An address by Charles S. Sanford, Jr.
Written by Charles S. Sanford, Jr. and Dan Borge
Delivered by Mr. Sanford
I am here to tell you today about the revolution happening right under our noses, on trading floors and in boardrooms and offices all over the world, a revolution that has been sparked by the competitive pressures of doing business in an increasingly global, technologically sophisticated world. Companies are under pressure to improve performance for their shareholders, governments are under pressure to increase economic growth and stability, investment managers are under pressure to do a better job of meeting the objectives of their clients, and individuals are under pressure to create their own financial safety nets. These pressures cannot be adequately addressed by old ways of managing risks — and avoiding risk is not a realistic choice.
But revolutionaries from both my world and yours, from business and academia, have created powerful new tools to identify and measure risks; to shed unwanted risks; to acquire attractive risks; and to enable companies, governments, fiduciaries and individuals to reach their preferred balance of risk and return more easily and more efficiently than ever before. We can do so because we are becoming adept at creating customized bundles of financial attributes that replicate particular patterns of results to fit clients' specific objectives — and we can do so at a price they find attractive. By developing tools that are both universal and precise, we have drastically reduced the gap between what clients really need and what they can actually get. This is the risk management revolution.
Of course, the power tools that this revolution is giving us must be used carefully, because accidents can be very painful — but few revolutions are bloodless. These new tools may be used to either magnify or reduce risks, depending on the objectives of the user. If a user's objectives are dangerous, that is not the fault of the tools serving those objectives, whether those tools are derivatives or Treasury bonds. The new power of risk management underscores the familiar principle that effective management requires skill and constant attention.
I am here today also to help you honor Norbert Wiener, whose work provided a mathematical foundation for many of the financial models that have fueled the changes now taking place. I am delighted to be here with many of the other mathematicians and economic theorists who contributed crucial ideas to the risk management revolution and also with those of you who have yet to take up arms.
Pressures and Uncertainty
Some people may ask, "Why do we need a revolution in risk management? After all, the old ways of doing business have served most of us well for a long time." But the risk environment in which our governments, businesses and markets operate has changed radically over the past decade. And it will continue to change. Substantially cheaper, faster and more versatile information technology has allowed us to design, execute and manage much more complex financial transactions and portfolios. News and financial information can be rapidly disseminated, making financial markets more transparent and efficient even as the markets become global and thus more complex.
Political and economic events have also raised the level of real and perceived risk in the world. Governments have abandoned most attempts to fix interest rates, exchange rates and the prices of goods and services. Today fewer central banks dominate their country's savings and investment process through a captive banking system. Restrictions on trade and capital flows have been relaxed. These cross-border flows continue to grow rapidly, creating a complex web of global commerce and finance. And the relative decline of the U.S. economy has left the world without a dominant, stabilizing leader. Central bankers, among others, have been struggling with their loss of control and the overwhelming complexity of the new environment.
The postwar rise of Japan and Europe as economic powers has been followed more recently by the emergence of the "tigers" of Asia and now China, India and the developing countries of Latin America. As these countries become economic forces in their own right, they greatly increase the level of global competition for jobs, resources and markets. The collapse of the Soviet Union and the centrally planned economies of Eastern Europe has led to the creation of other new markets. Ironically, it has also removed the polarizing discipline of the cold war from geopolitics, leaving a bewildering tangle of ethnic and religious conflicts.
Parallel to these developments, and partly because of them, markets have been much more volatile in the 1980s and '90s than they were in the 1950s and '60s. The direction, stability and liquidity of markets have fluctuated unpredictably at times over the last 15 years. Sensible market participants must be prepared for unexpected shocks to occur at any moment.
Perhaps because so much that was taken for granted in the past has become unstable, individuals in the advanced economies are feeling more vulnerable and insecure, losing their trust in the ability or willingness of institutions and governments to guarantee either job or retirement security. Statistically we may be more prosperous, but we are enjoying our prosperity less because we feel it is at greater risk of erosion by forces that seem to be out of our control.
But individuals are not alone in feeling this loss of control. Governments, corporations and financial institutions have also suffered some degree of anxiety over this state of affairs. This anxiety has led many to adopt costly defenses against risk:
- Businesses and financial institutions may hold an extra margin of precautionary capital — capital that could be released for more-productive uses. Firms may also be too cautious and so reject valuable opportunities to strengthen their franchises with attractive investments.
- Governments may try to hide, postpone or shift the consequences of troublesome risks. This usually hurts present or future generations of taxpayers.
- Fiduciaries and investment managers may adopt inappropriately cautious or risky strategies. They may have difficulty educating clients about the true risks they are taking on their clients' behalf.
- Fearful of their security, individuals may be overly cautious and so fail to accumulate enough wealth to provide themselves with an adequate safety net. Or they may be reckless and destroy the wealth that they have already accumulated. They may make uninformed decisions or fall prey to fraud or bad advice.
Fortunately, the risk management revolution has created powerful new tools that will give market participants much greater control over their risk positions. With considerable help from mathematicians and theorists, we can now do a far better job than we did in the past of identifying and quantifying risk at both the transaction level and the portfolio level. This is vital, since we cannot protect ourselves against an undefined risk.
