by Rick Nason, PhD, CFA
Partner
RSD Solutions Inc.
As I write this I am sitting in a great pub (Churchill’s) in my favorite city (Saint John, New Brunswick). I was born in Saint John (the Saint is never abbreviated – we leave that to Newfoundlanders and Quebecers). Like a really old tennis shoe, Saint John does not have a lot going for it on paper. The former industrial heart of the Maritimes has not quite kept up (although it is racing faster and further ahead in many ways) with some of the latest styles. Also, to be blunt it stinks sometimes – but a lot less than it used to. Having said all of that there is nothing that fits quite as well, or feels quite as comfortable as an old pair of sneakers. Saint John is like that. It feels very comfortable. Although it does not have a Nobu, or a permanent Cirque du Soliel, the city does have some of the nicest and most sincere people you will find on the planet. If you are in the Maritimes, make sure you visit Saint John – it truly is a wonderful place.
Back to my pub thoughts. Although I am not much of a drinker, I really do like a great Scotch (Laphroaig 30 year is my favorite, although the 15 year is the best value in Scotch period – also check out Glen Breton from Cape Breton – best Scotch for those who prefer a smoother drink) , or a great pint (Moosehead Ale – not the lager though).
Sitting in a pub with a good drink is a great way to get the ole cranium going. When I was a graduate student in Physics we spent a lot of time in pubs, and as graduate students we spent a lot of time thinking, arguing and doing physics in pubs. One of our favorite pub questions was; “If you could go back X years, what physics paper, textbook, or concept would you take back?” The point of the question of course was to get the conversation (arguments) going over what were the most important concepts in physics that if they had been known earlier would have helped the development of the field the most. The question always led to lots of discussion, and we all dramatically improved our knowledge of physics and our knowledge of the history of physics. Each week the “X years” was changed so we would have to think about different eras and different contexts for the question. Great fun! (Did I mention that we were physics students, and thus like the characters on the Big Bang Theory we really had no other social life or even prospects of a social life!?)
Now an interesting thought experiment (that I plan to do some academic research and development on – so don’t steal my idea – I need the publication for P&T) is to transfer the question to the field of finance and risk management. Namely, if you were transported back X years, what concept from Finance or Risk Management would you take back with you to help the development of the field? In physics we had no shortage of suggestions – whether we were going back 5, 10, 50, 150 or 500 years.
What would you take back in Finance or Risk Management? VAR? Markowitz Portfolios? CAPM? Black-Scholes Option Pricing Formula? Anything from Basle? (just accidentally spit out some of my beer laughing at that one!)
What would you take back 5 years? (Gaussian Copulas?) What about 10 years? (Income Trust Structures?) What about 50 years? (?)
Sometimes I miss physics, but at least I get to go back to Saint John every few months.
Monday, March 1, 2010
Wednesday, February 24, 2010
Player Piano
by Rick Nason, PhD, CFA
Partner
RSD Solutions Inc.
Just selected the novel Player Piano http://www.amazon.com/Player-Piano-Kurt-Vonnegut/dp/0385333781/ref=sr_1_1?ie=UTF8&s=books&qid=1266865993&sr=8-1 from my bookshelf to read on a plane trip that I am about to make. This 1952 novel from Kurt Vonnegut is one of my favorites. It tells the story of a future in which only those with a PhD have meaningful jobs. The novel also envisions a world in which the activities of skilled workers are digitized in a Tayloresque fashion so that robots can recreate their actions. The assumption is that computer controlled machines – with perfect replicability – will perform better and more efficiently than humans with all of their random flaws and emotions.
Re-reading this book brings to mind three questions. (1) What would the field of finance or risk management look like if everybody had a PhD?, (2) What would the field of finance or risk management look like if no one had a PhD (or no one had a graduate degree of any kind in finance), and (3) If we were going to digitize the actions of the best bankers and risk managers (their decision making processes), what would the algorithms be like?
If you have a graduate degree, the first two questions are likely to be non-sensical. At a minimum, you are likely to provide a very different answer from those that do not have an advanced degree in finance. I believe however that some interesting insights might come from some introspection on this question.
The last question is the one that I find to be most interesting. It is also the most troubling and challenging. It also raises a host of other questions such as; (a) are we trying to understand the actions of the best managers?, (b) what types of decisions do these managers actually make?, (c) are these decisions consistent enough that they could be modeled?, (d) would this process help further the field of finance and risk management, … I am sure you can come up with many more.
Interesting – or at least it is to me. I think I will actually enjoy this plane flight – once I get through the risk management system known as airport security.
