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See Nothing, Hear Nothing, Know Nothing - How much do senior management need to understand of the models being used?
Posted on 29-06-2009 | 0 comments
This can operate on a number of levels:
First, there needs to be an understanding of the questions that the model is trying to answer and their fundamental ramifications for the firm’s business model. For example, if the model is being used to calculate 1-yr VaR based on market-consistent asset and liability values, this might mean that pricing products at a sub-market-consistent-level is suddenly going to start looking untenable. So this needs to be joined up with the way the firm more broadly measures value creation, and there may be a need to recognize that previous practices of, say, managing to GAAP accounting rules may not perform well from a more economically coherent basis.
Second, banks and insurance groups are holding and writing complex products with complex market/credit risk profiles. There has to be some deep technical understanding of these complexities at a very senior level in order to effectively and responsibly manage the business.
Third, senior management don’t need to be quants. But they need to have an awareness of the fundamental limitations of the models that are being employed by the firm in internal, regulatory capital and financial reporting applications. There needs to be an appreciation of what the models leave behind; that financial modeling always has model risk; that calibration is far from an exact science. And that these limitations may create perverse incentives for their people that may conflict with what’s in the long-term interests of the firm .
The collapse of commodity prices - is anybody listening?
Posted on 23-06-2009 | 0 comments
In March 2007 the Financial Services Authority published a report entitled ‘Growth in commodity investment’ in which they state:
‘...this [commodity] boom has mainly been caused by dramatic growth in demand (particularly from the rapidly developing economies of China and India); i.e. it is underpinned by what seem to be long-lasting fundamentals. It is widely stated that institutional investors will stay for the long term’.
Writing two years later, this assertion seems somewhat void. The FSA and others with ill-conceived perceptions of the safety and diversifying properties of commodities were proven wrong. We have seen it all before.
S&P GSCI Excess returns indices (semi-log scale)
Data Source: Bloomberg derived
Managing your risks is never easy. Recent analysis at Barrie & Hibbert in the light of developments in commodity prices in 2008 concludes that there are three important lessons worth highlighting:
- Neither empirical evidence nor economic theory conclusively demonstrate that a risk premium is, or should, be earned on commodity investments over the long term.
- In the short term and during periods of wider market stress commodity investments may not prove to be a good hedge.
- The volatility of returns on commodities can be highly unstable over the short and medium term. Economic downturns are often related to volatile commodity markets.
Read more in our Model Insights report ‘Lessons for commodity investors’ by H. Hibbert, June 2009.