Macbeth

by Rick Nason, PhD, CFA

Partner, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

 

My daughter is currently studying Macbeth in her high school English class.  I studied Macbeth as well.  For kicks I thought it would be fun to reread Macbeth (I need some better hobbies!).  While reading Shakespeare for the first time in about 30 years a question came to mind.  If Shakespeare was alive today and creating a play about risk management, what genre of play would it be?  Would it be a comedy, a tragedy, a farce, a political ode, a drama …  ?  

Credit Default Swaps: Useful, Misleading, Dangerous?

by Don Alexander, MBA

Associate, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

 

Richard Portes, in a recent VOXEU communique (April 30^th), asks this question about the use of Credit Default Swaps (CDSs).  In particular, the use of naked CDSs may actually increase rather than decrease systemic risk.

 

CDSs are derivatives – financial instruments sold over-the-counter (OTC) that transfer only credit risk (corporate or sovereign bonds) to a third party.  The purpose of the CDS contract is to provide a form of insurance for an asset held by investors against default losses.  These contracts offer payment on default of a financial instrument, even if the buyer of the contract does not own the asset – a “naked” position.  This has evolved from the original use of the CDS contract that provided insurance against unexpected losses due to default by a corporate or sovereign entity. 

 

The CDS buyer who desires this protection pays a premium of the asset’s nominal value, in basis points, to a counterparty or protection seller expressed as a spread.  European politicians blamed the CDS market for destabilizing Greece.  As a result, a new EU regulation was implemented that restricts the use of “naked” CDS positions on sovereign debt. 

 

The gross notional value of these contracts stood at US$15 trillion during the third quarter of 2011, with the majority held on corporate debt.  Portes notes the CDS market is a useful innovation when it can provide efficient isolation of credit risk, and is not dominated by naked speculative CDSs positions that are not being used for hedging purposes.

 

CDS contracts can provide a useful function for price discovery and hedging positions.  However, he notes that early research on CDS markets were done with limited data and produced mixed results on how the market functioned.

 

Portes notes that price deviations can exist in the short-run as CDSs adjust more quickly to news than the cash market.  He notes that the derivative CDS market usually moves ahead of the bond market in price discovery, both before and during the financial crisis.  In addition, he noted that deviations from a long-run equilibrium could persist between market prices than would normally be anticipated. 

 

Like most financial innovations in recent years, naked CDSs are said to be beneficial in a move toward more complete markets.  However, a key lesson from the financial crisis is that innovations can be dysfunctional and dangerous.  In this case, naked CDS positions, however, may increase systemic risk.   Perhaps the lesson is that by making instruments more complex, we can increase risk and need to limit their use until we have a better understanding of how this market functions.

 

For more on this follow the link:  www.voxeu.org/index.php?q=node/7922

Derivatives Did It

by Rick Nason, PhD, CFA

Partner, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

 

I just watched parts 3 and 4 of the 4 part PBS Frontline documentary “Money, Power and Wall Street”, http://www.pbs.org/wgbh/pages/frontline/money-power-wall-street/   I cannot really comment fully on it as I have not yet watched the first two parts.  There is however one thing that caught my attention – as in all of these documentaries – and that is that derivatives are thoughtlessly and automatically given the blame.  Having spent a good chunk of my working life in derivatives, I obviously have a bit of a biased view.  However, just once I would like to see derivatives explained in context.

 

Derivatives, like fire, telecommunications, automobiles, oil, the wheel, pharmaceuticals, and virtually every other manmade invention and technological advance has positives and negatives that can be (and should be) associated with them.  Derivatives are not all bad.  Bankers are not all evil.  Financial engineers are not greedier than electrical engineers (perhaps financial engineers are more competitive, but that is not the same as greedy).

 

Derivatives did not build sewers to no-wheres, derivatives did not write laws that essentially said that banks had to grant mortgages to ninjas, derivatives did not create 60 years of unearned entitlement in Greece (as well as many other places), derivatives did not create credit cards and the consumer society.  Yes – derivatives did help to facilitate a lot of these activities, but derivatives were not the cause, nor the force behind going to extremes on many of these issues.

 

The next time I cut my finger, say something stupid, fall down some stairs, or bring on some negative activity that is caused by my inattention, lack of focus, lack of integrity, or inappropriate behavior, then I am simply going to scream out in anger that “Derivatives did it!” and wait for regulation to fix it.  That seems to be the orthodoxy.

The Big Miss

by Rick Nason, PhD, CFA

Partner, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

 

Just started reading “The Big Miss: My Years Coaching Tiger Woods”, by Hank Haney.  I need to state upfront that I am a tennis player, so that obviously makes me “anti-golf”, but a good risk manager always tries to think about how the “other side” thinks.

 

As someone who grew up playing hockey, went to college essentially to play tennis, and has daughters who play competitive rugby, I always have to wince when golfers talk about how physically demanding and tough their sport is.  Reading Haney’s book however I think I finally figured it out why golfers say that, and I think there is a real lesson for risk managers here – so bear me out for another 40 seconds or so.

 

In tennis, hockey, rugby, MMA, (put whatever sport you want in this sentence – except golf, bowling or any sport that depends on Russian judge’s toe signals to determine the score) you have to react to what your opponent is doing.  You can have a plan and a strategy going into the match, but you still have to be flexible, respond, counterattack and be willing to act decisively but purposefully in the moment.  In golf you have to hit a ball that is just sitting there.  You have time to think.  You have time to overthink.  You have time to overthink your overthinking. 

 

Golf is complicated.  Virtually all other sports are complex.  As my regular readers know, I make a very clear distinction between complicated systems and complex systems.  They require different skills.  They require different approaches.

 

How does this fit into risk?  Simple – risk management is complex like rugby, but we try to make it “hard” and complicated like golf.  Just as Tiger Woods (despite his Navy Seal style training) would not last long in a New Zealand All Black’s scrum, few tight props could wait until the 19^th hole to get their refreshment.  Golf, rugby – not the same thing.  Golf, risk management – not the same thing.  Let’s stop trying to make risk management complicated like golf!

 

(P.S.  if you don’t know the difference between a complicated or a complex system, read my article “It’s Not Complicated” http://www.rsdsolutions.com/files/Nason-RMA%20Article%20Mar-11.pdf or buy the forth-coming book of the same title.)