Making Risk Measures Agree with Accounting 100%

In my consulting experience, there are clients that use risk software to compliment financial reporting (accounting). Instead of being used solely by the risk department, even financial controllers use it. This is due to the current trend of making financial reporting reflective of the firm's economic value based on the risks it is taking (IAS 39 and even Basel II). As a consequence, they expect the results form the risk software to be consistent with accounting results to the last cent. I guess this is the ideal state that everyone wants to achieve but is this really necessary?

Though related, I believe that risk measurement and accounting are serving different purposes. Risk measurement need not be exact because of the uncertainty of risk. Because of the future-centric nature of risk measurement, generalizations and simplifications in the models are made and may not necessarily result into exact market values, etc. In risk measurement, benchmark results are acceptable as long as they are reasonable (where you can see the degree of sensitivity to different types of risks). So what is important in risk measurement is not the valuation of your positions to the exact cent but the model on how this value reacts with different types of risk. Contrary to risk measurement, accounting focuses on past performance. People tend to be very meticulous in this field to the point that they want things to be correct to the last cent. This is because in most organizations, even in today's banks, profit and loss (past performance) is still more important.

Nowadays, with all the innovation in software and the computing power of currently availabe hardware, people tend to assume that risk software can double as accounting software. But in reality, these two fields have different requirements (although they may be similar in some ways). It is true that a software can be made flexible enough to accommodate both requirements. Results may not be exact but good enough. But getting values to agree with the accounting system would result into more computing time due to the increase in inputs, variables, and complexity of models. Is the additional cost justifiable given that additional benefit is only to reconcile a few dollars and cents? Probably not today but probably (and hopefully) in the near future when hardware specs get better while prices get cheaper.

Tags: accounting finance risk measurement software

Model Validation - Not Just for Quants

In an article recently published in the ERisk Monthly Newsletter, it is stated that model validation is not a purely quantitative endeavor. Below is a quote from the article.

Model validation is often thought of as a rather technical and mathematical exercise. However, bank losses from model risk are often caused by poor governance of the wider modeling process, or by a poor understanding of the assumptions and limitations surrounding the model results, rather than by errors in equations.

The growing importance of models in helping executives answer some of banking’s most critical questions – from compliance and capital adequacy to business performance and risk-adjusted compensation – suggests that model validation is too important to be narrowly defined or left to the “quants”.

For both best practice and regulatory compliance reasons, senior bank executives must begin to take a more commanding role in ensuring that model validation is aligned with the overall interests of the bank – and that the bank’s investment in sound risk modeling can be easily communicated and proved to third parties.

Tags: financial engineering derivatives model validation governance audit

Quant Cartoons

This cartoon was sent to me by Financial Engineering News. Enjoy!

FENtoon

Tags: financial engineering derivatives algorithms

Hedge Funds Semantics

Hedge funds are very risky investments. They invest in derivatives, employ unconventional trading strategies, and are usually greatly leveraged... All for the pursuit of extraordinary profits. A lot of hedge funds have come and gone and the survival rate is not encouraging. So why are they called "hedge" funds in the first place?

When we hear the word "hedge" we usually think of protection and safety. In finance, a hedge, usually in the form of derivatives, is used to protect an investment from loss. But it also limits the gains of the position as well. This makes potential earnings predictable and constant. Risk is eliminated since risk is defined as "uncertainty".

But looking at the hedging instrument individually, it is just as exposed to losses as other instruments. Moreover, derivatives are leveraged and losses are potentially greater than conventional assets. The hedge only takes shape if the hedging instrument is taken together with another position, and their reaction to changes in market factors should cancel each other out.

Hedge funds act in the same way. Taken alone, hedge funds are risky investments. But when combined with conventional funds, they can provide diversification benefits and even enhanced returns due unconventional strategies and assets employed. These unconventional strategies and assets result into low correlations with conventional funds.

I guess a lot of people assume that hedge funds are supposed to be safe investments because of the word "hedge". But if these funds are meant to safe in the first place, they should be called "hedged" funds instead.

