Risk Management Three Lessons
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Transcript of Risk Management Three Lessons
October 09 Andrey Lvovsky 1
RISK MANAGEMENT
Author: Andrey Lvovsky
Date: October 2009
Several Lessons From the Crisis
October 09 Andrey Lvovsky 2
Introduction
• Somebody asked me recently during a job interview what did I learn during the recent crisis as a risk manager
• I thought it would be a good way to frame some of my thoughts and observations, to summarize it for my own benefit– Hopefully other risk professionals might find it
interesting too
October 09 Andrey Lvovsky 3
Disclaimer
• This presentation reflects perspectives of a risk manager in a credit/distressed hedge fund
• I am sure that risk managers at banks’ trading desks, brokerages, funds with other strategies or FOF would have different experiences and thoughts
• I don’t represent any organization, nor do I provide any advice or sell anything
October 09 Andrey Lvovsky 4
Agenda
Lesson 1: don’t be afraid to call the market
Lesson 2: there is no hedging
Lesson 3: to understand is to simplify
Appendix: general comments on risk management
October 09 Andrey Lvovsky 5
Lesson 1: Don’t Be Afraid to Call the Market
Sometimes it is more dangerous not to do so
October 09 Andrey Lvovsky 6
The Choice of Data: Looking Backward
• One of the important inputs in Risk Management process is historical data
– For Scenarios, VAR, regressions etc.
• Working with data, we must choose– Time horizon– Frequency– Relevant events/scenarios
Don’t be afraid to call the market: Sometimes it is more dangerous not to do so
October 09 Andrey Lvovsky 7
The Choice of Data: Looking Forward
• The choice of data says “The future will look like THIS piece of the past”
• The choice of relevant scenarios says “This kind of events might happen again in the near future”
• In effect, by the choice of historical data we are calling the market (implicitly)!
– Also, a market call is embedded in the assessment of richness/cheapness of the “tails” of the hedges
Don’t be afraid to call the market: Sometimes it is more dangerous not to do so
October 09 Andrey Lvovsky 8
What About Long-term Averages?
• Surely if we take long enough series of historical data, it will cover all sorts of risky scenarios?
• Yes, but averages are misleading– The average hospital patient’s temperature might be
normal, yet half the patients have high fever and the other half is already cold
– Markets can remain irrational (or simply away from the average) longer than we can remain solvent!
• Relationships change over time, hence timing is the key!
Don’t be afraid to call the market: Sometimes it is more dangerous not to do so
October 09 Andrey Lvovsky 9
Example: Loans vs. Bonds
Don’t be afraid to call the market: Sometimes it is more dangerous not to do so
October 09 Andrey Lvovsky 10
Loans Vs. Bonds (Cont’d)• Monthly returns of CSFB Leveraged Loan and
Merrill Lynch High Yield II indices show a highly non-linear relationship
• Even when bonds were slightly down, loans were usually up (marked by small red circle)
• However, when bonds went down significantly, loans followed
– Note the outlier December 2008: bonds were up, yet loans were down
Don’t be afraid to call the market: Sometimes it is more dangerous not to do so
October 09 Andrey Lvovsky 11
Loans vs. Bonds (cont’d)• Merton model sheds light on the non-linear
character of this relationship• Both bonds and loans can be viewed as short
puts on firm’s assets, loans are much further OTM than bonds
• Therefore, we (almost) observe a Put Spread profile
-4
-3
-2
-1
0
1
2
3
4
-5 -4 -3 -2 -1 0 1 2 3 4 5
Don’t be afraid to call the market: Sometimes it is more dangerous not to do so
October 09 Andrey Lvovsky 12
Loans Vs. Bonds (Cont’d)• Two following charts give more information
about loans vs. bonds• The first chart shows that happens if we look at
the months when bonds were up and the months when bonds were down separately
– Beta of loans to bonds on “up” months = 0– Beta of loans to bonds on “down” months = 0.5
• The second chart shows 24 months rolling beta of loans to bonds and how much it changed since the summer of 2007
Don’t be afraid to call the market: Sometimes it is more dangerous not to do so
October 09 Andrey Lvovsky 13
Loans Vs. Bonds (Cont’d)
Don’t be afraid to call the market: Sometimes it is more dangerous not to do so
October 09 Andrey Lvovsky 14
Loans Vs. Bonds (Cont’d)
Don’t be afraid to call the market: Sometimes it is more dangerous not to do so
October 09 Andrey Lvovsky 15
Lesson 2: There Is No Hedging
Just swapping one kind of risk for another
October 09 Andrey Lvovsky 16
The Tale of Two Greeks
• Hedge fund performance is often thought in terms of Alpha and Beta
• Beta is the performance that comes from systematic exposure to a broad risk factor
• Alpha is whatever is delivered on the top of the Beta (on average)
• Alpha is attributed to Manager’s skill/edge
ßά
There is No Hedging: Just swapping one kind of risk for another
October 09 Andrey Lvovsky 17
Why Hedge?
