Messmore’s Duration of Surplus

21 May

Sooner or later interest rates will rise and the market value of fixed-income portfolios will fall. This is not necessarily bad news: it’s not news because, as Figure 1 illustrates, rates have been low for years, and it’s not necessarily bad—or at least as not as bad as it may seem—for financial institutions whose assets and liabilities are interest-rate sensitive. The concept of surplus duration,[i] introduced by Thomas E. Messmore, CFA, in 1990,[ii] offers an intriguing approach to estimating the impact of interest rate changes on institutions that are broadly engaged in asset-liability management.

Messmore defines the duration of surplus as the term DS that satisfies the equation:

(A x DA) – (L x DL) = S x DS                                                    Equation 1

where A is the fair value of assets, DA is the duration of assets, L is the present value of liabilities, DL  is the duration of liabilities, and S is surplus, i.e., the difference between assets and liabilities. On the basis of this definition, Messmore observes that the duration of surplus equals the duration of liabilities plus leverage times mismatch (Equation 2) or the duration of liabilities plus mismatch divided by the surplus cushion (Equation 3). Figure 2 contains the three equations in good form.

 DS = DL + (A/S) (DA – DL)                                                        Equation 2

DS = DL + (DA – DL)/(S/A)                                                       Equation 3

Without attempting to relay all of Messmore’s insights, we can use the Rivanna District Retirement System (RDRS), a fictitious defined-benefit pension plan, to explore some implications for tactical market risk management in financial institutions. RDRS provides retirement benefits to District employees, including administrative staff, teachers, sheriffs, and firefighters. The system has assets fair-valued at $51.3 million, including debt securities of $19.7 million representing 38% of total assets.  The debt securities’ asset-weighted average effective duration is 3.73. RDSS has actuarial accrued liabilities present-valued at $72.8 million; therefore, it is about 70.5% funded. On the basis of a very rough estimate, the duration of the system’s liabilities is 13.13.

Let’s first consider the potential impact of a 100-basis point increase in interest rates on the system’s debt and liability portfolios. The fair value of the debt portfolio would decline by approximately 3.73%, or $735,000, from $19.7 million to about $19.0 million, while the present value of the liabilities would decline by approximately 13.1%, or $9.6 million, from $72.8 million to about $63.2 million. The net effect is to reduce the surplus deficit by roughly $8.8 million. Thus, assuming the system’s non-debt assets are unaffected, the increase in interest rates would boost the funded status to approximately 80%. That would, indeed, be good news for Rivanna District taxpayers.

In the absence of duration estimates for the system’s other investments, we might further assume that the average fixed-income asset duration of 3.73 applies to total assets. In that case, for RDRS as a whole:

  •  Leverage (A/S)  = –2.39
  • Surplus Cushion (S/A) = –0.42
  • Mismatch (DA– DL) = –9.4
  • Duration of surplus (DS) = 35.5

And, mathematically, a 100-basis point increase in interest rates would raise the system’s funded status to roughly 78%. Were rates to rise, then, RDRS would benefit from both components of surplus duration: its negative cushion and its short mismatch.

To be clear, in a more usual interest rate environment, RDRS’s volatile negative surplus would make it dicey to follow the seemingly risk-averse policy of holding the duration of assets substantially shorter than the duration of liabilities. But these are not normal times. Interest rates have little room to fall and ample room to rise.

[i] For the purpose of this discussion, duration may be described as the approximate percentage change in the price of a bond for a 1% change in interest rates.

[ii] Thomas E. Messmore, “The Duration of Surplus,” The Journal of Portfolio Management, Vol. 16, No. 2 (Winter, 1990), pp. 19-22.

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The Perfect Villain

10 May

[Author's Note: At CFA Institute’s 2012 Annual Conference this week, President and CEO John Rogers said, “There has been a marked and prolonged period where our industry has forgotten what it takes to maintain the trust of clients, regulators, and the public as a whole.” Rogers called upon all of us, as investment professionals, to take personal responsibility for restoring trust in the financial services industry. “This starts in our places of work,” he said, “and it extends from there out into the community.” I am reprinting “The Perfect Villain” in the context of this call to action.]

Thoughtful and experienced practitioners, acting on behalf of CFA Institute and other financial analysts’ associations around the world, have formulated principles-based ethical codes and standards of practice to guide investment professionals in their work. The various standards of professional conduct differ in their details but generally agree on fundamental values: the need to protect both the integrity of the capital markets and the priority of the clients’ interests. They offer useful guidelines for the true (and truly rare) ethical leader and for the many imperfect people of good will, people who want to do right but may not always know how to sort out conflicting demands in complicated situations. These individuals, undoubtedly the vast majority, deserve all the support the investment profession can offer them.

