International Finance What is Risk? Campbell R. Harvey January 19, 2017 1
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Three Greatest Systemic Risks General ideas 3
Brainstorm Local/Regional Macro Risks General ideas 4
Brainstorm Financial Risks General ideas (continued) 5
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International Finance What is Risk? Campbell R. Harvey January 13, 2017 7
A Partial List of Financial Risks Variability Downside variability Variability relative to a benchmark Higher moments Diversifiable vs. Systematic risk Factor exposure Risk vs. misvaluation Habitats and time diversification Uncertainty: Ellsberg s paradox Ex ante vs. ex post Conditional vs. unconditional Model risk (internal and external) Operational risk Delegation problem 8
Variability: standard deviation, mean absolute deviation, Value at Risk (VaR) 9
Downside: Semi variance, downside deviation 10
January 15, 2015 Daily CHF= BarOHLC, CHF=, Bid 1/19/2015, 0.8583, 0.8778, 0.8574, 0.8745, +0.0173, (+2.02%) 1/20/2005-7/29/2015 (GMT) Price /USD 1.28 1.24 1.2 1.16 1.12 1.08 1.04 1 0.96 0.92 0.8745 0.88 0.84 0.8 0.76 2006 2007 2008 Campbell 2009 R. 2010 Harvey: International 2011 2012 Finance, 2013 2017 2014 2015 2000 2010 0.72 Auto 11
January 15, 2015 1971 Jan. 14, 2015 mean 0.0001 1971 Jan. 14, 2015 std dev 0.007239 Sept. 6, 2011 max 0.095069 Jan. 15, 2015 min 0.15749 Sept. 23, 1985 2nd min 0.04313 Full sample Move= 21.7555 standard deviations 12
January 15, 2015 Prob of 21 std.devs Occurs once every Occurs once every 1.7922E 104 5.5797E+103 1.5287E+101 days years Excel: norm.dist(observed value, mean, stdev, cumulative=1) 13
January 15, 2015 Prob of 21 std.devs Occurs once every Occurs once every 5.3775E 101 1.8596E+100 5.0948E+97 days years Age of universe= 13.8 billion years Number of fundamental particles in the universe 1x10 80 14
Tracking error: Variability of deviation from benchmark 15
Higher moments: What if distribution is non Normal? Skew Kurtosis Value at Risk See Harvey and Siddique (2000) Journal of Finance 16
Higher moments: What if distribution is non Normal? Two distributions: Same mean, same variance Which one do you prefer? 17
Diversifiable vs. Systematic Should diversifiable or idiosyncratic risk be rewarded? Big question for both investments and corporate finance 18
Factors: Exposures, betas, loadings What are the factors? Financial vs. economic How do we measure loadings? 19
Factors: Exposures, betas, loadings See Harvey, Liu and Zhu (2016) Review of Financial Studies. 20
Misvaluation vs. risk premia Some factors might proxy for misvaluation Other factors genuine risk What is alpha? 21
Habitats and time diversification Risk premia determined by the marginal investor You might be different than the marginal investor 22
Uncertainty: Ellsberg Paradox Urn 1: 50 black balls, 50 white Urn 2: 100 white or black balls (unknown proportion) 23
Ex ante vs. ex post: Peso Problem 24
Ex ante vs. ex post: Beware: Abstracting from the financial crisis, we conclude that active management of both equity and fixed income has significantly contributed to the returns of the fund. 25
Ex ante vs. ex post: Beware: Abstracting from the financial crisis, we conclude that active management of both equity and fixed income has significantly contributed to the returns of the fund. <<Like saying: We made significant profit on the insurance policy we wrote 26
Ex ante vs. ex post: Beware: Abstracting from the financial crisis, we conclude that active management of both equity and fixed income has significantly contributed to the returns of the fund. Like saying: We made significant profit on the insurance policy we wrote not including the fire that burned down our client s house 27
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Conditional vs. unconditional Related to previous Unconditional is long term average Risk could vary through time depending on economic conditions When risk measurement is conditioned on current circumstances, it is conditional risk which is by definition ex ante 30
Model risk Internal/External 31
Model risk Internal/External 32
Model risk Madoff 33
Operational risk We will have a long list of risk with respect to project evaluation from: completion risk, input risk, output risks, political risk, etc. Operational risk also very important for investment firms 34
Delegation Classic problem in both investment and corporate finance You delegate certain decisions to a manager who is acting in his/her best interests not yours 35