Do you believe in safe sex? I know I don't.
If sex is safe, then it isn't sex at all.
I have not spent years impaling men with the spike of my stiletto in the boardroom and on the trading floor, only to wrap them (or myself) in various layers of emotional and physical protection when it comes to the bedroom or the kitchen floor.
This is not to say that I would seduce the VP of Compliance in my office without closing the door first. Just that by insisting on 100% safety, you might as well also insist on 0% excitement. After all, it's the VP of Non-Compliance I am more interested in seducing.
The same is unfortunately true of financial investment. It is hard to enjoy a position of potential reward without accepting a position of risk. And, to make matters worse, the existence (if not the quantum) of the risk will be certain, whereas the reward will not be.
The story of the last few years has been the temporary creation of a financial la-la land where investment bankers convinced the credit rating agencies and half the world's investors that with structured investment products like collateralised debt obligations ("CDOs") you could have return without an equal level of risk.
The story of the last few months is a brutal reminder that you can't.
So what is "risk" when it comes to business and financial instruments? How is risk measured and, perhaps most importantly of all, how is it mitigated?
What is risk?
Financial investment is all about having an opinion on something and then having the courage (and the capital) to take up an advanced financial position in support of that opinion and then hope that the market vindicates your view and rewards you.
So, by example, if you think that interest rates are likely to fall over the next year, as central banks act to alleviate the dangers of recession, you will also think that the price of existing bonds will rise as their fixed rates of interest will become relatively more attractive compared to the lower rates that will then be on offer from the issuance of new bonds. (Golden Rule: interest rates down = bond prices up.) So you will buy bonds and hope that interest rates fall.
Risk is the possibility that some extraneous event will intervene to spoil your plan and worsen your position, rendering you, and all those who depend on you "buggered" (not a technical term that needs any explanation). Like the risk the janitor will enter your office without knocking while you are seducing the VP of Compliance - even if you shut the door.
For example, interest rates might not fall. The recession might correct itself. The fear of inflation might be greater. Whichever bank you deposit your bonds for safe custody might burn down, someone might crash their 4 x 4 into you on the way to said bank, Gordon Brown might nationalise the bank (or you for that matter), aliens might land, the world might end, and so forth.
So risk is bad, right?
It is the uncertainty that stems from risk that means assets are priced at discounts to their true or later value, offering you the chance of a return. Most people know already that interest rates are likely to fall, so a good proportion of the effect this will have on future bond prices is already priced in today, illustrated in the so-called 'yield curve' - a plot of future interest rates and bond prices.
But the likelihood of falling interest rates is not fully priced into bonds, because nothing is certain. So if you bet on falling interest rates, and therefore accept a degree of uncertainty and its attendant risk, you will be rewarded if interest rates do, in actuality, fall.
An investor therefore needs to seek out risk to seek out return. Above-market returns or "alpha" will only arise from accepting above-market risks. The key is to know what they are, so you can match greater or lesser risk with a mirror of greater or lesser return.
What risks are out there?
Well, for starters, the risk of Gordon Brown nationalising things is present and very real. The risk of aliens landing less so, although I bet if they did land, our great leader would soon invent a little green man tax or appoint a career civil servant to take charge of their space ship.
But I digress...
Risk is not just one big ocean of risk. It is made up of separate currents and in order to measure risk and price it into your position, let alone mitigate it, you need to distil it into its constituent parts.
And there are lots of risks...
There is credit risk and market risk and systemic risk and counter-party risk and interest rate risk and environmental risk and political risk and many more besides. ('Janitus Interruptus' was always a risk in my office liaisons when the cleaner was wandering about).
Some risks are hard-wired. By definition investing in equity is more risky than lending debt as equity is only worth something after all debts are met. Debt 'ranks' before equity in the order of repayment and so is less risky.
Investing in small, early stage companies with little history and little capital is more risky than investing in large established companies with big balance sheets and lots of assets.
Investing in emerging markets is generally accepted as being more risky than investing in the developed world. Why? Because emerging markets are less established and less liquid. There are fewer market participants. Prices are more volatile with little historic precedent. Plus there are greater risks from physical threats, the harsher environment and lawlessness.
How risky is holding cash? You would think it would it be riskless. But it isn't. There is the risk of inflation eroding its purchasing power. And there is a form of risk in loss of opportunity because cash does not offer a return. There is the physical risk that it will be stolen.
Pretty soon it is easy to see risks everywhere. How do you make sense of them?
The bottom line is it's very hard to measure risk. Risk represents the sum of uncertainty, so by definition, if risk could be truly quantified, it would be not be risk at all.
