Does every cloud have a sell order lining?

While my days of sitting in front of a trading screen are now long ago and lost in the dim and distant past, every time I pass a trading screen, the familiar tightening of the chest, thumping of the blood and dampening of the palms still happen. How prices are made in the financial markets is a fascinating phenomenon. The theory is pretty simple. The current price of an asset in the markets is supposed to be best estimate of all the participants of the future performance of the asset. So if the price drops, then the market (or people like you and me) expect that the future performance will be bad. Of course there is much more to it than this.

We are not all Vulcans; we do not have a straight forward unemotional way of judging the future. Strange things do impact us. If I woke up, toddled off to take a shower and found that the hot water has finished, I would be miffed. My day would not be good after this not so good start and frankly I would not be in a good mood. My performance, my duties and responsibilities, my behaviour towards my family, colleagues and friends, howsoever tiny and picayune, will deteriorate. I will go about my day being grumpy and expect the future to be dark.

If I was woken up by my 4 year old little girl who clambered into bed with me early in the morning and then we spent 15 minutes whispering about frogs, princesses, flowers, babies, naughty elder brother, toys, dresses, boyfriends and so on and so forth, then I get out of bed after getting a big hug and a whispered, “you are the bestest daddy”, that’s it, my day is made. I will go through the day with a spring in the step, a smile on my face, a twinkle in my eye, a song on my lips and heart on the sleeve. My behaviour would be good, and I will do my duties with a cheery smile and it would be a great day. I will think the future will be great and wonderful.

So my mood influences how I feel about how the future will be. And this is why good moods, good news and good feelings/emotions push economies and markets up. People feel good about the future so that they go out and purchase stuff, go take up credit, buy houses, spend money and invest in stocks. When the mood goes bad, they stick the money under their mattress, sell their investments, plonk cash into gold and so on and so forth. Governments therefore constantly try to keep giving good news, putting a positive spin on things. That’s why they love big spectaculars, the 100^th anniversary of the country’s founding, the Olympics, the Birthday of the President/Queen, the launch of the first hospital, etc.. Good things, things that make you want to celebrate and feel good about the future. (Also if you feel good, you will re-elect the government…)

Since moods influence our perception of the future so much, it is not surprising to hear that stock prices are sensitive to time. For example, did you know that stock prices move differently on Mondays and in January? Or that they move differently between summer and winter? Yep, not only does time influence trading, the weather influences trading as well. And I was reminded of this when I read a recent paper by Chang, Chen, Chou and Lin in the Journal of Banking and Finance (2008, 32, 1754-1766). These doughty chaps went deeper into the weather and trading relationship to explore how prices moved intra day. In other words, is there a relationship between the prices on the New York Stock Exchange and the weather patterns during the day? As it turns out, yes Sir, there is indeed a relationship. Stock returns are lower on cloudier days. You have more seller initiated trades during market open if the weather is cloudy (akin to your hot water running out?). When the skies are cloudy, the price jumps about much more and does not settle down as much all through the day. There is a ton of research on this topic already, human bio-rhythms do drive trading and economic behaviour.

Strange, no? You normally would not expect the valuation of your pension fund or your mutual fund to be influenced by something as silly as the weather, would you? Especially when the offices these days are all air conditioned, with scientifically calibrated lighting and all the modern conveniences, and so on and so forth. And after all that, you find that those highly paid traders are being impacted by cloud cover? And you call yourself as BSD’s? Pah, buy some umbrellas, you wimps!

(PS: this has nothing to do with investment advice at all, please do not invest based upon this essay)

A million messages per second

I have been researching a wee bit on technology and impact on trading and I came across this rather interesting article about the rate of messages on market data. I quote:

Broader institutional participation, increased volatility, advancements in technology, remote market making, and regulatory changes are driving options quote volumes to higher and higher peaks. The six options exchanges in the U.S send their quote data to the Options Price Reporting Authority, which merges it into one feed and pushes it out to the market. During periods of heavy market activity, Opra sends out as many as 300,000 messages per second, far above what was seen just a few years ago.
To stay ahead of the curve, Opra has repeatedly advised the industry to boost its capacity to receive these market data messages. At the beginning of 2007, the required capacity level set by Opra was 359,000 messages per second. At the beginning of 2008, Opra had increased that level to 701,000 messages per second, and it is targeting 907,000 by the middle of 2008.

