Wednesday, January 06, 2010

The Nature of Risk In 2010 & Beyond

As a new year begins, people are prone to attempting forecast coming events which may be major opportunities or threats to expected 'business as usual' flow.

However, the day-in, day-out business of risk management, such as it is, at financial services firms, revolves around various mathematical models involving variance and various derivations thereof.

As I mentioned to a colleague recently, even after financial markets in 2007-2008 exhibited quite exceptionally above-average volatility and experienced some generational failures of institutions, what most people mean by 'risk management' at a bank, trading or investment firm continues to be dominated by these intricately-modeled approaches.

To me, however, the big lesson of the past two and a half years, beginning with the failure of two mutual funds at Bear Stearns in the summer of 2007, is that of large-scale, unmodelable events which overwhelm those intricately-calibrated, position-by-position, trader-by-trader or instrument-by-instrument, quantitative risk management systems throughout various financial institutions.

In early September of 2008, just days before the equity market took a dramatic, once-every-twenty-year plunge in value, my business partner and I, having blithely begun to invest in long-dated equity options about a year earlier, apprised the risk of buying calls as minimal.

Talk about risk.

That event set off a continuing, evolutionary process of development of risk monitoring tools for our options investments. We learned that the speed and nature of market impacts on options is distinctly different than it is on equities.

As with our equity risk tools, we explored and designed options risk monitoring tools to signal directional changes, rather than point-estimates of value or forecasts of indices.

Personally, I would venture to guess that such global risk indicators actually provide more value than the minutae generated by the complex mathematical risk management systems at major institutions.

It appears, in retrospect, that John Paulson's hedge fund, and Goldman Sachs, used such rudimentary approaches to place their investments on the more profitable side of the steep equity sell-off of 2008.

To me, that sort of correct macro move is, although simpler, more important than the very complex and higher-order risk management systems which hold so much sway at financial institutions.

I commented to my business partner this weekend that our conversations about risk are much richer, better-informed and useful now than they were on that fateful day in September of 2008.

For example, in the fall of 2008, I noted, we could have easily observed the mounting problems in CDO valuations, as well as the looming basic economic woes of the US economy.

Of course, we didn't have the options risk monitoring tools we now possess. Had we had them at our disposal that September, we'd have already been positions in puts, ready for the ensuing roller-coaster ride down with the S&P500.

The point is, now we have useful, effective monitoring tools which draw our attention to the things which might account for the indicators which we observe.

The risk monitoring tools don't explain why they are indicating the actions, or inactions, they do, but they give us a context in which to assess the information, usually qualitative, which we have at hand.

To me, that's what risk identification and management is really about. It's not the detailed minor decisions, so much as the sweeping, large-scale market inflections that so often surprise investors.

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