Seeing Tomorrow, I

Book review of Dembo and Freeman’s “Seeing Tomorrow: Rewriting the Rules of Risk”.

There is something breath-taking about the title of this book. The audacious title,  the equally audacious subtitle, and even the painting on the cover remind me of Peter Bernstein’s risk management opus, “Against the Gods”, a book that made Bernstein to risk management what Carl Sagan was to cosmology: a modern-day Prometheus who brought the fascinating story of a scientific discipline to the  understanding of mortals.

However, at just the second page of the Introduction, I was startled by a prosaic admission: “Even as this book was in preparation, one of the authors, who sold a house in 1994, watched in dismay as property prices…defied expectations and rose to new heights” -- weren’t these blokes going to teach us to see ‘tomorrow’?

Anyway, as with so many risk management books, this one  opens with an example of risk-taking gone wrong.  The authors pick on someone as big as they can get: George Soros, the man who broke the Bank of England. 

Apparently, naive George often makes the mistake of looking at the past to predict the future. “It is no use looking over our shoulder and assuming that we can find all there is we need to know”, says Dembo and Freeman.   Quite true, but quite unconvincing since the man you pick is several times wealthier than you and prides himself as being a philosopher of some calibre.  I do not quite think the circumstances and the mistake are quite as simple as what the book relayed.

Modern man, say the authors, is faced with far too many choices, and they have written the book to rewrite the rules of risk, calling approaches to risk ‘outmoded’ and ‘flawed’. 

They bring up a pausing image of what we all go through each time we come to a fork in the road and have to make a choice:

“…we are faced with a single, unique decision that will probably not be repeated or will only be repeated a few times. We need to make that decision despite the uncertainty the future brings, and we need to make it now.”

Do I buy this house? Do I take this job? Should I get this insurance? Should I sell these shares now?

The book is about a new risk-taking framework which the authors introduce to make use of a risk concept they call  ‘Regret.’  D&F say this framework is ‘no different’ from the system they use ‘to help the world’s most sophisticated banks manage their risks.’ The framework is focused on the future, with the past taking a backseat (though not ignored).

Towards the end of the Introduction, there is a brief excursion on the etymology of the word ‘speculator’.  Anyone familiar with  Benjamin Graham’s or Warren Buffet’s writings know what pejorative connotations the word ‘speculator’ can bring.  Everyone coming from reading Graham will want to be known as ‘investors’ and not ‘speculators'.’

D&F gives us an etymology of the word that might change our minds. ‘Speculator’ comes from the Latin ‘specula’ which refer to watchtowers ringing the boundaries of the Roman Empire. 

When guards in the watchtowers see danger coming (barbarian hordes, for example), they would send signal to the next specula, which in turn sends a signal to the next one, until the signal reaches Rome, which dispatches its legions.

A speculator was someone who ‘tries to see dangers in the future and acts on them.’

More in the next post.

Risk and Uncertainty

The Institute of Risk Management’s “A Risk Management Standard” defines risk as the combination of the probability of an event and its consequences.

A risk is connected to an event, its probability, and its consequences.

An event that has no probability of happening does not pose a risk.  There is no risk that your project team will be kidnapped by aliens tomorrow.

An event that has a 100% chance of happening should not be treated as a risk.  If you do not pay your employees, do not place in your risk register that “my employees might not want to work without pay.”

If the event has no consequences for you, it is not a risk.  The collapse of the Nigerian stock market may affects thousands of people, but of no consequence to you (presuming you have no investments there).

If the event (if it occurred) has a positive impact on you, you can take advantage of that by treating it as a risk.

Risk

Risk cannot be separated from benefits.  It is only because we enjoy benefits that we are concerned with risk. 

We undertake projects in the hope of reaping future benefits from the project. 

In order to understand the risks we face, first we identify the benefits we want to protect. 

There are two types of benefits.  First is the future benefit that we hope to acquire (e.g., a job promotion).  The second is the current benefit that we are enjoying (e.g., a healthy life).

