data management (in my view: consistency, security and quality of all types of data) into the front office then we will continue to get front-office mis-marking as described in this article in the FT.
Thanks to Ralph Baxter from Cluster7 for highlighting this article for me and those of you interested in this topic of operational risk and spreadsheet mis-use should maybe go along to EuSpRiG this year, and maybe take a look at a paper Xenomorph presented at a previous conference.
Posted by Brian Sentance | 4 February 2010 | 9:49 am
More Products, Less Complexity?
Decent article(and title!) explaining ETFs in FTfm today - growth of the market sounds impressive, from $40bn in the year 2000 to over $1,000bn under management now. Seemed like a bit of a day for new financial products in the FT, with the LSE announcement of opening up direct bond trading to retail investors through offering corporate bonds issued in sizes well below the usual £50,000 size (and catching up with more usual practice in Europe). Whilst not a retail product (I guess some of us already have life insurance?), longevity derivatives seem to continue their rise too in liability driven investment.
Meanwhile over on Linkedin, Structured Products magazine are asking just what constitutes a "complex" product? A decent question since complex products are not necessarily risky, but certainly "complexity is in the eye of the beholder" is most likely answer in my view - echoing a growing problem in finance, regulation and economics at the moment; there are too many people searching for the unique "right" answer to questions that simply do not have one. Maybe we should stick to the answer to everything being "42" and give up the search for the question?...
Posted by Brian Sentance | 2 February 2010 | 1:51 pm
Maths to Money - Quantitative Investment
I attended the Quant Invest 2009 event for the first time last week in Paris. The event is unsurprisingly about quantitative investment strategies, but with an institutional asset manager and hedge fund focus - so not so much about ultra-high frequency trading (although some present) but more about using quantitative techniques to manage medium/longer-term investment decisions and applied portfolio theory. A few highlights below that I found interesting:
- Pierre Guilleman of Swiss Life Asset Management gave an interesting 1/2 day workshop entitled "A random walk through models":
- He is a strong supporter of the need to understand more about the data and statistical assumptions upon which any quant investment model is based and how these fit with the desired investment objectives (similar to the Modeler's Manifesto)
- He made the point that good models can sometimes be almost annoyingly simple, and cited the example by a Professor Fair of Yale who had determined that US elections were predictable based on simple parameters such as past results, inflation and gdp and that policy did not seem to be a key factor at all - annoying for the politicians anyway!
- Pierre seems very concerned that the Solvency II regulation applied to Life Institutions will negatively influence the investment policies of many institutions - applying sell-side risk measures like VAR to the insurance industry will drive a more short-term approach to investment. He strongly believes that VAR applied to his industry should have an expected return parameter introduced to fit with longer term investment horizons of 10 to 25 years.
- Bob Litterman of Goldman Sachs Asset Management opened the first "official" day of the conference:
- Bob put forward his "scientific" approach to investment modelling going through the stages of hypothesis, test and implement. He warned against overconfidence in investment (apparently 70% of us think we are "above average"...) and impulsiveness (quick impulsiveness test: "if a bat costs $1 more than the ball, and the bat and ball together cost $1.10 then how much does the bat cost?...")
- He said that the failure of quantitative investment models in 2007 needed to be understood given the success of quant models over past decades. In particular he thought that quant investment became the "crowded trade" of 2007 with every hedge fund having a quant investment strategy. In terms of why this became a "crowded trade" Bob thinks that the barriers to entry into quant investment (particularly technology) have lowered significantly recently.
- He noted that factor-based investment opportunities decay quicker than they used to due to increased competition - implying the need for a more dynamic and opportunistic investment approach.
- GSAM are now looking at new markets and new investment instruments, trying to find areas of market disruption but without following what others are doing in the market.
- He pointed out the conflict between investors wanting more transparency over what is done for them, against the need to be more proprietary about the investment models developed.
- Next there was a talk on regulation from the French regulator that was dull, dull, dull both in terms of content and presentation style (when will regulators actually prepare well for the talks they give?)
- Panel debate was also pretty average, with the word "alpha" being used too much in my view - asset managers of a certain type seem to hide behind this word as an opaque "magic wand" to justify what they do.
