One must be very careful about assumptions. Getting volatility assumption wrong is a classic case of risk management failure.

--BY SUJIT MUNDUL

The International financial market has witnessed a series of evolutions over the past few decades resulting in a variety of newer products which have exposed the providers to complex risks. This has necessitated a different approach towards the management of financial risk. 

It was an extraordinary collision of extreme conditions in the financial market in the 1980s and a dramatic increase in computer power. In the space of a few years, outcomes which would be tested only by intuitive sketches on the back of an envelope or worked out after weeks of cranky iterations on a calculator, were performed in minutes on a desktop computer. It would not be out of place to mention that a Monte Carlo simulation- chaos theory, a neutral network- have all attempted to get close to modeling a real financial market. Of course a model will never be the real thing and those who did place too much faith in their financial model got caught wrongly at the end.

Nevertheless, financial firms have learned that mathematics has limited value in calculating the probability of the most extreme events.

Learning from experience, the regulators and forward thinking participants in the markets have got to grips with this problem and they have ventured into the more uncertain territory of designing stress tests, imagining scenarios and occasionally playing out entire fictions of the future. This is what makes the discipline of risk management more than just a computer training exercise. More fascinating than risk management successes, which generally are non events, are the spectacular failures which tell us about the gravity of financial stress. There are plenty of lessons to be learned from the collapse of Bearings, Mutallgesellschaft, Lehman Brothers and many others.

In September 1992, Euromoney’s cover story was about derivatives and the damage that they could do to the financial firms or their customers if they were not used correctly. This strong view of derivatives enraged the financial community at that time. Derivative sellers had taken a good deal of time and trouble to explain to their customers how these instruments were correctly used, as powerful devices that can improve financial performance, to ameliorate the damaging comments made by Euromoney.

However, Euromoney was right and there was another warning that derivatives cannot come with enough health warnings. Derivatives, as the name suggests, are derived from an underlying asset of or an index representing assets.

They are not assets themselves, although they can be traded as if they have an underlying value. Let’s take an example: Warrants to buy Volkswagen shares at a certain price three months from now will trade at a price related to the underlying shares, but supply and demand will also give the price of the warrants a life of its own. Buying warrants is a cheap way of getting exposure to a share with the risk of loss limited to the cost of the warrants. A few euro or dollars spent initially have the chance of being multiplied many times if the share price rises. This is of course more exciting than the return on a fixed G-sec.

As very rightly pointed out by David Shirreff, we must not forget that there is another side to this. In the derivatives market, for every winner there is a loser. The sellers of such warrants suffer an accelerated loss, or an opportunity cost, as the share prices move up. If they are sensible, the sellers will have covered themselves by owning the underlying shares in question- they will have written a so-called “covered” call option. When the warrant is cashed in, they simply hand over the shares in their possession at the agreed price. They have lost an opportunity to make money, but not their shirts. 

Taking interest-rate swaps, some of the early swaps had rather primitive documentation. Careful documentation is necessary because swaps, unlike most other financial contracts, rely on the performance of both counterparties, rather than just one. This is because, with a net exchange of cash flows, at each interest period a payment of the net difference could be due from either one counterparty or the other. Because of this two-sided credit risk, each party has documentary protection against the other’s default and can terminate the contract if certain conditions are not met. The players are required to read the fine prints of the documents. 

There were several instances of this. For example, in 1987, Texaco, an oil company, technically went bankrupt for a few days when ordered to pay USD 10.5 billion in damages in a wrangle over the purchase of Getty Oil. Bankers Trust, a big American bank, saw the opportunity to terminate a swap agreement with Texaco by which, because of the movement of interest and currency rates since it was signed, it would have had to pay Texaco an estimated USD 10 million, over its remaining life. Texaco, having insisted on its own documentation in the first place, was considered fair game; Bankers Trust walked off with a windfall profit.

It has often been seen that reliance on home grown risk modeling has led to significant losses, followed by a rethink of the business. Merrill Lynch, then an American investment bank, for example, lost USD 400m in the early 1980s on securitised mortgages.

One must be very careful about assumptions. Getting volatility assumption wrong is a classic case of risk management failure. Ultimately, it is more a failure of management than of mathematics, since every mathematical model has to be fed with assumption input by humans. Models can always be manipulated either deliberately or mistakenly by those who are applying them. It is up to managers and risk controllers to weed out these aberrations before they do damage.

The global financial crisis has taught us good lessons and it was also a turning point for sellers of derivatives. After about 15 years of fantastic growth in their use of the losses incurred by the sellers and their customers, the global financial crisis made them far more aware of the products’ hidden potential as an accelerator of losses. 

This experience had also actuated the regulators of the market as the respective monitory authority to become more cautious and intense in monitoring the market transactions. From then onwards more attention was paid to the appropriateness of the derivatives sold requiring the customers to understand how the product/products they are buying might perform in adverse conditions. For non-professional customers, and even for smaller, less sophisticated companies the onus was on derivative sellers to explain the dynamics of what they were selling. 

The risk control mechanism in tandem with the changes with the requirements of the markets and the risk control ecosystem is undergoing a transformation. The emerging and developing markets (which are mainly in the very early stages of development) are necessarily required to be more cautious on this aspect.

The writer is former Member in the Board of Directors of Standard Chartered Bank Nepal Ltd.