Gotta love you risk manager

Discussion in 'Trading' started by sle, May 12, 2003.

  1. sle

    sle

    Get a hang of the following story:

    Part 1, Tragedy: A new OTC step-up cap trade is consumated, where if the LIBOR rate goes above X, the seller pays LIBOR+50bp, on a notional of, let's say 100M. The cap's strike is set ATM. The trade description is taken to the risk manager, who has to OK it. Risk manger enters the trade into his risk management system and as soon as that happends the risk manager turns red and starts yelling at the trader:
    "Look, the delta on this trade is 180M!!! Dont you remember the delta limits? What the hell are you trying td do?" (Looking at the payoff for this instrument, it is clear that the payoff is discountinuous at the money and the "naive" delta would be approaching infinity there).
    The trader tries to argue that the delta can not be that high, that the most it could be is the 50bp * DV01 of the swap, but the risk manager does not listen. The marketer who already almost closed the deal, starts crying. The trader is in despair.

    Part 2, Comedy: Trader returns to his desk and phones the counterparty. They agree that instead of the step-up cap, they will enter into two separate deals - a regular cap with stirke X and a digital option with strike X and payoff of 50bp. The trader then gives the cap to the risk manager. which he signs off, since delta is about 0.5. Half an hour later, the trader gives the digital to RM and since the delta appears reasonable to the RM, he signs off on it too. Everyone is happy, marketer is almost having an orgasm.

    What do we learn from this story? :)
     
  2. Sounds like a story of the kind Nassim Taleb likes to tell. Reminded me of a couple of pages from Dynamic Hedging, where Taleb vents his frustration with risk managers who know little about the spirit of the math.

    One thing though. Are risk managers just inept or what? With their fancy phds and the like, wouldn't they know that deltas act funny when binary and some other exotics are involved? And wouldn't they be able to hence see the real risks involved in the trade and encourage the trader to get hedged immediately by buying call spreads?

    tragic comic maybe...

    mav.
     
  3. sle

    sle

    Well, fancy PhD is not a bad thing in itself - I got one too. The issue here was that in my mind the best RM's are ex-traders that know the instruments and markets. In real life, they are not getting enough to attaract ex-traders. Some RM's are pretty good, though - I had one that would (rightfully, too) bust my *** over some issue in my book.

    PS. There is no reason to take all Taleb's musing as gospel, he is a human being and did make mistakes in his life :)
     
  4. You didn't answer my question, which was, how can a phd (the risk manager) miss something as straightforward as that? And according to some, this type of lacking is widespread among risk managers. Wall Street banks are supposed to hire only the best but somehow these guys still don't get it.

    Secondly, I wasn't glorifying Taleb. Simply pointing out that he has a strikingly similar story to yours in his book. Taleb is not in the pantheon of the greatest traders. Great traders trade. They don't write books. Taleb can only use his long premium strategies because he being financed by a group that sells vol for a living and needs a hedge. I don't know if his fund would be in existence would it not be for that. And no one knows anything about his returns. They could be mediocre for all I know. That doesn't mean that Taleb hasn't provided some good insights into risk management.
     
  5. What book have you written if I may ask?

    Thanks,
    Maverick.
     
  6. sle

    sle

    Oh, "in my book" meaning my portfolio :) As for writing, the papers that I did write are of no use to anyone that does not trade exotics, it's the "obscure quant stuff".

    You are right - RM's should be more adept at what they do. Even though some more recent encounters with RM's were better then before, they are learning stuff. However, all of them who did learn everything, move to trading. Such is life.

    As for Taleb - I saw him at NYU and realized that he is waaay behind the times. Especially when he tried to say something about IR stuff - supposedly he traded them for CSD, but he has very little clue.
     
  7. Sle,

    This is not related to your last post, but just wanted to say that I have nothing against phds and quants stuff. I think that it takes great discipline and ability to earn a phd or quant status. If I have the opportunity to pursue a phd in the future I certainly will to improve my critical thinking and quantitative ability. Like Vic Sperandeo would say, you maximize risk control by maximizing knowledge. IN other words, what you don't know can kill you in the markets.

    I just wish that some quants and phds would learn to recognize the limitations of their modeling and analysis, no matter how complex. Please note that I am not branding all of them as overconfident/arrogant but it is undeniable that many are. Quintessential examples are Scholes and Merton who adamantly refused to recognize that their mean reversion mentality was also subject to the actions of mere mortals, that is the russian authorities. Their rationalizations, (10 sigma event or some crap like that) sound very weak and tinny to me and many others. And they nearly brought down the whole system with them. It's hard not to get the chills when you read Lowenstein's book.

