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

Planting a Tree

by Rick Nason, PhD, CFA

Partner, RSD Solutions Inc.

www.RSDsolutions.com 

info@RSDsolutions.com

 

 

 

We have all heard the story about when the best time to plant a tree is – as soon as possible.  Waiting to plant a tree only delays the time it takes for the tree to reach maturity.

 

The same can be said for when is the best time to implement a hedging strategy – as soon as possible.  Yes – it is true that rates may move favourably later, but more often than not they don’t.  Yes – it may be true that hedging costs have gone up, and the horses have already left the barn, but without the discipline to put the hinges back on the barn door, it will not be possible to corral the horses in the barn if the barn door is not repaired and the horses do return – besides, there are likely pigs and other animals that still need shelter.

 

Just as right now is always the best time to plant a tree, right now is generally always the best time to ensure that you have a conscious hedging plan in place (which by the way, may or may not involve the use of financial products).

 

 

 

 

 

 

 

 

 

 

 

 

 

Foreign Exchange Wrecking Ball

by Stephen McPhie, CA

Partner, RSD Solutions Inc

www.RSDsolutions.com

info@RSDsoulutions.com

 

 

If currency exchange rates have been volatile over the last few years, we are possibly looking at volatility squared over the next few years.  Portugal is joining Greece and Ireland in being bailed out.  These economies are relatively very small in the Eurozone.  However, many are wondering if Spain and then Italy will be in the cross hairs next and these are not small in the scheme of things.  Certainly Spain looks much better in many ways than Portugal but an employment rate in excess of 20% is a massive burden. 

 

Having been an observer and sometimes a victim of several economic cycles, I know that events, markets and politics can gain an unstoppable negative momentum.  Prices and rates tend to overshoot their proper level and correct, usually with little disruption on a macro scale.  However if a giant wrecking ball overshoots, it can knock down several buildings and that is a whole lot more difficult to correct.

 

Add to this the increasing number of voices expressing doubt over the whole future of the Euro itself, especially in the 2 large triple A rated Eurozone economies of Germany and France.  Especially so in Germany where more and more people are disquieted over the prospect of paying a high price to prop up much less developed Eurozone countries in order to save the Euro.

 

The Euro itself was a political creation.  It was weakened in its earlier days by Germany and France ignoring the fiscal rules.  Politicians are trying hard to ensure survival of the Euro.  For now, that is.  However, politicians do not always operate in a long term economically optimal way.  After all, politicians’ careers depend on voters in their own country at the next election and not on wider Eurozone’s economics.  Political winds can change direction very quickly.

 

All this suggests increasing exchange rate volatility.  While it does not appear likely that the Euro will die in the near term, there is a giant wrecking ball swinging around that has the ability to knock down a few houses.

 

Do you really have a handle on your company’s FX exposures?  Do you know the natural hedges and economics of your derivative hedges?  Have you done a full and proper evaluation of all this?  I have seen many companies that are comfortable with their positions until that giant wrecking ball comes crashing through the wall.

What can my phone bill tell companies about their hedging practices?

by Stephen McPhie, CA

Partner, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

When studying for my undergrad economics degree, we spent a lot of time learning what happen in the perfect world when all participants had perfect knowledge.  Then we figured out what would happen when introducing a few imperfections into the equation and that told us how the world economy works.  My teachers almost seemed to view such imperfections as a nuisance in the field of economic study.

 

This all seemed totally unrealistic to me, and the wrong approach.  Some attention was given to human behaviour, but not enough.  In fact that may be where we should start, and at least it is getting some more attention now.  Our economic system is based upon imperfect markets and knowledge.  Where imperfections do not exist, they get created.

 

As a small example, my phone bill now runs to several pages and has all sorts of detail about the various savings I’ve made under my particular calling plan. There are discounts for calling certain numbers, for calling at different times of the day or week, for letting the company take payment directly from my bank account, etc., etc.  All the discounts sound wonderful except that I seem to keep paying more and more for my phone bill!

 

I would rather be billed for simple low cost calls and get a bill that is understandable to me.  However, the phone company knows perfectly well that its charging structure makes it almost impossible for me to compare its costs with the costs of using a competitor, at least not without spending an inordinate amount of time that I don’t have.  In fact, I get the same sort of billing from all utility companies.  And of course, when it is very difficult to compare my utility provider’s costs with those of a competitor, I am less likely to change provider.

 

Many companies do not have the time to properly analyse their hedging instruments and costs and end up relying on their banks for advice.  However, in doing this, perhaps it’s worth bearing in mind that my phone company has set out to make it difficult for me to compare other solutions for a reason – and that reason is not necessarily to save me money or provide me with the optimum service for me.

World’s risk strategy hedge: $700 billion. Needed: Possibly. Used: No

by Michael Arbow MBA

Partner, RSD Solutions Inc.

www.rsdsolutions.com

info@rsdsolutions.com

 

One could argue that for the Western free democratic world, its hedge strategy for peace and global harmony is the US military machine which with a price tag of $700 billion per year is an expensive form of insurance.  However, as the US’s reluctance to provide a “no-fly” zone over Libya has demonstrated (to some), the risk parameters of the US government are changing and the desire to use the insurance that the US taxpayers have provided the world is dwindling.  At one time “humanitarian interventions” – going into jurisdictions, like Kosvo, where the citizens were being prosecuted – was deemed acceptable and a done deal.  No longer. 

So, it appears that the US is paying for a form of risk management beyond its needs or willingness to use.  Is this the situation in your firm?  Are you over-hedging or alternatively are you paying for a hedging strategy that you will not likely use?  In the case of the US, if your risk profile changes so to should the required hedge. 

For more information on the topic, follow the link below to an Economist article:

http://tinyurl.com/6jjksvh

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