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When Quantitative Models Fail and What We Can Learn From It
It seems that the pre-crisis risk agenda had become too heavily skewed towards quantitative measurement. As a result, these models are losing influence in risk functions. A new emphasis is being placed on pragmatic risk management instead.
The crisis challenges all the basic assumptions that credit modeling and other forms of modeling are accurate and that internal models are an appropriate mechanism for regulation.
Basel II established a framework that demands to set regulatory capital aside for three distinct risk types: market, credit and operational risk. Some argue that banks failed to cope with a crisis in which market and credit risks overlapped with and reinforced liquidity and funding risks because they were too busy implementing their internal capital calculation systems.
Now, regulators are facing intense political pressure to reopen Basel II. It certainly doesn’t mean the end of modeling: quantitative analysis is one of the industry’s pillars, and it would be impossible to abandon it. Technology vendors are looking to improve the capabilities and functionality of their systems to cope with current market conditions.
Instead of getting rid of the models, banks need to find a better way to use them.
The integrated model is an obstacle to effective capital allocation within a bank and makes the risk profile of the institution opaque to external stakeholders. One way to manage risk more effectively is to have specific business activities with specific risk profiles and to manage them separately.
One of the problems is that models can give the illusion of confidence. It’s hard for senior executives or board members to have a debate about a VAR number or to understand how reliable it is. So, instead of giving decision-makers numbers such as VAR, which shows how much money can be lost by a single trader, desk or portfolio at a given level of confidence, banks should spend more time looking at gross exposure numbers.
Banks need to start using simpler metrics and ask basic questions such as “Is this a business we should be in?” and “Do we understand it, can we manage it, what are the risks we are taking here?.”
At the tactical level, a number of firms are creating new roles for a kind of super-auditor responsible for reviewing the operations of the risk function. Currently, existing audits tend to be carried out by staff who lack the expertise and authority to be a guarantor of the risk function’s effectiveness.
Productivity = Focusing on Essentials
Getting the most work done in the shortest time possible with limited resources is an entrepreneur’s dream come true. Achieving this requires the discipline to focus on the essentials, allocating limited resources to projects that can be fully utilized with increasing returns. Inspired by the book “Power of Less”, I wanted to share 3 considerations for thinking about resource allocation within your business:
Outsourcing work to outside firms that are experts in a respective field and can do the work more efficiently and effectively is a good strategy for increasing productivity with limited resources. Many businesses are hesitant to outsource services because of fear of the unknown and losing control of the project however such risks can be managed by choosing a provider whose skills match your needs, outlining the project requirements and agreeing on how much control each party will have over the project.
Re-engineering the way you do business through investing in technologies –business process automation –that improve on the efficiency of your business operations and keeps up with its rapid growth. This saves you time and money without compromising on the quality of your products or services by eliminating human errors and repetitive work procedures.
Getting rid of the nice-to-have parts of your business that are not necessities in the day-to-day operations of your business. This helps you allocate the resources you were spending on non-essentials to more essential parts of your business. In business focus is everything and cash is king so for survival one must focus on revenue generating activities.
Small businesses don’t have the luxury of wasting resources by randomly assigning budgets to projects and therefore allocation of limited resources must be strategic, researched and included when planning for future growth. Always invest in future income generating projects.
Assessing Risk using Historical Data
In the hedge fund marketplace, nothing is more central than risk. Historical data is widely used as a basis for risk assessment, particularly to predict the current stress/beta/Value-at-Risk characteristics and future potential paths of the assets and portfolio. However, solely relying on historical data is not enough and thus it’s very important to rely on expert opinion to interpret the data in context with the investment strategy and market conditions. Here are some ways historical data can help you asses risk:
- It helps you determine how a portfolio behaves under stress so you can predict future performance, however its accuracy depends on the volume and quality of historical data.
- It helps you identify key betas that need to be avoided in context with investment objectives and market sentiment.
However, historical data has a number of limitations that need to be considered when being used to asses risk for example:
- Beta dependent stress testing of an asset and portfolio by using market conditions today and stress charecteristics from historical data might only be marginally useful as correlations between assets change over time..
- Statistical information is not always available on every kind of incident, so one can’t determine the exact rate and severity of occurrences of all incidents. Furthermore, the impact of the consequences is often quite difficult to evaluate for intangible assets.
- The accuracy and cleanliness of the information collected. Professionally usable data needs to be clearly distinguished out of the massive yet inapplicable information and one has to be careful to not “data mine.”
In order to improve the way we assess risk when working with historical data, risk measures should be complemented by information from hypothetical scenarios. Forward-looking information reflecting expectations of market participants such as implied volatilities should be used together with statistical estimates (which are necessarily based on past information).
