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 majestic wate…

Hume's Cutlery

David Hume is renowned for two pieces of cutlery, the guillotine and the fork.

Hume's guillotine is the sharp cut he makes between "is" statements and "ought" statements, to make the point that the former never ground the latter.

His "fork" is the division between what later came to be called "analytic" and "synthetic" statements, with the ominous observation that any books containing statements that cannot be assigned to one or the other prong should be burnt.

Actually, I should acknowledge that there is some dispute as to how well or poorly the dichotomy Hume outlines really maps onto the analytic/synthetic dichotomy. Some writers maintain that Hume meant something quite different and has been hijacked. Personally, I've never seen the alleged difference however hard they've worked to point it out to me.

The guillotine makes for a more dramatic graphic than a mere fork, hence the bit of clip art above.

I'm curious whe…

Cancer Breakthrough

Hopeful news in recent days about an old and dear desideratum: a cure for cancer. Or at least for a cancer, and a nasty one at that.

The news comes about because investors in GlaxoSmithKline are greedy for profits, and has already inspired a bit of deregulation to boot. 

The FDA has paved the road for a speedy review of a new BCMA drug for multiple myeloma, essentially cancer of the bone marrow. This means that the US govt has removed some of the hurdles that would otherwise (by decision of the same govt) face a company trying to proceed with these trials expeditiously. 

This has been done because the Phase I clinical trial results have been very promising. The report I've seen indicates that details of these results will be shared with the world on Dec. 11 at the annual meeting of the American Society of Hematology. 

The European Medicines Agency has also given priority treatment to the drug in question. 

GSK's website identifies the drug at issue as "GSK2857916," althou…