Risk Management and Hedge Funds Barry Schachter
Outline of My Remarks <ul><li>The Crisis as Microscope </li></ul><ul><li>Risk Measurement as Epistemology </li></ul><ul><l...
The Crisis as Microscope <ul><li>What is on the slide: </li></ul><ul><ul><li>Large losses and firm failures </li></ul></ul...
False Explanations Have Diverted Useful Discourse <ul><li>Errors of fact </li></ul><ul><ul><li>“ Risk-management models us...
Six Failures, but also Six Aspects of Reality <ul><li>“ Six Ways Companies Mismanage Risk” (Rene Stulz,  HBR  (March 2009)...
Explanation Requires Paradigm Shift  from Static to Dynamic <ul><li>Firms pursue idiosyncratic strategies with the goal of...
Network Dynamics and Risk Management <ul><li>Large price moves can follow shocks of any size (if the network exhibits self...
 
The Spread of the Credit Crisis:  View from a Stock Correlation Networ k Reginald D. Smith (Feb ’09) Rethinking the Financ...
Risk Measurement as Epistemology <ul><li>What do we want to know? </li></ul><ul><li>“ Ipsa scientia potestas est” (Bacon (...
Measurement <ul><li>Value at Risk </li></ul><ul><ul><li>VaR and GiGo </li></ul></ul><ul><ul><li>VaR and “everyday” vs. “ab...
Measurement <ul><li>Stress Testing – Placebo, Parasite, or Panacea? </li></ul><ul><li>The ever-growing love affair with sc...
Measurement <ul><li>What are we doing wrong? </li></ul><ul><ul><ul><li>Confusing calculation with measurement </li></ul></...
Risk Management – Form <ul><li>The independent risk function </li></ul><ul><ul><li>The good and bad of the idea </li></ul>...
Risk Management - Substance <ul><li>The way it works is more important than what it looks like. </li></ul><ul><ul><li>Wher...
Risk Management - Substance <ul><li>Enormous variation in risk management adaptations in hedge funds (compared to banks) <...
Future Direction <ul><li>Better VaR or Stress Testing is not an answer </li></ul><ul><li>Understanding and modeling networ...
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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.

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  • 18 countries with the nodes scaled in proportion to total external financial stocks, while the thickness of the links between nodes is proportional to bilateral external financial stocks relative to GDP.
  • Transcript of "Risk Management and Hedge Funds"

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