Nassim Taleb, an author who usually inspires (except in his second book, Black Swans) has co-authored a paper with a long-tailed title “On the Difference between Binary Prediction and True Exposure with Implications for Forecasting Tournaments and Decision Making Research”.
The paper isn’t paygated so check it out – it’s only 6 pages so definitely accessible. Don’t worry about the couple of typos in the paper, bizarre as it may be to find them in a paper that presumably was reviewed, the ideas are still good.
The key idea is that prediction markets usually focus on binary events. Will Person Y win the election? Will China invade Taiwan? These outcomes are relatively easy to predict and circumvent important challenges of extreme outcomes and Taleb’s Black Swans.
A quote from the paper, itself quoting Taleb’s book, Fooled By Randomness, sums up the problem of trying to live in. Binary world when the real world has a wide range of outcomes.
In Fooled by Randomness, the narrator is asked “do you predict that the market is going up or down?” “Up”, he said, with confidence. Then the questioner got angry when he discovered that the narrator was short the market, i.e., would benefit from the market going down. The trader had a difficulty conveying the idea that someone could hold the belief that the market had a higher probability of going up, but that, should it go down, it would go down a lot. So the rational response was to be short.
Best practice for matching non-profit annuities in most countries, certainly from a risk perspective, is still to cash flow match (or at the very least, match key durations) using government bonds.
The theory is that the insurer isn’t then exposed to changes in the term structure on interest rates, only exposed to illiqudity/reinvestment risk to the extent of mortality fluctuations, isn’t exposed to currency risk and certainly isn’t exposed to credit risk. Without complex margining requirements like some swaps and without the need to roll cash investments over, government bonds should allow ALM teams to sleep well.
Now, Solvency II is likely to adopt a swap yield curve rather than bond yield curve. There are some good reasons here, including arguably fewer distortions from temporary supply and demand imbalances, improved liquidity and so on. The same yield curve is used for liquid liabilities so the allowance for an illiquidity premium over and above the swap curve at some times, in some ways and for some products is still under debate.
But what should Greek insurers do in the meantime?
Frankly, Greek government bonds don’t remove credit risk and the huge credit spreads on these instruments will create huge funding gaps and variability in earnings unless a Greek govi yield curve is used to value liabilities as well. It’s not clear at all that Greece will stay part of the Euro, so German government bonds don’t remove currency risk. German government bonds in any case are show signs of nervousness as yields creep up.
The swap market is exposed to the same Euro break-up risks as bonds. Which banks will survive, what happens to currencies in the meantime and what does that do to long-term Euro swaps? What about Euro-Sterling swaps issued by Greek banks (I’m not sure if these even exist though).
All in all, it’s good to be involved in ALM in South Africa, and even the Middle East just at the moment.
I heard someone talking on Classic Business tonight. Pity I didn’t catch his name so I can avoid his advice in future.
He was saying that he doesn’t see the point in investing in debt instruments. He explained that the return is low and the risk high since if the company gets into trouble, you’ll likely only get a few cents on the dollar back.
Well, he’s wrong.
Risk and asset-liability matching
Fixed Interest investments are often the only investment that makes sense when you need to match or hedge fixed liabilities. Naively consdering expected return only and not asset-liability risks gives naive results.
Credit risk premia more than compensate for default experience over time
It’s worth exploring risk a little further. The caller stated that if the company gets into trouble, it’s likely the bondholders will also be hurt, and will likely only get a few cents on the dollar. Well he’s wrong here too.
The historical default frequency for investment great bonds (BBB and above) has been hardly more than a few single digit percent. The Loss Given Default (how much an investor will typically lose if the bond issuer does default) is anywhere from 35% to 80%, depending on the seniority of the instrument, which estimate you trust, how it is measured and when the estimate was made. It’s because there are so few investment grade defaults that the data is so sparse and the estimates so wide. However, it’s clear that the likely return won’t be “a few cents on the dollar”.
I’m going to hunt round for some references here so you’re not just trusting my word.
Illiquidity premia = higher returns for some
Given the illiquidity of many corporate bonds, the expected returns are even higher if you as an investors are not considered with easy liquidation of your investment. This is a “pure risk premium” that you will earn over time without expected loss. You could purchase extremely high quality, well-collateralised debt and earn a good return above risk-free as long as you have the patience and resources to hold it for long periods or until maturity.
Michael Lewis, of Liar’s Poker fame, has written an engaging account of the role that subprime lending played in the global financial crisis. The new book is called The Big Short: Inside the Doomsday Machine
The jargon that Lewis uses is generally explained and shouldn’t prevent non finance geeks from understanding the role of subprime lenders, mortgage originators and, of course, the Wall Street banks that fed the frenzy with CDSs, synthetic CDOs and bonuses for all.
The story places a few characters at the centre of the story. I wasn’t convinced that these guys were all skill and no luck, but they certainly seemed to have a clearer idea of what was going on in the murky, muddy waters of securitisations of that era than many of the supposed experts.
Overall, it’s won’t be the smash hit that Liar’s Poker is, but it’s entertaining reading all the time. The links to Gutfreund are tenuous and smell a little of name-dropping. If Lewis wanted to remind the reader of his role in toppling the ex CEO of Salomon Brothers he succeeded. If he wanted to somehow project the glory onto the new book, he failed.
