Efficient Diversification

Recently in class it seems that we have been talking quite a bit about effective diversification and how it can increase/decrease risks and returns. I thought this was interesting as well because it also ties into what I am learning in several other classes this semester, including my finance class. I think diversification is quite an important concept, so I decided to find some articles and learn a bit more about it. In class, we have been talking a lot about diversification through adding new projects, but I decided to look more in depth at diversification of a portfolio.


I found the following chart, which I think is quite interesting, as it shows the correlation between the risk one takes and the rewards/profits one receives. As you can see, small company stocks have the highest risk, but also the highest reward. Whereas, T-bills do not have a very high return, but they also have the lowest standard deviation in the chart, and are therefore the least risky.

The following picture was quite interesting to me, as it clearly shows the differences between all these different types of investments a company or person can make, and the risks and rewards associated with each.

Additionally, I found charts showing the benefits from efficient diversification of one's portfolio. For example, it seems that most people nowadays do not create well diversified portfolios for themselves. Many invest too heavily in just one company or stock, while others try to diversify their portfolios more so, but still confine themselves too much into one market segment, such as technology. By being more prudent, and investing in a variety of different market segments, in some risky and some less risky investments, one's portfolio will be much more well diversified and profitable.

The following chart gives a good example of how diversifying one's portfolio can be more profitable. Investing in some risky stocks, or projects (like we have talked about in class) can sometimes be a good thing, but this needs to be balanced out with investments, or projects that provide a more stable return.

From this you can see the effect of diversification, that a prudent investor can get great returns by balancing out their portfolio in both risky and less risky investments/projects. I think this connects well to a lot of the aspects we previously talked about in class about diversification, as well as our new topic talking about whether new projects should be undertaken or not, depending on their risk level.

Essentials of Investments


Diversification Benefits

Currency Hedging

After reading the case about Aspen Technology I decided to research and try to learn a bit more about currency hedging and some ways that companies that might engage in this strategy.

A simple way to describe currency hedging is that it is a strategy used by companies when engaging is some sort of foreign investment. Basically, the process compensates for any possible shifts in the relative value of the currency types used within the investment. This way, even if there are unfavorable shifts in the money market, a positive return on the investment will still likely be achieved.

Using currency hedging seems to be a great way to keep the amount of loss at a minimum when dealing with international investments. However, the strategy is quite useful because it doesn't diminish the ability of a firm to make large profits. By using currency hedging, the firm might even be able to become involved in great investment opportunities that otherwise would have been considered far too volatile and risky.

Currency Hedging Definition

I was interested in what other companies may engage in some sort of foreign exchange risk management and found an article about GM. GM seems similar to Aspen Technology in some ways as far as how they manage this risk. Like Aspen Technologies, GM does a lot of buying, selling, and financing in currencies other than the US Dollar. Therefore, they too face risk from the volatility of other currencies. In particular, GM has to deal a lot with financing, since most cars are purchased with some sort of financing contract, much like the ones in place for Aspen's software.

I also thought it was interesting, because I remember reading in the case that Aspen Technology has difficulties finding any counterparts willing to enter into long-dated forward contracts. Therefore, they typically only entered into one or two year forward contracts to protect them from the foreign exchange rate risks. GM is very similar to this, in the article it states that for transactions denominated in foreign currencies, GM typically hedges forecasted and firm commitment exposures up to three years in the future.

It seems that foreign exchange risk is hedged out a great deal among companies. Even some large companies, many people are familiar with, such as GM. Overall, I think it was just very interesting to see all the parallels between the risk management policy of Aspen Technology and that of GM in regard to this foreign exchange risk.

GM Foreign Exchange Risks

Homework Exercise

• Suppose the firm's new expected revenue was 106
• Cost of Capital is 0.05
• And we want to use the 99% confidence level for CaR (hint: use the Zc=2.326)
• Assume everything else is the same, should the Pharmaceutical company invest in the new drug?

The Cash Flow at Risk for this new drug needs to be calculated using the 99% (1%) level:

• 2.326*20=46.52 for new
• 2.326*25=58.15 for current
• 2.326*35=81.41 for combined (calculated by finding the variance of the cash flows, taking the square root, and then multiplying by Zc=2.326)

Then, the present value of cash flows for the new drug is found as follows:

• New Drug=106/(1+0.05)-100=0.9524

However, we also need to account for the fact that the new drug increases firm risk:

• 106/1.05-100-0.11*(change in CaR from new to old)
• =106/1.05-100-0.11*(81.41-58.15)
• = -1.6062

Even without accounting for the increased risk to the firm, the NPV of adding this new drug was barely greater than zero.

By including this factor of added risk, it puts the NPV of this new project less than zero.

Therefore, since adding the new drug would increase risk and result in a negative NPV, we should not engage in this project and should not add this new drug for the pharmaceutical company.

