Risk Management and Hedge Funds

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A discussion of risk lessons learned from the financial crisis. I argue that the public debate on risk management failures is mis-focused, and I propose an alternative paradigm for identifying the challenges to effective risk management and for directing future efforts to increase the effectiveness of risk management.

Transcript of Risk Management and Hedge Funds

  • 1.
  • 2. Risk Management and Hedge Funds Barry Schachter
  • 3. Outline of My Remarks
    • The Crisis as Microscope
    • Risk Measurement as Epistemology
    • Risk Management Form
    • Risk Management Substance
    • Future Direction
  • 4. The Crisis as Microscope
    • What is on the slide:
      • Large losses and firm failures
      • Losses exceeding risk estimates
      • Changes in some prices exceeding historical experience
      • Cascades in price moves across unrelated markets
      • Forced liquidation of portfolios
      • Rapid shift in investor sentiment/behavior
    • Interpreting the evidence
  • 5. False Explanations Have Diverted Useful Discourse
    • Errors of fact
      • Risk-management models used in banks were generally based on the simplified assumption that markets fluctuated randomly following a normal statistical distribution. This implied very low probabilities of extreme losses, ignoring financial history. Shahid Chaudhri and Richard Griffiths, The Times (London), March 9, 2009
    • Post Hoc fallacy
    • 20-20 Hindsight fallacy
  • 6. Six Failures, but also Six Aspects of Reality
    • Six Ways Companies Mismanage Risk (Rene Stulz, HBR (March 2009)
      • Relying on historical data;
      • Focusing on narrow measures;
      • Overlooking knowable risks;
      • Overlooking concealed risks;
      • Failing to communicate;
      • Not managing in real time;
  • 7. Explanation Requires Paradigm Shift from Static to Dynamic
    • Firms pursue idiosyncratic strategies with the goal of survival, and the practice of risk management is one adaptation in pursuit of that goal
    • Firms interact strategically with each other and adapt to changes market macro-dynamics (which itself is an outcome of those interactions)
    • Risk management failures are either (a) contributors to positive feedback or (b) ill-fit adaptations in the given market environment
  • 8. Network Dynamics and Risk Management
    • Large price moves can follow shocks of any size (if the network exhibits self-organized criticality)
    • Price shocks can cascade to apparently unrelated markets rapidly (depending on network connectedness and average degrees of separation)
    • Large price changes can be much more common than a normal distribution would suggest (if price changes follow a power law)
    • Disequilibrium states are more common than equilibrium states (and equilibrium states may be unstable)
    • Risk Management practices can contribute to network fragility
  • 9.
  • 10. The Spread of the Credit Crisis: View from a Stock Correlation Networ k Reginald D. Smith (Feb 09) Rethinking the Financial Network Andrew Haldane (Apr 09)
  • 11. Risk Measurement as Epistemology
    • What do we want to know?
    • Ipsa scientia potestas est (Bacon (1597))
    • What can be known (objectively)? We have...to content ourselves with partial knowledge knowledge mingled with ignorance, producing doubt. (Jevons (1877)) Our knowledge can only be finite, while our ignorance must necessarily be infinite. (Popper (1963))
  • 12. Measurement
    • Value at Risk
      • VaR and GiGo
      • VaR and everyday vs. abnormal markets
      • A few thoughts on MeasureRisk and RiskMetrics HedgePlatform hedge fund risk aggregators
        • Aggregation is useful, but drill-down is essential
        • Many hidden assumptions between position info and risk
  • 13. Measurement
    • Stress Testing Placebo, Parasite, or Panacea?
    • The ever-growing love affair with scenario stress tests; why?
    • Limits to inductive reasoning (Humes problem)
    • Economic scenarios and reverse stress tests have big problems
      • Ill-posed and ill-conditioned
  • 14. Measurement
    • What are we doing wrong?
        • Confusing calculation with measurement
        • Confusing statistics with sufficient statistics
        • Failing to incorporate macrodynamics into measurement (implicitly adopting a static or equilibrium world view)
        • Segue: confusing measurement with management
  • 15. Risk Management Form
    • The independent risk function
      • The good and bad of the idea
    • The importance of variation in form
      • Creative destruction, evolution, fitness
      • Risk management is a feature, an adaptation
  • 16. Risk Management - Substance
    • The way it works is more important than what it looks like.
      • Where the authority/responsibility lives (governance)
      • How the incentives are structured
      • How information flows
  • 17. Risk Management - Substance
    • Enormous variation in risk management adaptations in hedge funds (compared to banks)
    • The idea of independent risk management in HFs is mostly a fiction
    • Few HF CROs are key decision makers
  • 18. Future Direction
    • Better VaR or Stress Testing is not an answer
    • Understanding and modeling network risk
    • Qualitative or quantitative techniques for managing network risk (not just for normal accidents, but every day decisions)
    • Rethinking independent risk management from the desired end result