Once we’ve identified the benefits, then we can consider the risks we are concerned with.  For example, the risk that we do not get the promotion.  Or, the risk that our health suffers.

The Risks of Doing Nothing

The risk that companies face often come, not from activities originating from decisions they make, but very, very much often, from decisions made by others. 

They are out to get you.  Every one of of your competitors is out to get your customers.  Every single day they are plotting to change the world and make it more favourable to them (and less favourable to you, but you can relax, as that is merely a secondary purpose).

Failing to monitor, perceive, and anticipate the changes exposes your company to risks. Doing nothing against the changes means your risks are increasing.

For a simplistic example, imagine a company that did not adjust its salaries to keep pace with industry salaries. If its competitors pay much better, key people will tend to move to the competitors.  Doing nothing is not doing your responsibility.

Quantitative Risk Management

Notes for McNeil, A.J., Frey, R. & Embrechts, P. “Quantitative Risk Management: Concepts, Techniques, and Tools”, Princeton University Press, 2005, Chapter 1.

Risk is most often understood as a hazard, a chance of bad consequences, etc., or something that is primarily a downside event.  An initial definition might be ‘an action or event that may adversely affect an organization’s ability to achieve its objectives or execute its strategies’.  This does not capture all the essence of risk, however.

Risk is strongly related to uncertainty and therefore to randomness, another term that has defied a very firm universal definition for centuries until Kolmogorov’s axiomatic definition (1933). Kolomogorov’s probabilistic model is a triplet (Ω,F,P), where Ω is a state, F is the set of events, of which P is a member, and P(A) is the probability of event A occurring.

FINANCIAL RISK

In the context of finance and insurance, the most common types of risk include:

• Market risk – the risk of a change in the value of a financial position due to change in its underlying components.
• Credit risk – the risk of not receiving promised repayments.
• Operational risk – risk of losses resulting from inadequate or failed internal processes, people, systems, and external events.

Liquidity risk is the risk stemming from the marketability of an investment, that it cannot be sold in time to prevent a loss or achieve a gain.
The only viable way to achieve successes in financial risk management is through a holistic approach, taking all types of risks and their interactions into account.

Risk measurement. Measuring the risk of a portfolio of X holdings with w weightings requires a distribution function Fx(x) = P(X <= x).

Basel II defines operational risk a the risk of losses resulting from inadequate or failed internal processes, people and systems or from external events.

THE REGULATORY FRAMEWORK OF BASEL II

Basel II released in 2004. Focuses on more risk-sensitive minimum capital requirements for banking organizations, by laying out principles, enhancing transparency in financial reporting

3-Pillar Concept. In Pillar 1, banks are required to quantify their minimum capital charge (regulatory capital) in line with their economic loss potential. There is a capital charge for credit, market, and operational risk. There was no consideration for operational risk in Basel I. Pillar 2 focuses on ensuring there is a well-functioning corporate governance with appropriate checks and balances.  Pillar 3 is about ensuring appropriate public disclosure of risk measures.

Market Risk Capital Charge. Banks are allowed use internal VaR (Value at Risk) models.  Example: A 10-day VaR at 99% for $20 million means there is a 1% probability for the bank to lose at least $20 million by the end of the 10-day period.

Credit Risk. Under Basel I and Basel II, credit risk is assessed as the sum of risk-weighted assets. The risk weight is reflects the credit worthiness of the counterparty.  In Basel I, creditworthiness was crude and allowed only 3 categories: governments, regulated banks, and other.  Hence risk-weighting for all corporate borrowers are the same, independent of their actual creditworthiness.  In Basel II banks can choose to use standardised approaches or more advanced internal-ratings-based approaches.  The new standardised approaches provide substantially more classifications than the old Basel I.

The premise under Basel II is that while individual banks will reduce their credit risk capital charge through internal credit models, the overall size of regulatory capital will remain unchanged.  All agree that operational risk is important, but there is disagreement and uncertainty about how to quantify this risk.

Cooke ratio says that capital should be at least 8% of the risk-weighted assets of a company.