Tags: finance derivatives hedge funds investments

CFA Institute Defends the CFA Brand

CFA charterholders will be delighted to know that their organization is pretty busy upholding the integrity of the CFA brand.

Just this month, the Delhi High Court told the Institute of Chartered Financial Analysts of India (ICFAI) to stop (temporarily?) the use of the CFA marks. ICFAI runs a post-graduate program that eventually leads to a CFA Charter from the Council of Chartered Financial Analysts. The court stated that "Chartered Financial Analyst" and "CFA" is not a generic term to be used by any organization and is a recognized trademark owned by CFA Institute.

CFA Institute press release
ICFAI program details

Tags: CFA

Basel II Implementation in the Philippines

The Bangko Sentral ng Pilipinas (BSP) has set June 2007 as the date of implementation of the revised capital adequacy framework. The latest version of the framework is very much in line with Basel II. Major changes that are expected to have significant impact on the ratios would be the addition of an operational risk capital charge and the revision of the risk weight for Philippine government foreign currency bonds (ROP) from 0% to 100%.

In a previous circular, securities booked under Available for Sale (AFS) are taken out of market risk charge and are now considered as Banking Book exposures. I'm not sure why this is the case because these positions clearly have exposure to fluctuation in rates and are revalued accordingly. Profit or loss are then recognized in equity. This actually prompts banks to book everything under AFS (especially Philippine Gov't Peso bonds which have 0% credit risk weight) to avoid market risk charges.

As with Basel II, the framework does not directly address market risks in the banking book and leaves these as Pillar II issues.

Read more about Basel II initiatives in the Philippines:

Bangko Sentral ng Pilipinas (BSP)
The Asian Banker

Tags: finance risk management capital adequacy basel ii bsp philippines

An Option with a Negative Implied Volatility?

Previously, we talked about cases when an option will have a negative value. This time, it was asked in Wilmott if there are real-life cases where options have negative implied vols.

Here's my take on the subject matter:

Since implied volatilities are derived values, based on observed market parameters and a model or formula, it is indeed possible to have negative results. But does it make sense? Intuitively, we would think that the volatility measure should only be positive and it does not make sense if negative. I think negative implied vols are a result of either a misspecification in the model, or mispricing by the market (an arbitrage opportunity, as mutley pointed out).

Tags: finance derivatives options valuation volatility

Are fund managers really overcompensated?

CFA Magazine recently published an interview with Barton Biggs in its July-August 2006 Issue. Mr. Biggs has been with Morgan Stanley for 30 years acting as chief global strategist and is well respected by Wall Street. In 2003, He retired from Morgan Stanley to form Traxis Partners (hedge fund) with colleagues. In the interview, the following quote struck me the most...

"The hedge fund is another way for people to run money. It happens to be a way in which there are high fees charged. Eventually, the sheer size of the money going into hedge funds and the number of hedge funds that exist are going to inevitably result in a decline in hedge fund fees. In fact, my guess is that compensation across the investment management business is beginning a secular decline. It's the most overcompensated business in the world. Never have so many been paid so much for adding so little. It's an evolutionary process."

I am aware that competition forces fees in a downward trend and compensation will surely follow. But I still don't see the evidence of this happening at the moment based on the postings I see in jobs boards and the number of fresh grads wanting to go into the business (because it pays well).

I think it's all a matter of supply and demand. As more and more fund managers are needed, it becomes more difficult to get really good managers. The lack of supply raises the price for talents. The lack of supply also forces some funds to employ sub-standard managers (whether intentional or not) which results into Mr. Biggs observation of so little value added.

Some articles about Barton Biggs:
Morgan Stanley
Turtle Trader
Weeden & Co.

Tags: finance investing hedge funds CFA

Running Government Finances Like a Bank

Many investors are concerned about the increase in public debt of Asian countries since the Asian Financial Crisis. As justification, governments need to issue debt to support the financial markets, jump start the economy, and develop infrastructure, etc. Sovereigns with large outstanding debt are seen to be more credit risky and more more susceptible to something going wrong. Thus, the IMF issued guidelines on Public Debt Management (PDM).