The risk management revolution has also brought us more-accurate tools to manage the risks we identify. Analytical tools can help us break down blocks of risk into discrete risk attributes, such as French interest rates, Japanese stock prices, wheat prices, German inflation and rainfall in Iowa. We can then deal with such risk attributes one by one. Deeper and more efficient markets allow us to buy desired attributes and sell unwanted ones. Better analytics and information technology allow us to craft complex instruments that repackage the desired attributes into a customized bundle that accurately produces the desired change in a client's risk profile.
Like any other important management process, risk management requires clear objectives, but the power of the new tools means that users must be very careful about what they wish for. A new ability to pursue previously impractical goals may be dangerous if users ignore the full range of possible results or neglect to monitor and adjust their positions along the way as conditions change.
Much more skill and knowledge is required of the providers of risk management instruments than of the users, however, because one valuable role of the provider is to shield the user from much of the complexity and difficulty of the underlying technology. (One can, after all, use a television without understanding the electronics inside that are required to produce pictures and sound.)
Professionals who have joined the risk management revolution can use these new tools to help clients such as CEOs and their operating and financial managers focus on vital business objectives without being distracted or derailed by extraneous risks. We are able to reduce uncertainty about our clients' financial health. We can help them liberate excess capital, which they may then use for new strategic opportunities or return to shareholders.
As these new tools become more widely used, managements are beginning to be held accountable for actively assessing and managing their risks. The airline business once took for granted that expenses were at the mercy of fluctuating fuel prices. If fuel prices went up, all carriers suffered to similar degrees and the disappointing profits were attributed to "uncontrollable factors," not bad management. Today "uncontrollable factors" as an excuse for poor performance is rapidly going the way of the biplane, as analysts and investors come to understand that airline managers can use the markets to change the nature and the degree of their exposure to fuel prices.
And what happens to the manufacturer of capital equipment that begins to invest strategically in emerging markets where an infrastructure development boom is creating great demand for its product? The company's changing business mix will add a structural foreign exchange risk to its earnings equation. It will be subject to higher revenue and expense volatility than in the past, due to fluctuating exchange rates. Twenty years ago, that would have been just another part of the gamble involved in investing overseas, and the company would have allocated additional capital to buffer the risk. Fortunately, today the company can work with its financial advisors to offset all or part of that foreign exchange risk without the burden of an excess capital position and without handing off a complex and constantly changing risk to shareholders ill equipped to manage it themselves. (This raises an interesting question for all of us: How should we define the "neutral point" for currency risk? Should our net worth be invested in our home currency or in a basket of currencies? If our goal is to protect our purchasing power in a global economy, perhaps we should favor the latter.)
Derivatives: Power Tools for Risk Management
Many traditional risk management techniques, such as diversification and securitization, continue to be important tools. But the most powerful (and currently the most controversial) weapons in the risk management revolution's arsenal are derivatives.
What exactly are derivatives? They are financial contracts whose cash flows are specified by a formula linked to determinable events (often the market prices of traded financial instruments or commodities). And although some forms of derivatives are relatively new, others trace their origins back to Renaissance Europe. Dutch tulip growers in the 17th century were the first to hit on the idea of selling the rights to their future production — what we today call "futures contracts" or "forwards" — to finance the planting of their crops.
Today we still trade and sell derivatives based on commodities (although tulip bulbs are not quite as hot an item now as they were 300 years ago), as well as equities, bonds and currencies. And in addition to futures and forwards, one may choose to utilize swaps (i.e., contracts that pay the difference between a floating rate of interest, such as LIBOR, and a fixed rate of interest over a given period of time) or options (i.e., contracts that give the holder the right, but not the obligation, to buy a given amount of common stock at a fixed price for a given period of time) — traded on exchanges or sold over the counter on a negotiated basis. Over-the-counter (OTC) derivatives, which may prove to be the most useful risk-transformation tool, extend and complement the benefits of exchange-traded derivatives. Each OTC derivative contract consists of unique terms and conditions negotiated between the counterparties, tailored to fit specific needs. We are fortunate to be here today with some of the mathematicians and theorists who played a key role in the development of derivatives by creating logical frameworks that help us analyze and value these new tools.
Although advances in information technology played a vital role in making derivatives practical and in fueling their growth, the key contribution was the development of mathematics that allowed us to value the contracts more rigorously. One can only imagine how far the market would have developed by now if those 17th-century tulip growers had had today's valuation techniques.
The power of derivatives lies in their versatility and universality; the formulas for OTC derivatives are limited only by our creativity. Structure and payoff functions may be customized to fit a client's particular need, wholly or partially to offset existing risks or to gain exposure to desired risks. Unlike the one-size-fits-all products typical in the cash markets and on exchanges, OTC derivatives can be custom-tailored with unique structures and payoff functions that effectively dovetail with a client's particular risk profile and outlook.
- An insurance company wants fixed-income investments that match the maturity profile of its liabilities and is willing to take some credit risk to achieve higher yields than those available on Treasury securities. Mortgage-backed securities will provide the desired yield, but with the added risk of prepayment — which could unexpectedly make them "too short" to match closely the insurance company's longer-term liability profile. The company can buy mortgage derivatives that lock in a minimum effective life for its mortgage-backed securities, allowing it to take advantage of the higher yield with less risk.
- A company wants to acquire and control the distribution capability of another company but does not want the full range of risks buried in that company's business. The solution may be to acquire the company, use its distribution network, and hedge out the peripheral risks with a basket of stocks that mirror those unwanted risks.