• To offset unwanted risk, often defined as “market”, or “beta”. Presumably it will:– Allow to lever up the “alpha” – Decrease the volatility of the portfolio– Create stream of returns uncorrelated with
major markets (“alternative investments”)
• However, hedging is an implicit bet on correlations and covariance
There is No Hedging: Just swapping one kind of risk for another
October 09 Andrey Lvovsky 18
Swapping Market Risk for Basis Risk(s)
• Suppose we hedge a middle-market loan portfolio with on-the-run CDX HY
• What kinds of basis risk do we introduce?– Loans vs. Bonds– Cash vs. Synthetic– Levered vs. Un-levered– Illiquid vs. Liquid– Fundamental vs. Technical
There is No Hedging: Just swapping one kind of risk for another
October 09 Andrey Lvovsky 19
The Asymmetric World
• Each trade falls into one of two categories:– “Sell insurance/tails” – many small gains, few
large losses– “Buy insurance/tails” – many small losses, few
large gains
• Buying high yield debt is “selling tails”
• Buying OTM options is “buying tails”
There is No Hedging: Just swapping one kind of risk for another
October 09 Andrey Lvovsky 20
Where in the World Is the Alpha?
• Manager’s alpha is either– In “buying CHEAP tails” or – In “selling EXPENSIVE tails”
• It is easy to “hedge away” too much of the alpha
• Therefore, if PM is “selling expensive tails”, RM hedges by “buying cheap tails”
• Example: shorting EM instead of HY in ‘08
There is No Hedging: Just swapping one kind of risk for another
October 09 Andrey Lvovsky 21
So, Why There Is No Hedging?
• Because both hedges and hedged positions have non-linear pay-out profiles
• Because hedging depends on correlation and covariance, and those are unstable over time (basis risk)
• Because hedging for the best tracking normally would eat too much alpha
There is No Hedging: Just swapping one kind of risk for another
October 09 Andrey Lvovsky 22
Lesson 3: To Understand Is to Simplify
What The Risk Manager should focus on
October 09 Andrey Lvovsky 23
What the Risk Manager Can’t Know
• What risks pertain to each individual position– PM/Analyst knows that better
• How to size each individual position– Because it depends mostly on a subjective
assessment of risk of the position
To Understand Is to Simplify: What Risk Manager should focus on
October 09 Andrey Lvovsky 24
What the Risk Manager Must Know
• How different positions are related– Which of them move together or in the opposite
directions
• How positions can become related– What can trigger the change in their behavior
and make them move together
To Understand Is to Simplify: What Risk Manager should focus on
October 09 Andrey Lvovsky 25
To Understand Is to Simplify
• The key function of risk manager is to think through the complexity of the portfolio and links between positions…
• And to be able to summarize the entire portfolio in terms of handful of 2-5 major bets/risks hidden in the book
• That’s what makes the role of risk manager complimentary to portfolio manager
To Understand Is to Simplify: What Risk Manager should focus on
October 09 Andrey Lvovsky 26
What Events Should Risk Managers Focus on?
• Those that may affect more than just one position
• Those significant enough to threaten the desired investment profile
• Those probable enough to worth “worrying about them”
• Those that are out of portfolio manager’s scope of attention
To Understand Is to Simplify: What Risk Manager should focus on
October 09 Andrey Lvovsky 27
Too Much Diversification Is Bad
• As the number of positions grows, the number of connections between them grows exponentially
• Makes it impossible for risk manager to cover potential risks in depth
• Also makes it difficult for portfolio manager to control for the quality of positions– “Alpha” portfolio becomes “beta” portfolio
To Understand Is to Simplify: What Risk Manager should focus on
October 09 Andrey Lvovsky 28
Conclusion
October 09 Andrey Lvovsky 29
Three Lessons Revisited
1. It is okay to try to forecast the market• Implicitly we are doing it anyway• Often it is more dangerous not to try to do it
2. There is no hedging• There is only swapping one kind of risk for another• Properly done, it can add alpha and lay off unwanted
beta, but timing is the key
3. To understand is to simplify • The Risk Manager must be able to summarize the
portfolio risks in 2-5 major bets
Conclusion
October 09 Andrey Lvovsky 30
Appendix: General Comments on Risk Management
(Some of the following slides contain Notes)
October 09 Andrey Lvovsky 31
Risk Management at a Glance
Appendix: General Comments on Risk Management
Portfolio & Politics
Markets Systems
Risk Manag.
