Risk USA: pension woes and quant fixes

New angles

Pension funding shortfalls, hedge fund transparency and advances in derivatives and risk modelling were the leading topics at last month’s Risk USA conference in Boston.

Peter Hancock, JP Morgan’s former chief financial officer and head of risk management, who now runs a financial boutique called Integrated Finance, said in his keynote speech that he believes risk managers should spend more time developing enterprise-wide risk systems that can help top managers make crucial strategic business decisions.

While he “applauded the sophisticates” – typically quants that validate risk models – he said institutions are better off with an enterprise-wide approach to risk, rather than a specialised approach. With such procedures, risk managers are likely to be more successful in making an impact on the decisions made by top management, Hancock said.

The interlocking areas of risk management, transparency, budgeting, performance measurement – typically by economic value-added, as he believes Raroc ignores scalability – compensation and new investments should form the basis for business decisions.

Hancock also said the burgeoning under-funding of defined-benefit pension plans in the US has reached such proportions that only government intervention can solve it. “The [pensions] crisis is on the same scale as the thrift [savings and loans] crisis and can only be solved by the US government,” he said.

Apart from wrestling with the intractable issue of pension risk, buy-side delegates argued over ways to improve hedge fund transparency. But Barry Schachter, head of risk management at US hedge fund Sac Capital Advisors, said he thinks quantitative hedge fund information disclosure to investors is relatively meaningless (see page 24).

A number of advances in quantitative finance were also on display. Peter Carr, recipient of Risk’s 2003 quant of the year award, discussed the pricing and hedging of volatility derivatives. Traders and quants have traditionally used stochastic volatility models for volatility swaps, but this approach can be plagued with problems. For example, within this framework it is difficult to simultaneously fit long-dated and short-dated option prices.

But in his talk, Carr showed that volatility derivatives can be robustly replicated by a portfolio of dynamically traded European-style vanilla options, if a correlation assumption is specified. This novel approach, which Carr developed with Stanford University’s Roger Lee, is applicable to both swaps and options.

Meanwhile, Robert Jarrow, professor of finance and economics at Cornell University and an originator of the seminal Heath-Jarrow-Morton interest rate term-structure model, described a new method for incorporating liquidity risk – the additional price volatility due to the size and timing of a trade – into the arbitrage pricing framework.

Jarrow’s liquidity risk analysis uses a ‘martingale’ measure to test for the absence of arbitrage opportunities. It seeks to determine, at different points along a price history, the degree to which ever-increasing sales or purchases by a dealer affects the price of an asset. The result of Jarrow’s approach would be smooth trading strategies that exhibit ‘bounded variation’, he said. “I can minimise liquidity costs by trading continuously and using a finite variation process,” he said.

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