- A company wants to sell a large volume of goods to another company but does not want the large credit exposure on the resulting receivables, which could result in too great a risk concentration. The receivables could be sold at a steep discount, but it may be easier and cheaper to use credit derivatives to synthetically diversify the risk by exchanging the large exposure to a single counterparty for a diversified basket of exposures to many different credits.
Unlike custom-tailored suits, custom-tailored derivatives are often less expensive than off-the-rack securities. And from the client's point of view they may be less complex than the traditional alternatives. Take the example of a pension fund that wants to diversify its holdings across international borders. Ten years ago, the fund might have chosen to buy foreign stocks — which would have meant dealing in unfamiliar markets with high transaction costs and the additional complication of foreign currency exposures. Today the pension fund may purchase an equity derivative that provides a guaranteed principal and a yield tied to the dividends and price appreciation of the desired foreign securities. The fund gains a stake in the upside of foreign equities, limits its downside exposure, eliminates the necessity for transacting in foreign markets and avoids the high transaction costs of dealing in the cash markets. Thus the tailored derivative solution fits better and costs less than the traditional off-the-rack approach.
Using derivatives, we may now conquer (or at least tame) many illiquid, unusual or complex risks that previously defied solution. Many clients will be using derivatives to manage business risks, macroeconomic risks and insurance risks, not just traditional financial risks.
Take the case of a pharmaceutical company that is uncertain about the effects future regulation might have on its development and manufacturing margins. In the past, the pharmaceutical company might have decided to address the business risk by diversifying, perhaps entering the distribution business by acquiring a distributor. But if no distributor is immediately available, the company may use derivatives to achieve the same objective, by creating a contract that generates cash flow as and when regulation accelerates. The company may use this cash to acquire a distributor, if the right oppor-tunity presents itself, or to deploy elsewhere. In either case, the pharmaceutical company has protected itself against loss of earnings due to regulation.
Derivatives may also help a company avoid the business risk inherent in restructuring — for instance, when it wants to sell a subsidiary that no longer fits its core strategy. During the weeks or even months it takes to find a buyer, that company will be exposed to a decline in the subsidiary's value. Rather than accept this unwanted and uncontrollable exposure to the industry and the equity market, the company can substantially reduce its risk by buying an equity derivative — in this case, a "put option" on a basket of equities that mimic the characteristics of its subsidiary. The derivative would give the company the right to sell the basket at a predetermined price within a given period of time. If market or industry factors cause the subsidiary's value to fall, the value of its equity derivative may well rise, partially or wholly offsetting the loss.
In the near future, we may see derivatives addressing the macroeconomic variables that can have a strong impact on the fortunes of companies, institutions and individuals: inflation; taxes; and regional, national or global business cycles. For example, a municipality whose tax base and borrowing costs would be adversely affected by a regional recession could buy some "insurance" in the form of swaps or options whose payoffs are linked to an index of regional economic activity.
We will also see an increase in the use of contracts designed to protect against insurance risks — things like hurricane futures and flood options. Catastrophe reinsurance futures are being traded on the Chicago Board of Trade, and OTC insurance derivatives are gaining acceptance with clients. Derivatives seem like the perfect solution for the insurance industry, whose capital base is increasingly stretched as the industry copes with the scale of potential catastrophic risks.
The rapid growth of the derivatives market and its relentless extension to new applications demonstrate that clients appreciate the value of being able to gain greater control over their risks. Derivatives are not a laboratory curiosity. They are not an ephemeral fad. They have arrived in the real world and they are here to stay, because they have a real value to real-world applications.
But there are a number of people who are content with their current methods of risk management. They wonder why they should adopt new processes, use new tools, when they think that the old ones work just fine. Well, whiskey works just fine as a painkiller — ask any cowboy in the wild, wild West. But if I were going to have surgery tomorrow, I know I'd much rather have a shot of Demerol than a shot of Jack Daniel's. And though accountants in ancient Egypt may have kept perfect track of Pharaoh's dominions by using a tally stick, I think our stockholders rest easier knowing that we use computers.
Sometimes things that work quite well can be improved upon. An old vacuum-tube radio can play music as beautifully as a transistor radio, but the transistor gives the listener more options; you can slip the radio into your pocket and play it at the beach. The technology that has created derivatives has given risk managers more options, options they should examine seriously before deciding that they prefer the old ways. After all, if you are worried that rising interest rates will cut your profit by 30 percent, would you rather do nothing or purchase an interest-rate derivative tailored precisely to your need for interest-rate protection?
The real question, it seems to me, is not whether to use derivatives but how to use them. Chances are, most of us have the functional equivalent of derivatives in our portfolios already. Many common practices contain "embedded" options or futures: a prepayment clause in a home mortgage, a fixed-price supply contract, a government price support, a pension or benefit promise. Derivatives can help manage these derivativelike exposures properly. Ironically, while these embedded options are widely accepted, the derivative tools needed to manage them are subject to criticism. And although your company may choose not to use derivatives, at least some of your competitors will not have made the same choice. Derivatives can help them gain a competitive advantage by giving more-attractive pricing and financing options to their customers, by securing affordable long-term access to vital supplies, overseas markets and technology.
