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Measuring and Managing Risk in Innovative Financial Products – A Comment

Measuring and Managing Risk in Innovative Financial Products – A Comment. David M. Rowe, Ph.D. EVP for Risk Management – SunGard Federal Reserve Bank of Atlanta - Financial Markets Conference Jekyll Island, Georgia May 12, 2009. Lessons for Risk Management of Complex Financial Instruments.

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Measuring and Managing Risk in Innovative Financial Products – A Comment

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  1. Measuring and Managing Risk in Innovative Financial Products – A Comment David M. Rowe, Ph.D. EVP for Risk Management – SunGard Federal Reserve Bank of Atlanta - Financial Markets Conference Jekyll Island, Georgia May 12, 2009

  2. Lessons for Risk Management of Complex Financial Instruments • Statistical Entropy • Structural Imagination • Innovation, Complexity and Dark Risk • Self-Referential Feedback Compounds Dark Risk • Alternate Means of Valuation

  3. 1. Statistical Entropy Data Information Like water, information cannot rise higher than its source.

  4. 1. Statistical Entropy I o n r o f i a t n m This is extraction of information, NOTcreation of information Data I o n r o f i a t n m Information

  5. Mortgage Default Experience SOURCE: Mortgage Bankers Association - National Delinquency Survey

  6. Hypothetical Detachment Point Hypothetical Subprime Default Probability Density 0.2500 0.2000 0.1500 Probability Density 0.1000 0.0500 - 0 5 10 15 20 25 Defaults (%) Log-Normal Distribution: Mean = 5.97; StDev = 2.16

  7. Hypothetical Detachment Point Hypothetical Subprime Default Probability Density 0.2500 0.2000 0.1500 Probability Density 0.1000 0.0500 - 0 5 10 15 20 25 Defaults (%) .01% = AAA

  8. Hypothetical Detachment Point Hypothetical Subprime Default Probability Density 0.2500 0.2000 0.1500 Probability Density 0.1000 0.0500 - 0 5 10 15 20 25 Defaults (%) Largest Sample Observation = 9.6% Behavior in the Tail is Based on What Distribution is Assumed .01% = AAA

  9. The Basis for Diversification Through mid-2006 Idiosyncratic Causes for Default What unobserved contingency could upset this pattern?

  10. Threats to Diversification One candidate was fairly obvious. $ $ $ $ Falling housing prices would hurt ALL borrowers Defaults would no longer be statistically independent

  11. Threats to Diversification 12-month % change Strongly Positive: 1995-2006 10 City Composite U.S. Home Price Index 12-month % change Jan-95 S&P/Case-Shiller Home Price Indices

  12. Threats to Diversification Mar 1994 Aug 1990 12-month % change Negative for 3-1/2 years in early 1990s 10 City Composite U.S. Home Price Index 12-month % change S&P/Case-Shiller Home Price Indices

  13. Threats to Diversification September 2005 Mar 1994 Aug 1990 Month-to-Month % Change Peaked in September 2005 : Turned Negative in mid-2006 10 City Composite U.S. Home Price Index 12-month % change Monthly % Change (annual rate) S&P/Case-Shiller Home Price Indices

  14. 2. Structural Imagination The Lesson 1) Look for significant unrepresented variables. 2) Track these variables carefully as early warning indicators of emerging problems.

  15. 3. Innovation, Complexity and Dark Risk Complexity Limited Data Dark Risk  +

  16. 4. Beware Self-Referential Feedback Risk Estimates Based on Historical Data Become Progressively Less Reliable   Growth in Volume   DARK RISK Achieving Greater Volume Required Relaxing Underwriting Standards   Further Innovations (e.g. Compound Repackaging, CDO2 ) Increased Complexity   A Unique Innovation Generated Attractive Returns

  17. 5. Alternate Means of Valuation Old Credit Risk Mantra What is the second means of repayment? Proposed Capital Markets Mantra What is the second means of valuation?

  18. 4. Alternate Means of Valuation IRS CDS Corporate CDOs (2006) Subprime CDOs (2006) Ease of Current Valuation Level 1 Observable prices in active markets Observable prices in inactive markets or observable inputs to accepted pricing models Level 2 Few or no observable market prices and models requiring significant unobservable inputs Level 3

  19. 4. Alternate Means of Valuation Effectiveness of Alternate Means of Valuation Level 2 Level 3 Level ? Level ? IRS Corporate CDOs (2006) Subprime CDOs (2006) CDS (2006) Level 1 Ease of Current Valuation CDS (2008) Level 2 Corporate CDOs (2008) Level 3 Subprime CDOs (2008)

  20. A Question Was this crisis a Black Swan? ?

  21. Elements of the Risk Puzzle (Original: May 2006) Technological Change Pace of Innovation Product Complexity Geopolitical Risk Liquidity Model Risk Commodity Prices Extreme Events Volume Growth External Linkages Emerging Markets Information Security Operational Risk Effective Portfolio Mgt. Regulatory Uncertainty Miscellaneous ???? Unknown Unknowns ????

  22. Elements of the Risk Puzzle (Rev: October 2008) Pace of Innovation Product Complexity Technological Change Pace of Innovation Product Complexity Liquidity Model Risk Geopolitical Risk Liquidity Model Risk Volume Growth Commodity Prices Extreme Events Volume Growth External Linkages External Linkages Emerging Markets Information Security Operational Risk Effective Portfolio Mgt. Regulatory Uncertainty Miscellaneous ???? Unknown Unknowns ???? Commodity Prices Effective Portfolio Mgt.

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