If you are interested in risk management (market, credit, operational and legal as well), do sign up to this site, very useful indeed.

All this to be taken with a grain of piquant salt!!!

Converts and FX both heading for record volumes

Ha!, fun times are here again and as you can see, all the world's investors are rushing to protect themselves. Both the convertible and FX volumes are through the roof! I quote:

ICAP, the world’s premier interdealer broker, announced on Tuesday that average daily electronic broking volumes in spot foreign exchange had reached an all time high of $244.6 billion in November. This represents an increase of 61 percent on November 2006 ($151.5 billion) and compares to the previous record of $241.5 billion per day achieved in August 2007.

New issues of convertible bonds have surged to record levels this year, with volumes accelerating sharply since the start of the credit crisis as investors seek the safety of an instrument that is used more widely in volatile markets. Convertible bonds are protected on the down side because they guarantee a fixed rate of interest, while at the same time can be swapped into the issuing company’s shares. Nearly $170bn in convertible bonds have been issued this year – a record for the first 11 months of a year, according to Dealogic, the data provider. The figure is also close to surpassing the record-breaking full year of 2003, when volumes hit $172bn

All this to be taken with a grain of piquant salt!!!

Do big banks need more capital?

See this article from Risk Centre. I quote:

With all due respect to the Nout Wellink and the other members of the BCBS, we do not believe that the implementation of the Basel II proposal or anything that looks remotely like it would have alleviated the ongoing collapse of the market for complex structured assets. When an entire asset class literally dies in a matter of weeks, the risk is infinite. To us, measuring the liquidity or market risk of a Structured Investment Vehicle ("SIV"), with or without the Basel II framework, makes about as much sense as using statistics to predict corporate credit defaults.

Remember too that most of Basel II is based upon the very quantitative models and rating agency methods which caused the subprime crisis, thus offers of assistance from Basel II's creators within the BCBS should be viewed with caution. Basel II merely mimics the business processes of the Sell Side investment houses, systems which are intended first to enable new financial transactions and, as a secondary matter, manage the risk.

Without going into too much detail, I agree with the above sentiments. You see, I have a slightly different perspective on this. Based upon my previous research on extreme events, I am firmly of the belief that the relationships between various factors in these extreme events becomes dramatically non-linear in nature.

So a structure such as Basel II which relies on linear modeling to provide an indication of risk capital is ok for stable, linearly correlated markets but fails miserably when it moves into the fat tails. If you just look at the investment banks, they are taking billions of dollars in losses. My question, if you still are quibbling about it, why did the risk management models not pick up this problem?

Now the fact that the risk management models did not pick up the sub-prime mess leads me to wonder whether it makes sense to provide estimates of capital adequacy based upon these very same risk management models? No Sir.

The answer is that the banks need MORE capital, not less capital. More capital has the downside of implied opportunity cost, less capital has the downside of shaking the entire financial system through systemic risk. If I was a central banker, I would take a hard close look at Basel II.

Technorati Tags: corporate Governance , financial institutions , financial markets , market risk , credit risk , operational risk

Managing VaR at a time of liquidity and volatility problems

Value at Risk – the dangers within

The Bank of England warned earlier this year about the propensity of banks to rely on Value at Risk (VaR) models to manage and guide them on risks. We have been here before, for example during the 1990’s Russian Crisis. Almost exactly the same thing happened, at least on the market side. The was a liquidity crunch as everybody rushed to the exit at the same time.

When everybody rushes to the exit at the same time, one side of the bargain (the buy bit) disappears, and therefore the price formation process is seriously out of whack. When that happens, even small movements in price can and do influence volatility and correlations disproportionately.