Consider two companies in the office copier market: One also has a consumer electronics business, the other does not. Growth in the consumer business may enable the first company to price and invest more aggressively in copiers, giving it an edge over its competitor. The second company could mitigate this risk by using derivatives that will pay off in the event that the consumer business prospers. Or take this comparison of two airlines: Airline A flies both domestic and international routes, Airline B is strictly a domestic carrier, and they compete against each other in the potentially lucrative commuter shuttle business. It might seem as though Airline B does not need to worry about any foreign exposure. But if the overseas business booms, Airline A will have extra income — which it could use to subsidize drastically reduced prices on its commuter shuttle route, sparking a fare war that could easily drive its competitor right out of business. Airline B can protect itself against such a scenario by purchasing a basket of derivatives that would yield income in the event that international travel picks up. If Airline A's earnings rise because of increased international business, Airline B's will rise as well because of the payoff from the derivatives.
Despite the competitive benefits of derivatives as a risk management tool, some people remain fearful of them. Beyond the risks to particular investors, they argue, derivatives pose a risk to the entire global financial system by linking markets and counterparties in new and dangerous ways. We believe, however, that derivatives are more likely to reduce systemic risk than to increase it; further, the benefits of derivatives would more than justify any residual systemic risk — just as the benefits of money transfer outweigh the systemic risk that activity poses.
While we cannot rule out the possibility that a chain reaction would hit the global markets, we could argue with equal plausibility that derivatives decrease system risk by diffusing risks more widely throughout the financial system. Globalization of markets has given clients better choices at lower cost by promoting greater competition. The derivatives market is just one global market operating today and not even the largest one. Indeed, derivatives are dependent on the underlying markets for cash instruments. Sovereign bond markets are linked across the world. Currency markets, syndicated loan markets, commodity markets and major equity markets all operate on a global basis. The major risk to the global marketplace would be if the markets were to become unlinked, creating a costly setback for the governments, financial institutions, corporations and individuals who benefit from them.
Most of the fear, we believe, stems from unfamiliarity. While it is certainly good business practice not to commit resources casually to the unknown, it is also good business practice to keep learning new and better ways to solve problems.
Derivatives are no different from any other new business opportunity. Managers need to do some homework to prepare themselves to use derivatives, just as a manufacturer would prepare before installing a complex piece of equipment on its assembly line. Can you imagine a company's purchasing a new machine without understanding exactly what the machine does and how it will be used? Can you imagine the company's failing to continuously monitor and maintain the machine? Of course not. But neither would the company need to know as much about the inner workings of the machine as do the machine's designer and maker.
So how does a client begin the process of exploring derivatives? How does a company, a fiduciary, a government or an individual know if derivatives are right for the particular risk management processes at hand?
The first step is to define that process. Develop a risk management discipline that covers significant risks from all activities, not just derivatives. Many of those risks will be embedded in the operations of the company — the price of sugar to a beverage company, the price of oil to a utility, GNP growth to an auto company. Clients, working with their risk management advisors, must think hard about their objectives and about how much risk they are willing and able to take in pursuing those objectives. They must set boundaries on risk taking and stick to them. Before acting, managers must consider the full range of possible results from a transaction (whether a derivative or other instrument) and judge how that transaction fits their total portfolio and risk appetite. Risk managers must try to capture all the significant benefits and risks that could flow from the transaction. Finally, it is imperative to stay on top of the portfolio of risks and be ready to adjust as conditions change. A portfolio of risks may change even when the client is doing nothing, because external events never stop affecting the business and the markets. Just like any other business decision, good results in risk management depend on keen analysis and judgment.
Having worked through all those steps with a trusted financial advisor, what can clients expect of derivatives?
Corporations and Financial Institutions
At a tactical level, corporations and financial institutions can use derivatives to change their exposure to such things as interest rates, currencies, commodity prices and actuarial events. Fixed-rate debt may be changed to floating, foreign currency receivables may be converted to home currency, commodity investments may be hedged against loss. These kinds of transactions — which have very narrow and specific objectives — can reduce financing costs for the client, stabilize revenues or operating costs, and insure against unpleasant surprises.
Take the example of a U.S. pulp and paper company. With production and sales only in the United States, this company may feel it has no financial exposure to foreign exchange risk. But when the U.S. dollar strengthens, the company's product becomes more costly and its Scandinavian competitors receive a production cost advantage. The U.S. producer faces the business risk that its competitors will cut prices. To avoid being caught at a pricing disadvantage, the company and its financial advisors can develop a flexible program, using derivatives to offset all or part of the company's competitive exposure to the dollar.
At a strategic level, a firm is a complex interrelated portfolio of business and financial risks. A business risk in one part of the portfolio may diversify or reinforce a financial risk in another part of the portfolio. Derivatives may help balance out these risks so that the company can meet its business objectives without sacrificing financial security. Imagine that a company purchases shares in several high-tech start-up businesses as part of a program to acquire marketing and production rights to the start-ups' future products. Within a few years, the shares surge in value, creating large unrealized gains. Although the company's long-term view on the industry is bullish, it fears that an equity market correction could wipe out its gains in the high-tech stocks. It could sell the stock now and repurchase later — but selling and repurchasing such large blocks of stock would be costly, take some time to execute and disrupt its strategic relationship with its high-tech partners. A better alternative might be to use an equity derivative that increases in value as a basket of high-tech stocks goes down. Such a derivative offers protection against a market decline and allows the company to maintain its relationship with its strategic partners.
How does a firm decide on the amount and mix of risks that best fit its business strategy and risk appetite? That is the responsibility of the CEO, the only person with enough insight into the business operations, finances and critical objectives of the company to serve as "strategic portfolio manager." Until recently, many risks were poorly understood, while others were unmanageable because they were inextricably embedded in the business. There were fewer proactive measures CEOs could take to manage risks, so their role as strategic portfolio manager was relatively abstract. Now that the risk management revolution has given us the tools to assess and actively manage a much broader array of risks, many CEOs are recognizing that this new role gives them a valuable opportunity to take more control over their companies' destiny. Deciding whether and how to use derivatives becomes part of the same management process as deciding whether to build a new plant and at what cost.
