The idea of this article is for the government to issue bonds at points where their credit default swaps are trading. Some companies, such as John Deere, are doing this, and the government bank, or state-owned bank, could do the same but even at lower rates. They could fully hedge the associated credit risk in the CDS market. Companies who need the money would then receive it, instead of banks keeping the money and doing nothing with it. Arbitrage exists in the current CDS market, so this new CDS exchange to include the government could possibly change the amount of arbitrage, or inefficiencies in the market.
The risk that the CDS market is facing is an illiquidity premium, which would not be a problem for the government. The government has limitless liquidity. This will also encourage spending becaus ehte government can hold cash bonds and loan out money to companies that need it without the compnaies having to pay a large premium or loading, as we discussed in class.
Many comments were posted about this article, some agreeing and some disagreeing. I think it is a good idea to help the current financial crisis, but the government can only help so much. The government spends so much more money than it has. We have increased the deficit more and more, and this hedging would only increase it more. The government is already bailing out companies. One comment addresses my complaint: this proposal does not justify spending government money wastefully and unwisely.
http://www.portfolio.com/views/blogs/market-movers/2009/01/29/let-the-government-buy-corporate-bonds
Friday, January 30, 2009
Risk management strategies beyond insurance
The risk management profession is growing. This is what we want to see coming out of the current financial crisis. I found this article from Business Insurance about France's emerging market for risk management. They conducted a study with Deloitte and found that only 17% of respondents said their job was restricted to managing insurance risk and management. 30% pilot a global approach to risk management within their companies. Half have responsibility for strategic risks and insurable risks. This creates a broad spectrum of risks being monitored, which is the best strategy. Through our daily business examples in class, we have found that the hardest part of risk management is to identify all of your risks. With many people studying all types of risk, they are bound to find more and cover more for the company to reduce costs.
Results were also taken on communication within and throughout the companies. Most risk managers do not report directly to the CEO. Some report to financial departments, some to the top management, and some to the legal department. Only 6% have a specific risk management directorship. My first article posted on January 30 was about communication and improving it to improve risk management strategies. Communication is key to see who is covering what risks, how it can be improved, etc. If communication is lacking, companies go bankrupt.
France has seen the risk management profession growing. The majority of risk managers came from other jobs within the company. A small percentage have fewer years of experience and so are new to the profession. This percentage can be seen as a sign that the field is growing. More people recognize that risk management is necessary.
http://www.businessinsurance.com/cgi-bin/news.pl?post_date=2009-01-30&id=15217
Results were also taken on communication within and throughout the companies. Most risk managers do not report directly to the CEO. Some report to financial departments, some to the top management, and some to the legal department. Only 6% have a specific risk management directorship. My first article posted on January 30 was about communication and improving it to improve risk management strategies. Communication is key to see who is covering what risks, how it can be improved, etc. If communication is lacking, companies go bankrupt.
France has seen the risk management profession growing. The majority of risk managers came from other jobs within the company. A small percentage have fewer years of experience and so are new to the profession. This percentage can be seen as a sign that the field is growing. More people recognize that risk management is necessary.
http://www.businessinsurance.com/cgi-bin/news.pl?post_date=2009-01-30&id=15217
How will the financial crisis affect insurance and risks?
In class we discussed that one way to hedge against risk is to purchase insurance. An expert Dr. Robert Hartwig, answers questions about insurance weaknesses and issues with the current financial crisis. He predicted that we will see a lot of financial legislation and regulation from President Obama's administration, which has been seen to be true. We have mortgage legislation to help limit the foreclosures. We have also seen financial bailout legislation for struggling companies. Dr. Hartwig predicts that the insurance and entire financial services industry will be more conservative after the eventual improvement in the market. I think that this conservatism is what disasters help put into place. We need bad times to recognize the good times and to prevent future disasters. This crisis ccould help encourage more risk management.
People are worried that more and more companies will have committed the same risk mistakes as AIG and will also go bankrupt. We have seen companies fail, and we have seen more and more asking for bailout money. But, insurance companies operations are different from those of AIG and will not likely suffer the same fate. Banks and other companies separated the bearing of risk from the underwriting of risk. With this method, comes a huge moral hazard. Insurance companies do not operate this way and are not subject to acting in ways that cause more risk. As in our class discussion, you cannot simply take large risks with large returns to quickly turn your company around. If you have been losing money with small risks, you will most likely fail with large risks as well. This is how companies have been putting themseleves down, by taking last minute huge risks at the chance of making large returns to make up for loss. These companies just end up bankrupt and costing themselves large amounts of money, which could have been prevented through risk management.