But what to do about the others, those who exempt themselves from the rule of decency? How can we protect the investment profession—and the firm—from perfectly unethical people? Let us start by recognizing them.

We may take as a model the perfectly unjust man sketched in the second book of Plato’s Republic. Socrates is debating Thrasymachus about the merits of justice and injustice as competing ways of life. “But to come now to the decision between our two kinds of life,” he proposes, “if we separate the most completely just and the most completely unjust man, we shall be able to decide rightly, but if not, not.” In other words, to establish the superiority of the just man, Socrates suggests that we consider the opposing ideal, the paradoxical notion of the person who has perfected injustice.

Our immediate concern is more modest. It is neither to discern the nature of justice nor to argue in favor of the ethically good life but to identify the person who can do the greatest damage to our profession and, even more alarmingly, to our investment management firm. Our immediate concern is not with philosophy but rather with practical psychology and sound management. Socrates spoke of the perfectly unjust man; we shall think about the perfectly unethical person.

If perfectly unethical people were readily identifiable, we could simply take action to separate them from the firm and, in the best case, from the profession. They do not, however, publicly declare that industry standards of professional conduct apply only to others. On the contrary, they appear to be irreproachable. “For the height of injustice,” Socrates observes, “is to seem just without being so.” The perfectly unethical person is held in high esteem. He may be a philanthropist; she may be the keynote speaker at an industry conference. There’s the rub. Appearances deceive.

In addition to their reputation for integrity, perfectly unethical people exhibit three other characteristics. They are uncommonly competent, persuasive, and powerful.

“In the first place,” Socrates says, “the unjust man must act as clever craftsmen do. A first-rate pilot or physician, for example, feels the difference between impossibilities and possibilities in his art and attempts the one and lets the others go, and then, too, if he does happen to trip, he is equal to correcting his error.” In the investment profession, perfectly unethical individuals understand how the capital markets function. They know the features, characteristics, and behavior of investment instruments, and they grasp complex strategies in their area of specialization. They know how their firm monitors employees’ trades and how regulators examine their firm’s records. In short, they know what they can get away with and how to get away with it. Socrates remarks, “we must regard the man who is caught as a bungler.” Perfectly unethical people are not bunglers but competent practitioners.

They are also compelling speakers. Socrates states that when the perfectly unjust man does happen to slip, “we must concede to him the power to correct his mistakes by his ability to speak persuasively if any of his misdeeds come to light.” Perfectly unethical people have credible explanations ready, and when challenged they deliver their account with sincerity or disbelief or outrage. (After all, consider their good name.) It was not an unsuitable investment — had the transaction worked out more favorably, the client would have been grateful. It was not insider trading but a perceptive appraisal of the issuer’s near-term prospects. It was not market manipulation but a superior grasp of behavioral finance, not a conflict of interest but a win–win situation, not a failure of independence and objectivity so much as an excess of enthusiasm for a promising idea. It is a misunderstanding. Let it slide. You will hurt the firm.

Finally, perfectly unethical people have the forcefulness and self-assurance that accompany power. As investment professionals ourselves, we prize the qualities of intelligence and decisiveness. We admire successful risk-takers, and we reward them with wealth and influence. When necessary, Socrates says, the perfectly unjust man will “employ force by reason of his manly spirit and vigor and his provision of friends and money.” If you wish to keep your job, look away. If you wish to advance, be realistic. This is the way the world works. Perfectly unethical people may prefer to persuade, but they can be bullies too.

So what can we do?

Focusing first on our own attitudes, we can recommit ourselves to the values promoted by the investment profession and reorient ourselves with regard to the standards of practice. We may never reach an accord on what it means to live well, but we can and likely do agree on constitutive values in the limited domain of our professional activities. The work we do advances two goods greater than our own self interest. The investment profession promotes fair and efficient capital markets and serves the client’s financial wellbeing. On this foundation, we can see the standards of practice not as the rules of the game that we consult when the penalty flag is dropped but as guides to right conduct.

This philosophical approach, however, is most unlikely to turn perfectly unethical people from their ways. Thrasymachus was hard to convince, and Socrates himself proved to be the perfectly just man, put to death for seeming unjust. The practical answers are simpler and surer.

We must be no less skilled, articulate, and self-assured than those who seek only to advance their own interests. In addition, we must apply to our own and our colleagues’ ethical decisions the same critical thinking that we bring to such tasks as conducting a manager search, verifying a claim of compliance with the GIPS standards, or interviewing an issuer’s senior managers.

No less skilled: We are responsible to our clients, our firm, and ourselves to maintain and continuously improve our professional competence. However overextended we may be, it is vitally important to find the time to read a journal article, to master a new analytical technique, or to think about how the capital markets are changing.