The CEO as strategic portfolio manager must bridge the business side and the finance side of the company, bringing together the key operating and financial managers into a portfolio management process. This portfolio view should cascade down through the company. Because many risks are interrelated, they must be understood and managed at the portfolio level as well as at the transaction level.
Suppose a chemical company purchases a refinery in an attempt to secure feedstock for its chemical business. This move adds new risk (refining risk) to the company's portfolio and exposes it to a difficult, cyclical industry in which margins have been volatile. But the company does not need to take this risk; by using derivatives, it can lock in feedstock supplies at a constant price without actually acquiring the refinery. Or, if the company wants to make the acquisition, it can use derivatives to reduce its exposure to the refining business.
Which course of action should the company take? The CEO as strategic portfolio manager can consult a cross-functional team of inside and outside experts (business and financial) who can see all the risk dimensions involved. The earlier these cross-functional teams apply themselves to problems, the more flexibility they have in designing solutions.
Derivatives provide investment managers with quick and efficient substitutes for cash transactions — for example, using S&P index derivatives temporarily to get out of the way of a market correction or gaining exposure to foreign equities without actually having to deal with the unfamiliar complexities of operating in foreign markets. Derivatives offer speed, precision and low transaction costs.
At a strategic level, while picking individual stocks or bonds may significantly affect investment performance, the real payoff (for the ultimate client) lies in choosing the right mix of portfolio risks, actively adjusting that mix as conditions change and doing so without dissipating the client's resources with transaction costs.
Fiduciaries who have joined the risk management revolution understand that the "right" portfolio implies not only good market timing but also a mix and level of portfolio risk that fit the client's specific objectives and risk tolerance. The speed, flexibility and efficiency of derivatives allow fiduciaries to deliver a customized, easily adjustable portfolio payoff structure to the client. Take the example of a client who wants the upside potential of an equity portfolio but has limited tolerance for losses. The traditional approach might be to structure a "conservative" equity portfolio of low-risk stocks or to offer a 30 percent stock and 70 percent bond mix. With derivatives, we can offer most of the upside of an equity portfolio and put a floor under possible losses — a much closer fit with the client's preferences.
Traditional "asset allocation" funds shift in and out of cash securities to time the markets or to adjust risk profiles. This shifting may take a long time to execute, generate large transaction costs and deliver only a limited range of possible risk profiles. With derivatives, a wide range of risk profiles may be achieved quickly and with low transactions costs.
The risk management revolution has allowed fiduciaries to better match their knowledge of the markets with their clients' needs. We are now seeing fiduciaries shift assets from large, lightly managed pools under vague headings such as "growth fund" and "cyclical fund" to smaller, more sharply defined pools that are closely related to the particular skills of the managers and designed to fit a particular preference of the plan sponsor.
Sovereigns and local governments all sit on a complex collection of risks, many of which are dimly perceived or ignored. Some of these risks — price supports, credit guarantees, health and welfare entitlements, natural disaster insurance, pension commitments — look like futures and options. Derivatives could be used to manage these derivativelike exposures, and public servants who were truly worried about present and future taxpayers would demand better risk management in government.
Use of derivatives could enable a government not only to manage its own risks better but also to increase the market's confidence in its commitment to sound fiscal and monetary policies. Issuing puts on government debt or being the "payor" on Consumer Price Index swaps might convince the markets that the government cannot afford, in either the short or long run, to let inflation get out of hand. This greater confidence would translate into lower long-term interest rates for all borrowers in the economy by reducing the inflation risk premiums embedded in bond yields.
As governments and employers reduce their commitments to provide people with job and retirement security, individuals must assess their own financial positions and make more decisions about savings, investment and insurance on their own. They must also suffer the consequences if those decisions go wrong.
Most people have little interest in sorting through the bewildering array of financial products and investment alternatives being pushed at them by today's conventional financial firms. Most people would prefer an easy-to-understand and trustworthy solution to their financial problems.
Where should individual investors look for these solutions? When you or I want transportation, we go to a dealer who sells us a fully assembled car, ready to be driven off the lot. We don't go to the transmission store, the engine store and the fender store and try to assemble our own car. But today's financial industry expects untrained individuals to design and assemble their own financial security from component parts — and without an instruction manual.
Financial institutions that have joined the risk management revolution can harness the power of derivatives to help individuals achieve the results they desire. One derivative-based product that might easily become popular with investors is a retirement management account that guarantees investors a safety net, but one with an upside. Imagine knowing that regardless of what happens to inflation, the stock market, interest rates and health care costs, you will be guaranteed at least X percent of your current purchasing power — with the chance of doing much better.
Of course, institutions offering such products to individuals will have special obligations to give the consumer all the background necessary to make an informed decision. This is true for all financial services, however, not just for derivative-based products.
One of the critical benefits of derivatives is their flexibility, which allows a high degree of customization to each client's specific needs. Although they often fall into broad categories (dollar interest rate swaps, prime/LIBOR swaps, currency options and the like), most OTC derivatives transactions are unique in some respects. Few derivatives are sold "off the rack" as standardized products.
