Forethought Risk

Integrating the blog with the website

2011-04-10T15:03:00.002-04:00

I have moved the blog to the website
I am hoping to increase production and continue to provide insight on a more regular basis.
Please have a look at the website and provide feedback - it can only help me improve

Moving Forward from the Financial Crisis

2011-01-24T03:01:00.002-05:00

The Society of Actuaries risk management section is publishing a collection of essays on Systemic Risk, Financial Reform, and Moving Forward from the Financial Crisis and my essay on Actuaries and Assumptions is included.

I discuss the general difference between historically-based probabilistic assumptions and economic optimization assumptions. The point being that in cases where economic optimization can rationally be chosen by an economic agent, we should factor that in to actuarial models rather than using historical usage rates.

I would be interested in comments or questions at jj@forethoughtrisk.com

Equities - Canada vs Global

2010-12-15T17:07:00.002-05:00

I will be participating in an online debate on Canadian equities versus Global equities - what will provide superior returns and risk-adjusted returns over the next few years?
The debate is organized by the Canadian Investment Review and can be found here (I believe only members can access the debate)
Log-in, have a look and comment on the debate!

Japan - the new new QE

2010-11-08T11:45:00.002-05:00

With the US embarking on QE2, it may be instructive to observe Japan's experience, whether or not one believes that the US faces similar macro issues to Japan.

Japan is an economy in deflation, a situation which has lasted the better part of 15 years. For many years Japan subsidized its exports by printing money to buy Treasuries and maintaining a relatively weak Yen but when 2008 hit and all hell broke loose, so did the Yen. And there is nothing worse than an economy in deflation with an appreciating currency. Bring on QE4.0 Japanese style: buy REITs.

What does this mean?
It lends support to real estate in Japan

So how does that help?
If real estate remains stable or actually appreciates then the consumer will feel richer potentially enticing them to spend today rather than wait for goods to get cheaper tomorrow due to deflation.

Will this work?
Unlikely - if we focus on demographics, Japan's population has been shrinking since 2007 (see Wikipedia listing under Demographics of Japan) with fewer births than deaths and no net immigration. This despite one of the longest average life expectancies in the world at 81.25. Think about it: will a more valuable piece of real estate entice older Japanese to spend more readily?

The US should take note, however, and observe how Japan plays out. If this succeeds it may be the trump card Ben Bernanke is looking for.

What is the risky decision?

2010-10-27T09:05:00.002-04:00

We often evaluate decision-making risk relative to status quo as opposed to overall risk and I find this problematic. We assume that the status quo is our risk benchmark and that may be incorrect. And defined benefit plans are the perfect example.

Pension fund managers and trustees think of Liability-Driven Investing (LDI) as a risky decision: rates are low and equity markets are still 30% off their highs (at least in the US), and converting some equity holdings to fixed income would be a foolish decision, they claim. Although I personally think rates are lower than they should be, the context of the decision is where I have an issue. Those making the claim assume that the risky decision is to engage is risk mitigation, since historic wisdom suggested that a 60/40 equity to fixed ioncome ratio is appropriate. What they should be aware of, however, is that the current asset mix is an active bet that equities will outperform fixed income. And there is risk in maintaining that mix.

Risk-based Premia

2010-09-14T14:21:00.002-04:00

After a few spectacular failures (Nortel, GM) the pension world is not the wonderland it used to be. Both employees and regulators should consider the safety of their pensions when valuing their personal balance sheet.

As an employee:
Consider the future of your company and the likelihood of its survival. It may encourage you to save more lest you end up getting 60-something cents on the dollar like the Nortel pensioners. Your biggest decision will be when you leave the company - do you take a commuted value and truncate your risk to the pension fund's potential demise or do you retain the pension inside the fund?

As a regulator:
Consider the survival of a company. Use default swaps as a guide. Examine the solvency ratio of the company's pension fund. Consider its asset mix relative to the exposure of its liabilities. What is its net risk exposure? Should a company with matched assets and liabilities and a 105% solvency ratio pay the same PBGF/PBGC (pension benefit guarantee fund/corp) premium as one with a significant mismatch and a 75% solvency ratio? Now that is an easier question to answer than the same one with the second fund also having a 105% solvency ratio....after all the greater mismatch has a wider array of potential solvency ratios one year hence.

Call it risk based charges on the regulator side and employees better managing their credit risk.