No less articulate: We must practice ethical reasoning. That means determining the facts, sorting out conflicting demands, and applying the profession’s ethical principles and standards of practice so as to protect and foster the greater good. It also means bringing to light the flaws in arguments that would justify unethical actions or vindicate unethical individuals. Let us strive to become the ones to whom our colleagues turn for advice on ethical issues.

No less self-assured: Perfectly unethical people take pride in a sort of realism that dismisses ethical ideals as illusions and irrelevancies. In fact, the investment profession is built on trust no less than expertise. Our clients and colleagues legitimately expect us to act with diligence, respect, and independence as well as with competence. It is unrealistic to think that these qualities do not matter. Ethically sound values are essential to the investment profession, the firm, and our own identity. And sometimes in real life they require hard choices.

Finally, we are well advised to adhere to the Russian proverb that U.S. President Ronald Reagan quoted in disarmament negotiations with the former Soviet Union: “Trust, but verify.” Reagan repeated the admonition when he left office: “It’s still trust but verify,” he said. “It’s still play, but cut the cards. It’s still watch closely. And don’t be afraid to see what you see.”

Copyright (2006), CFA Institute. Reproduced and republished from CFA Magazine with permission from CFA Institute. All rights reserved.

Risk and Uncertainty

9 May

More than 90 years ago Frank H. Knight famously distinguished between measurable, insurable risk and unmeasurable, non-insurable uncertainty. Frequently cited in the risk management literature of today, the distinction seems useful—I’ll have more to say about that—but Knight himself was an economist (he was, in fact, one of the founders of the Chicago school of economics), not a businessman and certainly not a risk manager. It is interesting to explore his motivation for emphasizing the difference between risk and uncertainty as he used the terms. Knight was highly critical of his discipline’s traditionally simplistic view of human psychology and behavior, and he would, I think, approve of our squandering a few minutes this way. “Man’s chief interest in life,” he wrote, “is after all to find life interesting, which is a very different thing from merely consuming a maximum amount of wealth.”[1]

Knight’s concern in Risk, Uncertainty, and Profit (1921) was to resolve the problem of profit in distributive theory. In the perfect competition of classical economic thought, the values of goods and the costs of productive factors tend to reach an equilibrium point at which there is neither profit nor loss. In other words, “the tendency is toward a remainderless distribution of products among the agencies contributing to their production.”[2] In actual competition, however, there are usually profits and losses. It is in the context of explaining “pure profit,” defined as “a distributive share different from the returns to the productive services of land, labor, and capital,”[3] that Knight distinguishes between risk and uncertainty. “The only ‘risk’ which leads to a profit,” he wrote, “is a unique uncertainty resulting from an exercise of ultimate [entrepreneurial] responsibility which in its very nature cannot be insured nor capitalized nor salaried.”[4]

Pure profit is bound up with economic change, but change, in itself, does not create potentially profitable opportunities. Rather, change is “a necessary condition of our being ignorant of the future,” and that very ignorance—that uncertainty—accounts for the possibility of profit, understood, again, not as net income but as the residual share after imputed rents, wages, and interest. “Dynamic change gives rise to a peculiar form of income only in so far as the changes and their consequences are unpredictable in character.”  In fact, any surprise, including the failure of expected changes to materialize, may induce uncertainty. “It is not dynamic change, nor any change, as such, which causes profit, but the divergence of actual conditions from those which have been expected and on the basis of which business arrangements have been made.”[5]

In addition to the uncertainty occasioned by rapid economic change, there is the uncertainty associated with differences in business ability, differences, Schumpeter remarks, that are “are much more obviously relevant to the explanation of profits and losses in conditions of rapid economic change than they would be otherwise.”[6] Knight demonstrates at considerable length that the functions of making decisions and taking responsibility for them are inseparable even in large shareholder-owned corporations with hired managers. The owners whose capital is at risk have “indirect knowledge” and exercise “indirect control” by selecting managers in whom they have confidence.  “In the field of organization, the knowledge on which what we call responsible control depends is not knowledge of situations and problems and of means for effecting changes, but is knowledge of other men’s knowledge of these things.” In other words, the owners make judgments about the managers’ powers of judgment. “Like a large proportion of the practical problems of business life, as of all life, this one of selecting human capacities for dealing with unforeseeable situations involves paradox and apparent theoretical impossibility of solution. But like a host of impossible things in life, it is constantly being done.”[7]