Most risk measurement models rely on the statistical analysis of past events to predict the likelihood of future outcomes. Their practitioners feed them with millions of items of data from history and then 'run' them a million times to plot the probability of any combination of events occurring in the future.
These models usually lead to a normal distribution diagram - the infamous upside down bell curve with the mean and median in the middle of the bell and tails of increasingly unlikely outcomes either side of it.
So the chances of future events occurring in the middle of the bell are high, whereas the chances of them occurring at the tails are low. Using standard deviation techniques the probability of any particular outcome can be predicted in terms of deviations from the mean, leading to the expression of VAR - "value at risk". For example, we are 99% confident we will never lose more than 10% of your investment.
As soon as risk is quantified it can be priced by a lender, borrower, or investor in a transaction. The price is expressed in a risk premia - usually an interest rate or discount rate. The greater the risk borne by a lender or investor the greater will be their demand for a higher interest rate or a bigger discount to compensate.
The crescendo of increasing risk inherent in different debt instruments is expressed in ever greater interest rates or 'spreads'. The safest of all bonds are government bonds. In the UK, they are known as 'gilts' and in the US as Treasury or T bills.
Next come the banks (in pre-credit crunch days at least). The rate at which the Central Bank (in the UK the Bank of England) is willing to lend to the commercial banks is known as the 'Base Rate', whereas the interest rate at which those banks are willing to lend to each other is called LIBOR - the London Interbank Offered Rate.
The difference between the two rates is known as a 'spread' and is expressed in hundredths of a percent. So if base rate is 4.5% and LIBOR is 5%, the spread is 50 basis points or bps (pronounced 'bips').
The relative riskiness of equities over debt is expressed in the market risk premium ('MRP') in the Capital Asset Pricing Model ('CAPM') used to calculate the "price" of equity.
When valuing a company or other asset, the relative riskiness of future cashflows versus present-day cashflows is expressed in the discount rate used to reflect the time value of money to calculate their Net Present Value ("NPV"). This basically says that cashflows derived today are worth more than the same cashflows derived in the future. This is because future cashflows cannot be invested elsewhere until they accrue, their value could be eroded by inflation and there is a risk they might not materialise at all. Therefore in a discounted cashflow ("DCF") model, future cashflows are collapsed into their present day equivalent by applying a discount rate to them.
In the lead up to the credit crunch, investment bankers thought they had invented magic tricks to reduce risk by pooling together assets and then slicing them up again. They pooled together mortgages, credit card debts, and other loans and then separated them out again, wrapping together tranches of debt to represent magnitudes of risk and then dicing them into bonds. The uppermost tranches received AAA credit ratings from agencies like Standard and Poor and Moodys. The ratings were warranties that their credit worthiness was good and the bonds were very low in risk.
The great majority of this debt was mortgages lent to sub-prime borrowers in the United States. The ratings said their credit worthiness was good.
However, as interest rates rose to combat inflation, the lax credit terms offered to these poor homesteaders were exposed. They started to default and revealed the flaws in the credit ratings normal distribution models, assembled during the years of plenty.
1. Most risk management models are built during times of economic confidence. Buoyed by the mood of an upwards-moving market it is easy to under-estimate the risk discounts in a model by a few hundredths here and there. Each one modular entry on their own is small. Taken together, they add up to a lot.
2. A normal distribution is just that - a distribution of normal events. But risk management is not about anticipating times of normality. When the financial world is blowing up, markets will not behave normally. In the globalised integrated inter-dependent inextricably linked financial system, every market drives each other as never before, and the risk management models could not predict the effect of a tsunami of risks all washing over the world at the same time.
3. Moreover, many of the financial products that have caused all the recent trouble are new, and not enough people understood them. This unfortunately included the credit ratings agencies who tended to mis-apply their tried and tested techniques. CDOs are not companies the like of which the credit rating agencies were used to evaluating. It is impossible to assess the quality of management, the history, the cultural resilience of a structured investment vehicle ("SIV") because it does not have any. It is a made-up entity, a financial hologram, designed purely to obfuscate credit risk. It certainly fooled the rating agencies.
Can risk be mitigated? Historically, investors would answer 'yes' to this question and suggest that diversification reduces risk. The rules of diversification were 'don't put all your money in the same company / industry / stock market / asset class / country etc'.
It is true, diversification does mitigate risk, however, in a globalised economy it is becoming increasingly impossible to diversify and find asset classes that are decoupled from the wider economic system.
Increasingly, the only way to mitigate risk is to not to make a loss in the first place and be a genuine expert in whatever it is you are investing.
Investing in diamond mines in Sierra Leone is inherently very risky. War could return to the region, your miners might get shot by local war-lords or starve due to famine, or Gordon Brown might come along and nationalise the mine. (Sorry, I meant the Sierra Leone government might). However, all these risks reduce (slightly) if you were born in Sierra Leone and are the son of a former warlord or similar. You will have local knowledge, you will speak the language and will probably be on first-bribe terms with government officials.