Finally, you need a trained eye to interpret the data and thus utilizing an educated opinion of a risk management expert can play a crucial role, when working with historical data.
Tips for Entrepreneurs on How to Raise Capital
Raising capital for your start up is overwhelming and could turn into a full time job taking your focus away from growing your business and attracting new clients. Here are some tips on how to raise capital for your start up:
- Be The First Investor: A number of investors are pessimistic about investing in your idea when you don’t invest in it. Show confidence in your idea by investing some of your savings into it and showing that you are fully committed.
- Research, Research, Research: It is essential to research an industry, market, potential investors and their investment trends and appetites. This saves you time, effort and the frustration from pitching the wrong investors.
- Presentation: A clear, concise and consistent story with facts and figures to back it up is essential when presenting a pitch to potential investors. Many times entrepreneurs change their story as they go along and this sets them up because investors talk to investors and if your story varies from one to the other your reputation as an entrepreneur worth investing in is at risk.
- Involve Mentors: Some grey hair along with years of experience in a particular field instills a sense of confidence among potential investors. It is a good idea to involve a mentor when you are trying to raise capital for your start up from investors.
Some of these services like research and developing presentations can be outsourced from firms so you can focus on developing your business idea further. Remember, as a CEO you can’t wear all the important hats in your organization, so to really succeed you must focus on what you do best.
Minimising Risks When Outsourcing Services
Here are four ways you could mitigate risks involved in outsourcing:
- Carefully screen applicants to verify they are qualified to manage the project you are outsourcing. The reason for outsourcing is to save money – not to throw it away, so you want to be sure the firm you are outsourcing to is going to add value to your business, not putting your reputation at risk.
- Invest in having a good lawyer and create tight NCDA documents. You want to make sure that all your contracts, are clear, transparent and protect your interests and your clients.
- Be clear about scope of project or responsibilities, deliverable expectations, time line, and supplementary budget if project is over budget or other expenses come up. This should include, agree on a step-by-step project plan, specifics regarding project phases and clear dead lines.
- Appoint someone in the company to liaise with the outsourced firm. Communication is key in this partnership, so schedule progress meetings at intervals to be sure all parties are on the same page and there is no room for surprise that could jeopardise the project. This also minimises the risk of losing control to the outsourced firm.
What is VaR?
After continuously being asked by clients what Value-at-Risk (VaR) really is, other than a fancy statistical term, I thought to give a brief overview and discuss its pros, cons, and significance.
VaR is used as a measurement of probability of loss in value for a specified confidence interval. For example, to say that a portfolio has a 95% monthly VaR of -3.5%, would mean that the portfolio has a 95% confidence interval of not loosing more than 3.5% within any given month. Three ways of calculating VaR are Parametric VaR, Historical VaR, and Monte Carlo simulation.
Parametric VaR is the most criticized since it assumes the normal distribution of the returns. The cut-off point on the left tail of the bell-shaped curve, depending on the confidence interval, will define VaR. Therefore, all we need for the VaR calculation is the mean and the standard deviation of returns. Because the returns tend to be negatively skewed with the fat tails (defined by the term leptokurtosis), the parametric VaR tends to underestimate VaR which causes the outraged criticism of the whole concept.
Historical VaR overcomes this disadvantage: it does not make any assumptions about the returns distribution because it simply uses historical returns data. When these returns are sorted in order from the lowest to the highest, the percentile defined by the confidence interval determines VaR. As the Historical VaR uses the actual returns (losses) in order to define the maximum potential loss over a specific period, it is valid as long as the current economic environment is similar to the past. Since Historical VaR is the most routinely used measurement, let’s sum up its pros and cons.
Pros:
– Conceptually easy
– Uses the actual returns (as opposed to the assumptions about the normally distributed returns)
– Gives the operational and analyzable number
– Easy to use in conjunction with the expert opinion
Cons:
– Uses historical data to predict the future, hence not as strong in a changing economic environment
– Does not determine the optimal period of returns for the most reliable outcomes
– Does not give the probability and magnitude of the abnormal loss during extreme events
To solve the problems of Historical Var and to retain its advantages, Monte Carlo simulation can be used to estimate VaR. Monte Carlo simulation generates the set of outcomes with many various assumptions behind each outcome. VaR is determined by the same principle as the percentile of the chosen level of confidence. Unlike with Historical VaR, Monte Carlo simulation implements the great variety of the outcomes and scenarios to define VaR, and, therefore, works in a wider variety of the situations.
The VaR concept allows the systematic analysis and monitoring of the risk. As any other instrument, VaR can’t be used in isolation, but rather in sync with other techniques like stress testing and scenario analysis. With the uncertainty of future trends, VaR does not pretend to replace expert opinion, but rather supplement it. Therefore, without a VaR model that will quantify the risk, the portfolio manager is left with the philosophical generalizations about the economic environment and non-quantifiable perceptions of the risk.