In summary, then, profit arises not from known risks but “out of the inherent, absolute unpredictability of things, out of the sheer brute fact that the results of human activity cannot be anticipated and then only in so far as even a probability calculation in regard to them is impossible and meaningless.”[8] Not from calculable risks but from uncertainty about the future and about our capacity to evaluate others’ abilities, our “faculty of judging faculties,” especially in times of change. It is, Knight argues, “uncertainty in this sense which explains profit in the proper use of the term, the sense toward which economic usage has been groping, that of a pure residual income, unimputable by the mechanism of competition to any agent concerned in its creation.”[9]

It is hard to convey the richness of Knight’s thought in a short piece like this. Not impossible—Peter L. Bernstein explained risk and uncertainty admirably[10]—but, nonetheless, hard. In addition to elaborating the profit theory recapitulated here, Risk, Uncertainty, and Profit presents, almost incidentally, a view on the relationship between theoretical and empirical economics, a theory of knowledge, a discussion of the social basis for private property, and observations on the psychology of risk-taking, the impact of technological advances, and the nature of leadership, among many other things. But 90 years, while not a long time in the history of thought, is an abyss when we consider the practice of risk management. What meaning does Knight’s distinction between risk and uncertainty have for risk professionals now?

High-frequency, low-impact risk events, such as credit card fraud, retail pilferage, and grocery coupon redemptions, can be fully modeled and confidently reflected in product pricing. Low-frequency, high-impact risk events, such as operational failures, can be modeled only with difficulty, and the value of stochastic forecasts is conditional on the analyst’s skill in identifying dependencies and estimating probabilities. And some risk events cannot be modeled because they are unimaginable; such might be the sudden appearance of a radically new substitute that irremediably changes the competitive environment. Risk and uncertainty, as Knight defined them, are the extremes of a continuum. When we attempt to quantify the impact of risk events, it is salutary to ask ourselves where a given scenario falls on that gamut.

[1] Frank H. Knight, Risk, Uncertainty, and Profit (Boston and New York: Houghton Mifflin Company, 1921). The sentence quoted appears in Part III, Chapter XII, Social Aspects of Uncertainty and Profit; in the Kindle edition published by Signalman Publishing, Orlando, 2009, it can be found at Location 4418.

[2] Part I, Chapter I (Location 245).

[3] Part I, Chapter I, footnote 12 (Location 4556).

[4] Part III, Chapter X (Location 3667).

[5] Part I, Chapter II (Location 467).

[6] Joseph A. Schumpeter, History of Economic Analysis (New York: Oxford University Press, 1954), p. 894.

[7] Part III, Chapter X (Locations 3443 and 3516).

[8] Part III, Chapter X (Location 3667).

[9] Ibid. (Location 3685).

[10] Peter L. Bernstein, Against the Gods: The Remarkable Story of Risk (John Wiley & Sons, 1996), pp. 218-223.

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The Suitability of Complex Products

1 May

The Financial Industry Regulatory Authority (FINRA)[1] published in January a notice on complex products which is acquiring momentum as the July 9 effective date for Rule 2111—the new suitability rule—approaches. Regulatory Notice 12-03, “Complex Products,” offers guidance on the higher level of internal supervision expected of firms whose offerings include hard-to-understand investments. The present article does not purport to summarize Regulatory Notice 12-03. I will focus here on the special considerations that complex products raise in relation to the reasonable-basis and customer-specific components of Rule 2111,[2] with particular attention to the training implications.

FINRA states that Regulatory Notice 12-03 neither defines a complex product nor provides an exhaustive list of features that might make a product complex. The notice does contain the elements of a working definition: “Any product with multiple features that affect its investment returns differently under various scenarios is potentially complex. This is particularly true if it would be unreasonable to expect an average retail investor to discern the existence of these features and to understand the basic manner in which these features interact to produce an investment return.” Among the examples FINRA gives are asset-backed securities, unlisted REITS, products that contain embedded derivatives, and products tied to the performance of unfamiliar markets such as VIX futures.

These statements imply that firms are well advised to take a fairly broad, inclusive view of the products to be considered complex. Dividend-paying stocks and coupon-bearing bonds are unquestionably simple instruments, but each arguably has “multiple features that affect its investment returns differently under various scenarios.” At the risk of sounding curmudgeonly, I would also say it is most prudent to underestimate the average retail investor’s grasp of strategies and securities.[3] With that understanding, I would suggest that firms and registered representatives consider a product complex if it would be difficult to explain in such a way that the average customer could realistically evaluate its risk and return characteristics. In other words, rather than asking how hard it is to understand, consider how hard it is to explain to a typical customer.

