Risk Management and Hedge FundsBarry Schachter

Outline of My Remarks

• The Crisis as Microscope• Risk Measurement as

Epistemology• Risk Management – Form • Risk Management – Substance• Future Direction

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

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

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;

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

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

The Spread of the Credit Crisis: View from a Stock

Correlation Network Reginald D. Smith (Feb ’09)

Rethinking the Financial Network

Andrew Haldane (Apr ‘09)

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))

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

Measurement

• Stress Testing – Placebo, Parasite, or Panacea?

• The ever-growing love affair with scenario stress tests; why?

• Limits to inductive reasoning (Hume’s problem)

• Economic scenarios and “reverse” stress tests have big problems– Ill-posed and ill-conditioned

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

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

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

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

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