Pension Fund Leverage

2010-03-09T06:52:00.003-05:00

Is it only me who cringes when pension funds issue debt or create "special purpose vehicles" (I know I date myself on that last one).
With respect to SPV's, the sense is that pension funds have tremendous internal investment expertise which they can share with the rest of the world. There are 2 issues:

Taking your eye away from your fiduciary duty to pensioners
The obligation to hold the equity piece

Yes, SPV's are a thing of the past, but pension funds issuing debt? And using derivatives to leverage their hedges? The bottom line is that leverage introduces risk and if one cannot justify leverage ex-ante or especially ex-post (after something blows up) then it may not be the right approach for a pension fund.

SEI Survey

2009-12-01T14:19:00.001-05:00

A recent survey by SEI points to over 50% of pension funds moving to some form of Liability Driven Investing (LDI) mandate. Of course, defining that term is an imprecise science with plenty of debate. The range includes the hard-liners like Towers Perrin who advocate a 100% allocation to Fixed Income as part of its definition of LDI to softer versions with some allocation to equities.

To me, it is not about the actual asset allocation, but about education. It is about recognizing that risk emanates from the liability side of the balance sheet, not just the assets of a pension plan. It is about understanding that as a pension fund manager you are de facto short fixed income and likely inflation. These are not easy markets to navigate and the outlook is fairly bifurcated between doomsday prophets and cheerleaders of economic growth. And with respect to fixed income and inflation the picture is as murky as ever.

It is therefore imperative to understand, measure and interpret your risk based on an entire entity not single parts of that entity.

Bill Gross

2009-10-27T08:29:00.000-04:00

Well, how do you like that - Bill Gross singing my tune

Time to take chips off the table

2009-10-27T05:13:00.002-04:00

The panic of early 2009 has receded. Equities have rallied by 50% from the lows. Pension funding ratios are marginally better (corporate bond yields have decreased which means liability values have increased).

Markets feel a bit sluggish here. Some negative technicals have been cropping up.

Time to reduce equity exposure.

Liability driven investing (LDI) is being discussed, but it is not an all or nothing proposition. It is possible to transition to lower equity weights and now is the time to consider doing so.

Pension Risk

2009-10-13T01:41:00.002-04:00

Interesting article on public pensions:

http://www.washingtonpost.com/wp-dyn/content/article/2009/10/10/AR2009101002360.html

I am not sure that ramping up risk is the right solution but it would be in line with the attitude of banks this past decade...if you need to keep up with peers (or in pension case, liabilities) just keep increasing leverage (risk) and if worst comes to worst (it did and likely will again in the case of pensions) government will be there to help out. Certainly with respect to public plans government backing is explicit; it was less so for the banking industry but that did not seem to stop them.

Nortel Pensions

2009-07-29T08:45:00.002-04:00

And now this news piece to add to the murky waters of pensioners as company creditors. Not many employees consider the credit risk of their retirement funds when in a DB plan. A new regime has emerged. Pensioners need to be aware that the bankruptcy of their company may put their pension at risk.

Catch up Strategy

2009-07-24T14:24:00.002-04:00

The gambling credo of doubling down may work for some but I remain fearful for the State of California and the PBGC. See here

Totally irresponsible if you ask me, but if you don't have to pay the price for failure, then what are you really risking? Like those who bought overpriced houses largely with banks money, it was the banks who ended up with the major losses. So too the State & Federal Government.

Longevity Hedging

2009-07-16T08:48:00.002-04:00

The newest form of Liability Driven Investing involves longevity hedging. When I mentioned here that one of the reasons BP was closing their defined-benefit plan to new employees was due to longevity, I suggested that one solution was to raise the retirement age. This would give the employer a longer period over which to contribute and a shorter period over which to pay out from the plan.

Another approach is for pension plans to actively hedge their longevity risk. Who are the buyers? There are companies that benefit from an aging population, such as pharmaceuticals and retirement residence owners. And there are hedge funds that perceive the huge underlying demand from pension plans as driving implied life expectancy levels out to a point that they are tempted to step in.

More to come....

Deflation and the Run of the Bulls

2009-07-15T10:34:00.002-04:00

Paul McCulley of PIMCO fame has a recent article on the fear of deflation and its relationship to monetary policy. Taking a page out of Helicopter Ben's playbook, McCulley asserts that fear of deflation requires the Fed to maintain "inappropriate" monetary policy in order to conquer the demon which has plagued Japan for the better part of two decades.

While I think many would agree with that assertion, the point is there are few beneficiaries and many casualties of such a policy, if it is successful. The beneficiaries are debt-holders, such as the US Treasury and all those who irresponsibly overborrowed against their house to overconsume in the short-term. The worst casualties are retirees on fixed pensions whose buying power has declined in equal measure to the policy's success. Current workers who have saved will also suffer as the value of their savings decline in real terms.