Under the reasonable-basis component of Rule 2111, registered representatives must have “a reasonable basis to believe, based on reasonable diligence, that the recommendation is suitable for at least some investors.” This is a peculiar approach—one ardently hopes no brokerage firm would bring to market a product that is inappropriate for all investors—but the point is that registered representatives must be qualified to recommend an investment strategy or security by their comprehension of its potential risks and rewards. “The lack of such an understanding when recommending a security or strategy violates the suitability rule.”[4]

Rule 2111 effectively obligates financial advisors who recommend complex products to have reached a fairly advanced level of competence. Structured products are one of the examples given in Notice 12-03. Registered representatives should understand the payoff structure—ideally, FINRA states, they should be competent to develop a payoff diagram—as well as the likelihood of a call, any limitations on principal protection, and the characteristics of the reference asset, including its historical performance, volatility, and correlations with other asset classes. If a structured product contains multiple reference assets, registered representatives should understand their interrelationships.

Under the customer-specific component of Rule 2111, registered representatives must “have a reasonable basis to believe that the recommendation is suitable for a particular customer based on that customer’s investment profile.”  Accordingly, they must be qualified by education or training to determine the suitability of a recommendation on the basis of the relationship between the risk/reward profiles of specific strategies and securities, on one hand, and pertinent aspects of customers’ investment profiles, on the other. The customers’ investment experience (and, by implication, knowledge) is a key factor in determining whether a complex product is suitable. In addition, registered representatives are obligated to evaluate individual customers’ risk tolerances. This is not a rote exercise because the customers’ stated willingness to accept risks may, upon examination, prove inconsistent with their ability to sustain losses.

Nor can firms merely implement administrative procedures to spare registered representatives from having to demonstrate competence, conduct due diligence, and exercise professional judgment. In Regulatory Notice 12-03, FINRA encourages firms to adopt the approach that is mandatory for options trading accounts.[5] The regulator observes, however, that such expedients as pre-qualification agreements with customers do not relieve the firm or its registered representatives of the obligation to conduct thorough customer-specific suitability analyses before making investment recommendations.[6]

The suitability rule and FINRA’s concerns about complex products may jointly have a significant impact on the design and delivery of brokerage firms’ internal training programs (not to mention their record-keeping policies). There may also come about meaningful changes in the larger firms’ culture, hiring, social and organizational structure, compliance risk management platform, products and services, and sales practices. Interesting times.

[1] FINRA is the U.S. securities industry’s self-regulatory organization that oversees brokerage firms and registered representatives serving retail investors.

[2] See “Suitability” (January 9, 2012).

[3] H.L. Mencken is said to have said, “No one in this world, so far as I know—and I have searched the record for years, and employed agents to help me—has ever lost money by underestimating the intelligence of the great masses of the plain people.” I do not know the original source of this quotation.

[4] Rule 2111, Supplementary Material, .05(a).

[5] Rule 2360(b)(19)(B) states, “No member or person associated with a member shall recommend to a customer an opening transaction in any option contract unless the person making the recommendation has a reasonable basis for believing, at the time of making the recommendation, that the customer has such knowledge and experience in financial matters that he may reasonably be expected to be capable of evaluating the risks of the recommended transaction, and is financially able to bear the risks of the recommended position in the option contract.”

[6]Speaking at FINRA’s 2011 annual conference, Chairman and CEO Richard G. Ketchum said, “Brokers cannot rely on firm approval alone to satisfy their suitability obligations. This is particularly important with the proliferation of increasingly complex financial products, and at a time when certain investors are tempted to chase yield in today’s low-interest-rate environment.”

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Materiality

24 Apr

Few concepts in financial reporting and investment management are as fundamental, pervasive, and vague as the concept—perhaps I should say the “notion”—of materiality.

Financial accountants are cautioned against material misrepresentations in management’s estimates, and auditors, trained in the exercise of professional skepticism, are on the alert for material misstatements of financial position due to error or fraud. Investment professionals are ethically obligated to disclose material changes in the processes they use to analyze investments, select securities, and construct portfolios,[1] and they are legally as well as ethically obligated not to act on material nonpublic information. Performance analysts are expected to correct material errors in the presentation of investment results. Last year the SEC “brought actions against four hedge fund advisers identified through the aberrational performance inquiry for inflating returns, overvaluing assets and other actions that materially misled and harmed investors.”[2]

In short, the concept of materiality is ubiquitous in the field of finance. What does materiality mean, and how do accountants, auditors, and analysts decide whether information is material?

