Exotica?
If the Park Paradigm had a required (ok, recommended!) reading list - something that is on the “to-do” list (but don’t hold your breath) - the recent Economist Special Report on International Banking would be a recent addition. If you haven’t already, it’s definitely worth a read, especially for those of you that are from outside the financial services industry. Henry Tricks, the excellent Capital Markets Editor of the Economist, does a good job of framing and illuminating many of the key issues facing the industry today.
In a sidebar entitled Les fleurs du mal, the author highlights the emerging new risks and assets that are being traded and managed via markets, and comments on the increasing blurring of lines between banks and insurance companies in this context:
Now that technology and financial engineering have made it possible to isolate and trade all manner of risks, the insurance industry is marching ever more eagerly into the capital markets. Last year AXA, a French insurer, issued so-called mortality catastrophe bonds to protect itself in the event of large death tolls caused by, say, avian flu or terrorism. The bonds were put together by Swiss Re, a reinsurer, which had hired Jacques Aigrain, a former JPMorgan Chase investment banker, as its chief executive. It expects the market for insurance-backed bonds to leap from $25 billion now to at least $150 billion by 2015.
(I think this number will be much higher (than $150 billion) but is unlikely (only) to come in the form of a linear extension of today’s business, ie many new instruments and mechanisms for disaggregating, repackaging and distributing multi-faceted risks will emerge and contribute to this growth.)
The article goes on to speculate:
But the principle could be extended to all walks of life. Perhaps farmers will be able to buy weather products at their local bank as a hedge against a poor harvest.
Ahem…actually…farmers are already able to do that today (and do, as some of the early adopters and first customers) via Weatherbill. Indeed they have recently announced the addition of (quotes on) 170 new weather stations in the US improving even further the granularity of coverage on offer. (Here is my quick and dirty summary of Weatherbill.)
The article however finishes on a sceptic note, hightlighting the fact that the concept of
…”particle finance” in which every form of risk could be isolated and sold to the buyer with the biggest appetite for it…
had been first developed by Charles Sanford (Chairman of Bankers Trust from 1987-1996) and that it hadn’t worked out too well for Bankers. Entertaining and clever writing perhaps, but the greed and ethical vacuum that eventually brought down Bankers was not the inevitable result of smart, forward thinking on risk (but rather imo the result of insufficient and poor middle management overwhelmed by a gold rush mentality.) Indeed the number of Bankers Trust alumni that have driven innovation and risen to senior positions across the financial firmament is a more apt illustration of the importance of these ideas. I was also curious to learn that Mr. Sanford had first developed the concept of particle finance, I had not encountered this metaphor before first using it myself a few years ago (and I have to admit it made me smile to see a Park Paradigm post at the top of the “particle finance” Google search, just ahead of Mr. Sanford’s 1993 article ‘Financial Markets in 2020′, reprinted in the Federal Reserve Bank of Kansas City Economic Review!) but it is nice to see that this way of looking at the (inevitable) evolution of risk management has other significant champions. The vision he articulated in 1994 (when I was just a young whippersnapper of a bond trader, flinging around the front end of the French yield curve) is remarkably clear and insightful, and all the more so for having been written before the financial/technological boom of the late 1990s. I only wish I had first read it in 1993! And if any readers out there know Mr. Sanford, please let him know that I’d love to buy him a coffee and find out what he thinks now that we are halfway to 2020…and talk of risk quarks,
Of shoes—and ships—and sealing-wax—
Of cabbages—and kings—
And why the sea is boiling hot—
And whether pigs have wings.”
May 29th, 2007 at 9:41 pm
Non sequitur about hedging ag production with weather:
Having futzed around a lot with building models to hedge ag with weather derivatives the process is a real bear. This stuff is highly nonlinear. If dynamic hedging of corn price is hard, then dynamic hedging of corn yield is hard^3. In highly weather sensitive crops like grapes and citrus, micro climates really are a problem (basis risk). In addition, the interplay of temperature, timing, and precipitation confuses things.
For agriculture I suspect the risk quark may not be weather. Maybe the risk quark might be production volume (aka yield). If a large entity could aggregate the yield risk and then hedge the whole portfolio using weather derivatives, that might be more useful, and worth the time to build the models needed to dynamically hedge the book.
So this begs the following question: If the underlying risks are many and are diverse (such as with agricultural yield) does is the optimal model to have the lowest level of production aggregation also do the hedging? Or does it make more sense for an aggregator of risk to do the hedging and sell the services down stream?
Of course with so much US crop risk the issue is mute because federally subsidized crop insurance totally crowds out private risk management.
Related link with pay wall pierced:
WSJ.com - Small Firms Look To Derivatives Trading To Manage Costs
http://www.emailthis.clickability.com/et/emailThis?clickMap=viewThis&etMailToID=1901327412
-JD
May 31st, 2007 at 6:03 pm
Sean - I worked for Charlie as well back in the glory Bankers days - although as a young whippersnapper I flinged around the front end of the GBP curve - you are quite right about (a) his depth of vision re particle finance - and surely being able to buy car insurance from tesco is another form of this, and (b) why Bankers went down : great guy in charge, great people at the coalface (ahem, present company excepted) and a notable absence of effective management.
cheers
DL