DEALING WITH FINANCIAL RISK OTHER ECONOMIST BOOKS Emerging Markets Guide to Analysing Companies Guide to Business Modelling Guide to Business Planning Guide to Economic Indicators Guide to the European Union Guide to Financial Markets Guide to Management Ideas Numbers Guide Style Guide Dictionary of Business Dictionary of Economics International Dictionary of Finance Brands and Branding Business Ethics Business Strategy China’s Stockmarket E-trends Globalisation Successful Innovation Successful Mergers Wall Street Essential Director Essential Economics Essential Finance Essential Internet Essential Investment Essential Negotiation Pocket Asia Pocket Europe in Figures Pocket World in Figures DEALING WITH FINANCIAL RISK David Shirreff THE ECONOMIST IN ASSOCIATION WITH PROFILE BOOKS LTD Published by Profile Books Ltd 58A Hatton Garden, London ec1n 8lx Copyright © The Economist Newspaper Ltd 2004 Text copyright © David Shirreff 2004 All rights reserved. Without limiting the rights under copyright reserved above, no part of this publication may be reproduced, stored in or introduced into a retrieval system, or transmitted, in any form or by any means (electronic, mechanical, photocopying, recording or otherwise), without the prior written permission of both the copyright owner and the publisher of this book. The greatest care has been taken in compiling this book. However, no responsibility can be accepted by the publishers or compilers for the accuracy of the information presented. Where opinion is expressed it is that of the author and does not necessarily coincide with the editorial views of The Economist Newspaper. Typeset in EcoType by MacGuru [email protected] Printed in Great Britain by Creative Print and Design (Wales), Ebbw Vale A CIP catalogue record for this book is available from the British Library ISBN 1 86197 591 0 To Henry and George Contents Acknowledgements viii Introduction 1 Part 1 Financial risk: an endless challenge 5 1 The growth of modern financial markets 7 2 Market theory 16 3 Derivatives and leverage 23 4 Temples to risk management 34 5 Models for Everyman 44 6 Credit models get a thrashing 58 7 The rise of the firm-wide risk manager 64 8 Basel 2 is born – a new regulatory regime 73 9 In praise of liquidity, funding and time horizons 83 10 ART exhibitions 92 11 Sibylline books 103 12 The play’s the thing 108 13 What lies ahead 116 Part 2 Risk in practice: real and simulated examples 121 14 Lessons from Metallgesellschaft 123 15 Lessons from the collapse of Long-Term Capital Management 136 16 The crash of Mulhouse Brand 153 17 The Sigma affair 175 References 188 Glossary of key terms 190 vii Acknowledgements would like to thank Euromoney Institutional Investor for allowing me I to draw liberally on articles that I wrote for Euromoney magazine in the 1990s, and ifci Risk Institute on whose website my analysis of the Long-Term Capital Management crisis first appeared. For many thought- ful conversations on financial risk I would also like to thank the follow- ing: Luqman Arnold, Bob Blower, Brandon Davies, Matthew Elderfield, Michael Feeney, Desmond Fitzgerald, Bob Gumerlock, Andrew Hilton, Con Keating, Roger Kubarych, Karel Lannoo, David Lascelles, Ruben Lee, Ron Liesching, Chuck Lucas, John McPartland, Robin Munro-Davies, Maarten Nederlof, John Parry, Mike Peterson, Leslie Rahl, Neil Record, Eric Sepkes, Konstantin Graf von Schweinitz, Charles Smithson, Charles Taylor, Tim Shepheard-Walwyn and Simon Wills. Introduction Ships are but boordes, Saylers but men, there be land rats, and water rats, water theeues, and land theeues, I meane Pyrats, and then there is the perrill of waters, windes, and rockes. William Shakespeare, The Merchant of Venice, Act I, Scene 3 ntonio’s first big mistake in The Merchant of Venice was to bet his A whole fortune on a fleet of ships; his second was to borrow 3,000 ducats from a single source. The first rule of risk management is to iden- tify your risk. The second is to diversify it. Antonio broke the second rule, and his creditor Shylock flunked the first. He found he could not take his pound of Antonio’s flesh without shedding “one drop of Chris- tian blood”: blood had not been specified as part of the bargain. This is an unusual example. But it illustrates how financial risk man- agement is just an extension of sensible prudence and forethought: to imagine what might go wrong and to guard against it. Modern risk management has developed mathematics and other skills to narrow the field into bands of probabilities. It can never predict, it can only infer what might happen. Volatility meets computer power When did modern risk management begin? It was an extraordinary col- lision of extreme conditions in financial markets in the 1980s and a dra- matic increase in computer power. In the space of a few years, outcomes which could be tested only by intuitive sketches on the back of an envelope, or worked out after weeks of cranky iterations