There are really 2 questions that mus be pondered:

is the fear of deflation real?; and
can the Fed really enginner inflation when Japan has not been able to?

One point to ponder with respect to the US / Japan comparison: in the mid-90s, the US castigated Japan for maintaining zombie banks on life support rather than allowing them to fail and then driving on...is TALF and the assortment of other programs the Fed has engineered not doing precisely that?

Comments welcome...

GM, Nortel...Public Pensions?

2009-06-23T12:34:00.002-04:00

At an event last night, somebody remarked to me that he would not be confident as a participant in a public pension; this from an individual who earlier confessed that in the past he was envious of friends who were teachers and their pension plans.

At issue is a lack of confidence in the entire retirement system and the individuals running pension assets. Also at issue is the lack of knowledge of risk on an integrated basis: risk which includes both assets and liabilities. Finally, with respect to public plans, at issue is the ability to beat an inflation-tied liability.

Is my friend's fear justified?

Partial Solution to the Pension Crisis

2009-06-04T05:24:00.002-04:00

Recent headlines include CPP cutting benefits for those retiring before age 65, while BP is closing their defined benefit plan to new employees due to adverse results arising from (among other obvious issues) increased life expectancy.

I have held to the notion for a long time that the only way my peers and I will ever see benefits from CPP is if the retirement age is raised. It is only after reading about BP's situation that I realize this is a necessary fix for all DB plans. Some other side benefits incude:

allowing defined contribution participants extra years to make up for recent poor performance
demographically, it keeps more participants in the work force which will reduce the strain we will find ourselves in as baby boomers retire
for US participants, reduced health care costs as active members of the work force are less likely to complain of ill health
adjust to the new realities of longer life span

The solution must be implemented gradually, but to me it is obvious that beginning in 2010 the entire world should begin a 5 year campaign of raising the legal retirement age to 70. Anyway, when was the last time you saw an ad for "Freedom 55"?

GM Pension

2009-06-02T09:07:00.003-04:00

Who else out there is concerned about the precedent the GM pension bailout creates?

If you were a member of a company on the verge of bankruptcy with an underfunded plan, what would you think?

S&P Resistance

2009-05-13T12:17:00.003-04:00

200 d moving average proved too formidable and I suspect we test the lows over the summer. May not be lead by financials this time, but I would look to hedge downside risk here.

GM Pension

2009-05-13T12:08:00.002-04:00

In case anyone has missed it, pensions have become the centrepiece of negotiations on GM's potential bailout.

I understand why the unions have negotiated so hard for better pensions; what I am not sure is why they were so comfortable with the risks in the plan as of a year ago. The plan's deficit apparently exploded from 4.5B to over 7B under the watchful eye of the Investment Committee, GM executives and union representatives.

The lesson from this saga is clear (even if the provincial or federal government participate in teh pension bailout): union representatives must oversee all aspects of compensation for their members. This surely includes monitoring the future viability of those benefits. Time for union officials to read up on pension fund risk.

VAR

2009-05-11T17:24:00.002-04:00

Is VAR broken? Frequently debated, it is the equivalent of trying to determine whether the entire past 10 years of financial innovation has been a mere column of smoke. The answer is Yes and No. It really depends on the application and the user.

Let's take an example of a firm that used a 95% VAR so that 1 day in 20 the P&L should exceed the VAR number in terms of gains and losses. This firm saw over the end of 2007 20 days in 60 where P&L exceeded VAR and 18 of the 20 times it exceeded VAR in the plus column. Management chose to ignore this fact because gains are far more appreciated than losses and why stop a trader on a roll. Management consciously avoided tough risk management decisions - can we really blame VAR for this failure?

VAR is not a holy grail. There are many shortcomings due to the many assumptions in the number. But much of the blame for VAR should fall on the shoulders of management who did not understand or chose to ignore the many signals that VAR was giving.

UTAM

2009-05-08T06:27:00.002-04:00

The Globe has a revealing piece on University of Toronto Asset Management. Surely this is a debate throughout North America:

are previous asset management methodologies no longer tenable?
were 2008 returns predictable or within model expectations?
do we fully appreciate risk?
in an effort to make finance more quantitatively elegant have we made assumptions that are unrealistic?

Basically, is the model broken?

While I think we all recognize that many assumptions in our models are unrealistic, the real question is do we adjust for it? Are we equipped to interpret the data provided by our risk management systems and then make the mental adjustment for where we intuitively realize the risks in our portfolio exist?

