Risk Management

Foundations For a Changing Financial World

Walter V. "Bud" Haslett, Walter V. "Bud" Haslett, Jr.

• Publisher: Wiley
• Year: 2010
• Print ISBN: 9780470903391
• eBook ISBN: 9780470934111
• Edition: 1
• Topic: Business
• Subtopic: Finance
• Index: Business

Key readings in risk management from CFA Institute, the preeminent organization representing financial analysts

Risk management may have been the single most important topic in finance over the past two decades. To appreciate its complexity, one must understand the art as well as the science behind it. Risk Management: Foundations for a Changing Financial World provides investment professionals with a solid framework for understanding the theory, philosophy, and development of the practice of risk management by

• Outlining the evolution of risk management and how the discipline has adapted to address the future of managing risk
• Covering the full range of risk management issues, including firm, portfolio, and credit risk management
• Examining the various aspects of measuring risk and the practical aspects of managing risk
• Including key writings from leading risk management practitioners and academics, such as Andrew Lo, Robert Merton, John Bogle, and Richard Bookstaber

For financial analysts, money managers, and others in the finance industry, this book offers an in-depth understanding of the critical topics and issues in risk management that are most important to today's investment professionals.

PART I

OVERVIEW—TWO DECADES OF RISK MANAGEMENT

CHAPTER 1

A FRAMEWORK FOR UNDERSTANDING MARKET CRISIS^a

Richard M. Bookstaber

The key to truly effective risk management lies in the behavior of markets during times of crisis, when investment value is most at risk. Observing markets under stress teaches important lessons about the role and dynamics of markets and the implications for risk management.

No area of economics has the wealth of data that we enjoy in the field of finance. The normal procedure we apply when using these data is to throw away the outliers and focus on the bulk of the data that we assume will have the key information and relationships that we want to analyze. That is, if we have 10 years of daily data—2,500 data points—we might throw out 10 or 20 data points that are totally out of line (e.g., the crash of 1987, the problems in mid-January 1991 during the Gulf War) and use the rest to test our hypotheses about the markets.

If the objective is to understand the typical day-to-day workings of the market, this approach may be reasonable. But if the objective is to understand the risks, we would be making a grave mistake. Although we would get some good risk management information from the 2,490 data points, unfortunately, that information would result in a risk management approach that works almost all the time but does not work when it matters most. This situation has happened many times in the past: Correlations that looked good on a daily basis suddenly went wrong at exactly the time the market was in turmoil; value at risk (VAR) numbers that tracked fairly well day by day suddenly had no relationship to what was going on in the market. In the context of effective risk management, what we really should do is throw out the 2,490 data points and focus on the remaining 10 because they hold the key to the behavior of markets when investments are most at risk.

This presentation considers the nature of the market that surrounds those outlier points, the points of market crisis. It covers the sources of market crisis and uses three case studies—the equity market crash of 1987, the problems with the junk bond market in the early 1990s, and the recent problems with Long-Term Capital Management (LTCM)—to illustrate the nature of crisis and the lessons for risk management. This presentation also addresses several policy issues that could influence the future of risk management.

SOURCES OF CRISIS

The sources of market crisis lie in the nature and role of the market, which can be best understood by departing from the mainstream view of the market.

Market Efficiency

The mainstream academic view of financial markets rests on the foundation of the efficient market hypothesis. This hypothesis states that market prices reflect all information. That is, the current market price is the market’s “best guess” of where the price should be. The guess may be wrong, but it will be unbiased; it is as likely to be too high as too low. In the efficient market paradigm, the role of the markets is to provide estimates of asset values for the economy to use for planning and capital allocation. Market participants have information from different sources, and the market provides a mechanism that combines the information to create the full information market price. Investors observe that price and can plan efficiently by knowing, from that price, all of the information and expectations of the market.

A corollary to the efficient market hypothesis is that, because all information is already embedded in the markets, no one can systematically make money trading without nonpublic information. If new public information comes into the market, the price will instantaneously move to its new fair level before anybody can make money on that new information. At any point in time, just by luck, some traders will be ahead in the game and some will be behind, but in the long run, the best strategy is simply to buy and hold the overall market.

I must confess that I never felt comfortable with the efficient market approach. As a graduate student who was yet to be fully indoctrinated into this paradigm, I could look at the many simple features of the market that did not seem to fit.

Why do intraday prices bounce around as much as they do? The price of a futures contract in the futures market or a stock in the stock market moves around much more than one would expect from new information coming in. What information could possibly cause the price instantaneously to jump two ticks, one tick, three ticks, two ticks second by second throughout the trading day?

How do we justify the enormous overhead of having a continuous market with real-time information? Can that overhead be justified simply on the basis of providing the marketplace with price information for planning purposes? In the efficient market context, what kind of planning would people be doing in which they had to check the market and instantly make a decision on the basis of a tick up or down in price?

Liquidity and Immediacy

All someone has to do is sit with a broker/dealer trader to see that more than information is moving prices. On any given day, the trader will receive orders from the derivative desk to hedge a swap position, from the mortgage desk to hedge out mortgage exposure, and from clients who need to sell positions to meet liabilities. None of these orders will have anything to do with information; each one will have everything to do with a need for liquidity.

