Market Risk in Today's Environment

Now that we have been through very extreme market volatility, and while not as volatile as late 2008 markets continue to be quite volatile, how are people dealing with managing market risk? In the recent period of extreme stress correlations went to 1.0, tail events became more common and extreme (e.g., loan market volatility was 9 sigma in October 2008). Just take a look at the volatility index (VIX) as an example. I would think that traditional market approaches such as value at risk (VaR) would produce results that would be impossible to manage to. In other words, the amount of capital required to hedge the market risk would not make sense. Have people given up on trying to manage market risk in this environment? If not what are you doing?

Answers

John Kogan CEO/CFO • June 2, 2009

I have been CFO in Silicon Valley through two bust cycles (dot bomb and whatever we're going to call the current '08/'09 debacle) and my board's reactions were the same both times: retreat to the most conservative strategy possible, even if that means holding cash, diversify institutions and bail from any bank that has a hint of risk.

It is really quite remarkable how long boards can take to come around on the latest issues and how quickly they will turn and run once they finally confront the risk. This includes, in some cases, illogical responses which would only serve to weaken a company's finances. I think a critical part of the CFO's job, in addition to being a check on the CEO, is to be a trusted advisor to the board. Sometimes that means taking on more work and responsibility, such as extra research on holdings of your banks, creation of tighter investment policies and research on alternative investment vehicles, be they treasuries, currency hedges or other.

I can remember getting into a dust-up with my CEO about switching banks based on a news article he read. Once the facts were uncovered in direct research it turned out that our primary institution was far safer than the alternatives (many of which no longer exist) that he suggested. You just really have to do your homework and have an opinion.

Scott Lane CFO and CRO • June 3, 2009

I have experienced something similar: irrational fear when things go wrong. It seems to me that most managers out there follow a herd mentality. They load up on risk without truly understanding the risk when things are good and run for the exits when things get stressed.

Ultimately my view is that much, if not most, of the cause behind our current financial crisis was the over-reliance on quantitative models. It turns out the tail events were much more likely and much more severe than anyone expected. Risk managers should use statistical analysis as just one data point, not the only or primary data point / input for their analysis. Common sense and managerial judgment are critical and more important than quantitative models.

A couple good books in line with this sentiment:

When Genius Failed, Lowenstein
The Black Swan, Taleb

Scott Lane CFO and CRO • June 19, 2009

http://www.economist.com/businessfinance/displaystory.cfm?story_id=13881056

John Kogan CEO/CFO • June 19, 2009

Maybe the market is finally going to price derivatives commensurate with their risk.

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Market Risk in Today's Environment

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