- Jean-Phillippe Bouchard of Capital Fund Management did a great talk called "Why do Prices Move?". Some points from the talk:
- He started off with a reminder about the Efficient Markets Hypothesis (EMH) and how it says that crashes and market movements are caused by events outside (endogenous to) the market such as news, events etc.
- He then said this was not born out in the data, where extreme jumps in prices were only related to news only 5% of the time.
- Volatility looks like a long memory process with clustering of vol over time - similar to behaviour in complex systems
- The sign of order flow is predictable but the price movement is not, with only 1% of daily order volume accounting for price movements over 5%
- Even very liquid stocks have low immediate liquidity, meaning that price movements can play out over many hours and days as liquidity is sought to "play-out" some change in fundamental price levels.
- Joseph Masri of the Canadian Pension Plan Investment Board then did a good talk on Risk Management:
- Jo said that sell-side risk was easier to deal with in some ways since it involved fewer strategies in high volumes, and hence could be better resourced.
- Buy-side quantitative risk was harder due to its reliance onsell-side research and risk tools, the outsourcing of credit assessment to the credit rating agencies, the loss of Bear and Lehman's having caused the buy-side to have to do more risk management itself (and through third parties) rather than rely on the sell side risk management tools.
- He said that sell-side risk models are a good start for an asset manager, but need to be adapted to give both absolute and relative risk (to a benchmark fund for instance). All models are no substitute for risk governance.
- He described the cross over from risk methods: VAR, stress testing, factor-based and their applicability to market risk, credit and counterparty risk.
- Like Pierre he was not a fan of 1 or 10 day trading VAR being applied to investment managers since this risk measure was not suitable for long term investment in his view.
- On stress testing he said this needed to be top down (using historical events etc) as well as bottom up from knowing the detail of strategy/portfolio.
- In terms of challenges in risk management he said that VAR needed more stress testing to cope with the fat tails effect in markets, that liquidity risk both of counterparties and of illiquid products was vital and the importance of stress testing (he mentioned reverse stress testing) plus also the feedback (crowding effects) of having similar investment strategies to others in the market.
- Dale Gray of the IMF gave a very interesting talk on how he and Bob Merton have been applying the contingent claims model of a company (looking at equity in terms of option payoffs for shareholders and bondholders) to whole economies:
- He said that some of his work was being applied to produce a model for the pricing of the implicit guarantees offered by governments to banks
- He said these models were also applicable to macro-prudential risk
- Very interesting talk, and if he really has something of macro-level risk then this is great relative to the wooly approach by the regulators so far
There were some other good talks from Danielle Bernardi on Behavioural Finance, Martin Martens on Fixed Income Quant Investment, Vassilios Papathanakos on Stochastic Portfolio Theory (seemed to be a "holy grail" of investment model, giving good returns even in the crisis - begs the question why he is telling everyone about it?), Claudio Albanese on unified derivative pricing/calibration across all markets (again another "holy grail" worth more investigation) and Terry Lyons on speeding up monte carlo simulations.
Overall a good conference although the quality of the asset managers present seemed very digital from those who really seemed to know what they talking about to those who plainly did not (in my limited view!). Along this line of thought, I think it be good to test whether there is an inverse relationship between the quality of the asset manager and the amount of times they use the word "alpha" to explain what they are doing...
Posted by Brian Sentance | 5 December 2009 | 2:08 pm
It's in the hormones...
Taking the discussion on behavioural finance and news analytics a scientific step further, then this article in the FT today on how increased testorone equals an increased appetite for risk taking is interesting. Apparently experience of trading is also a big help in increasing a trader's Sharpe ratio, from which the authors suggest that markets are not efficient and the EMH does not hold. Now if only they could find a hormone that was correlated with increased returns, then I think they'd really have something...
Posted by Brian Sentance | 25 November 2009 | 7:12 pm
Regulatory moves and moods
Seems that the latest EU and Basel Committee proposals on banking regulation cannot make everyone happy (now there's a surprise...). Whilst many seem very happy at the incremental nature of the proposals to increase capital requirements for securitisations and proprietary trading, some of those in the Glass-Stiegal/banking utility camp are less than impressed. I am with the incremental camp myself, but have to acknowledge that the sceptics are not short of ammunition when saying that we are heading back to the future...meanwhile over in hedge fund land, London is currently in a very bad mood with the EU...
