Policy or Judgment?

by Rick Nason, PhD, CFA

Partner, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

Policy or judgment is a theme that I come back to again and again when I work with companies and their risk management departments on developing and implementing risk strategies.  In this age of regulation, the stress is increasingly becoming that of developing a strong airtight policy and then following that policy to the letter.  Judgment is better left solely for deciding on your sense of fashion.

 

My philosophy is that you need both.  You do not want people and groups in an organization making up decisions ad hoc in the moment – particularly when it relates to risk issues that could have major implications.  Conversely it has to be recognized that no risk policy is airtight and fool-proof.  Something is inevitably going to come up that knocks it for a loop.

 

Policy or judgment came up in the news today.  You likely heard the story about the lifeguard who was fired for saving a life.  The problem is that the life saved was that of someone who was swimming outside of the zone that the lifeguard was responsible for.  Policy was that lifeguards should only concern themselves with swimmers in their zone.  Since the lifeguard went out of his zone he was fired.  The company stated that the firing was for insurance reasons (good job on passing the buck on responsibility there!).

 

You can argue this many ways.  While the lifeguard was busy saving someone outside of the designated zone, a swimmer could have run into distress while swimming in the proper zone.  Other arguments can be made as well.  The point is that the lifeguard made a judgment call over policy.  Personally I believe it was the right call.  Imagine being a lifeguard and having someone drown within your sight, and within your ability to help them and you did nothing because of policy.  How would that feel for the rest of your life?

 

Does your company allow for exceptions of judgment, or would your company do the equivalent of letting the person drown?  What would you do if an analogous situation occurred at your company?  How would you or your colleagues deal with the authority figures at your company and the authorized policy?  What would Stanley Milgram think? 

 

For more on this, follow the link:  http://en.wikipedia.org/wiki/Milgram_experiment  

Preparing For Failure

by Rick Nason, PhD, CFA

Partner, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com 

 

If one asks for success and prepares for failure, he will get the situation he has prepared for.

                                                Florence Shiner

 

As risk managers, and as risk management departments how do we ask for success?  That might sound like a really stupid question, but when I ask risk managers what success is I either get a dumbfounded look, or the answer along the lines of “absence of failure”. 

 

What is success for a risk manager?  How many risk departments can answer this in a strong way that shows vision, passion, and a value added component.  I believe that the risk department should add to the value of the organization.  I believe that the risk department should not be the “Department of No!”, but instead be an integral part of allowing the strategic vision and more importantly the strategic opportunities to come to fruition.

 

However risk is often framed incorrectly.  Regrettably the risk objective is often framed in the negative (albeit a perverse form of a double negative, as in “we don’t want this bad thing to happen”).  Framing in the negative often means that you get the negative – as the above quote implies.  It is way past due that risk managers start to think in terms of the positive possibilities, rather than in terms of the negative possibilities.  It is time that risk managers defined success more positively and prepared for success more positively.

Autopilot

by Rick Nason, PhD, CFA

Partner, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com  

 

Autopilot is fantastic.  It greatly reduces pilot error in flying a plane, and reduces the overall risk of flying.  Except when there is a crisis – a hole in the roof, a flock of birds making a Hudson River landing necessary, a medical emergency on board which means landing at a different airport etc. etc.

 

The point about autopilot is that it is great when things are going as expected (and even for the mild unexpected).  Autopilot does reduce errors, mistakes and items that might otherwise get overlooked.  However autopilot is not for emergencies, or for when things are abnormal.

 

This raises the issue of whether or not your firm’s risk controls work on autopilot.  Are they so successful in normal conditions that they get trusted to act in abnormal conditions?  Who in the firm has the authority to override them?  How is an override decided upon?  All good questions to answer before hitting a flock of birds.

Paradigm Shift: Value investing comes to commodities

by Michael Arbow, MBA

Partner, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

 

Value investing as defined by Investopedia is a “strategy of selecting stocks that trade for less than their intrinsic values.”  In my years with brokerage firms in the England and Canada, it was very rare that commodity stocks were ever viewed as value type investments as their prices tended to be asset bubble driven.  But I have argued in the past that while commodity prices may fluctuate in the near term, in the long term the trend is up and at a rate faster than inflation.  Joining the “choir” of this thought is much-admired value investor Jeremy Grantham; chairman of global asset manager GMO LLC a firm that manages more than $100-billion (U.S.).  Mr. Grantham sites the usual reasons like increased world wealth (thanks Ben B.) but what seems to be the tipping point for Mr. Grantham is the fact that it took 100 years for the inflation adjusted price of commodities to fall 70% and only 8 years to wipe out those savings.  Mr. Grantham now sees value in investing in commodities.