In your organization: does management really understand the numbers put out by the risk system and do they know the limitations of said numbers?

Toronto CFA

2009-05-06T16:09:00.005-04:00

Yesterday I attended the Toronto CFA Pension Seminar and 2 contradictory approaches to the past were apparent, one from Malcolm Hamilton and the other from Zev Frischman.

Hamilton is a leading consultant at Mercer, one of the firms that has advocated the "one-size-fits-all" 60-40 equity-fixed income asset mix. In what can be interpreted as a mea-culpa, Hamilton basically admitted that this approach was and remains inappropriate. Although not explicitly atoning for sins past by using the age old method of confession, it was obvious that Hamilton was departing from his firm's line of thinking as he emphasized at the start of his presentation that "he was giving his views only, not those representative of Mercer." Other issues Hamilton tackled were: the issue of MTM of illiquid assets (see my post), that superfunds try to solve problems but do not actually solve them (see my post) and the behavioural finance fear that plans are just hoping to get back to 100% solvency ratio to match assets to liabilities but will not do so once we get there.

On the other hand, Frischman, head of public equities at Ontario Teachers' Pension Plan remained unrepentant and emphasized that 2008 results were "well within the bounds predicted by our risk models." Therefore, Frischman emphasized, Teachers' sees no need to depart from historical approaches to investing and will continue in 2009 in what can only be described as "business as usual". Of course, this is nonsense as yours truly can attest, being part of the group let go from Teachers' in late 2008 because we did not fit in to the 2009 business plan.

Another point Frischman brought up was that if OTPP started matching the risk of their assets relative to liabilities, they would be locking in losses which would be untenable to the interested parties; namely, the teachers and the government of Ontario. That may be correct, however I respectfully disagree with the conclusion. In effect what Frischman is saying is "I will not take a loss because I cannot afford to do so." As a former trader, I cringe at the thought that someone in such a high position at a money manager could subscribe to such nonsense. As we all know, not taking small losses can lead to larger losses.

Other interesting notes from the seminar:
- LDI was a much discussed topic, with many admitting that it has generated much talk but not enough action
- regarding LDI (and this is corroborated by my discussions with clients and prospective clients), there is a mentality which Hamilton spoke of: I will do it once my solvency ratio is at 100%. The trading analogy is the guy whose position has gone way offside and decides "I will unwind it when I am back to flat P&L"
- it is unclear from the market whether or not inflation or deflation is the bigger risk, but curve steepening will precede a fear of inflation trade (note: there was much academic background to this conclusion which I have skipped in the interest of time)

Site Upgrade

2009-04-29T21:33:00.003-04:00

Just upgraded my website (and the blog, as you can see). Future upgrades include integrating the blog into the website.

The change was pretty painful as it was done by yours truly, though I learned a great deal in the process. If you were wondering about the lack of posts, blame the site upgrade.

Would appreciate constructive criticism on the site/blog - use the comment section below or shoot me an email.

Media Exposure

2009-04-29T21:22:00.003-04:00

Got quoted on an article relating to CAW funding disputes.

Underfunded Pension Plans

2009-04-29T21:10:00.002-04:00

The number of underfunded plans in the danger zone in the US has exploded, according to IFEBP (Int'l Fdn of Employee Benefit Plans).

This is corroborated by discussions I have had with various market professionals. What if those plans "derisked" and pursued an LDI framework now? They would be locking in losses. On the other hand, imagine another 30% decline in equities...

Between a rock and a hard place.

Metlife

2009-04-28T23:08:00.002-04:00

From 2007 annual report:

Chairman's Letter:
"Our individual variable annuity business in the U.S. had a very strong year in 2007 with a record $16.5 billion in individual annuity premiums and deposits. We have increased our market position in this business from 11th in 2000 to 2nd at the end of 2007. Our expanding distribution reach over the past several years, as well as the introduction of new and innovative variable annuity offerings, has enabled us to achieve this significant growth."

"The growth in the Individual segment was primarily due to higher fee income from variable life and annuity and investment-type products and growth in premiums from other life products"

On exposures:
"The Company’s investments in equity securities and equity-based fixed maturity securities expose it to changes in equity prices, as do certain liabilities that involve long-term guarantees on equity performance. It manages this risk on an integrated basis with other risks through its asset/liability management strategies. The Company also manages equity market price risk through industry and issuer diversification, asset allocation techniques and the use of derivatives."

On hedging:
"Equity index options are used by the Company primarily to hedge minimum guarantees embedded in certain variable annuity products offered by the Company. To hedge against adverse changes in equity indices, the Company enters into contracts to sell the equity index
within a limited time at a contracted price."