http://www.rmmag.com/MGTemplate.cfm?Section=RMMagazine&NavMenuID=128&template=/Magazine/DisplayMagazines.cfm&IssueID=332&AID=3838&Volume=56&ShowArticle=1
People are worried that more and more companies will have committed the same risk mistakes as AIG and will also go bankrupt. We have seen companies fail, and we have seen more and more asking for bailout money. But, insurance companies operations are different from those of AIG and will not likely suffer the same fate. Banks and other companies separated the bearing of risk from the underwriting of risk. With this method, comes a huge moral hazard. Insurance companies do not operate this way and are not subject to acting in ways that cause more risk. As in our class discussion, you cannot simply take large risks with large returns to quickly turn your company around. If you have been losing money with small risks, you will most likely fail with large risks as well. This is how companies have been putting themseleves down, by taking last minute huge risks at the chance of making large returns to make up for loss. These companies just end up bankrupt and costing themselves large amounts of money, which could have been prevented through risk management.
http://www.rmmag.com/MGTemplate.cfm?Section=RMMagazine&NavMenuID=128&template=/Magazine/DisplayMagazines.cfm&IssueID=332&AID=3838&Volume=56&ShowArticle=1
Risk: The Unseen Predator
Risk Management:
I found an article in the Risk Management Magazine which defines risk. It discusses companies which have failed recently and analyzes their risk management strategies. What went wrong? The article makes the case for using effective risk management strategies to hedge your risk.
AIG was a global giant company that specialized in underwriting risk, providing risk management services and training risk professionals. Yet, the company still failed. The confidence in risk managers and the like has been shaken and questioned. The article also discusses that failures and defaults have occurred in companies who investment grade ratings are AAA or AA. AAA and AA ratings are the safest, so is the system of notifying people about risk not working? The AAA and AA ratings were obviously not true if the company defaulted. The ratings should be modified to prevent misleading information. Maybe the rating system could be changed to reflect financial stability and the effectiveness of the risk management practices of the company at the time.
Structure should be more important to the risk management system. Each officer in each department should report to each other about their strategies and progress. For Enron, risk management programs were in place; however, communication about the practices was lacking. Also, risk management should be encouraged and not viewed as a strain on profits. Risk management is supposed to minimize the costs of risk to the company. If the programs are reducing profit too much or making it negative, maybe the programs need adjusting because they are too extensive. You can't eliminate all risk, but you should try effectively and efficiently to minimize the costs of uncertainty in areas where it is possible and still make profits.
http://www.rmmag.com/MGTemplate.cfm?Section=RMMagazine&NavMenuID=128&template=/Magazine/DisplayMagazines.cfm&IssueID=332&AID=3831&Volume=56&ShowArticle=1
I found an article in the Risk Management Magazine which defines risk. It discusses companies which have failed recently and analyzes their risk management strategies. What went wrong? The article makes the case for using effective risk management strategies to hedge your risk.
AIG was a global giant company that specialized in underwriting risk, providing risk management services and training risk professionals. Yet, the company still failed. The confidence in risk managers and the like has been shaken and questioned. The article also discusses that failures and defaults have occurred in companies who investment grade ratings are AAA or AA. AAA and AA ratings are the safest, so is the system of notifying people about risk not working? The AAA and AA ratings were obviously not true if the company defaulted. The ratings should be modified to prevent misleading information. Maybe the rating system could be changed to reflect financial stability and the effectiveness of the risk management practices of the company at the time.
Structure should be more important to the risk management system. Each officer in each department should report to each other about their strategies and progress. For Enron, risk management programs were in place; however, communication about the practices was lacking. Also, risk management should be encouraged and not viewed as a strain on profits. Risk management is supposed to minimize the costs of risk to the company. If the programs are reducing profit too much or making it negative, maybe the programs need adjusting because they are too extensive. You can't eliminate all risk, but you should try effectively and efficiently to minimize the costs of uncertainty in areas where it is possible and still make profits.
http://www.rmmag.com/MGTemplate.cfm?Section=RMMagazine&NavMenuID=128&template=/Magazine/DisplayMagazines.cfm&IssueID=332&AID=3831&Volume=56&ShowArticle=1
Friday, January 23, 2009
Behavioral finance, actuarial science and you
Another article I found while researching the Society of Actuaries, discusses how to make risk management more attractive to people. The article states that there are certain behaviors to focus on when presenting risk management to customers. Many lessons about managing risk before a crisis arises can be taken from the current financial crisis. We need to balance and manage our risks and stay open to opportunities.
