Posted by Peter Orr on Mon, Jan 05, 2009 @ 04:24 PM
If you didn't catch it, the NYT magazine this weekend had a cover story on risk which posed the question, was management or specifically risk management more responsible for the current financial mess in which we now sit? Not unexpectedly, Mr. Black Swan himself got a good dose of coverage railing against the utter folly of VaR and seemingly anyone who attempts to quantify anything about risk in finance. The other corner is represented by the leadership at RiskMetrics, Sunguard, etc weighing in with the "calculating risk has benefits" position, given it (VaR) provides relevant and useful information the majority of the time. Taleb's point is the "majority of the time" doesn't matter much after insolvency.
Given the topic, the article provides predictable variations of common platitudes: "Guns (quantifying risk) don't kill people, people (dumb risk management) kill people," and "Those who ignore the lessons of history are bound to repeat it (particularly if you only use 2 years of data as a basis for your VaR calc)."
I couldn't help but notice how much the article echoes the debate about the degree of risk versus uncertainty present in financial management, and what to do about it. In fact, one way to look at the position of people like Taleb/Mandelbrot is that the uncertainty about which Dr. Knight wrote in his 1916 dissertation is really the driving force behind socio-economic variable movement and as such, if you're going to do any modeling, fractals are your best only choice. They argue fractals and power laws are the only things that give you a prayer of appreciating the potential magnitude out in the tails of the uncertainty.
I think the article properly highlighted one VaR shortcoming that has been reasonably well-known but under-addressed, "[VaR] failed to distinguish between leverage that came from long-term, fixed-rate debt…and loans that can be called at any time and…blow you up in 2 minutes." Coincidentally this is highly germane to my disagreement with Dr. Black, and perhaps even the mindset behind a lot of quant training.
I wish there was a bit on behavioral finance. The author hints at that quoting a risk manager, "It has to do with the human condition. People like to have one number they can believe in." It might've been nice if he touched on concepts like availability bias, overconfidence, and herding as additional contributors to the problem. What ramifications this all has for future policy is anyone's guess. In the end, we are still doing this democratic/capitalist experiment and it doesn't appear we're in any danger of getting it *right* anytime soon.
Of course, I'm sure some risk managers out there reveled in one of the author's concluding and resigned ruminations, "Maybe it would have been better if the people in charge had a better understanding of risk." I suppose that would've been nice.
Posted by Peter Orr on Tue, Dec 23, 2008 @ 10:03 PM
"What you risk reveals what you value."
- Jeanette Winterson 
I never had the opportunity to meet Fischer Black, the canonical first "quant" (though he was far more than that), but we did exchange emails in July, 1995. It started when I was supposed to be studying for a course in measure/probability at the University of Minnesota library. However in the frequent and sometimes fervent desire to avoid what I should've been doing, I found myself reading what I recall was a Journal of Derivatives article by Dr. Black. In this post, I describe a regrettable shortcoming among finance practitioners today related to that email exchange.
In the article, he was mentioning something about an adjustable rate mortgage pool with a more stable value, and hence, lower risk than a fixed rate pool. At the time I was also working as a financial advisor to states and local governments and from that experience, I knew that there were at least certain economic actors that didn't view variable or adjustable rate instruments as less risky than fixed rate versions. This was particularly so when those securities were liabilities. So I emailed Dr. Black and as cogently as possible tried to ask my clarifying question about risk. I wondered whether or not a homeowner would think of an adjustable rate mortgage in that pool as less risky than a fixed rate alternative, particularly in an inflationary economy.
He gave a fairly lengthy response which, to be frank, didn't fully compute at the time. But towards the end he said, "I think in purely present value terms." That got me wondering, should we all be thinking in purely present value terms, all the time? Is the variability in present value the only *right* way to think about risk? I'm guessing many of you might wholeheartedly agree, to the point that even asking the question is heretical.
Risk is undoubtedly a curious animal. Any creature that exhibits non-linearity the way risk does, where 1+1 might equal anything between 0 and 2, is naturally unsettling to the uninitiated. But isn't risk, akin to beauty, appropriately viewed in the eye of the beholder? The trivial example of variable rate bonds I think illustrates the point.
The value of (theoretically continuously resetting) variable rate bonds, no matter the interest rate environment, is par. To most quants, if there's no price movement in a security or portfolio than they must be riskless. That is, quants traditionally if not religiously tie the concept of risk to the potential price variation of an instrument portfolio. Certain GAAP/accounting guidelines reinforce this perspective which happens to be a hotly debated topic these days. The folks at RiskMetrics call the places where price volatility reign "financial environments." These are places like banks, mutual funds, insurance companies; not coincidentally where lots of quants have jobs.
Contrast this view with those of a company CFO or treasurer who's managing one or more series of variable rate bonds or other floating rate securities. In this context the bonds are liabilities (or assets with a minus sign). That the prices of these securities are stable to the investor is little consolation to the CFO whose bonds are resetting at 15%. In this financial economy, that particular CFO is likely very happy with her/his fixed-rate obligations despite the fact that the quant would label the fixed-rate bonds as the risky securities. The CFO has been trained cash is king; that the value of your variable rate bonds stayed at par from time of issuance all the way to today matters little in front of the bankruptcy judge. And bankruptcy is unfortunately what happens if nominal interest payments to debt holders could no longer be satisfied. These settings are corporate environments, where earnings and cash flow are driving considerations.
In short, I'd have to respectfully disagree with Dr. Black if he intimated that we all should think about risk only in present value terms. In our political economy, nominal cash flow variability often drives real risk that should be understood and considered. The unfortunate truth is that much analytic focus has been placed on problems that exist only in financial environments, largely because of the widespread adherence among quants to the same view expressed by Dr. Black. Not nearly as many tools are available to those trying to navigate corporate environments.
Does this mean that corporate environments don't have challenging cash flow or earnings problems to solve? Are these problems somehow unworthy of high quality, data-driven analytics? I think this question is answered well in a recent Sep08 Harvard Business Review article. Its contents are ones with which I totally agree. What do you think?