Risk Management
Recruiting is an entirely ridiculous sport that has become terribly popular in Cambridge. For a number of depressing reasons recruiters for most big name companies seem to feel that their investments are best placed in top-tier campuses, and focus nearly all their effort into these schools while neglecting the rest. Ultimately they’re recruiting from here and not from elsewhere for whatever reasons they feel are sound enough, so I will refrain from criticizing them on that point.
What is absolutely amazing is the amount of money, time, and effort they put into wowing everyone here. Because the market is so densely populated with consultancies, investment banks, ancillaries, and (fortunately) companies producing actual products, they compete fiercely for mindshare. This leads to great freebies, free food nearly every day of the week (provided you are willing to press flesh and listen to how great the company is), and most interestingly lots of face time with people who are at the top of their game.
Thus I have recently become casually interested in the quantification of risk by the large investment banks. Investment banks tend to buy and sell risk rather than equities and securities. Rather I should say that risk underpins the purchase or equities, securities and most importantly the numerous derivatives that spring up. It is hard to decouple the idea of risk from other sorts of valuation because risk doesn’t sound like it can be quantified but in fact it is immediately quantified by the price you are willing to pay for something. Simply put you will increase margins on risker investments, so whatever means you use to evaluate risk, you will always end up with risk in terms of percentage mark-up and/or included in the asking price.
Admittedly this makes intuitive sense, you invest based on the potential upside and the likelihood of achieving the upside, but until recently the means to evaluate risk have been specific to the particular investment you were making. Further if you invest in nearly everything you need to control your risk due to various market events and price fluctuations. Being able to value risk then is necessarily independent of the actual assets you hold, but it is nearly infinitely dimensional, because the risk of your oil futures to changes in the gas market is entirely independent of the risk of your gas futures to changes in the oil market. And let’s not even get into the foreign exchange market.
So risk is a really really interesting topic, and when you invest in a large portfolio of assets you can only make money by managing risk correctly. So one might say that risk management is the secret sauce that differentiates a successful bank from another. So for me attempting to tease out of these guys how they evaluate and manage risk is fascinating and thus far I’ve been able to come up with quite a few interesting revelations:
First, large banks like Goldmans and Morgan Stanley that have come to power in the post-derivative age have done so mainly on risk valuation because their ability to hedge against the millions of different risks they carry is second to none.
Second, that second tier banks that are particularly successful are generally specialized into one area of asset classes because their ability to value these assets and hedge them is for whatever reason better than their competitors. For example Macquairie Bank has an uncanny ability to value infrastructure assets along with a private equity-like means of combining assets together.
Third, hedge funds actually do generally operate on one strategy alone. In fact it is amazing that they don’t obliterate themselves out of existence. Those that have more than one strategy generally create cooperative strategies so that the two play off each other so that a good day is even better rather than actually hedging individual strategies. All hedges seem to be traded back and forth by investment banks as simple assets on their own, so it’s likely that their customers demand they remain simple rather than that they lack sophistication.
Fourth, there are quite a few hedges which do not have significant holdings from investment banks. Those hedges actually do have very complicated strategies and in a lot of cases behave like an investment bank. The benefit of them over an investment bank is that the investors get a piece of all the action, not just a particular part which is sold as a product from an investment bank.
That’s what my reconnaissance has turned up thus far. I’m amazed at what these guys consider to be secret information and what they don’t. The information they have given me combined with the publicly available information would form a very good basis for looking at the positioning of the company, and with free wine and six employees in the room who are geeks at heart it’s not hard to get a detailed picture of how they price things.
Anyway I believe my research will have to come to an end because it is becoming increasingly clear that I do not want to work at these places. They tend to have high numbers for employee satisfaction but it is a complete joke when you listen to them describe their lives. Or any interests they have outside work. That they would consider this sort of work indicates that they are ridiculously well paid or mentally disturbed. Perhaps that’s why they recruit from Cambridge.