Partner
RSD Solutions Inc.
Just selected the novel Player Piano http://www.amazon.com/Player-Piano-Kurt-Vonnegut/dp/0385333781/ref=sr_1_1?ie=UTF8&s=books&qid=1266865993&sr=8-1 from my bookshelf to read on a plane trip that I am about to make. This 1952 novel from Kurt Vonnegut is one of my favorites. It tells the story of a future in which only those with a PhD have meaningful jobs. The novel also envisions a world in which the activities of skilled workers are digitized in a Tayloresque fashion so that robots can recreate their actions. The assumption is that computer controlled machines – with perfect replicability – will perform better and more efficiently than humans with all of their random flaws and emotions.
Re-reading this book brings to mind three questions. (1) What would the field of finance or risk management look like if everybody had a PhD?, (2) What would the field of finance or risk management look like if no one had a PhD (or no one had a graduate degree of any kind in finance), and (3) If we were going to digitize the actions of the best bankers and risk managers (their decision making processes), what would the algorithms be like?
If you have a graduate degree, the first two questions are likely to be non-sensical. At a minimum, you are likely to provide a very different answer from those that do not have an advanced degree in finance. I believe however that some interesting insights might come from some introspection on this question.
The last question is the one that I find to be most interesting. It is also the most troubling and challenging. It also raises a host of other questions such as; (a) are we trying to understand the actions of the best managers?, (b) what types of decisions do these managers actually make?, (c) are these decisions consistent enough that they could be modeled?, (d) would this process help further the field of finance and risk management, … I am sure you can come up with many more.
Interesting – or at least it is to me. I think I will actually enjoy this plane flight – once I get through the risk management system known as airport security.
Monday, February 22, 2010
Archy and Mehitabel
by Dr. Rick Nason
Partner
RSD Solutions Inc.
It is a snowy day here in Halifax. Great excuse to catch up on some reading. While waiting for some pasta to boil I picked up an old classic – Archy and Mehitabel by Don Marquis. http://www.amazon.com/Archy-Mehitabel-Don-Marquis/dp/0385094787/ref=sr_1_1?ie=UTF8&s=books&qid=1266441496&sr=1-1
The book is a set of poems / stories written by a cricket on a journalist’s typewriter. The cricket (who in a former life used to be a “vers libre poet”) bangs out verse on the manual typewriter without punctuation – since that would require the ability to be on two keys at once. The series started in 1916 in one of the New York newspapers and was later published in book form.
In one of the daily posts – archy the cricket (remember, there is no punctuation or capitalization) asks the journalist to get one of those new-fangled electric typewriters so he (the cricket) will not have to jump so hard to bang out his story.
What in the world does this have to do with finance or risk management? (If you are not thinking that by this point then you are either drunk or not paying attention.) Well – it got me thinking (dangerous activity for me to engage in!). My thought is; “How would the field of finance and risk management be played out if we were back in the days of manual typewriters?” (I realize that some of you are now going to Wikipedia to find out what a manual typewriter is, and when they were used.)
How would finance and risk management be doing without computers? How would finance and risk management be doing without Excel, VBA or C++ programs? How would the field be doing if calculations were still done by hand, by slide rule, or by idiot savants? What if the only datasets available were those that were developed manually from ticker-tape or collecting data from daily newspapers?
What type of instruments would exist in the financial markets? What would we be teaching in the business schools? What certificate or charter programs and designations would those eager to get themselves qualified and noticed be chasing in order to enhance their career prospects in finance?
How would the financial industry look? What would be the state of regulation? What about globalization? What about economic development?
What would be the qualifications to be a successful banker or risk manager? Would those who are currently superstars in the field be superstars in the B.C. (before computers or before calculators) era?
Some food crumbs for thought. (archy likes it when the journalist leaves some food crumbs around.)
Partner
RSD Solutions Inc.
It is a snowy day here in Halifax. Great excuse to catch up on some reading. While waiting for some pasta to boil I picked up an old classic – Archy and Mehitabel by Don Marquis. http://www.amazon.com/Archy-Mehitabel-Don-Marquis/dp/0385094787/ref=sr_1_1?ie=UTF8&s=books&qid=1266441496&sr=1-1
The book is a set of poems / stories written by a cricket on a journalist’s typewriter. The cricket (who in a former life used to be a “vers libre poet”) bangs out verse on the manual typewriter without punctuation – since that would require the ability to be on two keys at once. The series started in 1916 in one of the New York newspapers and was later published in book form.