How do clients decide whether to use derivatives as part of their risk management program? (And if so, what structure should those derivatives take?)
Traditional financial firms, working in traditional ways, are often unable to see the totality of a client's risk profile. Revolutionary risk management techniques require revolutionary financiers. And a new class of financial institution is being created today (Bankers Trust is among the first) that can work with CEOs and their business and financial managers to achieve a company's risk management objectives. Not a commercial bank, not an investment bank, not an insurance company, the "risk merchant bank" is an amalgamation of all three types of institutions. Cutting through traditional product and institutional boundaries to operate at a deeper, more fundamental level, a risk merchant bank can provide a new process for delivering business solutions. Identifying, disaggregating, buying, selling and repackaging the risk attributes of our clients' companies, risk merchant bankers can create tailored solutions that more closely respond to the companies' underlying reality and objectives.
Risk merchant bankers will revolutionize the diagnosis and treatment of significant risk problems. Unlike traditional bankers, who either execute generic transactions in response to a client's stated desires or attempt to persuade a client that trading some object in inventory is consistent with the client's goals, risk merchant bankers — using what we at Bankers Trust call the derivative process — will ask not what transaction the client is considering but what ultimate goal the client desires. Client information is the spark that ignites the process. Taking that information, the banker produces a response, the client critiques the response and the process starts over again. This iterative approach is at the heart of the derivative process. Just as an expert tailor measures, remeasures and then pins and stitches until a suit fits perfectly, the risk merchant banker must constantly reassess, question and suggest ideas until the solution precisely fits the client's needs. Clients must define and state their objectives, know their risk tolerance and decide whether the transaction fits their portfolio. Clients must monitor their positions and seek adjustments as conditions change. This process is communication-intensive. It may even on occasion be uncomfortable. But we have found that by using the derivative process we can do more than create a novel financial instrument; we can build relationships, educate and help our clients to achieve their goals for themselves and their companies.
This working process is particularly relevant to strategic transactions that significantly transform a client's risk profile: a merger, acquisition or divestiture; a recapitalization; a major shift in business mix; a restructuring of operations; the emergence of an unexpected risk that threatens the franchise or of a strategic investment opportunity. The stakes are enormous, and the solution must address a complex web of business and financial issues.
"Old" corporate finance might try to fit such a transaction into the mold of the traditional products that a bank wants to sell: M&A, debt issuance, equity issuance. In the past, clients have had to make do with those products. But risk merchant banking uses the risk management process to discover what a client really needs and to deliver a customized solution — not a prefabricated corporate finance product. The client's need drives us toward a tailor-made solution that fits the client's strategy and objectives. Our newfound ability to assess, unbundle, buy, sell and rebundle risks means that we are not confined to standard approaches. The customized solution might contain several components that are woven together in a unique or innovative way.
A client wants to acquire another company? The risk merchant banker asks why. We may discover that what the client really wants is not all of the company but just a part of it. If we can strip out the unwanted risks, the client could get just that — with no excess baggage. More-favorable financing or a better valuation of the client's own shares may also be achievable if the benefits of this sharper risk management are clear.
A client wants to hedge a troublesome risk? After asking why, we may discover that the company is not equipped to manage the risk at all. Perhaps it makes sense for the company to outsource the management of the risk to us.
A client wants to issue equity? Why? On closer investigation, we may find that the company has too much capital invested in backing up unnecessary risks. If we can extract those risks from the franchise, the client may not need to issue equity at all.
Recently, one client of ours wanted to finance a very large oil-drilling platform. The traditional approach to financing such a project is to sell a working interest in it to other partners. But our client brought us into the discussions early on, before any major decisions had been made. We and the company examined the components of risk in the entire project and how those risks interacted with risks already in the client's portfolio — interest-rate risk, production risks, financing risks, risk of fluctuating oil prices — and we structured a multipart transaction to finance and manage the key risks of the project. This structure allowed the client to lock in the profit from the project for several years, no matter what happened to interest rates, oil prices and the availability of financing. This greatly reduced risk allowed the company to finance at lower rates and to tie up much less of its capital in the project.
Clearly, risk merchant banking is changing — and will continue to change — the way corporate finance is done. Customized strategic solutions require that the client's top management and its outside risk management experts have a portfolio view of the company's combined business and financial risks and of the principal factors that drive the value of the company, that they have a mutual understanding of the company's business objectives and appetite for risk, and that they trust each other and share ideas. As I said earlier, effective solutions to strategic issues usually cut across both the business and finance sides of the company. Therefore, it will be common to work in cross-functional teams: marketing, production, human resources and other "business-oriented" people will work with the client's own finance professionals and the risk merchant bank's team.
None of this work would be possible without the powerful ideas contributed to the revolution by mathematicians and theorists. Their ideas have inspired practical applications that have produced real-world benefits for businesses, governments, individuals and all of society.
As all of you know well, however, theories and models are not sufficient by themselves. No model, however elegant, can ever completely capture the rich detail, complexity and constant change of real economies and markets. By necessity, theories gravitate toward assumptions that produce solvable models — sacrificing realism in the process. But real-world decision makers cannot afford to ignore important complexities in the interest of tractable models. This is not a criticism. How many times have we each gone through an experience and thought, "If it hadn't happened to me, I wouldn't believe it was possible"? It is not only messy to replicate real-world possibilities in a model but often impossible to imagine the range of events that might transpire. In any event, once a model has been developed, we are able to improve the realism of its assumptions step by step. But unlike physics, which is a science with constant (if poorly understood) laws, the "laws" of economics and finance change constantly, even as we discover them. Sometimes they change because we have discovered them.