And the liquidity is manifest in the trader’s own activities. If inventory grows too large and the trader feels overexposed, the trader will aggressively hedge or liquidate a portion of the position, and the trader will do so in a way that respects the liquidity constraints of the market. If the trader needs to sell 2,000 bond futures to reduce exposure, the trader does not say, “The market is efficient and competitive, and my actions are not based on any information about prices, so I will just put those contracts in the market and everybody will pay the fair price for them.” If the trader puts 2,000 contracts into the market all at once, that offer obviously will affect the price, even though the trader does not have any new information. Indeed, the trade would affect the market price even if the market knew the trader was selling without any informational edge.

The principal reason for intraday price movement is the demand for liquidity. A trader is uncomfortable with the level of exposure and is willing to pay up to get someone to take the position. The more uncomfortable the trader is, the more the trader will pay. The trader has to pay up because someone else is getting saddled with the risk of the position—someone who most likely did not want to take on that position at the existing market price because otherwise, that person would have already gone into the market to get it.

This view of the market is a liquidity view rather than an informational view. In place of the conventional academic perspective of the role of the market, in which the market is efficient and exists solely for informational purposes, this view is that the role of the market is to provide immediacy for liquidity demanders. The globalization of markets and the Widespread dissemination of real-time information have made liquidity demand all the more important. With more and more market information disseminated to a wider and wider set of market participants, less opportunity exists for trading based on an informational advantage, and the growth of market participants means there are more incidents of liquidity demand.

To provide this immediacy for liquidity demanders, market participants must exist who are liquidity suppliers. These liquidity suppliers must have free cash available, a healthy risk appetite, and risk management capabilities, and they must stand ready to buy and sell assets when a participant demands that a transaction be done immediately. By accepting the notion that markets exist to satisfy liquidity demand and liquidity supply, the framework is in place for understanding what causes market crises, which are the times when liquidity and immediacy matter most.

Liquidity Demanders

Liquidity demanders are demanders of immediacy: a broker/dealer who needs to hedge a bond purchase taken on from a client, a pension fund that needs to liquidate some stock position because it has liability outflow, a mutual fund that suddenly has some inflows of cash that it has to put into the index or the target fund, or a trader who has to liquidate because of margin requirements or because of being at an imposed limit or stop-loss level in the trading strategy. In all these cases, the defining characteristic is that time is more important than price. Although these participants may be somewhat price sensitive, they need to get the trade done immediately and are willing to pay to do so. A huge bond position can lose a lot more if the bondholder haggles about getting the right price rather than if the bondholder just pays up a few ticks to put the hedge on. Traders who have hit their risk limits do not have any choice; they are going to get out, and they are not in a good position to argue whether or not the price is right or fair. One could think of liquidity demanders as the investors and the hedgers in the market.

Liquidity Suppliers

Liquidity suppliers meet the liquidity demand. Liquidity suppliers have a view of the market and take a position in the market when the price deviates from what they think the fair price should be. To liquidity suppliers, price matters much more than time. For example, they try to take a cash position or an inventory position that they have and wait for an opportunity in which the liquidity demander’s need for liquidity creates a divergence in price. Liquidity suppliers then provide the liquidity at that price.

Liquidity suppliers include hedge funds and speculators. Many people have difficulty understanding why hedge funds and speculators exist and why they make money in an efficient market. Their work seems to be nothing more than a big gambling enterprise; none of them should consistently make money if markets are efficient. If they did have an informational advantage, it should erode over time, and judging by their operations, most speculators and traders do not have an informational advantage, especially in a world awash in information.

So, why do speculators and liquidity suppliers exist? What function do they provide? Why do, or should, they make money? The answer is that they provide a valuable economic function. They invest in their business by keeping capital readily available for investment and by applying their expertise in risk management and market judgment. They want to find the cases in which a differential exists in price versus value, and they provide the liquidity. In short, they take risk, use their talents, and absorb the opportunity cost of maintaining ready capital. For this functionality, they receive an economic return.

The risk of providing liquidity takes several forms. First, a trader cannot know for sure that a price discrepancy is the result of liquidity demand. The discrepancy could be caused by information or even manipulation. But suppose somebody waves a white flag and announces that they are trading strictly because of a liquidity need; they have no special information or view of the market and are willing to discount the price an extra point to get someone to take the position off their hands. The trader who buys the position still faces a risk, because no one can guarantee that between the time the trader takes on the position and the time it can be cleared out the price will not fall further. Many other liquidity-driven sellers may be lurking behind that one, or a surprise economic announcement might affect the market.

The liquidity supplier should expect to make money on the trade, because there is an opportunity cost in holding cash free for speculative opportunities. The compensation should also be a function of the volatility in the market; the more volatile the market, the higher the probability in any time period that prices will run away from the liquidity suppliers. In addition, their compensation should be a function of the liquidity of the market; the less liquid the market, the longer they will have to hold the position and thus the longer they will be subject to the volatility of the market.

Interaction of Liquidity Supply and Demand in a Market Crisis

A market behaves qualitatively differently in a market crisis than in “normal” times. This difference is not a matter of the market being “more jumpy” or of a lot more news suddenly flooding into the market. The difference is that the market reacts in a way that it does not in normal times. The core of this difference in behavior is that market prices become countereconomic. The normal economic consequence of a decline in market prices is that fewer p...

Table of contents

• Title Page
• Copyright Page
• Foreword
• Acknowledgments
• Introduction
• PART I - OVERVIEW—TWO DECADES OF RISK MANAGEMENT
• PART II - MEASURING RISK
• PART III - MANAGING RISK
• ABOUT THE CONTRIBUTORS
• INDEX