In one of the daily posts – archy the cricket (remember, there is no punctuation or capitalization) asks the journalist to get one of those new-fangled electric typewriters so he (the cricket) will not have to jump so hard to bang out his story.
What in the world does this have to do with finance or risk management? (If you are not thinking that by this point then you are either drunk or not paying attention.) Well – it got me thinking (dangerous activity for me to engage in!). My thought is; “How would the field of finance and risk management be played out if we were back in the days of manual typewriters?” (I realize that some of you are now going to Wikipedia to find out what a manual typewriter is, and when they were used.)
How would finance and risk management be doing without computers? How would finance and risk management be doing without Excel, VBA or C++ programs? How would the field be doing if calculations were still done by hand, by slide rule, or by idiot savants? What if the only datasets available were those that were developed manually from ticker-tape or collecting data from daily newspapers?
What type of instruments would exist in the financial markets? What would we be teaching in the business schools? What certificate or charter programs and designations would those eager to get themselves qualified and noticed be chasing in order to enhance their career prospects in finance?
How would the financial industry look? What would be the state of regulation? What about globalization? What about economic development?
What would be the qualifications to be a successful banker or risk manager? Would those who are currently superstars in the field be superstars in the B.C. (before computers or before calculators) era?
Some food crumbs for thought. (archy likes it when the journalist leaves some food crumbs around.)
Thursday, February 18, 2010
Time To Short Oil
by Dr. Rick Nason
Partner
RSD Solutions Inc.
Is it a good time to short oil? I do not know, but my interest in shorting has been peaked and I will tell you why.
Normally I am not a fan of predicting markets. Fundamentally I believe that markets are not predictable. Over time I believe that the markets are more or less Efficient – in the technical use of the word – and thus you cannot reliably, or profitably make predictions about financial prices. So why do I think it might be a good time now to short oil? It is simple – because a major oil company has recently announced that it is removing its puts on oil as it believes that oil prices are going to remain sufficiently high.
This is a major Canadian oil company that is active in getting oil out of the Northern Alberta Tar Sands. While there is plenty of oil in Northern Alberta, it is very expensive to get at. Oil producers there need to be assured of a sufficiently high price for oil (generally north of mid 50’s) in order to make a profit.
While I do not have a fundamental problem with a company deciding to hedge or not to hedge, I do have a problem when the company’s hedging decision seems to be totally predicated on their price predictions for the financial variable in question. Price prediction is not the function of the company – finding and producing oil is their function, and should be their area of expertise. If they are so good at price prediction, then they should quit the oil business, and just go into the futures trading business. It is far easier, cleaner, and quicker to make money in the futures market if you are always going to be right about prices, than it is to try and produce the commodity.
When I was structuring derivatives in the early 1990’s, there was a certain high net worth customer who would regularly place the strangest directional trades using some of the funkiest exotic derivatives available at the time. Figuring out how to hedge these trades was a real pain. However the customer was always wrong on their prediction for the market direction. It got to be so bad, that for one specific trade the trader simply decided to leave the trade unhedged, as the track record indicated that this customer was not going to end up in the money (this was a much simpler time in the markets – oh, the good old days). True to form, the trade ended up out of the money, and the trader did not have to worry about his unhedged position. Fortunately the customer was real good at making money in other ways – predicting financial prices was not their expertise.
Companies should be good at making things and / or selling things. When companies suggest that they are now in the financial prediction market it might be a good time to take a contrary view. Track records seem to indicate that few mangers of these companies ever successfully set foot in a futures pit.
Hedging, like insurance, is not there solely because you expect something good or bad to happen. Hedging, like insurance is there because events (both bad and good) will happen. Unpredictable events will happen. Hedging, like insurance, should not be solely predicted on predictions.
Partner
RSD Solutions Inc.
Is it a good time to short oil? I do not know, but my interest in shorting has been peaked and I will tell you why.
Normally I am not a fan of predicting markets. Fundamentally I believe that markets are not predictable. Over time I believe that the markets are more or less Efficient – in the technical use of the word – and thus you cannot reliably, or profitably make predictions about financial prices. So why do I think it might be a good time now to short oil? It is simple – because a major oil company has recently announced that it is removing its puts on oil as it believes that oil prices are going to remain sufficiently high.
This is a major Canadian oil company that is active in getting oil out of the Northern Alberta Tar Sands. While there is plenty of oil in Northern Alberta, it is very expensive to get at. Oil producers there need to be assured of a sufficiently high price for oil (generally north of mid 50’s) in order to make a profit.