The Big Short at Amazon.co.uk
The Big Short at Kalahari.net
Check out Book Finder for prices from several stores (new and used) in your currency including delivery costs to your location.
I blogged recently about why I park on the fourth floor of the Cape Town airport parkade, and also about understanding and utilising unlikely but extreme events to your advantage. There is actually a link between these two posts.
Parking on the top floor does have a cost. It takes longer to drive up all the ramps and does, perhaps, on average take longer than parking on the most convenient floor every time. This extra time is a premium I pay to reduce the potential for really bad outcomes and thus optimising the parking problem. For example:
- I avoid the situation of attempting to park on a lower floor (trusting the untrustworthy electronic vehicle counter) and, after driving around for a while trying to find parking, having to give up and try a different floor. This much longer time, even if it only happens rarely, is a much worse outcome than 30 seconds on every flight. It can easily be the difference between making and missing a flight.
- I don’t have to worry about remembering where I parked my car. I don’t know that I am more forgetful than the average traveller, but travelling almost every week makes each trip blur into the next. I don’t waste headspace on trying to remember where I parked my car, and I don’t worry about forgetting. I have the peace of mind from having purchased a time of insurance against the risk of forgetting where I parked.
I get no value out of successfully memorising my car location, but gain from removing this risk and this worry from my routine.
If your company has a foreign currency exposure due to imported input components, this is a risk and a worry over which you have no control. Your energies are better expended elsewhere, on the operational and sales issues that you can effectively change. Get rid of these risks and get on with your real business.
Insurance and gambling have much in common. They both involve uncertainty and money and the rational consumer will, on average, lose money through the interaction. Both business models involve leveraging the tail of probability distributions (one nasty and one nice).
The tail of a distribution includes the very bad and very good possible outcomes, that typically have a very low frequency of occurring. Having your house burn down is a very bad outcome, but fortunately happens very infrequently. Winning the lottery is very good, but unfortunately in this case is also very unlikely for any particular individual.
Managing the nasty tail
A rational person who wants to avoid the unlikely but catastrophic risk of losing their house to fire will be prepared to pay more than just the average cost of the loss of the house in order to avoid the risk. Typically, we humans are risk averse (a wild generalisation given the research into utility and decision making that has led to behavioural finance and behavioural economics, but probably good enough for now). Insurance provides:
- genuine decrease in risk and indemnification of losses against the loss event happening
- peace of mind even if no loss is ever experienced, which has real value in terms of clearing the mind to think about other more important and more controllable personal and business matters
- reduction in the amount of capital / liquid assets individuals and businesses need to keep against unforeseen events. This capital can be better used and invested elsewhere
Contrary to the popular view, insurance has value even if you never claim.
Gearing to the nice tail
Gambling can be dangerous and addictive. It can also be entirely rational to gamble within certain parameters. Continue reading “Nasty or nice – playing the tail”
I blogged before about some medium-term concerns I have around Lebanon’s currency stability. A story I saw today shows an opposite view, so I’m linking it here. Moody’s have upgraded Lebanon’s bond ratings due to improved external liquidity.
My original post was to temper the irrational optimism around the currency peg, rather than to say there is bad news around the corner. However, I still feel Moody’s may be slightly optimistic, upgrading a small country’s bonds when the extent of the global recession is not clear.
Currencies aren’t what they used to be. The US Dollar can no longer be viewed as a safe bet as Obama and Bernanke spend their way out of a crisis partly fueled by too much spending. Inflation will come, it’s just a matter of time. Warren Buffet thinks so too. The current relative strength of the USD is a short-term reaction to the money flowing back into the US. It won’t last.
photo credit: plenty.r.
The Swiss are acting in the market to weaken the Swiss Franc to protect the economy. Given the problems Swiss banks have been having as a result of the credit crisis and pressure on banking secrecy rules out the franc.
The South African Rand? South Africa has a huge current account deficit, significant political risk, serious government spending and a decline in exports and production in our base metals economy.
The Pound Sterling is teetering on the back of a meltdown of the financial system – long the heart of the London and UK economy. I hear Ireland is in horrible shape too.
Some are suggesting the Norwegian Krone. It’s one of the world’s top ten traded currencies, which provides liquidity. Significant oil wealth has been accumulated and diversified in a “pension fund for the country”. However, currencies can be driven for extended multi-year period purely based on fashion. I don’t know that I want to risk being in a currency that simply goes out of favour.
The Japanese Yen has to deal with the worst economic declines in nearly 40 years. The Chinese Yuan is subject to state manipulation, usually pushing to keep it low to sustain an export-driven economy. Not sure I like my eggs fried in that basket either.
The argument typically turns to Gold. The shiny metal that has been a store of value for several hundred years. Only problem is that gold arguably has less intrinsic value than steel or wheat or oil. The price is driven by demand – demand that is driven by assumed future demand. Flows into Gold ETFs have been strong, and significantly responsible for the current prices. Getting in now at around $900 per ounce might not be smart if everyone else is already in and looking for a time to sell.
So, where’s the safe?