Posted by Brian Sentance | 15 July 2009 | 7:02 pm
Lessons for Risk Management - Wilmott and Rowe
Great event organised by PRMIA and IAFE last night at Goldman's London offices with a long title:
"A Little Thought Goes A Long Way and Lessons for Risk Management from the Current Crisis".
The event was moderated by Giovanni Bellossi of FGS Capital, and featured speaking slots by Paul Wilmott and David Rowe of Sungard. Here are my notes on the evening, please forgive any innaccuracies, and please persevere through some of the techy quant stuff, as their general points are well worth understanding.
- Giovanni quoted from Nassim Taleb about how VAR is invalid and that mainstream financial mathematics should be banned (or words to that effect, see earlier post on Taleb)
-
He added that whilst what Taleb says cannot be ignored, he said that despite the current crisis and its causes that we should not "throw the baby out with the bathwater" and added that Taleb "...is not only able to recognise a cow but also knows how to milk one."
-
Giovanni said that financial mathematics has much to offer and that whilst VAR is simply a number, one of its great benefits has to make one measure of risk simple and compelling enough to get traders and risk managers talking.
Paul Wilmott then took the floor and put forward his thoughts:
On Taleb and the Black-Scholes Model
- Paul mentioned that he and Taleb were great friends, and whilst he agreed with much of what Taleb says he has areas of disagreement, particularly over the use of the Gaussian distribution in finance and its implications for "fat tail" events
- Paul Googled "Taleb" and found more entries for Taleb than for Stephen Hawkin which shows how much attention had come his way due to the "Black Swan" debate
- He thinks that he and Taleb are the "Marmite of finance" (for those of you not in the UK who do not know Marmite, it is a sandwich spread that you either love or hate, never anything inbetween)
- He suggested that every quant needs a much more fundamental and practically grounded understanding of financial mathematics.
- Paul refered to some work (mentioned by Giovanni) that Peter Carr of Bloomberg had done on discrete daily hedging that showed that this option replication technique could remove up to 85% of the risk and that all quants should know about this 15% error term when trying to calculate an option price to the Nth decimal place.
- He described how in the past he had set up a volatility arbitrage hedge fund, wanting to improve upon the flawed assumption of the Black-Scholes (B-S) model that volatility is constant and to build the world's best volatility model for option pricing.
- Paul said that he did build the world's best volatility model (?!), but soon found it took too long to calculate, so he reverted back to B-S and has become an unfashionable fan of the model and its assumptions.
- He added that many of the variants on B-S to overcome its limitations have made the model worse and harder to calibrate.
- In some part due to Taleb's opinions on fat tails of distributions, B-S and other models are now very unpopular but Paul claims that not many people have actually bothered to robustly test the B-S model or take a practical, evidence based approach such as that adopted by Peter Carr.
-
Paul then showed some example charts and said that with a limited number of opportunities for regular time-period hedging it was not valid to use risk-neutral pricing whereas if the same number of hedges could be used optimally (implying at irregular time periods) then risk-neutral was valid and hedging could be more effective. He emphasised that this was the kind of practical stuff that a quant should know and that quants show know less about esoteric complex financial mathematics.
Correlation
- Paul said that of all of the issues that need addressing in mathematical finance, the one that he has very few answers on is correlation.
- He showed that even basic questions about correlation are poorly understood, even by quants - a question he asks some quants was that if two asset prices both start out at 100, and they have a correlation (of returns) of 1 (perfect correlation) what is the price of the second asset after a year if the first moves to 200. The answer is not 200, and he showed how assets could diverge in overall direction but still have a correlation of 1 or rise together with a perfect negative correlation of -1.