So it is with investing in a company, or a property or anything. The more you become an expert in it, the more you will understand the fundamentals that drive its value. In this way, you will not be caught out like the fund managers who invested in CDOs and believed the claims of the investment bankers that sold them that they simply by cutting the risk cake into different slices, the total quantum of the cake had been reduced.
So don't avoid risk. Instead you should learn to love it. I might even turn my charms towards the janitor himself one night. He is a handsome man and at least he knows how to clean up afterwards.
Risks and their mitigants
Credit risk - credit risk exists wherever there is a lender / borrower relationship and is the risk that the borrower will not pay back the lender in full and on time. A credit relationship usually consists of three elements: repayment of principal, payment of interest and lodgement of security. The payment of principal and repayment of interest obviously have a quantum and a timetable attached to them, so credit risk is the chance that the borrower will not keep to the timetable of payments, or default completely. Credit risk is / was thought to be mitigated by Credit Default Swaps - see below...
Counter-party risk - counter-party risk exists in non-settled positions where two parties have bet on something, commonly via derivatives. The great flood of financial products over the past few years has been principally in derivatives - options and swaps where two parties can make a bet without actually buying or selling an underlying asset. Counter-party risk exists because even if you win your bet, there is a risk that the other side might not be around to pay up - in other words, the bookie might go bust.
Market risk - market risk is the risk that the whole market pulls your position down with it, without anything specific happening to the underlying company, asset, commodity etc that you took your position in. If you buy the shares of a large FTSE100 company, like Vodafone for example, you will see that Vodafone shares often rise and fall each day with the general tide of the FTSE100, irrespective of whether anything is happening inside Vodafone itself or within the telecoms market. It is simply a barometer of the overall weather of facing all large companies. Market risk is hard to mitigate. The only way is to bet on another uncorrelated market, and in the modern world, there aren't any.
Interest rate risk - any party to a credit arrangement will have interest rate risk. This is the risk that while you owe or are owed money at a certain rate of interest, general interest rates might move up or down to make the rate you are paying or receiving less attractive. It is interest rate risk that partly caused the downfall of Northern Rock. They borrowed short and lent long, relaying on the historic generalisation that short term interest rates are lower than long term rates. The credit crunch inverted this rule and meant that The Rock's business model soon crumbled to dust. Interest rate risk can be mitigated with an interest rate swap ("IRS").
Political risk - political risk is the risk that the government will come along with some new legislation that supersedes your economic position. Changes in tax law infuriate all businesses because they negate years of planning and economic organisation. It is hard to mitigate political risk, which is why investors are cautious of investing in any country prey to political instability, and why shares tend to fall before a budget and rise after one (the flow and ebb of the tide of the uncertainty).
Environmental - environmental risk is a physical risk whereby an asset that you own might be harmed by fire, flood or pollution or similar. It would not be a good idea to build that baby-food factory next to that nuclear waste processing plant, now would it? Environmental risk can be mitigated by insurance. Farmers can buy weather futures to mitigate against the risk of a poor crop.
FX - foreign exchange risk is a risk that arises from doing business in a foreign currency. Even if you make a profit on an underlying transaction, you will lose money if your home currency falls by a proportionately greater amount. You can mitigate this risk with a currency swap.
And introducing the Daddy of all risks...
Systemic risk - systemic risk is the most scary risk of all, short of all-out global thermonuclear war or a Gordon Brown election win. It is the risk that all markets tank at the same time. Systemic risk has become much more real in an era of globalisation and near-perfect information. It is now accepted that it is very difficult to diversify because markets are inter-connected and tend to move in tandem.
Perhaps the greatest systemic risk faced today by the financial system arises from 'CDSs' - Credit Default Swaps. CDSs insure a creditor against default by a borrower, so they themselves are meant to be risk mitigators. However, like all insurance policies, they will only pay out if the insurer survives the insured event. CDSs unlike real life insurance don't have to be held by parties privy to the underlying assets. So anyone can buy or write CDSs irrespective of whether they are a borrower or a lender. Due to this, they have ceased to be insurance polices and devices of risk mitigation. Rather they have become instruments of speculation. This has led to the phenomena of there being more CDSs in issue than the value of the overall world economy. The possibility is that when one tranche of CDSs gets triggered, they will bankrupt their issuer, and so on, until all CDSs are triggered in a domino effect.
We don't want to worry you, but $300 billion of CDSs linked to Lehman's bankruptcy fall due for settlement soon. Now, who is holding those? Come on, own up....