From the 2008 report:

Chairman's Letter: (trying to remain confident about the future as well as past policies)
"This growth was driven by a significant increase in fixed annuity deposits as well as strong variable annuity deposits. Our annuity product portfolio remains competitive and, just as important, we are maintaining our pricing discipline. It is at times like these that consumers increasingly seek out the guarantees that only the insurance industry can provide, and we remain committed to delivering on the promises we make."

Business Outlook: (not as confident)
Management expects 2009 premium, fees and other revenues to be down slightly compared to 2008 results. Individual Business experienced a significant decline in asset-based fees in annuity and variable life products in the second half of 2008 due to equity market declines. This depressed level of fee revenue is expected to continue in 2009.

The economic crisis and the resulting recession have had and will continue to have an adverse effect on the financial results of companies in the financial services industry, including the Company. The declining financial markets and economic conditions have negatively impacted our investment income and the demand for and the cost and profitability of certain of our products, including variable annuities and guarantee riders.

My conclusion is that hedging certainly helped their business relative to others but the variable annuity business is a tough business these days.

Beginning of a Superfund Era?

2009-04-22T00:58:00.006-04:00

Michael Nobrega's suggestion of a superfund is clearly self-serving: earn fees on external funds. But does it make sense?

One might argue that it does - it would give smaller funds access to the brain trusts running the big public funds, including access to certain deals and asset classes. But is that really so? Can't smaller funds access venture capital, hedge funds and infrastructure deals by investing in funds dedicated to these asset classes? Well, the respondant argues, they could now get it at a lower fee. Even if that were the case (I believe it would be), there exists the danger of conflict of interest. Unless, of course, the funds are managed in one large pool.

Which brings me to the arguments against the superfund:

Asset mix- given the different nature of public vs private fund liabilities (inflation indexing), is it really appropriate to consider similar asset mixes?
Future Contributions- corporations must be more sensitive to ongoing concern of their entity than a government or quasi-government entity, which may lead to different risk tolerance of plan sponsors
Together We Fall - what if the "brain trust" at a superfund missteps? Recent scandals such as the ABCP blowup in Canada or Madoff in the US, which are not tied to the overall market decline, demonstrate the danger if a superfund has large exposure to a particular asset or fund. In an age where we support smaller banks in order that no single financial institution would pose significant danger economic stability, how can we advocate supersized pension funds which could just as easily wreak havoc? (Granted that it may not be as direct, since pension funds do not lend to retail, but the impact on the banking system would be substantial)

Pension Funding

2009-04-20T08:20:00.003-04:00

Apologies for my absence - had to point out this frightening article which highlights concerns about pension plan funding even if the economy recovers. Back to skimming the annual reports later today.

PBGC

2009-04-02T08:10:00.003-04:00

We interrupt the life insurance variable annuity program to bring this wonderful piece of news:

Just as stocks and other risky assets began to crater the Pension Benefit Guarantee Corp (PBGC) upped its allocation to risky assets. This from a government agency whose existence becomes essential in a time of declining risk allocations.

PBGC works like this: collect premiums from pension funds so that if a pension fund sponsor goes belly up and the pension plan has an unfunded liability (its assets are less than its liabilities), the PBGC makes up the difference. Basically, it insures pension plans.

So what on earth would possess these guys to strap on the same risks as the very funds they are insuring? Talk about misunderstanding one's place in the world.

Annual Reports: Manulife

2009-03-31T21:26:00.002-04:00

2008 annual report contains multiple admissions that the variable annuities were not hedged and that it cost shareholder's dearly
But they are now on top of the issue and they are hedging new business

2007 annual report does acknowledge risk of a sustained equity market decline but all talk of variable annuities trumpets their abilities in the product and how quickly it was selling

Next up: Metlife

WSJ on life insurers

2009-03-30T23:51:00.003-04:00

the Wall Street Journal weighs in on insurers and the risks they are carrying

just a quick survey of indices and the insurance cos gives us a good idea of what their betas are really like:

	6m	1y	6m Beta
S&P500	-32%	-40%	1
DOW	-31%	-38%

Manulife	-71%	-71%	2.2
Sun Life	-53%	-64%	1.7
MetLife	-62%	-64%	1.9
Prudential	-75%	-76%	2.3
Hartford	-81%	-90%	2.5

Risk management failure? Perhaps - or management actively decided to take this risk. Looks like it is time to rummage back through the annual reports to find out if shareholders were warned that these risks were being taken. After all, if we expect oil & gas and gold mining companies to reveal their hedges of future production, shouldn't we expect the same of lifecos?