While some intuitive “tools” of risk assessment relying only on expert opinion might work for an individual (such as stop losses, max position limits, gross/ net exposure limits) they fail to be effective in attraction of significant investors’ capital. Nowadays, risk management is not a novelty but more of a must for asset managers, thus confirming that investors and money managers need to use a common language understood by both.
Correct interpretation and understanding of VaR assumptions and limitations, as well as proper use with other risk metrics is the new common language of risk management, giving its user an advantage in the competition for the institutional capital. As affordable risk management vendors become increasingly available, saving your money and time, VaR evolves from a misunderstood number into a valuable decision-making tool. Feel free to check out our savings calculator to see just how much you could save when outsourcing your risk management services!
Application Of Automated Financial Risk Management Procedures
Assessing risk in connection with managing diverse and complex financial assets is a very complicated process, which requires sophisticated tools. Automating financial risk management procedures is a great way to establish an ongoing system that is capable of accessing numerous data points, thus providing a thorough analysis.
While some risks can not be mitigated such as a natural disaster happening or another random event, we can make sure to prepare our portfolios and businesses as best as we can to handle those events and save our assets.
Market and operational risks revolve around how the markets behave and the ability of the fund manager to respond in a timely fashion, or better yet to anticipate these events. A lot of up and coming fund managers are starting to recognize VaR monitoring, Stress Testing and Exposure analysis as relevant risk management techniques and yet many fail to perform them in a consistent fashion, due to lack of resources and capable people to perform the analysis. At the same time, when a negative event does occur in the market, they are faced with redemption pressure and general distractions from their investor pool asking about performance, positions, losses and other data. This kind of a nuisance only distracts the portfolio managers even further instead of giving them the space and peace they need to focus on the market and managing their portfolio.
In order to combat these distractions, a lot of the time a fund manager will have a junior analyst perform some of this very basic analysis and reporting, without having the time to check or interpret the work and to an extent throwing the money out the window so that they can say “me too” to their investors, but what happens when there is a typo, or a mistake?
In the asset management space, mistakes are unacceptable and fund managers fight for their reputation, track record and P&L. Therefore we strongly encourage automating manual processes, streamlining reporting and decision making systems (where possible) and outsourcing risk management work to qualified professionals, so that instead of saying “me too” the fund manager can say “custom, proprietary system with our own experts”.
While negative market events do happen, the risk of loss resulting from inadequate or failed internal processes, procedures, people and technology is heavily penalized. Operational risk is easier understood as the risk arising from an incident, such as a break-down in transactional processing or compliance issues, due to system or procedural failures, human errors, disasters or illegal activity. Erroneous trades and processing errors also pose an important source of operational risk. Automated systems and robust risk management procedures are indispensable for management of operational and market risk.
Automating risk management and development risk and reporting systems allows for accumulating of all available information that may be helpful to a financial institution in assessing and reporting risks in an optimized way. They tie together data sources and evaluate such data in a way that is meaningful for assessing the full picture of risk. Automated risk management systems can facilitate financial institutions in decreasing their potential losses, meeting statutory and legislative reporting requirements.
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Acute volatility in the market should pose a great opportunity for fund managers to blow away their expected numbers, rather than cause additional stress associated with market risks and the daily nagging from their investors. Here, at Bluefront Capital, LLC, we provide a full array of risk management services for financial institutions, including risk management, automated system development and risk reporting.
Outsourcing Financial Services in a Post-recession Environment
Expertise, peace of mind, and operational savings are the key benefits that drive entrepreneurs to outsource key functions for their company. To get value for your money by outsourcing it is essential to first determine whether it is the right time for you to outsource. Here are three signs it time for you to outsource:
- Your time is more valuable spent in a client facing role: if your (time) opportunity cost per hour is $150/hr and the cost of a contractor is $50/hr doing the same job which is their core competency – it is time for you to save money by outsourcing.
- The cost of hiring a full time staff – paying taxes, insurance and benefits marginalizes expected profits from that employee it is time for you to outsource and perhaps get a more productive employee. Some outsourcing firms have calculators to help you calculate your savings when deciding what services to outsource.
- You are not comfortable handling sensitive roles like the financials of your company and would prefer focusing your efforts on what you are confident in. It is time for you to outsource this service to experts.
Partner with Bluefront Capital to enjoy the benefits of expertise, reliability as well as saving time and money. Bluefront Capital has a comprehensive part-time CFO package that offers you more than the traditional budgeting, financial reporting and planning; it includes operations and back office support like AP, AR, collections and bookkeeping.
