Skip to main content

Risk in non-quantitative terms


But let’s leave the mathematics aside for a moment and discuss risk in intuitive terms.



It seems clear enough that as we move from one broad asset class to another we’ll see a trade-off.  U.S. Treasury bonds are safer, and produce a much lower return, than do corporate stocks.

Can we get more granular? Can we look within the world of corporate stocks and define subsets of that asset class, and find the same trade-off at work?

There are various sorts of risk. There are risks associated with the economy as a whole (the risk that the whole ocean will dry up so all the boats will find themselves on the bottom); the risk associated with specific markets or products (the risk that the horseless carriage will hurt all the buggy whip manufacturers); and the risk associated with one specific firm due, for example, to the excellence or incompetence of its managers. These are known as systemic risk, market risk, and idiosyncratic risk, respectively.

How might you protect against systemic risk? We’ll consider for the moment that you are a U.S. investor, with the usual “home bias” in investing, that is, most of your investments will be in U.S. based assets or issuers. On this premise, how might you hedge the risk that the whole of the U.S. equity markets will decline, and decline sharply?

You could take a short position on broad-based indices. And one way in which you could do that, arguably  the easiest and cheapest way, is by buying puts on the index. Just as with puts on stock, puts on an index reflect pessimism or hedge against a downward direction. If the index moves up between the purchase and the maturity date, the put expires unused. If the index heads down and crosses the line defined in the original contract, the index has a pay-off.

One of the sorts of risk that any financial concern must manage is liquidity risk, that is, risk immediately relating to cash flow. The balance sheet may look fine, a concern may have a lot of assets, but if it can convert them into cash as necessary to meet its obligations, the owners may well lose control of the enterprise and that value.

Banks are in the “maturity transformation” business.  Banks borrow money on short time frames (for example, from depositors who are entitled to withdrawal on demand) and lend money out on longer time frames.  Indeed, this is precisely why (in the views of many theorists) there is a pressing need for central banks with the power to control the money supply. The central banks can step in when the process of maturity transformation goes poorly, as in the case of a classic ‘run.’
But most enterprises aren’t in the maturity transformation business, and central banks don’t step in when they get in trouble (in the normal course of events, TBTF crises aside). Thus, liquidity risk management is an important part of the business model of anyone who doesn’t accidentally want to get into that business.

Comments

Popular posts from this blog

A Story About Coleridge

This is a quote from a memoir by Dorothy Wordsworth, reflecting on a trip she took with two famous poets, her brother, William Wordsworth, and their similarly gifted companion, Samuel Taylor Coleridge.   We sat upon a bench, placed for the sake of one of these views, whence we looked down upon the waterfall, and over the open country ... A lady and gentleman, more expeditious tourists than ourselves, came to the spot; they left us at the seat, and we found them again at another station above the Falls. Coleridge, who is always good-natured enough to enter into conversation with anybody whom he meets in his way, began to talk with the gentleman, who observed that it was a majestic waterfall. Coleridge was delighted with the accuracy of the epithet, particularly as he had been settling in his own mind the precise meaning of the words grand, majestic, sublime, etc., and had discussed the subject with William at some length the day before. “Yes, sir,” says Coleridge, “it is a maj...

Searle: The Chinese Room

John Searle has become the object of accusations of improper conduct. These accusations even have some people in the world of academic philosophy saying that instructors in that world should try to avoid teaching Searle's views. That is an odd contention, and has given rise to heated exchanges in certain corners of the blogosphere.  At Leiter Reports, I encountered a comment from someone describing himself as "grad student drop out." GSDO said: " This is a side question (and not at all an attempt to answer the question BL posed): How important is John Searle's work? Are people still working on speech act theory or is that just another dead end in the history of 20th century philosophy? My impression is that his reputation is somewhat inflated from all of his speaking engagements and NYRoB reviews. The Chinese room argument is a classic, but is there much more to his work than that?" I took it upon myself to answer that on LR. But here I'll tak...

The Lyrics of "Live Like You Were Dying"

Back in 2004 Tim McGraw recorded the song "Live Like You were Dying." As a way of marking the one-decade anniversary of this song, I'd like to admit that a couple of the lines have confused me for years. I could use your help understanding them. In the first couple of verses, the song seems easy to follow. Two men are talking, and one tells the other about his diagnosis. The doctors have (recently? or a long time ago and mistakenly? that isn't clear) given him the news that he would die soon. "I spent most of the next days/Looking at the X-rays." Then we get a couple of lines about a man crossing items off of his bucket list. "I went sky diving, I went rocky mountain climbing, I went two point seven seconds on a bull named Fu Man Chu." Then the speaker -- presumably still the old man -- shifts to the more characterological consequences of the news. As he was doing those things, he found he was loving deeper and speaking sweeter, and givin...