Now usually, you are ok to measure your VaR at daily intervals and you don’t update your correlation matrices more than weekly (if you are extremely particular, generally, you can go for 3 months without needing to change, market micro-structures do not change that fast). But as we know, markets have fat tails. Extreme events happen at a far greater frequency than what your normal distribution will suggest.

Consequently, what your VaR numbers will be telling you will not be an accurate reflection of the actual situation. In other words, these numbers tell you the risk that you are carrying. But if you decide to act on that risk number, you will find that the market does not support the consequent decision because there is simply nobody out there to offload your risk to. If nobody wants to purchase your debt or paper, then what are you going to do? You simply suck it up. Or you pray to the great gods of the central banks to provide you with some liquidity.

There is another problem and I quote from the FT article:

In the current environment, no bank chief executive who hopes to hang on to that job can afford to give regulators or shareholders the impression that they are being cavalier about risk. And since VAR is often used to define what level of margins – or financial buffers – are set against trades, some banks are doubly keen to cut VAR, to reduce pressure on their own balance sheets.

But as the banks embark on this task, some are finding themselves caught in an unpleasant trap. The easiest way to reduce a risk exposure is to sell risky assets, such as risky loans. In recent weeks, many banks have been trying to do precisely that.

But these sales have been occurring on such a large scale that they have pushed up market volatility. Thus, measured VAR has risen, exactly as the Bank warned all those months ago.

One big investment bank has recently analysed the impact of its own recent asset sales. These suggest that while these sales should have cut VAR by half in recent weeks on constant volatility levels, in practice this gain was more than wiped out by ensuring market price swings.

By scurrying to reduce risk, in other words, the banks may end up simply running to stand still.

The only way to resolve this is by having stringent stress testing or scenario analysis running. But very few banks that I know of have management trip wires or even have management who take action based upon these stress scenario’s. But all I can predict at this moment is that we will again have this issue. See my previous post on Carnegie as an example.

All this to be taken with a grain of piquant salt!!!

Ignore Risk Management at your peril, your entire bank might be at risk

Here we go again, now Carnegie, the Swedish investment bank, is being pummelled by the markets and country, for having completely mucked up its risk management, allowed traders to run amok and ended up with huge losses. 200 years of pristine reputation, clean and transparent firm, all firmly driven into the toilet.

How many times have we seen this? Risk management underinvestment and then traders take wrong posititions or mis vale or mark to model or something like that and then it blows up, usually bringing down the very management who did not pay money or attention to their risk management systems.

After thinking about it for 2 seconds, I came up with some questions arise which I would ask to the CEO

1. Who does the chief risk officer report to? If the CEO with NO dotted lines, then fine. If there are any dotted lines or matrix management, then there is a disaster waiting to happen. This is applicable to market, credit, ops, liquidity risk

2. Are each division's capital allocated based upon risk?

3. Do you match the divisional RoE with their P &L? On a monthly basis?

4. How do you base your bonus pool allocations? On revenue or adjusted risk levels?

5. Who develops your risk scenario's? How often do you do war gaming? Do your head of trading attend? What is your definition of comfort values?

6. Why are you not making your divisional risk and RoE transparent?

7. What is your investment in IT? What is the ratio of risk investments to trading investments? If less than 20 percent, why?

8. When was the last time you had an independent risk and trading systems audit? And seen the results? And acted upon them? And reviewed them? And fired somebody for not following them?

9. Where does product control fit it? Do they report to trading or risk heads?

10. Who is looking after your model risk? Do you know the stress scenario results? Under what circumstances do they fail? Negative interest rates? Liquidity risk? Spreads very wide? Exchange stops trading? A dr death scenario?

But I am afraid this will happen again and again and again, people just do not listen and short term profits will again overwhelm the risk manager's warnings. And then the bank will again drop into the muck!

All this to be taken with a grain of piquant salt!!!