Stress Test Your Way to Success
A very popular way to test the limits of a potential employee is to make this person endure stress. People fear extended silence or stair, unexpected tasks or strange behavior of the interviewer. This helps revealing and assessing something that was not prepared and rehearsed in advance: how a newly hired will probably act in when faced with a problem.
Similar to people that you hire, you need to test your portfolio for resilience in a crisis situation. Stress testing as a risk management technique is widely implemented to measure the response of the subject position, instrument, asset class, or portfolio to extreme changes of a particular factor or to an impact of a specific crisis scenario. Stress testing is crucial to risk management, despite the fact that statistically such scenarios or significant factor changes are unlikely and usually when they do occur, are different from the ones that happened in the past. As it is often compared, the probability of fire completely destroying your house is low, yet you buy insurance to protect your savings and well being. Similarly, the probability of severe financial crisis at any given day is low, but stress testing allows you to estimate the potential behavior of your portfolio value and be prepared for it.
Stress testing is essentially an attempt to model and measure the effect of changes in the relevant market factors on the performance of an instrument, portfolio, entity, or the entire economy. If only one factor is changed, we care about sensitivity analysis. If the factors are interconnected in a scenario, whether existent in the past or hypothetical, the procedure is called “Stress Test Scenario Analysis”. To perform a stress test, you must:
– Identify the scope of the test, whether you want to test the portfolio or a particular slice
– Determine the factors relevant to the portfolio performance and strategy
– Estimate the co-influence of the factors on each other and model their effect on the portfolio value
– Shock the factors separately and together to measure their effect on the portfolio
Naturally, the process involves trials and errors, follow-ups and corrections. However, the clear advantages make it a necessary part of risk management.
Stress testing:
– Measures the loss from extreme but plausible events not captured by VaR
– Identifies the relevant factors and the effect of their changes
– Assesses the resilience of the portfolio in the situation of crisis
– Allows for the development of any “what if” scenario according to expert opinion
Stress testing is not free of the disadvantages and risk manager needs to be cautious as the flaws include:
– Estimates are only as good as the model itself: simplification may result in significant approximations
-The relationships between the unique factors effecting the portfolio are hard to estimate
-Even estimated initially, the correlations between factors do not stay constant
-Crisis never repeats precisely, so old scenarios may not be valid and new ones are hard to construct and hypothetical
The cost of handling these disadvantages can be significantly cut by using the third party risk data provider like RiskMetrics, Measurisk, Investor Analytics, etc and even more so by allowing the specialized risk management vendors to develop, run and manage the risk of your portfolio.
When you test people, your most valuable asset, at a job interview there is no guarantee that the candidate, who knows how to spot counterfeited coins amongst 10 sacks of money, is the one who will actually perform best under pressure. Similarly, stress testing is not designed to give the precise answers but without it, portfolio managers are left blinded with regards to factors affecting the portfolio and hence unprepared for crisis.
10 Characteristics of a Successful CFO
1. Financial Foresight
The ability to anticipate financial management issues and address them is an essential character trait in creating wealth for the company.
2. Excellent Communication Skills
Written and oral communication skills are an essential quality for a CFO, as they must be able to effectively communicate the financial health of the company to all stakeholders.
3. Confidence
The ability to make decisions on behalf of the company with confidence and assertiveness are good character traits for a successful CFO.
4. Vision and Foresight
A CFO should have foresight and be in tune with his market, enabling him to create and implement business plans for the company and aligning them with the ‘bigger picture’ of the company’s future.
5. Accounting & Financial Competence
With the Sarbanes-Oxley Act of 2002 that requires CFO’s to sign off on financial statements and internal control systems confirming their accuracy it is essential for the CFO’s to know the Generally Accepted Accounting Principles (GAAP) and SEC regulations that are relevant to their business.
6. Deep Understanding of Business
A deep understanding of business is a must because a good CFO is more than just a ‘numbers guy.’ He should immerse himself in the operations of the company have a macro view of the numbers, drivers and pains relating to Sales & Marketing, R&D, Service providers, Vendors, etc.
7. Integrity and Ethical Standards
A strong will which ensures that one is always doing the right thing by upholding the ethical and professional standards and is honest in all transactions with the company and the stakeholders.
8. Perspective on Risk
The willingness to try new things and take calculated risks to grow the business and improve the financial position of the company.
9. Result Oriented Nature
The ability to set goals that are specific, measurable, achievable, relevant and traceable is a good trait which helps a successful CFO manage the expectations of the company’s stakeholders-employees, investors, board of directors, analysts- as well as direct the financial operations of the company.
10. Leadership skills
A CFO should posses leadership qualities to enable him to delegate and oversee the financial operations of the company effectively. These qualities include emotional intelligence; self awareness, self regulation, motivation, empathy and social skills.