Mark-to-Market (MTM)

2009-03-26T23:40:00.003-04:00

MTM in theory makes perfect sense - it gives a sense of real-time measurement of value.

In practice, it is a completely different story. First of all, how relevant is MTM on assets when liabilities are not really marked-to-market. What do I mean? Let's talk about 2 aspects of liability MTM: interest rates and mortality tables.

Interest Rates: are the cashflows being discounted off a MTM curve? What curve should that be: a generic corporate bond curve, or could we consider that obligations of the pension are really obligations of the corporation and discount each corporation's pension liabilities off that corporation's credit curve?

While the latter makes intuitive sense (and creates more work), it results in the peversions we witnessed throughout 2008: financials in the US were recognizing huge gains from their liabilities when their credit spreads exploded.

With either choice we may be discounting liabilities using a bond curve that is not achievable for the asset managers in the real market due to duration, issuance size constraints or credit diversification constraints. Derivatives may be employed to circumvent some of these issues, which I will address in a separate post.

Mortality: Anybody who discusses mortality MTM is out of their mind. By its very nature these tables are constructed using time series data which eliminate outliers. This is best illustrated by an example: if too many people died in 2008 versus what we would have predicted by extrapolating historical death rates, we may want an extra few years of data before determining that a particular trend (say declining death rates) has come to an end. Or perhaps we are on the cusp of discovering a cure to a disease; how would we factor that into our mortality tables?

So, maybe MTM is not all it is cracked up to be. Have a look at this post on asset MTM.

Fixed Income

2009-03-23T10:41:00.002-04:00

Clearly by waiting until the market indicated the correct position we dodged a mega-bullet: the biggest single day move in Treasuries since 1962 on Wednesday. How significant is the announcement from the Fed? Have they effectively sold puts on longer-term Treasuries? The short answer is "yes".

What are the risks of this plan? By strong-arming banks into lending the Fed has basically undertaken to support the entire banking system. The money-printing press is in full swing and that once again encourages bad borrowing. At least bankers memories aren't short enough that they would engage in bad lending....again.

And of course when that war against deflation has been won (and we will not know when) US Treasuries will be revalued a la currencies in a post-Bretton Woods world.

Melt-up?

2009-03-23T10:35:00.003-04:00

It appears we have seen the great melt-up / short-covering and the S&P struggled twice at the 805 level. As they say, third time is a charm - so do not be too surprised if we try to break that level; I am much more worried if we cannot, because I think it forbodes another test of the bottom.

Europe - the next shoe to drop?

2009-03-17T08:44:00.008-04:00

I have always maintained that the situation for European banks must be as dire as that in the US and yet the ECB has done little compared to the Fed to help out the banking sector. Here comes Paul Krugman, echoing those same sentiments.

The real question is: what are the trading implications? What positions can be enacted to best take advantage of this? Short EUR/USD? What about against a cross like being short EUR/AUD or EUR/CAD? I would prefer the latter, if only that the US Dollar Index seems to be rolling over (see chart below, where uptrend has broken and MACD divergence with higher price but lower MACD).

What about fixed income trade in Europe? Like fixed income in the US, historical volatility is dropping hard and signals like ADX and Bollinger Bands indicate that it should break soon. The only problem is that in this environment it is unclear which way it breaks (I am biased toward lower prices, higher yields).Caution dictates waiting until the market tells us what our position should be.

Overhaul of Risk Management?

2009-03-16T19:57:00.002-04:00

In the wake of the financial crisis, what percentage of banks are revamping their risk management process?
0-20, 20-35, 35-50, 50-65, 65-80, 80-100???

In a recent study, 90% of banks are looking into risk management practices while only 42% expect to make any changes. Where does that leave the 48% who are looking into it, but not making any changes? I can tell you: boardroom and executive education.

How many times have we heard of executives who panic when a trader exceeds their VAR on the downside once a quarter? Or, more frightening yet all too common in the heady days of 2005-07, the executives who ignore repeated VAR threshhold violations because they occur to the upside? Everybody complains how useless VAR is, and, believe me, I am no huge fan of VAR; but most of the negatives of VAR stem from a lack of understanding of its limitations and its uses.

Who controls asset allocation?

2009-03-13T17:46:00.004-04:00

This one is classic - it is called dollar cost averaging. Now I am motivated to find a reason why dollar cost averaging is not necessarily the best strategy. Hmmm - let's say they fixed their "allocation problem" back at the end of '08 - where would they be now? Enough said.