In a nutshell PDM takes Asset-Liability Management best practice from banks and insurance companies and applies them in managing government debt. This makes sense since the biggest financial portfolio in a country is the government's finances anyway.

Governments should focus on ALM issues like liquidity and interest rate risk management. It should analyze the cost-benefit trade off of borrowing in the short term - which is cheap but risky and volatile, as opposed to borrowing long term - which is expensive but predictable. They should also focus on minimizing unhedged foreign exchange exposures, debt with embedded put options (unpredictable maturities), and implicit contingent liabilities.

Governments should also push for the development of their domestic currency capital markets. A developed capital market would mean that there are a lot of investors and variety of issued securities. Development of derivatives markets will also be beneficial as investors are more willing to take and hedge risks. A developed capital market will also allow the government to issue longer-dated debt since there are willing investors.

Having a large public debt portfolio is not such as bad thing as it can be a catalyst for economic growth. The key here is proper risk management. All they (governments) have to do is to look at what the banks and other financial institutions are doing.

Sources:

International Monetary Fund
Financial Engineering News

Tags: finance derivatives risk management alm government debt bonds capital markets

Do you use Bloomberg for Risk Measurement?

Bloomberg is holding a Market Risk Seminar this month. But before the details, here are my comments.

I've attended Bloomberg seminars before and there is usually a sales pitch somewhere. Looking at the event's lineup of speakers, 4 out of 5 speakers are from Bloomberg (an Algo risk solution is embedded in Bloomberg). Although the topics may sound relevant, they're just intro material to Bloomberg functionalities and add-on services. For those looking for risk management solutions for their organization and looking to comply with Basel II, Bloomberg will present itself as a viable option in this seminar. Bloomberg would more likely say: "Since you are already Bloomberg users, why not leverage on your subscription and use our built-in risk solutions (at an added cost of course)?"

Generally, practitioners I know would trust Bloomberg in a majority of the raw figures that they give out. But when it comes to calculations, some would take them with a grain of salt. Personally, I find the risk solutions of Bloomberg to be less than adequate for the following reasons:

• Limited instrument coverage
• Not flexible
• Lack of transparency (Black Box)

But of course, it would never hurt to sit in a Bloomberg seminar and learn best practice (if ever they are presented) and to discover some new things that our beloved system has to offer.

And now for the seminar details.

Topics:

• Importance of Market Risk Management
• Risk measures for fixed income securities and derivatives
• Reliable data for your risk management systems
• Market risk management in alignment with Basel Accord
• Algo Risk on Bloomberg - a pre-integrated, real time market risk solution

Speakers:

• Nestor A. Espenilla, Jr. - Deputy Governor, Bangko Sentral ng Pilipinas
• Seet Kok Leong - Head of Algo Risk (Asia Pacific), Algorithmics
• Jiten Bhanap - Product Specialist, Bloomberg L.P.
• Ivan Koh - Regional Data Solutions Manager, Bloomberg L.P.
• Neo Siang Noi - Trading Systems Sales Specialist, Bloomberg L.P.

Date:

15 August 2006

Venue:

Makati Shangri-la Manila, Ayala Avenue corner Makati Avenue, Makati City 1200, Philippines

Time:

9:30am - 2:00 pm

Registration:

BU on Bloomberg

email: awang@bloomberg.net

tel: +63 2 849 7100 loc. 4794

*Lunch will be served

Tags: finance derivatives market risk risk management bloomberg seminars courses

Modelling Financial Risk Seminar

Just got an invitation through email to participate in a class offered by Macquire University's Advanced Finance Centre and PRMIA. It is a course designed for Risk Management Professionals. It involves lectures by Dr. Elizabeth Sheedy and some computer workshops after each topic.