- Paul illustrated how correlation was a very blunt measure that is mis-used by people to summarise the highly complex and historically unstable relationships between assets driven for example by industry sector success (leading to +ve correlation) or competitive success (leading to -ve correlation)
- As a result, he said that financial products whose value depends on correlation should not be transacted in any great size and moved on to the example of CDOs, where a CDO with 1,000 underlying mortgages has been modelled with 1/2 million correlations all assumed to be 0.6. Why this assumption should be made was his main point.
Sensitivity to Parameters
- His main point here was that a constant should not be varied, otherwise it is not a "constant", in particular focussing on volatility used in the B-S model and the calculation of Vega as prices are moving.
- Paul added that sensitivity measures may apply locally and is such may look comparible from one situation to another, but quants need to understand how outputs respond over a wider range of inputs, and not to be inhibited by accepted practices and beliefs.
Complexity
- Models need to be robust and transparent, and that quants should aim for the mathematical sweet spot.
- Paul put forward the following analogy that at least when driving an old car over a long distance, you knew that the car was likely to break down at least once, but you also knew that it was likely that you could fix it. Contrast this with driving a modern sports supercar and finding that it has (unexpectedly?) broken down - you don't know how to fix it, you do not complete your journey and it costs you an ordinate amount of money to put things right...
Self-Referential Feedback
- Paul described here how the hedging of derivatives contracts in the underlying markets can cause price movements in underlying markets that cause derivatives contracts to re-price that cause more hedging in the underlying markets...
- He was critical of credit derivative pricing as being too complex and too "mathsy" (...but had to admit that he had also endorsed some of this work at the time)
Calibration
- Paul said that model parameter calibration is the devil's work...
- He refered us to inverse problems in mathematics as a background to this issue in mathematical finance.
- He emphasised how markets and price behaviour is fickle and driven by human opinions and behaviours
- He said that on-going and regular re-calibration of a model is very, very likely to mean that the model is wrong (he had a particular example of calibrating a particular model he hates where vol is a function of underlying price and time.
David Rowe, Sungard's specialist spokesman on risk management, then took over from Paul and set out his five topics for discussion:
Some further notes from David's talk:
- AAA rating should imply a failing once every 10,000 years, with some super senior CDO tranches being rated as better than AAA - David pointed out that even as recently as the early 1990s there were problems in the US housing market that indicated that AAA did not mean what it was taken to mean.
- On structural imagination, David said that quants and risk managers must look for unrepresented variables in a model and track them early to monitor their effects
- On feedback he cited an example where increased returns drove product innovation which drove up (CDO) volumes, which caused underwriting standards to fall, that allowed further complexity, that then led to unreliable risk estimation which then led to more product innovation... and so on.
- He suggested that quants adopt the "second means of valuation" mantra in a similar way to credit specialists always having the mantra when assessing credit of "what is the second means of repayment" (e.g. a lien on a house) when the primary means (mortgage payments) goes away.
- David showed a nice classification from an IASB paper on classifying financial instruments:
Level 1: fair values measured using quoted prices in active markets for the same instrument.
Level 2: fair values measured using quoted prices in active markets for similar instruments or using other valuation techniques for which all significant inputs are based on observable market data
Level 3: fair values measured using valuation techniques for which any significant input is not based on observable market data
David additional proposed the interesting level of "Level ?" for some products, and said that obviously more attention needs to spent on Level 2 and 3 instruments under conditions of reduced (non-existant?) market liquidity.
Summary Session:
Paul and David then answered some questions from the audience:
- Paul said that some risk managers lacked the imagination necessary for good risk management, being confined in standard procedures, beliefs and ways of doing things. He wants risk managers who are good at thinking laterally.
- Paul said that risk management was often an afterthought, not part of the trading process.
- David said that VAR has proven useful despite its weaknesses, in his opinion preventing failures from non-extreme events regardless of the recent extremes
- David said that in answer to Taleb's criticism of using history in modelling, it quite frankly is all we have to go on. He quoted Mark Twain in that:
"History does not repeat itself but it does rhyme"
The talks were interesting, and even on points that have been discussed elsewhere both speakers had some interesting slants and good analogies. But maybe I am biassed, as the wine afterwards wasn't bad either!...