October 09 Andrey Lvovsky 32
Risk Management Objectives TO ACHIEVE DESIRED INVESTMENT PROFILE
Is measured by volatility, tracking, downside risk, Sharpe ratio
• Tools: performance attribution, optimization, marginal VAR
TO PRESERVE THE BUSINESS FROM TAIL EVENTS
Is measured by VAR, Conditional VAR, scenario analysis
• Tools: macro models, diversification, position size limits
TO ADD ALPHA BY LIMITING RISKS, HEDGING BETA
Is measured by correlation to risk factors, cost of hedging, basis
• Tools: factor and regression analysis, hedge optimization
Appendix: General Comments on Risk Management
October 09 Andrey Lvovsky 33
The Risk Management Process
Shaping It
(Reporting)
Positions Data
Market Data
Historical Risk Data
Models
Assumptions
Selecting Risk Metrics
Selecting Risk Factors
Calculating Exposures
Running Reports
Analyzing the reports
Testing the assumptions
Building forecasts
Turning into actions
Basic Ingredients
(Inputs)
Baking It
(Analysis)
The Proof is in the Pudding
Appendix: General Comments on Risk Management
October 09 Andrey Lvovsky 34
Risk Management: Systems
Appendix: General Comments on Risk Management
Administrator
Counter-parties
Pricing (BBRG,
Markit, LoanX)
Historical
Time Series
Scenario
Engine
Report
Generation
Distribution
Follow-Up
Analysis
October 09 Andrey Lvovsky 35
Portfolio Manager and Risk Manager: Friends, Not Foes
PM/Analyst:• Focuses on nuts and
bolts of every position
• Thrives on complexity (legal documents, market information…)
• Makes a call to long or short the market or a sector.
• Adds to alpha by buying “cheap tails” and assuming calculated risks.
Risk Manager:• Focuses on inter-
dependencies
• Must simplify. Summarizes the entire portfolio in few major bets or risks.
• Makes a call on correlations and covariance
• Also adds to alpha by selling “expensive tails” and taking timely beta risks.
The Portfolio
The MARKET
Positions
Appendix: General Comments on Risk Management
October 09 Andrey Lvovsky 36
Questions HF Investors Should Ask Risk Managers
• What are the biggest bets in your portfolio?• What events can trigger losses in many positions?• Why the historical data you use is relevant?• How do you quantify basis risks you run?• How do you make sure that you buy cheap tails or
sell expensive tails?• What are your scenarios for the near future?• What did you learn about the portfolio recently?
Appendix: General Comments on Risk Management
October 09 Andrey Lvovsky 37
Sometimes being a Risk Manager feels like this:
"Here is Edward Bear (later named Winnie-The Pooh), coming downstairs now, bump, bump, on the back of his head…. It is, as far as he knows, the only way of coming downstairs, but sometimes he feels that there really is another way, if only he could stop bumping a moment and think of it. And then, he feels that perhaps there isn't."
From Winnie-The-Pooh, by A.A. Milne.
Appendix: General Comments on Risk Management
October 09 Andrey Lvovsky 38
Good Risk Management Books• “The Plight of Fortune Tellers”
– by Ricardo Rebonato
• “A Demon of Our Own Design” – by Rick Bookstaber
• “Surely You’re Joking, Mr Feynman” – by Richard Feynman– Contains many examples of excellent risk management
thinking. Example: after a big forest fire the entire city rushed to buy fire insurance. Feynman bought flood insurance. He realized that deforestation greatly increases the probability of flooding. He was right.
Appendix: General Comments on Risk Management
October 09 Andrey Lvovsky 39
About the Author
• I am a risk and a quantitative analyst
• I am currently looking for a job
– In a hedge fund or a bank, in CT/NYC
• I can be reached at
– 203-273-2783 cell
• I managed risk for a large credit HF, and before that – for a large FOF
• MBA NYU Stern, MS in Mathematics