The article presents an interesting valuation of money and risk problem which I have seen previously in my finance and RMI classes. Q: If people are given the option of choosing $7000 or taking the opportunity to have an 80% chance of receiving $10,000 and a 20% chance of receiving nothing, the majority of people will choose the certain outcome of $7000. The expected value of the risky outcome is higher, but people are afraid of the loss. People focus on a loss frame of mind instead of a gain frame of mind. The article states risk managers should help switch the focus so companies can have an investment goal and higher future gains. Expected value is key to changing people's minds.
People also assume the more risky option is what you hear about more. For instance, an airplane crash is less likely to happen than a car crash, but people are more afraid of a plane crash because they end up on the news. Airplane crashes, however, are less likely and more unexpected than a car crash. The unexpected always catches our mind more and tends to become our focus. Therefore, if this recession was unexpected to some people and companies, those are the ones who risk managers should be seeking out to offer safe options. This is the ideal time to catch the business of those who were caught off-guard. They need the risk management the most.
Some people also don't focus enough on the future and focus more on what is happening to them at this moment. For example, most people will take $1000 today rather than $1500 in two years. I have taken finance classes and AS classes enough to know the present value of the future payment is more than the present value of $1000. It is just the uncertainty of the future payment that turns people away. Risk managers and actuaries can help people calculate these values to improve their investments. Actuaries and risk managers need to help people in this time of need to develop plans and educate them on minimizing the costs of their risk. People need to have financial plans to encourage security.
http://www.producersweb.com/r/SOA/d/contentFocus/?tk=2,f,23991,home&adcID=e6cca8ddd22a2ca79d25c6a845e9ff75&apID=0&aTp=3
The article presents an interesting valuation of money and risk problem which I have seen previously in my finance and RMI classes. Q: If people are given the option of choosing $7000 or taking the opportunity to have an 80% chance of receiving $10,000 and a 20% chance of receiving nothing, the majority of people will choose the certain outcome of $7000. The expected value of the risky outcome is higher, but people are afraid of the loss. People focus on a loss frame of mind instead of a gain frame of mind. The article states risk managers should help switch the focus so companies can have an investment goal and higher future gains. Expected value is key to changing people's minds.
People also assume the more risky option is what you hear about more. For instance, an airplane crash is less likely to happen than a car crash, but people are more afraid of a plane crash because they end up on the news. Airplane crashes, however, are less likely and more unexpected than a car crash. The unexpected always catches our mind more and tends to become our focus. Therefore, if this recession was unexpected to some people and companies, those are the ones who risk managers should be seeking out to offer safe options. This is the ideal time to catch the business of those who were caught off-guard. They need the risk management the most.
Some people also don't focus enough on the future and focus more on what is happening to them at this moment. For example, most people will take $1000 today rather than $1500 in two years. I have taken finance classes and AS classes enough to know the present value of the future payment is more than the present value of $1000. It is just the uncertainty of the future payment that turns people away. Risk managers and actuaries can help people calculate these values to improve their investments. Actuaries and risk managers need to help people in this time of need to develop plans and educate them on minimizing the costs of their risk. People need to have financial plans to encourage security.
http://www.producersweb.com/r/SOA/d/contentFocus/?tk=2,f,23991,home&adcID=e6cca8ddd22a2ca79d25c6a845e9ff75&apID=0&aTp=3
"Using Risk Management to Beat the Downturn"
I received an email from the Society of Actuaries and found this article interesting. It is always fun to see how your future career is working in the real world today. You get to see what kinds of things you will be working with during your developing career.
The article is formatted as a Q and A to help you learn how to manage risk and how actuaries contribute to risk management. On the first day of class, Professor Grace asked who was a RMI major and who was an AS major. Most of the class was AS, but he went on to say that the school as well as the working world are trying to relate AS and RMI and tie the programs together. We need to realize how we work together and how our jobs can be similar. In marketing I learned that companies have threats and opportunities. Threats can be detrimental to business, and opportunities are ways to expand business. You would think risk would fall into a threat, but the article discusses that the risks our economy is facing in this recession should be considered opportunities. Risk Management can help the companies suffering today.
Through risk management, actuaries can help the companies identify what their risks are. Through exercises in class, we have seen how difficult it can be to identify all sources of risk, since there are so many. In class we decided the goal of risk management is not to minimize risk but is to maximize the value of the firm. Risk management should reduce the costs of risk to the firm to maximize the value of the firm. This article talks about ways to minimize risk by diversifying the firm's bank accounts. In a perfect ideal world all companies would have diversified portfolios because it is the best way to minimize the costs of risk. We also learned, however, that most people do not diversify enough. This reason is why risk should be reassessed often to discover new problems, or opportunities as the article states.