Northern Rock - shutting the door after the horse has bolted

In the old days, you and I will get together, plonk some money into the cooperative building society as our deposits. Then Mr. X will come to ask for a mortgage and the building society will give him our deposit money. X will repay the money back to the building society at the mortgage rate and the society will give us a savings interest rate which is lower than the mortgage rate obviously. Now, sometimes it would happen that there wouldn't be sufficient deposits coming in from individuals so the society can approach other banks to give some money to the society. The society does not want to turn away borrowers, after all. And in the fullness of time, the lending from the other banks will be covered by other deposits and repayments, and life was good, simple, easy, low risk and fun.

Ok, so the basic problem with Northern Rock was that it was funding its mortgage lending through the wholesale markets rather than mainly through its deposit base. And when the market understood that there was far too much exposure to the wholesale markets compared to the deposit base, the market said, your business is too risky and we cannot lend our depositors money to you as we are not sure you can repay it back. In other words, there was a liquidity problem!

Now this is something that the Financial Services Authority is supposed to track and warn financial institutions if they are going to go off. Well, we know what happened, it all went potty and nobody knows who was responsible for this gruesome mess.

Guess what the FT is reporting now? I quote:

The Financial Services Authority has sent a comprehensive one-off liquidity questionnaire to all banks and building societies asking for details of how they plan to fund future mortgage commitments.
The spreadsheet is designed to pinpoint future problems among mortgage lenders – particularly if the capital markets in effect remain closed for the foreseeable future.
The FSA has asked lenders to give details of their current pipeline of home loans commitments to the end of the year, as well as how much funding they have from the capital markets.It also asks how often the lenders have monitored their liquidity position.
It also wants to know what management actions have been considered as well as what contingency planning is in place. In addition, it also asks lenders what other sources of funding they have.

All very good and nice to know. But very curiously, why NOW? what was it doing before when the credit crisis was in full flow? Or even before when the signals were flashing high and spreads were widening even further than normal?

Technorati Tags: Financial Markets , Credit Risk , Market Risk , Liquidity Risk , Financial Institutions , UK

Do Banks Overstate their Value-at-Risk?

The answer seems to be yes, at least when we are talking about Canadian Banks according to this manuscript. And the reason that the researchers give is that the banks are extra cautious in reporting their VaR's. That is totally understandable as nobody wants to play around with extreme events.

But more importantly, what they are reporting is that the banks are not fully measuring their diversification benefits from various products, regions, functions and risk categories. This is not surprising. Aggregating and collecting data across large banks is a gigantic task and for this to happen on a daily basis is incredibly difficult if not time consuming.

Despite increases in IT technology, hard disk and performance, grid computing, usage of bootstrapping, time series and other statistical techniques, we are still not at the age that every transaction can be captured, matrixed (algebra that is), correlations determined, risk factors updated and then overall VaR calculated is way away still. This is why the authors might have gotten better results if they had measured the monthly var rather than a daily var, but there you go!

Christophe Perignon, Zi Yin Deng and Zhi Jun Wang,
Do Banks Overstate their Value-at-Risk?,
Journal of Banking & Finance,
In Press, Accepted Manuscript, Available online 4 September 2007
Abstract:
This paper is the first empirical study of banks’ risk management systems based on nonanonymous daily
Value-at-Risk (VaR) and profit-and-loss data. Using actual data from the six largest Canadian commercial
banks, we uncover evidence that banks exhibit a systematic excess of conservatism in their VaR estimates.
The data used in this paper have been extracted from the banks’ annual reports using an innovative
Matlab-based data extraction method. Out of the 7,354 trading days analyzed in this study, there are only
two exceptions, i.e., days when the actual loss exceeds the disclosed VaR, whereas the expected number
of exceptions with a 99% VaR is 74. For each sample bank, we extract from historical VaRs a risk-overstatement
coefficient, ranging between 19% and 79%. We attribute VaR overstatement to several factors, including extreme
 cautiousness and underestimation of diversification effects when aggregating VaRs across business lines
and/or risk categories. We also discuss the economic and social cost of reporting inflated VaRs.

All this to be taken with a grain of piquant salt!!!