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...

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...

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:

• Statistical Entropy - fundamentally that information can only be extracted from data, with the emphasis on extraction of information (from that already in the data) rather than creation of new information.
• Structural Imagination - that we need to be aware of how the market assumptions we make are themselves a model and that we need to spend more time on thinking about what could happen outside our current understanding or market experience.
• Self-Referential Feedback - the feedback loops in pricing, risk management and economics
• Complexity and Dark Risk - when you add (untested) complexity of a model to limited data sets you get a recipe for disaster.
• Alternate Means of Valuation - when the primary means of valuing a security is not available (illiquid markets anyone?) then what is the secondary means of calculation value.

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!...

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...

 

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"?

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...

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...

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

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

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.