on a cal- culator, were replicable in minutes on a desktop computer. Monte Carlo simulations, chaos theory and neural networks have all attempted to get closer to modelling real financial markets. Of course a model will never be the real thing, and those who put too much faith in their financial model will get caught out, as the boffins at Long-Term Capital Management (a hedge fund which collapsed in 1998) spectacu- larly illustrated. Ultimately, even financial firms have learned that math- ematics has limited value in calculating the probability of the most bizarre and extreme events. As regulators and forward-thinking firms have got to grips with this problem, they have ventured into the more uncertain territory of 1 DEALING WITH FINANCIAL RISK designing stress-tests, imagining scenarios and occasionally playing out entire fictions of the future. This is what makes the discipline of risk management more than just a computer-driven exercise practised by nerds in back offices. It challenges the wildest imagination and the fron- tiers of creative genius. Like mountain climbing, it is about minimising danger and taking cal- culated risks. Alpinists learn that principle fast or they and their friends die. Dealing with risk in financial markets is different: the stakes are not usually so high. And in financial markets most risktakers are risking other people’s money, not their own. That makes financial markets a highly complex arena – far more complex, for instance, than a theatre of war. Every trading decision may have a plethora of motives and emo- tions behind it; in theory each trade adds new information, but mostly it adds noise. In the 21st century, the noise from newswires, websites, radio, tele- vision and newspapers has become so deafening that sometimes the entire world population seems to be a single thundering herd. All humankind is focused on the troops in Afghanistan, an earthquake in Iran, the fortunes of the Dax or the Dow, or the earnings of ibm, which are “disappointing” because they did not quite surpass those in the previous quarter. Like Pavlov’s dogs, we are being conditioned to salivate or recoil as massed ranks of financial news sources pump out their messages. The limits of mathematics Good financial risktakers have to make sense of all this garbage. And they have to combat their own emotions, because dealing in financial markets, even on others’ behalf, is an emotional business. Even if they are not your own dreams, you are seeing people’s dreams made or unmade every day. Money, or wealth, especially these days, is the chief means through which people hope to enhance their lives. So the finan- cial markets, apart from being a vital clearing mechanism for world commerce, are places of dreams and emotions. Someone who takes that on board will never make the mistake of believing that market behaviour can be mimicked by maths. Despite that caveat, a whole industry has grown up in the last 30 years based on the idea that the behaviour of financial markets can be interpreted and outsmarted by mathematical models. The modelmakers sell the illusion that patterns and prices will repeat themselves. Some- times the illusion is self-fulfilling. 2 INTRODUCTION The endless fascination of markets is that they are always changing, as if consciously seeking to spite human efforts to tame them. Just as fascinating is the behaviour of the institutions that make up the markets: banks, investment banks, insurance companies, corporate treasuries, brokers, exchanges, clearing houses, central banks, pension funds, hedge funds, day-traders and speculators. Like strings of mountain climbers they are keen to safeguard their own survival. But to stay in the game they have to take risks. Calculated financial risktaking, and the way in which institutions align themselves to do it, is the most compelling game of all and the underlying subject of this book. Individual investors and speculators make mistakes and they can lose their shirts. But financial institutions are like battleships: a mistake by one of the crew rarely sinks the ship – Nick Leeson’s rogue trading at Barings in 1995 being an exception. Nev- ertheless, an institution must be run in a disciplined enough way, not only to avoid destruction but also to be an effective fighting machine and score victories. Employees of financial firms are not usually amenable to military dis- cipline, although some managers have tried. Handling deal-hungry investment bankers – probably the greatest management challenge of all – has been compared with herding cats or squirrels. Trials and errors More fascinating than risk-management successes, which are generally non-events, are the spectacular failures. Failures tell us about the extremes of financial stress. There are plenty of lessons to be learned from the collapses of Barings, Metallgesellschaft, Long-Term Capital Management and other lesser blips, many of which are analysed in this book.