Intelligent asset allocation means not reallocating because the market has forced you to (one asset's poor performance forces money out of other assets and back into that one in order to keep allocations level). Rather, it means shifting asset allocation because the economy / market has told you to do so (ie. it is the right thing to do).

The truth is, there is so much job/career risk driving these decisions that I am not sure intellect even enters the picture.

Mo' Manulife

2009-03-12T21:34:00.003-04:00

I promised that I would share more of my thoughts about Manulife so here they are:

"we assumed more risk than our competitors" - that is fine, but I hope you can justify why
"There were more features in these products—I think they probably weren't charged adequate fees for the optionality embedded in them" - are you kidding me? You created a product and are finding out that you did not charge sufficiently? Is that why we find #3:
"they were somewhat difficult to hedge, although we've had very limited hedging, virtually none in that period" - what you mean is that you did not hedge...at all.

Now if I were a shareholder I would throw a shoe at Rubenovitch. You are an insurance company - not a leveraged stock market trade! What were you thinking?? And the non-hedging - was it because you looked at the market and found that the cost of puts were too high relative to what you were charging? Wouldn't that be a dead giveaway that you were not charging the right amount?

It is one thing, in my opinion to approach life contingencies with an actuarial mindset: historically mortality has been at this level then project changes when new info on life expectancy or new diseases emerge. It is a completely different animal to use history as a projection on the future of capital markets. Shame on you, Manulife.

Equity Rally

2009-03-12T21:30:00.002-04:00

These kind of bounces can be characterized in only one way - a bear market rally - because the market never rallies like this in bull markets. What we have seen is a classic short squeeze. I am looking to buy the April 625 puts to change the 725-675 1x2 into a butterfly; it makes it easier to sleep at night.

Implied Volatility in Equities

2009-03-11T05:24:00.003-04:00

While I do acknowledge that implied volatility in equity markets has come down quite a bit since the heady days of November, compared to any other point in history it remains at elevated levels. Perhaps one reason for this phenomenon is that insurers are getting an ugly wake-up call with respect to the risks they have been carrying on their books. Note the comments by Peter Rubenovitch, CFO of Manulife, which make it unlikely for volatility to ratchet down.

For the investor/trader who has risk capital to play with, one can create excellent breakeven strategies on the downside using 1x2 put strategies. For example, I looked at the following 3 structures (note that with yesterday's rally it has moved away from these levels slightly):

Buy the April 725-675 1x2 put spread for a credit of 13 - this creates a breakeven of 612 by mid-April
Buy the June 675-600 1x2 put spread for a credit of 5, which has a mid-June b/e of 520
Buy the December 550-460 1x2 put spread for even with a breakeven of 370

Admittedly, I would not bother with the third option as the expiry is too far away, and time decay does not really kick in to high gear until the last few weeks prior to expiry, but I found #1 extremely attractive especially given my/Ritholtz's view that we were due for an oversold bounce. Now I look for a trade up to 740 in S&P before we run into selling pressure.

Note also that while breakeven trades may appear very attractive there is huge mark-to-market (MTM) risk, and one must be prepared to deal with those consequences.

Finally, I intend to post further comments to Peter Rubenovitch's statement but I am still shell-shocked by the idea that an insurer would conciously retain the risk on such volatile exposure.

Fixed Income Volatility

2009-03-09T14:17:00.004-04:00

When thinking about fixed income volatility, one must recognize that the curve must be parsed in order to assess ultimate risk. The front end is highly dependent on the overnight target rate set by central banks, the back end is a commodity driven by multiple factors, such as fear, inflation expectations, regulatory regime (ie. UK pension LDI), carry considerations and investor preference. The belly of the curve is pulled by the front & back end considerations with varying degrees of strength.

So when I read a research report that tells me that the Fed has effectively sold puts on the back end by introducing the concept of quantitative easing into their player's manual, I am forced to look back at my post Macro Thoughts It is precisely at times like these, where the breadth of opinion is bifurcated and few sit in the precious middle, that makes for volatile times. Indeed, US 10y bonds found some yield resistance at 3%, and it appears bonds could break by 50bps either way in a very short period of time. Not a great time to be short fixed income volatility in the back end of the curve.

See chart here

The Pendulum

2009-03-05T14:16:00.002-05:00

"Stocks are screaming cheap" We have been hearing this mantra ever since the ink on Warren Buffett's contract with Goldman Sachs dried. Wake up people - Buffett bought call options on Goldman but he also gets paid 10% per year. Granted the notes are most certainly well offside but given the poor outcome of letting Lehman fail, I say it is unlikely that Goldman is put down to rest. The point being, given the timing Buffett got a sweet deal.