    It amazes me that the big banks on the street continue to pile in the relative value and arbitrage type trading. They load up on chinese, indian, french, russian, (insert flavor du jour) and local quants to unearth whatever correlations they can, come up with a product/bet that is deceptively alluring and then try to find some dumb folks who will step into their trap. Someone brought up the example of the libor trade by Goldman on another thread. Classic case. It involved a hidden variable (vol) that was certainly not included in the pitch to the pension funds and other funds that got their faces ripped off to the tune of $300million. For more examples refer to Fiasco.

    Can't those meatheads make money the old fashioned way? By earning it instead of screwing people? It wouldn't surprise me that if you could forced those suckers to trade directionally at gun point, they'd be six feet under by now.

    Someone posted an article a while back about the 'sophistication' of the bond traders at the bank. Profile of a great woman trader: she gets some crunch monkeys to identify some bonds with low credit default risk for her, buys them and shorts the stock as a hedge. Wow. That's 'breathtaking'. Good for her. A real hero. Yay.


    Maverick.
     


  8. a. Most Wall Street managers are still vastly overpaid vs. their value-added to their firms.

    b. The firm mentioned in this story has a pretty crappy risk measurement system in place.
     
  9. sle

    sle

    I think that quant traders recognize the limits of the methodology quite well - otherwise there would be no new work done in that field. All that was said about LTCM, you have to admit that if they were a bit less leveraged they would have made a killing over the last couple of years if their investors did not panic and they weren't forced to liquidate their positions. Look at the corp/gov spreads then and now. It was no different then any other trader blowing themselfs up by overleveraging combined with liquidity issues. Tonns of regular traders blow themselfs up in a similar manner every day. As we all know, any liquidity problem will last longer then you can stay solvent :)

    I was the one who brought up the Goldman story to illustrate smart trading on the side of institutional investors. Nobody FORCED the counterparties to buy the swaps, all of the conditions were openly discussed. If someone offers you free money, time to think again. OTC trading is like playing chess for money - all figures are open, both players see them, but there is a difference between Casparov and some fellow from Washington Square. When someone dumps/pumps some stock to kill a barrier option he/she is short - do you find that unethical too? What about if you happend to have a good model of volatility skews and short/long some options - are you cheating?

    Well, it is a pretty smart strategy and I do not see anything bad about it. Pretty much every strategy sounds simple if it is described to you in a few words and it is tempting to say - hah, I can do that too. I am in a hospital on chemo right now and over the past week I have discussed some of my work with the guy lying next to me. And he understands, even though he is an iron worker - but do you think he would be able to trade IR derivatives now?

    As for the firm in question - it is a hedge fund, a pretty good one at what they do. I am with a different firm,though and do not know the details - someone visiting me yesterday mentioned this story to me. Risk management is a tricky and difficult business and it would be difficult to know every instrument that is traded if you are, for example shared between credit and MBS desk. With all my clashes with our risk guys I have to admit that they get the job done - just like cops, nobody likes to get a speeding ticket, but they do prevent accidents this way.

    Well, and the last issue - overpayment of management on Wall Street. I think not. CEO's at large production firms get paid waay better. The fact that some traders get a few millions a year and pretty much every institutional trader gets more then 300K - makes sense, why else would you go into trading. It is very simple - money attracts good people, be it mathematicians or anyone else.
     
  10. Sle,

    First off, I want to say that even though I don't know you personally, you are in my thoughts and prayers as you go through your stay at the hospital. I know that many are made stronger through times like these and want to encourage you in your fight.

    I'm not a 'i've got to have the last word' kind of guy but your last post raised some interesting points that I felt I had to answer.


    " I think that quant traders recognize the limits of the methodology quite well - otherwise there would be no new work done in that field. All that was said about LTCM, you have to admit that if they were a bit less leveraged they would have made a killing over the last couple of years if their investors did not panic and they weren't forced to liquidate their positions. Look at the corp/gov spreads then and now. It was no different then any other trader blowing themselfs up by overleveraging combined with liquidity issues. Tonns of regular traders blow themselfs up in a similar manner every day. As we all know, any liquidity problem will last longer then you can stay solvent"