Most financial models assume that information is free, instantly available to everyone and interpreted in the same way by everyone. Thanks to modern information technology, this assumption is more accurate today than in the past, but in most markets it is still far from the truth. There are significant differences in timely access to some kinds of information and in the ability to analyze that information.
Most financial models assume that all assets can be quickly bought and sold at fair prices with no transaction costs. This assumption is also more accurate today, but in some markets at all times — and in all markets at some times — it can be disastrously wrong. Liquidity cannot be taken for granted. And an unexpected bout of illiquidity can prove fatal to individual market participants. It may cause systemic failure of the entire market. Earlier this year, many people lost large sums of money because they could not liquidate their positions quickly at "intrinsic" values. The assumption of perfect liquidity may be the most dangerous myth built into financial models, particularly since liquidity may dry up at precisely those moments when large price gaps or volatility increase losses (and increase the urgency of getting out of the position).
Most financial models assume that market participants are independent actors who cannot influence one another's beliefs or behavior and who cannot move market prices with individual transactions. In real markets, however, we have all seen the consequences of fads and lemminglike behavior, when fear, greed or simply naive trend-following temporarily overwhelms the fundamentals. And we have sometimes seen large or influential traders and investors move markets by their actions. The herd instinct can be very strong among money managers whose priority is to match the relative performance of their competitors. So in real markets players are not always playing against an indifferent nature. They are playing against recognizable opponents in a "game theory" setting.
Most financial models assume that economies and markets have an underlying structural stability — for example, the assumption of known and constant variances and correlations of asset returns. Such assumptions ignore political change, social change, regulatory change and technological change — to name just a few sources of structural evolution. Did any financial model envision the political exigencies that led to the total breakdown of the "fixed" correlations of ERM currencies when EC stabilization efforts collapsed in 1992? If correlations and variances are unstable, how should we assess them? What historical period should we look at for guidance?
Most financial models assume mathematically convenient probability distributions (normal or lognormal). But "extremely unlikely" events — acts of God and acts of man — occur all too frequently. We have seen too many $16 billion hurricanes. And who could invent a financial model that would have envisioned the possibility of interest rates in Sweden soaring to 500 percent a couple of years ago?
Most financial models assume that every market participant has equal access to credit. In the real world, there are huge differences in the amount of credit available to different market participants and in how much that credit will cost them. A company rated AAA may borrow at 20 basis points over Treasuries, while a junk bond issuer may pay 600 basis points. We cannot ignore the impact of different levels of counterparty credit risk when valuing a financial contract.
Most financial models ignore the differing regulatory constraints that market participants face, which may mean that two parties place dramatically different values (and risks) on the same financial contract. One example: the different capital requirements for banks and securities firms.
Most financial models assume that a market is naturally stable, implying that deviations from equilibrium generate corrective forces that quickly drive the market back to equilibrium. But haven't we seen episodes of falling prices generating more selling pressure and further price reductions? Also, when the very structure of economies and markets is constantly changing, how do we know if we are ever in equilibrium? The equilibrium point itself changes constantly.
Most financial models assume a simple goal and restrict themselves to a small number of variables with relatively simple relationships among the variables. Most business problems, however, involve several goals and a host of important variables whose relations to one another are often unclear. In real life, we ignore this at our peril.
Most financial models assume that people are relentlessly logical maximizers of their financial wealth. Well, I have been in this business for 34 years and I have yet to meet the famous Rational Economic Man theorists describe. Real people have always done inexplicable things from time to time, and they show no sign of stopping. Model users have frequently been surprised by the "irrational" behavior of people who prepay (or don't prepay) their home mortgages. Some choices are undoubtedly irrational by any reasonable standard, but many others may in fact be rational, once we understand that the mortgage holder was taking into account legitimate goals and important variables that the model user either ignored or knew nothing about. The model user's solution was perfectly logical, but the problem solved was not the problem the home owner faced.
This is hardly a complete list of gaps between assumptions and reality, but it is long enough to make the point that blind reliance on models is not a wise course of action for those who make decisions in the real world. (Good theorists are aware of this, but we often wonder if all their disciples are.) Again, this caution is meant not to criticize the model maker but to remind ourselves that models are just one tool, one source of insight into making real decisions that have real consequences.
Theorists can and should suspend judgment while they search for additional data, but businesspeople have to make split-second decisions on the basis of available information. The exigencies of business require us to bridge the inevitable gaps between an elegant model and a messy reality. To make matters even more difficult, the technical experts may disagree as to which model provides the best starting point; there is no agreed-upon standard.
Businesspeople must make judgments, intuitive leaps, reasonable approximations and creative guesses. They have to weigh the impact on the future value of customer relations and the need to avoid a risk position that may have no exits. They must put together a course of action, knowing that it cannot be proved "correct" in a narrowly logical sense. They must put their money and their egos on the line and live with the results.
Risk managers use trial and error, common sense and considerable imagination to compensate for the lack of total realism in models. For example, brute-force computation or simulation might provide guidance when an analytical solution does not fit the real problem. It is not very elegant, but increasing computing power allows brute force to be extended to a wider and more complex set of problems. Of course, mindless number crunching can produce a dangerous illusion of precision and relevance. Among other things, simulation relies on a wise choice of scenarios that encompass a realistic range of outcomes. If we fail to evaluate even one vital scenario, a given risk may be wrongly perceived as manageable.