As for the rest of us, we need to recognize that every cycle resembles a pendulum. The further it gets stretched in one direction, the greater the swing to the other side when the music stops. So too in this monetary cycle. The pendulum swung much too far toward easy money and it is already pretty ugly as we are in the overcompensatory phase of that excess. How far does the pendulum swing in the other direction? We won't know for another year or two. But as a mentor of mine used to say: "those with a penchant for picking bottoms end up with smelly fingers".

The New Mark-to-Market

2009-03-04T11:36:00.002-05:00

Much ink has been spilled of late in Canada on the performance of the public pension plans, since OMERS and the Caisse have released their results with HOOPP and Teachers' coming up. While I read a great deal about the fact that Caisse may have overestimated their performance, much of the discussion centred around ABCP. Wherefore art the questions on real estate, private equity and other illiquid assets? How are these valuations being set?

I recently spoke with a partner at a private equity firm who told me that he wrote down their portfolio by 15% in 2008. When asked how he got to that number, he licked his index finger and stuck it in the air to indicate that the entire process is very subjective. Needless to say, the last thing we need are valuations which are determined by those people whose bonuses are dependent on said valuations.

Hence the recent discussions by FASB
https://www.fis.dowjones.com/WebBlogs.aspx?aid=DJFVW00020090219e52k000jj&ProductIDFromApplication=&r=wsjblog&s=djflbo
and
http://blogs.wsj.com/privateequity/2009/02/19/fasb-vs-pe-industry-round-two/

anybody know what the CICA is doing on this front?

Pension Funding

2009-03-03T18:59:00.002-05:00

So companies are having a tough time in this environment; the last thing they need is to find that their funding surplus is now a massive deficit. Check this out:

http://www.chicagobusiness.com/cgi-bin/article.pl?articleId=31402

And the double whammy is key - lower interest rates means discounted liabilities have increased while lower stock market means assets have decreased.
Why do companies not understand that with pension funding on their balance sheet, they face this type of risk?
Just one aspect of growing my consulting business.

Market bounce?

2009-03-03T12:16:00.002-05:00

Barry Ritholtz comes up with top notch stuff day after day...here is an interesting chart:

http://www.ritholtz.com/blog/2009/03/sp-500-index-vs-200-day-moving-average/

Public Pensions - a great debate

2009-03-03T11:28:00.004-05:00

The Financial Post has had an interesting debate on public pensions...see here:

http://network.nationalpost.com/np/blogs/fpcomment/archive/2009/03/02/counterpoint-pension-funds-are-workers-best-bet.aspx

and the first part is here:

http://network.nationalpost.com/np/blogs/fpcomment/archive/2009/02/26/terence-corcoran-the-model-that-s-killing-pension-plans.aspx

There are multiple layers of questions surrounding public plans and this touches on 2 of them:

benefits - the benefits are too rich, as evidenced by the private sector - when was the last time you found a private sector pension plan with inflation indexing??
investment management - is the public being well served by the investment management of these funds? let's start with the alternatives: indexed portfolios, non-risky asset investments only - the real issue is that these complaints are only surfacing after a poor year - why were these self-righteous critics not out there complaining when year after year these plans were racking up 7% returns?

Macro thoughts

2009-03-02T19:56:00.002-05:00

Deflation vs Inflation - who will win?
Is this really in doubt? I mean, Helicopter Ben comes flying in to the rescue with thousand-dollar bills and it is all over...inflation solves many problems for the US but I have rarely read about the ills that it brings with it. Consider a retiree on a fixed pension, or the poor whose rent will potentially climb faster than their income. It is clear that inflation brings with it social unrest that will shake this continent worse than anything in its history.

Inaugural post

2009-03-02T19:43:00.002-05:00

Welcome to my blog - my intent is to post the following:
- various thoughts on risk management in the modern world
- macro thoughts on the world economy
- various trades in the FX and fixed income worlds, which is where I come from and leads into....

who am I?
An actuary by training, I meandered through pension plan consulting and life in the back rooms of an insurance company until a position opened in the investment department. I spent a few years modelling liabilities and designing hedging strategies for those products, when I moved to the "sell-side" and made markets for clients in fixed income options and interest rate swaps. Finally, I joined a pension plan as a portfolio manager in 2007, only to have my tenure there cut short in December 2008 due to current market conditions. I am now an independent risk management consultant with (in my opinion) a unique perspective on the world of money due to my varied work experiences.