Topics for Discussion

• Introduction
• Measuring Risk Under the Normal Distribution
• Historical Simulations for Measuring Risk
• Monte Carlo Simulations for Measuring Risk
• Stress Testing
• VaR in the Absence of Normality
• Liquidity Risk
• Model Risk
• Maximum Likelihood Estimation

Course Schedule

• Thursday 17 August 2006 - 5:30pm to 8:30pm
• Friday 18 August 2006 - 5:30pm to 8:30pm
• Saturday 19 August 2006 - 9:00am to 5:00pm
• Sunday 20 August 2006 - 9:00am to 5:00pm

Fees

• SGD 1785 (includes GST) - per person
• SGD 1575 (includes GST) - per person from the same entity

Venue

School of Financial Services and Risk Management, Singapore Human Resources Institute, Singapore Conference Hall, 7 Shenton Way #01-02 Singapore 068810

Contacts

• 65 6438 0012
• shortcourses@mafc.mq.edu.au

An outline is available at this link.

I'm quite knowledgeable in risk measurement so the initial topics are just the same old stuff. The latter topics though are quite interesting. Too bad I'm not in Singapore.

Tags: finance risk risk management seminars courses

An Option with a Negative Value?

A recent post in the Wilmott forums asked "Can an option have a negative value?"

Conceptually, an option with a negative value does not make sense. A negative value means that the option seller (writer) pays the option buyer. This results into a "free lunch" as described by one of the posters (waiter222). The option buyer will always win out in this case. He can exercise and make money when "in-the-money". He also has an instant gain even when the option expires worthless due to the initial cash flow. Indeed it is unfair.

Mathematically, an option value cannot be less than zero as well. (Please correct me if I'm wrong). I've played with several scenarios using the Black-Scholes and Binomial methods and the least value of an option is zero ("worthless").

But it is possible for an option position (note that I'm talking about an option position) to have a negative value when doing mark-to-market valuation. Marking-to-market is getting the close out (unwind) value of the position. And it can result into a loss (negative value). Here's an example, an option writer sells an option for $5. After some time, the value of an option at the same strike and expiration date rises to $6. This could mean that the option is getting more "in-the-money" and the possibility of an exercise increases. This is bad news for the option seller. The value of his position is obtained by assuming an offsetting transaction (he buys an option at $6) . The net result is -$1.

The point that I'm getting at here is that is quite unthinkable to have negative option value. So far no one has disputed that fact. But depending on one's position (P&L standpoint), the treatment of that option can be negative or positive depending on whether you treat is as an asset or liability. Does this make sense?

Tags: finance derivatives options valuation

Brushing up on my math skills...

I'm somewhat amazed on how I got myself into the world of Financial Derivatives. I do not have a quantitative degree (I majored in Management Economics) and didn't pay much attention to my math and statistics classes in college. Yet I find financial markets (derivatives in particular) fascinating. And becoming knowledgeable in them actually gave me an edge in the industry.

Looking back, it seems that I chose the wrong college course. But my interest in the subject matter and the willingness to learn did not stop me from attaining my goal. Although not for quants, the CFA program gave me a good background on the financial markets in general; as well as valuation methods for plain vanilla derivatives.

I searched the net for papers. Marketing and research papers published by the big banks are of great help. Sites like DefaultRisk has loads of papers on Risk Management and Derivatives. But reading them is no simple feat as most of them are written by PhDs or PhD students. My lack of academic foundation in mathematics do get in the way, especially when I encounter a lot of greek symbols.

Finding like-minded individuals to discuss topics of interests and ask for advice also did a lot of good. I am an active member of Wilmott -- an online community of quants (Username: Jomni). At first, I was the one asking questions, and now I give answers and advice myself (on topics that are not mathematically deep).

I never stop reading. Part II of the PRMIA Professional Risk Managers' Handbook is a good refresher on quantitative finance topics. It covers Matrix Algebra, Differential and Integral Calculus, Probability, and Statistics. Other good books would be Hull's Options, Futures and Other Derivatives and Paul Wilmott on Quantitative Finance.

Tags: derivatives finance math quant books cfa