While I do not have a fundamental problem with a company deciding to hedge or not to hedge, I do have a problem when the company’s hedging decision seems to be totally predicated on their price predictions for the financial variable in question. Price prediction is not the function of the company – finding and producing oil is their function, and should be their area of expertise. If they are so good at price prediction, then they should quit the oil business, and just go into the futures trading business. It is far easier, cleaner, and quicker to make money in the futures market if you are always going to be right about prices, than it is to try and produce the commodity.
When I was structuring derivatives in the early 1990’s, there was a certain high net worth customer who would regularly place the strangest directional trades using some of the funkiest exotic derivatives available at the time. Figuring out how to hedge these trades was a real pain. However the customer was always wrong on their prediction for the market direction. It got to be so bad, that for one specific trade the trader simply decided to leave the trade unhedged, as the track record indicated that this customer was not going to end up in the money (this was a much simpler time in the markets – oh, the good old days). True to form, the trade ended up out of the money, and the trader did not have to worry about his unhedged position. Fortunately the customer was real good at making money in other ways – predicting financial prices was not their expertise.
Companies should be good at making things and / or selling things. When companies suggest that they are now in the financial prediction market it might be a good time to take a contrary view. Track records seem to indicate that few mangers of these companies ever successfully set foot in a futures pit.
Hedging, like insurance, is not there solely because you expect something good or bad to happen. Hedging, like insurance is there because events (both bad and good) will happen. Unpredictable events will happen. Hedging, like insurance, should not be solely predicted on predictions.
Wednesday, February 17, 2010
The Risk Analyst’s Secret Weapon
by Dr. Rick Nason
Partner
RSD Solutions Inc.
Risk analysts have a secret that many managers are totally unaware of. Let me explain it by telling a little story that is only disguised to protect the innocent (and the guilty).
I was once brought in to a company to act as a risk consultant. A few days into the assignment I was scheduled to attend a high level executive meeting. The meeting started as these things tend to do. The third item on the agenda was a routine risk report. The risk analyst started the report as usual but used a risk term that I was unfamiliar with. I politely raised my hand and asked if the analyst would be so kind as to define the term for me. That was met with looks of shock and dismay around the table. How could a risk consultant not know this term! The manager who hired me for the engagement looked visibly shaken and embarrassed. After an embarrassing silence in the room that acknowledged my ignorance and faux pas, the risk analyst started to explain the measure – and indeed it was a commonly used measure that I was fully aware of – just not with the label that this specific company used for the term.
The meeting continued without further incident and ironically no one asked any more questions. Needless to say I thought that the assignment was blown and all credibility I might have had was now as good as cremated. I slinked back to my hotel, wondering how to rebuild credibility. However much to my surprise there were several messages waiting for me. Each was from a senior manager at that meeting – and each of them was thanking me profusely for asking the question. It appears as if no one else knew what the internal term meant either. A typical response was, “I am so glad that you asked that question today. I have been going to these monthly meetings for 6 years and never had a clue what they were talking about until you asked that question today! Thanks again – keep up the good work!”
This got me thinking - now with my much bigger brain seeing as I now knew that this institution had basically renamed many of the common risk management tools. The question I asked myself is this, “How many risk managers consciously or unconsciously invent language or techniques to confuse their audience?”
Risk management is not hard to conceptually understand (it is hard to implement), but yet it is frequently compared to rocket science and brain surgery. How much of this is caused by risk managers implementing their secret weapon of terminology confusion?
Partner
RSD Solutions Inc.
Risk analysts have a secret that many managers are totally unaware of. Let me explain it by telling a little story that is only disguised to protect the innocent (and the guilty).
I was once brought in to a company to act as a risk consultant. A few days into the assignment I was scheduled to attend a high level executive meeting. The meeting started as these things tend to do. The third item on the agenda was a routine risk report. The risk analyst started the report as usual but used a risk term that I was unfamiliar with. I politely raised my hand and asked if the analyst would be so kind as to define the term for me. That was met with looks of shock and dismay around the table. How could a risk consultant not know this term! The manager who hired me for the engagement looked visibly shaken and embarrassed. After an embarrassing silence in the room that acknowledged my ignorance and faux pas, the risk analyst started to explain the measure – and indeed it was a commonly used measure that I was fully aware of – just not with the label that this specific company used for the term.
The meeting continued without further incident and ironically no one asked any more questions. Needless to say I thought that the assignment was blown and all credibility I might have had was now as good as cremated. I slinked back to my hotel, wondering how to rebuild credibility. However much to my surprise there were several messages waiting for me. Each was from a senior manager at that meeting – and each of them was thanking me profusely for asking the question. It appears as if no one else knew what the internal term meant either. A typical response was, “I am so glad that you asked that question today. I have been going to these monthly meetings for 6 years and never had a clue what they were talking about until you asked that question today! Thanks again – keep up the good work!”