A diversified portfolio of many different kinds of transactions could have a large number of offsetting errors, so the net result would be tolerable. Of course, this is no defense against fundamental or systematic blunders.
These gaps in the realism of models are sometimes enormously important. The introduction of "real-world" considerations such as frictional costs and other model omissions may have a drastic effect on the value of a derivative contract. Depending on the circumstances, model valuation can easily miss the mark by 20 percent — and up to 50 percent in some cases.
But no calculations, no models can substitute for hands-on experience in the markets, for the "touch and feel" of what is really happening or what might happen. A savvy, experienced professional who is plugged into market flows may have insight and foresight that others lack — even though that insight cannot always be explained logically to others. To a rigorous logician, this may sound like voodoo, but it is really no different from any other art or talent. A great hockey player may never be able to explain the reflexes and instinct that allow him to score a hat trick. At times like that, talent, training and the muscle memory that builds up after years of playing the game all kick in and propel the player to a great performance. And while he may be thinking about the geometry of the net and the angle of attack, those calculations go on at such an automatic and unconscious level that they are impossible to explain. Beyond this, there is the critical but hard-to-measure contribution of many skilled players working as a team.
Intuition, art and logic all come together in the risk management revolution. We would not have reached the stage we are at today without a single one of them; we will not be able to move forward unless they continue to work together. Theorists will continue to make progress, steadily improving their models to replace judgment calls (or rules of thumb) with logic. Each piece of new knowledge, however, creates new issues requiring higher-order judgment, so the sphere of judgment never contracts but only expands. No matter how developed financial theory becomes, the role of judgment will always be critical.
To succeed, the risk management revolution needs artists and engineers as well as scientists and mathematicians. Successful risk merchant bankers will attract all types and will provide an environment where the collaborative process can flourish. They will also attract highly educated people, because the level of talent required for each specialty is rising rapidly. Ten years ago, an undergraduate engineering degree was adequate for risk modeling; today we need math Ph.D.'s. And there is tremendous competition for the best people. Risk merchant banks that can attract and retain the top level of this scarce talent can erect high barriers to entry.
Successful financial firms offering leading-edge solutions will have to defend their intellectual property rights — with or without patent protection. The best firms, however, will not succeed by creating "secret formulas." They will succeed by putting together an organization that can win the trust of the client and effectively engage the client in the process of finding the best solution.
The Future: 2020
The landscape of the financial markets changes rapidly. Decisions that were high art 10 years ago are now programmed into hand-held calculators. That is the nature of progress.
Processes that were innovative 25 years ago are now at best quaint, if not completely obsolete. Twenty-five years from now we will be approaching the year 2020, and the risk management revolution that we began in the 1990s will seem no more novel than the revolution in the '70s that brought increasing numbers of women into the workplace.
But what might today's risk management revolution lead to in 25 years? I believe we will create a fully wired global marketplace where most business and financial transactions take place; where vast databases are instantly available; where interactive communication is possible anytime, anywhere, with anybody. Today's primitive mechanisms for storing and transferring claims on wealth will be replaced by securely encrypted electronic book entry with instant settlement. Automated analytics will routinely perform many tasks that from today's perspective seem ultrasophisticated (if they are even imaginable at all). Everyone — individuals as well as firms — will have access to real-time, comprehensive, marked-to-market financial statements (what we have dubbed wealth accounts) so that they may monitor and manage their total net worth.
By 2020 we will have moved from today's "Newtonian Finance" to "particle finance," to use an analogy from physics (see Financial Markets in 2020). Today's finance operates for the most part at a highly simplified and aggregated level — the world of stocks, bonds, loans, commodities and the derivatives based on those assets. "Particle financiers" will be able to probe much deeper, identifying the discrete risk attributes that make up each of these securities. With a better understanding of how these attributes interact with one another to create and destroy value, we will be able to create highly sophisticated bundles of these attributes to satisfy very specialized needs.
While imagining all these innovations might threaten to make our heads swim, let me remind you that just as you do not need to understand quantum mechanics to use a transistor radio, which depends on the application of mysterious things like the Heisenberg uncertainty principle, you will not have to understand all the intricacies of particle finance to use it to improve your risk profile. That will be the job of the risk merchant banker.
One thing that has not changed — and that will never change, no matter what technology, what models, what imagination we apply to finance — is the benefit that society accrues when the financial system operates smoothly. The capital markets have served the same purpose since long before John Hume conceptualized the invisible hand and Adam Smith turned it into practice. That purpose is to create wealth, wealth that can be used to satisfy urgent human needs, to raise the standard of living, to advance human knowledge, to support the agriculture that feeds our bodies and the culture that feeds our souls (see The Social Value of Financial Services). When the capital markets function smoothly and efficiently, clients and their financial advisors benefit, of course, but the ultimate beneficiary is the society in which we all live and work.
© Copyright 1995 Bankers Trust New York Corporation. All rights reserved.
Charles S. Sanford, Jr., a 1958 graduate of the University of Georgia, is the retired chairman and chief executive officer of Bankers Trust Corporation. In 1997, the Terry College of Business dedicated Sanford Hall in recognition of the significant contributions made to the Terry College and the University of Georgia by Charles and Mary Sanford. He has served as a trustee of the University of Georgia Foundation since 1986, and his family's association with the University spans many generations, dating as far back as 1835.