Some companies may think they can take on large risky projects to save their company in the end. The larger the risk the larger the return. However, this rarely works, and the company fails. For this reason, risk management should not be implemented just at the last minute. The article calls the recession (risk) an opportunity because without the bad times, companies simply see risk management as an unnecessary cost. The bad times help companies realize they need to manage their risk, which when done properly will maximize their value.
http://www.businessweek.com/smallbiz/content/jan2009/sb2009018_717265.htm?campaign_id=rss_topEmailedStories
The article is formatted as a Q and A to help you learn how to manage risk and how actuaries contribute to risk management. On the first day of class, Professor Grace asked who was a RMI major and who was an AS major. Most of the class was AS, but he went on to say that the school as well as the working world are trying to relate AS and RMI and tie the programs together. We need to realize how we work together and how our jobs can be similar. In marketing I learned that companies have threats and opportunities. Threats can be detrimental to business, and opportunities are ways to expand business. You would think risk would fall into a threat, but the article discusses that the risks our economy is facing in this recession should be considered opportunities. Risk Management can help the companies suffering today.
Through risk management, actuaries can help the companies identify what their risks are. Through exercises in class, we have seen how difficult it can be to identify all sources of risk, since there are so many. In class we decided the goal of risk management is not to minimize risk but is to maximize the value of the firm. Risk management should reduce the costs of risk to the firm to maximize the value of the firm. This article talks about ways to minimize risk by diversifying the firm's bank accounts. In a perfect ideal world all companies would have diversified portfolios because it is the best way to minimize the costs of risk. We also learned, however, that most people do not diversify enough. This reason is why risk should be reassessed often to discover new problems, or opportunities as the article states.
Some companies may think they can take on large risky projects to save their company in the end. The larger the risk the larger the return. However, this rarely works, and the company fails. For this reason, risk management should not be implemented just at the last minute. The article calls the recession (risk) an opportunity because without the bad times, companies simply see risk management as an unnecessary cost. The bad times help companies realize they need to manage their risk, which when done properly will maximize their value.
http://www.businessweek.com/smallbiz/content/jan2009/sb2009018_717265.htm?campaign_id=rss_topEmailedStories
How does the risk premium reflect Beta? (JQ)
Beta tells you what your company would have to pay to attract investors. You would have to pay more if you are a risky company and less if you are less risky. Beta tells you how senisitive your company is to the market. When Beta=1, then your company moves with the market rate. When Beta is less than 1, the rate of your company stock is less sensitive to the changes in the market rate, making the investment in your company less risky. When Beta is greater than 1, the rate of your company stock is more sensitive to changes in the market rate, which makes your company a riskier investment depending on how high the Beta.
Risk premium tells you exactly the same things. From calculating the risk premium you should be able to estimate the beta. Risk premium also tell you how much more your company needs to pay to attract money to your company, which are also known as investments. The risk premium reflects the risk of your cash flows; therefore, the riskier your cash flows, the higher the risk premium. A higher risk premium means a riskier investment just as a higher Beta above 1 means a riskier investment. If you see you have a high risk premium (risky investment) you can assume you have a Beta greater than 1.
Beta tells you what your company would have to pay to attract investors. You would have to pay more if you are a risky company and less if you are less risky. Beta tells you how senisitive your company is to the market. When Beta=1, then your company moves with the market rate. When Beta is less than 1, the rate of your company stock is less sensitive to the changes in the market rate, making the investment in your company less risky. When Beta is greater than 1, the rate of your company stock is more sensitive to changes in the market rate, which makes your company a riskier investment depending on how high the Beta.
Risk premium tells you exactly the same things. From calculating the risk premium you should be able to estimate the beta. Risk premium also tell you how much more your company needs to pay to attract money to your company, which are also known as investments. The risk premium reflects the risk of your cash flows; therefore, the riskier your cash flows, the higher the risk premium. A higher risk premium means a riskier investment just as a higher Beta above 1 means a riskier investment. If you see you have a high risk premium (risky investment) you can assume you have a Beta greater than 1.
Wednesday, January 21, 2009
The capital asset pricing model was created because the assumptions in the Modigliani-Miller Theorem created an ideal world or a pure theory. The CAPM was adjusted with a beta which describes how the company relates to the market. CAPM works with all the M and M assumptions but uses beta to tell you if the company is more or less sensitive to the market. CAPM turns out to have some assumptions as well. The first assumption is that we have perfect information about our risks, investments, revenues, costs, etc. Second, there are no transaction costs to reducing risk. Third, there are many well diversified shareholders. Forth, there are no taxes, and fifth, there are no agency costs. We know these assumptions are not true. Most common shareholders do not have well diversified portfolios to hedge against risk. There are taxes, and managers are not always acting in the best interest of the shareholders causing agency costs.
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