It is generally agreed that information is material if it would affect a capable[3] person’s economic or financial decisions. The Financial Accounting Standards Board sees materiality as an aspect of relevance,[4] one of two fundamental qualitative characteristics of useful financial information, and states, “Information is material if omitting it or misstating it could influence decisions that users make on the basis of the financial information of a specific reporting entity. In other words, materiality is an entity-specific aspect of relevance based on the nature or magnitude or both of the items to which the information relates in the context of an individual entity’s financial report.”[5]

CFA Institute mentions the impact of material information on security prices as well as on investment decision-making:  “Information is ‘material’ if its disclosure would probably have an impact on the price of a security or if reasonable investors would want to know the information before making an investment decision. In other words, information is material if it would significantly alter the total mix of information currently available about a security in such a way that the price of the security would be affected.”[6]

And the GIPS Guidance Statement on Error Correction states, “Whether an error might affect a prospective client’s decision to invest is a key determinant of materiality and the appropriate action necessary to resolve the issue.”

But this just kicks the can down the road. How does one determine whether the information in question would affect a reasonable user’s or client’s financial decision? As the FASB indicated above, two factors are germane to this determination: the nature of the information and, where applicable, the magnitude of the item.

  • Evaluating the nature of the information in question presupposes an understanding of the business as well as the pertinent accounting and analytical standards and techniques. A software company’s failure to disclose that its ownership of critical intellectual property has been credibly contested would probably constitute a material omission of a significant event. A misstatement in an oil company’s depletion expense or movements in net proven reserves is more likely to be material than an error in its interest income account. In performance measurement and client reporting, a benchmark change is more meaningful than the composite creation date.
  • Establishing a materiality threshold also requires an appreciation of the setting, along with an informed sense of the appropriate scale. An auditor’s “tolerable misstatement”[7] may be higher at the parent company than the subsidiary level. A valuation error that distorts a rate of return by 25 basis points is probably more significant in a fixed-income than an equity portfolio. The GIPS Guidance Statement cited above suggests that firms additionally consider whether an error is material relative to the benchmark.

We can’t predetermine what will be material in a particular situation any more than we can establish a uniform threshold that would apply in all cases. In the end, deciding whether the nature and size of an item makes it material is a context-sensitive question of professional judgment, and a professional judgment is most likely to be valid if the professional is competent, independent, and objective. These are ethical qualities. Materiality is a financial concept grounded in ethics.

[1] CFA Institute Standards of Professional Conduct, Standard V.B.1.

[2] SEC Chairman Mary L. Shapiro, “Remarks at the SIFMA C&L Conference,” March 20, 2012.

[3]“The evaluation of whether a misstatement could influence economic decisions of users, and therefore be material, involves consideration of the characteristics of those users.” AU Section 312, Audit Risk and Materiality in Conducting an Audit, explains the user characteristics to be assumed when assessing materiality, e.g., they are assumed to “recognize the uncertainties inherent in the measurement of amounts based on the use of estimates, judgment, and the consideration of future events.” (Paragraph .06.)

[4]Information is relevant if it can make a difference in users’ financial decisions, and it is capable of making a difference if it has predictive or confirmatory value. Statement of Financial Accounting Concepts No. 8 (September 2010).

[5] Ibid. The other fundamental qualitative characteristic of useful financial information is faithful representation.

[6] Standards of Practice Handbook, 10th ed. (2010), Standard II-A, Material Nonpublic Information, p. 49.

[7] AU Section 312, paragraphs .34-.36. See also AU Section 350, Audit Sampling.

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OTC Derivatives and the Real Economy

16 Apr

For working purposes, let us think of the domain in which non-financial products and services are produced and exchanged as the real economy, and let us broadly differentiate three fairly distinct uses of derivative securities.

First, participants in the real economy use derivatives to reduce commercial risks due to fluctuations in commodity prices, interest rates, and foreign exchange rates. A cereal company, for example, might use wheat, corn, and sugar futures to attenuate the adverse impact of rising agricultural prices; a real estate developer might enter interest rate futures contracts when starting a major construction project; and a distributor of machine tools might use forex futures to manage currency risk. The list could be extended, but the idea is that non-financial companies make use of derivative securities to mitigate commercial risks that arise in the course of their business but are incidental to their profit-seeking operations. Regulators refer to these market participants as “end-users.”

Second, traditional investment managers use derivatives to modify portfolio characteristics. For instance, a firm might wish to equitize cash or reallocate assets quickly and without incurring high transaction costs; adjust the duration of a fixed-income portfolio; or manage country and currency risk separately. This activity—using derivative securities to change the risk profile of financial assets—could be said to take place in the semi-real economy. An earlier generation might have called it the paper economy, but it’s less tangible now.

Third, hedge funds and exchange-traded funds use derivatives to create long and short positions in capital markets, economic sectors, industries, national economies, commodities, interest rates, foreign currencies, the weather, and the creditworthiness of other companies. The speculative use of derivative securities to manage notional exposures, generally on the basis of quantitative methods and models, occurs in what might be called the abstract, symbolic, or unreal economy, an economy of mathematical variables. Trading opportunities arise when p is temporarily out of sync with q, or the spread between r and s exceeds the historical average, or a change in the level of x signals a likely adjustment in the level of y.