Posted by Brian Sentance | 3 July 2009 | 12:28 pm
Over The Counter Arguments
George Soros has waded back into the current saga concerning OTC derivatives in his article last week in the FT. The main part of the article focusses on financial markets reform, but ends with a vehement attack on derivatives, building upon some of his earlier ideas (see post) and seemingly going much further:
"Finally, I have strong views on the regulation of derivatives. The prevailing opinion is that they ought to be traded on regulated exchanges. That is not enough. The issuance and trading of derivatives ought to be as strictly regulated as stocks. Regulators ought to insist that derivatives be homogenous, standardised and transparent."
He ends by saying that "CDS are instruments of destruction that ought to be outlawed.". To the extent that Mr Soros attracts press/political attention is probably something the OTC markets should worry about, although it would seem his views are already consistent with many involved in influencing the US financial markets policy - take for instance the submission by Christopher Whalen to the US Senate on OTC Derivatives:
"Simply stated, the supra-normal returns paid to the dealers in the closed OTC derivatives market are effectively a tax on other market participants, especially investors who trade on open, public exchanges and markets."
Fortunately however there are also some more balanced views around - I found the following post on the "(in)efficient frontiers" blog, which references the earlier Senate submission by Richard Bookstaber on OTCs. Mr Bookstaber starts by saying that derivatives can improve financial markets, allowing investors to shape returns, exactly meet contingencies and package risk. Mr Bookstaber also puts forward a very clear summary how participants have also over recent years use derivatives to game the system to achieve tax avoidance, investment mandate avoidance, speculation and to hide risk-taking.
So back to the Soros article, there was a letter in response a few days later from a partner at the legal firm Ashurst's, saying that unfortunately risk does not confirm to a standard. In this I agree, standardising contracts can lead to increased complexity - there was a recent example given by a swaps dealer at JPMorgan who said that a corporate with particular cashflows to be hedged does want to be dealing with the basis risk and admin of using standardised contracts - the corporate treasurer wants something that matches the exposure they have and takes it away, end of story. Again this is an example of derivatives "risk" not being just about the product type, but also about which institution is holding the contract and what they are using it for (see earlier post).
Not sure however how much the Ashurst's partner who wrote the response letter is worried about lucrative legal fees for OTC derivative contracts dying off if Soros-like standardisation occurs - it is a world of vested interests at the moment, never more vested than in a crisis...
Posted by Brian Sentance | 2 July 2009 | 8:26 am
Risk in the Hands of the Holder?
Given the ongoing debate about "too big to fail" and whether we should head back to the days of the Glass-Steagal Act, then here is a slightly different slant on the problem of systematic risk put forward in an article by Avinash D. Persaud.
In the article, Avinash makes the very good point that increasing capital requirements across the board is not the only response that regulators should consider, and that the risk of a financial product cannot be determined in isolation of who is holding it:
"At the heart of modern regulation is the erroneous view that risk is a quantifiable property of an asset. But risk isn't singular. There are credit, liquidity, and market risks, for instance—and different parts of the financial system have different capacities to hedge each. Thus, risk has as much to do with who is holding an asset as with what that asset is. The notion—popular in the U.S. Congress—that there are "safe" instruments to be promoted and "risky" ones to be banned is deceptive."
Obviously the last point is very relevant to the OTC markets at the moment. Avinash suggests that capital requirements should be tailored to what type of organisation is holding a risk and that organisations ability to hedge it, and outlines past mistakes made by regulators:
"By requiring banks to set aside more capital for credit risks than nonbanks must, regulators unintentionally encouraged banks to shift their credit risks to those who wanted the extra yield but had limited ability to hedge this type of risk. By not requiring banks to put aside capital for maturity mismatches, they encouraged banks to take on liquidity risks they couldn't offset. Moreover, by supporting mark-to-market asset valuations (which make institutions value holdings at their current price) and short-term solvency requirements, regulators discouraged insurers and pension funds from taking the very liquidity risks they are best suited for."
On banks and credit risk, then for those interested there is a good regulatory arbitrage example for credit risk described in the following article. Fundamentally I think the paragraph above illustrates some of the reasons why it is right to worry about rushing in new regulation too quickly - certainly things need to change but when dealing with large and complex systems (i.e. in this case Financial Markets) changes should be introduced incrementally in order to understand how the system responds.