    I beg to disagree with the above. As Lowenstein put it, the LTCM guys were bending over to pick nickels in front of a bulldozer. That was their strategy, they needed the leverage to make it work. By DEFINITION, if you are cognizant of the limitations of your correlation analysis you DO NOT bet the farm and use 100:1 leverage. Your argument (I'm glad I took Logic in college) appeals to 2 flawed constructs. One is appealing to a fact that would not qualify as a 'Markov' time, to use a term from probability for finance. As you probably know, if a technical setup qualifies as a markov time, it is kosher and statistically testable. If not, it's no more helpful than tea leaves. A markov time simply does not let you draw any inference from FUTURE information. In your argument above, you are operating with the current knowledge that spreads did narrow, but this information was unknown to the Fed and LTCM at the time. More precisely, they simply could not know WHEN those spreads would narrow. If we could run alternative histories using a monte carlo simulator, I wouldn't be surprised if we find that more often that not, actions taken by those bozos would result in the destruction of the financial system. But unfortunately, that(monte carlo) is impossible, and we only have one isolated event to draw inferences from. This time, the Fed came to the rescue. Who knows what would have happened if they didn't take action.

    My point is, that Scholes, Merton, Meriwether and consorts, did not have ANY respect for risk. They really believed that they were right. Their post blow up statements don't even show a hint of remorse. I don't care that this time, we know that the spreads eventually narrowed. That's not the issue. The issue is that back then in 1998, no one could say what would happen because no one could know what would happen, no big surprise there. You can't brush away LTCM's lack of liquidity to meet margin calls under the carpet, that was not a minor issue, that was THE issue.
    They bet the farm and now had their heads handed to them, and not only that, risked maiming the system. You can't say now with the comfort of 20-20 hindsight, it would have been okay. Sorry mate, that's intellectual cheating.

    Second flaw in your argument is the use of a red herring. The fact that many traders blow up does not justify LTCM's blow up. All it does is remind us that LTCM is also on the list of failures. This has been belabored on other threads, if your strategy is such that it eventually leads you a situation where you can't meet margin calls and have to put your house on the market, then it ain't a strategy. It's a time ticking bomb. These are the rules of the game in finance and the futures markets. You either meet the margin call or you are OUT. No whining, no 'come-on-we-know-this-convergence-is-coming-back-someday' attitude. Take it like a man and play by the rules. Don't rationalize. Why do think Soros kicked out Niederhoffer? Because he had the wisdom to recognize the walking time bomb that he was. And history has vindicated Soros twice. (Note to Nied fans, I'm not going to argue with any of you, I've seen the other thread and have vowed not to waste my time)

    "I was the one who brought up the Goldman story to illustrate smart trading on the side of institutional investors. Nobody FORCED the counterparties to buy the swaps, all of the conditions were openly discussed. If someone offers you free money, time to think again. OTC trading is like playing chess for money - all figures are open, both players see them, but there is a difference between Casparov and some fellow from Washington Square. When someone dumps/pumps some stock to kill a barrier option he/she is short - do you find that unethical too? What about if you happend to have a good model of volatility skews and short/long some options - are you cheating?"

    You are absolutely right. No one forced nobody. True. However, what I cannot be sure of is whether those people really carried out their responsibilities in alerting their clients to the full list of risks involved in the trade. My guess is that they probably highlighted some risks and deliberately ignored others for obvious reasons. One may argue, ok, why would they even bother telling their clients what the risks were other than 'legal' stipulations? (makes me think of the mexican bonds fiasco in Partnoys book) Fair enough, then yeah, it's a jungle out there. Bt you know what, one of these days, no one is going to come out and play anymore with our favorite crocodiles.
    Not surprising that the volume of otc transactions is slowing down. People can only get shafted so many times.

    Last point. Re the bond trading prowess of some. Sure your sheet metal worker will not be able to handle IR derivatives. In life, there's a distribution of abilities out there. Some are in that right tail and get paid a lot of money to handle complex financial products. Good for them. I just don't think they are such a big deal.

    I'll tell you, the only people I esteem are those who can trade the markets. People who can put their cohones on the line and take a long or short position. People like Tudor Jones, John W Henry, Vic Sperandeo and the list goes on. Are they perfect? No. Did they have big drawdowns along the way? probably. Did they ever blow up? No. Were they CONSISTENT over the last 20 years? Yes.

    That's what I call sophistication man. Whether a strategy is simple/smart or not is irrelevant. It is your staying power that is a testament to your ability. And I can tell you that the record of Wall Street is cyclical. It moves from one hot area to another over time. The only consistent thing about big banks is that they always end up taking the little guy out.

    Over and out.
    Good trading to you,
    Maverick.
     
    #10     May 13, 2003