I am reserving “the surreal economy” for future use, possibly in the context of securities regulations.

Of course, the boundaries between the real, semi-real, and unreal economies are vague and, to use a fashionable word, porous. Whether or not they add value in the way skilled labor does, traditional investment managers are compensated in cash that they spend on food and drink, clothing, housing, transportation, luxuries, and, occasionally, leisure. The competitive games alternative asset managers play can have significant effects on traditional managers’ investment results as well as producer and consumer prices and the availability of credit for business and household formation. Nonetheless, it seems useful to distinguish among these economies, or sub-economies, however inexactly delineated. Wittgenstein wrote, “Frege compares a concept to an area and says that an area with vague boundaries cannot be called an area at all. This presumably means that we cannot do anything with it.—But is it senseless to say: ‘Stand roughly there’?”[1]

All this comes to mind because the Canadian Securities Administrators have released a consultation paper, CP 91-405, “Derivatives: End-User Exemption,” the fourth in a series of eight papers building upon the regulatory framework for over-the-counter derivatives that was proposed in November 2010.[2] The consultation paper, which is open for public comment through June 15, 2012, presents the CSA Derivatives Committee’s case for exempting end-users who do not pose systemic risks from proposed regulatory requirements pertaining to registration, trading, clearing, margin, capital, and collateral. Under the CSA proposal, they will be required to notify the regulator of their intention to rely upon the exemption, and, on an ongoing basis, they will have to report transactions to a trade repository.

Regulators in other jurisdictions have also addressed the applicability of OTC derivatives regulations to end-users. In the U.S., the Dodd-Frank Act states that the otherwise mandatory clearing of security-based swaps is optional if one of the counterparties meets three conditions: it is not a financial entity; it is using security-based swaps to hedge or mitigate commercial risk; and it informs the Securities and Exchange Commission how it generally meets the financial obligations associated with its use of non-cleared security-based swaps.[3] The SEC and the Commodity Futures Trading Commission (CFTC) have formulated extensive rules pertaining, in particular, to the third condition. Last month the U.S. Congress passed and sent to the Senate a bill, H.R. 2682, intended to clarify that end-users of derivatives are not subject to margin and capital requirements.

Under the CSA’s recommended eligibility criteria, an end-user:

  • trades OTC derivatives for its own account, and is neither a registrant nor an affiliate of a registrant;
  • is not a financial institution; and
  • conducts trading in OTC derivatives contracts for the purpose of hedging,[4] that is, mitigating a risk related to the operation of the business.

Affiliated legal entities trading with one another will be exempt if they individually satisfy the eligibility criteria. However, “large derivatives participants,” summarily defined here as end-users whose default would represent a systemic risk due to the size or significance of their trading relative to the overall market, will not be eligible for the exemption and will have to meet registration requirements. A future consultation paper on registration will contain the specifics for large derivatives participants.

[1] Philosophical Investigations, I, 71.

[3] Title VII, Section 763(a).

[4] The CSA Derivatives Committee recommends adopting the definition formulated by the Committee on Payment and Settlement Systems (CPSS) and the International Organization of Securities Commissions (IOSCO): “the term ‘hedge’ or ‘hedging’ generally refers to the taking of a position in a commodity derivative contract opposite to a position held in the physical market to minimize the risk of financial and/or economic loss from an adverse price change, or otherwise for risk management purposes.” Technical Committee of IOSCO, Report FR07/11, Principles for the Regulation and Supervision of Commodity Derivatives Markets: Final Report (15 September 2011).

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Book Review: “The Wrong Answer Faster”

8 Apr

Michael Goodkin’s delightfully unpretentious memoir, The Wrong Answer Faster: The Inside Story of Making the Machine that Trades Trillions (John Wiley & Sons, 2012), is at once an autobiographical narrative, a business history, and a case study in the commercial application of academic ideas in the second half of the 20th century.[1] Two case studies, in fact, because Goodkin tells about founding Arbitrage Management Company, Inc. with economists John Shelton, Harry Markowitz, Paul Samuelson, and Robert Merton in 1968 as well as Numerix LLC with physicists Mitchell Feigenbaum, Alexander Sokol, and Nigel Goldenfeld in 1996. (Arbitrage Management Company thrived, was sold, and is now defunct; Numerix is today a dominant factor in cross-asset deal structuring, valuation, and risk analysis.) In addition, The Wrong Answer Faster spans the industrial revolution of the investment management business—the arrival of desktop computers, the ascendancy of quantitative methods, and the engineering of new, complex, and transformative financial instruments. Goodkin tells his own story in a book that reads like a long, companionable chat, but the changes he helped bring about contributed to revamping the financial services industry and, arguably, reshaping the global economy.