Given the political imperative to "do something" then regulators find it all too tempting to stick their noses in everywhere, even in areas that did not lead us to the current crisis - take for instance the regulatory initiatives over the past year in short selling, hedge fund regulation and more recently the dangers of "dark pools" (at least dark pools sound scary I guess?). Where will the next "bogey man" appear on the regulator's radar and what will be the unintended consequences of government pressure on regulators to keep us all "safe"?
Posted by Brian Sentance | 2 July 2009 | 7:00 am
Liquidity Derivatives - the next OTC?
Given the drive the FSA is making in forcing financial institutions to implement "Liquidity Risk Management" (see background on JWG-IT site) are we going to see renewed interest in the creation of "Liquidity Derivatives" to hedge liquidity risk? I found the following post on the subject applied to hedge funds but not much information else where, although Tony Jackson did an interesting article on liquidity in the FT last week, indicating that liquidity derivatives have been tried before with little success.
I was thinking of the advent of credit derivatives being driven in no small part by Basel II regulation on capital charges for credit risk. Maybe given the current battle going on around OTC regulation (see FT feature today) there are institutions working on liquidity derivatives but nobody in the finance industry wants to admit that they are already creating the next "innovative" OTC to nullify regulatory charges?
Mr Geithner better watch out, innovation will always beat "rules" in my view...
Posted by Brian Sentance | 21 May 2009 | 7:20 am
Regulators and the law of unintended consequences
Interesting article in the FT fund management supplement on Monday, talking about some research Goldmans have done on the recent performance of US stocks that have a large percentage of their market cap owned by hedge funds.
It seems that hedge fund redemptions and deleveraging is having a strong effect on stock performance. The 50 US stocks most exposed to hedge fund investment have slumped by 19% in September, whilst in contrast the S&P has gone down by 9% and those stocks who little hedge fund investment have only gone down by 2%.
Again an interesting illustration of the systematic risks that are around in the market, ones that once the situation has got bad they only make things worse. The regulators should take a lot of care in identifying and categorising all of these types of systematic effects before they formulate the brave new world of tougher regulation. If they don't, then watch out for the law of unintended consequences, it will always catch you out if it can...
Posted by Brian Sentance | 17 October 2008 | 4:38 pm
Never ending liquidity for FX?
FX volumes grow from $99,000bn in 2007 from $71,000bn in 2006 - growth driven by automated trading, cheaper execution leading to more and more participants. How fluid can the market become? Article link:
http://www.ft.com/cms/s/0/10fc4512-2c4f-11dd-9861-000077b07658.html?nclick_check=1
Posted by Brian Sentance | 28 May 2008 | 10:02 pm
Hedge fund fee incentives and risk
FT pointed out interesting academic research on how the risk appetite of hedge fund managers seemingly changes in accordance with how close they are to the previous high of the fund: just short and they take more risk; way below they take less risk to limit losses; and well above the previous high they again take less risk.
Classic agency theory stuff in that it is hard trying to match manager (agent) incentives to investor (principal) - obviously topical given the current interest/criticism of bonus incentives at investment banks. Simple concept but (maybe surprisingly) hard to come up with schemes that work well. Abstract and link to download can be found at:
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1031096
Posted by Brian Sentance | 30 April 2008 | 5:45 pm
Hedge funds and the long-dated option...
Seems like Martin Wolf of the FT has re-discovered the story of hedge funds selling long-dated options to enhance returns:
http://www.ft.com/cms/s/0/c8941ad4-f503-11dc-a21b-000077b07658.html
I thought this had been around as a story for a fair while in academia, but the points he makes on trying to understand whether the manager is adding value to the investment process are good. He also discusses hedge fund fee structures and adds them into the current debate on city bonuses - getting shareholder value aligned with trading desk profits looks less simple than at first glance.
He also mentions the the "Taleb distribution", where an investment strategy has a high probability of a modest gain but a low probability of huge losses in a given period. I hadn't heard it called this before, but certainly sounds descriptive of what is/has gone on in credit.
Posted by Brian Sentance | 19 March 2008 | 1:18 pm