Are you sure you don’t have FX exposures?

by Stephen McPhie, CA

Partner, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

So your company operates only domestically and you are satisfied that all its purchases and sales are in the domestic currency.  No need then to spend any more time thinking about exchange rate volatility.  Are you sure?  How about your major suppliers?  Or your major customers?  Their currency exposures could affect you greatly. 

 

If your supplier gets a lot of inputs from abroad, he may be forced to jack up his prices to you if the domestic currency weakens.  Or if you sell inputs to a major customer who sells much of his product abroad, you are vulnerable to him passing on some or all of his currency exposures to you.  And of course, if your currency strengthens, you may suddenly be hit by a flood of cheap imports competing with your products.

 

So are your risk systems geared up to look at the bigger picture?

Risks from Complex Derivative Strategies

by Don Alexander, MBA

Associate, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

The recent losses by JP Morgan Chase on their hedging portfolio again raise questions about the use of derivatives and the risk profile they may create.  While we do not know the exact strategy they implemented, the positions they were hedging, or the risk profile created by the derivatives, it does raise questions about the use of complex derivatives and their risk management.

 

One place to look at the application of complex derivative strategies in their impact upon hedge funds and their potential benefit to investors.  A recent working paper by Jarkko Peltomaki called Do Investors Really Need Complex Derivative Strategies? The author investigates the benefits of using a more complex derivative strategy in relation to their performance and risk characteristics from a sample of hedge funds and funds of hedge funds.  The results of the study suggest that the use of a complex derivative strategy may increase the probability of suffering large losses and expose investors to weaker performance.

 

Earlier studies suggest that with mutual funds, the use of derivatives does not improve fund performance.  In this study, the use of a complex derivative strategy may actually have a negative impact on the performance of hedge funds.  However, there was a negative relationship between complex derivative strategies and performance of funds of funds.  This suggests that a good risk management system may prove a benefit to investors.

 

The author suggests that derivative strategies employed by hedge funds may be related to “hidden risks” due to larger tail distribution of returns.  This risk is more difficult to find in funds of funds since the use of derivatives has the opposite effect to that of complexity.  It may be the use of complexity and not just the use of derivatives which is associated with hidden risk in the returns of funds of funds.

 

Peltomaki notes that there is a difference in the origin of hidden risks between hedge funds and fund of funds.  For hedge funds, the risk is hidden in their exposures to market based factors while funds of funds risk are hidden in idiosyncratic returns.  Hedge funds take risk using market based factors following herding behavior that may serve to mitigate the difference in their relative performance.  Funds of funds are limited in their exposure to hedge funds and their hidden risks are more related fund-specific exposures.  Regulators need to be concerned about hidden risks used in derivative strategies used by hedge funds since they may have a more systemic feature.

 

Is JP Morgan Chase a large hedge fund or fund of funds – more disclosure may tell?  The lessons that we can draw from the JP Morgan Chase experience is that complex derivative strategies may not have a favorable benefit for investors and make increase their exposure to systemic risk.  The key lesson is simple derivative strategies combined with good risk management produce better outcomes and reduce exposure to hidden risks.

 

What is your derivative exposure?  Is it overly complex with hidden risks?

 

For more on this follow the link:  http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1344656

Giant chickens and Marks!

by Stephen McPhie, CA

Partner, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

There’s a giant game of chicken going on and many are predicting that it will end up with Greece exiting the Euro and returning to the Drachma.  This is seen as likely to lead to disaster for the Eurozone and many others, but especially for Greece.  However, there is a simple way to make it beneficial for all.  Why should Greece return to the Drachma?  If Greece is first out, the name “Mark” is going spare.  An announcement that Greece will adopt the Mark as its currency would calm markets and lead to a dramatic reduction in Greek debt yields ……….

 

OK, totally crazy and irrational I know.  But if rationality had anything to do with things, there likely would not have been a Euro in the first place.  Even if there had been, it’s a racing certainty that Greece would not have been a participant.  Politicians running currencies and economies is a bit like the animals running the zoo.  One thing we can rely on is a mess and sub optimal outcomes.  I hope your risk management systems and processes have this assumption.

 

The Coming Revolt Against Austerity

by Don Alexander, MBA

Associate, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

The push toward austerity as cure-all for rising debt levels resulting from the financial crisis is losing credibility with the euro zone electorate.  The elections in Greece and France have served as a shift in the electorate toward a more pro-growth view.  Charles Wyplosz discusses these issues in a recent VOXEU communique dated May 2^nd. 

 

Wyplosz argues that governments should not mix long-term growth and fiscal discipline objectives with short-term goals to contain rising debt levels.  Instead, countries should focus on a framework for fiscal policy cooperation, restructure debts, and implement fiscal discipline in the long-run.  The German view, however, is that countries with excessive debt levels should focus on deficit reduction. 

 

This recipe has produced two years of economic contraction and surging unemployment for Greece.  There is growing debate among academics and international agencies that advocacy of pro-cyclical austerity is not producing the desired results as the situation is more complicated.

 

The sovereign debt crisis implies that highly indebted countries cannot simply borrow their way out of the crisis.  Financial markets want growth as a necessary condition for deficit reduction, but this is complicated by the fact countries cannot borrow their way out of their predicament nor borrow at reasonable interest rates. 

 

Wyplosz makes five recommendations: (1) do not mix long-term growth with fiscal discipline since they should be treated as independent objectives since there is only evidence that high debt levels can stunt growth, not fiscal discipline; (2) do not create another Lisbon accord that produces another layer of regulations and bureaucrats and serves as a means for politicians to avoid making hard decisions; (3) establish a framework for fiscal policy cooperation at the Eurozone level since recent results implemented by national authorities have been sub-optimal – a fiscal framework may allow for countercyclical policies as needed; (4) authorities should implement debt restructuring ahead of the curve limiting contagion before the market imposes penalty rates and limit market access; and (5) de-emphasize  short-term deficit targets which do not have economic justification. 

 

National cooperation on long-term objectives is needed to limit potential risks.  However, these types of national agreements need to include short-term flexibility so as to any problems created by short-term market fluctuations.  The rigid structure of the infamous Stability and Growth Pact is the exact opposite of what is needed.

 

As more countries question the role of austerity and attempt to establish long-term fiscal policy cooperation and restructure debt, what kind of surprises can we expect?  Risk managers need to focus on this shift to avoid any JP Morgan Chase type of surprises.

 

For more on this, please follow the link:  www.voxeu.org/index.php?q=node/7933