This got me thinking - now with my much bigger brain seeing as I now knew that this institution had basically renamed many of the common risk management tools. The question I asked myself is this, “How many risk managers consciously or unconsciously invent language or techniques to confuse their audience?”
Risk management is not hard to conceptually understand (it is hard to implement), but yet it is frequently compared to rocket science and brain surgery. How much of this is caused by risk managers implementing their secret weapon of terminology confusion?
Monday, February 8, 2010
Nothing More, Nothing Less
by Dr. Rick Nason
Partner
RSD Solutions Inc.
The role of a risk management function is to increase the probability and magnitude of good events happening and decrease the probability and severity of bad events happening – nothing more and nothing less.
Risk management is not auditing.
Risk management is not forecasting.
Risk management is not always saying “thou must not”.
Risk management is not certainty.
Risk management is enabling.
Risk management is value adding.
Risk management is prudence.
Risk management is reasonableness.
Partner
RSD Solutions Inc.
The role of a risk management function is to increase the probability and magnitude of good events happening and decrease the probability and severity of bad events happening – nothing more and nothing less.
Risk management is not auditing.
Risk management is not forecasting.
Risk management is not always saying “thou must not”.
Risk management is not certainty.
Risk management is enabling.
Risk management is value adding.
Risk management is prudence.
Risk management is reasonableness.
Monday, January 18, 2010
Comment on “The Black Box Explodes”
by Dr. Rick Nason
Partner
RSD Solutions Inc.
There is a very interesting article in the Saturday, November 16, 2007 Globe and Mail newspaper titled “The Black Box Explodes”1. The article outlines in a very clear, readable and succinct form the events leading up to the Asset Backed Commercial paper (ABCP) credit crunch that occurred in Canada this past summer and for which the effects are still being keenly felt in the economy at large. As the title suggests, the culprit for the credit crisis is the “Black-Boxes” of credit instruments known as CDO’s (Collateralized Debt Obligations) and SIV’s (Special Investment Vehicles) created by bankers and other financial types.
Partner
RSD Solutions Inc.
There is a very interesting article in the Saturday, November 16, 2007 Globe and Mail newspaper titled “The Black Box Explodes”1. The article outlines in a very clear, readable and succinct form the events leading up to the Asset Backed Commercial paper (ABCP) credit crunch that occurred in Canada this past summer and for which the effects are still being keenly felt in the economy at large. As the title suggests, the culprit for the credit crisis is the “Black-Boxes” of credit instruments known as CDO’s (Collateralized Debt Obligations) and SIV’s (Special Investment Vehicles) created by bankers and other financial types.
It is hard to argue against the suggestion that CDO’s and SIV’s are “Black Boxes” (BB’s). In fact as one who was a player in the markets creating the underlying structures and also as one that currently conducts training programs for specialists on these structures I too have to embarrassingly admit that I do not understand all of the various structures. Even worse, for many of those that I do understand, I still do not have the knowledge or the ability to accurately and objectively price the structures. Perhaps there are those smarter than me who can, but I have yet in my travels to run into them.
Having said that, are BB’s really all that bad? After all we encounter many different BB’s in our daily lives that we do not fully understand. For example I am sitting at my laptop typing out this blog without the foggiest idea of how my computer gets my (clumsy) tapping of keys into words on a screen and then through the invisible internet into your computer – at which point you see them on a computer screen that I suspect you also have to treat as a BB.
Let’s take a different analogy. I suspect that the proportion of people who understand how their anti-lock braking system detects a skid and kicks into action is less than 0.01% of all drivers. However I suspect that no one has ever refused to take a drive in a car because they did not understand anti-lock brakes.
The point I am trying to get across is that not all BB’s are bad. We depend on many BBs to efficiently and more pleasantly live on a daily basis. It is the same with CDO’s and SIV’s. While it is true that they are BB’s, that does not mean that they are all bad. For example, the securitization techniques (which underlie CDO’s) have allowed banks to create a wider variety of mortgages at lower mortgage rates that have led to more people than ever owning their own homes. The same goes for car loans, credit card loans, home appliance loans and the such that have allowed consumers to increase their standard of living at a faster pace than would have been possible even 15 years ago. To paraphrase “Martha”, these are “good things”.
[1]“The Black Box Explodes”, by Boyd Erman, Jaquie McNish, Tara Perkins and Heather Scoffield, The Globe and Mail, November 16, 2007.
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