"Beyond the Normal Distribution"

Since we have recently been discussing the normal distribution in class, and its application in risk management, I thought it would be interesting to find an article and learn a bit more about it, beyond what I have learned in other classes thus far.

I found a great article titled "Beyond the Normal Distribution" by Ben Fehr about the normal distribution, and some new ways mathematicians are beginning to use this model and others, as well as possible problems it poses.

The article was really interesting because it explained that the normal distribution is a great tool for many situations, but for the true picture of the financial market as a whole, the normal distribution doesn't really do that great of a job. For example, using the normal distribution big shocks to the stock market would occur much less often than they do in reality. Like the crash in 1987, it should technically only happen every 10^87 years, but in reality it happens about every 38 years. So, by using the normal distribution one is really underestimating risk in this case.

I think this is quite interesting to think about, especially given the economy nowadays. Given the fact that we have never really seen an economy like the one of today, it would be very difficult to use such a mathematical model to predict what is going to happen, when everything is so volatile and unpredictable.

Another interesting thing the article discussed was the fact that they are replacing common risk measures such as "standard deviation," and "value at risk," with a new measure they call "expected tail loss." The traditional estimates we have learned about so far in class give an answer that for example, the daily loss of a particular company will not exceed $40 million with a probability of 99%. But this new approach answers the question about that remaining 1%, about what happens in that tail, which actually seems like a very interesting question to me. I think it would be interesting for example, so see how high this 1% likelihood of losses could get.

"Beyond the Normal Distribution"

"Personalizing Risk Management"

An article I read titled "Personalizing Risk Management" by Julian Birkinshaw and Huw Jenkins, gives a unique view into risk management, somewhat similar to what we have discussed in class thus far.

The article described risk management for a large firm with three complementary approaches, each with positive and negative aspects:

• The first is called formalization, which is basically just following all the formal procedures, rules, formulas, etc. to evaluate and decide what risks should be taken within the company.
• The second is called externalization, which is depending on the expertise and skills of third parties (such as auditors, regulators, credit ratings agencies, etc.). I discussed possible problems with this approach in my previous post.
• The third is called personalization, which involves giving the responsibility for evaluating and judging risk to those individuals who are making the decisions within a company.

I think that the switch of a company's risk management approach back to focusing on personalization is a great idea to make risks more effectively understood and controlled. For example, if you think about a company's management, it doesn't make sense for them to have sole control over risk management decisions, like they would get if the company followed formalization. Management doesn't always know all the information about what is going on in a company, and by getting input from lower level employees, or employees from various divisions in a company, they would have a wider view and be able to make better decisions. Personalization would allow this to occur, by giving more people input on risk management decisions and providing as much information as possible to make good decisions.

Personalization is also a good thing, because sometimes managers may be too focused on personal goals and not the overall good of the company. They may get bonuses or benefits for short term profits, so they will focus on this, rather than the long term status and future of the company. Making risk management decisions in this manner could be detrimental for the future long term good of the company simply due to a greedy manager. Personalization would reduce the sole power of these managers, and also refine their personal accountability. It seems to me that reorganizing their rewards would be a great way to fix part of the problem. It should be more focused on long-term behavior, rather than short-term profits. Companies need to make sure that those people who are making the key decisions are genuinely responsibility, and not too far removed to see what is really going on.

To me it seems that a supportive culture would also help out with this personalization of risk management. For example, if you look at those few companies that have been successful even during these difficult economic times, such as JP Morgan Chase and Goldman Sachs, you will see that they have a high level of team-based decision processes, open debates, intellectual honesty, and sufficient self confidence to make decisions. This way information is not hidden from any level of management or employees. It also helps manage risks better because employees see how their actions impact others, and have a clearer picture of the company, and everyone looks out for each other.

Though I think it is evident that all three types of risk management - formalization, externalization, and personalization - can be beneficial at times, but after reading this article I see the many benefits that come from personalization. It seems like a pretty intuitive thing that responsibility for evaluating and making a judgment on risks should be given to those individuals making the decisions, rather than pushing it solely upon top company managers or outside organizations with no real accountability.

Financial Times - "Personalizing Risk Managment"

"Do Not Destroy the Essential Catalyst of Risk"

I recently read the article "Do Not Destroy the Essential Catalyst of Risk" by Lloyd Blankfein, which seemed to tie in with many themes of risk management we have discussed in class so far this semester.

The article explained that the deterioration of risk management and finance practices was a large portion of this global economic crisis we are currently undergoing. One of the main points made in the article was that we cannot base risk management decisions on just historical data. I thought this was quite interesting insight, as it is exactly what we talked about in class this past week. Given the current state of our economy, there isn't really a "normal" historical time period that we can relate it to. These times of low stocks, failing companies, and layoffs are certainly the norm for this time period, but no time periods of the past had the same circumstances occurring. Therefore, to look back and base our risk management decisions on how things used to be, or how things nowadays were predicted to be 20 years ago, is certainly not a beneficial thing to be doing.