 

So what does this mean?  To me it indicates that the natural resource countries, especially those that can produce commodities from below and above the surface are in for solid economic growth and currency appreciation likely for years to come.  For commodity users and end sellers, hedging becomes more important to manage potentially highly variable cash flows.  This trend is a now a reality so has your risk strategy adjusted?

 

 

For more on Mr. Grantham’s views on value investing in the commodity sector click on this Globe and Mail link:

http://tinyurl.com/3rpgnmm

Shadow Risk Portfolio

by Rick Nason, PhD, CFA

Partner, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com 

 

One of the training tools for investors and investor wanna-bes is the shadow portfolio – or sometimes known as a paper portfolio.  A shadow portfolio is where the investor practices their trading by making trades “on paper” – that is recorded in a notebook, but never having executed the trades for real.  The trader however follows the valuation of their trades just as if they were done with real money, and this way they get investment experience without the “investment tuition”. 

Would it not be a great idea for corporations to also have a shadow risk portfolio – that is a set of strategies that they might be too timid to execute in real life, but they execute on paper – recording their hedging tactics and then tracking the results versus their “do-nothing” strategy.  This would allow corporations to gain valuable experience in hedging that they may not be willing to execute otherwise due to their fear of being wrong, or their lack of understanding of how the products might behave under various scenarios. 

A few years ago, RSD Solutions conducted a back-test for a corporation that wanted to see how a change in their hedging strategy would have worked.  They basically knew that how they were currently hedging was ineffective, but no one in the corporation wanted to be the first to attempt or even suggest a new strategy.  We conducted the study and showed them in clear and easy to understand terms how a different hedging strategy would not only be more cost effective, but would also hedge them in a way that was more consistent with their financial strategy and corporate goals.  The CEO, CFO and Board quickly approved a change in strategy once they saw how much a simple change in hedging tactics would improve the bottom-line and help unit managers with their planning. 

Not implementing a hedging strategy is more often a function of lack of inertia.  Creating a shadow portfolio is one way to get the ball rolling.

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).

 

 

 

 

 

 

 

 

 

 

 

 

 

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.

Car insurance. House insurance. Company survival insurance(?).

by Michael Arbow, MBA

Partner, RSD Solutions Inc.

www.rsdsolutions.com

info@rsdsolutions.com

 

Recently RSD Solutions was in a discussion with individuals who encourage Canadian companies to export.  At the meeting we discussed the idea of hedging the US dollar relative to the Canadian dollar.  It was pointed out by our host that local firms and possibly many smaller Canadian firms do not hedge either currency or commodities because it is considered risky.  Of course there are other reasons – the idea is seen as intimidating to some senior managers because of its sophistication but we will save that for another blog.

I pointed out to our host that hedging is a form of insurance much like automobile or house insurance but in a company’s case it is helping ensure the firm's very survival.  When I pointed out that effectively what a CEO or CFO is saying by not hedging, is that buying insurance on their corporate survival is “risky”: an epiphany moment was reached in the room. 

So my question is, is hedging considered risky at your firm and what do you think would be a recommended strategy for turning this perception around?  

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

Domestic Risk Management - Our Valentine's Blog

by Stephen McPhie, CA

Partner, RSD Solutions Inc.

www.rsdsolutions.com

info@rsdsolutions.com

Valentines Day is an appropriate time to ponder on some aspects of personal risk management, especially for those of us who have spouses or partners.  Actually, if some thought had not gone into Valentines Day before now, the risks of arguments, domestic splits, divorce or even being told that your partner has a headache increases dramatically. 

A basic domestic risk hedging program could include ordering flowers.  The addition of a present adds extra cost to the program but can provide a better hedge.  Booking a table at an expensive restaurant is again more expensive but can provide the most effective protection against domestic risk.  Each of these provides a progressively more expensive risk management program and the one chosen would depend upon a number of factors including risk appetite, past experience, etc. 

Of course, the risk management program can be poorly conceived or implemented.  If, for example, the present is a book entitled “How to Stop Snoring” or “10 Steps To A Cleaner House” or the dinner is not at a romantic venue with subdued lighting, but at the local sports bar when an important game is on, then the risk management program can significantly increase risk.  Of course, the same risk program can work for good or bad depending on the circumstances.  So in our sports bar example, if it is a female taking her boyfriend there she could gain a whole lot of brownie points, whereas the other way round, the boyfriend may well end up wearing a pitcher of beer and going home alone. 

Looking at the downside, a hedge may also include an escape plan.  I am told that France is a much friendlier jurisdiction then England for the male side of a relationship in a divorce.  (There are some people I am hoping won’t be reading this!!!)  You only have to spend a night in France to claim residence and give the courts jurisdiction … and assuming you file first! 

All the above considerations are completely applicable in a corporate context and show that a risk management program is individual to every company and should be developed and implemented according to specific circumstances. 

How do you handle your domestic risk management? 

For my part, I intend to rush out to the store immediately I stop typing.