Criticism of Basel II:

• Cost of setting up a compliant risk management system is substantial
• ‘Risk management herding’ could take place.  This is the phenomenon where organizations simply follow the same rules and behave the way during crisis, exacerbating the situation. 
• Overconfidence may come about due to regulation.

Some have raised the notion that regulatory risk management actually makes organisations even more risky.

SOLVENCY 2

Solvency 2 is a review of the capital adequacy of the European insurance industry.  Basel II is aimed to reinforce the soundness and stability of the international banking system.   Solvency 2 is aimed to protect policyholders against isolated bankruptcy of their insurance company.  Basel II addresses systematic risk, Solvency 2 does not (and is not intended to).

Solvency I was very basic and focused on solvency margins. It was not risk based.

Decision on solvency is based on a 2-tier approach. The first level is a target capital, based on risk-sensitive, market-consistent valuation.  Breaching the first level triggers regulatory intervention. The second level is the minimum capital, computed with the old Solvency I rules.

WHY MANAGE FINANCIAL RISK?

Different stakeholders have different interests as to an institutions investment in quantitative risk management.  A balance between the interests have to be sought. Stakeholders can include customers, shareholders, regulators, board of directors, politicians, etc. SOCIETAL VIEW

Modern society depends on the smooth and reliable functioning of the global financial system. There is  a danger of systemic risk.  Modern models attemp to spread out the risk to those most willing and presumably able, to accept the risk. Derivatives are instruments that help to enhance the stability of this system. Challenges of Quantitative Risk Management

It is the large, extreme, unexpected events that form one of the challenges for QRM.  Modelling the expected and normal outcomes may have the advantage of simplifying things but risk understating the risks.

Concentration of risks is about exposure to what was thought to be diversified risks, but which happened to experience simultaneous falls or rises.  It is a case where many things go wrong at the same time.

If a portfolio is too expansive, multivariate models for all risk factors may not be feasible.  QRM needs to be simplified to use broad brush strokes, concentrating on the key features only. This is a problem in scalability of QRM.

Successful QRM requires integration with many disciplines. Understanding QRM requires integrating techniques from various disciplines, such as mathematical finance, statistics, financial economics, and actuarial mathematics.

QRM FOR THE FUTURE

QRM has had an overall positive impact in the insurance and banking industry. Other industries (e.g., car manufacturing) have similar practices albeit called differently (e.g., total quality control).

QRM techniques have been adopted in the transport and energy industries, among others. Electrical power is traded on energy exchanges, derivative contracts are used to hedge price increases. There is debate on how much of Basel II can be transferred to the energy industry.

A new area of application is establishments of markets for environmental emission allowances.  The Chicago Climate Futures Exchange offers futures contracts on sulphur dioxide emissions.

Alternative risk transfer is the transfer of risks between industries.

Futures Contract

A futures contract is a form of a derivative.  It is a contract to buy a specified asset at a specified price at a specified future date. It is a tool to manage financial risk. 

Here’s how it works. Suppose a company has an obligation to pay a debt of US$1 million in 8 months time.  The company is based in Australia, and normally trades in its own local currency (AUD).  In order to protect itself from the uncertain currency fluctuation, it decides to purchase a futures contract to buy US$1 million in 8 months time from a bank at a guaranteed exchange rate of USD1 = AUD 1.7.  The contract specifies that the company will buy $1 million in 8 months,  at the pre-determined exchange rate.  By having this contract, the company does not have to worry about whether the US$ will fluctuate against its favour. It is guaranteed to be able to buy $1 million at the specified exchange rate.

If at the 8 month period, the exchange rate becomes USD 1.00 = AUD 2.00, the company is able to purchase the USD1 million at AUD1.7 million, very much in its favour.  The downside of course is that if at the 8-month period, the exchange rate has become USD1 = AUD1, then the company will be purchasing the USD1 million at an unfavourable, though surprise-free, rate.

Risk Roadshow

Interesting concept of a risk road show to introduce young children to the mathematics of probability: Risk Roadshow.