The article also discussed the problems with over-dependence on credit rating agencies. We have discussed the significance of these credit ratings many times in class. An AAA rating is the best, with investment quality going all the way down until BBB. Where BB down to CCC is considered high yield or "junk." During this time period the problems faced by risk management officials were more severe because they outsourced so much of their risk and depended too much on these credit rating agencies - many of which were over inflating ratings. For example, the article states that at this time there were over 64,000 structured finance instruments rated AAA. Clearly, the companies should have seen the problems with the credit agencies ratings and tried to evaluate some of the risk on their own, rather than completely relying on others. Therefore, personally I feel like a lot of the blame should be put on the credit agencies, but also some blame does belong to those financial institutions that did nothing to take on any responsibility for their own risk.

Another interesting thing this article brought up was the idea that "many risk models incorrectly assumed that positions could be fully hedged." Many new products to hedge had been created, such as basket indices and credit default swaps. However, they did not properly think through the fact that "liquidity would dry up, making it difficult to apply effective hedges." I think this is an interesting point, because we have talked a great deal about hedging in class, from examples we have seen in class it does sometimes seem that companies depend a great deal upon hedging to protect themselves from any risk possible. I think this brings up a good point, that though hedging is a great risk management tool, it isn't something that should be used in all instances for every risk management problem a company of institution faces.

And lastly, the article brought up the problem of risks in off-balance sheet activities. The management for these companies with huge risk off their balance sheet did not take necessary precautions and even worry about the great risks they faced. I think this also seems to relate to things we have talked about in class. This is one of those things that as investors, ordinary people can look through every financial document available, but some things, such as these huge off balance-sheet risks will still not be able to be seen. This is why reliable, responsible management, that won't get tied up with greed is a huge thing for a company. Management has great control over the risks of a company, and sometimes all these risks aren't as evident to lower level employees or the public as we would like them to be.

Overall, I think this article brought up a lot of great points about the economic problems institutions and companies currently face, and some risk management errors that are tied to these problems. It was really intersting to see how these tie to many things we have discussed in class already this semester. I think by realizing where these problems stem from is the first major step towards fixing them. However, it is evident that it is going to take time to "mend our financial system to restore stability and vitality."

Financial Times - "Do Not Destroy the Essential Catalyst of Risk"

Value at Risk and Beta

Professor Grace recently gave us a practice exam question, dealing with two firms with varying values for their value at risk, and their Beta.

Firm 1 had a Beta=1, and VaR of $2 billion
Firm 2 had a Beta=2 and VaR of $2 million

As discussed in class, these firms are both risky, as seen by these two different risk measures. Like Professor Grace taught us in class, a higher Beta, like that seen in Firm 2, shows that the firm is much more susceptible to changes in the market, making it quite risky. However, Firm 1 has a HUGE VaR of $2 billion, showing that it has a great deal of money on the line to lose.

The question got me thinking about which of these risk measures is actually better to look at, and is a better estimate of the true risk at hand.

I found a presentation by Oklahoma State University, which further expands upon ideas about Beta and VaR that we discussed in class. The expanded information in this presentation helped me further analyze the benefits of each of these risk management techniques, and try to figure out which one I feel is most beneficial.

Like we learned in class, beta shows the fluctuations of the firm (stock) in comparison to market changes. Beta=1 moves exactly with the market, Beta<1>1 is more sensitive to changes than the market. After some more research about beta, I determined that it seems to be a good determiner of just systematic/non-diversifiable risk, but not any other type of risk (diversifiable).

Therefore, it seems to me that VaR is a much better determination of overall risk. VaR gives an estimate of the worst possible loss an investment could realize over a given time period, under normal market conditions. To me, there seem to be many more advantages of using VaR than Beta. For example, the best thing about VaR seems to be that it gives a measure of total risk (diversifiable and non-diversifiable risk), that Beta is unable to analyze. Also, VaR is an easier number to explain to clients trying to understand the risks they face, since it translates portfolio volatility into a clear dollar value. Whereas, Beta would be much more difficult to explain to the clients. Another advantage of VaR is that it can measure the risk of many types of financial securities (stocks, bonds, foreign exchange, derivatives such as futures, forwards, options, etc.). And lastly, VaR is useful for comparing a portfolio with the market portfolio (S&P500).

From all these different qualities, personally I feel that VaR is a better risk measure than Beta. It seems that it has many advantages over Beta. Though I do agree that in the above problem, both firms are definitely risky, I would argue that Firm 1 is riskier due to its very high VaR, and to all the information that comes along with knowing this value.

Oklahoma State University Presentation on Beta and VaR