Regrettably, the book would have benefited from another round of copy-editing and proofreading. The author’s occasional repetitiousness is natural and excusable; this is, after all, a work of memory. There are, however, far too many sentences that are poorly constructed if not grammatically incorrect. Indeed, one has the impression the published work is simply an unedited transcript in the manner of an oral history. For example, Goodkin says, “Unlike with the bookmaker, who if I lost I was losing his money and that would be the end of it, the financier required….”[2] There are also errors of the sort an automated spell-checker won’t catch, such as “orders being executed with lightening speed,” two instances of “waived” where “waved” was meant, and misspelled names (“Carl Ichan” and, twice, “Solomon Brothers;” the latter misnomer is slavishly reproduced in the index). It is disappointing to see a distinguished publishing house overlook flaws like these.

Goodkin’s account opens with his formative high-school experiences as a card shark and shoe salesman, and carries through his undergraduate career at the University of Illinois and his successful graduate studies in law at Northwestern and business at Columbia. Despite his academic credentials, he was not a scholar, and, coming late to the study of mathematics, not a quant, either. While at Northwestern he started a company that employed his fellow students as contract research staff for small law firms, and of his first meeting with Markowitz in 1968 he writes, “It soon became obvious we were very different sorts of people. I was a pragmatist, only concerned with whether things worked. He, despite his commercial success, was an intellectual. He wanted to know why things worked. As much as he was soft-spoken, gentle, and calm, I was blunt and intense.”[3] Goodkin taught himself backgammon in order to socialize with prospective investors, and, after selling Arbitrage Management Company, he moved to London, played competitive backgammon, and idled with the beautiful people. In 1986, he recalls, he stumbled across a book entitled Chaos; “not seeing too many mathematical formulae or complex graphs,” he says, “I bought it.”[4] Goodkin’s notion that there might be a connection between chaos theory and derivatives pricing led, eventually, to the formation of Numerix.

Goodkin’s role, then, was entirely entrepreneurial. It would be a mistake, however, to think that he merely retailed other people’s original work. He himself had extraordinary ideas: he saw how concepts and techniques developed in one domain might solve problems in another. This betokens a distinctively creative mental process. Arthur Koestler wrote, “The creative act does not create something out of nothing, like the God of the Old Testament; it combines, reshuffles and relates already existing but hitherto separate ideas, facts, frames of perception, associative contexts. This act of cross-fertilization—or self-fertilization within the same brain—seems to be the essence of creativity, and to justify the term ‘bisociation.’”[5] Goodkin’s intuitions seem to have been bisociative in Koestler’s sense.

Moreover, as an entrepreneur, Goodkin recruited theoreticians before the universities took a serious proprietary interest in the inventions of their faculty members, and he turned to private investors for financing before the venture capital industry was fully organized. The most interesting, and often amusing, parts of Goodkin’s memoir are those in which he tells about pitching his ideas to bemused professors and skeptical financiers. For instance, he describes a meeting with Sir Sigmund Warburg in 1970: “’A computer,’ he said once more. ‘Fancy that.’ And then his eyes lost their twinkle. ‘Preposterous! Utterly preposterous!’”[6] The meeting ended on that note.

All autobiographies, of course, are suspect. “It is impossible,” Goodkin avows, “to be objective when writing a memoir.”[7] Other people might remember or interpret the same events differently and recall more ambiguous incidents that are not mentioned in this book. Nonetheless, we are most fortunate to have Goodkin’s first-person account of a career that contributed so much to crystallizing contemporary modes of thought and practice in the investment profession.

[1]The title expresses Goodkin’s discovery that traders did not want more precise valuations as much as they wanted conventional results sooner than other traders could calculate them.

[2] Prologue.

[3] “Recruiting the Brain Trust,” in Chapter 7, “Stepping Out in the World.”

[4] Chapter 12, “Does God Play with Loaded Dice?” Goodkin allows that “some events appear out of precise chronology.” (Acknowledgments.) I suspect the book he perused was James Gleick’s bestseller, Chaos: Making a New Science, published by Viking Penguin in 1987.

[5] The Ghost in the Machine (Viking Penguin, 1967), p. 184. See also Koestler’s earlier book, The Act of Creation (Viking Penguin, 1964), p. 35 seq., and my article on creativity and the unconscious, “Art, Science, and the Clear Blue Sky,” International Studies in the Philosophy of Science, vol. 7, no. 2 (1993), p. 111.

[6] “An American Capitalist in Sir Sigmund’s Court,” in Chapter 10, “Too Good to Be True.”

[7] Acknowledgments.

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